Text: Contemporary Financial

Management, 14th Edition

Financial by Moyer, McGuigan, and Rao

Management
-I Session_04: An overview of
financial markets
 Understand The regulatory and financial environment surrounding firms.

Learning
outcome Understand The role of financial markets, institutions and intermediaries.

s
The financial instruments (and their characteristics) used by
Identify firms.
Financial instruments/assets

• Financial assets are intangible whose value is derived from a

contractual claim.
• They represent a claim to future cash flow.
• These financial assets typically take the form of receipts, legal
documents, certificates, etc., and receive their worth from contractual
claims.
• For instance, stock certificates, bond certificates, bank deposits, loans,
etc.
• They are usually liquid and can be quickly converted into actual
money.
Security

• A security is a negotiable instrument that represents a financial claim.

• It can take the form of ownership (stock) or a debt agreement (bond).
Types of Securities

I. Debt Securities
• Firms borrow money by selling debt securities in the debt market.

Debt classification based on maturity period (abroad):

• Less than one year (issued in money market),
• one to ten years (called Note, issued in capital market),
• more than 10 years (called bond, issued in capital market)

• In India, the terminology is bond and debentures for more than 1 year of
maturity.
• Bonds are secured (backed by collateral) debentures are not.
Types of Securities

II. Equity Securities

• Equity securities represent ownership of the corporation.

There are two major types of equity securities:

• common stock
• preferred stock.

When you buy equity securities, you are making an investment that you
expect will generate a return
Types of Securities
II. A) Common stock (Ordinary Shares)
It is a security that represents
• equity ownership in a corporation,
• provides voting rights,
• entitles the holder to a share of the company’s success in the form of
dividends and any capital appreciation in the value of the security.

Other features:
• No fixed rate of dividend
• Perpetual
• Last preference in repayment of capital in case of liquidation
Investors who purchase common stock are the residual owners of the firm.
Hence, risky investment for investors.
Types of Securities
II. B) Preferred stock
It is an equity security which gives preference, relative to common
stockholders, regarding dividends and claim on assets.
• Thus, preferred shareholders receive their dividends before any dividends
are distributed to the common stockholders.

Other features:
• Fixed rate of dividend
• Preference over equity shares in payment of dividend and repayment in case
of liquidation
• No voting rights

Hence, this is less risky an investment than the equity/ordinary shares

Other financial instruments
We will discuss a host of different financial instruments used by firms to
raise money. We will look at their features from both issuers’ and investors’
perspective.

We begin with the shortest-maturity instruments that are traded in the

money market

and moving through to the longest-maturity instruments that are traded in

the capital market.
Money Market Debt instruments
FEATURES
For the Borrower/issuer:
• Good way of inexpensively raising money for short periods of time.
• Rates tend to be lower than long-term rates.
• Can borrow money to match short-term needs.
• If interest rates rise, the cost of borrowing will immediately rise accordingly.
For the Investor:
• Very liquid—investors have access to their money when they
need it.
• Safe—generally invested in high-quality investments for brief periods.
• Low returns—rates tend to be close to the rate of inflation.
Money Market Debt instruments
Treasury Bills
• Issued by the Reserve Bank of India (RBI) on behalf of the government of
India
• Default-free (highly liquid instruments)
• 91-day, 182 day and 364 day
• They are zero coupon bonds issued at a discount and redeemed at the face
value at maturity.
• For example, a 91-day Treasury bill of ₹100/- (face value) may be issued at say
₹ 98.20, that is, at a discount of say, ₹1.80 and would be redeemed at the face
value of ₹100/-. The return to the investors is the difference between the
maturity value or the face value (that is ₹100) and the issue price.
• https://rbiretaildirect.org.in/#/
Money Market Debt instruments
Commercial paper
• Issued by financially sound companies with good credit rating for short-
term needs in the denomination of at least ₹500,000
• Low default risk
• 7 days to 1 year
• They are issued at a discount and redeemed at the face value at maturity.
• Ensure that minimum credit rating for a CP is ‘A3’ as per rating symbol and
definition prescribed by SEBI.
• Example Commercial Paper issued by the State Bank of India. This security
has a maturity date of 180 days and requires no collateral. It carries a credit
rating of AA+ and offers investors an interest rate of 5.85%.
• https://rbi.org.in/upload/Notification/pdfs/14258.pdf
Money Market Debt instruments
Certificate of deposits
• Issued by a deposit accepting institution (Banks and FIs) in the
denomination of at least ₹100,000
• Default risk depends on the strength of the issuing bank
• 7 days to 1 year
• They are issued at a discount and redeemed at the face value at
maturity.
Money Market Debt instruments
Money market mutual funds
• Issued by mutual funds and invested in debt obligations such as Treasury bills,
CDs, and commercial paper; held by individuals and businesses
• Low degree of risk
• Average maturity is 1 year
Banker’s acceptance
• A short-term financial instrument that represents a promised future payment
from a bank
• Maturity between 30 and 180 days
• It is a guarantee from the bank that a buyer will pay to the seller at a future
date. A good credit rating is required by the company to draw this bill.
• It is used by importers and exporters just like a time draft in international trade.
Money Market Debt instruments
Repurchase Agreement
• Sale of a security with a commitment by the seller to repurchase the security at
a specified price at a future date
• Often used by the Central Bank to suck or infuse liquidity in the market
• Equivalent to a collateralized loan with the security as a collateral
• The lender earns interest at the `repo rate’.
• Most repos are for less than three months

