INDIAN FINANCIAL SYSTEM

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 MODULE I

INDIAN FINANCIAL SYSTEM

Introduction

The term "finance" in our simple understanding, is perceived as equivalent to 'Money'. But
finance exactly is not money; it is the source of providing fund for a particular activity. Finance is
a facility that built the Gap between deficit sectors to surplus sector by shifting funds.

Finance as a function is defined by the dictionary as under- 1:"To provide

or raise the fund or capital”

2: "To supply fund ". 3:

"To furnish credit ".

Financial System

Every country aiming at its progress depends on the efficiency of this economic system which
depends upon financial system. The economic development of a nation is reflected by the progress of
the various economic units. These units are broadly classified into corporate sector, government and
household sector. While performing their activities these units will be placed in a
surplus/deficit/balanced budgetary situations.

There are organisations or people with surplus funds and there are those with a deficit. A
financial system or financial sector functions as an intermediary and facilitates the flow of funds
from the areas of surplus to the areas of deficit. A Financial System is a composition of various
institutions, markets, regulations and laws, practices, money manager, analysts, transactions and
claims and liabilities. The financial system is the network of institutions and individuals who deal
in financial claims to various instruments. Financial System of any country consists of financial
markets, financial intermediation and financial instruments or financial products.

Definition of Financial System

“It is a set of institutions instruments and markets which fosters saving and channels them to
their most efficient use”.-(H.R. Machiraju)

In the worlds of Van Horne, “financial system allocates savings efficiently in an economy to
ultimate users either for investment in real assets or for consumption”.

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According to Prasanna Chandra, “financial system consists of a variety of institutions, markets and
instruments related in a systematic manner and provides the principal means by which savings are
transformed into investments”.

Structure of Indian Financial System

1) Financial Market: -

It is a system through which funds are transferred from surplus sector to the deficit sector.
On the basis of the duration of financial Assets and nature of product money market can be
classified into 3 types:

a) Money Market: -

It is the institutional arrangement of borrowing and lending into 2 sectors i.e.

organised sector headed by RBI and unorganized sector no way related with RBI.
Further depending upon the type of instrument used money is divided into various sub market

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b) Capital Market: -

It deals with long term lending’s and borrowings. It is a market for long term instruments
such as shares, debentures and bonds. It also deals with term loans. This market is also dividend
into 2 types:-

A) Primary or New Issue Market

B) Secondary Market of Stock exchange.

c) Foreign Exchange market: -It deals with foreign exchange. It is a market where the
exchanging of currencies will takes places. It is the market where
currencies of different country are purchased and sold. Depending on the exchange rate that is
applicable, the transfer of funds takes place in this market. This is one of the most developed and
integrated market across the globe.

d) Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium
and long-term loans to corporate and individuals.

ii) Financial Institution: -

It is classified into categories:-

a. Banking Institution:-

It includes commercial banks, private bank and foreign banks are operating in India. There are 27
Commercial Banks of Public Sector further, we have Development Banks (ICICI, IDBI),
Agriculture Bank (RRB, Cooperative Banks, NABARD).

b. Non-Banking Institution: -

These are established to mobilise saving idifferent modes. These institutions do not offer
banking services such as accepting deposit and Lending Loans. For example LIC, UTI, GIC.

Financial institutions are financial intermediaries. They intermediate between savers and
investors. They lend money. They also mobilise savings. The various financial intermediaries,
their performing areas and respective roles are given in following table:

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 Intermediary Market Role

Stock Exchange Capital Market Provide Secondary Market to

securities
Investment Bankers Capital Market, Corporate advisory services, Issue of
Credit Market securities
Underwriters Capital Market, Subscribe to unsubscribed portion of
Money Market securities
Registrars, Depositories, Capital Market Issue securities to the investors on behalf
Custodians of the company and handle share transfer
activity

Primary Dealers Money Market Market making in government

Satellite Dealers securities
Forex Dealers Forex Market Ensure exchange in currencies

iii) Financial Instruments: -

It includes through these instruments financial Institution mobilise saving. These are of 2 type’s i.e.

a) Long Term : -

Shares, Debenture, Mutual Funds, Term Loans.

b) Short Term: -

Call Loan (money market), Promissory Notes, Bills of exchange etc.

iv) Financial Services: -

a) Banking service provided by Commercial banks and Development banks. Accepting Deposits
and lending loans.

b) Non-Banking Services: -

These services are provided by Non-Banking Companies such as LIC and GIC. They
accept saving in different modes and mobiles to various channels of investments.
c) Other Services: -
In modern days banks are providing various new services such as ATM, Credit Cards,
Debit Cards, Electronic Transfer of Funds(ETF),Internet Banking, E- Banking, off shore Banking.

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Functions/important and role of financial system
1. It links the savers and investors. It helps in mobilizing and allocating the savings efficiently and
effectively. It plays a crucial role in economic development through saving-investment process.
This savings – investment process is called capital formation.
2It helps to monitor corporate performance.
3. It provides a mechanism for managing uncertainty and controlling risk.
4. It provides a mechanism for the transfer of resources across geographical boundaries
5. It offers portfolio adjustment facilities (provided by financial markets and financial
intermediaries).
6. It helps in lowering the transaction costs and increase returns. This will motivate people to
save more.
7. It promotes the process of capital formation.
8. It helps in promoting the process of financial deepening and broadening. Financial deepening
means increasing financial assets as a percentage of GDP and financial broadening means building
an increasing number and variety of participants and instruments.
In short, a financial system contributes to the acceleration of economic development. It
contributes to growth through technical progress.
Growth and Development of Indian Financial System
At the time of independence in 1947, there was no strong financial institutional mechanism in
the country. The industrial sector had no access to the savings of the community. The capital market
was primitive and shy. The private and unorganised sector played an important role in the provision of
liquidity. On the whole, there were chaos and confusions in the financial system.

After independence, the government adopted mixed economic system. A scheme of planned
economic development was evolved in 1951 with a view to achieve the broad economic and social
objective. The government started creating new financial institutions to supply finance both for
agricultural and industrial development. It also progressively started nationalizing some important
financial institutions so that the flow of finance might be in the right direction. The following
developments took place in the Indian financial system:

1. Nationalisation of financial institutions:

2. Establishment of Development Banks:

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4. Establishment of institution for housing finance:

5. Establishment of Stock Holding Corporation of India (SHCIL):

6. Establishment of mutual funds and venture capital institutions:

7. New Economic Policy of 1991

Weaknesses of Indian Financial System

Even though Indian financial system is more developed today, it suffers from certain
weaknesses. These may be briefly stated below:

1. Lack of co-ordination among financial institutions: There are a large number of financial
intermediaries. Most of the financial institutions are owned by the government. At the same time,
the government is also the controlling authority of these institutions. As there is multiplicity of
institutions in the Indian financial system, there is lack of co-ordination in the working of these
institutions.

2. Dominance of development banks in industrial finance: The industrial financing in India

today is largely through the financial institutions set up by the government. They get most of their
funds from their sponsors. They act as distributive agencies only. Hence, they fail to mobilise the
savings of the public. This stands in the way of growth of an efficient financial system in the
country.

3. Inactive and erratic capital market: In India, the corporate customers are able to raise
finance through development banks. So, they need not go to capital market. Moreover, they do not
resort to capital market because it is erratic and enactive. Investors too prefer investments in
physical assets to investments in financial assets.

4. Unhealthy financial practices: The dominance of development banks has developed unhealthy
financial practices among corporate customers. The development banks provide most of the funds in
the form of term loans. So there is a predominance of debt in the financial structure of corporate
enterprises. This predominance of debt capital has made the capital structure of the borrowing
enterprises uneven and lopsided. When these enterprises face financial crisis, the financial institutions
permit a greater use of debt than is warranted. This will make matters worse.

5. Monopolistic market structures: In India some financial institutions are so large that they
have created a monopolistic market structures in the financial system. For instance, the entire life
insurance business is in the hands of LIC. The weakness of this large structure is that it could
lead to inefficiency in their working or mismanagement. Ultimately, it would retard the
development of the financial system of the country itself.

