FINANCIAL-MARKET-munotes

Page 1

1MODULE -I
1
FINANCIAL SYSTEM
Unit Structure
1.1 Introduction
1.2 Structure of a Financial System
1.3 Summary
1.1 INTRODUCTIO N
This Unit presents bare elements of a financial system.
It discusses the constituents, economic developmental contribution and
constraints, and performance criteria of the financial system and
certain concepts in its development.
1.2 STRUCTURE OF A FI NANCIAL SYSTEM
The financial system or financial sector of any country consists of
specialised and non -specialised financial institutions, of organised and
unorganised financial markets, of financial instruments and services which
facilitate transfer of fun ds. Procedures and practices adopted in the
markets, and financial interrelationships are also parts of the system.
These parts are not always mutually exclusive; for example, financial
institutions operate in financial markets and are, therefore, a part o fs u c h
markets.
The word "system" in the term "financial system", implies a set of
complex and closely connected or interlinked institutions, agents,
practices, markets, transactions, claims and liabilities in the economy. The
financial system is concern ed about money, credit and finance -the three
terms are intimately related yet are somewhat different from each other.
Money refers to the current medium of exchange or means of payment.
Credit or loan is a sum of money to be returned, normally with interes t; it
refers to a debt of economic unit. Finance is a monetary resources
comprising debt and ownership funds of the state, company or person.
Figure 1.1 presents the typical structure of a financial system in any
economy.
Financial Institutions are busin ess organisations that act as
mobilisers and depositories of savings and as purveyors of credit or
finance. They also provide various financial services to the community.
They differ from non -financial (industrial and commercial) business
organisations in respect of their dealings, i.e. while the former deal in
financial assets such as deposits, loans, securities and so on, the latter deal
in real assets such as machinery, equipment, stocks of goods, real estatemunotes.in

Page 2

2and so on. The distinction between the financ ial sector and the "real
sector" should not be taken to mean that there is something unproductive
(ephemeral) about finance. At the same time, it means that the role of
financial sector should not be overemphasised. The activities of different
financial in stitutions may be either specialised or they may overlap; quite
often they overlap. Yet we need to classify financial institutions and this is
done on the basis of their primary activity or the degree of their
specialisation with relation to savers or borr owers with whom they
customarily deal or the manner of their creation. In other words, the
functional, geographic, sectoral scope of activity or the type of ownership
are some of the criteria which are often used to classify a large number
and variety of f inancial institutions which exist in the economy. However,
it should be kept in mind that such classification is likely to be imperfect
and tentative.
According to one classification, financial institutions are divided
into banking and non -banking instit utions. The banking institutions have
quite a few things in common with the non -banking ones, but their
distinguishing character lies in the fact that, unlike other institutions. they
participate in the economy's payments mechanism, i.e., they provide
transactions services, their deposit liabilities constitute a major part of the
national money supply, and they can, as a whole, create deposits or credit,
which is money.
Banks, subject to legal reserve requirements, can advance credit by
creating claims against themselves, while other institutions can lend only
out of resources put at their disposal by the savers. The distinction
between the two has been highlighted by Say ers by characterising the
former as "creators" of credit, and the latter as mere "purveyors" of credit.
While the banking system in India comprises the commercial banks and
co-operative banks, the examples of non -banking financial institutions are
Life Ins urance Corporation (LIC), Unit Trust of India (UTI) and Industrial
Development Bank of India (IBDI).munotes.in

Page 3

3Financial institutions are also classified as intermediaries and non -
intermediaries. As the term indicates, intermediaries intermediate between
savers and investors; they lend money as well as mobilise savings; their
liabilities are towards the ultimate savers; while their assets are from the
investors or borrowers. Non -intermediary institutions do the loan business
but their resources are not directly obta ined from the savers. All banking
institutions are intermediaries. Many non -banking institutions also act as
intermediaries and when do so they are known as Non -Banking
institutions also act as intermediaries and Insurance Corporation (GIC) are
some of the NBFIs in India. Non -intermediary institutions like IDBI,
Industrial Finance Corporation (IFC), and National Bank for Agriculture
and Rural Development (NABARD) have come into existence because of
governmental efforts to provide assistance for specific pur poses, sectors
and regions. Their creation as a matter of policy has been motivated by the
philosophy that the credit needs of certain borrowers might not be
otherwise adequately met by the usual private institutions. Since they have
been set up the govern ment, we can call them Non -Banking Statutory
Financial Organisations (NBSFO).
Financial markets are the centres or arrangements that provide
facilities for buying and selling of financial claims and services. The
corporations, financial institutions, in dividuals and governments trade in
financial products in these markets either directly or through brokers and
dealers on organised exchanges of off -exchanges. The participants on the
demand and supply sides of these markets are financial institutions,
agents, brokers, dealers, borrowers, lenders, savers and others who are
interlinked by the laws, contracts, covenants and communication
networks.
Financial markets are sometimes classified as primary (direct) and
secondary (indirect) markets. The primary mar kets deal in the new
financial claims or new securities and, therefore, they are also known as
new issue markets. On the other hand, secondary markets deal in securities
already issued or existing or outstanding. The primary market mobilise
savings and sup ply fresh or additional capital to business units. Although
secondary markets do not contribute directly to the supply of additional
capital, they do so indirectly by rendering securities issued on the primary
markets liquid. Stock markets have both primar ya n ds e c o n d a r ym a r k e t
segments.
Very often financial markets are classified as money markets and
capital markets, although there is essential difference between the two as
both perform the same function of transferring resources to the producers.
This c onventional distinction is based on the differences in the period of
maturity of financial assets issued in these markets. While money markets
deal in the short -term claims (with a period of maturity of one year or
less), capital markets do so in the long -term (maturity period above one
year) claims. Contrary to popular usage, the capital market is not only co -
existence with the stock market; but it is also much wider than the stock
market. Similarly, it is not always possible to include a given participant in
either of the two (money and capital) markets alone. Commercial banks,munotes.in

Page 4

4for example, belong to both. While treasury bills market, call money
market, and commercial bills markets are examples of money market,
stock market and government bonds markets are examples of capital
market.
Keeping in view different purposes, financial markets have also
been classified into the following categories:
a. Organised and unorganised
b. Formal and informal
c. Official and parallel and
d. Domestic and foreign.
There is no precise connotation with which the words unorganised
and informal are used in this context. They are quite often used
interchangeably. The financial transactions which take place outside the
well-established exchanges or without systematic and orde rly structure or
arrangements constitute the unorganised markets. They generally refer to
the markets in villages or rural areas, but they exist in urban areas also.
Interbank money markets and most foreign exchange markets do not have
organised exchanges. But they are not unorganised markets in the same
way the rural markets are. The informal markets are said usually involve
families and small groups of individuals lending and borrowing from each
other. This description cannot be strictly applied to the fo reign exchange
markets, but they are also mostly informal markets.
As mentioned earlier, financial systems deal in financial services
and claims or financial assets or securities or financial instruments. These
services and claims are many and varied in character. This is so because of
the diversity of motives behind borrowing and lending. The stage of
development of the financial system can often be judged from the
diversity of financial instruments that exist in the system.
The financial assets represent a claim to the payment of a sum of
money sometime in the future (repayment of principal) and / or a periodic
(regular or not so regular) payment in the form of interest or dividend.
With regard to bank deposit or government b ond or industrial debenture,
the holder receives both the regular periodic payments and the repayment
of the principal at a fixed date. Whereas with regard to ordinary share or
perpetual bond, only periodic payments are received (which are regular in
the c ase of perpetual bond but may be irregular in the case of ordinary
share).
Financial securities are classified as primary (direct) and secondary
(indirect) securities. The primary securities are issued by the ultimate
investors directly to the ultimate s avers as ordinary shares and debentures,
while the secondary securities are issued by the financial intermediaries to
the ultimate savers as bank deposits, units, insurance policies, and so on.
For the purpose of certain types of analysis, it is also usefu l to talk about
ownership securities (viz., shares) and debt securities (viz. debentures,
deposits).
Financial instruments differ from each other in respect of their
investment characteristics which, of course, are interdependent andmunotes.in

Page 5

5interrelated. Among the investment characteristics of financial assets of
financial products, the following are important:
1. Liquidity
2. Marketability
3. Reversibility
4. Transferability
5. Transaction Costs
6. Risk of default or the degree of capital and income uncertainty and a
wide array of other risks
7. Maturity period
8. Tax Status
9. Options such as call -back or buy -back options
10. Volatility of prices and
11. The rate of return -nominal, effective and real.
1.3 SUMMARY
The financial system or financial sector of any country consists of
specialised and non -specialised financial institutions, of organised and
unorga nised financial markets, of financial instruments and services
which facilitate transfer of funds. Procedures and practices adopted in
the markets, and financial interrelationships are also parts of the
system. These parts are not always mutually exclusive ; for example,
financial institutions operate in financial markets and are, therefore, a
part of such markets.
The word "system" in the term "financial system", implies a set of
complex and closely connected or interlinked institutions, agents,
practices, markets, transactions, claims and liabilities in the economy.
The financial system is concerned about money, credit and finance -the
three terms are intimately related yet are somewhat different from each
other.
Financial Institutions are business organisations that act as mobilisers
and depositories of savings and as purveyors of credit or finance. They
also provide various financial services to the community. They differ
from non -financial (industrial and commercial) business organisations
in res pect of their dealings, i.e. while the former deal in financial
assets such as deposits, loans, securities and so on, the latter deal in
real assets such as machinery, equipment, stocks of goods, real estate
and so on.
1.4 QUESTIO NS
1. What are financial markets? Explain their basis.
2. Explain the constituents of financial markets.
3. State the functions of financial markets.

munotes.in

Page 6

62
INDIANFINANCIAL SYSTEM
Unit Structure
2.1 Background
2.2 Indian Financial System at Present
2.3 Indicators of Financial Development
2.4 Flow -Of-Funds Accounts
2.5 Trends in Savings and Investment
2.6 Financial Integration
2.7 Regulation and Deregulation
2.8 Summary
2.9 Questions
2.1 BACKGROU ND
The politico -economic background of the financial development in
India has been determined by the nature our mixed economic system. The
objectives of this system with respect to growth, sectoral priorities,
distribution have influenced the functioning and development of IFS.
Some of the marked characteristics of Indian economy during the past 50
years are continuous inflation, increasing internal (fiscal) and external
deficits, industrialisation, urbanisation and significant structural
transformation. Functioning within this context, all sectors of the
economy, includin g the financial markets, have undergone significant
changes. Further, there has been a close interaction between the financial
and economic systems.
2.2 INDIANFINANCIAL SYSTEM AT PRESE NT
A striking feature of the IFS is its prodigious growth in the pas t5 0
years in terms of size, diversity, sophistication, and complexity. Money
supply, savings, bank deposits and credit, primary and secondary issues
and so on have increased tremendously, the supportive factor being the
continuous and high rate of inflati on. While the prices in 1996 were about
18times the prices in 1950, the commercial banks' deposits, to take just
one example, in 1997 were more than 618 times their deposits in 1951.
The bank deposits have increased from Rs. 909 crore in 1951 to Rs. 5, 61,
982 crore at the end of March 1997. This is a very remarkable growth
indeed, particularly as, with the passing years, it occurred on an expanding
base.munotes.in

Page 7

7The quantitative growth of the IFS has been accompanied by
significant diversification and innovation si nr e s p e c to fa na r r a yo f
financial institutions, instruments, and services. India has witnessed all
types of financial innovations, during the past 50 years. A large number of
totally new institutions catering to almost every sector have been set up
since 1950. As a result, today we have a highly diversified structure of
financial institutions. Similarly, a large number of new financial
instruments have come to be introduced, as a result of which we now have
a fairly diversified portfolio of financial cl aims. Further, significant
reorganisation, gloabalisation, privatisation, deregulation, automation,
computerisation, changes in ownership, consolidation and mergers of
financial institutions have been effected. A veritable financial revolution
appears to h ave occurred in India, as elsewhere, over the years.
Table 1 reflects the richness, diversity, complexity and well -
developed nature of the IFS as it stands today. It lists all the major
financial institution, financial instruments and financial services which
now exist in India. For the sake of clarity, only the major markets have
been specifically mentioned. Table 1 only mentions only the main types of
financial institutions and instruments, while their sub types are not
mentioned. The commercial banks, co-operative banks, mutual funds,
industrial debentures, preference shares, treasury bills, bank deposits, for
example, have many sub types.
2.3 INDICATORS OF FI NANCIAL DEVELOPME NT
The financial development of a country is usually studied by
examining changes in the following indicators:
a. Finance ratio -measures the total issues of primary and secondary
claims in relation to national income.
b. Financial Inter -relation Ratio (FIR) -ratio of financial assets to physical
assets, and it indicates the relationship between financial structure and real
assets structure of the economy.
c. New Issue Ratio (NIR) -ratio of primary issues to the physical capital
formation and it indicates how far investment has been financed by direct
issues to the savers by the investing sectors.
d. Intermediation Ration (IR) -ratio of secondary issues to primary issues.
IR indicates the importance of financial institutions or intermediaries as
mobilisers of funds relative to real sectors as direct mobilisers of funds. I t
indicates the institutionalisation of financing in the economy.
These four indicators of financial development for the span of
more than 40 years (1951 -94) are presented in Table 2. They have all
increased significantly implying the growing importance of financial
institutions in the economy and the growth of financial flows in relation tomunotes.in

Page 8

8economic activity, both in the form of direct and indirect finance. The
levels and changes in FIR indicate that the financial structure in India has
grown more rapidl y than the national income. Changes in FR indicate that
there has been a marked rise in the institutionalisation of financing
investment, and that separation between the acts of saving and investment
has grown.
2.4 FLOW -OF-FUNDS ACCOU NTS
Flow -of-funds accounts (FOFA) of a country are also very useful
in understanding the structure of financial institutions, assets -structure,
financial behaviour and inter -relationships and the nature of financial
development in that country. Before we turn to the study o f flow -of-
accounts in India, it would be useful to first understand the meaning and
general nature of flow -of-accounts.
The Flow -of-Funds Accounts are financial counterpart of the
National Income Accounts of the real sector of the economy. They contain
all-sectoral and aggregate -sources and uses of funds for a given
economy. The sources and uses of funds in the form of various financial
claims for a selected number of sectors are presented in the form of
matrix, and the complexity of the matrix depends upon the number of
sectors and the number of types of assets/liabilities or securities chosen.
The sectors are subdivisions of the economy and are more or less
homogeneous in respect of their functional and operational characteristics.
In India, for this purpose the economy is divided into six sectors, namely,
banking, other financial institutions, private corporate business,
Government, household and the rest of the World. In the USA, the number
of sectors for this purpose is nine. The FOFA may be prepare da n d
presented either for each quarter or year. In India, only the yearly Flow -of-
Funds tables are available so far.
In order to avoid confusion, it is necessary to understand the
interrelationships between the flows in the form of saving, investment,
sources, uses, assets, liabilities, borrowing and lending. Roughly speaking,
while uses, assets, lending and investment fall on one side; sources,
liabilities, borrowing, and saving fall on the other side.
The FOFA matrix is prepared by examining the bala nce sheets of
various sectors at the beginning and at the end of the period. The
convention is to treat increase in assets as uses of funds and increase in
liabilities as sources of funds. Thus, although constructed out of sectoral
stock statements, these tables contain changes or flows of funds between
two points of time. It may be noted that only net increases in assets are
treated as use of funds; dept repayment or dis -saving, which are in fact,
uses of funds are treated as negative sources of funds. In the same fact,
sources of funds, are treated as negative uses. Further, the sectoral flows
are also shown on the net basis i.e. while the inter -sectoral flows are
included, intra -sectoral transactions are not recorded. For example, a loanmunotes.in

Page 9

9from one househol d to another would not be reflected in the FOFA tables.
The sources and uses of funds for each sector and for the entire economy
must balance in theory. However, in practice they often do not balance and
we get discrepancies for the sector totals and for a ggregate totals. The lack
of balance reflects the enormous difficulties in combining transactions and
sectors in sources and uses matrix. Analytically, the lack of balance may
evidence the nature of likely future developments. The distinguishing
characteri stic FOFA which emerges is that they present net flows of funds
between sectors and between two points of time. To summarise, "the flow
of funds is an interlocking, complete system that depicts the balanced
sources and uses of funds for each sector, the in ter-relationship among
sectors, and the saving, investment, borrowing, lending and money flow
totals for a 3 -month or 1 -year period."
The examples of FOFA matrices for India are presented in Table
form relating to the years respectively. The position of any item in a
column shows the place of the item in the particular sector's total assets
(uses) and liabilities (sources). A sector's position in the row shows the
share of that sector's holding of a particular asset or liability in the national
total of a ssets/liabilities. Percentages of items to respective column totals
are given in brackets. These tables can be interpreted to reveal a good deal
of information regarding the institutional and assets structure in India over
the span of 20 years. However, we mention below two or three important
points only by way of illustration.
The total net financial flows have increased from Rs. 3771 crores
to Rs. 113, 751 crores, i.e by 3116 percent during 1966 -67 and 1987 -88. In
terms of their quantitative importance in 1987 -88, different financial
liabilities in India can be ranked in this descending order: currency and
bank deposits, loans and advances; central Government securities,
provident fund, securities of other financial institutions and corporate
securities in the total liabilities have increased marginally, that of loans
and advances, the Government securities has declined. While the share of
banking and other financial institutions in the total sources of funds has
increased, that of private corporate busin ess, Government, and households
has declined. The assets -wise distribution of financial savings of the
household sector to be presented later also would show that now bank
deposits, provident fund, other claims on the government, life insurance
policies, d eposits with companies, corporate securities and units are
important in this descending order as media for household savings. The
importance of contractual claims in India has increased over this period.
Since this change has occurred in the face of inflat ion, the hypothesis that
inflation discourages contractual savings needs to be reviewed. The top
position of bank deposits in India throughout this period is in contrast with
the developments in other countries, where the importance of banking
system was o bserved to have declined with the financial development.munotes.in

Page 10

102.5 TRE NDS INSAVI NGS A NDINVESTME NT
At this point the major changes that have occurred in the savings
and investment trends should be noted. We may do so by studying either
the net saving and i nvestments or gross saving and investment, the
difference between the gross and net quantities being equal to fixed capital
consumption allowance. In 1988 -89 the gross domestic saving was 84
times and the investment 98 times of 1950 -51. The rates of saving and
capital formation (i.e. each of them as percent of GDP) have shown a
remarkable increase from about 10% to 21 and 24 % respectively. These
rates of increase in India have been higher than in many developing as
well as developed countries. Thus, the IF S has amply fulfilled one of its
basic functions, namely the promotion of saving and investments.
Also we understand that the major part of saving has been due to
the household sector. The household sector saving as percentage of the
total savings has in creased from 74% in 1950 -51 to 81% in 1988 -89. The
contribution of the private corporate and public sectors together with the
national savings has not been even one fourth of that and it has remained
at that low level. Thus India differs from many other co untries where
"household savings play a minor role, with corporations generally playing
the dominant role in the accumulation of national surplus, with some
tendency for governments to compensate where the corporations share
falls below the median."
The household sector has been the only surplus sector in India,
while the investment of private corporate and public sectors has always far
exceeded their respective savings. A detailed study of the pattern of
financing of investment of different sectors has s hown that the dependence
of the private corporate and public sectors on the household sector and
financial institutions for the purpose of financing their investment, has
increased substantially over time.
2.6 FI NANCIAL I NTEGRATIO N
The financial system has now become much more integrated than
ever before. The dividing lines between the so -called "organised" and
"unorganised" sectors, between the "busy" and "slack" seasons, are getting
increasingly imperceptible. Among the factors that are behind greater
integration are:
a. The Government entry in a very big way in the wholesale trading of a
large number of commodities.
b. An unprecedented expansion of the network of rural branches of banks.
c. The transformation in the perception of the role of financial institutions.
d. The evolution of financial institutions as multifunction (mixed)
institutions.munotes.in

Page 11

11The banks and term lending financial institutions have become
more integrated through such methods as the use of "participation
certificates"; the adoption o f "participation approach" to granting loans
and offering financial services like underwriting and guaranteeing; and
their activities in the markets for call loans, commercial bills, and so on.
The refinance and rediscounting schemes of institutions like I DBI and
NABARD, have also contributed to greater integration.
2.7 REGULATIO NAND DEREGULATIO N
The financial sector in India today, is almost entirely owned and
controlled by the Government. One of the "commanding heights" of the
economy is almost totall y in the hands of the Government. This has been
achieved in two ways:
a. Through the nationalisation, one after another, of financial institutions.
This process started with the nationalisation of the RBI in 1949, followed
by that of the Imperial Bank of India, the life insurance companies,
commercial banks, and general insurance companies.
b. Through the creation of a host of new financial institutions in the public
sector. This process began with the setting up of the IFC in 1949 followed
by many other institutions mentioned earlier.
Apart from direct public ownership, the authorities closely
monitor, regulate and control the policies of financial institutions in
respect of personnel, expansion, and the pricing and distribution of credit.
Almost every single rate of interest and return on financial claims is
administered by the Government authorities. Further, the allocation of
credit is effected mainly through direct credit controls, credit ceilings, and
fixation of credit targets.
The policies of pu blic ownership, administrative regulations and
controls, and consolidation have led to the growth of
monopolistic/oligopolistic market structures in the Indian financial sector.
Financial markets in India are quite imperfect, and the institutional
structur e is characterized by a very high degree of centralisation and
concentration.
The unparalleled Government control of financial institutions can
hardly be said to have served the objectives of social justice. The
Government -owned and Government controlled financial system has, in
fact, promoted the interests of large private business organisations; it has
helped rather than curbed the concentration of economic power in the
hands of the powerful. It has, of course, helped the Government sector
also to appro priate huge sums of money easily and at concessional cost. In
fact, advancing credit to the Government sector has become, ipso facto,
justifiable and desirable.munotes.in

Page 12

12All this have, in the recent past, generated much discussion in
India, as in other countries, regarding the restructure, deregulation and
liberalization of the financial system. The authorities have therefore
liberalized the financial systems in many ways. They have removed
certain regulations in respect of the stock market (viz. regarding bonus
issues, issues of fresh capital), and they have removed the interest rate
ceiling in the call money market. Banks have been freed from ceiling on
their lending rates; interest rates on CDS, CPS, participation certificates
are market determined; the Credit Au thorization Scheme has been
discontinued.
It has been rightly pointed out in this context that financial
regulation and deregulation have to be relevant to both time and space,
and we cannot apply a priori, simplistic and borrowed ides to this subject.
In India, regulation promoted financial and institutional development; it
did not have the text -book effect of restructuring the growth of financial
intermediation. But it has also meant high cost of branch expansion of
banks, low quality and low return on assets, low profitability of banks, and
so on. Therefore, liberalisation should be brought about through
sequenced and structured steps rather than suddenly. It would help to
effect slow and progressive freezing of interest rates, and discontinuation
of the policy of direct credit allocation.
2.8 SUMMARY
The politico -economic background of the financial development in
India has been determined by the nature our mixed economic system.
The objectives of this system with respect to growth, sectoral
priorit ies, distribution have influenced the functioning and
development of IFS.
Some of the marked characteristics of Indian economy during the past
50 years are continuous inflation, increasing internal (fiscal) and
external deficits, industrialisation, urban isation and significant
structural transformation.
Functioning within this context, all sectors of the economy, including
the financial markets, have undergone significant changes. Further,
there has been a close interaction between the financial and econ omic
systems.
2.9 QUESTIO NS
Q1. Explain Indian Financial System at present.
Q2. Discuss on saving and investments in the financial markets.
Q3. Write explanatory notes on regulation and deregulation.
munotes.in

Page 13

133
REGULATORY I NSTITUTIO NS
Unit Structure
3.1 Introduction
3.2 Sebi (Guidelines for Disclosure and Investor Protection), 2000
3.3 Sebi (Issue and Listing of Debt Securities) Regulations, 2008
3.4 Filing of Draft Offer Document
3.5 Fimmada
3.6 Stock Exchanges in India
3.7 Major Financial Institu tions in India
3.8 Foreign Investment Promotion Board
3.9 Summary
3.10 Questions
3.1 INTRODUCTIO N
Financial Sector in India has experienced a better environment to
grow with the presence of higher competition. The Financial system in
India is regulated by independent regulators in the field of banking,
insurance, mortgage and capital market. Government of India plays
significant role in controlling the financial markets in Ind ia.
Ministry of Finance, Government of India control the financial
sector in India. Every year the Finance Ministry presents the annual
budget. The Reserve Bank of India (RBI) is an apex institution in
controlling the banking system in the country. It's monetary policy acts as
a major weapon in India's financial market.
Securities Exchange Board of India (SEBI) is one of the regulatory
authority of India's Capital Market.
Here in this Chapter a focus on major financial regulatory bodies
in financial m arket is made.
The debt markets in India are regulated by two agencies ----RBI
and SEBI. In a notification issued by the Government on March 2, 2000,
the area of responsibility between RBI and SEBI have been clearly
delineated. In terms of this notifica tion, the contracts for sale and purchase
of government securities, gold related securities, money market securities
and securities derived from these securities and ready forward contracts in
debt securities shall be regulated by the RBI.munotes.in

Page 14

14However, regu lation of money market mutual funds, which
predominantly invest in money markets, is done by the SEBI, which is the
regulatory authority for the mutual fund industry. SEBI is the regulating
agency for the stock markets and the member -brokers of the stock
exchanges, and therefore, regulates the listing and trading mechanism of
debt instruments. Regulation of corporate debt issuance is also under the
purview of SEBI.
The issuance of debt instruments by the government is regulated
by the Government Securitie s Act 2006. The issuance of corporate
securities is regulated by the SEBI Guidelines for Disclosure and investor
protection.
The Fixed Income Money Market & Derivatives Association of
Indian (FIMMDA), formed in 1998, is the Self -regulatory Organisation
for debt markets. Its objective is to enable market development by
involving market participants in the creation of good market practices,
uniform market conventions and high levels of integrity in the debt
markets.
INDIANDEBT MARKET: REGULATIO NSANDS E C U RITY
LEGISLATIO N
Reserve Bank of India a) Regulates
-Investment pattern of banks
-Money Markets
-NBFCs
b) Prescribes capital adequacy norms
and accounting policies for banks
SEBI a) Regulates Securities Markets
b) Protects investors’ interest and
stipulates disclosure guidelines
NSE Expected to regulate secondary market
activities in debt instruments
Companies Act, 1956 Requirements of a prospectus to be
drawn up when a company issues new
shares or debentures
Securities Contract
(Regulation) Act, 1956a) Listing of Securities
b) Right of appeal against refusal to
list securities
c) Free transferability of securities
GOVER NMENTS E C U R I T I E SA C T ,2 0 0 6
With a view to consolidating and amending the law relating to the
Government Securities and its management by the Reserve Bank of India,
the Parliament had enacted the Government Securities Act, 2006. The Act
received the presidential assent on August 30, 2006. The Government
Securities Act also provides that RBI may take regulations to carry out the
purpose of the Act.munotes.in

Page 15

15Government Securities Act, 2006 and Government Securities
Regulations, 2007 have come into force with effect from December 1,
2007. The Government Securities Act applies to Government securities
created and issued by the Centr al and State Governments. The new Act
and Regulations would facilitate widening and deepening of the
Government Securities market and its more effective regulation by the
Reserve Bank.
GOVER NMENTS E C U R I T I E SR E G U L A T I O NS, 2007
Government Securities Regulat ions, 2007 have been made by the
Reserve Bank of India to carry out the purpose of the Government
Securities Act. The Government Securities Regulations provides for
transfer of Government securities held in different forms.
a. Government security held in the form of Government Promissory Notes
is transferable by endorsement and delivery.
b. A bearer bond is transferable by delivery and the person in possessions
of the bond shall be deemed to be the holder of the bond.
c. Government Securities held in the f orm of Stock Certificates,
Subsidiary General Ledger account including a constituent Subsidiary
General Ledger Account & Bond Ledger Account are transferable,
before maturity, by executive of forms –III, IV & V respectively
appended to the Government Secu rities Regulations.
d. Government Securities held in subsidiary general ledger account
including a constituent subsidiary general ledger account or bond ledger
account, shall also be transferable by execution of a deed in an
electronic form under digital s ignature.
3.2 SEBI (GUIDELI NES FOR DISCLOSURE A ND
INVESTOR PROTECTIO N), 2000
SEBI Guidelines for issuance of corporate debentures is stipulated in
Chapter X of the DIP, 2000. Some of its major provisions are: -
Requirement for Credit Rating
No company shall make a public issue or rights issue of debt
instruments (whether convertible or not), unless credit rating is obtained
from at least one credit rating agency registered with the board and
disclosed in the offer document. Where ratings are obtained fr om more
than one credit rating agencies, all the ratings including the unaccepted
credit ratings, shall be disclosed in the offer document. All the credit
ratings obtained during the three years (3) preceding the public or rights
issue of debt instrument ( including convertible instruments) for any listed
security of the issuer company shall be disclosed in the offer document.
Requirement in respect of Debenture Trustee
No company shall issue a prospectus or a letter of offer to the
public for subscription of the debentures, unless the company hasmunotes.in

Page 16

16appointed one or more debenture trustees for such debentures in
accordance with the provisions of the Companies Act, 1956.
Creation of Debenture Redemption Reserves (DRR)
For the redemption of the debentures iss ued, the company shall
create debenture redemption reserve in accordance with the Provisions of
the Companies Act, 1956.
Distribution of Dividends
In case of the companies which have defaulted in payment of
interest on debentures or redemption of debentu res or in creation of
security as per the terms of issue of the debentures, any distribution of
dividend shall require approval of the Debenture Trustees and the Lead
Institution, if any, dividends may be distributed out of profit of particular
years only after transfer of requisite amount in DRR.
Redemption
The issuer company shall redeem the debentures as per the offer
document.
Disclosures in Respect of Debentures
The offer document shall contain:
i. Premium amount on conversion, time of conversion.
ii. In case of PCDs/NCDs, redemption amount, period of maturity, yield
on redemption of the PCDs/NCDs.
iii. Full information relating to the terms of offer or purchase including the
name(s) of the party offering to purchase the khokhas (non -convertible
portion of PCDs).
iv. The discount at which such offer is made and the effective price for the
investor as a result of such discount.
v. The existing and future equity and long term debt ratio.
vi. Servicing behaviour on existing debentures, payment of due inte rest on
due dates on term loans and debentures.
3.3 SEBI (ISSUE A NDL I S T I NG OF DEBT SECURITIES)
REGULATIO NS, 2008
Issue Requirements for Public Issues General Conditions
a. No issuer should make any public issue of debt securities if as on the
date of filling of draft offer document and final offer document as
provided in these regulations, the issuer or the person in control of the
issuer, or its promoter, has been restrained or prohibited or debarred by the
Board from accessing the securities marke t or dealing in securities and
such direction in order is in force.munotes.in

Page 17

17b. The following conditions have to be satisfied by an issuer for making
any public issue of debt securities as on the date of filing of draft offer
document and final offer document.
i.If the issuer has made an application to more than one recognised stock
exchange, the issuer is required to choose one of them as the designated
stock exchange. Further, where any of such stock exchanges have
nationwide trading terminals, the issuer shoul d choose one of them as
designated stock exchange. For any subsequent public issue, the issuer
may choose a different stock exchange subject to the requirements of this
regulation.
ii. The issuer has to obtain in principle approval for listing of its debt
securities on the recognised stock exchanges where the application for
listing has been made.
iii. Credit rating has been obtained from at least one credit rating agency
registered with SEBI and is disclosed in the offer document. If the credit
ratings h ave been obtained from more than one credit rating agency, then
all ratings including the unaccepted ratings have to be disclosed in the
offer document.
iv. It has to enter into an arrangement with a depository registered with
SEBI for dematerialisation o f debt securities that are proposed to be issued
to the public in accordance with the Depositories Act 1996 and regulations
made there under.
c. The issuer should appoint one or more merchant bankers registered with
SEBI at least one of whom should be a l ead merchant banker.
d. The issuer should appoint one or more debenture trustees in accordance
with the provision of Section 117 B of the Companies Act, 1956 and SEBI
(Debenture Trustee) Regulations 1993.
e. The issuer should not issue debt securities fo r providing loan to or
acquisition of shares of any person who is part of the same group or who
is under the same management.
3.4 FILI NG OF DRAFT OFFER DOCUME NT
No issuer should make a public issue of debt securities unless a
draft of offer document has to be filed with the designated stock exchange
through the lead merchant banker. The draft offer document filed with the
stock exchange has to be made public by posting the same on the website
of the designated stock exchange for seeking public comments f or a period
of seven working days for the date of filing the draft offer document with
such exchange. The draft offer document may also be displayed on the
website of the issuer, merchant bankers.munotes.in

Page 18

18The lead merchant bankers should ensure that the draft off er
document clearly specifies names and contact particulars of the
compliance officer of the lead merchant banker and the issuer including
the postal and email address, telephone and fax numbers. The lead
merchant banker should also ensure that all comment s received on the
draft offer document are suitably addressed prior to the filing of the offer
document with the Registrar of Companies. A copy of the draft and final
offer document should be forwarded to SEBI for its records,
simultaneously with filing of these documents with the designated stock
exchanges.
The lead merchant bankers should prior to filing of the offer
document with the Registrar of Companies, furnish to SEBI a due
diligence certificate as per the format provided in Schedule II of SEBI
(Issue and Listing of Debt Securities) Regulations, 2008.
Electronic Issuance
An issuer proposing to issue debt securities to the public through
the on -line system of designated stock exchange should comply with the
relevant applicable requirements as may be specified by SEBI.
Price Discovery through Book Building
The issuer may determine the price of debt securities in
consultation with the lead merchant banker and the issue may be at fixed
price or the price may be determined through the book building p rocess in
accordance with the procedure as may be specified by SEBI
Minimum Subscription
The issuer may decide the amount of minimum subscription which
it seeks to raise by issue of debt securities and disclose the same in the
offer document. In the even to fn o n -receipt of minimum subscription all
application moneys received in the public issue shall be refunded
forthwith to its applicants.
Listing of Debt Securities
An issuer desirous of making an offer of debt securities to the
public has to make an a pplication for listing to one or more recognised
stock exchanges in terms of sub -section (1) Section 73 of the Companies
Act, 1956 (I of 1956). The issuer has to comply with the conditions of
listing of such debt securities as specified in the Listing Agre ement with
the Stock Exchanges where such debt securities are sought to be listed.
3.5 FIMMDA
The Fixed Income Money Market and Derivatives Association of
India (FIMMDA), an association of Scheduled Commercial Banks, Public
Financial Institutions, Prima ry Dealers and Insurance Companies was
incorporated as a Company under Section 25 of the Companies Act, 1956
on June 3, 1998. FIMMDA is a voluntary market body for the bond,munotes.in

Page 19

19money and derivatives markets. FIMMDA has members representing all
major instituti onal segments of the market. The membership includes
Nationalised Banks such as State Bank of India, its associate banks and
other nationalised banks; Private Sector Banks such as ICICI Bank, HDFC
Bank, IDBI Bank, Foreign Banks such as Bank of America, ABN Amro,
Citibank, Financial institutions such as IDFC, EXIM Bank, NABARD,
Insurance Companies like LIC, ICICI Prudential Life Insurance company,
Birla Sun Life Insurance Company and all Primary Dealers.
The FIMMDA represents market participants and aids the
development of the bond, money and derivatives market. It acts as an
interface with the regulators on various issues that impact the functioning
of these markets. It also undertakes developmental activities, such as,
introduction of benchmark rates and new derivatives instruments etc.
FIMMDA releases rates of various Government securities that are used by
market participants for valuation purposes. FIMMDA also plays a
constructive role in the evolution of best market practices by its members
so that the market as a whole operates transparently as well as efficiently.
3.6 STOCK EXCHA NGES I NINDIA
3.6 (a) NATIO NAL STOCK EXCHA NGE OF I NDIA
In the year 1991 Pherwani Committee recommended to establish
National Stock Exchange (NSE) in India. In 1992 the Government of India
authorised IDBI for establishing this exchange.
In NSE, there is trading of equity shares, bonds and government
securiti es. India's stock exchanges particularly National Stock Exchange
(NSE) has achieved world standards in the recent years. The NSE India
ranked its 3rd position since last four years in terms of total number of
trading per calendar year.
Presently, there a re 24 stock exchanges in India, out of which 20
have exchanges, National Stock Exchange (NSE), Over The Counter
Exchange of India Ltd. (OTCEI), and Inter -connected Stock Exchange of
India Ltd (ISE) have nation -wide trading facilities.
NewNSE Reference Ra tes
Both MIBOR (Mumbai Inter Bank Offer Rate) and MIBID
(Mumbai Inter Bank Bid Rate) are the two new references rates of
National Stock Exchanges. These two new reference rates were launched
on 15 June1998 for the loans of inter -bank call money market. Bo th
MIBOR and MIBID work simultaneously. The MIBOR indicates lending
rates for loans while MIBID is the rate for receipts.
3.6 (b) BOMBAY STOCK EXCHA NGE (BSE)
BSE is one of the oldest stock exchanges in Asia and was
established in the year 1875 in the nam e of "The Native Share and Stock
Brokers Association."munotes.in

Page 20

20BSE is located at Dalal Street, Mumbai, India. It got recognition in
the year 1956 from the Government of India under Securities Contracts
(Regulation) Act, 1956. Presently BSE SENSEX is recognised wo rld-
wide. Trading volumes have drawn the attention over the globe.
BSE I NDICES
The well known index is BSE SENSEX. Others include BSE 500,
BSEPSU, BSEMIDCAP, BSEMLCAP and BSEBANKEX.
BSE 100Index:
The equity share of 100 companies from the list of 5 major stock
exchanges such as Mumbai, Calcutta, Delhi, Ahmedabad and Madras are
selected for the purpose of compiling the BSE National Index. The year
1983 -84 is taken as the base year for this index. The method of
compilation here is same as that of the B SE SENSEX.
BSE 200Index:
The BSE 200 Index was launched on 27th May 1994. The
companies under BSE 200 have been selected on the basis of their market
capitalisation, volumes of turnover and other fundamental factors. The
financial year 1989 -90 has been selected as the base year.
BSE 500Index:
BSE 500 Index consisting of 500 scrips is functioning since 1999.
Presently BSE 500 Index represents more than 90% of the total market
capitalisation on Bombay Stock Exchange Limited.
BSE PSU Index:
BSE PSU Ind ex has been working since 4th June 2001. This index
includes major Public Sector Undertakings listed in the Exchange. The
BSE PSU Index tracks the performance of listed PSU stocks in the
exchange.
RESERVE BA NKO FI NDIA
Reserve Bank of India is the apex m onetary Institution of India. It
is also called as the central bank of the country. The bank was established
on April1, 1935 according to the Reserve Bank of India act 1934. It acts as
the apex monetary authority of the country.
The preamble of the reserv e bank of India is as follows:
"...to regulate the issue of Bank Notes and keeping of 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."
3.7 MAJOR FINANCIAL I NSTITUTIO NSININDIA
This is a list on the major financial institutions in India and their
respective date of starting operations.munotes.in

Page 21

21Financial Institution Date of Starting
Imperial Bank of India 1921
Reserve Bank of India April 1, 1935
Industrial Finance corporation of India 1948
State Bank of India July 1, 1955
Unit Trust of India Feb. 1,1964
IDBI July 1964
NABARD July 12,1982
SIDBI 1990
EXIM Bank January 1, 1982
National Housing Bank July 1988
Life Insurance Corporation (LIC) September 1956
General Insurance Corporation (GIC) November 1972
Regional Rural Banks Oct. 2, 1975
Risk Capital and Technology Finance
Corporation Ltd. March 1975Technology Development & Information Co. ofIndia Ltd. 1989
Infrastructure Leasing & Fin ancial Services Ltd. 1988Housing Development Finance Corporation Ltd.(HDFC) 1977
3.8 FOREIG NINVESTME NT PROMOTIO NBOARD
The Foreign Investment Promotion Board is a special agency in
India dealing with the matters relating to Foreign Direct Investment. This
special board was set up with a view to raise the volume of investment to
the country. The sole aim of the board is to create a base in the country by
which a larger volume of investment can be drawn to the country.
On 18 February 2003, t he board was transferred to the Department of
Economic Affairs (DEA) Ministry of Finance.
Important functions of the Board are as follows:
Formulating proposals for the promotion of investment.
Steps to implement the proposals.
Setting friendly guidelines for facilitating more investors.
Inviting more companies to make investment.
To recommend the Government to have necessary actions for
attracting more investment.
With regards to the structure of the Foreign Investment Promotion
Board, the board comprises the following group of secretaries to the
Government:
Secretary to Government Department of Economic Affairs, Ministry
of Finance -Chairman.munotes.in

Page 22

22Secretary to Government Department of Industrial Policy and
Promotion, Ministry of commerce and Industry.
Secretar y to Government, Department of Commerce, Ministry of
Commerce and Industry.
Secretary to Government, Economic Relations, Ministry of External
Affairs.
Secretary to Government, Ministry of Overseas Indian Affairs.
In the recent years, particularly after the implementation of the new
economic policy, the Government has undertaken many steps to
attract more investors for investing in the country. The new proposals
for the foreign investment are allowed under the automatic route
keeping in view the sectoral pra ctices.
3.9 SUMMARY
Financial Sector in India has experienced a better environment to grow
with the presence of higher competition. The Financial system in India
is regulated by independent regulators in the field of banking,
insurance, mortgage and capital market. Government of India plays
significant role in controlling the financial markets in India.
Ministry of Finance, Government of India control the financial sector
in India. Every year the Finance Ministry presents the annual budget.
The Reserv e Bank of India (RBI) is an apex institution in controlling
the banking system in the country. It's monetary policy acts as a major
weapon in India's financial market.
Securities Exchange Board of India (SEBI) is one of the regulatory
authority of India's Capital Market.
3.10 QUESTIO NS
Q1. Name the regulatory Institutions.
Q2. Explain the role and functions of SEBI, RBI.
Q3. Write explanatory notes on the following:
a. Financial Institutions of India.
b. Foreign Investment Promotion Board.
munotes.in