Reverse repurchase agreement

• Involves the purchase of securities between parties with the promise to sell
them back at a given date in the future
Policy rates
• Cash Reserve Ratio (CRR)
• % of deposits to be maintained by the bank with RBI as cash
deposits
• Currently at 4.50%

• Statutory Liquidity Ratio

• % of deposits to be invested by the bank in approved securities
• Currently at 18%

• Cut in CRR/ SLR increases liquidity and reduces cost of funds,

increase in CRR/SLR reduces liquidity and increases cost of funds
Policy rates
• Repo Rate
• Rate at which RBI provides funds to the banks
• Reverse Repo Rate
• Rate at which RBI accepts funds from the banks
• Increase in Repo/Reverse Repo rate increases the cost of funds/
suck liquidity
• Current Rates
• Repo – 6.50%
• Reverse Repo – 3.35%
Capital market instruments:
Features
I. Long-Term Debt and Fixed-Income Securities
For the Borrower:
• Interest rates are locked in over the entire life of the debt.
• Has a tax advantage over common stock in that interest payments are tax
deductible, whereas dividend payments are not.
For the Investor:
• Can be used to generate dependable current income.
• Some bonds produce tax-free income.
• Long-term debt tends to produce higher returns than short-term debt.
• Less risky than common stock.
• Investors can lock in an interest rate and know the future returns (assuming
the issuer does not default on its payments).
Types of Long-Term or Fixed-Income
Securities
Govt. Securities (fixed rate)
• Mostly interest-bearing securities issued by RBI on behalf of the
Government of India for raising a long-term loan
• No default risk as the securities carry sovereign guarantee
• Ranging from 2 to 30 years
• Fixed Rate of interest (generally paid half yearly)*
• Since the date of maturity is specified in the securities, these are known as
dated Government securities, e.g., 7.18% GOI 2033 is a Central Government
security maturing in 2033, which carries a coupon of 7.18% payable half
yearly
• Yield on 10 years G Sec is often taken as the benchmark – currently 7.37%.
* Unless it is a floating rate security which has a variable coupon rate
Types of Long-Term or Fixed-Income
Securities
Govt. Securities (floating rate)
A floating rate security which has a variable coupon rate which is re-
set at pre-announced intervals (say, every six months or one year).
• Coupon rate is reset periodically in line with some predetermined
benchmark, spread and an adjustment Interval
• X decides to invest in an RBI Floating Rate Bond. This bond’s interest
rate is linked to the National Savings Certificate (NSC) rate with an
added spread of 0.35% to be added after every year.
• If the NSC rate is 5%, X will earn an interest rate of 5.35% for the
next period.
Types of Long-Term or Fixed-Income
Securities
Municipal bonds
• Issued by Municipalities at state and local level
• Riskier than government securities, with the level of risk
dependent on the issuer, but exempt from most taxes
• Less risky than corporate bonds
• Maturity up to 30 years

Mortgaged backed securities

• An investor who invests in a mortgage-backed security essentially
lends his money to those seeking to buy a home.
• Maturity up to 30 years
Types of Long-Term or Fixed-Income
Securities
Corporate bonds
• Issued by corporations
• Often secured by a specific charge against company assets
• Risk is dependent on the financial strength of the issuer;
• riskier than government securities but less risky than preferred and
common stocks.
• In general, up to 40 years
Capital market instruments:
Features
II. Preferred Stock

For the Issuer:

• Dividends can be omitted without the risk of bankruptcy.
• Has the disadvantage that dividends are not tax deductible for the issuer,
whereas interest payments from debt are tax deductible.

For the Investor:

• For corporate investors, it has fixed rate of dividend and preference in
dividend as well as repayment in case of liquidation.
Capital market instruments:
Features
III. Common Stock
For the Issuer:
• The issuing firm is not legally obligated to make dividend payments.
• No maturity date.
• Issuance of common stock increases creditworthiness because the firm has
more investor money to cushion the firm in the case of a loss.
• Has a tax disadvantage relative to debt; whereas debt interest payments are
deductible for tax purposes, common stock dividends are not tax deductible.

For the Investor:

• Over the long run, common stock has outperformed debt-based financial
assets.
• Along with the increased expected return comes increased risk.
Capital market instruments:
Features
Instrument Market Major Participants Riskiness Original Maturity Dividend

Preferred Capital— Issued by corporations Riskier than No maturity date Fixed rate of
stocks Equity to corporate dividend
(Preferred individuals, other bonds but less risky
Stock) corporations, than common stock
and institutional
Investors

Common Capital— Issued by corporations Risky No maturity date Dividends

stocks Equity to paid only
(Common individuals, other when they
Stock) corporations, are
and institutional Declared
investors
Imp links
Money market instruments and govt-securities related links
• https://www.rbi.org.in/Scripts/BS_NSDPDisplay.aspx?param=4
• https://www.rbi.org.in/commonperson/English/Scripts/FAQs.aspx?
Id=711#30
• https://rbiretaildirect.org.in/#/

Bond trading platforms

• RBI Retail Direct: https://rbiretaildirect.org.in/#/
• The Fixed Income: https://www.thefixedincome.com/
• GoldenPi: https://goldenpi.com/
• India Bonds: https://www.indiabonds.com/
• Bonds India: https://www.bondsindia.com/