Introduction to Financial Markets

and Institutions
Course Facilitator:

Dr. Rishi Manrai

Associate Professor
 Perfect Financial Markets

Large numbers of savers and investors operate in the

market.
Savers and investors are rational.
Information is available.
There are no transaction cost.
Financial Assets are infinitely divisible.
Savers and investors have homogeneous expectation.
There are no taxes.
 Financial System
The word "system", in the term "financial system",
implies a set of complex and closely connected or
interlined institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy.

The financial system comprises of a variety of

intermediaries, market, and instruments. It provide the
principal means by which savings are transformed into
investments.
 Financial System
The economic development of any country depends
upon the well organized financial system

 Financial system is a system which supplies the

necessary financial inputs for the production of goods
and service to improve the standard of life and well
being of the nation.
 Financial System and Economic
Development
Financial system are of crucial significance to capital
formation. The process of capital formation involves
three
distinct, although inter-related activities.
 Saving : the ability by which claims to resources are
set aside and become available for the other purpose.
 Finance : The activity by which claims to resources
are either assembled from those released by domestic
savings, obtained from abroad etc.
Investments : the activity by which resources are
actually committed to production.
Formal and Informal Financial system

Formal Financial Sector is characterized by presence

of an organized, institutional and regulated system
which caters the financial needs of the modern spheres
of the economy.

Informal Financial Sector is an unorganized, non-

institutional and non-regularized system dealing with
the traditional and rural spheres of the economy.
 Informal financial system
Informal Financial Sector is an unorganized, non-
institutional and non-regularized system dealing with
the traditional and rural spheres of the economy.

Advantages: 1). Low Transaction, 2). Minimum

default risk, 3). Less of formalities, 4). Less time
consuming, 5). Fulfillment of urgent requirements.

Disadvantages: 1). Unregulated 2). High rates of

interest 3). Less transparency of procedures, 4). Rise to
black money, 5). Exploitation of victims.
 Financial
Instruments
 Financial Instruments
Financial asset or the financial instrument is the claim
of money, against a particular person or institution, at a
future date, for a specific amount;
A financial asset may also include the claim of periodic
payment in form of interest or dividend, Im plies
Debentures, shares, bonds and notes;
1. Primary securities: Equity, Debentures;
2. Secondary securities: Bank deposits, Insurance
policies and Mutual funds
 Characteristics of Financial
Instruments

Liquidity
 Collateral value
 Transferability
 Maturity period.
 Transaction costs.
 Risk
 Future trading
 MEANING OF FINANCIAL
INSTRUMENTS
Financial instruments are financial contracts of different
nature made between institutional units. These comprise the
full range of financial claims and liabilities between
institutional units, including contingent liabilities like
guarantees, commitments, etc.
Financial instruments are contracts that gives rise to
financial asset to one equity, and a financial liability or and
equity instrument to another entity.
 Financial instruments include primary financial instruments
like receivables, payables loans and advances, debentures
and bonds, investment in equity instruments, cash and bank
balances, derivative instruments like options, futures,
swaps, forward rate agreement(FRA) etc.
 TYPES OF FINANCIAL
INTRUMENTS
 Deposits
 SDRs
 Borrowings
 Loans
 Shares and other equity
 Debentures or bonds
 Other account receivables and payables
 Financial derivatives
 Letter of guarantee
 Letter of credit
 Financial commitments
 Pledged financial assets
 Deposits

Deposits include all claims on the central bank and other

depository corporations, represented as bank deposits.
 In some cases, other financial corporations may also
accept deposits.
Deposits of depository corporations can fall into two
categories:
Transferable deposits and other deposits (non-
transferable deposits).
Normally, separate sub-categories are used for deposits
denominated in national currency and for those in
foreign currency.
 SDRs (Special Drawing Rights)
 SDRs are international reserve assets created by the IMF and
allocated to member countries to supplement existing official
reserves.
 SDR holdings represent unconditional rights to holders to obtain
foreign exchange or other reserve assets from other IMF
members
 SDRs are not treated as the IMF’s liability.
 SDRs are held only by the IMF member countries and by a
limited number of international financial organizations.
 SDR holdings are held exclusively by official authorities, which
are normally the central banks.
 Transactions in SDRs between the IMF members or between the
IMF and its members are treated as financial transactions.
 BORROWINGS
Normally, borrowings are not considered as a separate
financial instrument. Borrowing is carried out through
other financial instruments, for example, through loans,
deposits, etc.

