Indira Gandhi National Open University

School of Management Studies FINANCIAL TECHNOLOGIES KNOWLEDGE MANAGEMENT (0.

MFP-1 EQUITY MARKETS

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Introduction to Currency Markets

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"Education is a liberating force, and in our

age it is also a democratising force, cutting
across the barriers of caste and class,
smoothing out inequalities imposed by birth
and other circumstances. "
- I ndira Gandhi
 Indira Gandhi
National Open University
MFP·l
~ School of Management Studies Equity Markets

Block

1
INTRODUCTION TO FINANCIAL MARKETS
Unit I
Evolution and Significance Qf Financbtl Mark~ts

Unit 2
Concepts and Cases 29
Unit 3
Types of Markets 53
Unit 4
Market Institutions and Intermediaries 89

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 ,
COURSE DESIGN AND DEVELOPMENT
COMMITTEE
Prof. M.S. Narasimhan Mr. Shrikant Koundinya
Indian Institute of Management Asstt. Vice President, FrKMC
Bangalore Mumbai
Prof. G. Balasubramanian Ms. Shilpa Rasquinha
Institute for Financial Management Domain Expert and Asstt. Manager
and Research FTKMC, Mumbai
Chennai
Mr. Vinit Singh Kaler
Mr. Raghu Iyer Domain Expert and Senior Executive
Derivatives Consultant FTKMC, Mumbai
Mumbai
Prof. G. Subbayarnma
Mr. Amitabh Chakraborty Director
Managing Director and School of Management Studies
Chief Investment Officer IGNOU, New Delhi
Kitara Capital Private Limited
Prof. S. Narayan
Mumbai
School of Management Studies
Dr. Bandi Ram Prasad IGNOU, New Delhi
President, FrKMC
Prof. K. Ravi Sankar
Mumbai
School of Management Studies
Dr. Jinesh Panchali IONOU, New Delhi
Sr. Vice President, FTKMC
Mumbai Dr. Kamal Vagrecha
School of Management Studies ~ I
Mr. Abhinav Chopra' IGNOU, New Delhi
Asstt. Vie President, FTKMC
Mumbai
Mr. Venkat Oiridhar
Team Leader
Asstt. Vice President, FTKMC
Mumbai

PRINT PRODUCTION
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Dy.Registrar (P) Asstt.Registrar (P) Sec. Officer (P)
MPDD (IGNOU) MPDD (IGNOlJ) MPDD (IGNOU)

June 2011 (Reprint)

© Indira Gandhi National Open University, 2010 &
Financial Technology Knowledge Management Company

ISBN: 978-81-266-4505-3
All rights reserved. No part of this work may be repro~!tced in ~ny f~rm, by mimeo~rap~ or any
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Further information on the Indira Gandhi National Open University courses may be obtained from
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Printed and Published on behalf of the Indira Gandhi National Open University, New Delhi By Registrar, MPDD .
Printed At :- Print Pack (India),215121,Ambadker Gali Moujpur Delhi - 53.
BLOCK 1 INTRODUCTION TO FINANCIAL
MARKETS
Financial Markets have evolved over several centuries. Investment of financial resources
needs to be focused on sustainable growth and development for the benefit of people
across all strata of society. In the last 150 years, financial engineering and emergence of
exchange markets have characterized the development of Global Financial Markets. In
Block 1, we shall analyze the different components of financial systems, the evolution
and significance of financial markets, understand the basic concepts pertaining to risk
management, identify the different types of markets, institutions, intermediaries and
regulatory framework. The units in Block I provide an overall understanding of the
developments in the Indian Financial Markets.
Unit 1 explains the components of the Indian Financial System. It also traces the evolution
of financial markets from time immemorial. The major developments and milestones
achieved in the formation of global financial markets have been identified. Development
of organized financial markets in the post independence and post-liberalization era has
also been discussed in detail.
Unit 2 focuses on the basic concepts to be understood in financial markets and their
relevance in the global financial system. The need for risk management. theoretical
concepts in finance and definitions of important terminology has been discussed. The
unit also highlights sp clfic cases of historical significance to Indian financial markets.
Unit 3 elaborates the different types of markets prevalent in the global financial system
in general and the Indian Financial System in particular. This forms the foundation towards
understanding and appreciating the classifications of different markets based on "financial
claims" and instruments traded across different asset classes.
Unit 4 provides an overview of the important market institutions and intermediaries
prevalent in the contemporary financial marketplace to facilitate the efficient and effective
functioning of the Indian Financial Markets.

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UNITl EVOLUTION AND SIGNIFICANCE
OF FINANCIAL MARKETS
Objectives
After studying this unit, you should be able to:
• identify the components of the Indian Financial System;
• understand how the financial system works;
• know the evolutionary process and significance of financial markets; and
• appreciate the major developments and milestones in the Indian financial markets.

Structure
1.1 Introduction to the Indian Financial System
1.2 Developments in the Indian Financial System
1.3 Evolution of Global Financial Markets
1.4 Evolution of Indian Financial Markets
1.5 Financial Markets in the Real Economy: Interlinkages
1.6 Factors Affecting Global Financial Markets
1.7 Summary
1.8 Self Assessment Questions
1.9 Further Readings

1.1 INTRODUCTION
The financial system of a country is critical for its development and growth. In the
contemporary era of Globalisation, it is critical to align the economic structure in line
.with the developed economies, At the same time, the core objective of the Indian
Financial System needs to cater to the growth .and development of India. The Indian
Financial System has evolved over the past several decades since independence. Before
identifying the core developments in the Indian Financial System, let us understand the
constitution of a Financial System. In this section, we shall introduce the financial system
and its components, as well as their interdependencies.
A system is a collection of components (usually referred to as sub-systems) that interact
with each other. A Financial System is a comprehensive integration of many sub-systems,
comprising of Financial Institutions, Markets, Instruments and Services that facilitate
the efficient and effective transfer, allocation and utilization of resources / funds.
The different components/sub-systems of a Financial System are as follows:
1) Financial Markets
2) Financial Institutions
3) Financial AssetslInstruments
4) Services
The Financial System of any economy provides the foundation for growth and
development. Countries that are rich in resources - be ;t natural, human or any other
form - require to plan and strategize the development of their financial systems.
5

I
Introduction to Financial
Indian Financial
Markets
System

Financial Financial
Markets Services

The Government and business entities (including corporate, banks, financial institutions,
etc.) require capital for investment and operations. On the other hand, the householders
/ general public are net savers of capital and hence, deposit their savings in banks and
. financial institutions. In this process, this capital is channelized (either directly or through
the financial intermediaries such as banks and financial institutions) to the entities that
require capital.
A robust Financial System ensures that adequate management control systems are in
place to ensure that this process of transfer of funds is transparentThe effectiveness
of a financial system is in ensuring that there is no misuse of funds, as well as no default
by any ofthe entities in the financial system. This is extremely important, due to the fact
that if there is a default by any of the entities, this would result in a lack of confidence
among market participants.
Thus, a financial system facilitates transfer of funds from entities that are in surplus to
entities that are in deficit. This transfer of funds occurs either directly or through the
financial intermediaries.
The entities that are having a deficit of funds can sell "financial claims" in the form of
instruments on themselves. These "financial claims" are in form of bonds and treasury
bills issued by Government, debentures, shares and commercial papers issued by
corporate, fixed deposit receipts and savings bonds issued by banks / financial institutions,
mutual funds issued by Asset Management Companies, etc.
These instruments can be bought by those who have surplus funds, either directly or
through intermediaries. The reason for buying these instruments may be as follows:
a) Household savings would be safer in the hands of Government Institutions that
guarantee repayment of funds -. both principal and interest accumulated over a
period of time.
b) Returns linked to the risk involved in the investment vehicles depending on the risk
appetite. of the depositor - this provides supplemental income to the surplus funds
holder (Note that idle money has opportunity cost).
c) Opportunity to save on tax by investing in specific instruments applicable for tax
exemption / rebate.
d) Need for insurance to mitigate risk - life in urance and general insurance (e.g.,
motor vehicle insurance, home insurance, etc.),
e) Diversification of as et ba e for the investor.

Beneftt of Direct Transfer of Fund

An entity requiring funds can ell the in truments directly to the entities that have urplu
funds. This method i more eo t efficient a it en ures that there are no intermediaries
between the investor of fund and the u er of funds.

Transfer of funds through Financial Intermediaries

Usually large corporate, banks and financial institutions have economies of scale by
distributing the financial products through specific channels of distribution, including
banks and post offices. This increases the geographical reach for the issuer and hence,
6
minimizes the costs. For example, an investor living in a remote village can deposit his Evolution and Significance
savings in a post office, i.e., more easily accessible. of Financial Markets

Another benefit of an investor availing the services of financial intermediaries is the

advi ory ervices for wealth management. The layman investor who may require guidance
for investing in different markets can avail the services of wealth management experts
in financial intermediaries. Such advisory services should be impartial and transparent in
providing information to investors.

Capital Flow in an Economy

The following diagram illustrates the capital flow into different sectors of the financial
markets and real economy. The surplus funds generated as a result of earnings is either
invested or saved in either the' economy. The funds subsequently flow into business
activities for production of goods and services, infrastructure growth and other
developmental activities .

········I '
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Capital and Foreign ' Commodity Banks / Financial
Money Exchange

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Futures Markets Institutions, R;'~:s~::e, I::::

Markets Markets Intermediaries' Commodities

........................................................................... .........................................................................................................

Business Activity
Production of Goods and
Services, Infrastructure
(!rnurth

Funds are invested in the capital and money markets, foreign exchange markets,
commodity futures markets, banks / financial institutions and other intermediaries offering
financial services or in the real economy in the form of physical commodity, real estate,
etc. Ultimately, the funds are channeled towards production of goods, providing services,
developing infrastructure and other economic activities, leading to the overall growth
and development of the economy.

Financial Markets
"Market" is conventionally defined as a place where buyers and sellers meet to exchange
goods, services 'or even financial products I instruments for a consideration. This
consideration is usually money. In an Information Technology enabled environment,
buyers and sellers from different locations can transact business in an electronic
marketplace. Hence, the physical marketplace is not necessary for the exchange of
goods or services for a con ideration. Electronic trading and ettlement of transactions
ha created a revolution in global financial and commodity markets.
, ,

Markets can also be defined as channels through which buyers and sellers exchange
goods, services and resources. Markets may be classified as follows: '
•
• A product market where goods and services are traded,
• A factor market where labour, capital and land are exchanged; and
• A financial market where financial claims are traded.
7

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Introduction to Financial A Financial Market is a system of processes and functions that are usually regulated by
Marke •• means of rules and guidelines for enabling participants to transact in financial products
and instruments ("financial claims"). In the process of the continuous interaction between
the different entities that provide the demand and supply of these financial claims, the
"fair value" of the "financial claim" is "discovered". This is also referred to as price
discovery.
Traditionally, transactions used to take place only in unorganized marketplaces. These
unorganized marketplaces were not subject to specific rule or regulation. When countries
developed and as economies evolved, the need to regulate markets in order to remove
distortions and to facilitate free flow of funds gave rise to regulatory bodies. The concept
of organized markets evolved in order to entrust confidence among market participants.
The traditional organized financial markets in India are:
i) Money Markets - for maturity of less than or equal to 1 year
ii) Capital Markets - for maturity of more than 1 year
a) Equity markets
b) Debt market
Other emerging organized securities markets in India (that have played a significant role
in the last decade) are the organized commodity markets (for exchange traded commodity
futures) launched in 2003 and organized currency markets (for exchange traded currency
futures) launched in August, 2008.
The capital markets comprise of the equity markets and debt market. New equity stock
offering is issued in the primary market. Corporates issue new equity stock for raising
capital towards expansion of business activities. The stocks that are issued are
subsequently listed on the Indian equity exchanges - NSE, BSE and other regional
exchanges - which comprises the secondary markets.
The components of the Indian Financial Markets include not only the capital markets
and money markets, but also the foreign exchange markets, Insurance I PF I Pension
Fund markets, Loan Markets and Savings and Investment markets.

1.2 DEVELOPMENTS IN THE INDIAN FINANCIAL

SYSTEM
Having analyzed the different components of the Indian Financial System and their
interdependencies as well as the criticality of capital flows for the overall growth and
development of economy, we shall identify the major developments in the Indian Financial
System, during the past several decades.
In the pre-independence era, the securities market was devoid of financial institutions
that could provide long term financing for the industry. This restricted the access to
savings I funds for the industry. Generally, for growth to take place, investments need to
be made. Due to the absence of a robust financial system, the lack of capital flows
affected growth and development.
In the post independence era from 1947 to middle of 1980's, planned economic
development in the form of the five-year plans (which commenced in 1951) ensured
development of infrastructure. The introduction to economic planning led to distribution
of economic resources. This had implications for the growth and development of the
country.
Nevertheless, the mixed economy followed by the Government ofIndia led to protectionist
policies. There were restrictions on imports, exports and manufacturing (based on license
8
quota). The dominant fear of market failure provided the rationale for active state Evolution and Significance
of Financial Markets
intervention in the financial system. But until end of 1980's, the five year plans largely
ignored the role of financial system in the development process.
Due to the lack of transparent market mechanism to facilitate price discovery, the financial
system in India had a limited role in the overall development. In the ninth 5-year plan, it
was widely recognized that the transformation of savings into investments could be
largely facilitated by way of financial intermediation.
The Government of India nationalized privately owned banks into Government-owned
enterprises. This was aimed at ensuring equitable growth of the entire economy to
benefit all sections of the economy. Following are the major events pertaining to
restructuring the financial system in the post-independence era:
• 1948: Reserve Bank of India was nationalized.
• 1956: State Bank of India was established by takeover of the then Imperial Bank
of India.
• 1956: Over 245 life insurance companies were nationalized to form the Life
Insurance Corporation of India (LIC).
• 1969: Nationalization of 14 major commercial banks.
• 1972: The General Insurance Corporation was established.
• 1980: Six more commercial banks were nationalized.
The nationalization of banks resulted in significant changes in the banking system. The
need to establish systems and processes based on which lending is permissible towards
assisting corporates to access working capital lead to the formation of the Tandon
Committee (1974) and Chore Committee (1980). These committees enabled specifying
norms for credit lending.
New Financial Institutions for term lending facilities were established. These institutions
were both at Central Government level and State level. This also resulted in the formation
of the Unit Trust of India (an investment trust organization). Also, the pension and
provident funds were brought under Government control in terms of regulations governing
their investments. Thus, the entire financial system was controlled by the Government. .
Establishment of Development Banks / Financial Institutions / Term Lending Institutions
ensured availability of credit for industry. The Government intervention also ensured
that capital was disbursed in areas of priority - in other words, capital was directed
towards development. Following are the major events associated with establishment of
Government-owned entities, for the development of the Indian Financial System:
• 1948: Industrial Finance Corporation ofIndia was established.
• 1951: Under the State Financial Corporation Act, financial institutions at the state-
level (State Financial Corporation or the SFC) were established. These
institutions aided the small and medium scale enterprises.
• 1954: The National Industrial Development Corporation (NlOC) was established
for a more dynamic involvement in industrial growth.
• 1955: The Industrial Credit and Investment Corporation of India (ICICI) Ltd.
was established as a development banking institution. This pioneered
underwriting of capital issues and channelization of foreign currency loans
from the World Bank to private industry.
• 1958: The Refinance Corporation ofIndia (RCI) was created to provide refinance
to banks against ferm loans granted by them to medium and small enterprises.
This entity later merged with the Industrial development Bank of India (lOBI)
in 1964.
9

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 Introduction to Financial • 1964: Establishment ofIndustrial Development Bank of India (IDBI) as a subsidiary
,
Markets of RBI. IDBI not only disbursed funds towards planned economic
development, but also coordinated the activities of all other financial
institutions. IDBI was delinked from RBI in 1976 and was converted into a
holding company.
• . 1971: The Industrial Reconstruction Corporation of India (IRCI) was established
jointly by IDBI and LIC, to look after rehabilitation of sick mills. This was
renamed as the Industrial Reconstruction Bank of India in 1984. This was
once again converted into a full-fledged public financial institution (PFI)
and was renamed as the Industrial Investment Bank of India in 1997.

The establishment of the State Industrial Development Bank of India (SIDBl), State
Industrial Investment Corporations (SIlC) and the Technical Consultancy Organizations
(TCO) at the state level ensured percolation of benefits to the grassroots levels of the
society. This also aided in reviving growth and development of the Indian economy.
Commercial Banking between 1950 and 1985 saw the utilization of short term deposits
to fund trade and commerce. Industrial financing accounted for a small fraction of the
total bank credit. RBI attempted to orient the operations of the commercial banking
activities towards the growth and development of the Indian economy. Control of the
macroeconomic variables under the purview of central bank enabled selective credit
controls and moral suasion. This ensured that commercial banking activity supplemented
the impact of development banks on industrial growth. Commercial banks were
encouraged to underwrite new corporate issues and also provide term-lending facility.
Their exposures in these areas were refinanced by the Refinancing Corporation of
India. Joint underwriting by a consortium of banks and insurance companies mitigated
risk to a large extent. Banks also extended financial assistance by investing in shares /
debentures of corporate enterprises. Commercial banks were also encouraged to increase
their exposure to small scale industries, exports and agriculture. i

Credit Guarantee Corporation (CGO) was established to cover all credit made available
to small scale industries as part of the Credit Guarantee Scheme (CGS). For encouraging
~
.. credit towards export-oriented units, the Export Credit and Guarantee Corporation
(ECGC) was established (this was earlier known as the Export Risk Insurance
Corporation). Agricultural financing was guaranteed by the Agricultural Refinance
Corporation (ARC) which was established in 1963. The ARC provided refinance for all
agri loans made by banks and financial institutions.
In order to protect investors, apart from establishing the financial institutions, a
comprehensive legal framework was created, as follows:
• Companies Act, 1956
• Capital Issues (Control) Act, 1947
• Securities Contract (Regulation) Act, 1956
• Monopolies and restrictive Trade Practices Act, 1970
• Foreign Exchange regulation Act, 1973
The G.S. Patel Committee on stock exchanges reforms was appointed in 1984. This led
to the establishment of the Securities Exchange Board of India (SEBI) in 1988.
In section 1.2, we have identified the major developments in the Indian Financial System
in the post-independence period. In the following section 1.3, let us analyze the
development of Global Financial Markets that has significantly influenced the development
of Indian Financial Markets.

10
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 Evolution and Significance
of Financial Markets

Compnents of Indian Financial Markets

• Capital Markets: Comprises equity markets, debt markets, derivatives. Market
participants include financial institutions, High Net worth Individuals (HNI) and
even retail investors.
• Money Markets: Short-term debt securities issued by Government (Treasury
Bills), Commercial Paper, Certificate of Deposits, repo and reverse repo
transactions, etc. Banks, primary dealers, HNI, mutual funds, insurance companies,
Pension Funds are the major participants.
• Foreign Exchange Markets: Dealing in foreign currency by importers and
exporters with authorized forex dealers such as banks. This also lately includes
currency futures traded on exchange platform. Participants are banks, corporate
(importers / exporters).
• Loan Markets: Consists of commercial and retail loans to corporate and non-
corporate borrowers. Loans are issued by intermediaries such as banks with surplus
funds.
• Insurance / Pension Fund: Business of selling Insurance products / retirement
products and deploying such funds for investment purposes. Institutions include
LIC, GIC and other insurance companies, pension funds.
• Savings, Investments Market: Consists of Commercial and retail savings. Major
players are banks, financial institutions and finance companies, mutual funds, chit
funds, nidhis, etc.
In this section, we have analyzed the developments in the Indian Financial System in the
post-independence era upto the commencement of liberalization of the Indian economy.
This is critical for understanding the evolution of the Indian Financial System over several
decades of the twentieth century.

1.3 EVOLUTION OF GLOBAL FINANCIAL MARKETS

The earliest known organized market dates back to the second century BC. The Roman
Empire had developed many characteristics similar to modern capitalism. Markets
flourished because the contemporary Roman law allowed the following activities:
• Free transfer of property was permitted
• Money could be lent based on interest charges
11
 Introduction ~o Financial
• Money changers were allowed to deal in foreign currency
Markets
• Payment across the Roman territories could be made through banker's draft
The above activities enabled free flow of funds between those with excess funds and
entities to those that required capital. Traders used to assemble at the Forum, near the
Temple of Castor in Rome and buy (or sell) the following:
•. Shares and bonds of fanning companies
• Various goods on cash and on credit
• Farms and estates in Italy
• Ships
• Storehouses
• Cattle and other livestock
There is even a mention of the personality of traders - in line with the bulls and bears of
the modem markets. Shares were classified into large executive share holdings and
smaller share holdings. Investors used to send couriers for obtaining information, to
evaluate performance of shares.

In the later Middle-Ages, several Italian 'city-states commenced issuing marketable

Government Securities. In the middle of the 13th century, Venetian bankers began to
trade in government securities. In 1351, the Venetian Government outlawed spreading
rumors intended to lower the price of government funds. There were people in Pisa,
Verona, Genoa and Florence who also began trading in government securities during the
14th century. Later, the fairs conducted in Northern Europe used to be centres of
trading activity in shares. In the 15th century, shares of German mining companies were
traded. Fairs at St. Germaine near Paris, allowed trading in municipal bonds and bills of
exchange.

The fairs in Antwerp were conducted throughout the year subsequent to permission of
free trade. In the middle of the sixteenth century, the first settled bourse was established
in Antwerp. The word "bourse" owes' its origin to the "House de Bourse", where
traders assembled for exchange of securities. This development gradually spread across
rbany centres in Europe - including Amsterdam in Holland. The Dutch commenced the
joint stock companies, which let shareholders invest in business ventures and get a
share of their profits (or losses). In 1602, the Dutch East India Company issued the first
shares on the Amsterdam Stock Exchange. It was the first company to issue stocks and
bonds.

In the seventeenth and eighteenth century, the French Revolution and Napoleonic wars
resulted in the destruction of the securities markets in Amsterdam and Paris. This gave
an impetus to the securities markets in London. In 1801, London stock dealers who
were tradi~g in coffee houses formally established the London Stock Exchange. One of
the most famous market bubbles of all time reportedly occurred in Holland during the
early 1600's. Speculation increased the value of tulip bulbs. At the height of the bull
market, the rarest tulip bulbs traded for as much as six to ten times the average person's
annual salary. The tulip was brought to Europe in the middle of the sixteenth century
from the Ottoman Empire. Holland's upper classes c.ompeted for the rarest bulbs as
tulips became a status symbol. By 1636, Tulip bulbs were traded on the stock exchanges
of numerous Dutch towns and cities, encouraging all members of society to speculate in
the markets. Many people traded or sold possessions to participate in the tulip market
mania. Like any bubble, it all came to an end in 1637, when prices dropped and panic
selling began. Tulip bulbs were soon trading at a fraction of what they once had, leaving
many people in financial ruin.

12
On May 17, 1792, twenty-four supply broker signed the Buttonwood Agreement outside Evolution and Signiftcance
the premises of the address, No. 68, Wall Street in New York underneath a buttonwood of Financial Markets
tree. On March 8, 1817, the exchange was renamed as New York Stock & Exchange
Board. In the 19th century, exchanges commenced trading in forward contract and
ub equently by 1864, in future contracts.
Foll wing are some of the major events and mile tone in the proce s of evolution of the
global financial markets: .
• 2nd Century B : The first organized financial markets was establi hed in the
Roman Empire.
• 13th Century: Venetian Bankers traded in Government Securities.
• 15th Century: Fairs in Northern Europe traded in shares.
• 1632·37: First recorded asset bubble in trading of "Tulip" flowers.
• 1792: Formation of the New York Stock Exchange heralded the emergence
of the exchange markets for equity trading.
• 1848: Formation of Chicago Board of Trade for trading in forward contracts in
commodities.
• 1850: Industrial revolution led to economic growth and development.
• 1864: Commencement of the first futures contract transaction traded on Chicago
Board of Trade.
• 1870 to 1932: Establishment of the Gold Standard to link the currency value to
Gold.
• 1919: Formation of Chicago Mercantile Exchange.
• 1929: The Great Depression.
• 1944: Establishment of the Bretton Woods agreement and led to the formation of
the IMF and World Bank (formerly referred to as the International Bank for
Reconstruction and Development).
I
• 1960·1970: Eurodollar Market. - Dollars held outside the United States came
to be known as Eurodollars. In .the 1960s taxes and regulation in Unites States of
America (USA) made it cheaper to borrow and lend US Dollars in Europe than in
USA. This gave rise to a large market for Eurodollars.
• 1972: Commencement of Trading In· Financial Futures at The Chicago
Mercantile Exchange.
• 1973: Abolition of the fixed exchange rates and dissolution of the Bretton
Woods agreement.
• 1986: Capital Investment Decisions emerged as a key to infrastructure
development (after success of the infrastructure project for building the tunnel
under the English Channel).
• 1988: Mergers - The 1980s saw a wave of takeovers culminating in the USD 25
billion takeover of RJR Nabisco. This event established a benchmark for mergers
and acquisitions.
• 1990's: Inflation-Indexed Debt - United States Treasury issued 10-year
inflation-indexed notes. Many other countries, including Britain and Israel. had
done so previously.
• 1997: Asian Financial Crisis - Originated from Thailand and spread to South
East Asian countries. •
• 2000: Collapse of the Dot-corn Bubble.

13

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Introduction to Financial • 1999: Launch of Euro as a common currency in the European Economic Area
Markets (EEA).
• 2001: Recession in USA due to collapse of Dot Corn Bubble and Accounting
Scandals.
• 2003 onwards: Increase in Global Commodity Prices due to increasing growth in
emerging BRIC countries.
• 2007: Peaking of the Stock Indices world wide.
• Dec 2007 onwards: Sub-prime crisis and collapse of the housing bubble.
• 2008: Global stock markets enter into a bear phase. China becomes the largest
producer of Gold, overtaking South Africa.
• March 2009 onwards: Commodity and Equity Markets bounce back in a rally,
largely due to extensive imports by China.
• September 2009: Signals of revival of the global economies.
Today's global financial markets have evolved over several centuries. The processes
and systems have also developed over the decades. With the advent of information
technology, automation has facilitated efficient capital flows' across global financial
markets.

Activity 1
1) List down the components of the Indian Financial System.

2) What are the major developments in the Indian Financial System?

.................. ~ .

3) List down any five major events that influenced the evolution of Global Financial
Markets.

1.4 EVOLUTIO~ OF INDIAN FINANCIAL MARKETS

The following sections discuss the details about the evolution of Indian Financial Markets
since the post independence era.

14
Pre-Independence period Evolution and Significance
of Financial Markets
Equity brokerage industry in India is one of the oldest in Asia. India had an active stock
market for about 150 years that played a significant role in developing risk markets as
well as promoting enterprise and supporting growth of industry.
The foundations of the modern-day stock markets in India commenced in the 1860s.
The American Civil War that led t<?a sudden surge in the demand for cotton from India
resulted in establishment of a number of joint stock companies that issued securities to
raise finance. This trend was similar to the rapid growth of securities markets in Europe
and North America in the background of expansion of railroads and exploration of
natural resources and land development.
Historical records show that as early as 1864, there were approximately 1000 brokers
with the stock markets functioning at two locations in Mumbai:
• Between 9 am to 7 pm at the junction of Meadows Street and Rampart Row.
• From day break till 9 am and from 7 pm to early hours of next morning at Bazaargate.
Share prices of specific companies increased many times during this period. Mumbai
(formerly Bombay) was a major financial center with 31 banks, 20 insurance companies
and 62 joint stock companies.
An ordinary broker in 1864 earned about Rs. 200 per day, a huge sum in those days. In
July 1865, the stock market bubble collapsed. This ended the "share mania" that was,
prevalent in those days. An interesting aspect of the trading activity during this period is
that despite the creation of such a huge crisis, most of the brokers met their commitment.
India's securities markets has transformed into one of the leading and dynamic
marketplaces for wealth creation. In earlier times, buyers and sellers used to assemble
at stock exchanges to transact shares in open outcry format (floor trading). Stock
exchanges were initially established by association of brokers. Equity trading in the pre-
independence days was focused on shares from the banking sector .. Formation of
exchanges provided the issuers of stock to source capital from investors. This facilitated
faster growth and development. I

In the aftermath of the stock market crash in 1865, banks refused to permit brokers
from using their premises for trading purpose. Thus, the brokers identified a place for
themselves called the "Dalal Street".
In the early days, brokers used to do business under a banyan tree. Later a group of
about 300 brokers formed the stock exchange in July 1875. This led to the formation of
a trust in 1887 known as the "Native Share and Stock Brokers Association" - which
is popularly known today as the Bombay Stock Exchange.
A unique feature of the stock market development in India was that that it was entirely
driven by local enterprise. This was unlike banks which were owned and operated by
the British in the pre-independence period. The establishment of the first stock exchange
in Mumbai was followed by the formation of stock exchanges in other major cities in
India: Ahmedabad (1894), Calcutta (1908), Madras (1937), Uttar Pradesh and Nagpur
(1940), Hyderabad (1944), Bangalore Stock Exchange (1963), and Vadodara Stock
Exchange (1990). The stock markets gained from theboom in several industries such as
Jute (1870s), Tea (1880 and 1890s), Coal (1904 and 1908) etc. The Bombay Stock
Exchange is reportedly the oldest exchange established in Asia.
The first reform enacted in India was the Bombay Securities Contract Act of 1925 ..
However, these reforms were .opposed by the brokers as they believed that it would
hamper their direct interest in stock exchange. Finally, with the promulgation of the
Securities Contract Regulation Act, 1956 (SCRA) led to the regulation of the Capital
Markets in India. Active trading in shares as well as commodities was occurring at all
exchanges across India, until the partition of pre-independent India.
15

I
Introduction to Financial Post-independence Period
Markets
The depres ion that followed independent India led to the closure of everal exchanges.
Thi situation continued until mid-1950 . The Government of India which wa formed
after independence decided to in titute reform in the inancial Markets. Regulation of
ecurities market wa formaliz d thr ugh th ecuriti ontracts (R gulatlon) Act,
1956 (also known a C(R)A, 1956). Only recognized stock exchanges could operate.
·Under the SC(R)A, tock exchanges are tightly regulated as. elf regulatory organizations.
In 1956, the BSE became the fir t tock exchange to be recognized by the Indian
Government under the SC(R)A. Other exchanges in Madras (Chennai), Calcutta
(Kolkota), Ahmedabad, Delhi, Hyderabad, Bangalore and Indore were al 0 recognized
under the new Act. As the economy improved with establishment of Development
Financial Institutions, trading activity started increasing gradually. In 1970s, the introduction
of Foreign Exchange (Regulation) Act (commonly known as FERA) led to divestment
of foreign equity by the multinational companies, resulting in increased trading in equity
markets.
Until the middle of 1980's, the long term credit requirements of corporate sector, was
met predominantly by Development Financial Institutions (DF!) as well as LIC and
UTI. The financial markets did not facilitate a major role in raising capital. The entry of
Reliance Group in the early 1980s heralded the growth of a new and vigorous equity
culture that spread across the country. Not only was the importance of creating effective
and efficient secondary market institutions realized, but also strict regulatory framework
was identified as the foundation for the success of Indian Financial Markets.
With the renewed vigor for raising capital in financial markets, new stock exchanges
were established in 1980's. Following is the list of these exchange :
• Cochin Stock Exchange (1980)
• Uttar Pradesh Stock Exchange Association Limited (at Kanpur, 1982)
• Pune Stock Exchange Limited (1982)
• Ludhiana Stock Exchange Association Limited (1983)
• Guwahati Stock Exchange Limited (1984)
• Kanara Stock Exchange Limited (at Mangalore, 1985)
• Magadh Stock Exchange Association (at Patna, 1986)
• Jaipur Stock Exchange Limited (1989)
• Bhubaneswar Stock Exchange ASSOCIationLimited (1989)
• Saurashtra Kutch Stock Exchange Limited (at Rajkot, 1989)
• Vadodara Stock Exchange Limited (at Baroda, 1990)
.• Coimbatore Stock Exchange
• Meerut Stock Exchange
A new set of economic and financial sector reforms that began in the early 1990s gave
further impetus to the growth of the stock markets in India. As a part of the reform
process, it became imperative to strengthen the role of capital markets. Several measures
were taken to implement the processes and systems. Market infrastructure was
established to facilitate Indian Financial System to grow further and mature. The
importance of efficient and transparent market infrastructure came into focus following
the i~cidence of market abuses in securities and banking markets in 1991.
The Securities and Exchange Board of India (SEBI) which was established in 1988,
was given statutory powers with the enactment of SEBI Act, 1992. The broad objectives
of the SEBI include:
16
• Protection of inter sts of investors in s curities markets: Evolution and Slgnlftcance
of Flnnnclal Markets
• Promot dev lopment of securities markets; and
• Regulate securlti s mark ts.
The scope and functioning of the SEBI have widely expanded with the rapid growth of
s curities mark ts in India in the last two decad s, The Central Government or the
securities markets regulator SEBI' can appoint up to 3 members to a stock exchange's
board. It has also the right to regulate the functioning of stock exchanges. The rul s,
bye-laws and regulations of exchanges need to be approved by SEBI. SEBI also
supervises the activities of intermediaries and register Foreign Investors trading in
Indian markets. The role of SEBI has been discussed in greater detail in
Units 4 and 5.
In 1990s, following the recommendations of a High Powered Study Group on
"Establishment of New Stock Exchanges", National Stock Exchange of India (NSE)
was established. NSE was promoted by financial institutions with the objective of providing
access of markets to all investors across India.
NSE was incorporated in November, 1992 as a tax paying company. This was the first
such instance, because the stock exchanges established until 1992 were formed as
Trusts being run on no-profit basis. NSE was recognized as a stock exchange under the
Securities Contracts (Regulations) Act (1956) in April, 1993. It commenced operations
in wholesale debt segment in June, 1994 and capital market segment (equities) in
November, 1994. The setting up of the National Stock Exchange brought to Indian
capital markets several innovations. Some of these are as follows:
• Nationw idc tradmg network
• Electronic undine
• Greater trun-parcncy in price discovery
• Process driven operations
These developments had significant bearing on the future growth of the stock markets
in India.
Faster and efficient securities settlement system is an important ingredient of successful
stock markets. To speed the securities settlement process, The Depositories Act (1996)
was enacted. This allowed dematerialization (and rematerializationi of securities in
depositories and the transfer of securities through electronic book entry. The concept of
dematerialization and rematerialization is explained in Unit 13 of this course.
The National Securities Depository Limited (NSDL) which was established by leading
financial institutions, commenced operations in October, 1996. Regulations governing
selection of various types of market intermediaries as depository participants were
instituted. Subsequently, the Central Depository Services Limited (CDSL) promoted by
Bombay Stock Exchange and other financial institutions was also established.
Presently, due to the advent of state-of-the-art Information Technology systems and
software, the entire operations of NSE and BSE are automated. Trades are executed
electronically, with increased transparency. Now, investors do not have to gather at the
Exchanges, and can trade freely from their home or office through Internet.
As of today, there are 24 recognized stock exchanges in India, including the Over the
Counter Exchange of India for providing trading access to small and new companies
and Inter Connected Stock Exchange of India Limited - which is an exchange formed
by 15 Regional Stock Exchanges.
The key function of the Stock Exchanges is to provide nation-wide services to investors
and to facilitate the issue and redemption of securities and other financial instruments.
17
 Introduction to Flnandal
Inspite of the formation of many regional exchange ,the launch of automated trading in
. Markets
NSE resulted in deer asing volumes in regional exchange . This i because traders
located in remote geographical regions can access NS through internet.
The transformation of the Indian Financial Markets was heralded by the following major
events:

• .Rapid expansion in the funds raised through capital issues.

• Increase in number of investors subscribing to issues in the primary markets.
• Automation of stock exchanges and trading activity.
• Increased regulation - formation of SEBI.
• Increase in listed stocks; trading in financial instruments such as futures and options
on index and stock.
• Increase in market capitalization and volume of trade in secondary markets.
• Entry of Foreign Institutional Investors and Mutual funds.
The Bombay Stock Exchange developed the BSE Sensex in 1986, giving the BSE to
measure overall performance of the exchange. In the year 2000, the BSE used this
index to open its derivatives market, trading Sensex futures contracts. The development
of Sensex options along with equity derivatives followed in 2001 and 2002, expanding
the BSE's trading platform. Historically, an open outcry floor trading exchange, the
Bombay Stock Exchange switched to an electronic trading system in 1995. It took the
exchange only fifty days to make this transition. .

