Introduction to transmission mechanism with the help of which the providers of funds (investors/

Financial Markets, lenders) can interact with the borrowers/users (business units) and transfer the
Money Market and
Capital Market
funds to them as and when required. This aspect is taken care of by the financial
markets which provide a place where or a system through which, the transfer of
funds by investors/lenders to the business units is adequately facilitated

1.2 Meaning
We know that, money always flows from surplus sector to deficit sector.
That means persons having excess of money lend it to those who need money to
fulfil their requirement.

Similarly, in business sectors the surplus money flows from the investors or
lenders to the businessmen for the purpose of production or sale of goods and
services. So, we find two different groups, one who invest money or lend money
and the others, who borrow or use the money.

Now you think, how these two groups meet and transact with each other.
The financial markets act as a link between these two different groups. It
facilitates this function by acting as an intermediary between the borrowers and
lenders of money. So, financial market may be defined as „a transmission
mechanism between investors (or lenders) and the borrowers (or users) through
which transfer of funds is facilitated‟. It consists of individual investors, financial
institutions and other intermediaries who are linked by a formal trading rules and
communication network for trading the various financial assets and credit
instruments.
Let us now see the main functions of financial market-

(a) It provides facilities for interaction between the investors and the borrowers.
(b) It provides pricing information resulting from the interaction between
buyers and sellers in the market when they trade the financial assets.
(c) It provides security to dealings in financial assets.

(d) It ensures liquidity by providing a mechanism for an investor to sell the

financial assets.

(e) It ensures low cost of transactions and information.

4
 Financial
Check your progress 1
Markets: An
1. __________market provides facilities for interaction between the investors Introduction

and the borrowers.

a. Financial
b. Capital

2. __________may be defined as „a transmission mechanism between investors

(or lenders) and the borrowers (or users) through which transfer of funds is
facilitated‟.
a. Capital market

b. financial market

1.3 Nature and Role of Financial System

The financial system plays the key role in the economy by stimulating
economic growth, influencing economic performance of the actors, affecting
economic welfare. This is achieved by financial infrastructure, in which entities
with funds allocate those funds to those who have potentially more productive
ways to invest those funds. A financial system makes it possible a more efficient
transfer of funds. As one party of the transaction may possess superior
information than the other party, it can lead to the information a symmetry
problem and inefficient allocation of financial resources. By overcoming the
information a symmetry problem the financial system facilitates balance between
those with funds to invest and those needing funds.

According to the structural approach, the financial system of an economy

consists of three main components:

1) Financial markets;
2) Financial intermediaries (institutions);

3) Financial regulators.
Each of the components plays a specific role in the economy.

According to the functional approach, financial markets facilitate the flow

of funds in order to finance investments by corporations, governments and
individuals. Financial institutions are the key players in the financial markets as
they perform the function of intermediation and thus determine the flow of funds.

5
Introduction to The financial regulators perform the role of monitoring and regulating the
Financial Markets, participants in the financial system.
Money Market and
Capital Market

Fig 1.1 The structure of financial system

Financial markets studies, based on capital market theory, focus on the

financial system, the structure of interest rates, and the pricing of financial assets.
An asset is any resource that is expected to provide future benefits, and thus
possesses economic value. Assets are divided into two categories: tangible assets
with physical properties and intangible assets. An intangible asset represents a
legal claim to some future economic benefits. The value of an intangible asset
bears no relation to the form, physical or otherwise, in which the claims are
recorded. Financial assets, often called financial instruments, are intangible assets,
which are expected to provide future benefits in the form of a claim to future cash.
Some financial instruments are called securities and generally include stocks and
bonds.

Any transaction related to financial instrument includes at least two parties:

1) The party that has agreed to make future cash payments and is called the
issuer;
2) The party that owns the financial instrument, and therefore the right to
receive the payments made by the issuer, is called the investor.
Financial assets provide the following key economic functions.

 They allow the transfer of funds from those entities, who have surplus funds
to invest to those who need funds to invest in tangible assets;

 They redistribute the unavoidable risk related to cash generation among

deficit and surplus economic units.

The claims held by the final wealth holders generally differ from the
liabilities issued by those entities who demand those funds. They role is
performed by the specific entities operating in financial systems, called financial
intermediaries. The latter ones transform the final liabilities into different financial
assets preferred by the public.

