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INDIAN FINANCIAL SYSTEM
Unit Structure
1.1 Introduction
1.2 Financial System Functions
1.3 Financial Concepts
1.1 INTRODUCTION
Any nation's ability to expand its economy depends on the presence of a
sound financial system. The financial system is respons ible for providing
the capital inputs required for the production of products and services,
which in turn help to improve the welfare and standard of life of a nation's
citizens. As a result, the phrase "financial system" is more inclusive and
includes bot h the financial markets and the institutions that support them.
Money and monetary assets are the main assets traded in the financial
system. The financial system's job is to mobilize savings in the form of cash
and other monetary assets and invest them in profitable endeavors. An
efficient financial system allows funds to flow freely to more productive
activities, promoting investment. As a result, the financial system mediates
between savers and investors, promoting faster economic development.
1.2 FINANC IAL SYSTEM FUNCTIONS
1. Provision of liquidity
The provision of money and monetary assets for the creation of goods and
services is the primary duty of the financial system. There shouldn't be a
lack of funding for profitable endeavors. Liquidity is the term used to
describe money and other monetary assets in financial terminology. Cash,
money, and other assets that are easily and without risk convertible into
cash are referred to as having "liquidity." As a result, all operations inside a
financial system inc lude liquidity, either through the provision of liquidity
or through the selling of liquidity. In fact, in India the RBI has been vested
with the sole power of creating coins and currency notes. Through a
process known as "credit creation," commercial bank s can also generate
money (deposits), and other financial organizations also deal in currencies.
The economy is also at risk from an excess of money. As the head of the
Indian financial system, the Reserve Bank of India (RBI) is responsible
for regulating all financial institutions in the country and controlling the
money supply and the issuance of credit by banks. By bolstering the
institutional framework and encouraging savings and investment in the
nation, it must assume responsibility for creating a strong financial system.
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2 2. Mobilization of Savings
The financial system's ability to mobilize savings and direct them towards
beneficial endeavours is another crucial function. The financial system
should provide the right incentives to draw savings and make them
accessible for more profitable endeavours. As a result, the financial system
makes it easier for saving to become investment and consumption. In this
activity, the financial institutions must have a dominating position.
3. Size Transformation Function
The savings of millions of small investors are typically in the form of a
small unit of capital that cannot be invested successfully unless it is
converted into a credit unit of a visible size. The great majority of small
consumers' deposits are collected by banks and other financial
intermediaries, which then use those funds to lend a sizable amount of
money to other customers. As a result, this size translation function is
thought to be one of the financial system's most crucial components.
4. Maturity Transfor mation Function
The maturity transition function is one more crucial aspect of the financial
system. The financial intermediaries collect deposits from public in
different maturities according to their liquidity preference and lend them
to the borrowers in different maturities according to their requirement and
encourage the economic activities of a country.
5. Risk Transformation Function
With their small savings holdings, the majority of small investors are risk -
averse. As a result, they are hesitant to inve st directly in the stock market.
Financial intermediaries, on the other hand, collect savings from
individual savers and distribute them across various investment units using
their extensive knowledge and expertise. Individual investors' risks are
thus distributed. This risk transformation function encourages industrial
growth. Furthermore, various risk-mitigation tools, such as hedging,
insurance, and the use of derivatives, are available in the financial system.
1.3 FINANCIAL CONCEPTS
Understanding the financial system necessitates knowledge of the
following concepts:
A. Financial Assets
B. Financial Intermediaries
C. Financial Markets
D. Financial Interest Rates or Financial Rate of Return
E. Financial Instruments
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Marketable Assets Non-marketable Assets
Shares Govt. Bonds
Secu -
rities MF UTI Bearer Bank
Depo -
sits PF LIC Com. PO Units Units Deben - tures Sche - Depo - Certi - mes sits ficates A. Financial Assets
Any financial transaction should invol ve the creation or transfer of a
financial asset. As a result, the financial asset is the basic product of any
financial system. A financial asset is one that is used for production,
consumption, or asset creation. For example, A purchases equity shares,
which are financial assets because they will generate income in the future.
In this context, it is critical to understand the distinction between financial
assets and physical assets. Physical assets, unlike financial assets, are not
useful for further production of goods or earning income. For example, X
may buy land and buildings, as well as gold and silver. Because they
cannot be used for further production, these are physical assets. Many
tangible assets are only useful for consumption. It is worth notin g that the
nature of the asset is determined by the investment objective. For example,
if a house is purchased for residential use, it becomes a physical asset.
When purchased for the purpose of hiring, it becomes a financial asset.
A1. Classification of Financial Assets
Financial assets can be classified in a variety of ways depending on the
circumstances. One such classification is as follows:
a. Valuable Assets or Marketable Assets
b. Non-tradable Assets or Non-Marketable Assets
a. Valuable Assets or Marketable Assets
Marketable assets are those that can be transferred from one person to
another with little difficulty. Shares of publicly traded companies,
government securities, bonds issued by public sector undertakings, and so
on are examples.
b. Non-tradable Assets or Non-Marketable Assets
On the other hand, if the assets cannot be easily transferred, they fall into
this category. Bank deposits, provident funds, pension funds, national
savings certificates, insurance policies, and so on are examples.


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4 Yet another classification is as follows:
a) Money or Cash Asset - The RBI and the Ministry of Finance,
Government of India, issue all coins and currency notes in India.
Furthermore, commercial banks can create money by issuing credit.
Liquid cash is not provided when loans are approved. Instead, an account
in the borrower's name is opened, and a deposit is made. It is also a type of
financial asset.
b) Debt Asset - Debt assets are issued by a variety of organisations in
order to raise debt capital. Debt capital has a set r epayment schedule for
interest and principal. There are various methods for raising debt capital.
For instance, debentures, term loans, working capital advances, and so on.
c) Stock Asset - Business organisations issue stock to raise fixed capital.
There are two kinds of stock: equity and preference. Equity shareholders
are the true owners of the company, and they reap the benefits of
ownership while also bearing the risks. Preference shareholders, on the
other hand, receive a fixed dividend rate (as in the case of a debt asset)
while retaining some equity characteristics.
B. FINANCIAL INTERMEDIARIES
The term financial intermediary refers to any organisation that mediates
and facilitates financial transactions for both individual and corporate
clients. As a result , it refers to all types of financial and investing
institutions that facilitate financial transactions in financial markets. They
may work in the organised or unorganised sectors. They can also be
divided into two types:
B1. Capital Market Intermediaries - These intermediaries primarily
provide long-term funds to individuals and businesses. They include term
lending institutions such as financial corporations and investing
institutions such as LIC.
B2. Money Market Intermediaries - Money market intermediar ies only
provide short - term financing to private and business clients. These include
cooperative banks, commercial banks, etc.
C. FINANCIAL MARKETS
Usually speaking, a financial market cannot be identified by a single area
or locality. A financial transactio n is considered to have occurred in the
financial market wherever it occurs. Because financial transactions are so
common across the economy, financial markets are therefore widespread in
nature. For instance, issuing equity shares, receiving a loan from a term
lender, depositing money in a bank, buying debentures, selling shares, and
so forth.
Nonetheless, the centres and arrangements that enable the purchase and
sale of financial assets, claims, and services might be referred to as
financial markets. Some times, such as in the case of a stock exchange, we
do discover the existence of a particular site or location for a financial
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5 C1. Unorganised Markets or Independent Markets
Many moneylenders, local bankers, traders, etc. lend money to the general
population in these markets. The general public also makes deposits with
indigenous banks. Also, there are private financial firms, chit funds, etc.,
whose operations are not regulated by the RBI. By releasing Non -Banking
Financial Companies (Reserve Bank) Instructions, 1998, the RBI recently
took action to bring private finance organisations and chit funds under its
rigorous oversight. To integrate the unorganised sector into the organised
economy, the RBI has already taken some action. They haven't had any
luck. Their financial tools have not been standardised, and the restrictions
governing their financial activities are still insufficient.
C2. Organised Markets or Structured Markets
Standardized rules and regulations that govern financial transactions are in
place in organised markets. A significant amount of institutionalization
and instrumentalization is also present. The RBI or other regulatory
authorities have stringent oversight over and control over these markets.
These organised markets can be divid ed into another two categories. As
follows:
(i) Capital market
(ii) Money market
(i) Capital Market - Financial assets with a protracted or undetermined
maturity are traded on the capital market. It often deals with long-term
securities having maturities longer than a year. Three categories further
split the capital market:
(a) Industrial Securities Market - It is a market for industrial securities,
specifically (i) Equity shares or ordinary shares, (ii) Preference shares, and
(iii) Debentures or bonds, as the name already suggests. It is a market
where business concerns can issue the proper instruments to raise capital
or debt. It can be broken into two further categories. As follows:
(1) Primary Market: A primary market is one where new financial
claims or issues are traded. T hus, it is also known as the New Issue
Market. Securities that are first issued to the public are dealt with in the
primary market. Borrowers trade brand -new financial instruments for long-
term funds in the primary market. As a result, capital formation is
facilitated by the primary market. In a primary market, a corporation may
raise money in one of three methods. As follows:
(A) Public issue,
(B) Rights issue,
(C) Private placement are among the options.
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6 The public sale of securities is the most typical way for new businesses to
raise financing. It's known as a public issue. Securities are first issued on a
pre-emptive basis to the current shareholders when an established company
needs to raise more money. It's known as a rights issue. Selling stocks
privately to a select group of investors is done through a private placement.
(2) 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 traded in this market. Gene rally, 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 recognized by the Government of India.
The stock exchanges in India ar e 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.
(b) Government Securities Market - Alternatively, it is known as the
Gilt-edge d Securities Market. Government securities are traded on this
market. Both short - term and long-term government securities are available
in India. This market is where long -term securities are traded, whereas the
money market is where short -term securities are traded. Improvement
Trusts, State Electricity Boards, All India and State level financial
institutions, public sector firms, and securities issued by the Central
Government, State Governments, semi -government bodies like City
Corporations, Port Trusts , etc. are all traded in this market. Government
securities are issued in 100 -rupee bills. Half -yearly interest payments are
due, and there are tax exemptions as well. Since the majority of
institutional investors choose to hold these securities until matu rity, the
secondary market for these securities is quite small. There are numerous
types of government securities. They often include: (i) Stock certificates
or inscribed stock (ii) Promissory notes (iii) Bearer Bonds which can be
depreciated. Government Securities are marketed by the Public Debt
Office of the RBI, whereas Treasury Bills (short -term securities) are
offered through auctions. The government exchequer can raise money for
a reasonable price by selling government securities, and the interest paid
on these securities affects the market's prices and yields. As a result, this
market is essential for managing money.
(c) Long Term Loan Market – Development bank and commercial bank
play a significant role in this market by supplying long term loans to
corporate customers. Long term loan market may further be classified into
(a) Term Loan Market (b) Mortgages Market (c) Financial Guarantees
Markets.
(1) Term Loan Market - To provide long- and medium -term loans to
corporate customers directly as well as indirectl y, the government of India
has established numerous industrial financing organisations at the national
and regional levels. The bulk of India's industrial financing is provided by
these development banks. These organisations include IDBI, IFCI, ICICI,
and other state-owned financial firms. By offering long -term loans, these
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7 needs. They also support initiatives to modernise, foster new business
ventures, and find investment opportunities .
(2) Mortgages Market - The centres that primarily provide mortgage
loans to individual customers are referred to as the mortgage market. A
mortgage loan is a loan taken out in exchange for real estate or other
immovable property as security. Mortgage refers to the sale of a specific
immovable property's interest to fund a debt. This mortgage may be a legal
or equitable mortgage. Once more, it might be a first or second charge. A
legal mortgage is made when the borrower formally transfers ownership of
the prop erty to the lender, but an equitable mortgage is created by simply
depositing title deeds to properties as collateral. Legitimate mortgages are
less dangerous. Similar to the first charge, the mortgagee receives the
mortgager's interest in the specific pro perty as security from the
mortgager. When a property is mortgaged to a second party after having
previously been mortgaged to one creditor, it incurs a second charge. The
mortgagee has the option to further assign his interest in the collateral. A
sub- mortgage is what is used in this situation. There may be a primary
market and a secondary market for mortgages. The primary market is
where credit is first extended, and the secondary market is where existing
mortgages are sold and resold at market rates.
(3) Financial Guarantees Market - A guarantee market is a location
where financing is offered in exchange for the guarantee of a well -known
figure in the financial community. A guarantee is a contract that releases a
third party from responsibility in the event of their default. From the
perspective of the creditor, a guarantee serves as security. The guarantor is
responsible for loan repayment in the event that the borrower defaults. As
a result, the guarantor needs to be well-known to both the lender and the
borrower, and he also needs to be able to pay off his debt. Despite the fact
that there are numerous varieties of guarantees, the most popular kinds are
I performance guarantees and (ii) financial guarantees. The payment of
earnest money, retention money, ad vance payments, contract non -
fulfillment, etc. are all covered by performance guarantees. In India, the
market for financial guarantees is well organised. The financial guarantees
in India relate to: (i) Deferred payments for imports and exports (ii)
Mediu m and long -term loans raised abroad (iii) Loans advanced by banks
and other financial institutions.
Commercial banks, development banks, federal and state governments,
and other specialised guarantee organisations like the Export Credit
Guarantee Corporati on and the Domestic Investment Credit Guarantee
Corporation offer the majority of these guarantees (Deposit Insurance and
Credit Guarantee Corporation). Both individual and business customers
have access to this financial solution with a guarantee. This gu arantee
service is crucial for any financial system's smooth operation.
Importance of Capital Market
Capital formation and economic progress are hampered by a lack of a
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8 resources would be idle. The following succinct summary of the capital
market's significance is provided:
(1) The capital market is a crucial resource for putting the economy's
savings to good use. People's savings are mobilised for further
investment, preventing their loss to wasteful spending.
(2) It encourages saving and promotes capital development by offering
reasonable interest rates as the cost of capital.
(3) It gives investors, especially those in the household sectors, a way to put
money into financial investments that are more fruitful than those in
tangible assets.
(4) It makes it easier for the economy to produce more goods and services,
which improves the economic well -being of society. As a result, it
makes it easier for people who can use money in productive and
profitable ways to raise overall national income to "shift stream of
command over capital to the point of highest yield."
(5) The activities of various entities on the capital market stimulate
economic expansion. They direct the quantitative and qualitative flow
of mone y and ensure the wise distribution of limited resources.
(6) A stable capital market with knowledgeable intermediaries encourages
consistency in the values of the securities used to represent capital
funds.
(ii) Money Market - A market for short -term loans or finan cial assets is
known as a money market. It is a market where short -term funds are lent
and borrowed. It does not actually deal in cash or money, despite what the
name suggests. Yet, it actually deals with close substitutes for money or
close replacements f or money, such as trade bills, promissory notes, and
government papers drawn for a brief length of time that does not exceed
one year. These short -term financial products are easily convertible into
cash without incurring any losses and with minimal transa ction costs. The
money market is where most short - term money asset transactions take
place. It gives lenders with liquidity or cash and satisfies the short -term
needs of borrowers. It is the location where people, organisations, and the
government borrow short -term surplus money that are available to
financial institutions and individuals.
The word "money market" does not specifically relate to one location
where short -term funds are transacted. All people, organisations, and
middlemen who work with short -term funds are included. Via phone,
telegraph, mail, and agents, transactions between borrowers, lenders, and
middlemen are carried out. In a money market, there is no requirement for
direct communication or physical presence between the two parties.
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9 Feat ures of Money Market
The general characteristics of a money market are as follows:
 The near money market is solely for short -term investments or
financial assets.
 It only pertains to financial assets with a maturity of up to one year.
 It exclusively deals with assets that can be quickly and easily turned
into cash without incurring losses and with the least amount of
transaction costs.
 The majority of transactions involve oral conversation over the phone.
Subsequently, pertinent papers and written communica tions can be
traded. A formal setting like a stock exchange or capital market is not
there.
 Transactions must be carried out without the assistance of brokers.


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10 2
THE ROLE OF CENTRAL BANK - RBI
Unit Structure
2.1 Introduction
2.2 Central Banking
2.3 Organization and Management
2.4 The Role and Functions
2.5 Regulator of Money and Credit
2.1 INTRODUCTION
A study of financial institutions in India should appropriat ely begin with a
brief discussion of the functions, role, working, and policy of the Reserve
Bank of India (RBI or Bank). The RBI, as the central bank of the country,
is the nerve centre of the Indian monetary system. As the apex institution,
the RBI has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the IFS since its inception. The purpose of this
chapter is to help the reader to understand the functioning of the RBI by
highlighting the major aspects of its working.
2.2 CEN TRAL BANKING
The pattern of central banking in India was based on the Bank of England.
England had a highly developed banking system in which the functioning
of the central bank as a banker’s bank and their regulation of money
supply set the pattern. The c entral bank’s function as ‘a lender of last
resort was on the condition that the banks maintain stable cash ratios as
prescribed from time to time. The effective functioning of the British model
depends on an active securities market where open market operations can
be conducted at the discount rate. The effectiveness of open market
operations however depends on the member banks’ dependence on the
central bank and the influence it wields on interest rates. Later models,
especially those in developing countr ies showed that central banks play an
advisory role and render technical services in the field of foreign exchange,
foster the growth of a sound financial system and act as a banker to
government.
2.3 ORGANIZATION AND MANAGEMENT
The RBI is quite young comp ared with such central banks as the Bank of
England, Riksbank of Sweden, and the Federal Reserve Board of the USA.
However, it is perhaps the oldest among the central banks in the
developing countries. It started functioning from 1 April 1935 in terms of
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11 institution till January 1949. After which it became a state-owned
institution undo* the Reserve Bank (Transfer to Public Ownership) of
India Act, 1948. This Act empowers the Central Government , in
consultation with the Governor of the Bank, to issue such directions to it
as they might consider necessary in the public interest Further, the
Governor and all the Deputy Governors of the Bank are appointed by the
Central Government The Bank is manag ed by the Central Board of
Directors, four Local Boards of Directors, and the Committee of the
Central Board of Directors. The functions of the Local Boards are to
advise the Central Board on such matters as are referred to them; they are
also required to perform such duties as are delegated to them. The final
control of the Bank vests in the Central Board which comprises the
Governor, four Deputy Governors, and fifteen Directors nominated by the
Central Government. The Committee of the Central Board consis ts of the
Governor, the Deputy Governors, and such other Directors as may be
present at a given meeting. The internal organizational set -up of the Bank
has been modified and expanded from time to time in order to cope with
the increasing volume and range o f the Bank’s activities. The underlying
principle of the internal organization is the functional specialization with
adequate coordination. In order to perform its various functions, the Bank
has been divided and sub -divided into a large number of Departme nts.
Apart from the Banking and Issue Departments, there are at present twenty
Departments and three training establishments at the Central Office of the
Bank.
2.4 THE ROLE AND FUNCTIONS
The RBI functions within the framework of mixed economic planning.
The legal, economic, and institutional factors in India have rendered the
issue of the independence of the central bank almost irrelevant. With
regard to framing various policies, it is necessary to maintain close and
continuous collaboration between the Gov ernment and the RBI. In the
event of a difference of opinion or conflict, the Government view or
position can always be expected to prevail. Given this environment or
setting, the Bank performs a number of functions which are discussed in
the following sections.
1. NOTE ISSUING AUTHORITY
The RBI has, since its inception, the sole right or Authority or monopoly of
issuing currency notes other than one rupee notes and coins, and coins of
smaller denominations. The issue of currency notes is one of its basic
functions. Although one rupee coins and notes, and coins of smaller
denominations are issued by the Government of India, they are put into
circulation only through the RBI. The currency notes issued by the Bank
are legal tender everywhere in India without any limit. At present, the
Bank is sues notes in the following denominations: Rs. 2,5,10,20,50,100,
and 500. The responsibility of the Bank is not only to put currency into, or
withdraw it from, the circulation but also to exchange notes and coins of
one denom ination into those of other den ominations as demanded by the
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12 its Issue Department In order to discharge its currency functions, the Bank
maintains (at present) 14 local offices a nd the currency chests in which the
stock of new and reissuable notes, and rupee coins are stored. The total
number of currency chests at the end of March 1990 was 3791. Of these,
17 chests were with the RBI, 2745 with the SBI and associate banks, 622
with nationalized banks, 402 with tr easuries, and 5 with Jammu and
Kashmir Bank. As stated elsewhere, the currency even today forms the
major part of the money supply in India. The currency as percentage of
money supply (M t 195051,71.1% in 196061,51.0% in 1975= currency +
demand deposits with banks) was 69.2% in 76, and 59,0% in 198889. The
composition of currency in 1987 was: small coins=Rs. 440 crores; rupee
coins=Rs. 423 crores; rupee notes=Rs. 300 crores; and Bank notes=Rs.
28,743 crores. The volume of no te issue (including one rupee notes) has
increased from Rs. 1114 crores in 1952 to Rs. 29043 crores in 1987. The
Bank can issue notes against the security of gold coins and gold bullion,
foreign securities, rupee coins, Government of India securities, and such
bills of exchange and pro missory notes as are eligible for purchase by’ the
Bank. The RBI notes have a cent per cent backing or cover in these
approved assets. Earlier, i.e. till 1956, not less than 40 per cent of these
assets was t bulli on and ster ling/ o consist of gold coin and foreign
securities. In other words, (he proportional reserve system of note issue
existed in India till 1956. Thereafter, this system was abandoned and a
minimum value of gold coin and bullion and foreign securities as a pa rt of
total approved assets came to be adopted as a cover for the note issue.
2. GOVERNMENT BANKER
The RBI is the banker to the Central and State Governments. It provides to
the Governments all banking services such as acceptance of deposits,
withdrawal of funds by cheques, receipts collection of payments on
behalf of and the Government, transfer of funds, making payments on
Government behalf, and management of the public debt. The Bank
receives Government deposits flee of interest, and it is not entitled to a ny
remuneration for the c ad hoc onduct of the ordinary banking business of
the Government. The deficit or surplus in the Central Government account
with the RBI is managed by the creation and cancellation of Treasury bills
(known as treasury bills). As a banker to the Government, the Bank can
make “ways and means advances” (i.e. temporary advances made in order
to bridge the temporary gap between receipts and payments) to both the
Central and State Governments. The maximum maturity period of these
advances is three months. However, of ad hoc in practice, the gap between
receipts and payments in respect of the Central Government is met by the
issue treasury bills, while the one in respect of the State Governments is
met by the ways and means advances. The ways and means advances to t
b he State Governments are subject to some limits. These advances are of
the following types: (a) Normal or clean advances i.e. advances without
any collateral security; ( ) Secured advances, i.e. those which are secured
against the pledge of Central Governm ent securities; and (c) Special
advances, i.e. those granted by the Bank at its discretion. The interest rate
charged by the Bank on these advances did not, till May 1976, exceed the
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13 nterest based on the duration of the advance. ‘ Apart from the ways and
means advances, the State Governments have made heavy use of the
overdrafts from the RBI. An overdraft refers to drawls of credit by the
State Government s from the RBI in excess of the credit (ways and means
advances) limits granted by the RBI. In other words, overdrafts 8687 are
unauthorized ways and means advances drawn by the State Governments
on the RBI. At present, overdrafts up to arid inclusive of the seventh day
are charged at the Bank rate and from .the eighth day onwards at 3 per
cent above the Bank rate. The management of the States’ overdrafts has
gradually become one of the major responsibilities of the RBI on account
of the persistence of large proportions of those overdrafts. The issue,
management, and administration of the public (Central and State
Governments) debt are among the major functions of the RBI as the banker
to the Government. The Bank charges a commission from the
Governments for rendering this service.
3. BANKERS’ BANK
The RBI, like all central banks, can be called a banker’s Bank because it
has a very special relationship with commercial and co -operative banks,
and the major part of its business is with these banks. The Bank contro ls
the volume of reserves of commercial banks and thereby determines the
deposits/credit creating ability of the banks. The banks hold a part or all of
their reserves with the RBI. Similarly, in times of their needs, the banks
borrow funds from the RBI. It is, therefore, called the bank of last resort or
the lender of last resort. On the whole, the RBI is the ultimate source of
money and credit in India.
4. SUPERVISING AUTHORITY
The RBI has vast powers to supervise and control commercial and
cooperative banks with a view to developing an adequate and a sound
banking system in the country. It has, in this field, the following powers:
(a) to issue licenses for the establishment of new banks; (b) to issue
licenses for the setting up of the bank branches; (c) to pr escribe minimum
requirements regarding paid -up capital and reserves, transfer to reserve
fund, and maintenance of cash reserves and other liquid assets; (d) to
inspect the working of banks in India as well as abroad in respect of their
organizational set-up, branch expansion, mobilization of deposits,
investments, and credit portfolio management, credit appraisal, region -
wise performance, profit planning, manpower planning and training, and
so on; (e) to conduct ad hoc investigations from time to time into
complaints, irregularities, and frauds in respect of banks; (f) to control
methods of operations of banks so that they do not fritter away funds in
improper investments and injudicious advances, (g) to control appointment,
reappointment, termination of appointment of the Chairman and chief
executive officers of the private sector banks; and (h) to approve or force
amalgamations.

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14 5. EXCHANGE CONTROL AUTHORITY
One of the essential functions of the RBI is to maintain the stability of the
external value of the r upee. It pursues this objective through its domestic
policies and the regulation of the foreign exchange market. As far as the
external sector is concerned, the task of the RBI has the following
dimensions: (a) to administer the
foreign Exchange Control (b ) to choose the exchange rate system and fix
or manage the exchange rate between the rupee and other currencies; (c) to
manage exchange reserves; and (d) to interact or negotiate with the
monetary authorities of the Sterling Area, Asian Clearing Union, and other
countries, and with international financial institutions such as the IMF,
World Bank and Asian Development Bank. The RBI administers the
Exchange Control in terms of the Foreign Exchange Regulation Act
(FERA), 1947 which has been replaced by a more comprehensive Foreign
Exchange Regulation Act, 1973. The objective of exchange control is
primarily to regulate the demand for foreign exchange within the limits set
by the available supply. This is sought to be achieved by conserving
foreign exchange, by using it in accordance with the plan priorities, and by
controlling flows of foreign capital. In India, during most of the years
since 19S7, foreign exchange earnings have been far less than the demand
for foreign exchange, with the result that the latter had to be rationed in
order to maintain exchange stability. This is done through Exchange
control which is imposed both on receipts and payments of foreign
exchange on trade, invisible and capital accounts. The problem of foreign
exchange shortage has been so persistent and acute that the scope of
exchange control in India has steadily widened and the regulations have
become progressively more elaborate o ver the years. The Bank
administers the control through authorized foreign exchange dealers.
FERA lays down that the exchange rates used for the conduct of foreign
exchange business must be those which are fixed by the RBI. The
arrangements or the system under which exchange rate is fixed by the RBI
has undergone many changes over the years. Till about 1971 as a member
of the IMF, India had an exchange rate system of “managed flexibility.”
This arrangement changed during 1970s as a result of international
monetary crisis in 1971. Since 1975, the exchange rate of the rupee has
been fixed in terms of the “bask et of currencies”. The different exchange
rate systems in India will be discussed in detail in chapter 21 on foreign
exchange market. The RBI is the custodian of the country’s foreign
exchange reserves, and it is vested with the responsibility of managing the
investment and utilization of the reserves in the most advantageous
manner. The RBI achieves this through buying and selling of foreign
exchange from and to scheduled banks which are the authorized dealers in
the Indian foreign exchange market The Bank also manages the
investment of reserves in gold accounts abroad and the shares and
securities issued by foreign governments and international banks or
financial institutions.
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The Role of Central Bank - RBI
15 6. PROMOTER OF THE FINANCIAL SYSTEM
Apart from performing the functions already mentioned, the RBI has
distinguished itself by rendering “developmental” or “promotional”
services which have strengthened the country’s banking and financial
structure. This has helped in the mobilization of savings and directing
credit flows to desired channels, thereby helping to achieve the objective
of economic development with social justice. It has played a major role in
deepening and widening the financial system. As has been preempting
credit for certain sectors at a part of its promotional role, the Bank
concessional rates. In the money market, the RBI has continuously worked
for the integration of its unorganized and organized sectors by trying to
bring indigenous bankers into the mainstream of the banking business. In
order to improve the quality of finance provided by the money market, it
introduced two Bill Market Schemes, one in 1952, and the other in 1970.
With a view to increasing the strength and viability of the banking system,
it carried out a programme of a ma lg am actions and mergers of w eak
banks with the strong ones. When the Social Control of banks was
introduced in 1968, it was the responsibility of the RBI to administer the
country for achieving the desired objectives. After the nationalization of
banks, the RBI’s responsibility to de velop banking system on the desired
lines has increased. It has been acting as a leader in sponsoring and the
implementing the Lead Bank scheme. With the help of a statutory
provision for licensing the branch expansion of banks, the RBI has been
trying to bring about an appropriate geographical distribution of bank
branches. In order to ensure the security of deposits with banks, the RBI
took initiative in 1962 in creating the Deposits Insurance Corporation. The
RBI has rendered yeoman’s service in directin g an increased flow of credit
to the agricultural sector. It has been entrusted with the task of providing
agricultural credit in terms of the Reserve of India Act, 1934. The
importance with which the Bank RBI takes this function is reflected in the
fact t hat the since 1955, it has appointed a separate Deputy Governor in
charge of rural credit It has undertaken systematic stuas of the problem of
rural cred it and has generated basic data and information in this area.
This was first done in 1954 by conductin g an All India Rural Credit
Survey. And that was followed by the stu A the s of the All India Rural
Credit Review Committee in 1968, the Committee to Review
arrangements for Institutional Credit for Agriculture and Rural
Development in 1978, and the Agricu ltural Credit Review Committee in
1986. As a part of its efforts to increase the supply of agricultural credit,
the Bank has been striving to strengthen the cooperative banking structure
through provision of finance, supervision, and inspection. It provide s the
co-operative banks (through the State Co -operative Banks) short term
finance at a concessional rate for seasonal agricultural operations and
marketing of crops. It subscribes to the debentures of Land Development
Banks. It operates the National Agric ultural Credit (Long -Team
Operations) Fund, and foe National Agricultural Credit (Stabilization)
Fund, through which it provides long - term and medium -term finance to
cooperative institutions. It established the Agricultural Refinance
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Financial Markets & Instiution
16 medium -term and long -term finance, for agriculture. It also helped in
establishing an Agricultural Finance Corporation. The role of the Bank in
diversifying the institutional structure for providing industrial finan ce has
been equally commendable. All the Special Development Institutions at the
Central and State levels and many other financial institutions were either
created by the Bank on its own or it advised and rendered help in setting up
these institutions. The UTI, for example, was originally an associate
institution of the RBI. A number of institutions providing financial and
other services such as guarantees, technical consultancy, and so on have
come into being on account of the efforts of the RBI. Through t hese
institutions, the RBI has been providing short -term and long -term funds to
the agricultural and rural sectors, to small scale industries, to medium and
large industries, and to the export sector. It has helped to develop
guarantee services in respect of loans to agriculture, small industry,
exports, and sick units. It also co -ordinates the efforts of banks, financial
institutions, and Government agencies to rehabilitate sick units. The Bank
has evolved and put through practice the consortium, cooperati ve, and
participatory approach to lending among banks, and other financial
institutions, and among other financial institutions. By developing the
culture of inter -institutional participation, of expertise pooling, and of
geographical presence, it has helped to upgrade credit delivery and service
capability of the financial system. By issuing appropriate guidelines in
1977 regarding the transfer of loan accounts by the borrowers, it has
evolved mutually acceptable system of lending, so that the banking
business should grow in a healthy manner and without cutthroat
competition.
2.5 REGULATOR OF MONEY AND CREDIT
The function of formulating and conducting monetary policy is of
paramount importance for any central bank. Monetary policy refers to the
use of techn iques of monetary control at the disposal of the central bank for
achieving certain objectives.

