Financial Market Meaning and Types

Business needs finance from the conception of idea to start it.

It needs finance for the establishment, running, expansion, modernisation and diversification of business in the form of working capital as well as fixed capital. Finance is made available by different segments of Financial market.

 

Financial Market

An economic system consists of two main sectors – households which save funds and business firms which invest these funds.

The financial market is a common platform where buyers and sellers can meet for fulfilment of their individual needs.

A financial market helps to link the savers and the investors by mobilizing funds between them and performs an allocative function. Thus, it performs financial intermediation.

An allocative function is performed by directing funds available for investment into their most productive investment opportunity.

When the allocative function is performed well, two consequences follow:

  • The rate of return offered to households would be higher.
  • Scarce resources are allocated to those firms which have the highest productivity for the economy.

Two major alternative mechanisms through which allocation of funds can be done:

(a) via banks:

Households can deposit their surplus funds with banks, who in turn could lend these funds to business firms.

or

(b) via financial markets:

Households can buy the shares and debentures offered by a business using financial markets.

Banks and financial markets are competing intermediaries in the financial system, and give households a choice of where they want to place their savings.

A financial market is a market for the creation and exchange of financial assets.

Financial markets exist wherever a financial transaction occurs.

Financial transactions can be in the form of:

(a) creation of financial assets such as the initial issue of shares and debentures by a firm

or

(b) the purchase and sale of existing financial assets like equity shares, debentures and bonds.

 

Financial Market Meaning and Types

Functions of Financial Market

Financial markets perform the following four important functions.

  1. Channeling the savings into the most Productive Uses:

A financial market facilitates the transfer of savings from savers to investors. It gives savers the choice of different investments and thus helps to divert surplus funds into the most productive use.

  1. Facilitating Price Discovery:

Financial market facilitates establishing a price by balancing the demand and supply forces like in any other case, the demand for funds represented by business firms and the supply, by the households.

  1. Providing Liquidity to Financial Assets:

Financial markets provide liquidity to financial assets by facilitating easy purchase and sale of financial assets. Holders of assets can readily sell their financial assets through the mechanism of the financial market.

  1. Reducing the Cost of Transactions:

Financial markets saves time, effort and money of both buyers and sellers of a financial asset by providing valuable information about securities being traded in the market.

 

Financial Market Meaning and Types

Classification of Financial Market:

(on the basis of maturity of financial instruments)

Instruments with a maturity of less than one year are traded in the money market. Instruments with longer maturity are traded in the capital market.

 

Money Market:

The money market is a market for short term funds which deals in monetary assets whose period of maturity is up to one year. These assets are close substitutes for money.

 

Features of Money Market:

  1. Market for highly liquid assets:

It is a market where low risk, unsecured and short-term debt instruments that are highly liquid are issued and actively traded every day.

  1. No physical location:

It has no physical location, but is an activity conducted over the telephone and through the internet.

  1. For meeting temporary needs of funds:

It enables the raising of short-term funds for meeting the temporary shortages of cash and obligations and the temporary deployment of excess funds for earning.

  1. Major participants:

The major participants in the market are the Reserve Bank of India (RBI), Commercial Banks, Non- Banking Finance Companies, State Governments, Large Corporate Houses and Mutual Funds.

 

Financial Market Meaning and Types

Money Market Instruments

  1. Treasury Bill:

A Treasury bill is basically an instrument of short-term borrowing by the Government of India maturing in less than one year. They are also known as Zero Coupon Bonds issued by the Reserve Bank of India on behalf of the Central Government to meet its short-term requirement of funds.

  • Treasury bills are issued in the form of a promissory note.
  • They are highly liquid and have assured yield and negligible risk of default.
  • They are issued at a price which is lower than their face value and repaid at par.
  • The difference between the issue price and redemption value is interest but is called discount.
  • Treasury bills are available for a minimum amount of ₹ 25,000 and in multiples

Example: Suppose an investor purchases a 91-day Treasury bill with a face value of ₹1,00,000 for ₹92,000. By holding the bill until the maturity date, the investor receives ₹1,00,000. The difference of ₹8,000 represents the interest received by him.