Page 23

23MODULE -II
4
CAPITAL MARKETS
Unit Structure
4.0 Learning Objectives
4.1 Introduction
4.2 Definitions of Capital Market
4.3 Importance of Capital Market
4.4 Functions of Capital Market
4.5 Players in the Capital Market
4.6 The Growth of the Capital Market
4.7 Components of the Capital Market
4.8 Structure of Capital Market in India
4.9 Nature and Constituents
4.10 Industria l Securities
4.0 LEAR NING OBJECTIVES
After studying this unit, learner will be able to understand:
The meaning, structure, components, players of capital markets.
The learner will comprehend industrial securities market.
The learner will understand the meaning of primary markets.
The learner will understand the characteristics of primary markets, the
meaning of IPO and how IPO is issued.
The learner will also comprehend the process of book -building and the
meaning of red h erring prospectus.
The learner will understand the meaning of secondary markets, need
for secondary market, role of secondary market, equity and debt
market.
The learner will further understand the working of stock exchanges.
The learner will understand ho w the shares are bought and sold in
stock exchanges, gain knowledge on stock indices.
4.1 INTRODUCTIO N
Capital Market is a market for long -term sources of finance to the
industrial and corporate sector. The development of a nation depends uponmunotes.in

Page 24

24the rapid growth of industrialisation of a country. Asset formation is the
crucial factor for prosperity of nation. The asset creation is based on
supply of capital and technology. Capital alone will not create prosperity.
The prosperity is the combination of Techn ology, Capital and Human
Resources. The chemistry of these factors will definitely help the
underdeveloped countries towards developed nation.
4.2 DEFI NITIO NS OF CAPITAL MARKET
According to Arun K. Datta the capital market may be defined as,
"the capital market is a complex of institutions investment and practices
with established links between the demand for and supply of different
types of capital gains".
According to F. Livingston the capital market may be defined as,
"In a developing economy, it is t he business of the capital market to
facilitate the main stream of command over capital to the point of the
highest yield. By doing so, it enables, control over resources to pass into
the hands of those who can employ them must effectively thereby
increasi ng production capacity and spelling the national dividend."
4.3 IMPORTA NCE OF CAPITAL MARKET
Capital market deals with long -term funds. These funds are subj ect
to uncertainty and risk. It supplies long and medium term funds to the
corporate sector. It provides the mechanism for facilitating capital fund
transactions. It deals in ordinary shares, bond debentures and stocks and
securities of the government. In this market the funds flow will come from
savers. It converts financial assets into productive physical assets. It
provides incentives to savers in the form of interest or dividend to the
investors. It leads to capital formation. The following factors play an
important role in the growth of the capital market:
1.A strong and powerful Central Government
2.Financial dynamics
3.Speedy industrialisation
4.Attracting Foreign Investment
5.Investments from NRIs
6.Speedy Implementation of policies
7.Regulatory changes
8.Globalisation
9.The level of savings and investment pattern of the household sectors
10. Development of financial theories
11. Sophisticated technological advancesmunotes.in

Page 25

254.4 FU NCTIO NSO FC A P I T A LM A R K E T
Capital market plays a vital role in the development by mobilising
the savings to the needy corporate sector. In recent years there has been a
substantial growth in the Capital Market. The Capital Market involves in
various functions and significance. They are presented below:
i.Coordinator
ii.Motivation to savings
iii.Transformation to investments
iv.Enhances economic growth
v.Stability
vi.Advantages to the investors
vii. Barometer
i. Coordinator
The Capital Market functions as coordinator between savers and
investors. I t mobilises the savings from those who have surplus fund and
divert them to the needy persons or organisations. Therefore, it acts as a
facilitator of the financial resource. In this way it plays a vital role in
transferring the surplus resources to defici t sectors. It increases the
productivity of the industry which ultimately reflects in GDP and national
income of the country. It increases the prosperity of the nation.
ii. Motivation of Savings
The Capital Market provides a wide range of financial instr uments
at all times. India has a vast number of individual savers and the crores of
rupees are available with them. These resources can be attracted by the
capital market with nature. The banks and non -banking financial
institutions motivate the people to save more and more. In less developed
countries, there is no efficient capital market to tap the savings. In
underdeveloped countries there are very little savings due to various
factors. In those countries they invest mostly in unproductive sector.
iii.Transformation of Investment
The Capital Market is a place where the savings are mobilised
from various sources, is at the disposal of businessmen and the
government. It facilitates lending to the corporate sector and the
government. It diverts the savings amount towards capital formation of the
corporate sector. It creates assets by helping the industry. Thus, it
enhances the productivity and leads to industrialisation. The industrial
development of the country depends upon the dynamic nature of the
capita l market. It also provides facilities through banks and non -banking
financial institutions. The development of financial institutions made the
way easy to capital market. The capital has become more mobile. The
interest rate fall lead to an increase in the investment.
iv. Enhances economic growth
The development of the Capital Market is influenced by many
factors like the level of savings with the public, per capita income,munotes.in

Page 26

26purchasing capacity, and the general condition of the economy. The
capital market s moothens and accelerates the process of economic growth.
The Capital Market consists of various institutions like banking and non -
banking financial institutions. It allocates the resources very cautiously in
accordance with the development of needs of the country. The balanced
and proper allocation of the financial resources leads to the expansion of
the industrial sector. Therefore, it promotes the balances regional
development. All regions should be developed in the country.
v. Stability
The Capital Mark et provides a stable security prices in the stock
market. It tends to stabilise the value of stocks and securities. It reduces
the fluctuations in the prices to the minimum level. The process of
stabilisation is facilitated by providing funds to the borrow ers at a lower
interest rate. The speculative prices in the stock market can be reduced by
supply of funds. The flow of funds towards secondary market reduces the
prices at certain level. Therefore, the Capital Market provides funds to the
stock market at a low rate of interest.
vi. Advantages to the Investors
The investors who have surplus funds can invest in long -term
financial instruments. In Capital Market, a number of long -term financial
instruments are available to the investor at any time. Hence, th e investors
can lend their money in the Capital Market at reasonable rate of interest.
The Capital Market helps the investors in many ways. It is the coordinator
to bring the buyer and seller at one place and ensure the marketability of
investments. The st ock market prices are published in newspapers
everyday which enables the investor to keep track of their investments and
channelise them into most profitable way. The Capital Market safeguards
the interest of the investors by compensating from the stock ex change
compensating fund in case of fraud and default.
vii. Barometer
The development of the Capital Market is the indicator of the
development of a nation. The prosperity and wealth of a nation depends,
upon the dynamic capital market. It not only reflec ts the general condition
of the economy but also smoothens and accelerates the process of
economic growth. It consists a number of institutions, allocates the
resources rationally in accordance with the development needs of the
country. A good allocation o f resources leads to expansion of trade and
industry. It helps both public and private sector.
Generally, the corporate sector requires funds not only for meeting
their long -term requirements of funds for their new projects
modernisation, expansion and d iversification programmes but also for
covering their operational needs. Therefore, their requirement of capital is
classified as given below:
a. Long -term capital
b. Short -term capital
c. Venture capital
d. Export capitalmunotes.in

Page 27

27Long -term capital represents the amount of capital invested in the
form of fixed assets. Fixed assets are such as land, building, plant and
machinery necessary for every company at the initial stage of the
commencement of the production. Heavy amount of capital is required by
the companie s when they are going for modernisation or expansion or
diversification. Therefore, the requirement of long -term capital is supplied
by the capital market. This is also referred to as Fixed Capital. Usually the
corporate sector mobilises the fixed capital from the Capital Market
through various long -term maturity financial instruments. Therefore, it
provides adequate funds to the corporate sector by offering various
financial instruments. They mobilise the funds through issue of Equity
shares. Preference sh ares, debentures, bonds etc. These financial
instruments have a longer maturity period and they are treated by the
companies as permanent capital. Some instruments have no maturity until
the close down of a business unit.
Short -term capital represents t he amount of capital invested in
current assets. The Current Assets consist of cash, bank balances,
inventory, debtors etc. The short -term capital is required to meet the need
of working capital of the corporate sector. Working capital is required for
meet ing the operating cost of the business concern. They are required to
pay different amounts to different parties as per their schedule. Hence,
they procure the working capital from the commercial banks. In India a
majority of the corporate sector is funded by the banks through different
modes of finance. The working capital is known as circulating capital. An
adequate supply of working capital leads to smooth functioning of
production of goods. There are some other avenues available to the
corporate sector t o meet the needs of the working capital.
Venture capital is the capital which invested in highly risky
ventures. It is also known as seed capital. It is a quite recent entrant in the
capital market. It has great significance in helping technocrat
entrepre neurs at the commencement stage of the concern. It has technical
expertise. But it lacks finance.
Export capital refers for making payment in International Trade.
The payment of international trade involves in bills of exchange and other
instruments.
4.5PLAYERS I NTHE CAPITAL MARKET
Capital Market is a market for long -term funds. It requires a well -
structured market to enhance the financial capability of the country. The
market consists of a number of players. They are categorised as:
1. Companies
2. Financial Intermediaries
3. Investorsmunotes.in

Page 28

281. Companies
Generally every public company can access the capital market. The
companies which are in need of finance for their projects can approach the
market. The capital market provides funds from the savers of th e
community. The companies can mobilise the resources for their long -term
needs such as project cost, expansion and diversification of projects and
other expenditure items. In India, the companies should get the prior
permission from the SEBI (Securities E xchange Board of India) to raise
the capital from the market. The SEBI is the most powerful organisation to
monitor, control and guide the capital market. It classifies the companies
for the issue of share capital as new companies, existing, and unlisted
existing listed companies. According to its guidelines a company is a new
company, if it satisfies all the following conditions:
a.The company shall not have completed 12 months of commercial
operations.
b.Its audited operative results are not availab le.
c.The company may set -up by entrepreneurs with or without track
record.
A company can be treated as existing listed company, if its shares
are listed in any recognised stock exchange in India. A company is said to
be an existing listed company if it is a closely held or private company.
2. Financial Intermediaries
Financial intermediaries are those who assist in the process of
converting savings into capital formation in the country. A strong capital
formation process is the oxygen to the corporate sector. Therefore, the
intermediaries occupy a dominant role in the capital formation which
ultimately leads to the growth of prospering to the community. Their role
in this situation cannot be neglected. The government should encourage
these intermediarie s to build a strong financial empire for the country.
They can also be called as financial architectures of the Indian digital
economy. Their network cannot be ignored. Their financial capability
cannot be measured. They take active role in the capital mar ket. The major
intermediaries in the capital market are:
a.Brokers
b.Stock -brokers and sub -brokers
c.Merchant Bankers
d.Underwriters
e.Registrars
f.Mutual Funds
g.Collecting agents
h.Depositories
i.Agents
j.Advertising agenciesmunotes.in

Page 29

293. Investors
The capital market consists of many number of investors. All types
of investor's basic objectives are to get good returns on their investment.
Investment means, just parking one's idle fund in a right parking place for
a stipulated period of time . Every parked vehicle shall be taken away by
its owners from parking place after a specific period. The same process
may be applicable to the investment. Every fund owner may desire to take
away the fund after a specific period. Therefore, safety is the m ost
important factor while considering the investment proposal. The investors
comprise the financial and investment companies and the general public
companies. Usually, the individual savers are also treated as investors.
Return is the reward to the invest ors. Risk is the punishment to the
investors who wrongly made investment decision. Return is always chased
by the risk. An intelligent investor must always try to escape the risk and
capture the return. All rational investors prefer return, but most invest ors
are risk averse. They attempt to get maximum capital gain. The return can
be made available to the investors in two types and they are in the form of
revenue or capital appreciation. Some investors will prefer for revenue
receipt and others prefer capi tal appreciation. It depends upon their
economic status and the effect of tax implications. The institutions and
companies raise the resources from the market by designing various
schemes to meet the needs and convenience of the investors. They
schemes can be framed to attract all types of investors, who are selling in
the capital market. The main objective of any type of investor are safety,
profitability, liquidity and capital appreciation.
Distinction between Capital and Money Market
Money market is di fferent from Capital Market on the basis of the
following characteristics:
1.Period of time
2.Financial Instruments
3.Purpose of Loan
4.Risk
5.Market Regulation
6.Liquidity
7.Monitoring
8.Players
1. Period of time
The money market is a ma rket for lending and borrowing of the
short -term finance. The term short -term period refers to finance available
for one year or less to the borrowers. Generally the borrowers will procure
the fund for meeting their working capital requirements. Usually th e
working capital of the corporate sector is supplied by commercial banks
and players of the money market. The capital market is a market where the
long-term funds are available at reasonable rates of interest to the
borrowers. Usually the fixed capital of the corporate sector will be met by
the long -term nature of financial instruments. These financial instruments
are available in the capital market only. The fund will be supplied to themunotes.in

Page 30

30corporate sector by capital market for the purpose of project expansi on,
diversification and other needs.
2. Financial Instruments
The companies generally raise the fund from market by issuing a
number of financial instruments. The money market consists of short -term
financial instruments such as call money, CDs, Bills and collateral loans
etc. On the other hand, the main instruments are used in the capital market
for long -term basis. These financial instruments such as shares, debentures
and bonds are issued by the companies for their requirements.
3. Purpose of loans
Thecompanies enter the money market to meet the needs of their
short -term finance. The money market issues different types of financial
instruments for one year period to meet the needs of working capital. The
working capital arrangements will be adjusted by the money market while
the fixed capital by the capital market. The long -term needs of finance will
be adjusted by the capital market to the corporate sector.
4. Risk
Generally the financial markets involve some degree of risk. The
level of degree of r isk depends upon the nature of market. The money
market involves less risk level while the capital markets consist of higher
levels of risk. The money market maturity period is one year. On the other
hand, capital market caters to the long -term credit need s for the corporate
sector and arrangements will be made for fixed capital to but land or
machinery.
5. Market Regulation
In India, the market is closely observed by the prudential
authorities. It is necessary to regulate the market operations for better
functioning of the financial system. In the capital market the institutions
are not much regulated. The money market is regulated by RBI, SEBI and
Ministry of Finance.
6. Liquidity
Liquidity is the most important factor in the money market. The
role of mo ney market is creation of liquidity. The money market is a ready
market for its financial assets. The basic role of capital market is providing
funds to work on long -term basis. The financial instruments which are
available in the capital market are produc tive employment and generation
of assets in the economy. Asset formation is made by the capital market.
7. Monitoring
The money market is closely associated with the Central Bank of
the country. The Central Bank in India is RBI. The RBI is the supreme
authority in the money market. It is directly linked with the Central Bank
of India. But the capital market is regulated, observed and monitored by
the SEBI. The RBI has less control on capital market.munotes.in

Page 31

318. Players
The important players in the money market are Central Bank,
Acceptance house, Commercial Banks, non -banking financial institutions,
Bill brokers etc. But in capital market stock exchanges, insurance
companies, mortgage banks, non -banking institutions are important
players. The secondary market for money market is not active in India.
But the secondary market for capital market is very active. The investment
in money market is highest safety whereas the investment in capital
market is not so safe. The accessibility to money market by individual is
not possible but capital market provides easy accessibility to the
individuals.
4.6 THE GROWTH OF THE CAPITAL MARKET
The Indian financial system is both developed and integrated
today. Integration has been through a participatory approach in granting
loans as well as in saving schemes. The expansion in size and number of
59 institutions has led to a considerable degree of diversification and
increase in the types of financial instruments in the financial sector which
are wholly owned by the government. The development banks in the
Indian financial system have witnessed vast changes in the planning
periods. Now the development banks constitute the backbone of the Indian
Capital Market. The relevant of the development banks in the industrial
financial system is not merely qualitative, but they have overwhelming
qualitative dimensions in terms of their promotional and innovational
functions. The growth of the capital market is determined by the following
factors:
1.Economic Development
2.Rapid Industrialisa tion
3.Level of savings and investment of the household sector
4.Technological advances
5.Corporate performance
6.Regulatory framework
7.Participation of foreign institutional investors in the capital market
8.Development of financial services
9.Liquidity factors
10.Political stability
11.Globalisation
12.Financial Innovation
13.Economic and financial sector reforms
14.International developments
15.Agency costs
16.Emergence of financial intermediaries
17.Specialisation among in vestment managers
18.Incentives
19.Speed in acquiring, processing and acting upon information
20.NRIs investment.munotes.in

Page 32

324.7 COMPO NENTS OF THE CAPITAL MARKET
In a capital market, banks and financial institutions are the
important components. They act as catalysts in the economic development
of any country. These institutions mobilise financial savings from
household, corporate and other sectors of the economy and channelise the
into productive investments. They act as a Reservoir of resources of
Financia l Markets and form the backbone of the economic and financial
system. The Banking industry has undergone a sea change during the last
three decades. After the modernisation of banks, they not only lend for the
Social and Economic causes but also participat ed in the development
programmes of Central Government and State Government. The main
components of the capital market in India are:
1. New -issue Market (Public issues) (Primary Market)
2. Secondary Market (Stock Market) these topics will be covered in
forthcoming units. The Indian Capital Market is regulated by The
Securities and Exchange Board of India (SEBI).
4.8 STRUCTURE OF CAPITAL MARKET I NINDIA
The structure of the capital market has undergone vast changes in
recent years. The Indian capital mark et has transformed into a new
appearance over the last four and half decades. Now it comprises an
impressive network of financial institutions and financial instruments. The
market for already issued securities has become more sophisticated in
response to the different needs of the investors. The specialised financial
institutions were involved in providing long -term credit to the corporate
sector. Therefore, the premier financial institutions such as ICICI, IDBI,
UTI, LIC and GIC constitute the largest seg ment. A number of new
financial instruments and financial intermediaries have emerged in the
capital market, Usually the capital markets are classified in two ways:
1. On the basis of issuer.
2. On the basis of instruments.
On the basis of issuer the cap ital markets can be classified again
into two types
1. Corporate securities market.
2. Government securities market.
On the basis of financial instruments the capital markets are
classified into two kinds:
1. Equity Market
2. Debt Marketmunotes.in

Page 33

33Recently t here has been a substantial development of the Indian
Capital Market. It comprises various sub -markets. Equity market is more
popular in India. It refers to the market for equity shares of existing and
new companies. Every company shall approach the market for rising of
funds. The equity market can be divided into two categories:
1. Primary Market
2. Secondary Market.
Debt Market represents the market for long -term financial
instruments such as debentures, bonds etc.
4.9NATURE A NDC O NSTITUE NTS
The Cap ital Markets consist of a number of individuals and
institutions. The Government is also an important player in the capital
market. The players in the capital market channalise the supply and
demand for the long -term capital. The constituents of the capita lm a r k e t s
are, the stock exchange, commercial banks, cooperative banks, saving
banks, development banks, insurance companies, investment trusts and
companies etc.
4.10 I NDUSTRIAL SECURITIES
Industrial Securities Market
As the very name suggests, it is a market for industrial securities
namely:
1. Equity shares or ordinary shares
2. Preference Shares
3. Debentures or bonds. It is a market where industrial concerns raise their
capital or debt by issuing appropriate instruments.
It can be further divide d into two. They are:
a. Primary Market or New Issue Market
b. Secondary Market or Stock Exchange.
a. Primary Market
Primary Market is a market for new issues or new financial claims.
Hence, it is also called New Issue Market. The primary market deals wit h
these securities which are issued to the public for the first time. There are
three ways by which a company may raise capital in a primary market.
They are:
a. Public issue
b. Rights issue
c. Private Placementmunotes.in

Page 34

34The most common method of raising by new c ompanies is through
sale of securities to the public. It is called public issue. When an existing
company wants to raise additional capital, securities are first offered to the
existing shareholders on a pre -emptive basis. It is called rights issue.
Privat e placement is a way of selling securities privately to a small group
of investors.
b. Secondary Market
Secondary Market is a market for secondary sale of securities. In
other words, securities which have already passed through the new issue
market are tr aded in this market. Generally, such securities are quoted in
the Stock Exchange and it provides a continuous and regular market for
buying and selling of securities. This market consists of all stock
exchanges recognised by the Government of India. The st ock exchanges in
India are regulated under the Securities Contracts (Regulation) Act, 1956.
The Bombay Stock Exchange is the principal stock exchange in India
which sets the tone of the other stock markets.
SUMMARY
Capital Market is a market for long -term sources of finance to the
industrial and corporate sector.
Capital market deals with long -term funds. These funds are subject to
uncertainty and risk. It supplies long and medium term funds to the
corporate sector. It provides the mechanism for facilitating capital fund
transactions. It deals in ordinary shares, bond debentures and stocks
and securities of the government. In this market the funds flow will
come from savers. It converts financial assets into productive physical
assets. It provides incentives to savers in the form of interest or
dividend to the investors. It leads to capital formation.
Capital market plays a vital role in the development by mobilising the
savings to the needy corporate sector. In recent years there has been a
substa ntial growth in the Capital Market. The Capital Market involves
in various functions and significance.
Generally, the corporate sector requires funds not only for meeting
their long -term requirements of funds for their new projects
modernisation, expansion and diversification programmes but also for
covering their operational needs. Therefore, their requirement of
capital is classified as given below:
a. Long -term capital
b. Short -term capital
c. Venture capital
d. Export capital
Capital Market is a market for long -term funds. It requires a well -
structured market to enhance the financial capability of the country.
The market consists of a number of players. They are categorised as:
1. Companies
2. Financial Intermediaries
3. Investorsmunotes.in

Page 35

35The Indian financial sy stem is both developed and integrated today.
Integration has been through a participatory approach in granting loans
as well as in saving schemes. The expansion in size and number of 59
institutions has led to a considerable degree of diversification and
increase in the types of financial instruments in the financial sector
which are wholly owned by the government.
In a capital market, banks and financial institutions are the
important components. They act as catalysts in the economic development
of any c ountry. The main components of the capital market in India are:
1. New -issue Market (Public issues) (Primary Market)
2. Secondary Market (Stock Market) these topics will be covered in
forthcoming units. The Indian Capital Market is regulated by The
Securities and Exchange Board of India (SEBI).
The structure of the capital market has undergone vast changes in
recent years. The Indian capital market has transformed into a new
appearance over the last four and half decades. Now it comprises an
impressi ve network of financial institutions and financial instruments.
The Capital Markets consist of a number of individuals and
institutions. The Government is also an important player in the capital
market. The players in the capital market channalise the supp ly and
demand for the long -term capital. The constituents of the capital
markets are, the stock exchange, commercial banks, cooperative banks,
saving banks, development banks, insurance companies, investment
trusts and companies etc.
CHECK YOUR PROGRESS
1.Fill in the blanks with appropriate words:
a.Capital Market is a market for long -term finance to the -------------------
-and----------------- sectors. (Industrial, banking, retailing, corporate)
b.Capital market supplies ----------------- and------------ terms funds to
the corporates. (long, short, medium, very -long)
c.The role of money market is creation of ------------------- (liquidity,
time deposits, term deposits, foreign exchange).
d.Long -term capital represents the amount of capital in vested in the form
of---------------- . (fixed assets, immovable assets, movable assets,
money markets)
e.Short -term capital represents the amount of capital invested in ----------
-assets. (fixed, current, movable, immovable)
2.Answer in one sentence :
1.What is Capital Market?
2.What is venture Capital?
3.What is Export Capital?
4.What is meant by primary market?munotes.in

Page 36

365.What is meant by secondary market?
6.What is the role of industrial securities market?
3.Answer briefly:
1.Explain the functions of Capital Market.
2.Who are the players in Capital Market?
3.Explain the structure of Capital Market.
4.Comment on the components of capital market.
5.Write explanatory note on industrial securities market.
PRIMARY MARKET
1INTRODUCTIO N
Capital market consists of primary and secondary market. Primary
market is that part of the capital market that deals with the issuance of new
securities. Primary market is otherwise called as New Issue Market (NIM).
In the primary market the securities are purchased directly from the issuer.
This is the market for new long -term or permanent capital. In other words,
the money raised from the primary market provides long -term capital to
the companies.
Primary market is a market which accelerates the process of capital
formation in a country’s economy. Primary market provides opportunity to
corporates and the government to raise resources to meet their investment
requirements and to discharge their obligations. The companies use these
funds either for setting up of new businesses or to expand the existing
ones. At the same time, the funds collected through the primary capital
market, are also used for modernisation of business. The securities are
issued in the primary market either at face value, or at a discount or
premium. Companies will issue the securities either in domestic market or
in the international market through American Depository Receipt (ADR)
or Global Depository Receipt (GDR) or External Commercial Borrowings
(ECB) route.
2C H A R A C T E R I S T I CS OF PRIMARY MARKET
Primary capital markets are those security markets where the
equity and debt securities of corporations are offered to the investors for
the first time. Important features of primary market are the following:
1.Primary market is the ma rket for new long term capital.
2.In a primary market, the securities are issued for the first time by the
company to investors.
3.In primary market securities are issued by the company directly to the
investors.
4.In primary market the company receives the mone y and issues new
security certificates to the investors.munotes.in

Page 37

375.In primary market it is difficult to accurately gauge the investor
demand for a new security until several days of trading have occurred.
6.Primary market dost not include certain other sources of new long-term
external finance, such as loans from commercial banks and other
financial institutions.
7.Primary issues are used by companies for setting up new business for
expanding or modernising the existing business or for providing
permanent working capital .
8.The primary market performs the crucial function of facilitating capital
formation in the economy.
3K INDS OF ISSUES
There are different ways for offering new issues in the primary
capital market. Primary issues made by Indian Companies can be
classifi ed as follows:
a.Public Issue
b.Rights Issue
c.Bonus Issue
d.Private Placement.
Public and rights issues involve a detailed procedure whereas
private placements or preferential issues and bonus issues are relatively
simple.
a. Public Issue
This is one of the important and commonly used methods for
issuing new issues in the primary capital market. When an existing
company offers its shares in the primary market, it is called public issue. It
involves direct sale of securities to the public for a fixed price. In this kind
of issue, securities are offered to the new investors for becoming part of
shareholders’ family of the issuer. If everybody can subscribe to the
securities issued by a company, such an issue is termed as a public issue.
In terms of the Companies Act of 1956, an issue becomes public if it is
allotted to more than 50 persons. SEBI defined public issue as “an
invitation by a company to public to subscribe to the securities offered
through a prospectus.” Public issue can be further classified into tw o:
1. Initial Public Offer (IPO)
2. Further Public Offer (FPO)
1.Initial Public Offer (IPO)
An IPO is referred simply an offering or flotation of issue of shares
to the public for the first time. Initial Public Offer is the selling of
securities to the public in the primary market. When an unlisted company
makes either a fresh issue of securities or offers its existing securities for
sale or both for the first time to the public, it is called an Initial Public
Offer (IPO).munotes.in

Page 38

38The sale of securities can either be thr ough book building or
through normal public issue. IPOs are made by companies going through a
transitory growth period or by privately owned companies looking to
become publicly traded. IPO paves the way for listing and trading of the
issuer’s securities i n the stock exchanges. Initial Public Offering can be a
risky investment. For the individual investor, it is tough to predict the
value of the shares on its initial day of trading and in the near future since
there is often little historical data with whic h to analyse the company.
2.Further Public Offer (FPO)
When an already listed company makes either a fresh issue of
securities to the public or an offer for sale to the public it is called FPO is
otherwise called as Follow on Offer.
3.DIFFERE NCES BETWEE NIPOANDF P O
Often Initial Public Offer (IPO) and Further Public Offer (FPO) are
used interchangeably. When the company offers its shares to the investors
for the first time it is called initial public offering (IPO). At the time of
IPO the companies’ shares a re not listed on any stock exchange. When an
existing company subsequently issue more new shares in the primary
market, it is called Further Public Issue (FPO) and is not considered to be
an IPO.
b. Rights Issue
When a listed company which proposes to iss ue fresh securities to
its existing shareholders existing as on a particular dated fixed by the
issuer (i.e. record date), it is called as right issue. The rights are offered in
a particular ration to the number of securities held as on the record date.
The route is best suited for companies who would like to raise capital
without diluting stake of its existing shareholders.
c. Bonus Issue
When an issuer makes an issue of shares to its existing
shareholders as on a record date, without any consideration fr om them, it
is called a bonus issue. The shares are issued to the existing shareholders
out of company’s free reserves or share premium account in a particular
ratio to the number of securities held on a record date.
d. Private Placement
When a company of fers its shares to t select group of persons not
exceeding 49, and which is neither a rights issue nor a public issue, it is
called a private placement. Often a combination of public issue and private
placement can be used by the companies for the issue of securities in the
primary market. Privately placed securities are often not publicly tradable
and may only be bought and sold by sophisticated qualified investors. As a
result, the secondary market is not liquid as in the case of a private issue.
There ar e SEBI guidelines, which regulate the private placement of
securities by a company.munotes.in

Page 39

39Private placement is the fastest way for a company to raise equity
capital. Private placement can be of two types viz., preferential allotment
and qualified institutional placement.
4P R I NCIPAL STEPS OF A PUBLIC ISSUE
The new shares/debentures may be offered either directly to the
public through a prospectus or indirectly through an offer for sale
involving financial intermediaries or issuing houses.
1.Draft Prospectus
2.Fulfilment of Entry norms (EN)
3.Appointment of underwriters
4.Appointment of Bankers
5.Initiating allotment procedure
6.Brokers to the issue
7.Filing Documents
8.Printing of prospectus and application forms
9.Listing the issue
10.Publication in news papers
11.Allotment of sh ares
12.Underwriters Liability
13.Operational Listing.
5R E A S O NSF O RL I S T I NGINIPO
The following are the reasons for listing in IPO:
1.When a company lists its shares on a public exchange, it will almost
invariably look to issue additional new shares in order t o raise extra capital
at the same time. The money paid by investors for newly -issued shares
goes directly to the company (in contrast to a later trade of shares on the
exchange, where the money passes between investors).
2.An IPO, permits a company to tap a wide pool of stock market
investors to provide it with large volumes of capital for future growth. The
company is never required to repay the capital, but instead the new
shareholders have a right to future profits distributed by the company and
the right to a capital distribution in case of dissolution.
3.The existing shareholders will see their shareholdings diluted as a
proportion of the company’s shares. However, they hope that the capital
investment will make their shareholdings more valuable in absolut et e r m s .
4.Once a company is listed, it will be able to issue further shares via a
rights issue, thereby again providing itself with capital for expansion
without incurring any debt. This regular ability to raise large amounts of
capital from the general ma rket, rather than having to seek and negotiate
with individual investors, is a key incentive for many companies seeking
to list.munotes.in

Page 40

40Advantages Of IPO
IPO has a number of advantages. IPO helps the company to create
a public awareness about the company as these public offerings generate
publicity by inducing their products to various investors.
1.Increase in the capital: An IPO allows a company to raise funds for
utilising in various corporate operational purposes like acquisitions,
mergers, working capital, rese arch and development, expanding plant and
equipment and marketing.
2.Liquidity: The shares once traded have an assigned market value and
can be resold. This is extremely helpful as the company provides the
employees with stock incentive packages and the inve stors are provided
with the option of trading their shares for a price.
3.Valuation: The public trading of the shares determines a value for the
company and sets a standard. This works in favour of the company as it is
helpful in case the company is looking for acquisition or merger. It also
provides the shareholders of the company with the present value of the
shares.
4.Increased Wealth: The founders of the companies have an affinity
towards IPO as it can increase the wealth of the company, without
dividing th e authority as in case of partnership.
Disadvantages Of IPO
It is true that IPO raises huge capital for the issuing company. But,
in order to launch an Initial Public Offering (IPO), it is also necessary to
make certain investments. Drawbacks of IPO can b e explained as follows:
1.Setting up an IPO does not always lead to an improvement in the
economic performance of the company. A continuing expenditure has to
be incurred after the setting up of an IPO by the parent company. A lot of
expenses have to be inc urred in the form of legal fees, printing costs and
accounting fees, which are connected to the registering of an IPO. Such
expenses might cost hundreds of US dollars. Apart from such enormous
costs, there are other factors as well that should be taken int o
consideration by the company while introducing IPO.
2.Rules and regulations involved to set up public offerings and this entire
process, on the other hand, involve a number of complexities which
sometimes require the services of experts in relevant fields.
3.Some companies hire experts to do the needful to ensure a hassle -free
execution of the task. After the IPO is introduced, the expenses become a
routine in every activity involved. Besides, the CEO of the company
would have to spend a lot of time in handli ng the SEC regulations or
sometimes he hires experts to do the same. All these aspects, if not
handled with efficiency, prove to be some major drawbacks related to the
launch of IPOs.
4.Other disadvantages involve the public company’s loss of
confidentiality , flexibility, and control. SEC regulations require publicmunotes.in

Page 41

41companies to relate all operating details to the public, including sensitive
information about their markets, profit margins, and future plans.
6B O O KB U I L D I NG
Book building is a process of price discovery mechanism used by
corporates issuing securities. It is a mechanism used to discover the price
of their securities. Book building is a common practice in developed
countries and has recently been making inroads into emerging market as
well, includ ing India. As per the recommendations of Malegan
Committee, SEBI introduced the option of book building in public issue in
October, 1995. The option of book building was initially available only to
those companies when their proposed public issue exceeded Rs. 100 crore.
With effect from November 1996, the minimum size of the issue has been
removed and any company can make a public issue through the book
building process. However, issue of securities to the public through a
prospectus for 100 percent book bu ilding process shall be available to a
company only if their issue of capital shall be Rs. 25 crore and above.
Book building is a price discovery mechanism based on the bids
received at various prices from the investors, for which demand is
assessed and t hen the prices of the securities are discovered. In the case of
normal public issue, the price is known in advance to the investors and the
demand is known at the close of the issue. In case of public issue through
book building, demand can be known at the end of everyday but price is
known only at the close of the issue. Book building works on the
assumption that the underwriting syndicate estimates demand and takes
the allocation on their books, before the sale to investor who is a retail
one.
Definition
Securities and Exchange Board of India defined Book Building as
“a process undertaken prior to filing of prospectus with the Registrar of
Companies by which a demand for the securities proposed to be issued by
a body corporate is elicited and built up and the price for which such
securities is assessed for the determination of the quantum of such
securities to be issued by means of a notice, circular, advertisement,
document or information memoranda or offer document.” The objective of
book building is to find the highest market clearing price.”
The issuer company shall have an option of either reserving the
securities for firm allotment or issuing the securities through book
building process. The issue of securities through book building process
shall be separately identified as “placement portion category” in the
prospectus. The securities available to the public shall be separately
identified as “net offer to the public”. The issuer proposing to issue capital
through book building process has two opti ons, viz 75 percent book
building route and 100 percent book building route.
In case of 100 percent book building route adoption not more than
60 per cent of net offer to public can be allocated to qualified institutionalmunotes.in

Page 42

42buyers, not less than 15 percent of the net offer to the public can be
allocated to no -institutional investors applying for more than 1000 shares
and not less than 25 per cent of the net offer to public can be allocated to
retail investors applying for up to 1, 000 shares.
In case of 75 per cent of net public offer is made through book
building, not more than 60 percent of net offer can be allocated to
qualified institutional buyers and not less than 15 percent of the net offer
can be allocated to non -institutional investors. The balance 25 percent of
the net offer to public, offered at a price determined through book
building, are available to retail individual investors who have not received
any allocation in the book built portion. The book built portion, either 100
percent or 75 per ce nt, the requirement of minimum of 25 per cent of the
securities to be offered to the public shall be applicable.
7P R O C E D U R EI NBOOK BUILDI NGP R O C E S S
1.Book Building is a process of price discovery mechanism for issue of
new securities.
2.For book building the issuer company shall appoint an eligible
merchant banker or bankers as book runner/s and their names shall be
mentioned in the draft prospectus.
3.The lead merchant banker shall act as the lead book runner and the
other eligible merchant bankers so appoi nted by the issuer shall be
termed as co -book runners.
4.The primary responsibility for building the book is with the lead book
runner.
5.In case of appointment of more than one lead merchant banker or
book runners to the issue, the responsibilities of each of them should
be allocated and stated clearly.
6.In book building the entire offer other than promoter’s contribution,
reservation for permanent employees of the issuer company and
shareholders of the promoting companies should be fully
underwritten by the syndicate members or book runners.
7.The syndicate members shall enter into an underwriting agreement
with the book runners indicating the number of securities, which they
would subscribe at the predetermined price.
8.The book runner/s shall in turn enter int o an underwriting agreement
with the issuer company. In the event of syndicate members, not
fulfilling their underwriting obligations the book runner/s shall be
responsible for bringing in the amount devolved.
9.The draft prospectus has to be filed by the le ad merchant banker to
the SEBI containing all the information as per the existing guidelines,
except the information regarding the price at which the securities are
offered.
10.SEBI within 21 days of the receipt of the draft prospectus may
suggest modificati ons to it.munotes.in

Page 43

4311.The lead merchant banker shall be responsible for incorporating the
modifications and changes in the prospectus as suggested by the
SEBI.
12.The copy of the draft prospectus filed with the SEBI may be
circulated by the book runner to the instituti onal buyers who are
eligible for firm allotment and to the intermediaries eligible to act as
underwriters inviting offers for subscription to the securities.
13.However, the draft prospectus circulated to the institutional buyers
and eligible underwriters sha ll contain the price band within which
the securities are being offered for subscription.
14.Book building is used in IPO for efficient price discovery, wherein
when the offer is open, bids are collected from investors at various
prices, which are above or eq ual to the floor price.
15.Hence, the red herring prospectus does not contain a fixed price.
16.Instead, the red herring prospectus contains either the floor price of
the securities offered through it or a price band along with the range
within which bids can m ove.
17.The spread between the floor and the cap of the price band should not
be more than 20 percent. In simple words, the cap should not be more
than 120 percent of the floor price.
18.In book building process the issuer company can have an option for
revision of the price band.
19.But such a revision in the price band shall be widely disseminated by
informing the stock exchanges, by issuing press release and also
indicating the change on the relevant website and the terminals of the
syndicate members.
20.In case o f the price band is revised, the bidding period shall be
extended for a further period of 3 days subject to the total bidding
period does not exceed 13 days.
21.The issuer company after receiving the final observations if any, on
the offer document from the B oard should make an advertisement in
an English national daily with a wide circulation, one Hindi national
newspaper and a regional language newspaper with wide circulation
at the place where the registered office of the issuer company is
situated.munotes.in

Page 44

44Book Building Procedure
Steps In Book Building Procedure
1.SEBI as regulatory authorities does not play any role in fixing the
price for issue of securities.
2.It is up to the company to decide on the price or the price band, in
consultation with merchant bankers.
3.The basis of issue price is disclosed in the offer document.
4.The issuer is required to be disclosed in detail abo ut the qualitative
and quantitative factors justifying the price.
5.One day prior to the opening of the issue to the public, the book
runner shall collect from the institutional buyers and the underwriters
the application forms along with the application mon ey to the extent
of the securities proposed to be allotted to them.
6.The book runners shall have an option of demanding the underwriters
to the net offer to the public to pay in advance all money required to
be paid in respect of their underwriting commitm ent.
7.The number of bidding centres shall not be less than the number of
mandatory collection centres specified in the guidelines of the SEBI.
8.The norms which are applicable for collection centres shall be
applicable for the bidding centres also.
9.Only electronic bidding is permitted and bids are submitted through
syndicate members.
10.An electronically linked transparent facility is used for bidding.
11.Individual as well as institutional investors shall place their bids only
through the syndicate membe rs shall be present at the bidding centres
so that the at least one electronically linked computer terminal at the
bidding centres is available for the purpose of bidding.Underwriters/MerchantIssuerBook Runner
(Lead Manager)
Mutual FundsStock Brokersmunotes.in

Page 45

4512.Bidding demand is displayed graphically on the terminals at the end
of every day.
13.The lead manager analyses the demand generated and determines the
issue price in consultation with the issuer.
14.The retail investors have the option of bidding at cut -off.
15.During the fixed period of time for which the subscription is open, the
book runner co llects bids from investors at various prices, between
the floor price and the cap price.
16.The process aims at tapping both wholesale and retail investors.
17.The final issue price is not determined until the end of the process
when the book has closed.
18.There w ill be a standard bidding form to ensure uniformity and
accuracy in bidding.
19.The bidding form shall contain information about the investor, the
price and the number of securities that the investors wish to bid.
20.The investor can change or revise the quanti ty or price in the bid
using the form for revising the bid that is available along with the
application form.
21.However, the entire process of changing of revising the bids shall be
completed within the date of closure of the issue.
22.The bids remain open for at least 5 days.
23.After the close of the book building period, the book runner evaluates
the collected bids and the cut -off price is arrived at on the lines of
Dutch auction.
24.If demand is high enough, the book can be oversubscribed.
25.In these cases the green shoe option is triggered.
26.The mandatory requirement of 90 percent subscription should not be
considered with strictness, but the prospectus should disclose the
amount of minimum subscription required and sources for meeting
the shortfall.
27.In the case of b ook built issues, the basis of allotment is finalised by
the book running lead managers within 2 weeks from the date of
closure of the issue.
28.The investor is entitled to receive conformity allotment note in case
the investor has been allotted shares within 15 days from the date of
closure of a book built issue.
29.The registrar then ensures the demat credit or refund as applicable is
completed within 15 days of the closure of the issue.
30.The issuer company may pay interest on the application money till the
date of allotment or the deemed date of allotment provided the
payment of interest is uniformly given to all the applicants.munotes.in