National Stock Exchange (NSE) has overtaken BSE to become India's leading stock
exchange. The fully automated screen-based trading system provides national reach.
The exchange has brought about unparalleled transparency, speed, efficiency, safety
and market integrity. It has established facilities that serve as a benchmark for the
securities industry in terms of systems, practices and procedures. Within a short span of
time (just one year), NSE became the largest exchange in India in terms of volumes
transacted.

NSE has played a catalytic role in reforming the Indian securities market in terms of
best industry practices. Today, the market uses state-of-art information technology to
provide the following:

• Efficient and transparent trading platform

• Automated clearing and settlement mechanism
NSE's products and services offerings are unique when it commenced operations in
1990's. It innovated to transform the way in which traders can transact. Some of the
most important innovations are as follows:

• Demutualization of stock exchange governance (to separate ownership from

management)
• Screen based trading
• Compression of settlement cycles
• Dematerialization and electronic transfer of securities
• Professionalization of trading members
• Exchange risk management systems using Value at Risk and SPANfM models _
these are discussed in detail in Unit 12
• Emergence of clearing corporations to assume counterparty risks (process of
novation)
• Market of debt and derivatives instruments
18
• Extensive use of information technology Evolution and Slanlftcance
of Flnanclal Markets
Trading volumes in the equity segment have grown rapidly on NSE, due to the prior
mentioned innovative practices. NSE has registered the maximum volume of transactions
in stock futures in the world, as per data compiled by the World Federation of Exchanges
up to April, 2009.
More recently, SEBI has also given recognition to the MCX Stock Exchange based in
Mumbai. MCX Stock Exchange is a subsidiary of Multi Commodity Exchange of India
Limited (MCX), India's No. 1 Commodity Exchange with daily turnover of more than
Rs. 20,000 crores in Commodity Futures contracts. MCX Stock Exchange commenced
operations on October 7,2008 in currency futures. NSE has also commenced trading in
currency futures, effective from August 29, 2008. Both MCX-SX and NSE presently
have daily volumes exceeding Rs. 6,000 crores each in the Exchange-traded Currency
Futures segment.
Another perspective of the evolution of financial markets is discussed in Annexure 2,
which contains an article published in The Hindu Businessline newspaper. The list of
exchanges and the year of establishment is given in Annexure 1. Students are expected
to peruse through both Annexures at the end of this unit.
The major developments in the Indian Financial Markets discussed in this section, also
coincides with' increasing integration with the global financial markets. For example, the
performance of global equity and commodity markets has a direct bearing on the
performance ofIndian equity and commodity markets. In this perspective, it is important
to understand the integration of the financial markets with the real economy and the
specific interlinkages between different asset classes. The same is discussed in
section 1.5.

1.5 FINANCIAL MARKETS IN THE REAL ECONOMY:

INTERLINKAGES
The need for developed fmancial markets in Indiais also due to the increasing interlinkages
with global financial systems. The concept of globalisation today is no longer restricted
to its traditional sense, i.e., variety of cross-border transactions in goods and services,
but also extends to international capital flows, driven by rapid and widespread diffusion
of technology. In fact, most of the literature in recent years on globalisation has centered
on financial integration due to the emergence of worldwide financial markets and the
possibility of better access to external financing for a variety of domestic entities.
Integration of domestic economy with the global economy provides immense benefits.
At the same time, globalization can lead to exposure to price volatility in international
markets. Thus, it becomes imperative to facilitate market participants to hedge against
price volatility.
During the 1980s, capital account liberalisation came to be seen as necessity, and even'
as an inevitable step on the path to economic development. This was analogous to the
earlier reductions, in barriers to international trade in goods and services. However,
capital account liberalization also exposes the domestic economy to certain risks. Large
capital flow causes volatility, i.e., tendency of financial markets to go through boom and
bust cycles in which capital flows grow and then contract.
Another risk is contagion, which refers to the inability of the market to distinguish between
one type of borrower and another. These risks, if not managed well, could have serious
implications as was observed in the case of East Asian crisis in the mid-1990s. This is
also evident in the recent global credit crisis of 2008. The collapse in the housing market
was due to the sub-prime borrowers. Inadequate or mismanaged domestic financial
19

I
Introductlon'to Financial sector lib ralisation has been a major contributor to crises that may b associated with
Market financial integration, Thus. with gr at r financial integration. ad veloped, vibrant. ff' ctive
and stable financial sys; In assumes considerable significance,
With enhanced globallsation of trade and relatively free movement of financial assets,
risk management through derivativ products has also assumed significance in India.
The. Indian corporate sector is exposed to global markets, thereby, leading to increased
economic integration. They may be required to access international capital markets or
have currency exposure. This has lead to development of a broad-based, active and
liquid foreign exchange derivatives market which provides them with a spectrum of
hedge-products for effectively managing their foreign exchange exposures.
Derivative markets re-allocate risk among financial market participants and reduce
information asymmetry among investors. Derivative markets also facilitate efficient
price discovery and enable risk mitigation.
Thus, if benefits from financial integration are to bemaximized, it is imperative to pursue
efforts towards a greater sophistication of financial markets and develop instruments
that allow appropriate pricing, sharing and transfer of risks.
Developed and well-integrated financial markets are critical for achieving the following:

• Sustaining high growth

• Effective conduct of monetary policy
• Developing a diversified financial system
• Ensuring financial integration and stability.
Efforts are being made to fully develop financial markets and the financial system,
Financial markets today deal with complex and sophisticated products such as derivatives.
Introduction of such products would require clear regulatory framework, intermediaries
and development of human resource skills. The progress of financial markets would
thus depend on how quickly we are able to meet these requirements.
Enhancing efficiency, while at the same time avoiding instability in the system, has been
the challenge for the regulators in India. This approach to development and regulation of
financial markets has imparted resilience to the financial markets.
From the point of view of the economy as a whole, while developing financial markets,
it is essential to keep in view how such development helps overall growth and development.
The price discovery of interest rates and exchange rates, and integration of such prices
across markets helps in the efficient allocation of resources in the real sectors of the
economy. Financial intermediaries like banks also gain from better determination of
interest rates in financial markets so that they can price their own products better.
Moreover, their own risk management can also improve through the availability of
different financial instruments.

The accessibility of real sector entities to finance is also assisted by the appropriate
development of the financial markets and the availability of transparent information on
benchmark interest rates and prevailing exchange rates. The approach of the Reserve
Bank in the development of financial markets has been guided by these considerations,
while also keeping in view the availability of appropriate skills and capacities for
participation in financial markets, both among financial market participants and real
sector entities anti individuals.
~
The Reserve Bank's approach has, therefore, been one of consistent development of
markets while e~ercising caution in favour of maintaining financial stability in the
system, In the last few decades and especially since 1991, several reform measures
have been initiated to develop the financial markets in India. As a result, various segments
of thefinancial markets are now well developed and integrated. Despite considerable
20
progress made so far, financial markets need to develop further in line with the evolving Evolution and Slgnlncance
conditions. of Financial Markets

In a well integrated financial system, close linkages develop between the money market,
the Government Securities (G-sec) market, the corporate bond market, the securitized
debt market, the forex market and the derivatives market. The increase or decrease in
commodity prices depending on demand and supply of the physical commodity may
invariably affect performance of economies. At the same time, adverse currency price
volatility or interest rate fluctuations can impact commodity prices.
Volatility in anyone of the market segments gets transmitted to other market segments,
although the magnitude of the impact will depend upon the extent of integration. Interest
rates prevailing in different market segments would reflect their risk-reward relationships.
Exchange rates and interest rates are interlinked. For example, in an efficient market,
the forward rate differential on the exchange rate is usually a function of the interest
differential between the two currencies for the specific time period considered. As -
regards the interest rate linkages between the G-sec market and the corporate bond
market, any changes in interest rate in one market should lead to corresponding changes
in the rate structure of the other markets if markets are well developed and efficient.
For example, the yield curves for AAA rated corporate bonds and G-sec should reflect
a healthy difference (although not necessarily remaining parallel) along different
maturities. If the gap / differential between the two yield curves vary excessively for
different maturities, it is likely because either or both of these markets are not well-
developed.
Thus, having identified the interlinkages between different financial markets and asset
classes, it may be noted that one of the major reasons for increasing interlinkages is due
to automation. The impact of Information technology on financial markets has been
immense, especially in the last two decades. Let us analyze the impact of technology
and automation on the global financial markets landscape.

1.6 FACTORS AFFECTING GLOBAL FINANCIAL

MARKETS
Global Financial Markets are governed predominantly by the factors impacting different
asset classes including commodity, currency, equity and debt markets.
Excess demand for commodities or supply constraints can result in price volatility. For
example, the price of copper increased from USD 3000 per tonne to more than USD
8,800 per tonne between 2003 and 2006. Subsequently by Feb 2009, the price of copper
decreased to USD 3700 per tonne. The increase in copper price led to decrease in the
operating profit margin of manufacturing companies (that are predominantly consumers
of copper). This adverse impact on the operating profit margin of companies has resulted
in a decline in their share prices.
At the same time, the US Federal Reserve, over a series of Federal Open Market
Committee (FOMC) meetings, increased the bank rate prevailing in US from 1% to
5.25%. This led to a collapse of the financial system in US, due to the increase in
interest costs for sub-prime borrowers. Housing prices also declined due to declining
demand. Repayment of mortgage loans depends on the prevailing interest costs. Increase
in the interest rate had an immediate adverse impact on the repayment schedule of sub-
prime borrowers. This led to a chain reaction in the economy. By Sep 2007, the US Fed
was already decreasing the interest rates. But it was too late. The collapse of Lehman
Brothers led to a series of default in the international financial markets.
Declining confidence among the public (consumer sentiment about the confidence in
the economy) resulted in decreasing consumption trends. The entire series of events
21

I
 ,
Introduction to Financial·
Marketll ~t
also resulted in declining growth rate of global economies. USA being the largest economy
in the world has a direct bearing on the economies of other developed and d veloplng
1
countries. India has a direct exposure in the form of exports of IT sofiwnre solutions
and services. India also provides manpower to USA in th IT and IT =enabled field.
India's v ry own Businen Process Outsourcing (BPO) and Knowledse Process
Outsourcing (KPO) are dependent on the US economy.
Thus, it is important to understand the performnnce of the internntional markets before
making critical decisions offrnanciw Invesrm nts or borrowings. A thorough und rstanding
of the economic indicators is required to analyze the markets worldwide. I

Financial transactions always require the services of banks (whether acting as principal
or a agent) a well as the financial markets in which they can operate. Banks have also
expanded their operations to international markets - with the advent of concepts such
as global banking and universal banking to ensure a single client window interface.
In the late 1800's, the industrial revolution re ulted in increasing requirement for funds
for infrastructure growth. This led to frequent instances of American companies raising
capital through new issues in European markets and vice versa, European companies
were raising capital in USA. Increasing cooperation and financial integration between
the financial markets in USA and Europe laid the foundation for the formation of "Allies"
\ during the World wars.
The Great Depression of 1929 resulted in 3 prominent events that had great effect on
American banking:
• The passage of the Banking Act, 1933 that provided for the Federal Deposit
Insurance system and the Glass-Steagall provisions that completely separated
commercial banking and securities markets activities (or investment banking
operations).
• A 30-year period in which banking was confined to basic, slow-growing deposit
taking and loan making within a limited local market only.
• The rising importance of the government in deciding financial matters, especially
during the post-war recovery period. As a consequence, there was comparatively
little for banks or securities firms to do from the early 1930s until the early 1960s.
By then, world trade had resumed its vigorous expansion and U.S. banks, following the
lead of First National City Bank (subsequently Citicorp, now part ofCitigroup), resumed
their activities abroad.
The year J 971, witnessed the collapse of the fixed exchange rate system, in which the
USD was linked to Gold (and other currencies were linked to the dollar). Floating
exchange rates set by the market replaced this system, thereby, effectively removing
government capital controls. In turn, this led to widespread removal of restrictions on
capital flows between countries, and the beginnings of the global financial system that
we have today.
The effects of competitive capitalism have been seen and appreciated during the past
five decades as they had not been since 1929. The 1980s witnessed further rounds of
deregulation and privatization of government-ownedenterprises, indicating that
governments of industrial countries around the world found private-sector solutions to
problems of economic growth and development preferable to state-operated, semi socialist
programs.
Most large businesses are now effectively global, dealing with customers, suppliers,
manufacturing, and information centers all over the world. Many corporations are
repositioning themselves strategically because of changes in their industry and in traditional
markets and among their competitors.
22

I
In Europe, for exampl , most sizeable firms must consider themselves as at least Evolution and SllInlftcance
continental players, not just national players. The European market, in aggregate, is as or Financial Markeu
lllfge as the market for goods and services in the United States; indeed, it is larger if you
include Eastern Europe. It is important for a eomp tltor in any industry to be active in
such a market, and equally in the United States. And all competitors seem interested in
the emerging markets for goods MQ services that are d veloping in the BRIC countries
(Brazil, RUll!lia,India and Ch,ina), South Asia and Latin America since these regions
began to adopt mark t ecenemt s in a capitalistic form.
Global companies have thus become active in, world markets as never before, and as a
result have become major consumers of international financial services of many types:
for capital raising, mergers and acquisitions, and foreign direct investments; for foreign
exchange and, commodity brok rage; and for inve tment and tax advice. Governments
and financial institution also have become major u ers of the e financial ervices for
the investment of reserves, the issuance of debt securities, the privatization of state-
owned enterprises, the sale of deposits and other bank liabilities, mutual funds, and a ,
variety of investment and hedging services.
Global banking and capital market services proliferated during the 1980s and 1990s as a
result of not only an increase in demand from companies, governments, and financial
institutions, but also because financial market conditions were buoyant and, on the whole,
bullish. Indeed, financial assets grew then at a rate approximately twice the rate of the
world economy, despite significant and regular setbacks in the markets in 1987, 1990,
1994,1998, and 2001.
Such growth and opportunity in financial services, however, entirely changed the "
competitive landscape-some services were rendered into commodities, commissions
and fees were slashed, banks became bold and aggressive in offering to invest directly
in their clients' securities without the formation of a syndicate, traditional banker-client
relationships were shattered, and, through all this, a steady run of innovation continued-
new products, practices, ideas, and techniques for improving balance sheets and earnings.
As a result, many firms were unable to remain competitive, some took on too much risk
and failed, and others were taken up in mergers or consolidations.
Market integration has been accelerated by several factors that have occurred during
the past 20 years. The absence of need for foreign exchange controls has resulted in a
free flow of capital between markets of industrially developed countries. Deregulation
has removed barriers that impeded access to markets in different parts of the world, by
both issuers and financial service providers. Massive improvements in telecommunications
capability has made it possible for information available in one part of the world (such as
bond prices) to be simultaneously available in many other places. For example, in 1997,
the U.S. Federal National Mortgage Association (FNMA) issued five-year notes
denominated in Australian dollars that were sold in the United States, Europe, Asia, and
Australia. These notes were priced at a rate very close to the Australian government
bond rate, taking advantage of very strong market conditions in Australia.
With India adopting best industry practices for financial systems, increasing integration
with global financial markets is inevitable.

1.7 SUMMARY
The earliest known organized markets emerged in the Roman Empire in second century
B.C. Trading activity has also been noticed in Northern Europe - particularly Germany,
Netherlands and later in France and London.
Trading evolved in India with the establishment of the Bombay Stock Exchange in 1875.
Several other exchanges were established in India. In the post independence era, major
23

1
 Introduction to Financial reforms in Indian equity markets were instituted in the late 1980's and throughout the
Markets 1990's. This heralded the formation of the SEBI. National Stock Exchange of India
Limited (NSE) enabled the first automated screen based trading facility. Subsequently,
BSE also commenced electronic trading.
Financial Markets provide the mechanism for the flow of funds from investors who
have surplus funds to those who are seeking funds. Technology has emerged as one of
the major factors impacting the growth and development of financial markets. Electronic
transfer of funds has led to faster transactions, even from remote locations. The
globalization of economies has led to increasing interlinkages between Indian financial
markets and the world markets.
Having understood the evolution and significance of financial markets in Unit 1, we will
be discussing in Unit 2, specific concepts related to financial markets and risk management,
as well as case examples of historical significance.

1.8 SELF ASSESSMENT QUESTIONS

1) Discuss the evolution of global financial markets.
2) Explain the major events leading to the development of Indian Financial Markets.
3) Explain the interlinkages of financial markets with the real economy.
4) List the key factors governing global financial markets.
5) Explain using a diagram, the different components of the Indian Financial System
and their significance.
6) What are the developments in the Indian Financial System, since independence?
7) What is the contribution of India to the Global Securities Markets?

1.9 FURTHER READINGS

1) Chancellor, Edward (2000) Devil take the Hindmost: A History of Financial
Speculation, Penguin Books.
2) Smith, Mark B (2003) The Equity Culture: Story of the Global Stock Market,
Farar Straus and Giroux Books.
3) Michie, Ranald C. (1999) The London Stock Exchange, Oxford University Press.
4) Pathak, Bharati V. (2008) The Indian Financial System, Markets Institutions
and Services, Pears on Education.
5) Geisst, Charles R. (1997) Wall Street, A History, Oxford University Press.
6) Tandon, Prakash (1989) Banking Century, Penguin Books.
7) Endo, Tadashi (1998) Indian Securities Market, Vision Books.
8) Robert Alan Schwartz, Reto Francioni, (2004), Equity markets in action: The
fundamentals ofliquidity, market structure and Trading, John wiley and Sons, Inc.,
Hoboken, New Jersey.
9) Murali Patibandla (2006), Evolution of markets and Institutions: A Study of an
emerging economy, Routledge, Oxon, UK. .

. ~24~ _
 Annexure I Evolution and Significance
of Financial Markets

Snapshot of Development in Indian Financial Markets

Early Developments in Indian Stock Markets
, 18th Century East India Company was the dominant institution and by end of the century,
business in its loan securities gained full momentum.
1830's Business on corporate stocks and shares in Banks and Cotton presses started
in Bombay. Trading list by the end of 1839 increased.
1840's Recognition from banks and merchants to about half a dozen brokers.
\,

1850's Rapid development of commercial enterprise saw brokerage business

attracting more people into the business.
1860's The number of brokers increased to 60.
1860-61 The American Civil War broke outwhich caused a stoppage of cotton supply
from United States of America.marking the beginning ofthe "Share Mania"
in India.
1862-63 The number of brokers increased to about 200 to 250.
1865 A disastrous slump began at the end of the American Civil War (as an
example, Bank of Bombay Share which had touched Rs. 2850 could only be
sold at.Rs, 87). "

Pre-Independence Scenario: Establishment of Dlffer,ent Stock Exchanges

1874 With the rapidly developing share trading business, brokers used to gather
at a street (now well known as "Dalal Street") for the purpose of transacting
business.
1875 "The Native Share and Stock Brokers' Association" (also known as "The
Bombay Stock Exchange") was established in Bombay.
1880:8 Development of cotton mills industry and set up of many others.
1894 Establishment of "The Ahmedabud Share and Stock Brokers' Association" .
.
1980-90's Sharp increase in share prices of jute industries in 1870's was followed by a
boom in tea 'stocks and coal.
1908 "The Calcutta Stock Exchange Association" was formed.
1920 Madras witnessed boom and business at "The Madras Stock Exchange"
was transacted with 100 brokers. .. -.
1923 When recession followed, number of brokers came'down to 3 and the Exchange ".
was closed down.
1934 Establishment of the Lahore Stock Exchange.
1936 Merger of the Lahore Stock Exchange with the Punjab Stock Exchange,
1937 Re-organization and set up of the Madras Stock Exchange Limited (~d
Limited led by improvement in stock market activities in South India with '
'establishment of new textile mills and plantation companies.
- ,
1940 Uttar Pradesh Stock Exchange Limited and Nagpur StoCkExchange Limited
was established. '. '
\.
1944 Establishment of "The Hyderabad Stock Exchange Limited".
1947 "Delhi Stock and Share Brokers' Association Limited and "The Delhi Stocks
and Shares Exchange Limited" were established and later on merged into
''The Delhi Stock Exchange Association Limited".
~----------------------------------------~------------------~.
25. "

I
Introduction to Financial
Markets
Annexure 2 1
Contribution of India to Global Securities Markets
India's contributions in the field of mathematics are known to all. Our very own
Aryabhatta, the genius who introduced "Zero" and "Pi" (3.14) and their significance to
the 'world and Srinivas Ramanujam - who introduced the concept of "infinity". More
.recently, the Indian Space Research Organization (ISRO) has been credited by National
Aeronautics and Space Administration (NASA) for identifying the existence of water
on the Moon.
But few know about India's contribution in the field of finance. Long before the western
world had woken up to the idea of derivative instruments like options, our native traders
were already comfortable using them in their day-to day trading activities. We may take
pride in knowing that the history of the Bombay Stock Exchange and the history of
commodity options trade in India dates back to the mid-1800s, unlike the notion that
trading in stocks and derivative instruments has been adopted from the west.
, The below article encapsulates the contribution ofIndia to the Global Financial Securities
markets. It provides insight into the long history of equity and options trading in India.

BSE from Banyan tree to the Biggest Bourse

Published in The Hindu Business Line, April 27, 2004

The journey of the BSE is as eventful and interesting as the history of India's securities
markets. Its current status as the country's biggest bourse in terms of corporate listings
and market capitalisation has roots in more than a century of landmarks and milestones
in Indian financial markets.
A unique thing about the BSE is that perhaps it is the one domestic institution that was
always pioneering and on par with the international standards. Mr Shapurjee Burjorjee
Bharucha, during the inauguration of the Native Brokers Hall on January 18, 1899
addressing a huge gathering of European and native brokers said, "India being the original
home of the option, a native broker would give a few points to the brokers of other
nations on puts and calls." About its prominence and- importance he noted, "Without
doubt this is the largest rupee paper market in India, whether as regards the volume of
business or the extent of the fluctuations."
India itself was on even keel with the world trends and its indigenous enterprise and
initiative was at its best in the mid-1800s when the securities markets shot up to
significance as the most important business at the time, though the sentiment was largely
fuelled by the speculative boom. A little bit of history before the formation of the BSE
might be interesting.
The American Civil War (1860-61) led to the sudden surge in demand for cotton from
India, which resulted in a number of joint stock companies coming into being with issuance
of securities. Suddenly there was a share mania that gripped the city of Bombay with
the market functioning from three different places; between 9 a.m. to 7 p.m. at the
junction of Medows Street and Rampart Row; from day break till 9 a.m. and from 7 p.m
to the early hours of next morning at Bazaargate.
Sugar Market at Mandvi was another place. Between March, 1864 and July, 1865,
speculation was so rife and rampant that the market consisted of more than 1,000 brokers.
Share price rose sharply; a share of Coloba Land Company rose from Rs 10,000 at par
to Rs 1,20,000 and that of Backbay Shares went up from Rs 2,000 to 54,000. Bombay
was a major financial centre even as early as in 1865; it had 31 banks, eight land
reclamation companies, 16 cotton-pressing companies, 20 insurance companies and 62
joint stock companies.
26
 "During the years 1864-65, the whole community of Bombay from the highest English Evolution and Significance
officials to the lowest native broker utterly demoralised and abandoning business, gave of Financial Markets
themselves up to the delusion that they could all succeed in making fortunes on the stock
exchange," noted a newspaper of that time, which prompted the then Governor, Sir
Bartle Frere (1862-1867) to forbid all civil servants to indulge in speculation and refused
to promote those who disobeyed the order. A few found it more rewarding to disobey.
J.M. Maclean (1835-1906) a high-ranking British official was reported to have said, "I
have made more money out of these shares than I have saved during all my service in
India and I don't mean to give up."
Two thirds of the banks in Bombay changed their managers in the light of the share
mania.
All the trappings of a rising market were in evidence; tips-rumors-astrological forecasts-
press interview. People gambled on any thing; stocks, silver, and even rainfall. The
newspaper, Bombay Guardian, reported in 1872 an interesting incident of betting on
the rain or Barsat Ka Saua. "The rage of speculation of people in this country is
extraordinary. It finds vent in the chances of a day being rainy or otherwise. Over a
hundred people, most of them Marwaris assemble, it is said, in a chawl near Khetwadi
daily to bet on the probability of the rainfall." There were a few Nick Leesons too.
Chunilal D. Saraiya (1862-1913), manager ofIndia Specie Bank bet so heavily on silver,
which made the bank to lose one and quarter million leading to its closure. The original
Big Bull was Premchand Roychand who was also well known as the Cotton! Bullion
King. When he was on a visit to companies or banks, hordes of people used to follow
him for either a tip or an insight. He could persuade banks to lend huge sums of money
for share business that further buoyed the boom market at the time. An ordinary broker
around 1865 earned about Rs 200 per day, a huge sum in those days.
The party, however, did not last long. On July 1, 1865, when hundreds of "time bargains"
had matured which buyers and sellers alike defaulted that lead to the burst of the bubble.
" Never had I witnessed in any place a run so widely distributed nor such distress
followed so quickly on the heels of such prosperity," thus wrote Sir Richard Temple,
who served as the Governor of Bombay.
A share of Bank of Bombay which touched Rs 2,850 at the peak of the market slumped
to Rs 87 in the aftermath of the bust. Despite the intensity of the crisis, most of the
brokers met their commitments.
Banks, on whose building steps brokers used to hover around for tips and trades, found
it a big nuisance in the aftermath of the crash and drove them away out of their premises,
, which forced them to find a place of their own, which later turned out to be Dalal Street.
, Beginning with doing business under a banyan tree, a group of 318 persons, formed the
stock exchange in July, 1875, which led to the formation of a trust in 1887 known as
"Native Share and Stock Brokers Association".
In 1895, it.acquired premises on the same street and the new Native Brokers Hall was
inaugurated in 1899. The burst of 1865 share mania did not deter India finance to explore
new opportunities. Following the collapse of 1865, there were several booms led by
surge in the growth .prospects of several key industries such as jute (1870), tea (1880
and 1890s), coal (1904 and 1908).
The mid-1970s once again witnessed sudden interest in the stock markets following the
introduction of FERA which forced multinationals to dilute or divest their equity. Entry
of Reliance Group in the early 1980s heralded a new thrust in the growth of equity cult
and a new optimism was generated during the first phase of economic liberalisation in
the early 1990s latter to be followed by yet another big boom on the back of technology
and Internet companies.

27

I
Introduction to Financial The establishment of stock exchange in Bombay was quickly followed by other major
Markets centers; Ahmedabadin 1894, Calcutta Stock Exchange in 1908, Madras Stock Exchange
in 1937, Uttar Pradesh and Nagpur Stock Exchanges in 1940, Hyderabad Stock Exchange
in 1944.
As chequered and exciting more than a century of existence has been, equally swift and
smooth was the transformation of the BSE into one of the most modem stock exchanges
in the Asian region. It has several firsts to its credit even in the intensely competitive
environment.
First to introduce concepts such as free float indexing, obtain ISO certification for
surveillance, establish huge infrastructure to enhance knowledge and know-how, put in
place a trading platform that works on a sub-second response time and capacity of four
million trades a day, export of trading platform technology to other stock exchange in
Middle East, report highest delivery ratio among the major exchanges, lowest transaction
costs, a record of lowest defaults, offer highest compensation for investor in cases of
valid and approved claims. The most important change ofBSE has been on the governance
side which now consists of a rich and balanced mix of professionals and industry experts
and the entire administration steered by professionals.
Drawing from its rich past and its equally robust performance in the recent past, BSE
will continue to remain an icon and an indicator of the Indian securities markets.

,
..,'.,

..
28
UNIT 2 CONCEPTS AND CASES
Objectives
After studying this unit, you should be able to:
• understand the commonly used market terminology;
• identify different types of risks and distinguish between the same;
• know the risk management concepts and theories in finance; and
, .
• analyse historical events of significance in financial markets.

Structure
2.1 Introduction •• • r

2.2 Understanding Risk and Return

2,3 Types of Risk in the Financial System
2.4 Efficient Market Theory
2.5 Basic Market Terminology and Concepts
2.6 Contract Theory
2.7 Cases: Events of Historical Significance
2.8 Basic Quantitative Techniques for ~isk Measurement
2.9 Summary
2.10 Self Assessment Questions
, '

2.11 Further Readings

2~1 INTRODUCTION'
; ,"
In Unit 1, we have traced the development of financial systems in the later part of the
twentieth century and this decade. The growth in global financial markets has been
impacted by major developments in information technology, resulting in automation of
trading systems and settlement processes. This has facilitated faster transactions with
capital flows across continents. Globalization of economies and free trade has resulted
,I
in increased interlinkages. Advent of sophisticated financial instruments has increased
risk for the market participants. '
Global commodity prices have a direct impact on commodity prices in India. Increase in
I
consumption of food grain coupled with a decrease in production resulted in increase
price of-essential commodities in 2008. Fluctuations in Gold prices in London markets
have a direct impact on the gold prices in India. Similarly, if the US economy is undergoing
1-
a recessionary period with negative GDP growth rate, then there is a direct impact on ,
,

the Information Technology (IT) and Business Process Outsourcing (BPO) industry in 1

India. This is because theI'T and BPO industry is dependent on revenues provided by
clients in developed markets. This has resulted in increasedrisk for the shareholderin
India. The earnings of the Indian IT companies are impacted by the global economic
downturn affecting markets since 2008. This has translated risk across different ' : ."o:.''')'rr
" ", 1
geographies, countries and continents. Volatility in currency markets has also resulted in ,I

increased exposure to risk. ' :. ,,' .~.i,:I ~l~f;{ ::' ' . " I
~ ", ~.,"'. .
',:".;', \

i'
'

Risk is the extent of uncertainty associated with the outcome of an event. In' other' ' .. •......•".,...: ,
words, it is the chance / probability that an investment's actual return wi1115e"ilifIe~ff <unk1l!'t, . " ..
29 .\
-r- , J

I
Introduction to Financial than that which is expected. This includes the possibility of losing some or all of the
Markets original investment in a financial product / instrument. For example, assume that you
were tossing a Re. 1 coin. The chance that the toss of the coin would return a "Head"
or "Tail" is supposed to be equal. We cannot say for certain that the toss of the coin
would resulr in a "Head" or a "Tail". There is a certain amount of risk associated with
the uncertainty of the outcome.
In financial markets, risk is associated with the extent of uncertainty of asset prices
remaining the same. This fluctuation in asset prices is usually referred to as volatility.
Risk can be measured by calculating the volatility of asset / portfolio prices.
In the following sections of Unit 2, we shall try to Identify the terminology associated
with risk, return, finance theories and efficient market hypothesis. Events of historical
significance have been explained for the student to analyse the risk prevailing in financial
• markets.

2.2· UNDERSTANDING RISK AND RETURN

The risk-return tradeoff refers to the fact that potential return rises with an increase in
risk.
Low levels of uncertainty (low risk) are associated with low potential returns, whereas
high levels of uncertainty (high risk) are associated with high potential returns. According
to the risk-return tradeoff, invested money can result higher profits, only if it is subject to
the possibility of losing the invested capital. In other words, when a trader or investor
seeks higher returns, he may invest in assets / instruments that have potentially higher
volatility or risk.
Because of the risk-return tradeoff, an investor should be aware of hislher personal risk
tolerance (risk appetite or potential to take risk) when choosing investments for hislher
portfolio. Let us assume that risk is the price of achieving returns. If a trader or investor
wants to obtain high returns, he/she cannot avoid the uncertainty associated with risky
assets. The goal instead is to find an appropriate balance - one that generates some
profit, but still provides reasonable protection for the invested capital. Deciding what
amount of risk you can take while remaining comfortable with your investments is very
important.

Example of Risk Return Trade-off

Consider an index fund that gives an average of 12% return in the long run. Alternatively,
the return on Government Securities is considered as therisk-free rate because there is
no probability of default. If the risk-free rate is currently 8%, this means that with
virtually no risk, we can earn at least 8% per annum on the amount invested.
A common question arises: Who wants to earn 8%, when index funds average returns
of 12% per annum over a longer time period? The answer to this is that even the entire
market (represented by the index fund) carries risk. The return on index funds may not
be consistently 12% every year; but on the other hand, may be 10% In the first year,
+25% in the second year, etc. An investor still faces substantially greater risk and volatility
to get an overall return that is higher than a Government Security. We call this additional
return as the "risk premium", which in the prior mentioned example, is 4% (i.e., 12% -
8%).
Risk tolerance differs from one individual to another. Your decision will depend on your
goals, income and personal situation, among other factors. i'

30
 ,
Inverse Relationship between Risk and Return Concepts and Cases

If an investor invests in assets or securities that have high risk due to price volatility, then
the investor would automatically expect a higher return. The reason for this is that
investors need to be compensated for taking on additional risk.
For example, a US Treasury bond is considered to be one of the safest investments.
When compared to a corporate pond, the treasury bond gives a lower rate of return.
The reason for this is that a corporate is more likely to go bankrupt than the US
Government. Because the risk of investing in a corporate bond is higher, investors
automatically expect a higher rate of return.
Thus, for less risky assets or securities, the returns may be less, but the possibility of
default is also usually minimal."

Risk Appetite
There are three types of investors based on the risk taking capacity or risk appetite,
namely:

1) Risk-Averse Investor: A risk averse investor is one who, when faced with two
investments with a similar expected return (but different risks), will prefer the one with
the lower risk. A risk-averse investor is not comfortable investing in risk-prone assets.
Thus, such an investor stays away from adding high-risk stocks or investments to his
portfolio. They do not mind losing out on higher rates of return, but consider capital
protection as their primary objective. They are happy to obtain lower returns by investing
in safer/risk-free instruments.
Investors, who value safety of capital over everything else, usually prefer to invest in
government bonds, treasury bills, post office savings deposits, etc. These avenues of
investment generally give lower returns.

2) Risk-Taker: As the name suggests, a risk taker is an investor who is' willing to take
on additional risk for an investment that has a relatively low expected returs, This contrasts
with the typical investor mentality - risk aversion. Risk-Averse investors tend to take on
increased risks only if these are warranted by the potential-for higher returns.
There is always a risk/return tradeoff in investments. Lower returns are usually associated
with investments in assets that have low risk. Higher returns are associated with
investments in assets that have high risk profile. Usually, investors expect to be
compensated for taking on additional risk.

3) Risk-Neutral Investor: A description of an investor who purposefully overlooks

risk, when deciding between investments is commonly referred to as a risk-neutral
investor. A risk neutral investor is only concerned with an investment's expected return.
Having understood the basic definitions of risk and its generic relationship to returns, let
us identify in section 2.3, the different types of risks prevailing in financial markets.

2.3 TYPES OF RISK IN THE FINANCIAL SYSTEM

We have observed that greater is the risk associated with a financial investment, higher
should be the returns obtained. Thus, the risk premium or the return obtained over and
above the risk free rate of return should be proportional to the extent of risk. But there
are different types of risk in the markets. It is important to understand the different
types of risk in order to analyze if the return is commensurate to the extent of risk
associated with the investment.
31

1
..•.•
n. UUU\,.UUJI
~arkets
W r JlUlnCUlI KlSk m the financial system can be broadly classified as follows: I
a) Systematic Risk: In financial markets.those forces that are uncontrollable, external
and broad in their effect are usually referred to as sources of systematic risk. Systematic
risk refers to that portion of toal variability in return caused by factors affecting the
prices of all securities. Economic, political and sociological changes are sources of
systematic risk. Their overall effect is on the entire equity market. Some of the sources
of systematic risk in equity markets are market risk, interest rate risk and purchasing-
power risk.

b) Unsystematic Risk: On the other hand, controllable and internal factors which are
specific to industries or companies are usually referred to as sources of unsystematic
risk. It is the portion of risk that is unique to a firm or industry. They are independent of
factors affecting the equity markets in general. Unsystematic factors need to be analyzed
for the specific firm. Unsystematic variability of returns may also arise from changing
consumer preferences, extent of capability and competence of the top management,
labour dispute leading to a strike, etc. Such factors are usually unique to a particular
. company of industry and needs to be analyzed separately, Some of the major sources of
unsystematic risk includes -
a) Business risk: related to the operating environment of the business. For
example, increase in raw material costs or production expenses can induce
high variability in company's operating profit. This degree of variation of the
expected operating profit is the measure of business risk. Once again, the
business risk may be due to internal sources or external factors.
, ,0') Financing risk: This is associated with the way in which a company finances
its activities - for example, mix of debt, equity, etc.
Let us try to understand the different types of systematic and unsystematic risks in
financial markets. We shall discuss market risk, credit risk, operational risk and liquidity
risk, which are usually the major sources of concern for banks, financial institutions,
corporate in general and equity markets in particular:

1) Market Risk
The potential for an investor to incur losses due, to the fluctuation in prices of assets is
usually referred to as Market risk. Market risk as indicated above, is also known as
systematic risk, This risk results from the characteristic behaviour of an entire market
or asset class. If for example, there is a decline in rainfall during monsoon season, this
can adversely affect not only the rural population, but also urban areas. Farmers dependent
on monsoon rains for growing crops have less disposable income due to monsoon failure.
The prices of essential commodities can increase, leading toa strain in the budget for
the middle-class household in urban areas. This can have a potential cascading effect
on stock prices, due to lower demand for specific goods - for example, demand for
automobiles, consumer goods (durable and non-durable), etc. can be impacted. This will
eventually lead to lower share prices due to decreasing earnings.
Asset allocation is generally considered an antidote for market risk, since if the portfolio
includes multiple asset classes, it tends to be less vulnerable to a downturn in anyone
class, thereby, supposedly reducing the extent of risk associated with price fluctuations.

