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					                                  Industry Practice – BFS
                                          Session 2
                             Introduction to Financial Markets
                                        Version 3.0
                                     29th January 2005
         This training module introduces one to the financial markets. The focus is with
reference to the Securities Line of Business. The Banking, Credit Cards etc are not
covered.
 Session 2
    1. Overview and structure of Financial Markets
    2. Key entities in the Financial markets
    3. Trade Processes and Value Chain
Overview & Structure of Financial Markets
Introduction to Financial Markets
    A financial transaction takes place when a financial asset is created and/or
transferred. Examples of financial transactions are - grant of loan by a financial
institution or bank to a company, issue of equity shares by a company to the public at
large or to a particular segment of investors, or purchase of shares or bonds in the
secondary market. Financial transactions are very essential for the economic system.
Therefore, financial markets are created to transact business in financial instruments.
Securities Market is broader term embracing a number of markets in which securities are
created and traded.

   •   What are Financial Transactions and Financial Markets?
           • ―Markets in which spending units trade financial claims‖
Direct Finance (Stock Market, Bond Market) Vs Indirect Finance (Banks and Credit
Unions)
           • Financial Markets refers to different physical locations or environments in
              the investment system for the purchase and sale of securities, commodities
              & currencies‖
   • Functions of Financial Markets
           • facilitates price discovery
           • provide liquidity
           • reduces the cost of transacting - search costs & information costs
Three Functions of Financial Markets
Markets serve three important functions.
   • Economic Function
           – This mechanism facilitates the transfer of money from savers to
              borrowers.
           – Matches up would be borrowers with available savers.
   • Continuous Pricing Function
           – Prices are available moment by moment
           – Investors can discover the prices of various financial assets
              instantaneously during the business day.
   • Fair Pricing Function
           –     When you buy or sell your stock at the going market price, you are
                 assured of getting a fair price
             – Many people are competing for this business - the greater the number of
                 people and the more formal the market place the greater the assurance of a
                 fair price.
Classification of Financial Markets
         Financial market may be classified by maturities, securities of one year or less
than one year normally traded in the money market and those maturity of more than one
year are bought and sold in capital market.Money Market deals with short term capital
other wise known as working capital. It includes all the agencies providing short term
capital to the industry at large. The money market instruments constitute the various
instruments such as short term loans, credit instruments, treasury bills, commercial bills,
commercial paper, certificate of deposits, inter-bank participation certificates, call money
market and money market mutual funds. Short term money markets does not contribute
towards new investment or long term capital but it helps in the process of continuation of
business.Capital Market is concerned with long term finance that longer term maturity,
that is, more than one year. It is again divided into primary market and secondary market
. The capital market is the reflection of the performance of the economy in general and
industry in particular. The capital market includes all the agencies such as issuers,
intermediaries and investors. The capital market instruments consist of debt and
ownership instruments. Capital markets are, link the suppliers of capital with its users and
are able to help in the efficient transaction of business. In the Capital Market, long term
debt securities (mostly bonds) are traded, along with stocks (both common and
preferred). The market in which all long term fixed income securities, debts and bonds
are traded are called Bond Market or Debt Market or Fixed Income Market.The market in
in which stocks are traded are called Stock Market. Though some corporate bonds are
traded in the stock exchanges, most of the Bond Markets deals take place in the
unorganised market. It is also often called the Phone Market.Over-The-Counter (OTC) —
A market for securities made up of dealers who may or may not be members of a
securities exchange. The OTC market is conducted over the telephone and deals mainly
with stocks of companies without sufficient shares, stockholders or earnings to warrant
listing on an exchange. OTC firms may act either as principals or dealers (buying or
selling stock from their own inventory and charging a markup) or as a broker or agent
and charging a commission. of a regular or scheduled dividend.
Third market — Trading of stock exchange listed securities in the over-the-counter
market by non-exchange-member brokers.
     • By Nature of Claims
             • Debt Market
             • Equity Market
     • By Maturity of Claims
             • Money market - short term claims
             • Capital Market - long term claims
     • By Seasoning of Claims
             • Primary market - New claims
             • Secondary market - Outstanding claims
     • By Timing of Delivery
          • Cash / Spot Market
          • Forward / Futures Market
   • By Organization Structure
          • Exchange Traded
          • Over the counter
   • What are Third and Fourth Markets?
Money                      Debt                               Equity
Short Term                 Medium to Long Term                Long Term
                           Non - Permanent Fund               Permanent Fund


