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FINANCIAL MARKET

FINANCIAL MARKET

Introduction

  • A market is a medium that allows buyers and sellers of a specific good or service to interact and facilitate an exchange. This type of market may either be a physical marketplace where people come together to exchange goods and services in person (as in a bazaar or shopping centre), or a virtual market wherein buyers and sellers do not interact, as in an online market.
  • Financial market is a market for exchange of funds. In a financial market, people with surplus funds such as lenders or investors give funds to people in need, such as borrowers or other receivers for interest or share in profits.

Investment and Speculation

  • The decision to invest funds in a particular asset can be undertaken on mainly two basis: investment or speculation. Investment is a basis when the amount is invested with complete analysis in expectation of the safety of the amount invested and adequate return.
  • Conversely, speculation is a basis when the amount is invested in a risky financial transaction or asset in expectation of enormous profits from fluctuations in the market value of the financial asset. In speculation, there is a high risk of losing maximum or all initial outlay.
  • In investment, the time horizon for which money is invested is relatively longer, generally spanning at least one year while in speculation, the term may be short.
               Basis                                       Investment                                           Speculation
Meaning The purchase of an asset with the objective of earning normal returns The objective is to earn large profits in a short span of time
Basis for decision Fundamental       factors, i.e.

performance of the company, industry, and economy

Market psychology and intuition
Time period Long term Short term
Risk involved Moderate risk High risk

 

MONEY MARKET | FINANCIAL MARKET

A money market is a market where funds are exchanged for a period of less than 1 year. Various money market instruments are as follows:

  • Bill of exchange: It is a money market financial instrument. In a bill of exchange, the debtor is required to pay a fixed sum of money after a certain period of time to the creditor or bearer of bill of exchange as the case may be. The creditor writes the bills of exchange and the debtor signs it. On maturity of the bill, the bill is presented to the debtor for payment.
  • Promissory note: A promissory note is a money market financial instrument in which the maker of document (debtor) promises in writing to pay a certain sum of money at certain period of time to the first owner (creditor) or bearer of the document.
  • Short-term loans: These are loans for a duration of less than 1 year. Long-term loans are considered part of capital market.
  • Commercial paper: It is a promissory note issued by large corporations to obtain funds in order to meet their short-term obligation. It is usually unsecured. The corporation promises to make payment along with interest to the holder of the document.
  • Treasury bills: These are money market instruments issued by the government to collect funds to meet expenditure for a short period of time. The holders of treasury bills are given principal along with the interest.

CAPITAL MARKET | FINANCIAL MARKET

A capital market is a financial market where exchange of funds is for a period of 1 year or more. Various capital market instruments are as follows:

  • Long-term loans: These loans are taken for a period of more than 1 year.
  • Shares: A share is one of the equal parts into which a company’s capital is divided, entitling the holder to a proportion of the profits. Shareholders are owners of the company. Shares are of two types: equity and preference.
  • Equity shareholders are given share out of profits or repayment of capital on liquidation only after settling the claims of preference shareholders. Thus, they are the primary risk bearers in the company.
  • Preference shares are called so because their claim in profits and repayment of capital on liquidation is settled before payment is made to equity shareholders.

Venture Capital

  • Venture capital refers to finance provided by investors to start-up companies and small businesses that are believed to have long-term growth potential. For start-ups without access to capital markets, venture capital is an essential source of money. Risk is typically high for investors, but the potential for above-average returns is an attractive payoff.
  • Venture capital does not always take a monetary form; it can be provided in the form of technical or managerial expertise. For new companies or start-up ventures that have a limited operating history, venture capital funding is increasingly becoming a popular capital raising source, as funding through loans or other debt instruments is not readily available.

Angel Investors and Venture Capital Firms

  • Angel investors are typically a diverse group of individuals who gained their wealth through a variety of sources. However, the majority are usually entrepreneurs themselves, or are executives who retired early from previous ventures that developed into successful empires. These investors who act as venture capitalist are called angel investors.