2) Credit Risk
The risk that a loss will be experienced because of a default by the counterparty in a
transaction is usually referred to as credit risk. There may be a risk that an issuer of
corporate debt securities or a borrower may default on his obligations, or that the payment •
may not be made on a negotiable instrument - thus, giving rise to credit-or counterparty
32
default risk. The system of credit rating has evolved to mitigate this type of risk. Concepts and Cases
Nevertheless, when Lehman Brothers decided to file for bankruptcy protection, this led
to a series of defaults across the entire financial system, due to the huge exposure taken
by Lehman brothers in the OTC derivatives markets.

3) Operational Risk
The risk ofloss resulting from inadequate or failed internal processes, people and systems
or from external events is usually referred to as Operational risk. BasellI norms have
been stipulated for providing risk-based capital for banks. Basel 11 stipulates the
requirement for banks to provide for operational risk within their business operations.
This has transformed the perspective with which risk has been assessed. This is all the
more important because, operational risk can in turn lead to market risk and credit risk.
Thus, operating risk may come from mundane sources such as incompetent personnel
or miscommunication between a buyer and a seller, or it may stem from events beyond
a firm's control, such as terrorism, damage to goods in transport, or even a sudden drop
in demand. Because it is not (primarily) financial, it is the most difficult type of risk to
quantify. Sometimes, operating risks are predictable; for example, a farmer can prepare
for a drought that would harm hislher harvest and therefore profits. On the other hand,
risk from an employee's fraud is often impossible to anticipate. Consultancies often
offer operating risk management, identifying and attempting to eliminate it as much as
possible.

4) Liquidity Risk
The risk associated with lack of available counterparties to liquidate outstanding positions
in securities or any other asset is referred to as "liquidity risk". Usually, over-the-counter
markets have extensive liquidity risk, due to the customized nature of contracts.
You may also refer to Annexure 1, for the list of the different types of other risks in
financial markets.
Having identified the different types of risks in financial markets, let us understand in
section 2.4, concepts. related to the Random Walk Theory and Efficient Markets
Hypothesis.

2.4 EFFICIENT MARKET THEORY

The Random Walk theory states that stock market's price movements will not follow
any specific patterns or trends and that past price movements cannot be used to predict
future price movements.
Stock prices fluctuate in a random and unpredictable path. The random walk theory is a
school of thought that believes that it is impossible to outperform the market without
assuming additional risk. Critics of the theory, however, contend that stocks do maintain
price trends over ~Tl1e- in other words, that it is possible to outperform the market by
carefully selecting 'entry and exit points for equity investments.
This theory was discussed widely when the author of this theory, Burton Malkiel published
the book (1973), "A Random Walk Down Wall Street".
Random Walk theory is a special case of a general efficient-market model or hypothesis.
Let us analyze the efficient markel hypothesis.
~ ..
'.
.t: 't

Efficient Market Hypothesis

This is an investment theory that states that it is impossible to "beat the market" because
stock market efficiency causes existing share prices to always incorporate and reflect
33

I
Introduction to Financial all relevant information. According to the Efficient Market Hypothesis, stocks always
Markets trade at their fair value on stock exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices.
The conclusion of this theory is that it is impossible to outperform the overall market
through expert stock selection or market timing. In such a scenario, the only way an
investor can possibly obtain higher returns is by purchasing riskier investments. Although
it is a cornerstone of modern financial theory, the Efficient Market Hypothesis is highly
controversial and often disputed. Believers argue that it is pointless to search for
undervalued stocks or to try to predict trends in the market through either fundamental
or technical analysis. While one school of thought supports Efficient Market Hypothesis,
an equal amount of dissension also exists. For example, investors, such as Warren Buffett
have consistently beaten the market over long periods of time, which by definition is
impossible according to the EMH.
Detractors of the EMH also point to events, such as the 1987 stock market crash when
the Dow Jones Industrial Average (DJIA) fell by over 22% in a single day, as evidence
that stock prices can seriously deviate from their fair values.
Combining the Random Walk Theory together with the Efficient Market Hypothesis,
we can possibly conclude that we can have three forms of the Hypothesis:

Weak Form of Efficiency

One of the different degrees of efficient-market hypothesis (EMH) that claims all past
prices of a stock are reflected in today's stock price. This weak form of efficient market
hypothesis is popularly known as Random Walk Theory. Therefore, if the weak form of
efficient market hypothesis is assumed to be true, then technical analysis cannot be
used to predict and beat a market.

The Semi-Strong Form of Efficiency

A class of Efficient Market Hypothesis says that current prices of stocks not only
reflect all informational content of historical prices, but also reflect all publicly available
knowledge about the companies being studied. Furthermore, the semi-strong form says
that efforts by analysts and investors to acquire and analyze public information will not
yield consistently superior returns to the analyst. Examples of the type of public
information that will not be of value to the analyst include corporate reports, corporate
announcements, information relating to corporate dividend policy, forthcoming stock
splits, etc. This is because, the theory believes that when the information is made publicly
available, it is absorbed and reflected in the stock prices i.e. all publicly available
information is discounted into a stock's current share price. Even if the adjustment is not
the correct one, the analyst would not be able to obtain consistently superior returns.
This is because, incorrect adjustments will not take place consistently - in other words,
some of the adjustments may be over-adjustments and others, under-adjustments. Thus,
the analyst will not be able to develop an effectIve trading strategy for consistent returns.
Tests of the semi-strong form of the Efficient Market Hypothesis have tended to provide
support for the hypothesis. These tests were indirect in nature - for example, price
movement was tracked after corporate action announcement, such as dividend or stock
split, etc.
Thus, according to this theory, neither fundamental nor technical analysis can be used to
achieve superior and consistent returns.

Strong Form of Efficiency

The strong form of efficient market hypothesis maintains that not only is publicly available
information not of any relevance for an investor or analyst to achieve consistently superior
34
returns, but that all information is completely useless. Specifically, no information that is Concepts and Cases
available; be it, public or "inside", can be used to earn consistently achieve superior
returns.
Testing the srrong form of efficient market hypothesis is possible be analyzing mutual
fund performance. Tests on floor traders (in the open outcry system) and profitability on
insider trading suggest that the possibility of excess profits exists for these two very
special groups of investors, who can use their special information to earn profits in
excess of normal returns.
The strong form of efficient market hypothesis states that two conditions are met:
• Successive price changes or return changes are identically distributed - i.e., these
distributions will repeat themselves over time.
• When news information is readily available, stock prices will instantaneously adjust
to reflect it.
Thus, all information in a market, whether public or private, is expected to be discounted
in the stock price. This degree of market efficiency implies that profits exceeding normal
returns cannot be made, regardless of the amount of research or information investors
have access to.
The more general efficient market model acknowledges that the markets may have
some imperfections, such 'is transaction costs, information costs, and delays in getting
pertinent information to all market participants. But it states that these potential sources
of market inefficiency do not exist to such a degree that it is possible to develop trading
systems whose expected profits or returns will be in excess of expected normal,
equilibrium returns or profits. In this case, equilibrium profits are defined as the excess
earnings generated from a simple buy-and-hold strategy.

Efficient Market Hypothesis in Indian Stock Markets

As per a study conducted on bonus issued in Indian stock markets between 1990-95, it
was found that the returns on shares of companies that issued bonus (stock dividend)
was as high as 60% over a period of four-and-half months before the announcement of
bonus. After the bonus issue date, the returns on the stocks were found to be insignificant.
This indicates the presence of efficient market hypothesis in the Indian stock markets.
Another study conducted on impact of budget on share prices indicates that the market
discounted most of the information in the stock prices, well before the announcement.
This is also an indication of efficient market hypothesis being relevant in Indian stock
markets.
But the extent of the strength of Efficient Market Hypothesis in Indian Stock Markets is
subject to debate, given the fact that many instances of seams as well as insider trading
have found to have provided profits to certain individuals.
Studies by Firth (1976, 1979, and 1980) in the United Kingdom have compared the share
prices existing after a takeover announcement. Firth found that the share prices were
fully and instantaneously adjusted to their correct levels, thus concluding that the UK
stock market was semi-strong-form efficient.
Weak form of efficiency does not require that prices remain at or near equilibrium, but
only that market participants will not be able to systematically profit from market
"inefficiencies as well as the bear market rally in March~April2009 are prime examples
of this form of market efficiency.

Modern Portfolio Theory: Concept of the Optimal Portfolio

The optimal portfolio concept falls under the modern portfolio theory. The theory assumes
(among other things) that investors fanatically try to minimize risk while striving for the
35

I
Introduetien to Financial highest return possible. The theory states that investors will act rationally and always
Markets making decisions aimed at maximizing their return for their acceptable level of risk.
The optimal portfolio was used in 1952 by Markowitz, and it shows us that it is possible
for different portfolios to have varying levels of risk and return. Each investor must
decide how much risk they can handle and than allocate (or diversify) their portfolio
according to this decision.
The Figure 2.1 illustrates how the optimal portfolio works. The optimal-risk portfolio is
usually determined to be somewhere in the middle of the curve because as you go
higher up the curve, you take on proportionately more risk for a lower incremental
return. On the other end, low risk / low return portfolios are pointless because you can
achieve a similar return by investing in risk-free assets, like government securities.

__ --- Optlmat portfOlIoJ should

._ tie on thIs C.UM!'(know as
i the "Elftcfent frontfel")

Portfollo's !l;Now tfIe OI1'11e arl!

not .ffI<:~t,bee.us. tor the
same risk one could /lChi_ •
area* return.

RiskI (Standard Deviation).

Figure 2.1: Optimal Risk Portfolio
An investor can choose the extent of risk - return payoff that he/she wants. The extent
of volatility the investor is willing to bear can determine the extent of returns earned.
This will give the investor, the maximum return for the amount of risk he/she wishes to
accept. Optimizing the portfolio returns is a complicated process, resulting in several,
permutations for building the portfolio. There are dedicated computer programs that
determine optimal portfolios by estimating hundreds (and sometimes thousands) of
different expected returns for each given amount of risk.

Activity 1
1) Define risk and return.

2) What is the relationship between risk and return?

36
3) What is the meaning of risk appetite? Concepts and Cases

......................................................................................................................
,,
/

4) Distinguish between systematic and unsystematic risk.

5) Differentiate between Market Risk, Credit Risk, Operational Risk and Liquidity
Risk.

...................................................................................................................... ,p

2.5 BASIC MARKET TERMINOLOGY AND

CONCEPTS
In this section, we shall discuss some of the basic concepts related to markets and the
terminology associated with trading.

Perfect Markets
A market is said to be perfect, when all the potential sellers and buyers are promptly
aware of the prices at which transaction takes place. Any buyer can purchase from any
, seller. The principle underlying perfect markets are as follows:
• Expectations that there must be a uniform price for anyone standardized asset or
instrument at a particular time, at anyone place.
• There should not be restriction on the movement of the asset.
• There must be a good number of buyers and sellers.

Imperfect Markets
Imperfect markets are where, some buyers or sellers both are not aware of the offers
made by others. Restrictions for movement of goods exist and different price, rule in the
market for the same at a particular time.
Monopoly market: It is a market situation, wherein there is only one seller of a
commodity.
Duopoly market: It has two sellers of a commodity in the market.
Oligopoly market: In this market there are more than two but still a few sellers of
commodity.
Monopolistic competition: A large number of sellers deal in heterogeneous and
differentiated form a corn

37

I
Introduction to Financial Long Position
Markets
The term long position refers to buying an asset or security. The reason for the word
"long" to be associated with buy is that traders usually are "longing" to take possession
bf an asset, when they have bought a futures or options contract.

Short Position
The word short position refers to the selling all asset or security. This is the opposite of
long.

Price- Taker
A price taker is an investor who trades based on buy/sell price .quoted by a bigger
established counterparty - also referred to as the market maker (or price maker). The
price taker's trades do not have a significant impact on the market price movements.
This is because price takers usually do not trade in high volumes or may be restricted by
regulation. A firm that can alter its rate of production and sales, without significantly
affecting the market price of its product is also a price-taker. In the context of the
securities markets, individual investors are price-takers .

. Market Maker
Market Maker refers to a broker-dealer firm that accepts the risk of holding a certain
number of shares of a particular security, in order to facilitate trading in that security.
Each market maker competes for customer order flow by displaying both buy and sell
quotations for a guaranteed number of shares. Once an order is received, the market
maker immediately sells from its inventory or seeks an offsetting order. This process
takes place on electronic trading platform in less than a second.
The NASDAQ is the prime example of an operation of market makers. There are more
than 500 member firms that act as NASDAQ market makers, keeping the financial
markets running efficiently because they are willing to quote both bid and offer prices
for an asset. Market makers are vital to the efficiency and liquidity of the marketplace.
By quoting both bid and ask prices on the market, they always allow investors to buy or
sell a security if they need to.

Bid
Bid is an offer made by an investor, a trader or a dealer to buy a security. The bid will
stipulate both the price at which the buyer is willing to purchase the security and the
quantity to be purchased.
Bid is also the price at which a market maker is willing to buy a security. The market
maker will also display an ask price, or the amount and price at which it is willing to sell.
This is the opposite of "Ask", which stipulates the price a seller is willing to accept for
a security and the quantity of the security to be sold at that price.
An example of a bid in the market would be Rs. 1,300 for buying 1 share of say, Reliance
Industries Limited. This means that an investor is willing to purchase 1 share at the price
of Rs. 1,300. If a seller in the market is willing to sell 1 share for that price, then the
order is executed into a trade.

Ask
The ask price is the price that a seller is willing to accept for an asset / security, also
known as the offer price. Along with the price, the ask quote will generally also stipulate
the amount of the security willing to be sold at that price.

38
This is the opposite of bid. The ask price will always be higher than the bid. The terms Concepts and Cases
"bid" and "ask" are used in nearly every financial market in the world covering stocks,
bo.ids, currency and derivatives. An example of "Ask" in the stock market would be for
example, Rs. 1,301 quoted for selling 1 share of Reliance Industries Limited. This means
that the seller is offering to sell 1 share for Rs. 1,301.

Best Bid
The Best bid (best buy quote) is the highest of all buy quotes. Simply put, this is the
highest price someone is willing to pay for buying an asset/security.

Best Ask
The best ask (best sell quote) is the lowest of all sell quotes. In layman's terms, this is
the lowest price at which the seller of asset/security is willing to sell.

Bid-Ask Spread
The bid-ask spread is the difference between the best buy quote and best sell quote.
Consider the following snapshot of the best 5 buy quotes and best 5 sell quotes for the
Gold futures contract being traded (quotes in Rs. per 10 grams).

HI&.Q)
N'/e.Q)

, ~"'.Q)
~'. • ./JO

......~ 11 10
~
...".;
4I2).QO.
'-'ml.oo
7m.oo
,..,.,.00

The best buy quote is Rs. 9637 and the best sell quote is Rs. 9640.
Thus, the bid-ask spread is Rs. 3.

Insider Information
Insider information is material information about a company's activities that has not
been disclosed to the public. It is illegal for anyone with access to insider information to
make trades based on it.

Insider Trading
The buying or selling of a security by someone who has access to confidential material
/ non-public information about the security is usually referred to as Insider Trading.
Insider trading can be illegal or legal depending on when the insider makes the trade: it
is illegal when the material information is still non-public, i.e., the insider has indulged in
trading while having specific knowledge of the business activities or plans of the company.
This is unfair to other investors, who do not have access to such information. Illegal
insider trading therefore includes tipping others when you have any sort of non-public
information.
Insider trading is legal once the material information has been made public, at which
time the insider has no direct advantage over other investors. SEBI requires all insiders
to report all their transactions. So, as insiders have an insight into the workings of their
company, it may be wise for an investor to look at these reports to see how insiders are
legally trading their stock.
39

I
Introduction to Financial Market Timing
Markets
Market timing is described as the act of attempting to predict the future direction of the
market, typically through the use of technical indicators or economic data.
The practice of switching among mutual fund asset classes in an attempt to profit from
the changes in their market outlook can also be called as market timing.
Some investors, especially academics, believe it is impossible to time the market. Other
investors, notably active traders, believe strongly in market timing. Thus, whether market
timing is possible is really a matter of opinion.
It is very difficult to be successful at market timing continuously over the long-run. For
the average investor who doesn't have the time (or desire) to watch the market on a
daily basis, there are good reasons to avoid market timing and focus on investing for the
long-run.

Market Value and Price

Markets exist to determine price for an asset. If the investors are of the view that the
security would be in demand the prices would rise and if they are of the view that supply
for the asset is high then the prices would fall. Information about the demand and supply
of an asset or a security helps the market players to make their investment decisions this
in turn helps discovery of prices in the market.
An asset value is the intrinsic value an asset gains by the benefits it provides to the
investors or the value it gains due to the productivity of a firm. For example - A
company which is performing well in operations will be valued high by the investors and
thus would be pursued by the investors whereas a company with poor operations might
not be valued as high as the former company. The price for an asset is determined by
the value which investors attach to it.

Broker- Dealer
A person or firm in the business of buying and selling securities operating as both a
broker and a dealer depending on the transaction is referred to as a broker-dealer.
Technically, a broker is only an agent who executes orders on behalf of clients, whereas
a dealer acts as a principal and trades for his or her own account. Because most
brokerages act as both brokers and principals, the term broker-dealer is commonly used
to describe them.

Primary Dealer
A pre-approved bank, broker/dealer or other financial institution that is able to make
business deals with the central bank (RBI), such as underwriting new government debt.
These dealers must meet certain liquidity and quality requirements as well as provide a
valuable flow of information to the RBI about the state of the financial markets.
These primary dealers, which all bid for government securities competitively, purchase
the majority of Treasuries at auction and then redistribute them to their clients, creating
the initial market in the process.

Fundamentals
Information is qualitative and quantitative in nature that contributes to the economic
well-being and the subsequent financial valuation of a company, security or currency.
Analysts ~d investors analyze these fundamentals to develop an estimate as to whether
the underlying asset is considered a worthwhile investment. For businesses, information
such as revenue, earnings, assets, liabilities and growth are considered some of the
fundamentals. By looking at the economics of a business, the balance sheet; the income
40
statement, management and cash flow, investors are looking at a company's fundamentals, Concept and Callell
which help determine a company's health as well as its growth prosp cts. A company
with little debt and a lot of cash is considered to have strong fundamentals.
Fundamentals are most often considered factors that relate to businesses. Securities
and currencies also have fundamentals. For example, interest rates, GDP growth, trade
balance surplus / deficits and Inflation levels are some macroeconomic factors that are
considered to be fundamentals of a currency's value.

Novation
Novation is a term conceptualized by exchanges to minimize counterparty risk or credit
risk. In a transaction, the buyer has an obligation to take the delivery of the traded
security in exchange for funds being paid to the seller while the seller has an obligation
to give the delivery of the security in exchange of funds accepted from the buyer. If
either of the counter party fails to honor his or her obligation the transactions fails. The
risk arising out of the defaulting counterparties is termed as Counterparty risk or Credit
Risk. The exchange operates to mitigate this risk by replacing the obligations of the
counterparty by its own obligation i.e., it serves as a buyer to the seller or seller to the
buyer and hence ensures completion of the transaction. By this mechanism it allows
, smooth processing of trades contributing efficiency to the trading cycle.

Clearing
Clearing is one of the links of a trading cycle. Clearing serves to consolidate transactions
or trades and then it computes the obligations that need to be settled. It uses multi lateral
netting to do this. Clearing thus helps to reduce transaction costs and improves operating
efficiency by employing multi lateral netting in the clearing process, In a trading cycle
the clearing process takes T+1 i.e, 1 day after the trading day.

Transparency due to Automated Trading

Today, Indian capital markets follow screen based trading provided by the stock exchanges
which have made the markets transparent than before which used an open outcry system
to trade. Open outcry systems allowed the traders to use different prices to conduct a
favorable trade. But screen based trading allows uniform determination of prices which
helps mitigatin any informational asymmetry among th market participants. Thu ,
electronic syst ms have contributed towards improving efflc] ncy,

trading eyel
Trading Cycle is the process followed by the exchanges to carry out trades. Today
Indian Markets follow a T+2 trading cycle which comprises trading period, clearing,
settlement and post settlement period. Post settlement periods may vary depending
upon the outcome of settlement in case of failure to deliver then the trading cycle would
comprise of auctions and other related processes and would take up to 9 days depending
upon the outcomes.

Price Discovery
Price discovery refers to the method of determining the fair value of a specific commodity
or security. When large number of participants converge at a marketplace - it may be
noted tat the marketplace may be a physical marketplace or an electronic trading platform
- a continuous auction process between the buyers and sellers leads to creation of
active demand supply interest in the asset (security / financial instrument). This leads to
the discovery of the fair value of the asset.

41

I
Introduction to Flnanelal DI81ntermedlatlon
Markets
Disintermediation is the removal of intermediaries which help to mediate funds from the
savers to the borrowers. Disintermediation provides direct access for the borrowers to
directly borrow from the investors. For example - By issuing bonds a firm can borrow
funds to finance its projects without approaching the banks this allows the issuer of
securities to borrow at lower costs. Disintermediation thus creates a lot of opportunities
.for firms like investment banks to help these firms in capital raising decisions.

Public Interest in Context of Competition Issues and Mergers

In a market, an individual chooses to trade in a particular stock thinking that he/she
would benefit from the trade in terms of high returns. He/she makes investment decisions
depending upon how he evaluates the firm and whether he/she would be able to derive
value from its operations. If a new firm is more productive than the company in which
he/she is investing he might exit the firm and buy shares of the other firm. A merger or
a takeover would mean change in management or structure of the firm. An investor is
offered an opportunity to exit at the prevailing price depending upon how he views the
proposal. If he/she feels the merger would add value to the firm by increasing productivity
and employing good management practices then he would prefer to keep the stock with
himself but if he thinks otherwise he would prefer to do away with the shares and would
sell them.

Fungibility
Fungibility refers to the property/characteristic of a good or asset that describes its
interchangeability with other individual goods/assets of the same type. Assets possessing
this property simplify the exchange/trade process, as interchangeability assumes that
everyone values all goods of that class as the same.
Example: Shares trading in NSE and BSE in the cash segment are fungible - because
you 'can buy in NSE and sell in BSE or vice versa.

Equplity uf Treatment
Equality of treatment stresses that all shareholders should be treated equally Often it is
found during times of'takeovers, smaller (retail) shareholders are not treated equally, To
discourqge the same, SEBI came up with the Takeover Code in 1997. This ensured that
the minority shareholders' interests are protected as follows:
• There is fair and truthful disclosure of all information relating to the takeover.
• Shareholders get enough time to make informed decisions.
• No false market in the shares of the companies is created.
• Shareholders' approval is taken for any action by the target company.
However, there have been several criticisms of the regulation of takeovers. Financial
Institutions have been permitted to fund takeovers by foreign companies and this has
come under criticism - a little erroneously because any change of management that
leads more efficient management deserves to be encouraged. Secondly, figures show
that only 17.6% of corporate restructuring has been through open offers, indicating that
exemptions have been more common than the rule of open offers.

Agency Theory
Agency theory explains the relationship between principals (owners), such as a
shareholders, and agents, such as a company's executives. In this relationship, the principal
delegates or hires an agent to perform work. The theory attempts to deal with two
specific problems: first, that the goals of the principal and agent are not in conflict
42
(agency problem), and second, that the principal and agent reconcile different tolerances Concept8 and CIM
for risk, For example, a manager opting for a risky investment, whereas majority of the
shareholders are against it.

performs

Agency Theory (P: Principal, A: Agent)

Behavioral Finance
Behavioral Finance is one of aspects of finance which explains different stock market
events or happenings that come to light as an outcome of investor sentiments. Capital
Markets are platforms which have emerged from buyers and sellers who have varied
perceptions about how the prices or asset values would move. Investors take decisions
depending upon their know how of the asset demand and supply in the market. In other
words one can say that a market's existence relies on what investors or the market
participants think of the assets.
If all the investors think that if the prices of certain assets increase, then this would
impact the overall market, which would follow in tandem, and vice versa, Behllvioral
Finance uses a number of psychological tools to analyze the investment strategies used
by investors and their effectiveness,
The Herd Instinot is another market-phenomenon characterized by a lack of individuality,
causing people to think and act as the general population does, This term ill used in the
investing world to refer to the forces that cause unsubstantlated rallies orsell·offs.
We have -discussed some of the important terminology associated with markets and
trading this section. For analyzing information dissemination in financial markets and
their impact on asset prices, it is important to understand the theory associated asymmetry
of this information. In section 2.6, we shall analyze the "contract theory" and the
implications of information asymmetry.

2.6 CONTRACT THEORY

Contract theory studies the mechanism by which economic entities undertake contractual
obligations in the presence of information asymmetry - which can in turn lead to adverse
selection and moral hazard.

Information Asymmetry
This refers to the situation when one party to a transaction has superior information as
compared to the other counterparty. This often happens in transactions where the seller
knows more than the buyer, although the reverse can happen as well.
43

I
 . "

Introduction to Financial Potentially, this could be a harmful situation because one party can take advantage of
Markets the other party's lack of knowledge.
With increased advancements in technology, asymmetric information has been on the
decline as a result of more and more people being able to easily access all types of
information.
Information Asymm try can lead to two main problems: Adverse Selection and Moral
Hazard
Adverse Selection: This refers to the situation when immoral behaviour takes advantage
of asymmetric information before a transaction is completed. For example, a trader
who has inside information that a particular company is to announce liquidation might be
tempted to sell the company's shares.
Moral Hazard: Immoral behavior that takes advantage of asymmetric information
after a transaction is completed.
For example, in the recent period of global economic crisis, the US Government has
resorted to bailing out banks and insurance companies by providing capital. For example,
AIG, one of the largest insurers in the world was taken over by US Government and
provided with funds. Subsequent to this, there is always a risk that certain banks may
decide to increase lending based on the fact that any future losses would automatically
be funded by the US Government. This moral hazard has potential to emerge in the
system. Appropriate checks and balances need to be maintained. In the case of AIG,
bonus was issued to employees from the bailout funds given by the US Government,
which was a burden to the tax payer. This resulted in a few employees gaining at the
expense to the tax-payer and US Government.

Akerlof's Lemons
Akerlof's 1970 essay, "The Market for Lemons" is one of the most important studies in
economics of information and importance of information symmetry. He analyses a market
for an asset where the seller has more information than the buyer regarding the quality
of the product.
This is explained by referring to the market for used cars (Akerlof uses the word.
"L m n'' to r ~ r to ad u ctiv old car). Akerlof''a "1 mon ffeet" points out that when
a car own r tri Il to sell his brand new us d car which has b n driv n for only a f w
kllomet f8, he has to accept !lignificantly r due d pl'ic b caus now th r is an
asymm try of information between sell r and potential uyer about th quality of a used
car.
The latter fears that the reason the owner wishes to sell is because the car is a 'lemon,"
while even if it is not, there is no way the owner can give this information to the buyer.
At the same time demonstration cars which are tationed at dealer's shop, sell at a
relatively smaller discount because the dealer can stilI attach the producer's warranty
to it.
Another example is, assume that you purchased a new automobile. You have paid the
dealer the full price of a new car. Now, after 1 week, you decide to resell this new car
- which you have not driven around at all. The market price that the car fetches would
definitely be at a discount to the new car's showroom price. This is because the prospective
buyer would have doubts about the asset's performance, because the car is no longer
new - even though it is only a week old.
Similarly, if one compares the credit market in India, in the 1960's, local lenders charged
interest rates that were twice as high as the rates in large cities. They took advantage of
the non-availability of information to the rural areas, as well as operational difficulty in
44
disbursement of credit to the grassroots 1 vels of the society. This emphasizes the need Concepti and Cases
for Government and public financial institutions / banks to take adequate measure to
reduce information asymmetry. Lately, this has been largely off et with the emergence
of banking I developmental I microfinance institutions in rural India. By better information
dissemination, it i possible for the public ector banks to communicate the prevailing
rate of intere t to the rural population who require credit towards agricultural activities.
Thus, according to Akerlof, 'many market in titutions may be regarded as emerging
from attempts to resolve problems due to a ymmetric information.
Discussion of theoretical concepts of risk. associated relationship with returns as well
as information asymmetry is incomplete unless practical circumstances in the form of
case studies are analyzed. In section 2.7, let us under tand some of the events of historical
significance, that hav impacted not only the Indian financial markets but the global
financial system as a whole.

Activity 2
1) Differentiate between perfect and imperfect markets.

2) Who is a market maker?

2.7 CASES: EVENTS OF HISTORICAL

SIGNIFICANCE
A bubble (with specific reference to financial markets) is an economic cycle
characterized by rapid expansion followed by a contraction. It is a surge in asset prices,
often more than warranted by the fundamentals and usually in a particular sector. A
market bubble is usually followed by a drastic drop in prices as a massive sell off occurs.
The bubble theory asserts that security prices rise above their true value and will continue
to do so until prices go into freefall and the bubble 'bursts.
Bubbles occur in economies, securities, stock markets and business sectors because of
a change in the way the market participants conduct business. This can be a real change,
as occurred in the bubble economy of Japan in the 1980s when banks were partially
deregulated, or a paradigm shift, as happened during the dotcom boom in the late '90s
and early 2000s. During the boom people bought tech stocks at high prices, believing
they could sell them at a higher price until confidence was lost and a large market
correction, or crash, occurred. Bubbles in equities markets and economies cause resources
to be transferred to areas of rapid growth. At the end of a bubble, resources are moved
again, causing prices to deflate. Thus, there is little long-term return on those assets.
More recently, the housing markets bubble burst in the developed markets. This was
also due to the sub-prime mortgage crisis - which was the result of increase in interest
rates (US Fed rates) from 1% in June, 2004 to 5.25% in June, 2006.

45

I
Introdue&lon to I'IIIIIJGIII CASE 11 Th Or t D prIM Ion of 1929
M rkltl
The loek MlU'keter IIhof 1929 wa marked by Ilsever downturn in quity prie s thllt
oceurred in October of 1929 in th Unit d tates, tlnd which marked the end of the
"RoMn Tw nties." The crallh of 1929 did not occur in one day, but was spreed out
over a two-week period beginning in mid-October.

The first portion of the crash occurred on October 24, a day known as Black Thursday.
The "following week brought Black Monday (act. 28) and Black Tuesday (act. 29),
when the Dow Jones Industrial Average (commonly referred to as the DJIA) decreased
...more than 20% over those two days. Pre-existing selling pressures and fear in the stock
market were exasperated by a flood of sell orders that shut down the ticker-tape service
that provided stock prices to traders. With key information missing from the markets,
selling intensified even further.
Despite a few attempts at recovery, the stock market continued to languish, eventually
falling almost 90% from its peak in 1929. The period preceding the decline in October,
1929 witnessed equity prices increasing to all-time high multiples of more than 30 times
earnings. The benchmark DJIA had increased 500% in just five years. This type of
hyper-growth has shown itself to be unsustainable over time, as markets generally perform
their best when they can grow steadily.
It took over 25 years for the DJIA to get back to the highs of the 1929 market, as the
V.S. economy suffered through what we now call the Great Depression. Major new
legislative and regulatory changes were enacted following the speculative bubble and
crash of the 1920s in an effort to prevent the same situation from happening again.

CASE 2: Stock Market Decline in 1987

A rapid and severe downturn in stock prices occurred in late October of 1987. After
five days of intensifying stock market declines, selling pressure hit a peak on October 19
(commonly referred to as the known as Black Monday of 1987). The DJIA fell a record
22% on that day alone. Trading was halted in many stocks during the day as order
imbalances prevented true price discovery.
The exact cause of the crash has been analyzed by many experts. This was a rare
phenomenon in that the market made up most of its losses rather quickly, rather than
preceding a protracted economic recession. Some people point to the lack of trading
curbs. Some of the experts have identified the source of decline as the algorithmic 1
trading softwares in place at the time. The period before October, 1987 saw the DnA
more than triple in five years. The price-earnings (PIE) multiples on stocks had reached
above 20, implying very bullish sentiment. And while the crash began as a V.S. i
phenomenon, it quickly affected stock markets around the globe; 19 of the 20 largest ~
markets in the world saw stock market declines of 20% or more.
Investors and regulators learned a lot from the 1987 crash, specifically with regards to
the dangers of automatic or program trading. In these types of programs, human decision-
making is taken out of the equation, and buy or sell orders are generated automatically
based on the levels of benchmark indexes or specific stocks. In a disorderly market,
human intervention is required more than ever to assess the actual situation.

CASE 3: Collapse of the Long-Term Capital Management (LTCM)

This case refers to a large hedge fund led by Nobel Prize-winning economists and
renowned ~all Street traders that nearly collapsed the global financial system in 1998
as a.result of high-risk arbitrage trading strategies.

46
 'I

ThQfund farmed in 199~ and wa found d by r n wned elomon Broth rs bond trlld",r Concepti lod C
John Merlwether,
LTCM started withJu!lt over USD 1 billion in initial as ets and focused on bond tradins.
The trading strate y of the fund was to make C nv rgenc trade. which involve taking
advantage of arbitrage betw en securides that are incorrectly priced relative to each
other. Due to the small spread in .arbltrage opportunities, the fund had to leverage itself
highly to make money. At its height in 1998, the fund had USD 5 billion in assets,
controlled over USD 100 billion and had positions whose total worth was over a USD 1
trillion,
Due to its highly leveraged nature and a financial crisis in Russia (i.e., the default of
government bonds) which led to a flight to quality, the fund sustained massive losses and
was in danger of defaulting on its loans. This made it difficult for the fund to cut its
losses in its positions. The fund held huge positions in the market, totaling roughly 5% of
the total global fixed-income market. LTCM had borrowed heavily to finance its leveraged
trades. Had LTCM gone into default, it would have triggered a global financial crisis,
caused by the massive write-offs its creditors would have had to make. This would
have led to cascading effect (ripple effect) across the entire global financial markets.
In September, 1998, the fund, which continued to sustain losses, was bailed out with the
help of the Federal Reserve and its creditors took over its operations. A systematic
meltdown of the market was thus prevented.

CASE 4: The Indian Stock Markets in 1992

India had its fare share of turmoil, as a result of systemic deficiencies in processes and
financial systems. One such case was the stock market seam of 1992.
Harshad Mehta was an Indian stockbroker and is alleged to have engineered the increase
in share prices of the BSE in 1992. Exploiting several loopholes in the banking system,
Harshad Mehta and his associates siphoned off funds from inter-bank transactions and
bought shares heavily at a premium across many segments, triggering an increase in
Sensex (index of BSE).
When the scheme was exposed, the banks started demanding the morley back, causing
the collapse. Harshad Mehta was later charged with 72 criminal offenses and more
than 600 civil action suits were filed against him. He died in 2002 with many litigations
.still pending against him.
This incident exposed the dubious ways of accessing funds from the banking system to
finance share purchase. The mechanism through which the seam was effected was the
Ready Forward (RP) deal. The RP is in essence a secured short-term (typically 15-day)
loan from one bank to another. A bank lends against government securities just as a
pawnbroker lends against jewellery. The borrowing bank actually sells the securities to
the lending bank and buys them back at the end of the period of the loan, typically at a
slightly higher price. Ready-Forward deals were used to channel money from the banking
system into financial markets. Ready forward deals involve two banks brought together
by a broker in lieu of a commission. The broker handles neither the cash nor the securities,
though that wasn't the case in the lead-up to the seam.
In this settlement process, deliveries of securities and payments were made through the
broker. That is, the seller handed over the securities to the broker, who passed them to
the buyer, while the buyer gave the cheque to the broker, who then made the payment to
the seller. In this settlement process, the buyer and the seller might not even know
whom they had traded with, either being known only to the broker.
The brokers could manage primarily because by now they had become market makers
and had started trading on their account. To keep up a semblance of legality, they
pretended to be undertaking the transactions on behalf of a bank.
47

I
Introduction to Plnancl I Another instrument used in a big way was the "Bank Receipt" (BR). In a ready forward
Markets deal, securities were not moved back and forth in actuality. Instead, the borrower, i.e.,
the seller of securities, gave the buyer of the securities a BR. A BR confirms the sale of
securities. It acts as a receipt for the money received by the selling bank, hence the
name "Bank Receipt". It promi es to deliver the ecurities to the buyer. It al 0 states
that in the mean time, the seller holds the securities in trust of the buyer."
Two banks, the Bank of Karad (BOK) and the Metropolitan Co-operative Bank (MCB),
were alleged to have issued BRs as and when required, for a fee. Once these fake BRs
were issued, they were passed on to other banks and the banks in turn gave money to
the broker. The banks lending money against BR assumed that they were lending against
government securities and the BR were legitimate. This money was used to drive up the
price of stocks in the stock market. When time came to return the money, the shares
were sold for a profit and the BR was retired. The money due to the bank was returned.
Once the seam was exposed, though, a lot of banks were left holding BRs which did not
have any value. The banking system suffered loss of approximately Rs. 4,000 crores.

