A Course On

Financial Markets and Institutions

2015-16

(2nd Semester)

Department of Humanities & Social Sciences IIT, Ropar

Samaresh Bardhan
Why Study Financial Markets?

What is the Structure of Financial Markets?

Special Role of Banks and Financial
Institutions.

Role of money market, bond market, stock

market.
 Financial Markets and Institutions

Financial markets exist to facilitate the most efficient

allocation of capital: Financial markets are markets in
which funds are transferred from those who have excess
funds (savers, lenders) to those who have a shortages
(investors, borrowers).

Players Households, Firms, Government, Rest of the

World.

How they play and what motivates them to play is critical

to the role of financial markets and well-being of society.
Source: Mishkin, Frederic S. and Stanley G. Eakins, (2008) Financial Markets and
Institutions
Direct Finance (first route) Borrowers borrow funds directly from lenders in financial
markets by selling them securities (financial instruments) which are claims on borrowers
future income or assets.
Securities are assets to buyers of financial instruments but liabilities to sellers.

Example, (a) Bond (debt security) that promises to make payments periodically
for a specified period of time. (b) Stock refers to a security that entitles the owner
to a share of the companys profits and assets.

Indirect Finance (second route) It involves a financial intermediary that stands between
Lender-saver and Borrowers-Spenders and helps in transfer of funds.
Example, a bank might acquire funds by issuing a liability (asset to public) in the form of
savings deposits and then use these funds to acquire an asset by making a loan to
Reliance Industries or by purchasing a Treasury Bond in the financial market. This
process leads to funds transfer from lenders-savers (public) to borrowers-investors
(Reliance) through the bank (financial intermediary).
Why Transfer of funds is so important to the economy?

Ans: People who save are not always those who invest

In the absence of financial market, two persons would never

come together, both would be worse off.
why?
Ans : It is hard to transfer funds from a person having no
invt. opportunity to a person who has that.
It is financial markets which promote efficiency efficient
allocation of capital higher production efficiency
well being of the consumers and firms improves social
welfare.

Financial Institutions (Intermediaries) facilitate the allocation
of capital. Financial intermediaries channel funds between borrowers
and lenders.

the function of channeling (transforming assets or liabilities into

other assets or liabilities) is termed as financial intermediation.
-
Intermediation transformation of assets.
- Liabilities deposits
- Assets loans

- Financial Intermediaries entities which operate within or outside

financial markets in order to facilitate the trading of financial assets.
Why Financial Intermediaries are so Important?
Functions of financial Intermediaries (FI)
Four (4) Essential functions of FI in promoting Economic Growth

First, FIs are considered to reduce information costs through

their influences on savings rate, investment decisions and
innovations.

Second, FIs reduce transaction costs of collecting savings from

numerous individuals and facilitate mobilisation of capital from
savers to investors capital accumulation specialisation
technological innovation growth.
Third, FIs eliminate liquidity risk by transforming the instruments
that savers hold such as equity, bond, demand deposits into long-
term investments that facilitates economic growth.

Fourth, FIs contribute to economic growth through

diversification of risk efficient resource allocation greater risk
sharing technological progress innovation.

Finally, FIs may improve corporate governance by influencing

investors to act in the best interests of the savers. Savers can exert
corporate governance.
Therefore, it follows that Financial Development affects Economic Growth
through its impact on the level of investment and its composition in two
(2) ways:

(a) Improved financial intermediation fosters efficient mobilization of

resources thereby leading to an increase in the level of investment.

(b) financial development improves efficiency of investment rather than

increasing the sheer level of investment through better corporate
governance, diversification of risks. etc.
 Financial Intermediaries
Financial Intermediaries entities which operate within or outside
financial markets in order to facilitate the trading of financial assets.
Types (Examples)

Central Bank : FED (USA), Bank of England (UK), RBI (India)

Depository Institutions (e.g., Commercial Banks, Savings and Loan-
Associations, Mutual Savings Banks).
Contractual Savings Institutions (e.g., Life Insurance Companies, Fire
and Car Insurance Companies, Pension Funds).
Investment Intermediaries (e.g. Finance Companies, Mutual Funds,
Investment Banks).
Above financial intermediaries are institutions in that they mobilise funds
from those who have saved and in turn, make loans to others.
Central Bank : Government agency responsible for
conducting monetary policy that involves
management of money supply, interest rates.

Depository institutions are collectively known as

Banks:
Commercial Banks constitute largest segment of
depository institutions
MSB These are mutually owned by their investors who are
paid dividends on earnings and profits, designed to serve the poor
and working classes, issues no stock, intended to provide safe place
for individual savings and to invest those savings into stocks,
bonds, mortgages and other securities.

