PES UNIVERSITY

I SEMESTER B.COM

UNIT-1 FINANCIAL SYSTEM

Subject Code : UM20BC108

 Introduction

The Financial system is an integral part of the economy, when the system functions properly, it
channels funds from saver to investors the financial inputs emanate from the financial system,
while real goods and services are part of the real system(Goods and Services) and the financial
system(money and capital)is necessary for the productive process.

It plays an important role in Global, National, Institutional and Individual level.

 Meaning of Financial system

The financial system is a set of inter-related activities or services working together to achieve
some predetermined purpose or goal. It includes different markets, the institutions, instruments,
services and mechanisms which influence the generation of savings, investment, capital
formation and growth.

According to Amit Chaudhary,

“Financial system is the integrated form of Financial Instruments, Financial Markets, Financial
Services and Financial Instruments components which aim is to circulate the funds in an
economy for economic growth.”

 Definition of financial system

Prof .S.B Gupta defines the financial system as "a set of institutional arrangements through
which financial surplus available in the economy are mobilized

Dr. S Gurusamy defines "a set of complex and closely interconnected financial institutions,
markets, instruments, services, practices and transactions.

 Classification of financial system

 Financial Markets
 Financial Institution
 Financial Instruments
 Financial Services

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The brief outline of these four components is given below

1.Financial Markets: Financial Market refers to a marketplace, where creation and trading of
financial assets, such as shares, debentures, bonds, derivatives, currencies, etc. take place. It
plays a crucial role in allocating limited resources, in the country's .This a place or mechanism
where funds or savings are transferred from one section to another section of financial system.
These markets can be broadly classified into

a) Money market and capital Market: Money market deals with short-term claims or financial
assets(less than one year) whereas capital markets deal with those financial assets which have
maturity period of more than a year.

b)Primary and secondary market: Primary markets deal in new issue of securities whereas
secondary markets deal with securities which are already issues and available in the market.

2.Financial Institutions: A financial institution (FI) is a company engaged in the business of

dealing with financial and monetary transactions such as deposits, loans, investments, and
currency exchange. These are the institutions which are dealing in the financial market. They

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mobilize and transfer the savings or funds from surplus units to deficit units. They are back bone
of financial system, they deal with assets like deposits, securities and loans.

3.Financial instruments: Financial instruments are assets that can be traded, or they can also be
seen as packages of capital that may be traded, for example equity shares, Preference shares,
Debentures and Bonds etc.

In other words , A financial instrument is a monetary contract between parties. We can create,
trade, or modify them. We can also settle them.

4.Financial services: are the economic services provided by the finance industry, which
encompasses a broad range of businesses that manage money, including credit unions, banks,
credit-card companies, insurance companies, accountancy companies, consumer-finance
companies, stock brokerages, investment funds.Financial services is a part of financial system
that provides broad range of financial products and services by financial institutions. Examples :
Banking, Factoring , Mutual Funds , Insurance , Underwriting and merchant banking

 Meaning of Financial Markets

A financial market is an institution or arrangement that facilitates the exchange of financial

instruments like shares debentures loans etc. A market wherein financial instruments such as
financial claims, assets and securities are traded is known as a financial markets

 Importance and functions of Financial Markets:-

Financial markets are common to each country, and they play a major role in the economic
growth of the country.Such markets act as an intermediary between savers and investors, or they
help savers to become investors. On the other hand, they also help businesses to raise money to
expand their business.

It won’t be wrong to say that investors and businesses access the financial markets to raise
money and also to make more money. Moreover, they also help in lowering unemployment as
these markets create massive job opportunities.

 FUNCTIONS :

Price Determination: Demand and supply of an asset in a financial market help to determine
their price. Investors are the supplier of the funds, while the industries are in need of the funds.
Thus, the interaction between these two participants and other market forces helps to determine
the price.

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Mobilization of savings: For an economy to be successful it is crucial that the money does not
sit idle. Thus, a financial market helps in connecting those with money with those who require
money.

Ensures liquidity: Assets that buyers and sellers trade in the financial market have high liquidity.
It means that investors can easily sell those assets and convert them into cash whenever they
want. Liquidity is an important reason for investors to participate in trade.

Saves time and money: Financial markets serve as a platform where buyers and sellers can
easily find each other without making too much efforts or wasting time. Also, since these
markets handle so many transactions it helps them to achieve economies of scale. This results in
lower transaction cost and fees for the investors.

 Classification of Financial Market:

1. Capital market
2. Money market

Capital Market
Is a market for financial assets which have long or indefinite maturity, it generally deals with
securities which have maturity period above a year. It is divided into 3 categories:

1. Industrial securities
2. Government securities
3. Long term securities

1. Industrial Securities
It is market for industrial securities namely equity shares, pref shares, debentures or bonds. It is a
market where industries raise capital or debt by issuing appropriate instruments; it is divided into
2 types:

I. Primary or New issue Market

II. Secondary or Stock exchange

Primary Market
Securities which are issued to the public for first time. In this market borrowers exchange or
offer new financial securities for a long term funds ,hence it is capital formation.
a) Public issue: Raising capital by new companies is through sale of securities to the public.
b) Rights issue: It is raised by existing co for additional capital to existing share holders.
c) Private Placements: It is a way of selling securities privately to a small group of investors.