Venture Capital Process

  • The first step for any business looking for venture capital is to submit a business plan, either to a venture capital firm or to an angel investor. The firm or the investor evaluates the proposal. If satisfied with the potential of the project, the firm or the investor will pledge an investment in exchange for equity in the company. The firm or investor then takes an active role in the funded company. The capital is typically provided in rounds. Therefore, the firm or investor actively ensures that the venture is meeting certain milestones before receiving another round of capital. The investor then exits the company after a period, typically 4-6 years after the initial investment, through a merger, acquisition, or initial public offering (IPO).
  • Debentures: These refer to the unit of debt or loan. Debentures are issued at a fixed rate of interest by the company. Debenture holders are the lenders of the company. The interest on debenture is required to be paid even if the company suffers losses.
  • Bonds: Bonds, like debentures, carry fixed rate of interest. Usually bonds are issued by the government to collect money to carry out its expenditure. For example, the Government of India launched infrastructure bonds to raise funds for infrastructure development in India.

Difference between Bonds and Debentures

  • Debentures and bonds are types of debt instruments that can be issued by a company. In some markets (India, for instance), the two terms are interchangeable, but in the United States, they refer to two separate kinds of debt-based securities.
  • Debentures have a more specific purpose than bonds. Both can be used to raise capital, but debentures are typically issued to raise short-term capital for upcoming expenses or to pay for expansions.
  • Another important difference is that debentures are never asset backed (they are not secured by any collateral) and are only backed by the credit of the issuer. On the other hand, bonds ail secured by particular collateral.
  • However, as mentioned above, debentures and bonds are used almost interchangeably it India.
  • Green Bonds
  • A bond is a debt instrument with which an entity raises money from investors. The bond issuer gets capital, while the investors receive fixed income in the form of interest. When the bond matures, the money is repaid.
  • A green bond is very similar. The only difference is that the issuer of a green bond publicly states that capital is being raised to fund “green” projects, which typically include those relating to renewable energy, emission reductions, and so on.

What Are the Benefits of Issuing Green Bonds?

  • Green bonds enhance the reputation of issuers, as they help in showcasing their commitment towards sustainable development. They also provide issuers access to a specific set of global investors who invest only in green ventures. These investors often provide money at a low rate of interest.

Why Should an Investor Invest in Green Bonds Despite Low Return?

  • Green bonds inherently carry lower risk than other bonds. In a green bond, proceeds are raised for specific green projects, but repayment is tied to the issuer and not the success of the projects. This means the risk of the project not performing stays with the issuer rather than investor.

When Did the Concept Start?

  • In 2007, green bonds were launched by a few development banks such as the European Investment Bank and the World Bank. Subsequently, in 2013, companies also started issuing green bonds. Yes Bank was the first bank to come out with an issue worth RS.1000 crore in 2015.

Why Are Green Bonds Important for India?

  • India has embarked on an ambitious target of building 175 GW of renewable energy capacity by 2022, from just over 30 GW in 2017. This requires a massive investment. At higher interest rates and unattractive terms under which debt is available in India, the cost of renewable energy will be 24-32% higher compared to that in the United States and Europe. Thus, green bonds are a good option to source global investment at low interest rates.

PRIMARY MARKET AND SECONDARY MARKET  | FINANCIAL MARKET

  • Financial markets are also classified as primary market and secondary market.
  • A primary market is a market where an initial public offer (IPO) is made or in other words, the financial instruments are issued for the first time to the public at large. Primary markets facilitate the channelization of savings into investment, leading to the capital formation in the economy.
  • A secondary market facilitates sale and purchase of already issued financial instruments. The market provides liquidity to investors, i.e. investors can convert the financial instrument held by them into cash in the shortest possible duration and with minimal cost.
  • Stock exchanges are part of the secondary market. These exchanges facilitate trading of financial instruments. These exchanges act as medium to bring sellers and buyers across India together. The popular stock exchanges in India are as follows:
  • The Bombay Stock Exchange (BSE) is the largest stock exchange in India in terms of volume of trade. The number of listed companies on BSE was 5163 (as of 2012). BSE has an indicative index, called the BSE Sensitive Index (popularly called Sensex). Sensex was constituted in 197879 with the value of 100. The value of the index is based on the market value of top 30 companies listed on BSE. As the performance of these companies is dependent on the performance of overall economy, BSE Sensex reflects the overall performance of the Indian economy.
  • The National Stock Exchange (NSE) is another important stock exchange in India. The number of listed companies on NSE was 1635 (as of July 2013). Like Sensex, Nifty is the popular index in NSE. It was constituted in 1992-93 with the value of 100. Nifty (National Index of Fifty) is based on the market value of the top 50 companies listed on the NSE.
  • Apart from stock exchanges, there are exchanges for currency trading and commodities as well. The Multi Commodity Stock Exchange (MCX) is the largest commodity exchange in India.

