Introduction To Financial Markets PDF

CHAPTER 1 INTRODUCTION TO FINANCIAL MARKETS LEARNING OUTCOMES After going through the chapter student shall be able to understand:  Introduction to Financial Markets  Role of Financial Market in Ec...

CHAPTER 1 INTRODUCTION TO FINANCIAL MARKETS LEARNING OUTCOMES After going through the chapter student shall be able to understand:  Introduction to Financial Markets  Role of Financial Market in Economic Development of a country  Stakeholders in Financial Market (Domestic and Global)  Indian Financial Market Scenario © The Institute of Chartered Accountants of India  1.2 1.2 FINANCIAL SERVICES AND CAPITAL MARKETS CHAPTER OVERVIEW Introduction Introduction to Financial Market Role of Financial Market in Economic Development Stakeholders in Financial Market (Domestic and Global) Indian Financial Market Scenerio © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.3 1.3 1. INTRODUCTION TO FINANCIAL MARKETS Stock Markets Foreign Bond Exchange Markets Markets Insurance Financial Commodity Markets Markets Markets Futures Money Markets Markets Derivatives Markets Financial markets are a marketplace that provides an avenue for the sale and purchase of financial assets such as equity stocks, bonds, foreign exchange, commodities, derivatives, etc. 1.1 Major types of financial markets 1.1.1 Stock market The stock market is the market for trading in equity stocks of companies. Typically, dividend yield in stocks is on the lower side, as dividend is declared as a percentage of the face value of the stock whereas the price in the secondary market runs up. That is, as a percentage of market price, the return to the investor is on the lower side. Gains come from capital price appreciation in the secondary market. This market is volatile, as the price in the secondary market reflects expectations going forward on the economy and corporate earnings. 1.1.2 Bond market The bond market offers an avenue for companies and the government to raise money to finance a project or a deficit, with a defined repayment timeline. In a bond market, investors buy bonds from a company, and the company returns the amount of the bonds on the stipulated date, along with the coupon or interest payment as agreed. © The Institute of Chartered Accountants of India  1.4 1.4 FINANCIAL SERVICES AND CAPITAL MARKETS 1.1.3 Commodities market The commodities market is a market where traders and investors buy and sell natural resources or commodities such as corn, oil, pulses, meat, gold, etc. Prices for goods that will be delivered at a specific future date are determined in the present on the commodities future market. 1.1.4 Currency Markets The currency market is a market for traders of currencies. It is a boon to the importers and exports and others having foreign currency exposure. It provides the opportunity for participants to hedge their currency exposures, provides depth to the market, making cross currency transactions and hedging a reality. 1.1.5 Money Market ♦ It is a market for short term source of funds. ♦ Money market instruments have maturity of less than 1 year. ♦ The basic objective is to manage liquidity in the economy. ♦ The RBI along with other commercial banks are the key players in this market. ♦ It plays an important part in controlling inflation. 1.1.6 Derivatives market This market deals in derivatives or contracts whose value is based on the market value of the asset being traded, called the underlying. The commodities futures mentioned above are an example of a derivative. Currency and equity derivatives are popular. Further, according to one study, India and China top the world’s commodity market. © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.5 1.5 Source: https://www.accountingfoundation.org/jsp/Foundation/Page/FAFSectionPage&cid=1351027541272 1.2 Importance of Financial Markets There are many social benefits that financial markets facilitate, including: ♦ They provide individuals, companies, governments, and quasi-government organizations access to capital. ♦ People with surplus funds for investment get channels for investment and are assured of fair treatment as there is a regulator i.e., transfer of funds from surplus units to deficit units. For instance, people with extra money access the stock market despite being aware of the risk inherent in it as they look for higher return and assured of transparency in the market because of the presence of SEBI. © The Institute of Chartered Accountants of India  1.6 1.6 FINANCIAL SERVICES AND CAPITAL MARKETS ♦ Financial markets create jobs as there are many people involved in direct and indirect activities. For instance, the involvement of the brokers, underwriters, merchant bankers, custodians, depositories etc. in the financial markets. 1.3 Size of the Global Financial Market The biggest markets are those of derivatives, though conventionally we tend to think of Equity or Bond markets as large. Globally, derivatives markets are much more developed. Source: Google to https://topforeignstocks.com/2011/08/23/how-big-is-the-global-financial-industry/ The chart above shows that the notional amount of financial derivatives outstanding is much higher than the traded volume of stocks and bonds. 