Chapter 1

Financial Markets and Institutions

An overview of Indian Financial System

Topics:
Indian Capital Market and Money Market
Foreign Institutional Investors(FII)
Portfolio Management schemes of Indian Institutional
investors.
Global Capitals Flows-Hedge Funds, Private Equity
ADR and GDR
Indian Capital Market and Money
market
A financial market is a place where buyers and seller come together to
trade in financial assets such as bonds, stocks, derivatives, currencies and
commodities.
The main objective of a financial market is to fix prices for global trade,
increase capital and transfer risk and liquidity.
Financial market has various components; the two most important
components are the money market and capital market.
In the money market, only short-term liquid financial instruments are
exchanged.
 Whereas, in the capital market, only long term securities are dealt
with.
A financial market
Indian Capital Market
Capital market is the market that helps the
companies in raising long term investment credit.
It is the market for long term funds. It refers to
all the facilities and institutional arrangement for
borrowing and lending term funds.
 It does not deal in capital goods but it is
concerned with raising of money capital for
purpose of investment.
Money Market
The money market is a component of the economy which provides
short-term funds. The money market deals in short-term loans,
generally for a period of a year or less.

The money market consists of financial institutions and dealers

in money or credit who wish to either borrow or lend.
Participants borrow and lend for short periods, typically up to
twelve months. Money market trades in short-term financial
instruments commonly called "paper".
Difference between Capital Market and
Money Market
Capital Market Money Market
 Term: Long-term finance to  Term: Short-term financial tools
coincide with the capital are being settled is referred to as
necessary is called Capital Money Market.
Market.  Instruments involved
 Instruments involved Bonds, Commercial Papers, Treasury
Debentures, Shares, Asset Certificate of Deposit, Bills,
Securitization, Retained Trade Credit, etc.
Earnings, Euro Issues, etc.  Investor Types :Commercial
 Investor Types Stockbrokers, banks, non-financial
insurance companies, institutions, central bank, chit
Commercial banks, funds, etc.
underwriters, etc.
Difference between Capital Market and
Money Market
Capital Market Money Market
 Market Nature: Capital  Market Nature: Money
markets are formal in nature. markets are informal in
 Liquidity: Capital markets nature.
are comparatively less liquid.  Liquidity: Money markets
 Risk Involved: Capital are highly liquid.
markets are riskier in  Risk Involved: Money
comparison to money markets have low risk.
markets.  Purpose: To achieve short
 Purpose: To achieve long term credit requirements of
term credit requirements of the trade.
the trade.
Difference between Capital Market and
Money Market
Capital Market Money Market

 Functions: Increasing  Functions :Stabilizing

liquidity of funds in the economy by increase in
economy. savings.
 Return on investment: ROI  Return on investment:
is comparatively high in ROI is usually low in money
capital market market
Features of Money Market

 Fixed returns.
It’s maturity period up to one year.
It trades with assets that can be transformed
into cash easily.
All the transactions take place through phone,
email, text, etc.
Broker not necessarily required for the
transaction
The components of a money market are the
Commercial Banks, Non-banking financial
companies and Central Bank, etc.
Features of Capital Market
Unites entrepreneurial borrowers and savers
Deals with long-term investments.
Agents are required.
It is controlled by government rules and
regulations.
Deals in both commercial and non-
commercial securities.
Foreign Investors.
Significance of Capital Market in economic
development
1. Mobilization of Savings: Mobilizes savings through various
instruments but also channelizes them into productive avenues. Thus,
capital market mobilizes these savings and make the same available for
meeting the large capital needs of industry, trade and business.

2. Channelization of Funds into Investment: Capital market plays a

crucial role in the economic development by channelizing funds in
accordance with development priorities
Significance of Capital Market in
economic development
• Industrial Development: It provides funds for diversified purposes
such as for expansion, modernization, up gradation of technology,
establishment of new units etc.
• Modernization and Rehabilitation of Industries: The setting up of
development financial institutions in India such as IFCI, ICICI, IDBI
and so on has helped the existing industries in the country to adopt
modernization and replacement of obsolete machinery by providing
adequate finance.
Significance of Capital Market in economic
development
• Technical Assistance : By offering advisory services relating to the
preparation of feasibility reports, identifying growth potential and
training entrepreneurs in project management.
• Encourage Investors to invest in Industrial Securities: Secondary
market in securities encourage investors to invest in industrial securities
by making them liquid. It provides facilities for continuous, regular and
ready buying and selling of securities
• Reliable Guide to Performance: The capital market serves as a reliable
guide to the performance and financial position of corporate, and thereby
promotes efficiency.
What is the importance of the money
market?
1. It maintains a balance between the supply of and demand for the money.
2. It enables funds for businesses to grow and hence is responsible for the growth
and development of the economy.
3. It aids in the implementation of monetary policies.
4. It helps develop trade and industry in the country.
5. The short term interest rates influence long term interest rates. The money
market mobilizes the resources to the capital markets by way of interest rate
control.
6. It helps in the functioning of the banks. It sets the cash reserve ratio and
statutory liquid ratio for the banks. It also engages their surplus funds towards
short term assets to maintain money supply in the market.
7. The current money market conditions are the result of previous monetary policies.
Hence it acts as a guide for devising new policies regarding short term money
supply.
8. Instruments like T-bills, help the government raise short term funds. Otherwise,
to fund projects, the government will have to print more currency or take loans
leading to inflation in the economy. Hence the money market is also responsible
for controlling inflation.
Foreign investment-
Foreign Institutional Investor (FII)
 Foreign investment can be discussed in two forms - Foreign Direct
Investment (FDI)and Foreign Institutional Investment (FII)
Foreign investment refers to the investments made by the residents of a
country in the financial assets and production process of another country.

