Big picture
Households save; businesses need funds to invest. A financial market brings the two together. It allocates savings to their most productive use, as decided in the financial management chapter.
Financial markets are divided by the term of the funds: the money market deals in short-term funds (up to one year) and the capital market in medium- and long-term funds. The capital market itself has a primary market (new issues) and a secondary market (trading in existing securities on stock exchanges). The whole system is regulated by SEBI.
Learning goals
Explain the functions of financial markets.
Explain the money market and its five instruments.
Explain the capital market and distinguish it from the money market.
Distinguish the primary and secondary markets and explain the methods of floatation.
Explain the functions of a stock exchange and the screen-based trading and settlement procedure.
Explain dematerialisation and depositories.
Explain the objectives and functions of SEBI.
Core ideas
1. Functions of financial markets
Function | Meaning |
|---|---|
Mobilisation of savings and channelling them into the most productive uses | Savers' funds reach the businesses that can use them best |
Facilitating price discovery | The price of a financial asset is set by the forces of demand (investors) and supply (businesses) of funds |
Providing liquidity to financial assets | Investors can easily sell securities and convert them into cash |
Reducing the cost of transactions | The market provides information about securities, saving time, effort and money for buyers and sellers |
2. Money market
The money market deals in short-term funds with a maturity of up to one year. Its participants include the RBI, commercial banks, non-banking finance companies, state governments, large corporates and mutual funds. Individual investors are rarely direct participants.
Money market instruments
Instrument | Issued by | Features |
|---|---|---|
Treasury bill (T-bill) | RBI on behalf of the central government | Short-term borrowing by the government; issued at a discount and redeemed at par (a zero-coupon security); maturity under one year; minimum ₹25,000 and multiples; highly liquid and safe |
Commercial paper (CP) | Large, creditworthy companies | Unsecured promissory note; maturity 15 days to one year; issued at a discount; used for working capital and bridge financing (meeting floatation costs before a new issue) |
Call money | Banks among themselves | Very short-term loans repayable on demand, maturity 1 to 15 days; helps banks maintain the cash reserve ratio; the interest rate is the call rate |
Certificate of deposit (CD) | Commercial banks and financial institutions | Unsecured, negotiable, short-term bearer instrument; issued to individuals, companies and others in times of tight liquidity |
Commercial bill | Arises from credit sales | A bill of exchange drawn by the seller on the buyer; once accepted, it is a trade bill, and when a bank accepts or discounts it, a commercial bill; used for working capital |
3. Capital market
The capital market deals in medium- and long-term funds: shares, debentures, bonds, mutual funds and public deposits. It has two parts: the primary market and the secondary market.
Money market and capital market compared
Basis | Money market | Capital market |
|---|---|---|
Participants | RBI, banks, financial institutions, corporates; rarely individuals | Financial institutions, banks, corporates, foreign investors and ordinary retail investors |
Instruments | T-bills, CP, CD, call money, commercial bills | Equity shares, debentures, bonds, preference shares |
Investment outlay | Large; instruments have high values | Small; securities have low values, so small investors can take part |
Duration | Up to one year | Medium and long term |
Liquidity | High | Marketable, but less liquid than money market instruments |
Safety | Safe; issuers are financially strong and duration is short | Riskier, both in returns and principal |
Expected return | Lower | Higher, especially through capital gains over time |
4. Primary and secondary markets
Basis | Primary market | Secondary market |
|---|---|---|
Also called | New issues market | Stock market or stock exchange |
What is traded | New securities issued for the first time | Existing securities |
Who sells | The company | Investors sell to other investors |
Capital formation | Directly promotes it | Indirectly promotes it, by providing liquidity |
Location | No fixed place | Specific places (stock exchanges) with trading platforms |
Prices | Fixed by the company's management | Set by demand and supply |
Methods of floatation in the primary market
Method | Meaning |
|---|---|
Offer through prospectus | Inviting the public to subscribe by issuing a prospectus; advertised widely |
Offer for sale | Securities are first sold to an intermediary (such as an issuing house or brokers), who then resells them to the public |
Private placement | Securities are allotted to institutional investors and selected individuals; quicker and cheaper than a public issue |
Rights issue | Existing shareholders get the right to buy new shares in proportion to their existing holding |
e-IPO | Issuing securities through the online system of a stock exchange; the company appoints registered brokers to accept applications |
5. Stock exchange
A stock exchange is an institution that provides a platform for buying and selling existing securities. In India it is regulated by SEBI under the Securities Contracts (Regulation) Act, 1956.