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6. Other factors: Apart from the above, there are some other factors which put obstacles to the
growth of Indian financial system. Examples are:

a. Banks and Financial Institutions have high level of NPA.

b. Government burdened with high level of domestic debt.

c. Cooperative banks are labelled with scams.

d. Investors confidence reduced in the public sector undertaking etc.,

e. Financial illiteracy.

In the recent past, the most notable aspect of Indian economy is its financial system. Perhaps no
system in the world has changed so much as that of our financial system. Indian financial system
undergoing fast development and hence not matured like that of developed countries. The
government should take reasonable reforms to mould our financial system as healthy one.

MONEY MARKET

Meaning

Money market is a segment of financial market. It is a market for short term funds. It deals
with all transactions in short term securities. These transactions have a maturity period of one
year or less. Examples are bills of exchange, treasury bills etc. These short term instruments can be
converted into money at low transaction cost and without much loss. Thus, money market is a
market for short term financial securities that are equal to money.

According to Crowther, “Money market is a collective name given to various firms and
institutions that deal in the various grades of near money”.

Money market is not a place. It is an activity. It includes all organizations and institutions
that deal in short term financial instruments. However, sometimes geographical names are given to
the money market according to the location, e.g. Mumbai Money Market.

Characteristics of Money Market

The following are the characteristics of money market:

1) It is basically an over the phone market.

2) It is a wholesale market for short term debt instruments.
3) It is not a single market but a collection of markets for several instruments.

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 4) It facilitates effective implementation of monetary policy of a central bank of a country.
5) It is a market for short term financial a assets that are close substitutes of money.
6) Transactions are made without the help of brokers.
7) It establishes the link between the RBI and banks.
8) The players in the money market are RBI, commercial banks, and companies.

Functions of Money Market

Money market performs the following functions:

1. Facilitating adjustment of liquidity position of commercial banks, business undertakings

and other non-banking financial institutions.
2. Enabling the central bank to influence and regulate liquidity in the economy through its
intervention in the market.
3. Providing a reasonable access to users of short term funds to meet their requirements
quickly at reasonable costs.
4. Providing short term funds to govt. institutions.
5. Enabling businessmen to invest their temporary surplus funds for short period.
6. Facilitating flow of funds to the most important uses.

Characteristics of a Developed Money Market

In every country some types of money market exists. Some of them are highly developed
while others are not well developed. A well developed and efficient money market is necessary for
the development of any economy. The following are the characteristics or prerequisites of a
developed and efficient money market:

1. Highly developed commercial banking system

2. Presence of an efficient central bank

3. Existence of sub markets

4. Availability of ample credit instruments

5. Existence of secondary market

6. Availability of ample resources

7. Demand and supply of funds

8. Other factors:

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E.g.; a. industrial development, b. volume of international trade, c. political stability,

d. trade cycles, e. foreign investment, f. price stabilisation etc.

Money Market Instruments

The money market can be defined as a market for short-term money and financial assets that
are near substitutes for money. The term short-term means generally a period upto one year and
near substitutes to money is used to denote any financial asset which can be quickly converted into
money with minimum transaction cost.

Important money market instruments are:

1. Call/Notice Money
2. Treasury Bills
3. Term Money
4. Certificate of Deposit
5. Commercial Papers
6. REPO
7. MMMF
8. ADR/GDR

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent on demand for a very short period. When
money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays
and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on
the next working day, (irrespective of the number of intervening holidays) is "Call Money".

When money is borrowed or lent for more than a day and up to 14 days, it is "Notice
Money". No collateral security is required to cover these transactions.

2. Inter-Bank Term Money

Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money
market. The entry restrictions are the same as those for Call/Notice Money except that, as per
existing regulations, the specified entities are not allowed to lend beyond 14 days.

3. Treasury Bills.

Treasury Bills are short term (up to one year) borrowing instruments of the union
government. It is an IOU of the Government. It is a promise by the Government

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to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less
than one year). They are issued at a discount to the face value, and on maturity the face value is
paid to the holder. The rate of discount and the corresponding issue price are determined at each
auction.
Types of T-Bills
1. Ordinary or Regular T-Bills : These are issued to the public, banks and other
institutions to raise money for meeting the short term financial needs of the Govt. These are freely
marketable. These can be bought and sold at any time.
2. Ad hoc T-Bills: These are issued in favour of the RBI only. They are not sold through
tender or auction. They are purchased by the RBI on tap. The RBI is authorised to issue currency
notes against these.
On the basis of periodicity T-bills may be classified into four. They are as follows :
1. 91-Day T-Bills : The maturity of this T-bills is 91 days. They were discontinued from
April 1, 1997.
2. 14-Day T-Bills : This was introduced from April 1, 1997. The maturity period is 14 days.
3. 182-Day T-Bills : These were introduced in November 1986 to provide short term investment
opportunities to financial institutions and others. The maturity period of this T-bill is 182
days.
4. 364-Day T-Bills : In April 1992, the 364-day-T-bills were introduced to replace 182 day T-
bills. The maturity period is 364 days.
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiable money market instrument and issued in
dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other
eligible financial institution for a specified time period. Guidelines for issue of CDs are presently
governed by various directives issued by the Reserve Bank of India, as amended from time to
time.
CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks
(RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have
been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks
have the freedom to issue CDs depending on their requirements. An FI may issue CDs within
the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz.,
term money, term deposits, commercial papers and intercorporate deposits should not exceed 100
per cent of its net owned funds, as per the latest audited balance sheet.

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Features of CDs

1. These are unsecured promissory notes issued by banks or financial institutions.

2. These are short term deposits of specific maturity similar to fixed deposits.

3. These are negotiable (freely transferable by endorsement and delivery)

4. These are generally risk free.

5. The rate of interest is higher than that on T-bill or time deposits

6. These are issued at discount

7. These are repayable on fixed date.

8. These require stamp duty.

5. Commercial Paper

CP is an unsecured promissory note privately placed with investors at a discount rate to face
value determined by market forces. CP is freely negotiable by endorsement and delivery. A
company shall be eligible to issue CP provided –

(a) The tangible net worth of the company, as per the latest audited balance sheet, is not less than
Rs. 4 crore;

(b) The working capital (fund-based) limit of the company from the banking system is not less
than Rs.4 crore and

(c) The borrower account of the company is classified as a Standard Asset by the financing
bank/s.

(d) The minimum maturity period of CP is 7 days. The minimum credit rating shall be P-2 of
CRISIL or such equivalent rating by other agencies.

(e) CPs can be issued in multiples of Rs. 5 lakhs subject to the minimum issue size of Rs. 50
lakhs

6. Repurchase Agreements (REPO)

REPO is basically a contract entered into by two parties (parties include RBI, a bank or NBFC.
In this contract, a holder of Govt. securities sells the securities to a lender and agrees to repurchase
them at an agreed future date at an agreed price. At the end of the period the borrower
repurchases the securities at the predetermined price. The difference between the purchase price
and the original price is the cost for the borrower. This cost of borrowing is called repo rate.

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 A transaction is called a Repo when viewed from the perspective of the seller of the securities
and reverse when described from the point of view of the suppliers of funds. Thus whether a given
agreement is termed Repo or Reverse Repo depends largely on which party initiated the transaction.

Thus Repo is a transaction in which a participant (borrower) acquires immediate funds by

selling securities and simultaneously agrees to repurchase the same or similar securities after a
specified period at a specified price. It is also called ready forward contract.

7. Money Market Mutual Funds (MMMFs)

Money Market Mutual Funds mobilise money from the general public. The money
collected will be invested in money market instruments. The investors get a higher return. They
are more liquid as compared to other investment alternatives.

The MMMFs were originated in the US in 1972. In India the first MMMF was set up by
Kothari Pioneer in 1997. But this did not succeed.

8. American depository receipt and Global depository receipt

ADRs are instruments in the nature of depository receipt and certificate. These
instruments are negotiable and represent publicly traded, local currency equity shares issued by
non - American company. For example, an NRI can invest in Indian Company’s shares without
bothering dollar conversion and other exchange formalities.