Secondary market

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It is a market for secondary sale of securities, such shares quoted in the stock exchange market. It
provides continuous and regular market for buying and selling. It is also called as stock market.

2. Government securities market

It is a market where Government securities are traded. Government securities have both long
and short term securities. Long term is traded in stock exchange and short term in Money market.
Securities are issued by central, State and Semi Gov t Organization such as city corporation, Port
trusts, State electricity board etc, they also carry the benefit of Tax exemption.
It is a tradable instrument issued by the central government or the state government
acknowledges the govt debts obligation for example Treasury Bills, state developmental loans.

3. Long term Loans Market

Commercial banks and Development Banks play a significant role by supplying long term loans
to corporate.
a) Term loan market
b) Mortgage Market
c) Financial guarantee Market

 Functions of Primary Market

1. Transfer of resources
2. Investigative services /Origination provide information based on market analysis.
3. Advisory services
4. Guarantee/Underwriting
5. Distribution
6. Aids in expansion/diversification/modernization of existing units
7. Major players of primary market are merchant bankers, underwriting, brokers, advertise
agencies etc

 Significance of Primary Markets

1. Provides avenue for investment

2. Mobilization of savings
3. Channelizes savings for productive use
4. Source of large supply of funds
5. Enables rapid industrial growth
6. Source for expansions and up gradation.

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 Functions of Secondary market

1. Liquidity of securities as securities can be converted into cash readily

2. Marketability of securities as it facilitates buying and selling of securities.
3. Safety of funds belonging to investors
4. Availability of long term funds
5. Flow of funds to profitable projects.
6. Motivation for improved performance by companies to get competitive edge.
7. Promotion of investment opportunities.
8. Availability of business information.
9. Reflection of business cycle.
10. Promotes marketing of new issues by companies.

 Differences between primary and secondary market

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 Money Market Instrument :-
It is a market for dealing financial assets and securities which have a maturity period of up to
one year. It is a market for short term funds.

a) Call money Market

It is a market for extremely short period of time like one day to fourteen days, it is highly liquid.
They are associated with stock exchange and interest rates vary from day to day and even hour to
hour.
Call Money Features :
Call money is minimum 5% short-term finance repayable on demand
Maturity period of one to fourteen days or overnight to a fortnight
It is used for inter-bank transactions.
Commercial banks uses Call money to maintain CRR

b) Commercial Bills Market

It is a market for bills of exchange arising out of genuine trade transaction Where commercial
bill is a draft accompanied by a bill of lading and which is drawn by a seller in one country
against a buyer in another on account of goods sold by the latter, It is customary for the drawer
of a commercial bill to make it payable to himself.
Commercial Papers (CPs) - Issued by Highly rated companies, Features are:
 Unsecured short-term promissory note which is issued by purpose of raising capital to meet
requirements.
 CPs usually feature a fixed maturity period which can range anywhere from 1 day up to 270
days.
 Highly popular in countries like Japan, UK, USA, Australia and many others.
 Commercial Papers promise higher returns
 Commercial papers are actively traded in secondary market.

c) Treasury bill Market

It is a market for Treasury bill which has short term maturity. It is a promissory note or a finance
bill issued by Government. It is highly liquid as its repayment is guaranteed.
d) Short term loan market: Short term loans are given to corporate customers.

Treasury Bills (T-Bills) Features :-

 Issued by the Central Government

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 Safest money market instruments
 Carry zero risk
 Maturity periods like 3-month, 6-month and 1 year
 Issued at a lesser price than their face value
 Currently 3 types issued by the Government of India via auctions, which are 91-day, 182-
day and 364-day treasury bills.

D) Certificate of Deposits (CDs)
 First announced in 1989 by RBI
 Functions as a deposit receipt for money which is deposited with a financial organization or
bank.
 Certificate of Deposit is different from a Fixed Deposit Receipt in two aspects.
 The first aspect of difference is that a CD is only issued for a larger sum of money. Secondly,
a Certificate of Deposit is freely negotiable.

E) Repurchase Agreements (Repo) : REPO is a form of short-term borrowing for dealers in

government securities.A dealer sells government securities to investors, usually on an overnight
basis,
And buys them back the following day at a slightly higher price.
That small difference in price is the implicit overnight interest rate.
Repos are typically used to raise short-term capital. These transactions can only be carried out
between RBI approved parties. Transactions are only permitted between securities approved by
the RBI like treasury bills, central or state government securities, PSU bonds.

F) Banker's Acceptance (BA)

BA is a negotiable piece of paper. BA a document promising future payment which is
guaranteed by a commercial bank. BA specifies the details of the repayment like the amount to
be repaid, date of repayment and the details of the individual to which the repayment is due.
Maturity periods ranging between 30 days up to 180 days.
Banker's acceptances are used by companies for payment of large transactions.

 Capital Market

The part of a financial system concerned with raising capital by dealing in shares, bonds, and
other long-term investments are called capital market

 Importance of Capital Markets

1. Productive use of economy's savings

2. Provides incentives for saving
3. Facilitates capital formation
4. Increases production and productivity
5. Stabilizes value of securities

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6. Enables technological up gradation

 Importance of Money Market

1. Development of Trade and Industry

2. Development of Capital market
3. Enables smooth functioning of commercial banks
4. Effective functioning of central bank
5. Formulation of suitable Monetary policy
6. Non inflammatory source of Finance to government.

 Differences between Capital Market and Money Market

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