Friday, November 20, 2009

Unit - 2


                                                                          Money Market Institutions 

1)      Commercial Banks: The commercial banks are the most constituents of the money market. They use their short term surplus, funds to grand short term loans to the money market. They also discount and rediscount the commercial papers such as bill of exchange and Treasury bill. Commercial banks always try to maintain a balance between Liquidity and Profitability. 

2)      Non-Bank Financial Institutions: Non bank financial institutions such as insurance companies and other business corporations having short-period surplus funds also operate in the money market.

3)      Acceptance Houses: Acceptance houses and bill brokers are the important constituents of the money market in developed countries. These houses specialize in the acceptance of trade bills on behalf of their customers. Discount houses and bill brokers’ discount buy and sell bills drawn on the acceptance houses.

4)      Central Bank: The Central Bank is the top most financial institution in the money market. It is regarded as the lender of the last resort, banker to the government, banker’s bank and controller of the money market. As a lender of the last resort, the central bank gives temporary financial assistance to commercial banks by rediscounting their eligible bills. The central bank controls the money market with two main instruments, namely, the bank rate and the open market operations.


                                                                       Capital Market Institutions

Special financial institutions are the most active parts of Indian Capital Market. Such organizations provide medium and long term loan on easy installments to big business houses 

Such institutions help in promoting new companies; expansions and development of existing companies and meeting the financial requirements of companies during economic slow down.

The following are the main special financial institutions that are most active parts of the Indian Capital Market:

Development Banks : 

·        The Industrial Finance Corporation  of India (I.F.C.I)

·        The Industrial Credit and Investment Corporation of India  (I.C.I.C.I)

·        The Refinance Corporation of India (R.F.C)

·        State Financial Development Corporations (S.F.Cs)

·        National Industrial Development Corporation (N.I.D.C)

·        State Industrial Development Corporation (S.I.D.C)

·        National Small Industries Corporation (N.S.I.C)

·        Industrial Development Bank of India (I.D.B.I)


Mutual Funds

 Unit trust of India (UTI)

ICICI Prudential

Reliance Insurance

Birla Sun life Insurance


Life Insurance

L.I.C                         HDFC

Bajaj Allianz            Tata AIG


Nationalized Commercial Banks (N.C.Bs) 

SBI                           PNB

BOB                         OBC


Stock Exchange : 

Bombay Stock Exchange                  

National Stock Exchange


Investment Banks 

J P Morgan                           Goldman Sach

Morgan Stanley                     Citigroup

Deutsche Bank                      HSBC


Assets Management Companies (AMCs) 

Religare                                 HDFC

SBI                                       ICICI


Merchant Banking Institutions (M.B.Is)

SBI Capital Markets                                      Kotak Mahindra capital

Tata Finance Merchant Bankers Ltd          Punjab & Sindh Bank 

Types of Financial Markets

 The financial markets can be divided into different subtypes:

 1. Capital markets which consist of: 

      A) Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.

      B) Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

      The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.

      2. Commodity markets: Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.

Top five commodity exchanges: 

New York Mercantile Exchange           USA   

Tokyo Commodity Exchange                Japan  

NYSE Euronext                                   EU      

Dalian Commodity Exchange                China

Multi Commodity Exchange                  India

3. Money markets- The term money market is used in a composite sense to mean financial institutions which deal with short term funds in the economy. It refers to the institutional arrangements facilitating borrowing and lending of short term funds. The money market brings together the lenders who have surplus short term invest able funds and the borrowers who are in need of short term funds. In money market funds can be borrowed for a short period varying from a day, a week, a month, or 3 to 6 months and against different types of instruments such as bills of exchange, bankers acceptances, bonds etc, called near money

4. Derivatives markets - The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives

5. Insurance markets - Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed and known small loss to prevent a large, possibly devastating loss. An insurer is a company selling the insurance; an insured or policyholder is the person or entity buying the insurance. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice. In other words insurance market means which facilitate the redistribution of various risks.

 6. Foreign exchange markets - The foreign exchange market (currency, Forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. [1]

The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a Indian business to import U.S goods and pay US dollar even though the business's income is in rupees

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

                                                                                                Money Market

The term money market is used in a composite sense to mean financial institutions which deal with short term funds in the economy. It refers to the institutional arrangements facilitating borrowing and lending of short term funds. The money market brings together the lenders who have surplus short term invest able funds and the borrowers who are in need of short term funds. In money market funds can be borrowed for a short period varying from a day, a week, a month, or 3 to 6 months and against different types of instruments such as bills of exchange, banker’s acceptances, bonds etc, called near money

Functions of the Money Market

The money market performs the following functions:

1.      Adjustment of liquidity position - The basic function of money market is to facilitate adjustment of liquidity position of commercial banks, business corporations and other non banking institutions.