If the facilities extended globally, these instruments are called GDR. ADR are listed in American
Stock exchanges and GDR are listed in other than American Stock exchanges, say Landon,
Luxembourg, Tokyo etc.,

Components / Constituents / Composition of Money Market (Structure of Money Market)

Money market consists of a number of sub markets. All submarkets collectively constitute
the money market. Each sub market deals in a particular financial instrument. The main
components or constituents or sub markets of a money markets are as follows :
1. Call money market
2. Commercial bill market
3. Treasury bill markets
4. Certificates of deposits market

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5. Commercial paper market
6. Acceptance market
7. Collateral loan market

(Details of the above components already explained under the sub title ‘money market instruments’
except the following)

Commercial Bills and its market

When goods are sold on credit, the seller draws a bill of exchange on the buyer for the
amount due. The buyer accepts it immediately. This means he agrees to pay the amount mentioned
therein after a certain specified date. After accepting the bill, the buyer returns it to the seller. This
bill is called trade bill. The seller may either retain the bill till maturity or due date or get it
discounted from some banker and get immediate cash. When trade bills are accepted by
commercial banks, they are called commercial bills. The bank discounts this bill by deducting a
certain amount (discount) and balance is paid.

A bill of exchange contains a written order from the creditor (seller) to the debtor (buyer) to pay a
certain sum, to a certain person after a certain period.

According to Negotiable instruments Act, 1881, a bill of exchange is ‘an instrument in writing
containing an unconditional order, signed by the maker, directing a certain person to pay a certain
sum of money only to, or to the order of a certain person or to the bearer of the instrument’.

Features of Commercial Bills

1. These are negotiable instruments.

2. These are generally issued for 30 days to 120 days. Thus these are short term credit
instruments.
3. These are self liquidating instruments with low risk.
4. These can be discounted with a bank. When a bill is discounted with a bank, the holder
gets immediate cash. This means bank provides credit to the customers. The credit is
repayable on maturity of the bill. In case of need for funds, the bank can rediscount the bill
in the money market and get ready money.
5. These are used for settling payments in the domestic as well as foreign trade.
6. The creditor who draws the bill is called drawer and the debtor who accepts the bill is called
drawee.

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Types of Bills

Many types of bills are in circulation in a bill market. They may be broadly classified as follows:-

1. Demand Bills and Time Bills: - Demand bill is payable on demand. It is payable immediately
on presentation or at sight to the drawing. Demand bill is also known as sight bill. Time bill is
payable at a specified future date. Time bill is also known as usance bill.

2. Clean Bills and Documentary Bills: - When bills have to be accompanied by documents of title to
goods such as railway receipts, bill of lading etc. the bills are called documentary bills. These may
be further classified into documents against payment (D/P) and documents against acceptance
(D/A). In case of D/A bills, the documents accompanying bills have to be delivered to the
drawee immediately after his acceptance of the bill. Thus a D/A bill becomes a clean bill
immediately after acceptance. On the other hand, the documents have to be handed over to the
drawee only against payment in the case of D/P bills. When bills are drawn without
accompanying any document, they are called clean bills. In such a case, documents will be directly
sent to the drawee.

3. Inland and Foreign Bills: Inland bills are bills drawn upon a person resident in India and are
payable in India. Foreign bills are bills drawn outside India and they may be payable either in
India or outside India.

4. Accommodation Bills and Supply Bills: In case of accommodation bills, two parties draw bills
on each other purely for the purpose of mutual financial accommodation. These bills are then
discounted with the bankers and the proceeds are shared among themselves. On the due dates, the
parties make payment to the bank. Accommodation bills are also known as ‘wind bills’ or ‘kite
bills’. Supply bills are those drawn by suppliers or contactors on the Govt. departments for the
goods supplied to them. These bills are not considered as negotiable instruments.

Acceptance Market

Acceptance Market is another component of money market. It is a market for banker’s

acceptance. The acceptance arises on account of both home and foreign trade. Bankers acceptance
is a draft drawn by a business firm upon a bank and accepted by that bank. It is required to pay to
the order of a particular party or to the bearer, a certain specific amount at a specific date in future.
It is commonly used to settle payments in international trade. Thus acceptance market is a market
where the bankers’ acceptances are easily sold and discounted.

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Collateral Loan Market

Collateral loan market is another important sector of the money market. The collateral loan
market is a market which deals with collateral loans. Collateral means anything pledged as security
for repayment of a loan. Thus collateral loans are loans backed by collateral securities such as
stock, bonds etc. The collateral loans are given for a few months. The collateral security is
returned to the borrower when the loan is repaid. When the borrower is not able to repay the loan,
the collateral becomes the property of the lender. The borrowers are generally the dealers in stocks
and shares.

Features or Defects of the Indian Money Market

The features or defects of the Indian money market are as follows:

1. Existence of unorganised segment: The unorganised segment comprises of indigenous

bankers, moneylenders etc. This unorganised sector does not follow the rules and regulations
of the RBI. Besides, a higher rate of interest prevails in the unorganised market.

2. Lack of integration: Another important drawback of the Indian money market is that the
money market is divided into different sections. Unfortunately these sections are loosely
connected to each other.

3. Disparities in interest rates: Too many interest rates are prevailing in the market. For
example, borrowing rates of Govt. lending rate of commercial banks, the rates of co-
operative banks and rates of financial institutions. This disparity in interest rates is due to
lack of mobility of funds from one segment to another.
4. Seasonal diversity of money market: The demand for money in Indian money market is
of seasonal in nature.
5. Absence of bill market: The bill market in India is not well developed. There is a great
paucity of sound commercial bills of exchange in our country.
6. Limited instruments: The supply of short term instruments like commercial bills, treasury
bills etc. are very limited and inadequate.
7. Restricted secondary market: Secondary market for money market instruments is mainly
restricted to rediscounting of commercial bills and treasury bills.
8. No contact with foreign money markets: Indian money market has little contract with
money markets in other countries.

In totality it can be concluded that Indian money market is relatively underdeveloped.

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Players or Participants in the Indian Money Market

The following are the players in the Indian money market:

1. Govt.

2. RBI

3. Commercial banks

4. Financial institutions like IFCI, IDBI, ICICI, SIDBI, UTI, LIC etc.

5. Discount and Finance House of India.

6. Brokers

7. Mutual funds

8. Public sector undertakings

9. Corporate units

Recent Developments in the Indians Money Market

In recent years, the Indian money market is undergoing structural changes. Several measures
have been taken to transform the restricted and narrow market to an active and broad market. The
recent developments in the Indian money market are as follows:

1. Integration of unorganised sector with the organised sector

2. Widening of call money market
3. Introduction of innovative instruments
4. Introduction of negotiable dealing system
5. Offering of market rates of interest
6. Satellite system dealership
7. Promotion of bill culture
8. Introduction of money market mutual funds
9. Setting up of credit rating agencies
10. Adoption of suitable monetary policy
11. Establishment of Discount and Finance House of India (DFHI)
12. Setting up of Securities Trading Corporation of India Ltd. (STCI)

Money market is a need based market where the demand for and supply of money are major
factors determining the terms and conditions of operations. Money market

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provides a platform for the players in financial market to meet the short term fund requirements. It
also helps the participants to keep an optimum balance between liquidity and profitability.

Capital Market

Meaning

Capital market simply refers to a market for long term funds. It is a market for buying and selling
of equity, debt and other securities. Generally, it deals with long term securities that have a
maturity period of above one year.

Capital market is a vehicle through which long term finance is channelized for the various
needs of industry, commerce, govt. and local authorities. According to
W.H. Husband and J.C. Dockerbay, “the capital market is used to designate activities in long
term credit, which is characterised mainly by securities of investment type”.

Capital market may be defined as an organized mechanism for the effective and smooth
transfer of money capital or financial resources from the investors to the entrepreneurs.

Functions of a Capital Market

The functions of an efficient capital market are as follows:

1. Mobilise long term savings for financing long term investments.

2. Provide risk capital in the form of equity or quasi-equity to entrepreneurs.

3. Provide liquidity with a mechanism enabling the investor to sell financial assets.

4. Improve the efficiency of capital allocation through a competitive pricing mechanism.

5. Disseminate information efficiently for enabling participants to develop an informed

opinion about investment, disinvestment, reinvestment etc.
6. Enable quick valuation of instruments – both equity and debt.

7. Provide insurance against market risk through derivative trading and default risk
through investment protection fund.
8. Provide operational efficiency through: (a) simplified transaction procedures,
(b) lowering settlement times, and (c) lowering transaction costs.
9. Develop integration among: (a) debt and financial sectors, (b) equity and debt
instruments, (c) long term and short term funds.