6
 Financial
Check your progress 2
Markets: An
1. The___________system plays the key role in the economy by stimulating Introduction

economic growth.

a. Financial
b. Market

2. A financial system makes it possible a more efficient transfer of_________.

a. Capital

b. funds

1.4 Financial Markets as Components of Financial

System
A financial market is a market where financial instruments are exchanged or
traded. Financial markets provide the following three major economic functions:
1) Price discovery

2) Liquidity
3) Reduction of transaction costs

1) Price discovery function means that transactions between buyers and sellers
of financial instruments in a financial market determine the price of the
traded asset. At the same time the required return from the investment of
funds is determined by the participants in a financial market. The motivation
for those seeking funds (deficit units) depends on the required return that
investors demand. It is these functions of financial markets that signal how
the funds available from those who want to lend or invest funds will be
allocated among those needing funds and raise those funds by issuing
financial instruments.
2) Liquidity function provides an opportunity for investors to sell a financial
instrument, since it is referred to as a measure of the ability to sell an asset
at its fair market value at any time. Without liquidity, an investor would be
forced to hold a financial instrument until conditions arise to sell it or the
issuer is contractually obligated to pay it off. Debt instrument is liquidated
when it matures, and equity instrument is until the company is either
voluntarily or involuntarily liquidated. All financial markets provide some

7
Introduction to form of liquidity. However, different financial markets are characterized by
Financial Markets, the degree of liquidity.
Money Market and
Capital Market 3) The function of reduction of transaction costs is performed, when financial
market participants are charged and/or bear the costs of trading a financial
instrument. In market economies the economic rationale for the existence of
institutions and instruments is related to transaction costs, thus the surviving
institutions and instruments are those that have the lowest transaction costs.

The key attributes determining transaction costs are

 Asset specificity,

 Uncertainty,

 Frequency of occurrence.

Asset specificity is related to the way transaction is organized and executed.

It is lower when an asset can be easily put to alternative use, can be deployed for
different tasks without significant costs.

Transactions are also related to uncertainty, which has (1) external sources
(when events change beyond control of the contracting parties), and (2) depends
on opportunistic behaviour of the contracting parties. If changes in external events
are readily verifiable, then it is possible to make adaptations to original contracts,
taking into account problems caused by external uncertainty. In this case there is a
possibility to control transaction costs. However, when circumstances are not
easily observable, opportunism creates incentives for contracting parties to review
the initial contract and creates moral hazard problems. The higher the uncertainty,
the more opportunistic behaviour may be observed, and the higher transaction
costs may be born. Frequency of occurrence plays an important role in
determining if a transaction should take place within the market or within the
firm. A one-time transaction may reduce costs when it is executed in the market.
Conversely, frequent transactions require detailed contracting and should take
place within a firm in order to reduce the costs. When assets are specific,
transactions are frequent, and there are significant uncertainties intra-firm
transactions may be the least costly. And, vice versa, if assets are non-specific,
transactions are infrequent, and there are no significant uncertainties least costly
may be market transactions.
The mentioned attributes of transactions and the underlying incentive
problems are related to behavioural assumptions about the transacting parties. The
economists Coase (1932,1960, 1988), Williamson (1975, 1985), Akerlof (1971)
and others) have contributed to transactions costs economics by analyzing
8
behaviour of the human beings, assumed generally self-serving and rational in Financial
their conduct, and also behaving opportunistically. Markets: An
Introduction
Opportunistic behaviour was understood as involving actions with
incomplete and distorted information that may intentionally mislead the other
party. This type of behaviour requires efforts of ex ante screening of transaction
parties, and ex post safeguards as well as mutual restraint among the parties,
which leads to specific transaction costs.

Check your progress 3

1. _________function means that transactions between buyers and sellers of
financial instruments in a financial market determine the price of the traded
asset.
a. Price discovery

b. Cost discovery
2. ___________function provides an opportunity for investors to sell a
financial instrument.
a. Market

b. Liquidity

1.5 Financial System and Economic Growth

The term financial system is a set of inter-related activities/services working
together to achieve some predetermined purpose or goal. It includes different
markets, the institutions, instruments, services and mechanisms which influence
the generation of savings, investment capital formation and growth.

Van Horne defined the financial system as the purpose of financial markets
to allocate savings efficiently in an economy to ultimate users either for
investment in real assets or for consumption. Christy has opined that the objective
of the financial system is to "supply funds to various sectors and activities of the
economy in ways that promote the fullest possible utilization of resources without
the destabilizing consequence of price level changes or unnecessary interference
with individual desires."

9
Introduction to According to Robinson, the primary function of the system is "to provide a
Financial Markets, link between savings and investment for the creation of new wealth and to permit
Money Market and
Capital Market
portfolio adjustment in the composition of the existing wealth."

From the above definitions, it may be said that the primary function of the
financial system is the mobilisation of savings, their distribution for industrial
investment and stimulating capital formation to accelerate the process of
economic growth.

Fig 1.2 The Concept of the Financial System

The process of savings, finance and investment involves financial

institutions, markets, instruments and services. Above all, supervision control and
regulation are equally significant. Thus, financial management is an integral part
of the financial system. On the basis of the empirical evidence, Goldsmith said
that "... a case for the hypothesis that the separation of the functions of savings
and investment which is made possible by the introduction of financial
instruments as well as enlargement of the range of financial assets which follows
from the creation of financial institutions increase the efficiency of investments
and raise the ratio of capital formation to national production and financial
activities and through these two channels increase the rate of growth."