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17 3
STOCK EXCHANGES OF THE COUNTRY
AND PRIMARY MARKETS
Unit Structure
3.1 Introduction
3.2 Primary Market
3.3 Principal Steps of a Public Issue
3.4 Stock Market in India
3.5 Stock Market Information System
3.1 INTRODUCTION
Markets are gathering places for customers and sellers to exchange goods.
This definition holds true across all marketplaces and is universal. More
discussion regarding the capital market will be covered in this course. It is
a location where various sorts of capital are traded. Individ uals like you
are frequently the lenders or the capital suppliers. The recipients of capital
are businesses and numerous other institutions. The market is structured in
a variety of ways. The market can be broadly split into two categories: (a)
the short -term capital market, also known as the money market, and (b)
the long -term capital market, also known as the stock market. The
institutional market and the direct market are two other market
classifications.
If you can only spare a small portion of your sur plus funds, you'll need to
hunt for quick savings. You must seek out institutional support for such
savings because the amount available in such situations is typically quite
minimal. In other words, people don't engage with the money market,
which focuses on short -term capital, directly. People frequently contact an
institution for this reason. Your short -term surplus can be saved in a
mutual fund or bank deposit, both of which provide money market plans.
If you have extra cash that you can spare for a whi le, you should seek for
investments with a longer time horizon. Once more, you can visit a
business that sells long -term products or you can engage with the market
directly. In other words, you can put your money in a long -term fixed
deposit, a mutual fund programme, or by purchasing assets directly from
the market. There are two ways you might approach the market when you
want to handle it on your own. Accordingly, the markets are divided into
primary and secondary markets. The corporation pursues investor s in its
primary market in order to raise money. They have the option of asking
for loan, equity, or a combination of the two types of funding. Today,
trading in the primary market is fairly easy. Similar to opening a fixed munotes.in

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Financial Markets & Instiution
18 deposit, you must fill out an ap plication for the issue and then deposit the
required amount. Brokers and sub-brokers will typically assist you in
obtaining forms and directing you as you fill them out. The most crucial
thing is to make sure your investments align with your goals. Financ ial
newspapers and magazines also provide in-depth articles on major market
issues here to aid small investors. If the company accepts your application
forms after you submit them, you will receive a certificate or credit in your
depository. If there are too many applicants for the offer, the business may
reject some of the applications. You will receive a refund of your initial
investment in such circumstances.
There will be competition for the best problems because the price in the
primary market is fixed . Many investors who are directly willing to deal
with the market are forced to turn to the secondary market due to the
uncertainty of securing an allocation. It is a location where investors buy
from and sell to one another. The market is active since the re are many
vendors and buyers. Prices for securities fluctuate in response to changes in
supply and demand. There is a secondary market for a variety of securities,
including debt, equity, and others. Thanks to advancements in information
and computing te chnologies, investing in the secondary market has also
grown simpler. You must establish an account with one of the stock
exchanges of your choice's participants. The steps to opening an account.
The process to open an account is reasonably straightforward and
resembles creating a savings bank account with your banker in several
ways. You can place orders for buying and selling over the phone, and
you frequently receive an immediate confirmation of your transaction.
You may purchase and sell securities on t he internet these days. More
information about the stock market's structure and the buying and selling
of shares by investors will be included in this unit.
3.2 PRIMARY MARKET
The primary market is where brand -new issues are created, whereas the
secondary market is where current issues are traded. This explains why the
Secondary Market is also known as the Stock Market and the Primary
Market is also known as the New Issues Market. There are three ways to
create new issues in the primary market: public issue , rights issue, and
private placement. The sale of securities to the general public is a public
issue. Securities are sold through a rights issue to current shareholders and
bondholders. Selling shares privately to a chosen group of investors is
known as p rivate placement. Equity shares, completely convertible
debentures (FCD), partially convertible debentures (PCD), and
nonconvertible debentures (NCD) are the securities issued by non-
government public limited companies most frequently in the primary
market .
Bonds and equity shares are issued by government corporations. India's
primary market has seen a significant increase in activity after the
Controller of Capital Issue was abolished. Issues are made in the primary
market either "at par" or "at premium." The "Guidelines on Capital Issues"
or "Guidelines for Disclosure and Investors Protection" published by the munotes.in

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Stock Exchanges of the Country and Primary
19 Securities and Exchange Board of India (SEBI) regulate the pricing of
new Issues. These comprehensive guidelines address every aspect of
capital off erings. The pricing of new issues was governed by the
Controllers of Capital Issues (CO) pricing formula prior to the adoption of
the ordinance no. 9 of 1992, which repealed the Capital Issues (Control)
Act.
According to the recommendations of the Malegam Committee, all issues
by a new firm must be made at par, and for existing companies, the issue
price must be justified.
• The last three years' earnings per share (EPS) and a comparison of the
pre-issue price to earnings (P/E) ratio to the industry's P/E ratio.
A minimum return on increasing net worth is required to maintain pre -
issue EPS. Latest Net Asset Value. By issuing GDRs and ADRs, a
corporation can also obtain funding from the global financial markets.
3.3 PRINCIPAL STEPS OF A PUBLIC ISSUE
A draught p rospectus is created with information on the company, the
history of the promoters, the management, the terms of the offering, the
specifics of the project, the sources of funding, past financial results,
expected profitability, and other information. Addi tionally, in a document
known as a "placement memorandum," a venture capital firm must disclose
the specific conditions under which funds are to be raised in the proposed
issue. Some of the steps are as follows :
 The underwriters are chosen because they ag ree to take on the risk and
contribute to the shortfall should the issuance not receive enough
interest. They are eligible to receive a commission on the amount
underwritten for this pledge, up to a maximum of 2.5%.
 The appointment of bankers: Bankers serv e as the collecting agents
and handle the monies obtained during the public issue through their
branch network. A "bridge loan" is a short -term loan that the Banks
offer to cover the time between the issuance date and the day the issue
proceeds become available after allotment.
 The appointment of registrars is the first step in the allocation process.
Registrars process application forms, total the funds collected during
the Issue, and start the allotment process.
 Brokers are appointed to the Issue for the purpose of marketing it.
These brokers must be recognised members of the Stock Exchanges.
They are qualified for a 1.5% maximum brokerage.
 Draught prospectus along with copies of the agreements with the Lead
Manager, Underwriters, Bankers, Registrars, and Brokers to the issue
are filed with the Registrar of Companies in the state where the
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Financial Markets & Instiution
20  Application form printing and distribution: The prospectus and
application forms are printed and distributed to all merchant banke rs,
underwriters, and brokers involved in the offering.
 Initial listing application submission: A letter including the details and
a statement of intent to list the shares on the exchange is sent to the
stock exchanges where the issue is planned to be listed.
 Statutory notice: The prospectus and the start and close dates for the
issue are published in significant English daily and regional media.
 Application processing: Following the conclusion of the public
offering, each application form is carefully exam ined, the results are
calculated, and shares are subsequently allocated in accordance with
these applications.
 Establishing the underwriter's liability: If the issue is fully subscribed,
the underwriters are responsible for making up the difference if they
haven't raised the full amount that was committed to them under the
underwriting agreement.
 Share allotment: Following the Issue's minimum level of subscription,
SERI's allotment process is started.
 Listing of the Issue: Following allocation, the shares must be listed
mandatorily on the regional stock exchange and optionally on other
stock exchanges.
3.4 STOCK MARKET IN INDIA
From scattered and small beginnings in the 19th Century, India' s stock
market has risen to great heights. By 1990, we had 19 Stock Exchanges in
the country and by 2002 there were 23 Stock Exchanges as listed in the
later sections of this unit. You might be interested in knowing more about
the origin and the growth of stock market in India. What functions does it
perform? What is the f orm of organization of stock exchanges in India?
How are these administered? We shall, now, address to these and other
questions.
Origin and Growth Organizations and institutions, whether they are
economic, social or political, are products of historical e vents and
exigencies. The events continually replace and/or reform the existing
organizations, so as to make them relevant and operational in contemporary
situations. It is, therefore, useful to briefly acquaint ourselves with the
origin and growth of the stock market in India. Stock exchanges of India in
a rudimentary form originated in 1800 and since that time have developed
through six broad stages.
1800 -1865 : The East India Company and few commercial banks floated
shares sporadically, through a very sm all group of brokers. According to a
newspaper in 1850, in Bombay during 1840 -1850 there were only half a
dozen recognised brokers. The year 1850 marked a watershed. A wave of munotes.in

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Stock Exchanges of the Country and Primary
21 company flotations took over the market ; the number of brokers spurted
to 60. T he backbone of industrial growth and the resulting boom in share
flotation was the legendary personality of the financial world, Premchand
Roychand.
In 1860 the stock market created a unique history. The entire market was
gripped by what is known as ‘share mania’. The American Civil War
created cotton famine. Indian cotton manufacturers exploited this situation
and exported large quantities of cotton. The resulting increase in export
earnings opened opportunities for share investments. New companies
started to come up. Excessive speculation and reckless buying became the
order of the day. This mania lasted upto 1865. It marks the end of the
first phase in the Indian stock exchange history because with the cessation
of the Civil War, demand for Indian cotton slumped abruptly. The share
became worthless pieces of paper. To be exact, on July 1, 1865 all shares
ceased to exist because all time bargains which had matured could not be
fulfilled.
1866 -1900: We find another distinct phase during 1866 -1900. The mania
effect haunted the stock exchange of Bombay during these 25 years.
Above everything else, it led to foundation of a regular market for
securities. Since the market was established in Bombay, it soon became
and still is the leading and the most organized stock exchange in India. A
number of stock brokers who geared up themselves, set up a voluntary
organization in 1887, called Native Share and Stockbrokers Association.
The brokers drew up codes of conduct for brokerage business and
mobilized private funds for industrial growth. It also mobilized funds for
government securities (gilt edged securities), especially of the Bombay
Port Trust and the Bombay Municipality. A similar organization was
started at Ahmedabad in 1894.
1901 -1913: Political developments gave a big fillip to share investment.
The Swadeshi Movement led by Mahatma Gandhi encouraged the
indigeneous trading and business class to start industrial enterprises. As a
result, Calcutta became another major centre of share trading. The trading
was prompt ed by the coal boom of 1904 - 1908. Thus the third stock
exchange was started by Calcutta stock brokers. During Inter-war years
demand for industrial goods kept increasing due to British involvement in
the World Wars. Existing enterprises in steel and cotto n textiles, woolen
textiles, tea and engineering goods expanded and new ventures were
floated. Yet another stock exchange was started at Madras in 1920.
The period 1935 -1965 can be considered as the period of development of
the existing stock exchanges in India. In this period industrial
development planning played the pivotal role of expanding the industrial
and commercial base of the country. Two more stock exchanges were set
up, at Hyderabad in 1943 and at Delhi in 1947. At the time of
Independence seven stock exchanges were functioning located in the
major cities of the country. Between 1946 and 1990, 12 more stock
exchanges were set up trading the shares of 4843 additional listed
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Financial Markets & Instiution
22 There are 23 stock exchanges in the country, 23 of them being regional
ones with allocated areas. Three others set up in the reforms era, viz.,
National Stock Exchange (NSE), the Over the Counter Exchange of India
Limited (OTCEI), and Interconnected Stock Exchange of India Limited
(ISE) have mandate to nationwide trad ing network. The ISE is promoted
by 15 regional stock exchanges in the country and has been set up at
Mumbai. The ISE provides a member -broker of any of these stock
exchanges an access into the national market segment, which would be in
addition to the local trading segment available at present. The NSE and
OCTEI, ISE and majority of the regional stock exchanges have adopted the
Screen Based Trading System (SBTS) to provide automated and modern
facilities for trading in a transparent, fair and open manner w ith access to
investors across the country. 9,877 companies were listed on the stock
exchanges as on 31 March 1999, and the market capitalization was
5,30,772 crore. The number of primary listed companies at various stock
exchanges in India was 9,644 as on end of March, 2002. The market
capitalisation at NSE was Rs. 6,36,861 crore by March 2002. The following
are the names of the various stock exchanges in India.
 The Bombay Stock Exchange
 The Ahmedabad Stock exchange Association
 Bangalore Stock Exchange
 The Calcutta Stock Exchange Association
 Cochin Stock Exchange
 The Delhi Stock Exchange Association
 The Guwahati Stock Exchange
 The Hyderabad Stock Exchange
 Jaipur Stock Exchange Kanara Stock Exchange
 The Ludhiana Stock Exchange Association
 Madras stock Exchan ge Madhya Pradesh Stock Exchange
 The Magadh Stock Exchange
 Mangalore Stock Exchange
 Pune Stock Exchange
 Saurashtra Kutch Stock Exchange
 The Uttar Pradesh Stock Exchange Association
 Vadodara Stock Exchange
 Coimbatore Stock Exchange
 Over The Counter Exchange of India
 The National Stock Exchange of India
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Stock Exchanges of the Country and Primary
23 Role and Functions
The history of stock exchanges in foreign countries as well as in India
shows that the development of joint stock enterprise would never have
reached its present stage but for the facilities which the stock exchanges
provided for dealing in securities. Stock exchanges have a very important
function to fulfil in the country's economy. In Union of India vs. Allied
International Products Ltd (1971) 41 Comp Cas 127 (SC) : (1970) 3 SCC
5941], the Supreme Court of India has enunciated the role of the stock
exchanges in these words: “A Stock Exchange fulfils a vital function in the
economic development of a nation: its main function is to `qualify' capi tal
by enabling a person who has invested money in, say a factory or a
railway, to convert it into cash by disposing off his shares in the enterprise
to someone else. Investment in joint stock companies is attractive to the
public, because the value of the shares is announced day after day in the
stock exchanges, and shares quoted on the exchanges are capable of
almost immediate conversion into money. In modern days a company
stands little chance of inducing the public to subscribe to its capital, unless
its shares are quoted in an approved stock exchange. All public companies
are anxious to inform the investing public that the shares of the company
will be quoted on the stock exchange”.
The stock exchange is really an essential pillar of the private sector
corporate economy. It discharges three essential functions in the process
of capital formation and in raising resources for the corporate sector. They
are :
First, the stock exchange provides a market place for purchase and sale of
securities viz., shares, bonds, debentures, etc. It, therefore, ensures the free
transferability of securities which is the essential basis for the joint stock
enterprise system. The private sector economy cannot function without the
assurance provided by the stock exchange to th e owners of shares and
bonds that they can be sold in the market at any time. At the same time
those who wish to invest their surplus funds in securities for long -term
capital appreciation or for speculative gain can also buy stocks of their
choice in the market.
Secondly, the stock exchange provides the linkage between the savings in
the household sector and the investment in corporate economy. It
mobilizes savings, channelises them as securities into those enterprises
which are favoured by the investors o n the basis of such criteria as future
growth prospects, good returns and appreciation of prevalence on the
Indian scene of such interventionist factors as industrial licensing,
provision of credit to private sector by public sector development banks,
price controls and foreign exchange regulations. The stock exchanges
discharge this function by laying down a number of regulations which
have to be complied with while making public issues e.g. offering at least
the prescribed percentage of capital of the public, keeping the subscription
list open for a minimum period of three days, making provisions for
receiving applications at least at the centres where there are recognised
stock exchanges and allotting the shares against applications on a fair and munotes.in

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Financial Markets & Instiution
24 uncondit ional basis with the weightage being given to the applications in
lower categories, particularly those applying for shares worth Rs.500 or
Rs.1,000, etc. Members of stock exchanges also assist in the floatation of
new issues by acting as managing brokers/o fficial broker of new issue. In
that capacity, they, inter alia, try to sell these issues to investors spread all
over the country. They also act as under - writers to new issues. In this
way, the broker community provides an organic linkage between the
primary and the secondary markets. 14 Securities Market in India Thirdly,
by providing a market quotation of the prices of shares and bonds, a sort
of collective judgement simultaneously reached by many buyers and
sellers in the market -the stock exchanges ser ves the role of a barometer,
not only of the state of health of individual companies, but also of the
nation's economy as a whole. It is often not realised that changes in share
prices are brought about by a complex set of factors, all operating on the
markets simultaneously. Share values as a whole are subject to secular
trends set by the economic progress of the nation, and governed by factors
like general economic situation, financial and monetary policies, tax
changes, political environment, internation al economic and financial
developments, etc. These trends are influenced to some extent by
periodical cycles of booms and depressions in the free market economies.
As against these long-term trends, the day-to-day prices are influenced by
another variety of factors notably, the buying or selling of major operators,
the buying and selling of shares by the investment financial institutions
such as the U.T.I. or L.I.C. which have in recent years emerged as the
largest holders of corporate securities, speeches and pronouncements by
ministers and other government spokesmen, statements by company
chairmen at annual general meetings and reports of bonus issues or good
dividends by companies, etc., while these factors, both long -term and short -
term, act as macro inf luences on the corporate sector and the level of stock
prices as a whole, there is also a set of micro influences relating to
prospects of individual companies such as the reputation of the
management, the state of industrial relations in the enterprises, the volume
of retained earnings and the related prospects of capitalization of reserves,
etc., which have a bearing on the level of prices. In the complex interplay
of all these forces, which leads to day-to-day quotation of prices of all listed
securities , speculation plays a crucial role. In the absence of speculative
operations, every purchase by an investor has to be matched by a sale of
the same security by an investor -seller, and this may lead to sharp
fluctuation in prices. With speculative sale and purchases taking place
continuously, actual sale and purchase by investors on a large scale are
absorbed by the market with small changes in prices. There are always
some professional operators who are hoping that the prices would rise.
There are others pr edicting that prices will fall. Both these groups acting
on their respective assumption buy or sell continuously in the market.
Their operation helps to bring about an orderly adjustment of prices.
Without these speculative operations, a stock exchange can become a very
mechanical thing. However, excessive speculation endangers market
equilibrium and must be discouraged through appropriate safeguards. The
regulatory authorities should always take necessary precautionary
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Stock Exchanges of the Country and Primary
25 trading. A fact which needs to be emphasized is that the stock exchanges
in India also serve the joint sector units as also to some extent public sector
enterprises. There is substantial private participation in the share capital of
a number of government companies such as Balmer Lawrie, Andrew Yule,
Gujarat State Fertilizers Corporation, Gujarat Narmada Fertilizers
Corporation, State Bank of India, ICICI, etc. In recent times some of the
Central public sector companies have gone in for public debentures
through the stock exchanges. Also, there are some public sector companies
like VSNL which have made their share capital open for public
subscription. Another important function that the stock exchanges in India
discharge i s of providing a market for gilt-edged securities i.e. securities
issued by the Central Government, State government, Municipalities,
Improvement Trusts and other public bodies. These securities are
automatically listed on the stock exchanges when they are issued and
transactions in these take place regularly on the stock exchanges.
Membership, Organisation and Management
By virtue of the century -old tradition, stock exchanges is a highly
organized and smooth functioning network in the world. The membership
of stock exchanges initially comprised of individuals and partnership firms.
Later on companies were also allowed to become members. A number of
financial institutions are now members of Indian stock exchanges. Over
the years, stock exchanges have been or ganized in various forms. For
example, while the Bombay Stock Exchange, Ahmedabad Stock
Exchange and M.P. (Indore) Stock Exchange were organised as voluntary
non-profit making association of persons, the Calcutta Stock Exchange,
Delhi Stock Exchange, U.P. (Kanpur) Stock Exchange, Ludhiana Stock
Exchange, Cochin Stock Exchange, Gauhati Stock Exchange, Jaipur Stock
Exchange, and Kanara (Mangalore) Stock Exchange were organised as
public limited companies. Quite a few others have been organised as
companies li mited by guarantee. The internal governance of every stock
exchange rests in a Governing Board Comprising Members of the Board
and Executive Director/President. Members of the Governing Board
include brokers and non-brokers. Governing Bodies of stock excha nges
also have government nominees. The Executive Director/President is
expected to ensure strict compliance by all members of the exchange of
rules/by laws, margin regulations and trading restriction, etc. Subject to
the previous approval of SEBI, under t he law, Governing Bodies of stock
exchanges have wide powers to make bye -laws. Governing Bodies can
admit, punish, censure and also expel any member, any partner, any
remisier, and authorised clerk and employee. It has the power to adjudicate
disputes. Abo ve all, it has the power to make, amend, suspend and enforce
rules, by -laws, regulations and supervise the entire functioning of a stock
exchange.
Trading System Trading system differ from exchange to exchange. In the
next few pages, the trading system followed by the National stock
Exchange is described. Students desire to know more about the trading
system of other exchanges in India as well as outside India can visit
respective web sites of stock exchanges. NSE operates on the 'National munotes.in

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Financial Markets & Instiution
26 Exchange for Auto mated Trading' (NEAT) system, a fully automated
screen based trading system, which adopts the principle of an order driven
market. NSE consciously opted in
favour of an order driven system as opposed to a quote driven system.
This has helped reduce jobbing spreads not only on NSE but in other
exchanges as well, thus reducing transaction costs. Till the advent of NSE,
an investor wanting to transact in a security not traded on the nearest
exchange had to route orders through a series of correspondent brokers to
the appropriate exchange. This resulted in a great deal of uncertainty and
high transaction costs. NSE has made it possible for an investor to access
the same market and order book, irrespective of location, at the same price
and at the same cost.
Mark et Types
The NEAT system has four types of market. They are :
Normal : All orders which are of regular lot size or multiples thereof are
traded in the Normal Market. For shares which are traded in the
compulsory dematerialised mode, the market lot is one share. Normal
market consists of various book types wherein orders are segregated as
Regular lot orders, Special Term orders, Negotiated Traded orders and Stop
Loss orders depending on their order attributes.
Odd Lot Market : All orders whose order size is less than the regular lot
size are traded in the odd-lot market. An order is called an odd lot order if
the order size is less than regular lot size. These orders do not have any
special terms attributes attached to them. In an odd-lot market, both the
price and quantity of both the orders (buy and sell) should exactly match
for the trade to take place. Currently the odd lot market facility is used for
the Limited Physical Market as per the SEBI directives.
Spot Market : Spot orders are similar to the norma l market orders except
that spot orders have different settlement periods vis -à-vis normal market.
These orders do not have any special terms attributes attached to them.
Currently the Spot Market is being used for the Automated Lending &
Borrowing Mechani sm (ALBM) session.
Auction Market : In the Auction Market, auctions are initiated by the
Exchange on behalf of trading members for settlement related reasons.
There are 3 participants in this market :
Initiator : The party who initiates the auction process is called an initiator.
Competitor : The party who enters orders on the same side as of the
initiator is called a Competitor.
Solicitor : The party who enters orders on the opposite side as of the
initiator is called a Solicitor.
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27 Order Books The NSE trad ing system provides complete flexibility to
members in the kinds of orders that can be placed by them. Orders are first
numbered and time-stamped on receipt and then immediately processed for
potential match. Every order has a distinctive order number and a unique
time stamp on it. If a match is not found, then the orders are stored in
different `books'. Orders are stored in price -time priority in various books
in the following sequence: - Best Price - Within Price, by time priority. Price
priority means that if two orders are entered into the system, the order
having the best price gets the higher priority. Time priority means if two
orders having the same price are entered, the order that is entered first gets
the higher priority.
The Capital Market segmen t has following types of books:
Regular Lot Book : The Regular Lot Book contains all regular lot orders
that have none of the following attributes attached to them.
– All or None (AON)
- Minimum Fill (MF)
- Stop Loss (SL)
Special Terms Book : The Special Terms book contains all orders that
have either of the following terms attached:
- All or None (AON)
- Minimum Fill (MF) (Note : Currently, special term orders i.e. AON
and MF are not available on the system as per the SEBI directives. )
Negotiated Trade Book : The Negotiated. Trade book contains all
negotiated order entries captured by the system before they have been
matched against their counterparty trade entries. These entries are matched
with identical counterparty entries only. It is to be noted that these entries
contain a counterparty code in addition to other order details.
Stop -Loss Book : Stop Loss orders are stored in this book till the trigger
price specified in the order is reached or surpassed. When the trigger price
is reached or surpassed, the order is released in the Regular lot book. The
stop loss condition is met under the following circumstances:
SELL ORDER - A sell order in the Stop loss book gets triggered when the
last traded price in the normal market reaches or falls below the trigger
price of the order.
BUY ORDER - A buy order in the Stop Loss book gets triggered when the
last traded price in the normal market reaches or exceeds the trigger price
of the order.
Odd Lot Book : The Odd lot book contains all odd lot orders (orders with
quantity less than marketable lot) in the system. The system attempts to
match an active odd lot order against passive orders in the book. Currently,
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Financial Markets & Instiution
28 which have a quantity less than or equal to 500 (Qty more than the market
lot) for trading. This is referred as the Limited Physical Market (LPM).
Spot Book : The Spot lot book contains all spot orders (orders having only
the settlement period different) in the system. The system attempts to
matc h an active spot lot order against the passive orders in the book.
Currently the Spot Market book type is being used for conducting the
Automated Lending & Borrowing Mechanism (ALBM) session.
Auction Book : This book contains orders that are entered for al l auctions.
The matching process for auction orders in this book is initiated only at the
end of the solicitor period.
Order Matching Rules The best buy order is matched with the best sell
order. An order may match partially with another order resulting in
multiple trades. For order matching, the best buy order is the one with the
highest price and the best sell order is the one with the lowest price. This is
because the system views all buy orders available from the point of view of
a seller and all sell o rders from the point of view of the buyers in the
market. So, of all buy orders available in the market at any point of time, a
seller would obviously like to sell at the highest possible buy price that is
offered. Hence, the best buy order is the order with the highest price and
the best sell order is the order with the lowest price. Members can
proactively enter orders in the system which will be displayed in the system
till the full quantity is matched by one or more of counter -orders and result
into trade(s) or is cancelled by the member. Alternatively, members may be
reactive and put in orders that match with existing orders in the system.
Orders lying unmatched in the system are `passive' orders and orders that
come in to match the existing orders are called `active' orders. Orders are
always matched at the passive order price. This ensures that the earlier
orders get priority over the orders that come in later.
Order Conditions
A Trading Member can enter various types of orders depending upon
his/her requirements. These conditions are broadly classified into three
categories: time related conditions, price -related conditions and quantity
related conditions.
Time Conditions
• DAY - A Day order, as the name suggests, is an order which is valid for
the day on which it is entered. If the order is not matched during the day,
the order gets cancelled automatically at the end of the trading day.
• GTC - A Good Till Cancelled (GTC) order is an order that remains in
the system until it is cancelled by the Trading Mem ber. It will therefore be
able to span trading days if it does not get matched. The maximum number
of days a GTC order can remain in the system is notified by the Exchange
from time to time.
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Stock Exchanges of the Country and Primary
29 • GTD - A Good Till Days/Date (GTD) order allows the Trading
Membe r to specify the days/date up to which the order should stay in the
system. At the end of this period the order will get flushed from the
system. Each day/date counted is a calendar day and inclusive of holidays.
The days/date counted are inclusive of the day/date on which the order is
placed. The maximum number of days a GTD order can remain in the
system is notified by the Exchange from time to time.
• IOC - An Immediate or Cancel (IOC) order allows a Trading Member
to buy or sell a security as soon as the order is released into the market,
failing which the order will be removed from the market. Partial match is
possible for the order, and the unmatched portion of the order is cancelled
immediately.
Price Conditions
• Limit Price/Order - An order which allows the price to be specified
while entering the order into the system.
• Market Price/Order - An order to buy or sell securities at the best
price obtainable at the time of entering the order.
• Stop Loss (SL) Price/Order - The one which allows the Trading
Membe r to place an order which gets activated only when the market price
of the relevant security reaches or crosses a threshold price. Until then the
order does not enter the market. SELL ORDER A sell order in the Stop
Loss book gets triggered when the last traded price in the normal market
reaches or falls below the trigger price of the order. BUY ORDER A buy
order in the Stop Loss book gets triggered when the last traded price in the
normal market reaches or exceeds the trigger price of the order. e.g. If for
stop loss buy order, the trigger is Rs. 93.00, the limit price is Rs. 95.00 and
the market (last traded) price is Rs. 90.00, then this order is released into the
system once the market price reaches or exceeds Rs. 93.00. This order is
added to the regular lot book with time of triggering as the time stamp, as a
limit order of Rs. 95.00
Quantity Conditions
• Disclosed Quantity (DQ) - An order with a DQ condition allows the
Trading Member to disclose only a part of the order quantity to the
market. For example, an order of 1000 with a disclosed quantity condition
of 200 will mean that 200 is displayed to the market at a time. After this is
traded, another 200 is automatically released and so on till the full order is
executed. The Exchange may set a minimum disclosed quantity criteria
from time to time.
• MF - Minimum Fill (MF) orders allow the Trading Member to specify
the minimum quantity by which an order should be filled. For example, an
order of 1000 units with minimum fill 200 will require that each trade be
for at least 200 units. In other words, there will be a maximum of 5 trades
of200 each or a single trade of 1000. The Exchange may lay down norms
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Financial Markets & Instiution
30 • AON - All or None orders allow a Trading Member to impose the
condition that only the full order should be matched against. This may be
by way of multiple trades. If the full order is not matched it will stay in the
books till matched or cancelled.
3.5 STOCK MARKET INFORMATION SYSTEM
Stock exchange quotations and indices published in daily newspapers are
the main source of information on stock exchange trades and turnover.
Dailies like Economic Times, Financial Express, Business Standard,
Business Line, Times of India and Hindustan Times publish daily
quotations and indices. As for Bombay S tock Exchange quotations
published in Economic Times, information on equity shares, starting from
the first column, is presented in the following order: Company's name;
previous day's closing price in brackets; all the daily traded prices as
published by t he BSE ; key financial parameters such as earnings per share
(EPS), cash earnings per share (CPS), cash P/E (price to earnings ratio),
return on net worth (RN W) and gross profit margin (GPM) etc. on
different days; P/E ; and the high and low prices in the preceding 52
weeks. The first traded price is the day's opening price. If only one such
price is recorded, it is also the day's closing price. If there are two prices,
then the middle quote is either the high or low price. If there are four prices,
then one of the middle quotes is the day's high and the other, the low. If
there are no transactions in a company's share on any day, the previous
day's closing price is presented in brackets. The EPS is the average net profit
after tax per equity share and the CPS the average cash profit (after adding
back depreciation) per share. The cash P/E is the ratio of the day's closing
price to the cash earnings per share as distinct from the P/E ratio, which
relates price to the net profit per share. PE values are not printed when
earnings are either nil or negative. The RNW is the net profit as a
percentage of the net worth and measures the return earned on the
shareholders' fund i.e. equity capital plus reserves. The GPM is the gross
profit margin (before depreciation and tax) as a percentage of gross sales
and measures the company's profit margin which is available to absorb
depreciation charges arising from capital expenditure, tax payments,
dividend distribution and profit ploughback. All the figurers are taken
from the latest available results (audited / unaudited) of the company. The
52-week high and low prices of each share are worked out every day on
the basis of the highest and lowest points scaled during the immediately
preceding 52 weeks. The high and low price s are adjusted for bonus and
rights issue of equity shares. If any of the day ’s traded price is a yearly
high or low, the entire line, including the name of the company, is shown
in bold types, with a ‘H’ attached to the high value or `L ’ attached to the
low value. Whenever there is a significant change in the day’s closing value
as compared to the previous closing, it is shown in bold types with a `plus ’
or `minus ’ sign as the case may be, after the closing value. For specified
shares, a three per cent change and for non-specified shares a 15 per cent
change is treated as significant. Whenever a share goes ex -divided or ex -
bonus or ex-rights, it is indicated by notation XD or XB or XR, as the case
may be placed next to its closing price. Symbol of face valu es other than munotes.in

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Stock Exchanges of the Country and Primary
31 Rs. 10. Are also indicated along with the names. Since Indian regulations
allow stock splits, a number of firms have face value other than Rs. 10.
For debentures, the information starting from the first column, is presented
in the following order: the nominal rate of interest on the face value,
company name, face value, previous day ’s closing price, the day ’s
opening price, yield to maturity (YTM) and yield (both annualized). The
yield is nominal interest expressed in percentage terms of closi ng value.
The YTM adjusts the nominal return for the maturity period, frequency of
interest payments, manner of principal repayment, redemption premium, if
any, and thereby enables investors to compare different investment
options in debentures on a unifor m scale. If there are no quotations for a
company ’s debenture on a day, the opening price is shown as nil, and the
closing price the same as the previous day’s closing. Besides these
quotations share price indices are also published in different dailies.
Bombay Stock Exchange ’s 30- share ‘Sensex’ and 100 –share `National ’
indices are quite popular. In addition, NSE -50 (Nifty) has also become
popular with institutional and retail investors in recent times. Besides
these, there are other indices also which in clude The Economic Times
Index of Ordinary Share Price, Business Standard Index of Ordinary Shares
Price and a few others. Reserve Bank of India also publishes Share Price
Index.