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 10. Direct the flow of funds into efficient channels through investment and
disinvestment and reinvestment.

Components of Capital Market

There are four main components of capital market. They are:

1. Primary market
2. Secondary Market (Details are given in last module)
3. Government Securities Market (Gilt Edged Security Market)
4. Financial Institutions

These components of capital market may be discussed in detail in the following

pages:

Primary Market /New Issue Market (NIM)

When a company wishes to raise long term capital, it goes to the primary market. Primary
market is an important constituent of a capital market. In the primary market the security is
purchased directly from the issuer.

The primary market is a market for new issues. It is also called new issue market. It is a
market for fresh capital. It deals with the new securities which were not previously available to
the investing public. Corporate enterprises and Govt. raises long term funds from the primary
market by issuing financial securities.

Both the new companies and the existing companies can issue new securities on the
primary market. It also covers rising of fresh capital by government or its agencies.The primary
market comprises of all institutions dealing in fresh securities. These securities may be in the form
of equity shares, preference shares, debentures, right issues, deposits etc.

In short, primary market is a market where the securities are offered to the investing public
for the first time.

Functions of Primary Market

The main function of a new issue market is to facilitate transfer of resources from the
savers to the users. The savers are individuals, commercial banks, insurance companies etc. The
users are public companies and the government.

The main function of a primary market can be divided into three service functions. They
are: origination, underwriting and distribution.

1. Origination: Origination refers to the work of investigation, analysis and

processing of new project proposals. Origination begins before an issue is

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 actually floated in the market. The function of origination is done by merchant bankers
who may be commercial banks, all India financial institutions or private firms.
2. Underwriting: When a company issues shares to the public it is not sure that the whole
shares will be subscribed by the public. Therefore, in order to ensure the full subscription
of shares (or at least 90%) the company may underwrite its shares or debentures. The act of
ensuring the sale of shares or debentures of a company even before offering to the public is
called underwriting. It is a contract between a company and an underwriter (individual or
firm of individuals) by which he agrees to undertake that part of shares or debentures
which has not been subscribed by the public. The firms or persons who are engaged in
underwriting are called underwriters.
3. Distribution: This is the function of sale of securities to ultimate investors. This service is
performed by brokers and agents. They maintain a direct and regular contact with the
ultimate investors.

Methods of Raising Fund in the Primary Market (Methods of Floating New Issues)

A company can raise capital from the primary market through various methods. The
methods include public issues, offer for sale, private placement, right issue, and tender method.

1. Public Issues

This is the most popular method of raising long term capital. It means raising funds directly
from the public. Under this method, the company invites subscription from the public through the
issue of prospectus (and issuing advertisements in news papers). On the basis of offer in the
prospectus, the investors apply for the number of securities they are willing to take. In response to
application for securities, the company makes the allotment of shares, debentures etc.

Types of Public Issues: Public issue is of two types, namely, initial public offer and follow-on
public offer.

Initial Public Offering (IPO): This is an offering of either a fresh issue of securities or an offer
for sale of existing securities or both by an unlisted company for the first time in its life to the
public. In short, it is a method of raising securities in which a company sells shares or stock to the
general public for the first time.

Follow-on Public Offering (FPO): This is an offer of sale of securities by a listed company. This
is an offering of either a fresh issue of securities or an offer for sale to the public by an already
listed company through an offer document.

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2. Offer for Sale Method

Under this method, instead of offering shares directly to the public by the company itself, it
offers through the intermediary such as issue houses/ merchant banks/ investment banks or firms of
stock brokers.

Under this method, the sale of securities takes place in two stages. In the first stage, the
issuing company sells the shares to the intermediaries such as issue houses and brokers at an
agreed price. In the second stage, the intermediaries resell the securities to the ultimate investors at
a market related price. This price will be higher. The difference between the purchase price and
the issue price represents profit for the intermediaries. The intermediaries are responsible for
meeting various expenses. Offer for sale method is also called bought out deal. This method is not
common in India.

3. Private Placement of Securities

Private placement is the issue of securities of a company direct to one investor or a small
group of investors. Generally the investors are the financial institutions or other existing companies or
selected private persons such as friends and relatives of promoters. A private company cannot issue a
prospectus. Hence it usually raises its capital by private placement. A public limited company can also
raise its capital by placing the shares privately and without inviting the public for subscription of its
shares. Company law defines a privately placed issue to be the one seeking subscription from 50
members. In a private placement, no prospectus is issued. In this case the elaborate procedure required
in the case of public issue is avoided. Therefore, the cost of issue is minimal. The process of raising
funds is also very simple. But the number of shares that can be issued in a private placement is
generally limited.

Thus, private placement refers to the direct sale of newly issued securities by the issuer to a
small number of investors through merchant bankers.

4. Right Issue

Right issue is a method of raising funds in the market by an existing company. Under this
method, the existing company issues shares to its existing shareholders in proportion to the number of
shares already held by them. Thus rights issue is the issue of new shares in which existing
shareholders are given pre-emptive rights to subscribe to the new issue on a pro-rata basis.

According to Section 81 (1) of the Companies Act, when the company wants to increase the
subscribed capital by issue of further shares, such shares must be issued first of all to existing
shareholders in proportion of their existing shareholding. The existing shareholders may accept or
reject the right. Shareholders who do not wish to

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take up the right shares can sell their rights to another person. If the shareholders neither subscribe the
shares nor transfer their rights, then the company can offer the shares to public.

5. Tender method:

Under tender method, the issue price is not predetermined. The company announces the public
issue without indicating the issue price. It invites bids from various interested parties. The parties
participating in the tender submit their maximum offers indicating the maximum price they are
willing to pay. They should also specify the number of shares they are interested to buy. The
company, after receiving various offers, may decide about the price in such a manner that the
entire issue is fairly subscribed or sold to the parties participating in the tender.

6. Issue of bonus shares:

Where the accumulated reserves and surplus of profits of a company are converted into paid up
capital, it is called bonus issue. It simply refers to capitalization of existing reserves and surpluses
of a company.

7. Offer to the employees:

Now a days companies issue shares on a preferential basis to their employees (including whole
time directors). This attracts, retains and motivates the employees by creating a sense of belonging
and loyalty. Generally shares are issued at a discount. A company can issue shares to their
employees under the following two schemes: (a) Employee stock option scheme and (b) employee
stock purchase scheme.

8. Offer to the creditors:

At the time of reorganization of capital, creditors may be issued shares in full settlement of their
loans.

9. Offer to the customers:

Public utility undertakings offer shares to their customers.

Procedure of Public Issue

Under public issue, the new shares/debentures may be offered either directly to the public
through a prospectus (offer document) or indirectly through an offer for sale involving financial
intermediaries or issue houses. The main steps involved in public issue are as follows:

1. Draft prospectus: A draft prospectus has to be prepared giving all required

information. Any company or a listed company making a public issue or a right issue

Page 25
of value more than Rs. 50 lakh has to file a draft offer document with SEBI for its observation. The
company can proceed further after getting observations from the SEBI. The company can open its
issue within 3 months from the date of SEBI’s observation letter.
2. Fulfilment of Entry Norms: The SEBI has laid down certain entry norms (parameters) for
accessing the primary market. A company can enter into the primary market only if a company
fulfils these entry norms.
3. Appointment of underwriters: Sometimes underwriters are appointed to ensure full
subscription.
4. Appointment of bankers: Generally, the company shall nominate its own banker to act as
collecting agent. The bankers along with their branch network process the funds procured during
the public issue.
5. Initiating allotment procedure: When the issue is subscribed to the minimum level, the
registrars initiate the allotment procedure.
6. Appointment of brokers to the issue: Recognised members of the stock exchange are
appointed as brokers to the issue.
7. Filing of documents: Documents such as draft prospectus, along with the copies of the
agreements entered into with the lead manager, underwriters, bankers, Registrars, and brokers to
the issue have to be filed with the Registrar of Companies.
8. Printing of prospectus and application forms: After filing the above documents, the
prospectus and application forms are printed and dispatched to all merchant bankers, underwriters
and brokers to the issue.
9. Listing the issue: It is very essential to send a letter to the stock exchange concerned where
the issue is proposed to be listed.
10. Publication in news papers: The next step is to publish an abridged version of the prospectus
and the commencing and closing dates of issues in major English dailies and vernacular
newspapers.
11. Allotment of shares: After close of the issue, all application forms are scrutinised tabulated
and then the shares are allotted against those applications received.
Players or Participants (or Intermediaries) in the Primary market/Capital Market

