UNIT - 2

FINANCIAL MARKETS

Meaning of Financial Markets

A Financial Market is a platform or system
Where individuals, businesses and
governments can buy and sell various financial
instruments such as stocks, bonds, currencies,
commodities, and derivatives. It is a
mechanism through which participants can
trade assets, manage risks, and raise capital.
Functions of Financial Markets
Facilitating Capital Formation - Financial markets provide
a platform for companies, governments, and other entities to
raise capital by issuing and selling financial instruments such
as stocks and bonds. This enables them to finance new
projects, expand operations, and invest in growth
opportunities.
Efficient Allocation of Capital - Financial markets help
allocate capital to its most productive uses. Investors can
choose from various investment options based on risk and
return profiles, directing funds to projects and businesses
with the highest potential for growth and profitability.
Functions of Financial Markets
Price Discovery - Financial markets enable the determination
of market prices for financial assets. Through the forces of
supply and demand, prices reflect the collective assessment of
market participants regarding the value and future prospects of
assets. Price discovery helps investors make informed
decisions and facilitates fair valuation of investments.
Risk Management and Hedging - Financial markets offer a
range of derivative instruments, such as options and futures
contracts, that allow participants to manage risks. Investors can
hedge against adverse price movements, reducing the potential
impact of market fluctuations on their portfolios.

Functions of Financial Markets

Liquidity Provision - Financial markets enhance the liquidity

of financial assets by creating a secondary market where
investors can buy or sell their holdings. This liquidity allows
investors to convert their investments into cash relatively
quickly, enhancing market efficiency and facilitating trading
activity.
Investor Participation and Wealth Accumulation - Financial
markets provide individuals and institutions with opportunities
to invest their savings and accumulate wealth over time. By
investing in stocks, bonds, and other assets, individuals can
grow their wealth, plan for retirement, and meet financial goals.

Functions of Financial Markets

Economic Indicators and Information Transmission - Financial
markets serve as important indicators of economic health and trends.
Market movements, such as stock market indices and bond yields,can reflect
investor sentiment and provide insights into economicconditions. Financial
markets also facilitate the transmission of
information, as investors react to news, earnings reports, and
economic data, influencing asset prices.
Economic Stabilization - Central banks and government entities
utilize financial markets as tools for economic stabilization. They
can intervene in markets by adjusting interest rates, implementing
monetary policies, and intervening in times of financial crises to
maintain stability and promote economic growth.
Importance of Financial Markets
Capital Formation: This market provides companies,
governments, and individuals a platform for raising
capital. Companies can issue stocks or bonds to fund
business expansion, research, development, or
infrastructure projects. Governments can issue bonds to
finance public initiatives. Financial markets facilitate the
flow of savings and investments, enabling capital
formation and economic growth.

Importance of Financial Markets

Risk Management: It offers tools and instruments
that help manage and mitigate risks. For example,
derivatives such as options and futures enable
investors to hedge against price fluctuations in
commodities, currencies, or interest rates. Insurance
products protect against potential losses. By
allowing participants to transfer or diversify risks,
financial markets contribute to stability and
resilience in the face of uncertainties.
Efficient Resource Allocation: Financial markets
play a vital role in allocating resources efficiently.
Investors assess investment opportunities based on
risk and return profiles, directing funds to the most
promising ventures. This process encourages
innovation, entrepreneurship, and productivity
growth. Efficient resource allocation contributes to
overall economic efficiency and development.

Liquidity and Marketability: It provides liquidity,

allowing investors to buy or sell financial assets
easily. This liquidity enhances the marketability and
credibility of securities, making them attractive
investment options. Investors can quickly convert
their investments into cash, providing flexibility
and facilitating the flow of funds in the economy.

Price Discovery: Financial markets facilitate

discovery by reflecting financial assets’ supply and
demand dynamics. The interaction between buyers
and sellers leads to fair and transparent pricing.
Market prices reflect the collective assessment of
market participants regarding the value and
prospects of the underlying assets. Price discovery
supports efficient resource allocation and informs
investment decisions.

Economic Stability and Growth: Financial

markets that are effectively regulated play a vital
role in ensuring economic stability and growth.
They establish a reliable and safe setting for
individuals to engage in transactions, enforce
agreements, and safeguard the rights of investors.
These markets foster the efficient allocation of
capital, thereby promoting productive investments,
job generation, and holistic economic progress.