CASE 5: Indian Stock Markets in 2001

Another similar incident was the stock market seam which occurred in 2001.
The seam unfolded as the stock market crashed on 1st March, 200l. It was alleged that
Ketan Parekh was involved in this incident. He is said to have serviced his network of
clients by buying huge stakes in several companies. These stocks were bought at low
prices and pledged as collateral for funds when they gained value in the market.
A cooperative bank provided funding for the huge stakes kept as collateral. Funds were
accessed through the pay orders and borrowings from the bank. The pay orders affected
a number of public sector banks also. When the stock markets crashed in March, 200 1,
the SENSEX declined by 23% and the stocks purchased declined by 70% ..
Unanticipated volatility in stock markets led to liquidity problems. Even the Calcutta
Stock Exchange had to bear the brunt of this scam due to its lack of regulation which
allowed illegal badla practices.
SEBI implemented various measures in the trading system to monitor such unhealthy
practices to safeguard the interest of the investors like banning of Badla System which .
was replaced by Rolling Settlement by mid 2001, by imposing deposit margins and
restrictions on short sales.

CASE 6: Global Credit Crisis of 2008

The increase in interest rates by the United States Federal Reserve (commonly referred
to as US Fed), from 1% in June 2004 to 5.25% by June, 2006, led to a cascading effect
on the Housing markets in US. By this time, there was a housing market bubble that
was created due to lending to sub-prime borrowers. These sub-prime borrowers are a
class of investors who did not have a substantially high individual credit rating.
Nevertheless, many mortgage loans were issued to this class of investors, due to increasing
housing rates and low interest rates.
Thus, when the interest rates increased, there was an immediate decline in demand of
new-home sales and even existing-home sales declined in US. The housing market
bubble collapsed, leading to decrease in home rates. The high interest rates also resulted
in increasing default by home loan borrowers. The mortgage loans which used the high
value of the houses as collateral were unsustainable, because the secured asset's value
itself declined. This led to a cascading effect on the global economy. High interest rates
also led to decreasing bond prices, resulting in losses for investment banks which had
too much exposure to financial assets.
48
Lehman Brothers, which was one of the largest investment banks in the world, with Concepts and Cases
over USD 600 billion in exposure to financial assets suffered huge losses. These huge
losses were a result of decreasing bond prices and unreasonable valuation of exotic
derivative instruments such as Credit default Swaps which were executed in the over-
the-counter markets. Lehman could not unwind its exposures to such financial assets
and derivative instruments. This was because there were no takers for such high-risk
assets. This led to margin calls on Lehman. Subsequently, Lehman filed for bankruptcy.
The US Governrnent did not intervene in the collapse of Lehman, thus increasing the
counterparty default risk for the entire market. All institutions which executed deals
with Lehman were exposed to risk of default by Lehman. This led to a huge selloff in
financial markets. Equity, commodity and currency markets were impacted due to this
event. The global financial markets were even more impacted because, it was not clear
as to which institution in the world has executed contracts with Lehman.
The credit crisis necessitated the United States Governrnent to institute crisis-funding
(bailout) of specific banks / financial institutions. The terms of the funding ensured that
such institutions abided by strict regulations as laid down by the US Fed, the US Congress
and the regulators such as Securities Exchange Commission (SEC), etc.
Thus, we have analyzed some of the major events that have caused volatility and
increased risk in the global financial markets. Theoretical concepts are usually incomplete
without a brief background of the quantitative techniques for measuring risk. In section
2.8, let us analyze the basic quantitative techniques for measuring risk.

Activity 3
1) What is the difference between bid and ask?

2) Explain briefly the concept of Agency theory .

••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• .,!••••••••••••••••••••••••••••••••••••••••••••••••••••

2.8 BASIC QUANTITATIVE TECHNIQUES FOR RISK

MEASUREMENT

Quantifying Risk
Risk is usually measured by calculating the standard deviation of the historical returns or
average returns of an asset / portfolio investment returns over a period 'of time. Standard
deviation is the extent of deviation of a set of values, say the NIFfY on a daily basis
from the mean (average). Volatility is the measure of the extent of uncertainty in prices
remaining the same over a given period of time.

Historical Volatility
The deviation in returns over a historical time period for any particular asset is referred
to as historical volatility. Daily historical volatility is usually measured
as the standard deviation of the log normal daily returns of an asset over a
period of time.
49

I
 Introduction to Financial
Hypothetical example: Calculation of Historical Volatility for spot
Markets
USDINR rate
1) Consider the USDINR spot reference rate in an excel sheet for a specified period
of time.
2) Calculate the daily log normal returns by using the formula
Tt= LN(S/St_l)
Where:
rt is the Log Normal return
St is the Price of the Ass t at time t
St.l is the Price of the Asset at time t-l

3) Use the formula STDEVP (numbed, number2 ... )

.v.or calculate using the following formula:
Standard Deviation is calculated using the formula:

p:'(xn-i)'
Where:

i' - Average (mean) of all asset values in the time series data

x - Individual asset value of the time series data

n - Number of observations

4) To convert daily volatility into annualised volatility, multiply the daily volatility by
square root of 252 ANNUALIZED HISTORICAL VOLATILITY = DAILY
HISTORICAL VOLATILITY X (SQRT(252»
For example, consider the following time series data:
Calculation of Log-normal Returns and Standard Deviation

Date NIFIY LN(St/St-l)

3-Mar-08 4953.00 -
4-Mar-08 4864.25 -0.018080912
5-Mar-08 4921.40 0.Q11680502
7-Mar-08 4771.60 -0.030911364
10-Mar-08 4800.40 0.006017569
Il-Mar-08 4865.90 0.013552446
12-Mar-08 4872.00 0.001252837
13-Mar-08 4623.60 -0.052330908
14-Mar-08 4745.80 0.026086394-
17-Mar-08 4503.10 -0.052493968
18-Mar-08 4533.00 0.006617923
19-Mar-08 4573.95 0.008993192
24-Mar-08 4609.85 0.007818154
25-Mar-08 4877.50 0.056437475
26-Mar-08 4828.85 -0.010024449
27-Mar-08 4830.25 0.000289882
28-Mar-08 494-2.00 0.022871881
31-Mar-08 4734.50 -0.042893983
50
 Concepts and Cases
Standard Deviation (Daily) 2.82%
2.82% x sqrt(252) = 0.0282 x 15.8745
=44.766%
Standard Deviation (Annual) I 44.766% I

2.9 SUMMARY
Risk is the extent of uncertainty associated with the outcome of an event. Risk
management is an extremely important activity in the process of investment management
and business activity. The different types of risk such as operational risk, market risk,
credit risk, liquidity risk, etc. needs to be identified and mitigated.
In any market it is important to understand the extent of influence of the Efficient
Market Hypothesis (EMH) theory. The "Contract Theory" that elucidates on the concepts
of Moral hazard and Information Asymmetry need to be applied in the Indian Financial
Markets. The major events of historical significance such as the Great Depression of
1929, Black Monday of 1987, Global Credit crisis of 2008 and the events which led to
stock market declines in 1992 and 2001 have been discussed.
In Unit 3, we shall identify the different types of markets in the Indian Financial System
and their characteristics.

2.10 SELF ASSESSMENT QUESTIONS

1) How can you manage risk?
2) List down the major risks associated with the Indian Financial Markets.
3) What is price discovery?
4) What is the meaning and significance of Agency Theory? Explain with a diagram.
5) Explain the concept of bid and ask prices. What is the meaning of bid-ask spread?
6) How can you measure volatility?
7) What is the Capital Asset Pricing Model (CAPM)?

2.11 FURTHER READINGS

1) Fischer, Donald E., Jordan, Ronald J. (2004), Security Analysis and Portfolio
Management, Prentice Hall.,
2) Fabozzi, Frank J., Modigliani, Franco (2003) Capital Markets: Institutions and
Instruments, Prentice Hall.
3) Eugene, F. Fama et al, (February 1969), The Adjustment of Stock Prices to New
Information, International Economic Review 10, no I, pp. 1-21.
4) Lorie H. James, Niederhoffer, Victor (1968) Predictive and Statistical Properties
of Insider Trading, Journal of Law and Economics 11, pp. 35-53.
5) Scholes, Robert (April 1972), The Market for Securities: Substitution Versus
Price Pressure and the Effects of Information on Share Prices, Journal of
Business, Vol. 45, No. 2.
6) Thomas, Susan, (Feb 18, 2009) Efficient Markets Hypothesis of Speculative
Markets - Part 1 and 2.

51
Introduction to Financial ANNEXURE 1
Markets

DifferentJypesofEtisk

• Accounting risk
• Liquidity risk
• Bankruptcy risk
• Market risk
• Basis risk
• Modeling risk
• Call risk
• Optional risk
• Capital risk
• Personnel risk
• Collateral risk
• Political risk
• Commodity risk
• Prepayment risk
• Contract risk
• Price Risk
• Counterparty Default risk
• Publicity risk
• Currency risk
• Raw data risk
• Curve construction risk
• Regulatory risk
• Daylight risk
• Reinvestment risk
• Equity risk
• Rollover risk
• Extrapolation risk
. • Suitability risk
•• Hedging risk
• Systemic risk
• Horizon risk
• Systems risk
• Interest rate risk
• Tax risk
• Interpolation risk
• Technology risk
• Knowledge risk
• Time lag risk
• Legal risk
• Volatility risk
• Limit risk
• Yield curve risk

52
UNIT 3 TYPES OF MARKETS
Objectives
After studying this unit, you should be able to:

• identify the different types of markets;

• understand the difference between primary markets and secondary markets, over
the counter markets and exchange traded markets;
• know the characteristics of different markets - money markets, debt, equity,
currency and commodity; and
• appreciate the significance of different markets .
.•. """
Structure
3.1 Introduction
3.2 Money Markets
3.3 Capital Markets
3.4 Debt Markets
3.5 Equity Markets ,.
3.6 Foreign Exchange (Currency) Markets
3.7 Commodity Markets
3.8 Derivatives Markets
3.9 Other Classifications of Markets
3.10 Summary
3.11 Self Assessment Questions
3.12 Further Readings

3.1 INTRODUCTION
The economy of a country depends on the fundamental mechanism of savings and
investment of financial capital, leading to sustainable growth and development. The
impetus for the economic activities as a result of the flow of funds is provided by entities
that have surplus funds to other entities seeking funds. For effectively implementing this
mechanism, it is critical to develop "markets".
A market is a place where buyers and sellers meet to exchange goods, services or even
financial products / instruments for a consideration. This consideration is usually money.
Markets can also be defined as channels through which buyers and sellers exchange
goods, services and resources. There are broadly three types of markets:
• A product market where goods and services are traded,
• A factor market where labour, capital and land are exchanged ;and
• A financial market where financial claims are traded.
The broad classification of the different types of markets in the Indian Financial System
is illustrated in Figure 3.1:

53

I
Introduction
to Financial Financial Markets in
Markets India
.•--_ ..
I
I I r+:':

Money Capital Curr enc y Commodity

Markets Markets Market s Markets
I
I I

Debt Equity
Markets Markets
_. ._-" ...... -

Figure 3.1: Indian Financial Systems

Thus, the different types of markets may be broadly classified as Money Markets,
Capital Markets, Debt Markets, Equity Markets, Currency Markets and Commodity
Markets. Detailed discussion of each of these markets is provided in the different sections
of this unit. But before we discuss each of these markets, it is important to understand
the evolution of a market and marketplace.

Emergence of the concept of Markets and Marketplaces: Historical Perspective

The history of markets dates back more than five thousand years in the present day Iraq
(also referred to as the "Fertile Crescent" in ancient Mesopotamia), when camels and
donkeys were used to carry goods - including precious stones, ivory, weapons, etc. -
between the ancient cities of Babylon and Ur. From time immemorial, man has felt a
need to exchange goods. The desire to trade (initially goods were bartered - exchange
of one good for another of equivalent values as perceived and agreed upon by the buyer
and seller - when the concept of currency did not exist) led to the formation of
marketplaces - where buyers and sellers meet.
Incidentally, the development of trade and establishment of markets in the ancient
civilizations resulted in the development of culture. Writing originated as a means of
recording information pertaining to economic activity. The earliest method of recording
information was by making "tally marks" on baked clay. These marks were made to
record the inventory of grain, livestock, oil and other goods that were traded. These
written records were used by tax collectors and merchants. Mathematics also originated
in this era, to compute the costs and set prices. The "wheel" was also invented to
facilitate faster movement of goods between different locations. Thus, trade and
development of markets led to growing commerce and evolution of knowledge, culture
and technology.
Another example of existence of markets in ancient period is the central marketplace in
Agora in ancient Athens. Traders used to sell their goods - fish, meat, clothing, perfumes,
jewelry, pottery, metal artifacts, etc. in separate stalls.
These references confirming the existence of markets in ancient civilizations provide an
indication of the extent to which they have influenced economic activity, growth and
development over several centuries.

Spot Market Transactions

Spot transaction results in immediate delivery of a good (or financial product / instrument)
for a particular consideration between the buyer and seller. Marketplaces that facilitate
spot transaction is referred to as the spot (or cash) market and the transaction price is
usually referred to as the spot price.
54
 ,
Buyers and sellers meet face to face and deals are struck ..These are traditional markets. Types of Markets
Example of a cash market is a mandi where food grains are sold in bulk. Farmers would
bring their products to this market and merchants/traders would immediately purchase
the products, and they settle the deal in cash and take or give delivery immediately. Spot
markets thus call for immediate delivery of goods against actual payment.

Contemporary Markets .
The present-day markets gradually evolved over several hundreds of years. The objective
of establishing a marketplace is to facilitate a congregation of buyers and sellers in a
single location, to facilitate their interaction. This is traditionally a physical marketplace
- where buyers and sellers need to by physically present. Sellers need to transport their
goods, to be able to negotiate their sales. Once a sale is completed, then the delivery of
the goods is also made instantaneously on receipt of a consideration.
With the advent of the Informational Technology (IT) revolution, the physical marketplace
has gradually been replaced with electronic trading platforms. In an IT-enabled
environment, buyers and sellers from different locations can transact business in an
electronic marketplace. Hence, physically presence is not necessary for the exchange
of goods or services for a consideration. Electronic trading and settlement of transactions
has created a revolution in global securities markets.
The financial markets in India have evolved over the last six decades since independence.
The five year plans led to the growth of infrastructure and economic development. It
was only in 1991, when India liberalized its economy - from decades of import/export
and manufacturing restrictions - that importance was given to financial and securities
markets reforms.
The need for institutional intervention in terms of banking and non-banking financial
intermediaries was ascertained. Though Development Financial Institutions (DFI) were
in existence from 1950's and 1960's, the credit distribution was skewed towards the
large-scale industries. The entrepreneur having a small and medium scale enterprise
(SME) and micro-SME sector was largely ignored. The free flow of capital from
household savings and investments towards sectors including capital markets, insurance
and pension / provident fund were liberalized in the 1990's and after 2000.
Having identified some of the key developments in financial markets and the different
types of markets, we shall discuss each of these markets in the following sections. In
section 3.2, let us trace the growth, development and significance of money markets in
India.

3.2 MONEY MARKETS

The Money Market is defined as a market for overnight to a short term money and for
financial assets that are close substitute for money. The meaning of "short-term" refers
to a duration of less than or equal to 1 year. The phrase "close substitute for money"
denotes any financial asset that can be quickly converted into money with minimum
transaction cost and without loss of value. Participants in this market either have excess
funds which they would like to invest for short duration (from overnight to 1 year) or
have an immediate shortage of funds and would like to borrow in the short-term. The
market is a wholesale market for a collection of different short term debt instruments.
Its principal feature is the credit worthiness of the participants.

Participants in Money Markets

The main players in this market are: Reserve Bank ofIndia (RBI), Discount and Finance
House of India, Mutual Funds, Banks, Corporate Investors, Non-Banking Finance
55
Introduction Companies (NBFC), State Governments, Provident Funds, Primary Dealers, Securities
to Financial Trading Corporation ofIndia (STCI), Public Sector Undertakings (PSU) and Non-resident
Markets
Indians (NRI).
Until the early 1990s, participation in Money Market in India was restricted to banks,
LIC and UTI. There were no other participants who could actively trade in the short
term money market instruments. The only available money market instruments were
the call / notice money, interbank deposits/loans, commercial bills and 91-day Treasury
bilL The interest rates were controlled directly by the RBI or involuntarily by means of
agreement between banks through the Indian Banks Association.

Significance of Money Markets

The pre-requisites for an efficient money markets system is the availability of low-risk
but highly liquid short term money market instruments, deregulated interest rates, flexibility
in transactional procedures and also an existence of a number of participants including
market makers - to create liquidity for the instruments.
After 1990, a liquid money market emerged in India. Specialized institutions called Primary
Dealers (PD) were established. This also coincided with the formation of the Money
Market Mutual Fund (MMMF). Interest rates were also deregulated and eligible
participants were enlarged. Also many new instruments were launched.
Presently, the structure of the Indian money market instruments consist of call / notice
money market, commercial bills market, Treasury Bills (T-Bills), Commercial Papers
(popularly known as CP), Certificates of Deposit (CD) and the Repo Market.
The RBI uses open market operations (OMO), bank rate, Cash Reserve Ratio (CRR),
Statutory Liquidity Ratio (SLR), Repo transactions as active instruments of monetary
policy.
The key objective of money markets is:
• To facilitate an equilibrium between demand and supply of short term funds.
• Provide a focal point for central bank intervention for influencing liquidity in the
economy.
Facilitate easy access for users and suppliers of short term funds to meet their
requirements at an efficient market clearing price.

Instruments Traded in Money Markets

1) Treasury Bills: Treasury Bills (T-Bills) are short-term instruments issued by the
RBI on behalf of the Government of India. This provides short-term credit to Government
for any intermittent financing requirements - this bridges the temporary gap between
revenue and expenditure. T-Bills are repaid at par upon maturity. RBI usually issues the
91-day, 182-day and 364-day T-Bills.

2) Commercial Paper: A Commercial Paper (CP) is an unsecured short-term

promissory note that is negotiable and transferable by endorsement and delivery with a
fixed maturity period. It is usually issued at a discount to the face value of the CP, by
companies with a high credit rating in the form of a promissory note redeemable at par
to the holder on maturity. CP is used to meet the working capital requirements of the
company. The tenor of issue for CP is between 7 days to 1 year (effective from April,
2004).

56
 Activity 1 Types of Markets

1) List down the different types of markets and the classifications .

..............................................................................................................•..............

2) What is the meaning of money markets?

Having analyzed the key developments related to money markets, let us analyse in
section 3.3, the major developments related to Capital Markets.

3.3 CAPITAL MARKETS

Capital markets involve raising finance through issue of publicly traded financial
instruments in equity and debt that can be bought and sold at any time for a longer
duration. For facilitating this framework, financial intermediaries play a very important
role. The "financial claims" - bonds, fixed deposit receipts, shares, etc. - that were
discussed in Unit 1 of this course can be issued to investors by those seeking funds. The
investors - comprising participants in the financial markets such as individuals, banks,
high net worth individuals (HNI) and other entities - could buy these "financial claims"
" in the primary markets. Such instruments can also be traded in the secondary markets.
"Primary Markets" enable fresh issue of "financial claims" (in the form of Initial Public
Offering or IPO, Follow-on Public Offering or FPO, Open Market Operations by the
RBI for issue of Government Securities or even sale of corporate bonds and debentures).
The establishment of "Secondary Markets" in the form of stock exchanges (for trading
in equity market offerings such as shares) and Primary Dealers (PD) - who provide
two-way quotes for Government Securities and Corporate Bonds - facilitated the liquidity
for the purchase of these financial claims.
Typically an investor can directly purchase these "financial claims". Alternatively,
investors can purchase these financial claims indirectly by way of mutual fund units,
security receipts or pass through certificates. Even Insurance companies commenced
issuing innovative financial products called "Unit Linked Insurance Products" (ULIP)
to facilitate a portion of the funds are invested in the capital markets.
Capital Markets also offer a wide scope of raising debt capital through issue of long-
term debt. Capital through issue of debt securities, as distinguished from loans provided
by banks and financial institutions. This enabled corporate, who were until then, dependent
on banks and fmancial institutions for raising capital, could directly approach the markets
by issue of corporate bonds. This kind of debt capital is 'convenient for both the issuers
as well as investors, because of the tradable nature of these securities in the secondary
markets.
Thus, the capital markets become an avenue of bank disintermediation, in that, it not
.r •
only brings the investors of funds and issuers of "financial claims" together on an alternative
platform, but also helps in movement of debt capital- a function that was primarily the
57

-,
Introduction domain of banks and financial institutions until the mid-1980s and early 1990s.
to Financial
Markets The contemporary. market micro structure provides for co-existence of banks and financial
institutions as well as capital markets. The inherent competition in the form of availability
of capital has spurred competition among the different market participants to provide
capital at optimal cost. This has also resulted in depositors of funds and investors multiple
avenues to choose from, based on their risk appetite. The formation of stock exchanges
for trading in equity products, primary dealers for bonds and other intermediaries such
as' Asset Management Companies offering mutual fund units, the opening up of the
insurance companies has greatly resulted in the growth of the Indian Financial Markets.
Investors have alternate avenues for choosing their investments across multiple asset
classes and financial products.
Modern Capital Markets have become a catalyst for wealth creation. A vibrant and .
efficient Capital Market is the backbone of a healthy economy. India has become a
global reference point and the Indian Capital Markets structure - systems, processes
and institutions - have become a global benchmark to be emulated. Many developing
countries have taken cues from the Indian Capital Markets for establishing similar
structure in their respective countries.

Functions of Capital Markets

The major functions of Capital Markets are as follows:
• Improve the efficiency of capital allocation through a competitive pricing mechanism.
• Lower the costs of transactions.
• Encourage broader ownership of productive assets.
• Provide liquidity with a mechanism enabling the investor to sell financial assets - in
the form of active secondary markets.
• To mobilize long-term savings to finance long-term investments.
• Provide risk-capital in the form of equity or quasi-equity to entrepreneurs.
• Disseminate information efficiently.
• Price discovery of financial instruments.
• Risk Management to mitigate against market risk (price volatility).
• Enable wider participation.
• Improve operational efficiency simplified procedures for transactions, faster
settlement process and lower transaction costs.
• . Improved integration between different markets and different asset classes, real
and financial sectors of the economy, long and short term funds, private and
Government sectors, domestic and external funds.
• Direct flow of funds into efficient channels through investment, disinvestment and
reinvestment.

Capital Market Segments: Primary and Secondary Markets

Capital Markets may be classified into Primary and Secondary Markets, which deal
with issue of new securities and trading of existing securities, respectively. Leyus
understand the characteristics of Primary and Secondary markets.

1) Primary Market: Primary Market is a segment of capital markets that deals with
the issuance of new securities. Corporate, Government, Public Sector Units, Banks and
Financial Institutions can obtain funding through the sale of financial claims such as
stocks, bonds, debentures, etc. This is typically done through a syndicate of securities
58 .
dealers. In the case of a new stock issue, this sale is usually referred to as an "Initial Types of Markets
Public Offering" (IPO). Dealers earn a commission i.e., built into the price of the security
offering, though it can be found in the prospectus.
The fund raising in the Primary Markets can be classified as follows:
l) Public Issue by Prospectus
2) Private Placement
3) Rights Issues
4) Preferential Issues

2) Secondary Markets: Secondary Market is the segment of Capital Markets relating

to trading of already-issued (outstanding) securities. After the security is issued in the
Primary Market, it is listed on a recognized stock exchange in case of equity shares or
is traded on the Negotiated Dealing System of RBI in case of debt market securities.
Secondary markets provide liquidity for investors. Secondary Markets usually follow
either an auction-based system or dealer-based system. While the stock exchange is
part of an Auction Market, Over-the-Counter (OTC) market is a dealer-based system.
For the general investor, the Secondary Market provides an efficient platform for trading
of securities. The fair price of the security is "discovered" in the secondary markets -
thus leading to either price appreciation or depreciation. Banks facilitate secondary
market transactions by opening direct accounts to individuals and companies. Banks
also extend credit against securities. Banks may also act as clearing house banks.
The Indian Secondary market can be segregated into two parts:
a) Secondary market for corporate and fmancial intermediaries on recognized stock
exchanges such as BSE and NSE, OTCEI, ISE and other regional exchanges. The
participants in these markets are registered brokers - both individuals and institutions.
They operate through a network of sub-brokers and sub-dealers and are connected
through a network of electronic trading system.
b) Secondary market for Government Securities, PSU Bonds, corporate debt
instruments. The Government Securities markets is divided into short term money
market instruments such as treasury bills and long term Government bonds of
maturity up to even 30 years. The main participants in the secondary debt markets
are primary dealers, banks, mutual funds, and financial institutions. Since the
September, 1994, trading in Government Securities were conducted through the
subsidiary general ledger (SGL). Presently, Government Securities and PSU bonds
are traded on the Wholesale Debt Market (WDM) segment of NSE, BSE and
OTCEI.
Financial Instruments Traded in Secondary Markets include:
• Equity Shares, Rights Issue/Rights Shares, Bonus Shares.
• Preferred StocklPreference shares, Cumulative Preference Shares, Cumulative
Convertible Preference Shares; Participating Preference Share.
• Security receipts.
• Government Securities, PSU Bonds.
• Debentures, Corporate Bonds.
• Commercial Paper, Treasury Bills.

59
Introduction
to Financial , . caPltal Marketl
Instrument, In
Markets India

• i i
~
I i i ,
I EqullY/
Ordinary
Shares .I Preference
Shares
I Debenture! /
Bonds / Notes I Innovative
' Debt
tnstruments I Forward
Contracts
I Forward/
Futures
Contracts I Ol>tlon/
Option
Contracts

Figure 3.2: Captal Market Instruments in India

Following are some of the Financial ProductslInstruments traded in Indian Securities
Markets:
• Equity Shares, Rights IssuelRights Shares, Bonus Shares
•.
• Preferred StocklPreference Shares, Cumulative Preference Shares, Cumulative
Convertible Preference Shares, Participating Preference Share
• Security Receipts
• Government Securities, PSU Bonds
• Debentures, Corporate Bonds
• Commercial Paper, Treasury Bills
A more detailed discussion on each of these instruments in the specific markets is given
. in the following sections of Unit 3. Let us analyze the characteristics of the debt markets
in India in section 3.4.

3.4 DEBT MARKETS

Debt Markets involve issuance, trading and settlement of fixed income securities such
as bonds of various tenors. Debt Market instruments can be issued by Central and State
Governments, Public Sector Units, Statutory Corporations, Banks, Financial Institutions
and Corporate Bodies.

Objectives of Debt Markets in India

The key objectives of Debt Markets in India are:
• Efficient mobilization and allocation of resources in the economy.
• Financing the development activities of the Government.
• Transmitting signals for implementation of the monetary policy.
,• Facilitating liquidity management in tune with overall shah-term and long-term
objectives.
• Reduction in the borrowing cost of the Government and enable mobilization of
resources at a reasonable cost.
• Provide greater funding avenues to public-sector' and private sector projects and
reduce the pressure on institutional financing.

Components of Indian Debt Market

The debt market in most developed countries is many times larger than other financial
markets - including the equity markets. In the post reforms era, since the liberalization
of the Indian economy in 1991, following debt market segments have emerged:
• Private Corporate Debt Market
• PSU Debt Market .'
• Government Securities Markets (usually referred to as the G-Sec market)
60
The G-Sec market commands over 90% of the volume of transactions in the debt market Types of Markets
- it is the principal segment of the debt market in India.

Reforms in Indian Debt Market

Before 1990, in order to provide cheap capital for state enterprises, the government had
established a well-knit structure of national and state level development financial institutions
(DFIs), for meeting the requirements of medium- and long-term finance of all ranges of
industrial units. In order to enable term-lending institutions to finance industry at
concessional rates, the Government and the RBI gave them access to low-cost funds.
But it did not produce the expected result.
The situation changed significantly after financial sector deregulation in 1991. The DFIs
no longer enjoyed their protective policy climate, and had no access to concessional
sources of finance like government guaranteed bonds or budgetary support. DFI's, thus,
found it difficult to remain viable by raising funds from the market and competing with
commercial banks. Moreover, banks started substantially increasing their term-lending
with the help of the low-cost deposit funds. During the 1990s, therefore, the DFIs were
increasingly withdrawing themselves; others, like ICICI and IDBI, merged with
commercial banks and lost their original identity. On the other hand, the banking sector
witnessed sweeping changes, including elimination of interest rate controls, reductions
in reservelliquidity requirements, and an overhaul in priority sector lending, and commercial
banks gradually diversified into several new areas of business like, merchant banking,
mutual funds, leasing, venture capital, and other financial services. In India, external
capital borrowings are being permitted by the Government for providing an additional
source of funds to Indian corporations. The Indian Government through the Ministry of
Finance - monitors and regulates these borrowings through policy guidelines. The
discouragement of external debt has restricted domestic entities' ability to issue bonds
on international markets and the entry offoreign investors to the domestic bond market.
Moreover, the restrictions on purchases by foreigners in the corporate and government
bond markets are much more strict. Hence, the market for private bonds remains
underdeveloped. By contrast, the approach to equity inflows has been much more liberal.
Restrictions on FDI inflows have been relaxed progressively.
Traditionally, the Indian debt market has been restricted to a few institutional players -
mainly Banks, other participants include primary dealers, mutual funds. Banks have a
statutory requirement (under RBI regulations) to main a specific percentage of their
deposits in the form of Government Securities - also called the Statutory Liquidity Ratio
(or SLR). This is the reason for banks to actively trade in Government Securities.
Due to the administered interest rate regime, the volume. in the debt market segment
was extremely negligible until the early 1990's. Also, the return from investing in
Government Securities was lower as compared to other alternative investment avenues.
Thus, RBI instituted reforms in the debt market. But in spite of these reforms, volumes
are usually low in the corporate debt market and the PSU debt market segments.
An integral aspect of the financial liberalization initiated in the early 1990s was the
process of reforming the debt market.
Two of the main reasons for this reform are as follows:
1) Realization that the growing budget deficit would have to be funded through a
liquid, efficient government securities market.
2) Recognition that sustained economic growth will require a significant improvement
of the nation's infrastructure, which itself will require a deep and liquid domestic
debt market. '

/61

I
Introduction Increasing Issuance of Government Debt
to Financial
Markets - The central government is the largest issuer of debt. The growing national budget deficit
has required the increased issuance of government securities. The annual primary (gross)
issuance of central government debt increased 18 times during the 15 years since the
reform process began, from Rs. 8,989 crores in FY 1991 to Rs. 160,018 crores in FY
2006. In·FY 2008, this figure touched an all time high ofRs. 188,205 crores and was at
Rs; 175,780 crores in FY 2009.
In addition, the growing needs of the state governments have led to their growing issuance
(gross basis) in the debt market. The annual issuance of state government debt has
increased as much as 20 times, from Rs. 2,569 crores in FY 1991 to Rs, 50,521 crores
in FY 2004. In FY 2008, this figure touched an all time high of Rs. 67,779 crores and
. was Rs. 59,062 crores in FY 2009 ..
Although the Indian private corporate sector raises a large part of their financial
requirements through bank loans, there has been increasing reliance on both the debt
and equity markets. Within the debt market, especially the corporate bond market,
issuances by state-owned public sector undertakings have persistently outstripped those
by private companies. Further, there has been a strong preference for the private
placement route for corporate bond issues rather than public issues owing to lesser
regulatory requirements in private placements. Also, the high cost associated with public
issuance deters corporate entities from accessing funds through this route.

Government Securities (G-Sec)

These are sovereign (credit risk-free) coupon.beatjtg instruments which are issued by
the Reserve Bank of India on behalf of Government of India, in lieu of the Central
Government's market borrowing programme. These securities have a fixed coupon i.e.,
paid on specific dates on half-yearly basis. These securities are available in wide range
of maturity dates even up to 30 years.

Corporate Debt Market

In the last decade, a number of innovations have taken place in the corporate bond
market, such as securitized products, corporate bond strips and a variety of floating rate
instruments with floors and caps and bonds with embedded put and call options. However,
the secondary market has not yet developed in the debt segment of the Indian capital
market. Furthermore, the corporate debt market in India remains underdeveloped as
large domestic institutional investors, such as pension funds and the insurance sector,
are restricted from allocating large portions of their investment funds in the corporate
bond segment. •

• A number of policy initiatives were taken during the 1990s to activate the corporate
debt market in India. The interest rate ceiling on corporate debentures was abolished in
1991, paving the way for market-based pricing of corporate debt issues. In order to
improve the quality of debt issues, ratings were made mandatory for all publicly Issued
debt instruments, irrespective of their maturity. The role of trustees in bond and debenture
issues has .strengthened over the years. All privately placed debt issues are required to
be listed on the stock exchanges and follow the disclosure requirements. However,
despite the policy initiatives, corporate debt still constitutes a small segment of the debt
market in India. Whereas the primary market for debt securities is dominated by the
private placement market, the secondary market for corporate debt is characterized by
poor liquidity - although this has relatively improved over the years. Corporations in
India continue to prefer private placement of debt issues rather than floating public
issues. The dominance of private placement has been attributed to several factors, such
as ease of issuance, cost efficiency, primarily institutional demand, and so forth. About
90% of outstanding corporate debt is usually privately placed.
62
The major events in the Indian Debt Markets has been encapsulated in the. Annexure 1 Types of Markets
to this Unit. I

Debentures
Debentures are a type of financial claims issued by a company. The buyers of
debentures are the creditors of the company, who have invested capital in the company.
In return for the invested capital, the debenture holders would obtain a fixed rate of
interest usually payable annually or half yearly on specific dates. The principal amount
is paid back by the company to the debenture holders on particular future date - this is
the redemption date of the debentures.
The terms of reference of the debenture or bond may be customized in such a way that
the principal may be payable (back to debenture holder) at regular pre-specified intervals.
In some instances, convertible debentures are also issued, whereby the debentures can
be exchanged for equity shares at a later date.

Features of Debentures
Some of the major features of Debentures are as follows:
• At the time of issue of debentures, a trustee is appointed through an indenture /
trust deed. It is a legal agreement between the issuing company and the trustee,
who is usually a financial institutionlbanklinsurance company/or a firm of attorneys.
The trust deed provides the specific terms of agreement, such as description of
debentures, rights of debenture holders, rights of issuing company and responsibilities
of the trustee. The trustee is responsible for ensuring that the borrower of funds
(the company issuing the financial claims - debentures) fulfills all its contractual
obligations.
• Unlike an equity shareholder, whose dividend income is subject to the risk of
company's performance, debenture holders are assured of receiving the fixed
interest payable to them. This is a legally binding and enforceable contract.
Debenture / bond holders have the first right to residual claims on assets, at the
time of liquidation of the company. The issuing company can choose the fixed rate
of interest payable for the debenture issued, based on the credit rating of the
company. The interest rate is usually a fixed rate, but may also be a floating interest
rate.
• A Debenture Redemption Reserve (DRR) is created for the redemption of all
debentures with maturity period exceeding 18 months. The amount in this DDR
(which is a sinking fund) should be equivalent to at least 50% of the total amount of
issue / redemption, before commencement of the redemption.
• Debentures may also have features of a "call option" - whereby, the company
may have the right to redeem all the issued debentures - with settlement based on
specific price. On the other had, if the debenture holder is given a right to seek
redemption of the debenture held by the investor, this is called a "put option".
The call or put option may be exercised at predetermined prices, keeping an
allowance for the option premium - which is the extra amount related to the right
but not the obligation, provided by the option.
• Debentures are normally secured/charged against the asset of the company in
favour of the debenture holder. This is usually on the present and future immovable
assets of the company by way of an equitable mortgage.
• Non-Convertible debentures can only be redeemed by the issuing company. On
the other hand, Convertible Debentures, which may be either Fully Convertible
Debentures (FCD) or Partly Convertible Debentures (PCD) are eligible for
conversion of either a full or part of the holdings into equity shares.
63
Introduction • All debenture issuers are rated by credit-rating agencies namely, ICRA, CRISIL,
to Financial Fitch or CARE.
Markets
• Zero Interest Debentures are issued at a discount to the face value (i.e., the face
value amount redeemable on maturity date is discounted).
• Secured Premium Notes (SPN) is a secured debenture, redeemable at a premium
over the purchase price. Usually, there is a lock-in price for the SPN, during which
no interest is paid. The redemption is made in instalments after the lock-in period.
SPN is usually a tradable instrument.