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32 4
SECONDARY MARKETS
Unit Structure
4.1 Secondary Market - Meaning
4.2 Nature of Secondary Market
4.3 Organization of Stock Exchanges
4.4 Regulatory Framework for Stock Exchange in India
4.5 Defects in working of Indian Stock Exchange
4.1 SECONDARY MARKET - MEANING
A secondary market is a platform wherein the shares of companies are
traded among investors. It means that investors can freely buy and sell
shares without the intervention of the issuing company. In these
transactions among investors, the issuing company does not participate in
income generation, and share valuation is rather based on its performance
in the market. Income in this market is thus generated via the sale of the
shares from one investor to another.
Some of the entities that are funct ional in a secondary market include –
1. Retail investors.
2. Advisory service providers and brokers comprising commission
brokers and security dealers, among others.
3. Financial intermediaries including non-banking financial companies,
insurance companies, banks and mutual funds.
4.2 NATURE OF SECONDARY MARKET
1. Gives liquidity to all investors. Any seller in need of cash can easily sell
the security due to the presence of a large number of buyers.
2. Very little time lag between any new news or information on the
comp any and the stock price reflecting that news. The secondary
market quickly adjusts the price to any new development in the
security.
3. Lower transaction costs due to the high volume of transactions.
4. Demand and supply economics in the market assist in price discovery.
5. An alternative to saving.
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33 6. Secondary markets face heavy regulations from the government as
they are a vital source of capital formation and liquidity for the
companies and the investors. High regulations ensure the safety of the
investor’s money.
Functions of Secondary Market
1. Economic Barometer: A stock exchange is a reliable barometer to
measure the economic condition of a country. Every major change in
country and economy is reflected in the prices of shares. The rise or fall
in the share prices indicates the boom or recession cycle of the
economy. Stock exchange is also known as a pulse of economy or
economic mirror which reflects the economic conditions of a country.
2. Pricing of Securities: The stock market helps to value the securities
on the b asis of demand and supply factors. The securities of profitable
and growth oriented companies are valued higher as there is more
demand for such securities. The valuation of securities is useful for
investors, government and creditors. The investors can kn ow the value
of their investment, the creditors can value the creditworthiness and
government can impose taxes on value of securities.
3. Safety of Transactions: In stock market only the listed securities are
traded and stock exchange authorities include the companies names in
the trade list only after verifying the soundness of company. The
companies which are listed they also have to operate within the strict
rules and regulations. This ensures safety of dealing through stock
exchange.
4. Contributes to Economi c Growth: In stock exchange securities of
various companies are bought and sold. This process of disinvestment
and reinvestment helps to invest in most productive investment
proposal and this leads to capital formation and economic growth.
5. Spreading of Equ ity Cult: Stock exchange encourages people to
invest in ownership securities by regulating new issues, better trading
practices and by educating public about investment.
6. Providing Scope for Speculation: To ensure liquidity and demand of
supply of securitie s the stock exchange permits healthy speculation of
securities.
7. Liquidity: The main function of stock market is to provide ready
market for sale and purchase of securities. The presence of stock
exchange market gives assurance to investors that their inves tment can
be converted into cash whenever they want. The investors can invest in
long term investment projects without any hesitation, as because of
stock exchange they can convert long term investment into short term
and medium term.
8. Better Allocation of Capital: The shares of profit making companies
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Financial Markets & Instiution
34 can easily raise fresh capital from stock market. The general public
hesitates to invest in securities of loss making companies. So stock
exchange facilitates allocation of investor’s fund to profitable
channels.
9. Promotes the Habits of Savings and Investment: The stock market
offers attractive opportunities of investment in various securities.
These attractive opportunities encourage people t o save more and
invest in securities of corporate sector rather than investing in
unproductive assets such as gold, silver, etc.
4.3 ORGANIZATION OF STOCK EXCHANGES
The first organized stock exchange in India was started in Bombay in
1875 with the formatio n of the “Native share and Stock Brokers
Association”. Thus the Bombay Stock Exchange is the oldest one in the
country. With the growth of Joint stock companies, the stock exchanges
also made a steady growth and at present these are 23 recognized stock
exchanges with about 6000 stock brokers.
1. Traditional Structure of stock Exchanges The stock exchanges in India
can be classified into two broad groups on the basis of their legal structure.
They are:
1. Three stock exchanges which are functioning as associati on of person
viz., BSE, ASE and Madhya Pradesh Stock Exchange.
2. Twenty stock exchanges which have been set up as companies, either
limited by guarantees or by shares.
3. They are
1. Bangalore Stock Exchange 2. Bhubaneswar Stock exchange 3. Calcutta
Stock Exchange 4. Cochin Stock Exchange 5. Coimbatore Stock
Exchange 6. Delhi Stock Exchange 7. Gauhati Stock Exchange 8.
Hyderabad Stock Exchange 9. Interconnected Stock Exchange 10. Jaipur
Stock Exchange 11. Ludhiana Stock
Exchange 12. Madras Stock Exchange 13. M agadh Stock Exchange 14.
Mangalore Stock Exchange 15.National Stock Exchange 16.Pune Stock
Exchange 17.OTCEI
2. Demutualization of Stock Exchanges The transition process of an
exchange from a ―mutually -owned association to a company ―owned
by Shareholders ‖ is called demutualization. Demutualization is
transforming the legal structure, of an exchange from a mutual form to a
business corporation form. In a mutual exchange, the three functions of
ownership, management and trading are intervened into a single group. It
means that the broker members of the exchange are owners as well as
traders on the exchange and further they themselves manage the exchange.
These three functions are segregated from one another after
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Secondary Markets Markets
35 1. The National Stock Exchange (NSE)
2. over the Counter Exchange of India (OTCEI)
3. Corporatization of Stock Exchanges The process of converting the
organizational structure of the stock exchange from a non -corporate
structure to a corporate structure is called Corporatization of stock
exchanges. As stated earlier, some of the stock exchanges were
established as Association in India of like BSE, ASE and MPSE.
Corporatization of thes e exchanges is the process of converting them into
incorporated companies.
Management: The recognized stocks exchanges are managed boards
consist of elected member directors from stock broker members, public
representatives and government nominees nominate d by the SEBI. The
government has also powers to nominate Presidents and Vice-presidents of
stock exchanges and to approve the appointment of the chief Executive and
public representatives. The major stock exchanges are managed by the
Chief Executive Direc tor and the smaller stock exchanges are under the
control of a Secretary.
Membership: To become a member of a recognized stock exchange, a
person must possess the following qualifications:
• He should be a citizen of India,
• He should not be less than 21 years of age,
• He should not have been adjudged bankrupt or insolvent,
• He should not have been convicted for an offence involving fraud or
dishonesty,
• He should not be engaged in any other business except dealing in
securities,
• He should not have been expelled by any other stock exchange or
declared a defaulterby any other stock exchange.
4.4 REGULATORY FRAMEWORK FOR STOCK
EXCHANGE IN INDIA
The growth of security market of a country is influenced by the legislative
measures taken by that country from time to ti me. The policy change has
great impact on the minds of public which ultimately affects their saving
habits. For effective mobilization of funds, it is necessary that the interest
of the potential investors should be protected adequately. In the pre -
indepen dence, the earliest legislation relating to stock market was
introduced in the 19* Century. This legislation was passed in 1865 but it
lost its impact due to outbreak of the American Civil War. Thereafter, the
Atly Stock Exchange Enquiry Committee was set -up in 1923. This
committee in its report, emphasized on necessity of the Stock Exchanges'
framing and maintaining a systematic set of rules and regulations in the munotes.in

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Financial Markets & Instiution
36 interest of the general investing public and of the trade itself. The next step
towards speci al legislation for controlling stock markets was Bombay
Securities Contracts Control Act, 1925. This Act gave certain powers to
government in regard to recognition of Stock exchanges etc. but this act
proved ineffective -in regulating security trading and government control
there under was nominal, practically. The Bombay Security Contracts
Control Act remained in force till the Securities Contract (Regulation) Act,
1956 enacted by the Central Government. The main Acts which effect the
Securities markets are Companies Act, 1956, Capital Issues Control Act,
1947, Securities Contract (Regulation) Act, 1956, Securities Contract
(Regulation) Rules 1957 and Securities and Exchange Board of India Act,
1992, which was set up as a Securities and Exchange Board of India
(SEBI) on April 1988. It took almost four years for the government to bring
about a separate legislation in the name of Securities and Exchange Board
of India Act, 1992 conferring statutory powers. The Act charged to SEBl
with comprehensive powers over practically all aspects of capital market
operations. The Securities and Exchange Board of India (SEBI), has
emerged as an important constituent of the system that now exists to
regulate, control and monitor the Indian Financial System (IFS) as certain
powers of some other constituents of this system have been delegated to
the SEBl.
Companies Act, 1956
After Independence, the Government of India passed various legislations
so that investors can have confidence while investing their savings. With a
view to p rotect the interest of a large number of shareholders and creditors
on healthy lines and to help the attainment of the ultimate ends of social
and economic policy of the Government, the Companies Act, 1956 was
passed. It was not enacted purely from legalis tic point of view but it was
also passed on the changing social needs of the country. The Companies
Act, 1956 which together with its amendments, is the substantive law in
our country today and contains a large number of new and startling
provisions for pu blic control over the functioning of joint stock
companies.
The following are the basic objectives of the Companies Act, 1956:
(a) Minimum assured standard of business integrity and conduct in the
promotion and management of companies;
(b) Full and fair disclosure of all reasonable information relating to
the affairs of the company;
(c) Effective participation and control by shareholders and the
protection of their legitimate interests;
(d) Enforcement of proper performance of their duties by the company
management; and
(e) Power of intervention and investigation into the affairs of
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37 of the shareholders or to the public interest. A company has to
operate with in the legal framework prevailing in the country. The
Companies Act deals with the formation and management of new
companies. With the growth of joint stock companies, the capital
market has taken a new turn in the development of the country.
The Capital Issues (Control) Act, 1947
Another ingredient of regul atory legislation is the Capital Issues (Control)
Act, 1947, 3 which prescribes the approval of the Controller of Capital
Issues for all issues of capital. It is one of the major instruments through
which the Government regulates the working of capital market
particularly the new issues. Capital issues control was first introduced
under the Defence of India Rule 94 -A which was promulgated on 17*
May, 1943 under the Defence of India Act, 1939, Capital Issue Control
was retained after the War and Defence Rule 94-A was replaced by the
Capital Issues (Continuance of Control) Act, in April, 1947. The main
objective of this pragmatic step was to ensure those investments in the
country in the various sectors of economy which takes place in a planned
manner and in a ccordance with the priorities laid down in the plans.
Despite of it, this legislation had the following objectives:
a) To protect the investing public;
b) To ensure that investments by the corporate sector were in accordance
with the plans and that they were not wasteful and in non-essential
channels;
c) To ensure that the capital structure of companies was sound and in the
public interest;
d) To ensure that there was no undue congestion of public issues in any
part of the year; and
e) To regulate the volume, terms and co nditions for foreign investment.
For the purpose of achieving the above objectives, an office of the
Controller of Capital Issues (CCI) was set-up.
It was entrusted with the responsibility of regulating the capital issues in
the Country. The CCI was vested with the powers to approve the kinds of
instruments, size, timing and premium of issues. The Capital Issues
(Control) Act, (CICA) is only of historical interest now as it was repealed
by the Capital Issues (Control) Repeal Act 1992. It played an important
part in the functioning of the Indian capital market for as many as 45 years
since 1947, and its provisions have now become the powers and functions
of the SEBI. It was administered by the Controller of Capital Issues (CCI)
in the Ministry of Finance, Department of Economic Affairs, Government
of India. While the Securities (Control) Repeal Act, (SCRA) mainly
regulates the secondary market. The CICA mostly regulates the primary or
new issue market for securities. The Act required companies to obtain
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Financial Markets & Instiution
38 of public and right issues. It empowered the Government of India (GOI) to
regulate the timing of new issues by private sector companies, the
composition of securities to be issued, interest (dividend) rates, which can
be offered on debentures and preference shares, the timing and frequency
of bonus issues, the amount of prior allotment to promoters, floatation
costs, and the premium to be charged on securities.
The Securities Contract (Regulation) Act, 1956
It was proved over time that the provision in Capital Issues (Control) Act
were totally inadequate to regulate the growing dimensions of capital
market activity. The government realized the necessity of creating a broad
based and a more secure environment for the business to grow. This led to
the enactment of Companies Act and Securities Contracts (Regulation)
Act in 1956. These legislations contained several provisions relating to the
issue of prospectus, disclosure of accounting and financial information and
listing of securities etc. The Securities Control (Regulation) Act, 1956
came into force throughout India on 20 Feb, 1957. This Act permits only
those exchanges which have been recognized by the Central Government
to function in any notified state or area. It prescribes the requirements
which a company must comply with before its shares can be listed on any
recognized stock exchange in the country. There is no statutory obligation
that every public limited company should get its s hares listed on a
recognized stock exchange. However, a company declaring in the
prospectus, its intention of applying for enlistment, is bound Under
Section 73 of the Companies Act, to make a listing application to the stock
exchange concerned. It is also bound to abide by the prescribed
requirements in order to have its shares admitted to dealings failing which;
it has to refund the application money to those who have subscribed for
the share capital. Further, the Government reserves the powers under
section 21 of the Securities Contracts (Regulation) Act, 1956 to compel a
Public Limited Company when it is so necessary or expedient, in the
interest of the trade or of the public to comply with the prescribed
requirements and list its shares on a recognized stock exchange. The
objective of the Securities Contracts (Regulation) Act (SCRA) is to
regulate the working of stock exchanges or secondary market with a view
to prevent undesirable transactions or speculation in securities, and thereby,
to build up a healthy and strong investment market in which the public
could invest with confidence. It empowers the GOl to recognize and
derecognize the stock exchanges, to stipulate laws and by -laws for their
functioning, and to make the listing of securities mandatory on stock
exchanges by Public Limited Companies (PULCOs). It prohibits securities
transactions outside the recognized stock exchanges. It lays down that all
contracts in securities except short delivery contracts, can be entered only
between and through the members of recognized stock exchanges. It
prescribes conditions or requirements for listing of securities on
recognized stock exchanges. It empowers the GOI to supersede the
governing bodies of stock exchanges, to suspend business on recognized
stock excha nges, to declare certain contracts illegal and void under certain
circumstances, to prohibit contracts in certain cases, to license the security
dealers, and to lay down penalties for contravention of the provision of the munotes.in

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39 Act. It is administrated by the Mi nistry of Finance, Department of
Economic Affairs, GOI. This Act aims at having a strong and healthy
investment market so that members of the public may invest their savings
with full confidence.
The Reserve Bank of India (RBI)
The financial system deals in other people's money and, therefore, their
confidence, trust and faith in it is crucially important for its smooth
functioning. Financial regulation is necessary to generate, maintain and
promote this trust. One reason why the public trust may be lost is that some
of the savers or investors or intermediaries may imprudently take too
much risk, which could engender defaults, bankruptcies, and insolvencies.
A regulation is needed to check prudence in the system. The modern
trading technology and the possibi lity of high leveraging enable market
participants to take large stake which are disproportionate with their own
investments. There are frequent instances of dishonest, unfair, fraudulent,
and unethical practices or activities of the market intermediaries or
agencies such as brokers, merchant bankers, custodians, trustees, etc. The
regulation becomes necessary to ensure that the investors are protected;
that disclosure and access to information are adequate, timely, and equal;
that the participants measure upto the rules of the market place; and that
the markets are both fair and efficient. To regulate financial system, RBI
has special role and responsibility. The RBI, as the central bank of the
Countiy, is the centre of Indian financial and monetary system. As the apex
institution, it has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the Indian Financial System (IFS) since its
inception. It started functioning from April 1, 1935 on the terms of the
Reserve Bank of India Act, 1934. It was a private shareholders' institution
till January, 1949, after which, it became a State -owned institution under
the Reserve Bank (Transfer to Public Ownership) of India Act, 1948. This
Act empowers the Central Government, in consultation with the Governor
of the Bank, to issue such directions to it as they might consider necessary
in the public interest. Further, the Governor and all the Deputy Governors
of the Bank are appointed by the Central Government. The Bank is
managed by a Central Board of Directors; four Local Boards are to
advise the Central Board on matters referred to them. They are also
required to perform duties as are delegated to them. The final control of
the Bank vests in the Central Board which comprises the Governor, four
Deputy Governors, and fifteen Directors nominated by the Central
Government. The committee of the Central Board consists of the
Governor, the Deputy Governor and such other Directors as may be
present at a given meeting.
Securities and Exchanges Board of India (SEBI) Act, 1992
The year 1991 witnessed a big push being given to liberalization and
reforms in the Indian financial sector. For sometime thereafter, the volume
of business in the primary and secondary securities markets increased
significantly. As part of the same reform process, the globalization or
internationalization of the Indian financial system made it vulnerable to munotes.in

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40 external shocks. The multi -crore securities scam rocked the IFS in 1992.
All these developments impressed on the authorities the nee d to have in
place a vigilant regulatory body or an effective and efficient watchdog. It
was felt that the then existing regulatory framework was fragmented, ill -
coordinated, and inadequate and that there was a need for an autonomous,
statutory, integrated organization to ensure the smooth functioning of the
IFS. The SEBI came into being as a response to these requirements. The
SEBI was established on April 12, 1988 through an administrative order,
but it became a statutory and really powerful organization only since 1992.
The CICA was repealed and the office of the CCl was abolished in 1992,
and SEBl was set -up on 21 February, 1992 through an ordinance issued on
30 January, 1992. The ordinance was replaced by the SEBI Act on 4 April,
1992. Certain powers un der certain sections of SCRA and CA have been
delegated to the SEBI. The regulatory powers of the SEBI were increased
through the Securities Laws (Amendment) Ordinance of January, 1995
which were subsequently replaced by an Act of Parliament. The SEBI is
under the overall control of the Ministry of Finance, and has its head office
at Mumbai. It has become now a very important constituent of the
financial regulatory framework in India. The philosophy underlying the
creation of the SEBI is that multiple regul atory bodies for securities
industry i.e. the regulatory systems get divided, causing confusion among
market participants as to who is really in command. In a multiple
regulatory structure, there is also an overlap of functions of different
regulatory bodies. Through the SEBI, the regulation model which is sought
to be put in place in India, is one in which every aspect of securities
market regulation is entrusted to a single highly visible and independent
organization, which is backed by a statute, and whi ch is accountable to the
Parliament and in which investors can have trust.
4.5 DEFECTS IN WORKING OF INDIAN STOCK
EXCHANGE
1. Speculative activities: Most of the transactions in stock exchange are
carry forward transactions with a speculative motive of derivi ng
benefit from short term price fluctuation. Genuine transactions are
only less. Hence market is not subject to free interplay of demand and
supply for securities.
2. Insider trading: Insider trading has been a routine practice in India.
Insiders are those who have access to unpublished price -sensitive
information. By virtue of their position in the company they use such
information for their own benefits.
3. Poor liquidity: The Indian stock exchanges suffer from poor liquidity.
Though there are approximately 8000 listed companies in India, the
securities of only a few companies are actively traded. Only those
securities are liquid. This means other stocks have very low liquidity.
4. Less floating securities: There is scarcity of floating securities in the
Indian st ock exchanges. Out of the total stocks, only a small portion is
being offered for sale. The financial institutions and joint stock munotes.in

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41 companies control over 75% of the scrips. However, they do not offer
their holdings for sale. The UTI, GIC, LIC etc. indulge more in
purchasing than in selling. This creates scarcity of stocks for trading.
Hence, the market becomes highly volatile. It is subject to easy price
manipulations.
5. Lack of transparency: Many brokers are violating the regulations
with a view to cheating the innocent investing community. No
information is available to investors regarding the volume of
transactions carried out at the highest and lowest prices. In short, there is
no transparency in dealings in stock exchanges.
6. High volatility: The Indian stock market is subject to high volatility in
recent years. The stock prices fluctuate from hour to hour. High
volatility is not conducive for the smooth functioning of the stock
market.
7. Dominance of financial institutions: The Indian stock market is being
dominated by few financial institutions like UTI, LIC, GIC etc. This
means these few institutions can influence stock market greatly. This
actually reduces the level of competition in the stock market. This is
not a healthy trend for the growth of any stock market.
8. Competition of merchant bankers: The increasing number of
merchant bankers in the stock market has led to unhealthy competition
in the stock market. The merchant bankers help the unscrupulous
promoters to raise funds for non - existent projects. Inv estors are the
ultimate sufferers.
9. Lack of professionalism: Some of the brokers are highly competent
and professional. At the same time, majority of the brokers are not so
professional. They lack proper education, business skills, infrastructure
facilities etc. Hence they are not able to provide proper service to their
clients.
SEBI measures for Secondary Market
SEBI has introduced a wide range of reforms in the secondary market.
These can be discussed under the headings, namely, Governing Body of
the stock exchange. Infrastructure Development of the stock exchange,
Settlement and Clearing, Debt Market Segment, Price Stabilization,
Delisting, Brokers; and insider trading.
Governing Body of the stock exchange
1. The Board of directors of stock exchange has to be reconstituted so as
to include non - members, public representatives, government
representatives to the extent of 50% of total number of members.
2. Capital adequacy norms should be complied with regard to members
of various stock exchanges on the basis of their turnover of trade.
3. Working hours of stock exchanges should be from 12 noon to 3 p.m. munotes.in

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42 4. All recognized stock exchanges should report about their transactions
within 24 hours.
Infrastructure Development of Stock Exchange
Sufficient infrastructure should be available in any stock exchange to
facilitate trade. For example, National Stock Exchange, (NSE) was set up
with sophisticated screen -based trading. SEBI grants recognition only to
those new stock exchanges which have online screen -based trading
facility.
Settlement and Clearing
SEBI has withdrawn carry forward transactions and introduced certain
modified regulations. All stock exchanges should follow the practice of
weekly settlement. Apart from this, SEBI has instructed all stock
exchanges to set up clea ring houses, clearing corporations or settlement
guarantee fund for ensuring prompt settlement of the transactions. SEBI
has allowed institutional investors, foreign investments, stock brokers to
avail the facility of warehousing of trade.
Debt Market Segm ent
NSE has a wholesale debt market segment to enable the traders to trade in
debt instruments. SEBI has allowed the listing of debt instruments of those
companies which have not even listed their equity shares previously.
Foreign institutional investors h ave been permitted to invest up to 100
percent of the funds in debt instruments of Indian companies.
Price Stabilization
SEBI keeps a constant watch over the unusual fluctuations in prices. It has
instructed the stock exchanges to monitor the prices of newly listed
securities. When there is an abnormal price variation in newly listed
securities, SEBI would impose additional margin on purchase of such
securities. SEBI has also introduced adequate measures to prevent price
rigging and circular trading.
Delist ing
SEBI has streamlined the norms for delisting of securities from stock
exchanges. In case of voluntary delisting from regional stock exchanges,
the company would offer to buy the shares from shareholders of the region.
Moreover, it also stipulates that the listing fee for three years be paid by the
company concerned at the time of delisting.
Brokers SEBI has regulated the functioning of brokers through the
following measures:
1. Each broker and sub-broker should get their names registered with the
stock exchange.
2. Capital adequacy norms have been fixed for the brokers in order to
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43 3. A code of conduct has been laid down for their discharge of duties,
resulting in the execution of orders, issue of cont ract note, breach of
trust, being fair to clients; and rendering investment advice.
4. Audit of the books of brokers and filing of audit report with SEBI
have been made compulsory.
5. Brokers should preserve the books of accounts and other records for a
minimum period of five years. SEBI has the right to inspect the books,
records and documents of the brokers.
6. Brokers should disclose transaction price and brokerage separately in
the contract notes issued to their clients to ensure transparency in the
broker -clien t relationship.
7. Brokers cannot underwrite more than 5% of public issue.
Overview of National Stock Exchange (NSE)
National Stock Exchange of India Limited (NSE) is the leading stock
exchange of India, located in Mumbai, Maharashtra. NSE was established
in 1992 as the first dematerialized electronic exchange in the country. NSE
was the first exchange in the country to provide a modern, fully automated
screenbased electronic trading system which offered easy trading facilities
to investors spread across the length and breadth of the country.
Historical Overview
National Stock Exchange was incorporated in the year 1992 to bring about
transparency in the Indian equity markets. Instead of trading memberships
being confined to a group of brokers, NSE ensured that anyone who was
qualified, experienced and met the minimum financial requirements were
allowed to trade. In this context, NSE was ahead of its time when it
separated ownership and management of the exchange under SEBI's
supervision. Stock price information which could earlier be accessed only
by a handful ofpeople could now be seen by a client in a remote location
with the same ease. The paperbased settlement was replaced by electronic
depository -based accounts and settlement of trades was always done on
time. One of the most critical changes involved a robust risk management
system that was set in place, to ensure that settlement guarantees would
protect investors against broker defaults. NSE was set up by a group of
leading Indian financial institutions at the behest of the Government of
India to bring transparency to the Indian capital market. Based on the
recommendations laid out by the Pherwani committee, NSE was
established with a diversified shareholding comprising domestic and
global investors. The key domestic investors include Life Insurance
Corporation, State Bank of India, IFCI Limited , IDFC Limited and Stock
Holding Corporation of India Limited. Key global investors include Gagil
FDI Limited, GS Strategic Investments Limited, SAIF II SE Investment s
Mauritius Limited, Aranda Investments (Mauritius) Pte Limited and PI
Opportunities Fund I.[10] The exchange was incorporated in 1992 as a tax -
paying company and was recognized as a stock exchange in 1993 under munotes.in

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44 the Securities Contracts (Regulation) Act, 1956, when P. V. Narasimha
Rao was the Prime Minister of India and Manmohan Singh was the
Finance Minister. NSE commenced operations in the Wholesale Debt
Market (WDM) segment in June 1994. The capital market (equities)
segment of the NSE commenced operatio ns in November 1994, while
operations in the derivatives segment commenced in June 2000. NSE
offers trading, clearing and settlement services in equity, equity derivative,
debt, commodity derivatives, and currency derivatives segments. It was
the first exc hange in India to introduce an electronic trading facility thus
connecting the investor base of the entire country. NSE has 2500 VSATs
and 3000 leased lines spread over more than 2000 cities across India. NSE
was also instrumental in creating the National Securities Depository
Limited (NSDL) which allows investors to securely hold and transfer their
shares and bonds electronically. It also allows investors to hold and trade
in as few as one share or bond. This not only made holding financial
instruments convenient but more importantly, eliminated the need for paper
certificates and greatly reduced incidents involving forged or fake
certificates and fraudulent transactions that had plagued the Indian stock
market. The NSDL's security, combined with the transp arency, lower
transaction prices and efficiency that NSE offered, greatly increased the
attractiveness of the Indian stock market to domestic and international
investors. NSE EMERGE NSE EMERGE is NSE's new initiative for Small
and medium -sized enterprises (SME) & Start -up companies in India.
These companies can get listed on NSE without an Initial public offering
(IPO). This platform will help SME's & Startups connect with investors and
help them with the raising of funds.[12] In August 2019, the 200th
comp any listed on NSE's SME platform. Markets NSE offers trading and
investment in the following segments: Equity: Equity, Indices, Mutual
fund, Exchange -traded funds, Initial public offerings, Security Lending
and Borrowing etc. Derivatives: Equity Derivative s Currency derivatives,
Commodity Derivatives, Interest rate futures Debt: Corporate bonds
Overview of Bombay Stock Exchange The BSE, formerly known as the
Bombay Stock Exchange Ltd. is an Indian stock exchange located at Dalal
Street, Mumbai. Established in 1875, it is Asia's oldest stock exchange.
The BSE is the world's 10th largest stock exchange with an overall market
capitalization of more than US$2.2 trillion on as of April 2018. Historical
Overview While BSE Ltd is now synonymous with Dalal Street, i t was not
always so. In 1850s, five stock brokers gathered together under Banyan
tree in front of Mumbai Town Hall, where Horniman Circle is now
situated. A decade later, the brokers moved their location to another leafy
setting, this time under banyan trees at the junction of Meadows Street and
what was then called Esplanade Road, now Mahatma Gandhi Road. With a
rapid increase in the number of brokers, they had to shift places repeatedly.
At last, in 1874, the brokers found a permanent location, the one th at they
could call their own. The new place was, aptly, called Dalal Street
(Brokers' Street). The brokers group became an official organization
known as "The Native Share & Stock Brokers Association" in 1875. On
August 31, 1957, the BSE became the first s tock exchange to be
recognized by the Indian Government under the Securities Contracts munotes.in