Page 46

4631.On determination of the issue price within 2 days, the final prospectus
containing all disclosures as per the SEBI guidelines including the
price and the number of securities proposed to be issued shall be filed
with the Registrar of Companies, thus completing the issue process.
32.The listing on the stock exchanges is done within 7 days from the
finalisation of the issue.
Nominate Book Runner
Form Syndicate of Brokers, Arrangers, Underwriters, Financial
Institutions etc.
Submit Draft Offer Document to SEBI without mentioning coupon Rate or
Price
Circul ate Offer Document Among the Syndicate Members
Ask for bids on Price and Quality of Securities
Aggregate and Forward all Offers to Book Runner
Rn the Book to maintain record of subscribers and their orders
Consult with Issuer and determine the issue price as a Weighted Average
of the Offers Received
Firm up underwriting commitments
Allot Securities among Syndicate Members
Securities issued and listed
Trading commences on Exchanges
Advantages Of Book Building
Book buildi ng process has certain advantages to the company
when compared to the fixed price method of issue of securities. Important
advantages of book building process are of the following:
1.Book building process is more flexible than fixed price method of
issue. In book building process the issuer company may be given the
flexibility to revise the price band during the bidding period.
2.In book building process, book runners and the issuer company have
the freedom to determine the issue size based on the demand in the
market.
3.Public issue carries the risk of failure, if it does not receive a 90
percent minimum subscription. In book building, these risks can be
avoided because the issuer can withdraw from the market, if the
demand for the security does not exist.munotes.in

Page 47

474.Book b uilding has made the primary issuance process comparatively
faster by reducing the delay in issue process. In book building
allotment for the placement portion can be made on the second day
from the closure of the issue. The public offer portion of the off er
could be launched simultaneously and listing on the stock exchanges
can be done within 7 days from the finalisation of the issue.
5.Book building process is comparatively cost effective than fixed price
method of issue.
6.Book building process eliminates re funds except in case of direct
applications.
8M A I NDIFFERE NES BETWEE NNORMAL IPO A NDB O O K
BUILDI NG
Price at which securities will be allotted is not known in case of
offer of shares through Book Building while in case of offer of shares
through normal pu blic issue, price is known in advance to investor. Under
Book Building, investors bid for shares at the floor price or above and
after the closure of the book building process the price is determined for
allotment of shares.
In case of Book Building, the demand can be known everyday as
the book is being built. But in case of the public issue the demand is
known at the close of the issue.
9.ROLE OF MERCHA NTB A NKERS I NFIXI NGT H EP R I C E
Indian Primary Market ushered in an era of free pricing in 1992.
SEBI d oes not play any role or fix any formula for price fixation. As per
SEBI guidelines (1992) companies which are eligible to make public have
the freedom to price their equity shares or any security convertible into
equity at a later date. Pricing is done by companies themselves, in
consultation with the lead merchant bankers. For fixing the price of a
share the merchant bankers consider the following factors viz., earnings
per share, book value, average market price for two or three years, future
prospects o f the company, market conditions etc. Premium on share has to
be determined after taking into consideration the net asset value, profit -
earning capacity of the company, market price etc. Justification of price
including premium has to be stated in the pros pectus.
In the case of public issue of equity shares, following types of
companies have the freedom to price their issue:
1.A listed company whose equity shares are listed on a stock exchange,
may freely price its equity shares and any security convertible into
equity at a later date, offered through a public or rights issue.
2.An unlisted company eligible to make a public issue and desirous of
getting its securities listed on a recognised stock exchange pursuant to
a public issue, may freely price its equity shares or any securities
convertible at a later date into equity shares.munotes.in

Page 48

483.An eligible infrastructure company shall be free t o price its equity
shares subject to compliance with the disclosure norms as specified
periodically by SEBI.
4.The public and private sector banks can freely price their issue of
equity shares or any securities convertible at a later date into equity
shares subject to the approval of RBI.
10 TYPES OF PRICI NG
There are two types of pricing of issues:
a.Fixed Price: In this case the issuer is allowed to freely price the issue.
Where the company and the lead merchant banker fix a price for its issue,
it is called fixed price. The issuer company can mention a price band of 20
percent (cap in the price band and should not be more than 20 percent of
the floor price) in the offer documents filed with the SEBI and actual price
can be determined at a later date before f iling of the offer document with
the Registrar of Companies.
If the Board of Directors has been authorised to determine the offer
price within a specified price band such price would be determined by a
Resolution to be passed in the meeting by the Board o f Directors. In the
case of listed companies the Merchant Bankers should ensure that 48
hours -notice of meeting of the Board of Directors for passing a resolution
for determination of price is given to the Designated Stock Exchange.
In case of a public is sue by a listed company, issue price or price
band may not be disclosed in the draft prospectus filed with the Board. In
case of a rights issue, issue price or price band may not be disclosed in the
draft letter of offer filed with the Board. The issue pri ce may be
determined at any time before fixation of the record date, in consultation
with the Designated Stock Exchange. The final offer document should
contain only one set of financial projections, if applicable.
b.Floor Price: Where the company and the l ead merchant banker
stipulate a floor price or a price band and leave it to market forces to
determine the final price is called floor price. It is otherwise called the
price discovery through book building process. This method provides an
opportunity to t he market to discover price for securities.
c.Differential Pricing: Any listed or unlisted company making a publ ic
issue of equity shares or any securities convertible at a later date into
equity shares, may issue such securities to applicants in the firm allotment
category at a price higher than the price at which securities are offered to
the public A listed compa ny making a composite issue of capital may
issue securities at different prices in its public and rights issue.
11 FIXI NGO FF A C EV A L U EO FS H A R E SF O RP U B L I C
ISSUE/RIGHTS ISSUE
An eligible company is free to make public or rights issue in any
denomination determined by it in accordance with sub -Section 4 ofmunotes.in

Page 49

49Section 13 of the Companies Act 1956 and in compliance with the norms
as specified by SEBI.
In case of Initial Public Offerings by unlisted company, if the issue
price is Rs. 500 or more, the issuer com pany shall have the discretion to
fix the face value at Rs. 10 per share, subject to the condition that the face
value shall in no case be less than Rs. 1 per share. However, in case the
issue price is less than Rs. 500 per share, the face value shall be R s. 10 per
share. However, a company is not allowed to issue shares in the
denomination of decimal of a rupee.
The companies which have already issued shares in the
denomination of Rs. 100 or Rs. 10 may change the standard denomination
of the shares by spl itting or consolidating the existing shares. The
denomination of the existing shares shall not be altered to a denomination
of decimal of a rupee. The company seeking to change the standard
denomination may do so only after amending the Memorandum and
Articles of Association, if desired.
Issue Of Shares At A Premium
Shares are generally issued by a company to the public at 1) face
value or at 2) premium or at 3) discount. When shares are issued to the
public, at a price higher than the face value, it is ca lled issue of shares at a
premium. The difference between the offer price and the face value is
called the premium. Share premium is a capital profit for the company and
the amount so earned has to be credited to a separate account called share
premium acc ount. There are no restrictions on issue of shares at a
premium and the power to issue shares at a premium need not be taken in
the Articles of Association. However, there are restrictions on the ways
share premium can be utilised.
As per the SEBI guideli nes, new companies can issue shares to the
public at a premium only if the following conditions are satisfied:
1.The promoter company has a 3 year record of consistent profitable
working.
2.The promoter takes up atleast 50 percent of the shares in the issue.
3.All parties applying for the issue should be offered the same
instrument at the same terms, especially the premium.
4.The prospectus should provide justification for the proposed premium.
On the other hand, existing companies can make a premium issue
withou t the above restrictions.
Issue Of Shares At A Discount
When shares are issued by a company to the public at a price lower
than the face value it is called issue of shares at a discount. In order to
issue shares at a discount, a company has to fulfil all the conditions laidmunotes.in

Page 50

50down in Section 79 of the Indian Companies Act of 1956. The conditions
are as follows:
1.The issue of shares at a discount must be authorised by a resolution
passed by the company in a general meeting and sanctioned by the
Company Law Boa rd.
2.The shares to be issued at a discount must be of a class already issued.
3.The maximum rate of discount shall not exceed 10 per cent. However,
a higher discount may be allowed by the Company Law Board under
special circumstances.
4.At the time of issue of shares at a discount, the company must have
been working for at least a year from the date it was entitled to
commence business.
5.The shares to be issued at a discount must be issued within two months
after the date on which the issue is sanctioned by Compa ny Law
Board.
After a company has issued shares at a discount, every subsequent
prospectus for further issue of shares must contain particulars of the
discount allowed on the issue of shares or of so much of that discount as
has not been written off by th e date of the issue of prospectus.
12 REDHERRI NGP R O S P E C T U S
Ar e d -herring prospectus is a preliminary prospectus. It is given to
prospective purchasers during the 20 -day waiting period between the
filing date of the registration statement and the effectiv ed a t e .T h er e d -
herring does not contain information such as the public offering price or
the underwriter’s spread.
According to Companies Act, 1956, “A prospectus which does not
have complete particulars on the price of securities offered and the
quantum of securities offered is known as red -herring prospectus.” Such a
prospectus is issued where a company offers its securities through the
‘book -building mode’.
The purpose of issuing a red -herring prospectus is to acquaint
potential investors with essential facts concerning the issue. A red -herring
prospectus summarises many of the important details contained in the
registration statement. It can never be used to solicit orders, only
indications of interest. These indications of interest not binding
commitments –they are not binding on the broker/dealer or the customer.
A Registered Representative (RR) is not allowed to write comments or
statements on a red -herring (preliminary) prospectus or mean it in anyway.
Unless an exemption applies, it is unl awful for any person to use the mails
or any other instrument of inter -state commerce to offer a security for sale
unless a registration statement has become effective. Therefore, a security
can be offered for sale only after a registration statement is ef fective.
According to sub -sections (2), (3) and (4) of Section 60B of the
Companies Act, 1956, “A prospectus which does not have completemunotes.in

Page 51

51particulars on the price of securities offered and the quantum of securities
offered is known as red -herring prospect us.” Such a prospectus is issued
where a company offers it securities through the ‘book -building mode’.
To summarise, during the period between the filing date and
effective date of the registration statement:
1.No sales of the security may take place.
2.Offers of the security mat take place, but a written offer may be made
only through a preliminary prospectus or red -herring prospectus
(tombstone advertising is permitted during the period).
3.Brokers may answer unsolicited requests for information by sending
out a preliminary prospectus and accept unsolicited orders for the
security.
4.Brokers cannot send out the company’s research report or any report
projecting the company’s future sales and earnings.
Features Of Red -Herring Prospectus
The features of red -herri ng prospectus are as follows:
1.Filing: Red -herring prospectus shall be filed with RoC at least 3 days
before the opening of the offer. A copy of this prospectus must also be
filed with the SEBI.
2.Obligations: It carries the same obligations and liabilities a sa r e
applicable to an ordinary prospectus.
3.Contents: It must contain all the details as required in Schedule II of
the Companies Act.
4.Signature: It must be signed by all the directors of the company or their
constituted attorneys.
SUMMARY
Capital market consists of primary and secondary market. Primary
market is that part of the capital market that deals with the issuance of
new securities. Primary market is otherwise called as New Issue
Market (NIM). In the primary market the securities are purchased
directly from the issuer. This is the market for new long -term or
permanent capital. In other words, the money raised from the primary
market provides long -term capital to the companies.
There are different ways for offering new issues in the primary capital
market. Primary issues made by Indian Companies can be classified as
follows:
a. Public Issue
b. Rights Issue
c. Bonus Issue
d. Private Placement.
Book building is a process of price discovery mechanism used by
corporates issuing securities. It is a mechan ism used to discover the
price of their securities. Book building is a common practice inmunotes.in

Page 52

52developed countries and has recently been making inroads into
emerging market as well, including India.
Price at which securities will be allotted is not known in cas eo fo f f e r
of shares through Book Building while in case of offer of shares
through normal public issue, price is known in advance to investor.
Under Book Building, investors bid for shares at the floor price or
above and after the closure of the book buil ding process the price is
determined for allotment of shares.
Indian Primary Market ushered in an era of free pricing in 1992. SEBI
does not play any role or fix any formula for price fixation. As per
SEBI guidelines (1992) companies which are eligible to make public
have the freedom to price their equity shares or any security
convertible into equity at a later date. Pricing is done by companies
themselves, in consultation with the lead merchant bankers. For fixing
the price of a share the merchant bankers consider the following
factors viz., earnings per share, book value, average market price for
two or three years, future prospects of the company, market conditions
etc. Premium on share has to be determined after taking into
consideration the net asset v alue, profit -earning capacity of the
company, market price etc. Justification of price including premium
has to be stated in the prospectus.
An eligible company is free to make public or rights issue in any
denomination determined by it in accordance with sub-Section 4 of
Section 13 of the Companies Act 1956 and in compliance with the
norms as specified by SEBI.
Ar e d -herring prospectus is a preliminary prospectus. It is given to
prospective purchasers during the 20 -day waiting period between the
filing dat e of the registration statement and the effective date. The red -
herring does not contain information such as the public offering price
or the underwriter’s spread.
QUESTIO NS
1.What is the meaning of private placement?
2.Define the term public issue.
3.What is Red herring Prospectus?
4.Define the terms Rights Issue.
5.State the advantages of book -building.
6.What is primary market? Explain the features of primary market.
munotes.in

Page 53

535
SECO NDARY MARKET
Unit Structure
5.1 Introduction
5.2 Meaning and Definition
5.3 Need for Secondary Market
5.4 Role of Secondary Market
5.5 Distinction between Primary Market and Secondary Market
5.6 Parts of the Secondary Market
5.7 Instruments of Secondary Market
5.8 Summary
5.9 Questions
5.1 INTRODUCTIO N
All securities are first created in the primary market and then they
enter into the secondary market. Thus securities generally have two stages
of their life span. The first is the stage when the company issues them in
the market and makes them available f or the general public from its
treasury at a predetermined offer price. This is known as the primary
market offer or Initial Public Offer (IPO). In their second stage of life
securities, the securities are traded further after being initially offered to
public. Thus the Big Brokers and / or investment dealers frequently buy
initial offer on the primary market and resell securities in secondary
market. Secondary market is the base upon which primary market rests.
Most of the trading is done in secondary mark et. This kind of trading deals
with previously issued instruments and needs essentially an organised
market. Examples can be New York Stock Exchange, NASDAQ, Bombay
Stock Exchange (BSE), National Stock Exchange (NSE), bond market etc.
5.2 MEA NINGAND DEFI NITIO N
Secondary Market, also known as the aftermarket, is the place
where goods which are already used by someone are sold and/or bought.
Thus we can define secondary market as "the financial market where
previously issued securities and financial instru ments such as stocks,
bonds, futures and options are manoeuvred from one investor into
another." Secondary market primarily deals with used products or an
alternative use of an existing product or assets where the customer base is
the second market. For ex ample, rice is primarily known as food item so
the food market is the first or primary market for rice. Broken rice is themunotes.in

Page 54

54by-product in rice mills and is used for producing liquid glucose. About
90% of liquid glucose produced in India is used in confectio nary industry.
Thus it can be said that confectionary industry is the secondary market for
rice which is in the form of liquid glucose.
5.3NEED FOR SECO NDARY MARKET
Two basic needs of the investors can be proposed:
1.Need for buying and selling of exi sting securities
Investors who are able to gather some information about a
particular security from the market or from some other sources tend to
believe that they have superior information than other market players.
They develop this misconception that th e security is not correctly priced
by the market.
If the information is good, this suggests that security is currently
underpriced and investors who have access to such information will want
to buy the security. On the other hand, if the information is bad, the
security will be currently over priced and such investors will want to sell
their securities in the market as soon as possible.
2.Need for liquidity
Investors who are motivated by the liquidity factor, t ransact in the
secondary market in order to come out of the position of either excess
liquidity or insufficient liquidity. Investors who are having surplus funds
(e.g. due to ancestral property or some other reason) will buy securities,
and investors who a re having dearth of funds (e.g. desire to purchase land)
will sell securities in the market.
5.4 ROLE OF SECO NDARY MARKET
1. Facilitate liquidity
Secondary Market helps to create sufficient liquidity and
marketability of outstanding debt and equity instr uments. They help to
connect investors desire for liquidity with the capital users' wish of using
their capital for a longer period of time. For example in a traditional
partnership, a partner cannot access the other partner's investment but only
his or he r investment in that partnership, even on emergency basis. Then if
he or she may break the ownership of equity into parts and sells his or her
respective proportion to another investor. This kind of trading is facilitated
only by secondary market.
2. Help s in Capital Formation
Secondary Market contributes to economic growth by proper
allocation of funds towards most efficient channel through process of
disinvestment to reinvestment. Secondary markets of a country play
catalytic role behind development and improvements in the Capitalmunotes.in

Page 55

55Markets. An active secondary market in fact promotes the growth of the
primary market and helps in capital formation.
3. Acts as a "ready market"
For general investor, secondary market provides a ready market for
carrying out h is trading activities. An investor can sell stocks/shares which
he might have purchased from primary market through Initial Public
Offering process or he might have purchased them from another investor
through secondary market. On the other hand, investors who are not able
to purchase stocks/shares of a particular company through Initial Public
Offering process in the primary market due to any reasons can purchase
the same in secondary market. Thus we can say that secondary market
helps investors to sell th eir holdings readily thereby ensuring liquidity.
4. Induces companies to improve their performance
Secondary Market induces those companies whose shares are listed
in the stock exchange to improve their performance as the market price
reflects company's p erformance and this price is very easily available to
the investors. For the management of the company, secondary equity
market serves as the monitoring and control conduit -by facilitating value -
enhancing control activities; enabling implementation of ince ntive -based
management contracts, and aggregating information (via price discovery)
that guides management decisions.
5. Helps in instant valuation of securities
Secondary market provide for instant valuation of securities caused
by changes in the interna l environment such as company -wide or industry -
wide factors. Valuation of securities makes it easy to measure cost of
capital and rate of return of the economic entities at the micro economic
level.
6. Protection of investors' interest
Secondary Market provides a safe platform to the investors for
carrying out their trading activities. It ensures investors of fair dealing and
protects their interest.
5.5 DISTI NCTIO NBETWEE NPRIMARY MARKET
AND SECO NDARY MARKET
Both primary market and se condary market serve the Indian Financial
System and helps the investors to invest their funds into profitable
avenues. The proper functioning of both of them is very vital for the
process of sound development and smooth functioning of Indian Capital
Marke t. Both markets are complementary of each other but differ from
each other on some major points. These are as follows:munotes.in

Page 56

56Primary Market Secondary Market
Role Primary market provides a
platform where securities
are to public for
subscription for the
purpose of raising capital.It provides a platform to the
investors to trade
existing/pre -issued securities.
Therefore, it is also known as
the "aftermarket".
Players Players of primary market
are Merchant Bankers,
R&T agents,
Underwriters, Broke rs and
sub-brokers, depositories.Players involved in secondary
market are Stock Exchanges,
Stock brokers, investors, FIIs
Instruments Primary market deals in
IPO (Equity and
Preference shares) and
NFO (Mutual Funds)Secondary market
instruments are mainly
shares, debentures, mutual
funds and bonds
Types of
accounts
requiredIn Primary Market an
investor needs only Demat
account.Here demant account as well
as trading account is also
required.
Settlement Here settlement means that
shares are credited into
investors Demat Account.Here settlement takes place
on T+1 for intra -day and on
T+2 for delivery base.
5.6 PARTS OF THE SECO NDARY MARKET
Secondary Market can be divided into three parts. These are:
1. Equity Market
2. Debt Market
3.Derivative Segment
1. Equity Market
Shares of a company which are also termed as equities make the
person or organisation holding them as the shareholder of the company.
Most of the investors prefer to invest in them because equities have the
proven trac k record of outperforming other forms of the investments. The
value of most of the equities tends to increase over a period of time. But
this does not mean that all equities would be giving similar higher returns.
Being high risk investments equities need to be studied carefully and
patiently. As investors have bear higher risk in equities companies reward
them back by paying dividend annually. Dividend is a percentage of the
face value of a share that a company returns to the shareholders from its
annual p rofits.munotes.in

Page 57

57Equity as an Investment
In a laymen term equity can be defined as a stock or any security
that represents ownership of a company. On company's financial
statements such as balance sheet equity denotes those funds which are
contributed by the owners plus the retained earnings (or losses), also
known as the stakeholders' equity. It can be said that equity is a term
whose meaning depends very much on context. In general, one can think
of equity as ownership in any asset after all the debts that are rel ated to
that asset are paid off. For example a house will be counted as owners'
equity only when all the loans taken for construction of house and
purchase of land are paid off and the owner is free to sell the house for
requirement of cash.
Equity is giv en preference over other forms of investments because
they can outperform and they are supposed to deliver better returns over
longer periods of time. But one needs to be careful if he/she is investing in
equities for shorter period of time because equitie s tend to be very risky
and due to their inclusion in portfolios makes portfolios highly volatile.
And due to this very reason it is recommended time frame for equity
investment is a sufficient long period of time (at least 3 years). Similarly,
it is also advised that investors who are typically closer to their retirement
age and who have lower risk appetite must include very negligible equity
holdings in their portfolios.
Dutch East India Company was the first company to issue its share
to general public in 1602. In India, it was Reliance that came out with the
first ever IPO in January 1978. Equity markets world over were passing
through a bearish phase in the late 80s and then the decade of 90s was
followed by a largest ever bull market which lasted for about 10 years.
This led to growth and development of equity market in the entire world.
As a result of liberalisation in 1990s Indian Economy flourished and
benefitted a lot. Series of financial sector reforms were introduced in
which majority were capita l market reforms. Controller of Capital Issues
was completely abolished and free pricing of shares started. Hence
development of Indian Equity Market matching to the standards of global
equity markets took place.
Indian Equity Markets depend mainly on mon soons, global funds
flowing into equities and the performance of various companies. Indian
Equity Market is almost majorly dominated by the two oldest and biggest
stock exchanges of the country. These are BSE and NSE. The benchmark
indices of the two excha nges are Nifty for NSE and Sensex for BSE are
closely followed.
Investing Principles
Investing in equities can be difficult proposition for retail
investors. However, equity must form a part of every investor's portfolio.
The proportion could vary, depend ing on the investor's age, monetary
requirement, risk appetite etc. To cope up with volatility in equities it ismunotes.in

Page 58

58important to have a disciplined and systematic approach to equity
investment.
Set your own rules and more importantly, follow them religiously .
Indeed the mantra for successful equity investment is a well thought -out
disciplined investment strategy.
Here are some golden rules which are followed to sail through
different market scenarios.
1. Be a long term investor
This is the first and most im portant rule of equity investment.
Timing the market at low levels and exiting at higher levels is almost
impossible. Thought often heard on the street, this strategy is difficult to
implement, as it is nearly impossible to gauge when the market has peaked
and when it has bottomed out. Investors should not indulge in the guessing
game; it is more sensible to put money into the market with a long term
commitment.
2. Invest time and efforts in doing homework
Investing in equities is not a onetime affair. A lot of time and
effort, apart from money has to be spent in order to understand the
industries, economic trends and so on. Further one should dedicate time in
order to analyse companies, as it will help to avoid costly mistakes.
First hand information su ch as annual company reports, company
announcements etc. should be read with priority. Revisiting financial
fundamentals periodically is a good habit of a prudent investor. Basic
concepts such as Price Earnings Ratio (P/E ratio), operating margin,
earnings per share etc. should be very clear in mind. Further technicalities
of investment should also be understood such as how the stock market
operates, how to buy or sell, settlement procedures etc.
3. Pay the right price
It is very imperative to pay only the 'right' price, i.e the price an
investor can comfortably pay. Stocks should not be bought because others
are buying this will help in holding the stock for longer duration.
Conversely, if one has decided when to sell, then if one feels that the
market is overheated and prices have reached unrealistic levels then one
should exit from the market.
4. Portfolio Diversification
Diversion is a very old and popular strategy, applied to reduce
portfolio risk. To reduce risk, diversify within equities by investing across
sectors. Investing in just one or two sectors is not advised because any
negative development pertaining to those sectors will impact profitability
of portfolio. A good blend of small, mid and large cap stocks must be
present in portfolio. While la rge cap stocks could lend stability tomunotes.in

Page 59

59portfolio, small and mid cap stocks will be giving an above average
appreciation.
5. Do not buy on tips and rumours rather focus on fundamentals
Tips and rumours are an integral part of the stock market and these
areengineered by group of traders. Therefore, a sharp rally based on
rumours could fizzle out in short time. Therefore, investors should strictly
stay away from rumours suggestions or tips received from brokers or
friends or investor circles. Rather you woul d be better off investing based
on industry and company fundamentals.
6. Buy Shares of the Company whose business you understand
In long term, the stock market rewards companies with strong
fundamentals and good financial performance. Therefore, it is ess ential for
an investor to invest in those companies whose industry dynamics and
business models are well understood by him/her. This will help him/her to
gauge whether a transformation in an industry is positive or negative, at an
early stage itself and it s likely impact on the company's fundamentals.
7. Don't sell in panic
Markets go through cycles of boom and bust and volatility is a way
of life in equities. Do not sell your holdings in a hurry and panic just
because your stocks have witnessed a sudden c orrection. Always focus on
company fundamentals; if they are intact, there's nothing to worry about.
8. Do not borrow money to invest in equities
It is true that equities tend to outperform other investment avenues
in the long run. However, there is no gu arantee that you will make money
on your stocks either in terms of dividends or capital gains, if your sale of
shares is time -bound. Therefore, if you borrow funds to invest in equities,
it might be difficult for you to repay the interest or principal on t he loan,
on time.
9. Invest regularly and build up your position gradually
Investment into equities must be on periodic basis. It is very
similar to putting your money regularly in fixed interest bearing securities.
One should buy small and regular lots. This will help in buying at
reasonable price.
10. Monitor your portfolio
Investing in equity is not a onetime affair. Buying shares is perhaps
the smallest part of the overall investment activity. It is important to
periodically monitor and review your in vestment portfolio. It is always
prudent to sell a stock if you feel that the fundamentals have deteriorated
and the stock is overpriced in comparison to its fair values. Money has an
opportunity cost and by selling an overvalued stock you can invest the
same money somewhere else to get the benefit of better capital
appreciation opportunities.munotes.in

Page 60

602. Debt Market
Debt Market is that part of secondary market where investors buy
and sell debt securities which are mostly in the form of bonds. It is the
market wher e fixed income securities are issued and traded. For a
developing economy like India, debt markets are crucial source of capital
funds. Indian Debt Market is almost third largest in the world and one of
the largest in Asia. It includes government securitie s, public sector
undertakings, other government bodies, financial institutions, banks and
companies. Total size of the Indian Debt Market is in the range of $92
billion to $100billion i.e. approximately 30% of GDP.
Impact of Debt Market on Indian Economy
Increased funds for implementation of government development plans.
It is easy for government to raise funds at lower cost by issuing
government securities.
Conducive to implementation of a monetary policy.
Lesser risk as compared to equity markets, thus equity markets
encourages low risk instruments. This leads to inflow of funds into the
economy.
Higher liquidity and control over credit.
There is enough opportunity for investors to diversify their investment
portfolios.
Better corporate governance.
Impro ved transparency because of stringent disclosure norms and
auditing norms.
Classification of the Indian Debt Market
Indian Debt Market can be broadly classified in two categories:
1. Government Securities Market
2. Bond Market
1. Government Securities Market
In G -sec market securities are issued by the Governments of the
state and centre for the purpose of taking loans. However, securities issued
by the state governments constitute only a very small portion of their fiscal
deficits. In India it is manda tory for banks to maintain a certain percentage
of their liabilities in Government securities and other specified liquid
assets which creates a captive demand for Government securities. At
present, the Statutory Liquidity Ration (SLR) for the banks is 25%.
Similarly other types of financial institutions such as insurance companies,
provident funds, non banking financial institutions etc., are required to
fulfil certain statutory conditions.munotes.in

Page 61

612. Bond Market
Bond Market link issuers, i.e. governments, state owned
institutions, local bodies and corporate having financing needs, with the
investors having investible funds. In an efficient bond market
requirements of both the issuers and investors are met effectively at a price
(interest rates) determined compet itively and price adjustment to some
new information is seamless.
Bond Market consists of the following:
Corporate Bonds
Public Sector Unit Bonds
Banks and Financial Institutions Bonds
Corporate Bonds and Debentures
Have maturities beyond 1 year and gene rally up to 10 years.
Corporate also issue short term commercial paper with maturity ranging
from 15 days to 1 year.
Public Sector Unit Bonds
PSU Bonds are generally treated as surrogates of sovereign paper,
sometimes due to explicit guarantee of Governme nt, and often due to
comfort of public ownership. As compared to G -Secs, corporate bonds
carry higher risks, which depend upon the corporation, the industry where
the corporation is currently operating, the current market conditions and
the rating of the c orporation. However, these bonds also give higher
returns as compared to G -Secs. Some of the PSU Bonds are tax -free; a
status enjoyed which is not by even Government securities.
Banks and Financial Institutions Bonds
Most of the institutional bonds are in the form of promissory notes
transferable by endorsement and delivery. They are negotiable certificates
issued by the Financial Institutions such as the IDBI/ICICI/IFCI or by the
commercial banks. These instruments have been issued both the regular
income bonds and as discounted long term instruments (deep discount
bonds).
Participants in Debt Market
Given the large size of trades, Debt Market is predominantly a
wholesale market, with dominant institutional investor participation. The
investors in debt ma rket are mainly banks, financial institutions, mutual
funds, provident funds, insurance companies and corporate.
In order to understand the participants and products dealt in debt
market following table can be studied.munotes.in

Page 62

62Issuer Instrument Maturity Majo r
Investors
Central
GovernmentDated Securities
Treasury Bills2-30 years
91/364 daysRBI, Banks,
Insurance
Companies,
Provident
Funds, PDs,
Individuals.
State
GovernmentDated Securities 5-10 years Banks,
Insurance
Companies,
Provident Funds
PSUs Bonds 5-10 years Banks,
Insurance
Companies,
Corporate,
Provident
Funds, Mutual
Funds,
Individuals
Corporate
Debentures
PDs
BanksBonds and
Commercial
Paper
Commercial
Paper
Bonds issued of
tier II Capital
Certificates of
Deposits1-12 year
15 days to 1
year
Minimum 5
years 3 months
to 1 yearBanks, Mutual
Funds,
Individual
Banks,
Corporate,
Financial year
Institutions,
Mutual Funds,
Individuals.
Banks,
Corporate
3. Derivative Segment
Financial markets are well known for their volatile nature and
hence risk factor is an important factor for financial agents. To reduce this
concept of derivatives comes into picture. Derivatives are product whose
values are derived from one or more basic variables called bases. These
bases can be underlyin g assets (for example forex, equity etc.) bases or
reference rates. For example rice farmers may be willing to sell their
harvest at a future date to eliminate risk of changes in the price by that
date. The transaction in this case will be called derivativ e, while spot price
of the wheat would be underlying assets. Derivatives were introduced in
the Indian Stock Market to enable the investors to hedge their instruments
against adverse volatile price movements. However, they are now
commonly being used for t aking speculative positions.munotes.in

Page 63

63The need for Derivative Market
The derivative market performs a number of economic functions:
They help in transforming risks from risk averse people to risk
oriented people.
They help in discovering the current as well as futu re prices.
They catalyze entrepreneurial activity.
They increase the volume traded in the markets because of
participation of risk averse people in greater number.
They increase savings and investments in the long -run.
The Derivative Market
Derivatives Market can broadly be classified in two categories,
those that are traded on the exchange and those that are traded one to one
or 'over the counter'. They are hence known as
Exchange traded derivatives
OTC Derivatives (Over The Counter)
Exchange traded de rivatives
They are the most common and popular kind of derivatives traded
normally on the exchanges.
OTC Equity Derivatives
They have long history in India in OTC Market. Options of various
kinds were available (called Teji, Mandi and Fatak) in un -organis ed
markets and were traded in Mumbai as early as 1900. However, SCRA
banned all kind of option in 1956 and this can was lifted in 1995.
The Participants in Derivatives Market
Hedgers use futures or option markets to reduce or eliminate the risk
associated with price of assets.
Speculators use futures and options contract to get extra leverage in
betting on future movements in price of an asset. They can increase both
the potential gains and potential losses by usage of derivatives in a
speculative venture .
Arbitrageurs are in business to take advantage of a discrepancy between
prices in two different markets. If, for example if they forecast that future
price of an asset is getting out of line with the cash price, they will take
offsetting positions in th e two markets to lock in profit.
Types Of Derivatives
Forwards
A forward contract is customised contract between two entities,
where settlement takes place on a specific date in future on today's pre -
agreed price.munotes.in

Page 64

64Futures
A future contract is an agreement between two parties to buy or
sell an asset at a certain time in future at a certain price. They are special
kind of forwards contracts in the sense that former are standardised
exchange traded contracts.
Options
Options are of two types -calls and put option. 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 given future date. On the
other the 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
given future date.
Warrants
Options generally have life of one year, the majority of options
traded on options exchange having a maximum maturity of nine months.
Longer dated options are called warrants and are generally traded over the
counter.
LEAPS
Long term Equity Anticipation Securities are options having
maturity of 3 years.
Baskets
Baskets options are options on portfolios of underlying asset. The
underlying asset is usually a moving average or a basket of asset. Equity
index options are form of basket options.
Swaps
Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be
regarded as portfol ios of forward contracts. The two most commonly used
swaps are:
Interest Rate Swaps:
They involve swapping only interest related cash flows between
the parties in the same currency.
Currency Swaps:
They involve swapping of both the principal and interest between the
parties, with cash flows in one direction being in a different currency than
those in the opposite direction.
Swaptions
Swaptions are options to buy or sell a swap that will become
operative at the expiry of the option. Thus, it can be said that Swaption, is
an option on a forward swap. Rather than having calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receivermunotes.in

Page 65

65swaption is an option to receive fixed and pay floating, on the other a
payer swaptions i s an option to pay fixed and receive floating.
5.7 INSTRUME NTS OF SECO NDARY MARKET
Following are the main instruments or products dealt in Secondary
Market:
Shares
Debentures
Bonds
Mutual Funds
SHARES
"A share in the share capital of the company and includes stock except
where a distinction between stock and share is expressed or implied." For
example, if the capital of the company is 10, 000 and is divided into 1000
units of Rs. 10/ -each then each unit of Rs. 10/ -shall be called share of the
compan y.
Preference Shares
Preference Shares are those which enjoy some preferential rights.
These rights may be concerning:
As to the payment of dividend at a fixed rate during the whole life of
the company.
As to the return o f the capital at the time of winding up of the
company.
But at the time of liquidation, preference shareholders rank below
the claims of the company's creditors, bond holders/debenture holders.munotes.in

Page 66

66Voting rights of Preference Shareholders
Preference Sharehold ers do not enjoy normal voting rights as the
equity shareholders do. However they are entitled to vote under the
following two conditions:
When any resolution directly rights is to be passed.
When the dividend due (whether declared or not) on their preference
shares or part thereof has remained unpaid.
Kinds of Preference Shares
Preference shares are broadly classified into two types:
1. Cumulative Preference Shares
2. Non -Cumulative Preferen ce Shares.
Cumulative Preference Shares
In this kind of shares dividend accumulates if it remains unpaid if
the company earns no and/or lean profits and when the company earns
good profits all the arrears of preference dividend have to be paid out
before paying dividend on equity shares. Preference shares shall always be
cumulative unless any e xpress provision is mentioned in the articles.
Non-Cumulative Preference Shares
Non-cumulative preference shares are those shares on which arrear
of dividend do not accumulate. Therefore, if dividend is not paid on these
shares in any year, the right to r eceive the dividend lapses and as such, the
arrear of dividend is not paid out of the profits of the subsequent years.
Cumulative Preference Shares and Non -Cumulative Preference
Shares fall under the following three categories:
1. Participating and Non Participating Preference Shares
The right of certain preference shareholders to participate in the
profits after a specified fixed dividend contracted for is paid. Participation
right is linked with quantum of dividend paid on the equity shares over
and abo ve a specified level. Thus, these kinds of shares entitle their holder
to get a portion in surplus profits or surplus assets of the company at the
time of liquidation or both, if the Articles of Association provides for it.
On the other, Non -Participating Preference Shares do not enjoy such
participating rights. Preference shares are always deemed to be non -
participating unless otherwise mentioned.
2. Convertible and Non-Convertible Preference Shares
A type of preference shares where the dividend payable on the
same accumulates if it is not paid. After a specified date these shares will
be converted into equity capital of the company. Such shares are known as
Cumulative Convertible Preference Shares. W hereas when such shares are
not converted into equity shares they are termed as Cumulative Non -
Convertible Preference Shares.munotes.in

Page 67

673. Redeemable and Irredeemable Preference Shares
Redeemable preference shares are those shares which can be
redeemed by the compa ny on or after the certain date after giving the
prescribed notice. These shares are redeemed in accordance with the terms
and Sec. 80 of the Company's Act, 1956. Irredeemable preference shares
are those shares, which cannot be redeemed by the company duri ng its
lifetime, in other words it can be said that these shares can only be
redeemed by the company at the time of winding up. But according to the
Sec. 80 (5A) of the Company's (Amendment) Act, 1988 on company can
issue irredeemable preference shares.
Equity Shares
An equity share commonly known as ordinary share also
represents the form of fractional ownership in which shareholder, as a
fractional owner, undertakes the maximum entrepreneurial risk associated
with a business venture. Their holders are th e actual owners of the
company and have voting rights. A company may issue such shares with
deferential rights to voting, paying of dividend etc., directors of the
company have the sole right of recommending dividends to such shares
and as such they may no t get any dividends in case the directors choose
so.
These shares are also known as the "risk capital" because they get
dividend on the balance of profit if any, left after payment of dividend on
preference shares and also at the time of wingding up of th ec o m p a n y ,
they are paid from the balance asset left after payment of other liabilities
and preference share capital. Apart from this they can claim dividend only,
if the company in its AGM declares the dividend. The rate of dividend on
such shares is not predetermined, but it depends on the profits earned by
the company.
Distinction between Preference Shares and Equity Shares
Basis of Difference Preference Shares Equity Shares
Rate of Dividend These shares are
entitled to a fixed rate
of dividend.The rate of dividend
on equity shares
depend upon the
amount of profit
available and funds
requirement of the
company for future
expansion.
Preferential Rights They enjoy some
preferential rights over
equity shares. Such as
dividend on preference
shares are p aid before
paying the same to
equity shareholders.
Preference shares alsoEquity shares do not
enjoy such preferential
rights with the regards
to payment of
dividend and capital
the time winding up
on the company. Their
claims are the settledmunotes.in

Page 68

68get preference at time
of winding up of the
company are paid back
their capital before the
payments to equity
shareholders is made.last, i.e. only after the
company's creditors,
bond holders are paid
off.
Redemption Redeemable
preference shares may
be redeemed by the
company.Equity shares cannot
be redeemed except
under a scheme
involving reduction of
capital or buy back of
its own shares.
Voting Rights Their voting rights are
restricted.An equity shareholder
can vote on all matters
that are concerned
with the comp any.
Arrears of Dividend If dividend is not paid
on these shares in any
year, the arrear of
dividend may
accumulate.In case of equity
shares, dividend do
not accumulates.
Deferred Shares
They are also known as 'founder shares' as they are mostly held by
the founder/promoter of the company. They are issued as other ordinary
shares and they get fixed dividend just like preference shares. But they are
last to receive both as regards dividend and payment of capital.
Rights Issue/Rights Shares
The issue of new securities to existing shareholders at a ratio to
those already held.
Bonus Shares
Shares issued by the companies to their shareholders free of cost
by capitalisation of accumulated reserves from the profits earned in the
earlier years.
DEBE NTURES
Adebenture is a unit of loan amount. When a company intends to
raise the loan amount from the public it issues debentures and the person
holding debenture or debentures is called the debenture holder. A
debenture holder is the creditor of the company. Debe ntures bear a fixed
rate of interest on them and the same is paid on some pre specified date on
half yearly basis. The bond amount is paid on a particular date on the
redemption of the bond. Debentures are normally secured against the
assets of the company in the favour of the debenture holder.munotes.in

Page 69

69As per Section 2(12) of Companies Act 1956, "Debenture includes
debenture stock, bond and any other securities of the company whether
constituting a charge on the company's assets or not."
BONDS
Bond is a negotiabl e certificate evidencing indebtness. It is
normally unsecured. A debt security is generally issued by a company,
government agency or municipality.
MUTUAL FU NDS
Mutual Fund can be described as a common pool of money where
many small and retail investors put in their money. This money is
allocated towards some objective which is predefined. Thus it can be said
that ownership of the fund is joint or mutual, as this belongs to all those
investors who have contributed to it. Ownership of an investor is in sam e
proportion as the contribution made by him bears toot the total pool
(amount) of the fund created.
5.8 SUMMARY
All securities are first created in the primary market and then they
enter into the secondary market. Thus securities generally have two
stages of their life span. The first is the stage when the company issues
them in the market and makes them available for the general public
from its treasury at a predetermined offer price.
Secondary Market, also known as the aftermarket, is the place whe re
goods which are already used by someone are sold and/or bought.
Thus we can define secondary market as "the financial market where
previously issued securities and financial instruments such as stocks,
bonds, futures and options are manoeuvred from one investor into
another."
Secondary Market helps to create sufficient liquidity and marketability
of outstanding debt and equity instruments.
Secondary Market contributes to economic growth by proper
allocation of funds towards most efficient channel through process of
disinvestment to reinvestment.
For general investor, secondary market provides a ready market for
carrying out his trading activities.
Secondary Market can be divided into three parts. These are: Equity
Market, Debt Market and Derivative Segmen t.
Debt Market is that part of secondary market where investors buy and
sell debt securities which are mostly in the form of bonds. It is the
market where fixed income securities are issued and traded.
Indian Debt Market can be broadly classified in two ca tegories:
Government Securities Market and Bond Market.munotes.in

Page 70

70Derivatives Market can broadly be classified in two categories, those
that are traded on the exchange and those that are traded one to one or
'over the counter'. They are hence known as Exchange trade d
derivatives and OTC Derivatives (Over The Counter).
The instruments of Secondary Market are Shares, Debentures, Bonds
and Mutual Funds.
5.9 QUESTIO NS
Q1. Fill in the blanks with appropriate words:
a.--------------- is a percentage of the face value of a share that a company
returns to the shareholders from its annual profits. (dividend, bond,
debenture, equity share)
b.------------------ an agreement between two parties to buy or sell an asset
at a certain time in future at a certain price. (Futures, forwards, options,
equities)
c.---------------- 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
given future date.
d.---------------- swaption to receive fixed and p ay floating.
e.---------------- swaption is an option to pay fixed and receive floating.
Q2. Answer in One Sentence:
a. Define Secondary Market.
b. What is meant by Equity Market?
c. What is meant by Debt Market?
d. Define Derivative Market.
e. State the instruments of secondary market.
Q3. Answer briefly:
a. Explain the need for secondary market.
b. What is the role of secondary market.
c. Distinguish between primary market and secondary market.
d. Write short notes on:
i. Equity Market
ii. Debt Marke t
iii. Derivative Market
e. Explain in detail the instruments of secondary Market.