Advantages of Debentures
Following are the advantages of Debentures:

• Lower cost due to lower risk.

• Tax deductibility of interest payment.
• Debentures do not carry voting rights - hence there is no dilution of control over
the company if debentures are issued.
• Debentures, unlike equity offer stable returns for the investors.
• Debentures have a fixed maturity.
• Debentures are also protected long term capital investments. The Debenture
Redemption Reserve and the trust protect the interests of the debenture holders.
• Debenture holders also have preferential claim over the assets of the company at
the time ofliquidation.

Disadvantages of Debentures
Following are the disadvantages of Debentures:
• The company issuing debentures has the disadvantage of the limitations of the
covenants in the trust deed that contains legally enforceable contractual obligations
with reference to periodic interest payment and principal repayment at time of
redemption.
• Debentures result in a steady cash outflow for the company - by way of interest
payment - even if the company makes losses. In the case of equity shares, this is
not a problem, since dividends are the prerogative of the company management.

Warrants
Warrants issued by a company entitle investors to subscribe to equity capital of the
company on a specified future date, at a specific pre-determined price. The holder only
has the right to buy, but no obligation - this is similar to selling call options. Warrants
may be issued independently on a stand-alone basis or in combination with debentures
or secured premium notes.
In a Convertible Debenture (CD), the debenture portion that earns a fixed rate of interest
and the right to convert the debenture into equity shares cannot be separated. This is in
contrast to a Warrant, which can be issued independently also. Warrants are exercisable
directly for cash - i.e., exercising a warrant would result in purchase of equity shares
for a consideration paid for in cash.

Bonds
Bonds refer to negotiable certificates evidencing indebtedness. It is normally unsecured.
A debt security is generally issued by a company, municipality or government agency. A
bond investor lends money to the issuer and in exchange, the issuer promises to repay
the loan amount on a specified maturity date. The issuer usually pays the bond holder
64
periodic .uterest payments over the life of the loan. The various types of Bonds are as Types of Markets
follows:
• Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No •
periodic interest is paid. The difference between the issue price and redemption
price represents the return to the holder. The buyer of these bonds receives only
one payment, at the maturity of the bond.
• Convertible Bond: A bond giving the investor the option to convert the bond into
equity at a fixed conversion price.
• Callable Bonds: This provides flexibility to the company to redeem the issued
outstanding bonds on a specific future date.
• Puttable Bonds: This provides flexibility to the investor to seek redemption of the
bonds that he/she has purchased, on specific future date.
Debenture is a type of bond. But the debenture is secured by way of a trust deed.

Activity 2
1) What is the definition of debt market?

2) What is the difference between the Government Securities markets and the
Corporate debt market?

3) What is the difference between money markets and debt markets?

...................... , , " , " , , , .

The latest development in Indian debt markets is the launch of Interest Rate Futures on
exchanges. In the section 3.5, let us analyze the characteristics of equity markets.

3.5 EQUITY MARKETS

The stock market reforms received a major impetus with the recommendation of a high
powered committee (G S Patel Committee) instituted in 1985. The Committee was
established by the Ministry of Finance, Government of India for suggesting structural
reforms in the constitution and other matters relating to capital markets in general and
stock exchanges in particular. The establishment of Securities Exchange Board of India
(SEBI) in 1988 was based on the recommendations of the GS Patel Committee Report.
After the establishment of SEBI, most of the reforms in the Indian equity markets have
been instituted under the section 11 0 the SEBI Act.
One of the most important concerns of SEBI was that all stock exchanges were owned,
controlled and managed by the brokers. The process of the Corporatization of Stock
65

I
Introduction Exchanges was commenced, to separate the ownership of the exchange, management
to Financial and the trading interests. This facilitated transparency and efficiency in a non-partisan
Markets
environment. This process is usually referred to as "Demutualization". The process of
demutualization was instituted at a faster pace based on the roadmap provided by the
Justice Kenia Committee - appointed by SEBI. This process was also made easier by
way of providing tax breaks - announced in the budget of 2003-04. With this process,
the stock exchanges were converted into companies under the Companies Act, 1956,
wherein, shareholding, membership and management of the stock exchange would not
be interlinked.
Subsequently, broking firms and sole proprietorship concerns were encouraged to convert
themselves into companies registered under the Companies Act, 1956. To facilitate this
transformation, suitable changes were brought into the Securities Contract Regulations
Act, 1956 as well as in the bye-laws of the stock exchanges. These have also been
supported by way of tax breaks in the form of a one-time tax exemption for capital
gains, arising out of such conversion. By March 2003, almost 40 of the brokers registered
with SEBI were corporate entities. Corporatization of broking businesses resulted in
greater transparency and also enabled the broking houses to conduct business (trading)
operations with the advantage of limited liability.
SEBI also facilitated multiple types of membership in stock exchanges - depending on
specific criteria such as net worth, deposit requirements and function of the member
based on clearingltradinglboth clearing and trading.
Another major change instituted by the reforms agenda was the permission of SEBI to
allow Foreign Institutional Investors (FII) to trade in Indian Stock Markets - based on
specific criteria. Also, overseas trading terminals were permitted to be established - to
facilitate Non-resident Indians (NRI) to trade on Indian stocks on a real-time basis.
Other major developments in the reform agenda aid down by SEBI for regulation of
equity markets include:
• Compulsory SEBI registration of all brokers and sub-brokers.
• Documentation by way of "Know Your Client" norms between brokers and clients.
• Maintenance of books of accounts and transaction records.
• Monitoring and inspection of stock exchanges.
• Adherence to code of conduct for different market participants.
• Capital adequacy norms for brokers - minimum net worth criteria.
• Restructuring of Governing Boards of Stock Exchanges.
• Compulsory audit of books of stock brokers.
The reforms instituted in the primary markets clearly demarcated the role and
responsibilities of different market participants and intermediaries. The process for issue
of new shares has become transparent. The roles and responsibilities of specialist
merchant banks, lead managers, underwriters, bankers to an issue, registrars to an issue,
share transfer agents, portfolio managers, brokers depositories, FIIs, custodians, rating
agencies, venture capital funds and mutual funds have been demarcated. These
intermediaries offer specialist institutional services under the SEBI guidelines. The pre-
issue and post-issue procedures and activities have been streamlined. Rigorous compliance
procedures have been laid down.
In the context of secondary markets, the established exchanges such as Bombay Stock
Exchange (BSE) and National Stock Exchange (NSE) as well as regional exchanges
op~rate under the purview of SEBI regulations.

66
The NSE introduced screen based trading at its inception in 1992. Online electronic Types or Markets.
trading provides transparency and increases geographical reach for the participants.
The transactions are anonymous and order driven. Order matching is done strictly on
price-time priority. Screen based trading has improved the depth and liquidity of the
markets.
Equity is viewed by the market as an ownership "share" ip the revenue stream of a
corporation's income after all prior obligations (including outstanding debt) has been
satisfied. The "share" price is the relative value given to the Corporate's earning potential
based on a number of factors. These include general economic conditions, both in the
industry and in the overall economy, earnings projection, projected corporate growth,
stage of development and financial ratio analysis. •
Generally, the structure of equity is that a "share" of the corporation represents the
current market value of the firm, and secondary to this is the potential for dividend
income. There are various classes of equity for the individual investor to consider.

Major Reforms in Primary Markets: Equity

Major Reforms in the Primary Markets for Equity since 1990's are as follows:
• Merit based regime to disclosure based regime.
• Disclosure and Investor Protection Guidelines issued.
• Pricing of Public Issues determined by the market.
• System of proportional allotment of shares introduced.
• Banks, FI and PSU allowed to raise funds from the primary markets.
• Acceptance of International Accounting Standards.
• Corporate Governance guidelines issued.
• Discretionary allotment system to Qms withdrawn.
• FIIs allowed to invest in primary issues within the sectoral limits (including G-
secs).
• Mutual Funds are encouraged both in public and private sectors and they have
been permitted to invest overseas.
• Guidelines for Private Placements of debt issued.
• SEBI promoted Self Regulatory Organizations (SRO).
• Allocation to retail investors increased.
• Separate allocation of 5% to domestic mutual funds within the Qm category.
• Freedom to fix face value of shares below Rs. 10 per share only in cases where
the issue price is Rs. 50 per share or more.
• Shares allotted on a preferential basis as well as the pre-allotment holding are
subject to a lock-in period of six months to prevent sale of shares ..

Major Reforms in Secondary Markets: Equity

Major Reforms in Secondary Markets since 1990's are as follows:
• Mandatory Registration of Market Intermediaries.
• Capital Adequacy norms specified for the brokers, sub-brokers of exchanges.
• Guidelines issued for listing agreement between stock exchanges and corporate.
• Shortening of settlement cycle for cash segment to T+2 and derivatives segment
to T+1.

67

I
Introduction
to Financial
• Regular inspection of stock exchanges and other intermediaries including mutual
funds put in place.
Markets
• Regulation of Substantial Acquisition of Shares and Takeovers.

• FIIs allowed to invest in Indian Capital Markets since 1992.

• Order driven, fully automatic, anonymous screen based trading introduced.

• Depositories Act enabled.

• Guidelines on Corporate Governance issued.

• SEBI has prohibited fraudulent and unfair trade practices, including insider trading,

• Separate trading platform called Indonext for SME.

• Corporatizationand Demutualization of stock exchanges notified.

• Settlement and Trade Guarantee fund/lnvestor Protection Fund established.

• Comprehensive Risk management system established - capital adequacy, trading

limits, exposure limits, margin requirement, index based market wide circuit breaker,
online position monitoring, automatic disablement of terminals.
• Comprehensive surveillance system established for tracking circular trading, price
manipulation, market abuse.
• Securities Appellate Tribunal (SAT) established.
• Mutual Funds, FIIs to enter Unique Client Code (UCC) pertaining to parent entity
at the order entry level.
• Clients provided with Unique Client Code.
• Introduction of exchange traded derivatives including futures and options on stocks
and indices.
• Introduction of SPAN based margining system based on Value at Risk measures
(Exponential Weighted Moving Average).

Types of Equity
The primary three groups into which equity may be subdivided are common stock,
preferred shares and warrants.

Types of Ordinary Shares (based on Industry Classification)

• Blue Chips: Corporate who are considered to have established business model
with large market capitalization
• Utilities: Infrastructure companies (including power generation, transmission and
distribution companies, construction, etc.).
• Established growth: Corporate who have successful business model (may be
cash-cows in their segment).
• Emerging growth: Corporate whose business have opportunities for future growth.
• Penny stocks: Small-cap stocks (with small market capitalization including SME).
List of different Types of Preference Shares
• Convertible Preference shares
• Cumulative and Non-cumulative Preference Shares
• Redeemable Preference Shares
• Participating and Non-participating Preference Shares
0'
o

68
Generally, equity refers to the ownership interest in a company, of holders of its common
and preferred stock. An ordinary (or common) equity share, represents the form of -
Lt')
fractional ownership in which a shareholder, as a fractional owner, undertakes the Types of Markets
maximum entrepreneurial risk associated with a business venture. The holders of such
shares are members of the company and have voting rights.

Types of Share Capital

The equity share capital is of several types.
• The Authorized Equity/Share Capital represents the maximum amount that a
company can raise from the ordinary shareholders.
• The portion of the authorized share capital offered by a company to investors is the
Issued Capital. The issued share capital has to be equal to or less than the authorized
share capital. .
• Subscribed Share Capital is that part of the issued share capital that has been
issued and accepted/subscribed by the investors.
• The actual amount paid by the subscribers is the Paid up share capital.

Par Value (Face Value) and Book Value

Ordinary shares have a "Par" or "Face Value" in terms of the price of each share.
This usual denomination of the Face Value (FV) is Rs. 10/-. SEBI has specified that
companies can reduce the face value of a share to a minimum amount of Re. 1.
The price at which equity shares are issued is referred to as the "Issue Price". The
issue price for new companies is usually equal to the face value. For existing companies,
the issue price may be greater than the face value, in which case, the excess amount
over an above the face value of each share, is called the "Share Premium".
The "Book Value" (BV) of each ordinary share refers to the paid up capital plus
reserves and surplus (net worth) divided by the number of outstanding shares. The price
at which equity shares are traded in the market is called the "Market Value".

Features of Equity Shares

Features of Equity shares are as follows:
• Residual Claim to Income or Assets: Equity shareholders have the right to the
profits/surplus/assets of the company; after all outside claims to bond holders,
creditors, preference shareholders, etc. are met. The amount of dividend distributed
to shareholders depends on the Board of Directors of the company, which would
be subject to shareholder's approval. This is in sharp contracts to debenture holders,
whose obligation's need to be honoured by the company. In case of liquidation of
the company due to bankruptcy, if the liquidation value of the assets is insufficient,
then the claims to shareholders may be unpaid.
• Right to Control: Equity shareholders have "indirect" right to control the operations
of the company. The Board of Directors are appointed by the company's
shareholders, through a nomination and voting process in the shareholder's meeting.
The Board appointed management is responsible for the day-to-day operations.
The shareholders have the legal right / power to elect the board of directors and to
vote on every resolution placed in various meetings of the company. Usually, the
individual or entity, which holds the majority of shares have direct control over the
affairs of the company. The most commonly used system of voting in the
shareholder's meeting is the "majority rule voting", whereby, each share is eligible
for 1 vote. Thus, the number of shares owned by the shareholder is directly
proportional to the extent of votes that may be cast. As a result, shareholders who
have more than 50% of the shares in a company would be able to have substantial
say in the functioning of the company. An alternative to this system is the
69

I
 Introduction "Proportionate Voting Rule", by which the number of votes held by a shareholder
to Financial equals the number of shares owned, multiplied by the number of directors to be
Markets
elected. Thus, in this situation, the total votes cast may be spread out between
different candidates, based on the shareholder's discretion. The proportionate voting
system has the advantage of allowing even some minority shareholders to elect
representatives to the Board of Directors.
• Pre-emptive rights: If a company was to issue new shares, then the existing
shareholders would have the first right of refusal of such shares, on a pro-rata
basis, based on the number of shares held by the shareholder as compared to the
total number of outstanding shares, before the rights issue.
• Limited Liability: The liability of the shareholders of a company is limited to the
investment made to own their respective shareholding.

Advantages of Equity Share Capital

The advantages of equity share capital are as follows:
• Equity shares are a permanent source of funds, without any mandatory repayment
obligation. Even if the company is bankrupt, the shareholders would not be eligible
to receive funds against outstanding shares held by them, in case of insufficient
funds to meet creditor's demand.
• There is no obligatory dividend payment.
• Equity shareholding forms the basis for determining the extent of long-term
borrowing that a company can mobilize. The creditors would have more confidence
in a company that is well capitalized in terms of the issued and paid up share
capital. This is the reason for closely tracking the "debt to equity" ratio.
• The major advantage for the shareholders is that, even with a limited liability, they
can exercise major control over the affairs of the company.

Disadvantages of Equity Share Capital

The disadvantages of equity share capital are as follows:
• The cost of equity capital is higher for the company. This is a function of the higher
required rate of return for investors, as compared to the risk undertaken by them.
• Equity dividends, which are usually paid out of post-tax profits, are not tax
deductible. At the time of issuing dividends, the company needs to make the tax on
the dividend being issued.
• At the time of issue of the equity hares, the floatation costs incurred by the company
for brokerage, underwriting, issue expen es - for media publicity - is usually high.
• The issue of new shares to the public may also result in dilution of the stake held by
the promoter of the company.
• For the shareholders of the company, equity capital is a risk, as the shareholders
have the last right towards any claim made for the asset - at the time of possible
liquidation of the company, due to bankruptcy.
• Also, the minority shareholders may not be able to exercise adequate influence
due to the promoter possibly have majority control over the company, due to the
larger shareholding.
•. Also, share prices are highly volatile and this form of investment involves high risk.

Issue of Equity Shares

Following are the mechanisms usually utilized by companies to distribute equity shares
in the Primary Markets:
. ~70~ _
 I
• Initial Public Offering (IPO): Issue of new securities by companies. Types of Markets

• Rights Issue or Follow-on Public Offering to issue Rights Shares: The

issue of new securities to existing' shareholders at a ratio to those already held.
• Bonus Shares: Shares issued by the companies to their shareholders free of cost
by capitalization of accumulated reserves from the profits earned in the earlier
years. •

Preferred StocklPreference shares

Preference share (or preference capital) is a long-term capital market instrument that
combines the features of an ordinary equity share as well as a debenture. It is a hybrid
security.

Features of Preference Shares

• Preference share holders are eligible for a fixed rate of dividend.
• Preference shareholders are ranked higher in the hierarchy as compared to ordinary
shareholders, for being a claimant of income and assets.
• Preference shareholders usually do not have voting rights.
• Preference shareholders do not have a share in the residual earnings or assets -
because they have a fixed rate of dividend.
• The dividend for preference shares is payable based on the capital invested. It is
paid out from after-tax profits - thus, the dividend is not tax deductible.
• The payment of most types of preference share dividends is at the discretion of the
management - hence, it is not obligatory on part of company's management. The
terms of the dividend policy are established at time of issue of the preference
shares.
• In the event 'of liquidation, their claims rank below the claims of the company's
creditors, bondholders / debenture holders.

Types of Preference Shares

Following are some of the types of preference shares issued by compahies:
• Cumulative Preference Shares: A type of preference shares on which dividend
accumulates if remains unpaid. All arrears of preference dividend have to be paid
out before paying dividend on equity shares.
•• • Cumulative Convertible Preference Shares: A type of preference shares
where the dividend payable on the same accumulates, ifnot paid. After a specified
date, these shares will be converted into equity capital of the company.
• Participating Preference Share: The right of certain preference shareholders
to participate in profits after a specified fixed dividend is paid. Participation right is
linked with the quantum of dividend paid on the equity shares over and above a
particular specified level.

Activity 3
1) List out the different types of equity in Indian markets?

71
Introduction 2) List out the difference between equity shares and preference share capital?
to Financial
Markets

3) List out the different types of preference shares.

3.6 FOREIGN EXCHANGE (CURRENCY) MARKETS

The foreign exchange market in India is regulated by Reserve Bank of India (RBI).
Guidelines have been established for trading in foreign exchange. Limits for investments
abroad and policy for purchase of foreign exchange when an individual is travelling to a
foreign country or for any other purpose has been clearly been specified by the RBI.
Exposure to derivative transactions for foreign currency as the underlying asset can be
done only by corporate who have exposure to imports/exports, Recently, trading in
USDINR currency futures has been launched by RBI and SEBI on national level
currency futures exchanges. This provides for SME and MSME to also hedge their risk
on currency futures segment.
Currency derivatives transactions in the OTC market can be undertaken only with banks.
Banks, in turn, need to hedge their exposures on a back-to-back basis, with counterparties
in India or abroad (especially for Non-USDINR derivatives transactions).
During the early 1990s, India embarked on a series of structural reforms in the foreign
exchange market. The exchange rate regime that was pegged earlier was floated partially
in March, 1992 and fully in March, 1993. The unification of the exchange ra e was
instrumental in developing a market-determined exchange rate of the rupee and an
important step in the progress towards current account convertibility, which was achieved
in August, 1994. Banks are now permitted to approve proposals for commodity hedging
in international exchanges from their corporate customers. Cancellation and rebooking
of all eligible forward contracts booked by residents, irrespective of tenor, has been
allowed. The closing time for inter-bank foreign exchange market in India has been
extended by one hour up to 5.00 p.m. The ceiling for remittances for resident individual
under the Liberalized Remittance Scheme for Resident Individuals has been enhanced
in an phased manner and currently it stands at US $ 200,000 (per financial year).
The limit on remittances for overseas investments to facilitate overseas acquisitions by
corporates has been enhanced and the guidelines for external commercial borrowings
have also been liberalized by raising the prepayment limits. The foreign exchange market
has acquired a distinct vibrancy as evident from the range of products, participation,
liquidity and turnover.
The phrase "Foreign Exchange" itself refers to money denominated in the currency of
another nation or a group of nations. Any person who exchanges money denominated in
his own nation's currency for money denominated in another nation's currency acquires
foreign exchange.
This holds true whether the amount of the transaction is equal to a few rupees or to
billions of rupees; whether the person involved is a tourist cashing a Traveller's Cheque
in a restaurant abroad or an investor exchanging hundreds of millions of rupees for the
72
acquisition of a foreign company; ana whether the form of money being acquired is Types of Markets
foreign currency notes, foreign currency-denominated bank deposits, or other short-
term claims denominated in foreign currency.
A foreign exchange transaction is still a shift of funds or short-term financial claims
from one country and currency to another. Thus, within India, any money denominated
in any currency other than the Indian rupee (INR) is, broadly speaking, "foreign
exchange". Foreign exchange can be cash, funds available on credit cards and debit
cards, traveller's cheques, bank deposits, or other short-term claims. It is still "foreign
exchange" if it is a short-term negotiable financial claim denominated in a currency
other than INR.

Almost every nation has its own national currency or monetary unit - Rupee, Dollar,
Peso - used for making and receiving payments within its own borders. But foreign
currencies are usually needed for payments across national borders. Thus, in any nation
whose residents conduct business abroad or engage in financial transactions with persons
in other countries, there must be a mechanism for providing access to foreign currencies,
so that payments can be made in a form acceptable to foreigners. In other words, there
is need for "foreign exchange" transactions: exchanges of one currency for another.
The exchange rate is a price.fhe number of units of one nation's currency that must be
surrendered in order to acquire one unit of another nation's currency. There are scores
of 'exchange rates' for INR and other currencies, say US dollar. In the spot market,
there is an exchange rate for every other national currency traded in that market, as
well as for various composite currencies or constructed monetary units such as the euro
or the International Monetary Fund's Special Drawing Rights (SDRs). There are also
various "trade-weighted" or "effective" rates designed to show a currency's movements
against an average of various other currencies (e.g., US dollar index, which is a weighted
index against world major currencies like euro, pound sterling, yen, and Canadian dollar).
Quite apart from the spot rates, there are additional exchange rates for other delivery
dates in the forward markets.
A market price is determined by the interaction of buyers and sellers in that market, and
a market exchange rate between two currencies is determined by the interaction of the
official and private participants in the foreign exchange rate market. For a \.urrency
with an exchange rate that is fixed, or set by the monetary authorities, the central bank,
or another official body is a key participant in the market, standing ready to buy or sell
the currency as necessary to maintain the authorized pegged rate or range. But in
countries like. the United States, which follows a complete free floating regime, the
authorities do not intervene in the foreign exchange market on a continuous basis to
influence the exchange rate. The market participation is made up of individuals, no~-
financial firms, banks, official bodies, and other private institutions from all over the
world that are buying and selling US dollars at that particular time.
The participants in the foreign exchange market are thus a heterogeneous group. The.
various investors, hedgers, and speculators may be focused on any time period, from a .
few minutes to several years. But, whatever is the constitution of participants, and
whether their motive is investing, hedging, speculating, arbitraging, paying for imports,
or seeking to influence the rate, they are all part of the aggregate demand for and supply
of the currencies involved, and they all play a role in determining the market price at that
instant. Given the diverse views, interests, and time frames of the participants, predicting
the future course of exchange rates is a particularly complex and uncertain business. At
the same time, since the exchange rate influences such a vast array of 'participants and
business decisions, it is a pervasive and singularly important price in an open economy,
influencing consumer prices, investment decisions, interest rates, economic growth, the
location of industry, and much else. The role of the foreign exchange market in the
determination of that price is critically important.
73
 1
Introduction During the past quarter century, the concept of a 24-hour market has become a reality.
to Financial Somewhere on the planet, financial centres are open for business, and banks and other
Markets
institutions are trading the dollar and other currencies every hour of the day and night,
except for possible minor gaps on weekends. In financial centres around the world,
business hours overlap; as some centres close, others open and begin to trade. The
foreign exchange market follows the sun around the earth.
Business is heavy when both the US markets and the major European markets are
open; that is, when it is morning in New York and afternoon in London. In the New York
market, nearly two-thirds of the day's activity typically takes place in the morning hours.
Activity normally becomes very slow in New York in the mid to late afternoon, after
European markets have closed and before the Tokyo, Hong Kong, and Singapore markets
have opened.
Given this uneven flow of business around the clock, market participants often will
respond less aggressively to an exchange rate development that occurs at a relatively
inactive time of day and will wait to see whether the development is confirmed when
the major markets open. Some institutions pay little attention to developments in less
active markets. Nonetheless, the 24-hour market does provide a continuous 'real-time'
market assessment of the ebb and flow of influences and attitudes with respect to the
traded currencies, and an opportunity for a quick judgment of unexpected events. With
many traders carrying pocket monitors, it has become relatively easy to stay in touch
with market developments at all times.

Currency Market Participants

The market consists of a limited number of major dealer institutions that are particularly
active in foreign exchange, trading with customers and (more often) with each other.
Most of these institutions, but not all, are commercial banks and investment banks.
These institutions are geographically dispersed, located in numerous financial centres
around the world. Wherever they are located, these institutions are in close communication
with each other; linked to each other through telephones, computers, and other electronic
means.
Each nation's market has its own infrastructure. For foreign exchange market operations
as well as for other matters, each country enforces its own laws, banking regulations,
accounting rules, and tax code, and, as noted above, it operates its own payment and
settlement systems. Thus, even in a global foreign exchange market with currencies
traded on essentially the same terms simultaneously in many financial centres, there are
different national financial systems and infrastructures through which transactions are
executed, and within which currencies are held.
With access to all the foreign exchange markets generally open to participants from all
countries, and with vast amounts of market information transmitted simultaneously and
almost instantly to dealers throughout the world, there is an enormous amount of cross-
border foreign exchange trading among dealers as well as between dealers and their
customers.
At any moment, the exchange rates of major currencies tend to be virtually identical in
all the financial centres where there is active trading. Rarely are there such substantial
price differences among major centres as to provide major opportunities for arbitrage.
In pricing, the various financial centres that are open for business and active at anyone
time are effectively integrated into a single market.
The dollar is by far the most widely traded currency. In part, the widespread use of the
dollar reflects its substantial international role as 'investment' currency in many capital
markets, 'reserve' currency held by many central banks, 'transaction' currency in many
international commodity markets, 'invoice' currency in many contracts, and 'intervention'
74

I
 1
currency employed by monetary authorities in market operations to influence their own Types of Markets
exchange rates.
In addition, the widespread trading of the dollar reflects its use as a 'vehicle' currency
in foreign exchange transactions, a use that reinforces, and is reinforced by, its international
role in trade and finance. For most pairs of currencies, the market practice is to trade
each of the two currencies against a common third currency as a vehicle, rather than to
trade the two currencies directly against each other. The vehicle currency used most
often is the dollar, although very recently euro also has become an important vehicle.
Thus, a trader who wants to shift funds from one currency to another, say from INR to
Philippine peso, will probably sell INR for USD and then sell the USD for peso. Although
this approach results in two transactions rather than one, it may be the preferred way
since the USDINR market and the USD/Philippine peso market are much more active
and liquid and have much better information than a bilateral market for the two currencies
directly against each other. By using the dollar or some other currency as a vehicle,
banks and other foreign exchange market participants can limit more of their working
balances to the vehicle currency. rather than holding 'and managing many currencies,
and can concentrate their research and information sources on the vehicle.
Use of a vehicle currency greatly reduces the number of exchange rates that must be
dealt with in a multilateral system. In a system of 10 currencies. if one currency is
selected as vehicle currency and used for all transactions, there would be a total of nine
currency pairs or exchange rates to be dealt with (i.e., one exchange rate for the vehicle
currency against each of the others), whereas if no vehicle currency were used, there
would be 45 exchange rates to be dealt with. In a system of 100 currencies with no
vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates
[the formula is: n(n-l)/2], Thus, using a vehicle currency can yield the advantages of
fewer, larger, and more liquid markets with fewer currency balances, reduced informational
needs, and simpler operations.
The US dollar took on a major vehicle currency role with the introduction of the Bretton
Woods par value system, in which most nations met their IMF exchange rate obligations
by buying and selling US dollars to maintain a par value relationship for their own currency
against the US dollar. The dollar was a convenient vehicle because of its central role in
the exchange rate system and its widespread use as a reserve currency. The dollar's
vehicle currency role was also due to the presence of large and liquid dollar money and
other financial markets, and, in time, the euro-dollar markets, where the dollars needed
for (orresulting from) foreign exchange transactions could conveniently be borrowed
(or placed).

Some Major Currencies

• Euro: The euro was designed to become the premier currency in trading by simply
being quoted in American terms. Like the US dollar, the euro has a strong
international presence and over the years has emerged as a premier currency,
second only to the US dollar.
• Yen: The Japanese yen is the third most traded currency in the world. It has a
much smaller international presence than the US dollar or the euro. The yen is
very liquid around the world, practically around the clock.
• Pound: Until the end of World War 11,the pound was the currency of reference.
The nickname cable is derived from the telegrams used to update the GBP/uSD
rates across the Atlantic. The currency is heavily traded against the euro and the
US dollar, but it has a spotty presence against other currencies. The two-year bout
with the Exchange Rate Mechanism (ERM), between 1990 and 1992, had a
soothing effect on the British pound, as it generally had to follow the Deutsche
75
Introduction mark's fluctuations, but the crisis conditions that precipitated the pound's withdrawal
to Financial
from the ERM had a psychological effect on the currency.
Markets
• Swiss Franc: The Swiss franc is the only currency of a major European country
.that belongs neither to the European Monetary Union nor to the G-7 countries.
Although the Swiss economy is relatively small, the Swiss franc is one of the major
currencies, closely resembling the strength and quality of the Swiss economy and
finance. Switzerland has a very close economic relationship with Germany, and
thus to the euro zone.

Need for Exchange Traded Currency Futures

With a view to enable entities to manage volatility in the currency market, RBI on April
20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,
swaps and options in the OTe market. At the same time, RBI also set up an Internal
Working Group to explore the advantages of introducing currency futures. The Report
of the Internal Working Group of RBI submitted in April, 2008, recommended the
introduction of exchange traded currency futures.

OTC and Exchange Traded Derivatives

Exchange traded futures as compared to OTe forwards serve the same economic
purpose, yet differ in fundamental ways. An individual entering into a forward contract
agrees to transact at a forward price on a future date. On the maturity date, the obligation
of the individual equals the forward price at which the contract was executed. Except
on the maturity date, no money changes hands. Only cash settlement of the positions is
done. This enhances the counterparty default risk in over-the-counter markets.

On the other hand, in the case of an exchange traded futures contract

• Mark to market obligations are settled on a daily basis. Since the profits or losses
in the futures market are collected/paid on a daily basis,the scope for building up
of mark to market losses in the books of various participants gets limited.
• The counterparty risk in a futures contract is further eliminated by the presence of
a clearing corporation, which by assuming counterparty guarantee eliminates credit
risk.
• Further, in an Exchange traded scenario where the market lot is fixed at a much
lesser size than the OTe market, equitable opportunity is provided to all classes of
investors whether large or small to participate in the futures market.
• The transactions on an exchange are executed on a price time priority ensuring
that the best price is available to all categories of market participants irrespective
of their size.
• Other advantages of an Exchange traded market would be greater transparency,
efficiency and accessibility.
• Margining system based on Value-at-risk measures with extreme loss margins to
be incorporated to ensure exchange and clearing corporation manage settlement
risk. Real-time management and monitoring of MTM obligations and margins
requirements would be in place.
The main beneficiaries of the currency futures trading would include anybody having
exposure to.imports or exports (corporates) as well as banks who are authorized dealers
of forex. They would benefit due to the better price discovery of the fair value of the
USDIINR and also due to smaller lot sizes, better risk management capabilities (due to
mark to market of profits/losses), settlement on next day, etc.

76

I
 Types of Markets
1
The benefit of trading in urrency Futures is encapsulated as follows:
• Linear Payoff - not complicated for market participants to understand
• Standardized Contracts, small lot ize - US$ 1,000 •
• Electronic Settlement of MTM Profit /Los es
• No counterparty default risk - novation by clearing house
• Efficient price discovery due to high liquidity
• Large number of market participants
• Transparency - realtime dissemination of prices
• Access through intemet from remote locations
• Additional tool for hedging currency risk
• Broader participation - leading to enlarged forex market
• Permit trades other than hedges with a view to moving gradually towards fuller
capital account convertibility.
• Enhanced retail participation
• Efficient method of credit risk transfer through the Exchange
• Facilitate large volume transactions
• Trade match is anonymous
• Well regulated structure
• Ready national level reference rates at any point of time during trading hours
A more detailed discussion on currency markets is included in Course 4, when the
market structure, valuations and trading strategies in currency markets is discussed. In
the section 3.7, let us analyze the characteristics of commodity markets in India.

Activity 4
1) What is the meaning of currency markets?

2) Why do we require currency markets?

3) List out the major currencies used in global markets.

77
 1
IntroduQtion
to Flnln"hd 3.7 COMMODITY MARKETS
Mlrketl
Global commodity markets have evolved in th la t ISO years with the emergence of the
organized financial marketplace. The ne d to mitigate risk due to the volatility in asset
prices led to innovation of sophisticated financial lnstrumeara Improved satellite technology
with superior digital communication and faster processing speed facilitated emergence
of electronic trading platforms that are accessible with secure connectivity even from
distant locations.
Active trading in commodity markets enables discovery of the fair price of an asset.
Initially, when trading was possible only in over-the-counter markets, it exposed genuine
hedgers to default risk. If a trader wanted to offset an existing open position, it was
difficult to liquidate the same due to the customized nature of the contract. There was
no mechanism to ensure guarantee of settlement, after the trade was made.
This eventually gave rise to organized marketplaces - namely, commodity exchanges.
These exchanges provided the platform to trade in financial instruments and ensured
guarantee of settlement. Further, the standardization of the traded contracts led to
increased liquidity. The following sections discuss the evolution of the global commodity
markets and distinguish between the specific instruments available for hedging against
commodity price risk.
A market where commodities are traded is referred to as a commodity market.
These commodities include bullion (gold, silver, platinum, palladium), ferrous (steel) and
non-ferrous metals (copper, zinc, nickel, lead, aluminium, tin), energy products (crude
oil, natural gas, heating oil, gasoline, etc.), agricultural commodities (refined soya oil,
pepper, palm oil, coffee, pepper, cashew, almonds, etc.).
Existence of a vibrant, active, and liquid commodity market is normally considered as a
healthy sign of development of a country's economy. Growth of a transparent commodity
market is a sign of development of an economy. It is therefore important to have active
commodity markets functioning in a country.
Markets have existed for centuries worldwide for selling and buying of goods and
services. The concept of market started with agricultural products and hence it is as old
as the agricultural products or the business of farming itself. Traditionally, farmers used
to bring their products to a central marketplace in a town/village where grain merchants/
traders would also come and buy the products and transport, distribute and sell them to
other markets.
In a traditional market, agricultural products would be brought and kept in the market
and the potential buyers would come and see the quality of the products and negotiate
with the farmers directly on the price that they would be willing to pay and the quantity
that they would like to buy. Deals were struck once mutual agreement was reached on
the price and the quantity to be bought! sold.
Shortage of a commodity in a given season would lead to increase in price for the
commodity. On the other hand, oversupply of a commodity on even a single day could
result in decline in price - sometimes below the cost of production. Neither farmers nor
merchants were happy with this situation since they could not predict what the prices
would be on a given day or in a given season. As a result, farmers often returned from
the market with their products since they failed to fetch their expected price and since
there were no storage facilities available close to the marketplace. It was in this context
that farmers and food grain merchants in Chicago started negotiating for future supplies
of grains in exchange of cash at a mutually agreeable price. This type of agreement was
acceptable to both parties since the farmer would know how much he would be paid for
his products, and the dealer would know his cost of procurement in advance. This
78
 1
@ffectivelyIiltartedthe sy~tem of eOffiffl()ditymarket forward ecntraets, which lIubHeQuently
led to futurelil market tee,
It is interellting and also necessary to know more about the btstcrleal evolution of
commodity markets, global commodity exchanges and their operations.
It is widely believed that the futures trade first started about approximately 6,000 years
ago in China with rice as the commodity. Futures trade first started in Japan in the 17th
century. Forward markets were also reportedly started in Antwerp around the same
time. In ancient Greece, Aristotle described the use of call options by Thales of Miletus
on the capacity of olive oil presses. The first organized futures market was the Osaka
Rice Exchange, in 1730.