  1. Commercial Paper:

Commercial paper is a short-term, unsecured, promissory note, negotiable and transferable by endorsement and delivery with a fixed maturity period. It is

  • Issued by large and credit worthy companies to raise short-term funds at lower rates of interest than market rates.
  • Usually with a maturity period of 15 days to one year.
  • Sold at a discount and redeemed at par.
  • Used to provide short-terms funds for seasonal and working capital needs like bridge financing i.e.to arrange funds to meet the floatation costs (costs associated with floating of an issue are brokerage, commission, printing of applications and advertising etc.).
  1. Call Money:

Call money is short term finance repayable on demand, with a maturity period of one day to fifteen days, used for inter-bank transactions.

  • Commercial banks have to maintain a minimum cash balance known as cash reserve ratio which is regulated by Reserve Bank of India.
  • Banks use the method of Call money to borrow from each other, to maintain the cash reserve ratio.
  • The interest rate paid on call money loans is known as the call rate. It is a highly volatile rate that varies from day-to-day and sometimes even from hour-to-hour.
  1. Certificate of Deposit:

Certificates of deposit (CD) are unsecured, negotiable, short-term instruments in bearer form, issued by commercial banks and development financial institutions.

  • They can be issued to individuals, corporations and companies.
  • During periods of tight liquidity when the deposit growth of banks is slow but the demand for credit is high.
  • They help to mobilise a large amount of money for short periods.
  1. Commercial Bill:

A commercial bill is a bill of exchange used to finance the working capital requirements of business firms.

  • It is a short-term, negotiable, self-liquidating instrument which is used to finance the credit sales of firms.
  • When goods are sold on credit, the seller (drawer) of the goods draws the bill and the buyer (drawee) accepts it. On being accepted, the bill becomes a marketable instrument and is called a trade bill and can be discounted with a bank if the seller needs funds before the bill matures.
  • When a trade bill is accepted by a commercial bank it is known as a commercial bill.

 

Capital Market

'Capital market' refers to facilities and institutional arrangements through which long-term funds, both debt and equity are raised and invested.

  • It is concerned with directing the savings of community into their most productive use in commerce and industry leading to growth and development of the economy.
  • It consists of development banks, commercial banks and stock exchanges.
  • An ideal capital market is one where finance is available at reasonable cost, so it becomes essential that financial institutions are sufficiently developed and that market operations are free, fair, competitive and transparent.

 

Financial Market Meaning and Types

Capital Market can be divided into two parts:

  1. Primary Market
  2. Secondary Market

 

Distinction between Capital Market and Money Market:

The major points of distinction between the two markets are as follows:

  1. Participants:

The participants in the capital market are financial institutions, banks, corporate entities, foreign investors and ordinary retail investors from members of the public.

Participation in the money market is by and large undertaken by institutional participants such as the RBI, banks, financial institutions and finance companies.

Individual investors although permitted to transact in the secondary money market, do not normally do so.

  1. Instruments:

The main instruments traded in the capital market are equity shares, debentures, bonds, preference shares etc.

The main instruments traded in the money market are short term debt instruments such as T-bills, trade bills reports, commercial paper and certificates of deposit.

  1. Investment Outlay:

Investment in the capital market i.e. securities does not necessarily require a huge financial outlay. The value of units of securities is generally low i.e. ₹10, ₹100 or so. This helps individuals with small savings to subscribe to these securities.

In the money market, transactions involve huge sums of money as the instruments are quite expensive.

  1. Duration:

The capital market deals in medium- and long-term securities such as equity shares and debentures.

Money market instruments have a maximum tenure of one year and can be issued for a single day.

  1. Liquidity:

Capital market securities are considered liquid investments because they are marketable on the stock exchanges.

Money market instruments on the other hand, enjoy a higher degree of liquidity as there is formal arrangement for this.

The Discount Finance House of India (DFHI) has been established for the specific objective of providing a ready market for money market instruments.

  1. Safety:

Capital market instruments are riskier both with respect to returns and principal repayment. Issuing companies may fail to perform as expected and promoters may defraud investors.

The money market is comparatively safer with a minimum risk of default. This is due to the shorter duration of investing and also to financial soundness of the issuers, which primarily are the government, banks and highly rated companies.

  1. Expected return:

The investment in capital markets generally yield higher return for investors than the money markets. The possibility of earnings is higher if the securities are held for a longer

duration. First, there is the scope of earning capital gains in equity share. Second, in the long run, the prosperity of a company is shared by shareholders by way of high dividends and bonus issues.