0                             1


             Money                       Debt                 Equity
             Markets                    Markets               Markets

Types of Financial Markets


Capital Market                    Equity, Debt                Retail, Corporate, Banks,
                                                              FI, FIIs
Money Market                      T bills, Call Money, ICD,   Banks, Corporate, FI, FIIs
                                  CP, CD
Forex Market                      Spots, Forwards             Banks, Corporate, FI, FIIs
Derivatives Market                Agricultre, Produces,       Banks, FIs, Corporate
                                  Metals, Financial futures
                                  like Interest, currency
                                  indices etc

Money Market Features

    •   It is not one market, but collection of Markets.

    •   Net work of large number of participants mostly by institutional players.

    •   It is a wholesale market.

   • The transactions take place over phone/fax in a one-to-one communication.
   Money Market is collection of markets such as Call Money Market, Treasury Bill
Market, Commercial Bill Market, Commercial Paper Market and Certificate of Deposit
Market. All these markets have close interrelationships that makes the money market.
Network of large number of participants in the money market is essential. Larger the
number of participants, greater will be the depth of the market.
Money Market is a wholesale market. The volume of funds or the financial assets
representing money traded in the market are very large. Hence, it is necessary that there
are skilled personnel to undertake transactions. Therefore, the access is normally by
banks, financial institutions, corporate bodies and government agencies.
Unlike the Stock Market or commodity market where trading is conducted on the floor of
the exchange or network of computers, trading in the money market is conducted over the
telephone followed by transaction confirmation from both the borrower and the lender.
Honouring of the commitments is most essential part on both sides and generally
transactions are on ―same day settlement ― basis. The brokers, if any, are not registered
with any board or exchange, but informally represent the parties concerned.
Money Market
Entities
     • Government Bodies
     • Corporate Bodies
     • Banks
     • Money Market Mutual
Funds
     • Insurance Companies
     • Institutional Investors
     • Primary Dealers
     • Money Market Brokers
Instruments /securities
     • Treasury Bills
     • Treasury Notes
     • Commercial Paper
     • Certificate of Deposit
     • Call Money Receipts
     • Inter Corporate Deposit
     • Commercial/Trade Bills
     • Repos
Money Market Mutual Fund - A mutual fund whose investments are in high-yield money
market instruments such as federal securities, CDs and commercial paper. Its intent is to
make such instruments, normally purchased in large denominations by institutions,
available indirectly to individuals.
It invests in cash and other liquid securities. A Money Market Fund generally has a stable
net asset value        (NAV). Primary Dealers: Primary dealers are specialised financial
institution acting as wholesale buyers (underwriters) of various money market
instruments. They also act as key players in the secondary market for these instruments
by offering bids and asks as a market maker. Money Market Brokers: These are Brokers
in the Money Market instruments act as agents facilitating buy and sell on behalf of their
institutional clients. They earn brokerage and deal with market makers or among
themselves. They conduct transaction either on a telephone market or a trading system if
present in a country. They are often referred to as Bond Delaers. T- Bills - Treasury Bills,
the common name for a short term securities issued by Government. There are generally
in the nature of promissory notes issued for a period between 18 days to 364 days. They
are generally issued at discount to the face value. Treasury Notes are also known as
Government Securities in the Indian context. The duration of these Government
Securities (Central or State) are for a period of 1 year or more. Central Bank of the
country normally issues these on behalf of the Governments. These securities are
considered risk free investments. They are oftern referred as Gilts (Gilt edged Securities)
Certificate of Deposit - These are investment instruments created by banks, which pays
stated interest at either fixed or variable rates. This is an agreement with a bank that you
will leave your money on deposit for a specified period of time in return for a specific
amount of interest. If sold directly by banks, principal is returned at maturity subject only
to penalties for early cashing in. If sold through brokers (called Broker CDs), principal
value can vary as with bonds and early cashing in can fetch a principal lower than amount
paid. Commercial Paper are Debt instruments issued by companies to meet short-term
financing needs. These are Unsecured short-term debt, usually from 2 to 270 days, issued
by corporations, which is generally safe and flexible. It is usually a major component of
money market fund investment portfolios. Call and Notice Money Receipts are the
receipts for funds borrowed and lend for one day (call) and for a period upto 14 days
(notice) without any collateral security. These receipts are issued to the lender who on
recalling the funds, discharge the receipt and give back to the borrower upon which the
borrower will repay the amount. The participants in this market are commercial banks
and co-operative banks who can borrow and lend funds. Inter Corporate Deposit are
deposit receipts for short term lending and borrowing between corporates.
Commercial/Trade Bills are Bills of Exchange drawn by the seller (drawer) on the buyer
(drawee) for the value of goods delivered to him. Such bills are are called trade bills.
When trade bills are accepted by commercial banks, they are called commercial bills.
During the currency of the bill, if the seller is in need of funds, he may approach his bank
for discounting the bill.
Repos are repurchase agreements. In such agreements, the owner of the securities sells
them with a simultaneous agreement to buy them back at some agreed-upon future time
and price. The price is set so that when combined with interest, the buyer receives an
adequate return on his investment. These usually are for only a few days.
Participants and Products in Debt Market