Credit Unions A Credit Union is a profit sharing,

democratically run financial co-operative that offers convenient
savings and low interest loans to its members.
Investment Banks An investment bank is a financial institution that assists
individuals, firms and governments by underwriting and or acting as the clients
agent in the issuance of securities. Unlike commercial banks, investment
banks do not take deposits.

Example : In USA, Separation of Investment Banking and Commercial Banking due to

GlassSteagall Act (1933) and GrammLeachBliley Act (1999).
No separation in other developed countries including G8 countries.

Underwriting refers to the process that a service provider (e.g. bank, insurer,
investment house) uses to assess the eligibility of the customers
to receive their products (such as equity capital, insurance, mortgage, credit) and
raise investment capital from investors on behalf of firms, govts that are issuing
securities. Here bank is the underwriter. The underwriter buys the newly issued
securities from the company and sells them to investors in the stock market.
Globalisation of Financial Markets
Until 1980s, US financial market were much larger than
those outside US.
However, in recent years, dominance of US markets
decreased substantially.
Reason (i) Extraordinary growth of foreign financial
markets due to large increase in the pool of savings
in foreign countries.
(ii) Deregulation of foreign financial markets that enable
them to expand their activities.
Instruments in foreign markets: Foreign bonds, Euro
Bonds etc.

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 Structure of Financial markets
Financial markets may be classified in terms of:
(a) Type of instruments traded; debt vs equity Markets

(b) Types of markets where various instruments Traded; primary,

Secondary : exchanges, OTCs.

(c) Maturities of the securities traded; short-term vs long-term: Money vs

Capital markets.

Secondary market : (i) make it easier and quicker to sell the instruments. (ii)
they determine the price of the security that the issuing firm sells in the
primary market.

(iii)Secondary markets can be organised in two ways: exchange and OTC.

 Structure of Financial Markets
Financial Market

Capital Market Money Market

Primary Market Secondary Market Call Money Bill Mkt CDs

(New Issues Market (Existing Issues Mkt) Market
Brokers, Dealers CP(firms,
Investment Bank) Commercial
Ex, NYSE, NASDAQ Treasury 1 yr)
Bills (30d/60d/90d) Bills (govt)
Foreign exchange mkt, future
Market, option market etc. (91d/182d/364d)

Call money
Market for 24 hours Short notice
Repayable on demand) Market(<14 days)
Reqd for maintaining CRR
 Money Market It deals with short-term financial instruments, generally
with original maturity of less than one year.
It does not deal with money or cash but close substitutes of money viz. CP,
T-bill, that can be quickly converted to cash with low transactions cost and
quickly.
These are more widely traded than longer term securities and so tend to be
more liquid. Moreover, short-term securities are subject to smaller
fluctuations in prices than long-term securities.
It constitutes of central bank, commercial banks, NBFCs

Objectives of Money Markets:

To make available a parking place in order to make use of short term surplus.
To offer room to overcome short term deficits.
To allow the central bank to influence and control liquidity in the economy
by means of intervention in this market.
To provide access to users of short-term funds so that they can meet their
requirements quickly, adequately, and at reasonable costs.
Capital Marker Deals with longer-term debts (generally with
original maturity of one year or more) and equity instruments.
For example, stocks and long-term bonds, pension funds.
Example: (i) Government Securities market
(ii) Industrial Securities market
(iii) DFIs
(iv) Financial Intermediaries
Structure of capital Market
Money market: India
 Money markets vs Capital markets
Money market Capital market

Duration Deals with financial It deals with is instruments

instruments of short-term of long-term maturity
maturity
Nature of Funds Meets working capital Supplies Capital for Fixed
reqirements Capital requirements
Instruments T-Bills, Commercial papers, Shares, Debentures,
certificates of Deposits etc. Bonds etc.
Amt of Instruments Each single instrument is of Each single instrument is of
large amount small amount
Institutions Central banks, SCBS, NBFIs Stock Exchanges, OTCs,
etc. SCBS, NBFIs viz. LIC
Risks Less due to smaller maturity, Higher
probability of default is less

Contd..
 Money markets vs Capital markets
Money market
Transactions Transactions take place over
phone, fax, internet
Broker Meets working capital
Reqirements
Role To ease the liquidity
constraints in the economy
Relation with central bank Closely and directly
linked with central bank
of the country
Market Regulation Commercial banks are
closely regulated by the
central bank
Less due to smaller maturity, Higher
probability of default is less
Capital Market
It takes place in formal
markets e.g. stock market
Supplies Capital for Fixed
Capital requirements
Helps in mobilisation of LT
funds
Capital mkt. feels central
banks intervention, but
mainly indirectly through
money market.
SEBI