Structure of Financial Markets

Types of Financial Markets

Financial Market Description
Stock Market Market for buying and selling shares (ownership) of publicly
traded
companies. Investors can purchase shares to gain ownership and
potentially earn returns through capital appreciation and dividends
Bond Market Market for trading debt securities (bonds) issued by governments,
corporations, and municipalities. Investors buy bonds and receive
periodic interest payments and the return of principal amount at
maturity
Foreign Exchange
Market (Forex)
Market for exchanging one currency for another. Participants
include individuals, businesses, and financial institutions. Forex
trading facilitates international trade and investment, and currency
speculation

Commodity Market Market for buying and selling commodities like gold, oil,
agricultural products, and metals. Investors trade commodity
contracts, either for immediate delivery or future delivery at a
predetermined price
Derivatives Market Market for financial instruments derived from underlying
assets,
such as options, futures, and swaps. Derivatives allow investors to
speculate on price movements, manage risks, and hedge against
potential losses
Financial Market Description
Futures Market Market for trading futures contracts that obligate buyers
and sellers to transact a specific asset at a predetermined
price and date in the future. It allows participants to
speculate on price movements and manage risks
Over-the-Counter Market (OTC) Markets with customized procedures and
decentralized
organization is an OTC market. It is a type of secondary
market. Smaller organizations prefer this market as it has
fewer regulations and is less expensive.

Money Market - Meaning

Money Market refer to the segment of the financial
market where short-term borrowing and lending of
funds take place. It primarily deals with highly liquid
and low-risk instruments that have maturities
typically ranging from overnight to one year.
Importance of Money Market
Short-term financing: Facilitating borrowing
and lending for immediate funding needs.
Liquidity management: Providing a platform
for efficient management of cash positions.
Low-risk investments: Offering secure
investment options with stable returns.

Benchmark interest rates: Establishing reference

rates for pricing other financial instruments.
Monetary policy implementation: Supporting
central banks in managing liquidity and interest rates.
Market stability and transparency: Ensuring a
stable and transparent marketplace through regulations
and oversight.

Types of Money Market Instruments

Treasury Bills
(T-bills)
Short-term debt securities are issued by RBI on behalf of central governments to
fund short-term
cash requirements. Issued at a discount to face value. Maturity typically in three
months, six
months, or one year. They are non-interest bearing i.e. 0 coupon or 0 interest,
and hence
are also called 0 coupon bonds.
Being backed by the Government, these bills are considered risk-free and are
highly liquid. As
of now, there are 3 types of T-Bills auctioned by the RBI:
91-day T-Bills – Have a maturity period of 91 days.
182-day T-Bills – Have a maturity period of 182 days.
364-day T-Bills – Have a maturity period of 364 days.
Certificates of
Deposit (CDs)
Certificate of Deposit (CD) is a security issued by the Scheduled Commercial
Banks
(SCBs) and some other Financial Institutions (FIs) that have been permitted by
the RBI to
raise short-term funds. Cooperative Banks and Regional Rural Banks
(RRBs) are not
allowed to issue Certificates of Deposit (CDs). Certificates of Deposit (CDs)
should be issued
in multiples of ₹1 lakh, with a minimum amount of
₹1 lakh. They are issued at a discount
on face value and are redeemed at par or face value. Their maturity period is,
usually, more
than 7 days and less than 1 year. Withdrawal of a CD before the maturity date
results in a
penalty. Banks are not allowed to provide loans against the CDs.
ion
Commercial
Papers (CPs)
Commercial Paper (CP) is a type of unsecured, short-term debt instrument
issued by large Corporations, Primary Dealers, and Financial Institutions
(FIs). The eligible institutions may issue Commercial Papers (CPs) to finance
their
short-term needs, such as inventory management, meeting payroll expenses,
funding new projects, etc. A Commercial Paper is issued as an unsecured
promissory note and is placed privately. They should be issued in multiples of
₹5
lakh, with a minimum amount of
₹5 lakh. Their maturity period is a minimum
of 7 days and a maximum of up to 1 year.
Commercial Bill /
Trade Bill
Commercial Bill (CB) is a negotiable instrument drawn by the seller or buyer
of
goods/services for the value of goods/services delivered. Commercial Bills
(CBs)
act as a way for a seller (drawer) to extend credit to a buyer (drawee) for goods
or
services purchased. When a Commercial Bill gets accepted by a Commercial
Bank, it is called as Trade Bill. A Commercial Bill or Trade Bill is discounted
by the Commercial Bank first. The Bank, then, gets it re-discounted by the
RBI.
Types of Money Market Instruments
Instruments Description
Repurchase
Agreements
(Repos)
Short-term agreements are where one party sells
securities with an agreement to repurchase at a
later date. Commonly used for short-term
borrowing or lending of funds. Government
securities are often used as collateral.

Capital Market - Meaning

Capital Market refers to that part of the broader
financial market which provides a market for
borrowing and lending of medium and long-term
funds, above 1 year.