Regulation of Exchanges

  • The Securities and Exchange Board of India (SEBI) is the regulator of the securities market (stock exchange) in India. It was established in 1988 and given statutory powers on 30 January 1992 through the SEBI Act, 1992.
  • SEBI is managed by its members, which consists of the following:
    • The chairman who is nominated by the Government of India
    • Two members, i.e. officers from the union Finance Ministry
    • One member from the Reserve Bank of India
    • The remaining five members are nominated by the Government of India, and out of them at least three should be whole-time members.
  • SEBI has the objective to protect the interests of investors in securities and to promote development regulate the securities market. It has to be responsive to the needs of three groups and protect their interests, which constitute the market:
    • Issuers of securities
    • Investors
    • Market intermediaries
  • Earlier, SEBI used to regulate stock exchanges, and the Forwards Market Commission used to regulate commodities markets. However, the Forwards Market Commission was abolished in 2015. The powers to regulate commodities markets were also vested in SEBI.
  • List of Approved Stock Exchanges in India
    • Ahmedabad Stock Exchange
    • Bombay Stock Exchange
    • Calcutta Stock Exchange
    • India International Exchange (India INX)
    • Metropolitan Stock Exchange of India
    • National Stock Exchange of India
    • NSE IFSC Ltd.
  • Earlier, there were numerous regional stock exchanges in India. However, these stock exchanges have been closed due to their passive working.

India International Exchange (INX)

  • The India International Exchange (INX) is located in the country’s first International Financial Services Centre (IFSC), which is located in GIFT City, Gujarat. It was opened in 2017. The India INX is a wholly owned subsidiary of BSE Ltd.

Important Facts About India INX

  • World’s fastest international exchange: India INX will be the fastest international exchange in the world in terms of order response time, with a median trade speed of four microseconds. This is better than BSE’s domestic exchange in Mumbai, which has an order response time of six microseconds. In comparison, the second fastest international exchange in Singapore has an order response time of 60 microseconds.
  • In step with the rest of the world: India INX will be open for trading for 22 hours every day. The exchange will open for trading activity daily at 4 am when exchanges in Japan open, and close at 2 am when exchanges in the United States close.
  • What will be traded in it? The exchange can trade securities and products other than Indian rupees. The securities and products that could be traded on the India INX are equity shares of companies incorporated outside India, depository receipts, debt securities, currency and interest rate derivatives, index-based derivatives, commodity derivatives, and such other securities that may be allowed.
  • Only derivative products presently: It will offer only derivative products—in equity, currency, and commodities.
  • More instruments to follow: During the second phase, it shall offer depository receipts and bonds.