munotes.in

Page 71

716
STOCK EXCHA NGES
Unit Structure
6.1 Introduction
6.2 Meaning of Stock Exchanges
6.3 Definition of Stock Exchanges
6.4 Characteristics of Stock Exchanges
6.5Objectives of Stock Exchanges
6.6 Functions of Stock Exchanges
6.1 INTRODUCTIO N
Over the last few years, there has been a rapid change in the Indian
securities market, especially in the secondary market. Advanced
technology and online -based transactions have modernized the stock
exchanges. Stock exchanges were permitted to expand their trading to
locations outside their jurisdiction through computer terminals. Trading is
much more transparent and quicker than in the past.
Stock market refers to a market place where investors can buy and
sell securities. Primary market deals with only new issue of shares,
debentures and bonds, whereas secondary market provides a place for
securities which have already been issued in an initial private or public
offering. After the securities are issued in primary market, they are traded
in the secondary market by the companies issuing securities, investors,
brokers and the regulators. The stock exchanges along with a host of
intermediaries provide the necessary platform fo r trading in secondary
market and for clearing and settlement.
6.2 MEA NIG OF STOCK EXCHA NGES
The word ‘stock’ means a fraction of the capital of a company and
the word ‘exchange’ means a place for buying and selling something. The
market or place, where securities are exchanged or traded is called stock
exchange or stock market.
A stock exchange thus provides a trading platform for the sale and
purchase of securities. Stock exchange is a structured market place for the
proper conduct of trading activiti es in shares, stocks and other securities
issued by companies and government. Stock exchange provides
marketability and price continuity for shares and helps a fair evaluation of
securities in terms of their intrinsic worth.munotes.in

Page 72

72Stock exchanges are formal orga nisations, approved and regulated
by the regulatory authorities of a country. Stock exchanges deals in
securities like shares, debentures or bonds issued by the companies or
corporations in the private, as well as public sector and bonds issued by
the cent ral and state governments, municipal corporations etc.
In addition, the stock exchange sometimes buys and sells
certificates representing commodities of trade. Stock exchanges also
facilitate the issue and redemption of securities and other financial
instruments.
Members are only permitted to trade those securities, which are
generally entered in the official list of the exchange. The right to trade
securities or make markets on an exchange floor is granted only to an
individual or firm on becoming a memb er of the exchange.
An organised and recognised stock market ensures liquidity and
marketability to securities, encourage investments in securities and
support corporate growth.
6.3 DEFI NITIO NOF STOCK EXCHA NGE
The Securities Contracts (Regulations) Act , 1956 defines stock
exchange “as an association, organisation or body of individuals, whether
incorporated or not, established for the purpose of assisting, regulating and
controlling the business of buying, selling and dealing in securities.”
According to the Oxford Dictionary of the business world, the
stock market also known as the stock exchange is defined “as a place in
which stock, shares and other securities are bought and sold, price being
controlled by demand and supply.”
6.4 CHARACTERISTICS OF STOCK EXCHA NGE
Following are the salient features of a stock exchange:
1.Stock Exchange is an organised market place where securities are
purchased and sold.
2.Stock Exchange is a formal organisation which provides facilities to
their members to transact only in securities.
3.By tradition stock exchange was a voluntary association of persons
owned by its members and stockbrokers. Recently, stock exchanges
got transformed from a mutually owned association to a shareholder
owned company.
4.Recognition to a stock exchange is accorded by the Central
Government.
5.Stock exchange does not conduct business for them.munotes.in

Page 73

736.The right to trade securities or make markets is strictly restricted to the
members of the exchange.
7.The trading in a stock exchange is under the overall su pervision of the
regulatory authorities of the nation.
8.Each stock exchange formulates its own rules and regulations. Any
member who acts against the rules of the exchange can be removed
from its membership.
9.Trading is strictly regulated and rules and regul ations are prescribed
for various types of transactions.
10.Securities listed in the official list of the stock exchange alone are
traded in an exchange.
11.The trading platforms of stock exchanges are now accessible through
internet from anywhere in the country .
12.Both genuine investors and speculators can buy and sell shares in
stock exchange.
13.Stock exchange provides information about the market price of the
securities.
14.Members of the stock exchange generally elect a governing body
which control and direct the ac tivities of their members. However in a
demutualised stock exchange, shareholders elect board of directors and
they exercise direct and proper control over the activities of the
exchange.
6.5 OBJECTIVES OF STOCK EXCHA NGE
Main objectives of stock exchange are the following:
1.To create an efficient securities market in the country.
2.To regulate stock market practices and to protect the interest of
investors.
3.To control illegitimate speculation, manipulation and other undesirable
trade practices.
6.6 FU NCTIO NS OF STOCK EXCHA NGE
Stock Exchange is a vital organ in a modern society. Stock exchanges
have a vital role to play in the economic development of the country in
general and the growth of industrial sector in particular. Stock exchanges
perform an importan t function of mobilising and channelizing resources
which remain otherwise scattered. Apart from the above basic function it
also assists in mobilising funds for government. Thus stock exchanges
help orderly flow and distribution of savings between differe nt types of
investments. Stock exchanges perform multiple functions, which are given
below:munotes.in

Page 74

741.Capital Formation and Economic Growth:
Stock exchanges help in mobilisation of surplus funds of individuals
and business firms for investment in securities. The funds, which could
have been consumed, or to be kept in idle deposits are mobilised and
redirected to invest in securities, resulting in a stronger economic
growth and higher productivity levels.
2.Ensure Continuous And Ready Market For Securities:
Byregular dealings in securities, stock exchange ensures continuous
and ready market for the securities. This enables it to attract people
who have surplus money even for a short period of time.
3.Rational Allocation of Resources to the Various Sectors:
Stock exchange enables mobilisation of funds by allocation of the
same rationally which would otherwise be invested in not so
productive bank deposits and funds. Investment in various types of
securities leads to rational allocation of resources, which promote
divergent economic sectors such as agriculture, commerce and
industry.
4.Provide Liquidity:
Stock exchange is a place for selling and buying of securities. The
trading facility in stock exchange allows the small investors to quickly
and easily sell off the securities thereby converting them into cash.
This is an attractive feature of investing in securities over other less
liquid investments like real estate.
5.Evaluation of Securities:
Stock exchange provides information about the demand and market
price of various securities traded in the exchange. This information is
published by the exchange in newspaper and other media. This helps
investors to ascertain the current market prices of their holdings.
6.Acts as Barometer of the Economy:
Stock Exchange acts as a barometer of the business conditions in the
country. At the stock exchange, share prices rise and fall depending,
largely on market forces. Booms and depressions are reflected in the
index of prices of various securities maintained by the stock exchange.
7.Better Control over Corporate Sector:
Every company indenting to list their securities has to fulfil certain
conditions and rules framed by the stock exchange. Through these
rules, stock exchange influence on the management and working of
companies in pu blic interest.
8.Ensure Fair Dealings and Safety:
Stock exchange ensures fair dealings and safety of investors’ funds
because trading in a stock exchange is under the overall supervision of
the regulatory authorities of the nation and in accordance with the
rules and regulations of the exchange.munotes.in

Page 75

759.Creating Investment Opportunities for Small Investors:
An investor can buy the number of shares as he/she can afford.
Therefore stock exchanges provide the opportunity for small as well as
large investors to own sha res of the same companies.
10.Facilitate Takeovers and Acquisitions:
Takeovers, acquisitions or mergers are means of expansion of
businesses for companies, which are made easier through the stock
exchanges. Stock exchange facilitates takeovers by acquiring m ajority
of shares in another company.
11.Assist in Primary Issue:
The efficient functioning of stock exchanges creates a conducive
environment for an active and growing primary market for new issues.
12.Facilitate the Growth of Companies:
Stock market motivate s companies to go public, or raise additional
capital. It helps the companies with an opportunity to expand product
line, increase distribution channels, increase market share and acquire
other necessary business assets.
13.Assist Government to Raise Capital:
Stock exchange helps governments to raise capital finance for many
public works such as development of water supply, housing estates etc.
by selling bonds. The general public buy these bonds thereby giving
loan to the government.
6.7 SUMMARY
Stock market refers to a market place where investors can buy and sell
securities. Primary market deals with only new issue of shares,
debentures and bonds, whereas secondary market provides a place for
securities which have already been issued in an initial pri vate or public
offering.
The word ‘stock’ means a fraction of the capital of a company and the
word ‘exchange’ means a place for buying and selling something. The
market or place, where securities are exchanged or traded is called
stock exchange or stock m arket.
Main objectives of stock exchange are the following:
a. To create an efficient securities market in the country.
b. To regulate stock market practices and to protect the interest of
investors.
c. To control illegitimate speculation, manipulation an d other undesirable
trade practices.munotes.in

Page 76

76Stock Exchange is a vital organ in a modern society. Stock exchanges
have a vital role to play in the economic development of the country in
general and the growth of industrial sector in particular. Stock
exchanges perform an important function of mobilising and
channelizing resources which remain otherwise scattered.
6.8 QUESTIO NS
1.What is meant by Stock Exchange?
2.Define Stock Exchange.
3.State the characteristics of Stock Exchange.
4.Describe various functions of Stoc kE x c h a n g e .
EVOLUTIO NANDG R O W T HO FS T O C KE X C H A NGES
One of the oldest stock markets in Asia, the Indian Stock Markets
have a 200 years old history.
18thCentury –East India Company was the dominant institution and
by the end of the century, business in its loan securities gained full
momentum.
1830’s –Business on corporate stocks and shares in Bank and Cotton
presses started in Bombay. Trading list by the end of 1839 got broader.
July 9, 1875 –Native brokers formed the Native Share and Stock -
Broker’s Association in Mumbai, with membership fee of Re. 1.munotes.in

Page 77

771899 –Bombay Stock Exchange acquires own premises in Mumbai.
1921 –Clearing houses are established for settlem ent of trade as
volumes increase.
1923 –K. R. P Shroff became the President of BSE.
1925 –Bombay Securities Contract Act (BSCCA) comes into force.
December 1, 1939 –Stock Exchange building is acquired.
1943 –Forward trading banned till 1946. Only ready -to-delivery and
hand -delivery contract permitted.
1956 –Securities Contract Registration Act, drafted on the lines of
BSCCA, comes into force.
1957 –BSE becomes the first exchange in India to get permanent
recognition.
1964 –Unit Trust of India (UTI) i s born, gives fillip to capital
markets.
April, 1 1966 –K. R. P. Shroff retires and Shri Phiroze J. Jeejeebhoy
becomes Chairman.
June 29, 1969 –Morarji Desai bans forward trading.
1973 –Construction of P. J. Towers, named after late Phiroze
Jamshedji Je ejeebhoy starts.
1974 –Foreign Exchange Resolution Act, 1973 ended MNC
shareholdings cut to 40%.
1977 –Reliance goes public and the equity cult is born. The public
issue of Reliance Textiles & Ind is oversubscribed 8 times.
January 2, 1986 –BSE Sensex l aunched as the first stock market index
with 1978 -79 as the base year.
November 1987 –SBI Mutual Fund launches Magnum regular income
scheme.
April 1988 –Securities and Exchange Board of India set up. S. A.
Dave, SEBI’s First Chairman.
January 1992 –Secu rities and Exchange Board of India given statutory
powers.
May 1992 –Harshad Mehta securities scam breaks.
May 27, 1992 –Reliance is the first Indian Company to make a GDR
issue.
May 30, 1992 –The Capital Issues Control Act, 1947 is replaced. Free
pricing of public issue allowed.
September 1992 –Foreign institutional investors are permitted to
invest in Indian securities market.munotes.in

Page 78

78November 1992 –National Stock Exchange is born.
November 1992 –Manmohan Singh, the then Finance Minister,
inaugurates OTCEI –the Over the Counter Exchange of India.
February 1993 –Infosys launches IPO at a premium of Rs. 95.
April 1993 –Sensex climbs more than 2, 500 points.
July 1993 –Kothari Pioneer (now merged with Franklin Templeton)
registered as the first private sect or mutual fund.
October 30, 1993 –The First private sector mutual fund –Kothari
Pioneer MF begins operations.
1993 –SEBI banks badla trading on BSE.
June 1994 –NSE commences operations in wholesale debt market
segment with 100 companies listed.
Novembe r1 9 9 4 –Capital Market segment of NSE goes on stream.
Trading is screen -based for the first time in India.
March 1995 –BSE online trading system (BOLT) replace open outcry
system.
June 1995 –NSCCL, India’s first clearing corporation is set up.
October 1 995–National Stock Exchange overtakes the Bombay Stock
Exchange as the largest stock exchange in terms of volumes of trading.
April 1996 –NIFTY is born.
November 1996 –The National Securities Depository is created.
February 1997 –SEBI releases norms for takeovers and acquisitions.
May 1997 –BSE introduces screen -trading.
November 1998 –SEBI gives recognition to integrated stock
exchanges founded by 16 regional stock exchanges.
February 1999 –Launch of automated lending and borrowing
mechanism (ALBM ), on NSE.
March 11, 1999 –Infosys Technologies is the first company to list on
NASDAQ through a public offering of American Depository Receipts.
March 22, 1999 –Central Depository Services (India) promoted by
BSE commence operations.
September 1999 –ICICI is the first Indian Company to list NYSE.
October 11, 1999 –For the first time in BSE’s history, the Sensex
closed above 5, 000 market at 5, 031.78.
January 2000 –SE creates ‘Z’ category of Scrips, in addition to A, B1
and B2, comprising scrips that breached or failed to comply with the
listing agreement.munotes.in

Page 79

79February 2000 –Internet trading commences on NSE. On February 21,
NSE records peak market capitalization of Rs. 11, 94, 282 crore. On
February 14, 2000 BSE Sensex hits an all -time high of 6, 150.
April 10, 2000 –The Sensex is revamped to include Dr. Reddy’s Lab,
Reliance Petroleum, Satyam Computers and Zee Telefilms, replacing
Indian Hotels, Tata Chemicals, Tata Power and IDBI.
June 2000 –BSE and NSE introduce derivatives trading in the form of
index futures.
July 9, 2000 –BSE turns 125.
October 19, 2000 –Wipro lists on NYSE.
January 22, 2001 –Borrowing and Lending Securities Scheme
(BLESS) launched on BSE to promote securities lending and
borrowing activities.
March 2001 –Ketan Parekh scam breaks. SEBI suspends all the
broker -directors of the BSE in relation to the KP scam on March 13.
May 2001 –BSE advises compulsory demat for B2 scrips.
June 2001 –Index options start trading on NSE.
July 2001 –A SEBI directive bans c arry-forward, all major securities
are moved to rolling settlement. Options of individual scrips start
trading on NSE.
November 9, 2001 –BSE and NSE launch futures in individual stocks.
July 2, 2001 –The age old badla system is abolished and replaced by
rolling settlement and option trading.
August 2002 –Government announces Rs. 500 crore boil out package
for UTI.
February 2003 –SEBI directs exchanges to monitor the ‘possibility of
price manipulations.’
September 2003 –BSE Sensex moves to “free float m arket
capitalisation” from the earlier “full market capitalisation.”
January 2005 –Only ten of the original Sensex 30 survive. TCS and
NTPC added to the list.
August 19, 2005 –BSE transformed into a corporate entity BSE Ltd.,
with Rajanikant Patel as its CEO.
September 2005 –The Sensex crossed the 8000 mark and closed at
8052.56 mark on 8 -9-05, raising the investor’s wealth to Rs. 22 lakh
crore.
April 20, 2006 –The Stock market breached the milestone with the
benchmark Sensex surging past the 12, 000 po int mark on 20 -04-2006
for the first time in history.munotes.in

Page 80

80November 2006 –The stock market bounced back. Took merely 113
trading days to regain peak, crosses 13, 000 mart to close at 13, 130
mark.
May 15, 2007 –The BSE index (Sensex) 14K mark again on May 16
and ended higher at 14, 127 points.
July 6, 2007 –The BSE Index scaled to 15, 007.22.
July 26, 2007 –Indian Stock Market achieved a historical land mark as
the combined volume of business crossed Rs. 1 lakh crore (Rs. 1
trillion) (Rs. 1, 00186 crore) for the first time.
August 29, 2007 –SEBI DE -RECOGNISES HYDERABAD
EXCHANGE.
August 29, 2007 –Market regulator SEBI has de -recognised
Hyderabad Stock (HSE) as the course failed to dilute 51 per cent stake
to non -brokers by August 28 as is mandated by law. T he recognition
granted to HSE stands withdrawn with effect from August 29, 2007.
1274 companies are listed with NSE.
September 21, 2007 –The cumulative market capitalisation of all the
4,500 -odd companies listed on the BSE, the world’s biggest course in
terms of listed firms, soared to a new peak of Rs. 50, 18, 265.06 crore
on Friday 21 -09-2007.
October 2007 –SEBI banks.
2006 -2007 –Investors complain against 1, 000 firms in just a year:
Investors lodged 2, 415 complaints against over 1, 000 firms includi ng
mutual funds and NBFCs in the past one year (2006 -2007). Around
90% of the companies against which investors had grievances were
listed on the stock exchanges, according to official data. As many as
264 complaints were spread over 200 cities in the coun try. There were
also some grievances coming from foreign countries.munotes.in

Page 81

81ORGA NISATIO NAL STRUCTURE OF A STOCK EXCHA NGE
October 5, 2007 –NSE NIFTY MIDCAP 50 –Trading in futures
and options commenced. The aim is to capture the surging movement and
be a benchmark of the mid -cap segment.
QUESTIO NS
1.Write explanatory notes on history of Stock Exchanges.
2.Discuss the organisation structure of Stock Exchange of India.
munotes.in

Page 82

82STOCK EXCHA NGES I NINDIA
S. No Name of the Exchange Year of
Establishment
1. Bombay Stock Exchange, Mumbai 1875
2. Ahmedabad Stock Exchange, Ahmedabad 1894
3. Calcutta Stock Exchange, Kolkata 1908
Madhya Pradesh Stock Exchange, Indore 1919
Madras Stock Exchange, Chennai 1920
Hyderabad Stock Exchange, Hyderabad 1941
7. Delhi Stock Exchange, Delhi 1947
8. Bangalore Stock Exchange, Bangalore 1963
Cochin Stock Exchange, Cochin 1978
10. Uttar Pradesh Stock Exchange. Kanpur 1982
11. Pune Stock Exchange, Pune 1982
12. Ludhiana Stock Exchange, Ludhiana 1983
13. Guwahati Stock Exchange Ltd. Guwahati 1984
14. Mangalore Stock Exchange, Mangalore* 1985
15. Magadh Stock Exchange, Patna** 1986
16. Jaipur Stock Exchange, Jaipur 1989
17. Bhubaneshwar Stock Exchange, Bhubaneshwar 1989
18. Saurashtra Kutch Stock Exchange, Rajkot 1989
19. The Vadodara Stock Exchange, Baroda 1990
20. Over The Counter Stock Exchange of India,
Mumbai1990
21. Coimbatore Stock Exchange, Coimbatore 1991
22. National Stock Exchange of India, Mumbai 1992
23. Inter-Connected Stock Exchange of India Ltd.,
Mumbai1999
24. MCX Stock Exchange, Mumbai 2008
25. United Stock Exchange of India, Mumbai 2010munotes.in

Page 83

83* As per Securities Appellete Tribunal order dated October 4, 2006, the
Managalore Stock Exchange is a de -recognised Stock Exchange under
Section 4 (4) of SCRA.
** SEBI vide order dated September 3, 2007 refused to renew the
recognition granted to Magadh Stock Exchange Ltd.
QUESTIO NS
1. List the stock exchanges in India.
BOMBAY STOCK EXCHA NGE
1.INTRODUCTIO N
The Stock Exchanges in India as elsewhere have a vital role to play
in the development of the country. It helps the Government to raise
internal resources for the implementation of various development
programmes in the public sector. It performs an importa nt function in
mobilising and channelizing resources which remain otherwise unutilised.
Stock Exchange is a vital organ in a developing economy like India.
Bombay Stock Exchange (BSE) is the oldest and the largest stock
exchange in Asia. Bombay Stock Exch ange traces its history to the 1980s,
when a dozen stockbrokers gathered under a banyan tree in front of
Mumbai’s Town Hall. As the number of brokers kept increasing this
location kept changed and finally they moved to Dalal Street in 1874.
These stock br okers then organised an informal association in 1875
known as ‘The Native Share and Stock Brokers Association’ Bombay.
The Bombay Stock Exchange was recognised in May 1927 under the
Bombay Securities Contracts Control Act of 1925.
BSE is the first stock e xchange in the country to secure permanent
recognition from the Government of India in 1956 under the Securities
Contracts (Regulation) Act of 1956.
In 2002, the name “The Stock Exchange, Mumbai” was changed to
‘Bombay Stock Exchange.’ Subsequently on Aug ust 19, 2005, the turned
into a corporate entity (Corporatisation and Demutualisation Scheme
2005) from an Association of Persons (AoP) and renamed as Bombay
Stock Exchange Limited.
Bombay Stock Exchange is the largest of 25 exchanges in India.
According toThe World Federation of Exchanges ,a so nD e c e m b e r2 0 1 1 ,
BSE was the 14thlargest stock exchange in the world and 6thlargest in
Asia with a market capitalisation of US$ 1 trillion. BSE is also world’ s
number one exchange in terms of number of listed companies. BSE has a
nation -wide reach with a presence in 417 cities and towns. 5, 133
companies were listed with the stock exchange and over 9, 275 scrips
were being traded as in April 2012.munotes.in

Page 84

84BSE was migra ted from the open outcry system to an online screen
based order driven trading system in 1995. BSE is the first exchange in
India and the second in the world to obtain an ISO 9001:2000
certifications. It was also the first exchange in the country and secon di n
the world to receive Information Security Management System Standard
BS 7792 -2-2002 certification for its BSE On -Line Trading System
(BOLT). It is undeniable from its history that majority of the corporates in
India raised capital through utilising se rvices of BSE. The BSE was the
first exchange in India to list derivatives, such as futures, options etc. The
BSE is also actively involved in the development of the retail debt market.
The Department of Investor Services of BSE redresses grievances
of investors. BSE is the first exchange in the country to provide an amount
of Rs. 1 million towards the investor protection fund and this amount is
higher than that of any exchange in the country. BSE also launched a
nationwide investor awareness programme ‘Sa fe Investing in the Stock
Market’ under which 264 programmes were held in more than 200 cities.
2.BOARD OF DIRECTORS:
From an Association of Persons (AoP), BSE has become a
corporatized and demutualised entity which is incorporated under the
provisions o f the Companies Act of 1956. The Exchange is managed
professionally under the overall supervision of Board of Directors.
The Governing Board of BSE comprises 20 directors which
exercises complete control and formulates policy issues. Its Board of
Director s comprises of eminent professionals, representatives of trading
members and of SEBI. Among these 20 Directors, 9 members are elected
Directors of which one third retire every year by rotation.
Three members are nominees of Securities and Exchange Board o f
India, 6 are from public representatives and a Managing Director and
Chief Operating Officer. The routine operations of BSE are managed by
the Managing Director and are assisted by the professional management
team.
3.MEMBERSHIP OF BSE
Individuals and c orporate entities can apply for membership in
BSE. Membership in BSE can be obtained in the following two ways:
1.Nomination by existing members or legal heirs in case of deceased
member.
2.New membership.
Conditions for Eligibility for Becoming a Member:
The selection criteria for individual members and directors in case of
corporate members are same.
1.Minimum age or 21 years.
2.Not been adjudged bankrupt or insolvent.munotes.in

Page 85

853.Not compounded with his creditors.
4.Not been convicted of an offence involving fraud or dish onesty.
5.Not engaged as principal or employee in any business other than of
securities.
6.Not been at any time expelled or declared a defaulter by any other
Stock Exchange.
7.Either matriculates or has the 10 plus 2 years qualification. Generally,
preference is given to professionally qualified persons.
8.Minimum 2 years experience as a partner or authorised clerk or
apprentice with a member or in other connected areas in capital
market.
9.Minimum net worth requirement for individual members Rs. 30 lakh
and for corp orate members Rs. 50 lakh.
Monitoring Business of Members:
With the help of various markets monitoring reports BSE closely
monitors the outstanding positions of the members on a daily basis.
These reports are scrutinised by officials of the Surveillance
Department to ascertain the excessive purchase or sale position compared
to normal level of business of each member. It also helps to examine the
scrip -wise concentration of securities, quality and liquidity of scrips,
margins already paid, capital deposit ed, pay -in position etc. of the
members.
4.ON-LINES U R V E I L L A NCE SYSTEM
BSE’s On -Line Surveillance System (BOSS) monitors on a real -
time basis the price movements, volume positions and members’ positions
and real -time measurement of default risk, market r econstruction and
generation of cross market alerts.
Capital for BSE Membership
The trading members of BSE are required to maintain three types
of capital with the Exchange.
Base Minimum Capital
All trading members of BSE are required to keep Rs. 10 lakh as
base capital with the Exchange, which is not available for adjustment
towards margin obligations.
Trade Guarantee Fund
Trading members are also required to deposit with the Exchange a
sum of Rs. 10 lakh towards his contribution to the Trade Guarantee Fund
(TGF). Trading members are allowed to deposit cash, fixed deposit
receipts, bank guarantee (i.e Cash and Cash Equivalent) towards their
contribution to TGF. Trade Guarantee Fund will be available for
adjustment towards margins.munotes.in

Page 86

86Additional Capital
Foravailing higher trading limits, trading members can deposit
additional capital in the form of cash and non -cash equivalents. Additional
capital will be available for adjustment towards margins.
In addition to the above, a person becoming a member of BSE has to pay
an admission fee of Rs. 2, 50, 000 brokers capital fund Rs. 2, 50, 000 and
annual subscription amounting to Rs. 70, 000.
5.CLASSIFICATIO NSO FS E C U R I T I E S
During the past three decades, the BSE had been facilitating the
growth of the Indian corp orate sector by providing it with an efficient and
ready access to resources. The securities traded in BSE have been
classified into various groups based on certain qualitative and quantitative
parameters. Following are the classifications in the equity se gment:
‘A’ Group or ‘Specified’ is a category in which there is a facility
for carry forward (Badla) for a period not exceeding 90 days. It contains
the shares of the companies which have fairly a good growth and track
record in terms of dividend and capi tal appreciation. The scrips included
in this group are on the basis of equity capital, market capitalisation,
number of years of listing on the exchange, public share -holding, floating
stock, trading volume etc.
‘B1’ Group is a subset of the other lis ted equity shares that enjoy a
higher market capitalisation and liquidity than the rest. ‘B2’ Group of
shares comprises those shares which are not covered by the above two
categories.
‘Z’ Group was introduced by BSE in July 1999. ‘Z’ Group
category compris es of shares of the companies which does not comply
with the rules and regulations of the BSE. It includes companies which
failed to comply with its listing requirements, failed to resolve investor
complaints, not made the required arrangements with the de positories for
dematerialisation of their securities etc.
‘F’ Group represents the fixed income securities (debt market)
segment. Debentures and bonds issued by companies are listed under F
Group (i.e fixed income securities). Trading in Government Securit ies by
the retail investors is done under the ‘G’ Group. The ‘T’ Group represents
scrips which are settled on a trade -to-trade basis as surveillance measure.
The ‘S’ Group represents scrips forming part of the BSE -Indonext
segment. The ‘TS’ Group consists of scrips in BSE -Indonext segment,
which are settled on a trade -to-trade basis as a surveillance measure. BSE
also provides a facility to the market participants for on -line trading of
odd-lot securities in physical form in ‘A’, ‘B’, ‘T’, ‘S’, ‘TS’ and ‘Z’
groups and in rights renunciations in all groups of scrips in the equity
segment.munotes.in

Page 87

876.COMPULSORY ROLLI NGS E G M E NT
All transactions in all groups of securities in the equity segment
and fixed income securities listed on BSE are settled on T+2 basis. Under
rolling settlement, the trade done on a particular day are settled after a
given number of business days. A+2 settlement cycle means that the final
settlement of transactions done on T, i.e trade day by exchange of money
and securities between the buyers a nd sellers respectively take place on
second business day after the trade day (excluding Saturdays, Sundays,
Bank and Exchange trading holidays). However, a transaction in securities
of companies, which are in ‘Z’ Group, are settled only on a gross basis a nd
the facility of netting of buy and sell transactions in such scrips is not
available.
SUMMARY
The Stock Exchanges in India as elsewhere have a vital role to play in
the development of the country. It helps the Government to raise
internal resources for the implementation of various development
programmes in the public sector. It performs an important function in
mobilising and channelizing resources which remain otherwise
unutilised. Stock Exchange is a vital organ in a developing economy
like India.
Bombay Stock Exchange (BSE) is the oldest and the largest stock
exchange in Asia. Bombay Stock Exchange traces its history to the
1980s, when a dozen stockbrokers gathered under a banyan tree in
front of Mumbai’s Town Hall. As the number of brokers kept
increasing this location kept changed and finally they moved to Dalal
Street in 1874.
From an Association of Persons (AoP), BSE has become a
corporatized and demutualised entity which is incorporated under the
provisions of the Companies Act of 1956. The Excha nge is managed
professionally under the overall supervision of Board of Directors.
Individuals and corporate entities can apply for membership in BSE.
Membership in BSE can be obtained in the following two ways:
Nomination by existing members or legal heir s in case of deceased
member.
New membership.
BSE’s On -Line Surveillance System (BOSS) monitors on a real -time
basis the price movements, volume positions and members’ positions
and real -time measurement of default risk, market reconstruction and
generatio n of cross market alerts.
During the past three decades, the BSE had been facilitating the
growth of the Indian corporate sector by providing it with an efficient
and ready access to resources. The securities traded in BSE have been
classified int o various groups based on certain qualitative and
quantitative parameters.munotes.in

Page 88

88All transactions in all groups of securities in the equity segment and
fixed income securities listed on BSE are settled on T+2 basis. Under
rolling settlement, the trade done on a particular day are settled after a
given number of business days.
QUESTIO NS
1.What is On -Line Surveillance System?
2.What is meant by Group ‘A’ shares?
3.What is screen based trading system?
4.Explain compulsory rolling settlement.
5.What are the eligibility criter ia for trading membership in BSE?
6.Discuss the classification of securities in BSE.

munotes.in

Page 89

897
NATIO NAL STOCK EXCHA NGE OF
INDIA
Unit Structure
7.1 Introduction
7.2 Promoters of NSE
7.3 Objectives of NSE
7.4 Management of NSE
7.5 Screen Based Trading System
7.6 Membership in NSE
7.7 Conditions for Membership
7.8 Circuit Breakers
7.9 Price Bands
7.10 Subsidiaries of NSE
7.11 Objectives of setting NSCCL
7.1 INTRODUCTIO N
The 1991 -92 securities scam revealed the inadequacies and
inefficiencies in the Indian financial system. It was scam, which prompted
a reform of the equity market. The 1990s will go down as the most
important decade in the history of the capital market of India.
Liberalisation and globalisation were the new terms coined and marketed
during this decade. The Capital Issues (Control) Act of 1947 was repealed
in May 1992. The decade was also characterised by a new industrial
policy, emergence of SEBI as a regulator of capital market, advent of
foreign institutional investors, euro -issues, free pricing, new trading
practices new stock exchanges, entry of new players such as private sector
mutual funds and private sector banks.
NSE was established to provide a fair, efficient and transparent
securities market in India. The conventional stock exchanges in India are
failed to prevent price rigging, insider trading, unfair trade practices,
market manipulations and lack sophisticated infrastructural facilities at par
with international standards. The settlement period in conventional stock
exchan ges was also very long. Hence, a Higher Power Study Group
(Pherwani Committee) was appointed by the Government of India to
recommend suitable measures for overcoming the defects of conventional
stock exchanges.munotes.in

Page 90

90NSE was the outcome of the recommendations o faH i g h e rP o w e r
Study Group. The Higher Power Study Group recommended for the
promotion of NSE by financial institutions to provide access to investors
from all over the country on an equal footing. Based on the
recommendations, NSE was promoted by leadin g public sector financial
institutions, Indian commercial banks and insurance companies at the
behest of the Government of India. NSE was incorporated in November
1992. It was registered as a limited company under the Companies Act of
1956 with an equity c apital of Rs. 25 crore. NSE was given recognition as
a stock exchange in April 1993 under Securities Contracts (Regulation)
Act, 1956. The NSE is situated in Mumbai.
7.2 PROMOTERS OF NSE
The National Stock Exchange was promoted by the following
financial institutions:
1.Industrial Development Bank of India (IDBI).
2.Industrial Credit and Investment Corporation of India (ICICI).
3.Industrial Finance Corporation of India (IFCI).
4.All Insurance Corporations.
5.Select Commercial Banks and other Financial Institutions.
7.3 OBJECTIVES OF NSE
NSE was set up with the following specific objectives:
1.To provide a nationwide trading facility for equities, derivatives, debt
and hybrid instruments.
2.To ensure equal access to all investors all over the country through
appropriate communication network.
3.To provide a fair, efficient and transparent securities market to
investors using electronic trading system.
4.To reduce settlement period through book entry settlement system.
5.To ensure timely delivery of documents.
6.To pro tect members from default risk.
7.To meet the international benchmarks and standards.
Within a short span of operation, the above objectives have been
attained and the exchange has played a leading role in transforming India
capital markets to its present f orm. NSE has set up an infrastructure that
serves as a role model for the security industry in terms of trading system,
clearing and settlement practices and procedures.
The standards set by NSE in terms of market practices, products,
technology and servi ce standards have become industry benchmarks and
are being emulated by other market participants. More than a mere marketmunotes.in

Page 91

91facilitator NSE is a force which guide the industry towards new horizons
and greater opportunities.
NSE is the most advanced exchange with 1611 companies listed as
on April 30, 2012.
The National Stock Exchange of India has stringent requirements
and criteria for the companies listed on the Exchange. Minimum capital
requirements, project appraisal, and company’s track record are just s ome
of the criteria. In addition, listed companies pay variable listing fees based
on their corporate capital size.
7.4 MA NAGEME NTO F NSE
NSE is one of the first demutualised stock exchanges in India. As a
demutualised stock exchange, the ownership, man agement and trading
rights of NSE are in the hands of three different sets of people. NSE is
owned by a set of leading financial institutions and is managed by
professionals, who do not directly or indirectly trade on the exchange.
Only qualified traders c an be involved in the securities trading.
NSE is different from other exchanges where membership
automatically implies ownership of the exchange. However, the ownership
and management of NSE have been totally delinked from the right of
trading members. Si nce broker owned stock exchanges are also broker
managed there is clear conflicts of interest. Demutualisation completely
eliminates any conflict of interest helped NSE in aggressively pursuing
policies and practices within a public interest framework.
The Board of Directors of NSE comprises of senior executives
from promoter institutions, eminent professionals in the fields of law,
economics, accountancy, finance, taxation, public representatives,
nominees of SEBI and one full time Executive of the Exchan ge. Its Board
of Directors does not have any representative of brokers. However, the
Executive Committee, which is concerned with the management of the
exchange, has four brokers nominated by the Board to reflect different
types of interests in the market. NSE has benefitted from the experience
and expertise of trading members in their advisory capacities. The
exchange has also appointed different committees to advice in areas such
as best market practices, settlement procedures and risk containment
systems .
7.5 SCREE NBASED TRADI NGS Y S T E M
The trading in stock exchanges in India used to take place through
open outcry without use of information technology for immediate
matching or recording of trades. This was time consuming and inefficient.
NSE is the firs t stock exchange in the country to be set up as a nationalmunotes.in

Page 92

92exchange having a nation -wide access and with fully automated screen
based trading system. In order to ensure efficiency, liquidity and
transparency, NSE introduced a nationwide, on -line, fully aut omated
screen based trading system (SBTS). The main advantages of trading in
NSE are that an investor can transact from any part of the country at
uniform prices. The prices at which the buyer and seller are willing to
transact will be displayed on the scr een. When the prices match, the
transaction will be completed.
7.6 MEMBERSHIP I NNSE
There is no entry or exit barriers to the membership in NSE. The
members are admitted to the different segments of the Exchange subject to
the provisions of the Securiti es Contracts (Regulation) Act of 1956, the
Securities and Exchange Board of India Act of 1992, the Rules, circulars,
notifications, guidelines etc., issued there under and the Bye laws, Rules
and Regulations of the Exchange. The following persons are eligi ble to
becoming trading members in NSE:
1.Individuals
2.Partnership firms registered under the Indian Partnership Act of 1932.
3.Institutions including subsidiaries of banks engaged in financial
services.
4.Body corporates including companies as defined in the Companies Act
of 1956.
Eligibiliy Criteria For Trading Membership
The types of securities trading in NSE are divided into three segments:
1. Wholesale Debt Market Segment.
2. Capital Market Segment.
3. Futures and Options (F&O) Market (Derivatives Market)
The NS E is one of the few exchanges in the world trading in all
types of securities on a single platform. In June 1994, NSE commenced its
operations in the Wholesale Debt Market (WDM), In November, the same
year, the Capital Market (Equities) segment also commen ced operations
and the Derivatives segment in June 2000.
The minimum standards stipulated by NSE for membership are in
excess of those laid down by the SEBI. The standards for admission of
members laid down by the Exchange stress on factors such as corpor ate
structure, capital adequacy, track record, education, experience etc. and
reflect a conscious effort on the part of NSE to ensure quality broking
services so as to build and sustain confidence among investors in the
Exchange’s operations. NSE have been encouraging corporatisation of the
broking industry. As a result, a number of brokers -proprietor firms and
partnership firms have converted themselves into corporates.munotes.in

Page 93

937.7 CO NDITIO NS FOR MEMBERSHIP
No person shall be admitted as a trading member if:
1.He has been an adjudged bankrupt.
2.He has compounded with his creditors for less than full discharge of
debts.
3.He has been convicted of an offence involving a fraud or dishonesty.
4.He is engaged as a principal or employee in any business other than
that of s ecurities, except as a broker or agent not involving any
personal financial liability or for providing merchant banking,
underwriting or corporate or investment advisory services, unless he
undertakes to severe its connections with such business on admissi on,
if admitted.
5.He has been at any time expelled or declared a defaulter by any other
Stock Exchange or he has been debarred from trading in securities by
any Regulatory Authorities like SEBI, RBI etc.
6.He has been previously refused admission to trading m embership by
NSE unless a period of one year has elapsed since the date of such
rejection.
7.He incurs such disqualification under the provisions of the Securities
Contract (Regulations) Act, 1956 or Rules made there under so as to
disentitle him from seekin g membership of a stock exchange.
Education And Experience
Where an applicant is a corporate, not less than two directors of the
company (in case of a sole proprietorship, individual and in case of a
partnership firm, two partners) should satisfy the foll owing criteria.
They should be at least graduates and each of them should possess
at least two years’ experience in an activity related to broker, sub -broker,
authorised agent or authorised clerk or authorised representative or
remiser or apprentice to a member of a recognised stock exchange. Such
experience will include working as a dealer jobber, market maker or in
any other manner in the dealing in securities or clearing and settlement
thereof, as portfolio manager or merchant bankers or as a researcher with
any individual or organisation operating in the securities market.
Minimum capital, net worth, deposits and fees payable by members in
different market segment are given below.
Trading Membership In Wholesale Debt Market (WDM)
In wholesale debt mark et segment, applicants like companies and
institutions are only eligible for membership. Individual and partnership
firms are not eligible to apply for membership on wholesale debt market
segment. Minimum net worth requirement for members in debt marketmunotes.in

Page 94

94segment shall be Rs. 2 crore. The deposits and fees payable by members
of wholesale debt market segment are the following:
1.Minimum paid up capital Rs. 30 lakh.
2.Minimum net worth Rs. 2 Crore.
3.Interest free security deposit Rs. 1.50 crore.
4.Annual subscription Rs. 1 lakh.
Trading Membership In Capital Market And Futures And Options
Market:
Individuals, partnership firms, institutions and corporations are
eligible for membership in these segments and the deposits and fees
payable by the members are the following :
1.Minimum paid up capital Rs. 30 lakh.
2.Minimum net worth Rs. 1 Crore.
3.Interest free security deposit Rs. 1.25 crore.
4.Annual subscription Rs. 1 lakh.
5.Collateral security deposit Rs. 2 Lakh.
Trading Membership In Capital Market, Futures And Options And
Wole sale Debt Market:
Corporates and institutions are only eligible for membership in
these three segments and the deposits and fees payable by the members are
the following:
1.Minimum paid up capital Rs. 30 lakh.
2.Minimum net worth Rs. 2 Crore.
3.Interest free security deposit Rs. 2.75 crore.
4.Annual subscription Rs. 2 lakh.
5.Collateral security deposit Rs. 25 Lakh.
NSE is one of the first exchanges in the world to use a satellite
communication technology for its trading. The trading system of NSE
called National Exchange for Automated Trading (NEAT), is a state of -
the-art client -server -based application. At the server end, all trading
information is stored in memory database to ensure minimum response
time and maximum system availability for its users. For all tr ades entered
into NEAT system, there is a uniform response time which is less than one
second. It is one of the very few exchanges in the world to adopt an
anonymous order matching system.
The member punches in the NEAT system, the details of his order
like the quantities and prices of securities on which he desires to transact.
The transaction is executed as soon as it finds a matching sale or buys
order from a counter party. All the orders are electronically matched on a
price/time priority basis. This h as resulted in reducing considerably the
time spent, cost and risk of error as well as frauds thus ensuring improved
operational efficiency. Further, the system allows a large number of
participants, irrespective of their geographical locations, to trade w ith one
another simultaneously, improving the depth and liquidity of the market.
A single consolidated order book for each stock displays, on a real timemunotes.in

