ILO8022 FINANCE MANAGEMENT

Module 1
Overview of Indian Financial System: Characteristics, Components and Functions of
Financial System.
Financial Instruments: Meaning, Characteristics and Classification of Basic Financial
Instruments — Equity Shares, Preference Shares, Bonds-Debentures, Certificates of Deposit,
and Treasury Bills.
Financial Markets: Meaning, Characteristics and Classification of Financial Markets —
Capital Market, Money Market and Foreign Currency Market
Financial Institutions: Meaning, Characteristics and Classification of Financial Institutions
— Commercial Banks, Investment-Merchant Banks and Stock Exchanges

Overview of the Indian Financial System: Characteristics, Components, and Functions

Characteristics of the Indian Financial System

1. Well-Structured: The system is organized, comprising financial markets, institutions,

instruments, and services that work cohesively.
2. Regulated: It is governed by strict regulations from authorities like the Reserve Bank
of India (RBI), Securities and Exchange Board of India (SEBI), and Ministry of
Finance.
3. Diverse: It supports various financial instruments and markets, catering to a wide range
of investors and businesses.
4. Integrated: Both formal and informal sectors are connected, and different markets are
interdependent.
5. Dynamic: The system has evolved with globalization, technological advancements,
and policy changes, adapting to the changing needs of the economy.

Indian Financial System Overview

Topic Details Key Subtopics
Framework for mobilizing Characteristics:1. Intermediation (connects
Indian
and allocating financial savers and borrowers).2. Regulation (RBI, SEBI,
Financial
resources efficiently to IRDAI).3. Diverse : Variety of instruments.4.
System
promote economic growth. Market integration/ efficiency / dynamics.
Components:1. Financial Institutions.2.
Financial Markets.3. Financial Instruments.4.
Financial Services.
Functions:1. Mobilize savings into
investments.2. Provide credit.3. Facilitate risk
management.4. Allocate resources.
Components of the Indian Financial System
1. Financial Instruments: These are tools through which capital is raised or invested.
They include Equity Shares, Preference Shares, Bonds-Debentures, Certificates of
Deposit, and Treasury Bills, debt securities, derivatives, etc.
2. Financial Markets: Provide a platform for buying and selling financial instruments.
They include:
o Capital Market
o Money Market
o Foreign Currency Market
3. Financial Institutions: Serve as intermediaries that facilitate transactions in financial
markets. These include:
o Commercial Banks
o Investment Banks
o Insurance Companies
o Pension Funds
4. Financial Services: Provide various value-added services to facilitate financial
transactions. These include wealth management, financial planning, etc.
Insurance Regulatory and Development Authority of
Insurance sector regulation.
India (IRDAI)
Pension Fund Regulatory and Development Authority Regulation of pension funds (e.g.,
(PFRDA) NPS).

Functions of the Financial System

1. Mobilization of Savings: The system converts savings into investments, making funds
available for economic growth.
2. Facilitates Payments: It offers mechanisms for transferring funds and settling
payments.
3. Risk Management: It provides instruments like insurance and derivatives to help
manage and mitigate risks.
4. Capital Formation: The system enables efficient allocation of resources to sectors that
need capital for growth and expansion.
5. Liquidity: Ensures that investors can buy and sell financial instruments with ease,
promoting confidence in the markets.
Financial Instruments: Meaning, Characteristics, and Classification
Category Description Examples
Financial tools representing Examples include equity shares,
Meaning ownership, a debt obligation, or an preference shares, bonds, and
agreement to transfer funds. treasury bills.
1. Liquidity.2. Risk and return.3.
Characteristics
Maturity period.4. Marketability.
Types
Represent ownership in a company.
Equity Shares High-risk and high-return
instruments.
Fixed dividend payments. Priority
Preference Shares over equity shares during
liquidation.
Secured bonds (backed by
Debt instruments issued by
assets) and Unsecured bonds
Bonds/Debentures companies or governments,
(backed by issuer’s
offering fixed returns.
creditworthiness).
Certificates of Short-term instruments issued by High liquidity; typically issued to
Deposit (CDs) banks to raise funds. institutional investors.
Government securities with short-
Treasury Bills (T- term maturities (e.g., 91 days, 182 Issued by the Reserve Bank of
Bills) days). Sold at a discount and India.
redeemed at face value.