2.      To utilize surplus of Institutions - It provides outlets to commercial banks, business corporations, non bank financial concerns and other investors for their short term surplus funds.

3.      Funds for various borrowers- It provides short terms funds to the various borrowers such as businessmen, industrialists, traders etc.

4.      To government- It provides short terms funds even to government institutions.

5.      Credit control- The money market constitutes a highly efficient mechanism for credit control. It serves as a medium through which the Central Bank of the country (RBI) exercises controls on the credit.

6.      To utilize surplus of businessmen- It enables businessmen to invest their temporary surplus for a short period.

 7.      Provide funds for various uses- It plays a vital role in the flow of funds to the most important uses like expansion plan of any existing company or in forming a new company even in meeting shortcomings of creditors.

Essentials of Money market: 

The money market is not a single homogeneous market but it is composed of several specialized sub markets, each one of which deals in different types of short term credit.

1. Call Money Market: The money market refers to the market for extremely short period loans. Bill brokers and dealers in the stock exchange usually borrow money for short periods from commercial banks. The money is advanced by the commercial bank to bill brokers and dealers in the stock exchange for very short periods of one day, overnight or maximum seven days. Such short period loans are called “call loans” as these can be recalled by the lending bank at any time. There is no collateral security demanded against these loans and the borrower has to repay the loans immediately whenever called for.

Call loans are found useful by commercial banks as they are like cash and bring some income for the banks. Inter-bank call money market is very common in India. The bank which has surplus money for a short period lends to the needy bank.

2. Collateral loan market: The market which deals with collateral loans, i.e., loans backed up by collateral securities like stock and bond etc. is called collateral bond market. The collateral loans are given for a short period generally lasting few months. The borrowers in the market are generally brokers and dealers in stocks and shares, and the lenders are commercial banks. Sometimes, even a smaller bank may raise collateral loans from a bigger bank. The collateral security is returned by the lender on the repayment of loan but if the loan is not repaid the collateral security may be retained by the lender.

3. Bill market or Discount market: The bill market or the discount market refers to the market in which short period papers and bills are bought and sold. The most important short period papers, which are dealt in the bill market, are commercial bills. There are two types of commercial bills, (1) bill of exchange, and (2) treasury bills. The bill of exchange, popularly know as bill, is written instrument containing an unconditional order, signed by the drawer, directing a certain person to pay a certain sum of money only to, or order of a certain person, or to the bearer of the instrument at a fixed time in future or on demand.

 The treasure bill, on the other hand, is a short term government security, usually of the duration of 91 days, sold by the central bank of behalf of the government. There is no fixed rate or interest payable on the treasury bills. The treasure bills are sold by the central bank on the treasury bills. The treasury bills are sold by the central bank on the basis of competitive bidding.

4. Acceptance Market: It refers to the market for banker’s acceptances involved in trade transactions. A banker’s acceptance may be defined as a draft drawn by an individual or a firm upon a bank and accepted by it to pay to the order of a specified person or to the bearer, a certain specified sum of money at specified date in future. It is commonly used to settle payments in international trade.


                                                                                             CAPITAL MARKET

The term ‘capital market’ refers to the institutional arrangements for facilitating the borrowing and lending of long term funds.

In the widest sense, it consists of a series of channels through which the savings of community are made available for industrial and commercial enterprises and public authorities. It is concerned with those private savings, individual as well as corporate, that are turned in investments through new capital issues and also new public loans floated by government and semi-government bodies.

A capital market may be defined as an organized mechanism for effective and efficient transfer of money-capital or financial resources from investing parties, i.e. individuals or institutional savers to the entrepreneurs (individuals or institutions) engaged in industry or commerce in the business would either be in the private or public sectors of an economy.






                                                                                                    PRIMARY MARKET 

The primary market, also called the new issue market, is the market for issuing new securities. Many companies, especially small and medium scale, enter the primary market to raise money from the public to expand their businesses. They sell their securities to the public through an initial public offering.  The primary market is a market for new capitals that will be traded over a longer period.

Definitions of Primary market on the Web: 

The market in which investors have the first opportunity to buy a newly issued security.


The first buyer of a newly issued security buys that security in the primary market. All subsequent trading of those securities is done in the secondary market.



Features of primary markets are: 

1.      This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

2.      In a primary issue, the securities are issued by the company directly to investors.

3.      The company receives the money and issues new security certificates to the investors.

4.      Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

5.      The primary market performs the crucial function of facilitating capital formation in the economy.

6.      The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as "going public."


Methods of issuing securities in the primary market are:

Initial public offering;

Rights issue (for existing companies);

Preferential issue.