Page 95

95basis, buy and sell orders originating from all over the country. Thus,
NEAT system provides an Open E lectronic Consolidated Limit Order
Book (OECLOB), which ensures full anonymity by accepting orders, big
or small, from members without revealing their identity. The NEAT
system also provides equal access to all the investors.
NSE carries the trading platf orm to the PCs at the residence of
investors through the internet. NSE also allows using of internet facility
for buying and selling of securities through registered brokers. These
brokers should obtain the permission of their respective stock exchanges.
In February 2000, NSE become the first exchange in the country to
provide web -based access to investors to trade directly in the exchange
followed by BSE in March 2001. The orders originating from PCs of
investors are routed through the internet to the trad ing terminals of the
designated brokers with whom they have relations and then further to the
exchange. After these orders are matched, the transaction is executed and
the investors get the conformation of the same directly on their PCs.
7.8 CIRCUIT BREAK ERS
NSE implemented index -based market -wide circuit breakers in
compulsory rolling settlement with effect from July 02. 2001. In addition
to the circuit breakers, price bands are also applicable on individual
securities.
Index -based Circuit Breakers
The index -based market -wide circuit breaker system applies at 3
stages of the index movement, either way viz. at 10 percent, 15 and 20
percent. These circuit breakers when triggered bring about a coordinated
trading halt in all equity and equity derivative mar kets nationwide. The
market -wide circuit breakers are triggered by movement of either as BSE
Sensex or the NSE S&P CNX Nifty, whichever is breached earlier.
In case a 10 per cent movement of either of these indices, there would
be a one -hour market halt i f the movement takes place before 1.00
p.m. In case the movement takes place at or after 1.00 p.m. but before
2.30 p.m. there would be trading halt for ½hour. In case movement
takes place at or after 2.30 p.m. there will be no trading halt at the 10
per c ent level and market shall continue trading.
In case of a 15 per cent movement of either index, there shall be a two -
hour halt if the movement takes place before 1.00 p.m. If the 15 per
cent trigger is reached on or after 1.00 p.m., but before 2.00 p.m., there
shall be a none -hour halt. If the 15 per cent trigger is reached on or
after 2.00 p.m. the trading shall halt for reminder of the day.
In case of a 20 per cent movement of the index, trading shall be halted
for the remainder of the day.munotes.in

Page 96

967.9 PRICE BA NDS
Daily price bands are applicable on securities as below:
1.Daily price bands of 2 per cent (either way) on securities as specified
by the Exchange.
2.Daily price bands of 5 per cent (either way) on securities as specified
by the Exchange.
3.Daily price band s of 10 per cent (either way) on securities as specified
by the Exchange.
4.No price bands are applicable on scrips on which derivative products
are available or scrips included in indices on which derivative products
are available. In order to prevent membe rs from entering orders at non -
genuine prices in such securities, the Exchange has fixed operating
range of 20 per cent for such securities.
5.Price bands of 20 per cent (either way) on all remaining scrips
(including debentures, warrants, preference shares etc.)
6.For auction market the price bands of 20 per cent are applicable.
7.10 SUBSIDIARIES OF NSE
National Securities Clearing Corporation Ltd. (NSCCL)
The National Securities Clearing Corporation Ltd. (NSCCL) is a
wholly owned subsidiary of National Stock Exchange of India. It was
incorporated in August 1995 and commenced its clearing operations in
April 1996. It was formed to build confidence in clearing and settlement
of securities and to promote and maintain the short and consistent
settlement cycl es.
National Securities Clearing Corporation Ltd. (NSCCL) carries out
the clearing and settlement of the trades executed in the Equities and
Derivatives segments. It also operates Subsidiary General Ledger Account
(SGL) for settlement of trades in governm ent securities and undertakes
settlement of transactions on other stock exchanges like the Over the
Counter Exchange of India (OCTEI). The clearing corporation is
responsible for post -trade activities such as the risk management and the
clearing and settle ment of trades executed on a stock exchange. Clearing
and settlement of trades and risk management are its central functions.
7.11 OBJECTIVES OF SETTI NGNSCCL
NSCCL was set up with the following specific objectives:
1.To build confidence in clearing and se ttlement of securities.
2.To promote and maintain short, consistent and well defined settlement
cycles without any derivatives.munotes.in

Page 97

973.To provide counter -party risk guarantee.
4.To operate a tight risk containment system.
National Securities Clearing Corporation Ltd . (NSCCL) determines
the funds/securities obligations of the trading members and ensures that
trading members meet their obligations. NSCCL becomes the legal
counterpart to the net settlement obligations of every member. This
principle is called “novation” and NSCCL is obligated to meet all
settlement obligations, regardless of member defaults, without any
discretion. NSCCL immediately cuts off trading and initiates recovery.
The NSCCL clears all trades, arranges for pay -in of funds/securities,
receives funds/securities, processes for shortages in funds/securities,
arranges for pay out of funds/securities to members, guarantees settlement,
and collects and maintains margins/collateral/base capital/other funds. It
follows a rigorous ‘risk containment’ fram ework involving collateral and
intra-day monitoring. Due to setting up of the Clearing Corporation, the
market has full confidence that settlements will take place on time and will
be completed irrespective of possible default by isolated trading members.
NSE IT Ltd.
It is also a wholly owned subsidiary of NSE and is its IT arm. This
arm of the NSE is uniquely positioned to provide products, services and
solutions for the securities industry. NSE.IT primarily focuses on the area
of trading, broker front -end and back -office, clearing and settlement, web -
based, insurance etc. Along with this, it also provides consultancy and
implementation services in Data Warehousing, Business Continuity Plans,
Site Maintenance and Backups, Stratus Mainframe Facility management,
Real Time Market Analysis & Financial News.
INDIA I NDEX SERVICES A NDP R O D U C T SL t d .( I I S L )
It is a joint venture between NSE and CRISIL Ltd. to provide a
variety of indices and index related services and products for the Indian
Capital Market. It was set up in May 1998. IISL has a consulting and
licensing agreement with the Standard and Poor’s (S&P), which is the
world’s leading provider of investible equity indices, for co -branding
equity indices.
NATIO NAL SECURITIES DEPOSITORY Ltd. ( NSDL)
NSE joined hands with IDBI and UTI to promote dematerialisation
of securities. This step was taken to solve problems related to trading in
physical securities. It commenced its operations in November 1996.
DotEx I NTERNATIO NAL LIMITED
DotEx was formed to pro vide a well -structured inter trading
platform for the members to further offer on -line trading facilities to their
customers. With this facility, the members can serve big customers with
the use of automated risk management features and thus increase themunotes.in

Page 98

98volume of trade. The investors also get comprehensive, relevant and
updated information through it.
OVER THE COU NTER EXCHA NGE OF I NDIA
OTCEI was set up in 199 -as Section 25 Company under the
Companies Act 1956 and is recognised as a Stock Exchange under S ection
4 of Securities Contracts Regulation Act, 1956. It was set up to provide
small and medium sized enterprises access to the capital markets and to
investors a convenient mode of investments. It is a ring less electronic
national exchange listing entir ely new companies, which will not be listed
on any other exchange.
Companies engaged in investment, leasing, finance, hire purchase,
amusement parks etc. and the companies listed on any other stock
exchange are not eligible for getting listed on OTCEI. Al so, listing is
granted only if the issue is fully subscribed to by the public and sponsor.
Promoters of the Exchange
OTCEI was promoted by a consortium of leading Financial
Institutions of India, such as:
1. Unit Trust of India (UTI)
2. ICICI
3. Industri al Development Bank of India (IBRD)
4. SBI Capital Markets Limited
5. Industrial Finance Corporation of India (IFCI)
6. Life Insurance Corporation of India (LIC)
7. Canbank Financial Services Limited
8. General Insurance Corporation of India & its subsidiaries.
Members on the exchange are responsible for getting companies
on the exchange through the mechanism of sponsorship. Dealers may
perform the dual roles of broker and the market maker, and along with
members, are responsible for trading of sec urities on the exchange. The
Custodian/Settler is responsible for validation of trading documents,
storage of trading documents, and share certificates as also clearing of
daily transactions and giving each member/dealer his net monetary
position with resp ect to the market as a whole. Registrars and the transfer
agents are responsible for share transfers, allotment and keeping
shareholders informed of all developments in the companies concerned.
SUMMARY
The 1991 -92 securities scam revealed the inadequacies and
inefficiencies in the Indian financial system. It was scam, which prompted
a reform of the equity market. The 1990s will go down as the most
important decade in the history of the capital market of India.
The National Stock Exchange was promoted by t he following
financial institutions:munotes.in

Page 99

99a. Industrial Development Bank of India (IDBI).
b. Industrial Credit and Investment Corporation of India (ICICI).
c. Industrial Finance Corporation of India (IFCI).
d. All Insurance Corporations.
e. Select Commercial Ba nks and other Financial Institutions.
NSE is one of the first demutualised stock exchanges in India. As a
demutualised stock exchange, the ownership, management and trading
rights of NSE are in the hands of three different sets of people. NSE is
owned by a set of leading financial institutions and is managed by
professionals, who do not directly or indirectly trade on the exchange.
Only qualified traders can be involved in the securities trading.
The trading in stock exchanges in India used to take place through
open outcry without use of information technology for immediate
matching or recording of trades. This was time consuming and inefficient.
NSE is the first stock exchange in the country to be set up as a national
exchange having a nation -wide access and with fully automated screen
based trading system. In order to ensure efficiency, liquidity and
transparency, NSE introduced a nationwide, on -line, fully automated
screen based trading system (SBTS).
There is no entry or exit barriers to the membershi p in NSE. The
members are admitted to the different segments of the Exchange subject to
the provisions of the Securities Contracts (Regulation) Act of 1956, the
Securities and Exchange Board of India Act of 1992, the Rules, circulars,
notifications, guidel ines etc., issued there under and the Bye laws, Rules
and Regulations of the Exchange. The following persons are eligible to
becoming trading members in NSE:
a. Individuals
b. Partnership firms registered under the Indian Partnership Act of 1932.
c. Instit utions including subsidiaries of banks engaged in financial
services.
d. Body corporates including companies as defined in the Companies Act
of 1956.
NSE implemented index -based market -wide circuit breakers in
compulsory rolling settlement with effect fro m July 02. 2001. In addition
to the circuit breakers, price bands are also applicable on individual
securities.
QUESTIO NS
1.What is NSE?
2.What is on -line surveillance system?
3.State the objectives of NSE.
4.Discuss the rationale of NSE.
5.Who are promoters of NSE?
6.What are the trading segments in NSE?
7.What is meant by index -based circuit breaker?munotes.in

Page 100

1008.Name the subsidiaries of NSE.
9.What are the objectives of National Securities Clearing Corporation
Limited?
10.Write explanatory notes on Price Bands.
RECE NTD E V E L O P M E NTSINSTOCK EXCHA NGES
Reforms and developments
Till recent past floor trading took place in all the stock exchanges in
India. In this system the trade takes place through open outcry system
during the official trading hours. Trading posts are assigned for
different securities where buy and sell activities of securities took
place.
In 1994 NSE and OTCEI was set up with the screen based trading
facility. After one year BSE introduced the screen based trading
system. And after that more and more stock exchanges adopted screen
based trading system.
In 1992 foreign institutions investors have been allowed to invest in
India.
In 1993 private sector mutual funds have been allowed.
In 2001 Derivatives in the form of futures and options are introduced
for trading and h edging purpose.
SEBI has made compulsory to all the intermediaries to register with it.
At present trader can trade through laptops, palmtops and mobile
phones also.
The trading cycle has been shortened to T+2 from T+5 so that investor
should not wait for sale proceeds of his investments.
At present almost 99% of the scrips are dematerialized. Almost all the
traders are in the demat form.
Now balance sheet and prospectus of the company are available to the
investors.
At present NAV has to be published.
Insider trading and unfair practices are strictly prohibited.
The Original OTCEI Mandate Yesterday
India’s first online, real time exchange.
Unique market maker concept to provide liquidity and support.
Transparency would attract the small investors.
Commitme nt of large institutions will give a boost to OTCEI.
Day-to-day affairs will be looked after by the Exchange Committee.
The Reality Today
Connectivity problems.
Trading software not up to the mark.munotes.in

Page 101

101Market making not understood as a concept.
Low volumes and no depth.
Lack of investor education.
Orphan exchange: apathetic promoters of OTCEI.
No provision for exchange of the committee members.
Share transfers take up to six months.
Too many dealers and too few companies.
Low discounting of OTC listed compan ies. No speculation: OTC ideal
exchange for forward trading.
POSSIBLE SOLUTIO NTOMORROW
Switch over to VSAT.
Make the software more -friendly.
Let the promoters of OTCEI get active or
Sell the Exchange to those who are willing to develop it.
Sponsor track record gets included in new issue prospectus.
Co-ordinated effort by all OTC players for investor education.
Most active dealers and members represented on Exchange
Committee.
Product segmentation and development of the retail debt market.
Penalise inactiv em e m b e r sa n dd e a l e r s .
Improve the performance of the registrars.
Introduce forward trading in a regulated regime.
STOCK MARKET I NDICES
INTRODUCTIO N
Stock Market is a place where the stocks of listed companies are
traded. A stock index is a simple barometer reflecting the value of the
underlying scrips in the market. Stock indices are used as reliable
benchmarks to observe the vibrancy of the capital markets and to evaluate
their performance. A good stock index captures the movement of the well
diversified and highly liquid stocks. Financial indices are generally created
to measure the movements of price of stocks, bonds, treasury bills and
other types of financial instruments.
An index is a statistical average, which can be a simple or
weighted ave rage, of a few leading shares in the market. The average
number so arrived at is called an index. A stock index consists of a set of
stocks that are representative of either the whole market, or a specified
sector, to measure the change in the overall beha viour of the markets or a
sector over a period of time. The level of the index reflects the total
market value of all the stocks in the index of a particular base period.
19thcentury mathematicians were the first to propose modern
indices. The grandfathe r of all equity indices is the Dow Jones Industrial
Average, which was first published in 1896. Since then indices have come
a long way, not only in their sophistication but also in their variety. Inmunotes.in

Page 102

102India, till the decade of eighties, there was no scale t o measure the ups and
downs in the Indian Stock market. The Bombay Stock Exchange Ltd.
(BSE) in 1986 came out with a stock index called ‘SENSEX’ that
subsequently became the barometer of the Indian Stock Market. The
launch of SENSEX in 1986 was later follo wed up in January 1989 by
introduction of BSE National Index. Subsequently the national index was
renamed as BSE -100. In 1996 the National Stock Exchange (NSE)
developed their index called Nifty 50.
Indices are mainly of price index, quantity index and va lue index.
Price index measures changes in prices of debt, government and equity
securities. Price index is widely used in financial market than the quantity
and value indices. Of these indices, equity indices are more important than
indices of debt securi ties. Most of the indices are developed and computed
by using the market capitalisation weighted method.
SIGNIFICA NCE OF I NDEX MOVEME NT
Stock Index generally indicate the overall performance of the
market on a daily basis. It is the average of a large num ber of shares which
shows the level of changes in stock prices with respect to time. It helps to
measure the change in overall behaviour of the markets or sector over a
period of time. For example if the share price index in June 2010 is 5000
and if the av erage share price in 1984 -85 taken as 100, it means that on an
average, share prices in the market have grown up by about 50 times since
1984 -85. The year for which the average price is assumed to be 100 (in
this case, 1984 -85) is known as the base year.
Ups and downs of an index reflect the changing expectations of the
stock market regarding future earnings of the corporate sector. When the
index goes up, it is because the stock market thinks that the prospective
earnings will be better than previously th ought. When prospects of
earnings in the future become pessimistic, the index drops. The ideal index
gives us instant -to-instant readings about how the stock market perceives
the future of a country’s corporate sector. Every stock price moves up or
down be cause of three possible reasons:
1.News about the company (e.g. a product launch, or the closure of a
factory)
2.News about the industry.
3.News about the economy as a whole including political and
sentimental factors.
USES OF STOCK I NDEX
Following are the uses of stock market index:
1.It Acts as a Barometer: Stock index is a barometer which indicates the
overall performance of the economy or a sector of the economy. The
ups and downs in the stock index represent the volatility of the equitymunotes.in

Page 103

103market. It acts as a s ignal to the government to the ‘good or bad’ factor
prevailing in the economy.
2.It Acts as a Benchmark for Portfolio Performance: The most important
use of an equity market index is to remain as a benchmark for a
portfolio of stocks. All diversified portfol ios, belonging to either retail
investors or mutual funds, use the common stock index as a yardstick
for evaluation of their performance.
3.Index is an Underlying for Derivatives like Index Futures and Options:
Indices are useful in modern financial applicat ion of derivatives.
Indices serve as the underlying for futures, options and index funds
etc.
4.Helps Companies in Raising Capital: An index is an indicator of the
overall mood of the investors in the secondary market and it helps
companies to determine the price of the new issue and the ideal time of
making an IPO.
5.Helps in Studying the Market Behaviour: Stock index is used to
monitor and measure market movements, either in real time or daily or
even decades, helping us to understand economic conditions and
prospects.
6.Helps in Comparison: It provides a historical comparison of returns on
money invested in securities against other forms of investments. It is
also helpful to the investors for comparison of performance of scrips in
various sectors and companies.
7.Helps in Choosing Portfolio Investment: Another important use of an
equity market index is to act as a benchmark for a portfolio of stocks.
All diversified portfolios, belonging either to retail investors or mutual
funds, use the common stock index as a y ardstick for evaluation of
their performance. An index is thus useful to the investors in choosing
appropriate portfolio for investment.
8.Index can be used as a standard against which to compare the
performance of an equity fund.
9.Index supports research, ri sk measurement and asset allocation.
DISADVA NTAGES OF STOCK I NDEX
A Stock Index reflects changing expectations of the market about
the future of the corporate sector. Stock index has several uses but it is a
double edged sword with some serious defects. S uppose an investor thinks
that the stock of the company is going down and if this feeling prevails
across the investors, then everyone would want to get out of the
company’s stock. This would automatically lead to the stock prices
crashing. Any downturn in the market would be reinforced by the
collective action of the investors to hedge against any losses and get out of
the market. Even though an index is a popular guide to the investors, it is
riddled with imperfections which can often confuse rather than help. For
instance when the index rises, the market expects the future to be bettermunotes.in

Page 104

104than previously expected and drops when the expectations about future
become pessimistic.
TYPES OF I NDEX
Index can be classified into two types:
Broad Market Index: Broad Market Index is an index which
consists of all the large, liquid stocks of the country and becomes the
benchmark for the entire capital market of the country. Examples of this
index are BSE -500 Index, S&P CNX 500.
Specialised Index: Specialised Index is a n index which specialises
an industry or a sector of the economy which serves as benchmark for that
particular industry or sector. Examples of specialised or sectoral indices
are BSE auto, BSE Metal, S&P CNX Energy Index etc.
DETERMI NANTS OF STOCK I NDEX
Following parameters should be taken into consideration while
constructing a stock index:
1.The stocks selected for forming an index should be highly liquid.
Illiquid stocks should be avoided for the construction of an index.
2.The number of scrips selected sho uld have sizable proportion of the
total market capitalisation of scrips. The index should include
primarily the stock of companies that have significant market
capitalisation with respect to the index such that any major change in
the price of the stock i s reflected in the index.
3.Each scrip should be properly weighted so that it influences the index
n proportion to its respective market importance.
4.While selecting securities for forming an index, due representation
should be given to each industry in the i ndex sample and all major
scrips should be included.
5.While selecting scrips, balanced representation should be given for all
sectors.
6.Base year selected be normal and free from major fluctuation.
7.The size of the scrips selected for an index should be optim um.
Number of scrips selected should be neither too small nor too large.
More stocks lead to greater diversification but increasing the number
of stocks beyond a point does very little in risk reduction.
DIFFERE NTM E T H O D O L O G I E SF O RC A L C U L A T I O NOF
STOCK I NDICES
Following are the different methods, which are adopted for the
calculation of stock indices:
1.Price Capitalisation Methodology
2.Free-Float Market Capitalisation Methodology
3.Price -Weighted Index
4.Equal Weighted Indexmunotes.in

Page 105

105Market Capitalisation Methodology: Market Capitalisation Method
takes into account the entire equity for calculation of index and do not
eliminate shares that are held by promoters and other companies which
have a controlling interest. In this method weightage is calculated by
multiplying t he number of shares outstanding with the market price of the
share. The shares with higher market capitalisation have higher weightage
and will be most dominant in the index.
Free-Float Market Capitalisation Methodology: Free -Float
methodology refers to a n index construction methodology that takes into
consideration only the free -float market capitalisation of a company for
the purpose of index calculation and assigning weight to stocks in index. It
takes into account only those shares that are freely avai lable for trading in
normal course. It excludes those shares that are held by promoters,
strategic holding, government holding, lock -in shares etc. In other words,
the market capitalisation of each company in a free -float index is reduced
to the extent of its readily available shares in the market.
Price -Weighted Index: It is a stock index in which each stock
influences the index in proportion to its price per share. The value of the
index is calculated by adding the prices of each of the stocks in the ind ex
and dividing them by the total number of stocks. Stocks with a higher
price will be given more weight and, therefore, will have a greater
influence over the performance of the index. Dow Jones Industrial
Average, one of the oldest indexes which were lau nched in 1896 is an
example of one that is calculated on this methodology.
Equal Weighted Index: In this method the weights are equal and
assigned irrespective of both market capitalisation and price. An equally
weighted index makes no distinction between large and small companies,
both of which are given equal weights. The good performance of large -cap
stocks is negated one -for-one by poor performance of smaller -cap stocks
in this index.
STOCK I NDICES OF BOMBAY STOCK EXCHA NGE
SENSEX: SENSEX (Sensitive In dex) is the blue chip index of the
BSE. Up to the eighties of the last century, there was no scale to measure
the ups and downs in the Indian Stock Market. SENSEX, first compiled in
1986, was calculate on a ‘Market Capitalisation Weighted’ methodology
of 3 0 component stocks representing large, well established and
financially sound companies across key sectors. The BSE Sensex is
generally regarded as the most popular and widely tracked index of the
Indian Stock Market. SENSEX today is widely reported in bot h domestic
and international markets through print as well as electronic media. The
values of all BSE indices are updated on real time basis during market
hours and displayed through the BOLT system, and BSE website. This is
done automatically on the basis of prices at which trades in index
constituents are executed. BSE also disseminates information on the Pricemunotes.in

Page 106

106Earning Ratio, the Price to Book Value Ratio and the Dividend Percentage
on day -to-day basis of all its major indices.
SENSEX is not only scienti fically designed but also based on
globally accepted construction and review methodology. SENSEX
consists of 30 largest, well -established and most vigorously traded stocks,
representing various sectors of the BSE. SENSEX is thus a basket of 30
constituent stocks representing a sample of large and liquid companies.
The set of companies which make up the index was changed only very
few times during the past 25 years. These companies account for around
one-fifth of the market capitalisation of the BSE.
The in dex includes 30 companies which figure in top 100 in terms
of market capitalisation and are also among the leaders in their industry
groups. Presently the following are the constituent companies: ACC,
Infosys, Reliance, Infra, Jaiprakash Associate, HDFC Ba nk Ltd., Wipro
Ltd., Tata Power, Hindalco Industries, L&T, Housing Development
Finance Corporation, ITC Ltd., State Bank of India, CIPLA Ltd., Grasim
Industries Ltd., Tata Motors, Sterlite Industries, NTPC Ltd., Tata Steel,
Bharathi Airtel, BHEL, ONGC, TCS Ltd.
SENSEX Criteria for the Selection of Scrips: The general
guidelines for selection of constituents in SENSEX are as follows:
1.Listing History
The company should have an acceptable record of accomplishment on
the opinion of the Index Committee. The sc rip should have a listing
history of at least 3 months at BSE. Minimum requirement of 3
months is reduced to one month, if full market capitalisation of a
newly listed company ranks among top 10 in the list of BSE universe.
In case of a company, which is l isted because of either merger or
demerger or amalgamations, minimum listing history is not be
required.
2.Trading Frequency
The scrip should have to be traded one which is on each and every
trading day during the past three months.
3.Final Rank
The scrip should figure in the top 100 companies listed as per final
ranking. The final rank is arrived at by assigning 75 per cent
weightage to the rank on the basis of a three -month average full
market capitalisation and 25 percent weightage to the liquidity rank
based on three -month average daily turnover and three -month average
impact cost.
4.Market Capitalisation Weightage
The weightage of each scrip in SENSEX based on three -month
average free -float market capitalisation should be at least 0.5 percent
of the Inde x.munotes.in

Page 107

1075.Industry Representation
Scrip selection generally takes into account a balanced representation
of the listed companies in the universe of BSE.
SENSEX CALCULATIO NMETHODOLOGY
The base year of SENSEX was taken as 1978 -79 and the base
value is 100 index points. The SENSEX was initially calculated based on
the “Full Market Capitalisation” methodology but was changed to the
“Free -Float Market Capitalisation” methodology with effect from
September 1, 2003. The free -float market Capitalisation -Weighted
method ology is a widely followed index construction methodology on
which majority of global equity benchmarks are based.
DOLLAR SERIES OF BSE I NDICES
All BSE indices reflect the growth in market value of constituent
stocks over its base period in rupee terms th en a need was felt to design a
yardstick by which these growth values are measured in dollar terms. Such
an index would reflect, in one value, the changes in both the stock prices
and the foreign exchange variation. This is facilitated by the introduction
of a dollar -linked index emerged in the backdrop of Indian equity markets
increasingly getting integrated with global capital markets and felt need to
assess the market movements in terms of international benchmarks. This
index is useful to overseas invest ors, as it helps them to measure their real
return after providing for exchange rate fluctuations. Earlier BSE
calculates dollar -linked version of SENSEX and BSE -200. Presently BSE
calculated dollar -linked version of Dollex -30, Dollex -100 and Dollex -200
and displays them in BSE on -line trading terminals (BOLT) by taking into
account real -time Rs/US$ Exchange rate.
BSE-100 Index: The BSE National Index was launched on January 3,
1989. It comprises 100 stocks listed at five of the major stock exchanges
in In dia i.e at Mumbai, Kolkatta, Delhi, Ahemdabad and Chennai. The
criterial for selection are market activity, due representation to various
industry groups and representation of trading activity on major stock
exchanges. The BSE National Index was renamed as BSE-100 Index from
October 14, 1996 and since then it is calculated taking into consideration
only the prices of stock listed at BSE. BSE also calculates a dollar -linked
version of BSE -100 Index. The base period of BSE -100 is 1983 -84 with a
base value of 100.
BSE-200 Index: BSE-200 Index was constructed and launched on 27th
May 1994. Equity shares of 200 selected companies from the specified
and non -specified lists of BSE have been considered for inclusion in the
sample for BSE -200. The selection of compa nies is primarily done on the
basis of current market capitalisation of the listed scripts on the exchange.
Besides market capitalisation, the market activity of the companies as
reflected in the volumes of turnover and certain fundamental factors are
considered for the final selection of the 20 companies. The base period for
BSE-200 Index is 1989 -90 with a base value of 100.munotes.in

Page 108

108BSE-500 Index: BSE-500 Index consists of 500 scrips in its basket, which
was launched on August 9, 1999. The changing patterns of the economy
and that of the market are kept in mind while constructing this index.
BSE-500 index represents nearly 93 percent of the total market
capitalisation on BSE Ltd. This means BSE -500 Index closely represents
the whole market. This index represents al most all the 20 major industries
of the economy. The base period for BSE -500 index is 1stFebruary 1999
with a base value of 100.
BSE Mid -Cap and BSE Small -Cap Index: BSE introduced BSE Mid -
Cap and BSE Small -Cap Index to track the performance of the companies
with relatively small market capitalisation that would exclusively
represent the mid and small cap companies listed on the BSE. This index
was constructed to capture the trend in the specific class of companies
(with lower capitalisation). Scrips that are included in Z group are taken
into account for this calculation. The number of companies in each of
these indices periodically varies. The base period for BSE Mid -Cap and
BSE Small -Cap Index is 2002 -03 with base value of 1000 and it was
launched on April 2005. Free -Float market capitalisation methodology is
used for calculation of the index.
Sectoral Indices of BSE: BSE calculates various sectoral indices. All the
indices are calculated and disseminated on BOLT which is BSEs trading
terminal on a real time basis. Number of scrips in each of the sectoral
indices at BSE is variable as they aim to represent minimum of 90 percent
market capitalisation from the universe of BSE -500 index. Similar to other
BSE indices, sectoral indices at BSE are also ca lculated and disseminated
with in a frequency of 15 seconds. The base value of all sectoral indices is
1000. Some of the sectoral indices are given below:
BSE Fast Moving Consumer Goods (FMCG): Index developed for fast
moving consumer goods and products, which are non -durable and
characterised by mass consumption. The index was introduced by the BSE
on 9thAugust, 1999. The base period for the index is February 1, 1999
with a base index value of 1000.
BSE Capital Goods: It was introduced by BSE on August 9, 1999. The
base period for the index is February 1, 1999 with a base value of 1000.
BSE Consumer Durables: It was introduced by BSE on August 9, 1999.
The base period for the index is on February 1, 1999 with a base index
value of 1000.
BSE Healthcare :BSE Healthcare index was developed to capture the
performance of the companies engaged in the manufacture of healthcare
products. It was introduced by BSE on August 9, 1999. The base period
for the index is February 1, 1999 with a base index of 1000. The se indices
were initially calculated on free -float capitalisation method since August
16, 2005.munotes.in

Page 109

109BSE Capital Goods, BSE Consumer Durables, BSE IT: BSE Capital
Goods, BSE Consumer Goods, BSE IT are the various other sectoral
indices introduced by BSE on 9thof August, 1999. The base period for
these indices is February 1, 1999, with the base index value of 1000.
These indices were initially calculated on full market capitalisation
method, which is now changed to free -float capitalisation method since
August 1 6, 2005.
BSE Tech Index comprises IT, Media and Telecommunication sector. It
was introduced by the BSE on July 11, 2001. The base period for the
indices is on April 2, 2001 and base index value is 1000. It is calculated on
free-float methodology.
BSE BA NKEX: BSE BANKEX was commenced on June 23, 2003. Base
period for this index is January 1, 2002 with a base index value of 1000.
BSE Auto: BSE Auto was commenced on August 23, 2004. The base
period for BSE Auto index is February 1999, with a base index valu eo f
1000. It is calculated only on free -float methodology.
BSE Metal: BSE Metal index with free -float methodology for calculation
was introduced on August 23, 2004. The base period for these indices is
February 1, 1999 with a base index value of 1000.
BSE Oil and Gas: BSE Metal and BSE Oil and Gas were the indices
introduced by the BSE on August 23, 2004. The base period for the
indices is February 1, 1999 with a base index value of 1000. It is
calculated on free -float methodology.
BSE Realty: BSE Real ty Index was developed to synergise the emerging
opportunities in the real estate sector. This sector thrusts on development
of buildings, building townships and scaping land. There are plenty of
opportunities in real estate sector which are backed by favo urable tax
regimes. BSE Realty was commenced by the BSE on July 9, 2007 and it
was based on January 3, 2005. Prices.
BSE Power: BSE Power Index was developed to appraise the
performance of the companies in the energy sector. BSE Power was
commenced by the BSE on November 19, 2007 based on January 3, 2005
prices.
INDICES OF NATIO NAL STOCK EXCHA NGE OF I NDIA
Nifty 50 is the blue chip index of the NSE of India Ltd. Besides
Nifty 50, the various sectoral indices are also offered by the NSE of India.
Nifty is owned and managed by India Index Services and Products Ltd.
(IISL) which is a joint venture of NSE and C RISIL. IISL is India’s first
specialised company focused upon the index as a core product. IISL is
India’s first specialised company focused upon the index as a core
product. IISL has a marketing and licensing agreement with Standard &munotes.in

Page 110

110Poor’s. Standard and Poor’s (S&P) is one of the World’s leading provider
of equity indices.
S and P stands for US based ‘Standard and Poor’s Financial Information
Services. The CNX stands for CRISIL NSE indices, the two companies
that come together to form the index. CNX ind ices are useful for fund
managers, corporates, brokers and all such enterprises connected with
investments in the equity markets. These indices can be used for tracking
the markets, understanding the performance of a company vis -à-vis the
market, determini ng how an investors portfolio is performing as compared
to the market, trading derivative products and most importantly for
development of index based funds by mutual funds. The various indices of
NSE are given below:
S&PC NXNIFTY: Standard and Poor’s CRISIL NSE Index 50 or S &
P CNX Nifty is the leading index of the NSE of India Ltd. S&P CNX
Nifty 50 has nicknamed as Nifty 50 or simply Nifty. It consists of well -
diversified 50 stocks accounting for 22 sectors of the economy. Nifty 50
has attained great popularity among the investors. The index is composed
of top 50 most liquid stocks of largest companies in India. It is used for a
variety of purposes such as benchmarking fund portfolios, index based
derivatives and index fund. Thus, Nifty reflects the s tock market
behaviour and it is also used for the applications of index fund and index
derivatives. It has now become one of the most popular and widely used
stock market indicators of the country.
Nifty 50 was introduced on January 1996. The base period selected for
Nifty 50 is November 1995 and the base value of the index has been set at
1000. It includes 50 of the approximately 935 companies listed on the
NSE, captures approximately 60 percent of its equity market capitalisation
and is a true reflection of the Indian Stock Market.
A. Nifty-Eligibility Criteria for the Selection of Scrips: All
common shares listed on the NSE (which are of equity and not a fixed
income nature) are eligible for inclusion in the S&P CNX Nifty Index.
Convertible stocks, bonds, warrants, rights and preferred stock that
provide a guaranteed fixed return are not eligible. Selection of stocks in
nifty fifty is based on four criteria:
1.Liquidity (Impact Cost): Impact cost is the cost of executing a
transaction in a security in proport ion to the weight of its market
capitalisation against the index market capitalisation, at any point in
time. For inclusion in the index, the security should have traded at an
average impact cost of 0.75 per cent or less during the last six months,
for 90 percent of the observation.
2.Market Capitalisation: For being included in the S&P CNX Nifty 50,
the companies should have an average market capitalisation of Rs. 500
crore or more during the last six months.munotes.in

Page 111

1113.Floating Stock (Outstanding Shares): Companies el igible for inclusion
in the S&P CNX Nifty should have at least 12 percent of its stocks
available to investors (float). For this purpose, float shall mean stocks
which are not held by the promoters and associated entities of such
companies.
4.Others: The com pany must be domiciled in India and trade on the
NSE.
B. Additions: The index is reviewed every quarter and a six -week
notice is given to the market before making any changes to the index
constituents. The complete list of eligible securities is compiled bas ed on
the market capitalisation criteria. After that, the liquidity (impact cost) and
free float filter are applied to them, respectively, short listed companies
form the replacement pool. The top stocks, in terms of size (market
capitalisation), are then identified for inclusion in the index from the
replacement pool.
C. Deletions: Stocks may be deleted due to mergers, acquisitions or
spin offs. Otherwise, as noted above, every quarter a new eligible stock
list is drawn up to review against the current constituents. If this new list
warrants changes in the existing constituent list, then the smallest existing
constituents are dropped in favour of the new additions.
S&P C NXNifty Junior: CNX Nifty Junior consists of the most liquid
stocks, but which are excluded from the Nifty 50. Nifty 50 and CNX
Nifty Junior shows different stocks . CNX Nifty Junior was introduced in
January 1997. The base period selected for CNX Nifty is November 1996
and the value of the index has been set as 1000.
S&P C NX1 0 0 : CNX 100 is a diversified 100 stock index accounting for
35 sectors of the economy. Thi s index is a combination of Nifty 50 and
CNX Nifty Junior. The CNX 100 has a base of January 2003 and a base
value of 1000.
S&P C NX 500 Equity Index: The S&P CNX 500 is India’s first broad -
based benchmark of the Indian Capital Market used for comparing
portfolio returns vis -à-vis market returns of companies share and stocks.
Stocks are selected based on their market capitalisation, industry
representation, trading interest and financial performance. The S&P CNX
500 Equity Index currently has 79 industry gr oups accounting for over 73
percent of total market capitalisation and over 98 percent of total turnover
making it an ideal market benchmark. The CNX 100 index is based on the
calendar year 1994 with a base value of 1000.
S&P Nifty Midcap 50: The primary objective of the Nifty Midcap 50
Index is to track the movement of the midcap segment of the market. The
significance of Nifty Midcap 50 Index has of late increased mainly due to
the increased attraction of investors for the medium capitalized segment ofmunotes.in

Page 112

112the stock market. The Nifty Midcap 50 Index has a base date of January 1,
2004 and a base value of 1000.
S&P C NX Midcap: The CNX MidCap 200 Index comprises 200
companies. The distribution of industries in the index represents the
industry distribution in the Midcap Universe. The Index represents 71
percent of the total midcap market capitalisation and 72 percent of its
trading value making it an optimal index for measuring the stock market
performance of the Midcap segment. The CNX midcap index with a base
date of January 2003 was introduced as a benchmark of the midcap
segment of the market.
S&P C NXD e f t y : S&P CNX Defty is Nifty 50, measured in dollars. This
index is very useful for overseas investors having an equity exposure in
India. It helps them to c alculate their real return on investment in dollar
terms. The S&P CNX Defty Index has a base date of November 3, 1995
and a base value of 1000.
Sectoral Indices of NSE:NSE also calculates various sectoral indices.
These indices cover 90 percent of the se ctoral market capitalisation. Most
of the sectoral indices are market capitalisation weighted index and the
base value of all sectoral indices is 1000. Some of the sectoral indices of
NSE are given below:
CNXM NCI n d e x : CNX Multination Companies Index com prises 50
listed companies in which the foreign shareholding is over 50 percent or
the management control is vested in the foreign company. The base period
of the index is December 1994 and its base value is 1000.
CNXP S EI n d e x : With a view to provide reg ulators, investors and market
intermediaries with an appropriate benchmark that truly captures the
performance of the stocks of Public Sector Enterprises, an index was
introduced called CNX PSE Index. CNX PSE Index includes only those
companies with 51 per cent of their outstanding share capital held by the
Central and State Governments directly or indirectly. The index comprises
stocks of 20 Public Sector Enterprises. Market capitalisation weighted
aggregate method is used for the calculation of the index. The base period
is the month of December 1994 and its base value is 1000.
CNXI TI n d e x : CNX IT Index reveals the real performance of the IT
segment in the capital market. It is a benchmark for the investors and
market intermediaries to know the performanc eo fI Ts t o c k s .C o m p a n i e s
in this index have more than 50 percent of their turnover from IT related
activities like software development, hardware manufacturing, vending,
support services and maintenance. This index is market capitalisation
weighted index with its base period during December 1995.
CNXF M C GI n d e x : CNX FMCG Index developed for fast moving
consumer goods and products, which are non -durable, mass consumptionmunotes.in

Page 113

113products which are available off the shelf. CNX FMCG Index comprises
of 15 stocks from the FMCG sector that are traded on the NSE. The base
period is the month of December 1995, with a base value of 1000.
CNXS e r v i c eS e c t o rI n d e x : CNX Service Sector Index was introduced
with the objective of highlighting the performance of the companies
belonging to the service sector. CNX Service Sector Index is a 30 stocks
index and includes those companies belonging to the service sectors like
computers, banks, telecommunication services, power, media courier,
shipping etc. The base period is the month o f May 1999, and its base value
is 1000.
CNXB a n k Nifty: In order to have a good benchmark for the Indian
banking sector, Bank Nifty was developed. CNX Bank Nifty comprises
the most liquid and large capitalised Indian banking stocks. It provides
investors and market intermediaries with a benchmark which captures the
capital market performance of Indian banks. This index is composed of 12
stocks from the banking sector, which are traded on the NSE. The index is
a market capitalisation weighted index with bas ed date of January 1, 2000
indexed to a base value of 1000.
S&P C NX Industry Indices: S&P CNX 500 equity index is desegregated
in 72 industry sectors. S&P CNX Industry Index is developed very
carefully to include stocks of industries in the entire univers e of securities.
The changes to the weightage of various sectors in the S&P CNX 500
would dynamically reflect the changes in the universe of securities.
CNXE n e r g yI n d e x : CNX Energy Index was developed to capture the
performance of the companies in the en ergy sector. Energy sector include
those companies belonging to petroleum, gas and power sectors. The
index is a market capitalisation weighted index with base date of January
1, 2001 indexed to a base value of 1000.
CNXP h a r m aI n d e x : CNX Pharma Index was developed to capture the
performance of the companies in the pharma sector. The index is a market
capitalisation weighted index with base date of January 1, 2001 indexed to
ab a s ev a l u eo f1 0 0 0 .
CNXI n f r a s t r u c t u r eI n d e x : CNX Infrastructure Index has deve loped to
capture the performance of the companies in the infrastructure sector.
CNX Infrastructure Index comprises 25 stocks of various infrastructure
companies namely Telecom, Power, Port, Air, Roads, Railways, Shipping
and other Utility Service providers . The index is a market capitalisation
weighted index with base date of January 1, 2004 and indexed to a base
value of 1000.
CNXP S UB A NKI n d e x : CNX PSU Bank Index was developed to
indicate the performance of the Indian banking industry especially publicmunotes.in

Page 114

114sector banks. This index is Free Float methodology based weighted index
with base date on January 2004.
CNX Reality Index: CNX Reality Index is to indicate the performance of
the stocks of Indian Realities company’s viz. companies engaged in
development o f buildings, building townships and developing land. The
index is a Free Float methodology based weighted index with base date of
January 1, 2004, indexed to a base value of 1000.
QUESTIO NS
1.Explain BSE Index.
2.Explain Nifty 50.
3.What are the different types of indices?
4.What is Dollex series of BSE indices?
5.Define stock index. What are the purposes of stock index?
6.Explain the different methodologies adopted for calculation of index.
7.Explain the significance of stock index.
8.Discuss the criteria for the selection of shares in Nifty 50.
9.How are stock market indices constructed?