Meaning of Financial Instruments

Financial instruments are contracts or documents representing a financial asset, which can be
bought, sold, or traded. They represent an agreement between two parties that defines the terms
of the financial transaction.

Characteristics of Financial Instruments

1. Value: The monetary worth of the instrument.
2. Tradability: The ability to be bought or sold in financial markets.
3. Liquidity: How quickly an instrument can be converted into cash without significant
loss of value.
4. Risk: The level of uncertainty regarding returns.
5. Maturity: The period until the instrument's value is due to be paid or redeemed.
Classification of Basic Financial Instruments
1. Equity Shares (Common Stocks):
o Meaning: Represents ownership in a company.
o Characteristics:
 Voting rights
 Dividends (variable)
 High-risk and high-reward
 Residual claim on assets in case of liquidation
o Classification: Long-term capital instruments, traded on stock exchanges.
2. Preference Shares:
o Meaning: Shares that give holders preferential treatment in dividends and
during liquidation.
o Characteristics:
 Fixed dividend payout
 No voting rights (in most cases)
 Priority over equity shareholders in case of liquidation
o Classification: Hybrid between debt and equity, offering fixed income.
3. Bonds-Debentures:
o Meaning: Debt instruments issued by corporates or governments to raise
capital.
o Characteristics:
 Fixed interest (coupon) payments
 Maturity date (the principal is repaid)
 Lower risk compared to equity instruments
o Classification: Long-term debt instruments; debentures are unsecured,
whereas bonds may be secured.
4. Certificates of Deposit (CDs):
o Meaning: Short-term debt instruments issued by banks to raise funds.
o Characteristics:
 Fixed interest rate
 Maturity period ranges from a few months to a few years
 Low risk
o Classification: Short-term money market instruments.
5. Treasury Bills (T-Bills):
o Meaning: Short-term debt instruments issued by the government to meet short-
term liquidity needs.
o Characteristics:
 Issued at a discount and redeemed at par
 No interest, but the difference between issue price and redemption value
is the return
 Low-risk
o Classification: Short-term instruments with maturity periods of 91, 182, or 364
days.
 Equity Preference Bonds / Certificates of Treasury Bills
Feature
Shares Shares Debentures Deposit (CDs) (T-Bills)
Hybrid Debt instrument
Ownership in Short-term
security with where investors Short-term time
a company government
Definition fixed lend money to deposits issued
with voting securities issued at
dividends but companies or by banks.
rights. a discount.
limited rights. governments.
Commercial
Companies, Central
Issuer Companies Companies Banks, Financial
Governments Government
Institutions
Typically
Perpetual Medium to long- Short-term (7 Short-term (91,
Tenure long-term (5+
(No maturity) term (1–30 years) days to 1 year) 182, or 364 days)
years)
Variable
Fixed Fixed interest
(Dividends + Fixed but lower Lower but risk-
Returns dividends (if (coupon
Capital than bonds free returns
declared) payments)
Gains)
Moderate
(Dividend Low to moderate Low (Bank’s Very low
High (Market
Risk Level payments (Credit rating creditworthiness (Government-
fluctuations)
depend on dependent) ) backed)
profits)
Voting
Yes No No No No
Rights
Can be
Some bonds are
Convertibili Non- convertible or
convertible into Non-convertible Non-convertible
ty convertible non-
equity
convertible
High (Traded Moderate Moderate to high Moderate
High (Highly
Liquidity on stock (Less traded (Depends on bond (Transferable
liquid)
exchanges) than equity) market) but less traded)
No (For unsecured
Collateral
No No bonds), Yes (For No No
Required
secured bonds)
No direct No direct Some tax-exempt
Tax Benefits Taxable Tax-free
benefits benefits bonds exist
High-risk, Income- Short-term
Conservative Ultra-safe, short-
Investment long-term focused, investors
investors seeking term parking of
Suitability growth moderate-risk looking for
fixed returns funds
seekers investors secure returns
Preferred
Common RBI-issued
stocks (e.g., Corporate Bonds,
Example stocks (e.g., Negotiable CDs Treasury Bills
Convertible Government
Instruments Apple, issued by banks (91-day, 182-day,
Preferred Bonds, Debentures
Tesla,Tata) 364-day)
Shares)
 Shares Debentures Bonds

Shares are fractions of the Debentures are medium or long- Bonds are debt instruments

company's capital. term debt instruments that a that private and public

company issues to borrow capital. companies issue to borrow

capital.