Development of Commodity Exchanges

Historically, organized trading in futures began in the USA in the mid-19th century with
maize contracts at the Chicago Board of Trade (CBOT) and a bit later, cotton contracts
in New York. In the first few years of CBOT, weeks could go by without any transaction
taking place and even the provision of a daily free lunch did not entice exchange members
to actually come to the exchange! Trade only took off in 1856, when new management
decided that the mere provision of a trading floor was not sufficient and invested in the
establishment of grades and standards as well as a nation-wide price information system.
CBOT preceded futures exchanges in Europe.
In the 1840s, Chicago had become a commercial centre since it had good railroad and
telegraph lines connecting it with the East. Around this same time, good agriculture
technologies were developed in the area, which led to higher wheat production. Midwest
farmers therefore used to come to Chicago to sell their wheat to dealers who, in turn,
transported it all over the country.
Farmers usually brought their wheat to Chicago hoping to sell it at a good price. The city
had very limited storage facilities and hence, the farmers were often left at the mercy of
the dealers. The situation changed for the better in 1848 when a central marketplace
was opened where farmers and dealers could meet to deal in "cash" grain-that is, to
exchange cash for immediate delivery of wheat.
Farmers (sellers) and dealers (buyers) slowly started entering into contract for forward
exchanges of grain for cash at some particular future date so that farmers could avoid
taking the trouble of transporting and storing wheat (at very high costs) if the price was
not acceptable. This system was suitable to farmers as well as dealers. The farmer
knew how much he would be paid for his wheat and the dealer knew his costs of
procurement well in advance.
Such forward contracts became common and were even used subsequently as collateral
for bank loans. The corltracts slowly got "standardized" on quantity and quality of
commodities being traded. They also began to change hands before the delivery date. If
the dealer decided he didn't want the wheat, he would sell the contract to someone who
needed it. Also, if the farmer didn't want to deliver his wheat, he could pass on his
contractual obligation to another farmer. The price of the contract would go up and
down depending on what was happening in the wheat market. If the weather was bad,
supply of wheat would be less and the people who had contracted to sell wheat would
hold on to more valuable contracts expecting to fetch better price; if the harvest was
bigger than expected, the seller's contract would become less valuable since the supply
of wheat would be more.
Slowly, even those individuals who had no intention of ever buying or selling wheat
began trading in these contracts expecting to make some profits based on their knowledge
of the situation in the market for wheat. They were called speculators. They hoped to
79
Introduction buy (long position) contracts at low price and sell th m at high price or sell (short position)
to Financial the contracts in advance for high price and buy later at a low price. This is how the
Mllrkets
futures market in commodities developed in the U.S. The hedgers began to efficiently
transfer their market ri k of holding physical commodity to the e speculators by trading
in futures exchanges .
. The history of commodity market in the United States of America (USA) has the
following landmarks:
• Chicago Board of Trade (CBOT) was established in Chicago in 1848 to bring
farmers and merchants together. It start d active trading in futures-type of contracts
in 1865.
• The New York Cotton Exchange was started in 1870.
• Chicago Mercantile Exchange was set up in 1919.
• Legalized options' trading was started in 1934.

MCX, India's No. 1 Commodity Exchange

Multi Commodity Exchange of India Ltd. (MCX) is a "new order" exchange with
permanent recognition from the Government of India. MCX is a nationwide, online
(electronic) multi-commodity marketplace that offers "unparalleled efficiencies", .
"unlimited growth", and "infinite opportunities" to market participants. MCX is a
demutualised exchange since inception. Promoted by Financial Technologies (India)
Limited, MCX has introduced a state-of-the-art, online digital exchange for commodities
trading in the country. MCX has emerged as the largest commodity derivatives exchange
in India. It facilitates trading in bullion, energy, agricultural commodities, base metals,
ferrous and other commodities including electricity and emissions trading.

Major Commodities Traded Worldover

Following is the list of major commodities traded world over in global commodity
exchanges:
Bullion: Gold, Silver, Platinum, Palladium.
Energy: Light Sweet Crude Oil, Natural Gas, Heating Oil, Brent Crude, Electricity,
Propane, Coal, Gasoline, Kerosene.
Metals (Ferrous And Non-Ferrous): Copper, Aluminium, Nickel, Tin, Lead, Zinc, Metal
Alloys.
Agri And Livestock: Live Cattle, Feeder Cattle, Lean Hog, Pork, Milk, Butter, Egg,
Poultry and other farm products, Cocoa, Coffee, Sugar, Wheat, Rice, Corn, Soybean,
.. '

Soybean Meal, Soybean Oil, Rubber, Cotton Yarn, Woollen Yarn, Fine Wool, Greasy
Wool, Broad Wool, Barley, Canola, Canola Meal, Feed Peas, Oats, Beer-Barley, Crude
Palm Oil, Green Benn, Potato, Pig, Rape Seed, Wheat, Corn, Wine, Red Beans, Cotton .1
Yarn, Sheel Egg, Feed Barley, Sunflower Seed, Raw Silk, Rubber, Grains And Flours,
Potato, Sunflower Seed And Oil, Black Matpe, Timbers, Spices Such As Pepper, Cumin,
Cardamom, Cashew Nut.

Regulation of Commodity Markets in India

In India, the Forward Markets Commission is the regulator of commodities trading.
There are 3 national level commodity exchanges, namely:
1) Multi Commodity Exchange of India Limited (MCX), India's largest commodity
derivatives exchange

80

I
 1
2) National Commodity and D rivatives Exchange (N D X) Types of Markets
3) National Multi Commodity Exchange (NM E)
There are also 20 regional exchanges in India, the largest of them being the National
Board of Trade (NBOT), Indore. There is also another national level exchange that is to
be e tablished. Thi is called the Indian Comm dity xchange, which is proposed to be
established jointly by MMTC and Indiabulls. Thi i tentatively slat d for commencing
operations in Oct. 2009.

3.8 DERIVATIVES MARKETS

Financial instruments that derive their value from underlying asset are commonly referred
to as derivatives. When the need arose to mitigate risk due to vagaries of commodity
prices, derivative instruments were developed. Initially, these pertained to linear pay-off
structures such as forward and futures contracts. Subsequently, in the early 1980's,
more complicated derivative contracts such as options and swaps were structured.
Risk associated with over-the-counter market instruments is significantly high. This
pertains to the risk of default by counterparties to transaction. Legal recourse to such
default is usually expensive and time-consuming. There was also the risk of illiquidity, in
case the hedger wants to exit from the contract. This was the reason for emergence of
organized marketplaces such as commodity exchanges.
The exchange platform enables trading in standardized contracts (for example, the stand
lot size of NIFfY futures is 50). Due to the clarity in the contract terms and conditions
for clearing and settlement as well as the standardization of quantity and quality, the
liquidity also increased manifold.
Development of exchanges also led to the system of novation, by which, the clearing
house became the central counterparty for all transactions. This ensured that there was
no risk of default in settlement. The actual settlement of profits and losses was completed
on daily basis, giving rise to the concept of mark-to-market settlement.
Derivatives are presently traded in not only commodity markets, but also equity markets,
currency markets and debt market. In India, exchange-traded equity derivatives were
launched in J 998. Index options, index futures, stock futur s and stock options are traded
in N E. Pr s ntly, the av rage daily turnover of d rlvativ s segm nt in NSE is many
tim s mor than that of th cash segm nt,
Exchange-traded commodity futures w re launch d in India as r cently as in 2003.
Currency derivatives are traded (since 1998) in the ov r-the-eounter markets und r the
strict supervision and regulatory control of RB!. Recently RBI and SEBI have launched
trading in currency futures on currency derivatives exchanges.

Difference between the Exchange Markets and Over-the-counter markets

Financial market transactions can also be broadly classified as follows:
• Over-the-counter (OTC) markets: All transactions that are directly negotiated
between entities (also referred to as counterparties to the transaction) outside the
exchange trading platform. Such transactions result in counterparty default risk
and liquidity risk.
• Exchange markets: The organized marketplace with rules and regulations for
trading in financial products and instruments.

81
Introduction The difference between the exchange markets and OTe markets are highlighted in
to FInancial Table 3.1.
Markets
Table 3.1: Difference between Exchange Markect and OTe
Exchange Markets Over-the-counter Markets

Exchange markets are organized trading The over- the-counter market is largely a direct
platforms, whereby; buyers and sellers can market between two counterpartles who know
transact. The financial products and and trust each other. Contracts are directly
instruments are standardized in terms of negotiated, tailor-made for the needs of the
quantity and quality. It is easy to buy and sell parties, and are often not easily reversed.
contracts (and to reverse positions) and no Since OTC transactions are directly entered
direct negotiation is required - it is a into by counterparties, there is a high risk of
continuous auction system. These are highly default.
regulated markets, with no possibility of
default by market participants.

The most common form of organized trading In contrast, public price quotations for the
of futures and options, the open-outcry over-the-counter market are only just being
system with its shouting and hand waving by introduced, and the quotations are only for
traders on the exchange trading-floor, is highly the more heavily traded instruments. Even
transparent. The transactions are, at least in these quotations are not instantaneous, only
theory, highly competitive; the market reacts indicative (as opposed to futures market
very fast and prices and transactions are quotations, which represent prices at which
monitored every second. Prices on the open- deals actually took place). To get a fair deal
outcry market are almost instantly distributed on the over-the-counter market, good
worldwide. information gathering and negotiation skills
are required.

A clearinghouse guarantees transactions on Over-the-counter market transactions' are

organized exchanges; a default by an guaranteed only by the reputation of the
intermediary is unlikely to lead to losses for counterparty; if the counterparty goes broke
market users. (and some very large trading houses and
banks have gone broke in recent years), large
losses may ensue.

Examples of Over-The-Counter market transactions

• The purchase (or sale) of currency in the spot or forward markets through banks
is an example of the over-the-counter market.
• A trader enters into an agreement with a farmer to buy his produce of potato,
expected to be harvested after two months, at a fixed price.
Examples of Exchange markets transactions
• The purchase (or sale) of equity shares on NSE or BSE.
• Trading in commodity futures contract on MCX, NCDEX, NMCE.
• Trading in currency futures.

Forward and Futures contracts

Forward contract is a contractual agreement between a buyer and a seller to purchase
/ sell respectively a mutually agreed quantity and quality of an underlying asset on a
fixed future date at a pre-determined negotiated price.
Futures contracts are standardized forward contracts. The quality and quantity of the
underlying asset is standardized. Futures contracts are transferable in nature. For all
practical purposes, a forward contract becomes a futures contract if the quality and
quantity are standardized and the contract is traded on a derivatives exchange. This
provides for offsetting deals to square off the open position. Futures contracts are traded
82
 1
in equity markets (with the index and equity stock as the underlying assets), commodity Types of Markets
markets, currency markets (presently trading is allowed for the USDINR currency
exchange pair).
Futures contracts in equity markets were introduced in 1998. Since their introduction,
the volume in equity futures markets has increased phenomenally. NSE is one of the
largest global exchanges for trading in stock and index futures. Options have also been
launched in Indian equity markets successfully.
".-:,.--
Commodity futures contracts were permitted to be traded on Nationally recognized
exchanges since 2003. Trading in commodity futures has been permitted for bullion,
base metals, energy, agriculture, etc. The volumes of increased to more than Rs. 30,000
crores on a daily basis (single side turnover) by all exchanges combined.
Recently, in Aug 2008, RBI-SEBI permitted the launch of USDINR futures trading on
nationally recognized exchanges. MCX and NSE have a combined average daily turnover
of approximately USD 2.50 to 3 billi?n.
The latest .development in' Indian derivatives markets is the introduction of exchange
traded interest rate futures (also referred to as ETIRF). Market participants and even
an individual who has exposure to a home loan or personal loan, are exposed to volatility
in interest rates. To facilitate mitigation of risk due to interest rate volatility, the RBI -
SEBI Standing Technical Committee Report (June 2009) issued guidelines for launch of
Exchange Traded Interest Rate Futures (ETIRF) contracts. ETIRF refers to a contractual
agreement to buy or sell underlying interest bearing instrument(s) on a future date, at a
pre-determined price on the exchange.

Benefits of Exchange Platform

The launch of futures contracts is significant for the Indian market due to the non-
availability of a simple and easy to understand risk management tool with high liquidity in
the OTC markets. The electronic exchange trading platform is aimed at increasing
geographic reach for market participants. The exchange clearing-house ensures zero
counterparty default risk, due to the process of novation. The mark-to-market (MTM)
profits and losses as well as margin deposits (for taking futures positions) are tracked on
a real-time basis. Settlement of MTM is on aT + 1 day (rolling settlement) basis. before
the commencement of trading on the subsequent business day.
In the years to come, exchange trading platforms will gain immense importance in ensuring
an efficient an~ effective platform for risk mitigation to market participants.

Activity 5
1) What is the meaning of commodity markets?

2) Which are the major commodity exchanges in India?

•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• <t •••••••

83
 ]
Introdu tlon 3) List down the major commodities and commodity categories traded in global markets.
to Financial
Markets
• ••••••••••••••••••• 11 •••••••• 1.' ••••• , ••••••••••••••• , ••• ,' ••••• 11 •••••••••••• " •••••• ' ••••• 11 ••••••••••••••••••••••••

4) What is the difference between OTC markets and exchange market ?

3.9 OTHER CLASSIFICATIONS OF MARKETS

We have analyzed in the preceding few sections of Unit 3, the specific characteristics
of money markets, capital markets comprising of debt and equity markets, currency
markets, commodity markets and the derivatives markets. In this section, we shall analyze
characteristics of classification of markets from a perspective based on investment and
business activities.

Loan Markets
Loan Market refers to the activities of banks and financial institutions to make available,
credit for corporate sector. The credit may be extended for trading, manufacturing,
infrastructure, service, industrial manufacturing, and financial activity or otherwise. Loans
may be for short term or long-term. Usually, credit rating agencies assess the credit
worthiness of the corporate. The specific credit rating is used for making decisions by
banks and financial institutions to lend to the borrower,

Insurance Markets
The regulator for the insurance market ill Insurance Regulatory Development Authority
(IRDA). Until beginning of 1990's, LIe was th sole lif insurer in India. ubs quent to
th liberalization of th Indian onomy and institution of financial s ctorr forms, private
sector was allowed to commence IW insuranc and n ral in uranc activities. With a
growing population, insurance is r quir d by ev rybody. But Insurance eompanle are
allowed to operate by adhering to strict compliance measures, due to the high level of
risk involved.
Retirement Savings Market
Retirement Savings Market are long term funds pooled from investors by provident
funds, pension funds and superannuation funds. They perform the important activity of
providing resources and security for individuals in their old age. These funds are invested
in long term securities.

Mutual Funds
Mutual Funds provide the means for the small investors to reduce transaction cost,
while trading in the securities markets. Professional mutual funds have analysts who
take calls on the market for collectively investing the corpus of the funds provided by
the investors. Based on the market value of the exposure - Assets Under Management
(AUM) - the net asset value (NAV) is communicated to the investors. The investors
buy/sell mutual fund units based on the NAV. Mutual funds are regulated by the
Association of Mutual Funds in India (AMFI), which is a self regulatory organization.
84
 1
Savings and Investment Markets Types of Markets

The savings and investment markets consist of several retail financial savings products
for the household sector. Whereas the corporate sector relies on banks and financial
institutions for credit, the household sector is dependent on not only banks and financial
institutions (that provide retail products), but also chit funds, nidhis and IJ1utualbenefit
societies.

3.10 SUMMARY
A market is a place where buyers and sellers meet to exchange goods, services or even
financial products/instruments for a consideration. This consideration is usually money.
Markets can also be defined as channels through which buyers and sellers exchange
goods,services and resources. The present-day markets gradually evolved over several
centuries. The objective of establishing a marketplace is to facilitate a congregation of
buyers and sellers in a single location, to facilitate their interaction. With the advent of
the Informational Technology (IT) revolution, the physical marketplace has gradually
been replaced with electronic trading platforms. Cash or spot markets refer to transaction
for immediate delivery.
Capital markets involve raising finance through issue of publicly traded financial
instruments in equity and debt that can be bought and sold at any time. For facilitating
this framework, financial intermediaries play a very important role. The "financial claims"
- bonds, fixed deposit receipts, shares, etc. - that were discussed in Unit 1 of this
course can be traded are issued to investors by those seeking funds. The investors -
comprising participants in t~e financial markets such as individuals, banks, RNI and
other entities - could buy these "financial claims" in the primary and secondary markets.
Capital Markets include money markets, debt markets and equity markets, savings and
loan markets, retirement / pension fund market. Other markets include commodity and
currency markets and more sophisticated markets such as the derivatives markets.
The characteristics of currency and commodity markets, derivatives markets including
the concept of OTC and Exchange traded derivatives markets has been discussed.
Thus, having indentified the different types of markets and their salient features
(characteristics), we shall discuss in Unit 4, the different market participants including
financial institutions and intermediaries which are critical for growth and development
of an effective ad efficient financial system.

3.11 SELF ASSESSMENT QUESTIONS

1) What is the meaning of a market?
2) Why do we require markets?
3) Discuss the evolution of markets?
4) What are the different types of markets in the contemporary context?
5) What is the meaning and significance of capital markets?
6) What are the functions of capital markets?
7) .What is the difference between primary and secondary markets?
8) What is the meaning of equity markets? Discuss the reforms initiated in the Indian
equity markets?
9) What are the different types of equity traded?
10) Discuss the major reforms initiated in the primary and secondary equity markets?
85

I
Introduction 11) What is the debt market? What are the components of the Indian Debt Market?
to Financial
Markets 12) Discuss the major events in the Indian Debt Market?
13) . What is the meaning and significance of Money Markets?
14) What is the foreign exchange (currency) market? Which are the major currencies
traded?
15) Discuss other markets such as savings and loan markets, retirement (pension fund)
markets, mutual funds, insurance markets, etc.
16) Explain the evolution of commodity markets and its significance.
17) Explain the meaning of "Derivatives".
18) What is the difference between OTC and Exchange Markets?

3.12 FURTHER READINGS

1) Khan, M.Y. (2007) Indian Financial System, Tata McGraw-Hill.
2) Endo, Tadashi (1998) Indian Securities Market, Vision Books.
3) Pathak, Bharati V. (2008) The Indian Financial System, Markets Institutions
and Services, Pearson Education, Second Edition.
4) Crane, Dwight B. (1995) The Global Financial System: A Functional
Perspective,Harvard Business School.
5) UNCTAD (2005) Survey of the world's commodity exchanges, Aristotle, Politics
1259 a 6-23.

. .

86
 Annexure 1: Manjor Events in the Debt Market Types of Markets

Year Reform Initiated

.. Objectives
Jun-1992 Commenced auction of Central Government To induce transparency into the process
Securities at market determined rates for the
first time
Jan-1993 91 day Treasury Bills offered through To offer an instrument for managing the
auctions at market determined rates liquidity
Jan-1994 Issued Zero coupon Bond for the first time. To add new instruments and intermediaries
Securities Trading Corporation of India
(STCn commenced operations
Aug-1994 A historic agreement was signed between To pave way for abolition of adhoc treasury
REI and the government on the net issue of bills
adhoc treasury bills
Mar-1995 Guidelines and procedures for enlistment of To strengthen the market
primary dealers issued
Jul-1995 Delivery-versus-Payment (DVP) in G-secs To reduce settlement risk
was introduced
Sep-1995 Floating Rate Bonds (FREs) was introduced To add more instruments
Jan-1997 Technical Advisory Committee (TAC) was To advise REI on developing G-sec market
constituted
Mar-l 997 Historical agreement between Government To discontinue automatic monetization
and REI to, inter alia, discontinue adhoc T-
Bills
Apr-1997 FIMMDA was established. Repo was Self regulation To deepen the repo market and
permitted in all G-secs to SGL alc holders to shift the money market from Call to collater-
alized repo market
Jul-1997 FITs were permitted to invest in G-secs To broaden the market
Dec-1997 Capital Indexed Bonds were issued PDAI To help investors hedge the risk
was formed
Apr-2000 Sale of securities allotted in primary issues To improve secondary market
on the same day
Jun-2000 Introduction of Liquidity Adjustment To manage short liquidity mismatches
Facility (LAF)
Feb-2oo2 Negotiated Dealing System (NDS) (Phase I) For improved trading and settlement!
operationalised Clearing Corporation of Guaranteed Settlement by a CCP.
India Ltd.(CCIL) was operationalised c,

May-2oo2 Compulsory holding of G-secs in demat To reduce the settlement risk

form by RBI regulated entities
Jun-2oo2 PDs were brought under the BFS jurisdiction To offer variety instruments
Jul-2oo2 G-secs with call and put option was To offer variety instruments
introduced
Oct-2002 Trade data of NDS is being made available To improve transparency
on REI website
Jan-2oo3 Trading of G-secs on stock exchanges To facilitate easier access and wider participation
Feb-2oo3 Eligibility to participate in the repo market To widen the market
was extended to non-banks
Jun-2oo3 Interest Rate Derivatives (IRD) have been To facilitate the market to hedge their market
introduced risk
Jul-2oo3 Government Debt Buy-Back scheme was To reduce interest burden of government and to
successfully implemented market participants offload their illiquid securities
Mar-2004 RTGS system trial run and final Real time, online, value inter-bank payment
implementation and settlements
Dec-2oo7 Enactment of Government Securities Act, 2006 Investments in Government Securities
and Government Securities Regulations, 2007. become investor- friendly
Apr-2oo8 Increase in inflation leads to increasing Yield rates of bonds increase
repol reverse repo rates, CRR
Dec-2oo8 Decrease in inflation; Commencement of Bonds become attractive
decrease in repo I reverse repo rates
87
 1
Introduction Annexure 2
to Financial
Markets Structure of Markets

Securities Markeb

I.

Commodity Cu""rn:v
Capital Markets Money Markets Markets Markets

Treasury 8111s, Call money

markets, commerdal bill., orc market -for tr.ding In
commercial papers, OTC market -Ior trading in forward contracts, swaps
Equity Markets OebtMarkets ertiflcate, 01 Deposit, Ter and other exotit: derivatives
IO/ward contracts
Money

Primary Market
Publici!>stJes. private
Government Securitles
Commodily futures Exchange r raded Currency
placement. Exchanges futures

Sewndary Market
NSE, BSE and regional, tock
PSU60ndMarket
exchanges

Oerivatives: Markets
change traded future. an
option,; OTC market Private Corporate Debt

j
j
1
I
88
 1
UNIT 4 MARKET INSTITUTIONS AND
INTERMEDIARIES
Objectives
After studying this unit, you should be able to:
• identify the different fmancial market institutions;
• understand the role and significance of regulators;
• identify the intermediaries involved in different markets; and
• appreciate the role of financial institutions, exchanges, intermediaries and regulators
in financial markets.

Structure
4.1 Introduction
4.2 Reserve Bank of India
4.3 Securities Exchange Board of India
4.4 Bombay Stock Exchange of India Limited
4.5 National Stock Exchange of India Limited
4.6 Other Stock Exchanges in India
4.7 Intermediaries Involved in Settlement
4.8 Banking Institutions

4.9 Intermediaries to a Primary Markets Issue

4.10 Intermediaries Involved in Trading and Facilitating Investment
4.11 International Financial Markets Institutions: An Overview
4.12 Summary
4.13 Self Assessment Questions
4.14 Further Readings

4.1 INTRODUCTION
Both the primary and secondary markets in India have demonstrated phenomenal growth
in both number of corporate entities that are listed, as well as market capitalization,
market value of listed companies to the Gross National Product (GNP), number of
shareholders (especially participation by the retail public, which is still set to increase
further) and various other parameters. The success of the capital market structure is
due to the policy making institutions, regulatory institutions, self regulatory institutions
(SRO), independent watchdogs, depositories / custodians, and other intermediaries.
The key to efficient and effective performance of global financial markets is regulation
based on sound policy framework. The recent credit crisis (2007-08) was due to the
lack of effective governance of the over-the-counter markets. The US government has
instituted widespread reforms in the regulatory structure of financial and securities
markets. Many banks have Collapsed in US during the recent economic crisis.

89
Introduction The Government of India through the regulator, Securities Exchange Board of India
to Financial (SEBI) ensures broad uniformity in the structure and functioning of the equity markets.
Markets
As of today, there are 24 recognized stock exchanges in India - some of them have
. permanent recognition and other exchanges need to renew their license every year.
The largest stock in India is the National Stock Exchange (NSE). Even though Bombay
Stock Exchange (BSE) is the oldest stock exchange in Asia, NSE has substantially
overtaken the volumes traded in the Indian equity markets - both in the cash segment
and derivatives segment.
With the advent of currency futures trading, the latest stock exchange to be established
is the MCX Stock Exchange (MCX -SX), a subsidiary of Multi Commodity Exchange of
India Limited, (MCX). MCX-SX was established for trading in currency futures. It is
expected to be allowed to trade in equity and interest rate futures also, shortly, subject to
regulatory approval.
While stock exchanges play a very important role in enabling the development of the
secondary market, the primary markets allow companies to raise capital by issue of
shares - Initial Public Offering, Follow-on Public Offering, Rights Issue, Debentures,
and other instruments. Intermediaries in the primary markets include, Merchant Banker,
Registrars (to the issue) and Bankers to the issue.
Banks, Financial Institutions, Insurance companies, Mutual Funds (Asset Management
Companies) are major participants in the Indian capital markets.
I

The term financial intermediary usually refers to an institution, firm or individual who
performs intermediation between two or more parties in a financial context. Typically
the first party is a provider of a product or service and the second party is a consumer
or customer.
Financial Intermediaries are banking and non-banking institutions which transfer funds
from economic agents with surplus funds to economic agents that would like to utilize
those funds. Such intermediaries are broadly classified into two types:
1) Bank Financial Intermediaries, consisting of Central Bank, Commercial banks
2) Non-Bank Financial Intermediaries, such as insurance companies, mutual funds
(asset management companies), investment companies, pensions funds and discount
houses.
The regulatory structure in Indian Financial Markets has to a large exten~, not impacted
the performance of financial markets in India. Not a single banking institution in India
has been affected due to the credit crisis that originated in the developed rriarkets. The
regulation in Indian Financial Markets is governed by a multi-layered structure of
Government and its Regulatory bodies, as well as self-regulatory organizations.
In India, the first level of the regulatory structure is the Government of India. The
regulatory bodies effectively report to the Government of India and are accountable for
the efficient and effective performance of the Indian Financial System.
The banking institutions are regulated by the central bank, Reserve Bank of India (RBI).
RBI regulates all commercial banks, scheduled and non-scheduled banks, urban
cooperative banks, state and central district cooperative banks, All-India Financial
Institutions such as the Industrial Finance Corporation of India (lFCI) , Industrial
Investment Bank of India (lIBI), Export-Import (Exim) Bank, TFCI, State Industrial
Development Bank of India (SIDBI), National Bank for Agriculture and Rural
Development (NABARD), National Housing Board (NHB), Non-banking Financial
Companies (NBHC) and the debt market and money market participants including primary
dealers, and foreign exchange markets participants - authorized forex dealers.

90
 1
The Securities Exchange Board of India (SEBI) is the regulator for all Capital Market Market Institutions
and Intermediaries
Institutions, intermediaries, mutual funds (the Association of Mutual Funds in India or
AMFI is also a self-regulatory organization overseeing the functioning of mutual fund
activities), venture capital, foreign institutional investors and the corporate bond market.
The currency futures market is regulated by both SEBI and RBI. SEBI oversees the
functioning of the stock exchanges that permit trading in equity products and currency
futures. It may be noted that while the Government Securities markets and money
markets are governed by ~I, the Corporate Bond markets is regulated by SEBI. The
Insurance Regulatory and Development Authority has complete jurisdiction over the
functioning of the insurance companies - both life insurance companies and non-life
insurance companies.
The RBI, State Government and State Industrial Development Bank of India (SIDBI)
jointly regulate the functioning of the Urban Cooperative Banks, State and District level
Cooperative Banks, State Financial Corporation (SFC) and the State Industrial
Development Corporations (SIDC). NABARD, which has been formed with specific
focus on rural development and agricultural financing, oversees the functioning of Rural
Cooperative Banks and Regional Rural Banks (RRB).
The Indian Securities Markets is also regulated by Government agencies such as
Department of Economic Affairs (DEA) and Department of Company affairs (DCA).
The activities of these entities are coordinated with the functioning of SEBI and RBI, by
a high level committee on capital and financial markets.
All stock exchanges are managed by a governing body that consists of elected broker-
directors (except National Stock Exchange and Over-the-Counter-Exchange-of-India),
public representatives and Government / SEBI nominees. The number of stock broker
members has now been reduced to 40%. For regulation and control of transactions,
each stock exchange has its own bye-laws and regulations which are almost uniform
across all exchanges.
Until end of 1980s, stock exchanges were working as self-regulatory organizations
supervised by the Ministry of Finance under SCRA. This was until SEBI was established,
which became the regulator of all stock exchanges in India.
Stock exchange regulations focus on several important activities, including:
1) Market Operations: Risk Management, Trading and Surveillance, Clearing and
Settlement (through exchange clearing departments of clearing corporations).
2) Enrolment of members - brokers and their authorizes assistants.
3) Enlistment of securities of companies.
4) Imposition of margins, limits is also the function of the stock exchange. Client
registrations and exposures are also tracked. To prevent any disruption in trading
activity, circuit breakers - with floor and ceiling prices - are put in place by the
exchange, as part of risk management.
5) Disciplining in case of malpractices - constitutes measures such as giving warning,
reprimand, censure, fine, or withdrawal of all or any membership rights. In the
case of errant listed companies, the stock exchanges are empowered to suspend
dealings in securities and delist securities.
Some of the major committees that have recommended reforms in the organization of
stock exchanges in India are G S Patel Committee (1985), L C Gupta Committee (1991),
Pherwani Committee (1991), G S Patel Committee (1995) and Varma Committee (1997).
Stock exchanges create a wealth effect for the economy. As companies continue to
gen.erate profit, reserves and surplus of the company increases. This in turn increases
the confidence of the shareholders and results in increase in the share price, due to
expected future earnings. This in turn increases the market capitalization of the firm.
91
Introduction
to Financial 4.2 RESERVE BANK OF INDIA (RBI)
Markets
The Reserve Bank of India (or RBI) was established enacting the Reserve Bank of
India Act in 1934. RBI commenced functioning on 1si April 1935 and is headquartered
in Mumbai. Upon inception, RBI was a private entity. Subsequently, Government of
India nationalized RBI in 1949.
The major objectives of RBI are as follows:
• Secure the monetary stability of India.
• Operate currency and credit system to the advantage of India.
Thus, price stability, ensuring adequate availability of credit to fmance economic activities
for the benefit of the country are the major objectives of RBI.

Structure of RBI
RBI is managed by a central board of directors and four local boards of directors. The
central board is appointed/nominated by the central government for a period of four
years. It consists of official directors and non-official directors.
The RBI Governor and not more than four Deputy Governors can be full-time official
directors. Non-official directors are 15 in number. Ten directors are come various fields
and one government official are nominated by the Government of India. Four directors
from four local boards are nominated as non-official directors.
The functions of the central board are general superintendence and c!irection of the
bank's affairs. The four local boards are located in Mumbai, Kolkota, Chennai and New
Delhi. The membership of each local board consists of five members appointed by the
central government, for a term of four years.
The functions of the local board is to advise the central board on local matters, to
represent territorial and economic interns of local cooperative and indigenous bank's
interests and to perform such other functions as delegated by the Central Board,
periodically.
RBI has 22 regional offices in major state capitals. RBI also has six facilities for providing
training to bank employees.

Legal Framework
RBI functions under the framework of the following legislations:
• The Reserve Bank of India Act, 1934 - this governs the functions of RBI.
• The Banking Regulation Act, 1949 - this governs the financial sector.
Both the prior mentioned Acts provide wide-ranging powers to RBI.
The following acts govern specific functions of RBI:
• Public Debt Act of 1944 and is replaced by the Government Securities Act, 2006.
• Securities Contract regulation Act, 1956.
• Indian Coinage Act, 1906.
• FERA, 1973 is replaced by FEMA, 1999.
The acts that govern banking operations are as follows:

• Companies Act, 1956.

• Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/ 1980,
is associated with nationalization of banks.
92
• Banker's Book Eviderice Act. Market Institutions
I
and Intermediaries
• Banking Secrecy Act.
..
• Negotiable Instruments Act, 1881.
The acts governing individual iristitutions are as follows:

• State Bank of India Act, 1954.

• The Industrial development Bank of India Act.
• Industrial Finance Corporation of India Act.
• National Bank· for Agricultural and Rural Development Act.
• National Housing Bank Act.
• Deposit Insurance and Credit Guarantee Corporation Act.

Functions of RBI
RBI was originally constituted to regulate the issue of bank notes and to keep reserves
to secure monetary stability and operate currency and credit system of the country. The
major functions of RBI are as follows:
• To maintain monetary stability, facilitating growth and development of Indian
economy.
• Maintain financial stability.
• Regulate financial institutions.
• Build confidence among the public, in the Indian economic strength.
• Promote development of financial infrastructure.
• Ensure credit allocation by the financial system broadly reflects the national economic
priorities and societal concerns.
• To regulate the overall volume of money and credit in the economy.

Role of RBI
RBI is the lender of last resort. Following are the roles' and responsibilities of RBI:
• RBI is the note issuing authority and the only authorized issuer of currency notes.
One-Ruppee coins and other coins of smaller denominations are issued by the
central Government. But RBI has the responsibility of circulating the coins, apart
from issuing,currency notes.
• RBI is also the Government's banker - both for central and state governments.
RBI is not eligible to receive any interest for the activities conducted on behalf of
the Government. RBI performs all banking activities on behalf of the Government
- including acceptance of deposits, withdrawal of funds by cheques, making!
receiving payment, transfer of funds, management of public debt, etc. RBI also
provides safe custody facilities, manages special funds such as the Calamity Relief
Fund, Consolidated Sinking Fund, etc. RBI also issues and manages RBI relief
bonds. It also administers disbursal of pension for Government employees. The
management of public debt is facilitated by special mechanism such as the Ways
and Means Advances (WAMA).
• RBI also functions as a Banker's Bank, by stipulating the Statutory Liquidity Ratio
(SLR) and Cash Reserve Ratio (CRR) which banks need to maintain.
• RBI also has powers to regulate the functioning of the Non-Banking Financial
Companies (NBFC).
• RBI also oversees the functioning of the currency markets is the Exchange Control
Authority. This is done under the FEMA (discussed in the previous sections) ..
93
 1
Introduction • RBI has the important function of regulating the money supply in the country and
to Financial credit availability. This is done through a series of techniques / tools / instruments
Markets
of monetary control, as follows:
• Open Market Operations (OMO): sale and Purchase of central and State
Government Securities, Treasury Bills, etc. .
• Bank Rate (BIR): This is the standard rate at which RBI buys / rediscounts
bills of exchange or other eligible securities, such as commercial papers.
• Refinance: This facility is executed through the "export credit refinance" and
the "general refinance". It facilitates directional flow of credit for selective
sectors, as well as relieve temporary liquidity shortages faced by banks.
• Cash Reserve Ratio (CRR): Cash which banks have to maintain with RBI,
as a percentage of their demand and time liabilities. This is a primary reserve
requirement specified by RBI to banks.
• Statutory Liquidity Ratio (SLR): This is the secondary and supplementary
reserve requirements on the banking system. SLR aims at restricting expansion
of bank credit, encourage bank's investment in Government Securities and
ensure solvency of banks.
• Liquidity Adjustment Facility (LAF): In order to transform RBI's
intervention from direct method (such as sector specific refinance facilities
and collateralized lending facilities) to more indirect methods of general
refinancing, RBI commenced using repo and reverse Repo rate effectively, to
implement monetary control. This was based on the recommendations if the
Narasimham Committee II (1998).
It may be noted that the LAP operations combined with OMO and BIR changes have
become the major technique (operating procedure) for controlling the monetary policy
in India, by RBI. .

Activity 1
1) . List down any five major functions of RBI?

2) What is the structure of RBI?

4.3 SECURITIES EXCHANGE BOARD OF INDIA

The securities markets which emerged from the periphery into the mainstream of the
financial markets from. 1980s, and especially since the beginning of 1990s. The equity
markets in India have witnessed a spectacular growth in terms of its ability to raise
resources and to allocate with efficiency.