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45 Regulation Act. In 1980, the exchange moved to the Phiroze Jeejeebhoy
Towers at Dalal Street, Fort area. In 1986, it developed the S&P BSE
SENSEX index, giving the BSE a means to measure the overall
performance of the exchange. In 2000, the BSE used this index to open its
derivatives market, trading S&P BSE SENSEX futures contracts. The
development of S&P BSE SENSEX options along with equity derivatives
followed in 2001 a nd 2002, expanding the BSE's trading platform.
Historically an open outcry floor trading exchange, the Bombay Stock
Exchange switched to an electronic trading system developed by CMC Ltd.
in 1995. It took the exchange only 50 days to make this transition. This
automated, screen -based trading platform called BSE On -Line Trading
(BOLT) had a capacity of 8 million orders per day. Now BSE has raised
capital by issuing shares and as on 3 May 2017 the BSE share which is
traded in NSE only closed with Rs.999. The BSE is also a Partner
Exchange of the United Nations Sustainable Stock Exchange initiative,
joining in September 2012. BSE established India INX on 30 December
2016. India INX is the first international exchange of India. BSE launches
commodity derivatives contract in gold, silver. Today BSE provides an
efficient and transparent market for trading in equity, currencies, debt
instruments, derivatives, mutual funds. BSE SME is India’s largest SME
platform which has listed over 250 companies and continues to g row at a
steady pace. BSE StAR MF is India’s largest online mutual fund platform
which process over 27 lakh transactions per month and adds almost 2 lakh
new SIPs ever month. BSE Bond, the transparent and efficient electronic
book mechanism process for pri vate placement of debt securities, is the
market leader with more than Rs 2.09 lakh crore of fund raising from 530
issuances. (F.Y.2017 -2018).
Recent Trends
Keeping in line with the vision of Shri Narendra Modi, Hon’be Prime
Minister of Inida, BSE has launched India INX, India's 1st international
exchange, located at GIFT CITY IFSC in Ahmedabad. Indian Clearing
Corporation Limited, a wholly owned subsidiary of BSE, acts as the
central counterparty to all trades executed on the BSE trading platform
and provi des full innovation, guaranteeing the settlement of all bonafide
trades executed. BSE Institute Ltd, another fully owned subsidiary of BSE
runs one of the most respected capital market educational institutes in the
country. BSE has also launched BSE Sammaa n, the CSR exchange, is a 1st
of its kind initiative which aims to connect corporate with verified NGOs
BSE's popular equity index - the S&P BSE SENSEX - is India's most
widely tracked stock market benchmark index. It is traded internationally
on the EUREX as well as leading exchanges of the BRCS nations (Brazil,
Russia, China and South Africa)
Overview of OTC Exchange of India
The OTC Exchange of India (OTCEI), also known as the Over -the-
Counter Exchange of India, is based in Mumbai, Maharashtra. It is Ind ia's
first exchange for small companies, as well as the first screen -based
nationwide stock exchange in India. OTCEI was set up to access high-munotes.in

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46 technology enterprising promoters in raising finance for new product
development in a cost-effective manner and to provide a transparent and
efficient trading system to investors. OTCEI is promoted by the Unit Trust
of India, the Industrial Credit and Investment Corporation of India, the
Industrial Development Bank of India, the Industrial Finance Corporation
of India, and other institutions, and is a recognized stock exchange under
the SCR Act. The OTC Exchange Of India was founded in 1990 under the
Companies Act 1956 and was recognized by the Securities Contracts
Regulation Act, 1956 as a stock exchange. The OTCEI i s no longer a
functional exchange as the same has been de-recognized by SEBI vide its
order dated 31 Mar 2015. Features of the Over -The- Counter Exchange of
India (OTCEI) The OTCEI has some special features that make it a unique
exchange in India as well a s being a growth catalyst for small - to medium -
sized companies.
The following are some of its unique features:
1. Stock Restrictions: Stocks that are listed on other exchanges will not
be listed on the OTCEI and conversely, stocks listed on the OTCEI
will not be listed on other exchanges.
2. Minimum Capital Requirements: The requirement for the
minimum issued equity capital is 30 lakh rupees, which is
approximately $40,000.
3. Large Company Restrictions: Companies with issued equity capital
of more than 25 crore rupees ($3.3 million) are not allowed to be
listed.
4. Member Base Capital Requirement: Members must maintain a base
capital of 4 lakh rupees ($5,277) to continue to be listed on the
exchange.
Over -The-Counter Exchange of India (OTCEI) Listing Requirements
Thoug h the requirements of the OTCEI make it easier for small - to mid -
cap sized companies to be listed, there are still some requirements that
companies must meet before being allowed to be listed. Listing does
require sponsorship from members of the OTCEI and it needs to have two
market makers. In addition, once a company is listed, it cannot be delisted
for at least three years, and a certain percentage of issued equity capital
needs to be kept by promoters for a minimum of three years. This
percentage is 20%.
Transactions on the Over -The-Counter Exchange of India (OTCEI) The
transactions on the OTCEI revolve around the dealers. Dealers operate in a
few capacities, the two most important being as a broker and as a market
maker. As a broker, the dealer transacts on behalf of buyers and sellers. As
a market maker, the dealer has to ensure the availability of the shares for
transaction purposes as well as to ensure that the price remains reasonable
through supply and demand levels. In addition to the dealers, the O TCEI
also has custodians. The custodian, or settler, is the individual that
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47 functioning of the OTCEI. These tasks include validating and storing
documents as well as facilitating daily clearing transactions. The last
group of players consists of the registrars and transfer agents that make
sure the correct transfer and allotment of shares take place.
Recent Trends OTC Exchange of India introduced certain new concepts in
the Indian trading system:
1. Screen based nationwide trading known as OTCEI Automated
Securities Integrated System or OASIS
2. Market Making
3. Sponsorship of companies
4. Trading done in share certificates
5. Weekly Settlement Cycle
6. Short Selling
7. Demat trading through National Securit ies Depository Limited for
convenient paperless trading
8. Tie-up with National Securities Clearing Corporation Ltd for
Clearing. Listing of Securities - Meaning Listed Securities are shares,
debentures or any other securities that is traded through an exchang e such
as BSE, NSE, etc. When a private company decides to go public and issue
shares, it will need to choose an exchange on which to be listed. To do so, it
must be able to meet that exchange's listing requirements and pay both the
exchange's entry and yearly listing fees. Listing requirements vary by
exchange and include minimum stockholder's equity, a minimum share
price and a minimum number of shareholders. Exchanges have listing
requirements to ensure that only high quality securities are traded on them
and to uphold the exchange's reputation among investors.
Merits of Listing Securities Listing offers advantages to both the investors
as well as the companies. Merits of listing of Securities to investors
1. It provides liquidity to investments. Security ho lders can convert their
securities into cash by selling them as and when they require.
2. Shares are traded in an open auction market where buyers and sellers
meet. It enables an investor to get the best possible price for his
securities.
3. Ease of entering into either buy or sell transactions.
4. Transactions are conducted in an open and transparent manner subject
to a well defined code of conduct. Therefore investors are assured of
fair dealings.
5. Listing safeguards investor’s interests. It is because listed compa nies
have to provide clear and timely information to the stock exchanges munotes.in

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48 regarding dividends, bonus shares, new issues of capital, plans for
mergers, acquisitions, expansion or diversification of business. This
enables investors to take informed decisions.
6. Listed securities enable investors to apply for loans by providing them
as collateral security.
7. Investors are able to know the price changes through the price
quotations provided by the stock exchanges in case of listed securities.
8. Listing of shares in stock exchanges provides investors facilities for
transfer, registration of rights, fair and equitable allotment. 9. Share
holders are provided due notice with regard to book closure dates, and
they can take investment decisions accordingly.
Merits of listin g to companies
1. Listed securities are preferred by the investors as they have better
liquidity.
2. Listing provides wide publicity to the companies since their name is
mentioned in stock market reports, analysis in newspapers, magazines,
TV news channels. This increases the market for the securities. As
Hasting has observed,
3. Listing provides a company better visibility and improves its image
and reputation.
4. It makes future financing easier and cheaper in case of expansion or
diversification of the business.
5. Growth and stability in the market through broadening and
diversification of its shareholding. 6. Listing attracts interest of
institutional investors of the country as well as foreign institutional
investors. 7. Listing enables a company to know its market v alue and
this information is useful in case of mergers and acquisitions, to arrive
at the purchase consideration, exchange ratios etc. 8. By complying
with the listing requirements, the operations of the company become
more transparent and investor friendl y. It further enhances the
reputation of the company. Demerits of listing Securities Listing is not
without its limitations.
The following are the limitations of listing:
1. Listing might enable speculators to drive up or drive down prices at
their will. The violent fluctuations in share prices affect genuine
investors.
2. In case of excessive speculation, share prices might not reflect its
fundamentals. The stock markets may fail to be the true economic
barometer of an economy’s performance.
3. In case of bear mark ets share prices might be hammered down, and the
standing of a company might be lowered in the eyes of the investors, munotes.in

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49 shareholders, bankers, creditors, employees etc.
4. Listing of securities may induce the management and the top level
employees to indulge in ‘insider trading‘by getting access to important
information. Such actions adversely affect the common security
holders.
5. The management might enter into an agreement with brokers to
artificially increase prices before a fresh issue and benefit from that.
Common public might be induced to buy shares in such companies,
ultimately the prices would crash and the common investors would be
left with worthless stock of securities.
6. Listing requires disclosing important sensitive information to stock
exchanges such as plans for expansion, diversification, selling of
certain businesses, acquisition of certain brands or companies etc.
Such information might be used by the competitors to gain advantage.
7. Outsiders might acquire substantial shares in the company and threa ten
to take over the company or they might demand hefty compensation to
sell their shares.
8. Stock exchanges in India still suffer from shortcomings. Listed
securities might be utilized by scamsters to indulge in scams.
Objectives of Listing The major object ives of listing are
1. To provide ready marketability and liquidity of a company’s securities.
2. To provide free negotiability to stocks.
3. To protect shareholders and investors interests.
4. To provide a mechanism for effective control and supervision of
trading.
Listing requirements
A company which desires to list its shares in a stock exchange has to
comply with the following requirements:
1. Permission for listing should have been provided for in the
Memorandum of Association and Articles of Association.
2. The company should have issued for public subscription at least the
minimum prescribed percentage of its share capital (49 percent).
3. The prospectus should contain necessary information with regard to
the opening of subscription list, receipt of share application etc.
4. Allotment of shares should be done in a fair and reasonable manner. In
case of over subscription, the basis of allotment should be decided by
the company in consultation with the recognized stock exchange where
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50 5. The co mpany must enter into a listing agreement with the stock
exchange. The listing agreement contains the terms and conditions of
listing. It also contains the disclosures that have to be made by the
company on a continuous basis.
Minimum Public Offer A compa ny which desires to list its securities in a
stock exchange, should offer at least sixty percent of its issued capital for
public subscription. Out of this sixty percent, a maximum of eleven
percent in the aggregate may be reserved for the Central governme nt, State
government, their investment agencies and public financial institutions.
The public offer should be made through a prospectus and through
newspaper advertisements. The promoters might choose to take up the
remaining forty percent for themselves, or allot a part of it to their
associates.
Fair allotment Allotment of shares should be made in a fair and
transparent manner. In case of over subscription, allotment should be
made in an equitable manner in consultation with the stock exchange
where the shares are proposed to be listed. In case, the company proposes to
list its shares in more than one exchange, the basis of allotment should be
decided in consultation with the stock exchange which is located in the
place in which the company’s registered office is located.
Listing Procedure
1. Decision about listing on the Exchange: The company compares the
benefits of a presence on the Exchange (the “profit” of the listing) with
the challenges connected with it (primarily the disclosure obligations of
its pres ence on the Exchange, but also one -off and ongoing expenses).
If the company considers that the benefits outweigh the costs of listing,
it may then decide to apply for a listing on the Exchange.
2. Selection of the contributors: The first and most important task during
the preparatory phase is the selection of the contributing players.
Investment firms have a dual role. On the one hand, they carry out
advisory services, the preparation of the issue process, and the
transaction itself, while on the other hand t hey offer/sell the securities
to the public. In a public offering, they also provide an underwriting
guarantee on behalf of the issuer. Fees are generally charges in
accordance with these main services. Choosing the right investment
firm is of paramount importance since this is the player who will
assist the issuer during the entire listing process and who organises
this multiplayer and complex negotiation. It is reasonable to select the
advising bank (or banks) based on a tender, and selecting the other
players together with the advising bank is recommended. The issuer
has to make preparations even prior to the selection of the advisor and
needs to have knowledge of the qualification criteria and the
requirements expected during the selection and listing pr ocess.
Auditors’ responsibility is far larger and far more complex in the case
of a public company and transactions resulting in an increase in the
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51 auditor prepares a more detailed financial report (the so -called long
form report) in the preparation of a listing, and its tasks often include
an assessment (but not a certification) of the management's earnings
forecasts. Legal advisors deal with the examination of the legal status,
significant contracts and legal relationships of the issuer, as well as
with the documentation of shareholder rights (statutes, deed of
foundation, shareholders’ agreements etc.). Legal advisors’ main task
is to prepare a final report. The role of lawyers is very important in the
preparation of a public offering, subscription and underwriting
contracts linked to the sale of shares. Given that at this stage of the
process the interests of the issuer and of the lead manager may differ,
both parties often have th eir own legal counsel. Marketing and PR
advisors provide assistance with the distribution of shares during the
public offering and with marketing the securities to potential buyers.
These advisors participate in organising road shows preceding the sale
of the shares and in providing logistic services. If the company intends
to make a simple listing on the Exchange, it is not necessary to involve
all of the players listed above – the respective regulation does not
require the contribution of an advisor in th is case. Still, if a package of
new or existing shares is to be sold to the public, contribution of an
investment firm has to be involved.
3. Preparations for listing on the Exchange: The Company shall
prepare not only for the listing, but for the maintenance associated
with listing on the Exchange. It is necessary that an appropriate level
of investor relations and a harmonisation of the internal corporate
processes among the different business units are ensured. It is
particularly important in the case of a public offering, but also useful
in a simple listing, to devise an appropriate marketing campaign at this
stage.
4. Preparation of a prospectus: The most important document of a
listing is the so -called prospectus. The prospectus shall contain all
relevant information on the economic, market, financial and legal
situation of the company (and their likely developments in the future),
giving investors the widest possible range of information to ensure
proper decision -making. The prospectus shall explicitly conta in a
statement that the shares are to be listed on an Exchange and shall
indicate as a prime risk factor, if no investment firms participated in its
compilation. The prospectus prepared for a listing on the BSE shall be
submitted for approval to the Centra l Bank of Hungary, which shall
make a decision within 20 working days. Issuing the Prospectus can
only be done following the MNB’s approval. As a consequence of
Hungary ’s EU membership and on the basis of a “single passport”,
the BSE also accepts prospect uses approved by the supervisory
authority of any other EU member state. The provisions regarding the
contents of the prospectus are determined by the respective EU
regulation.
5. Compilation of the listing documentation: This documentation
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52 documents (to assist in this, the Exchange has compiled an application
form).
6. Official submission of the listing documentation to the Exchange
(application for listing): In order to ensure smoother administration, it
is recommended that an unofficial draft version of the application be
submitted to the Exchange for a preliminary assessment prior to the
official submission of listing documentation. This shall be followed by
the official submission of the papers already agreed upon.
7. Public notice of new listing applications: Subsequent to the receipt
of the application, the Exchange issues a public notice informing the
market of the receipt of the application.
8. Review of the application: The Exchange has 10 Exchange days to
review the application and must make a decision within 30 calendar
days of its receipt. If necessary, the Exchange may request the issuer to
submit any missing documents, and the issuer shall appropriately
supplement the documentation wi thin ten working days – in such
cases, the deadline for the assessment by the Exchange shall be
extended by the period needed to submit the missing documents.
9. Publications on the Exchange website regarding the listing: The
documents relevant to investors s hall be published at least two
Exchange days before the listing. 10. If the documentation is complete
and appropriate, a decision on listing shall be made (otherwise, the
application shall be rejected). 11. First trading day Trading in the
shares officiall y commences on the Exchange.
Delisting of Securities
Delisting of securities means removal of the securities of a listed company
from the stock exchange. It may happen either when the company does not
comply with the guidelines of the stock exchange, or th at the company has
not witnessed trading for years, or that it voluntary wants to get delisted or
in case of merger or acquisition of a company with/by some other
company. So, broadly it can be classified under two head:
1. compulsory delisting.
2. Voluntary delisting.
Compulsory delisting refers to permanent removal of securities of a listed
company from a stock exchange as a penalizing measure at the behest of
the stock exchange for not making submissions/comply with various
requirements set out in the Listing agreement within the time frames
prescribed. In voluntary delisting, a listed company decides on its own to
permanently remove its securities from a stock exchange. This happens
mainly due to merger or amalgamation of one company with the other or
due to t he non - performance of the shares on the particular exchange in the
market.
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53 A stock exchange may compulsorily delist the shares of a listed company
under certain circumstances like:
1. Non-compliance with the Listing Agreement for a minimum period of
six mont hs.
2. Failure to maintain the minimum trading level of shares on the
exchange.
3. promoters', Directors' track record especially with regard to insider
trading, manipulation of share prices, unfair market practices (e.g.
returning of share transfer documents un der objection on frivolous
grounds with a view to creating scarcity of floating stock, in the
market causing unjust aberrations in the share prices, auctions, close -
out, etc.
4. The company has become sick and unable to meet current debt
obligations or to adequately finance operations, or has not paid interest
on debentures for the last 2 -3 years, or has become defunct, or there
are no employees, or liquidator appointed, etc
Where the securities of the company are delisted by an exchange under
this method, the promoter of the company shall be liable to compensate the
security -holders of the company by paying them the fair value of the
securities held by them and acquiring their securities, subject to their
option to remain security -holders with the company. In such a case there is
no provision for an exit route for the shareholders except that the stock
exchanges would allow trading in the securities under the permitted
category for a period of one year after delisting. Companies may upon
request get voluntarily delisted from any stock exchange other than the
regional stock exchange, following the delisting guidelines. In such cases,
the companies are required to obtain prior approval of the holders of the
securities sought to be delisted, by a special resolution at a General
Meeting of the company. The shareholders will be provided with an exit
opportunity by the promoters or those who are in the control of the
management.
The SEBI (Delisting of Securities) Guidelines 2003
The SEBI (Delisting of Securities) Guide lines 2003 is the regulating Act
framing the guidelines and the procedure for delisting of securities. Under
this the prescribed procedure is:
1. The decision on delisting should be taken by shareholders though a
special resolution in case of voluntary delisting & though a panel to be
constituted by the exchange comprising the following in case of
compulsory delisting: Two directors/ officers of the exchange (one
director to be a public representative). One representative of the
investors. One representative from the Central government
(Department of Company Affairs) / regional director/ Registrar of
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54 2. Due notice of delisting and intimation to the company as well as other
Stock Exchanges where the company's securities are listed to be given.
3. Notice of termination of the Listing Agreement to be given.
3. making an application to the exchange in the form specified, annexing
a copy of the special resolution passed by the shareholders in case of
voluntary delisting.
4. Public announcement to be made in this regard with all due
information.
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55 5
EMERGING MARKETS AND PRODUCTS
Unit Structure
5.0 Learning Objectives
5.1 Introduction
5.2 Concept of Emerging Markets and Products
5.3 Alternate finance products and players
5.3.1 Crowdfunding
5.3.2 Product to product finance
5.3.3 Interest -free financial products
5.3.4 Thematic indexe s
5.4 Summary
5.5 Unit End Questions
5.6 References
5.0 LEARNING OBJECTIVES
After studying this unit, you will be able:
 To discuss the concept of Emerging Markets and Products
 To understand alternate finance products and players
 To explain Crowdfunding
 To discuss Product to product finance
 To describe Interest -free financial products
 To understand Thematic indexes
5.1 INTRODUCTION
An economy of a developing country that is expanding and becoming
increasingly integrated with international markets is known as an
emerging mar ket economy. Countries possessing some but not all of a
developed market's features are categorised as emerging market
economies.
Strong economic development, high per capita income, liquid equities
and debt markets, accessibility to foreign investors, and a stable
regulatory structure are some traits of developed markets.
An emerging market economy often integrates more into the global
economy as it grows. This implies that it may result in higher trade
volume, foreign direct investment, and increased liqu idity in the local
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56 financial entities. Currently, significant emerging market nations include
Saudi Arabia, China, Brazil, Mexico, Russia, and Pakistan.
A significant transition from a low income, less developed, frequently
pre-industrial economy to a modern, industrial economy with a greater
standard of living is occurring in an emerging market economy.
5.2 CONCEPT OF EMERGING MARKETS AND
PRODUCTS
“Emerging markets” is a term that refers to an economy that experiences
considerable economic growth and possesses some, but not all,
characteristics of a developed economy. Emerging markets are countries
that are transitioning from the “developing” phase to the “developed”
phase.
Characteristics o f Emerging Markets
Some common characteristics of emerging markets are illustrated below:
1. Market volatility
Political unrest, changes in external prices, and/or supply -demand shocks
as a result of natural disasters are the main causes of market volatili ty.
Investors are subjected to the risk of changing currency rates and market
performance.
2. Growth and investment potential
Because they can offer a high rate of return on investment, emerging
markets are frequently appealing to overseas investors. Count ries
sometimes require a sizable injection of cash from foreign sources during
the transition from an agriculture -based economy to a sophisticated
economy due to a lack of native capital.
By utilising their comparative advantage, these nations concentrate on
exporting inexpensive items to wealthy countries, which increases GDP
growth, stock prices, and investment profits.
3. High rates of economic growth
Emerging market governments frequently enact laws that encourage
industrialisation and rapid economic ex pansion. Such measures result in
lower unemployment, greater per capita disposable income, increased
investments, and improved infrastructure. On the other hand, developed
nations with early industrialisation, like the USA, Germany, and Japan,
have low rat es of economic growth.
4. Income per capita
Due to their reliance on agricultural industries, emerging markets typically
have low -middle per capita incomes in comparison to other nations.
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57 industrializ ation and manufacturing activity. Higher economic growth is
also encouraged by lower average wages.
Is India an Emerging market?
India's 7.3% growth in the Financial Year 23 made it a "Star" among the
emerging market economies.
India's foreign policies up until a few years ago were primarily defensive.
In order to open up the economy and make India an appealing location for
foreign investors, the government has implemented a number of
adjustments to the foreign direct investment (FDI) policy after realising
the need for a relaxation of foreign investment laws.
The government cleared the path for an internationally acclaimed
investment structure in India with the implementation of legislation
governing real estate investment trusts, alternative investment fun ds, and
infrastructure investment trusts by the Securities and Exchange Board of
India.
According to the S&P, the global macroeconomic performance during the
upcoming quarters indicates that growth will slow down due to tightening
financial circumstances brought on by central banks raising interest rates.
It further stated that the majority of leading and sentiment indicators also
pointed to slower growth.
It stated, "We are now expecting a mild recession in the US," adding that
rising rates, increased Eur opean energy insecurity, and the lingering
effects of COVID -19 are affecting growth almost everywhere. This
suggests that central banks' aggressive rate increases to combat inflation
may not prevent generating a sharp downturn. Though the numbers have
not yet fully converged, this economic slowdown may be the biggest
predicted on record.
Risk factors in an emerging economy:
Political unrest is a major factor in the development of the emerging
economy. An emerging economy's development is impacted by rising
geopolitical, shifting societal attitudes, and environmental threats. For
instance, the Turkish economy has suffered as a direct result of the Syrian
refugee crisis.
Since their stocks can be unpredictable and a variety of factors, including
inflationary p ressures, rising interest rates, and indications of a global
economic slowdown, could have a negative impact on the investment
environment in such markets, emerging markets are riskier than most
developed economies. However, these emerging nations also off er the
potential for rapid economic growth and higher returns on investment.
India is also a safe bet among its peers due to its strong, diversified, and
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58 5.3 ALTERNATE FINANCE PRODUCTS AND PLAYERS
Crowdfunding, product -to-product financing, interest -free financial
products, and theme indexes are only a few examples of alternative
finance products and players.
The following financial products are examples of alternative finance
products:
5.3.1 Crowdfunding:
Crowdfunding is a method of raising capital to sponsor endeavours and
companies. Fundraisers can use online platforms to gather money from a
sizable audience. Startups and expanding enterprises most frequently use
crowdfunding as a mea ns of obtaining alternative capital.
GoFundMe:
One example of crowdfunding is GoFundMe. Although GoFundMe is best
known for being utilised for more altruistic causes, companies can also
benefit from the site. It is a donation -based crowdfunding organisati on.
For corporations and charitable groups with service -based projects, this is
a fantastic choice.
How Does Crowdfunding Work?
Websites that facilitate communication between fundraisers and the public
are known as crowdfunding platforms. The crowdfunding platform can be
used to solicit and collect financial pledges.
If the fundraising campaign is successful, crowdfunding platforms
typically charge fundraisers a fee. Platforms for crowdfunding are required
to offer a safe and simple service in exchange.
A funding strategy that is all -or-nothing is used by many platforms. This
implies that if you meet your goal, you will receive the money, and if not,
everyone will receive their money back with no repercussions or financial
loss.
There are several different s orts of crowdsourcing, which are described
here. This article offers unbiased guidance to help you comprehend the
three forms of crowdfunding that profitable SMEs and start -ups most
frequently use: equity, peer -to-peer, and rewards crowdfunding.
There are followings type of Crowdfunding:
Peer -to-peer lending:
With the idea that interest will be added to the loan, the public lends
money to a business. It is fairly comparable to regular bank borrowing,
with the exception that you borrow from several investors instead.
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59 Equity crowdfunding:
Sale of a portion of a company to several investors in exchange for capital.
The concept is comparable to the purchase or sale of common stock on a
stock exchange or to a venture capitalist.
Rewards -based crowdfunding:
A non -financial reward, such as goods or services, is typically expected in
compensation for a person's contribution when they donate to a cause or
business.
Donation -based crowdfunding:
Individuals donate small amounts to meet the larger funding aim of a
speci fic charitable project while receiving no financial or material return.
Profit -sharing / revenue -sharing:
Businesses may accept investment from the public in exchange for a share
of their future earnings or sales.
Debt -securities crowdfunding:
Investors bu y bonds or other debt securities that the company has issued.
Hybrid models:
Give companies the option to combine components of several
crowdfunding models.
5.3.2 Product to Product finance :
A financial product is a tool that enables someone to save money , make an
investment, or borrow money.
Contracts that are purchased and sold on a market are, in essence, what
financial products are. This is a rather broad description because financial
products, also known as financial vehicles, are varied and come in m any
different shapes and sizes.
The fundamental idea behind a financial product is that it enables you to
change your fiat currency into something that can be exchanged for other
goods and services on a market. There are various categories under which
financial items might be placed.
There are 4 major types of financial products bought and sold on
markets:
1. Securities,
2. Derivatives,
3. Commodities
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60 Securities:
An instrument used to directly finance businesses, banks, public
institutions, or government s is known as a security. Securities essentially
represent a right to something, such as an asset or a contract.
According to the quantity of securities that they have, security is
guaranteed anything. Long -term or short -term securities are available, and
the funds utilised to buy them are used to directly finance various
companies.
Stocks:
Stocks, which represent a share of ownership in a company, are likely the
most popular type of security. You purchase a stake in a corporation when
you purchase a stock.
Typically, stock ownership includes the ability to vote on certain company
matters. You are entitled to a piece of the value of the entire company
because stocks reflect ownership. To raise money for operations,
businesses sell stock to private investors.
Depending on the state of the market, the value of stocks may increase or
decrease. The main way that investors make money is by purchasing
stocks, holding them until their value rises, and then selling them for a
profit.
Bonds:
Bonds are essentially loan s that an individual makes to a business, a
government, or a public organisation. Bonds are sold by firms to fund
operations, similar to stocks.
Bonds are regarded as long -term investments, and their typical maturity
dates range from 20 to 35 years. Bond m arkets are less risky than stock
markets, but as a result, they offer lower returns because the primary way
to profit from bonds is through interest payments rather than capital gains.
Mutual Funds:
A unique sort of financial vehicle called a mutual fund c onsists of a
number of investors pooling their capital to buy securities.
The advantage of mutual funds is that they enable investors to pool their
assets to purchase more than one thing.
Since mutual funds can contain a variety of financial products, incl uding
cash instruments, the debt of insurance firms, foreign exchange, shares,
and derivatives, they can be difficult to categorise.
Derivatives:
A derivative is a class of security that derives its value from a single or
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61 and a seller, and its price fluctuates in response to changes in the value of
the underlying asset (known as the benchmark).
Commodities:
A sort of financial product known as a commodity denotes ownership or a
share of a certain tangible good or raw material.
As a rule, trading in commodities entails things like precious metals (gold,
silver, platinum) or natural resources (coal, oil, natural gas, etc.), but it is
also possible to trade in so -called "soft" commodit ies, such as agricultural
goods or cattle.
Currencies
Since currencies can be exchanged on a market, even though they are
typically not thought of as a separate asset class or financial product, we
are included them in this list. On foreign exchanges (or c ryptocurrency
exchanges), currencies are swapped, allowing users to change one sort of
currency into another. Since various nations and organisations need to deal
with one another, currency trading is essentially a requirement.
5.3.3 Interest -free financia l products:
Loans that have no interest due are known as interest -free loans. Only the
original principal must be paid back to the lender in the case of interest -
free loans. To give protection in the event that they are unable to make
loan payments, many c ustomers opt to get loan protection insurance.
The Reserve Bank of India (RBI) is now looking into the idea of providing
interest -free banking in the nation in order to increase financial inclusion
in the nation.The Reserve Bank of India (RBI) is now looki ng into the idea
of providing interest -free banking in the nation in order to increase
financial inclusion in the nation. .
Instead of providing cash loans under the interest -free banking system, the
lender purchases and leases the item for which a loan is needed, earning
rental income in the process. Islamic banking follows a similar tenet, and a
few foreign lenders, including the National Development Bank and others,
have been in contact with the regulator to request permission to establish
an Islamic Bank in the nation.
These lenders think that this type of banking can be useful in helping to
provide credit, particularly to those parts of the small and medium
enterprise segment that banks might not feel particularly comfortable
lending to due to the credit risk associated or the little amount of loans.
5.3.4 Thematic indexes:
Sector indices focus on a single sector, whereas thematic indices choose
companies from a variety of sectors that fit a theme. Usually, a sector
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62 Investment managers use the data they have obtained from researching
megatrends to establish a thematic index when developing strategies for
global thematic investment.
The goal of thematic investing is to identify long -term structural patterns
that will result in strong economic growth and a positive return on
investment. After identifying these tendencies, it's critical to have a way to
monitor the development and performance of the strategy. Thematic
investment moves from study and planning to actual investment in this
way. This transition is made possible using a topical index. Investors can
target their investments appropriately and have a way to gauge their
performance by monitoring the performance of businesses related to the
subject they have chosen.
Every mutual fund has an underlying asset that generates income. The
underlying assets in the case of large -cap funds are the equities of several
of India's largest corporations based on market capitalization. Similar to
this, thematic funds have underlying assets that are stocks of firms that are
connected by a predetermined theme.
Thematic funds differ from traditional investment strategies like those
focused on market capitalization (large -cap, mid -cap, small -cap), style
(value & growth), or sectoral investing because of this (pharma,
technology, infrastructure). As long as it links to the topic, it makes
investments across a range of industries and market caps. Additionally,
according to SEBI, 80% of total assets must be invested in equities and
equity -related securities of a specific subject.
Who Should Invest in Thematic Funds?
Investors with High -Risk Appetite:
One of the riskiest types of mutual fund is thematic funds. That's because
the range of investing opportunitie s is constrained when a portfolio is
constructed with a theme in mind. It would have to invest only in those
stocks that are related to that theme.
Investors Seeking Returns in the Long Term:
Sometimes it takes time for a theme to reach its full potential. For
instance, since the early 1990s, we have known that software and internet
technology have enormous promise. But it's only now, 20 years later, that
we can truly see these concepts in action. As a result, turning these topics
into profitable investment s takes time and perseverance. Thematic funds
may be a smart choice for you if you're an investor searching for solid
returns over the long term. At the beginning of their investment adventure,
novice investors are advised against investing straight into t hematic funds.
Well -Informed and Evolved Investors:
A thematic fund's portfolio comprises of stocks from companies in various
industries relevant to its topic. Not every investor would be familiar with
how each of these sectors is developing. You can decid e whether certain munotes.in

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63 sectors can help you earn good returns when you have a basic
understanding of them in relation to the fund's subject. Thematic funds are
thus a good option for investors who routinely read the news and have a
talent for researching a wide range of industries. Investors can decide
whether to invest in a theme by keeping tabs on many regions and gaining
insightful information.
Taxation on Thematic Funds:
 Short Term Capital Gain Tax (STCG): If you sell your investments
within 1 year, the gain s are classified as Short -Term Capital Gain
(STCG), and you need to pay 15% tax on them.
 Long Term Capital Gain Tax (LTCG): Whereas any thematic
investment held for more than one year, the gains are classified as taxed
Term Capital Gain (LTCG). Gains of up to 1 lakh in a financial year are
tax-free. Beyond 1 lakh, the gains are taxed at a rate of 10%.
5.4 SUMMARY
● “Emerging markets” is a term that refers to an economy that
experiences considerable economic growth and possesses some, but
not all, characterist ics of a developed economy.
● India's 7.3% growth in the Financial Year 23 made it a "Star" among
the emerging market economies.
● Political unrest is a major factor in the development of the emerging
economy.
● Startups and expanding enterprises most frequently use crowdfunding
as a means of obtaining alternative capital.
● The fundamental idea behind a financial product is that it enables you
to change your fiat currency into something that can be exchanged for
other goods and services on a market.
● Sector indice s focus on a single sector, whereas thematic indices
choose companies from a variety of sectors that fit a theme.
5.5 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. What are Emerging Markets? Discuss its characteristics.
2. Enumerate Risk factors in an emerging economy .
3. Discuss alternate finance products and players.
4. How Does Crowdfunding Work?
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64 B. Fill in the blanks:
1. Loans that have no interest due are known as……………..
2. …………….. is a major fa ctor in the development of the emerging
economy.
3. …………….. is a method of raising capital to sponsor endeavours and
companies.
4. STCG stands for ………………..
5. Gains of up to ……………. in a financial year are tax -free in thematic
funds.
Answers :
1- interest -free loans, 2 - Political unrest, 3 - Crowdfunding , 4- Short -Term
Capital Gain , 5- 1 lakh
5.6 REFERENCES
 Mishkin, F. (1999) ‘Global financial instability: framework, events,
issues’, Journal of Economic Perspectives, Vol. 13.
 Padoa -Schioppa, T. (2003) ‘Centra l banks and financial stability:
exploring the land in between’, The Transformation of the European
Financial System.
 Rahim, N.H.A. and Abedin, N.F.Z. (2014) ‘Trade liberalisation,
financial development and growth in Malaysia’, International
Proceedings of Economics Development and Research.
 Luintel, K.B. and Khan, M. (1999) ‘A quantitative reassessment of the
finance -growth nexus: evidence from a multivariate VAR’, Journal of
Development Economics, Vol. 60.
 Mattoo, A. (1998) Financial Services and the WTO : Liberalization in
the Developing and Transition Economies, Staff Working Paper, No.
TISD9803, World Trade Organization Trade in Services Division.