Shareholders are company Those who lend money to the Those lending money are the
owners who own an equal company are debenture holders. creditors and, therefore, bond

proportion of the company of owners.

the shares held by them.

The company pays Debenture holders receive interest Bond owners receive interest

dividends to its shareholders payments periodically. It depends on payments on an accrual basis.

when it makes profits. the issuing company's performance. It doesn't depend on the

company's performance.

Performance of shares is Debentures are risky investments as Bonds are considerably safer

highly dependent on market usually there is no collateral to back investment option as it is

fluctuations. them up. An investment decision is backed by collateral.

made based on reputation and credit

ratings.

Shares have high liquidity as Debentures do not have much Bonds have the lowest

they can be sold and liquidity when compared to shares. liquidity as these are long-

purchased at any time on term debt instruments.

stock exchanges.

Shares do not have any credit Debentures receive credit ratings Bonds are reviewed

rating. from credit rating agencies after periodically and given credit

review. ratings by credit rating

agencies.
Financial Markets: Meaning, Characteristics, and Classification
Market Type Details Examples and Characteristics
Primary Market: New securities issued via
IPOs.
Capital Long-term market for raising
Secondary Market: Trading of existing
Market and investing funds.
securities (e.g., stock exchanges like NSE
and BSE).
Instruments include:
Short-term market for
1. Treasury Bills.
Money Market financial assets with maturities
2. Commercial Papers.
up to one year.
3. Certificates of Deposit.
Foreign Facilitates currency exchange Participants include commercial banks,
Currency for trade, investment, or central banks, multinational corporations,
Market speculation. and foreign investors.

Meaning of Financial Markets

Financial markets are platforms where buyers and sellers trade financial instruments. They
serve to allocate resources, facilitate the transfer of capital, and manage risk in the economy.

Characteristics of Financial Markets

1. Liquidity: Ensures that assets can be bought or sold easily.

2. Price Discovery: Helps determine the prices of financial instruments based on supply
and demand.
3. Transparency: Provides public access to market information.
4. Efficiency: Facilitates the optimal allocation of resources.
5. Regulation: Ensures that market activities comply with established norms to prevent
fraud and maintain stability.

Classification of Financial Markets

1. Capital Market:
o Meaning: The market for long-term debt and equity securities.
o Instruments: Bonds, stocks, debentures, etc.
o Submarkets:
 Primary Market: Where new securities are issued.
 Secondary Market: Where existing securities are traded.
o Function: Provides long-term capital for businesses and governments.
2. Money Market:
o Meaning: A market for short-term, highly liquid instruments with maturities of
one year or less.
o Instruments: Treasury bills, commercial papers, repurchase agreements, etc.
o Function: Provides short-term financing and liquidity management.
3. Foreign Currency Market (Forex Market):
o Meaning: The market for trading currencies.
 o Function: Facilitates international trade and investment by determining the
exchange rates of currencies.
o Instruments: Currency futures, options, and swaps