munotes.in

Page 115

115Module III
8
INTRODUCTIO NOF M ONEY MARKET.
Unit Structure
8.1 Meaning of money market
8.2 Features of money market
8.3 Money Markets instruments
8.4 Institutions of money market
8.5 Functions of money markets.
8.1 MEA NINGO FM O NEY MARKET
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 s uch 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 thei rs h o r t -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 b orrowers. 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 specialized financial institutions.
The Reserve Bank o f 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.
8.2 FEATURES OF THE MO NEY MARKET
The following are the main features of a money market: -
1.It is a market only for short -term funds.
2.It deals with financial assets having a maturity period up to one
year only.
3.It deals with only those assets which can be converted into cash
readily without loss and with minimum trans action cost.munotes.in

Page 116

1164.Transactions have to be conducted without the help of brokers.
5.It comprises of several sub -markets, each specializing in particular
type of financing e.g., call money market, acceptance market, bill
market etc.
6.The components of a money market are the central bank,
commercial banks, non -banking financial companies, discount
houses and acceptance houses. Commercial banks are playing a
dominant role in this market.
8.3MONEY MARKET I NSTRUME NTS
Following are some of the important money market i nstruments or
securities.
(a)Call Money : Call money is mainly used by the banks to meet their
temporary requirement of cash. They borrow and lend money from each
other normally on a daily basis. It is repayable on demand and its maturity
period varies i n between one day to a fortnight. The rate of interest paid on
call money loan is known as call rate.
(b)Treasury Bill : A treasury bill is a promissory note issued by the RBI
to meet the short -term requirement of funds. Treasury bills are highly
liquid i nstruments 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 t he 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
(c)Commercial Paper : 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.
(d)Certificate of Deposit: 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 pe riod of CDs ranges from 91 days to one year. These can be
issued to individuals, co -operatives and companies.
e)Trade Bill : Normally the traders buy goods from the wholesalers or
manufactures on credit. The sellers get payment after the end of the creditmunotes.in

Page 117

117period. But if any seller does not want to wait or in immediate need of
money he/she can draw a bill of exchange in favour of the buyer. When
buyer accepts the bill it becomes a negotiable instrument and is termed as
bill of exchange or trade bill. This t rade bill can now be discounted with a
bank before its maturity. On maturity the bank gets the payment from the
drawee 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
instrume nt, which enables the drawer of the bill to get funds for short
period to meet the working capital needs.
Institutions of the Money Market:
The various financial institutions which deal in short term loans in
the money market are its members. They compris e the following types of
institutions:
1.Central Bank:
The central bank of the country is the pivot around which the entire
money market revolves. It acts as the guardian of the money market and
increases or decreases the supply of money and credit in th e interest of
stability of the economy. It does not itself enter into direct transactions.
But controls the money market through variations in the bank rate and
open market operations.
2.Commercial Banks:
Commercial banks also deal in short -term loans wh ich they lend to
business and trade. They discount bills of exchange and treasury bills, and
lend against promissory notes and through advances and overdrafts.
3.Non-bank Financial Intermediaries:
Besides the commercial banks, there are non -bank financia l
intermediaries which lend short -term funds to borrowers in the money
market. Such financial intermediaries are savings banks, investment
houses, insurance companies, provident funds, and other financial
corporations.
4.Discount Houses and Bill Brokers:
In developed money markets, private companies operate discount
houses. The primary function of discount houses is to discount bills on
behalf of other. They, in turn, form the commercial banks and acceptance
houses. Along -with discount houses, there are b ill brokers in the money
market who act as intermediaries between borrowers and lenders by
discounting bills of exchange at a nominal commission. In underdeveloped
money markets, only bill brokers operate.
5.Acceptance Houses :
The institution of acceptance houses developed from the bankers
who transferred their headquarters to the London Money Market in the
19th and the early 20 the century. They act as agents between exporters
and importers and between lender and borrower traders. They accept bil lsmunotes.in

Page 118

118drawn on merchants whose financial standing is not known in order to
make the bills negotiable in the London Money Market. By accepting a
trade bill they guarantee the payment of bill at maturity. However, their
importance has declined because the comme rcial banks have undertaken
the acceptance business.
Functions of a Money Market:
A money market performs a number of functions in an economy.
1.Provides Funds :I tp r o v i d e ss h o r t -term funds to the public and private
institutions needing such financing for their working capital requirements.
It is done by discounting trade bills through commercial banks, discount
houses, brokers and acceptance houses. Thus the money market helps the
development of commerce, industry and trade within and outside the
count ry.
2.Use of Surplus Funds : It provides an opportunity to banks and other
institutions to use their surplus funds profitably for a short period. These
institutions include not only commercial banks and other financial
institutions but also large non -financial business corporations, states and
local governments.
3.NoNeed to Borrow from Banks : The existence of a developed money
market removes the necessity of borrowing by the commercial banks from
the central bank. If the former find their reserves short of cash
requirements they can call in some of their loans from the money market.
The commercial banks prefer to recall their loans rather than borrow from
the central banks at a higher rate of interests.
4.Helps Government : The money market helps the go vernment in
borrowing short -term funds at low interest rates on the basis of treasury
bills. On the other hand, if the government were to issue paper money or
borrow from the central bank. It would lead to inflationary pressures in the
economy.
5.Helps i n Monetary Policy : A well developed money market helps in
the successful implementation of the monetary policies of the central
bank. It is through the money market that the central banks are in a
position to control the banking .system and thereby influen ce commerce
and industry.
6.Helps in Financial Mobility : By facilitating the transfer for funds from
one sector to another, the money market helps in financial mobility.
Mobility in the flow of funds is essential for the development of
commerce and indus try in an economy.munotes.in

Page 119

1197.Promotes Liquidity and Safety: One of the important functions of the
money market is that it promotes liquidity and safety of financial assets. It
thus encourages savings and investments.
8.Equilibrium between Demand and Supply of Funds :T h em o n e y
market brings equilibrium between the demand and supply of loan able
funds. This it does by allocating saving into investment channels. In this
way, it also helps in rational allocation of resources.
9.Economy in Use of Cash : As the mone y market deals in near -money
assets and not money proper, it helps in economizing the use of cash. It
thus provides a convenient and safe way of transferring funds from one
place to another, thereby immensely helping commerce and industry.
TRY YOURSELF: -
A) Fill in the blanks.
1.The ___________of the country is the pivot around which the entire
money market revolves.
2.The primary function of ___________ is to discount bills on behalf of
other.
3.___________ is a popular instrument for financing working capital
requirements of companies.
4.___________ is mainly used by the banks to meet their temporary
requirement of cash.
B) Answer in one or two lines.
1.Acceptance Houses.
2.Trade bills
3.Money Market
C). Long Answers.
Q1. Give meaning of money market and explain its instruments in detail?
Q2. Explain features of money market.
Q3. Elaborate functions of money market in detail?
Q4.What are the institutions involved in money market, explain in detail?
munotes.in

Page 120

1209
CALL MO NEY MARKET
Unit Structure
9.1 Introduction to Call Money Market
9.2 Features of Indian call money market
9.3 Operations in Call Market
9.4 Participants of Indian call money market
9.5 Advantages of call money
9.6 Drawbacks of call money
9.7 Conclusion
9.1INTRODUCTIO NTO CALL MO NEY MARKET
Call money market means the market for extremely short period
loans; say one day to fourteen days. These loans are repayable on demand
at the option of either the lender or the borrower. When the money is lent
for one day in this market it is known as “ Call Money ”, and if it exceeds
one day (but less than 15 days) it is re ferred to as “ Notice Money ”.Term
Money refers to Money lent for 15 days or more in the Inter Bank
Market. These loans are given to brokers and dealers in stock exchange.
Similarly, banks with ‘surplus’ lend to other banks with ‘deficit funds’ in
thecallmoney market . Thus, it provides an equilibrating mechanism for
short term surpluses and deficits. Moreover, commercial banks can
quickly borrow from the call market to meet their statutory liquidity
requirements. They can also maximize their profits easily by investing
their surplus funds in the call market during the period when call rates are
high and volatile.
The call money market is a highly competitive and sensitive
market. It registers very quickly the pressures of demand and supply for
funds operat ing in the money market. Thus it acts as possibly the best
available indicator of the liquidity position of the organized money
market.
9.2 FEATURES OF I NDIANCALL MO NEY MARKET
a)Nature of loan: In call money market, very short -term loan is arranged.
b) Time of repayment of loan: Generally the loan is to be repaid within
15days. So time of repayment of loan is very short.munotes.in

Page 121

121c) Safety: Loan of call money market is repayable on demand. This kind
of loan is considered as very safe by the bank. Discount hous es are
also participants of call money market and they can repay the loan on
request.
d) Conversion into liquid cash: The loan is repayable on demand and at
the option of either the lender or the borrower. So such loan can be
easily and quickly converted i nto liquid cash. In fact, such loan is
known as “Money at call and short notice.”
e) Object: The primary object of call money market is to meet up
temporary cash deficiency of internal banks.
f)Nature of transactions: Daily surplus funds are transacted in this
market. As a result, supply of short term fund in money market
increases.
g) Investment: Call money market makes short term investment in share
market, government securities, Treasury bill and other short term
securities.
9.3 OPERATIO NSINCALL MARKET
Borrowers and le nders in a call market contact each other over
telephone. Hence, it is basically over -the-telephone market. After
negotiations over the phone, the borrowers and lenders arrive at a deal
specifying the amount of loan and the rate of interest. After the deal is
over, the lender issues FBL cheque in favor of the borrower. The borrower
is turn issues call money borrowing receipt. When the loan is repaid with
interest, the lender returns the lender the duly discharges receipt.
Instead of negotiating the deal di rectly, it can be routed through the
Discount and Finance House of India (DFHI), the borrowers and lenders
inform the DFHI about their fund requirement and availability at a
specified rate of interest. Once the deal is confirmed, the Deal settlement
advice is lender and receives RBI cheque for the money borrowed. The
reverse is taking place in the case of landings by the DFHI. The duly
discharged call deposit receipt is surrendered at the time of settlement.
Call loans can be renewed on the back of the depo sit receipt by the
borrower.
Discount andFinance House ofIndia (DFHI): The Working Group of
Money Market, in its Report submitted in 1987, recommended, among
other things, that a Finance House should be set up to deal in short -term
money market instrume nts. As a follow -up on the recommendations of the
Working Group, the Reserve Bank in India, in collaboration with the
public sector banks and financial institutions, set up the Discount and
Finance House of India Limited (DFHI) in April 1988. DFHI is the a pex
body in the Indian money market and its establishment is a major step
towards developing a secondary market for money instruments. DFHI,
which commenced its operations from April 25, 1988, deals in short -termmunotes.in

Page 122

122money market instruments. As a matter of po licy, the aim of the DFHI is
to increase the volume of turnover rather than to become the repository of
money market instruments. The initial paid up capital of DFHI is Rs.150
crores. Apart from this, it has lines of refinance from RBI and a line of
credit from the consortium of public sector banks. As the apex agency in
the Indian money market, the DFHI has been playing an important role
ever since its inception. It has been promoting the active participation of
the scheduled commercial banks and their sub sidiaries, state and urban
cooperative banks and all -Indian financial institutions in the money
market. The objective is to ensure that short -term surplus and deficits of
these institutions are equilibrated at market -related rates through inter -
bank transa ctions and various money market instruments.
The main objective of DFHI is to facilitate the smoothening of the
short term liquidity imbalances by developing an active money market and
integrating the various segments of the money market. At preset DFHI’s
activities are restricted to:
1.Dealing in 91 days and 364 days Treasury Bills.
2.Re-discounting short term commercial bills.
3.Participating in the inert bank call money, notice money and term
deposits.
4.Dealing in Commercial Paper and Certificate of deposits.
5.Government dated Securities.
Call loan market transactions
In India, call loans are given for the following purposes:
1.To commercial banks to meet large payments, large remittances to
maintain liquidity with the RBI and so on.
2.To the stock brokers and speculators to deal in stock exchanges
and bullion markets.
3.To the bill market for meeting matures bills.
4.To the Discount and Finance House of India and the Securities
Trading Corporation of India to activate the call market.
5.To in dividuals of very high status for trade purposes to save
interest on O.D or cash credit.
9.4 PARTICIPA NTS OF I NDIANCALL MO NEY
MARKET
The participants in this market can be classified into categories viz.
1.Those permitted to act as both lenders and borrow ers of call loans.
2.Those permitted to act only as lenders in the market.
The first category includes all commercial banks. Co -operative
banks, DFHI and STCI. In the second category LIC, UTI, GIC, IDBI,
NABARD, specified mutual funds etc., are included. Th ey can only lend
and they cannot borrow in the call market.munotes.in

Page 123

1239.5 ADVA NTAGES OF CALL MO NEY
In India, commercial banks play a dominant role in the call loan
market. They used to borrow and lend among themselves and such loans
are called inter -bank loans. They are very popular in India. So many
advantages are available to commercial banks. They ar e as follows:
High Liquidity : Money lent in a call market can be called back at any
time when needed. So, it is highly liquid. It enables commercial banks
to meet large sudden payments and remittances by making a call on
the market.
High Profitability :B a n ks can earn high profits by lending their
surplus funds to the call market when call rates are high volatile. It
offers a profitable parking place for employing the surplus funds of
banks temporarily.
Maintenance ofSLR: Call market enables commercial bank to
minimum their statutory reserve requirements. Generally banks borrow
on a large scale every reporting Friday to meet their SLR
requirements. In absence of call market, banks have to maintain idle
cash to meet their reserve requirements. It will tell up on their
profitability.
Safe andCheap : Though call loans are not secured, they are safe
since the participants have a strong financial standing. It is cheap in
the sense brokers have been prohibited from operating in the call
market. Hence, banks need not pay brokers on call money transitions.
Assistance ToCentral Bank Operations : Call money market is the
most sensitive part of any financial system. Changes in demand and
supply of funds are quickly reflected in call money rates and give an
indication to t he central bank to adopt an appropriate monetary policy.
Moreover, the existence of an efficient call market helps the central
bank to carry out its open market operations effectively and
successfully.
9.6 DRAWBACKS OF CALL MO NEY
The call market in India suffers from the following drawbacks:
Uneven Development : The call market in India is confined to only big
industrial and commercial centers like Mumbai, Kolkata, Chennai,
Delhi, Bangalore and Ahmadabad. Generally call markets are
associated with stock ex changes. Hence the market is not evenly
development.
Lack ofIntegration : The call markets in different centers are not fully
integrated. Besides, a large number of local call markets exist without
an\y integration.
Volatility inCall Money Rates : Another drawback is the volatile
nature of the call money rates. Call rates vary to greater extantmunotes.in

Page 124

124indifferent centers indifferent seasons on different days within a
fortnight. The rates vary between 12% and 85%. One cannot believe
85% being charged on c all loans.
9.7 CO NCLUSIO N
Thecallmoney market as a significant component of the money
market possesses a few special characteristics: -
1.Call money is an instrument for ultra -short period management of
funds and is easily reversible.
2.It is primarily a “telephone” market and is therefore,
administratively convenient to manage for both borrowers and
lender.
3.Being an instrument of liability management, it provides
incremental funds and adds to the size of balance sheet of banks.
TRY YOUR SELF: -
Fill in the blanks
1)_____________ refers to Money lent for 15 days or more in the Inter
Bank Market.
2) ______________ is also participants of call money market and they can
repay the loan on request.
3) ________________ is the apex body in the Indian money market and
its establishment is a major step towards developing a secondary
market for money instruments.
4) The initial paid up capital of DFHI is Rs.____________.
5)Match the following.
Particip ants of Indian call money
marketan instrument for ultra -short period
management of funds
Call money Banks can earn high profits by
lending their surplus funds to the
call market
Time of repayment of loan Is a drawback
Volatility inCall Money Rates UTI, GIC, IDBI, NABARD
High Profitability within 15days
6)Long Answers: -
Q1. Define call money? Explain the Features of Indian call money market.
Q2. Give a brief note on Operations in Call Market?
Q3. Give Participants of Indian call money market.
Q4. Explain Advantages of call money in detail.
Q5.Give drawbacks of call money.
munotes.in

Page 125

12510
COMMERCIAL BILL MARKET/
DISCOU NTM A R K E T S
Unit Structure
10.1 Introduction to Commercial Bill Market
10.2 Types of Commercial Bill
10.3 Operations in Commercial Bill Market
10.4 Advantages of Commercial Bill Market
10.5 Drawbacks of Commercial Bill Market
10.6 Conclusion
10.1INTRODUCTIO NTO COMMERCIAL BILL
MARKET
A commercial bill is one which arises out of a genuine trade
transaction, i.e. credit transaction. As soon as goods are sold on credit, the
seller dra ws a bill on the buyer for the amount due. The buyer accepts it
immediately agreeing to pay amount mentioned therein after a certain
specified date. Thus, a bill of exchange contains a written order from the
creditor to the debtor, to pay a certain sum, to a certain person, after a
creation period. A bill of exchange is a ‘self -liquidating’ paper and
negotiable; it is drawn always for a short period ranging between 3 months
and 6 months.
Definition of a bill
Section 5 of the negotiable Instruments Act defi nes a bill exchange a
follows:
“an instrument in writing containing an unconditional order, signed by the
maker, directing a certain person to pay a certain sum of money only to, or
to the order of a certain person ort to the beater of the instrument”.
10.2 TYPES OF COMMERCIAL BILL
Many types of bills are in circulation in a bill market. They can be
broadly classified as follows:
1.Demand and Usance bills.
2.Clean bills and documentary bills.
3.Inland and foreign bills.munotes.in

Page 126

1264.Export bills and import bills.
5.Indigenous bills.
6.Accommodation bills and supply bills.
1. Demand and Usance
Demand bills are others called sight bills. These bills are payable
immediately as soon as they are presented to the drawee. No time of
payment is specified and hence they are payable at sight. Usance bills are
called time bills. These bills are payable immediately after the expiry of
time period mentioned in the bills. The period varies according to the
established trade custom or usage prevailing in the country.
2. Clean Bill s and Documentary Bills
When bills have to be accompanied by documents of title to goods
like Railways, receipt, Lorry receipt, Bill of Lading etc. the bills are called
documentary bills. These bills can be further classified into D/A bills and
D/P bills. In the case of D/A bills, the documents accompanying bills have
to be delivered to the drawee immediately after acceptance. Generally D/A
bills are drawn on parties who have a good financial standing. On the
order hand, the documents have to be handed ove r to the drawee only
against payment in the case of D/P bills. The documents will be retained
by the banker. Till the payment o0f such bills. When bills are drawn
without accompanying any documents they are called clean bills. In such a
case, documents wil l be directly sent to the drawee.
3. Inland and Foreign Bills
Inland bills are those drawn upon a person resident in India and are
payable in India. Foreign bills are drawn outside India and they may be
payable either in India or outside India. They may be drawn upon a person
resident in India also. Foreign boils have their origin outside India. They
also include bills drawn on India made payable outside India.
4. Export and Foreign Bills
Export bills are those drawn by Indian exports on importers outsi de
India and import bills are drawn on Indian importers in India by exports
outside India.
5. Indigenous Bills
Indigenous bills are those drawn and accepted according to native
custom or usage of trade. These bills are popular among indigenous
bankers on ly. In India, they called ‘hundis’ the hundis are known by
various names such as ‘Shah Jog’, ‘Nam Jog’, Jokhani’, Termainjog’.
‘Darshani’, ‘Dhanijog’, and so an.
6. Accommodation Bills and Supply Bills
If bills do not arise out of genuine trade transacti ons, they are
called accommodation bills. They are known as ‘kite bills’ or ‘wind bills’.
Two parties draw bills on each other purely for the purpos4 of mutual
financial accommodation. These bills are discounted with bankers and themunotes.in

Page 127

127proceeds are shared amo ng themselves. On the due dates, they are paid.
Supply bills are those neither drawn by suppliers or contractors on the
government departments for the goods nor accompanied by documents of
title to goods. So, they are not considered as negotiable instrumen ts. These
bills are useful only for the purpose of getting advances from commercial
banks by creating a charge on these bills.
10.3 OPERATIO NSINCOMMERCIAL BILL MARKET
From the operations point of view, the bill market can be classified into
two viz.
Discount Market
Acceptance Market
Discount Market
Discount market refers to the market where short -term genuine
trade bills are discounted by financial intermediaries like commercial
banks. When credit sales are affected, the seller draws a bill on the bu yer
who accepts it promising to pay the specified sum at the specified period.
The seller has to wait until the maturity of the bill for getting payment.
But, the presence of a bill market enables him to get payment
immediately. The seller can ensure payme nt immediately by discounting
the bill with some financial intermediary by paying a small amount of
money called ‘Discount rate’ on the date of maturity; the intermediary
claims the amount of the bill from the person who has accept6ed the bill.
In some c ountries, there are some financial intermediaries who
specialize in the field of discounting. For instance, in London Money
Market there are specialize in the field discounting bills. Such institutions
are conspicuously absent in India. Hence, commercial b anks in India have
to undertake the work of discounting. However, the DFHI has been
established to activate this market.
Acceptance Market
The acceptance market refers to the market where short -term
genuine trade bills are accepted by financial intermedi aries. All trade bills
cannot be discounted easily because the parties to the bills may not be
financially sound. In case such bills are accepted by financial
intermediaries like banks, the bills earn a good name and reputation and
such bills can readily d iscounted anywhere. In London, there are specialist
firms called acceptance house which accept bills drawn by trades and
import greater marketability to such bills. However, their importance has
declined in recent times. In India, there are no acceptance h ouses. The
commercial banks undertake the acceptance business to some extent.munotes.in

Page 128

12810.4 ADVA NTAGES OF COMMERCIAL BILLS:
Commercial bill market is an important source of short -term funds
for trade and industry. It provides liquidity and activates the mone y
market. In India, commercial banks lay a significant role in this market
due to the following advantages:
Liquidity : Bills are highly liquid assets. In times of necessity, bills can
be converted into cash readily by means of rediscounting them with
thecentral bank. Bills are self -liquidating in character since they have
fixed tenure. Moreover, they are negotiable instruments and hence
they can be transferred freely by a mere delivery or by endorsement
and delivery.
Certainty of Payment : Bills are drawn and accepted by business
people. Generally, business people are used to keeping their words and
the use of the bills imposes a strict financial discipline on them. Hence,
bills would be honored on the due date.
Ideal Investment : Bills are for periods not exceeding 6 months. They
represent advances for a definite period. This enables financial
institutions to invest their surplus funds profitably by selecting bills of
different maturities. For instance, commercial banks can invest their
funds on bills in s uch a way that the maturity of these bills may
coincide with the maturity of their fixed deposits.
Simple Legal Remedy : In case the bills are dishonored the legal
remedy is simple. Such dishonored bills have to be simply noted and
protested and the whole amount should be debited to the customer’s
accounts.
High And Quick Yield : The financial institutions earn a high quick
yield. The discount is dedicated at the time of discounting itself
whereas in the case of other loans and advances, interest is payable
only when it is due. The discounts rate is also comparatively high.
Easy Central Bank Control : The central bank can easily influence
the money market by manipulating the bank rate or the rediscounting
rate. Suitable monetary policy can be taken by adjust ing the bank rate
depending upon the monetary conditions prevailing in the market.
10.5 DRAWBACKS OF COMMERCIAL BILLS:
In spite of these merits, the bill market has not been well
developed in India. The reasons for the slow growth are the following:
Absence of Bill Culture : Business people in India prefer O.D and
cash credit to bill financing therefore, banks usually accept bills for themunotes.in

Page 129

129conversion of cash credits and overdrafts of their customers. Hence
bills are not popular.
Absence of Rediscounting amo ng Banks : There is no practice of re -
discounting of bills between banks who need funds and those who
have surplus funds. In order to enlarge the rediscounting facility, the
RBI has permitted financial institutions like LIC, UTI, GIC and ICICI
to rediscount genuine eligible trade bills of commercial banks. Even
then, bill financial is not popular.
Stamp Duty : Stamp duty discourages the use of bills. Moreover,
stamp papers of required denomination are not available.
Absence of Secondary Market : There is no ac tive secondary market
for bills. Rediscounting facility is available in important centers and
that too it restricted to the apex level financial institutions. Hence, the
size of the bill market has been curtailed to a large extant.
Difficulty in Ascerta ining Genuine Trade Bills : The financial
institutions have to verify the bills so as to ascertain whether they are
genuine trade bills and not accommodation bills. For this purpose,
invoices have to be scrutinized carefully. It involves additional work.
Limited Foreign Trade : In many developed countries, bill markets
have been established mainly for financing foreign trade.
Unfortunately, in India, foreign trade as a percentage to national
income remains small and it is reflected in the bill market also.
Absence of Acceptance Services : There is no discount house or
acceptance house in India. Hence specialized services are not available
in the field of discounting or acceptance.
Attitude of Banks : Banks are shy rediscounting bills even the central
bank. They have a tendency to hold the bills till maturity and hence it
affects the velocity of circulation of bills. Again, banks prefer to
purchase bills instead of discounting them.
10.6 CO NCLUSIO N
The development of bill financing and bill culture would enable
industry and commerce to borrow funds at a lower rate than under cash
credit/overdraft arrangements. Bill culture can develop if government,
public sector enterprises and large private sector undertakings accept it as
a basis for financing business. Bill financing would enable banks to plan
their cash management efficiently since the amount and the date of
repayment are definite in case of bill. The bills also provide liquidity to the
banks in the bill rediscounting market.munotes.in

Page 130

13010.7 QUESTIO NS
Fillin the blanks.
1.Banks prefer to ________ instead of discounting them.
2.Stamp duty __________ the use of bills.
3.Bills are drawn and accepted ____________ people.
4.Bills are __________ assets
5.Export bills are those drawn by Indian exports ___________ outside
India
Write short notes.
1.Inland and foreign bills
2.Acceptance Market
3.Export/ Import Bills
4.Definition of commercial bill
Write Long Answers.
Q1. Explain commercial bill market in detail.
Q2. Explain types of bill markets?
Q3. Briefly explain the operations w here bill market takes place.
Q4. Elaborate the advantages and disadvantages of bill market .

munotes.in

Page 131

13111
TREASURY BILLS MARKET
Unit Structure
11.1 Introduction of treasury bills market.
11.2 Types of Treasury bills.
11.3 Benefits of Investment in Treasury Bills
11.4 Process of Treasury bill market
11.5 Treasury bill in Primary Market
11.6 Treasury bill in Secondary Market
11.7 How to Purchase Treasury Bills
11.8 Discount and Finance House of India (DFHI)
11.9 Role of Discount and Financial House of India in the Indian money
market
11.1 I NTRODUCTIO NOF TREASURY BILLS MARKET
Treasury bill is a monetary policy instrument through which
government raise funds for short period requirements and commercial
banks invest their short period surpluses by buying these bills from
government.
Three types of treasury bills are important:
1.91 days Treasury bill;
2.182 days Treasury bill; and
3.364 days Treasury bills.
It may be noted that 91 day Treasury bill is a traditional
instrument. During 1980’s and 1990’s the other two treasury bills were
introduced. 182 days Treasury bill was introduced by auction for financing
fiscal -deficit for the short period. Introduction of 364 day Treasury bills
discontinued the use of 182 day Treasury bill.
11.2 TYPES OF TREASURY BILLS
Treasury bills are of two types:
ad hoc and
Regular.
The ad hoc treasury bills were used to support the borrowing
program of the government. The ad hoc treasury bills are not marketablemunotes.in

Page 132

132because they are not sold o the public or banks. In the past, the bulk of the
Treasury bill issue was of ad hoc 91 day bills. The treasury bills sold to the
public or banks are regular treasury bills. These are marketable.
All treasury bills are bought and sold at a discounted value. The
amount of interest due on the bills is paid in the form of discount at the
time of purchase. The discounted price is obviously lower than the face
value.
In industrially developed countries, treasury bills are one of the
important forms of holding short -term surplus funds by the financial
institutions and firms because they are highly liquid and offer a risk -free
reasonable rat e of return. The government raises a large amount of funds
through treasury bills. But in India, the RBI is the main holder of treasury
bills. The financial institutions and firms are not active buyers in the
Treasury bill market because of the low rate of discount on treasury bills.
The RBI was made a captive buyer of ad hoc treasury bills. This has been
responsible for the conversion of government debt into Reserve Money.
As a result, money supply was growing more rapidly than the growth in
money demand. The system of ad hoc treasury bills was discontinued from
the year 1997 -98.
11.3 BE NEFITS OF I NVESTME NTINTREASURY
BILLS
No tax deducted at source
Zero default risk being sovereign paper
Highly liquid money market instrument
Better returns especially in the short term
Transparency
Simplified settlement
High degree of tradability and active secondary market facilitates
meeting unplanned fund requirements.
11.4 PROCESS OF TREASURY BILL MARKET
FORM: -The treasury bills are issued in the form of promissory note
in physical form or by credit to Subsidiary General Ledger (SGL)
account or Gilt account in dematerialized form.
MINIMUM AMOU NTO FB I D S : -Bids for treasury bills are to be
made for a minimum amount of Rs 25000/ -only and in multiples
thereof.
ELIGIBILITY: -All entities registered in India like banks, financial
institutions, Primary Dealers, firms, companies, corporate bodies,
partnership firms, institutions, mutual funds, Foreign Institutional
Investors, State Governments, Provident Fu nds, trusts, researchmunotes.in

Page 133

133organizations, Nepal Rashtra bank and even individuals are eligible to
bid and purchase Treasury bills.
REPAYME NT:-The treasury bills are repaid at par on the expiry of
their tenure at the office of the Reserve Bank of India, Mumba i.
11.4.1 Treasury bill in Primary Market
In the primary market, treasury bills are issued by auction technique.
Salient Features of the Auction Technique
The auction of treasury bills is done only at Reserve Bank of India,
Mumbai.
Bids are received at M umbai office during banking hours i.e. up to 2
pm on the date of auction.
The bids are received in terms of price per Rs 100. For example, a bid
for 91 day Treasury bill auction could be for Rs 97.50. Further, bids
cannot be submitted with prices for more than two decimals.
The auction committee of Reserve Bank of India decides the cut -off
price and the results are announced on the same day.
Bids above the cut -off price receive full allotment; bids at cut -off price
may receive full or partial allotment and bids below the cut -off price
are rejected.
Types of Auctions
There are two types of auction for treasury bills:
Multiple Price Based or French Auction: Under this method, all
bids equal to or above the cut -off price are accepted. However, the
bidder has to obtain the treasury bills at the price quoted by him. This
method is followed in the case of 364days treasury bills and is valid
only for competitive bidders.
Uniform Price Based or Dutch auction: Under this system, all the
bids equal to or above the c ut-off price are accepted at the cut -off
level. However, unlike the Multiple Price based method, the bidder
obtains the treasury bills at the cut -off price and not the price quoted
by him. This method is applicable in the case of 91 days treasury bills
only.
Classification of Bids
The bids submitted can be classified as competitive andnon
competitive bids.
Competitive Bids
Competitive bids can be submitted by any person or institutions
like, banks, financial institutions, Primary Dealers, firms, compa nies,
corporate bodies, institutions and trusts in India.munotes.in

Page 134

134Non Competitive Bids
There is a provision to accept non -competitive bids in respect of
all treasury bills auctions. State Governments, Provident Funds and Nepal
Rashtra bank are allowed to submit non-competitive bids in the case of 91
days treasury bills. In the case of 364 days treasury bills however, only
State Governments can participate as non -competitive bidders. The
Reserve Bank of India participates as a non -competitive bidder in the
auction . The unsubscribed portion of the competitive bids also devolves
on the Reserve Bank of India. In the case of non -competitive bids, only
the amount is indicated. They do not indicate any price. All the non -
competitive bids are accepted at the weighted aver age price of the
competitive bids.
To summarize,
The Reserve Bank of India conducts the auction of treasury bills of
varying maturities as per the notified amount on pre announced auction
dates.
The auction for the notified amount is conducted on a competitive bid
basis, which is submitted on a price basis.
Non-competitive bids are also submitted and accepted, but the
allotment is outside the notified amount and based only on quantity
and not price.
For consideration of competitive bidding, the biddi ng starts with the
bid with lowest yield or highest price being awarded Treasury bills at
their bid price.
Successively higher yielding bids are accepted and are awarded
Treasury bills at their bid price until the total amount accepted equals
the notified amount.
The highest yield accepted by the Reserve Bank of India is referred to
the cut -off yield and the corresponding price is called the cut -off price.
11.6 TREASURY BILL I NSECO NDARY MARKET
Participants
The major participants in the secondary market are scheduled banks,
financial Institutions, Primary dealers, mutual funds, insurance
companies and corporate treasuries. Other entities like cooperative and
regional rural banks, educational and religious trusts etc. have also
begun investing their short term funds in treasury bills.
Advantages
Market related yields
Ideal matching for funds management particularly for short term
tenors of less than 15 days.munotes.in

Page 135

135Transparency in operations as the transactions would be put through
Reserve Bank of India’s SGL or Client’s Gilt account only
Two way quotes offered by primary dealers for purchase and sale of
treasury bills.
Certainty in terms of availability, entry & exit
11.7 HOW TO PURCHASE TREASURY BILLS
Treasury bills can be purchased either from the primary market or
the secondary market.
Primary Market
A bid will have to be made in the weekly auctions of Treasury bills
as given earlier. The bid will have to be submitted to RBI, Mumbai. The
bid can be submitted to RBI, Mumbai, or through the bank/Primary De aler
with whom he has a Constituent SGL account.
Secondary Market
A treasury bill can be purchased at any point of time from the
secondary market, commensurate with the short term period for which
funds are available.
11.8 DISCOU NTANDF I NANCE HOUSE OF INDIA
(DFHI)
The Working Group of Money Market, in its Report submitted in
1987, recommended, among other things, that a Finance House should be
set up to deal in short -term money market instruments.
As a follow -up on the recommendations of the Working G roup, the
Reserve Bank in India, in collaboration with the public sector banks and
financial institutions, set up the Discount and Finance House of India
Limited (DFHI) in.
April 1988. DFHI is the apex body in the Indian money market and
its establishmen t is a major step towards developing a secondary market
for money instruments. DFHI, which commenced its operations from
April 25, 1988, deals in short -term money market instruments.
As a matter of policy, the aim of the DFHI is to increase the
volume of turnover rather than to become the repository of money market
instruments. The initial paid up capital of DFHI is Rs. 150 crores.
Apart from this, it has lines of refinance from RBI and a line of
credit from the consortium of public sector banks.
Asthe apex agency in the Indian money market, the DFHI has
been playing an important role ever since its inception. It has been
promoting the active participation of the scheduled commercial banks andmunotes.in

Page 136

136their subsidiaries, state and urban cooperative banks and all-Indian
financial institutions in the money market.
The objective is to ensure that short -term surplus and deficits of
these institutions are equilibrated at market -related rates through inter -
bank transactions and various money market instruments.
In 1990 -91 the DFHI opened its branches at Delhi, Calcutta,
Madras, Ahmadabad and Bangalore in order to decentralize its operations
and provide money market facilities at the major money market centers in
the country.
Discount and Finance House of Indi a Ltd. (DFHI), a unique
institution of its kind, was set up in April 1988. The share capital of DFHI
is Rs 200 cores, which has been subscribed by Reserve Bank of India
(10.5%), Public sector banks (62%) and Financial Institutions (26.6%).
The discount has been established to deal in money market instruments in
order to provide liquidity in the money market. Thus the task assigned to
DFHI is to develop a secondary market in the existing money market
instruments.
The establishment of a discount House was r ecommended by a
Working Group on Money market. The main objective of DFHI is to
facilitate the smoothening of the short term liquidity imbalances by
developing an active money market and integrating the various segments
of the money market. At preset DFHI’ s activities are restricted to:
1.Dealing in 91 days and 364 days treasury bill
2.Re-discounting short term commercial bills.
3.Participating in the interbank call money, notice money and term
deposits.
4.Dealing in commercial paper and certificates.
5.Government da ted securities.
Treasury bills are issued by Reserve bank of India on behalf of the
Government of India. Such bills are sold at fortnightly auctions. The
Discount House regularly participates in such auctions. Moreover, it
provides a ready market to othe r institutions/individuals to buy or sell the
Treasury Bills. It purchases the same either as outright purchase or on
repos basis. Repos mean the right to re -purchase the same bills again. For
this purpose the DFHI quotes two way prices with fine spread. S uch
operations in Treasury Bills impart greater flexibility to banks in their
funds management. Moreover, with the creation of a secondary market for
treasury Bills, corporate bodies and other institutions could also invest
their short term surplus funds i n such bills.
Rediscounting of commercial bill: -
The Discount House aims at imparting liquidity to Commercial
bills which have already been discounted by banks and financial
institutions. It further re -discounts them and also enables banks and other
institutions to re -discount from it such bills. For this purpose DFHI
announces its bid and offers re -discount rates on a fortnightly basis.munotes.in

Page 137

13711.9 ROLE OF DISCOU NTANDF I NANCIAL HOUSE
OF INDIA I NTHE I NDIANMONEY MARKET
Discount House plays a very important role in money market. The
money market can function well if there is adequate supply of money.
Discount house helps the money market to function smoothly by providing
the following services.
(a) External source of money supply: The central bank or the discount
houses provide finance to the commercial banks and other financial
institutes operating in the money supply in various forms.
(b) Helps in smooth function of the money market: Discount house
helps in smooth functioning of the money market by remo ving the
irregularities in the process of handover of money among the
intermediaries. The Discount houses are experienced and experts in such
job.
(c) Providing short -term loan: They provide loan for very short period,
in other, in other words any busines s houses or government can take loan
from discount house for urgent requirements. Such is paid at once i.e., on
demand.
(d) Money supply to government or private enterprise: They not only
provide loan to private enterprise but also supply money to state
governments it needed by taking deposit of bills of exchange, treasury
bills and other valid documents.
(e) Discounting and Re -discounting of bills: The RBI and the Discount
house discount bills and it re -discount the bills which have already been
discount ed by the commercial banks and other financial intermediaries.
(f) Monetary Stability: Discount house provides monetary stability in the
money market. Shortage of liquid fund affects the stability of money
market severely. Whenever there is shortage of fu nd, discount house
provide fund and brings liquidity in the money market.
(g) Indispensable: Money is required for any activity; since discount
house provide money, they are indispensable for the development of the
economy.
(h) Development of Financial m arket: The Discount houses work in
both primary and secondary markets, as a result financial market is
developed.munotes.in

Page 138

138QUESTIO NS
Fill in the blanks.
1.Discount houses work in both ___________ and secondary markets.
2.The discount houses provide finance to the __________banks.
3.Treasury bills are issued by ____________ on behalf of the
Government of India
4.High degree of ______ and _____________secondary market
facilitates meeting unplanned fund requirements.
Write short notes on: -
1.Regular treasury bills
2.Treasur y bills in secondary market
3.DFHI
Write long answers.
Q1. Give detailed meaning of Treasury bill with examples.
Q2.Explain the Role of Discount and Financial House of India in the
Indian money market.
Q3.Explain the types of Treasury bill and benefits of treasury bills.
Q4. Explain the Treasury bills in primary market.

munotes.in

Page 139

139Module -IV
12
FOREIG NEXCHA NGE MARKET
(Nature, Organisation and Participants)
Unit Structure
12.0 Learning Outcomes
12.1 Introduction
12.2 Fact File on International Markets
12.3 Nature of Foreign Exchange Market
12.4 Characteristics of the International Forex Market
12.5 Organisation of Foreign Exchange Market
12.6 Dealing Room Transactions
12.7 Foreign Exchange Dealing Room Operations
12.8 Structure
12.9 Dealing Room Transactions
12.10 Distinction between Merchant And Interbank Transactions
12.11 Summary
12.0 LEAR NING OUTCOMES
After completion of study of this unit, a learner will come to know
Learner will come to know about forex market.
Learner will comprehend the working of forex market.
Learners will understand who the participants of the forex market are.
Learners will understand different characteristics of forex market.
12.1 I NTRODUCTIO N
The foreign exchange market is the largest and most liquid
financial market in the world. Traders include large banks, currency
speculators, corp orations, governments, foreign currency remittance
companies and other financial institutions.
Forex market is an organizational setting within which individuals,
business, governments and banks buy and sell foreign currencies. It is a
worldwide market w hich operates round the clock due to time zone that is,
when it is morning in Hong Kong, it is evening in New York. Forex
market is not a single physical place.munotes.in

Page 140

140Foreign exchange market is a mechanism where various national
currencies are purchased or sol d like any other commodity. Demand for
and supply of foreign exchange determines its price, that is, foreign
exchange rate. When we say, Rs. 67 is the price of a dollar, it is the
foreign exchange rate or the price of dollar expressed in terms of rupees.
From a national point of view we may state the foreign exchange rate is a
price of a rupee in dollar or cents. Accordingly we may say the value in
terms of cents, but, for practical purpose it is expressed in terms of number
of rupees for one dollar, i.e., Rs. 67 = $1 or Rs. 67.50 = $1.
Foreign exchange market can either be completely free or
restricted. Restrictions vary from country to country. In India, full
convertibility is allowed only on current account and not on capital
account. Even under free ex change market or floating exchange rate, the
Government intervenes whenever there is wide fluctuation in exchange
rate. Such intervention is essential to avoid negative effects of unstable
exchange rate.
Fluctuations in exchange rates are usually caused by actual
monetary flows as well as by anticipation of changes in monetary flows
caused by changes in gross domestic product (GDP) growth, inflation
(purchasing power parity theory), interest rates (interest rate parity
theory), budget and trade deficits o r surpluses, large cross -border deals
and other macroeconomic developments.
Supply and demand for any given currency, and thus its value, are
not influenced by any single element, but rather by several in different
proportions. These elements generally f all into three categories: economic
factors, political conditions and market psychology.
12.2 FACT FILE O NINTERNATIO NAL MARKETS
Average daily turnover is approximately USD 3 trillion with an
additional USD 2 trillion turnover in foreign currency derivatives. Major
component of this turnover is speculative.
This market is predominantly made up of day -traders which means
that positions built up in currencies are mostly squared off during the day
and there is very little carry forward of open specul ative positions.
US Dollar is the most heavily traded currency. The most heavily
used currency pairs are EUR/USD, GBP/USD (called CABLE) and
USD/JPY.
London, New York and Tokyo are the biggest foreign exchange
centres and Deutsche Bank (Germany) is the single largest trading entity
in international foreign exchange markets.munotes.in