94
But this process requires strict regulatory compliance, due to possible malpractices by Market Institutions
unscrupulous companies. Although a strict regulatory compliance policy was in place and Intermediaries
before the liberalization of the Indian economy, the focus was on greater control. The
legal framework before 1990s was highly fragmented, both in terms of laws and acts
under which the regulations allowed the functioning of Government departments.
For example, the Capital Issue (Control) Act, which was administered by t~e Controller
of Capital Issues (CCI) in the Ministry of Finance required all companies to obtain prior
approval for issues of capital to the public. Under this arrangement the pricing as well as
the features of the capital structure such as debt-equity ratios were controlled by the
Government. Similarly, the Securities Contract Regulation Act was administered by the
Directorate of Stock Exchanges, also in the Ministry of Finance. Its aim was to prevent
undesirable transactions in securities issued and traded. It empowered the Government
of India to recognize/derecognize stock exchanges, stipulate rules / byelaws for their
functioning; compel listing of securities by pubic companies, etc. Such a system of
regulation and control was inadequate in the context of liberalized economy. '
Thus, the next phase of reforms in the capital markets was initiated. This required for an
integrated and focused regulatory framework with its administration by an independent
/ autonomous body. The Capital Issues (Control) Act was repealed in 1992 and Office
of the Controller of Capital Issues (CCI) was abolished. The Securities Exchange Board
of India was established in April, 1988 by a regulatory order and acquired a statutory
status in 1992.
With the announcement of the liberalization of the Indian economy in 1991, by way of
reforms package, the volume and value of business in the primary and secondary
segments of the capital markets increased. But this also was accompanied by stock
market seams, The prevailing regulatory framework was fragmented and required
integration.
It was in this perspective that the Securities and Exchange Board of India (or SEBI)
which was in existence from 1988, was given statutory powers to regulate the capital
markets. The SEBI obtained legal regulatory powers by way of an ordinance issued on
30th January, 1992. The ordinance conferred wide ranging powers on SEBI including:

• Prohibition of insider trading

• Regulation of acquisition of substantial shares
• Takeover of business
• Recognition of stock exchanges
• Membership criteria
• Powers to regulate other specific functions of capital markets
This enabled the repealing of the Capital Issues (Control) Act and the abolition of the
office of the Controller of Capital Issues (CC I) in 1992. The statutory powers to SEBI
were conferred on 21 st February, 1992. The objectives of establishing SEBI includes
investor protection, promotion and development of capital markets while simultaneously
regulating the functioning of the securities markets, risk containment, broadbasing the
markets by enlargement of participation, maintaining market integrity and promoting
long-term investments.
The ordinance that was passed was repealed, after the SEBI Act was enacted on 4th
April, 2009. Thus, the SEBI Act of 1992 along with the Companies Act, 1956, ensured
devolvement of specific powers to SEBI. The regulatory powers of SEBI were further
enhanced through the Securities Law (Amendment) ordinance of Jan 1995. The SEBI
functions as an independent body under the Ministry of Finance and is accountable to
Parliament. Thus, SEBI functions as an independent body and are accountable to the
Indian Parliament. There are specific statutes for governing the markets.
95
Introduction Scope of SEBi' Act
to Financial
Markets The SEBI Act rays down the constitution for the management of SEBI. The SEBI
board of members consists of Chairman, two members from amongst the officials of
the ministries of the Central Government dealing with finance and law, 1 member from
amongst the officials of the RBI (constituted under the RBI Act, 1934), two other
members appointed by the Government of India - who shall be professionals and inter
alia,' have experience and knowledge of the securities markets.
In its endeavour to protect the investors' interests in securities markets, and to promote
the development of capital markets, following comprise of the powers and functions of
SEBI:
• Regulating the stock exchanges; extending/cancelling their recognition.
• Registering and regulating the working of stock brokers, sub-brokers, share transfer
agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant
bankers, underwriters, portfolio managers, investment advisors, and other
intermediaries associated with the securities markets. .
• Registering and regulating the functioning of the Collective Investment Schemes;
including mutual funds - portfolio management services, etc.
• Promoting and regulating self regulatory organizations.
• Prohibiting fraudulent- and unfair trade practices in the securities markets.
• Promoting investor education and trading practices in the securities markets.
• Prohibiting insider trading in securities markets.
• Regulating substantial acquisition of shares and takeovers of companies.
• Conducting external audit, inquiries by calling for specific information, undertaking
inspection activities of stock exchanges and intermediaries, self-regulatory
organizations in the securities markets. -
• Performing functions under the SCRA, 1956 and as directed by the ernment
of India.
• Levying fees .or other charges from intermediaries in the capital marke
The SEBI has powers to implement the following actions:
• Call for information from any intermediary or market participant.
• Inspect books of depository participants, issuers or beneficiary owners.
• Suspend or cancel a certificate o~ registration granted to a depository partic
or issuer.
• Request the RBI to inspect books of a banker to an issue.
• Suspend or cancel the registration of the banker to an issue.
• Suspend or cancel the certification issued to the custodian of securities.
• Suspend or cancel registration of a foreign institutional investor,
• Investigate and inspect the books of accounts of and records of 'insiders. '
• Investigate an acquirer, a seller, or merchant banker for violating takeover rules.
• Suspend or cancel registration of a merchant banker to an issue.
• Investigate the functioning of mutual funds, their trustees, and asset management
companies.
• Investigate any p~rson dealing in securities on complaint of contravention of trading
regulation.
• Suspend or cancel registration of errant portfolio managers.
96

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• Suspend or Cancel the certification of registrars and share transfer agents. .;Market Institutions ,<

and Intermediaries
• Suspend or Cancel the certification of brokers who fail to furnish information of
transactions in securities or who furnish false information.
Since then, it has emerged as an autonomous and independent statutory body with the
following' objectives:

• To protect the interest of investors in securities.

• Promote the development of the securities markets in India.
• Regulate the securities markets in India.
In order to achieve the above objectives, SEBI was provided with special statutory
powers based on the following legislation:

• The SEBI Act.

• Securities Contract Regulation Act.
• Depositories Act.
• Delegated powers under the Companies Act.
• SEBI supervises the markets based on specific regulations and guidelines of
schemes.·

SEBI Securities Markets Regulations and Guidelines

Regulations
• SEBI (Stock Brokers and Sub-brokers) Regulations.
• SEBI (Prohibition of Insider Trading) Regulations.
• SEBI (Merchant Bankers) Regulations.
• SEBI (Portfolio. Managers) Regulations.
• SEBI (Registrars to an Issue and Share Transfer Agents) Regulations.
• SEBl (Underwriters) Regulations.
• SEBI (Debenture Trustees) Regulations.
• SEBI (Bankers to an Issue) Regulations.
• SEBI (Foreign Institutional Investors) Regulations.
• SEBI (Custodian of Securities) Regulations.
• SEBI (Depositories and Participants) Regulations.
• SEBI (Venture Capital Funds) Regulations.
• SEBI (Mutual Funds) Regulations.
• SEBI (Substantial Acquisition of Shares and Takeovers) Regulations.
• SEBI (Buyback of Securities) Regulations.
• SEBI (Credit Rating Agencies) Regulations.
• SEBI (Collective Investment Schemes) Regulations.
• SEBI (Foreign Venture Capital Investors) Regulations.
• SEBI (Procedure for Board Meeting) Regulations.
• SEBI (Issue of Sweat Equity) Regulations.
• ,SEBI (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty)
Regulations.
• SEBI (Prohibition of Fraudulent and Unfair Trading Practices relating to Securities
Markets) Regulations.
97

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 1
Introduction • SEBI (Central Listing Authority) Regulations.
to Financial
Markets • SEBI (Ombudsman) Regulations.
• SEBI (Central database of Market Participants) Regulations.
• SEBI (Self Regulatory Organization) Regulations.
• SEBI (Criteria for Fit and Proper Person) Regulations.

Guidelines
• SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme)
Regulations.
..• Guidelines for opening up of Trading Terminals abroad.
• SEBI (Disclosure and Investor Protection Guidelines).
• SEBI (Delisting of Securities) Guidelines.
• SEBI (STP Centralized Hub and STP Service Providers) Guidelines.
• Comprehensive Guidelines for Investor Protection Fund / Customer Protection
Fund at Stock Exchanges.

Schemes
• Securities Lending Scheme.
• SEBI (Informal Guidance Scheme).

Role of SEBI
SEBI prohibits unfair and fraudulent trading practices - such as insider trading, price
manipulation, price rigging, circular trading, etc. It also regulates substantial acquisition
of shares and takeovers. In order to safeguard the integrity of the markets and to provide
investor protection, there is a comprehensive real-time surveillance mechanism. The 3-
tier level of regulation involves the Government of India under the Ministry of Finance,
SEBI and the stock exchanges themselves. Stock exchanges are the first level of
regulation from the traders and broker-members point of view. The stock exchanges
themselves have surveillance cells, which track malpractices. SEBI also keeps a constant
vigil on the trading activities. News and rumours appearing in the media as discussed in
the weekly surveillance meetings with the representatives of stock exchanges. In
exceptional circumstances, SEBI initiates special investigation on basis of reports received
from various sources. In order to increase the stringency of surveillance measures,
SEBI has signed an agreement with a consortium consisting of the following entities:
HCL Technologies Ltd., Securities Markets Automated Reach and Training and
Surveillance Limited, Australia. The agreement was to establish a comprehensive
"Integrated Market Surveillance System" (lMSS) in March, 2006. IMSS would generate
automatic alerts that would help the regulator to identify and track market manipulations,
insider trading activity, etc.
In order to resolve the overlapping of regulatory control between multiple regulators, a
High Level Coordination Committee (HLCC) has been formed under the chairmanship
of the RBI Governor. The Committee meets at regular intervals to resolve any issues.
There ate also Standing Technical Committees (STC) for RBI regulated, SEBI regulated
and IRDA regulated entities. These Standing Technical Committees deliberate on inter-
regulatory issues and provide input for the HLCC meetings.

Enforcement of Regulation
Strict enforcement of regulations is done through investigations and adjudications. If
after a preliminary investigation, it is found necessary, then a formal investigation team
is formed. In such circumstances, SEBI may call for specific information from market
98
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participants and institutions, compelling production of documents and examination of Market Institutions
witnesses, etc. There is an elaborate procedure for adjudication and prosecution of and Intermediaries
participants / agencies responsible for violation of the regulations. The Chairman and
Whole Time Members of SEBI are vested with statutory power to impose penalties,
issue directions, suspend / cancel a registration, etc. Also, a set of adjudicating officers
work independently and have powers to pass orders. These orders are also posted on
SEBI website for public information.
The orders of SEBI under the securities laws are appealable before a Securities Appellate
Tribunal (SAT). The orders of SAT are appealable before the Supreme court.
SEBI has powers to register and regulate all intermediaries in capital markets. It has the
powers to levy penalty in case of violations of the Act, Rules or Regulations within its
purview. SEBI can also conduct inquiry into the role of intermediaries, in case of seams
or other market abuses. The list of intermediaries under its jurisdiction is given in the
above table.
Broadly, the responsibilities of SEBI under the SEBI Act, 1992 can be summarized as
follows: ' .

• Register and regulate the working of stock brokers, sub-brokers, share transfer
agents, bankers to an issue, trustee of trust deeds, registrars to an issue, merchant
bankers, underwriters, portfolio managers, investment advisors, and such other
intermediaries associated with the securities markets.
• Register and regulate the working of the depositories, depository participants,
custodian of securities, foreign institutional investors, credit rating agencies, or any
other intermediary associated with the securities markets as notified by SEBI.
• Register and regulate the working of venture capital funds, collective investment,
mutual funds.
The prior mentioned intermediaries can operate in securities markets, only after obtaining
certificate of registration from SEBI. The regulator has the powers to suspend or cancel
a certificate of registration that has been issued. It has sub-coIilrnittees for specifying
r •
the aggregate disclosure of critical information from market intermediaries. SEBI also
has powers to promote and regulate Self-Regulatory Organizations (SRO).

Supervisory Role of SEBI

SEBI has the authority to inspect the books of accounts and records of depository
participants, registrar to a primary issue and other market intermediaries. SEBI can also
issue show cause notices to companies on the basis of reports submitted by the
depositories. SEBI periodically inspects stock exchanges, with the following objectives
• To ensure that the stock exchange provides an environment that is conducive for
all the market participants, i.e., the market should be fair and equitable for all
market participants, without any bias.
• To ensure that the stock exchange has complied with the necessary rules for the
grant of recognition to the stock exchange, under the SCRA.
• To ensure that the stock exchange's organizational structure, rules, bye-laws,
regulations are within the purview of the regulatory structure as well as the SCRA.
., To ensure that the stock exchange has implemented the directions, guidelines and
instructions issued by SEBI.
• To ensure that the stock exchanges have adequate trading and surveillance
capabilities, exchange risk management systems, and management control systems
in place.

99
Introduction Inspection of the exchange involves a thorough review of existing operations,
to Financial management, organizational structure and administrative control. The inspection of the
Markets
brokers and sub-brokers is periodically conducted by SEB!. SEBI has also laid down
regulations for audit to be conducted by the stock exchanges, on its members' accounts.
The disclosure requirement framework has been put in place, to maintain checks and
balances on the trading activities. The books of accounts maintained by the intermediaries
including the subsidiaries of stock exchanges (that have become members of larger
exchanges themselves), need to adhere to the SCRR.
SEBI also conducts periodic inspection of the depositories. In order to verify the technology
used by market intermediaries, a system audit is also conducted. SEBI has also laid
down guidelines for conducting the system audit by stock exchanges. This is to ensure
quality of technology and software systems used by stock exchanges. The audit also
covers the front-end Trader Work Stations used by brokers.
SEBI has established market surveillance mechanisms for ensuring safety and integrity
of the markets, Even though the frontline surveillance responsibility lies with the stock
exchanges, SEBI has a separate surveillance department which monitors market . I

movement (volatility in prices) and analyzes trades between specific market participants.
In case of any malpractice or market abuse that is identified, SEBI takes immediate
action with the assistance of the stock exchanges and depositories. The surveillance
cells of the stock exchanges also play a very important role in ensuring market discipline.
In this perspective, violation in open interest position limits, circuit filter limits and other
validation and verification parameters are tracked on a real-time basis. Market abuses
such as insider trading, circular trading, price rigging, price manipulation, etc. is closely
monitored. Inspection of mutual funds is done through independent chartered accountant
firms.
SEBI has initiated several measures to facilitate Investor protection and investor education.
In this regard, SEBI has published booklet, "Quick Reference Guide for Investors" - so
that investors who are uninitiated in the securities markets would be able to understand,
and identify the intricacies involved in securities trading. SEBI also publishes
advertisements, makes public announcements and also conducts investor awareness
campaigns of the overall benefit of investors. SEBI also has formed an Investor
Grievances Redressal and Guidance Division, for the benefit of investing public. SEBI
has also encouraged formation of investor associations and has laid down modalities for
the registration of the same.
In order to promote the concept of corporate governance among companies, SEBI has
informed stock exchanges to incorporate corporate governance norms as part 'of the
listingagreement of companies. Good corporate governance leads to better confidence
among the public. SEBI appointed a committee under the chairmanship of Shri.
Kumaramangalam Birla of the Aditya Birla' Group and a former member of the SEBI ' .:
I

board. Based on the committee recommendations, code of ethics and corporate

governance standards has been framed. Subsequently, another committee under the
chairmanship of Shri. N. Narayana Murthy, Chairman and Chief Mentor, Infosys, was
constituted. SEBI has also proposed corporate governance ratings - the credit rating
agencies, CRISIL and ICRA, have done analysis in this regard.

Achievements of SEBI
Some of the major achievements of SEBI in its 20 years of existence are as follo\'vs:
• SEB] has formulated new proJrams, policies and has continuous reviewed the
capital markets in India for the overall growth and development. ,' I

,I
• Under SEBI's stewardship, the secondary markets have grown from an average ~ ,
1
daily turnover in stock exchanges of less than Rs. 500 Crores to more than RS._
100·
100,000 Crores.
l
~
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I
• The primary markets have developed in a major way. Market Institutions
and Intermedlarles
• Computerization facilitated electronic trading. SEBI has been instrumental in
ensuring effective regulations and governance of markets.
• Improvements in the clearing and settlement systems.
• Establishment of depositories - facilitating dematerialization.
• Immediate and prompt action on malpractices and entities involved in the same -
this has instilled confidence among the public.
• SEBI streamlined and simplified the issue procedure in primary markets.
• Overseeing the development of mutual funds as investment vehicles - regulation
of mutual funds was a major challenge. which SEBI has lived up to.
• SEBI's regulations on substantial acquisition and takeovers has ensured a framework
to be put in place for mergers, amalgamations and takeovers.
• SEBI. has demarcated the functioning. roles and responsibilities of market
intermediaries such as merchant bankers - they are prohibited from undertaking
leasing and bills discounting activities.
• SEBI has also been responsible for implementing the rolling settlement system.

Other Services
SEBI has also launched a Securities Markets Awareness Program (SMAP) as a proactive
measure to ensure investor education. Based on the Narayana Murthy Committee Report
on Corporate Governance, companies are expected to adhere to standards prescribed
for the same.
The Office of Investor Assistance and Education (OIAE) is the interface between
SEBI and investors - for taking complaints from investors and to pursue the same either
directly or through the Investors Complaint Cell of the concerned department.

Activity 2
1) List down any five major functions of SEBI?

2) What is the role of SEBI?

4.4 BOMBAY STOCK EXCHANGE OF INDIA

LIMITED
Securities' trading has been in existence for the last 200 years. Incidentally. trading in
securities dates back to 1793 - when Loan securities of the East India Company were
traded. Rampant speculation was a common feature even during those times. The broking
101

I
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Introduction community prospered as there WU!! an lncreas in prices. This led to the "share mania"
to Financial in 1861=6S. This bubble burst in l86S when the American Civil Wnrended. The broker
Markllt8
realized that investor confidence in the securities market could be sustained only by
organizing thems Ives in n r sui at d body, with defined rules and regulations. This
realization resulted in the formation of "The Native Share and Stock brokers' association,
which later came to be known as the Bombay Stock Exchange. In 187S, these brokers
tUlllembledat a place, now popularly known UII D"lal Street.

Transformation of B E: D mutualization
The Bombay Stock Bxchang (BSE) is a voluntary, non-profit making association of
broker members. It emerged as a premier stock exchange after the 1960s. The increased
pace of industrialization caus d by the two World Wars, protection t the domestic
indu try, Government's fiscal policies helped the growth of new issues in the primary
market and the trading in secondary market. More than 50% of the turnover in the
Indian equity markets was taking place in BSB.
BSE is the first stock exchange in the country which obtained permanent recognition (in
1956) from the Government of India under the Securities Contracts (Regulation) Act,
1956. BSE's pivotal and pre-eminent role in the development of the Indian capital market
is widely recognized. It migrated from the open outcry system to an online screen-based
order driven trading system in 1995. Earlier an Association of Persons (AOP), BSE is
now a corporatised and demutualised entity incorporated under the provisions of the
Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation)
Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). Until the
formation of SEBI and the commencement of the process of demutualization, BSE was
operating like a closed club of select members. With the securities (Harshad Mehta)
seam in 1992 and increasing powers of SEBI, BSE had to incorporate changes in its
policies. With demutualisation, BSE has two of world's best exchanges, Deutsche Borse
and Singapore Exchange, as its strategic partners.

From Open Outcry to Electronic Trading: BOLT

Until March, 1995, BSE had an open outcry system of trading. Due to stiff C -ipetition
from NSE, India's first modem and automated (computerized) stock exch •..ige, that
facilitated online trading, BSE had to change its system of trading and operations. On
14th March, 1995, BSE commenced electronic trading. Members could trade online
using computers - the software is known as BSE Online Trading System (or BOLT).
Screen based trading was initially confined to 818 major scrips. By 3rdJuly, 1995, trading
in all the 5000 scrips was transferred to the automated system. The introduction of
BOLT increased trading volumes and also reduced -the bid-ask spread. Trading in odd
lot shares was also easier. In 1995, BOLT was limited only within Mumbai. Alternatively,
NSE was operating on an All-India basis. Thus, BSE requested SEBI for approval to
enable online trading terminals to be established outside Mumbai. After rejecting the
request for 4 times, SEBI finally approved the request on 29th Oct. 1996.

BSE and the Indian Corporate Sector

Over the past 133 years, BSE has facilitated the growth of the Indian corporate sector
by providing it with an efficient access to resources. There is perhaps no major corporate
in India which has not sourced BSE's services in raising resources from the capital
market. Today, BSE is the world's number 1 exchange in terms of the number of listed
companies. An investor can choose from more than 4,700 listed companies, which for
easy reference, are classified into A, B, S, T and Z groups.

102
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DSE Indices Market In8titutlonll
and Intermedlarlell
The BSB Index, SENSBX, is India's first stock mark t index that enjoys an iconic
stature, and is tracked worldwide. It is an index of 30 stocks representing 12.major
sectors. The SBNSBX is constructed on a 'free-float' methodoloSY, and is sensitive to
market sentiments and market realities. Apm from the SBNSBX, BSB offers 21 indices,
including 12 sectoral indices. BSB has entered into an index cooperation agreement
with Deutsehe 8~rse. Thislgreement hes made SBNSBX Md other BSB indices nvnilable
to investors in Burep and America. Moreov r, Bnrctnys Global Investors (1301), the
global leader in BTFs through its is hares brand, has created the iShares 8SE SENSEX
India Tracker' which tracks the SENSEX. The ETF nables investors in Hong Kong to
take an exposure to the Indian equity market.
The first Exchange Traded Fund (ETF) on S NSEX, called "SPIcE" is listed on BSE.
It brings to the investors a trading tool that can be easily used for the purposes of
investment, trading, hedging and arbitrage. SPIcE allows small investors to take a long-
term view of the market.

Developing Markets
BSE provides an efficient and transparent market for trading in equity, debt instruments
and derivatives. It has a nation-wide reach with a presence in more than 359 cities and
towns ofIndia. BSE has always been at par with the international standards. The systems
and processes are designed to safeguard market integrity and enhance transparency in
operations. BSE is the first exchange in India and the second in the world to obtain an
ISO 9001 :2000 certification. It is also the first exchange in the country and second in the
world to receive Information Security Management System Standard BS 7799-2-2002
certification for its BSE On-line Trading System (BOLT).
BSE continues to innovate. In recent times, it has become the first national level stock
exchange to launch its website in Gujarati and Hindi to reach out to a larger number of
investors. It has successfully launched a reporting platform for corporate bonds in India,
christened the ICDM or Indian Corporate Debt Market and a unique ticker-cum-screen
named "BSE Broadcast" which enables information dissemination to the common man
on the street.
In 2006, BSE launched the Directors Database and ICERS (Indian Corporate Electronic
Reporting System) to facilitate information flow and increase transparency in the Indian
capital market. While the Directors Database provides a single-point access to information
on the boards of directors of listed companies, the ICERS facilitates the corporates in
sharing with BSE their corporate announcements.

Services offered by BSE

BSE also has a wide range of services to empower investors and facilitate smooth
transactions:
• Investor Services: The Department of Investor Services redresses grievances
of investors. BSE was the first exchange in the country to provide an amount of
Rs.l million towards the investor protection fund; it is an amount higher than that
of any exchange in the country. BSE launched a nationwide investor awareness
programme - 'Safe Investing in the Stock Market' under which 264 programmes
were held in more than 200 cities.
• The BSE On-line Trading (BOLT): BSE On-line Trading (BOLT) facilitates
on-line screen based trading in securities. BOLT is currently operating in 25,000
Trader Workstations located across over 359 cities in India.

103
 1
Introduction • BSEWEBX.com: In February, 200 I, BSE introduced the world's first centralized
to Financial exchange-based Internet trading system, BSEWEBX.com. This initiative enables
Markets
investors anywhere in the world to trade on the BSE platform.
• .Surveillance: BSE's On-Line Surveillance System (BOSS) monitors on a real-
time basis the price movements, volume positions and members' positions and
real-time measurement of default risk, market reconstruction and generation of
cross market alerts.
Drawing from its rich past and its equally robust performance in the recent times, BSE
will continue to remain an icon in the Indian capital market.

4.5 NATIONAL STOCK EXCHANGE OF INDIA

NSE was given recognition as a stock exchange in April, 1993 and started operations in
June 1994, with trading on the Wholesale Debt Market Segment. Subsequently, it launched
the Capital Market Segment in November, 1994 as a trading platform for Equities and
the Futures and Options segment in June, 2000 for various derivative instruments.
The NSE is owned by a set of leading financial institutions, banks, insurance companies
and other financial intermediaries. It is managed by professionals, who do not directly or
indirectly trade on the Exchange. The trading rights are with trading members who
offer their services to the investors. The Board of NSE comprises of senior executives
from promoter institutions and eminent professionals, without having any representation
from trading members. While the Board deals with the broad policy issues, the Executive
Committees (EC), which include trading members, formed under the Articles of
Association and the Rules of NSE for different market segments, set out rules and
parameters to manage the day-to-day affairs of the Exchange. The day-to-day
management of the Exchange is delegated to the Managing Director and CEO who is
supported by a team of professional staff. Therefore, though the role of trading members
at NSE is to the extent of providing only trading services to the investors, th Sxchange
involves trading members in the process of consultation and participation in al inputs
towards decision making.
NSE provides a trading platform for of all types of securities for investors Ul er one
roof - Equity, Corporate Debt, Central and State Government Securities, T-Bills,
Commercial Paper (CPs), Certificate of Deposits (CDs), Warrants, Mutual Funds (MFs)
Units, Exchange Traded Funds (ETFs), Derivatives like Index Futures, Index Options,
Stock Futures, Stock Options. The Exchange provides trading in 3 different segments
viz., Wholesale Debt Market (WDM) segment, Capital Market (CM) segment and the
Futures & Options (F&O) segment.
The Wholesale Debt Market segment provides the trading platform for trading of a
wide range of debt securities which includes State and Central Government securities,
T-Bills, PSU Bonds, Corporate debentures, CPs, CDs etc. However, along with these
financial instruments, NSE has also launched various products e.g., FIMMDA-NSE
MIBIDIMIBOR owing to the market need. A reference rate is said to be an accurate
measure of the market price. In the fi xed income market, it is the interest rate that the
market respects and closely matches. In response to this, NSE started computing and
disseminating the NSE Mumbai Inter-bank Bid Rate (MIBID) and NSE Mumbai Inter-
Bank Offer Rate (MIBOR). Owing to the robust methodology of computation of these
rates and its extensive use, this product has become very popular among the market
participants. Keeping in mind the requirements of the banking industry, FIs, MPs, insurance
companies, who have substantial investments in sovereign papers, NSE also started the
dissemination of its yet another product, the 'Zero Coupon Yield Curve'. This helps in
valuation of sovereign securities across all maturities irrespective of its liquidity in the
104
 1
market. The incr used activity in the govei nm nt sccuriti S market in India and Mnrkct Inlltltutlon~
simultaneous emcrg ne of MFs (Gilt Ml-s) had giv n rise to th n d for a well def Dud Interm dhwics
ned bond index to measur the returns JI1 the bond market NSE construct d such an
index the. 'NSE Gov Inment Sccuritt s lnd '. I'his inde provid sub n .hrnurk for
portfolio monug m nt by VUriOlISinv suncnt mnnnu III und gilt funds.
The Capital Market segrn nt offers u fully automat d SCI'C n bas d tl'l\ding sys; m.
known as the National Exchange for Automated Trading (NEAT) system. This op rates
on a price/time priority basis and enables members from across the country to trade
with enormous ease and efficiency. Various types of securities e.g., equity shares,
\\ .urants, debentures etc. are traded on this system. The average daily turnover in the
CM Segment of the Exchange during 2007-08 was nearly Rs. 14,148 crore. (US $ 3,540
million).

Futures & Options segment of NSE provides trading in derivatives instruments like
Index Futures, Index Options, Stock Options, Stock Futures. Though only eight years
into its' operations, the futures and options segment of NSE has made a mark for itself
globally. In the Futures and Options segment, trading in S&P CNX Nifty Index, CNX IT
index, Bank Nifty Index, CNX Nifty Junior, CNX 100 index, Nifty Midcap 50 index and
single stocks are available. The average daily turnover in the F&O Segment of the
Exchange during 2007-08 was nearly Rs. 52,153 cr. (US $ 13,048 millions). NSE has
also launched the currency futures trading in Aug. 2008. Recently, in Aug. 2009, NSE
re-launched trading in interest rate futures under new guidelines issued by RBJ and
SEBI.

New Developments in NSE

• Based on the evolving needs of the market and the investors, NSE introduced
futures and options trading on Nifty Midcap 50 index in October, 2007. Mini Nifty
derivative were available for trading from I January, 2008. Index is the most
I

actively traded index based derivative product in India.

• The long term options contract which was introduced in March, 2008 has expected
to deepen this market further.
• SEBI issued a SLB scheme on December 20, 2007. NSCCL, as an Approved
Intermediary (AI) launched the Securities Lending & Borrowing Scheme from
April 21, 2008. Lending & Borrowing is carried on an automated screen based
platform where the order matching is done on basis of price time priority.
• During April, 2008, Securities & Exchange Board of India (SEBI) allowed the
direct market access (DMA) facility to the institutional investors.
• The India VIX, the volatility Index was launched on 08th April, 2008.
• SEBI has allowed Cross Margining benefit, whereby, positions in the cash and
derivatives segment can be set off with each other, for margin computation purpose.
• The currency futures trading at NSE has commenced on 29th Aug. 2009. Presently,
the average daily trading turnover of currency futures at NSE has surpassed USD
1billion.
Power Exchange India Limited (PXI) a joint venture of National Stock Exchange of
India Ltd (NSE) and National Commodity & Derivatives Exchange Ltd (NCDEX) has
been set up in response to the guidelines issued by Central Electricity Regulatory
Commission (CERC).

Technology
"'"
Technology has been the backbone of the Exchange. NSI ~,~ ~I";"lfN xchange in the
world to use satellite communication technology for trading.It use- '>011, lluc communication
105
 1
Introduction technology to energise participation from about 2,956 VSATs from nearly 245 cities
to Financial spread all over the country. Its trading system, called National Exchange for Automated
Markets
Trading (NEAT), is a state of-the-art client server based application.

4.6 OTHER STOCK EXCHANGES IN INDIA

In addition to BSE and NSE, the following exchanges also exist in the Indian Financial
Markets. These are discussed briefly below:

Over the Counter Exchange of India Limited (OTCEI)

The OTCEI was recognized as a stock exchange under the SCRA with effect from
23rd August, 1989. It was incorporated under section 25 of the Companies Act on 20th
September, 1990. It is based on the model ofNASDAQ in USA. It commenced operations
.on 6th October, 1992.
The OTCEl arose out of the need to have a second tier market in the country. It was
established to provide srrmll and medium scale enterprises, easy access to the capital
market for raising finance in a cost effective manner, and also investors with a transparent
and efficient avenue for capital market investment.
OTCEI was the first electronic national exchange with a screen based trading system,
listing an entirely new set of companies - in the SME sector. Even companies with a
paid up capital of as low as Rs. 30 Lakhs can be listed on OTCEl. The volumes in
OTCEI was not significant due to the stringent measures for allowing listing companies,
right from inception. The concept of Counter Receipts (CR) which was introduced in
early 1990's became outdated mode of settlement. This was replaced with the concept
of dematerialization of the share certificates. In spite of recommendations by the
Malegam and Dave Committees (which were set up by SEBI to analyze how the volumes
in OTCEl can improve), the volumes continued to be low. In order to minimize the
transaction cost, OTCEl established a subsidiary, OTCEl Securities Limited (OSL),
which became a member of NSE. Thus, all members of OTCEI registered as sub-
brokers of NSE. This resulted in increased business opportunities for members and
lower brokerages for investors.

Interconnected Stock Exchange (ICSE)

In the late 1990's, the competition between BSE and NSE and their national reach
threatened the very existence of Regional Stock Exchanges (RSE). Due to this threat,
the RSE formed the Federation of Indian Stock Exchanges (FISE) in early 1996. The
eroding market share, dwindling volumes and declining profitability of members of the
RSE provided FISE with the choice of either integrate operations with BOLT or wait
for revival of the trading activity in their respective exchanges. It was not possible for
RSE to become members of NSE or BSE. Hence, to improve market efficiency and
facilitate trading among the RSE, FISE proposed to establish the Interconnected Market
System, in early 1996 - this ultimately culminated in the formation of the Interconnected
Stock Exchange ofIndia Limited (ICSE). The ICSE was promoted by 15 RSE. It opened
a new national segment of trade for all its members, while retaining the regional segment.
The ICSE became a stock exchange of all regional stock exchanges - with over 4500
members and 3500 securities listed across all 15 RSE. Ironically, investors preferred
dealing directly with NSE or BS~ and the volumes in the ICSE was not high.

INDOnext
Due to declining volumes of the Regional Stock Exchanges (RSE), SEBI issued an
order asking them to either collectively form a separate exchange or merge with BSE or _
106

1
 1
NSE. In response to this directive. the federation of Indian Stock Exchanges (FISE), Market Institutions
which is a representative body of all the Regional Stock Exchanges in India proposed to and Intermediaries
establish the INDOnext. BSEand FISE proposed to establish a common trading platform
to provide small and medium scale enterprises (SME), easy and efficient access to
capital markets. BSE launched this market on T" January, 2005.
The idea behind INDOnext, was to model a trading platform along similar lines to Euronext
in Europe - formed due to the merger of stock exchanges in Paris, Amsterdam, Brussels
and Lisbon. INDOnext was also aimed at integrating markets across the nation. Members
are allowed to issue contracts in the name of the regional exchanges and trades are
settled through respective clearing houses. The RSE along with ICSE handle the functions
of listing, investor grievances redressal, arbitration and investor education.

MCX St.ock Exchange (MCX-SX)

MCX-SX, the new generation stock exchange promoted by Multi Commodity Exchange
of India Limited, the largest commodity derivatives exchange in India, after obtaining
approval from RBI and SEBI, has commenced trading in Currency Futures for USDINR
from October 7,2,008. Presently, the average daily turnover in currency futures trading
at MCX-SX has surpassed USD 1 billion (single-side).

Other Exchanges
The United Stock Exchange which has been established by a group of banks is slated to
launch trading in currency futures in a few months time. There are also a host of regional
exchanges that have been established. The details regarding the list of regional exchanges
has been provided in UnitI of this course.

Activity 3
1) List down the major stock exchanges in India.

4.7 INTERMEDIARIES INVOLVED IN SETTLEMENT

There are many Intermediaries that are involved in the process of settlement of securities
transactions. Some of them are:

Depositories
National Securities Depository Limited (NSDL) and Central Depository Services (India)
Limited (CDSL) are depositories for Equity, Corporate Debt and some Government
Securities. They are incorporated under the Companies Act, 1956 as public limited
companies limited by shares and are for profit institutions. NSDL and CDSL facilitate
clearing of trades through depository participants, by enabling securities transfers across
beneficial owners, inter-se and to/from clearing members, based on transfer instructions.
The National Securities Depository Limited (NSDL), promoted by Industrial Development
Bank of India, Unit Trust of India and National Stock Exchange of India Limited, is a
company established to provide electronic depository facilities for securities traded in
the equity and debt markets. The National Securities Depository Limited has been
107
Introduction r gister d by SEBI on Jun 7, J 996, us India's first depository to facilitate settlement of
to Financial securities in d marerializ d form.
Markets
NSDL provides for holding of s curiti s in the lectronic form and settlement of trades
done for these electronic holdings. N DL has designed the software for the operating
systems in such a way that the software systems at the Depository and the Depository
Participant (OP) office are connected and NSDL has access to all the accounts of
individual investors to ensure adequate control.

Depository Participants
While NSDL can be compared to a bank, a Depository Participant (DP) is like a bank's
branch and acts as an agent of NSDL. It is evaluated by NSDL to ensure its capability
to meet with the strict service standards of NSDL. A further evaluation and approval by
SEBI is required by a DP in order to be functional. Investors can open an account with
NSDL through its DPs in order to avail of the services provided by NSDL.

Custodians
As the name suggests, the custodians perform the task of keeping the securities in a
safe manner/custody. They hold the documentary proof of securities, keeping the title of
securities intact in the name of the holder. In NSCCL, custodian is only a clearing
member and not a trading member. A custodian is required to settle the trades only after
confirming to the NSCCL that it will be settling the trade or not. If it takes the obligation,
it will have to settle the trades and if not, then the obligation is assigned back to the
trading member for whom the custodian works.

