FM303: Financial Markets and Services • Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners.

• Groups of persons operating as ‘funds’ or ‘associations.’ These groups function under a

Module 1, Unit 1 system of their own rules and use names such as ‘fixed fund,’ ‘association,’ and ‘saving club.’
• Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial
intermediaries such as finance, investment, and chit-fund companies.
INTRODUCTION In India, the spread of banking in rural areas has helped in enlarging the scope of the formal
A financial system plays a vital role in the economic growth of a country. It intermediates financial system.
between the flow of funds belonging to those who save a part of their income and those who
invest in productive assets. It mobilizes and usefully allocates scarce resources of a country. A
financial system is a complex, well-integrated set of sub-systems of financial institutions,
markets, instruments, and services which facilitates the transfer and allocation of funds,
efficiently and effectively.
A financial system is a complex, well-integrated set of sub- systems of financial institutions,
markets, instruments, and services which facilitates the transfer and allocation of funds,
efficiently and effectively.

FUNCTIONS
The main function of financial systems is the collection of savings and their distribution for
industrial investment, thereby stimulating the capital formation and, to that extent, accelerating
the process of economic growth.
The process of capital formation involves three distinct, although inter-related activities:
(i) Savings: The ability by which claims to resources are set aside and become
available for other purposes.
(ii) Finance: The activity by which claims to resources are either assembled from those
released by domestic savings, obtained from abroad, or specially created usually as
bank deposits or notes and then placed in the hands of the investors.
(iii) Investments: The activity by which resources are actually committed to production.
The volume of capital formation depends upon the intensity and efficiency with
which these activities are carried on. The effective mobilisation of savings, the
efficiency of the financial organisation/system and the channelisation of these
savings into the most desirable and productive forms of investment are all inter-
connected and have a great bearing on the contribution of capital formation to
economic development. Their relevance to the saving-investment process is derived
from what is called the transfer process

The Indian Financial System

The Indian financial system can also be broadly classified into the formal (organized) financial
system and the informal (unorganized) financial system. The formal financial system comes
under the purview of the Ministry of Finance (MoF), the Reserve Bank of India (RBI), the
Securities and Exchange Board of India (SEBI), and other regulatory bodies.
The informal financial system consists of:
Financial Assets and Instruments Financial Markets
Financial assets can be defined as investment assets whose value is derived from a contractual Financial markets are an important component of the financial system. They are a mechanism
claim of what they represent. These are liquid assets as the economic resources or ownership for the exchange trading of financial products under a policy framework. The participants in
can be converted into matter, such as cash. These are also referred to as financial instruments the financial markets are the borrowers (issuers of securities), lenders (buyers of securities),
or securities. They are widely used to finance real estate and ownership of tangible assets and financial intermediaries.
The financial assets fall into three broad categories: (i) Direct/primary, (ii) Indirect and (iii) Financial markets comprise two distinct types of markets:
Derivatives.
• the money market
Primary/Direct Securities: Primary securities are new securities issued by companies,
government entities or public institutions. The primary securities market is also referred to as • the capital market
the new issues market (NIM)1. In the primary market, investors are able to purchase securities Money Market - A money market is a market for short-term debt instruments (maturity below
directly from the issuer. Types of primary market issues include an initial public offering (IPO),
one year). It is a highly liquid market wherein securities are bought and sold in large
a private placement, a rights issue, and a preferred allotment.
denominations to reduce transaction costs. Call money market, certificates of deposit,
The main types of primary securities are (i) ordinary/equity shares, (ii) preference shares and commercial paper, and treasury bills are the major instruments/segments of the money market.
iii) debentures/bonds including innovative debt instruments. It caters to the borrowing needs for short term projects and investments (Working Capital) of
Indirect Securities/Financial Assets: Indirect securities are financial assets issued by an org.
financial intermediaries, such as units of mutual funds, policies of insurance companies, The functions of a money market are
deposits of banks, security receipts issued by securitisation and asset reconstruction companies,
securitised debt instruments issued by special purpose vehicles (SPVs) and so on. The indirect • to serve as an equilibrating force that redistributes cash balances in accordance with the
financial assets are coined from the underlying primary security and bearing their own utilities. liquidity needs of the participants;
They are better suited to the requirements of investors, particularly small investors.
• to form a basis for the management of liquidity and money in the economy by monetary
Derivatives: The term derivative refers to a type of financial contract whose value is dependent authorities; and
on an underlying asset, group of assets, or benchmark. A derivative is set between two or more
parties that can trade on an exchange or over-the-counter (OTC). The most common types of • to provide reasonable access to the users of short-term money for meeting their requirements
derivatives are Futures, Options, Forwards and Swap. at realistic prices

Financial Intermediaries Capital Market - A capital market is a market for long-term securities (equity and debt).
Capital Market refers to that part of the broader financial market which provides a market for
A financial intermediary is an entity that acts as the middleman between two parties in a borrowing and lending of medium and long-term funds, above 1 year. Thus, it caters to the
financial transaction, such as a commercial bank, investment bank, mutual fund, or pension borrowing needs for medium to long term projects and investments.
fund. Financial intermediaries offer a number of benefits to the average consumer, including
safety, liquidity, and economies of scale involved in banking and asset management. Although The purpose of capital market is to
in certain areas, such as investing, advances in technology threaten to eliminate the financial • mobilize long-term savings to finance long-term investments;
intermediary, disintermediation is much less of a threat in other areas of finance, including
banking and insurance. • provide risk capital in the form of equity or quasi-equity to entrepreneurs;