The inter-relationship between varied segments of the economy is

illustrated below:-

10
 Financial
Markets: An
Introduction

Fig 1.3 Inter-relationship in the Financial System

Check your progress 4

1. __________defined the financial system as the purpose of financial markets
to allocate savings efficiently in an economy to ultimate users either for
investment in real assets or for consumption.

a. Van Horne
b. Robinson

2. According to __________ the primary function of the system is "to provide

a link between savings and investment for the creation of new wealth and to
permit portfolio adjustment in the composition of the existing wealth."
a. Van Horne

b. Robinson

1.6 Financial System Designs

A financial system provides services that are essential in a modern
economy. The use of a stable, widely accepted medium of exchange reduces the
costs of transactions. It facilitates trade and, therefore, specialization in
production. Financial assets with attractive yield, liquidity and risk characteristics
encourage saving in financial form. By evaluating alternative investments and
monitoring the activities of borrowers, financial intermediaries increase the
efficiency of resource use. Access to a variety of financial instruments enables an
economic agent to pool, price and exchange risks in the markets. Trade, the
efficient use of resources, saving and risk taking are the cornerstones of a growing
economy. In fact, the country could make this feasible with the active support of
the financial system. The financial system has been identified as the most

11
Introduction to catalyzing agent for growth of the economy, making it one of the key inputs of
Financial Markets, development.
Money Market and
Capital Market

1.6.1 Bank-Based and Market Based

In countries such as Japan, France and Germany, where banks provide
around 20% of the corporate financing, it is known that banks are making
significant effort to develop a relationship banking culture, with long-term loans
and preferential interest rates for clients with a „good history‟. These economies
can be called Bank-Based Economies.
There are also countries where the borrowing-lending activities take place
through organized markets, such as London Stock Exchange, in the UK, or New
York Stock Exchange in USA. These are known as Market-Based Economies.
Although banks are present in these countries, they are highly competitive, the
relationship with lenders and borrowers is purely limited to the transactions of
granting loans or taking deposits and loans are usually granted on short-term.

Check your progress 5

1. The use of a stable, widely accepted medium of exchange reduces the costs
of __________.
a. Transactions.

b. Money
2. The financial system has been identified as the most catalyzing agent for
growth of the __________.
a. Money

b. economy

1.7 Let Us Sum Up

This unit was of great help in making us understand the basic concepts of
financial markets.
In this unit we have learnt in very detail about the meaning, nature and role
of financial system. In this unit we have learnt in very detail about financial
market as components of financial system. The financial system and economic
12
growth were even discussed here in very detail. Apart from this in this unit we Financial
even covered the financial system designs. Overall the whole of the unit covered Markets: An
Introduction
the financial market in very detail and after going through this unit the readers
would have got a sufficient idea about the financial system and the various aspects
connected with it.

1.8 Answers for Check Your Progress

Check your progress 1

Answers: (1-a), (2-b)

Check your progress 2

Answers: (1-a), (2-b)

Check your progress 3

Answers: (1-a), (2-b)

Check your progress 4

Answers: (1-a), (2-b)

Check your progress 5

Answers: (1-a), (2-b)

1.9 Glossary
1. Financial Market - It is a market in which people trade financial securities,
commodities, and other fungible items of value at low transaction costs and
at prices that reflect supply and demand.

1.10 Assignment
What are the functions of a financial system?

13
Introduction to  Intermediates in the money market.
Financial Markets,
Money Market and  Development of money market in India.
Capital Market
 Money Market Instruments.

2.1 Introduction
The money market is a market for short-term funds, which deals in financial
assets whose period of maturity is up to one year. It should be noted that money
market does not deal in cash or money as such but simply provides a market for
credit instruments such as bills of exchange, promissory notes, commercial paper,
treasury bills, etc. These financial instruments are close substitute of money.
These instruments help the business units, other organisations and the
Government to borrow the funds to meet their short-term requirement.
Money market does not imply to any specific market place. Rather it refers
to the whole networks of financial institutions dealing in short-term funds, which
provides an outlet to lenders and a source of supply for such funds to borrowers.
Most of the money market transactions are taken place on telephone, fax or
Internet. The Indian money market consists of Reserve Bank of India,
Commercial banks, Co-operative banks, and other specialised financial
institutions. The Reserve Bank of India is the leader of the money market in India.

Some Non-Banking Financial Companies (NBFCs) and financial

institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.

2.2 Meaning
The purpose of money markets is facilitate the transfer of short-term funds
from agents with excess funds (corporations, financial institutions, individuals,
government) to those market participants who lack funds for short-term needs.
They play central role in the country‟s financial system, by influencing it
through the country‟s monetary authority.
For financial institutions and to some extent to other non-financial
company‟s money markets allow for executing such functions as:

 Fund raising

 Cash management

16
 Risk management Money
Market
 Speculation or position financing

 Signaling

 Providing access to information on prices.

