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FINANCIAL SYSTEM

A financial system is the set of implemented procedures that tracks the financial activities of

the company or firm, enables the lenders and borrowers to exchange funds through the

Financial institutions and contributes to the well being of the people of any country.

The Financial System of any country consists of financial markets, financial intermediaries

and financial instruments or financial products.

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Overview of Financial Market in India

A Financial Market is the structure through which the funds flow. A real transaction involves exchange of money for real goods or services whereas a

financial transaction involves creation or transfer of a financial asset.

Financial Assets or Financial Instruments represents a claim to the payment of a sumof money sometime in the future and /or periodic payment in the form of interest or

dividend.

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Money MarketA market where Short term funds are borrowed and lent is called money market. Money

Market is a market for Short term financial assets, which are near substitutes for money.

The instruments dealt within the money market are liquid and can be turned over quickly at

low transaction cost and without loss.

Characteristics

Short term fund No fixed place Brokers Close substitute for money Period of one year Sub markets

Importance

Ideal investment

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Effective Monetary Management Economic development Efficient banking System Facilitating Trade

Segments or Sub Markets

Call money Market Collateral Loan Market Bill Market Acceptance market Discount Market

Financial Institutions

Commercial banks NBFCs Acceptance Houses Central bank

Characteristics or Requirements for a Developed Money Market

Developed Banking and Financial System Powerful Central bank

Integrated interest Structure

Specialized Sub Markets Efficient Co ordination High sensitivity Large Number of Instruments and Dealers Cheap Remittance Facilities Adequacy of Funds

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Highly organized Banking System A large volume of international trade Rapid and Massive industrial development Political Stability Freedom of Investment

The important money market instruments are

1. Call/Notice Money

2. Treasury Bills

3. Banker's Acceptance

4. Repurchase Agreement

5. Certificate of Deposit

6. Commercial Papers

Capital MarketThe capital market is designed to finance the long-term investments. The transactions

taking place in this market will be for periods over a year.

HARSHAD SCAM

Characteristics

Securities Market Security prices Participants Location

Functions

Allocation Liquidity

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Indicative Function Savings and Investment Transfer Merger

Financial Instruments of the Capital market

1. Commercial Paper2. Certificate of deposit3. Secured Premium Notes4. Non Convertible Debenture (NCD)5. Zero coupon Bonds

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6. Zero Interest Fully convertible Debentures7. Deep Discounts8. Stock invest9. Equity shares with detachable warrants10.Equi pref Shares11.Preference shares with warrants attached12.Euro issues13.Non Voting right shares14.Other innovative instruments

Role of Capital Market In India

1. Capital Formation2. Economic Growth3. Development of Backward areas4. Generates employment5. Long term Capital to Industrial Sector6. Generation of Foreign Capital7. Developing the role of Financial institutions8. Investment opportunities

Assignment Questions

1. Mention and explain the overview of financial market with structured diagram.2. What role does capital market play in the development of Indian economy?3. Mention and explain the financial instruments of financial markets.4. Explain the role of RBI in the developing the money market and role of SEBI in the

developing the Capital market.

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The following measures were taken by SEBI

Dematerialization of shares:SEBI introduced dematerialized holding of shares andsecurities after the Depositories Act was passed in 1996. This Act did away with

physical certificates, which were prone to postal delays, theft and forgery.

Faster settlement process:It is credited with quickly moving from a T+5 settlementcycle in 2001 to T+2 in 2003. This meant two days between the trade and shares

being credited to the buyers' account, down from five.

Fostering mutual fund industry:SEBI has adopted many steps to increase thepopularity of mutual fund products and prevent mis-selling of products. Some of the

initiatives include know your customer (KYC) norms for small investors. And by

banning entry loads for mutual fund schemes in 2009, SEBI curbed mis-selling of

mutual fund products as investors would now only voluntarily pay the distributor for

advisory service.

Advantages of Financial Markets

Financial markets play a critical role in the accumulation of capital and theproduction of goods and services.

The price of credit and returns on investment provide signals to the producers andconsumers through financial market participants.

In a similar way, the existence of robust financial markets and institutions alsofacilitates the international flow of funds between countries.

In addition to this the efficient financial markets and institutions tend to lower thetransactions costs in the economy by providing a large array of financial products,

with varying risk and pricing structures as well as maturity.

A well-developed financial system offers products to participants that provideborrowers and lenders with a close match for their needs.

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Individuals, businesses, and governments in need of funds can easily discover whichfinancial institutions or which financial markets may provide funding and what the

cost will be for the borrower. This allows investors to compare the cost of financing

to their expected return on investment, thus making the investment choice that best

suits their needs.

In this way, financial markets direct the allocation of credit throughout the economyand facilitate the production of goods and services.

Capitalization The Companies require money and resources in order to expand their products and

services and to reach more consumers.