Common Types of Financial Intermediaries: • encourage broader ownership of productive assets;

o Banks: Highly regulated institutions that play a key role in economic stability. • provide liquidity with a mechanism enabling the investor to sell financial assets;
o Investment Banks: Specialized in large and complex financial transactions.
• lower the costs of transactions and information; and
o Credit Unions: Member-owned financial cooperatives.
o Pension Funds: Manage retirement savings. • improve the efficiency of capital allocation through a competitive pricing mechanism
o Insurance Companies: Provide coverage against risks.
o Mutual Funds: Pool funds from multiple investors. Components of Financial Market
o Stock Exchanges: Facilitate buying and selling of securities. Financial markets are broken down into various components based on the asset that is traded
o Clearing Houses: Handle settlement and clearing of financial transactions. and the length of financing offered:
  Capital Markets: Capital markets are concerned with raising capital for entities • Markets are dominated by financial intermediaries who take investment decisions as well as
through issuing equity stock or long-term debt. Let us explore some of the elements of risks on behalf of their depositors.
capital markets.
• Negative externalities are associated with financial markets. A failure in any one segment of
a) Stock markets: They are markets that companies leverage to raise capital by creating shares. these markets may affect other segments, including non-financial markets.
The shares are sold to external investors, who can either be corporations or individual buyers.
• Domestic financial markets are getting integrated with worldwide financial markets. The
Companies can sell the shares on their own or engage the services of stockbrokers.
failure and vulnerability in a particular domestic market can have international ‘ramifications.’
b) Bond markets: When organizations need large-scale financing, they may resort to bonds. Similarly, problems in external markets can affect the functioning of domestic markets.
Bonds are borrowing instruments which generate a fixed interest rate after a predefined period.
Different types of bonds include treasury bonds, corporate bonds, and municipal bonds. Functions of Financial Markets
 Commodity Markets: This is where companies trade in natural resources such as oil, The cost of acquiring information and making transactions creates incentives for the
corn or gold, for short-term financing emergence of financial markets and institutions. Different types and combinations of
information and transaction costs motivate distinct financial contracts, instruments and
 Money Markets: Money market instruments are also referred to us 'paper'. They entail institutions.
trading of financial instruments which are highly liquid and have short-term maturity
dates. The maturity dates of papers could be as short as a few hours but not more than Financial markets perform various functions such as
one year. • enabling economic units to exercise their time preference;
 Derivatives Markets: These are markets that facilitate the trading of financial • separation, distribution, diversification, and reduction of risk;
instruments like futures contracts or options which are derived from other forms of
assets like stocks, bonds, commodities, and market index price • efficient payment mechanism;

 Futures Markets: A futures market is one where participants agree to buy or sell an • providing information about companies. This spurs investors to make inquiries themselves
asset at a future date at an agreed-upon price. and keep track of the companies’ activities with a view to trading in their stock efficiently;

 Insurance Markets: Insurance markets are a means of protection against financial loss • transmutation or transformation of financial claims to suit the preferences of both savers and
or any other uncertain loss. Insurance companies compensate to the insured party in borrowers;
case of occurrence of the insured loss. • enhancing liquidity of financial claims through trading in securities; and
 Foreign Exchange Markets: Forex markets deal with the buying and selling of foreign • providing portfolio management services.
currencies.
Financial Instruments and Multiplicity of Financial Instruments
 Mortgage Markets: They are classified as primary and secondary mortgage markets.
In a primary mortgage market, mortgage brokers, commercial banks, and credit unions Financial instruments are monetary contracts between parties. They can be created, traded,
give out mortgage loans needed to acquire property. A secondary mortgage market modified and settled. They can be cash (currency), evidence of an ownership interest in an
involves the buying and selling of existing home loans, which have been bundled entity or a contractual right to receive or deliver in the form of currency (forex); debt (bonds,
together and traded as mortgage-backed securities. loans); equity (shares); or derivatives (options, futures, forwards).

Characteristics of Financial Markets Multiplicity of Financial Instruments

• Financial markets are characterized by a large volume of transactions and the speed with
The multiplicity of financial instruments refers to the wide range of instruments available to
which financial resources move from one market to another.
meet different needs of investors, companies, and governments. This diversity is crucial for
• There are various segments of financial markets such as stock markets, bond markets— several reasons:
primary and secondary segments, where savers themselves decide when and where they should
invest money. o Risk Management: Different instruments help in managing various types of financial
risks. For example, derivatives like futures and options can hedge against price
• There is scope for instant arbitrage among various markets and types of instruments. fluctuations.
• Financial markets are highly volatile and susceptible to panic and distress selling as the
behaviour of a limited group of operators can get generalized.
o Funding and Capital: Companies and governments can raise capital through different
instruments suited to their needs, such as issuing bonds for debt financing or stocks for
equity financing.
o Investment Diversification: Investors can diversify their portfolios by investing in a
mix of financial instruments, thus spreading risk and potentially enhancing returns.
o Market Efficiency: A multiplicity of instruments contributes to more efficient
financial markets by providing various avenues for trading and risk management,
leading to better price discovery and liquidity.
o Innovation: The financial markets continuously innovate, creating new instruments to
address evolving financial needs and opportunities. For example, the development of
cryptocurrencies and related financial products has added new dimensions to financial
markets.