Financial System – Meaning

• A financial system is a network of financial institutions, financial markets, financial

instruments and financial services to facilitate the transfer of funds
• The system consists of savers, intermediaries, instruments and the ultimate user of
funds
• The financial system mobilizes the savings and channelizes them into the
productive activity and thus influences the pace of economic development
• The level of economic growth largely depends upon the condition of financial
system prevailing in the economy
• Borrowers are demanders of funds for consumer durables, housing or business
plants and equipment's etc, in anticipation of earning higher incomes in future
• Financial system deals with three inter-related and interdependent variables, i.e.,
money, credit and finance
FUNCTIONS OF FINANCIAL SYSTEM
1. Facilitates OPTIMUM ALLOCATION OF FINANCIAL RESOURCES in an economy
2. Facilitates transfer of ECONOMIC RESOURCES FROM LENDER TO ULTIMATE
BORROWERS
3. It establishes A LINK BETWEEN THE SAVERS AND THE INVESTORS
4. Financial system allows ‘ASSET-LIABILITY TRANSFORMATION’ by lending long and
borrowing short, with the interest rate differential being its transformation revenues
5. TRANSFER OF FUNDS is possible from one party to another ONLY through the
financial system
6. SMOOTHENS ALL FINANCIAL TRANSACTIONS
7. Helps in RISK TRANSFORMATION BY DIVERSIFICATION, as in case of mutual funds.
8. Enhances LIQUIDITY OF FINANCIAL CLAIMS – (easy transferability or convertibility
into cash)
9. Helps in DETERMINATION OF PRICES OF SECURITIES based on market forces in the
capital market
10. Financial system HELPS IN REDUCTION OF COST OF TRANSACTIONS.

Classification of Financial System

1. Financial Markets-
2. Financial Institutions -
 3. Financial Instruments -
4. Financial Services-
Financial Markets consists of:
I. Money Market and Capital Markets
II. Primary and Secondary Markets
• Money Market deals with short term claims of less than a year
• Capital Markets deals with long term claims of more than a year
• Primary markets deals with new issue of securities whereas
Secondary markets deals with sale and purchase of already issued securities
Classification of Financial System
2. Financial Institutions mobilize savings and transfer the savings from surplus units to
deficit units. They deal with deposits, securities, loans etc. Examples are Banks and
other lending institutions
3. Financial instruments are various types of securities which are traded in the financial
market as per the requirements of lenders and borrowers. Examples are Equity
shares, preference shares, debentures, bonds etc.
4. Financial services include the services offered by financial institutions such as leasing
companies, mutual funds, merchant bankers, issue/portfolio managers, bill
discounting houses and acceptance houses.
Examples are credit cards, factoring (outright sale of trade debts by a firm to a third
party at discounted prices), banking, insurance etc

INVESTMENT
• Investment is defined as the employment of funds with the aim of achieving
additional income or growth in value
• It involves a reward for waiting
• Investment is the allocation of monetary resources to assets that are expected to
yield some gain or positive return over a given period of time
• Investments of this form are also called Financial Investments
• For an economist Investment means the net addition to the stock of capital goods
and services
• An Investment function refers to investment -interest rate relationship. There is a
functional and inverse relationship between rate of interest and investment. The
investment function slopes downward.
I = f (r)
• I= Investment (Dependent variable)
• r = Rate of interest (Independent variable)
IMPORTANCE OF INVESTMENT
• Investments are important and useful in the context of present day conditions.
• Some factors that have made investment decisions more important are as follows:
1. Longer Life expectancy – due to this a portion of the earnings have to be put away
as savings to take care of future emergencies
2. Taxation – it’s a must to save for future by making wise investments
3. Interest rates – should be considered before making an investment
4. Inflation – as value of money reduces due to inflation over a period of time, safety of
the invested amount is very important criteria to be looked into to avoid future
losses
5. Larger incomes – have given rise to investments in order to earn more incomes and
to support their regular incomes.