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65 6
DERIV ATIVES
Unit Structure
6.1 Introduction
6.2 Definitions of Derivatives
6.3 Features of a Financial Derivatives
6.4 Products of Derivatives
6.5 Interest Rate Derivatives
6.6 Other Types of Financial Derivatives
6.0 INTRODUCTION
The past decade has witnessed the multiple growths in the volume of
international trade and business due to the wave of globalization and
liberalization all over the world. As a result, the demand for the
international money and financial instruments increased significantly at
the global level. In this respect, changes in the interest rates, exchange
rates and stock market prices at the different financial markets have
increased the financial risks to the corporate world. Adverse changes have
even threatened the very survival of the business world. It is, therefore, to
manage such risks; the new financial instruments have been developed in
the financial markets, which are also popularly known as financial
derivatives.
The basic purpose of these instruments is to provide commitment s to
prices for future dates for giving protection against adverse movements in
future prices, in order to reduce the extent of financial risks. Not only this,
they also provide opportunities to earn profit for those persons who are
ready to go for higher risks. In other words, these instruments, indeed,
facilitate to transfer the risk from those who wish to avoid it to those who
are willing to accept the same.
Today, the financial derivatives have become increasingly popular and
most commonly used in the world of finance. This has grown with so
phenomenal speed all over the world that now it is called as the derivatives
revolution. In an estimate, the present annual trading volume of derivative
markets has crossed US $ 30,000 billion, representing more than 100 times
gross domestic product of India.
Financial derivatives like futures, forwards options and swaps are
important tools to manage assets, portfolios and financial risks. Thus, it is
essential to know the terminology and conceptual framework of all t hese
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66 The prices of these financial derivatives contracts depend upon the spot
prices of the underlying assets, costs of carrying assets into the future and
relationship with spot pri ces. For example, forward and futures contracts
are similar in nature, but their prices in future may differ. Therefore,
before using any financial derivative instruments for hedging, speculating,
or arbitraging purpose, the trader or investor must careful ly examine all
the important aspects relating to them.
6.2 DEFINITIONS OF DERIVATIVES
The term “Derivative” indicates that it has no independent value, i.e., its
value is entirely derived from the value of the underlying asset. The
underlying asset can be securities, commodities, bullion currency,
livestock or anything else. In other words, derivative means forward,
futures, option or other hybrid contract of predetermined fixed duration,
linked for the purpose of contract fulfilment to the value of a speci fied real
or financial asset or to an index of securities. The Securities Contracts
(Regulation) Act 1956 defines “derivative” as under:
“Derivative” includes:
 Security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrume nt or contract for differences or any other form
of security.
 A contract which derives its value from the prices, or index of prices of
underlying securities.
The above definition conveys that: The derivatives are financial products.
Derivative is derived from another financial instrument/contract called the
underlying. In the case of Nifty futures, Nifty index is the underlying. A
derivative derives its value from the underlying assets. Accounting
Standard SFAS 133 defines a derivative as, ‘a derivative instrument
financial derivative or other contract with all three of the following
characteristics: It has
(1) one or more underlying, and
(2) one or more notional amount or payments provisions or both. Those
terms determine the amount of the settlement or settlement s.
It requires no initial net investment or an initial net investment that is
smaller than would be required for other types of contract that would be
expected to have a similar response to changes in market factors.
Its terms require or permit net settlem ent. It can be readily settled net by
means outside the contract or it provides for delivery of an asset that puts
the recipients in a position not substantially different from net settlement.
The term “financial derivative” relates with a variety of finan cial
instruments which include stocks, bonds, treasury bills, interest rate,
foreign currencies and other hybrid securities. Financial derivatives
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67 most important form of derivatives, which are in existence long before the
term ‘derivative’ was coined. Financial derivatives can also be derived
from a combination of cash market instruments or other financial derivative
instruments. In fact, most of the financial derivatives are not revo lutionary
new instruments rather they are merely combinations of older generation
derivatives and/or standard cash market instruments.
In the 1980s, the financial derivatives were also known as off -balance
sheet instruments because no asset or liability underlying the contract was
put on the balance sheet as such. Since the value of such derivatives depend
upon the movement of market prices of the underlying assets, hence, they
were treated as contingent asset or liabilities and such transactions and
positi ons in derivatives were not recorded on the balance sheet. However,
it is a matter of considerable debate whether off -balance sheet instruments
should be included in the definition of derivatives. Which item or product
given in the balance sheet should be considered for derivative is a
debatable issue.
6.3 FEATURES OF A FINANCIAL DERIVATIVES
As observed earlier, a financial derivative is a financial instrument whose
value is derived from the value of an underlying asset; hence, the name
‘derivative’ came in to existence. There are a variety of such instruments
which are extensively traded in the financial markets all over the world,
such as forward contracts, futures contracts, call and put options, swaps,
etc. A more detailed discussion of the properties of these contracts will be
given later part of this lesson. Since each financial derivative has its own
unique features, in this section, we will discuss some of the general
features of simple financial derivative instrument. The basic features of the
derivat ive instrument can be drawn from the general definition of a
derivative irrespective of its type. Derivatives or derivative securities are
future contracts which are written between two parties (counter parties)
and whose value are derived from the value of underlying widely held and
easily marketable assets such as agricultural and other physical (tangible)
commodities, or short term and long term financial instruments, or
intangible things like weather, commodities price index (inflation rate),
equity pri ce index, bond price index, stock market index, etc. Usually, the
counter parties to such contracts are those other than the original issuer
(holder) of the underlying asset. From this definition, the basic features of a
derivative may be stated as follows :
1. A derivative instrument relates to the future contract between two
parties. It means there must be a contract -binding on the underlying
parties and the same to be fulfilled in future. The future period may be
short or long depending upon the nature of co ntract, for example, short
term interest rate futures and long term interest rate futures contract.
2. Normally, the derivative instruments have the value which derived
from the values of other underlying assets, such as agricultural
commodities, metals, financial assets, intangible assets, etc. Value of
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68 which changes as per the changes in the underlying assets, and
sometimes, it may be nil or zero. Hence, they are closely related.
3. In general, the counter parties have specified obligation under the
derivative contract. Obviously, the nature of the obligation would be
different as per the type of the instrument of a derivative. For example,
the obligation of the counter parties, under the different derivatives,
such as forward contract, future contract, option contract and swap
contract would be different.
4. The derivatives contracts can be undertaken directly between the two
parties or through the particular exchange like financial futures
contracts. The exchange - traded derivatives are quite liquid and have
low transaction costs in comparison to tailor -made contracts. Example
of exchange traded derivatives are Dow Jones, S&P 500, Nikki 225,
NIFTY option, S&P Junior that are traded on New York Stock
Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay
Stock Exchange and so on.
5. In general, the financial derivatives are carried off -balance sheet. The
size of the derivative contract depends upon its notional amount. The
notional amount is the amount used to calculate the pay off. For
instance, in the option contract, the potential loss and potential payoff,
both may be different from the value of underlying shares, because the
payoff of derivative products differs from the payoff that their notional
amount might suggest.
6. Usually, in derivatives trading, the taking or making of delivery of
underlying assets is not involved; rather underlying transactions are
mostly settled by taking offsetting positions in the derivatives
themselves. There is, t herefore, no effective limit on the quantity of
claims, which can be traded in respect of underlying assets.
7. Derivatives are also known as deferred delivery or deferred payment
instrument. It means that it is easier to take short or long position in
deriva tives in comparison to other assets or securities. Further, it is
possible to combine them to match specific, i.e., they are more easily
amenable to financial engineering.
8. Derivatives are mostly secondary market instruments and have little
usefulness in mobilizing fresh capital by the corporate world;
however, warrants and convertibles are exception in this respect.
9. Although in the market, the standardized, general and exchange -traded
derivatives are being increasingly evolved, however, still there are so
many privately negotiated customized, over -the-counter (OTC) traded
derivatives are in existence. They expose the trading parties to
operational risk, counter -party risk and legal risk. Further, there may
also be uncertainty about the regulatory status of s uch derivatives.
10. Finally, the derivative instruments, sometimes, because of their off -
balance sheet nature, can be used to clear up the balance sheet. For munotes.in

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69 example, a fund manager who is restricted from taking particular
currency can buy a structured note w hose coupon is tied to the
performance of a particular currency pair.
6.4 PRODUCTS OF DERIVATIVES
In this section, we discuss a range of derivatives products that derive their
values from the performance of five underlying asset classes: equity,
fixed -income instrument, commodity, foreign currency and credit event.
However, given the speed of financial innovation over the past two
decades, the variety of derivatives products have grown substantially.
Thus, a few key examples will be discussed below:
Equity Derivatives :
Equity futures and options on broad equity indices are perhaps the most
commonly cited equity derivatives securities. Way back in 1982, trading of
futures based on S&P’s composite index of 500 stocks began on the
Chicago Mercantile Exchange (CME). Options on the S&P 500 futures
began trading on the CME in the following year. Today, investors can buy
futures based on benchmark stock indices in most international financial
centres. Index futures contract enable an investor to buy a stock index a t a
specified date for a certain price. It can be an extremely useful hedging
tool.
For example : An investor with a stock portfolio that broadly matches the
composition of the Hang Seng index (HSI), he will suffer losses should the
HSI record a fall in ma rket value in the near future. Since he means to
hold the portfolio as a long term strategy, he is unwilling to liquidate the
portfolio. Under such circumstances, he can protect his portfolio by selling
HSI futures contracts so as to profit from any fall in price. Of course, if his
expectations turned out to be wrong and the HSI rose instead, the loss on
the hedge would have been compensated by the profit made on the
portfolio. Some investors prefer to purchase options on futures (or “futures
options”) instead of straight futures contracts. The option strike price is the
specified futures price at which the future is traded if the option is
exercised. For some market participants, the pricing of an option reveal
valuable information about the likely future volatility of the returns of the
underlying asset.
One commonly cited example is the Chicago Board Options Exchange
Market Volatility Index (VIX index), which is calculated based on a range
of options on the S&P 500 index. When investors are concerned about a
potential drop in the US stock market, they buy the VIX index as an
insurance against losses in the value of their portfolio. The more
investors demand, the higher the price of the VIX. As such, the VIX can
be viewed as an “investor fear gauge”.
Other c ommonly traded equity derivatives are equity swaps. Under an
equity swap contract, an investor pays the total return on a stock to his
counterparty and receives in return a floating rate of interest. With this
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70 ownership of his share. At the same time, the party receiving equity return
enjoys exposure without actually taking ownerships of shares.
6.5 INTEREST RATE DERIVATIVES
One of the most popular interest rate derivatives is interes t rate swap. In
one form, it involves a bank agreeing to make payments to a counterparty
based on a floating rate in exchange for receiving fixed interest rate
payments. It provides an extremely useful tool for banks to manage
interest rate risk. Given tha t banks’ floating rate loans are usually tied
closely to the market interest rates while their interest payments to
depositors are adjusted less frequently, a decline in market interest rates
would reduce their interest income but not their interest paymen ts on
deposits. By entering an interest rate swap contract and receiving fixed
rate receipts from counterparty, banks would be less exposed to the
interest rate risk. Meanwhile, interest rate futures contract allows a buyer to
lock in a future investment rate.
Commodity Derivatives
The earliest derivatives markets have been associated with
commodities, driven by the problems about storage, delivery and
seasonal patterns. But modern day commodity derivatives markets
only began to develop rapidly in the 19 70s. During that time, the
break -up of the market dominance of a few large commodity
producers allowed price movements to better reflect the market
supply and demand conditions. The resulting price volatility in the
spot markets gave rise to demand of com modity traders for
derivatives trading to hedge the associated price risks.
Foreign Exchange Derivatives
The increasing financial and trade integration across countries have led to
a strong rise in demand for protection against exchange rate movements
over the past few decades. A very popular hedging tool is forward
exchange contract. It is a binding obligation to buy or sell a certain amount
of foreign currency at a pre -agreed rate of exchange on a certain future
date. Consider a Korean shipbuilder who expects to receive a $1 million
payment from a US cruise company for a boat in 12 months. Suppose the
spot exchange rate is 1,200 won per dollar today. Should the won
appreciate by 10 per cent against the dollar over the next year, the Korean
shipbuilder w ill receive only 1,090 millions of won (some 109 millions of
won less than he would have received today). But if the shipbuilder can
hedge against the exchange risk by locking in buying dollars forwards at
the rate of say 1,100 won per dollar. For thinly t rade currencies or
currencies of those countries with restrictions on capital account
transactions, the profit or loss resulting from the forwards transaction can
be settled in an international currency. This is the so-called non-
deliverable forwards cont ract, and very often they are traded offshore.
Another type of foreign exchange derivatives are cross -currency swaps.
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71 spot rate at inception) and interest in different currencies. According to
many market participants, having a liquid cross - currency swap market is
an important for local currency bond market developments.
This is because such instruments allow foreign borrowers in local bond
markets to swap back their proceeds to their own currencies while hedging
against the interest rate risk.
Credit Derivatives
A credit derivative is a contract in which a party (the credit protection
seller) promises a payment to another (the credit protection buyer)
contingent upon the occurrence o f a credit event with respect to a
particular entity (the reference entity). A credit event in general refers to
an incident that affects the cash flows of a financial instrument (the
reference obligation). There is no precise definition, but in practice, it
could be filing for bankruptcy, failing to pay, debt repudiation or
moratorium.
The fastest growing type of credit derivatives over the past decade is credit
default swap (CDS). In essence, it is an insurance policy that protects
the buyer against the loss of principal on a bond in case of a default by
the issuer. The buyer of CDS pays a periodic premium to the seller over
the life of the contract. The premium reflects the buyer’s assessment of the
probability of default and the expected loss given defau lt. In its simplest
form, the CDS is written with respect to one single reference entity, the so
called single - name CDS. Some data providers compile indices of a basket
of single -name CDSs of similar ratings (e.g., the S&P US Investment
Grade CDS Index co nsists of 100 equally weighted investment grade US
corporate credits). These index trenches give investors the opportunity to
take on exposures to specific segments of the CDS index default loss
distribution.
Participants and Functions
Banks, financial ins titutions, corporate, brokers and individuals are the
participants of the derivative market in India. It is observed that financial
derivatives are those assets whose values are determined by the value of
some other assets, called as the underlying. Presen tly, there are
bewilderingly complex varieties of derivatives already in existence, and
the markets are innovating newer and newer ones continuously. Now let
us discuss the various participants and economic functions of derivative
market in the following sub-sections:
Participants in a Derivative Market : The derivatives market is similar
to any other financial market and has following three broad categories of
participants:
 Hedgers: These are investors with a present or anticipated exposure to
the underlyi ng asset which is subject to price risks. Hedgers use the
derivatives markets primarily for price risk management of assets and
portfolios. Example: An importer has to pay US $ to buy goods and munotes.in

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72 rupee is expected to fall to Rs. 50/$ from Rs. 48/$, then the importer
can minimize his losses by buying a currency future at Rs. 49/$.
 Speculators: These are individuals who take a view on the future
direction of the markets. They take a view whether prices would rise
or fall in future and accordingly buy or sell futures and options to try
and make a profit from the future price movements of the underlying
asset. Example: If you will the stock price of Reliance is expected to
go up to Rs. 400 in 1 month, one can buy a 1 month future of Reliance
at Rs. 350 and make profits.
 Arbitragers: These are the third important participants in the
derivatives market. They take positions in financial markets to earn risk
less profits. The arbitragers take short and long positions in the same
or different contracts at the same time to create a position which can
generate a risk less profit.
Economic Function of the Derivative Market : The derivatives market
performs a number of economic functions. In this section, we discuss
some of them.
 Detection of Prices: Prices in an organized derivatives market reflect
the perception of the market participants about the future and lead the
prices of underlying to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration
of the derivative c ontract. Thus derivatives help in discovery of future
as well as current prices.
 Transfer of Risk: The derivatives market helps to transfer risks from
those who have them but do not like them to those who have an appetite
for them.
 Liquidity and Volume Tra ding: Third, derivatives due to their
inherent nature are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses higher
trading volumes. This is because of participation by more players who
would not ot herwise participate for lack of an arrangement to transfer
risk.
 Encourages participating more people: An important incidental
benefit that flows from derivatives trading is that it acts as a catalyst for
new entrepreneurial activity. The derivatives have a history of
attracting many bright, creative, well - educated people with an
entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the
benefit of which are immense. In a nut shell, der ivatives markets help
increase savings and investment in the long run. Transfer of risk
enables market participants to expand their volume of activity.
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73 Types of Derivatives
It is observed that financial derivatives are those assets whose values are
determ ined by the value of some other assets, called as the underlying.
Presently, there are bewilderingly complex varieties of derivatives already
in existence, and the markets are innovating newer and newer ones
continuously. For example, various types of financial derivatives based on
their different properties like, plain, simple or straightforward, composite,
joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC
traded, standardized or organized exchange traded, etc., are available in the
market.








Due to complexity in nature, it is very difficult to classify the financial
derivatives, so in the present context, the basic financial derivatives which
are popular in the market have been described in brief. The details of their
operations, m echanism and trading, will be discussed in the forthcoming
respective units. In simple form, the derivatives can be classified into
different categories which are shown in the Figure 1.1.
One form of classification of derivative instruments is between
comm odity derivatives and financial derivatives. The basic difference
between these is the nature of the underlying instrument or asset. In a
commodity derivatives, the underlying instrument is a commodity which
may be wheat, cotton, pepper, sugar, jute, turme ric, corn, soybeans, crude
oil, natural gas, gold, silver, copper and so on. In a financial derivative,
the underlying instrument may be treasury bills, stocks, bonds, foreign
exchange, stock index, gilt-edged securities, cost of living index, etc. It is
to be noted that financial derivative is fairly standard and there are no
quality issues whereas in commodity derivative, the quality may be the
underlying matters. However, the distinction between these two from
structure and functioning point of view, both are almost similar in nature.
Another way of classifying the financial derivatives is into basic and
complex derivatives. In this, forward contracts, futures contracts and
option contracts have been included in the basic derivatives whereas
swaps and other complex derivatives are taken into complex category
because they are built up from either forwards/futures or options contracts,
or both. In fact, such derivatives are effectively derivatives of derivatives. Figure 1.1 Forwards Futures Basic Options Financial Warrants & Convertibles Derivatives Swaps Commodities Complex Exoctic
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74 Popular Derivative Instruments : The most pop ularly used derivatives
contracts are Forwards, Futures, Options and Swaps, which we shall
discuss in detail later. Here we take a brief look at various derivatives
contracts that have come to be used.
 Forwards: A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future at
today’s pre-agreed price. The rupee -dollar exchange rates is a big
forward contract market in India with banks, financial institutions,
corporate and exporters being the market participants.
 Futures: A futures contract is an agreement between two parties to
buy or sell an asset at a certain time in the future at a certain price.
Futures contracts are special types of forward contracts in the sense that
the former are standardized exchange - traded contracts. Unlike forward
contracts, the counterparty to a futures contract is the clearing
corporation on the appropriate exchange. Futures often are settled in
cash or cash equivalents, rather than requiring physical delivery of the
underlying asset. Parties to a Futures contract may buy or write
options on futures.
 Options: An option represents the right (but not the obligation) to buy
or sell a security or other asset during a given time for a specified price
(the “strike price ”). Options are of two types - calls and puts. Calls
give 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. Puts give the buyer the right, but not the obligation t o sell a given
quantity of the underlying asset at a given price on or before a given
date.
 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 portfolios of forward contracts. Swaps generally are
traded OTC through swap dealers, which generally consist of large
financial institution, or other large brokerage houses. There is a recent
trend for swap dealers to mark to market the swap to reduce the risk of
counterparty default. The two commonly used swaps are:
 Interest rate swaps: These entail swapping only the interest
related cash flows between the parties in the same currency.
 Currency swaps: These entail swapping both principal and
interest between the par ties, with the cash flows in one direction
being in a different currency than those in the opposite direction.
Swaps may involve cross -currency payments (U.S. Dollars vs.
Mexican Pesos) and cross market payments, e.g., U.S. short -term
rates vs. U.K. short -term rates.
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75 6.6 OTHER TYPES OF FINANCIAL DERIVATIVES
 Warrants: Options generally have lives of up to one year, the
majority of options traded on options exchanges having a maximum
maturity of nine months. Longer - dated options are called warrants and
are generally traded over -the-counter.
 LEAPS: The acronym LEAPS means Long -term Equity Anticipation
Securities. These are options having a maturity of up to three years.
 Baskets: Basket options are options on portfolios of underlying assets.
The underlying asse t is usually a moving average of a basket of assets.
Equity index options are a form of basket options.
Exchange -Traded Vs. OTC Derivatives Markets
Derivatives that trade on an exchange are called exchange traded
derivatives, whereas privately negotiated d erivative contracts are called
OTC contracts. The OTC derivatives markets have witnessed rather sharp
growth over the last few years, which have accompanied the
modernization of commercial and investment banking and globalization of
financial activities. T he recent developments in information technology
have contributed to a great extent to these developments. While both
exchange -traded and OTC derivative contracts offer many benefits, the
former have rigid structures compared to the latter. It has been widely
discussed that the highly leveraged institutions and their OTC derivative
positions were the main cause of turbulence in financial markets in 1998.
These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.
The first exchange -traded financial derivatives emerged in 1970’s due to
the collapse of fixed exchange rate system and adoption of floating
exchange rate systems. As the system broke down currency volatility
became a c rucial problem for most countries. To help participants in
foreign exchange markets hedge their risks under the new floating
exchange rate system, foreign currency futures were introduced in 1972 at
the Chicago Mercantile Exchange. In 1973, the Chicago Boa rd of Trade
(CBOT) created the Chicago Board Options Exchange (CBOE) to
facilitate the trade of options on selected stocks. The first stock index
futures contract was traded at Kansas City Board of Trade. Currently the
most popular stock index futures contract in the world is based on S&P 500
index, traded on Chicago Mercantile Exchange. During the mid -eighties,
financial futures became the most active derivative instruments generating
volumes many times more than the commodity futures. Index futures,
futur es on T-bills and Euro -Dollar futures are the three most popular futures
contracts traded today. Other popular international exchanges that trade
derivatives are LIFFE in England, DTB in Germany, SGX in Singapore,
TIFFE in Japan, MATIF in France, Eurex etc .
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76 7
INTERMEDIARIES
Unit Structure
7.0 Learning Objectives
7.1 Introduction
7.2 Mutual funds
7.3 Insurance firms
7.4 Hedge funds
7.5 Commercial banks
7.6 Investment banks
7.7 Summary
7.8 Unit End Questions
7.9 References
7.0 LEARNING OBJECTIVES
After studying this unit, you will be able:
 To discuss Intermediaries Mutual funds
 To analyse Insurance firms
 To understand Hedge funds
 To explain Commercial banks
 To discuss Investment banks
7.1 INTRODUCTION
A commercial bank, investment bank, mutual fund, or pension fund are
examples of orga nisations that serve as the middleman between two
parties in a financial transaction. Consumers as a whole gain from
financial intermediaries' safety, liquidity, and economies of scale in the
banking and asset management industries. Disintermediation is
significantly less of a concern in other areas of finance, such as banking
and insurance, even though it does threaten to abolish the financial
intermediary in other areas, such as investing.
Deposits from the general public are not accepted by a non -bank fi nancial
intermediary. The middleman may offer leasing, factoring, insurance
policies, or other financial services. In order to manage and increase their
funds, many intermediaries participate in securities exchanges and use
long-term strategies. The action s of financial intermediaries and the
expansion of the financial services sector can both reveal a nation's
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77 Financial middlemen transfer money from those with extra capital to
those that need it. The method minimises the cost of doing business and
produces effective markets. An investment in insurance, stocks, bonds,
real estate, and other assets, for instance, might help a financial advisor
establish a connection with a client.
7.2 MUTUAL FUNDS
Modern financial systems depend he avily on mutual funds, which have
exploded in growth during the past 20 years. In addition to the
organisations with that name in Canada and the USA, they also include a
large number of thrift and related organisations there, as well as unit trusts,
invest ment trusts, building societies, and friendly societies in the UK.
Since the early nineteenth century, mutual funds have been created to give
groups of modest investors access to diversification options that they
otherwise wouldn't have. Prior to the inven tion of mutual funds, only
institutional investors or extremely wealthy individuals could successfully
diversify their portfolios due to the search, transaction, and other fixed
expenses of investing. The typical small investor was forced to make due
with an under -diversified portfolio and accept the risk that came with it.
Such investors were given the chance to pool their resources through
mutual funds and invest in a diverse portfolio that none of them could
have done on their own.
The majority of funds have a particular area of expertise, such as growth
stocks, income -producing stocks, small -company stocks, short -term or
long-term bonds, tax -exempt bonds, precious metals, overseas equities,
and the like. A money market fund, which focuses on high -quality , short -
term securities with market returns on cash equivalents and allows check
writing, is another option for investors.
Existing Growth of Mutual Funds (Since May 2014)
In September 2012, SEBI adopted a number of progressive steps in
response to India' s low mutual fund penetration, particularly in Tier II and
Tier III towns. These procedures were put in place to increase security and
transparency for the benefit of numerous stakeholders. Additionally,
SEBI's plan was to increase mutual fund penetration and "re -energize" the
Indian mutual fund business. During the course, measures were taken to
counter the negative trend because of the global financial crisis. However,
the situation improved significantly after the new government was formed
at the centre.
Structure
The Fund Sponsor the Fund's sponsor The Fund Sponsor is the top tier of
the three -tiered organisational structure for Indian mutual funds. A fund
sponsor is defined by SEBI regulations as any individual or entity that has
the authority to cre ate a mutual fund with the intention of profiting from
fund management. The management of the fund is entrusted to an
associate company. A sponsor might be compared to the publicist for the
affiliated company. A sponsor must get in touch with SEBI to submi t a munotes.in