Clearing Corporation
The NSCCL, a wholly owned subsidiary of NSE, was incorporated in August, 1995.
NSCCL commenced clearing operations in April, 1996. It was set up for the following
purposes:
• To provide and sustain confidence in clearing and settlement of securities,
• To promote and maintain, short and consistent settlement cycles,
• To provide counter-party risk guarantee, and
• To operate a tight risk containment system.
NSCCL carries out the clearing and settlement of the trades executed in the Equities
and Derivatives segments and operates Subsidiary General Ledger (SGL) for settlement
of trades in government securities. It performs the following tasks: . I

• Clears all trades;

• Determines obligations of members;
• Arranges for pay-in of funds and securities;
• Arranges for pay-out of funds and securities;
• Assumes the counter-party risk of each member and guarantees financial settlement.
• It also undertakes settlement of transactions on other stock exchanges like, the
• Over the Counter Exchange of India.
Through NSCCL, NSE has been able to up-grade the clearing and settlement procedures
in the Indian Stock Market and has brought Indian financial markets in line with
international markets.
Similarly, MCX-SX also clears its trades through the MCX-SX Clearing Corporation.

108
Clearing Members Market Institutions
and Intermediaries
Clearing memb rs are responsible for settling the trades Ut ne on all the counters. Settling
the trade involves taking the re pon ibility 01 making availabl th r sourc required
on lime, i. ., making available the funds and securities on th eut m nt day. ttlem nt
day would m UII T+2 day. Funds ar mad available through the clearing banks where
the clearing mcmb r has his account and s curiti sure mad availabl through th
depository participant, In case of trad s don on the capital market segment, all trading
memb rs have to be their own clearing member too, i.e., they only have to settle th
trades done by them (every 'I M has to b his own M). In case of trades have done in
'Futures and Options' market clearing member can he a separat entity than trading
member as the volume of trades done in this segment is huge. A clearing member has to
get himself registered with NSCCL.

Clearing Banks
Clearing banks act as a link between the clearing members and the NSCCL for the
settlement of funds, i.e. pay-in and pay-out of funds. Every clearing member gets an
account opened with a clearing bank for this purpose only. A clearing bank works on the
instructions of the clearing member. A clearing member after defining the obligations in
terms of funds informs the clearing bank about the obligations to be fulfilled. The clearing
bank makes available the funds required on the pay-out day to meet the obligations on
time.

Professional Clearing Members (PCM)

Professional Clearing Members (PCM) are special category of members who undertake
to clear & settle trades done by the brokers/traders who have appointed them to do the
job. They take the responsibility of clearing the trades done by their clients & in no
circumstances; they perform the task of trading. The clearing banks and the depository
act as an interface between the NSCCL and the clearing members/custodians. Let us
now understand the process that is followed in settl ment.

4.8 BANKING INSTITUTIONS

The Reserve Bank of India (RBI) is the overall regulator of the currency and credit
system in India Since liberalization of the Indian economy in 1991, monetary policy has
become the vehicle for instituting financial sector reforms in the country.
RBI is the regulator and supervisor of the financial syst III to ensure the following:
i) Mamtam public confidence in the financial system.
ii) Protect depositor's int rest and their investm nts.
iii) Provide cost effective banking system tor the pubhc
RBI is completely owned by the Government of India. Rbl is responsible for securing
the monetary stability within the country, through eff ctive policy decision making. RBI
lays down the framework for the efficient functioning of the currency, monetary and
debt markets. RBI is also the manager of exchange rate control. RBI also controls the
currency liquidity in the country, by effecting changes III the money supply. RBI tracks
the macro economic variables and also control •.•banking activity within the country. In
order to meet the above objectives, RB 1prescribes broad parameters of banking operations
within which the banking and financial system operate. If the Government of India
decides to borrow funds by issuing Government securities, then it instructs RBI to issue
bonds on its behalf. RBI conducts open market operations to issue Government debt.
Corporate can also raise debt by issuing commercial papers and bonds. Recently, RBI

109

I
 1
Introduction and SEBI have given permission for the trading in currency futures on the exchange
to Financial platform.
Markets
The organization of the Indian financial system since the mid-eighties has been
characterized by profound transformation. The fundamental focus shifted towards 'free
market economics, since the economic liberalization in 1990s.
Following are some of the important events and policy decisions that have transformed
the Indian financial systems landscape:
Nationalization of privately owned banks into Government enterprise is an important
event in the Indian Financial System.
• 1948: Reserve Bank of India was nationalized.
• 1956: State Bank of India was established by takeover of the then Imperial Bank
of India.
• 1956: Over 245 life insurance companies were nationalized to form the Life
Insurance Corporation of India (UC).
• 1969: Nationalization of 14 major commercial banks.
• 1972: The General insurance Corporation was established.
• 1980: Six more commercial banks were nationalized.
Commercial Banking between 1950 and 1985 saw the utilization of short term deposits
to fund trade and commerce. Industrial financing accounted for a small fraction of the
total bank credit. RBI attempted to orient the operations of the commercial banking
activities towards the growth and development of the Indian economy. Control of the
macroeconomic variables under the purview of central bank enabled selective credit
controls and moral suasion, in order to ensure that commercial banking activity
supplemented the impact of development banks on industrial growth. Commercial banks
were encouraged to underwrite new corporate issues and also provide term-lending
facility. Their exposures in these areas were refinanced by the Refinancing Corporation
of India. Joint underwriting by a consortium of banks and insurance compam,.s mitigated
risk to a large extent. Banks also extended financial assistance by investing in shares /
debentures of corporate enterprises. Commercial banks were also encouraged tt ncrease
their exposure to small scale industries, exports and agriculture.
• Credit Guarantee Corporation (CGO) was established to cover all credit made
available to small scale industries as part of the Credit Guarantee Scheme (CGS).
• For encouraging credit towards export-oriented units, the Export Credit and
Guarantee Corporation (ECGC) was established (this was earlier known as the
Export Risk Insurance Corporation).
• Agricultural financing was guaranteed by the Agricultural Refinance Corporation
(ARC) - established in 1963. The ARC provided refinance for all agri loans made
by banks and financial institutions.
Presently, public and private sector banks are competing in the Indian financial markets
for sourcing deposits and providing credit lending facilities.
New Financial Institutions for term lending facilities were established. These institutions
were both at Central Government level and State level. This also resulted in the formation
of the Unit Trust of India (an investment trust organization). Also, the pension and
provident funds were brought under Government control, in terms of regulations governing
their investments. Thus, the entire financial system was controlled by the Government.
Establishment of Development Banks / financial institutions / term lending institutions
ensured availability of credit for industry. The Government intervention also ensured
that capital was disbursed in areas of priority - in other words, capital was directed
,
towards development.
110

j
I

1
• 1948: Industrial Finance Corporation of India was established. Market Institutions
and Intermediaries
• 1951: Under the State Financial Corporation Act, financial institutions at the state-
level (State Financial Corporation or the SFC) were established. These institutions
aided the small and medium scale enterprises.
• 1954: The National Industrial Development Corporation (NIDC) was established
for a more dynamic involvement in industrial growth.
•
•
1955: The Industrial Creditand Investment Corporation of India (ICICI) Ltd. was
established as a development banking institution. This pioneered underwriting of
issues of capital and channelization of foreign currency loans from the World Bank
to private industry.
• 1958: The Refinance Corporation of India (RCI) was created to provide refinance
to banks against term loans granted by them to medium and small enterprises. This
entity later merged with the Industrial Development Bank of India (IDBI) in 1964.
• 1964: Establishment ofIndustrial development Bank of India (IDBI) as a subsidiary
of RBI. IDBI not only disbursed funds towards planned economic development,
but also coordinated the activities of all other financial institutions. IDBI was delinked
from RBI in 1976 and was converted into a holding company.
• 1971: The Industrial Reconstruction Corporation of India (IRCI) was established
jointly by IDBI and LIC, to look after rehabilitation of sick mills. This was renamed
as the Industrial Reconstruction Bank of India in 1984. This was once again
converted into a full-fledged public financial institution (PFI) and was renamed as
the Industrial Investment Bank of India in 1997.
The establishment of the State Industrial Development Bank of India (SIDBl), State
Industrial Investment Corporations (SIIC) and the Technical Consultancy Organizat hI)' .•

(TCO) at the state level added new dimensions to the Indian Financial System and aided
in reviving growth and development.
Indian banking which experienced rapid growth following the nationalisation in expanding
nationwide presence and business began to face pressures on asset quality by the 1980s.
Simultaneously, the banking world everywhere was gearing towards new prudential
norms in operational standards pertaining to capital adequacy, accounting and risk
management. In the early 1990s, India embarked on an ambitious economic reform
programme in which the banking sector reforms formed a major part. The Committee
on Financial System (1991) more popularly known as the Narasimham Committee
prepared the blue print of the reforms leading to modern Indian banking. A few of the
major aspects of reform include moving towards international norms in income recognition
and provisioning, liberalization of entry and exit norms leading to the establishment of
several new private sector and entry of a number of foreign banks, freeing of deposit
and lending rates (except the Saving Deposit rate), allowing access to public equity
markets for capital by the public sector banks, introduction of technology in banking
operations etc. The reforms led to major changes in the approach of the banks that was
reflected in growth of competition, focus on profitability and productivity, rationalization
and more efficient use of human resources and greater use of technology in banking
operations and promotion of electronic banking etc.
The reforms led to significant changes in the strength and sustainability of Indian banking.
Following the reforms, Indian banking industry grew in strength and stature. In addition
to significant growth in business, Indian banks experience sharp growth in profitability,
focus on prudential norms with higher provisioning levels, reduction in the non performing
assets and surge in capital adequacy.

III
Introduction Activity 4
to Financial
Markets I) List down the intermediaries involved in equity markets settlement.

2) What is the significance of banking institutions in India? (any five major reasons)

,
......................................................................................................................

4.8 INTERMEDIARIES INVOLVED IN PRIMARY

MARKETS ISSUE
The efficient operation of the primary market is possible by a host of financial
intermediaries and institutions that facilitate the efficient sourcing and investment of
funds for new issues. Following is the different types of participants in primary markets:

Categories Participants
Regulators RBI, SEBI, FMC, Ministry of Company Affairs, Ministry of Finance
Issuers of Securities Companies (Promoters), Government Mutual Funds, Banks
Intermediaries Merchant Bankers (Lead Manager), Registrar to an Issue,
Bankers to an Issue, Credit Rating Agencies and Depositories,
Underwriters
Appellate Tribunals SAT, National Company's Law Appellate Tribunal
Investors Retail 0)' individual investors, Partnership/HUF, Societi d
Trusts, Companies, Mutual Funds, Financial Instituti <; and
Foreign Institutional Investors
-
1
Other important entities which interact with the issuing company and the merchant I
banker include: I

• Underwriters who take the responsibility of buying the shares from the companies.
I
,I
• Brokers who manage the issuance at retail level.
• Bankers who manage funds.
• Advertising agencies - critical for communication of the primary markets issue.
• Printers.
• Auditors.
• Legal advisers.
In the following sections, we shall discuss the role of each of the intermediaries in detail:

Merchant Banker
The term "Merchant Banker" refers to "any entity which is engaged in the business of
issue management either by making arrangement regarding selling, buying or subscribing
to securities as manager, consultant, advisor or rendering corporate advisory services in
112

I
relation to such issue management". Merchant Bank is the agency at the apex level, Market Institutions
which plans, coordinates and controls the entire issue activity and directs different agencies and Intermedlarles
to contribute to the successful marketing of securities. The merchant banker should be
regi tered with the SEBI as per the SEBI (Merchant Bankers) regulations, 1992 to act
as a Book Running Lead manager to an issue. The lead merchant banker performs
most of the pre-issue and post-issue activities. The pre-issue activities of the lead manager
include due diligence of company's operations / management / business plans / legal,
etc., drafting and designing the offer document, finalizing the prospectus, drawing up
marketing strategies for the issue and ensuring compliance with stipulated requirements
and completion of prescribed formalities with the stock exchanges and the registrar of
Companies (ROC).

Issuers of Securities
Issuers of publicly traded securities are subject to direct regulation relating to issues
such as the voting rights of securities holders, information disclosure, prohibition of insider
trading, and accounting and auditing procedures.

Intermediaries
An intermediary is a third party that offers intermediation services between two trading
parties. Examples: Banks, Brokers, Institutions like Investment Banks.

Regulators
Regulators protect investors and their moriey. They also educate and regulate and promote
the market. Promotion includes introducing new product, policies from time to time.
Any company must be authorised and registered with the regulator. These firms are
required to ensure all the people who work for them meet the standards laid down by
the regulator.

Country Regulatory Authorities

Australia Australian Securities and Investment Commission

Canada Ontario Securities Commission
France Commission des Operation de Bourse
Hong Kong Securities and Futures Commission
India Securities and Exchange Board of India (SEBI)
UK Financial Services Authority
USA SEC

Securities Appellate Tribunal (SAT)

Security Appellate Tribunal is a quasi judicial authority which deals with judicial matter
between SEBI and companies
Registrars to the Issue: The role of the registrar is to finalize the list of eligible
allottees, ensure crediting of shares to the demat accounts of the eligible allottees and
dispatch refund orders
Bankers to the Issue: They are appointed in all the mandatory collection centers, and
by the lead merchant banker to carry out activities relating to collection of application
amount, transfer of this amount to the escrow account and despatching refund amounts.
Auditors of the company and the Solicitors also play a very important role in the
launch of a primary market issue.

113
 T 1

Introduction
to Financial '4.10 INTERMEDIARIES INVOLVED IN TRADING AND
Markets
INVESTMENT
If a retail investor wants to invest funds in the equity markets, he has several options.
He can even apply for membership at the stock exchange. But this is usually expensive
proposition and has many regulatory compliance procedures such as minimum net worth
criteria, deposits to be maintained, admission fee, etc. Alternatively, a layman investor
can approach an established member-broker such as Kotak Securities, ICICI Ditect,
Angel Broking, Indiabulls, India-Infoline etc. for participating in equity markets.
The retail investor can also invest through a mutual fund. Mutual Funds are established
by Asset Management Companies, which are in turn set up by trusts. They play a very
important role by sourcing capital from investors and collectively investing the same in
the securities markets.

Retail investors need to identify a reputed broker or mutual fund before investing funds.
Different types of mutual funds enable investors to access the different markets. It is a
practice for the mutual fund to publicly announce the nature of investments - whether in
debt market, equity markets, which segment of markets and the proportion of investments,
etc.

Retail investors may also invest in Insurance companies such as LIC, ICICI Prudential,
BirIa Sunlife, etc. in different insurance products. Some of these insurance products
facilitate investment of a portion of the insurance amount paid in equity and bond markets
- for example "Unit Linked Plans". LIC and GIC have played a very important role in
providing credit to corporate and investment in the capital markets.
Retail Investors, Corporate, High Networth Individuals (HNI), financial institutions, banks,
insurance companies and other market participants invest in Mutual Funds in a major
way. They may also directly invest through the members of the stock exchanges - often
called "Trading Members" of the exchange. Each exchange has different classification
of membership. The details will be discussed separately in Block 3 and subsequent
courses.

'Owning shares gives investors the right to vote at company meetings and to obtain
dividends that the company pays out. In some international markets, they may even
qua Iify for shareholder perks, such as discounts off the company's products. Shareholders
are usually split into two types: institutional and individual. Institutional holders are
companies who may, for example, invest the pension schemes of their staff in shares.
They can also be mutual fund managers who run investment schemes such as unit
trusts or investment trusts. Institutions have the biggest influence on the market's
performance simply because they have millions or billions to invest. If they, for example,
own a reasonable percentage of a company's shares, selling them will have a significant
influence on the price. Individual shareholders are individual investors, often investing
relatively small sums.

For the purpose of investing in new issues offered in the primary markets, SEBI has
classified investors under following categories:
1) Retail Individual Investor (RIIs): an investor who bids for securities for a
value of not more than Rs. 100,000. If the investor bids for a greater amount, then
such bids will be classified under the High Net-worth Individual (HNI) category
2) Qualified Institutional Buyers (QIBs): As defined in clause 2.2.2B (v) of DIP
Guidelines, QIB shall mean public financial institution as defined in section 4A of
the Companies Act, 1956, scheduled commercial banks, mutual funds, SEBI
registered foreign institutional investor, multilateral and bilateral development
financial institutions, SEBI registered Indian or foreign venture capital funds, State
114
 Industrial Development Corporations. insurance Companies registered with the Market Institutions
Insurance Regulatory and Development Authority (IRDA), Provident Funds and and Intermediaries
Pension Funds with minimum corpus of Rs. 25 Crores, National Investment fund
as defined by the government.
3) Non-Institutional Investors (NUs): Investors who do not fall within the definition
ofthe ·above two categories are categorized as "Non Institutional Investors". These
include Companies, Overseas Corporate Bodies (OCB), Non-Resident Indians
(NRI), High Net-worth Individuals (HNI), Hindu Undivided Families (HUF),
societies and trusts.

4.11 INTERNATIONAL FINANCIAL MARKET

INSTITUTIONS: AN OVERVIEW
Following are some of the world's major stock exchanges:

New York Stock Exchange

The New York Stock Exchange (NYSE) was originally formed under the Buuonwood
tree in the year 1972. It has a very colorful and long history. It started with 24 New York
City stock brokers and merchants signing the Buttonwood agreement. This agreement
set in motion the NYSE's unwavering commitment to investors and Issuer"
In the initial days, NYSE brokers used to trade outdoors in the streets this was the
reason for popularly being known as the "Curb" market or "Kerb Market". The brokers
and investors traded shares of companies in emerging industries and new investment
opportunities.
In the beginning there were five securities traded with the first listed company as Bank
of New York. It provided a robust market for entrepreneurial growth companies and
helped a large segment of corporations to grow and prosper. The first Constitution (or
the NYSE was established in the year 1817. It was then experiencing u sustained rise in
the trading volume (tripled between 1896 and 1899).
In 1896, the Wall Street Journal began publishing the Dow Tones Industrial Average
with a starting value of 40.74. The Dow was initially comprised ol twelve stocks and
became an overall indication of the NYSE's daily performance. The NYSE got first
incorporated on February 18, 1971 as the New York Stock Exchange Inc - a not-for
profit corporation. NYSE was firmly established as one of America's eminent financial
institutions and became a public entity in 2005 - formerly run as private organization -
following the acquisition of electronic trading exchange Archipelago.
It was then later incorporated as NYSE Group Inc., a for-profit corporanon, on March
7,2006. NYSE Group, Inc. (NYSE:NYX) operates two securities exchanges: the New
York Stock Exchange (the "NYSE") and NYSE Area (formerly known as the
Archipelago Exchange, or ArcaEx, and the Pacific Exchange).
NYSE Group is a leading provider of securities listing, trading and market data products
and services. The NYSE is the world's largest and most liquid cash equities exchange.
It provides a reliable, orderly, liquid and efficient marketplace where investors buy and
sell listed companies' common stock and other securities. The New York Stock
Exchange is the most investor-friendly market in the world. The Exchange is dedicated
to protecting the interests of all investors, large and small. NYSE brings together investors
and issuers, trades securities and fuels economic growth. It is now considered as the
largest equity-based exchange in the world based on the total market capitalization of
the listed securities.

us

I
Introduction Tokyo Stock Exchange
to Financial
Markets The period of industrialization In Japan during the mid to late nineteenth century had
created a need for its own exchange. This gave rise to the creation of the exchange in
the year 1878. The exchange was established through the "Stock Exchange Ordinance",
which was enacted In May 1878. Based on this ordinance, the "Tokyo Stock Exchange
Co., Ltd."· was established on May 15, 1878. Trading began on June 1, 1878.
In response to World War-II, there was a reorganization of the Japanese stock markets
in 1943. Eleven stock exchanges in Japan, including the Tokyo Stock Exchange, were
combined to form the Japan Securities Exchange, which was partially run by the
government Between August 10, 1945 and April 1, 1949 official trading on the exchange
was suspended due to the war. After several post-war reorganizations, the TSE emerged
as the largest of the five stock exchanges including the Sapporo Securities Exchange,
Osaka Securities Exchange, Nagoya Stock Exchange and Fukuoka Stock Exchange, in
addition to the Tokyo Stock Exchange.
In 1969, the Tokyo Stock Exchange developed the Tokyo Stock Price Index (TOPIX).
This index is calculated with ,~IIFirst Section Japanese common stocks and gave an
overall indication of how well the stock market is performing. The stock exchange has
calculated the TOPTX every minute since 1987.
The Tokyo Stock Exchange closed its trading floor in 1999 to replace it with a fully
electronic system. This move was made as many world exchanges were beginning to
go electronic and it was seen as a way to improve the efficiency and increase
competitiveness of the Tokyo Stock Exchange. The Tokyo Stock Exchange uses an
electronic, continuous auction system of trading. This means that brokers place orders
online and when a buy and sell price match, the trade is automatically executed. Deals
are made directly between buyer and seller, rather than through a market maker. The
TSE uses price controls so that the price of a stock cannot rise or fall below a certain
point throughout the day. These controls are used to prevent dramatic swings in prices
that may lead to market uncertainty or stock crashes. If a major swing in price occurs,
the exchange can stop trading on that stock for a specified period of time. Stocks listed
on the TSE are assigned to one of three markets: the First Section, Second Section, or
Mothers (market of the high-growth and emerging stocks). The highest listing criteria
must be met for the First Section and all newly listed stocks begin on the Second Section,
with less strict requirements. Stocks for high growth, emerging companies are listed on
the Mothers market.

As of August, 2008, there are around 2377 companies listed on the Tokyo Stock Exchange
with a total market capitalization ofUSD 3.80 trillion.

NASDAQ
The abbreviation of National Association of Securities Dealers Automated Quotations
is NASDAQ. It was developed in 1971 as the first electronic stock exchange in the
world. It was created as a means to increase the trading of Over-the-Counter stocks,
those that were unable to meet listing requirements for larger exchanges. On the first
trading day, February 8, 1971 about 2,500 OTC stocks were traded on the NASDAQ
stock exchange.

The division between the NASDAQ National Market and the NASDAQ Small-Cap
Market developed from 1982 to 1986, as the larger companies separated themselves
from the smaller ones. It was in the 1990's that the NASDAQ began to be seen as a
competitor of the NYSE, and in 1994 the NASDAQ beat the NYSE in annual shares
traded. In 1998, the NASDAQ merged with the American Stock Exchange, which
mostly traded options and derivatives, creating the NASDAQ-AMEX Market Group.
The combined company still operates as two separate exchanges, but is better able to
compete with the NYSE.
116
It has a listing of 3300 companies and has a greater trading volume than any other V.S. Market Institutions
exchange, making approximately 1.8 billion trades per day. The NYSE is still considered and Intermecllarles
the biggest exchange because its market capitalization far exceed that of the NASDAQ.
The NASDAQ trades shares in a variety of companies, but is well known for being a
high-tech exchange, trading many new, high growth, and volatile stocks. This is partially
due to the fact that the listing fees on the NASDAQ are ignificantly lower than tho e
for the NYSE. ..
The NASDAQ, as an electronic exchange, has no physical trading floor, but makes all
its trades through a computer and telecommunications system. The exchange is a dealers'
market, meaning brokers buy and sell stocks through a market maker rather than from
each other. A market maker deals in a particular stock and holds a certain number of
stocks on his own books so that when a broker wants to purchase shares, he can
purchase them directly from the market maker. Since there is no trading floor where the
NASDAQ operates, the stock exchange built the NASDAQ MarketSite in New York's
Times Square to create a physical presence.

London Stock Exchange

The London Stock Exchange is one of the oldest in the world. It began in 1698, when a
man named John Castaing began publishing lists of stock prices called 'The Course of
the Exchange and Other Things'. London's stock dealers were at this time making
trades in the streets and in coffee houses. In 1761, 150 of these stockbrokers started a
club for buying and selling shares in a dealing room on Sweeting's Alley, which eventually
became known as The Stock Exchange. It became an official, regulated exchange in
1801.
The London Stock Exchange was closed for five months during World War I, and again
for six days during World War II. In 1973, all the regional exchanges in England and
Ireland merged with the London Stock Exchange.
Presently, there are around 3000 companies listed on the exchange and is the most
international of all exchanges with 350 of the companies from 50 different companies.
The London Stock Exchange is comprised of two different stock markets: the Main
Market and the Alternative Investment Market (AIM). The Main Market is solely for
established companies with high performance, and the listing requirements are strict.
Approximately, 1,800 ofthe LSE's company listings trade on the Main Market, and the
total market capitalization is over 3,500 billion. The Alternative Investment Market on
the other hand trades small-caps, or new enterprises with high growth potential. Over
1,060 companies list on this market, with a total capitalization of j7 billion.
The LSE is completely electronic, but different shares are traded on different systems.
Highly liquid shares are traded using the SETS automated system on an order driven
basis. This means that when a buy and sell price match, an order is automatically
executed. For 'securities that trade less regularly, the London Stock Exchange has
implemented the SEAQ system, where market makers keep the shares liquid. These
market makers are required to hold shares of a specific company and set the bid and
ask prices, ensuring that there is always a market for the stock.

Hong Kong Stock Exchange

Hong Kong Stock 'Exchange history dates back to 1866. But the first formal stock
market, the Association of Stockbrokers in Hong Kong, was established only in 1891. It
was renamed the Hong Kong Stock Exchange in 1914. A second exchange was
incorporated in 1921 - the Hong Kong Stockbrokers' Association. The two exchanges
merged to form the Hong Kong Stock Exchange in 1947.

117
Introduction The rapid growth of the Hong Kong economy led to the establishment of three other
to Financial exchanges in the late 1960s and early 1970s. Prompted by the 1973 market crash and
Markets
the need to strengthen market surveillance, the Hong Kong government set up a working
committee in 1977 to consider the unification of the four stock exchanges. As a result,
the unified exchange - the tock xchange of Hong Kong ( EHK) - was incorporated
on 7th July, 1980. The foul' exchanges ceased trading after the close of business on 27th
March, 1986. This was a pivotal point in Hong Kong Stock Exchange history as this
merger allowed the market to grow and compete on an international scale.
After the October Crash in 1987, SEHK underwent a complete reform, including the
establishment of a more widely representative Council and a strong, professional executive
management team, to safeguard the interests of all participants and to operate and
develop the market effectively.
In 1993, the Exchange launched the Automatic Order Matching and Execution System
(AMS) that was replaced by the third generation system (AMS/3) in October, 2000.
The new system enabled the exchange participants to trade from their offices. In 1999,
the HKSE opened the Growth Enterprise Market (GEM) that made the access to the
capital market easier for riskier businesses.
After a year, the Growth Enterprise Index (GEl) was launched. Finally, the Stock
Exchange of Hong Kong together with Hong Kong Futures Exchange Ltd. established
in 1976 and Hong Kong Securities Clearing Company Ltd. incorporated in 1989 merged
to form a unified company Hong Kong Exchanges and Clearing Limited (HKEx) in
2000. Shares of the HKEx were listed on the Stock Exchange of Hong Kong.
With its total securities market capitalization ofHK$ 8,260.3 billion (US$ 1,063.9 trillion),
the HKSE ranks 8th place by market capitalization in the world. The HKSE has more
than 4000 stocks listed on the exchange. The Hang Seng Index is widely followed as a
barometer of the East and South East Asian economies.

Shanghai Stock Exchange (SSE)

Shanghai Stock Exchange is the first exchange in mainland China established in the
year 1904. However it was closed as result of the communist takeover in 1949 and was
re-established in 1990. It has been operational since December 19, 1990.
It is a membership institution directly governed by the China Securities Regulatory
Commission (CSRC). After several years' operation, the SSE has become the most
preeminent stock market in Mainland China in terms of number of listed companies,
number of shares listed, total market value, tradable market value, securities turnover in
value, stock turnover in value and the T-bond turnover in value. The exchange has a
total of eight hundred and seventy-eight listed companies.
The main indices used on the exchange are:
• E SO index
• S E 180 Index
• SE Composite Index
• H - SZ E 300 Index.
he Shanghai Stock Exchange is administered by the China Securities Regulatory
Commission and works as a non-profit institution. The exchange list two different
kinds of tocks: A and B shares. The difference between the two stocks is the currency
that they are traded in. The A shares is traded in the local Renminbi Yuan currency,
whereas the B shares are traded in US Dollars. Traditionally A hares were only traded
within the country, but now both A and B shares may be traded world wide. The majority
of the stocks listed on the exchange are A shares. There are eight hundred twenty-foul'
118 A shares and fifty-four B Shares listed on the market.
SSE is fully committed to the goal of State-owned industrial enterprises reform and Market Institutions
and Intermediaries
developing Shanghai into an international financial center with great confidence.

Singapore Stock Exchange (SGX)

The Singapore Stock Exchange established in Singapore in Decernber-l, 1999 was the
result of the merger of two financial institutions - the tock Exchange of Singapore and
the Singapore International Monetary Exchange. The Singapore International Monetary
Exchange was a futures exchange that was established in 1984. The Stock Exchange
of Singapore, on the other hand, traded in stocks. By 1998, the Stock Exchange of
Singapore had a market capitalization of S$263 billion and 307 listed companies. The
Singapore Stock Exchange is Asia's first demutualised and integrated securities and
derivatives exchange. It was also the first publicly held exchange in the Asia Pacific.
On 23rd November 2000, the Singapore Stock Exchange was the first exchange to be
listed through the public offer and the private placement.
The following are the indices used in the Singapore Stock Exchange:
• MSCI Singapore Free Index
• Strait Times Index
The products offered by the Singapore Stock Exchange are traded through the electronic
screen based system. The products include Equities, Warrants, Bonds, Debentures and
Loan Stocks, Exchange Traded Funds, Real Estate Investment Trusts, Business Trusts,
Infrastructure Funds and Depository Receipts.
The derivative products include short-term and long-term Long term interest rate futures
and options on futures, Equity Index futures and options on futures, Single Stock Futures
and Structured Warrants
The Singapore Stock Exchange is the first stock exchange in Asia that trades in equity
index futures. The company listings under the Singapore Stock Exchange is divided into
the following:
• Singapore Stock Exchange Mainboard: The companies that are listed under
this head have to fulfill certain criteria relating to market capitalization, pre-tax
profits and operating track records.
• Singapore Stock Exchange SESDAQ: This is listing of new companies which
do not have to fulfill any quantitative requirement. On application the companies
listed on the SESDAQ can be transferred to the former category provided they
fulfill the criteria of this list.
sax also hosts trading in futures on S&P CNX NIFTY - the stock index of the NSE.
This is popularly known as the sax NIFTY. Since the sax opens earlier than the
Indian stock markets, traders can track the movement of the sax NIFTY to identify
investor sentiment before the markets in India opens. This is critical for under tanding
the positions taken by Foreign Institutional Investors and other entities in sax NIFTY.

Growing Interlinkages between Global Financial Markets and Indian Financial

Markets
There have been growing interlinkages between different markets acros the world. In
India, this is all the more pronounced, after the liberalization of Indian economy in 1990' .
The movement of stock indices in China, Hong Kong, Singapore, Australia, Europe and
USA has significant impact on the investor sentiment in India. It is not unusual to observe
a high correlation between different equity markets across the globe.
Before a trader commences trading on Indian stock markets, he analyzes the volatility
of the East and South East Asian markets. The trader also analyzes the movement of
Dow Jones Industrial Average on the previous business day - this is because the DJIA
119

I
 Introduction is long open after the Indian market are closed on the previous business day. The
to Financial investor interest in Indian markets is predominantly also due to investments by Foreign
Markets
Institutional Investors (FII).
Thus, it is critical for a trader in Indian financial markets to closely observe the trend
prevailing in international markets.

·4.12 SUMMARY
SEBI is the regulator of the Indian equity markets. It has complete control over the
activities of the stock exchanges and the market participants involved In the primary and
secondary market activities.
BSE and NSE are the major stock exchanges in India. MCX Stock Exchange has been
recently established and has commenced trading in currency futures. There are different
market intermediaries in the financial markets including depositories, merchant bankers,
depository participants, registrars, banking institutions, etc.
Some of the major stock exchanges in the world include: New York Stock Exchange,
NASDAQ, Tokyo Stock Exchange, London Stock Exchange, Shanghai Stock Exchange
and Hong Kong Stock Exchange.

4.13 SELF ASSESSMENT QUESTIONS

1) Discuss the evolution of stock exchanges in India.
2) Draw a flowchart to depict the structure of the financial market participants in
India.
3) Discuss the role and significance of SEBI.
4) What are the major reforms instituted in the stock markets in India?
5) What are the major reforms instituted in the banking industry since independence?
6) Why have banks been nationalized in late 1960's?
7) What is the role of banks in the Indian Financial Markets?
8) List some of the major global stock exchanges.

4.14 FURTHER READINGS

1) Khan, M.Y. (2007) Indian Financial System, Tata McGraw-Hill.
2) Endo, Tadashi (1998) Indian Securities Market, Vision Books.
3) Pathak, Bharati V. (2008) The Indian Financial System, Markets Institutions
and Services, Pearson Education.
4) Geisst, Charles R. (1997) WaUStreet, A History, Oxford University Press.
5) Tandon, Prakash, (1989) Banking Century, Penguin Books.
6) Refer to websites: www.rbi.org.in <http://www.rbi.org.in> and www.sebi.gov.in
<http://www.sebi.gov.in>

120

,
 Annexure! Market Institutions
and Intermediaries
Financial Intermediaries in India

[ Plnancial
Intermedlnrle

1 I

[ Bunkins 1 [ Non-Banking Mutunl

Insurnnce,
HOUNlnll Flnan~e
IJ
intermediaries IntermedlnrleM Funds
1 Companies

Scheduled Scheduled Non-Bunking Development Public

Commercial Cooperative Finance Finance Sector
Banks Bunks companies Institutions

All India
financial
I- Public Sector institutions: Private
L-
Banks fFCl,IDBI,IfBI, Sector
SIDBl, IDFC,
NABARD, EXIM
Bank, NHB

I- Private Sector State level

Banks
- institutions
SFC,SIDC

Other
I- Foreign Banks
institutions
in India
ECGC,DICGC

Regional Rural
L-
Banks

,r

121

I
Introduction Annexure 2
to Financial
Markets Primary Market Intermediaries in India

Prnnary Market Intermediaries

, Merchant Bankers/ LE-ad Managers :

Underwriters :
Registration, Obligation and Responsibilities.
Inspection. Action in Default. Default points. Registration. Obligation and Responsibilities
Pre and post Issue Obligation an Other Disciplinary Proceedings
Requirements

Registrar to Issue and share Transfer

Agent:
Brokers to an issue
Registration, Responsib ilities, Inspection and
Action in Default
. .-..-
..•.•...
Prohibition of Frnudul ent and Unfair
Debenture Trustee :
Practice Relating to the securtnes Market
Registra ion, Ob ligat ions. Insp ecti 011, Act ion
Prohibition of Fraudulent and Unfair ill Default
Practice. Iuvetigauou

BIlUkt'l'H to IHNue :
r ""

Prohlbltton on Registrntiou.Obligation nnd Re~pol\sibiJitieH

DenUng./colDulllcatlnglColuISt'UlllZ on
Mnttt'l'H Rellltlll~ to Insider Trading:
Investigation. Policy on disclosure and
internal disclosure 1'01' prevention of'lnsider
- Action in Default
-

Trading ~
\.. ~
Portfolto Managers :
Registration. Obhgation and Responsibilities.
Disciplinary Proceedings

122
 Annexure 3 Market Institutions
and Intermediaries
Intermediaries in Indian Stock Markets

Stock Market

/
Custodial Services
Securtttes Lending
Rezrstrauou Scheme
Ohhzatron ReSp~)1I8Ibl Ehglblhty Cntena
Stock Broklng lilies Depository Systt'ID
Obliaatron
Audit
Action m Default
Umfonn Nonus and
Practices

'----------'~ ,'----------'~ ,~---------'~

Depositories A<'t
Sebl Depusitorfes nnd '
Cel nficatron of • i
Couuuencement of Pnrtlcll)1111
Rt'gllldtloli "
t' I
Business
Reli\stl"dticltl'l
Rights Oblizaticn of
Depositories. I- - Code'oHOIiad~t" I
Particrpants.Issuer and Rishts and obhgntldilll
Beneficial 0\\111'1;; '\
Inspection
Brokers: Inquuy Inspectton
.-\, non III (kfn'li'I/'
Reaistmnon pennlties
Code of COlldllct
Obit ations/Respom Ibll\tle~, Inspection "
Penalty Capitnl Ad quacy Reeulaticn of
Trnnsacnons Exhllm&
___ Deposltorles
NSDL.C'DSL

FOI't'11I1IBrokers
Rezrstrnnon: Transnctiou JI1 Accounts
Market Op erntious; Repot tlllg System
Inspection
\..

Trading und C'lenrtng

••.•• Registratron Fee, Code of Con duct
Obhgations.Action on Default

123

I
 MPDDIRGNOU/P.O.5H/June.2011 (Reprint}

ISRN-978-81-266-4505-3
f •