There are many players (intermediaries) in the primary market (or capital market). Important
players are as follows:

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1 Merchant banker: In attracting public money to capital issues, merchant bankers play a vital role.
They act as issue managers, lead managers or co-managers (functions in detail is given in
following pages)
2. Registrars to the issue: Registrars are intermediaries who undertake all activities connected
with new issue management. They are appointed by the company in consultation with the
merchant bankers to the issue.
3. Bankers: Some commercial banks act as collecting agents and some act as co- ordinating
bankers. Some bankers act as merchant bankers and some are brokers. They play an important role
in transfer, transmission and safe custody of funds.
4. Brokers: They act as intermediaries in purchase and sale of securities in the primary and
secondary markets. They have a network of sub brokers spread throughout the length and breadth
of the country.
5. Underwriters: Generally investment bankers act as underwriters. They agreed to take a
specified number of shares or debentures offered to the public, if the issue is not fully subscribed
by the public. Underwriters may be financial institutions, banks, mutual funds, brokers etc.
Government Securities Market
Govt. securities are also known as Gilt-edged securities. Gilt refers to gold. Thus govt.
securities or gilt-edged securities are as pure as gold. This implies that these are completely risk free
(no risk of default). Govt. securities market is a market where govt.
securities are traded. It is the largest market in any economic system. Therefore, it is the benchmark for
other market. Government securities refer to the marketable debt issued by the government of semi-
government bodies. A government security is a claim on the government. It is a totally
secured financial instrument ensuring safety of both capital and income. That is why it is called
gilt- edged security or stock. Central Government securities are the safest among all securities.
Government securities are issues by:

 Central Government
 State Government
 Semi-Government authorities like local government authorities, e.g., city corporations
and municipalities
 Autonomous institutions, such as metropolitan authorities, port trusts,
development trusts, state electricity boards.
 Public Sector Corporations
 Other governmental agencies, such as SFCs, NABARD, LDBs, SIDCs, housing boards
etc.

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Characteristics of Gilt-edged Securities Market
Gilt-edged securities market is one of the oldest markets in India. The market in these securities is
a significant part of Indian stock market. Main characteristics of government securities market are
as follows:
a. Supply of government securities in the market arises due to their issue by the Central, State of
Local governments and other semi-government and autonomous institutions explained
above.
b. Government securities are also held by Reserve Bank of India (RBI) for purpose and sale
of these securities and using as an important instrument of monetary control.
c. The securities issued by government organisations are government guaranteed securities
and are completely safe as regards payment of interest and repayment of principal.
d. Gilt-edged securities bear a fixed rate of interest which is generally lower than interest rate
on other securities.
e. These securities have a fixed maturity period.
f. Interest on government securities is payable half-yearly.
g. Subject to the limits under the Income Tax Act, interest on these securities is exempt
from income tax.
h. The gilt-edged market is an ‘over-the-counter’ market and each sale and purpose has to be
negotiated separately.
i. The gilt-edged market is basically limited to institutional investors.
Financial Institutions
Financial institutions are the most active constituent of the Indian capital market. There are
special financial institutions which provide medium and long term loans to big business houses.
Such institutions help in promoting new companies, expansion and development of existing
companies etc. The main special financial institutions of the Indian capital are IDBI, IFCI,
ICICI, UTI, LIC, NIDC, SFCs etc.
Capital Market Instruments.
1) Traditional instruments
This includes: a. Equity shares
b. Preference shares and its various classes
c. Debentures and its types
d. bonds etc.,

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 2) Innovative/recent instruments

Some of the new financial instruments introduced in recent years may be briefly
explained as below:

1. Floating rate bonds: The interest rate on these bonds is not fixed. It is a concept
which has been introduced primarily to take care of the falling market or to provide
a cushion in times of falling interest rates in the economy. It helps the issuer to
hedge the loss arising due to interest rate fluctuations. In India, SBI was the first to
introduce FRB for retail investors.

2. Zero interest bonds: These carry no periodic interest payment. These are sold at a huge
discount. These can be converted into equity shares or non- convertible debentures

3. Deep discount bonds : These bonds are sold at a large discount while issuing them.
These are zero coupon bonds whose maturity is very high (say,
15 years). There is no interest payment. IDBI was the first financial institution to offer
DDBs in 1992.

4. Auction related debentures: These are a hybrid of CPs and debentures. These are
secured, redeemable, non-convertible instrument. The interest on them is determined by the
market. These are placed privately with bids. ANZ Grind lays designed this new instrument
for Ashok Leyland Finance.

5. Secured Premium Notes: These are issued along with a detachable warrant. This
warrant gives the holder the right to apply for, or seek allotment of one equity share,
provided the SPN is fully paid. The conversion of detachable warrant into equity shares is
done within the time limit notified by the company. There is a lock in period during
which no interest is paid for the invested amount. TISCO was the first company to issue
SPN (in 1992) to the public along with the right issue.

6. Option bonds: Option bonds can be converted into equity or preference shares at
the option of the investor as per the condition stated in the prospectus. These may be
cumulative or non-cumulative. In case of cumulative bonds the interest is accumulated
and is payable at maturity. In case of non-cumulative bonds, interest is payable at
periodic intervals.

7. Warrants: A share warrant is an option to the investor to buy a specified number of

equity shares at a specified price over a specified period of time. The warrant holder has
to surrender the warrant and pay some cash known as ‘exercise price’ of the warrant to
purchase the shares. On exercising the

Page 29
 option the warrant holder becomes a shareholder. Warrant is yet to gain popularity in
India, due to the complex nature of the instrument.

8. Preference shares with warrants: These carry a certain number of warrants. These
warrants give the holder the right to apply for equity shares at premium at any time in
one or more stages between the third and fifth year from the date of allotment.

9. Non-convertible debentures with detachable equity warrants: In this instrument, the

holder is given an option to buy a specified number of shares from the company at a
predetermined price within a definite time frame.

10. Zero interest fully convertible debentures: On these instruments, no interest will be
paid to the holders till the lock in period. After a notified period, these debentures will be
automatically and compulsorily converted into shares.

11. Fully convertible debentures with interest: This instrument carries no interest for a
specified period. After this period, option is given to apply for equities at premium for which
no additional amount is payable. However, interest is payable at a predetermined rate from
the date of first conversion to second / final conversion and equity will be issued in lieu of
interest.

12. Non-voting shares: The Companies Bill,1997 proposed to allow companies to issue non-
voting shares. These are quasi -equity instruments with differential rights. These shares do
not carry voting right. Their divided rate is also not predetermined like preference shares.

13. Inverse float bonds: These bonds are the latest entrants in the Indian capital market.
These are bonds carrying a floating rate of interest that is inversely related to short term
interest rates.

14. Perpetual bonds: These are debt instruments having no maturity date. The investors
receive a stream of interest payment for perpetuity.

Reforms of Indian Capital Market

Capital market reforms to the institutional arrangements for long term lending and borrowings
with a view to increase number of service to introduce improved practices, the Government had
various reforms of capital market in the post reforms era (1992) few of those are discussed below:-

Page 30
General Reforms:-

i. Statutory Status to SEBI:- With an act of parliament, statutory status was given to SEBI
from March 31, 1992. It was provided with the necessary power to control regulate and
supervise stock market.

ii. Permission to foreign institutional investors:- Investment norms for NRIs have been
liberalized so as to attract more funds into the capital market. The foreign institutional
investors can invest into the Indian Capital Market on registration with SEBI.

iii. Permission to Indian Companies: Indian companies have been permitted to raise capital
for modernization and raise capital from the international capital market.

Reforms of Primary Market:-

The important reforms of Indian primary market areas under:-

1. Merchant banking has been brought under the regulation act of SEBI.

2. Companies are required to disclose all material facts and specific risk factors, which are
associated with their project while making public issues.