           Issuer   Instrument        Maturity             Investors
           Central    Dated          2 - 20 years   RBI, Banks, Insurance
         Government Securities                   Companies, Provident Funds,
                                                     Mutual Funds, PDs
           Central        T-Bills    91/364 days    RBI, Banks, Insurance
         Government                              Companies, Provident Funds,
                                                     PDs, Mutual Funds,
                                                          Individuals
            State     Dated           5-10 years Banks, Insurance Companies,
         Government Securities                         Provident Funds
            PSUs      Bonds,          5-10 years       Banks, Insurance Companies,
                     Structured                         Corporate, Provident Funds,
                     Obligations                         Mutual Funds, Individuals
          Corporates Debentures          1-12 years        Banks, Mutual Funds,
                                                           Corporates, Individuals
           Corporates, Commercial 3 months to Banks, Corporate, Financial
              PDs            paper          1 year      institutions, Mutual Funds,
                                                                 Individuals
             Banks       Certificates 3 months to            Banks, Corporates
                          of Deposit        1 year
Capital Market – Features
    • Characterized by issue of large number of securities to a large number of
        investors - retail as well as institutional
    • Securities are traded on the stock exchange through registered members (brokers)
        of the exchange
    • Trading in Stock Exchanges could be either in open out cry method or electronic
        screen based trading
    • Trading could be on either order based or quote based trading
    • Trades between brokers settled through Clearing and Settlement Organisations
Open Outcry - The trading in stocks in the stock exchanges used to take place in the
trading rings. The Brokers assemble in the trading pits for the respective securities and
deal by exchanging quotations. The exchange of quotations takes place openly by
shouting it out. This method of manual trading is called as open outcry trading. Today,
most of the stock exchanges in the world have given up this method of trading. NewYork
Stock Exchange, however, continues to have some amount of outcry trading, even now.
Screen Based Trading - The trading in stock exchanges have moved form open outcry to
electronic trading through network of computers. The trading through network of
computers are referred as Screen Based Trading. The NASDAQ in US is considered to
be pioneer in Screen Based Trading in Stocks. Order Based - When the trading takes
place in the stock exchanges, there are two types of trading. In Order Based trading,
Brokers place their order in the market. The price of an order for buying is called BID
and the price for selling is called ASK or OFFER. The buy and sell orders are attempted
for match and if the prices match , a trade takes place. We will understand more about
Order Based Trading in the next module. Quote Based - As against order based trading,
there is quote based trading. In this type of trading, the dealers (jobbers) or specialists
give a two way quote for the securities they trade. They provide both BID and ASK. The
difference between the two is called the SPREAD of the specialist. This is two way open
offer to the counterparty to buy or sell. Depending on the choice, the counterparty can
trade with the specialist at the quoted price. Specialist — A member of the NYSE who
has two primary functions. First, to maintain an orderly market in the securities assigned
to the specialist. To do this, the specialist must, to a reasonable degree, buy or sell for
their own account when there is a temporary disparity between supply and demand.
Second, the specialist acts as a broker’s broker. When commission brokers on the
Exchange Floor receive a limit order, say, to buy at $50 a stock then selling at $60, they
cannot wait at the post where the stock is traded to see if the price reaches the specified
level. They leave the order with the specialist, who will try to execute it in the market if
and when the stock declines to the specified price. At all times the specialists must put
their customers’ interests above their own. Clearing and Settlement Organisations - After
the trade is done, the settlement of the trade i.e.. Exchange of stocks for money will take
place at the contracted time. The Clearing and Settlement of trades in the stock exchanges
takes place in an organised manner either through the specialised organisations called
Clearing and Settlement Organisations. We will understand more about these
organisations in the next module.
Evolution and Growth of Markets
    • What is a Stock Exchange?
             • 1631 - Antwerp (Netherlands)
             • 1773 - London Stock Exchange
             • 1790 - Philadelphia Stock Exchange
    • Why Stock Exchanges ?
    • What is a Market?