2. ROLE OF FINANCIAL MARKET IN ECONOMIC DEVELOPMENT OF A COUNTRY For economic development, a country needs capital, and the capital markets discussed above e.g., equities, bonds, etc. channelize those resources. Through the financial market or capital market system, funds flow from those who have surplus funds to those who have a shortage of funds, either by direct, market-based financing or by indirect, bank-based finance. Without a properly functioning stock market, price discovery of corporations would not happen and resource mobilization through IPOs would be hampered. How a financial market helps to boost an economic of a country has been highlighted in the following points: © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.7 1.7 The financial market is a mode of channelizing savings to investments. It helps in creating more capital for the industries. Which in turn creates more jobs because of the increase in production. More jobs increase the standard of living which leads to more demand for goods and services. Which further leads to more capex and the process goes on. Further this process helps generate more taxes for the Government. More tax collection facilitates more spending by the Government. Which in turn creates more jobs and more demand again. And the process goes on. 2.1 Functions of Financial Markets The role of financial markets in the success and strength of an economy is immense. Some important functions of financial markets are:  Puts savings into more productive use Money in the savings account should be put to productive use. Financial institutions like banks loan it out to individuals and companies that need it for say home loan, study loan, business purposes, big projects, etc. Further, savings as such do not have any meaning; it is investment that puts it to productive use.  Determines the price of securities Once a security is listed, buyers and sellers trade in it, and the traded price reflects the prospects of the company whose instruments are being traded. This is called price discovery. Prices of securities are determined in financial markets, which is an important function.  Makes financial assets liquid Buyers and sellers can decide to trade their securities anytime, provided there is a counterpart. Financial markets provide this avenue, and that creates liquidity in the security. This imparts liquidity to investors and incentivizes them to invest.  Lowers the cost of transactions In financial markets, various types of information regarding securities can be acquired without the need to spend. The Exchanges and market participant associations disseminate relevant © The Institute of Chartered Accountants of India  1.8 1.8 FINANCIAL SERVICES AND CAPITAL MARKETS information. The companies also can disseminate information, but they would put forth only what they want to propagate, not what is useful for investors. Source: Google to https://slideplayer.com/slide/5737595/ Financial markets facilitate the flow of savings and investment in the economy for generation of capital and the production of goods and services. 2.2 The linkages in financial flows As we see in the diagram above, households save and invest through financial institutions. Apart from households, the corporate or business sectors also may have surplus from time to time, which is invested through financial institutions. For economic development of a country, the business sector and the government need resources, which are mobilized by the financial institutions and markets? The government may need to borrow from the market, which is facilitated by financial markets. Resources may be mobilized from abroad as well, depending on the relative growth potential of the two economies. The resources, i.e., funds, are deployed in the real economy by the government and private sector business firms, for creation of capacities and for running the wheel i.e., necessary revenue expenditure. The production of business firms is consumed by the household sector. Government © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.9 1.9 taxes are collected from the business sector. Economic development happens through increasing the size of the pie shown above, which is denoted by the GDP growth rate, by generating efficiencies in the production process and increasing the speed of the cycle. While generating efficiencies is the job of the participants in the production process, the resource that moves the wheel is finance. Financial markets provide this resource. It must be done at an optimum cost; it should be low enough to incentivize producers to raise resources and high enough for households to save. The more efficient financial markets are, the more efficient is this process of price discovery. 