DEMAND PULL INFLATION DIAGRAM

In the adjacent diagram,
• the supply curve rises initially and becomes vertical at full employment level (q1)
• After this point any increase in supply is absolutely impossible
• If the demand increases after this point (q1), the prices also increase (because supply
is constant)
• Since the increase in demand has pulled the prices up – it is called as Demand – Pull
Inflation
Cost – Push Inflation
• In this price rises as a result of increase in the production cost.
• Production cost refers to the money spent by the producer to produce goods.
(R+W+I+P)
• Producer spends money on 4 factors, for Land – Rent, for Labour – Wages, for capital
– Interest and for organizing these three factors and initiating the production
process – Profit
• If the prices of all these factors increase (say for example: if the rent rate increases)
then cost of production also increases. There is a direct relationship between cost of
production and price level
• Such a type of increase in prices due to increase in cost of production is called Cost
Push Inflation
Reasons for increase in cost of production
1. The rent of the land increases.
2. The trade unions of employees demand higher wages.
3. The banks and financial institutions charge higher interest rates.
4. The producer / seller fixes higher profit margins.
5. The government increases tax rate.
6. The government effects an increase in minimum wages and administered prices.
non banking financial intermediaries
• Banks are the traditional institution which handles deposits and extends credit
• Non-banking finance companies don't have a full banking licence, don't provide all
of the services that an individual bank provides and aren't subject to the same
regulations
• Non-Bank Financial Intermediaries (NBFIs) are a group of financial institutions other
than commercial and co-operative banks
• They raise funds from the public, directly or indirectly, to lend them to ultimate
spenders
• The development banks such as the IDBI, IFCI, ICICI, SFCs, land development banks
etc, specialize in extending term loans to their borrowers.
• Three other all-India big term-lending institutions are the LIC, GIC and UTI. Of these,
only the UTI is a pure NBFI, the others raise funds from sale of Insurance.
• Then, there are provident funds and post offices that mobilize public savings in a big
way for onward transmission to ultimate spenders.
• A large number of these institutions are public-sector undertakings
• Besides them, there is a large number of small NBFIs, such as investment
companies, loan/finance companies, hire-purchase finance companies and the
equipment leasing companies which are private sector companies, with only a few
exceptions.
• There are also specialized Finance Corporations for providing finance for only one
specific economic activity like Housing, agriculture, electrification or Industries etc.
• The important examples are Rural Electrification Corporation, Housing and Urban
Development Corporation (HUDCO), Housing Development Finance Corporation
(HDFC) and Film Finance Corporation etc. 
• They compete vigorously with banks for the public’s savings and work as sources of
finance to borrowers
• In India their progress is more recent and that, too, with a lot of initiative from the
government and the RBI
• They fill important gaps in the financial structure of India’s economy and play an
important role in the industrial as well as agricultural development of the country
• There is still vast scope as well as need for growth of the existing NBFIs and
improvement in their organization and working and for promoting new types of
NBFIs, especially those that specialize in the provision of mortgage finance for
residential houses, like the building societies in the UK or the savings and loan
 associations in the USA which, unlike the HUDCO and the HDFC, mobilize directly
the savings of the public for housing finance.
Regulation of NBFC’s
• In terms of Section 45-IA of the RBI Act, 1934, it is mandatory that every NBFC
should be registered with RBI to commence or carry on any business of non-banking
financial institution
• The minimum net owned funds should be Rs 25 lakhs.
• The RBI has powers to cancel registration of NBFCs.
• They have to maintain 15% of their deposits in liquid assets effective from April 1,
1998.
• They have to create reserve fund and transfer not less than 20% of their net deposits
to it every year.
• The RBI will direct them on issues of disclosures, prudential norms(liquidity and
solvency norms for commercial banks contained in the Core Principles for Effective
Banking Supervision) credit , investment, etc.

Financial Instruments
• A financial instrument is a real or virtual document representing a legal agreement
involving any kind of monetary value. 
• Financial instruments are assets that can be traded
• Most types of financial instruments provide efficient flow and transfer of capital
• These assets can be in for form of cash, a contractual right to deliver or receive cash
or another type of financial instrument, or evidence of one's ownership of an entity
• Financial instruments may be divided into three types: Cash instruments, derivative
instruments & Foreign Exchange Instruments
Types of Financial Instruments
1. CASH INSTRUMENTS:
• The values of cash instruments are directly influenced and determined by the
markets and they are easily transferable. They may also be deposits and loans
agreed upon by borrowers and lenders.
2. DERIVATIVE INSTRUMENTS
• The value of Derivative is based on the value of an underlying asset or interest
rates
• For example, an equity options contract, is a derivative because it derives its value
from the underlying stock
• As the price of the stock rises and falls, so does the value of the Option although
not necessarily by the same percentage.
• Derivative can be traded Over-the-counter (OTC) market whereby securities that
are not listed on formal exchanges are priced and traded.
3. FOREIGN EXCHANGE INSTRUMENTS :- are financial instruments that are
represented on the foreign market and primarily consist of currency agreements and
derivatives, they can be broken down into three categories: -
a) SPOT: A currency agreement is in which the actual exchange of currency happens
NOT later than the Second working day from the original date of the agreement. It
is termed as “SPOT” because the currency exchange is done “on the spot”
b) OUTRIGHT FORWARDS: A currency agreement in which the actual exchange of
currency is done in “future”. It is beneficial in cases of fluctuating exchange rates.
c) CURRENCY SWAPS: refers to the act of simultaneously buying and selling currencies
with different specified value dates.
Characteristics of Financial Instruments
1. LIQUIDITY - Liquidity refers to the efficiency or ease with which
an asset or security can be converted into ready cash without affecting its market
price. The most liquid asset of all is cash itself.
2. MATURITY – Maturity refers to a finite time period at the end of which the financial
instrument will cease to exist and the principal is repaid with interest.
3. SAFETY - These financial instruments are one of the most secure investment since
issuers of money market instruments have a high credit rating and the returns are
fixed beforehand, the risk of losing your invested capital is less.
4. YIELD – is a return measure for an investment over a set period of time, expressed as
a percentage.
• Higher yields are perceived to be an indicator of lower risk and higher income, but a
high yield may not always be a positive, such as the case of a rising dividend yield
due to a falling stock price