DERIVATIVES | FINANCIAL MARKET

  • Derivatives refer to those financial instruments whose value is derived on the basis of underlying asset or security. Derivatives are of three types: forwards, futures, and options.
  • Forwards refer to an agreement between two parties to exchange a particular commodity or financial Instrument at a particular price on a certain future date. For instance, two parties decide to exchange 100 Kg mangoes at ₹40/kg on some fixed future date.
  • Futures refer to the standardized forwards agreements that are undertaken through stock exchanges. The standardized agreements are in nature of pre-decided lot sizes. For instance, the lot size for a share of a particular company can be 400 shares. Parties can trade in one lot or more but not less than that.
  • Options are further of two types:
    • Call option is an option to purchase a particular commodity or share at a pre-decided price on a future date, on payment of a premium to enter into an agreement. The purchaser of a call option has the option to purchase. The purchaser will exercise the option only if he/she can purchase the asset at a lower price than the prevalent market price on the pre-decided future date.
    • Put option is an option to sell the commodity or share at a pre-determined price on a future date, on payment of a premium. The purchaser of put option has the option to sell. The purchaser will exercise the option only if he/she can sell the asset at a higher price than the prevalent market price on the pre-decided future date.
  • Futures and options are traded in stock exchanges under the Futures & Options (F&O) segment. As mentioned earlier, forwards are not traded in stock exchanges.

Spot and Forwards Markets

  • The forwards rate is the settlement price of a forwards contract, while the spot rate is the settlement price of a spot contract.
  • A spot contract is a contract that involves the purchase or sale of a commodity, security, or currency for immediate delivery and payment on the spot date, which is normally two business days after the trade date. The spot rate or spot price is the price quoted for the immediate settlement of the spot contract.
  • Unlike a spot contract, a forwards contract is a contract in which terms and conditions are decided on the current date and the delivery and payment is done at a specified future date. Contrary to a spot rate, a forwards rate is used to quote a financial transaction that takes place on a future date. However, the forwards rate is calculated using the spot rate.

Maior Stock exchanges as on 31 January 2015 on the basis of market capitalization

Rank

 

 

Exchange Economy

 

Headquarters Market cap
(USD bn)

 

1 New York Stock Exchange United States New York 19,223
2 NASDAQ United States New York 6,831
3 London Stock Exchange Group United Kingdom, Italy London 6,187
4 Japan Exchange Group: Tokyo Japan Tokyo 4,485
5 Shanghai Stock Exchange China Shanghai 3,986
6 Hong Kong Stock Exchange Hong Kong Hong Kong 3,325
7 Euronext European Union Amsterdam, Brussels, Lisbon, London, Paris 3,321
8 Shenzhen Stock Exchange China Shenzhen 2,285
9 TMX Group Canada Toronto 1,939
10 Deutsche Borse Germany Frankfurt 1,762
11 Bombay Stock Exchange India Mumbai 1,682
12 National Stock Exchange of India India Mumbai 1,642

Source: World Federation of Exchanges

MUTUAL FUND | FINANCIAL MARKET

  • A mutual fund is a pool of funds collected from many investors for the purpose of investing in securities such as shares, bonds, money market instruments, and similar assets.
  • Mutual fund units are issued to the participants of the mutual fund. These units can typically be purchased or redeemed as needed at the fund’s current net asset value (NAV) per unit. A fund’s NAV per unit is derived by dividing the total value of its investments by the total number of units outstanding.
  • Load or No-Load Funds
  • When investors purchase units in a mutual fund, they are usually charged a fee known as the load of a mutual fund. A fund’s load is the summation of its advisory fee or management fee, its administrative costs and profits.
  • Additionally, this load can be charged during the initial purchase or sale of mutual fund units. When the load is charged at the time of initial purchase, the mutual fund has a front-end load. When the load is charged at the time of sale of units, the mutual fund has a back-end load.
  • Sometimes a mutual fund company offers a no-load mutual fund, which is a fund sold without commission or sales charge. These funds are usually distributed directly by an investment company rather than through a secondary party.

Advantages of investing in a mutual fund

  • Professional management: One of the main advantages of mutual funds is that they give access of professionally managed and monitored investments to small investors.
  • Fund ownership: Mutual funds permit investors to invest small amounts of money and earn benefits associated with a large amount of investment. All investors in a mutual fund share the gains and losses arising from collective investments proportionately to the amount they have invested.
  • Mutual funds are diversified: By investing in mutual funds, even a small investor can diversify investments across a large number of securities to minimize risk. By spreading investment over numerous securities, which is what a mutual fund does, one need not worry about the fluctuation of individual securities in the fund’s portfolio.