2.3 Contribution of market to economy The state of development of the financial markets reflects the state of development of the economy, and vice versa. It is a relationship of symbiosis, as the market and the economy feed from each other. According to Baily and Elliott, there are three major functions of the financial system: Credit Provision - Credit supports economic activity. Governments can invest in infrastructure projects by reducing the cycles of tax revenues and correcting spends, businesses can invest more than the cash they have, and individuals can purchase homes and other utilities without having to save the entire amount in advance. Banks and other financial service providers give this credit facility to all stakeholders. Liquidity provision - Banks and other financial providers protect businesses and individuals against sudden cash needs. Banks provide the facility of demand deposits which the business or individual can withdraw at any time. Similarly, they provide credit and overdraft facilities to businesses. Moreover, banks and financial institutions offer to buy or sell securities as per need and often in large volumes to fulfill sudden cash requirements of the stakeholders. Risk management services - Finance provides risk management from the risks of financial markets and commodity prices by pooling risks. Derivative transactions enable banks to provide this risk management. These services are extremely valuable even though they receive a lot of flak due to excesses during financial crisis. According to Global Financial Development Report of World Bank of 2014, “Fundamentally, financial sector development concerns overcoming “costs” incurred in the financial system. This process of reducing costs of acquiring information, enforcing contracts, and executing transactions results in the emergence of financial contracts, intermediaries, and markets. Different types and combinations of information, transaction, and enforcement costs in conjunction with different regulatory, legal and © The Institute of Chartered Accountants of India  1.10 1.10 FINANCIAL SERVICES AND CAPITAL MARKETS tax systems have motivated distinct forms of contracts, intermediaries, and markets across countries in different times.” According to Levine, “The five key functions of a financial system in a country are: (i) information about possible investments and capital allocation; (ii) monitoring investments and the exercise of corporate governance after providing financing; (iii) facilitation of the trading, diversification, and management of risk; (iv) mobilization and pooling of savings; and (v) promoting the exchange of goods and services.” 3. STAKEHOLDERS IN FINANCIAL MARKET (DOMESTIC AND GLOBAL) Various stakeholders in the financial market can be categorized into following four segments: (i) Primary stakeholders in financial market  Shareholders  Lenders  Companies  Mutual fund Organizations/holders/fund managers (ii) Service providers in financial market  Merchant Bankers  Brokers  Underwriters  Depositories  Custodians (iii) Regulators in financial market  Securities and Exchange Board of India (SEBI)  Reserve Bank of India  Insurance Regulatory and Development Authority of India (IRDAI)  Pension Fund Regulatory and Development Authority (PFRDA) (iv) Administrators to facilitate the financial market © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.11 1.11  Association of Mutual funds of India (AMFI)  Foreign Exchange Dealers Association of India (FEDAI)  Fixed Income Money Market and Derivative Association of India (FIMMDA)  Association of Investment Bankers of India (AIBI) (i) Primary stakeholders in financial market (a) Shareholders: In simple language, shareholders are the owners of a company. So, a shareholder is any person such as an individual, company or other institution who holds at least one share out of the company’s total shares. As shareholders are owners of the company, they benefit when the share prices increase. In the same way, the shareholders lose out when the company’s shares plummet. The shareholders participate in the financial market (secondary market) by buying and selling shares. Their actions depend upon which way the market is behaving. If the market price is low, they tend to buy more shares. On the other hand, if the market price of shares is high, they will sell more shares to make a profit. Thus, they provide the much-needed liquidity in the stock market. (b) Lenders: A lender in relation to a financial market is either a company or any other form of corporation that issues bonds or debentures to make its end meet. Funds are available to another with the expectation that the funds will be repaid, in addition to any interest and/or fees, either in increments or as a lump sum. They also provide the much-needed liquidity in the financial market by facilitating the flow of funds from deficit spending to surplus spending sectors. (c) Corporates: Corporates raise money either through the share market route or through the bond market route. Raising money by issuing shares to the public generally helps the companies to amass huge amounts of capital. It keeps the financial market ticking by enabling mobilization and allocation of saving from the people, be it, individual investors, companies, and institutional investors whether foreign or domestic. However, raising equity share capital has its repercussions. The cost of equity share capital is costly. Moreover, companies must meet a lot of regulatory compliances at the time of initial public offerings which takes a lot of time, energy, and money. But, if the company managed to keep its share prices on