 

Primary Market (New issues market)

It deals with new securities being issued for the first time.

  • Main function of a primary market is to facilitate investment into new enterprises or to expand the existing enterprises by way of fresh issue of securities.
  • The investors in this market are banks, financial institutions, insurance companies, mutual funds and individuals.
  • Securities traded in the primary market are equity shares, preference shares, debentures, loans and deposits.
  • Funds raised can be used for setting up new projects, expansion, diversification, modernisation of existing projects, mergers and takeovers

 

Financial Market Meaning and Types

Methods of Flotation in the primary market:

  1. Offer through Prospectus:

This is the most popular method of raising funds by public companies in the primary market. This involves inviting subscription from the public through issue of prospectus. A prospectus is a direct appeal to investors to raise capital, through an advertisement in newspapers and magazines.

The issues may be underwritten and also are required to be listed on at least one stock exchange. The prospectus should fulfill the provisions of the Companies Act and SEBI guidelines.

  1. Offer for Sale:

Under this method securities are not issued directly to the public but are offered for sale through intermediaries like issuing houses or stockbrokers. In this case, a company sells securities enbloc at an agreed price to brokers who, in turn, resell them to the investing public.

  1. Private Placement:

Private placement is the allotment of securities by a company to institutional investors and some selected individuals. It helps to raise capital more quickly than a public issue.

Access to the primary market can be expensive on account of various mandatory and non-mandatory expenses. Some companies, therefore, cannot afford a public issue and choose to use private placement.

  1. Rights Issue:

This is a privilege given to existing shareholders to subscribe to a new issue of shares according to the terms and conditions of the company. The shareholders are offered the ‘right’ to buy new shares in proportion to the number of shares they already possess.

  1. e-IPOs:

A company proposing to issue capital to the public through the on-line system of the stock exchange has to enter into an agreement with stock exchange. This is called an Initial Public Offer (IPO). SEBI registered brokers have to be appointed for the purpose of accepting applications and placing orders with the company.

The issuer company should also appoint a registrar to the issue having electronic connectivity with the exchange. The issuer company can apply for listing of its securities on any exchange other than the exchange through which it has offered its securities.

 

Secondary Market/ Stock Market / Stock Exchange

  • A market for the purchase and sale of existing securities.
  • Helps existing investors to disinvest and fresh investors to invest the market.
  • Provides liquidity and marketability to existing securities.
  • Contributes to economic growth by channelizing funds towards the most productive investments through the process of disinvestment and reinvestment.
  • Securities are traded, cleared and settled within the regulatory framework of SEBI.
  • Stock exchanges are online, accessible from anywhere through trading terminals

Stock Exchange:

A stock exchange is an institution which provides a platform for buying and selling of existing securities. It facilitates the sale of a security (share, debenture etc.) and vice versa.

According to Securities Contracts (Regulation) Act 1956, "stock exchange means anybody of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying and selling or dealing in securities."

 

Financial Market Meaning and Types

Functions of a Stock Exchange

An active and healthy secondary market in existing securities leads to growth of primary market. The following are some of the main functions of a stock exchange.

  1. Providing Liquidity and Marketability to Existing Securities:

The basic function of a stock exchange is to facilitate continuous market for purchase and sale of existing securities. It gives investors the chance to disinvest and reinvest. This provides both liquidity and easy marketability to already existing securities in the market.

  1. Pricing of Securities:

A stock exchange is a mechanism of constant valuation through which the prices of securities are determined by the forces of demand and supply. Such valuation provides important instant information to both buyers and sellers in the market.

  1. Safety of Transaction:

The membership of a stock exchange is well regulated, and its dealings are well defined according to the existing legal framework. This ensures that the investing public gets a safe and fair deal on the market.

  1. Contributes to Economic Growth:

A stock exchange is a market in which existing securities are resold or traded. Through this process of disinvestment and reinvestment savings get channelised into their most productive investment avenues. This leads to capital formation and economic growth.

  1. Spreading of Equity Cult:

The stock exchange can play a vital role in ensuring wider share ownership by regulating new issues, better trading practices and taking effective steps in educating the public about investments.

  1. Providing Scope for Speculation:

The stock exchange provides sufficient scope for lawful speculative activity in a restricted and controlled manner.  Certain degree of healthy speculation is necessary to ensure liquidity and price continuity in the stock market.

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