When a corporation decides to go public and become listed on a stock exchange, itoffers shares of stock to any individual or institution who wishes to invest in the

company. The initial public offering (IPO) immediately raises a large amount of

capital quickly.

A company can have millions or billions of dollars at is disposal nearly overnight afterselling its shares to the public.

This money is then used to develop new products and services which will hopefullyinfluence the society positively. The manufacture of goods is often an expensive

process that requires the kind of capital that only public investing can provide.

Investment Returns While a company can benefit handsomely from an Initial Public Offering ,the

individual investors gets access to the possibly remunerative returns on their

investment if the company performs well. This relationship is mutually beneficial to

both parties.

There is no guarantee of corporate success but the potential rewards match theserisks.

There is technically no limit to the profit that corporate investment can generate. Share prices can rise by extraordinary amounts and provide investors with excellent

return

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Monetary Policies

On the basis of an assessment of the current macroeconomic situation, it has beendecided to: keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0

per cent of their net demand and time liabilities

keep the policy repo unchanged at 7.25 per cent. Consequently, the reverse repo rate will remain unchanged at 6.25 per cent, the marginal standing facility (MSF) rate and the Bank Rate at 8.25 per cent.

The above monetary policy stance has been informed by the evolving growth-inflation

dynamic, the balance of risks as well as recent developments in the external sector.

In the fuel category, coal and mineral oil prices declined, partly offsetting the upwardrevision in administered prices of electricity.

Non-food manufactured products inflation too ebbed, driven by metal prices whichfell for the eighth successive month in response to softening of global prices.

Still elevated food inflation, particularly in respect of cereals and vegetables,sustained upside pressures on overall inflation.

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Retail inflation, as measured by the new combined (rural and urban) CPI, edgeddown from an average of 10.2 per cent last fiscal year to 9.3 per cent in May

External Sector

The most significant development in the external sector has been the movement inthe exchange rate. The rupee depreciated by 5.8 per cent against the US dollar

during the current financial year up to June 14.

It fell by 6.6 per cent during May 22-June 11 due to sell-off by foreign institutionalinvestors, reflecting risk-off sentiment triggered by apprehensions of possible

tapering off of quantitative easing by the US Fed.

While the trade deficit has widened sharply due to a surge in festival-related/seasonal gold imports, available evidence suggests that a moderation in gold

imports could be underway in June.

On the inflation front, easing commodity prices at the global level and weaker pricingpower of corporate at the domestic level are having a softening influence.

Given that food inflation remains high, the inflation outlook will be influenced byconcerted efforts to break food inflation persistence.

The inflation outlook going forward will be determined by suppressed inflation beingreleased through revisions in administered prices, including the minimum support

prices as well as the recent depreciation of the rupee.

Softer global commodity prices and recent measures to dampen gold imports areexpected to moderate the CAD in 2013-14 from its level last year.

The main challenge is to reduce the CAD to a sustainable level; the near-termchallenge is to finance it through stable flows.

The most recent number on the Centres fiscal deficit, at 4.9 per cent of GDP for2012-13, has turned out better than expected and instills confidence in the

Governments commitment to contain the fiscal deficit for 2013-14 at 4.8 per cent.

While several measures have been taken to contain the current account deficit, weneed to be vigilant about the global uncertainty, the rapid shift in risk perceptions

and its impact on capital flows.

The Reserve Bank stands ready to use all available instruments and measures torespond rapidly and appropriately to any adverse developments.

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Role played by Central Bank

The Reserve Bank of India (RBI) is India's central bank. It formulates India's monetarypolicy with regard to the Indian rupee.

RBI was established on 1 April 1935 during the British Raj in accordance with theprovisions of the Reserve Bank of India Act, 1934. The share capital was divided into

shares of 100 each fully paid, which was entirely owned by private shareholders in

the beginning.

Following India's independence in 1947, the RBI was nationalized in the year 1949.

Broad functions and structure

RBI assumes an important role in the development strategy of the Government ofIndia, and as a leading member of the Alliance for Financial Inclusion, a global

network of financial policymakers from developing and emerging countries working

together to increase access to appropriate financial services for the poor.

RBI is also a member of the Asian Clearing Union. The general superintendence and direction of the RBI is entrusted with the 21-

member-strong Central Board of Directorsthe Governor (currently Duvvuri

Subbarao, to be succeeded on 5 September 2013 by Dr. Raghuram Rajan), four

Deputy Governors, two Finance Ministry representatives, ten government-

nominated directors to represent important elements from India's economy, and

four directors to represent local boards headquartered at Mumbai, Kolkata, Chennai

and New Delhi.

Each of these local boards consists of five members who represent regionalinterests, as well as the interests of co-operative and indigenous banks.