Page 141

141Unlike a stock market, the foreign exchange market is divided into
levels of access which means that all participants cannot operate in all
segments of the market and are subject t o different categories of exchange
rates. At the wholesale level, generally called ‘The Interbank Market’,
interbank rates are used between participants whereas, at the retail level
the rates used are called ‘Merchant Rates’. Each localized market is
gover ned by the domestic exchange control regulations which determine
the different levels of access.
Generally, for a given currency pair, either currency can function
as the base currency while the other acts as the variable or quoted
currency. By conventio n the LHS currency is stronger than the RHS
currency at the time of creation of the pair. However, when the euro was
created, the European Central Bank mandated that EUR be the base
currency in any pairing. Similarly, GBP has traditionally been base
curren cy in all cases.
12.3NATURE OF FOREIG NEXCHA NGE MARKET
The forex market is an over -the-counter (OTC) market, which
means that there is no central exchange and clearing house where orders
are matched. With different levels of access, currencies are traded in
different market makers:
The Inter -bank Market: Large commercial banks trade with each other
through the Electronic Brokerage System (EBS). Banks will make their
quotes available in this market only to those banks with which they trade.
This mar ket is not directly accessible to retail traders.
The Online Market Maker: Retail traders can access the FX market
through online market makers that trade primarily out of the US and UK.
These market makers typically have a relationship with several banks on
EBS; the larger the trading volume of the market maker, the more
relationship it likely has.
Market Hours: Forex is a market that trades actively as long as there are
banks open in one of the major financial centres of the world. This is
effectively f rom the beginning of Monday morning in Tokyo until the
afternoon of Friday in New York. In terms of GMT, the trading week
occurs from Sunday night until Friday night, or roughly 5 days, 24 hours
per day.
12.4 CHARACTERISTICS OF THE I NTERNATIO NAL
FOREX MAR KET
The primary objective of the foreign exchange market is to
facilitate international trade and investment, by allowing end -users to
convert one currency into another. The conversion rates between
currencies are called foreign exchange rates. The marke t also facilitatesmunotes.in

Page 142

142speculation, arbitrage and borrowing/lending of currencies for financing
different transactions. Therefore this market connects exchange rates with
interest rates. The modern foreign exchange market started with the
introduction of the “ Flexible Exchange Rate System” during the 1970s.
The main characteristics of this market are:
i.It is a decentralized, over -the-counter (OTC) market, engaged in
negotiated transactions.
ii.In comparison to all other markets, it enjoys the highest trading
volum e which results in high liquidity.
iii.International foreign currency transactions do not involve transfers of
currencies in physical cash form. All settlements, receipts and
payments are conducted through demand deposit accounts with
commercial banks and sinc e only banks provide such accounts it
follows that all transactions in this market get routed through the
banking system.
iv.The actual settlement of transactions is done through a network of
‘NOSTRO’ and ‘VOSTRO’ accounts maintained by banks
worldwide.
v.It is geographically dispersed across all countries which makes it a
universal market. However in each country there is a domestic foreign
exchange market governed by individual regulations.
vi.It operates 24 hours a day, except weekends, across all time zones.
vii.Itoperates on very fine (low) profit margins compared to other
markets (Fixed income securities, commodities etc.)
viii.It provides for a ‘Barter’ of currencies. If person ‘A’ wants to sell
USD to get INR, there must be a person ‘B’ wanting to sell INR for
the U SD at the same exchange rate. Therefore, as in the case of Barter
there has to be a double coincidence of wants. The forex market thus
functions as an international clearing mechanism or currency
exchange bringing together participants wishing to exchange
currencies at mutually agreed exchange rates.
ix.It has no physical existence and operates as an electronically
connected network of end -users, banks, brokers and service providers.
x.The most modern communication systems are used thereby reducing
transaction c ost, eliminating interest loss factor and the problem of
idle funds. Settlement systems worldwide have been synchronized so
that participants are able to shift from one market to another and from
one currency into another without settlement gaps.munotes.in

Page 143

14312.5 OR GANISATIO NOF FOREIG NEXCHA NGE
MARKET
Participants in Foreign Exchange Market:
The main participants in the foreign exchange market are (i) retail
clients (ii) commercial banks (iii) foreign exchange brokers and other
authorised agents. The central banks too participate in this market as per
its policy decisions. Let us briefly explain the main participants in the
forex market.
Retail Clients: These comprise people, international investors,
multinational corporation and others who need foreign exchange. Retail
clients deal through commercial banks and authorised agents.
Commercial Banks: They carry out buying and selling orders from their
retail clients and of their own account. They deal with other commercial
banks and also through foreign exchange brokers.
Foreign Exchange Brokers: Each forex market centre has some
authorised brokers. Brokers act as intermediaries between buyers and
sellers, mainly the banks. Commercial banks prefer the brokers as banks
could obtain the most favourable quotations f rom them.
Central Banks: Under the floating exchange rate the central bank of a
country normally does not interfere in the exchange market. Since 1973
however most of the central banks frequently intervened to buy and sell
their currencies in an attempt t o influence the rate at which their currencies
are traded.
The above groups are the sources from where demand and supply
forces generate which in turn help determine the foreign exchange rate.
The forex market is broadly divided into (i) Retail and (ii) Wholesale
market.
In the retail market travellers, tourists and people who are in need
of foreign exchange for permitted small transactions, exchange one
currency for another. The retail market is a secondary price maker.
The wholesale market is also c alled the interbank market.
Commercial banks, business corporations and central banks are the main
participants in this segment of the market. The size of transaction in the
market is very large. The dealers here are highly professional and are the
primary price makers. It is big players like multinational banks that exert a
lot of influence in the market and are mainly responsible for determining
the exchange rate.
Brokers act as middlemen between the price makers. They provide
information to the banks a bout the prices at which there are buyers and
sellers of a pair of currencies. Most of the banks except the major onesmunotes.in

Page 144

144deal through brokers who purchase and sell on behalf of others. Brokers
possess more information and better knowledge of market.
The price takers in the foreign market are those who buy the
foreign exchange which they require and sell what they earn at the price
determined by the primary price makers.
Indian Foreign Exchange Market is made up of three tiers. In the
first, the dealings t ake place between Reserve Bank of India and
Authorised Dealers (ADs) comprising mainly commercial banks. In the
second tier the ADs deal with each other and in the third the ADs deal
with their corporate customers. The retail market mainly caters to the
tourists. In this segment there are money changers who deal in foreign
currencies.
12.6 DEALI NG ROOM TRA NSACTIO NS
TREASURY OPERATIO NS
The Treasury of a commercial bank or financial institution can be
described as an independent profit centre within the organisation which
deals specifically with optimising returns on surplus resources or
arranging resources at the lowest cost. In a commercial bank the treasury
operations are normally divided into four activities:
Call Money Operations involve management of short term financial
resources so that the bank meets its obligations as per the Cash Reserve
Ratio (CRR) stipulated by the RBI at a given time.
Securities Operations involve management of medium and long term
financial resources and requirements, ther eby ensuring compliance of the
Statutory Liquidity Ratio (SLR) specified by RBI from time to time. Debt
instrument values have an inverse relationship with nominal interest rates
and it is the prime objective of this group to protect the bank from interest
rate risk, on investments in debt securities.
Commodity Operations involve buying and selling of commodities for
clients as well as an proprietary basis. Therefore this group operates as
both a service delivery channel to customers and generating trading profits
for the bank.
Foreign Currency Operations involve buying and selling of foreign
currencies and providing all international trade related services to the
banks customers. This group also undertakes speculative and arbitrage
transactions on behalf of the bank. All such activities are collectively
called Foreign Exchange Dealing Room Operations.munotes.in

Page 145

14512.7 FOREIG NEXCHA NGE DEALI NGR O O M
OPERATIO NS
It is a profit centre for the bank and functions as a centralised
service branch to meet the needs of all o ther branches to buy/sell foreign
currencies. It is manned by specially trained personnel called 'dealers or
traders', who undertake all foreign currency treasury operations.
The primary function of the Dealing Room is to provide rates for
various transa ctions being put through at branch level with customers.
Therefore every foreign currency related transaction gets reported to the
Dealing room. Rates provided by a bank to its customers are called
'Merchant Rates'. These rates can be subdivided as:
Card Rates -at the start of every trading day the market first establishes
the vehicle currency quotation. The dealers then prepare cross rates for
currencies normally used by their customers. Profit margins are loaded for
different categories of transactions and tabulated under eight heads: TT
Buying, Bills Buying, TC Buying, CN Buying, TT Selling, Bills Selling,
TC Selling and CN Selling. These rates collectively called Card Rates are
conveyed to all branches. All transactions undertaken at branches
involving amounts less than USD 5000 or equivalent during the day are
put through at the Card Rates. These rates generally remain constant for
the given day. (TC = travellers cheque, CN = Currency banknote, TT =
telegraphic transfer, Bills = Documentary transaction s).
Ready Rates -when branches receive transactions involving amounts to
excess of USD 5000 or equivalent, a transaction specific rate is provided
by the Dealing Room in each case based on the ongoing market rate. Thus,
while Card Rates are standardised, Ready Rates are customised. These
rates are finer than Card Rates in terms of profit margins.
Transactions reported throughout the day are segregated currency -
wise and separate dealers consolidate the exposure of the bank in each
currency on an on-going basis. Depending on the view of the dealer the
exposures are covered in the inter -bank market. The Dealing Room
therefore represents the point of interface between the Retail and
Wholesale components of the forex market.
Currency exposures are c alled 'positions.' A 'position' can therefore
be described as an uncovered transaction in which the bank has assumed
exchange rate risk by providing a committed rate to the opposite party. A
dealer has to maintain two positions -funds position and currenc y
position. The funds position reflects inflows and outflows of funds i.e.
receivables and payables. A mismatch in funds position will expose the
bank to interest rate risks in the form of overdraft interest in the Nostro
a/c, loss of interest income on cr edit balances etc. Currency position deals
with overbought and oversold positions, arrived after taking various
merchant and/or inter -bank transactions. The overall net currency positionmunotes.in

Page 146

146exposes the dealer to exchange risks from market rate movements.
Transactions undertaken in the inter -bank market to eliminate merchant
exposures are called 'Cover Transactions'.
Customers of the bank require derivatives for hedging their
currency risks. Forward Contracts and Swaps being OTC derivatives, they
are provided by banks. Providing rates for such transactions and covering
the same is also the function of the dealers.
An important feature of a dealer's job is to keep abreast of market
developments, international events and news items which would have an
impact o n exchange rates. This helps them to take informed decisions
regarding open positions to be maintained.
Dealers are required to comply with the Code of Conduct specified
by RBI, and operational guidelines provided by the Foreign Exchange
Dealers Associat ion of India (FEDAI).
12.8 STRUCTURE
A standard structure of the dealing operations in a commercial
bank involves three compartments:
Front Office: It is manned by dealers who represent the bank in all
market operations at both retail and wholesale lev els. They therefore
function as the 'face' of the bank in the market. All dealing operations take
place in this compartment.
Mid Office: This section deals with the risk management function. The
parameters for evaluating and controlling risks are establis hed by this
section. Every transaction undertaken by a dealer is recorded in a 'Deal
Slip' which provides all particulars of the transaction. Each deal slip is
processed in this section to ensure adherence to all risk control limits
specified by the manage ment.
These control limits include:
Limits on intra -day open position in each currency called 'Daylight
limits'. (Exposure control).
Limits on overnight open positions in each currency (lower than intra -
day)called 'Overnight limits'. (Exposure Control)
Limits on aggregate open position for all currencies. (Exposure
control)
Stop-loss limits. (For each currency) (Control over loss), A turnover
limit on daily transaction volume for all currencies. (Control of
overtrading)
Deal Size limits. (Distribution of Risk)munotes.in

Page 147

147Country -wise exposure limits. (Control of Market Risk)
Broker -wise business limits. (Control of Operational Risk)
Counterparty limits. (Control of Credit Risk)
Forward settlement date -wise limits. (Control of Settlement Risk)
Currency -wise Individua l Gap Limits (IGL's) -(Control of Maturity
Risk / Interest Rate Risk)
Currency -wise Aggregate Gap Limits (AGL's) -(Control of Maturity
Risk / Interest Rate Risk)
The Mid Office therefore represents the Risk Management hub of
all dealing operations. It provides a constant flow of market information to
the dealers.
Back Office: Takes care of processing deals, maintaining mirror accounts
(or nostro accounts reconciliation, recording of utilisation of forward
contracts by customers, recovering overdue inte rest, preparing returns to
be submitted to RBI, etc. It represents the administrative hub of all dealing
operations.
12.9 DEALI NG ROOM TRA NSACTIO NS
All transactions in the dealing room can be classified as either:
Merchant transactions entered into with customers of the bank and
Interbank transactions undertaken with other banks or institutions.
Merchant Transactions: Customers of the bank continuously approach
the bank for rates for various types of transactions. Either Card or Ready
rates are applied depending on the volume of each transaction. Every deal
is reported to the dealing room where it is recorded into the respective
currency position. The impact of the deal on the funds position and
forward gaps is also recorded separately. The evolving open currency
position is offset through opposite transactions in the interbank market.
These are called 'Cover Transactions'. All merchant deals are customised
in nature.
Interbank Transactions: Such transactions are undertaken either to
'Cover' merchant tra nsactions to lock the profit margins or represent
proprietary trading or speculative transactions done in keeping with the
view of the dealers regarding anticipated rate movements. All such
transactions are conducted at interbank rates and are standardised in
nature. Interbank deals are classified in terms of their settlement maturity
i.e. Cash, Tom, Spot or Forward.
Irrespective of the nature of the transaction, they are each recorded
in 'Deal Slips' providing full particulars and forwarded to the Mid -Office.
This section processes each deal slip against all control parametersmunotes.in

Page 148

148specified by the management. The deal slip then gets forwarded to the
Back -Office.
In addition to verification of adherence to the control limits the
mid-office also maintains a ' Rate Scan System'. Market rates are recorded
at fixed intervals to cross check that deals have been done at reasonable
rates and that there are no wide variations from the market rates at the
corresponding deal timings.
Dealing Rooms in India are now req uired to maintain 'Voice
Recording Systems.' Most deals are concluded verbally on 'Over -the-
phone' (OTP) basis and are therefore subject to mis -understandings, mis -
interpretations and disputes. Therefore all conversations in the dealing
room between banks, bank and brokers with customers, branches and
between dealing staff are recorded and stored for minimum six months.
These records are kept to verify the stand taken by market participants in
the case of disputes, litigations etc.
The back -office is the administrative section where the deal is
actually processed. Each deal is recorded in term of maturity, confirmed
with counterparties, settled through receipt/payment of respective
currencies etc. All statistical and regulatory returns are compiled by this
section.
12.10 DISTI NCTIO NBETWEE NMERCHA NTA ND
INTERBA NK TRA NSACTIO NS
Sr.No.Merchant Transactions Interbank Transactions
1. Represent transactions
between the bank and its
customers.Represent transactions
between the bank and other
banks or institutions.
2. Transactions are initiated by
the customers. (end -users).Transactions are initiated by
the bank to cover merchant
deals or acquire speculative
positions.
3. Customised deals. Standardised deals.
4. Do not involve brokers. May or may not involve
brokers.
5. Conducted at merchant rates
which are quoted to nearest
0.0025 paisa.Conducted at interbank rates
which are quoted to nearest
0.0005 paisa.
6. Transactions classified as per
rate types:
TT, Bills, TC and CN.Transactions classified in
terms of settlements types:
Cash, Tom, Spot and Forward.
7. Represent the retail segment
of the market and are
governed by Exchange
Control Regulation of RBI.Represent the wholesale
segment of the market and are
subject to RBI rules and
guidelines of the FEDAI.munotes.in

Page 149

14912.11 SUMMARY
Foreign exchange market is not a physical place, but an
organisational mechanism operating through satellite link SWIFT (Society
for World Wide International Financial Transactions), headquarters in
Brussels, Belgi um-Europe.
This operates works round the clock. The forex market is an over -
the-counter (OTC) market, which means that there is no central exchange
and clearing house where orders are matched.
Currencies are traded in different market makers such as Inter
Bank Market and Online Market Maker. Each market works at different
hours.
The primary objective of the foreign exchange market is to
facilitate international trade and investment, by allowing end -users to
convert one currency into another. The con version rates between
currencies are called foreign exchange rates. The market also facilitates
speculation, arbitrage and borrowing/lending of currencies for financing
different transactions. Therefore this market connects exchange rates with
interest rat es. The modern foreign exchange market started with the
introduction of the “Flexible Exchange Rate System” during the 1970s.
The characteristics is discussed.
The main participants in the foreign exchange market are (i) retail
clients (ii) commercial ba nks (iii) foreign exchange brokers and other
authorised agents. The central banks too participate in this market as per
its policy decisions.
Foreign exchange dealing room is a profit centre for the bank and
functions as a centralised service branch to m eet the needs of all other
branches to buy/sell foreign currencies. It is manned by specially trained
personnel called 'dealers or traders', who undertake all foreign currency
treasury operations. The primary function of the Dealing Room is to
provide rate s for various transactions being put through at branch level
with customers. Therefore every foreign currency related transaction gets
reported to the Dealing room. Rates provided by a bank to its customers
are called 'Merchant Rates'.
The structure of t he foreign exchange dealing room is divided into
front office, mid office and back office. There are two types of
transactions in the dealing room and they are merchant transactions and
interbank transactions. The difference between the two transactions is
mentioned.munotes.in

Page 150

150Check Your Progress
1. Fill in the blanks:
a. Foreign Exchange Market is an organisational mechanism operating
through satellite link --------------------------- .( S W I F T ,S F I T ,R I F D )
b. Foreign exchange market is ------------- market. (OTC, OTR, OTB)
c. During 1970's ------------ system was commonly used. (Managed Float
System, Flexible Exchange Rate System, Fixed Exchange Rate system)
d. Main participants of foreign exchange market are: retail clients,
commercial banks, foreign exchang eb r o k e r sa n d --------------- .
(Authorised dealers, speculators, hedgers, arbitrageurs)
e. Rates provided by a bank to its customers are called ' --------------------- '.
(Merchant rates, interbank rates, spot rates)
Q2. Answer the following:
a. What is for eign exchange market? State its characteristics.
b. Explain the following concepts:
i. Merchant rates
ii. Card rates
iii. Ready rates
iv. Merchant transactions
v. Inter bank transactions
Q3. Write short notes on the following:
i. Forex market
ii. Dealing room operations
iii. Dealing room transactions
iv. Treasury operations
Q4. Distinguish between Merchant transactions and inter -bank
transactions.
munotes.in

Page 151

15113
FOREIG NEXCHA NGE TRA NSACTIO N
Unit Structure
13.0 Learning Outcomes
13.1 Elements of a Foreign Exchange Transaction
13.2 Balance of Payments as Determinant of Demand for and Supply of
Currency
13.3 Adjustment of Bop Imbalances
13.4 Demand -Supply Factors in Exchange Rate Determination
13.5 Factors Affecting Foreign Exchange Rates
13.0 LEAR NING OUTCOMES
After learning this chapter, a learner will be able to understand
Meaning of FIAT currency
NOSTRO, VOSTRO and LORO accounts
The meaning of correspondent banks
BOP statements
Demand and Supply Factors in Exchange rate Determination
Foreign Exchange Market
The need for a foreign exchange market arises out of the fact that
the power of domestic legal tender, circulating in the form of currency
notes, to redeem commercial liabilities legally, is limited by national
boundaries. Both the seller and the buyer want to receive and make
payment in their respective domestic currencies. The task of fulfilling this
requirement is handled by international commercial banks.
All countries have their own currencies like India -Indian Rupee,
United States -US Dollars, United Kingdom -Sterling Pound etc. Any
economic transaction that takes place between residents of two different
countries involve exchange o f some currency between those two residents.
This may involve import/export of goods or services, investments or
redemptions, borrowing/lending. or personal transfers such as family
maintenance, tourism etc. In all these cases, the source of purchasing
power is available in one currency whereas its utilisation after conversion
is in another currency. When these transactions get executed through the
intermediation of banks, one currency gets converted into another. This
process is called 'Foreign Exchange.'munotes.in

Page 152

15213.1 ELEME NTS OF A FOREIG NEXCHA NGE
TRA NSACTIO N
Presuming 'X' wishes to buy pen for USDOLLAR 1 and is prepared
to pay Rs. 45 for the same then, 'X' would expect to be relieved of his
liability on payment of Rs. 45 whereas the foreign supplier would dem and
satisfaction through payment of USDOLLAR 1. Thus an intermediary
would become necessary who would accept Rs. 45 from 'X' and pay
USDOLLAR 1 to the foreign supplier. This role is always played by
international commercial banks.
Now, 'X' would pay Rs. 4 5 to his bank which would then send a
message to their overseas agent (called correspondent bank) to pay the
supplier the corresponding amount in foreign currency from the account
(called NOSTRO account) maintained with the agent.
Concepts of Foreign Exchange Transaction
FIAT currencies
FIAT currencies are paper currency notes issued by the Central
Monetary Authority of the respective countries, incorporating a promise to
redeem these notes at face value. The intrinsic value of these notes is
always l ess than the face value. The notes derive their ability to discharge
commercial liabilities up to the face value through the legally enforceable
promise of the note issuing authority contained in the notes.
Foreign Currency
It can be defined as the legal tender applicable in a country outside
the domestic area. Thus a foreign currency represents 'money' only in the
country of issue. All other locations it should be viewed as a commodity
having time value.
The Foreign Exchange Management Act, 1999, defines :
'Foreign Exchange means foreign currency and includes -
1. Deposits, credits and balances payable in any foreign currency;
2. Drafts, traveller's cheques, letters of credit or bills of exchange,
expressed or drawn in Indian currency but payable in any fo reign
currency; and
3. Drafts, traveller's cheques, letters of credit or bills of exchange drawn
by banks, institutions or persons outside India, but payable in Indian
Currency."
The term 'foreign currency' and 'foreign exchange' are thus
interchangeable, but, 'foreign currency' should be viewed as the
commodity being bought or sold e.g. US dollar, pound sterling etc.
whereas 'foreign exchange' should be viewed as the process ofmunotes.in

Page 153

153purchasing/selling currencies, that is, the mechanism by which one
currency ge ts converted into another. Foreign currency would include
NOSTRO balances and instruments.
NOSTRO accounts
Demand deposit accounts, denominated in foreign currencies
maintained by domestic banks with banks overseas are called NOSTRO
accounts. Nostro means 'our account with you'. For instance, if Bank of
Maharashtra, Mumbai has a US Dollar account with Citibank, New York,
then such an account would be called NOSTRO account.
VOSTRO accounts
Demand deposits accounts denominated in domestic currency
maintained by overseas banks with domestic banks are called VOSTRO
accounts. Vostro means 'your account with us'. For example, if Barclays
Bank, London has an INR account with Punjab National Bank, Mumbai
then such an account would be called VOSTRO accoun t.
LORO accounts
The term LORO is used when the NOSTRO/VOSTRO account is
referred to by a bank other than the account maintaining bank and the
bank with which the account is maintained. In simpler words, it is used
when referring to third party accounts. For example, if Bank of India,
Mumbai has an account with Citibank, New York denominated in US
Dollars then when Bank of Baroda has to refer to this account which
corresponding with Citibank, it would be referred to as LORO account,
meaning 'their account with you.'
NOTE: (a) The nationality of the banks at both ends is not material to this
classification. If Deutsche Bank, Mumbai (GERMAN Bank) has a US
Dollar denominated account with Barclays Bank New York (British
Bank), the account would still be classi fied as a NOSTRO account.
NOTE: (b) Every such account can be classified as both NOSTRO and
VOSTRO depending on whether the reference is being made from
domestic or foreign perspective. If SBI Mumbai has a US Dollar account
with Citibank, New York, it is aN O S T R Oa c c o u n tf r o mI n d i a n
perspective but a VOSTRO account from US perspective.
The structure of the transaction shows that when the transaction is
denominated in a foreign currency the exchange is effected by a bank
located at a domestic centre wherea s when the transaction is denominated
in the domestic currency the exchange is effected by a bank located at a
foreign centre. In effect, the entities at the two ends of the transaction
purchase / sell the foreign currency whereas the actual exchange (the
conversion) is undertaken by the intermediating banks.munotes.in

Page 154

154Correspondent Banks
The foreign exchange market functions around the system of
transfers and payments established between international commercial
banks. This mechanism operates through NOSTRO and V OSTRO
accounts being maintained by banks in different countries. The bank with
whom such a NOSTRO or VOSTRO account relationship is established is
called correspondent bank. This bank (in whose books the account is
created) essentially acts as an agent of the bank in whose name the
account stands (principal) and undertakes various functions is as follows:
1. Maintaining the foreign currency account and receiving and making
payments on behalf of the counterparty (Principal) bank.
2. Providing temporary overd rafts as and when necessary.
3. Providing credit reports on companies located in the country of the
correspondent bank.
4. Assisting the principal bank in all agency functions such as presentation
of documents, advising of LC, confirmation of LC, reimbursi ng the
negotiating bank etc.
5. Providing trade related data and product data to help the principal bank,
provide information for business development to their customers.
All communications between correspondent banks are generally
conducted through a unique code mechanism which overcomes security
related problems. The concept of correspondent banking has developed
because it is not always financially viable to establish representative
offices or branches in various countries due to inadequate volume of
business and high capital cost of multinational banking model.
Foreign Exchange
It can be defined as a transaction or mechanism which facilitates
the exchange between one legal tender and another. It involves transfers
through demand deposit accounts at both ends of an international
transaction. The actual conversion takes place through the use of
NOSTRO/VOSTRO accounts between international banks.
Foreign Exchange Market
The ability of FIAT currencies to discharge commercial liabilities
is limited by na tional boundaries. This limitation gives rise to the need for
a foreign exchange market facilitating exchange between currencies. The
foreign exchange market can be defined as an electronically connected
network of international banks, brokers and service providers:
The main characteristics of this market are:
1. This market does not involve any physical transfer of currencies in the
form of cash.
2. This market does not have any physical structure (It is an OTP market).munotes.in

Page 155

1553. This market helps to establish the rate of conversion between
currencies. The conversion rates are called foreign exchange rates.
4. Receipts and payments in foreign currencies take place by way of
transfers to and from demand deposit accounts at both ends of the
transaction. This proce ss is facilitated by international banks through
NOSTRO/VOSTRO accounts maintained with correspondent banks.
Role of Banks in Foreign Exchange Transactions
Since only commercial banks provide demand deposit accounts
which are essential for any foreign exc hange transaction to be executed,
every transaction involving foreign exchange therefore passes through the
international banking sector. The actual conversion takes place through the
NOSTRO and VOSTRO accounts maintained between banks. Effectively,
banks are the best placed participants in the foreign exchange market to
establish the demand -supply equilibrium between currencies. Thus, the
activity of quoting foreign exchange rates is associated with international
commercial banks.
The foreign exchange m arket includes end -users (individuals and
corporate) commercial banks, brokers, Central Banks and service
providers.
(Messaging service providers: SWIFT etc. Information service providers:
Reuters, Telerate, Bloomberg etc.)
The foreign exchange market provides the environment for
establishing the demand supply equilibrium between currencies based on
which the rate of conversion is established. Thus the rate of exchange for a
currency is known from the quotation in the foreign exchange market. The
banks operating at a given financial centre, and dealing in foreign
exchange, constitute/represent the foreign exchange market. The rates in
the foreign exchange market are determined by the interaction of the
forces of demand for and supply of the commodity dea lt in, viz: foreign
currencies. Foreign currencies cannot be created domestically. Therefore,
every country strives to balance the inflows and outflows of foreign
currencies. Therefore, the need arises for regulating or controlling foreign
currency transac tions. In India such measures are collectively called
'Exchange Control Regulations.' (ECR).
From the foregoing we can deduce that:
Trade is the basis for international monetary flows.
International trade contributes to economic growth.
Trade transactions involve conversion between currencies.
The ratio of conversion is called the Foreign Exchange Rate.
The environment in which the exchange rate is established is called
the Foreign Exchange Market. This rate is based on the demand
supply factors affecting each currency pair.munotes.in

Page 156

15613.2 BALA NCE OF PAYME NTS AS DETRIMI NANTO F
DEMA NDF O RA ND SUPPLY OF CURRE NCY
In the present context exchange rates in most major economies
(exception: China) follow the Floating Exchange Rate System, which
means that exchange rates are established through market demand -supply
equilibrium. Demand -supply of currencies is based on currency flows
into and out of the economy. The factors which contribute to such flows
are:
Export and Import of goods and services.
Personal remittances.
Investments and Redemptions.
Borrowing and Lending.
All the above transactions pertaining to an economy over a given
period are captured in the Balance of Payments Account (BOP) for the
country.
BALA NCE OF PAYME NTS
Definition
The BOP of a country is a systematic account, in the form of
summarised record, of all economic transactions between residents of a
country and non -residents over a given period. (normally the BOP covers
a period of one year). The account is prepared using the double entry
accounti ng system with both the debit and credit aspects of each
transaction being recorded under different heads within the account which
implies that the BOP account always balances. (i.e Debit and Credit
summations are equal).
COMPO NENTS OF BOP ACCOU NT
The BOP account has three components:
a) Current Account
b) Capital Account
c) Reverse Account
a) Current Account
The current account of the BOP is made up of three balances viz.,
Merchandise (Visibles) balance, Services (Invisibles) balance and
Unilateral Trans fers Balance. Effectively it reflects the net flow of goods,
services and unilateral transfers (gifts, donations, legacies etc.) Balance on
current account can thus be defined as the net value of the balances of
visible trade, invisible trade and unilatera lt r a n s f e r s .
Balance of Trade (BOT) is described as the difference between the
value of merchandise (goods) exports and the value of merchandise
imports. It can also be described as the 'Goods Balance' or the 'Balance of
Merchandise Trade.' This balance r eflects the country's capacity to provide
material requirements of the population. An 'active' (positive) or 'passive'munotes.in

Page 157

157(negative) BOT by itself does not signify economic status. An analysis of
the underlying elements of exports and imports is critical. The BOT
represents the net trade in tangibles.
BOP on current account thus covers all receipts and payments
arising out of trade and personal remittances. There is no reverse flow in
current account transactions. This means that the Current Account
represent s all self -liquidating transactions which constitute 'ready' or
immediate demand for and supply of currencies for an economy over a
given period. It thus has a direct impact on the exchange rate of the
domestic currency.
b) Capital Account
The Capital Acc ount records all international transactions that
involve creation of assets and liabilities in foreign currencies. These
transactions involve a 'reverse flow' e.g. a loan taken in a foreign currency
creates a ready inflow with a corresponding future liabil ity/payable. On
maturity of the loan, the (reverse)outflow would take place. The Capital
Account thus records all 'receivables and payables' which would impact
the demand -supply equilibrium in the future. The classification of a
transaction as either cur rent or capital therefore does not depend on the
nature of the asset but on the nature of the transaction.
The net effect of the Current and Capital accounts taken together
represents the status of the BOP. If the net effect is positive, that is,
inflows are more than outflows, then the BOP is said to be 'Surplus',
whereas, if the net effect is negative, that ism outflows are more than
inflows, then the BOP is said to be 'Deficit'.
Surplus or Deficit in Balance of Payments Account;
Accommodating & Autonom ous Capital Flows Concept
An autonomous transaction is a transaction undertaken in the
normal course of business in response to the given environment of price
levels, exchange rates, interest rates etc. It does not take into account the
equilibrium aspect of the BOP. An accommodating transaction is a
transaction undertaken with the specific intention of adjusting the
imbalance arising out of other transactions. All foreign currency flows can
thus be classified as 'autonomous' or 'accommodating'. Obviously t he net
effect of the accommodating and autonomous items must be zero, since all
entries in the BOP account must get reflected under one of the two
headings. (The BOP always). Whether the BOP is in surplus or deficit
depends on the balance of the autonomous items. The BOP is said to be in
surplus if autonomous receipts are greater than the autonomous payments
and in deficit if vice versa. Autonomous transactions are viewed as 'above
the line whereas accommodating transactions are viewed as 'below the
line.'
Effectively all the elements of currency flows captured in the
Balance of Payments get recorded in either the Current or Capitalmunotes.in

Page 158

158Accounts which together constitute the 'Autonomous Transactions'. The
monetary authority through the use of the Reserve Account makes the
necessary adjustments for balancing the above transactions and these
transactions therefore represents 'Accommodating Transactions.'
Distinction between Autonomous and Accommodating Transactions
Sr. No. Autonomous Transactions Accommoda ting
Transactions
1. These transactions are
undertaken in the normal course
of business without considering
the equilibrium of the BOP.These transactions are
undertaken with the specific
intention of balancing the
BOP.
2. These transactions effectively
represent Current and Capital
Account transactions.These transactions
effectively represent Reserve
Account Transactions.
3. These are classified as "Above
the line' transactions.These are classified as
'Below the Line'
transactions.
4. These transa ctions are normally
undertaken by market
participants other than the
Central Bank.These transactions are
undertaken by the Central
Bank.
5. BOP is surplus if net balance of
autonomous transactions is
positive. BOP is deficit if net
balance of autonomous
transactions is negative.Surplus BOP is an increase
in reserves whereas a deficit
BOP results is a decrease in
reserves account.
6. In the case of economies using
the Fixed exchange rate system
or the Managed Float System,
the Central Bank participates in
the domestic market through the
Reserve Account transactions
(accommodating transactions)
which adjust the imbalance in
the Autonomous transactions.
Thus both types of transactions
exist in such systems.In the case of economies
using the independent fl oat
system, the Central Bank
does not participate in the
market which implies that
there is no change in Reserve
Account. This means there
are no Accommodating
transactions and
Autonomous transactions
self-balance. Thus only
Autonomous transactions
exist i n such a system.
The Official Settlement Concept
Another approach for indicating, a deficit or surplus in the BOP is
to consider whether the net monetary transfer that has been made by the
monetary authority is positive or negative. This means that the t ransfer to
or from the Reserve Account represents the extent of accommodation
being provided by the monetary authority for balancing the surplus /munotes.in

Page 159

159deficit in the autonomous transactions. Effectively, the monetary authority
settles the disequilibrium in the BOP and hence such actions are called
'Official Settlements'.
If the net transfer by way of official settlements is negative i.e
there is an outflow from Reserve Account then the BOP is said to be in
deficit, and if there is an inflow then it is surplus. This means that the
monetary authorities are the ultimate financers of any deficit in the
balance of payments or the recipients of any surplus. The official
settlements thus represent the accommodating items, whereas all others
are autonomous.
The moneta ry authorities may finance a deficit by reducing their
reserves of foreign currencies, by borrowing from multilateral institutions
or by borrowing from foreign monetary authorities. The settlements
approach has greater relevance under the Fixed Exchange Ra te System
than the Flexible Exchange Rate System since participation of the
monetary authority in managing the demand -supply equilibrium is
implied in pegged rates.
Current Account Monetary Model
This model is based on the Purchasing Power Parity theory and on
the assumption that flexible exchange rates keep the balance of payment in
continuous equilibrium. Consequently, it is implied that there are no
changes in foreign exchange reserves. Nominal domestic money supply is
determined by domestic credit cr eation which is controlled by domestic
monetary authorities. The monetary authority is not bound by any
compulsion to intervene in markets for protecting the exchange rate.
The philosophy of this model is that domestic residents, when
faced with an imbala nce between the desired amount of domestic money
and the actual amount of domestic money created by the monetary
authority will strive to correct it by creating a balance of payments deficit
or surplus. If there is excess supply of domestic money it would be used to
purchase both domestic goods as well as foreign goods and services. This
will result in a higher domestic price level (inflation) and depreciation of
the exchange rate. If there is excess demand for domestic currency then
the exchange rate of th e domestic currency will appreciate.
Capital Account Monetary Model
This Model was developed by economist Frankel in 1979. The
Frankel model suggests (like the current account monetary model) that an
increase in domestic money supply will, in the long -rundepreciate the
domestic money supply will, in the long -run depreciate the domestic
currency while an increase in demand for the domestic currency will lead
to its appreciation. The interest rate of a currency also has an impact on
the appreciation or depr eciation of the domestic currency. If interest rate
increase due to tight monetary conditions i.e: greater demand for the
domestic currency, then the currency would appreciate whereas if themunotes.in

Page 160

160interest rate increase is a consequence of higher inflation then the currency
would depreciate.
Detailed Outline of the BoP Statement & Sub Accounts
Balance of Payments is a summary of all the transactions between
the residents of one country and non -residents for a given period of time,
usually one year. A BoP stateme nt (revised) includes the following sub
accounts, as shown in the table below:
Items Credits Debits Net
A. Current Account
1. Merchandise
a. Private
b. Official
Non-Monetary gold account.
2. Invisibles
a. Transportation
b. Travel
c. Insurance
d. Investment Income
e. Government (not included elsewhere)
f. Miscellaneous
3. Transfer Payments (Unilateral Transfers)
a. Private
b. Official
Total Current Account (1+2+3)
B. Capital Account
1. Private
a. Short term
b. Long term
2. Banking
a. Short term
b. Long term
3. Official
a. Loans
b. Amortisation
c. Miscellaneous
Total Capital Account (1+2+3)
Errors and Omissions Account
C.Reserves Account
a. IMF Account
b. SDR Account
c. Reserve -Monetary gold account
-Foreign currency account
Note:This is not the official format of the BoP but a simplified version to
facilitate understanding of the concept s discussed herein.
Benefits of BoP Analysismunotes.in

Page 161

1611. It helps to identify areas of strength within the economy where the
country enjoys a comparative advantage. This enables the government
to channelise resources to optimise resource utilisation.
2. It helps to identify areas of weakness in the economy which require
protection against foreign competition. This is achieved through
qualitative and quantitative trade restrictions.
3. It helps the government to rationalise direct and indirect taxes. The
purchasing power of the domestic currency (as reflected by the
changes in the BoP) in relation to income levels, guides the
government in this regard.
4. It identifies changes in consumption trends which guides the
government in changing policies. Transaction -wise l imits fixed under
the Exchange Control Restrictions are governed by such studies.
5. It represents the basis on which the government makes changes in trade
and investment policies, including sector -wise limits for Foreign
Direct Investments, range of inves tment avenues available to Foreign
Portfolio Investors etc.
13.3 ADJUSTME NT OF BOP IMBALA NCES
If the domestic expenditure of the economy is more than the
domestic output, then it results in balance of payment deficit. The
difference represents excess of imports over exports. Therefore, the
monetary authority takes measures to reduce the domestic expenditure to
eliminate BOP deficit. The effort to reduce budget and fiscal deficit by the
government represents its attempt to reduce expenditure. The different
policies adopted for reducing/eliminating BOP deficit are:
1). Monetary Policies
2) Fiscal Policies
3) Trade Policies
4) Devaluation/Depreciation of exchange rate
Monetary Policies
The usual monetary policies adopted by the government in such a
situation are:
a. Increase in the interest rates (Cost of money increases)
b. Increase in Cash Reserve Ratio or Statutory Liquidity Ration (reduces
credit creation)
c. Issue government treasury bills, bonds and securities by way of open
market operations (reduces m oney in circulation)
d. Increase margin requirements. (reduces borrowing capacity)munotes.in

Page 162

162The ultimate effect of these policies is that the money with the
public reduces and the market velocity reduces. When the money with the
public reduces, the consumption expe nditure also declines thus reducing
the BOP deficit.
Fiscal Policies
Fiscal policies relate to the Government Budget. The income side
of the budget comprises the direct and indirect taxes collected by the
government. Increase in direct taxes i.e. income t ax etc. reduces the
disposable income of the population which reduces both consumption and
savings. An increase in indirect taxes like customs duty, excise duty etc.
increases the cost of acquiring goods and services reducing consumption.
Historically chan ges in fiscal policies have been more effective in
reducing expenditure/deficit.
Trade Policies
If the major cause of BOP deficit is the adverse balance of trade,
then trade policy changes are very effective. In such situations the
government tends to pro mote exports and import substitution and to
achieve this objective announces promotional policies providing subsidies
and incentives to exporters such as concessional credit, reduced margins
on borrowings, income tax benefits, reliefs in excise duties, cus toms duties
and concessions in other inputs such as transportation, land, electricity,
power and raw materials.
Devaluation / Depreciation of Exchange Rate:
Economies which operate on either a fixed exchange rate system or
a Managed Float System use the e xchange rate to achieve equilibrium in
international trade. Devaluation is a conscious step taken by the monetary
authority to reduce the exchange rate of the domestic currency whereas
depreciation is a market led reduction in the currency value. Both resu lt in
increasing the cost of imports and make exports more profitable. The
higher cost of foreign currencies reduces imports and boosts exports
thereby reducing the trade deficit and achieving equilibrium.
Distinction between Devaluation and Depreciation
Sr.
No.Devaluation Depreciation
1. Represents reduction in Represents reduction in the valuemunotes.in