Mutual fund objectives

  • There are many different types of mutual funds, each with its own set of goals. Depending on investment objectives, funds can be broadly classified in the following types:
  • Aggressive growth funds (equity funds) mean that the mutual fund will be investing into shares that have a chance of high growth and may gain value rapidly.
  • A combination of growth and income funds, also known as balanced funds, has a mix of goals. They seek to provide investors with current income while still offering the potential for growth. Some funds buy shares and bonds because shares provide the growth potential, while the fixed-income securities provide stability to the income especially during volatile times in the share markets.
  • Income funds (debt funds) generally invest in a number of fixed-income securities. These funds provide with regular income. Retired investors prefer this type of funds because they would receive regular returns. The fund managers choose to invest in debentures, fixed deposits, etc. in order to provide steady income.
  • The most cautious investor opts for the money market mutual fund. They are highly liquid so that the investors can alter their investment strategy anytime.

Closed-End Funds

  • A closed-end fund has a fixed number of shares outstanding and operates for a fixed duration (generally ranging from 3 to 15 years). The fund would be open for subscription only during a specified period, and there is an even balance of buyers and sellers, thus someone should be selling in order for the other to be able to buy. Closed-end funds are also listed on the stock exchange, so they are traded just like other shares on an exchange. Usually the redemption is also specified, which means that they terminate on specified dates when the investors can redeem their units.

Open-End Funds

  • An open-end fund is one that is available for subscription and is not listed on the stock exchanges. The majority of mutual funds are open-end funds. Investors have the flexibility to buy or sell any part of their investment at any time at a price linked to the fund’s NAV.

PENSION FUND

  • A pension fund works like a mutual fund. The funds are accumulated from regular contributions by employers, employees, or both. These funds are invested, and thereafter based on the contributions and additions on account of the growth in investments, pension is paid to the employees post-retirement.

 TERMS RELATED TO STOCK EXCHANGE | FINANCIAL MARKET

  • Bear market: The time period when stock market follows a downward trend or a period of falling stock prices. This is the opposite of bull market.
  • Bull market: When the stock market as a whole is in a prolonged period of increasing stock prices or stock market follows a upward trend, it is a bull market. It is the opposite of bear market.
  • Blue chip stocks: These are the large, industry-leading companies. They offer a stable record of significant dividend payments and have a reputation of sound fiscal management. The expression is thought to have been derived from blue gambling chips, which is the highest denomination of chips used in casinos.
  • Initial public offering (IPO): The first sale or offering of a stock by a company to the public at large is called initial public offering, rather than just being owned by private or inside investors.

COMPANY

  • A company is a legal entity made up of an association of people, be they natural, legal, or a mixture of both, for carrying on commercial activities. Company members share a common purpose and unite in order to pool their talents and resources.
  • Company uses the word “Limited” or “Ltd.” at the end of their name. The word means that the shareholders of the company have limited liability, i.e. the liability of shareholders is to the extent of value of shares subscribed by them. Thus, in case of losses, shareholders will not be required to contribute from their private assets.

Types of Companies

  • Mainly, there are two types of companies: private limited and public limited.
  • Private Limited Companies
    • Private limited companies are those companies whose capital is held by people who are closely known to each other. The maximum number of members in a private limited company is 100.
    • As the capital in these companies is contributed by the people who are closely known to each other, these companies are not required to be listed on stock exchanges. Listing of a company on a stock exchange is required to facilitate trading of its securities. Such companies use the word “Private Limited” or “Pvt. Ltd.” at the end of their name.
  • Public Limited Companies
    • Public limited companies are those companies whose capital is held by the public at large. There is no restriction on the number of members. These companies use the word “Limited” or “Ltd.” in the end of their name.
    • As public limited companies raise capital from the public at large, they are required to follow excessive regulations as compared to those followed by private limited companies and are mandatorily required to be listed on a stock exchange.

Limited Liability Partnership

  • A limited liability partnership (LLP) is a partnership in which some or all partners have limited liabilities. It, therefore, exhibits elements of partnership (i.e. persons coming together to carry on business and liable for action of one another) and company (i.e. limited liability of partners).