In the primary market, securities are issued on an exchange basis. The underwriters, that is, the investment banks, play an important role in this market: they set the initial price range for a particular share and then supervise the selling of that share.

Investors can obtain news of upcoming shares only on the primary market. The issuing firm collects money, which is then used to finance its operations or expand business, by selling its shares. Before selling a security on the primary market, the firm must fulfill all the requirements regarding the exchange.

After trading in the primary market the security will then enter the secondary market, where numerous trades happen every day. The primary market accelerates the process of capital formation in a country's economy. The primary market categorically excludes several other long-term finance sources, such as loans from financial institutions.

What is "public issue"? 

Many companies have entered the primary market to earn profit by converting its capital, which is basically a private capital, into a public one, releasing securities to the public. This phenomena is known as "public issue" or "going public."


                                                                                                         Secondary Market

It is a market for used goods. Here one investor can buy a security from other investors instead of the issuer. All the securities are first created in the primary market and then, they enter into the secondary market. In the Bombay Stock Exchange (BSE), all the stocks belong to the secondary market.

The secondary market, also known as the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold..

In other words a newly issued IPO will be considered a primary market trade when the shares are first purchased by investors directly from the underwriting investment bank; after that any shares traded will be on the secondary market, between investors themselves. In the primary market prices are often set beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of the security


The secondary market has an important role to play behind the developments of an efficient capital market. Secondary market connects investors' favoritism for liquidity with the capital users' wish of using their capital for a longer period. For example, in a traditional partnership, a partner can not access the other partner's investment but only his or her investment in that partnership, even on an emergency basis. Then if he or she may breaks the ownership of equity into parts and sell his or her respective proportion to another investor. This kind of trading is facilitated only by the secondary market.

Example of Secondary market:

In the Bombay Stock Exchange (BSE), National Stock Exchange (NSE) in the India, all the securities belong to the secondary market

Major stock exchanges

Africa              Johannesburg Securities Exchange 

Americas        NASDAQ      

Americas        São Paulo Stock Exchange   

Americas        Toronto Stock Exchange      

Americas        New York Stock Exchange   

Asia-Pacific    Australian Securities Exchange       

Asia-Pacific    Bombay Stock Exchange      

Asia-Pacific    Hong Kong  Stock Exchange

Asia-Pacific    Korea Exchange       

Asia-Pacific    National Stock Exchange of India   

Asia-Pacific    Shanghai Stock Exchange    

Europe            London Stock Exchange        

Europe            Madrid Stock Exchange

Europe            Milan Stock Exchange

Players in the Primary Market

 The important players in the new issue (primary) markets are :

Merchant Banks


Collecting and Coordinating banks


Brokers, Agents


Advertising Agencies

Mailing Agencies





                                                                                                         FORWARD MARKET 

A forward rate (or toward exchange rate) is the one which applies to a foreign exchange transaction to be effected on a specific future date. Both the buyer and seller of exchange in the forward market agree that the forward rate will sell a stated amount of the ‘foreign’ currency at an agreed exchange rate to the buyer on a specified future date (say, three month hence) irrespective of the actual exchange rate that may prevail on the said future date. The deal also involves a corresponding payment, in (normally) domestic currency by the buyer of foreign currency to the seller of to.

The spot market is for foreign exchange traded within two business days. However, some transactions may be entered into on one day but not completed until sometime in the future. For example, a French exporter of perfume might sell perfume to a US importer with immediate delivery but not required payment for 30 days. The US importer has an obligation to pay the required francs in 30 days, so he or she may enter into a contract with a trader to deliver dollars for francs in 30 days at a forward rate – the rate today for future delivery.

Thus, the forward rate is the rate quoted by foreign exchange traders for the purchase or sale of foreign exchange in the future. There is a difference between a spot rate and the forward rate known as the ‘spread’ in the forward market. In order to understand how spot and forward rates are determined, we should first know how to calculate the spread between the spot and forward rates.

Consider another example. Suppose the spot Japanese yen of August 6, 1991, sold at $0.006879 while 90 day forward yen was priced at $0.006902. Based on these rates, the swap rate for the 90 day forward yen was quoted as a 23 point premium (0.006902 – 0.006879). Similarly because the 90 day British pound was quoted at $1.6745 while the spot pound was $1.7015, the 90 day British pound sold at a 2.70 point discount.

With reference to its relationship with the spot rate, the forward rate may be at par, at a discount or at a premium.

1)      At par : If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract, forward exchange rate is said to be at par.

2)      At premium : The forward rate for a currency, say, the US dollar, is said to be at premium with respect to the spot rate when one dollar buys more units of another currency, say t   he rupee, in the forward rather in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on per annum basis.

3)      At discount: The forward rate for a currency, say, the US dollar, is said 10 be at a discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market.