Comparison

Foreign Currency Market

Feature Capital Market Money Market
(Forex)
Short-term funding and
Long-term funding Facilitates exchange of Indian
liquidity management
for businesses and Rupee (INR) with foreign
Purpose for banks,
government projects currencies for trade and
corporations, and
in India investment
government
- Stocks (Equity - Treasury Bills (T- - Currency Pairs (e.g.,
Securities) bills) USD/INR, EUR/INR)
- Bonds
- Certificates of
Instruments (Government and - Forex Futures and Options
Deposit (CDs)
Corporate)
- Debentures - Commercial Papers
- Forex Spot Transactions
(Unsecured Bonds) (CPs)
- 91-day T-bills issued
- BSE: Shares of - USD/INR for
by the Government of
Tata, Infosys, TCS importing/exporting goods
India
Examples
- NSE: SBI Bonds, - Bank CDs from
- EUR/INR for international
Government of ICICI Bank, HDFC
transactions
India Bonds Bank
Very short-term (minutes to
Long-term (over 1 Short-term (under 1
Time Horizon hours) to medium-term
year) year)
(days/weeks)
- Institutional
- Banks, Financial - RBI, Commercial Banks,
Investors (e.g.,
Participants Institutions, Corporations, Speculators,
Mutual Funds,
Corporations Forex Traders
Pension Funds)
- Individual - Reserve Bank of - Currency Exchanges and
Investors India (RBI) Forex Dealers
Higher risk (due to
Low risk (due to short-
long-term High risk (due to currency
Risk term, high-quality
investments and volatility and leverage)
instruments)
market fluctuations)
High potential
Variable returns (depends on
returns (e.g., growth Low returns (due to
Return forex fluctuations and trading
in stocks and bond short-term nature)
strategies)
yields)
Moderate to high Very high (high Extremely high (one of the
Market
(depending on the demand for short-term largest financial markets
Liquidity
instrument) instruments) globally)
 Foreign Currency Market
Feature Capital Market Money Market
(Forex)
- Buying shares of - Purchasing T-bills or - Trading USD/INR for
Tata or SBI Bonds Bank CDs import/export transactions
Example - Investing in
Transactions Government of - Corporate firms - Speculating on currency
issuing Commercial movements using Forex
India Savings
Papers (CPs) Futures/Options
Bonds
- Securities and
Market - Reserve Bank of
Exchange Board of - RBI, SEBI, Forex Dealers
Regulators India (RBI)
India (SEBI)
Financial Institutions: Meaning, Characteristics, and Classification
Institution Type Description Examples and Functions
Institutions that accept
Regulated by the Reserve Bank of
deposits and offer loans,
Commercial Banks India (RBI).Examples: SBI, HDFC
along with other financial
Bank, ICICI Bank.
services.
Specialize in underwriting,
issuing securities, and
Investment/Merchant Example: Kotak Mahindra Capital
advisory services for
Banks Company, ICICI Securities.
corporate mergers,
acquisitions, or IPOs.
Examples: Bombay Stock Exchange
Platforms for trading
(BSE), National Stock Exchange
financial securities like
Stock Exchanges (NSE).Functions include liquidity,
shares, bonds, and
price discovery, and investor
derivatives.
protection.

Meaning of Financial Institutions

Financial institutions are entities that provide financial services like lending, borrowing, and
facilitating investment. They serve as intermediaries between savers and borrowers.

Characteristics of Financial Institutions

1. Intermediation: Facilitating the flow of funds from savers to borrowers.

2. Risk Management: They provide services like insurance, hedging, and diversification.
3. Regulation: They are heavily regulated to ensure financial stability.
4. Capital Mobilization: Collect funds from individuals and institutions to allocate them
to productive uses.

Classification of Financial Institutions

1. Commercial Banks:
o Meaning: Banks that provide services such as accepting deposits, making loans,
and offering basic investment products.
o Characteristics:
 Offer deposit accounts (savings, current)
 Lend to businesses and individuals
 Provide payment and money transfer services
o Examples: State Bank of India (SBI), HDFC Bank, ICICI Bank.
2. Investment/Merchant Banks:
o Meaning: Financial institutions that assist companies in raising capital and
provide advisory services for mergers, acquisitions, and other corporate
strategies.
o Characteristics:
 Specialize in underwriting new securities
  Offer advisory services for mergers and acquisitions
 Deal with institutional investors
o Examples: JM Financial, Kotak Mahindra Capital Company.
3. Stock Exchanges:
o Meaning: Organized platforms for buying and selling securities such as shares,
bonds, and derivatives.
o Characteristics:
 Provide a regulated and transparent environment for securities trading
 Ensure liquidity and price discovery
 Operate under the oversight of regulators like SEBI
o Examples: Bombay Stock Exchange (BSE), National Stock Exchange (NSE).
 EXTRA

https://www.rbi.org.in/commonman/English/Scripts/FAQs.aspx?Id=711#1
Government Securities Market in India – A Primer

1. What is a Bond?

1.1 A bond is a debt instrument in which an investor loans money to an entity (typically
corporate or government) which borrows the funds for a defined period of time at a variable or
fixed interest rate. Bonds are used by companies, municipalities, states and sovereign
governments to raise money to finance a variety of projects and activities. Owners of bonds are
debt holders, or creditors, of the issuer.