The lender gives the borrower money under the loan

agreement, and the borrower undertakes to return the
received amount to the lender as and when specified by
the agreement.
 LOANS
 Loans are financial assets that are created when a creditor lends funds directly
to a debtor (borrower), evidenced by non-negotiable documents.

 Short-term loans – short-term loans normally involve loans with maturity of

one year or less. All loans that will mature upon request are classified as short-
term, even if it is expected that these loans will not be repaid within one year.

 Medium-term loans - depending on practices applied in countries, loans with

maturity from 1 to 5 years are classified as medium-term loans.

 Long-term loans – long-term loans include the loans with maturity that
exceeds those of short- and medium-term loans.

 According to statistical classification, repo agreements, financial leasing,

factoring operations and other similar agreements are classified under the
category of loans.
 SHARES AND OTHER EQUITY
 Shares are financial instruments that represent or provide evidence on ownership
rights of the holders over enterprises or organizations, including financial
institutions. Shares and other equity comprise all instruments and records
acknowledging, after the claims of all creditors have been met, claims on the
residual value of a corporation (companies, corporations).

 Normally, these instruments entitle the holders both of distributed profits of

enterprises or organizations, and the residual value of the assets in the event of
liquidation. Ownership of equity is usually evidenced by shares, stocks,
participation's and similar documents. This category also includes preferred shares
that provide for participation in the residual value on dissolution of an enterprise.

Types of equity are:

 Ordinary shares that provide for ownership right in an enterprise or corporation;
 Preferred shares that provide right for claim over residual value of an enterprise,
 Equity participation in limited liability companies.
 DEBENTURES OR BONDS
 The term ‘creditorship securities’ also known as ‘debt capital’
represents debentures and bonds. They occupy a significant
place in the financial plan of the company. A debenture or a
bond is an acknowledgement of A debt.
 It is a certificate issued by a company under its seal
acknowledging a debt due by its holders.
Types of debentures and bonds
I. Unsecured and secured debentures
II. Redeemable and irredeemable debentures
III. Zero interest bonds/debentures
IV. Zero coupon bonds
V. Guaranteed debentures
VI. Collateral debentures
 OTHER ACCOUNT RECEIVABLES
AND PAYABLES
 Accounts receivable/payable include trade credits, advances and other
receivables or payables. Trade credits comprise trade credit extended
directly to buyers of goods and services (enterprises, government,
NPISHs, households, and nonresidents).
 Advances are prepayments made for work that is in progress or for
purchase of goods and services. Any agreement, which does not assume
direct payment by cash or other financial instrument to purchase goods
or services, will create a trade credit extended by the seller to the buyer.
 Here, it does not involve loans acquired to finance the trade credit since
these credits are classified under the category of loans.
 This category includes only direct trade credits and advances.
 This category includes also items such as debtors and creditors, tax
liabilities and other accounts receivable/payable.
 FINANCIAL DERIVATIVES
 Financial derivatives are financial instruments that are linked to specific assets (other
financial instruments, goods).
 By nature, these instruments are similar to contingent instruments.
 Claims and liabilities related to financial instruments will arise after a specific period
of time.
 In this case, contingency of an instrument relates only to the time regardless of
occurrence of any other event or condition.
 Derivative instruments are not considered a financial claim or liability for the holder
thereof at the given moment.
 However, financial derivatives can be traded in the market and thus they will obtain a
market value, which will depend on the market price of the underlying financial or
nonfinancial asset.
 Thus, the price of a derivative instrument “derives” from the price of the underlying
asset.
 In the event when the contract price of the underlying financial asset is preferable to
the current market price, the derivative would have a positive market value.
 If a financial derivative instrument has a market value it must be recorded in the
balance sheet as a financial asset.
 FORWARDS
In a forward contract, the counterparties agree to exchange,
on a specified date, a specified quantity of an underlying
item (financial or real asset) at an agreed-upon contract
price.