Importance
Money moves between people who need capital and
who have the capital.
There is more efficiency in the transactions.
Securities like shares help in earning dividend
income.
With the passage of time, the growth in value of
investments is high.
The interest rates provided by securities like Bonds
are higher than interest rates given by banks.
Can avail tax benefits by investing in stock markets.
Scope for a wide range of investments.
Securities of capital markets can be used as collateral
for getting loans from banks.

Types of Capital Market

The Primary Market is the type of Capital Market

where new securities are issued for the first time.
Thus, it is also called the New Issue Market. The
primary market provides the channel for the sale
of new securities. The issuer of securities sells the
securities in the primary market to raise funds for
investment and/or to discharge. In other words, the
market wherein resources are mobilized by
companies through the issue of new securities is
called the primary market.
The Secondary Market refers to a market
where those types of securities are traded, which
have already been issued and offered to the
public in the Primary Market and/or listed on the
Stock Exchange. Thus, it is also called the Old
Issue Market. The secondary market enables
securities holders to adjust their holdings in
response to changes in their assessment of risk
and return or to buy/sell their securities as per
their liquidity needs.

Types of Capital Market Instruments

 Equities - Equities are the instruments of capital market that involve buying
and selling
shares. They represent ownership in a company and enable individuals to share
in the
profits or losses generated by the company. By owning equities, investors may
receive a
dividend income from companies when they declare dividends and any potential
capital
appreciation. Investors can purchase equities directly from the companies
offering them
or through stock exchanges.
 Bonds - Bonds function as tools for issuers to secure funds from investors
by offering
them a debt-based investment opportunity. These instruments guarantee periodic
interest
payments and the repayment of the principal amount upon maturity, all at a
predetermined interest rate. The value of bonds can fluctuate in the secondary
market,
influenced by various factors such as credit ratings, changes in the economy, and
other
pertinent considerations. In this type of capital market instrument, investors can
take part
in this market by buying and selling bonds, considering these factors and
potential
returns.

Types of Capital Market Instruments

Derivatives - Investors can efficiently and profitably reach their
financial goals by using derivatives. Financial derivatives derive their
value from an underlying asset, like stocks, commodities, or currencies.
They are mainly used to hedge against price fluctuations in the
underlying asset and to speculate on future market trends.
Commodities - Commodities serve as tangible capital market
instruments that encompass essential raw materials and primary goods of
commerce. These include agricultural products, steel, other metals,
energy sources such as coal and oil, and livestock. Commodities are
traded on a regulated exchange through futures contracts that require the
buyer to purchase the commodity at a fixed price in the future.
Mutual Funds - Mutual funds are an ideal choice for people who want to
invest but lack the expertise or time to manage their portfolio of stocks and
bonds. It involves pooling together money from various investors with
similar investment objectives and investing in various securities such as
equities, debt instruments etc. The performance of these funds depends on
the type of fund, its asset composition, the market conditions, etc.
Exchange Traded Funds (ETFs) - ETFs are like mutual funds that track
an index, commodity or basket of assets like an index fund, but they trade
like a stock on an exchange throughout the day. ETFs have become
increasingly popular over recent years due to their low cost, tax efficiency,
and diversity. They are an easy way to diversify a portfolio and take
advantage of different market sectors without purchasing multiple stocks.
Initial Public Offerings (IPOs) - An IPO signifies when a privately-held
company transforms into a publicly-traded entity, making its shares
available for the general public to purchase for the first time. Companies
utilize IPOs to raise capital from public investors and list their shares on a
stock exchange.
Real Estate Investment Trusts (REITs) - REITs serve as a capital
market instrument that amass funds from investors to invest in real estate
properties that generate income. They allow individuals to invest in real
estate without directly owning physical properties. REITs distribute a
significant portion of their income as dividends to investors. The appeal
of REITs lies in their liquidity, providing the flexibility to buy or sell
shares, diversification benefits, and the potential for regular income,
making them an attractive investment option.

Primary Market - Meaning

The Primary Market is the type of Capital Market
where new securities are issued for the first time. Thus,
it is also called the New Issue Market. The primary
market provides the channel for the sale of new
securities. The issuer of securities sells the securities in
the primary market to raise funds for investment and/or
to discharge. In other words, the market wherein
resources are mobilized by companies through the issue
of new securities is called the primary market.

Primary Market - Importance

Companies can raise capital at a relatively low cost, and the
securities so issued in the primary market have high liquidity
because they can be sold in the secondary market almost
immediately.
Primary markets are important for the mobilization of savings in
an economy. Communal savings are mobilized to invest in other
channels. Investment options are financed by this.
Compared to the secondary market, the primary market has
considerably fewer chances of price manipulation. Manipulations
such as these affect the fair and free operation of the market by
deflating or inflating a security’s price.