Money markets are wholesale markets with very large amounts of

transactions, e.g. with transactions from 500 million Euro to 1 billion Euro or
even larger ones. This is the most active financial market in terms of volumes of
trading.

From the start of emergence the traditional money markets performed the
role of monetary policy. In order to influence the supply side, governments have
employed methods of direct regulation and control of the savings and investment
behaviour of individuals and companies. However due to fast technological
advances, internationalization and liberalization of financial markets, possibilities
to carry out policy objectives through such measures have diminished. Current
policy through market oriented measures is aimed primarily at demand side. Thus
money markets serve the interface between execution of monetary policy and the
national economies.
Another role of domestic money markets is to serve public policy
objectives, i.e. financing public sector deficits and managing the accumulated
government deficits. Government public debt policy is an important determinant
of the money markets operations, since government debt typically forms a key
part of the country‟s money markets (as well as debt markets). The scope and
measures of monetary policy are also linked to the government‟s budget and fiscal
policies. Thus the country‟s money market shifts are dependent upon the goals of
national public policy and tools used to reach these goals.
Changes in the role and structure of money markets were also influenced by
financial deregulation, which evolved as a result of recognition that excessive
controls are not compatible with efficient resource allocation, with solid and
balanced growth of economies. Money markets went through passive adaptation
as well as through active influence from the side of governments and monetary
authorities.

Finally, money markets were influenced by such international dimensions as

increasing capital mobility, changing exchange rate arrangements, diminishing
monetary policy autonomy. The shifts in European domestic money markets were
made by the European integration process, emergence and development of
European monetary union.
17
Introduction to
Financial Markets,
Check your progress 1
Money Market and
1. Changes in the role and structure of money markets were also influenced by
Capital Market
financial ___________.

a. regulation
b. deregulation.

2. Role of __________money markets is to serve public policy objectives.

a. International

b. domestic

2.3 Characteristics and Functions of Money Market

The money market is a market for financial assets that are close substitutes
for money. It is a market for overnight short-term funds and instruments having a
maturity period of one or less than one year. It is not a place (like the Stock
market), but an activity conducted by telephone. The money market constitutes a
very important segment of the Indian financial system.

Characteristics of Money Market

1. It is not a single market but a collection of markets for several instruments.
2. It is wholesale market of short term debt instruments.

3. Its principal feature is honour where the creditworthiness of the participants

is important.
4. The main players are: Reserve bank of India (RBI), Discount and Finance
House of India (DFHI), mutual funds, banks, corporate investor, non-
banking finance companies (NBFCs), state governments, provident funds
and primary dealers. Securities Trading Corporation of India (STCI), public
sector undertaking (PSUs), non-resident Indians and overseas corporate
bodies.
5. It is a need based market wherein the demand and supply of money shape
the market.

18
Functions of Money Market Money
Market
A well-developed money market is essential for a modern economy.
Though, historically, money market has developed as a result of industrial and
commercial progress, it also has important role to play in the process of
industrialization and economic development of a country. Importance of a
developed money market and its various functions are discussed below:

1. Financing Trade:
Money Market plays crucial role in financing both internal as well as
international trade. Commercial finance is made available to the traders through
bills of exchange, which are discounted by the bill market. The acceptance houses
and discount markets help in financing foreign trade.

2. Financing Industry:
Money market contributes to the growth of industries in two ways:

(a) Money market helps the industries in securing short-term loans to meet their
working capital requirements through the system of finance bills,
commercial papers, etc.

(b) Industries generally need long-term loans, which are provided in the capital
market. However, capital market depends upon the nature of and the
conditions in the money market. The short-term interest rates of the money
market influence the long-term interest rates of the capital market. Thus,
money market indirectly helps the industries through its link with and
influence on long-term capital market.

3. Profitable Investment:
Money market enables the commercial banks to use their excess reserves in
profitable investment. The main objective of the commercial banks is to earn
income from its reserves as well as maintain liquidity to meet the uncertain cash
demand of the depositors. In the money market, the excess reserves of the
commercial banks are invested in near-money assets (e.g. short-term bills of
exchange) which are highly liquid and can be easily converted into cash. Thus, the
commercial banks earn profits without losing liquidity.