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78 request for permission to launch a mutual fund. However, a sponsor
cannot operate independently. Once SEBI accepts the commencement, a
Public Trust is established in compliance with the Indian Trust Act, 1882,
and is registered with SEBI. After the tru st has been properly established,
trustees are selected to manage the trust, protect the interests of unit
holders, and follow SEBI's mutual fund criteria. Trustee registration with
SEBI is required. The sponsor then creates an asset management company
that must abide by the Companies Act of 1956 in order to regulate the
handling of money. Due to the fact that the sponsor is the primary entity
promoting the mutual fund company and that the mutual funds will
manage public funds, SEBI has specified qualificat ions for the fund
sponsor. The sponsor's net worth must have improved over the past five
years, and they must have at least five years of experience in the financial
services sector. The AMC's capital contribution cannot be less than the
sponsor's net wort h as of the previous year. The sponsor must show
financial success in at least three of the previous five years, including the
most recent. At least 40% of the net worth of the asset management
company must be owned by the sponsor.
Although it may seem obv ious, a sponsor's role is crucial and necessitates
the highest level of credibility. According to the strict and strict standards,
the sponsor is required to have sufficient liquidity and to be dependable in
order to return investors' money in the case of a financial crisis or
meltdown.
Therefore, any organisation that satisfies the aforementioned criteria may
be referred to as the mutual fund's sponsor.
Trust and Trustees
Trust and trustees make up the second tier of the Indian mutual fund
structure. Trus tees, often known as the guardians of the fund, are
frequently staff members of the fund sponsor. As implied by their name,
they play a critical role in maintaining investors' trust and keeping track of
the fund's success. The fund sponsor creates a trust in the interests of the
trustees through the use of a trust document. Trustees manage the trust on
behalf of the investors and are answerable to them. They might be seen as
the primary custodians of finances and assets. Trustees can be appointed
either by a trustee company or a board of trustees. The trustees keep an
eye on the Mutual Fund's operations and make sure that SEBI (Mutual
Fund) regulations are followed. They also monitor the systems,
procedures, and general operation of the asset management comp any.
Without the trustees' approval, AMC is not allowed to launch any schemes
in the market. The trustees are expected to provide SEBI with a report
detailing the AMC's operations every six months. SEBI has also put in
place stricter transparency standards in an effort to prevent any kind of
conflict of interest between the sponsor and the AMC. Therefore, trustees
must act independently and in a proper manner in order to safeguard the
investors' hard -earned money. It is a requirement for trustees to registe r
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79 revoke or suspend the registry if any conditions are found to have been
breached.
Asset Management Companies
Asset management companies make up the mutual fund system's third
layer. It is a certain kind of company that was established under the
Companies Act and is registered with SEBI. An AMC's function is to
maintain a list of various mutual fund schemes that abide by investor and
market expectations. The trust's investment man ager or fund manager is
the asset management company. A little charge is paid to the AMC for
managing the fund. The AMC is in charge of all activities involving the
funds. It begins various plans and puts them into action. Along with the
trustee and sponso r, it also creates mutual funds and manages their
expansion. The AMC must supervise investments and provide investors
with services. Along with other elements like brokers, auditors, bankers,
registrars, lawyers, etc., it engages in business with them and solicits their
services. To ensure that there is no competition between the AMCs,
several restrictions have been placed on the firms' ability to conduct
business.
Custodian
A custodian is one such company in responsibility of keeping the assets of
the Mut ual Fund secure. They manage the mutual fund's investment
account, are registered with SEBI, and ensure that the securities are
delivered and transferred. Custodians also allow investors the ability to
upgrade their holdings at specific times and assist th em in keeping track of
their investments. They also compile and keep account of dividends,
interest, and bonus payments paid on mutual fund assets.
Distributors/Intermediaries:
Distributors take on the role of brokers, directing customers and investors
to mutual fund plans or other investment alternatives that will match their
objectives. Distributors generally advertise the mutual fund offerings of
the AMCs that they have contracts with. The distributor is required to
have an AMFI registration number and t o have successfully completed the
National Institute of Securities Market (NISM) accreditation programme.
An investor's financial advisor may occasionally be a distributor. Banks,
brokers, brokerage firms, financial institutions, and others may distribute
the mutual fund scheme. The distributor is qualified to join numerous
mutual fund companies' panels.
Registrar and Transfer Agent (RTA):
Investor records must be maintained by RTAs. In addition to buying,
selling, and redeeming money, investors often updat e personal information
and tell them of the worth of their portfolios. The mutual fund company
finds it challenging to maintain such a record. It is therefore transferred to
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80 One example of an RTA is Computer Age Management Services (CAMS)
and KARVY, which control 80% of the RTA industry in India. In their
offices, they serve as Investor Service Centers (ISCs), collecting, logging,
storing, and managing paperwork.
RTAs assist the mutual fund organi sation in lowering record -keeping
expenses.
It provides a thorough breakdown of the investments they have made
across a number of mutual schemes, regardless of the AMC.
The RTAs' facilities act as an AMC branch office.
Auditors :
The Trustees appoint the au ditor for the schemes, while the AMC appoints
the auditor for the AMC. Auditing the AMC's and its schemes' financial
records is the auditing firm's main duty. In order to protect the interests of
the unitholders, it is necessary to ensure that all transact ions are honest
and fair. The AMC auditor is unable to examine the AMC's schemes. The
auditor needs to be a capable individual. The auditor ought to be a neutral
party who works independently and impartially.
Fund Accountants:
The fund accountant's job is to take care of all the accounting
requirements of the mutual fund and its schemes, as the title would imply.
The following are the duties of the fund accountant:
a. Calculating Net Asset Value of the schemes.
b. Recording of the transactions of the fund and the schemes.
c. Calculating the dividened to be distributed .
d. Review , research,analyseis, reconciliation and rectification of the
accounting records.
e. Prepareing financial statements,financial reports ,tax reports etc in a
timely manner.
f. Providing the required a nd adequate information to the auditor.
g. Providing periodic accounting and financial information about the
performance of the fund.
Collecting Bankers:
A banker is chosen by the AMC to assist with money collection and
transfer. The banks offer scheme -specif ic accounts to ensure that the unit
holder's money is allocated to the preferred schemes. The investor must
directly deliver the application and required funds to the designated
collecting banker or bankers, as well as to AMC, RTA, or both. The aspect
of the fund's inflow and outflow is examined by the collecting bank.
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81 7.3 INSURANCE FIRMS
Insurance Firms:
Most individuals have insurance of some type, whether it is for their life,
their home, or their car. Insurance policies are intended to protect against
the possibility of financial losses, both large and minor, that may be
caused by harm to the insured or their property or by liability for harm or
injury to a third party.
How Insurance Works:
There are many various kinds of insurance policies available, and almost
any person or organisation can find an insurance firm that will insure
them —for a fee, of course). Auto, health, homeowners, and life insurance
are the most popular categories of personal insurance plans. Most
Americans have at least one of thes e insurance policies, and car insurance
is mandated by law.
Types of Insurance:
There are many different types of insurance. Let’s look at the most
important:
Health Insurance :
A business and a customer enter into a contract for health insurance. In
exchan ge for the payment of a monthly premium, the corporation offers
to cover all or part of the insured person's medical expenses.
Home Insurance:
Your home, which is your biggest asset, can be safeguarded with
homeowner's insurance. Learn more about the exten t of the liability,
interior versus outside damage, on -property injuries, and other topics.
Auto Insurance:
It's crucial to safeguard your investment when you purchase or lease a
car. Having auto insurance can give you peace of mind in the event that
you a re in an accident or your car is stolen, vandalised, or suffers natural
disaster damage.
Life Insurance:
A contract for life insurance is made between the policyholder and the
insurer. In return for the premiums paid by the policyholder during their
lifeti me, a life insurance policy promises that the insurer will pay a
certain amount to designated beneficiaries after the insured passes away.

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82 Travel Insurance:
Travel insurance is a type of insurance that covers the costs and losses
associated with travelin g. It is useful protection for those traveling
domestically or abroad.
7.4 HEDGE FUNDS
In the context of investment, the term "hedging" refers to safeguarding
against risks. Accredited investors including banks, insurance companies,
High Net Worth Individu als (HNIs) and their families, endowments, and
pension funds contribute money to a hedge fund. This is the rationale
behind the fact that these funds frequently act as foreign investment
companies or private investment partnerships. Unlike other mutual fun ds,
they are not required to periodically reveal their NAV or to register with
SEBI.
Hedge funds are mutual funds that are professionally and privately
managed. Because of this, they are frequently a little more expensive. As a
result, only those who are f inancially secure can afford and use them.
Because the management buys and sells assets at a breakneck pace to keep
up with market fluctuations, you must not only have excess funds but also
be a risk -taker who doesn't back down from a challenge.
As you are aware, risks increase as structural complexity increases. Hedge
funds therefore have a much higher expense ratio than traditional mutual
funds (charge to the fund management). It might be 15% to 20% of your
earnings. So, until you have a lot of experience in the sector, we advise
first-time depositors to stay away from these funds.
Even then, everything is up to the fund manager. Consequently, investing
in hedge funds may cause you to have sleepless nights if you don't have
complete faith in your fund mana gement.
What are the Features & Benefits of Hedge Funds?
The relatively new Indian hedge fund market received a green light from
the Securities and Exchange Board of India (SEBI) in 2012, allowing
alternative investment funds (AIF). These characteristics apply to them:
High Net -Worth Investors
Hedge funds are only open to accredited or qualified investors. High net
worth individuals (HNIs), banks, insurance firms, endowments, and
pension funds make up the majority of them. Investors investing in these
funds must have a minimum ticket size of Rs 1 crore.
Diverse Portfolio
Hedge funds have a wide range of investments in their portfolio, including
stocks, real estate, shares, bonds, and derivatives. Yes, they must cover all
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83 Higher Fees
Both the management fee and expense ratio concepts are used in their
work. The global standard is "Two and Twenty," which entails a set fee of
2% and a profit share of 20%. The management fee for hedge funds in
India ranges fro m well below 2% to below 1%. Additionally, the profit
sharing typically ranges from 10% to 15%.
Higher Risks
Hedge fund investment strategies put money at risk of enormous losses.
Lock -in periods for investments are typically quite lengthy. Leverage used
by these funds has the potential to significantly reduce investment returns.
Taxation
Hedge funds in Category III AIF are still not eligible for pass -through tax
treatment. This suggests that the investment fund level is where revenue
from these funds is ta xed. As a result, the tax liability won't be passed on
to the unit -holders. This puts them at a competitive disadvantage with
other mutual funds, which is bad for business.
Regulations
Hedge funds are not required to register with the securities markets
regulator, and they are not subject to any reporting obligations, such as a
requirement to disclose net asset values on a regular basis (NAV).
How do Hedge Funds work?
Hedge fund returns speak more to the fund manager's abilities than to the
state of the ma rkets. The asset managers here try their hardest to minimise
or eliminate market exposure while still producing solid returns. They
operate in niche market segments where greater diversification helps to
lower risks. Among the tactics employed by hedge fun d managers are:
Sell short
Here, the manager can sell shares in anticipation of future price declines
and buy them back at a lower cost.
Use arbitrage
The price of the securities may occasionally be inconsistent or ineffective.
Managers take advantage of t his.
Invest in an upcoming event
Examples of significant market events that may have an impact on a
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84 Invest in securities with high discounts
Some businesses that are experiencing financial difficulty or perhaps
insolvency will sell their securities for an absurdly low price. After
considering the options, the management might decide to purchase.
Types of Hedge Funds:
Hedge funds target select investments and pools of securities pri med for
gains. Four common types of hedge funds include:
 Global macro hedge funds:
Global macro hedge funds, which are actively managed, aim to profit
from significant market fluctuations brought on by political or economic
events. After considering the o ptions, the management might decide to
purchase.
 Equity hedge fund:
An equity hedge fund may invest in profitable stocks globally or only in a
single nation, protecting itself against equity market declines by selling
short expensive equities or stock indi ces.

 Relative value hedge fund :
A relative value hedge fund looks to take advantage of short -term price
discrepancies between linked securities by capitalising on spread or price
inefficiencies.
 Activist hedge fund:
An activist hedge fund invests in comp anies with the intention of
increasing the stock price by demanding that expenses be reduced, assets
be reorganised, or the board of directors be replaced.
7.5 COMMERCIAL BANKS AND INVESTMENT BANKS
Commercial bank is the term used for a normal bank to dis tinguish it from
an investment bank. This is what people normally call a "bank". The term
"commercial" was used to distinguish it from an investment bank. Since
the two types of banks no longer have to be separate companies, some
have used the term "commer cial bank" to refer to banks which focus
mainly on companies. In some English -speaking countries outside North
America, the term "trading bank" was and is used to denote a commercial
bank. During the great depression and after the stock market crash of
1929, the U.S. Congress passed the Glass -Steagal Act 1930 (Khambata
1996) requiring that commercial banks only engage in banking activities
(accepting deposits and making loans, as well as other fee -based services),
whereas investment banks were limited to ca pital markets activities. This
separation is no longer mandatory. It raises funds by collecting deposits
from businesses and consumers via checkable deposits, savings deposits,
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85 also buys corporate bonds and government bonds. Its primary liabilities
are deposits and primary assets are loans and bonds. Commercial banking
can also refer to a bank or a division of a bank that mostly deals with
deposits and loans from corporations or lar ge businesses, as opposed to
normal individual members of the public (retail banking).
THE FUNCTIONS OF COMMERCIAL BANK
A: General Functions:
1. Receiving Deposits: The first and foremost function of commercial
bank is to receive or collect deposits from the public in different forms
of accounts e.g. current, savings, term deposits. No interest is charged
in the current account, lower rate of interest is charged in the savings
account and comparatively higher interest rates charged in fixed
deposits. Thus , commercial bank builds up customer network.
2. Accommodation of loans and advances: Commercial Bank attaches
much importance to providing loans and advances at a higher rate than
the deposit rates and thus earns profits on it. Working capital is
accommo dated to the borrower for expansion and smooth running of
business. In the similar manner, commercial bank extends financial
accommodation for the development of agriculture and industry.
Credit accommodation is provided to the entrepreneurs for reviving
sick and old industries as per Govt. directives. Thus, commercial bank
also extends welfare services to the people at large.
3. Creation of Loan Deposits: Commercial Bank not only receives
deposits from public and accommodates loans to public but also
creates loan deposits. For example: while disbursing loans as per
sanction stipulation, the amount of loan is credited to the borrower’s
account. The borrower may not withdraw the full amount at a time.
The residual amount i.e. balance left in the account cre ates loan
deposits.
4. Creation of medium of exchange: Central Bank has got exclusive
right to issue notes. On the other hand, Commercial Bank creates
medium of exchange by issuing cheques. Like notes, cheque is
transferrable being popularly used in the b anking transactions.
5. Contribution in foreign trade: Commercial Bank plays a vital role in
expediting foreign exchange and foreign trade business e.g. import,
export etc. It contributes greatly in the economy through import
finance and export finance an d thus, earn foreign exchange for the
country.
6. Formation of capital: Commercial Bank extends financial assistance
for the formation of capital in the trade, commerce and industry in the
country which expedites its economic development.
7. Creation of Investment Environment: Commercial Bank plays a
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86 B. Public Utility Functions: In modern banking, commercial bank
executes public utility services:
1. Remittance of Money: Remittance of m oney to the public from one
place to another is one of the functions of commercial bank.
Remittance is affected in the form of demand draft, telegraphic
transfer etc. through different branches and correspondents’ home and
abroad.
2. Help in trade and com merce: Commercial Bank helps expand trade
and commerce. In inland and foreign trade customers are allowed
credit accommodation in the form of letter of credit, bill purchased and
discounted etc.
3. Safe custody of valuables: Commercial Bank introduces „lo cker
services to the customers for safe custody of valuables e.g. documents,
shares, securities etc.
4. Help in Foreign Exchange business: While opening letter of credit,
commercial bank obtains credit report of the suppliers and thus help
expedite import an d export business.
5. Act as a Referee: Commercial Bank acts as a referee for and on
behalf of the customers.
6. Act as an Adviser: Commercial Bank provides valuable advice to the
customers on different products, business growth and development,
feasibil ity of business and industry.
7. Collect utility service bills: As a social commitment, Commercial
Bank collects utility service bills e.g. water, electricity, gas, telephone
etc. from the public.
8. Purchase and sale of prize bonds, sanchaya patra, shar es etc.
Commercial Bank undertakes to purchase and sale of prize bonds,
sanchaya patra, shares etc. as a part of social commitment.
9. Help people travel abroad: Commercial Bank helps customers in
traveling abroad through issuance of traveller’s cheques, drafts, cash
etc. in favour of the customers.
C. Agency Functions: Besides above stated functions, commercial bank
acts as a representative of the customers.
1. Collection and payment: Commercial Bank is engaged in collection
and payment of cheque, bill of exchange, promissory notes, pension,
dividends, subscription, insurance premium, interest etc. on behalf of
the clients.
2. Purchase and sale of shares and securities: Commercial Bank is
entrusted with the responsibility of purchase and sale of shares and
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87 3. Maintenance of secrecy: Maintenance of secrecy is one of the most
important functions of commercial bank.
4. Act as a trustee: Commercial Bank acts as a trustee on behalf of the
customer.
5. Economic Develop ment and Welfare activities: Commercial Bank
contributes much for the welfare and economic development of the
country.
Prof. Syers, defined banks as “institutions whose debt —usually referred to
as ‘bank deposits’ —are commonly accepted in final settlement o f other
people’s debts”. According to Banking Regulation Act of 1949, “Banking
means the accepting for the purpose of lending or investment of deposits
of money from the public, repayable on demand or otherwise, and
withdrawal by cheque, draft, order or ot herwise”. From the above
definitions we can analyse that the primary functions of banks are
accepting of deposits, lending of these deposits, allowing deposits to
withdraw through cheque whenever they demand. The business of
commercial banks is primarily t o keep deposits and make loan and
advances for short period up to one or two years made to industry and
trade either by the system of overdrafts of an agreed amount or by
discounting bills of exchange to make profit to the shareholders. From the
above disc ussion, we can say that the following are the functions of
commercial banks.
1. Receiving deposits from the public. The primary function of
commercial banks is receiving of deposits in the form of savings bank
account, current account and term deposits fro m the savers usually
from the public. People usually prefer to deposit their savings with the
commercial banks because of safety, security and liquidity. The
aggregate deposits of scheduled commercial banks in India rose
rapidly from Rs. 822 crores in 1951 to Rs. 3,763 crores in 1967. The
total deposits of commercial banks were Rs. 4,661 crores in 1969 that
increased to Rs. 34,237 crores by 735 per cent by 1979. The total
deposits of commercial banks increased in the decade of 1981 to 1991
from Rs. 40,413 c rores to Rs. 2,00,569 crores by 5 times. Out of which
the proportion of current, saving and fixed deposits were Rs. 6,286,
Rs.11,805 and Rs. 22,322 crores which is almost 1: 2: 3 ratios
increased to Rs. 30,335, Rs. 56,152 and Rs. 114082 crores i.e., almost
5 times during one decade with almost same proportion. The total
deposits with commercial banks by the end of 2005 increased to Rs.
21,00,000 crores.
2. Giving loans and advances. The second major function of the
commercial banks is giving loans and adva nces to the all types of
persons, particularly to businessmen and investors, against personal
security, gold and silver and other movable and immovable assets. The
bank advances loans in the form of cash credit, call loans, overdraft
and discounting bills of exchange to businessmen. After reforms in
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88 foreign banks, the other commercial banks also started giving loans
and advances not only to their traditional businesses but also for
vehicles, h ousing, consumer durables, etc. by increasing the base of
lending activities.
3. Use of cheque system and credit cards. The commercial banks will
allow the depositors of the bank to withdraw and make payment of
their amount in their bank account through c heques. Now the banks
are allowed to use debit and credit cards for making their payments.
4. Credit creation. Credit creation is one of the most important functions
of the commercial banks. Like other financial institutions, they aim at
earning profits. F or this purpose, they accept deposits and advance
loans by keeping small cash in reserve for day -to-day transactions.
When a bank advances a loan, it opens an account in the name of the
customer and does not pay him in cash but allows him to draw the
money by cheque according to his needs. By granting a loan, the bank
creates credit or deposit.
5. Financing foreign trade. The commercial banks finance foreign trade
of its customers by accepting foreign bills of exchange and collecting
them from foreign bank s. It also transacts other foreign exchange
business and buys and sells foreign currency.
6. Transfer of funds. Commercial banks will help the customers to
transfer their money from one account to another account, from one
place to another place through c heques. Now the transfer of funds
from one place to another place, or from one party account to another
party account or one bank to another bank is done through Electronic
Fund Transfer (EFT). This facility helps in transferring funds from one
bank to ano ther bank or to another party account easy. The technology
like MICR helps the banks to have innovative banking like anywhere
banking, anytime banking, and virtual banking and so on.
7. Agency functions. The commercial banks act as agents for customers
to buy and sell shares, securities on their behalf. It pays subscriptions
to insurance premiums, mutual funds, rent, water taxes, electricity bills
etc on behalf of its clients. It also acts as a trustee and executor of the
property and will of its customers .
8. Miscellaneous functions. The miscellaneous functions performed by
the commercial banks are: it provides safety locker facility, making
and receiving payments on behalf of its depositors, issuing letters of
credit and traveller’s cheques etc.
Advances . A bank makes investments for the purpose of earning profits.
First it keeps primary and secondary reserves to meet its liquidity
requirements. Banks invest in securities either for fulfilment of SLR/CRR
requirements or for earning profit on the idle fund s. Banks invest in
“approved securities” (predominantly Government securities) and “others”
(shares, debentures and bonds). The values/rates of these securities are
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89 transacted freque ntly and some are held till maturity. The Ghosh
Committee recommended that “a bank’s investment portfolio should be
bifurcated into two parts, namely, ‘permanent investment’ and ‘current
investment’. The committee recommended that banks should make
necessa ry provision for the depreciation in the value of current investment
and there is no need to provide for permanent investment.
RBI has also advised the banks to classify the existing investment in
approved securities into two categories. Initially from the accounting year
1992 -93, banks should not keep more than 70% of their investment in
permanent category, and 30% of the portfolio as current investments to
facilitate valuing all the investments on fully ‘marked to market’ basis.
Guidelines were laid down for transfer of approved securities from
‘current’ to ‘permanent’ and ‘vice versa’ in 1992. These guidelines ensure
that latent losses are provided for at the time of such transfer. In 1993 the
entire investment portfolio of banks other than investments cl assified as
‘permanent’ has to be classified into six categories for the purpose of
valuation. The valuation will be done for each category of investments.
While net depreciation has to be provided by debit to the profit and loss
account, net gains have to be ignored. Permanent investments can be
carried at book value. Premium will have to be amortized over the life of
the investment but discount cannot be recognized as income. In between
1993 to 1998 the said minimum ratio of 30 per cent has been increased in
a phased manner to 60 per cent as on March 31, 1998. It has further been
decided to increase the ratio to 70 per cent for the year ending March 31,
1999. New private sector banks are required to market their entire
investments in approved securities si nce March 31, 1997.
OBJECTIVES OF A COMMERCIAL BANK
1. To establish as an institution for maximizing profits and to conduct
overall economic activities.
2. To collect savings or idle money from the public at a lower rate of
interests and lend this public money at a higher rate of interests.
3. To create propensity of savings amongst the people.
4. To motivate people for investing money with a view to bringing
solvency in them.
5. To create money against money as an alternative for enhancing supply
of mo ney.
6. To build up capital through savings.
7. To expedite investments.
8. To extend services to the customers. 9. To maintain economic stability by means of controlling money market.
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90 11. To assist the Govt. for trade& business and socio -economic
development
What is Investment Banking?
Investment banking is focused on supporting companies, institutions, and
other significant organisations (such as governments) with their financial
management. It is made to give customers a wide range of options to help
them achieve financially.
Investment banks aid their m ain clients by issuing stocks, creating money,
and underwriting equity and debt securities. Additionally, investment
banks are frequently involved in mergers and acquisitions.
Investment banking is set up to benefit big businesses. Issuing stock for
compan ies, specifically during an initial public offering, is one of the most
significant tasks investment banks conduct (IPO). Money flow can
become perplexing when a corporation first makes its stock accessible to
the public. Investment banks intervene to assi st in handling the situation.
Investment banks also serve as counsellors, assisting companies and other
organisations in deciding whether doing business with other companies is
a good idea. Investment banks serve as counsellors to their clients,
assisting them in determining the wisdom of purchasing or merging with
another business.
Because investment banking is a highly specialised sector that typically
requires more education or experience, careers in this field are frequently
more competitive than those in commercial banking. In this industry, some
well-liked job options include:
The most senior management of an investment bank is known as a
managing director. You manage a section or a department as a managing
director, and you also find new clients.
Vice president : A vice president oversees analysts and associates and
helps manage daily client relations. The continual development of
financial models and presentations is also overseen by vice presidents.
Associate: An analyst who collaborates with customer s to write deal
proposals and deliver marketing presentations is known as an associate.
Associates frequently travel to present agreements, so their success
depends on their ability to establish and keep positive relationships.
Trading expert : A trading ex pert maintains stock holdings and conducts
business concerning the assets of a corporation. In order to ensure that
they are able to give their clients sound advise, this position demands good
analytical and forecasting abilities.
A stock market analyst ev aluates opportunities and makes investment
recommendations based on customer needs. Analysts can find solid
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91 The basic difference between investment bank and commercial bank are
indicated below:
1. An investment bank is a type of financial intermediary created to offer
companies consulting and investment services. A bank called
Commercial Bank was founded to offer banking services to the general
people.
2. Commercial banks give uniform services whereas i nvestment banks
offer services tailored to the needs of the customer.
3. In comparison to an investment bank, a commercial bank has a larger
customer base.
4. The performance of the stock market affects the investment bank, but
the commercial bank's interest rat e is influenced by economic
expansion and loan demand.
5. The investment bank acts as a banker for people, organisations, and
governments. However, a commercial bank serves as a banker for all
of the nation's residents.
6. Fees and commissions are how the invest ment bank makes money. In
contrast to Commercial Bank, who makes money via interest and fees.
7.6 SUMMARY
● The Fund Sponsor is the top tier of the three -tiered organisational
structure for Indian mutual funds.
● A custodian is one such company in responsibili ty of keeping the
assets of the Mutual Fund secure.
● The primary difference between these two financial intermediaries is
the audience they cater to as well as their area of business. While
commercial banks serve all the citizens of the country and its main
business is to accept deposits and grant loans.
● Investment banks deal in securities and so its primary activity is to
trade in financial assets and provide advisory services.
● The relatively new Indian hedge fund market received a green light
from the Sec urities and Exchange Board of India (SEBI) in 2012,
allowing alternative investment funds (AIF).
7.7 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Discuss the various types of insurance.
2. Write note on Hedge funds.
3. Explain the various types of Hedge funds.
4. Difference between commercial and investment bank. munotes.in

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92 5. Discuss about Objectives of a commercial bank .
6. What is Investment Banking?
B. Fill in the blanks:
1. In September 2012, …………. adopted a number of progressive steps in
respon se to India's low mutual fund penetration, particularly in Tier II
and Tier III towns .
2. ………….. and trustees make up the second tier of the Indian mutual
fund structure.
3. A ……………… looks to take advantage of short -term price
discrepancies between linked securities by capitalising on spread or
price inefficiencies.
4. A ……………. oversees analysts and associates and helps manage daily
client relations.
5. ……………. aid their main clients by issuing stocks, creating money,
and underwriting equity and debt securit ies.
Answers :
1- SEBI, 2 - Trust, 3 - relative value hedge fund , 4- Vice president, 5 -
Investment banks
7.8 REFERENCES
References book
 Mishkin, F. (1999) ‘Global financial instability: framework, events,
issues’, Journal of Economic Perspectives, Vol. 13.
 Padoa -Schioppa, T. (2003) ‘Central banks and financial stability:
exploring the land in between’, The Transformation of the European
Financial System.
 Rahim, N.H.A. and Abedin, N.F.Z. (2014) ‘Trade liberalisation,
financial development and growth in Malaysi a’, International
Proceedings of Economics Development and Research.
 Luintel, K.B. and Khan, M. (1999) ‘A quantitative reassessment of the
finance -growth nexus: evidence from a multivariate VAR’, Journal of
Development Economics, Vol. 60.
 Mattoo, A. (199 8) Financial Services and the WTO: Liberalization in
the Developing and Transition Economies, Staff Working Paper, No.
TISD9803, World Trade Organization Trade in Services Division.


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93 8
FIXED INCOME SECURITIES - I
Unit Structure
8.0 Learning Objectives
8.1 Introduction
8.2 Fixed income securities
8.3 Meaning and Characteristics of Bond
8.4 Types of Bonds
8.5 Coupon types
8.6 Computation of different yields and bond price
8.7 Relationship between yield and p rice
8.8 Floaters and inverse floaters
8.9 Summary
8.10 Unit End Questions
8.11 References
8.0 LEARNING OBJECTIVES
After studying this unit, you will be able:
 To understand Fixed income securities
 To discuss characteristics of Bond
 To analyze Types of Bonds and Coupon types
 To explain Computation of different yields and bond price
 To understand the relationship between yield and price
 To discuss Floaters and inverse floaters
8.1 INTRODUCTION
An economy of a developing country that is expanding and becoming
increasingly integrat ed with international markets is known as an
emerging market economy. Countries possessing some but not all of a
developed market's features are categorised as emerging market
economies.
Strong economic development, high per capita income, liquid equities
and debt markets, accessibility to foreign investors, and a stable
regulatory structure are some traits of developed markets.
An emerging market economy often integrates more into the global
economy as it grows. This implies that it may result in higher tr ade
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94 debt and equity markets. It can create cutting -edge regulatory and
financial institutions. Currently, significant emerging market nations
include Saudi Arabia, China, Brazil, Mexic o, Russia, and Pakistan.
A crucial transition from a low income, less developed, frequently pre -
industrial economy to a modern, industrial economy with a greater
standard of living is occurring in an emerging market economy.
8.2 FIXED INCOME SECURITIES
An investment that offers a return in the form of regular, set interest
payments as well as the ultimate repayment of principal at maturity is
referred to as a fixed -income security. A fixed -income security's
payments are predetermined, as opposed to variable -income securities,
whose payments fluctuate depending on some underlying factor, such as
short -term interest rates.
Fixed -Income Securities are debt products that offer investors fixed
interest payments in the form of coupon payments. The invested money i s
returned to the investor at maturity, while interest payments are normally
made every two years. The most popular type of fixed -income securities
are bonds. Businesses raise funds by selling investors fixed -income
products.
8.3 MEANING AND CHARACTERISTIC S OF BONDS
The bond market, also known as the debt market or credit market, is a
financial exchange where investors can trade in debt instruments issued by
both governments and corporations. Bonds are frequently issued by
governments to raise money for deb t repayment or infrastructure
development. When they need to finance corporate expansion initiatives or
support ongoing operations, publicly traded corporations issue bonds.
The primary market and secondary market are the two main divisions that
make up th e bond market. The main market, often known as the "new
issues" market, is where strictly all transactions between bond issuers and
bond buyers take place. Essentially, the primary market results in the
production of entirely new debt securities that have never been made
available to the general public.
Securities that have already been sold in the primary market are then
acquired and sold at a later time in the secondary market. These bonds are
available for purchase from brokers, who serve as a middleman between
the buyers and sellers. Among many other product formats, these
secondary market issues may be packaged as pension funds, mutual funds,
or life insurance policies.