What is a Government Security (G-Sec)?

1.2 A Government Security (G-Sec) is a tradeable instrument issued by the Central

Government or the State Governments. It acknowledges the Government’s debt obligation.
Such securities are short term (usually called treasury bills, with original maturities of less than
one year) or long term (usually called Government bonds or dated securities with original
maturity of one year or more). In India, the Central Government issues both, treasury bills and
bonds or dated securities while the State Governments issue only bonds or dated securities,
which are called the State Development Loans (SDLs). G-Secs carry practically no risk of
default and, hence, are called risk-free gilt-edged instruments.

a. Treasury Bills (T-bills)

1.3 Treasury bills or T-bills, which are money market instruments, are short term debt
instruments issued by the Government of India and are presently issued in three tenors, namely,
91 day, 182 day and 364 day. Treasury bills are zero coupon securities and pay no interest.
Instead, they are issued at a discount and redeemed at the face value at maturity. For example,
a 91 day Treasury bill of ₹100/- (face value) may be issued at say ₹ 98.20, that is, at a discount
of say, ₹1.80 and would be redeemed at the face value of ₹100/-. The return to the investors is
the difference between the maturity value or the face value (that is ₹100) and the issue price
(for calculation of yield on Treasury Bills please see answer to question no. 26).

b. Cash Management Bills (CMBs)

1.4 In 2010, Government of India, in consultation with RBI introduced a new short-term
instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches in
the cash flow of the Government of India. The CMBs have the generic character of T-bills but
are issued for maturities less than 91 days.

c. Dated G-Secs

1.5 Dated G-Secs are securities which carry a fixed or floating coupon (interest rate) which is
paid on the face value, on half-yearly basis. Generally, the tenor of dated securities ranges from
5 years to 40 years.
1. Derivatives
 What Are They?
o Contracts that derive their value from an underlying asset or benchmark.
o The underlying asset could be a stock, bond, commodity, currency, or even
interest rates or market indexes.
 Types of Derivatives:
o Futures: Obligation to buy/sell an asset at a fixed price on a future date.
o Options: Right (but not obligation) to buy/sell an asset at a fixed price within a
specified time.
o Swaps: Agreements to exchange cash flows (e.g., fixed vs. floating interest
rates).
o Forwards: Customized contracts similar to futures but traded OTC.
 Participants:
o Hedgers: Use derivatives to reduce risk (e.g., farmers hedge crop prices).
o Speculators: Trade derivatives to profit from price changes.
o Arbitrageurs: Exploit price differences between markets.
 Risks: High risk due to leverage, requiring careful management.
 Example:
An airline buys oil futures to lock in fuel costs, reducing the risk of fluctuating oil
prices.

Key Terms:

 CE (Call Option): A type of option that gives you the right to buy the underlying asset
at a specified price (strike price) before or on the expiration date.
 Premium: The price you pay to purchase the option.
 Strike Price: The price at which the underlying asset can be bought.
 Spot Price: The current market price of the underlying asset.

Scenario Analysis:

1. **If the Call Option Expires In the Money (ITM):

o A call option is ITM when the spot price of the underlying asset is above the
strike price at expiration.
o If you do not sell the option before expiration:
 The intrinsic value (Spot Price - Strike Price) will be credited to your
account if it's cash-settled.
 If it's a physical settlement market, you'll need to take delivery of the
underlying asset (and pay the strike price).
 Your premium won't be zero as you’ll recover some value based on the
option's intrinsic value.
Example:
o Strike Price: ₹100
o Spot Price: ₹120
o Intrinsic Value: ₹120 - ₹100 = ₹20
o If you let it expire, you gain ₹20 (less any transaction or settlement fees).

2. **If the Call Option Expires Out of the Money (OTM):

o A call option is OTM when the spot price is equal to or below the strike price
at expiration.
 oIf you do not sell the option, it will expire worthless because there is no value
in exercising the right to buy at the strike price when the market price is equal
to or lower.
o Your premium will become zero, and you will lose the entire amount you paid
for the option.
Example:

o Strike Price: ₹100

o Spot Price: ₹90
o Intrinsic Value: ₹0
o The option expires worthless, and you lose the premium paid.
Conclusion:

 If the call option is ITM, it has value at expiration, and you'll recover some or all of the
intrinsic value depending on the settlement method.
 If the call option is OTM, it will expire worthless, and the premium paid will be lost.