the higher side, it will easily get more funds in the future whether through equity or debt. If the company opting to raise funds through the debt route, it has certain advantages and disadvantages. The benefits are lower cost of capital in comparison © The Institute of Chartered Accountants of India  1.12 1.12 FINANCIAL SERVICES AND CAPITAL MARKETS to equity. The debt route also tends to increase the earnings per share (EPS) of the company which consequently leads to escalation of share prices of the company. However, the demerit is that a debt must be repaid along with interest. So, too much debt may lead an organization to financial/default risks and may land it in financial distress. (d) Mutual fund Organizations: A mutual fund is a financial institution or intermediary that pools the savings of investors for collective investment in a diversified portfolio of securities. A fund is ‘mutual’ as all its returns, minus its expenses, are shared by the fund’s investors. A mutual fund serves as a link between the investor and the securities market by mobilizing savings from the investor and investing them in the securities market to generate returns. (ii) Service providers in financial market (a) Merchant Bankers: As per the Securities and Exchange Board of India (Merchant Banker) Regulations, 1992, merchant banker means any person who is engaged in the business of issue management, either by making arrangements regarding selling, buying, or subscribing to securities, or acting as a manager, consultant, or advisor, or rendering corporate-advisory services in relation to such issue management. It is mandatory to appoint a merchant banker in case of a public issue. The functions of merchant banker include – submitting offer documents to SEBI, due diligence i.e., certifying that all the disclosures made in the draft prospectus or letter of offer are true and fair and will enable the investors to make an informed decision etc. Globally, merchant bankers play the same role as discussed above. Some of the top Merchant Bankers in USA are Merrill lynch, Citigroup, Goldman Sachs, J.P. Morgan, and Morgan Stanley. They provide services to top companies in the world. For example, Morgan Stanley has been responsible for hundreds of technology financing and M&A transactions aggregating over $500 billion in value. Further, Goldman Sachs has served all the big names in tech, including Microsoft, Apple, Facebook, Twitter, Ebay and Alibaba. (b) Brokers: Stockbrokers participate in the stock market on behalf of their clients. They buy and sell shares on behalf of the clients on their instructions. To actively participate in the capital market, they should be SEBI registered. So, they facilitate trading in the stock market (secondary market) by undertaking buys and sell transactions on behalf of the client. In the USA, most "brokers" must be registered with the Securities Exchange Commission (SEC) and join a "self-regulatory organization," or SRO. Globally, margin financing is popular, in which, many large broking houses provide financing facilities to clients who borrow money © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.13 1.13 to invest in stocks. Therefore, Stock exchanges monitor the extent to which brokers are lending in line with their net worth. (c) Underwriters: Underwriters are those people who assume the risk of others. In the capital market, in case of new issues, they assume risk by guaranteeing that in case the shares are not subscribed fully by the public, the unsubscribed portion will be subscribed by the underwriter itself. They do it by charging a small fee. So, how do the underwriters make profit? They buy the shares of the company before they are listed on a stock exchange. The underwriters make their profit on the difference in price between what they paid before the IPO and when the shares are offered to the public. (d) Depositories: Depository is an institution which maintains investors account in electronic form. One of the main functions of the Depository is to transfer the ownership of shares from one investor to another whenever the trading of shares takes place. It helps in reducing the paperwork involved in trade, expedites the transfer, and reduces the risk associated with physical shares such as damage, theft, and subsequent misuse of the certificates or fake securities. There are two types of depositories in India which are known as NSDL (National Securities Depository Limited) and CSDL [Central Depository Services (India) Limited]. They interface with the investors through their agents called Depository participants (DPs). DPs could be the banks (private, public, and foreign), financial institutions or SEBI registered trading members. Globally, depositories provide the same set of services as has been rendered by CDSL and NSDL. (e) Custodians: Custodians provide custodial services for safe keeping of securities. Besides safe keeping, they provide other services for a fee (generally 1% of the total volume of transactions) such as physical transfer of share certificates, collecting dividends and interest warrants and conforming to transfer regulations. Besides that, it also updates client status on their investment