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95 Characteristics
Most bonds share some common basic characteristics including:
 Face value is the amount of money the bond will be worth when
it matures. It also serves as the benchmark for the bond issuer for
determining interest payments.
 Coupon rate is the interest rate, represented as a percentage, that
the bond issuer will charge o n the bond's face value.
 The dates on which the bond issuer will pay interest are known as
coupon dates. Annual or semi -annual coupon payments are
typical periods.
 The bond's maturity date is the day on which it will reach
maturity and the bond's issuer wi ll pay the bondholder the bond's
face value.
 Issue price is the price at which the bond issuer originally sells
the bonds.
 The main determinants of a bond's interest rate are two
characteristics: credit quality and length.
 If the issuer has a low credit ra ting, there is a higher danger of
default, and these bonds typically trade at a discount.
 Credit rating agencies determine and publish credit ratings. Bond
maturities might be anything from one day to over 30 years. The
likelihood of negative outcomes incr eases with bond maturity or
length.
 Bonds with longer maturities also typically have less liquidity.
Bonds with a longer duration to maturity often carry a higher
interest rate due to these characteristics.
 When considering the riskiness of bond portfolios , investors
typically consider the duration (price sensitivity to changes in
interest rates) and convexity (curvature of duration).
8.4 TYPES OF BONDS
Types of Bonds:
1. Government Securities Bonds:
2. Corporate:
3. Convertible:
4. Zero -Coupon:
5. Inflatio n-Linked:
6. RBI Bonds:
7. Sovereign Gold Bonds:
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96 1. Government Securities Bonds:
A debt instrument issued by the central or state governments of India is a
government securities bond.
Government securities (G -Sec), which primarily offer long -term
investme nts between 5 and 40 years, include Government Bonds in India.
State Development Loans are another name for the bonds that the state
government issues.
These government securities were created by the Indian government to
allow small investors to invest mod est sums and earn interest while taking
less risks.
These bonds have semi -annual interest payments that can be either fixed
or floating. However, the majority of government bonds are offered at a
set interest rate.
2. Corporate:
Companies issue corporate b onds to borrow money from investors for a
set period of time while charging them a set interest rate throughout that
time.
Companies typically sell bonds to investors to fund new projects or to
expand their operations in order to develop in the future.
Instead of getting a loan from the banks, the company seeks investors to
invest their money in exchange for a particular rate of return over a set
period of time.
Investors receive the face value and interest rate after the term is over.
Investors that wish t o earn a set interest rate for the course of their
investment prefer this type of bond.
3. Convertible:
These provide both the benefits of debt and equity, but not simultaneously.
The bondholders can convert this into a specified number of stocks,
becoming shareholders of the company and receiving all the rewards
provided to shareholders.
After buying convertible bonds, investors can gain from both debt and
equity securities.
4. Zero -Coupon:
It is also known as a "pure discount bond" since, until the bond m atures,
the invested funds do not provide a regular interest rate.
The face value of the bond, which is returned to the investor when it
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97 5. Inflation -Linked:
This kind of bond is designed to reduce the inflation risk of an investment
that is primarily issued by the government and protects against inflation.
Bonds that are linked to inflation see their principal and interest rates
fluctuate in line with inflation.
6. RBI Bonds:
The variable rate saving bonds 2020 (FRSB) that the RBI issues are also
known as RBI bonds. 7 -year taxable bonds with an interest rate that
fluctuates throughout the course of the bond's term.
As a result, rather than being paid at maturity, the interest rate is reset
every six months, with the first reset occurring on January 1, 2021.
When interest rates in the economy increase, the floating interest rate may
as well.
7. Sovereign Gold Bonds:
The central government issues these bonds to investors who wish to invest
in gold but do not want to carry physical gold around with them.
This bond's interest income is not subject to taxation. Because it is being
offered by the government, it is also regarded as a highly secured bond.
After the first five years, investors who cho ose to redeem their investment
may do so; however, doing so will merely change the date on which future
interest payments are made.
8.5 COUPON TYPES
A coupon bond is a specific kind of bond that has attached coupons and
makes periodic interest payments (us ually annually or semi -annually)
throughout its life as well as its par value upon maturity. The yield on
these bonds at the time of issuance is indicated by the coupon rate, which
is included with the bonds. Bonds with higher coupon rates provide
investor s with larger returns on their capital.
Such bonds were issued in the form of bearer certificates. This means that
the physical possession of the certificate was sufficient proof of
ownership. No records of the original or any subsequent buyer of the bond
was retained by the issuer. They came to be known as “bearer bonds”
because anyone bearing the appropriate coupon could present it to the
issuer’s agent and receive the interest payment. The coupons were printed
on the bond, from which they could be detach ed and presented for
payment.
Since most bonds are issued electronically without physical certificates,
physical forms of bonds are rare. Even so, the term "coupon" is still in use,
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98 How Does a Coupo n Bond Work?
The issuer of the bond agrees to make annual or semi -annual interest
payments equal to the coupon rate to investors. These payments are made
until the bond’s maturity.
Formula for Calculating the Coupon Rate
Where:
C = Coupon rate
i = Annualiz ed interest
P = Par value, or principal amount, of the bond
Coupon Types – Fixed Rate and Floating Rate Bonds
A zero -coupon bond is a specific variety of fixed -rate bond. In this
instance, there is no interest paid from the time the bond is issued until it
matures. they "pay" a set coupon of 0% as a result. This does not imply
that bondholders receive no return because zero -coupon bonds are
frequently offered at a discount but are fully repaid when they mature.
Investors will therefore profit throughout the course of the bond's
existence from this discrepancy between the purchase and redemption
prices.
Most bonds are fixed -rate bonds, which are very common.
Bonds with fluctuating rates are an alternative to fixed -rate bonds. In
contrast to fixed -rate bonds, the coupon formula used in this case
determines the coupon amount every month throughout the duration of the
bond. Frequently, these coupon calculations are presented as LIBOR or
some comparable reference rate plus or minus a spread. By doing so, the
LIBOR or another comparable reference rate's future development or
trajectory will determine the real interest payments, which are not known
in advance. Therefore, interest rate payments are either floating or
variable. For this reason, these bonds are also kno wn as "floating -rate
notes," or FRNs.
8.6 COMPUTATION OF DIFFERENT YIELDS AND
BOND PRICE
Daily monitoring of bond prices is valuable for determining the trajectory
of interest rates and, more broadly, the future of the economy. Not
surprisingly, they play a significant role in a properly managed and
diversified investment portfolio. Bond yields and prices are always
subject to price fluctuations, particularly during times of rising or falling
interest rates. Let's talk about the connection between bond yiel ds and
prices.
If you purchase a bond right away, its face value will be its price, and its
yield will be equal to its coupon rate. In other words, if you purchase a munotes.in

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99 bond with a three -year interest rate of 1%, you will receive just that. You
will receive t he bond's face value back after it matures. You are not
interested in its value at any point in the future unless you intend to sell it.
Calculating a Bond's Dollar Price:
A bond's dollar price and cash flows are correlated by a yield. The
principle repaym ent and coupon payments make up a bond's cash flows.
When a bond reaches its maturity date at the end of its term, the principal
is returned.
The yield on a bond is the discount rate that can be applied to bring the
bond's price and the present value of al l of its cash flows into balance. In
other words, the present value of all the cash flows is added to determine
the price of a bond. The same discount rate is used to value each cash
flow in the present. The yield is the discount factor.
8.7 RELATIONSHIP B ETWEEN YIELD AND PRICE
Bonds :
Bonds are a significant component of the financial market and serve as a
vital source of money for governments and businesses. Understanding
the idea of bond yield is crucial when dealing in fixed -income
instruments. Debt -oriented funds, such as short -term mutual funds,
invest in bonds in the mutual fund industry to give investors short - to
medium -term investment horizons and a chance to generate significant
returns.
RELATIONSHIP OF THE BOND PRICE AND YIELD :
Bond prices and y ields have a significant but opposing link. Bond yields
are higher than coupon rates when the bond price is less than the bond's
face value. Bond yields are lower than coupon rates when the bond price
is greater than the bond's face value. As a result, the bond yield
computation is based on the bond's price and coupon rate. The yield
increases as the bond price decreases, and decreases when the bond
price increases. Let's examine the reasons why this is the case:
1. When interest rates fall, it causes a fal l in the value of the related
investments. However, bonds that have been issued will not be affected
in such a way. They will keep paying the same coupon rate as issued
from the beginning, which will now be at a higher rate than the
prevailing interest rat e. This higher coupon rate makes these bonds
attractive to investors willing to buy these bonds at a premium.
2. Conversely, when interest rates rise, newer bonds will pay investors
better interest rates than existing bonds. Here, the older bonds are less
attractive and will drop their prices as compensation and sell at a
discounted price.
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100 Inverse Relationship Between Bond Prices and Bond Yields
Bond yields and prices are inversely correlated, thus when bond prices
increase, their yield decreases (and vice versa).
Notably, the environment of current interest rates is the component that
probably has the most impact on bond yields.
As a general rule, if interest rates rise, bond prices fall because of the
inverse relationship between yields and interest rates (and vice versa).
 Bond yields rise as interest rates rise because market bond prices
decline (i.e. higher coupon).
 Bond yields fall as market prices for bonds rise in response to
declining interest rates (i.e. lower coupon).
8.8 FLOATERS AND INVERSE FLOA TERS
Floater :
A floating rate note (FRN), also known as a floater, is a bond or other
type of debt instrument whose interest payment is variable and linked to a
predefined benchmark index, such as the London Inter -bank Offer Rate
(LIBOR), that adapts to t he state of the market.
A fixed -rate note, which offers the same interest rate throughout its full
maturity, can be compared to a floating -rate note.
A fixed income security called a floater makes coupon payments in
accordance with a reference rate. The co upon payments are modified in
response to changes in the current market interest rates. The value of the
coupons is increased to reflect an increase in interest rates as they occur.
A floater typically pays less interest than a comparable fixed -rate note o f
the same maturity since it is based on short -term interest rates, which are
normally lower than long -term interest rates. Investors may ask for a
higher interest rate, such as the three -month T -bill rate + 0.75%, if they
believe the issuer's creditworthi ness is declining.
A floater is more beneficial to the holder as interest rates are rising
because it allows a bondholder to participate in the upward movement in
rates since the coupon rate of the bond will be adjusted upwards.
Investors who choose floate rs are willing to accept a lower initial rate in
exchange for the possibility of a higher rate if market rates rise.
What Is an Inverse Floater?
A bond or other type of paper that has a coupon rate that is inversely
correlated to a benchmark rate is known as a "inverse floater." Inverse
floaters alter their coupon payments in response to changes in interest
rates. An inverse floater is often referred to as a reverse floater or an
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101 These bonds are typically issued by governments an d businesses, who sell
them to investors in order to raise money. While businesses might use the
money from a bond issue to create a new plant or purchase equipment,
governments might utilise these cash to construct roads and bridges.
Investors of an inver se floater will receive cash payments in the form of
periodic interest payments, which will adjust in the opposite direction of
the prevailing interest rate.
How an Inverse Floater Works?
In contrast to a floating -rate note (FRN), which is a fixed income s ecurity
that issues coupon payments that are correlated to a reference rate, an
inverse floating rate note (or inverse floater) operates in a completely
different manner. A floating -rate note's coupon payments are modified in
response to shifts in the mark et's benchmark interest rate. The coupon's
value rises in response to an increase in interest rates.
As their reference or benchmark interest rates, floating -rate notes may use
the London Interbank Offered Rate (LIBOR), Euro Interbank Offer Rate
(EURIBOR), the prime rate, or the U.S. Treasury rate.
The coupon rate on a note with an inverse floater varies in opposition to
the benchmark interest rate. By dividing fixed -rate bonds into two
classes —a floater, which moves in direct correlation with some interest
rate index, and an inverse floater, which represents the fixed -rate bond's
residual interest after deducting the floating rate —inverse floaters are
created.
Calculating an Inverse Floater
Given that the rate is subtracted from the coupon payment, when the
reference rate rises, the coupon rate will also rise. The noteholder will
receive less money if the interest rate is greater since more will be
withheld. Similarly, as interest rates fall, the coupon rate increases
because less is subtracted.
An inverse f loater's coupon rate can be calculated using the following
general formula:
Floating rate = Fixed rate – (Coupon leverage x Reference rate)
The coupon leverage is the multiple by which the coupon rate will change
for a 100 -basis point (bps) change in the r eference rate. The fixed -rate is
the maximum rate the floater can realize.
Special Considerations:
Inverse floaters significantly increase interest rate risk, just like any
investments that use leverage. The market price and yield of the inverse
floater bo th rise in response to a decline in short -term interest rates,
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102 On the other hand, when short -term interest rates increase, the bond's
value may drastically decline, leaving holders with a security that only
pays m inimal interest. Consequently, interest rate risk is increased and
has a high level of volatility.
8.9 SUMMARY
● The bond market, also known as the debt market or credit market, is
a financial exchange where investors can trade in debt instruments
issued by both governments and corporations .
● The primary market and secondary market are the two main divisions
that make up the bond market.
● The variable rate saving bonds 2020 (FRSB) that the RBI issues are
also known as RBI bonds. 7 -year taxable bonds with an i nterest rate
that fluctuates throughout the course of the bond's term.
● A coupon bond is a specific kind of bond that has attached coupons
and makes periodic interest payments (usually annually or semi -
annually) throughout its life as well as its par value upon maturity.
8.10 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. What Bonds? Discuss its characteristics.
2. Explain the different types of bonds.
3. Differentiate between primary market and secondary market.
4. Write note on inverse floa ter.
5. Discuss the Inverse Relationship Between Bond Prices and Bond
Yields.
B. Fill in the blanks:
1. …………… is the amount of money the bond will be worth when it
matures.
2. A …………… issued by the central or state governments of India is a
government secu rities bond.
3. LIBOR stands for………….
4. A floating rate note (FRN), also known as a…………...
5. The central government issues ……………. bonds to investors who
wish to invest in gold but do not want to carry physical gold around
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103 Answers :
1- Face valu e, 2- debt instrument, 3 - London Inter -bank Offer Rate , 4-
floater , 5- Sovereign Gold Bonds .
8.11 REFERENCES
References book
 Mishkin, F. (1999) ‘Global financial instability: framework, events,
issues’, Journal of Economic Perspectives, Vol. 13.
 Padoa -Schioppa, T. (2003) ‘Central banks and financial stability:
exploring the land in between’, The Transformation of the European
Financial System.
 Rahim, N.H.A. and Abedin, N.F.Z. (2014) ‘Trade liberalisation,
financial development and growth in Malaysia’, Inte rnational
Proceedings of Economics Development and Research.
 Luintel, K.B. and Khan, M. (1999) ‘A quantitative reassessment of the
finance -growth nexus: evidence from a multivariate VAR’, Journal of
Development Economics, Vol. 60.
 Mattoo, A. (1998) Financ ial Services and the WTO: Liberalization in
the Developing and Transition Economies, Staff Working Paper, No.
TISD9803, World Trade Organization Trade in Services Division.


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104 9
FIXED INCOME SECURITIES - II
Unit Structure
9.0 Learning Objectives
9.1 Introduction
9.2 Spot rates and forward rates
9.3 Zero coupon yield curve
9.4 Theories of term structure of interest rates.
9.5 Fixed income risk measures: duration, modified durati on, convexity
and price

9.6 Value of basis point.
9.7 Summary
9.8 Unit End Questions
9.9 References
9.0 LEARNING OBJECTIVES
After studying this unit, you will be able:
 To analyse Fixed income securities
 To discuss Spot rates and forward rates
 To expl ain Zero coupon yield curve
 To discuss Theories of term structure of interest rates.
 To describe Fixed income risk measures: duration, modified duration,
convexity and price value of basis point
9.1 INTRODUCTION
The term "spot rates" describes the interest rates on financial instruments
that are traded on the stock exchanges and are due "on the spot." These
might include overnight bank loans, commercial paper, or short -term
securities like Treasury bills. The fair value of a financial instrument,
such as a bond, is frequently calculated using spot rates as a benchmark.
On the other hand, forward rates are interest rates that are established now
but won't be paid until a later time. They show a spot rate's anticipated
future worth at a specific time. on insta nce, if the spot rate on a 1 -year
Treasury bond is 2% right now, the 1 -year forward rate for the same bond
could be 2.5%, suggesting that higher interest rates are anticipated over
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105 9.2 SPOT RATES AND FORWARD RATES
Forward Rate vs. Spot Rate:
In many markets, "ahead rate" and "spot rate" have slightly different
exact definitions. A forward rate, on the other hand, refers to the price or
yield for the same product or instrument at a specific future date. In
speaking, a spot rate r efers to the current price or bond yield.
A spot rate is the price for a commodity that is being exchanged right
away, or "on the spot," in the markets for commodities futures. The
settlement price for a transaction that won't happen until a future date is
known as a forward rate.
Spot Rate :
The price stated in real -time for the immediate settlement of a contract is
known as a spot rate or spot price. The current cost to buy or sell a
commodity, security, or currency is represented by the spot rate in
comm odities markets.
Since the contract's delivery date often falls within two business days of
the transaction date, a spot rate is linked to an item's immediate necessity.
Any price variations between the Settlement Date and the Delivery Date
shall not affec t the Contract's completion at the agreed -upon Spot Rate.
Buyers and sellers who agree to a spot rate contract are sacrificing
potentially advantageous future market conditions in order to reduce the
risk of price fluctuation.
Forward Rate :
A forward rate is a set price that is agreed upon by all parties for the
delivery of a good at a particular future date. If a buyer thinks the price of
a good will increase in the future beyond the forward rate, using forward
rates could be considered speculative. As an alternative, dealers employ
forward rates to reduce the chance that the price of a good will drop
significantly in the future.
How Do You Calculate the Forward Rate?
By comparing the anticipated future yields of two bonds, the forward rate
for a bond is d etermined. The yield that will be obtained if the funds from
the bond maturing sooner are reinvested to match the term of the bond due
later is known as the forward rate.
The steps to calculate the forward rate are:
1. Determine the expected future return of the two -year bond. This is
calculated as ((1 + rate) ^ term). In this example, the value is 1.15562.
2. Determine the expected future return of the one -year bond. This is
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106 3. Divide the resu lts obtained in steps 1 and 2. In this example, the result
is 1.0851%.
4. Divide the result obtained in step 3 by the difference in the number of
periods between the two bonds, then subtract 1 from the result. In this
example, 1.0851% is divided by 1 (2 years - 1 year), and 1 is
subtracted. The result of 8.5% is the one -year forward rate.
9.3 ZERO COUPON YIELD CURVE
An accrual bond, also known as a zero -coupon bond, is a financial
security that doesn't pay interest but trades at a significant discount,
making money when it matures and is redeemed for its full face value.
Zero -Coupon Bonds :
Some bonds are issued as zero -coupon securities right away, while others
become zero -coupon securities after being decoupled from their coupons
and repackaged as zero -coupon securities by a financial institution. Zero -
coupon bonds are more prone to market fluctuations than coupon bonds
because they deliver the entire payment at maturity.
A corporate or governmental entity can raise capital by issuing bonds.
Investors buy bond s when they are issued, effectively lending money to
the issuing entity. Throughout the bond's existence, the investors receive
a return in the form of semi -annual or yearly coupon payments.
These bonds are issued at a significant discount and, when they m ature,
pay back the par value. The investor's return is calculated as the
difference between the purchase price and par value. The investor will be
paid the amount of their initial investment plus interest that has been
accrued at a specified yield and com pounded semi -annually.
Pricing a Zero -Coupon Bond:
The price of a zero -coupon bond can be calculated as:
Price = M ÷ (1 + r)n
where:
 M = Maturity value or face value of the bond
 r = required rate of interest
 n = number of years until maturity
The price of the bond decreases as the remaining time to maturity
increases, and vice versa. Zero -coupon bonds often have lengthy maturity
dates, with initial maturities of at least ten years. Investors can plan for
long-term objectives, such saving for a child's colle ge education, using
these long -term maturity dates. An investor can make a small initial
investment that will rise over time thanks to the bond's substantial
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107 9.4 THEORIES OF TERM STRUCTURE OF INTEREST
RATES
Theories of term structure of interest rates:
The graph that shows the correlation between interest rates (or yields on
bonds) and a variety of different maturities is known as the interest rate
structure. The graph is referred to as a "yield curve" itself. By enabling
easy comparison of yields depending on time and anticipating the future
trajectory of rates, the term structure of interest rates plays a significant
role in every economy.
Types of Term Structure of Interest Rates :
 Normal/Positive Yield
 Steep
 Inverted/Negative Yield
 Humped/Bell -Shaped
 Flat
1 – Normal/Positive Yield
The slope of the typical yield curve is upward. This is valid for securities
with longer maturities, which are more exposed to risk than short -term
securities. Therefore, a rational investor would expect more compensat ion
(yield), leading to a typical yield curve with a positive slope.

Bond yields or interest rates are plotted against X -axis while time horizons
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108 2 – Steep
The only difference between the steep yield curve and the standard yield
curve is the rate at which interest rates climb for long -maturity securities
relative to short -maturity instruments.

#3 – Inverted/Negative Yield :
When there is a strong likelihood that long -maturity yields would
eventually fall below short -maturity yield s, the curve becomes inverted.
An key sign of the impending economic recession is an inverted yield
curve.

4 – Humped/Bell -Shaped
This type of curve is atypical and very infrequent. It indicated that yields
for medium -term maturity are higher than both l ong and short terms,
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109

5 – Flat
Similar returns for long -, medium -, and short -term maturities are shown
by a flat curve.

Term Structure Theories :
The background theories are essential to any study of term structure. The y
are important for comprehending the causes and mechanisms underlying
the yield curves' structure.
 1 – The Expectations Theory/Pure Expectations Theory
 2 – Liquidity Preference Theory
 3 – Market Segmentation Theory/Segmentation Theory
 4 – Preferred Habita t Theory
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110 1- The Expectations Theory/Pure Expectations Theory :
According to expectations theory, future short -term rates can be predicted
from current long -term rates. By combining the returns of various bonds,
it simplifies the return on a single bond. A 3-year bond, for instance,
would produce about the same return as three 1 -year bonds.
2 – Liquidity Preference Theory
 The more widely accepted view of investors' desires for liquidity is
improved by this theory. Investors tend to favour short -term assets
because they offer greater liquidity than long -term securities, which
can keep money locked up for an extended period of time. This
theory's main arguments are as follows:
 The price change for long -term debt securities is greater than for short -
term debt securities;
 Liquidity restrictions on long -term bonds prevent the investor from
selling the bond whenever he wants; and
 The investor needs an incentive to make up for the various risks he is
exposed to, particularly price risk and liquidity risk.
 Less liq uidity leads to an increase in yields, while more liquidity leads
to falling yields, thus defining the shape of upward and downward
slope curves.
3 – Market Segmentation Theory/Segmentation Theory
 This theory relates to a market's supply -demand dynamics. T he
following factors influence the yield curve's shape:
 Investor preferences for long -term and short -term securities.
 The maturities of an investor's assets and obligations are matched as
closely as possible. Any discrepancy can result in a loss of wealth or
income.
 Varied supply and demand curves are created by securities with
different maturities, and these curves ultimately give rise to the final
yield curve.
 High demand and little supply cause interest rates to rise.
4 – Preferred Habitat Theory
Accordi ng to this hypothesis, an investor's preferences may change
depending on their level of risk tolerance. If they are fairly compensated
for their risk exposure, they can also opt to invest in bonds that are not
generally their preference.
These were some of the key hypotheses that determined the yield curve's
structure, however this list is not all -inclusive. Additionally, theories like munotes.in

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111 the substitutability theory and Keynesian economic theory have been put
forth.
Conclusion :
The term structure of interest rates is one of the most potent predictors of
economic well being. All recessions in the past have been linked to
inverted yield curves, showing how important a role they play in the credit
market. Yield curves aren’t ever constant. They keep changing, ref lecting
the current market mood, helping the investors and financial
intermediaries stay on top of everything.
9.5 FIXED INCOME RISK MEASURES: DURATION,
MODIFIED DURATION, CONVEXITY AND PRICE
VALUE OF BASIS POINT
Duration :
Two tools are used to control t he risk exposure of fixed -income
investments: duration and volatility. The duration gauges how sensitive
the bond is to fluctuations in interest rates.
Duration of a Bond
The "duration" of the bond is what Canadian economist Frederick
Robertson Macaulay c alled the effective -maturity idea in 1938. As a
result, he proposed that this duration be calculated as the weighted
average of the dates until maturity of each coupon, or principal payment,
made by the bond. The following is the Macaulay formula for durat ion:
D=∑i=1T(1+r)tC+(1+r)t
∑i=1T(1+r)tt∗C+(1+r)tT∗F
Where,
D=The bond’s MacAulay duration
T=the number of periods until maturity
i=the ith time period
C=the periodic coupon payment
r=the periodic yield to maturity
F=the face value at maturity
Modified duration :
An expression expressing the quantifiable change in a security's value in
response to an interest rate change is called modified duration. Modified
duration is based on the idea that bond prices and interest rates fluctuate
in op posing directions. This equation is used to calculate the impact of a
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112 Formula and Calculation of Modified Duration:
Modified Duration = Macaulay Duration
1 + YTM
n
where :
Macaulay Duration =Weighted average term tomaturity of the cash flows f
rom a bond
YTM =Yield to maturity
n=Number of coupon periods per year
The modified duration is a development of the Macaula y duration that
enables investors to gauge how sensitive a bond is to interest rate
changes. The weighted average period of time until a bondholder receives
cash flows is determined by Macaulay duration. The Macaulay duration
must be determined before the modified duration can be determined. The
Macaulay duration is calculated as follows:
Macaulay Duration = ∑t=1n(PV×CF)×t
Market Price Of Bond
Where:
PV×CF=Present value of coupon at period t
t= time to each flow in years
n = Number of coupon periods per year
Here, (PV) * (CF) is the present value of a coupon at period t, and T is
equal to the time to each cash flow in years. This calculation is performed
and summed for the number of periods to maturity.
What Are Duration and Convexity?
Two strategies are used to control the risk exposure of fixed -income
investments: dur ation and convexity. The duration gauges how sensitive
the bond is to fluctuations in interest rates. Convexity refers to the
relationship between an interest rate change's impact on a bond's yield
and price.
Investors use a statistic called duration to as sess a bond's price sensitivity
to changes in interest rates when dealing with coupon bonds. Fixed -
income investors need a mechanism to calculate the average maturity of a
bond's promised cash flow because coupon bonds make a series of
payments during thei r tenure. This figure may then be used to calculate
the bond's actual maturity. This is achieved through the length, enabling
fixed -income investors to manage their portfolios' level of uncertainty
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113 Convexity in Fixed Income Management
Given a change in yields, the curved line depicts the change in prices. By
using the duration statistic, a straight line that is perpendicular to the
curve represents the estimated change in price. The discrepancy between
the duration estimate and the actual price movement is shown in the
darkened area. As previously mentioned, the error in forecasting the
change in bond price increases as interest rates move more dramatically.
By measuring the change in length as interest rates vary, convexity, a
measure of t he curvature of the changes in a bond's price in proportion to
changes in interest rates, corrects for this mistake. The equation reads as
follows:
C= f′′(B(r))
BDr2
Where:
f′′=Second order derivative
B=Bond price
r=Interest rate
D=Duration

What Does Price Value of a Basis Point Mean?
The term "price value of a basis point" (PVBP) is used to quantify how a
change in yield of one basis point impacts the price of a bond. The term
"price value of a basis point" can also refer to the dollar value of a basis
point, the value of a basis point, or the basis point value (BPV).
Price Value of a Basis Point (PVBP):
One way to gauge a bond's price sensitivity is by looking at its basis point
price value. This is frequently determined by evaluating the absolut e
change in a bond's price if the necessary yield increases by one basis
point (BPS). PVBP, then, is the change in a bond's price caused by a.01%
(one basis point) change in yield. Whether the needed yield increases or
decreases by one basis point, price v olatility remains constant.
A higher basis point price value indicates a larger change in the bond's
price as a result of an interest rate adjustment. The modified duration can
be used to determine PVBP as Modified duration x Dirty Price x 0.0001.
The modi fied duration calculates how much a bond's price will vary
proportionally to a change in yield. It is merely a measurement of the
cash flows of a fixed income security's weighted average maturity.
Modified duration rises as yields decline, and a higher mod ified duration
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114 paid for a bond on the date of purchase, including accumulated interest, is
known as the "dirty price," which is taken into account in the formula.
9.6 SUMMARY
● The price s tated in real -time for the immediate settlement of a contract
is known as a spot rate or spot price.
● Zero -coupon bonds are more prone to market fluctuations than coupon
bonds because they deliver the entire payment at maturity.
● Zero -coupon bonds often have lengthy maturity dates, with initial
maturities of at least ten years.
● Bond yields or interest rates are plotted against X -axis while time
horizons are plotted on Y -Axis.
● The "duration" of the bond is what Canadian economist Frederick
Roberts on Macaulay called the effective -maturity idea in 1938.
9.7 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Write note on Price Value of a Basis Point.
3. Differentiate between Spot rate and Forward rate.
4. Write note on Zero coupon yield c urve.
5. What do you mean by Duration and Convexity?
B. Fill in the blanks:
1. A …………… is the price for a commodity that is being exchanged
right away .
2. An accrual bond, also known as a ……………. bond .
3. A key sign of the impending economic recession is an ………… yield
curve.
4. ………………. type of curve is atypical and very infrequent.
5. Yield curves are not always …………
Answers :
1- spot rate , 2- zero-coupon , 3- inverted , 4- Humped/Bell -Shaped ,
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115 9.8 REFERENCES
 Mishkin, F. (1999) ‘Global financial instability: framework, events,
issues’, Journal of Economic Perspectives, Vol. 13.
 Padoa -Schioppa, T. (2003) ‘Central banks and financial stability:
exploring the land in between’, The Transformation of the European
Financial System.
 Rahim, N.H.A. and Abedin, N.F.Z. (2014) ‘Trade liberalisation,
financial development and growth in Malaysia’, International
Proceedings of Economics Development and Research.
 Luintel, K.B. and Khan, M. (1999) ‘A quantitative reassessment of the
finance -growt h nexus: evidence from a multivariate VAR’, Journal of
Development Economics, Vol. 60.
 Mattoo, A. (1998) Financial Services and the WTO: Liberalization in
the Developing and Transition Economies, Staff Working Paper, No.
TISD9803, World Trade Organization Trade in Services Division.


