Introduction to the Financial System

Introduction to the Financial System (Part 1)

• Financial System: The entire set of institutionalized arrangements by which funds are transferred from surplus units to deficit units at terms acceptable to both sides.
• Components of Financial System:
  • Financial Market: A mechanism that allows traders to deal in financial securities, commodities, etc., at low costs.
  • Financial Markets Infrastructure Institutions (MIIs): Institutions that facilitate the functioning of financial markets, such as depositories, stock exchanges, and clearing corporations.
  • Financial Intermediaries: Entities that provide intermediation services in the financial system, such as merchant bankers, stock brokers, and portfolio managers.
  • Financial Securities: Instruments used to raise funds, such as stocks, bonds, and debentures.

Key Concepts

• Financial Market:
  • Definition: A market in which financial assets such as equities, bonds, currencies, and derivatives are created or transferred.
  • Types:
    • Money Market: A market for short-term financial assets with a maturity period of one year or less.
    • Capital Market: A market for long-term financial assets with a maturity period of more than one year.
    • Forex Market: A market for exchanging currencies.
    • Credit Market: A market for borrowing and lending funds.
    • Insurance Market: A market for transferring risks.
• Financial Markets Infrastructure Institutions (MIIs):
  • Depositories: Institutions that hold securities in electronic form.
  • Stock Exchanges: Platforms for buying and selling securities.
  • Clearing Corporation: An entity that undertakes the activity of clearing and settlement of trades.
  • Social Stock Exchange: A separate segment of a recognized stock exchange for Not for Profit Organizations.
• Financial Intermediaries:
  • Merchant Bankers: Entities that assist companies in originating issues of securities.
  • Stock Brokers: Intermediaries that execute buy and sell transactions on behalf of clients.
  • Portfolio Managers: Entities that administer portfolios of individuals or provide advice on investments.
  • Mutual Funds: Trusts that mobilize funds from investors and invest in securities.
  • Custodians: Entities that hold securities on behalf of institutional investors.
  • Credit Rating Agency: A body that rates the creditworthiness of securities.
  • Debenture Trustee: A trustee that secures the issue of debentures.
  • Vault Manager: An entity that provides vaulting services for gold.

Introduction to the Financial System (Part 2)

• Financial Securities: According to the Securities Contracts (Regulation) Act, 1956, the term “securities” includes:
  • Shares, scrips, stocks, bonds, debentures, debenture stock, or other marketable securities of a company or pooled investment vehicle
  • Derivatives: Financial contracts that derive their value from underlying assets, such as options, futures, and swaps
  • Units or instruments issued by collective investment schemes, mutual funds, or pooled investment vehicles
  • Security receipts, government securities, and other instruments declared by the Central Government to be securities
• Types of Securities:
  • Stocks: Represent ownership in a corporation and signify a claim on part of the corporation’s assets and earnings
  • Equity Shares: Represent an ownership interest in a company, with residual claims on earnings and assets
  • Preference Shares: Have a preferential right to dividend and repayment of capital, but do not carry voting rights
  • Debentures: Debt securities with a definite life, paying coupon interest at regular intervals
  • Bonds: Debt securities with similar features to debentures, but often secured by specific collateral
  • Warrants: Long-term call options issued by a company, giving the holder the right to buy equity shares at a specified price
• Derivatives:
  • Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset
  • Futures Contracts: Guarantee delivery of a specific quantity of an asset on a specified future date, at the price currently quoted
  • Index Derivatives: Futures contracts based on stock or financial indices, such as the BSE Sensex or NSE Nifty 50
• Other Financial Instruments:
  • Structured Products: Typically comprise bonds, equities, and derivatives, offering capital protection or diversification
  • Alternate Investment Fund (AIF): A privately pooled investment vehicle that collects funds from sophisticated investors for investing in real estate, private equity, or hedge funds
  • American Depository Receipts (ADRs): Securities denominated in US Dollars, traded on US exchanges, representing a specific number of equity shares of a foreign company
  • Global Depository Receipts (GDRs): Instruments denominated in foreign currency, allowing foreign investors to invest in shares of foreign companies
  • Indian Depository Receipts (IDRs): Rupee-denominated securities traded on Indian stock exchanges, representing a specific number of shares of a foreign company
  • Mutual Fund (MF) Units: Represent the share of investors in the assets of the scheme, with fund managers investing the money collected to achieve the specified investment objective
  • Exchange-Traded Funds (ETFs): Open-ended mutual funds that allow trading of their units throughout the day, offering a passively managed investment option
  • Currency Derivatives: Contracts whose values are derived from the underlying assets, i.e., currency amounts, offering risk management tools in the forex and money markets
  • Interest-Rate Derivatives: Contracts that enable investors or borrowers to hedge against the risk of adverse interest-rate movement, including interest-rate futures, swaps, and options.

Introduction to the Financial System (Part 3)

• Interest-Rate Futures: A corporate treasurer can lock in a higher yield by buying an interest-rate futures contract if they anticipate a fall in interest rates. Conversely, a banker can lock in a lower rate by selling an interest-rate futures contract if they fear a rise in interest rates.
• Interest-Rate Swaps: Agreements between two or more parties to exchange a series of cash flows in the same currency over an agreed period. This can be beneficial when two parties have opposite views on interest rate movements.
• Interest-Rate Options: A derivative financial instrument that can be used to limit interest rates or earn a minimum rate of return. This includes caps and floors.
• Forward Rate Agreement (FRA): A forward contract that allows a borrower to lock in a specified interest rate for a pre-determined time period in the future.
• Securities Lending and Borrowing Scheme (SLB): Allows short sellers to borrow securities for making delivery, enabling short selling.
• E-warehouse Receipts: Negotiable warehouse receipts issued in electronic format, representing an acknowledgement of stored goods.
• REITs and InvITs: Real Estate Investment Trusts and Infrastructure Investment Trusts allow developers to monetize revenue-generating assets, providing liquidity to investors and favorable tax treatment.

Review Questions

• 1. Financial systems consist of banks, non-banks, and financial markets.
• 2. Custodians are responsible for safekeeping and record-keeping of securities.
• 3. Registrars collate data on subscriptions regarding primary issuances.
• 4. The term 'Security' excludes bullion as per the Securities Contract Regulation Act (SCRA).