Methods of Floatation of New Issues in Primary Market

1. OFFER THROUGH PROSPECTUS: 
  A prospectus makes a direct appeal to investors to raise capital through an
advertisement in newspapers and magazines.
2. OFFER FOR SALE: 
 The company sells securities to issue houses / ---- ------ intermediaries / broker/s a
t an agreed price and they resell them to investors at a higher
3. Private Placements: 
It refers to the process in which securities are allotted to institutional
investor(companies) and some selected individuals
4. RIGHTS ISSUE: It refers to the issue in which new shares are offered to the existing
shareholders in proportion to the number of shares they already hold.
5. e-IPOs: Initial Public Offering means issue of securities through an on-line system of stock
exchange. A company proposing to issue capital to the public through this has to enter into
an agreement with the stock exchange.
• SEBI’s registered brokers have to be appointed for the purpose of accepting
applications and placing orders with the company

Classification of capital market

The capital market can be divided into two parts:
I. Primary Market and II. Secondary Market
1. PRIMARY MARKET –
• Issues new securities
• Transfers investible funds from savers to entrepreneurs
• Funds used for setting up new projects, expansions, diversification, modernization
of existing projects, mergers and take overs etc
Secondary Market
• Refers to a market where existing securities are bought and sold.
• The company is not involved in the transaction at all.
• It is between two investors. 
• Features of Secondary market are: 
1) Creates liquidity
2) Fixed location
3) Comes after primary market
4) Encourages new investment on already issued securities
Difference between Primary Market and Secondary Market