4. Self-Sufficiency of Commercial Bank:

Developed money market helps the commercial banks to become self-
sufficient. In the situation of emergency, when the commercial banks have
scarcity of funds, they need not approach the central bank and borrow at a higher

19
Introduction to interest rate. On the other hand, they can meet their requirements by recalling their
Financial Markets, old short-run loans from the money market.
Money Market and
Capital Market 5. Help to Central Bank:
Though the central bank can function and influence the banking system in
the absence of a money market, the existence of a developed money market
smoothens the functioning and increases the efficiency of the central bank.
Money market helps the central bank in two ways:

(a) The short-run interest rates of the money market serves as an indicator of
the monetary and banking conditions in the country and, in this way, guide
the central bank to adopt an appropriate banking policy,
(b) The sensitive and integrated money market helps the central bank to secure
quick and widespread influence on the sub-markets, and thus achieve
effective implementation of its policy.

Check your progress 2

1. Industries generally need ____________term loans, which are provided in
the capital market.

a. long-
b. Short-

2. __________market enables the commercial banks to use their excess

reserves in profitable investment.
a. Capital

b. Money

2.4 Role of the Reserve Bank in the Money Market

The Reserve Bank of India (RBI) has always been playing the major role in
regulating and controlling the India money market. The intervention of RBI is
varied - curbing crisis situations by reducing the cash reserve ratio (CRR) or
infusing more money in the economy.
Having talked about financial sector and the on-going reform process in the
sector, let us now turn our attention to what exact role RBI is playing for the

20
financial sector in general and the financial reform process in particular. As all of Money
Market
you know, RBI is the central bank of the country. Central banks are very old
institutions. The Bank of England was set up way back in 1694, the Bank of
France is more than 200 years old and the Federal Reserve Bank was set up in
1913. As aptly stated by our Governor, Dr. Bimal Jalan, although RBI, set up in
1935, may appear a „toddler or at most a young adult‟, it is one of the oldest
central banks among the developing world. Traditionally, central banks have
performed roles of currency authority, banker to the Government and banks,
lender of last resort, supervisor of banks and exchange control (now it would be
more appropriate to call it exchange management) authority. Generally, central
banks in developed economies have price or financial stability as their prime
objective. The RBI has the twin objectives of maintaining price stability and
promoting growth. The objectives are the following:

 Provision of adequate liquidity to meet credit growth and support

investment demand in the economy while continuing a vigil on movements
in the price level. In line with the above to continue the present stance on
interest rates including preference for soft interest rates.
 To impart greater flexibility to the interest rate structure in the medium-
term. In developing economies, however, the growth objective assumes
greater importance. Recent experience has shown that during recessionary
or deflationary conditions achievement of higher growth becomes the
dominant objective of central banks, both in developing and developed
economies.

Let us now look at the evolution of RBI and its changing role and strategy
over time. RBI was set up to regulate the issue of currency and keep reserves with
a view to securing monetary stability in India and generally to operate the
currency and credit system of the country to its advantage (RBI Act, 1934).
Within these overall objectives, RBI performs a wide range of promotional
functions, which are designed to support the country‟s efforts to accelerate the
pace of economic development with social justice. In keeping with the overall
logic of reforms that market based allocation rather than directed allocation of
resources led to greater efficiency, the functions of the RBI have undergone a
strategic shift under the current reforms. The strategy shifted from controlling
institutions and markets to facilitation of efficient functioning of markets and
strengthening of the supporting institutional infrastructure. The pre-emptions in
the form of CRR and SLR have been progressively reduced. The scope of priority
sector has been expanded. The interest rate has been deregulated both on deposits
and advances. Allowing DFIs and banks to lend in the short as well as the long
21
Introduction to end of the market has reduced segmentation of credit market. From conservation
Financial Markets, of foreign exchange through control of transactions, the focus has shifted to
Money Market and
Capital Market
facilitation of foreign exchange transactions. Intervention in the foreign exchange
market has shifted from fixing of exchange rate to merely curbing speculative
volatility.

Stability issues came to the fore especially after the crises in South East
Asian countries in late 1990s. The RBI progressively strengthened prudential
regulation relating to capital adequacy, income recognition, asset classification,
provisioning, disclosures and transparency. Sequencing of reforms among various
segments of the financial sector (banks, DFIs, co-operative banks, NBFCs, money
market, debt market and forex market) was determined by the importance of each
segment, extent of regulatory powers enjoyed by the RBI and the evolving
situation. Furthermore, institutional strengthening was undertaken to ensure the
progressive development and integration of the securities, money and forex
markets. The RBI has made significant improvements in the quality of
performance of regulatory and supervisory functions. Our standards are
comparable to the best in the world. Attention is being paid to several
contemporary issues such as, relative roles of onsite and off-site supervision,
functional versus institutional regulation, relative stress on internal management,
market discipline and regulatory prescriptions, consolidated approach to
supervision, etc. Several legislative initiatives have also been taken up with
Government, covering procedural law, debt recovery systems, Credit Information
Bureau, Deposit Insurance, etc. Progress in these is critical for effectiveness of
RBI in the regulatory sphere. A recent important legislative development, which
will improve the momentum of recovery of dues, is the enactment of
Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interest (SRFAESI) Act. Under this Act RBI has been entrusted with the
role of stipulating suitable norms for registration of securitisation or
reconstruction companies, prescribing prudential norms, recommending proper
and transparent accounting and disclosure standards and framing appropriate
guidelines for the conduct of asset reconstruction and securitisation.