3. Stock exchanges are required to ensure that the companies should have a valid acknowledgement
card issued by SEBI. In other words the companies should fulfil all the requirements to be listed
in the stock market as per SEBI guidelines.

4. SEBI has also introduced a code of advertisement for public issue to ensure fair and truthful
disclosures.

Reforms of Secondary Market:

i. Unit Trust of India has been brought under the regulatory jurisdiction of SEBI.

ii. Private Mutual Funds have been permitted and all Mutual Funds are allowed to apply for
firm allotment in public issues.

iii. Fresh guidelines were issued for advertising mutual funds.

iv. SEBI has also introduced capital adequacy norms for brokers and main rules for marking
client broker relationship more transparent.

v. SEBI also issued guidelines to make the governing body of stock exchange more broad
based. It should have 5 elected members not more than 4 members

Page 31
 are nominated by SEBI and 3 or 4 members are nominated as public representatives
further an Executive Director will also be there

Differences between Money Market and Capital Market

Money market Capital market

1. Short term funds. 1. Long term funds.

2. Operational/WC needs. 2. FC/PC requirements.
3. Instruments are: bills, CPs, T- 3. Shares, debentures, bonds etc.
bills, CDs etc., . 4. Small face value of securities.
4. Huge face value for single 5. Development banks, investment
instrument. institutions are major players.
5. Central and coml. banks are major 6. Formal place, stock exchanges.
players. 7. Brokers playing a vital role.
6. No formal place for
transactions.
7. Usually no role to brokers.

Primary markets are markets in which companies raise funds through new issue of stocks.
The new securities are sold to initial investors such as households and qualified institutional
buyers (QIBs). As the new issue market (NIM)/ Primary market directs the flow of
savings into long term investments, it is of paramount importance for the economic growth and
industrial development of a country. The availability of financial resources for the corporate
enterprises, to the great extent, depends upon the status of primary market in a country.

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STOCK EXCHANGES

Meaning of Secondary Market

Secondary market is a market for old issues. It deals with the buying and selling existing
securities i.e. securities already issued. In other words, securities already issued in the primary
market are traded in the secondary market. Secondary market is also known as stock market. The
secondary market operates through ‘stock exchanges’.

In India, stock market consists of recognised stock exchanges. In the stock exchanges,
securities issued by the central and state governments, public bodies, and joint stock companies
are traded.

Stock Exchange

In India the first organized stock exchange was Bombay Stock Exchange. It was started in
1877. Later on, the Ahmadabad Stock Exchange and Calcutta Stock Exchange were started in
1894 and 1908 respectively. At present there are 24 stock exchanges in India. In Europe, stock
exchanges are often called bourses.

Meaning and Definition of Stock Exchange/ Security Exchange

It is an organized market for the purchase and sale of securities of joint stock companies,
government and semi- govt. bodies. It is the centre where shares, debentures and govt. securities
are bought and sold.

According to Pyle, “Security exchanges are market places where securities that have been listed
thereon may be bought and sold for either investment or speculation”.

The Securities Contract (Regulation) Act 1956, defines a stock exchange as “an association,
organiastion or body of individuals whether incorporated or not, established for the purpose of
assisting, regulating and controlling of business in buying, selling and dealing in securities”.

In short, stock exchange is a place or market where the listed securities are bought and sold.

Characteristics of a Stock Exchange

1. It is an organized capital market.

2. It may be incorporated or non-incorporated body (association or body of individuals).

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3. It is an open market for the purchase and sale of securities.

4. Only listed securities can be dealt on a stock exchange.

5. It works under established rules and regulations.

6. The securities are bought and sold either for investment or for speculative purpose.

Economic Functions of Stock Exchange

The stock exchange performs the following essential economic functions:

1. Ensures liquidity to capital: The stock exchange provides a place where shares and stocks
are converted into cash. People with surplus cash can invest in securities (by buying
securities) and people with deficit cash can sell their securities to convert them into cash.
2. Continuous market for securities: It provides a continuous and ready market for buying
and selling securities. It provides a ready market for those who wish to buy and sell securities
3. Mobilisation of savings: It helps in mobilizing savings and surplus funds of individuals,
firms and other institutions. It directs the flow of capital in the most profitable channel.
4. Capital formation: The stock exchange publishes the correct prices of various securities.
Thus the people will invest in those securities which yield higher returns. It promotes the
habit of saving and investment among the public. In this way the stock exchange facilitates
the capital formation in the country.
5. Evaluation of securities: The prices at which transactions take place are recorded and made
public in the forms of market quotations. From the price quotations, the investors can
evaluate the worth of their holdings.
6. Economic developments: It promotes industrial growth and economic development of the
country by encouraging industrial investments. New and existing concerns raise their capital
through stock exchanges.
7. Safeguards for investors: Investors’ interests are very much protected by the stock exchange.
The brokers have to transact their business strictly according to the rules prescribed by the stock
exchange. Hence they cannot overcharge the investors.
8. Barometer of economic conditions: Stock exchange reflects the changes taking place in
the country’s economy. Just as the weather clock tells us which way the wind is blowing, in
the same way stock exchange serves as an indicator of the phases in business cycle-boom,
depression, recessions and recovery.

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 9. Platform for public debt: The govt. has to raise huge funds for the development activities.
Stock exchange acts as markets of govt. securities. Thus, stock exchange provides a platform
for raising public debt.
10. Helps to banks: Stock exchange helps the banks to maintain liquidity by increasing the
volume of easily marketable securities.
11. Pricing of securities : New issues of outstanding securities in the primary market are based
on the prices in the stock exchange. Thus, it helps in pricing of securities.

Thus stock exchange is of great importance to a country. It provides necessary mobility to

capital. It directs the flow of capital into profitable and successful enterprises. It is indispensable
for the proper functioning of corporate enterprises. Without stock exchange, even govt. would find
it difficult to borrow for its various schemes. It helps the traders, investors, industrialists and the
banker. Hence, it is described as the business of business.

Benefits of Stock Exchange

Stock exchange offers the following benefits:

A. Benefits to Investors
a. The stock exchange plays the role of a friend, philosopher and guide to investors
by providing information about the prices of various securities.
b. It offers a ready market for buying and selling securities.
c. It increases the liquidity of the investors.
d. It safeguards the interests of investors through strict rules and regulations.
e. It enables the investors to know the present worth of their securities.
f. It helps investors in making wise investment decisions by providing useful
information about the financial position of the companies.
g. The holder of a listed security can easily raise loan by pledging it as a collateral
security.

B. Benefits to Companies

a. A company enjoys greater reputation and credit in the market. Image of the
company goes up.
b. A company can raise large amount of capital from different types of
securities.
c. It enjoys market for its shares.

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 d. The market price for shares and debentures will be higher. Due to this the
bargaining power of the company increases in the events of merger or
amalgamation.

C. Benefits to Community and Nation

a. Stock exchange encourages people to sell and invest their savings in shares and
debentures.
b. Through capital formation, stock exchange enables companies to undertake
expansion and modernization. Stock exchange is an ‘Alibaba Cave’ from which
business community draw unlimited money.
c. It helps the government in raising funds through sale of government securities. This
enables the government to undertake projects of national importance and social value.
d. It diverts the savings towards productive channels.
e. It helps in better utilisation of the country’s financial resources.
f. It is an effective indicator of general economic conditions of a country.

Listing of Securities

Listing of securities means permission to quote shares and debentures officially on the trading
floor of the stock exchange. Listing of securities refers to the sanction of the right to trade the
securities on the stock exchange. In short, listing means admission of securities to be traded on the
stock exchange. If the securities are not listed, they are not allowed to be traded on the stock
exchange.

Advantages of Listing

A. Advantages to Company:

a. It provides continuous market for securities (securities include shares, debentures,

bonds etc.)
b. It enhances liquidity of securities.
c. It enhances prestige of the company.
d. It ensures wide publicity.
e. Raising of capital becomes easy.
f. It gives some tax advantage to the company.

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B. Advantages to Investors:

a. It provides safety of dealings.

b. It facilitates quick disposal of securities in times of need. This means that
listing enhances the liquidity of securities.
c. It gives some tax advantage to the security holder.
d. Listed securities command higher collateral value for the purpose of bank
loans.
e. It provides an indirect check against manipulation by the management.