             • Primary Market Vs Secondary Market
    • What is a Share Certificate ?
    • Listing with Stock Exchange
What is Market? Market is a place where both buyers and sellers meet to buy and sell
goods. Ex. Vegetable Market. A shop or a shopping mall is a market place. The market
provides a meeting point for buyers and sellers to meet. As money is scarce, the capital
for business is scarce to find. The buyers or people who need money to do business has
to meet sellers who can provide capital to do business. Hence there is need for a place to
trade in capital ! Primary Market - The process by which a corporation’s stock is issued
for the first time. New Issue — A stock or bond sold by a corporation for the first
time.To issue invite applications, corporation issues a prospectus. Proceeds may be used
to retire outstanding securities of the company, for new plants or equipment, for
additional working capital, or to acquire a public ownership interest in the company for
private owners. Thus Primary Market for capital is not a place, but a process by which
the sellers and buyers are networked to exchange the capital. The buyer of the capital i.e.
a company sells an instrument (a stock or a bond). The sellers of capital (investors who
invest money) buy the instruments (securities that represent their investment like a stock
or a bond). Prospectus — A document that provides details about a new offering of
securities for sale to the public. It gives a detailed financial background of the issuing
company, how the proceeds of the securities will be used, and other pertinent information
investors will need to make an informed decision Secondary Market -When stocks or
bonds are traded or resold, they are said to be sold on the secondary market. The majority
of all securities transactions takes place on the secondary market. As we know, the
company does not return the capital in case of a equity shares, the holders of equity
shares can realise their investments only by selling their securities in the secondary
market. What is Share/Stock Certificate?The actual piece of paper that is evidence of
ownership of stock in a corporation. Watermarked paper is finely engraved with delicate
etchings to discourage forgery. The certificates carry the name and address of the
company, the name of the shareholder, the distinctive number of share and the certificate
number and is given under the common seal of the company. Bearer Certificate- A
security whose owner is not registered on the books of the issuer and which is, therefore,
payable to the person possessing the certificate. A bearer bond has coupons attached,
which the bondholder sends in or presents on the interest date for payment. Bearer stock
certificates are negotiable without endorsement. What is a Stock Exchange ? Stock
Exchange is an organized marketplace for securities featured by the centralization of
supply and demand for the transaction of orders by member brokers for institutional and
individual investors. Why Stock Exchanges? As we know, the basic attribute of a sound
investment is liquidity, the buyers of securities need an opportunity to sell their securities
to convert them in cash. They need a market place to exchange their stocks and bonds for
money. As more and more companies raised capital in the market, there is more need for
organised markets for secondary market for these securities. As private enterprise grew
around the world, more and more stock exchanges came into existence providing
liquidity to share issued by companies. Listing with Stock Exchanges - A listed security
is one that is approved for trading on an exchange. It provides opportunity for the stock
of a company to be traded on a stock exchange. The various stock exchanges have
different standards for listing. Various norms for listing in an exchange include the
number of outstanding shares, the number of shareholders, the profitability of the
company etc. A delisted security is one that is removed because of financial insufficiency
or breaking of exchange rule.
Capital Markets
Entities
    • Issuer Company
    • Investor
    • Stock Exchange
    • Broker Member
    • Clearing House/ Corporation
    • Clearing Member
    • Share Registrar/Transfer Agent
    • Investment Manager
    • Depository
    • Depository Participant
    • Custodian
Instruments /securities
    • Share
    • Preference Share
    • Debenture
    • Bond
Issuer -The official name of the company issuing a given security. Investor - One who
invests money in various investments. Broker Member— An agent who is a member of
the exchange and handles the public’s orders to buy and sell securities, commodities or
other property. For this service a commission is charged. Commission- The broker’s
basic fee for purchasing or selling securities or property as an agent. Clearing
house/Corporation -a department of an exchange or a separate legal entity that provides a
range of services related to the clearance and settlement of trades and the management of
risks associated with the resulting contracts. A clearinghouse is often central counterparty
to all trades to be settled through the clearing house, that is, the buyer to every seller and