 FDI-Foreign Direct Investment involves in direct production activities

and in a long and medium term nature.
FII-As far as the FIIs concern it is the short term nature and short term
investments.
FII-registered as FIIs in accordance with Section 2(f ) of the SEBI (FII)
Regulations, 1995.
 FIIs invest in financial markets such as money markets, stock markets
and foreign exchange markets
 A foreign institutional investor
Foreign Institutional Investment refers to the investment
made by the investors by infusing capital into the financial assets
of any foreign country.
Institutional investors are nothing but companies desiring to
make a quick buck by investing into the various investment
banks, hedge funds, pension funds, mutual funds, insurance
bonds, debentures, etc. of a foreign country.
They generally have no control on the management of any
companies or banks in the host country in which they are
investing.
 Advantages of FII”s
1. Enhanced flows of equity capital
2. Building the investment gap.(FIIs have a greater appetite for equity than
debt in their asset structure)
3. Managing uncertainty and controlling risks by promoting hedging
instruments and improve the competition in financial market and also
alignment of assets which help in stabilizing markets...
4. Enhances competition in financial markets.
5. Improving capital markets.
6. FIIs as professional bodies of asset managers and financial analysts
enhance competition and efficiency of financial markets.
 Advantages of FII”s
7.Equity market development aids economic development.
9.corporate governance as FIIs constitute professional
bodies of asset managers and financial analysts.
10.Institutionalization increases dividend payouts, and
enhances productivity growth.
 FIIs impact on Indian Economy
1. When there is a high flow of FII into India, there will be a big demand
for Indian currency.
2. FII increases leads to increase in domestic currency appreciation.
3. FII flows have made an important contribution to the Balance of
Payments.
4. FII leads to appreciation of currency and to inflation, with the huge
amount of FII flow into the country.
5. When FII cap is on high, they can bring in lot of funds in stock
market.
6. FII inflow of capital helps in financial innovation and development of
hedging instruments.
7. FII improves capital markets and corporate governance. FIIs
constitute professional bodies of asset managers and financial analysts,
who contribute for the improvement of corporate governance.
8. The FIIs help in the process of economic development by increasing
firm’s incentives to supply more information about them.
9. Improves trade Deficits by building up foreign exchange reserves.
FII Present scenario
Since Liberalization, FII flows have grown importance in India.
Due to covid wave-2 FII stayed away from investing in India until may 2021
Foreign Institutional Investors (FII) and Domestic Institutional Investors (DII)
both increased their holdings in nearly half of Nifty 50 companies during the April-
June quarter 2021.
India was the second most favored country for foreign investors looking to invest in
emerging markets across the globe during July 2021.
Foreign investors invested >Rs. 1.4 trillion (US$ 19 billion) in the Indian
stock market in 2020.
 What is a Portfolio ?
A portfolio refers to a collection of investment tools such as stocks, shares, mutual
funds, bonds, cash and so on depending on the investor’s income, budget and
convenient time frame.

What is a Portfolio Management ?

The art of selecting the right investment policy for
the individuals in terms of minimum risk and
maximum return is called as portfolio management.
Portfolio management refers to managing an
individual’s investments in the form of bonds,
shares, cash, mutual funds etc so that he earns the
maximum profits within the stipulated time frame.
Portfolio management refers to managing money
of an individual under the expert guidance of
portfolio managers.
In a layman’s language, the art of managing an
individual’s investment is called as portfolio
management.
Reason for Portfolio Analysis
 Need for Portfolio Management
Best investment plan.
Portfolio management minimizes the risks.
Portfolio management enables the portfolio managers to provide
customized investment solutions to clients

Types of Portfolio Management

Active Portfolio Management: The portfolio managers are actively involved in buying and
selling of securities to ensure maximum profits to individuals.

Passive Portfolio Management: In a passive portfolio management, the portfolio manager

deals with a fixed portfolio designed to match the current market scenario.

Discretionary Portfolio management services: In Discretionary portfolio management

services, an individual authorizes a portfolio manager to take care of his financial needs on his
behalf. the portfolio manager has full rights to take decisions on his client’s behalf.

Non-Discretionary Portfolio management services: In non discretionary portfolio

management services, the portfolio manager can merely advise the client what is good and bad
for him but the client reserves full right to take his own decisions.
Global Capitals Flows-Hedge Funds, Private
Equity ADR and GDR
 Hedge Funds
What is Hedge Funds?