Functions of a stock exchange
Providing liquidity and marketability to existing securities.
Pricing of securities, through demand and supply, which also guides valuation of companies.
Safety of transactions, because members are regulated and trading follows the rules.
Contributing to economic growth, by encouraging savings to flow into investment.
Spreading the equity cult, by promoting investment among the public.
Providing scope for speculation within the law, which adds liquidity.
6. Trading procedure and dematerialisation
Trading on Indian stock exchanges is screen-based and online. The traditional open outcry system has been replaced.
Steps in trading
Selecting a broker: an individual, partnership or company registered with SEBI.
Opening a demat account and trading account: the investor also needs a PAN and a bank account, completed through KYC (know your customer) checks.
Placing the order: the investor instructs the broker on the security, quantity and price (a limit or market order).
Executing the order: the broker places the order on the exchange's screen-based system, and a contract note is issued to the investor confirming the trade.
Settlement: securities and funds are exchanged. Indian stock exchanges follow a T+1 settlement cycle (one working day after the trade).
Dematerialisation is holding securities in electronic form instead of paper certificates. They are held in a demat account with a depository participant (DP), such as a bank or broker, which is an agent of the depository. India's two depositories are NSDL (National Securities Depository Limited) and CDSL (Central Depository Services (India) Limited).
Benefits of demat: no risk of theft, loss, forgery or damage of certificates; faster transfer and settlement; no stamp duty on transfer; easier handling of corporate benefits (bonus, rights); lower paperwork and costs.
7. SEBI: Securities and Exchange Board of India
SEBI was set up in 1988 and given statutory powers in 1992 by the SEBI Act. Its purpose: to protect the interests of investors, promote the development of the securities market, and regulate it.
Objectives of SEBI
To regulate stock exchanges and the securities industry to promote their orderly functioning.
To protect the rights and interests of investors, especially individual investors, and guide and educate them.
To prevent trading malpractices and achieve a balance between self-regulation by the industry and statutory regulation.
To regulate and develop a code of conduct and fair practices for intermediaries such as brokers and merchant bankers.
Functions of SEBI
Type | Examples |
|---|---|
Regulatory functions | Registering brokers, sub-brokers and other intermediaries; registering collective investment schemes and mutual funds; regulating stock brokers, portfolio managers and merchant bankers; regulating takeovers; conducting inquiries and audits of exchanges; levying fees |
Development functions | Training intermediaries of the securities market; conducting research and publishing information useful to market participants; promoting activities of stock exchanges through flexible approaches |
Protective functions | Prohibiting fraudulent and unfair trade practices (misleading statements, price manipulation); controlling insider trading and imposing penalties; educating investors; promoting fair practices and a code of conduct |
A reliable approach to case-based questions
Short-term funds under a year: money market; identify the instrument from the issuer (government: T-bill; company: CP; bank to bank: call money; bank to public: CD).
New securities: primary market; identify the method (existing shareholders: rights issue; select institutions: private placement; through an intermediary: offer for sale).
Existing securities: secondary market (stock exchange).
For SEBI, decide whether the action regulates (registration), develops (training, research) or protects (insider trading, fraud, education).
Connections that matter
Financial management decides how much to raise and from which sources; this chapter shows where those funds are raised.
Accountancy: share capital and debentures records the securities issued in the primary market.
Consumer protection has a parallel in SEBI's role protecting investors.
Common mistakes
Treating commercial paper as secured. It is unsecured.
Thinking T-bills pay periodic interest. They are issued at a discount and redeemed at par.
Saying the secondary market directly raises capital for companies. It only provides liquidity.
Classifying investor education as a regulatory function. It is a protective function.
Confusing a rights issue with private placement.
Revision checklist
I can explain the four functions of financial markets.
I can explain all five money market instruments.
I can distinguish money and capital markets, and primary and secondary markets.
I can explain the five methods of floatation.
I can describe stock exchange functions, trading steps and dematerialisation.
I can classify SEBI's functions as regulatory, development or protective.