The Central Board of Directors is the main committee of the central bank. The Government of India appoints the directors for a four-year term. The Board consists of a governor, four deputy governors, fifteen directors to

represent the regional boards, one from the Ministry of Finance and ten other

directors from various fields.

Main functions

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Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right toissue bank notes of all denominations. The distribution of one rupee notes and coins

and small coins all over the country is undertaken by the Reserve Bank as agent of

the government.

The Reserve Bank has a separate Issue Department which is entrusted with the issueof currency notes.

The assets and liabilities of the Issue Department are kept separate from those ofthe Banking Department.

Monetary authority

The Reserve Bank of India is the main monetary authority of the country and besidethat, in its capacity as the central bank, acts as the bank of the national and state

governments.

It formulates, implements and monitors the monetary policy as well as it has toensure an adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system The institution is also the regulator and supervisor of the financial system and

prescribes broad parameters of banking operations within which the country'sbanking and financial system functions.

Its objectives are to maintain public confidence in the system, protect depositors'interest and provide cost-effective banking services to the public.

The Banking Ombudsman Scheme has been formulated by the Reserve Bank of India(RBI) for effective redress of complaints by bank customers.

The RBI controls the monetary supply, monitors economic indicators like the grossdomestic product and has to decide the design of the rupee banknotes as well ascoins.

Management of foreign exchange

The RBI is in charge of facilitating the achievement of the goals of the ForeignExchange Management Act, 1999.

Objective: to facilitate external trade and payment and promote orderlydevelopment and maintenance of foreign exchange market in India.

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Issuer of currency

The bank issues and exchanges or destroys currency notes and coins that are not fitfor circulation. The objectives are to give the public an adequate supply of currency

of good quality and to provide loans to commercial banks to maintain or improve the

GDP.

The basic objectives of RBI are to issue bank notes, to maintain the currency andcredit system of the country, and to maintain the reserves.

RBI maintains the economic structure of the country so that it can achieve theobjectives of price stability as well as economic development, because both

objectives are diverse in themselves

Banker of banks

Nagpur branch holds most of India's gold deposits RBI also works as a central bank where commercial banks are account holders and

can deposit money. RBI maintains banking accounts of all scheduled banks.

It is the duty of the RBI to control the credit through the CRR, bank rate and openmarket operations.

As the bankers' bank, the RBI facilitates the clearing of cheques between thecommercial banks and helps inter-bank transfer of funds.

It can grant financial accommodation to schedule banks. It acts as the lender of last resort by providing emergency advances to the banks. It supervises the functioning of the commercial banks and take action against it if

need arises.

Detection of fake currency

In order to curb the fake currency menace, RBI has launched a website to raiseawareness among masses about fake notes in the

market.www.paisaboltahai.rbi.org.in provides information about identifying fake

currency.

Developmental role

The central bank has to perform a wide range of promotional functions to supportnational objectives and industries.

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The RBI faces a lot of inter-sectorial and local inflation-related problems. Some ofthis problems are results of the dominant part of the public sector.

Related functions

The RBI is also a banker to the government and performs merchant banking functionfor the central and the state governments. It also acts as their banker. The National

Housing Bank (NHB) was established in 1988 to promote private real estate

acquisition.

The institution maintains banking accounts of all scheduled banks, too.Changes in the Money Supply

An increase in a countrys money supply causes its currency to depreciate. A decrease in a

countrys money supply causes its currency to appreciate.

When there is an excess supply of money, there is, correspondingly, an excess demand for

interest-bearing assets.

People holding excessive money balances are willing to acquire interest bearingassets (by buying them with money) at a lower interest rate.

Potential money holders are more willing to hold additional quantities of money asthe opportunity cost of holding money (interest rate) falls.

When there is an excess demand for money, there is, correspondingly, an excess supply of

interest-bearing assets.

People who desire money are willing to sell off the assets that offer higher nominalinterest rates in return for the money balances that they desire.

Those with money balances are more willing to give them up in return for interestbearing assets as the interest rate on these assets rises and as the opportunity cost

of holding money (the nominal interest rate) rises.

Money Supply has a powerful effect on economic activity.

An increase in money supply stimulates increased spending because it puts moremoney in the hands of consumers which makes them feel wealthier, stimulating

them to increase their spending.

A decrease in money supply or a decrease in the growth of money supply, results indecreased spending because there is less money in the hands of consumers which

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stimulates them to decrease their spending. This causes a decline in economic

activity and can cause disinflation (reduced inflation) or deflation (falling prices)

Money Supply is directly linked to inflation, as shown by the Monetary Exchange Equation:

velocity * money supply = real GDP * GDP deflatorwhere:

velocity = the number of times per year that money changes hands

real GDP = GDP - GDP deflator

GDP deflator = measures the price of inflation or deflation with respect to a specific base

year.