Check your progress 3

1. The___________has always been playing the major role in regulating and
controlling the India money market.

a. Reserve Bank of India

b. State bank of India

22
 2. ____________performs a wide range of promotional functions, Money
Market
a. SBI
b. RBI

2.5 Intermediates in the Money Market

Money market participants include mainly credit institutions and other
financial intermediaries, governments, as well as individuals (households).
Ultimate lenders in the money markets are households and companies with a
financial surplus which they want to lend, while ultimate borrowers are companies
and government with a financial deficit which need to borrow. Ultimate lenders
and borrowers usually do not participate directly in the markets. As a rule they
deal through an intermediary, who performs functions of broker, dealer or
investment banker.
Important role is played by government, which issue money market
securities and use the proceeds to finance state budget deficits. The government
debt is often refinanced by issuing new securities to pay off old debt, which
matures. Thus it manages to finance long term needs through money market
securities with short-term maturities.

Central bank employs money markets to execute monetary policy. Through

monetary intervention means and by fixing the terms at which banks are provided
with money, central banks ensure economy‟s supply with liquidity.
Credit institutions (i.e. banks) account for the largest share of the money
market. They issue money market securities to finance loans to households and
corporations, thus supporting household purchases and investments of
corporations. Besides, these institutions rely on the money market for the
management of their short-term liquidity positions and for the fulfilment of their
minimum reserve requirements.
Other important market participants are other financial intermediaries, such
as money market funds, investment funds other than money-market funds,
insurance companies and pension funds. Large non-financial corporations issue
money market securities and use the proceeds to support their current operations
or to expand their activities through investments.

In general issuance of money market securities allow market participants to

increase their expenditures and finance economic growth.

23
Introduction to Money market securities are purchased mainly by corporations, financial
Financial Markets, intermediaries and government that have funds available for a short-term period.
Money Market and
Capital Market
Individuals (or households) play a limited role in the market by investing
indirectly through money market funds. Apart from transactions with the central
bank, money-market participants trade with each other to take positions dependent
upon their short-term interest rate expectations, to finance their securities trading
portfolios (bonds, shares, etc.), to hedge their longer-term positions with short-
term contracts, and to reduce individual liquidity imbalances.

Check your progress 4

1. Important role is played by government, which issue money market
securities and use the proceeds to finance state budget _________.
a. Deficits

b. surplus
2. Central bank employs _________markets to execute monetary policy.

a. Capital
b. money

3. Credit institutions account for the largest share of the_________market.

a. Money

b. capital

2.6 Development of Money Market in India

While the need for long term financing is met by the capital or financial
markets, money market is a mechanism which deals with lending and borrowing
of short term funds. Post reforms age in India has witnessed marvellous increase
of the Indian money markets. Banks and other financial institutions have been
able to meet the high opportunity of short term financial support of important
sectors like the industry, services and agriculture. It performs under the regulation
and control of the Reserve Bank of India (RBI). The Indian money markets have
also exhibit the required maturity and flexibility over the past two decades.
Decision of the government to permit the private sector banks to operate has
provided much needed healthy competition in the money markets resulting in fair
amount of improvement in their performance.
24
 Till 1935, when the RBI was set up the Indian money market remained Money
highly disintegrated, unorganized, narrow, shallow and therefore, very backward. Market
The planned economic development that commenced in the year 1951 market is
an important beginning in the annals of the Indian money market. The
nationalization of banks in 1969, setting up of various committees such as the
Sukhmoy Chakraborty Committee (1982), the Vaghul working group (1986), the
setting up of discount and finance house of India ltd. (1988), the securities trading
corporation of India (1994) and the commencement of liberalization and
globalization process in 1991 gave a further fillip for the integrated and efficient
development of India money market.

Check your progress 5

1. Till 1935, when the_________was set up the Indian money market remained
highly disintegrated, unorganized, narrow, shallow and therefore, very
backward.

a. RBI
b. banks

2. Banks and other financial institutions have been able to meet the high
opportunity of _________term financial support of important sectors like the
industry, services and agriculture.
a. Long
b. short

2.7 Money Market Instruments

Money Market is the part of financial market where instruments with high
liquidity and very short-term maturities are traded. It's the place where large
financial institutions, dealers and government participate and meet out their short-
term cash needs. They usually borrow and lend money with the help of
instruments or securities to generate liquidity. Due to highly liquid nature of
securities and their short-term maturities, money market is treated as safe place.