1)      Traders: Traders use spot and forward markets to eliminate the risk of loss of value of export or import orders that are dominated in foreign currencies. The purpose is usually to hedge a position. Traders buy and sell currency in the spot and forward market.

2)      Arbitrageurs: This class of participants seek to earn risk free profits by seeking advantage of differences in prices of currencies (spatial arbitrage), in interest rates among countries (interest rate arbitrage). They use forward contract to hedge risk.

3)      Hedgers : Many multinational firms engage themselves in forward contract to protect the home currency values of foreign currency dominated assets and liabilities on their balance sheet that are not to be realized over the life of the contract. These companies also hedge receivables and payables.

4)      Speculators:  This class of participant actively expose themselves to currency risk by buying and selling currencies in the forward market to profit from the exchange rate fluctuation. The speculators keep their position open. The participation of this class does not depend on their business transaction in other currencies; instead these are based on current prices in the forward market and their expectation about the future spot rates.

5)      Banks: The banks participate in the foreign exchange market for various reasons. When the banks keep their position open, they are speculating and become speculators. The banks also appear as hedgers when they hedge their positions. Since the banks provide foreign exchange services therefore these also conduct transactions on behalf of their clients.

6)      Governments: The participation of the governments in the foreign exchange markets for stabilizing the exchange rate is very important activity because these activities infuse confidence in the functioning of forex markets. Governments may regularly monitor markets and intervene for policy targets they set in for the economy.


                                                                                                         Option Market 

A option or currency option confers on its buyer the right either to buy or to sell a specified amount of a currency at a set price known as the strike price. An option that gives the right to buy is known as a ‘call’ while one that gives the right to sell is known as ‘’put’. Depending on the contract terms, an option may be exercisable on any date during the specifies period or it may be exercisable only on the final or expiration date of the period covered by the option contract in return guaranteeing the exercise of an option at its strike price, the option seller or writer charges a premium which the buyer usually pay upfront. Under favorable circumstances, the buyer may choose to exercise it. Alternatively the buyer may be allowed to sell it.

Options Terminology 

Before we proceed to discuss option pricing and applications, we must understand the market terminology associated with options. While our context is that of option on spot foreign currencies, the terms describes below carry over to other types of options as well.

The   two parties to an option contract are the option buyer and the option seller also called option writer. For exchange traded option, as in the case of futures, once an agreement is reached between two traders, the exchange (the clearing house), interposes itself between the two parties, becoming buyer to every seller and sealer to every buyer. The clearing house guarantees performance on the part of every seller.

i)  Call Option: A call option gives the option buyer the right to purchase a currency X; at a stated price Y/X, on or before a stated date. For exchange traded option, one contract represents a standard amount of the currency Y. The writer of a call option must deliver the currency Y if the option buyer chooses to exercise his option.

ii) Put Option: A put option gives the option buyer the right to sell a currency Y against a currency X at a specified price, on or before a specified date. The writer of a put option must take delivery if the option is exercised.

iii) Strike price ( also called  Exercised price ) :  The price specified in the option contract at  which the option buyer can purchase the  currency (call ), or sell the currency  (put ) Y against X . Note carefully that this is not the price of the option; it is the rate of exchange between X and Y that applies to the transaction if the option buyer decides to exercise his option.


                                                                              Foreign Exchange Market (Forex Market)

The foreign exchange market (currency, Forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies.

 According to Kindleberger – 

“The foreign exchange market is a place where foreign moneys are bought and sold”

The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a Indian business to import U.S goods and pay U.S doller even though the business's income is in rupees.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate rule, which remained fixed as per the Bretton Woods system.

Functions of Foreign Exchange Market

 1. Transfer Function: The basic function of any foreign exchange market is to facilitate the conversion of one currency into another, i.e. to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is affected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills.

2. Credit Function: Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade; obviously when foreign bills of exchange are used in international payments a credit for about 3 moths, till their maturity, is required.

3. Hedging Function: A third function of foreign exchange market is to hedge foreign exchange risk. In a free exchange market when exchange rate i.e. the price of one currency in terms of another currency, change there may be a gain or loss to party concerned. Under this condition a person or a firm undertake a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money. Exchange risk as such should be avoided or reduced. For this exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the same time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate. The existence of a forward market thus makes it possible to hedge an exchange position.

Participants in Foreign Exchange Market 

The major participants in the forex market are the large commercial banks; foreign exchange brokers in the interbank market; commercial customers, primarily multinational corporations and central banks, which intervene in the market from time to time smooth exchange rate fluctuations or to maintain target exchange rates. Central bank interference involving buying or selling in the market is often indistinguishable (the same) from the foreign exchange dealing of commercial banks or of other private participants.


No comments:

Post a Comment