FINANCIAL SECTOR REGULATORS | FINANCIAL MARKET

  • The two most important financial sector regulators have already been discussed, namely, the Reserve Bank of India (regulator of banking sector and non-banking financial companies) and the Securities and Exchange Board of India (regulator of stock exchanges). The other regulators are as follow:
  • Competition Commission of India
    • The Competition Commission of India (CCI) was established in 2003 as an autonomous body to implement provisions of the Competition Act, 2002. This act seeks to promote fair competition, control monopolies, and prevent adoption of unfair and restrictive practices that hamper the interest of consumers.
    • For instance, the CCI has been given powers to prevent cartelization among producers. Similarly, if a merger of two or more companies leads to control of more than 25% output of the industry in the hand of a single entity, then CCI can prevent such a merger.
  • Insurance Regulatory Development Agency
    • The Insurance Regulatory Development Agency (IRDA) was created in 1999 after the entry of private sector companies in the insurance sector. It is an autonomous statutory body tasked with the regulation and promotion of insurance and re-insurance in India.
  • Pension Fund Regulatory Development Authority
    • The Pension Fund Regulatory Development Authority (PFRDA) was established in 2003 as an autonomous body to regulate and develop pension funds in India. A pension fund is a fund that provides retirement income on the basis of investment made in it during the tenure of service (or after retirement). Pension funds typically have large amounts of money to invest and are the major investors in the companies.
  • Financial Stability and Development Council
    • The central government established the Financial Stability and Development Council (FSDC) in December 2010 with the Finance Minister as its chairman. The FSDC is a super-regulatory body for regulating the financial sector, which is vital for bringing healthy and efficient financial system in the economy. The FSDC envisages for
      • Maintaining financial stability
      • Financial sector development
      • Inter-regulatory coordination
      • There are regular meetings of the FSDC. The meetings are chaired by the union Finance Minister and are attended by heads of all the financial sector regulators as its members.
    • Composition of FSDC
    • Chairman: Union Finance Minister
    • Members: Heads of the financial sector regulatory authorities (i.e. RBI, SEBI, IRDA, PFRDA), Finance Secretary and/or Secretary, Department of Economic Affairs (Finance Ministry), Secretary, Department of Financial Services and Chief Economic Adviser

CREDIT RATING AGENCIES | FINANCIAL MARKET

  • Big Three Rating Agencies: Moody’s Investors Service, Standard & Poor’s (S&P), and Fitch
  • “Big Three” credit rating agencies control approximately 95% of the ratings business. Moody’s Investors Service and Standard & Poor’s (S&P) together control 80% of the global market, and Fitch Ratings controls a further 15%. The largest credit rating agency in India is CRISIL (Credit Rating Information Services of India Limited).
  • Ratings are based on the lending risks or estimation of the borrower’s ability to repay debt.

 

India’s Position in Leading Credit Ratings

  • India’s (Government of India) credit rating has remained unchanged for the past several years at “BBB (—)” or at the lowest level on investment grade, which is only a grade above the “junk” status for government/ sovereign bonds.

Rating Scheme of the Big Three

Moody’s Long Tern Short term S&P long term Fitch Short term Long term Short term Rating description
Aaa P-1 AAA A-1+ AAA F1+ Prime
Aa1 AA+ AA+ High grade
Aa2 AA AA
Aa3 AA- AA-
A1 A+ A-1 A+ F1 Upper medium grade
A2 A A
A3 P-2 A- A-2 A- F2
Baa1 BBB+ BBB+ Lower medium grade
Baa2 P-3 BBB BBB F3
Baa3 BBB- A-3 BBB-
Ba1 Not
Prime
BB+ B BB+ B Non-investment grade
speculative
Ba2 BB BB
Ba3 BB- BB-
B1 B+ B+ Highly speculative
B2 B B
B3 B- B-
Caa1 CCC+

_

C CCC+ C Substantial risks
Caa2 CCC CCC
Caa3 CCC- CCC-
Ca CC CC Extremely speculative
C C Default imminent
C RD D DDD D In default
/ SD DD
/ D D

 

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Indian Economy

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