Page 163

163the value of the currency
through official action.of the currency through market
action.
2. It is a one time action. It is a continuous process.
3. It cannot be predicted. It can be anticipated.
4. Associated with fixed
exchange rate system.Associated with flexible exchange
rate system.
5.
13.4 DEMA ND-SUPPLY FACTORS I NEXCHA NGE
RATE DETERMI NATIO N
The foreign exchange rate is the relative price of one currency in
terms of another. In the context of floating exchange rates, these prices
should be determined by forces of supply and demand. The objective is to
correctly incorporate all the factors that influence the demand for and the
supply of currency. Foreign currencies represent commodities and as in
the case of all such assets, the price at any time i.e the spot exchange rate,
is influenced by anticipations regarding the future changes in the price and
these expectations are in tu rn influenced by economic events, political
developments, resource discoveries, technological developments etc.
Demand for any given currency in the international markets arises from
private end users i.e. individuals and corporate entities who undertake
foreign currency transactions and central banks who hold a part of their
reserves in the currency. Similarly, supply of the foreign currency arises
out of non -residents wishing to buy domestic country goods and services,
acquire domestic currency denominate d assets, service liabilities and
central bank interventions. Exchange rate is the equilibrium price that
equates these factors.
The BoP theory of Exchange Rate determination is therefore the
connecting link between demand supply of foreign exchange due t o
current account transactions, the corresponding asset / liability values
represented by Capital account and Reserve Account transactions which
help to balance the net surplus or deficit.
13.5 FACTORS AFFECTI NGF O R E I G NEXCHA NGE
RATESmunotes.in

Page 164

164Foreign Exchange ra tes are influenced by several factors in the
international market. All tangible factors that is, those which represent
quantifiable commercial and personal transactions are captured in the BoP
Account and the net disequilibrium in the BoP represents the si ngle most
important demand -supply element affecting an exchange rate. However,
90% of the volume in the foreign exchange market is made of speculative
transactions, which are transactions without any underlying commercial
base. These transactions are under taken in anticipation of future changes
in demand or supply. Factors which influence the trading decisions of
speculators are called intangible factors since their impact cannot be
quantified. These factors such as Economic indicators, political changes,
Psychological elements etc. which also influence the exchange rate can be
summarised as follows:
A. Gross Domestic Product (GDP)
GDP is the broadest measure of aggregate economic activity in a
country and represents the total value of final goods and servi ces produced
in a country. GDP is the primary indicator of the strength of economic
activity. So, the growth in the GDP positively influences the foreign
exchange price of the currency. A fast growing economy will reflect
strength in the exchange rate and vice versa.
B. Trade Balance
This represents the difference between imports and exports of
tangible goods. The changes in exports and imports are recorded in the
current account of the BoP and therefore have a ready/immediate effect on
the demand -supply equation. This data is thus widely followed by the
foreign exchange market. A positive BoT would result in an appreciation
in the domestic currency which would make imports cheaper and exports
costlier and vice versa.
C. Inflation
Inflation is the rate of change in the price level of a fixed basket of
goods and services in an economy. In most countries the most widely
followed measure of inflation is the Consumer Price Index (CPI) i.e rate of
change in the price level of a fixed basket of goods and servi ces purchased
by consumers. Inflation reduces the purchasing power of the currency.
This reduction in domestic purchasing power gets reflected internationally
through depreciation in the exchange rate of the domestic currency.
D. Employment Levels
Emplo yment levels in an economy reflect the development and
stability in the economy. An expanding economy would result in greater
investments which would result in more employment generation. This
increases income within the economy resulting in higher consump tion and
savings. This again would mean more investments and the economymunotes.in

Page 165

165would continue in its growth trajectory. Higher employment data therefore
reflects a growing economy and leads to appreciation in the domestic
currency.
E. Interest Rate Differential s
Interest rate applicable to a currency has a dual impact on the
currency valuation. If increase in the interest rate is a reflection of the
strength of the economy then it would have a positive effect on the
exchange rate. However if the interest rates i ncrease due to expectations of
higher inflation then it would have a negative effect on the value of the
currency. In any exchange rate there are two currencies involved.
Therefore, there are situations when interest rates of both currencies may
rise simul taneously. In such situations the interest rate differential is
relevant. Sometimes the interest rates of the two currencies could move in
opposite directions thereby increasing the gap between the two. In such
cases the effect on the exchange rate would b em o r ep r o n o u n c e d .
F. Excnage Rate Policy
In many countries the exchange rate policy is decided by the
Finance Ministry i.e by the government while monetary policy is decided
by the central bank. However, the execution of the exchange rate policy is
alway s managed by the Central Bank. The Central Bank of the country
participates in the local foreign exchange market by way of intervention to
stabilise the exchange rate or maintain it in a particular range. This also
affects the exchange rate of the currency .
G. Political Factors
The forex market can be influenced by political events and
changes. These events may be anticipated or unforeseen. Some of the
common political developments are elections, public announcements by
Central Bank or government officials , military takeovers, political
instability etc. All such factors affect the exchange rate.
H. View of Speculators
More than 90% of the turnover in international foreign exchange
markets represents speculative activity. The view or perception of the
likely value of the currency of these participants in the market has a
critical effect on the exchange rate.
These are some of the factors that affect the exchange rate but the
objective of establishing a precise model for rate determination is a
complex task because individual factors work together or in isolation in
different proportions at different times.
At the centre of this complex environment are the forces of
demand and supply that determine the prices of commodities in a free
market. In the forei gn exchange market, the commodity is the foreign
currency. If at any given rate, the demand for a currency is greater than its
supply, its price will rise. If supply exceeds demand, the price will fall.munotes.in

Page 166

166The supply of a nation's currency is determined by t hat nation's
monetary authority, which is usually its Central Bank. Government and
Central Banks closely monitor economic activity to keep money supply at
a level appropriate to achieve their economic goals. Too much money
increases inflation, causing the value of the currency to decline and prices
to rise, whereas too little money would slow economic growth and
possibly cause unemployment.
The demand for and supply of a currency ultimately originates
with the end users. The governments set monetary policy through their
central banks to fulfill the needs of their residents. Banks equalise the
supply and demand by trading with each other. The Central banks
ultimately undertake the balancing act between the domestic economy and
the external economy represente d by the exchange rate and management
of reserves.
SUMMARY
The need for a foreign exchange market arises out of the fact that
the power of domestic legal tender, circulating in the form of
currency notes, to redeem commercial liabilities legally, is limited
by national boundaries.
NOSTRO and VOSTRO accounts are opened and maintained by
the Correspondent Banks.
Foreign Exchange deals with currency while forex rate represents
the rate which is fixed.
Since only commercial banks provide demand deposit ac counts
which are essential for any foreign exchange transaction to be
executed, every transaction involving foreign exchange therefore
passes through the international banking sector.
The BOP of a country is a systematic account, in the form of
summarised record, of all economic transactions between residents
of a country and non -residents over a given period.
An imbalance in BoP creates either surplus or deficit. These could
be adjusted through monetary, fiscal, trade policies, devaluation
and depreciation of exchange rate as well.
GDP, Trade balance, inflation, employment levels, interest rate
differentials, exchange rate policy political factors and view of
speculators influence exchange rates.
QUESTIO NS
Q1. Explain the following concepts
a. FIAT curren cy
b. Foreign Currency
c. Foreign Exchangemunotes.in

Page 167

167d. Foreign Exchange Market
e. Correspondent Bank
f. NOSTRO/VOSTRO/LORO accounts
g. Balance of Payments
Q2. Write short notes on the following
a. Balance of Payment as representative of Demand -Supply factors for
foreign currencies.
b. Factors affecting demand for and supply of foreign currencies
c. Factors influencing foreign exchange rates
d. Benefits of BOP analysis.
Q3. Answer in detail
a. The Current Account of the BoP is the key to establishing foreign
currency demand/supply equilibrium. Discuss.
b. Distinguish between Autonomous and Accommodating flows.

munotes.in

Page 168

16814
FOREIG NEXCHA NGE RATE
Unit Structure
14.0 Learning Outcomes
14.1 Exchange Rate Quotations
14.2 Foreign Exchange Rate Convention
14.3 Distinction between Direct and Indirect Rates
14.4 Characteristics of Exchange Rates
14.5 Arbitrage, Speculation and Trading
14.6 Classification of Rates in Terms of Settlement
14.0 LEAR NING OUTCOMES
After reading this chapter, a learner will be able to understand:
Direct, Indirect and Cross Rates
The meaning of Vehicle currency
How to calculate spread, spread percentage
Meaning of arbitrage, speculation and trading
How the rates are classified according to the settlement dates
The meaning of Holgate's Principle.
14.1 EXCHA NGE RATE QUOTATIO NS
The foreign exchange market includes end -users (individuals and
corporate) commercial banks, brokers, Central Banks and Service
Providers such as:
Interbank Messaging Service Providers: SWIFT etc.
Information Service Providers: Reuters, Telerate, Bloomberg etc.
The foreign exchange market provides the environment for
establishing the demand and supply equilibrium between currencies based
on which the rate of conversion is established. These conversion rates are
called 'Foreign Exchange Rates' or 'Exchange Rates'. Thus the rate of
exchange for a currency is known from the q uotation in the forex market.
All foreign exchange transactions operate through the banking system and
therefore, the banks operating at a financial centre, and dealing in foreignmunotes.in

Page 169

169exchange, constitute/represent the foreign exchange market. The rates in
theforeign exchange market are determined by the interaction of the
forces of demand for and supply of the commodity dealt in, viz: foreign
exchange.
SOME IMPORTAT NTC U R R E NCIES REGULARLY QUOTED I N
India
COUNTRY CURRENCY ABBREVIATION SYMBOL
USA
UK
Japan
Euro-Area
Indian
Switzerland
Canada
Australia
Singapore
Sweden
Germany
FranceUS Dollar
Pound Sterling
Japanese Yen
Euro
Indian Rupee
Swiss Franc
Canadian Dollar
Australian
Dollar
Singaporean
Dollar
Swedish Kroner
Deutsche Mark
French FrancUSD
GBP
JPY
EUR
INR
CHF
CAD
AUD
SGD
SEK
DEM
FRF$
£
¥
€
SFr
C$
A$
S$
SKr
Dm
FFr
(Deutsche Marks and French Francs are not in use now).
Generally, the above abbreviations have been used for all numerical
examples in this book.
14.2 FOREIG NEXCHA NGE RATE CO NVENTION
A foreign exchange rate is an equality which provides a
relationship between two currencies. 1 USD = INR 56.0625 -56.0650 is
conventionally written as USD/INR 56.0625 -56.0650. (USD = base
currency and INR = variable currency). A rate therefore represe nts the
value of the base currency expressed in terms of the variable currency.
Currencies are bought and sold against one another. Each currency
pair therefore constitutes an individual product. ISO 4217 provides unique
three -letter abbreviations (codes )f o re a c hc u r r e n c yw h i c ha r e
internationally used. A rate expressed as EUR/USD is the price of the
EURO expressed in US dollars, as in 1 euro = 1.2835 US dollars. The
LHS (Left Hand Side) currency in the pair is the base currency, whereas
the RHS (Right H and Side) currency is the counter, quoted or variablemunotes.in

Page 170

170currency. Representation of rates in this form is called as the ACI
convention.
Note:
Exchange rates are represented under different conventions. Some
patterns are as follows:
1U S D=I N R5 6 . 0 6 2 5 -56.0650
INR 56.0625 -56.0650 per USD
INR 56.0625 -56.0650 / USD
INR 56.0625 -56.0650 = 1 USD
Students should rewrite the quotations as per desired convention.
In this book the ISO 4217 abbreviations for currencies and the ACI
conventions for exchange r ates will be followed i.e Base currency /
variable currency.
CLASSIFICATI NOF RATES: (DIRECT, I NDIRECT A NDC R O S S
RATES)
A foreign exchange rate which provides a relationship between
fixed number of units of foreign currency against variable number of uni ts
of domestic currency is called a direct rate. {This format of expressing
exchange rates is operative in India since August 1993}. In such rates the
foreign currency acts as the base currency whereas the domestic currency
acts as the variable currency.
A foreign exchange rate which provides a relationship between
fixed number of units of domestic currency against variable number of
units of foreign currency is called an Indirect rate {This form of
expressing exchange rates prevailed in India prior to Au gust 1993}. In
such rates the domestic currency acts as the base currency whereas the
foreign currency acts as the variable currency.
A foreign exchange rate which provides a relationship between two non -
domestic currencies is called a cross currency rate .E g .
Quotation India USA Japan
USD/INR
INR/USDDirect
IndirectIndirect
DirectCross -currency
Cross -currency
Direct, Indirect and Cross Currency rates are therefore a function
of location and the location of the quotation must always be indicated
when classifying rates.munotes.in

Page 171

17114.3 DISTI NCTIO NBETWEE NDIRECT A ND
INDIRECT RATES
DIRECT RATES INDIRECT RATES
1. Foreign exchange rates which
represent a relationship between a
fixed number of units of foreign
currency against variable number of
units of domestic currency are
called Direct Rates.
2. An example of a direct rate in
India would be:
1U S D=I N R5 8 . 3 8 2 5 -58.385 0
3. Direct rates were introduced in
India effective from 2nd August,
1993.
4. When trading in foreign currency
with the use of direct rates, the
strategy used is 'Buy low -Sell
High'.
5. Direct rates are generally
expressed in India to the base of 1
unit of foreign currency except
Japanese Yen whose relationship is
expressed to the base of 100 units.
6. In the US market, direct rates are
called 'Rates on American Terms'.
7. An example of a quotation on
American terms would be:
1GBP = USD 1.7675 -1.7685
8. In the case of direct rates, the
base currency is always a foreign
currency while variable currency is
always the domestic currency.Foreign exchange rates which
represent a relationship between a
fixed number of units of domestic
currency against variab le number of
units of foreign currency are called
Indirect Rates.
An example of an indirect rate in
India would be:
100INR = USD 2.0605 -2.0610
Indirect rates were used in India
from 1971 up to 2nd August, 1993.
4. When trading in foreign currency
using indirect rates, the strategy
used is 'Buy high -Sell low'.
Indirect rates in India were
expressed to the base of 100 INR.
In the US market, indirect rates are
called 'Rates on European terms'.
An example of a rate on European
terms would be:
1USD = CHF 1..2950 -1.2960
In the case of indirect rates, the base
currency is always domestic
currency while variable currency is
always a foreign currency.
14.4 CHARACTERISTICS OF EXCHA NGE RATES
1. Foreign exchange rates are quoted by banks on a two -way basis e.g.
USD / INR 56.0675 -56.0680.
2. The LHS rate in the quotation is called BID rate and represents the rate
at which the bank would buy one unit of the base currency (USD).
3. The RHS rate in the quotation is called ASK or OFFER rate and
represents the r ate at which the bank would sell one unit of the base
currency. (USD).munotes.in

Page 172

1724. The difference between the Ask and Bid rates, in a given quotation is
called the spread. Therefore spread is denoted as (ASK -BID). Since
ASK > BID, the spread is always positive.
5. Foreign exchange rates are normally quoted up -to two or four decimal
places. In India the general practice in the inter -bank market is to
quote rates up to four decimal places.
6. Foreign exchange rates are always expressed to the base of 1, 10, 100 or
1000 units of base currency. In India, rates are expressed either to the
base of 1 unit or 100 units of base currency.
7. Unless otherwise specified, an inter -bank quotation in India is usually
valid for USD 1 million.
8. Percentage spread = Spread÷Mean Rat eX1 0 0=A S K -BID÷ASK +
BID/2 X 100 = ASK -BID÷ASK + BID X 200
FACTORS WHICH I NFLUE NCE SPREAD RATE
Transaction cost (This includes brokerage, operating expenses and
correspondent bank charges).
Volatility in the market (Higher the volatility, wider wi ll be the spread
and vice versa etc.)
Depth of the market (Depth of the market is associated with volume
available for covering the transaction. Greater the depth, narrower will
be the spread and vice versa).
Exchange control regulations (The RBI does not specify any minimum
or maximum spread for quotations in India
SIGNIFICA NCE OF SPREAD TO E NDU S E R S
%age spread of cross rate = %age spread of vehicle currency quotation +
%age spread of cross currency quotation.
Effectively this means that the fineness of a foreign exchange
quotation decreases for the end user when the transaction is undertaken in
any currency other than the vehicle currency. The spread therefore
represents a level of safety for the person making the quotation whereas it
represents cost to the person using the quotation.
Thus the spread represents the nominal difference between the
'ASK' and 'BID' rates of a quotation whereas the % age spread helps to
compare the fineness of different quotations.
CALCULATIO NOF % SPREAD A NDC R O S SR A T E S
RULES:
1. When rates are provided in any form other than the ACI Convention,
the given data may be reconstructed as per ACI Convention and a remark
to that effect may be made in the solution.munotes.in

Page 173

1732. When a quotation is to be derived with INR as base currency then it
should always be calculated for 100 units of INR.
3. Mean Rate, Mid -Rate, Average Rate and Flat Rate all mean the same.
4. The terms 'PIPS' and 'POINTS' can be used interchangeably in the
context of exchange rates. They represent the last decima lp l a c eo fa
conventionally expressed exchange rate. They represent the smallest
increase or decrease in the rate. In the Indian foreign exchange market,
rates are quoted to the fourth decimal point. Thus 1 'pip' would be 1% of
the small currency unit = 1/ 100th of the small currency unit = 1/100 X
1/100 = 1/10000th of major currency unit. Therefore INR 46.3825 can be
interpreted as 46 rupees, 39 paisa, 25 pips.
5. Therefore to convert pips / points to rate we divide by 10, 000 and to
convert rate to pips / points we multiply by 10, 000.
6. As previously indicated, foreign exchange rates may be quoted to two
or four decimal places. If the given data shows rates in a two decimal form
the multiplication or division factor would be 100.
7. Identification of c ountry in 'Direct' form is done by identifying the
country of variable currency and identification of country in 'Indirect' form
is done by indentifying the country of the base country.
8. A 'Basis Point' can be defined as last decimal place of a conventio nally
written interest rate. Since interest rates are quoted to two decimal places 1
Basis Point = 1/100 of 1% = 1/100 of the rate. If the interest rate changes
from 2.25% to 2.50% then change = 25 Basis Points.
SOLVED EXAMPLES
1. USD / INR 53.8425 -75
GBP / USD 1.5365 -75
Calculate GBP/INR quotation.
Solution
(GBP/INR) B= (GBP/USD) BX( U S D / I N R ) B
=1 . 5 3 6 5X5 3 . 8 4 7 5
=8 2 . 7 2 9 0
(GBP/INR) A= (GBP/USD) AX( U S D / I N R ) A
=1 . 5 3 7 5X5 3 . 8 4 7 5
=8 2 . 7 9 0 5
QUOTATION: GBP / INR 82.7290 -82.7905
2. Given: USD/SEK 6.4750 -6.4850
Calculate % spread.munotes.in

Page 174

174Solution
%S p r e a d=A S K -BID÷ASK + BID X 200
=6 . 4 8 5 0 -6.4750÷6.4850 + 6.4750 X 200
=0 . 0 1 0 0 ÷ 1 2 . 9 6 0 0X2 0 0
= 00.1543%.
3. Given: GBP/USD Mid rate 1.5316
Spread = 0.0012
Calculate % spread.
Solution
% Spread = Spread ÷ Mean Rate X 100
=0 . 0 0 1 2÷1 . 5 3 1 6X1 0 0
=0 . 0 7 8 3 %
NOTE: Mean rate, Mid rate, Average Rate and Flat Rate all mean the
same.
4. A bank in New York quotes: GBP/USD 1.5493 -03
a. Isthis an 'American' or 'European' quote.
b. Find Mean rate, spread and spread percentage.
c. Calculate the Inverse quote.
Solution
a. Given quote is an 'American' quote.
b. Mean Rate = ASK + BID ÷ 2 = 1.5503 + 1.5493 ÷ 2 = 1.5498.
Spread = ASK -BID = 1.5503 -1.5493 = 0.0010
Spread Percentage = Spread ÷ Mean Rate X 100
=0 . 0 0 1 0÷1 . 5 4 9 8X1 0 0
=0 . 0 6 4 5 %
c. (USD/GBP) B=1÷1 . 5 5 0 3=0 . 6 4 5 0
(USD/GBP) A=1÷1 . 5 4 9 3=0 . 6 4 5 5
Therefore, inverse quote: USD/GBP 0.6450 -0.6455.
14.5ARBITRAGE, SPECULATIO NAND TRADI NG
Arbitrage can be defined as an operation which involves
simultaneous purchase and sale of equal quantity of asset or currency with
the intention of deriving risk -free profit out of imperfect quotations in one
or more ma rkets.munotes.in

Page 175

175An arbitrageur is an entity who identifies an opportunity for
arbitrage and derives profit from it. Arbitrageurs are not market makers
and therefore do not provide any quotations. They only utilize quotations
made by others and profit from them.
Arbitrage operations help to equalize prices and remove
imperfections. There are no arbitrage possibilities in a perfect market. The
volume and profit of arbitrage transactions is market dependent. The
arbitrageur does not use his/her assessment in this o peration.
Factors which lead to arbitrage opportunities are:
1. Sudden imbalance in demand -supply equilibrium.
2. Time zone factors
3. Information arbitrage
4. Exchange control regulations.
The various types of arbitrage can be classified as follows:
2-point arbitrage is also called as Geographical Arbitrage and it
involves 2 currencies.
3-point arbitrage is also called as Triangular Arbitrage and it involves
3 currencies.
SPECULATIO N
Speculation can be defined as an operation which involves buying
and selling of equal amounts of base currency, security or asset at two
different times so as to derive profit from favourable rate movement in the
interim period. Speculation involves a deliberate acceptance of risk since
the anticipated rate movement may not materialise. Speculation may
therefore result in either profit or loss depending on the accuracy of the
speculators view or judgement. Entities who undertake such operations are
called speculators. These entities normally operate contrary to marketmunotes.in

Page 176

176views and therefore help to provide liquidity in the market when critically
needed.
While the volume of arbitrage operations depend on the
opportunities provided by the market, the volume of speculative
transactions depend on the resources of the speculato rs and the conviction
of their view on rate movements. Speculation requires a high level of
technical knowledge of the underlying asset.
TRADI NG
Trading can be defined as an operation involving buying and
selling of currencies, securities, assets etc. through a process of
continuously quoting two -way prices providing an instant entry -exit
opportunity to all other participants in the market. Entities who undertake
such operations are called traders or dealers. They are market makers since
their presenc e ensures availability of entry -exit prices at all times during
market hours. These entities help to make the market liquid and generally
deliver the larger volumes of operations in the market. Traders are
therefore both buyers and sellers at all times a nd act as 'buyer' for all
sellers and as 'seller' for all buyers coming to the market. They provide
continuity to the price discovery process.
14.6 CLASSIFICATIO NOF RATES I NTERMS OF
SETTLEME NT
The function of quoting exchange rates is performed only by
banks. However, they quote rates at two levels:
a. To their customers -such rates are called 'Merchant Rates' and involve
an addition or subtraction of Exchange Margin which represents profit
margin, transaction handling commission and overhead expense s. These
rates are classified in terms of nature of transaction undertaken; and
b. To other banks -such rates are called 'Interbank Rates' and are used to
settle interbank contracts. The various rates discussed so far represent
interbank rates. These rate s are classified in terms of their settlement
maturities.
Interbank Foreign exchange transactions do not involve any
pre/post payment of either currency. In all sale/purchase transactions the
two currencies are always exchanged on the same calendar date but at two
different times. The time difference is due to time -zone factors. This
concept is called the Principle of Compensated Value.munotes.in

Page 177

177Contract Date -The date on which the two counter parties to a
foreign exchange contract agree to the currencies to b e bought/sold, the
rate of conversion, the amount and the settlement date is called the
contract date. Represented as 'C'.
The settlement of any transaction takes place through transfers of
deposits between the two contracting parties. The date on which t he actual
transfer/exchange of currencies takes place is called the settlement date or
the value date. To effect the transfers, the correspondent banks in the
countries of the two currencies involved must be open for business. The
concerned countries are c alled settlement locations. The locations of the
two principal banks involved in the trade are called dealing locations,
which need not be the same as the settlement locations.
There are four different maturities possible in interbank contracts:
Contract D ate Settlement Date Classification
C
C
C
CC+O
C+1
C+2
C+3o n w a r d sCash or value today
Tom or value tomorrow
Spot
Forward
(C = Contract Date)
Cash Contracts
Foreign exchange contracts which provide for settlement on the
contract date itself called 'cash' or 'value today' contracts and the rate
applicable to them are called 'Cash' or 'Ready' rates. Such contracts are
represented as C + O. The rates for such transactions are derived from the
ongoing spot rates. It is not possible to deal on 'ca sh' basis in all currencies
due to time zone limitations.
Tom Contracts
Foreign exchange contracts which provide for settlement on the
first working day after the contract day are called Tom or Value tomorrow
contracts and are represented as C + 1. The rates applicable to such
contracts are called Tom rates. Rates for such transactions are derived
from the ongoing spot rate. It is possible to deal on 'Tom' basis in all
currencies.
Spot Contracts
A foreign exchange transaction which involves settlement o f
currencies on the second working day after the contract date is called a
spot contract and the rate applicable to such contracts is called the spot
rate. The Spot rate represents the standard conversion value between a
given pair of currencies which is i ndicative of the relative strength and
weakness of the respective currencies. Rates for all other settlement
maturities are derived from the sport rate by adding or subtracting a factor
called swap margin. The increase or decrease in the spot rate indicate st h emunotes.in

Page 178

178appreciation or depreciation in the base currency. Such contracts are
represented as C + 2.
Forward Contracts
Foreign exchange transactions in which the counter parties agree to
a settlement beyond the spot date are called 'Forward transactions' or
'forward contracts'. Rates applicable to such transactions are called
'Forward rates'. Forward rates are derived from the Spot Rates by adding
or subtracting a factor called Forward Margin. Forward Margin represents
the interest differential between the tw o currencies for the given maturity.
Forwards margins are also referred to as SWAP POINTS or SWAP
MARGINS.
Forward Margins
They can be classified as either PREMIUMS or DISCOUNTS.
When the interest rate of the variable currency is more than the interest
rate of the base currency, the forward margin is added to the spot rate to
arrive at the forward rate. Such margins are called PREMIUMS on base
currency. When the interest rate of the variable currency is less than the
interest rate of the base currency, the forward margin is subtracted from
the spot rate to arrive at the forward rate. Such margins are called
DISCOUNTS on base currency.
The value of a currency is represented by the spot rate. The
forward rate being higher or lower than the corresponding spot rate does
not signify appreciation or depreciation of the currency. The difference
between the forward and the spot rate signifies the compensation being
exchanged between the two parties for the difference in the interest rates
for the given forward peri od. Effectively it compensates the net
opportunity cost in terms of interest rates.
When the buyer compensates the seller it results in premium that is
the forward rate is greater than the spot rate whereas when the seller
compensates the buyer it results in discount that is the forward rate is
lesser than the spot rate. The premium / discount is thus always viewed in
the context of the base currency.
HOLGATE'S PRI NCIPLE
This principle states that -
1. Premium on base currency is always added whereas disco unt on base
currency is always subtracted from the spot rate to arrive at the
corresponding forward rate.
2. Premium on base currency implies discount on variable currency and
discount on base currency implies premium on variable currency.munotes.in

Page 179

179EXPLA NATIO N
Consider a situation where Bank A and Bank B contract with each
other that Bank A would buy USD 1 million from Bank B @ INR
64.6800. If the contract day is Wednesday 19th May 2015, then in the
ordinary course the settlement would take place on the spot day i .e Friday
21st May 2015. Now, if the two banks agree to postpone the settlement to
Monday 21 June 2015 i.e by one month, then Bank B will be able to
deposit USD 1 million for one month and earn interest. However, they will
be deprived of INR funds for one month and would on an opportunity
basis lose the interest on INR funds. If INR interest rate is more than USD
interest rate, Bank B suffers an opportunity loss equivalent to the
difference in the interest rates of the two currencies for one month.
Suppose this loss = X then Bank B would expect Bank A not only to pay
the spot price but also compensate for the loss = X. The effective rate for
the contract would thus be 64.6800 + X. Similarly, if INR interest rate is
less than USD interest rate, then Bank A wo uld expect to be compensated
for opportunity loss. In that case the effective contract rate would be
64.6800 -X. The factor 'X' in the example represents forward margin.
When the factor is added to the spot rate it is called 'Premium' whereas
when the fac tor is subtracted from the spot rate it is called 'Discount'.
FORWARD RATES THEREFORE REPRESENT THE CONNECTING
LINK BETWEEN EXCHANGE RATES AND INTEREST RATES.
SUMMARY
a. The foreign exchange market includes end -users (individuals and
corporate) commercial banks, brokers, Central Banks and Service
Providers such as:
Interbank Messaging Service Providers: SWIFT etc.
Information Service Providers: Reuters, Telerate, Bloomberg etc.
b. A foreign exchange rate is an equality which provides a relationship
between two currencies. 1 USD = INR 56.0625 -56.0650 is
conventionally written as USD/INR 56.0625 -56.0650. (USD = base
currency and INR = variable currency). A rate therefore represents the
value of the base currency expressed in terms of the variable currency.
c. A foreign exchange rate which provides a relationship between fixed
number of units of foreign currency against variable number of units of
domestic currency is called a direct rate
d. A foreign exchange rate which provides a relationship between fixed
number of units of domestic currency against variable number of units of
foreign currency is called an Indirect rate.munotes.in

Page 180

180e. A foreign exchange rate which provides a relationship between two
non-domestic currencies is called a cross currency rate.
f. Arbitrage can be defined as an operation which involves simultaneous
purchase and sale of equal quantity of asset or currency with the intention
of deriving risk -free profit out of imperfect quotations in one or more
markets.
g. Speculation can be defined as an operation which involves buying and
selling of equal amounts of base currency, security or asset at two
different times so as to derive profit from favourable rate movement in the
interim period.
h. Trading can be defined as an operation involving buying and selling of
currencies, securities, assets etc. through a process of continuously quoting
two-way prices providing an instant entry -exit opportunity to all other
participants in the market. Entities who undertake such operations are
called trad ers or dealers.
i. Interbank Foreign exchange transactions do not involve any pre/post
payment of either currency. In all sale/purchase transactions the two
currencies are always exchanged on the same calendar date but at two
different times. The time di fference is due to time -zone factors. This
concept is called the Principle of Compensated Value.
j. Holgate's Principle states that:
1. Premium on base currency is always added whereas discount on base
currency is always subtracted from the spot rate to arrive at the
corresponding forward rate.
2. Premium on base currency implies discount on variable currency and
discount on base currency implies premium on variable currency.
QUESTIO NS
Q1. Explain the following concepts:
a. Foreign Exchange Rates
b. Dir ect Rates, Indirect Rates and cross rates.
c. Spread and % spread
d. Arbitrage, Speculation and trading
e. Settlement value / date
f. Holgate Principle
Q2. Write short notes on the following:
a. Foreign exchange market
b. Arbitrage, speculation and tradingmunotes.in

Page 181

181Q3. Distinguish between the following:
a. Direct and indirect rates
b. Arbitrage and speculation
c. Speculation and trading
Q4. Answer in detail the following:
a. Define forward rates. Explain the concept of Premiums and Discounts
in the context of Holgate's Principle.
b. The term 'Cash Contract' does not refer to currencies in physical cash
form. Discuss.
c. A market is imperfect without the presence of market makers. Explain
the importance of Foreign Exchange traders.

munotes.in

Page 182

18215
CURRE NCY CO NVERTIBILITY
Unit Structure
15.1 Introduction
15.2 Current Account Convertibility
15.3 Capital Account Convertibility (CAC)
15.4 Pro's and Con's of Currency Convertibility
15.5 Current Status of Exchange Rate Mechanism in India
15.6 Co-Relation between Currency Convertibility and Exchange Control
15.1 I NTRODUCTIO N
Floating of a currency is a pre -requisite to convertibility of a
currency. While floating deals with the method used to establish the value
of the currency, convertibility deals with the operational ease with which
domestic currency is allowed to be converted into foreign currency.
Convertibility therefore represents procedural simplification of foreign
exchange transactions for persons dealing in a currency.
Although the INR was floated, which means market demand /
supply factors would determine the exchange rate, the transactions
constituting the demand / supply continued to be controlled by the RBI.
Most transactions required licenses or permits from RBI. Effectively, the
RBI controlled the elements forming the demand / supply for the foreign
currencies. If the exchange rate determined by the market was to truly
represent the economy, then it was essential to free the transactions
constituting the demand an ds u p p l yf o rf o r e i g nc u r r e n c i e s .
Foreign Exchange transactions arising in an economy can be
broadly classified as:
1. Export and Import of goods and services.
2. Personal remittances.
3. Investments and Redemptions.
4. Borrowing and Lending.
All the ab ove transactions pertaining to an economy over a given
period are captured in the Balance of Payments Account (BoP) for the
country. All the above transactions get recorded in either the Current or
the Capital Accounts in the BoP. The concept of convertibi lity is thusmunotes.in

Page 183

183viewed at two levels: Current Account Convertibility and Capital Account
Convertibility (CAC).
15.2 CURRE NTA C C O U NTC O NVERTIBILITY
In August 1994, the INR was made convertible on current account
transactions. This means that all impediments such as licensing etc. were
removed in so far as foreign exchange transactions involved purchase /
sale of foreign currencies for permitted imports and exports of goods and
services. Convertibility does not mean unlimited ability to convert
domestic curre ncy. Limits were placed on conversion allowed for several
categories of activities. Ex., Currently, each resident individual is
permitted to purchase foreign currencies only to the extent of USD 10000
per calendar year for international tourism described a sB a s i cT r a v e l
Quota.
The Current Account of the Balance of Payments represents the
cash / ready transactions which have an immediate impact on the demand -
supply equilibrium. Making the INR convertible on Current Account thus
implies that not only is t he currency valued by the market but the factors
contributing to the rate determination are also decontrolled thereby
ensuring that the exchange rate truly represents the economic status of the
currency.
15.3 CAPITAL ACCOU NTC O NVERTIBILITY (CAC)
In 1997 , a committee headed by Mr. S. S. Tarapore, the Deputy
Governor of RBI, was constituted to recommend step -wise
implementation of capital account convertibility (CAC). The
recommendations of this committee could not be implemented because of
international d evelopments such as the South East Asian Crisis, currency
failures in Brazil and Russia and events such as 11th September, 2001 in
the USA.
While there is no formal definition of CAC the committee under
the chairmanship of Mr. S. S. Tarapore defined CAC as the freedom to
convert local financial assets into foreign financial assets and vice -a-versa
at market determined rates of exchange. It is associated with changes of
ownership in foreign / domestic financial assets and liabilities in the form
of Receiva bles and Payables and involves the creation and liquidation of
claims on or by, non -resident entities.
The critical preconditions specified by the committee in the 'road -
map' for introducing CAC were:
Fiscal consolidation.
Control of inflation within tar geted levels.munotes.in

Page 184

184Strengthening of the Financial System.
Maintenance of domestic economic stability.
Adequate foreign exchange reserves.
Restrictions on inessential imports.
Comfortable current account position.
An appropriate industrial policy and a friendly investment climate.
The International developments between 1997 and 2001 showed
that CAC is a double -edged sword. Outflow of capital from economies
which had introduced CAC, created serious problems for their regulators
as well as domestic market partici pants. India therefore took a conscious
decision to modify their approach to CAC and gradually move towards
'Fuller Capital Account Convertibility'. This means that the INR would be
made convertible on Capital Account in stages only to the desired extent.
A second committee to suggest a road map for achieving 'Fuller
Capital Account Convertibility' was constituted. The recommendations of
this committee received in 2006, will be implemented by the RBI in a
phased manner so as to achieve the desired level of CAC by 2011 -12.
In the interim period, the RBI has progressively allowed greater
freedom in capital transactions. Some of these relaxations are:
a. Individual residents are permitted to invest up to USD 75, 000 in
international securities.
b. Individ ual residents are permitted to establish non -interest bearing
accounts in specified currencies with banks in India. (Resident Foreign
Currency Accounts).
c. In a gradual manner, the RBI has allowed Indian Corporate entities to
raise resources and invest ov erseas in higher quantities.
d. Branches of Indian Banks located in SEZ's (Special Economic Zones)
are permitted to conduct banking operations, i.e., accept deposits and give
loans, in non -resident currencies (Offshore banking) Bank branches
undertaking su ch operations are accorded the status of Offshore Banking
Units (OBU's).
15.4 PRO's A NDC O N's OF CURRE NCY
CONVERTIBILITY
PRO's
It represents confidence of the country in maintaining a stable Balance
of Payments position.munotes.in

Page 185

185It assures international investors about being able to exit their
investments without any restrictions.
It provides domestic entities with access to international financial
markets and wider avenues for investments.
It ensures that the forward market is in conformity with the Inte rest
Parity Condition. Domestic participants are better placed to gain from
arbitrage opportunities.
It promotes Foreign Direct and Portfolio Investments which results in
higher economic growth and employment generation.
It provides greater depth to both t he domestic foreign exchange market
and the derivatives market. It eliminates unregulated markets such as
the NDF (Non Deliverable Forward) Market.
CON's
It makes the economy vulnerable to withdrawal of capital by both
residents and non -residents.
Exchang e rate tends to be more volatile due to larger volumes of
transactions.
The economy becomes susceptible to international 'Hot Money' flows
which have a disruptive effect on both the foreign exchange and
capital markets.
Greater integration with the global economy increases the influence of
international events on the domestic economy. This was proved during
the recent global recession of 2007 -2009.
Integration with the global economy results in domestic product prices
getting aligned to International prices which increases inflation risk.
(Purchasing Power Parity effect is more pronounced).
International capital has greater influence on domestic matters. The
domestic economy becomes more dependent on foreign capital.
15.5 CURRE NT STATUS OF EXCHA NGE RATE
MECHA NISM I NINDIA
Currency Convertibility
The current status of the INR is that it is fully convertible on
current account transactions and partially convertible on capital account
transactions. The limitations in capital account transactions apply only to
residents and not to non -residents which means that for non -resident
entities the INR is for all practical purposes, fully convertible subject to
quantitative sector -wise limits for investments.munotes.in

Page 186

186Currency valuation
As regards the currency valuation pr ocess, the INR is fully floated
effective from March 1993. However, the RBI has adopted the 'Managed
Float Mechanism' to control the external value of the INR. This means that
the vehicle currency quotation USD / INR is established through market
demand / supply factors but the RBI intervenes periodically when market
conditions warrant such interventions. The advantages of this approach
are:
a. Volatility in the exchange rate is controlled.
b. Stability in the exchange rate assures international investors since it
protects them against exchange rate risk.
c. Stability in the exchange rate enables domestic importers and exporters
to factor possible rate changes in their trade transactions.
d. It helps to control speculation.
15.6 CO -RELATIO NBETWEE NCURRE NCY
CONVERTIBILITY A ND EXCHA NGE
CONTROL
The FEMA clearly defines both current and capital transaction and
broadly classifies current account transactions under four categories:
a. Freely permitted transactions.
b. Prohibited transactions.
c. Transa ctions requiring prior approval of the Central Government. and
d. Transactions requiring prior approval of the RBI which are in excess of
the quantitative limits allowed under the act.
This classification shows that quantitative limits would continue to
operate for permitted transactions. Exchange control in the current account
context therefore means various limits imposed on the purchase / sale of
foreign currency by residents and the purchase / sale of domestic currency
by non -residents. Further, the FEMA also prohibits private transactions in,
and possession of, foreign currency by residents. It also requires all
foreign exchange transactions to be conducted through authorised persons.
Effectively, what exchange control does is to channelise all for eign
currency transactions through identified entities and prioritise the use of
scare foreign currency resources so that the country has adequate
resources for critical imports. The benefits of exchange control are:
a. It protects scare foreign currency r esources.
b. It helps to control the current account deficit in the BoP.
c. It consequently reduces the debt burden on the country.munotes.in

Page 187

187d. It helps in making suitable policy changes.
e. It reduces the need for intervention and thereby helps in better reserve
management.
f. It helps in proper economic planning.
As regards Capital Account transactions, the RBI regulations
provide for general permissions / automatic routes for investments in India
by non -residents, as well as investments and borrowings overseas by
residents, etc. The control aspect covers sector -wise permissions and
investment limits within sectors. Since the RBI is the recipient of all
market data, it guides the government on policy changes pertaining to
Foreign Direct Investment and Foreign Por tfolio Investments.
The philosophy of FEMA in the context of this issue is that "all
BOP Current account transactions are permitted unless specifically
prohibited whereas all BOP Capital account transactions are prohibited
unless specifically permitted."
SUMMARY
Floating of a currency is a pre -requisite to convertibility of a currency.
While floating deals with the method used to establish the value of the
currency, convertibility deals with the operational ease with which
domestic currency is allowed to be converted into foreign currency.
Convertibility therefore represents procedural simplification of foreign
exchange transactions for persons dealing in a currency.
Foreign Exchange transactions arising in an economy can be broadly
classified as:
1. Export and Import of goods and services.
2. Personal remittances.
3. Investments and Redemptions.
4. Borrowing and Lending.
In August 1994, the INR was made convertible on current account
transactions. This means that all impediments such as licensing etc.
were removed in so far as foreign exchange transactions involved
purchase / sale of foreign currencies for permitted imports and exports
of goods and services.
In 1997, a committee headed by Mr. S. S. Tarapore, the Deputy
Governor of RBI, was constituted to recommend step -wise
implementation of capital account convertibility (CAC).
The critical preconditions specified by the committee in the 'road -
map' for introducing CAC were:
a. Fiscal consolidation.munotes.in

Page 188

188b. Control of inflation within targeted levels.
c. Strengthening of the Financial System.
d. Maintenance of domestic economic stability.
e. Adequate foreign exchange reserves.
f. Restrictions on inessential imports.
g. Comfortable current account position.
h. An appropriate industrial policy and a friendly investment
climate.
The current status of the INR is that it is fully convertible on current
account transactions and partially convertible on capital account
transactions.
As regards the currency valuation process, the INR is fully floated
effective fro m March 1993. However, the RBI has adopted the
'Managed Float Mechanism' to control the external value of the INR.
The FEMA clearly defines both current and capital transaction and
broadly classifies current account transactions under four categories:
a.Freely permitted transactions.
b. Prohibited transactions.
c. Transactions requiring prior approval of the Central Government.
and
d. Transactions requiring prior approval of the RBI which are in excess
of the quantitative limits allowed under the act.
QUESTIO NS
Q1. Write Short notes on the following:
1. Convertibility of a currency is a two -edged sword, why?
2. Discuss the issue of Convertibility of INR.
3. Describe in detail the step -wise progress towards Convertibility of INR.
munotes.in