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Introduction to 2.7.1 Treasury Bills
Financial Markets,
Money Market and A treasury bill is a promissory note issued by the RBI to meet the short-term
Capital Market requirement of funds. Treasury bills are highly liquid instruments that mean, at
any time the holder of treasury bills can transfer of or get it discounted from RBI.
These bills are normally issued at a price less than their face value; and redeemed
at face value. So the difference between the issue price and the face value of the
Treasury bill represents the interest on the investment. These bills are secured
instruments and are issued for a period of not exceeding 364 days. Banks,
Financial institutions and corporations normally play major role in the Treasury
bill market.

2.7.2 Commercial Papers

Commercial paper (CP) is a popular instrument for financing working
capital requirements of companies. The CP is an unsecured instrument issued in
the form of promissory note. This instrument was introduced in 1990 to enable the
corporate borrowers to raise short-term funds. It can be issued for period ranging
from 15 days to one year. Commercial papers are transferable by endorsement and
delivery. The highly reputed companies (Blue Chip companies) are the major
player of commercial paper market.
The aim of its issuance is to provide liquidity or finance company‟s
investments, e.g. in inventory and accounts receivable.
The major issuers of commercial papers are financial institutions, such as
finance companies, bank holding companies and insurance companies. Financial
companies tend to use CPs as a regular source of finance. Non-financial
companies tend to issue CPs on an irregular basis to meet special financing needs.
Thus commercial paper is a form of short-term borrowing. Its initial maturity is
usually between seven and forty-five days. In US, the advantage of issuing CPs
with maturities less than nine months is that they do not have to register with the
Securities Exchange Commission (SEC) as a public offering. This reduces the
costs of registration with SEC and avoids delays related to the registration
process. CPs can be sold directly by the issuer, or may be sold to dealers who
charge a placement fee (e.g. 1/8 percent). Since issues of CPs are heterogeneous
in terms of issuers, amounts, maturity dates, there is no active secondary market
for commercial papers. However, dealers may repurchase CPs for a fee.

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2.7.3 Certificate of Deposit Money
Market
Certificates of Deposit (CDs) are short-term instruments issued by
Commercial Banks and Special Financial Institutions (SFIs), which are freely
transferable from one party to another. The maturity period of CDs ranges from
91 days to one year. These can be issued to individuals, co-operatives and
companies.
Certificate of deposit (CD) states that a deposit has been made with a bank
for a fixed period of time, at the end of which it will be repaid with interest.

Thus it is, in effect, a receipt for a time deposit and explains why CDs
appear in definitions of the money supply such as M4. It is not the certificate as
such that is included, but the underlying deposit, which is a time deposit like other
time deposits. An institution is said to „issue‟ a CD when it accepts a deposit and
to „hold‟ a CD when it itself makes a deposit or buys a certificate in the secondary
market. From an institution‟s point of view, therefore, issued CDs are liabilities;
held CDs are assets.
The advantage to the depositor is that the certificate can be tradable. Thus
though the deposit is made for a fixed period, he depositor can use funds earlier
by selling the certificate to a third party at a price which will reflect the period to
maturity and the current level of interest rates.
The advantage to the bank is that it has the use of a deposit for a fixed
period but, because of the flexibility given to the lender, at a slightly lower price
than it would have to pay for a normal time deposit.

The minimum denomination can be 100 000USD, although the issue can be
as large as 1million USD. The maturities of CDs usually range from two weeks to
one year. Non-financial corporations usually purchase negotiable CDs. Though
negotiable CD denominations are typically too large for individual investors, they
are sometimes purchased by money market funds that have pooled individual
investors‟ funds. Thus money market funds allow individuals to be indirect
investors in negotiable CDs. This way the negotiable CD market can be more
active. There is also a secondary market for these securities, however its liquidity
is very low.

2.7.4 Commercial Bills

Normally the traders buy goods from the wholesalers or manufactures on
credit. The sellers get payment after the end of the credit period. But if any seller

27
Introduction to does not want to wait or in immediate need of money, he/she can draw a bill of
Financial Markets, exchange in favour of the buyer. When buyer accepts the bill it becomes a
Money Market and
Capital Market
negotiable instrument and is termed as bill of exchange or trade bill. This trade
bill can now be discounted with a bank before its maturity. On maturity the bank
gets the payment from the drawer i.e., the buyer of goods. When trade bills are
accepted by Commercial Banks it is known as Commercial Bills. So trade bill is
an instrument, which enables the drawer of the bill to get funds for short period to
meet the working capital needs.