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116 10
FOREIGN EXCHANGE MARKET
Unit Structure
10.0 Learning Objectives
10.1 Introduction
10.2 Foreign Exchange - Introduction
10.2.1 Foreign Exchange Market Structure
10.3 Risk Management in Foreign Exchange Market
10.4 Exchange Rate Determination
10.5 Foreign Capital
10.5.1 Foreign Direct Investment (FDI)
10.5.2 Foreign Institutional Investors (FII)
10.6 Central Bank Intervention in Foreign Exchange Market
10.7 Summary
10.8 Unit End Questions
10.9 References
10.0 LEARNING OBJECT IVES
After studying this unit, you will be able to:
 Illustrate the concept of Foreign Exchange Market Structure.
 Explain the concept of Risk Management in Foreign Exchange
Market.
 Illustrate the concept of Foreign Capital.
10.1 INTRODUCTION
After the Second War and the IMF par value sy stem came into existence,
we became part of the new world system. Countries had exchange control
and various sorts of trade restrictions. It was after the Seventies that
gradually a scheme of flexible exchange rates came into existence among
leading develo ped countries. Gradually the developed countries started
freeing their exchange rates and also moved towards their system off free
trade. The World Trade Organization, of which we are a member, is now
introducing all over the world a free trade system. Aft er the advent of munotes.in

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117 Economic Reforms from 1991 -1992, we have moved over to currency,
convertibility on current account. The importance of the World Bank as
financier has diminished considerably. The world is now dependant on
private capital imports. Even the role of the IMF has diminished with most
countries adopting currency convertibility. Capital flows are moving on a
large scale dependent on incentives. Most countries have lifted trade
barriers and reduced import duties. The WTO is introducing system in
which domestic subsidies have to be removed and uniform and low import
duties have now to become the standard. There is no place for tariff
barriers and non -tariff barriers are also now getting lifted. The world’s
industries are now organized largely in term s of multinational corporations
whose operations transcend many countries. International demonstration
effects are working powerfully in determining the living styles in all
countries
In June 1991, Indian government initiated Programme of macroeconomic
stabilization and structural adjustment supported by IMF and the World
Bank. As part of this Programme a new industrial policy was announced
on July 24, 1991 in the Parliament, which has started the process of full -
scale liberalization and intensified the pro cess of integration of India with
the global economy. A Foreign Investment Promotion Board (FIPB),
authorized to provide a single window clearance has been set up. India
became a signatory to the convention of MIGA for protection of foreign
investments. Co mpanies with more than 40 per cent of foreign equity are
now treated on par with fully Indian owned companies. New sectors such
as mining, banking, telecommunications, high -way construction, and
management have been thrown Open to private, including foreig n owned
companies.
10.2 FOREIGN EXCHANG E- INTRODUCTION
When you are trading Forex you are trading one currency against another.
An example would be when you are trading your Dollars for Euros. Most
people have experienced this when visiting another countr y with a
different currency. Because the rate for which you can trade your money
fluctuates over time, it is also possible to earn money with currency
trading. The only rule you have to follow says ‘buy low, sell high’. Of
course this is not as easy as it sounds as you never know in advance what
would be considered ‘low’ and ‘high’. However, if you know which
factors influence the rate of a currency, you can make predictions about
the future rate of this currency. An important aspect to know when trading
is called the ‘spread’ of the currency. This is the difference between the
rate to buy and the rate to sell the currency.
Every nation has its central bank which is responsible for the wellbeing of
the economy. Central banks watch some economic factors that affect the
economy and adjust their economic policy accordingly. These factors are
announced regularly and the exact time of the announcement is known in
advance. These factors are the fundamental indicators of the economy.
The most important central banks are FED of USA, ECB of European
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118 fundamental indicators but there are few of them that are called the
“market movers”. They are called so because when they are announced
they provide to the mark et the necessary steam to move. That happens
because they have a great impact on economy and to traders’ positions
also. As I say earlier fundamentals are important economic indicators that
influence the direction of the market. Forex fundamentals are thus
important economic numbers that represent the state of the economy of a
certain country/region and therefore the underlying currency. There are
thousands of fundamentals but most of them have very limited influence.
For instance, typically, when a Fundame ntal analyst is asked to predict the
Forex market rates, would look at existing and expected interest rates,
GDP growth rates, inflationary trends, weather changes affecting
agricultural output, international trade balances, exchange rate policies of
the c ountries involved, capital market status etc. before saying, “I believe
given these indicators, the Forex market ought to be behaving in this way”
and would conclude whether a currency is likely to appreciate or
depreciate visa -via the other one.
10.2.1 Fo reign Exchange Market Structure
Foreign Exchange market is a market where foreign currencies are bought
and sold. It is simply a virtual place where buyers and sellers meet for
purchasing, selling and exchanging currencies of different countries with
one a nother.
This market is also termed as Forex market or currency market. Foreign
exchange market is an international decentralized market which does not
have any physical existence. This market determines the exchange rate for
every currency. Forex market is the largest and highly liquid market in the
world where trillions of dollars’ changes hand each day.
The market is open for 24 hours a day and 5 days in a week excluding
holidays. It is one of the key financial markets that facilitate the
international pa yments system. Forex market has 2 tiers: Interbank market
and over the counter market. Interbank market is one where large banks
exchange currencies with each other whereas over the counter market is
one where individuals and companies trade. This global market is highly
risky in nature as it is not regulated by any central body. Spot market,
Future market, Forward market, Option market and Swap market are
major types of foreign exchange market.
The structure of foreign exchange market is composed of diffe rent
participants who are the main players and occupies different positions.
These participants are commercial banks, central banks, immigrants,
importers, exporters, tourists and investors.
Commercial banks are important organs of foreign exchange market
which are termed as “market makers”. These banks trade in foreign
currencies for themselves and also for their clients. Commercial banks
quote the foreign exchange rate on a daily basis for purchasing and selling
of foreign currencies. They act as a cleari ng house by facilitating the
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119 currencies. Currencies are purchased from broker by commercial banks for
selling them to buyers. Central bank is the apex body in foreign exchange
market whi ch has power to regulate operations related to trading of
foreign currency. It directly intervenes in the functioning of forex market
to avoid aggressive fluctuations. For controlling fluctuations, currency is
sold off when it is overvalued and purchased i n case it is undervalued.
Central bank ensure that an exchange rate is at optimum that fulfils the
needs of national economy, Broker in foreign exchange market work as an
intermediary in between the commercial bank and central bank and also in
between the commercial banks and buyers. These persons carry a large
source of information about market. Brokers only facilitate the currency
trade but do not get themselves involved in market transactions. They
work on a commission basis where the task of striking th e deal in -between
the seller and buyer do. These are real buyers and sellers of foreign
currencies who trade in foreign exchange market with the help of brokers.
They approach commercial banks for purchasing and selling off
currencies. Importer, exporters, tourist, immigrants and investors are some
of these peoples.
10.3 RISK MANAGEMENT IN FOREIGN EXCHANGE
MARKET
Managers and even treasurers are sometimes inclined to believe that they
can predict FX rate movements. Some of the smartest firms on the planet
spend hundreds of millions of dollars to hire in -house economists and
leverage technology such as Artificial Intelligence etc. to try to predict
FX rates, and no one succeeds over time.
Treasurers must accept that, even if certain developing currencies may
look like a one way bet for significant time periods, the future is
unknowable, This why treasurers need to follow a clear FX policy that
spells out how they must hedge the business’ FX risk.
Once the policy has been set, which is normally an infrequent a ctivity;
treasuries need to identify the FX exposures that must be hedged. This is
the most critical part of FX risk management inaccurate exposure data will
lead to wrong hedging which will increase, rather than reduce, volatility.
FX exposures are derive d from FX cash flow forecasts. Cash flow
forecasting is the foundational requirement for all treasury operations –
treasury cannot be managed effectively and safely without cash flow
forecasts.
The FX cash flow forecast is typically different from the 12 month cash
flow which is normally in base currency. For FX risk management, we
need to know the cash flows expected in each currency. In some cases, the
12 month cash flow may be in transaction currency, in which case this can
be used for FX risk managemen t as well as for the subsidiaries and
group’s short term funding and liquidity. When forecasting FX cash flows,
it is important to identify the economic exposure currency, particularly if
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120 a currency clause or automatic reprising of a commodity globally priced in
USD. This is referred to as indirect FX risk. When the invoice currency is
the same as the risk currency, it is referred to as a direct FX risk.
10.4 EXCHANGE RATE D ETERMINA TION
Exchange rate determination refers to the process by which the value of
one currency is established in relation to another currency. Exchange rates
are important because they affect international trade, investment, and
capital flows.
A central objecti ve of theoretical models of exchange rate determination
ought to be a clearer understanding of the economic mechanisms
governing the actual behaviour of exchange rates in the real world and of
the relationships between exchange rates and other important ec onomic
variables. In surveying theoretical models of exchange rate determination,
therefore, it is appropriate to examine the empirical regularities that have
been characteristic of the behaviour of exchange rates and other related
variables under floating exchange rate regimes. It is also relevant to
discuss the minimum requirements for any theoretical model of exchange
rate determination to be consistent with these empirical regularities
Using the concept of the “real exchange rate” (defined as the price of a
unit of foreign money in terms of domestic money, divided by the ratio of
the home consumer price index to the foreign consumer price index), these
facts may be summarized in the following characteristic: Monthly changes
in nominal exchange rates are closely correlated with monthly changes in
real exchange rates, and cumulative changes in real exchange rates over a
period of a year have been quite large. Fourth, during the recent period of
floating exchange rates, there may have been a weak general ten dency for
countries that experienced sharp deteriorations in their current accounts
subsequently to experience depreciation in the nominal and real foreign
exchange value of their currencies. There also may have been a weak
general tendency for countries t hat experienced sharp appreciations in
nominal and real foreign exchange values of their currencies subsequently
to experience deterioration in their current accounts. It has not been the
case, however, that exchange rates have adjusted rapidly to eliminat e
current account imbalances, nor has there been strong correlation between
exchange rate changes and either levels of changes in current account
balances that has held up consistently over time and across countries,
These facts may be summarized in the fo llowing characteristic: There is
no strong and systematic relationship between movements in nominal or
real exchange rates and current account balances that allows for an
explanation of a substantial fraction of actual exchange rate movements.
10.5 FOREIGN CAPITAL
Foreign investment refers to investments made by the residents of a
country in the financial assets and production processes of another
country. The effect of foreign investment, however, varies from country to
country. It can affect the factor productivity of the recipient country and munotes.in

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121 can also affect the balance of payments. Foreign investment provides a
channel through which countries can gain access to foreign capital. It can
come in two forms: FDI and foreign institutional investment (FII). Foreign
direct investment involves in direct production activities and is also of a
medium - to long-term nature. But foreign institutional investment is a
short -term investment, mostly in the financial markets. FII, given its short -
term nature, can have bidir ectional causation with the returns of other
domestic financial markets such as money markets, stock markets, and
foreign exchange markets. Hence, understanding the determinants of FII is
very important for any emerging economy as FII exerts a larger impac t on
the domestic financial markets in the short run and a real impact in the
long run. India, being a capital scarce country, has taken many measures
to attract foreign investment since the beginning of reforms in 1991.
10.5.1 Foreign Direct Investment (F DI)
Foreign direct investment (FDI) is an investment from a party in one
country into a business or corporation in another country with the
inten tion of establishing a lasting interest. Lasting interest differentiates
FDI from foreign portfolio investments, where investors passively hold
securities from a foreign country. A foreign direct investment can be made
by obtaining a lasting interest or by expanding one’s business into a
foreign country.
An investment into a foreign firm is considered an FDI if it establishes a
lasting interest. A lasting interest is established when an investor obtains at
least 10% of the voting power in a firm.
The key to foreign direct investment is the element of control. Control
represents the intent to actively manage and influence a foreign firm’s
operations. This is the major differ entiating factor between FDI and a
passive foreign portfolio investment.
For this reason, a 10% stake in the foreign company’s voting stock is
necessary to defin e FDI. However, there are cases where this criterion is
not always applied. For example, it is possible to exert control over more
widely traded firms despite owning a smaller percentage of voting stock.
A foreign direct investment (FDI) is an investment m ade by a firm or
individual in one country into business interests located in another
country. Generally, FDI takes place when an investor establishes foreign
business operations or acquires foreign business assets in a foreign
company. However, FDIs are d istinguished from portfolio investments in
which an investor merely purchases equities of foreign -based companies.
Foreign direct investments are commonly made in open economies that
offer a sk illed workforce and above -average growth prospects for the
investor, as opposed to tightly regulated economies. Foreign direct
investment frequently involves more than just a capital investment. It may
include provisions of management or technology as well . The key feature
of foreign direct investment is that it establishes either effective control of
or at least substantial influence over the decision -making of a foreign
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122 The Bureau of Economic Analysis ( BEA ), which tracks expenditures by
foreign direct investors into U.S. businesses, reported total FDI into U.S.
businesses of $4.46 trillion at the end of 2019. Manufacturing represented
the top industry, with just over 40% of FDI for 2019.
Foreign direct investments can be made in a variety of ways, including the
opening of a subsidiary or associate company in a foreign country,
acquiring a controlling interest in an existin g foreign company, or by
means of a merger or joint venture with a foreign company.
The threshold for a foreign direct investment that establishes a controlling
interest, per guidelines established by the Organisation of Economic Co -
operation and Developme nt (OECD ), is a minimum 10% ownership stake
in a foreign -based company. However, that definition is flexible, as there
are instances where effective controlling interest in a firm can be
establis hed with less than 10% of the company's voting shares
Foreign direct investments are commonly categorized as being horizontal,
vertical or conglomerate. A horizontal direct investment refers to the
investor establishing the same type of business operation in a foreign
country as it operates in its home country, for example, a cell phone
provider based in the United States opening stores in China.
A vertical investment is one in which different but related business
activities from the investor's main busine ss are established or acquired in a
foreign country, such as when a manufacturing company acquires an
interest in a foreign company that supplies parts or raw materials required
for the manufacturing company to make its products.
A conglomerate type of for eign direct investment is one where a company
or individual makes a foreign investment in a business that is unrelated to
its existing business in its home country. Since this type of investment
involves entering an industry in which the investor has no pr evious
experience, it often takes the form of a joint venture with a foreign
company already operating in the industry.
10.5.2 Foreign Institutional Investors (FII)
Foreign Institutional Investors (FII) are an investment fund or a gathering
of investors. S uch a fund is registered in a foreign country, i.e. not in the
country it is investing in. Such institutional investors mostly involve hedge
funds, mutual funds, pension funds, insurance bonds, high -
value debentures , investment banks etc.
We use this term FII for foreign players investing funds in the financial
market of India . They play a big role in the development of our economy.
The amount of funds they invest is very considerable.
So when such FII’s buy shares and securities the market is bullish and
trends upwards. The opposite may also happen when they withdraw their
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123 There are many ways for a foreig n investor to invest in a country. The
most direct method, of course, is Foreign Direct Investment . However,
there are other ways to enter an economy, like Foreign Institutional
Investors.
A foreign institutional investor (FII) is an investor or investment
fund investing in a country outside of the one in wh ich it is registered or
headquartered. The term foreign institutional investor is probably most
commonly used in India, where it refers to outside entities investing in the
nation's financial markets. 1the term is also used officially in China. FIIs
can in clude hedge funds , insurance companies, pension funds, investment
banks, and mutual funds . FIIs can be important sources of capital in
developing economies, yet many developing nations, such as India, have
placed limits on the total value of assets an FII can purchase and the
number of equity shares it can buy, particularly in a single company. 3 This
helps limit the influence of FIIs on individual companies and the nation's
financial markets, and the potential damage that might occur if FIIs fled en
masse during a crisis.
FIIs are allowed to invest in India's primary and secondary capital
markets only through the country's portfolio investment scheme. This
scheme allows FIIs to purchase shares and debentures of Indian companies
on the nation's public exchanges.
10.6 CENTRAL BANK IN TERVENTION IN FOREIG N
EXCHANGE MARKET
There exists a plethora of studies analysing the role of Central Bank’ s
intervention in the foreign exchange market. However, there is a lack of
literature comprehensively analysing the effectiveness of Central Bank’s
intervention in the forex market under a managed float exchange rate
regime. The analysis becomes even more nuanced when the central bank
(CB) has other objectives (like inflation targeting) and/or when it does not
reveal the band of the managed float. This makes a modest attempt to
understand the nuances of such intervention when the CB tries to maintain
the ex change rate within a desired band along with keeping a check on the
domestic inflation level as foreign capital flows in. Economic theory tells
us that intervention in the forex market by the CB is contingent upon the
country’s exchange rate regime. Theore tically, the CB needs (does not
need) to intervene if the country follows a fixed (flexible) exchange rate
regime. Such behaviour on part of the CB of a country becomes pivotal
when we allow for capital flows ending up in the ‘impossible trinity’ of
the Mu ndell -Fleming framework1 . When foreign capital flows into an
economy, broadly two things can happen. If the country follows a flexible
exchange rate regime (no intervention by the CB) capital flows would lead
to an appreciation of the domestic currency wh ich in turn may lead to
current account deficit. However, if the country follows a fixed exchange
rate regime, the CB would intervene by buying up foreign exchange to
keep the exchange rate unchanged leading to an increase in the foreign
exchange reserve o f the country . Following the ‘impossible trinity’, it is
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124 economy prefers an independent monetary policy along with free capital
flows. However, capital flows can lead to inflationary situ ations if the CB
does not take any sterilization measures. Thus, majority of the countries,
particularly the developing ones, find it apt to follow a managed float
regime which helps them to keep exchange rates within a desired band3
along with mitigating inflationary pressures that may arise due to partial
intervention. Hence, the role of the CB becomes a mix of intervention and
non-intervention depending on the desired and realized values of the
exchange rates.
 Zone of no intervention (within a desired b and),
 Zone of intervention when the exchange rate tends to reach the lower
value of the band and
 Zone of intervention when the exchange rate tends to reach the upper
value of the band. Accordingly, the number of regimes in the TVAR
model is chosen to be three. Further, as discussed later, Likelihood
Ratio (LR) tests reject the null hypothesis of linear VAR model against
both two -regime and three -regime TVAR models. In this we consider
the case of India and analyze the effectiveness of the interventions of
the Reserve Bank of India (RBI) in influencing the Indian Rupee -US
Dollar (Re/$) exchange rate4 . The stated aim of RBI is to dampen the
fluctuations of the exchange rate. However, it has regularly intervened
in the forex market through sale and purchase of foreign currency.
Interestingly, the details are not made public. Still, the bulging foreign
exchange reserve held by RBI5 speaks volumes about its intervention
in the forex market.
Characteristics of the Foreign Exchange Market
The international busine ss context requires trading and investing in assets
denominated in different currencies. Foreign assets and liabilities add a
new dimension to the risk profile of a firm or an investor's portfolio:
foreign exchange risk. This chapter has two goals. First, this chapter
introduces the terminology used in foreign exchange markets. Second, this
chapter presents the instruments used in currency markets.
 Most Liquid Market in the World
Currency spot trading is the most popular FX instrument around the world,
comp rising more than 1/3 of the total activity. It is estimated that spot FX
trading generates about $1.5 trillion a day in volume, making it the largest
most liquid market in the world.
Compare that to futures $437.4bn and equities $191bn and you will see
that foreign exchange liquidity towers over any other market. Even though
there are many currencies all over the world, 80% of all daily transactions
involve trading the G -7 currencies i.e. the “majors.”
When compared to the futures market, which is fragmente d between
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125 equities market, with 50,000 listed stocks (the S&P 500 being the
majority), it becomes clear that the futures and equities provides only
limited liquidity when compared to currenci es.
Liquidity has its advantages, the primary one being no manipulation of the
market. Thin stock and futures markets can easily be pushed up or down
by specialists, market makers, commercials, and locals. Spot FX on the
other hand takes real buying/sellin g by banks and institutions to move the
market. Any attempted manipulation of the spot FX market usually
becomes an exercise in futility.
Thus, surveys have indicated that there is more foreign exchange trading
in dollars in London than in the United State s, and more foreign exchange
trading in marks than in Germany. However, the bulk of trading in
London, about 85 percent, is accounted for by foreign -owned (non -U.K.
owned) institutions, with U.K. -based dealers of North American
institutions reporting 49 pe rcent, or three times the share of U.K. -owned
institutions there.
 Most Dynamic Market in the World
Foreign exchange market is the most dynamic market in the world.
Regardless of which instrument you are trading – be it stocks, municipal
bonds, U.S. treasur ies, agricultural futures, foreign exchange, or any of the
countless others – the attributes that determine the viability of a market as
an investment opportunity remain the same.
Namely, good investment markets all possess the following
characteristics - liquidity, market transparency, low transaction costs, and
fast execution. Based upon these characteristics, the spot FX market is the
perfect market to trade.
 It is a Twenty -Four Hour Market
During the past quarter century, the concept of a twenty -four-hour market
has become a reality. Somewhere on the planet, financial centres are open
for business, and banks and other institutions are trading the dollar and
other currencies, every hour of the day and night, aside from possible
minor gaps on weekends. In f inancial centres around the world, business
hours overlap; as some centres close, others open and begin to trade. The
foreign exchange market follows the sun around the earth.
The International Date Line is located in the western Pacific, and each
business day arrives first in the Asia -Pacific financial centres first
Wellington, New Zealand, then Sydney, Australia, followed by Tokyo,
Hong Kong, and Singapore. A few hours later, while markets remain
active in those Asian centres, trading begins in Bahrain an d elsewhere in
the Middle East.
The twenty -four hour market means that exchange rates and market
conditions can change at any time in response to developments that can
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126 participants must be alert to the possibility that a sharp move in an
exchange rate can occur during an off hour, elsewhere in the world.
However, foreign exchange activity does not flow evenly. Over the course
of a day, there is a cycle characterized by periods of very heavy activity
and other periods of relatively light activity. Most of the trading takes
place when the largest number of potential counterparties is available or
accessible on a global basis.
Market liquidity is of great importance to participants. Sellers wan t to sell
when they have access to the maximum number of potential buyers/ and
buyers want to buy when they have access to the maximum number of
potential sellers.
 Market Transparency
Price transparency is very high in the FX market and the evolution of
online foreign exchange trading continues to improve this, to the benefit of
traders. One of the biggest advantages of trading foreign exchange online
is the ability to trade directly with the market maker. A reputable forex
broker will provide traders with streaming, executable prices. It is
important to make a distinction between indicative prices and executable
prices.
Furthermore, trading online directly with the market maker means traders
receive a fair price on all transactions. When trading equities or futures
through a broker, traders must request a price before dealing, allowing for
brokers to check a trader’s existing position and ‘shade’ the price a few
pips depending on the trader’s position.
Online trading capabilities in FX also create more effic iency and market
transparency by providing real time portfolio and account tracking
capability. Traders have access to real time profit/loss on open positions
and can generate reports on demand, which provide detailed information
regarding every open posit ion, open order, margin position and generated
profit/loss per trade.
 International Network of Dealers
The market is made up of an international network of dealers. The market
consists of a limited number of major dealer institutions that are
particularly active in foreign exchange, trading with customers and with
each other. Most, but not all, are commercial banks and investment banks.
These dealer institutions are geographically dispersed, located in
numerous financial centres around the world. Wherever l ocated, these
institutions are linked to, and in close communication with, each other
through telephones, computers, and other electronic means.
At a time when there is much talk about an integrated world economy and
“the global village,” the foreign excha nge market comes closest to
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127 trading centres from around the world into a single, unified, cohesive,
worldwide market.
Foreign exchange trading takes place among dealers and other m arket
professionals in a large number of individual financial centres New York,
Chicago, Los Angeles, London, Tokyo, Singapore, Frankfurt, Paris,
Zurich, Milan, and many, many others. But no matter in which financial
centre a trade occurs, the same currenc ies, or rather, bank deposits
denominated in the same currencies, are being bought and sold.
 Most Widely Traded Currency is the Dollar
The dollar is by far the most widely traded currency. According to the
1998 survey, the dollar was one of the two currenc ies involved in an
estimated 87 percent of global foreign exchange transactions, equal to
about $1.3 trillion a day. In part, the widespread use of the dollar reflects
its substantial international role as “investment” currency in many capital
markets, “r eserve” currency held by many central banks, “transaction”
currency in many international commodity markets, “invoice” currency in
many contracts, and “intervention” currency employed by monetary
authorities in market operations to influence their own exch ange rates.
In addition, the widespread trading of the dollar reflects its use as a
“vehicle” currency in foreign exchange transactions, a use that reinforces,
and is reinforced by, its international role in trade and finance. For most
pairs of currencies, the market practice is to trade each of the two
currencies against a common third currency as a vehicle, rather than to
trade the two currencies directly against each other. The vehicle currency
used most often is the dollar, although by the mid -1990s the Deutsche
mark also had become an important vehicle, with its use, especially in
Europe, having increased sharply during the 1980s and ’90s.
 “Over -The-Counter” Market with an “Exchange -Traded” Segment
Until the 1970s, all foreign exchange trading in the Un ited States (and
elsewhere) was handled “over -the-counter,” (OTC) by banks in different
locations making deals via telephone and telex. In the United States, the
OTC market was then, and is now, largely unregulated as a market.
Buying and selling foreign c urrencies is considered the exercise of an
express banking power. Thus, a commercial bank or Securities &
brokerage firms in the United States do not need any special authorization
to trade or deal in foreign exchange.
There are no official rules or restri ctions in the United States governing
the hours or conditions of trading. The trading conventions have been
developed mostly by market participants. There is no official code
prescribing what constitutes good market practice.
However, the Foreign Exchange Committee, an independent body
sponsored by the Federal Reserve Bank of New York and composed of
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128 regularly updates its report on Guidelines for Foreign Exchange Trading.
These Guid elines seek to clarify common market practices and offer “best
practice recommendations” with respect to trading activities, relationships,
and other matters.
Although the OTC market is not regulated as a market in the way that the
organized exchanges are regulated, regulatory authorities examine the
foreign exchange market activities of banks and certain other institutions
participating in the OTC market.
As with other business activities in which these institutions are engaged,
examiners look at trading s ystems, activities, and exposure, focusing on
the safety and soundness of the institution and its activities. Examinations
deal with such matters as capital adequacy, control systems, disclosure,
sound banking practice, legal compliance, and other factors relating to the
safety and soundness of the institution.
The OTC market accounts for well over 90 percent of total U.S. foreign
exchange market activity, covering both the traditional products (spot,
outright forwards, and FX swaps) as well as the more rec ently introduced
(post -1970) OTC products (currency options and currency swaps). On the
“organized exchanges,” foreign exchange products traded are currency
futures and certain currency options.
 Determinants of FDI
There are various factors that influence the FDI inflows into a country.
The investors consider and evaluate various aspects of a country before
investing in it. The relative importance of these determinants of FDI varies
not only between countries but also between different types of FDI.
Traditi onally, the determinants of FDI include the following:
 Size of the Market
The developing countries possess substantial markets where the
consumers demand for certain goods far exceed the available supplies.
This demand potential is a big draw for many fore ign enterprises. In many
cases, the establishment of a low cost marketing operation represents the
first step by a multinational company into the market of the country. This
establishes a presence in the market and provides important insights into
the ways of doing business and possible opportunities in the country.
 Political Stability
In many countries, the institutions of government are still evolving and
there are unsettled political questions. Companies will generally be
unwilling to contribute large a mounts of capital into an environment
where some of the basics political questions have not yet been resolved.
 Macro -Economic Environment
Instability in the level of prices and exchange rate enhance the level of
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129 perceived risk of making investments and therefore adversely affects the
inflow of FDI
 Legal and Regulatory Framework
The transition to a market economy entails the establishment of a legal and
regulatory framework that is compatib le with private sector activities and
the operation of foreign owned companies. The relevant areas in this field
include protection of property rights, ability to repatriate profits, and a free
market for currency exchange. It is important that these rules and their
administrative procedures are transparent and easily comprehensive.
 Access to Basic Inputs
Many developing countries have large reserves of skilled and semi -skilled
workers that are available for employment at wages significantly lower
than in developed countries. This provides an opportunity for foreign
firms to make investments in these countries to cater to the export market.
Availability of natural resources such as oil and gas, minerals and forestry
products also determine the extent of FDI .

 Global Financial Markets and Instruments
International economic management relied on the dominant power to lead
the system. The concentration of power facilitated management by
confining the number of actors whose agreement was necessary to
establish r ules, institutions, and procedures and to carry out management
within the agreed system. That leader was, of course, the United States. As munotes.in

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130 the world’s foremost economic and political power, the United States was
clearly in a position to assume the responsi bility of leadership. The United
States had emerged from the Second World War as the strongest economy
in the world, experiencing rapid industrial growth and capital
accumulation. The U.S. had remained untouched by the ravages of World
War II and had built a thriving manufacturing industry and grown wealthy
selling weapons and lending money to the other combatants; in fact, U.S.
industrial production in 1945 was more than double that of annual
production between the pre -war years of 1935 and 1939. In contra st,
Europe and Japan were militarily and economically shattered. As the
Bretton Woods Conference convened, the relative advantages of the U.S.
economy were undeniable and overwhelming.
Shortcoming of Foreign Capital
 Unbalanced Growth Foreign capital tends to lopsided rather than
balanced growth. In many cases it was observed that the foreign
speculation was in these sectors and areas not in the priority list
consequently the basic and key industries could not develop.
 Political Strings Many times the forei gn capital has certain restrictive
strings attached to it, with a motive to earn profits the borrowing
country’s monetary fiscal, industrial and commercial policies must be
conform to the requirement and conditions of the donor country.
 Obsolete Technology there are instances of obsolete machines and
technology being passed on to the Indian partners by the foreign
collaborators. In some cases technology have been imported not quite
appropriate to the Indian situation.
 Adverts Effect on Balance of Payment t he foreign collaborations’ effect
on India’s balance of payments has been negative. The main reason for
this was high re maintenance abroad, high level of imports and low
level of exports.
 Decline in Domestic construction in the Economy Domestic producers
suffer because of the established by industries financed by foreign
capital. They are unable to compete with foreign enterprises.
 Increase in Foreign Dependency Yearning for foreign capital and
through its foreign technology and technicians increases our
dependence on external sources. It moreover increases the exposure of
the borrowing country towards the instability of the donor country.
 Setback to Indigenous Development of knowledge Foreign technology
accompanies foreign capital. It has an adverse effe ct on the
development of Indian technology and research.
 Uncertainty it is often observed that foreign capital becomes scarce
when it is needed the most. This happens because foreign capital can be
repatriated at any time. Thus an element of uncertainty l ooms large in
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131  Favouritism it is often observed that in residential countries, foreign
companies reserve higher managerial and technical posts for their own
national thus denying adequate opportunity of training to people in
deve loping countries. Usually, this foreign business avoid revealing
important technical and trade secrets to the people or government of the
developing country.
10.7 SUMMARY
 As mentioned earlier, the objectives of this are to find out when does
RBI intervene to influence the Re/$ exchange rate and examine
whether RBI has been successful in attaining its goal of bringing the
Re/$ exchange rate within a desired band along with keeping a check
on the domestic inflation level as FII comes in. To do so, we have
employed a three regime threshold VAR (TVAR) model where the
threshold variable is taken as the past values of difference between
Re/$ exchange rate and its long run trend value, which can be
explained as an exchange rate cycle13. Two threshold values,
specif ying three different regimes, are considered as unknown and
estimated along with other parameters.
 As a nonlinear model, TVAR allows different parameters in different
regimes, which can capture impact of RBI’s intervention (either
through OMO or CRR) on I NF, Re/$ exchange rate and net FII inflow
depending upon the regime itself. However, it must be noted that both
OMO and CRR are endogenous in nature and are not exogenously
chosen by RBI. As discussed earlier, the existing studies find
conflicting results on the effectiveness of RBI’s intervention in the
forex market.
 According to our understanding, such results are obtained
predominantly because of inappropriate econometric modelling which
fail to capture the nuances of a managed float regime. We have
considered a linear VAR model considering the above mentioned
variables and compare the results with those of TVAR analysis so as to
compare the effectiveness of linear and non -linear models in
comprehensively capturing the nuances of CB intervention in forex
market under a managed float exchange rate regime.
 In this section we present the estimation results of our analyses. We
begin with the results of linear VAR models. Two different VAR
models have been estimated14 separately by taking either OMO or
DCRR alo ng with other three variables, mentioned above. In these
models, it is clear that all the four variables are positively affecting
their future values implying existence of significant auto correlation.
Apart from that, it has been found that there is a pos itive impact of
OMO on inflation.
 This result is trivial, as higher OMO implies higher purchase of
securities by RBI leading to increase in the supply of Re in the
economy and hence, in turn, causing higher inflation. The estimated munotes.in

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132 coefficient is 0.00197 (significant at 10% level). As per the impact of
exchange rate is concerned, it has been found that ERS is positively
affecting FII (significant at 5% level). This implies that a depreciation
of Indian rupee will increase the inflow of FII into the economy . On
the other regression, where we have considered DCRR as an
instrument of RBI, we have found an increase in ERS will
significantly increase FII and reduce DCRR. Further, DCRR
negatively affects ERS. The estimated coefficient is -0.93927 which is
signifi cant at 1% level.
10.8 UNIT END QUESTI ONS
A. Descriptive Questions
1. What is Foreign Exchange?
2. Define the term Market Structure?
3. What is term of Exchange Rate?
4. Define Foreign Direct Investment?
5. What is Foreign Institutional Investors?
6. Explain the concept of Foreign Exchange Market Structure.
7. Explain the concept of Risk Management in Foreign Exchange
Market.
8. Illustrate the concept of Exchange Rate Determination.
9. Illustrate the concept of Foreign Capital.
10. Examine the Central Bank Intervention in Foreign Exchang e Market.
10. Fill in the Blanks
1. The foreign direct investment include ………….
2. The Treaty of Rome was signed in the year ………….
3. In ……….. year Austria join the European Union.
4. The foreign policy decision -makers rely on for spreading information
through………….
5. FDI stands for……………
Answers
1- Tangible goods , 2-1957 , 3-1995 , 4- Media, 5 - Foreign Direct
Invetsment
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133 10.9 REFERENCES
 Mishkin, F. (1999) ‘Global financial instability: framework, events,
issues’, Journal of Economic Perspectives, Vol. 13.
 Padoa -Schioppa, T . (2003) ‘Central banks and financial stability:
exploring the land in between’, The Transformation of the European
Financial System.
 Rahim, N.H.A. and Abedin, N.F.Z. (2014) ‘Trade liberalisation,
financial development and growth in Malaysia’, Internationa l
Proceedings of Economics Development and Research.
 Luintel, K.B. and Khan, M. (1999) ‘A quantitative reassessment of the
finance -growth nexus: evidence from a multivariate VAR’, Journal of
Development Economics, Vol. 60.
 Mattoo, A. (1998) Financial Serv ices and the WTO: Liberalization in
the Developing and Transition Economies, Staff Working Paper, No.
TISD9803, World Trade Organization Trade in Services Division.
 McGrath, J.E. and Brinberg, D. (1983) ‘External validity and the
research process: a comment on the Calder/Lynch dialogue’, Journal
of Consumer Research,

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