Execution of a forward contract is mandatory but only in

the case of expiry of the period specified in the contract.
Each of the counterparties has both claim and liability upon
execution.

The net value of the instrument (difference between claims

and liabilities) is zero.
 FUTURES

A future contract is an agreement between seller and the

buyer that calls for the seller to deliver to the buyer a
specific quantity, grade of an identified commodity at a
fixed time in the future and at a price agreed to when the
contract is first entered into.
 OPTIONS
The buyer of an option acquires the right but not the obligation
to purchase or sell a specific asset.
Options too, contain contingency: the acquirer of an option
may not wish to exercise it.
The buyer pays a certain amount to the seller of the option and
thus acquires the right but not the obligation to sell or purchase
a specified item at an agreed-upon price in a specified period.
The buyer of an option can sell the option contract, i.e. the
right to exercise the option, whereby the option obtains a
market value.
The statistical recording of options should be carried out in the
same way as for the forwards.
 SWAPS
A swap represents a spot purchase (sale) of a financial
asset with a condition of forward sale (purchase).
 Swap agreement is a type of a forward, in which the
parties agree to exchange different currencies, that is to
buy (sell) any currency for another currency in spot
market and concluding at the same time a repurchase
agreement on sale (purchase) of these currencies in
forward market at prices determined beforehand, pursuant
to the rules specified.
Types of SWAPs
 Interest rate Swaps
 Currency Swaps
 LETTER OF GUARANTEE
Guarantee involves an obligation by the economic
entity to assume the other entity’s financial obligation
if that other party defaults.

To issuer, a guarantee is not treated as a financial

liability as far as the party, to whom the guarantee has
been issued, has not shown its inability to meet such a
liability.

Therefore, until availability of this condition, letters of

guarantee will be recorded as off-balance sheet items.
 LETTER OF CREDITS
Letter of credit is an obligation to make payment
against documents received. The amounts to be paid
upon receipt of the documents become liabilities of the
bank.

Letters of credit are used to finance international trade

operations
 FINANCIAL COMMITMENTS
Financial commitments involve contracts between
institutional units by which the entities make arrangements
on specific financial transactions to be carried out in some
future time.
The party assuming liabilities usually is obliged to provide
financial assets to the other party if specific conditions are
met.
Unlike the letters of guarantee whereby the issuer of
guarantee assumes liability of an entity, the issuer of
commitment will be responsible for fulfilment of the terms
of the contract, in case of the commitments. Nonfinancial
commitments will not be treated as financial instruments.
 PLEDGED FINANCIAL ASSETS
 There is a common practice to provide loans against a certain
financial asset taken as collateral.
 The residual maturity of the pledged asset should be longer
than the duration of the loan.
 Securities, deposits, currency, shares, and similar assets can
qualify as pledged financial assets against loans.
 Financial assets are returned to the original owner as the loan
is repaid.
 Thus, the risks associated with change in market value of
pledged financial asset will stay with the original owner
thereof (the borrower) throughout the period of the
collateralized loan agreement.
Inflation Adjusted Bonds(IABs)- These are the bonds
on which both interest as well as principal are adjusted
in line with the price level changes or the inflation rate.
WEAKNESSES OF INDIAN FINANCIAL
SYSTEM
Lack of co-ordination among financial institutions

 Dominance of development banks in industrial

finance

 Inactive and erratic capital market

 Unhealthy financial practices

Monopolistic market structures

THANK YOU
VERY MUCH!!