Check your progress 6

1. ____________ Market is the part of financial market where instruments with
high liquidity and very short-term maturities are traded.
a. Money

b. capital
2. A __________is a promissory note issued by the RBI to meet the short-term
requirement of funds.
a. commercial paper

b. treasury bill
3. ___________is a popular instrument for financing working capital
requirements of companies.
a. Commercial paper
b. treasury bill

2.8 Collateralized Browsing and Lending Obligation

“Collateralized Borrowing and Lending Obligation (CBLO)", as the name
implies is a fully collateralized and secured instrument for borrowing / lending
money. CBLO as a product is conceived and developed by CCIL for the
facilitating deployment in a collateralized environment. As a product, CBLO aims
to benefit those entities who have been phased out of Call/ Notice money market
and / or those entities on restrictions have been placed on the borrowing / lending
in call / notice money market. CBLO Dealing system is hosted and maintained by
Clear corp Dealing Systems (India) Ltd, a fully owned subsidiary of CCIL. CCIL
becomes Central Counterparty to all CBLO trades and guarantees settlement of
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CBLO trades. CBLO is an RBI approved money market instrument which can be Money
issued for a maximum tenor of one year. CBLO is a discounted instrument traded Market

on Yield Time priority. CBLO instrument that are generally made available for
trading are those with maturity of next seven business days and three month end
dates. The balances are maintained in electronic book entry. The access to CBLO
Dealing system for NDS Members is made available through INFINET and for
non NDS Members through Internet. The Funds settlement of members in CBLO
segment is achieved in the books of RBI for members who maintain an RBI
Current Account and are allowed to operate that current account for settlement of
their secondary market transactions. In respect of other members, CBLO Funds
settlement is achieved in the books of Settlement Bank.

Check your progress 7

1. _________as a product is conceived and developed by CCIL for the
facilitating deployment in a collateralized environment.

a. CBLO
b. ILO

2. CBLO is a ________approved money market instrument which can be

issued for a maximum tenor of one year.

a. Government
b. RBI

2.9 Call Money Market and Term Money Market

The call money market deals in short term finance repayable on demand,
with a maturity period varying from one day to 14 days. S.K. Muranjan
commented that call loans in India are provided to the bill market, rendered
between banks, and given for the purpose of dealing in the billion market and
stock exchanges. Commercial banks, both Indian and foreign, co-operative banks,
Discount and Finance House of India Ltd.(DFHI), Securities trading corporation
of India (STCI) participate as both lenders and borrowers and Life Insurance
Corporation of India (LIC), Unit Trust of India(UTI), National Bank for
Agriculture and Rural Development (NABARD)can participate only as lenders.
The interest rate paid on call money loans, known as the call rate, is highly
volatile. It is the most sensitive section of the money market and the changes in
29
Introduction to the demand for and supply of call loans are promptly reflected in call rates. There
Financial Markets, are now two call rates in India: the Inter-bank call rate' and the lending rate of
Money Market and
Capital Market
DFHI. The ceilings on the call rate and inter-bank term money rate were dropped,
with effect from May 1, 1989. The Indian call money market has been
transformed into a pure inter-bank market during 2006–07. The major call money
markets are in Mumbai, Kolkata, Delhi, Chennai and Ahmedabad.
The money market is a market for short-term financial assets that are close
substitutes of money. The most important feature of a money market instrument is
that it is liquid and can be turned over quickly at low cost and provides an
opportunity for balancing the short-term surplus funds of lenders and the
requirements of borrowers. By convention, the term "Money Market" refers to the
market for short-term requirement and deployment of funds. Money market
instruments are those instruments, which have a maturity period of less than one
year. The most active part of the money market is the market for overnight call
and term money between banks and institutions and repo transactions.
Call Money / Repo are very short-term Money Market products. There is a
wide range of participants (banks, primary dealers, financial institutions, mutual
funds, trusts, provident funds, etc.) dealing in money market instruments. Money
Market Instruments and the participants of money market are regulated by RBI
and SEBI.As a primary dealer SBI DFHI is an active player in this market and
widely deals in Short Term Money Market Instruments.
The below mentioned instruments are normally termed as money market
instruments:

 Call/ Notice/ Term Money

 Repo/ Reverse Repo

 Inter Corporate Deposits

 Commercial Paper

 Certificate of Deposit

 T-bills

 Inter Bank Participation Certificate

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 Money
Check your progress 8 Market

1. The__________money market deals in short term finance repayable on

demand, with a maturity period varying from one day to 14 days.

a. Call
b. black

2. The ___________market is a market for short-term financial assets that are

close substitutes of money.

a. Capital
b. money

2.10 Let Us Sum Up

The whole of this unit focussed on the Money market of India. Here the
readers have been briefed about what exactly is a money market. They have been
explained in very detail the various functions and characteristics of money market.
These whole units aim to provide sufficient information on money market and
thus also cover the role of RBI in the money market of India. This unit focussed
on development of money market in India. Various money market instruments
have even been discussed here in very detail. The whole of this unit has been
explained here in very detail and interesting manner to make it interesting for the
students.
After going through this unit the readers would get enough idea about the
money market.

2.11 Answers for Check Your Progress

Check your progress 1

Answers: (1-a), (2-b)

Check your progress 2

Answers: (1-a), (2-b)

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