Disadvantages of Listing

a. It leads to speculation
b. Sometimes listed securities are subjected to wide fluctuations in their value. This
may degrade the company’s reputation.
c. It discloses vital information such as dividends and bonus declared etc. to
competitors.
d. Company has to spend heavily in the process of placing the securities with
public

Classification of Listed Securities

The listed shares are generally divided into two categories - Group A shares (cleared
securities) and Group B shares (non-cleared securities). Group A shares represent large and well
established companies having a broad investor base. These shares are actively traded. Forward
trading is allowed in Group A shares. These facilities are not available to Group B shares. These
are not actively traded. Carry forward facility is not available in case of these securities.

Procedure for Dealing at Stock Exchange (Trading Mechanism or Method of Trading on

a Stock Exchange)

Outsiders are not allowed to buy or sell securities at a stock exchange. They have to
approach brokers. Dealings can be done only through brokers. They are the members of the stock
exchange. The following procedure is followed for dealing at exchanges:

a. Selection of a broker: An individual cannot buy or sell securities directly at stock exchange.
He can do so only through a broker. So he has to select a broker through whom the purchase or
sale is to be made. The intending investor or seller may appoint his bank for this purpose. The
bank may help to choose the broker.

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b. Placing an order: After selecting the broker, the next step is to place an order for purchase or
sale of securities. The broker also guides the client about the type of securities to be purchased
and the proper time for it. If a client is to sell the securities, then the broker shall tell him about
the favourable time for sale.

c. Making the contract: The trading floor of the stock exchange is divided into different parts
known as trading posts. Different posts deal in different types of securities. The authorised clerk of
the broker goes to the concerned post and expresses his intention to buy and sell the securities. A
deal is struck when the other party also agrees. The bargain is noted by both the parties in
their note books. As soon as order is executed a confirmation memo is prepared and is given
to the client.

d. Contract Note: After issue of confirmation memo, a contract note is signed between the broker
and the client. This contract note will state the transaction fees (commission of broker), number of
shares bought or sold, price at which they are bought or sold, etc.

e. Settlement: Settlement involves making payment to sellers of shares and delivery of share
certificate to the buyer of shares after receiving the price. The settlement procedure depends
upon the nature of the transactions. All the transactions on the stock exchange may be
classified into two- ready delivery contracts and forward delivery contracts.

Ready delivery contract: A ready delivery contract involves the actual payment of the amount
by the buyer in cash and the delivery of securities by the seller. A ready delivery contract is
to be settled on the same day or within the time period fixed by the stock exchange
authorities.

Forward delivery contracts: These contracts are entered into without any intention of taking
and giving delivery of the securities. The traders in forward delivery securities are interested
in profits out of price variations in the future. Such transactions are settled on the settlement
days fixed by the stock exchange authorities. Such contracts can be postponed to the next
settlement day, if both the parties agree between themselves. Such postponement is called
‘Carry over’ or ‘badla’. Thus ‘carry over’ or ‘badla’ means the postponement of transaction
from one settlement period to the next settlement period.

Rolling Settlement

Rolling settlement has been introduced in the place of account period settlement. Rolling
settlement system was introduced by SEBI in January 1998. Under this system of settlement,
the trades executed on a certain day are settled

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based on the net obligations for that day. At present, the trades relating to the rolling settlement are
settled on T + 2day basis where T stands for the trade day. It implies that the trades executed on the
first day (say on Monday) have to be settled on the 3rd day (on Wednesday), i.e., after a gap of 2 days.

This cycle would be rolling and hence there would be number of set of transactions for
delivery every day. As each day’s transaction are settled in full, rolling settlement helps in
increasing the liquidity in the market. With effect from January 2, 2002, all scrips have been
brought under compulsory rolling mode.

Members in a Stock Exchange

Only members of the exchange are allowed to do business of buying and selling of
securities at the floor of the stock exchange. A non-member (client) can buy and sell securities only
through a broker who is a member of the stock exchange. To deal in securities on recognised stock
exchanges, the broker should register his name as a broker with the SEBI.

Types of Members in a Stock Exchange

o Jobbers: They are dealers in securities in a stock exchange. They cannot deal on behalf of
public. They purchase and sell securities on their own names. Their main job is to earn profit
due to price variations.

o Commission brokers: They are nothing but brokers. They buy and sell securities no behalf
of their clients for a commission. They are permitted to deal with non-members directly.
They do not purchase or sell in their own name.

o Tarawaniwalas : They are like jobbers. They handle transactions on a commission basis for
their brokers. They buy and sell securities on their own account and may act as brokers on
behalf of the public.

o Sub-brokers: Sub brokers are agents of stock brokers. They are employed by brokers to
obtain business. They cannot carry on business in their own name. They are also known as
Remisiers.

o Arbitrageurs: They are brokers. They buy security in one market and sell the same in
another market to get opportunistic profit.

o Authorised clerks: Authorised clerks are those who are appointed by stock brokers to assist
them in the business of securities trading.

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Speculation

Speculation takes place in the forward market. Speculation means buying and selling of
financial instruments (including foreign exchange) with the expectation of a profit from
anticipated changes in the price of securities or foreign exchange rates. It simply means taking a
foreign exchange risk in hope of making profit. One who is engaged in speculation is called
speculator. His success or failure depends upon how correctly he is able to anticipate the exchange
rate variations.

Type of Speculators

1. Bull : A bull or Tejiwala is a speculator who buys shares in expectuation of selling them at
higher prices in future. He believes that current prices are lower and will rise in the future.

2. Bear : A bear or Mandiwala is a speculator who sells securities with the intention to buy at
a later date at a lower price. He expects a fall in price in future.

3. Lame duck : A lame duck is a bear speculator. He finds it difficult to meet his
commitments and struggles like a lame duck. This happens because of the non- availability
of securities in the market which he has agreed to sell and at the same time the other party is
not willing to postpone the transaction.

4. Stag: Stag is a member who neither buys nor sells securities. He applies for shares in the
new issue market. He expects that the price of shares will soon increase and the shares can
be sold for a premium.

5. Wolf : Wolf is a broker who is fast speculator. He is very quick to perceive changes in the
market trends and trade fast and make fast profit.

Speculative Transactions

Some of the speculative dealings are as follows:

1) Option deals: This is an arrangement or right to buy or sell securities at a predetermined price on
or before a specified date in future.

2) Wash sales: It is a device through which a speculator is able to reap huge profits by creating a
misleading picture in the market. It is a kind of fictitious transaction in which a speculator
sells a security and then buys the same at a higher price through another broker. Thus he
creates a false or misleading opinion in the market about the price of a security.

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3) Rigging : If refers to the process of creating an artificial condition in the market whereby the
market value of a particular security is pushed upon. Bulls buy securities, create demand for
the same and sell them at increased prices.

4) Arbitrage : It is the process of buying a security, from a market where price is lower and
selling at in another market where price is higher.

5) Cornering : Sometimes speculators make entire or a major share of supply of a particular security
with a view to create a scarcity against the existing contracts. This is called cornering.

6) Blank transfer : When the transferor (seller) simply signs the transfer form without
specifying the name of the transferee (buyer), it is called blank transfer. In this case share can
further be transferred by mere delivery of transfer deed together with the share certificate. A
new transfer deed is not required at the time of each transfer. Hence, expenses such as
registration fees, stamp duty, etc can be saved.

7) Margin trading: Under this method, the client opens an account with his broker. The client
makes a deposit of cash or securities in this account. He also agrees to maintain a minimum
margin of amount always in his account. When a broker purchases securities on behalf of his
client, his account(client’s account) will be debited and vice versa. The debit balance, if any, is
automatically secured by the client’s securities lying with the broker. In case it falls short of the
minimum agreed amount, the client has to deposit further amount into his account or he has to
deposit further securities. If the prices are favourable, the client may instruct his broker to sell
the securities. When such securities are sold, his account will be credited. The client may have a
bigger margin now for further purchases.