To avoid losing the entire premium, it's common practice to close the position (sell the option)
before expiration if you believe the option might expire worthless. This strategy helps you
recover some value if the premium still has time value remaining.

2. Commodities
 What Are They?
o Tangible goods or raw materials used in production or consumption.
o Divided into hard commodities (natural resources like gold, oil) and soft
commodities (agricultural products like wheat, coffee).
 Market Features:
o Spot Market: Immediate delivery and payment.
o Futures Market: Standardized contracts for future delivery.
 Uses:
o Producers (e.g., miners, farmers) sell commodities for revenue.
o Manufacturers (e.g., food companies, refineries) buy commodities as inputs.
o Investors trade commodities to diversify portfolios or hedge inflation risks.
 Example:
A coffee producer sells futures contracts to stabilize income regardless of market price
fluctuations.
3. Bonds
 What Are They?
o Fixed-income securities representing loans made by investors to issuers (e.g.,
governments or corporations).
 Key Features:
o Principal: The amount borrowed.
o Coupon Rate: Regular interest payments made to bondholders.
o Maturity: When the bond’s principal is repaid.
o Credit Rating: Assesses the issuer’s ability to repay (AAA being the highest).
 Types of Bonds:
o Government Bonds: Issued by governments (e.g., U.S. Treasury Bonds).
o Corporate Bonds: Issued by companies to finance operations or projects.
o Municipal Bonds: Issued by local governments.
 o Convertible Bonds: Can be converted into equity under certain conditions.
 Participants:
Investors looking for steady income with lower risk compared to equities.
 Example:
A retiree invests in municipal bonds to receive tax-free interest income.
4. Equities (Stocks)

 What Are They?

o Shares representing partial ownership in a company.
o Equity holders have voting rights and a claim on the company’s profits and
assets.
 Market Characteristics:
o Traded on stock exchanges (e.g., NYSE, NASDAQ).
o Prices fluctuate based on supply, demand, and company performance.
 Earnings Potential:
o Dividends: Regular payments from company profits.
o Capital Gains: Profit from selling shares at a higher price than purchased.
 Risks:
Equity investments are subject to market volatility and company-specific risks.
 Participants:
Retail and institutional investors seeking higher returns over the long term.
 Example:
An investor buys shares of Apple, anticipating growth in the technology sector.

5. Currencies

 What Are They?

o Legal tender used as a medium of exchange in various economies.
 Trading Market:
o The foreign exchange (Forex) market is the largest and most liquid financial
market, trading trillions of dollars daily.
 Market Participants:
o Hedgers: Protect against currency risk (e.g., exporters/importers).
o Speculators: Profit from exchange rate fluctuations.
o Central Banks: Influence currency value through monetary policy.
 Key Concepts:
o Exchange Rate: Value of one currency relative to another.
o Pair Trading: Currencies are traded in pairs (e.g., USD/EUR).
 Example:
A U.S. importer buys Japanese goods and hedges against yen appreciation using
currency futures.

How They Relate

 Derivatives: Often based on commodities, bonds, equities, or currencies.

 Commodities: Can be traded directly or as the underlying asset of derivatives.
 Bonds: Provide stable returns and act as a benchmark for pricing derivatives.
 Equities: Represent ownership, with derivatives like options based on stock prices.
 Currencies: Traded in Forex markets, often used to hedge international investments or
trade.
Comparison Table
Feature Derivatives Commodities Bonds Equities Currencies
No No
Prices depend on Determined by
Yes production levels, company
Underlying
(depends on geopolitical No earnings, revenue, No
Value
asset) events, and assets, liabilities,
consumption and growth
trends. prospects.
Ownership
No No No Yes (partial) No
Claim
High
Risk Level High (volatile) Low/Medium Medium/High Medium
(leveraged)
Income Interest Exchange
None None Dividends, growth
Source (coupon) rate changes
Hedging, Trade, Income, Ownership, Trade,
Purpose
speculation consumption capital growth hedging

Each plays a unique role in financial markets and serves different purposes for investors,
producers, and traders.