Role of Primary Market in New Issues Market

New issue offer - A primary market allows for the offering of new
issues that have not previously been traded on other exchanges.
Organizing a fresh issue market involves, among other things, a
thorough evaluation of the project’s feasibility. As a result, a fresh issue
market is also called a “new issue market.
Services for underwriting - Underwriting is crucial when launching a
new issue. Underwriters are responsible for acquiring unsold shares in
a primary market if the company cannot sell the required number of
shares. Financial institutions can earn underwriting commissions by
acting as underwriters. In order to determine whether taking the risk
and reaping the rewards is worth it, investors rely on underwriters.
IPOs can be purchased by underwriters who sell them to investors.Role of
Primary Market in New Issues Market
New issue distribution - New issues are also
distributed in a key marketing arena. These
distributions begin with the issuance of a new
prospectus. In it, the general public is invited to
purchase a new issue, and detailed information about
the issue, underwriters, and the firm is provided.

Secondary Market - Meaning

The Secondary Market refers to a market where those
types of securities are traded, which have already
been issued and offered to the public in the Primary
Market and/or listed on the Stock Exchange. Thus, it
is also called the Old Issue Market. The secondary
market enables securities holders to adjust their
holdings in response to changes in their assessment of
risk and return or to buy/sell their securities as per
their liquidity needs.Secondary Market - Features
Liquidity: Facilitates swift transactions of securities
for instant cash conversion.
Price Discovery: Establishes fair values of securities
based on market forces.
Transparency: Most markets, especially stock
exchanges, exhibit openness regarding pricing,
fostering equality.Secondary Market - Features
Accessibility: Online platforms simplify trading
access for all, not just elite investors.
Market Orders: Various order types empower
investors to manage their transactions effectively.Role of Secondary Market in
Stock Trading
Acts as a Reliable Source – Secondary markets check a
company’s value before listing it on their trade list. As a result,
investors can be assured that they are purchasing from a trusted
source.
Trading Platform – Stock exchanges offer investors a platform
to trade securities, including stocks, bonds, and more. This
happens without the involvement of the issuing companies.
Supports Active Trading – You can trade anytime. The market
allows quick buying and selling, and prices change little across
many trades.Role of Secondary Market in Stock Trading
Creates Liquidity – Investors can sell their shares on
a trading platform, and you can sell the securities you
own on various stock markets.
Market Valuation Data – Investors can use it to
estimate how many securities they have bought. They
do this using secondary market values.
Easy Share Exchange – Investors can quickly sell
their holdings for cash on the secondary market.Role of Secondary Market in
Stock Trading
Maintaining Fair Stock Value – Secondary markets
are benchmarks for pricing assets. They are based on
demand and supply in transactions. The price is
public, and investors can use it to make decisions.
Indicator of a Country’s Economy – It bridges
investment and savings. It shows a country’s
economic health.
Stock Indices
A stock market index, often known as a stock index,
is a statistical metric that measures market
fluctuations. It is established by collecting a few
similar stocks from among the securities listed on the
exchange, and the selection criterion could be a
company's size, market capitalization, or industry
type.
NIFTY
NIFTY is a mix of "National Stock Exchange" and "Fifty,"
and it's a top stock market index at the National Stock
Exchange (NSE).
NIFTY is the largest stock market index of the NSE. It
includes the 50 leading companies traded on the NSE, chosen
based on their free-float market capitalization.
Among all the indices, NIFTY50 is the most widely utilized
and traded by investors. It showcases the top 50 stocks traded
on the NSE out of 1600.

SENSEX
A stock market analyst Mr Deepak Mohoni introduced the term
Sensex. The term Sensex is a combination of Sensitive and
Index. The Sensex is an index that reflects the Bombay Stock
Exchange (BSE).
The Sensex Index comprises 30 stocks on BSE. These stocks are
the largest and most actively traded stocks on the BSE. The
criteria for selecting stocks is as follows:
• Listed on BSE
• It should be a large to mega-cap stock.
• Relatively liquid stocks
• Revenue generated from core activities
• SENSEX
• A diversified and balanced sector involvement in line with
the Indian equity market
The Sensex reflects the movements in the Indian stock
market. If the Sensex increases, it means the prices of the
underlying 30 stocks have increased. If the Sensex has
decreased, it means the prices of the underlying 30 stocks
have decreased
The Sensex is the oldest index in India, and people consider
it to be a reflection of the Indian economy. Market research
analysts refer to the Sensex to understand the overall growth,
development in industry, country’s stock market trend.