Derivatives
• There are four different types of Derivatives in India they are
1. Future Contracts
2. Options Contracts
3. Forward Contracts
4. Swap Contracts
futures contract
• is an agreement that involves buying or selling an underlying instrument at a future
date at a specified price
• The clearing house will serve as the counter party for both parties of the contract
which will further minimize credit risk
• The contract is fixed and also regulated by the Stock exchange.
• Futures contract are listed on the stock exchange and are standardized in nature,
which is why they cannot be modified in any way
• In a futures derivative securities contract, an initial margin(the initial amount of
money a trader must place in an account to open a futures position) is often
required as collateral while a settlement is carried out on a daily basis
Options Contracts
 • This type of derivative is quite different from both the future and forward contracts,
as there it is not mandatory to dispense with the contract on a certain predecided
date.
• Options contracts give the trader the right without the obligation to either sell or buy
an underlying asset
• There are two different types of options:
1. PUT OPTION
2. CALL OPTION
3. In Put option, the buyer has the opportunity, but not the obligation to sell some
underlying asset at a predetermined rate when she or he chooses to enter into the
contract
4. In Call option, the buyer receives the right to purchase an asset at a price that is
predetermined when they are entering the contract
5. In both these contracts, the buyer receives the option to settle their contract either
on or before the expiry period.
6. Options are traded at the stock exchange and over the counter market
Swap Contracts
• A swap contract is a private agreement between two trading parties
• Both parties in the contract choose to exchange their cash flow at some point in the
future as per a predetermined formula
• The currency derivatives underlying a swap contract is either an interest rate or
currency itself - both of which are volatile in nature.
• Hence, swap contracts tend to protect parties from various risks
• Such types of Derivative securities are not traded on public exchanges, instead,
investment bankers serve as the middlemen for these transactions.
Forward Contracts
• A forward contract is where Two trading parties enter into an agreement where
they either sell or buy an underlying asset at an agreed price at some future date.
• Forward contracts are customized to possess a decent amount of counterparty risk,
which depends upon the term and size of the contract.
• Unlike Futures Contracts, THERE IS NO COLLATERAL NECESSARY FOR A
FORWARD DERIVATIVE SECURITIES CONTRACT, as they are self-regulated.
• Forward contracts Derivatives in India are settled on their maturity date, and they
must, hence, be redeemed before the expiry period.
INFLATION
• Inflation – as defined by Crowther “as a state in which the general price level is rising
and as a result there is a decline in the purchasing power (value) of money”.
• It is a situation of “too much money chasing too few goods” – Prof. Coulborn.
There are various categories of inflation. On the basis of rate it is classified as:
• (i) Moderate inflation - A single digit rate of annual inflation
• (ii) Galloping inflation - A double digit rate of annual inflation
• (iii) Hyper inflation – More than three digits rate of increase in prices
Types of inflation
On the basis of Aggregate Demand and Aggregate Supply there are two types of inflation.
namely:
1. Demand – Pull Inflation
2. Cost – Push Inflation
Demand – Pull Inflation
• When Demand is more than the supply (DD> SS) – it leads to rise in the price level.
• When aggregate demand exceeds Aggregate Supply, the price level increases. This
further leads to decrease in the purchasing power of money.
• This process can be explained through a diagram:
Measures to control inflation
1. There are various measures to control the inflation. However there are two
measures which are very important. They are:
2. Monetary measures (Exercised by the Central Bank)
3. Fiscal measures (Exercised by the Government)
I. MONETARY MEASURES & II. FISCAL MEASURES
A. QUANTITATIVE WEAPONS: B. QUALITATIVE WEAPONS:
1. Bank rate policy(4.25%) 1. Margin requirements
2. Open Market Operations 2. Regulation of consumer credit
3. Cash reserve ratio (3%) 3. Differential rates of interest
4. Statutory Liquidity ratio(18%) 4. Publications
 5. Moral Suasion
6. Direct action
Cost – Push Inflation
• In this price rises as a result of increase in the production cost.
• Production cost refers to the money spent by the producer to produce goods.
(R+W+I+P)
• Producer spends money on 4 factors, for Land – Rent, for Labour – Wages, for capital
– Interest and for organizing these three factors and initiating the production
process – Profit
• If the prices of all these factors increase (say for example: if the rent rate increases)
then cost of production also increases. There is a direct relationship between cost of
production and price level
• Such a type of increase in prices due to increase in cost of production is called Cost
Push Inflation

INTEREST RATES

Financial Markets and Instruments

 • A Financial Market is referred to a place where selling and buying of financial assets
and securities take place that includes stocks and bonds, raw materials and precious
metals which are known in the financial markets as commodities
• These are markets where businesses enter to grow their cash, companies decrease
their risks by investing in diverse types of assets and individual investors make
more cash
• It serves as an agent of the investors as it mobilizes capital from them
• The stock market allows investors to purchase and trade publicly shares of
companies
• The issue of new stocks happens in the Primary stock market and
already issued stocks & securities are traded in the Secondary market
Types of Financial Markets
1. Over the Counter (OTC) Market – deals with instruments of small companies that
can be traded in cheap with less regulations
2. Bond Market – A financial market is a place where investors loan money on bonds as
security at a predefined rate of interest. Bonds are issued by corporations, states,
municipalities and federal governments across the world.
3. Money Markets – They trade in securities that matures in less than a year
4. Derivatives Market – They trade with securities that determine its value from its
primary asset. It includes:
1. FUTURES (which obligate the parties to transact an asset at a
predetermined future date and price),
2. OPTIONS - (are derivatives based on the value of underlying securities such
as stocks), CONTRACTS-FOR-DIFFERENCE (where the differences in the
settlement between the open and closing trade prices are cash-settled),
3. FORWARD CONTRACTS (future dated contracts) and
4. SWAPS (is a derivative contract in which one party exchanges or swaps the
values or cash flows of one asset for another.
5. FOREX MARKET
– It is a financial market where investors trade in currencies. In the entire world, this
is the most liquid financial market.

Money market
 • The money market refers to trading in very short-term debt instruments
• At the wholesale level, it involves large-volume traded between institutions and
traders.
• At the retail level, it includes money market mutual funds bought by individual
investors and money market accounts opened by bank customers
• The money market involves the purchase and sale of large volumes of very short-
term debt products, such as overnight reserves or commercial paper.
• Money market investments are characterized by safety, liquidity and relatively low
rates of return.
Features of Money market
1. It’s maturity period is up to one year.
2. It trades with assets that can be transformed into cash easily.
3. All the transactions take place through phone, email, text messages etc.
4. Broker is not required for the transactions in this kind of market
5. Money market consists of Commercial Banks, Non-banking financial companies and
Central Bank etc.

Differences between Money Market and Capital Market