Factors Influencing Prices on Stock Exchange

The prices on stock exchange depends upon the following factors :

a. Financial position of the company

b. Demand and supply position
c. Lending rates
d. Attitudes of the FIIs and the developments in the global financial markets.
e. Govt. Policies (credit policies, monetary policies, taxation policies etc.)
f. Trade cycle
g. Speculation activities

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Defects of Stock Exchanges (or Capital Market) in India

The Indian stock market is suffering from a number of weaknesses. Important weakness
are as follows:
1. Speculative activities : Most of the transactions in stock exchange are carry forward
transactions with a speculative motive of deriving benefit from short term price fluctuation.
Genuine transactions are only less.
2. Insider trading : Insider trading has been a routine practice in India. Insiders are those
who have access to unpublished price-sensitive information. By virtue of their position in the
company they use such information for their own benefits.
3. Poor liquidity : The Indian stock exchanges suffer from poor liquidity. Though there are
approximately 8000 listed companies in India, the securities of only a few companies are
actively traded. Only that securities are liquid. This mean other stocks have very low
liquidity.
4. Less floating securities: There is scarcity of floating securities in the Indian stock
exchanges. Out of the total stocks, only a small portion is being offered for sale. The
financial institutions and joint stock companies control over 75% of the scrips. However,
they do not offer their holdings for sale. The UTI, GIC, LIC etc. indulge more in purchasing
than in selling. This creates scarcity of stocks for trading.
5. Lack of transparency : Many brokers are violating the regulations with a view to
cheating the innocent investing community. No information is available to investors
regarding the volume of transactions carried out at the highest and lowest prices.
6. High volatility : The Indian stock market is subject to high volatility in recent years. The
stock prices fluctuate from hour to hour. High volatility is not conducive for the smooth
functioning of the stock market.
7. Dominance of financial institutions : The Indian stock market is being dominated by few
financial institutions like UTI, LIC, GIC etc. This means these few institutions can
influence stock market greatly.
8. Competition of merchant bankers : The increasing number of merchant bankers in the
stock market has led to unhealthy competition in the stock market.
9. Lack of professionalism: Some of the brokers are highly competent and professional. At
the same time, majority of the brokers are not so professional. They lack proper education,
business skills, infrastructure facilities etc.

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Difference between Primary and Secondary Market

Primary Market Secondary Market

A. It is a market for existing or
A. It is a market for new securities.
second hand securities
B. It is directly promotes capital
B. It is directly promotes capital
formation.
formation.
C. Investors can only buy securities.
C. Both buying and selling of
They cannot sell them.
securities takes place
D. There is no fixed geographical
location. D. There is a fixed geographical
location (stock exchanges)
E. Securities need not be listed.
F. It enables the borrowers to raise
E. Only listed securities can be
bought and sold
capital
F. It enables the investors to invest
money in securities and sell and
encash as they need money

Major stock exchanges in India

1. Bombay Stock Exchange (BSE)

BSE is the leading and the oldest stock exchange in India as well as in Asia. It was
established in 1887 with the formation of "The Native Share and Stock Brokers' Association". BSE
is a very active stock exchange with highest number of listed securities in India. Nearly 70% to
80% of all transactions in the India are done alone in BSE. Companies traded on BSE were 3,049
by March, 2006. BSE is now a national stock exchange as the BSE has started allowing its
members to set-up computer terminals outside the city of Mumbai (former Bombay). It is the only
stock exchange in India which is given permanent recognition by the government.

Some important facts about BSE:

 BSE exchange was the first in India to launch Equity Derivatives, Free Float Index, USD
adaptation of BSE Sensex and Exchange facilitated Internet buying and selling policy
 BSE exchange was the first in India to acquire the ISO authorization for supervision,
clearance & Settlement
 BSE exchange was the first in India to have launched private service for economic training
 Its On-Line Trading System has been felicitated by the internationally renowned standard
of Information Security Management System.

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Bombay Online Trading System (BOLT)

BSE online trading was established in 1995 and is the first exchange to be set up in Asia. It
has the largest number of listed companies in the world and currently has 4937 companies listed
on the Exchange with over 7,700 traded instruments. BSE introduced online trading system

The only thing that an investor requires for online trading through BSE is an online trading
account. The trading can then be done within the trading hours from any location in the world. In
fact, BSE has replaced the open cry system with automated trading. Open cry system is a
common method of communication between the investors at a stock exchange where they shout and
use hand gestures to communicate and transfer information about buy and sell orders. It usually
takes place on the 'pit' area of the trading floor and involves a lot of face to face interaction. However,
with the use of electronic trading systems trading is easier, faster and cheaper; and is less prone to
manipulation by market makers and brokers/dealers.

2. National Stock Exchange (NSE)

Formation of National Stock Exchange of India Limited (NSE) in 1992 is one important
development in the Indian capital market. The need was felt by the industry and investing
community since 1991. The NSE is slowly becoming the leading stock exchange in terms of
technology, systems and practices in due course of time. NSE is the largest and most modern stock
exchange in India. In addition, it is the third largest exchange in the world next to two exchanges
operating in the USA.

The NSE boasts of screen based trading system. In the NSE, the available system provides
complete market transparency of trading operations to both trading members and the participates
and finds a suitable match. The NSE does not have trading floors as in conventional stock
exchanges. The trading is entirely screen based with automated order machine. The screen
provides entire market information at the press of a button. 3 segments of NSE are:

 Wholesale debt market segment,

 Capital market segment, and
 Futures & options trading.

NSE uses satellite communication expertise to strengthen contribution from around 400 Indian
cities. It is one of the biggest VSAT incorporated stock exchange across the world.

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3. Over the Counter Exchange of India (OTCEI)

The OTCEI was incorporated in October, 1990 as a Company under the Companies Act
1956. It became fully operational in 1992 with opening of a counter at Mumbai. It is recognised by
the Government of India as a recognised stock exchange under the Securities Control and
Regulation Act 1956. It was promoted jointly by the financial institutions like UTI, ICICI, IDBI,
LIC, GIC, SBI, IFCI, etc.

The Features of OTCEI are:-

1. OTCEI is a floorless exchange where all the activities are fully computerised.
2. Its promoters have been designated as sponsor members and they alone are entitled to sponsor
a company for listing there.
3. Trading on the OTCEI takes place through a network of computers or OTC dealers located at
different places within the same city and even across the cities. These computers allow dealers to
quote, query & transact through a central OTC computer using the telecommunication links.
4. A Company which is listed on any other recognised stock exchange in India is not permitted
simultaneously for listing on OTCEI.
5. OTCEI deals in equity shares, preference shares, bonds, debentures and warrants.

OTC Exchange Of India designed trading in debt instruments commonly known as PSU bonds
and also in the equity shares of unlisted companies.

STOCK INDICES

The stock market index is a barometer of market behaviour. It functions as an indicator of

the general economic scenario of a country. If stock market indices are growing, it indicates that
the overall general economy of country is stable if however the index goes down it shows some
trouble in economy.

Construction of Stock Index. A stock index is created by choosing high performing stocks.
Index can be calculated by two ways by considering the price of component stock alone. By
considering the market value or size of the company called market capitalization method. Two
main stock index of India are Sensex and Nifty.

Any of the following methods can be used for calculating index

a. Weighted capitalisation method - full market capitalisation and free float market
capitalisation.

b. Price weighted index method

c. Equal weighting method

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The important indices in India:

1. BSE Sensex

2. S&P CNX Nifty

3. S&P CNX 500

4. BSE 500

5. BSE 100

6. BSE 200/Dollex

7. BSE IT

8. BSE CG

9. BSE FMCG

10. S&P CNX Defty

BSE SENSEX

The 'BSE Sensex' or 'Bombay Stock Exchange' is value-weighted index composed of 30

stocks and was started in January 1, 1986. The Sensex is regarded as the pulse of the domestic
stock markets in India. It consists of the 30 largest and most actively traded stocks, representative of
various sectors, on the Bombay Stock Exchange. These companies account for around fifty per cent
of the market capitalization of the BSE

S&P CNX NIFTY

The Standard & Poor's CRISIL NSE Index 50 or S&P CNX Nifty nicknamed Nifty 50 or
simply Nifty (NSE: ^NSEI), is the leading index for large companies on the National Stock
Exchange of India. The Nifty is a well diversified 50 stock index accounting for 23 sectors of the
economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based
derivatives and index funds. Nifty is owned and managed by India Index Services and Products
Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is India's first specialized
company focused upon the index as a core product. IISL has a marketing and licensing agreement
with Standard & Poor's.

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