the seller to every buyer Clearing member -A member of an exchange clearing house.
Clearing members are responsible for the financial commitments of customers that clear
through their firm. All trades of a non-clearing member must be registered and
eventually settled through a clearing member. Registrar - Usually a trust company or
bank charged with the responsibility of keeping a record of the owners of a corporation’s
securities and preventing the issuance of more than the authorized amount. Transfer
Agent - A transfer agent keeps a record of the name of each registered shareowner, his or
her address, the number of shares owned, and sees that certificates presented for transfer
are properly cancelled and new certificates issued in the name of the new owner.
Investment Manager –An organization employed by a mutual fund or any institutional
investor to give professional advice on the fund’s investments and asset management
practices. Depository
An entity which maintains an electronic record of all dematerialized or immobilised
shares and all subsequent transactions and transfers therein. (NSDL & CDSL in India and
DTC in US, SIS in Switzerland, STRATE in South Africa). Depository Participant - An
agent of the depository who opens account of the individual investors and maintains a n
account of holdings with the Depository. Various Banks and Brokers act as Depository
participants. Custodian - An entity which keeps custody of all shares held by a client and
keeps track of dividends, bonus and rights issues on behalf of the client. Its services are
typically used by portfolio managers, mutual funds and other large holders of shares.
Preference Shares - Shares with some preferential treatment in terms of dividend payout.
Typically financial instruments which are half equity, half bond. Payout is fixed and
compulsory subject to certain conditions
Debenture- A bond issued by a corporation. A promissory note backed by the general
credit of a company and usually not secured by any specific collateral, such as a
mortgage or property.
Money Market Vs Capital Market
Money Market
    • Institutional
    • Less number of Transactions
    • High Value Deals
    • Same day or next day settlement
    • Unorganized Market
Capital Market
    • Institutional and Retail
    • More number of transactions
    • High/Low Value Deals
    • Varied period of Settlement
    • Organized Market
Other Markets
    • Foreign Exchange Market - Where the currencies of various countries are traded,
        and their value determined. Currency dealings are either on spot or forward basis.
        The deals take between banks dealers. This market is either telephone or network
        based.
    • Derivatives Market - Where the transacted securities derive their
  value from the value of an underlying asset dealt the cash markets e.g. options, futures,
forward contracts. Derivatives are either Financial Derivatives or Commodity
Derivatives.
   •    Financial Derivatives - Financial Derivative Contracts are interest futures,
        currency futures, futures and options on stock indices, options on stocks.
    • Commodities Derivatives - These contracts are futures and options on standard
        contracts of various commodities transacted in wholesale e.g. bullion, tea,
        oilseeds, metals and other products like energy, bandwidth etc.
Cash Market
A market in which security or commodity settlements occur within a few days of the
trade date. Also called the spot market. The opposite is the futures market, where
transactions are completed at a specified future date, price and quantity, which is
determined in the present. Stock, bond and mutual funds trade in the cash .
Overview of the Worldwide Markets
    • Worlds Biggest Markets
            • USA - EQUITY MARKETS
       NYSE, NASDAQ-AMEX, MID-WEST, PACIFIC
            • USA- FUTURES MARKETS
       CBOT, CBOE, CME
            • EUROPE - LONDON , FRANKFURT, SWISS,PARIS
       LIFEE, EUREX
            • Tokyo, Taiwan, HongKong, Singapore, Australia

   •   Various Types of Markets in the Exchanges. Ex:
                   • NASDAQ : National Market, Small Order Execution System,
                      NASDAQ International, Small Cap Market, OTC Bulletin Board
Overview of the Indian Stock Market
   • The first Indian Stock Exchange is formed in 1875 in Bombay under a Banyan
       Tree situated at what is today called DALAL STREET. It is now called The Stock
       Exchange, Mumbai or popularly as BSE.
   • 22 Stock Exchanges exist in India. Major Centers are Calcutta, Delhi,
       Ahmedabad, Chennai, Bangalore, Kanpur, Pune, Ludhiana.
   • OTCEI - Over The Counter Exchange of India is established in 1992 to meet the
       needs of smaller companies.Is the first Screen Based Trading System in India.
   • NSE - National Stock Exchange of India is established in 1994 which popularised
       the Screen Based Trading through V Sat based Network of Computer Terminals.
   • NSE and BSE contribute more than 70% business in the Indian Market.
   • National Securities Depository Limited (NSDL) and Central Depository for
       Securities Limited (CDSL) are two Depositories.

				
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