A hedge fund is a pool of money contributed by investors and run by a fund manager
whose goal is to maximize returns and eliminate risk.

A hedge fund is basically an investment pool contributed by a limited number of

partners (investors) and operated by a professional manager with specific goals in
mind - mainly to maximize returns and minimize risk.

Hedge Funds try to make money despite the market fluctuating up or down. So,
hedge fund managers often act more like traders.
Features Of Hedge Funds
 Features Of Hedge Funds
1. Accredited Investors: An ordinary investor cannot invest in hedge
funds. Only qualified or accredited investors like banks, insurance
companies and even high net worth individuals are allowed to invest in
such funds.
2. Wide Investment Latitude: The hedge funds cover almost all kinds of
asset classes, including stocks, bonds, real estate, currencies, equities,
derivatives, etc.
3. Uses Leverage: The funds which are invested as hedge funds are usually
the borrowed sum in the hands of the fund manager.
 Features Of Hedge Funds
4.Risk Factor: Some of the hedge funds are exposed to a high risk which may lead
to huge losses. The lock-in period is comparatively very high regarding other
investment options.

5.Fee Structure: The fees of hedge fund managers are ‘Two and Twenty’, i.e. 2% is
the fixed fees, whereas the manager takes 20% on the profit earned. This fee
structure is quite high as compared to other investment options.

6.Tax Obligation: The hedge fund is not exempted from tax and is taxable on the
grounds of the level of investment. This tax will not be borne by the unit holders.

7.No Regulation: These funds are not registered and do not lie under the
regulation of the securities market regulators.
Main Hedging Methods
Currency Futures
2. Currency Futures:
Currency futures contract involves a standardized contract between two
parties to buy/sell an amount of currency at a fixed price on a specified
date in the future and are traded on organized exchanges.
 Futures contracts are more liquid than forward contracts as they are
traded in an organized exchange.
Between two parties who do not necessarily know each other.
Guaranteed performance by intermediaries
Thus, inflow and outflow of different currencies with respect to each
other can be fixed by selling and buying currency futures, eliminating the
Foreign Exchange Exposure.
It’s a faceless trading
Difference between Forwards and
Futures
 Currency options
Options:

Options are financial derivatives that give buyers the right, but not the
obligation, to buy or sell an underlying asset at an agreed-upon price
and date.

There are two types of Options:

1. Call options
2. Put options
 Options
1. Call Options: Call option gives the buyer the right
but not the obligation to buy a given quantity of
the underlying asset at a given price on or before a
future given date.
2. Put Options: Put option gives the buyer the right
but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a
future given date.
Difference Between Call and Put Options
Rights
Put Option
Call Option
1. The buyer has the right to
1. The buyer has the right to
sell the assets at the pre-
buy the shares at the pre-
defined price.
defined price at the time of
maturity. 2. Put option will be used when
the market price of the asset
2. Call option will be exercised
decreases.
when the market price of
3. The buyer has the asset or
underlying asset increases.
required amount of
3. The seller has the asset or investment to buy the assets
required amount of prior to the exercise of the
investment to buy the assets option.
4. The profit would be 4. The profit would be
market price – strike price – strike price – market price –
premium premium
 Private Equity

1. Private equity firms, on the other hand, are groups of

investors that use collected pools of capital from wealthy
individuals, pension funds, insurance companies,
endowments, etc. to invest in businesses.
2. Private equity is an alternative investment class and
consists of capital that is not listed on a public
exchange.
3. Private equity is composed of funds and investors that
directly invest in private companies
The main Private Equity firms operating in
India are
• ICICI Venture Fund Management
• Kotak Private Equity Group
• Chrys capital
• Sequoia Capital
• India Value Fund
• Baring Private Equity Partners
• Ascent Capital
• Everstone Capital
 PE funds vs hedge funds
•Both private equity funds and hedge funds are
restricted to accredited investors.
•However, the biggest differences between PE funds
and hedge funds are fund structure and investment
targets.
•Hedge funds tend to operate in the public markets,
investing in publically-traded companies while PE
funds focus on private companies.
 ADR-GDR
What is ADR?

ADR stands for American Depository Receipts.

Kind of negotiable security instrument that is issued by a US Bank
Represents a specific number of shares in a foreign company that trades in US
financial markets.
Currency-US Dollars only

ADRs make it easy for US investors to purchase stock in foreign companies.

What is GDR?

GDR stands for Global Depositary receipts.

 It is a type of bank certificate that acts as shares in foreign companies.
 It is a mechanism by which a company can raise equity from the international
market.
Both US Dollars, Euro

GDR is mostly traded in the European Market. Issuing GDR is one of the
best ways to raise equity from overseas.
 Marketable Instruments

Domestic Custodian
 Difference between ADR and GDR

ADR GDR
 Stands For: American  Global Depository Receipts.
Depository Receipts.
 Currency traded in: US  US Dollars, Euro
Dollars  To acquire resources in the
 Purpose: To acquire International Market
resources in the US Market  Listed in Non-US stock
 Listed in: NASDAQ exchanges such as LSE
(London Stock Exchange)
and Euro next (France)
 Issued By US Capital Market  European Capital Market