Types of Bonds

Government Bonds Corporate Bonds

Types of Corporate bonds

Straight Bonds Zero coupon Bonds Floating Rate Bonds Bonds with embedded options1. Convertible bonds2. Callable Bonds3. Puttable Bonds Commodity Linked Bonds

Risks in Bonds

Default Risk Interest Rate Risk1. Price Risk2. Reinvestment Risk

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Characteristics of Duration

1. Other factors remaining the same, the higher the market interest rate, lower theduration.

2. Other factors remaining the same, the longer the maturity period of bond, higherthe duration.

3. Other factors remaining the larger the coupon rate, the shorter the duration.4. When a bond has coupons, the duration of the bond will always be less than its

maturity period since duration gives weight to the periodical payments in increasing

order of the period.

5. Duration of a zero coupon bond is equal to the bonds term to maturity.6. If the duration of a bond is significantly different from the desired holding period of

an investor, the investor will consider the bond risky.

Relationship between Change in Yield to Maturity and Change in Bond price1. There is an inverse relationship between bond prices and yields.2. An increase in yield causes a proportionately smaller price change than a decrease in

yield of the same magnitude.

3. Prices of long term bonds are more sensitive to interest rate changes than prices ofshort term bonds.

4. As maturity increases, interest rate risk increases but at a decreasing rate.5. Prices of low coupon bonds are more sensitive to interest rate changes than prices

of high coupon bonds.

Bond Prices are more sensitive to yield changes when the bond is initially selling at a loweryield

Ratings of Bonds

Meaning of Debt Ratings

Functions of Debt Ratings

Provide superior information Offer low cost information

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Serve as basis for a proper risk return trade off Impose healthy discipline on Corporate borrowers Lend greater credence to financial and other representations Facilitate the formulation of public policy guidelines on institutional investors.

Rate Methodology

Key Financial Ratios

Coverage Ratio- interest earned ration and fixed coverage ratio Leverage Ratio- debt equity ratio Liquidity ratio-current ratio and quick ratio Profitability Ratio- return on Capital employed and return on equity.

Rating Symbols

Highest Safety-AAA High Safety-AA Adequate Safety -A Modern Safety-BBB Inadequate Safety- BB Risk proneB Substantial Risk-C DefaultD

Determinants of Interest rates

Short term Risk free Interest rate Expected Real Rate of Return Expected Inflation Maturity Premium Default Premium

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Special Features

Mutual Funds

Meaning of Mutual Funds

Entities in Mutual Fund operation in India

Sponsor Mutual Fund Trustees Asset management Company Custodian Registrar and transfer Agents

Open End Schemes and Close End Schemes

Mutual Fund invest in three broad classes of financial assets.

Stocks: Equity and Equity related instruments Bonds: Debt instruments that have a maturity of more than on year(treasury bonds,

quasi government bonds ,corporate debentures and asset based securities.

Cash: Debt instruments that have a maturity of less than on year. (Treasury bills,commercial paper, certificates of deposit, reverse repos and call money) and bank

deposits

Depending on asset mix mutual fund schemes are classified into three broad categories:

Equity schemes1. Diversified Equity schemes2. Mid Cap, Small Cap and Micro Cap Equity Schemes3. Thematic Equity Schemes4. Index Schemes5. Tax Planning Schemes Hybrid Schemes

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1. Equity oriented Schemes2. Debt Oriented Schemes3. Variable Asset Allocation Debt Schemes

1.Gilt Schemes

2. Mixed Debt Schemes

3. Floating Rate Debt Schemes

4. Liquid Schemes

5. Fixed Maturity Plans

6. Capital Protection Funds

Mutual Fund Evaluation

Asset Mix Net Asset Value

NAV= Market Value of the funds investments+ Receivables + Accrued Income

Liabilities- Accrued Expenses /N umber of Outstanding shares or units outstanding

Rating of Mutual fund Schemes

CRISIL Value Research India Economic Times Style boxes

Costs of Investing in a Mutual Fund

Initial Issue expense Entry load Exit load

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Annual Recurring expenses

Styles of Investment and Evaluation of Mutual Fund performance

Styles

a. Value Investingb. Growth Investingc. Blendd. Aggressivee. Momentum

Foreign Exchange market

Meaning

Characteristics

a. Electronic marketb. Geographical dispersalc. Transfer of purchasing powerd. Intermediarye. Volumef. Provision of creditg.

Minimizing of risks

Participants

Foreign exchange dealers Individuals and Firms Speculators and Arbitragers Central Banks and Treasuries

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Foreign Exchange Brokers

Transactions

1. Spot transaction2. Forward Transaction

Rates and Quotations

a. Interbank Quotationb. Direct Quotationc. Indirect Quotationd. Bid Quotatione. Ask (offer) Quotationf. Cross Rates