status. Even though securities are in the custody of depositories, the custodians act as a complementary to them by providing various services as mentioned above. In India, The Stock Holding Corporation of India (SHCIL) and the SBI Share Holding Corporation are the leading custodians. After liberalization in 1991, foreign institutional investors (FIIs) were allowed to invest in the Indian Capital Market. Most of the FII business in India is routed through foreign custodians. According to US laws, no US fund is allowed to use a custodian that does not © The Institute of Chartered Accountants of India  1.14 1.14 FINANCIAL SERVICES AND CAPITAL MARKETS have a capital adequacy of USD 200 million. No Indian custodian meets this requirement. Therefore, only foreign banks operate as custodians for US based FIIs, pension funds, and corporates. Hong Kong Bank, Deutsche Bank, Citi Bank, and Standard Chartered Bank are some leading foreign banks which operate as custodians. (iii) Regulators in financial market (a) Securities and Exchange Board of India (SEBI): SEBI was born in 1992. The basic objective was to protect the interest of investors in securities and promote the development of the securities market. The important objectives of SEBI are: i) Protect the interest of investors in securities. ii) Promotes the development of securities market. iii) Regulating the securities market. Major Roles of SEBI  Regulate the Business in Securities Exchanges.  Register & Regulate intermediaries, collective investment schemes (including Mutual Funds).  Promote & regulate SRO’s. (Self-Regulatory Organizations)  Prohibit unfair & fraudulent trade practices.  Promote investor education & Training  Prohibit Insider trading.  Regulate substantial acquisition of shares & takeover of companies  Inspection/Audit of intermediaries & SRO’s.  Any other function as provided under the SCRA 1956, as delegated by the govt. Outside India: Securities Exchange Commission (SEC) in USA performs more or less the same functions as given to SEBI. But the stark difference is the amount of penalty. SEC can impose an unlimited amount of fine which SEBI cannot. That is the reason SEC has more teeth in comparison to SEBI and acts as an effective deterrent against malpractices in the stock market. (b) Reserve Bank of India: The Reserve Bank of India was established in 1935 with the provision of Reserve Bank of India Act, 1934. Though privately owned initially, in 1949 it was © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.15 1.15 nationalized and since then fully owned by Government of India (GoI). The preamble of the Reserve Bank of India describes its main functions as to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage, RBI is Apex body for regulation of Banking Sector, Controls money supply in India, Banker to Government and banker to banks, Responsible for monetary and fiscal policy, Regulates the debt securities of Government and forex markets. Outside India: Federal Reserve (Fed) in the USA’s policies is primarily driven by growth and employment figures, at the expense of inflation. On the other hand, we have the RBI, whose policies are primarily driven by inflation, at the expense of growth. So which approach is better depending upon the situation of the economy. In the USA and European Union, where the rate of interest is very low encourages industry to borrow at cheaper cost and contributes towards economic development and growth. However, in India, the aim of RBI is to keep the rate of interest high to discourage the industry to borrow large amount of money and consequently to contain inflation. However, recently, due to the Covid–19 pandemic, RBI has lowered the interest rates to give a firm push to the dwindling economic growth, but not by much. The reason is that too much lowering of interest rates will give not contain the rising inflation rate. So, what is the way out to keep interest rates low and bring them down further? One solution is - given the prevailing environment, more proactive bond purchases will be required over a longer period of time to provide support to the bond market and the overall economy. Bank credit growth is expected to rise in the coming quarters even though NBFCs are likely to stay in consolidation mode. Banks are unlikely to be able to support both private credit demand and higher borrowings simultaneously. In this backdrop, the RBI needs to step in proactively to buy bonds and keep longer duration yields from inching higher. (c) Insurance Regulatory and Development Authority of India (IRDAI): IRDA Act was passed in 1999. The main aim of the Insurance Regulatory and Development Authority of India is to protect the interest of holders of Insurance policies to regulate, promote and ensure orderly growth of Insurance industry & for matters connected therewith or incidental thereto. Under this Act, Controller of Insurance under Insurance Act,1938 was replaced by newly established authority called Insurance Regulatory and Development Authority (IRDA). Outside India: In USA, insurance is almost regulated by the individual state governments. In Canada, Office of the Superintendent of Financial Institutions Canada (OSFI)sets the minimum regulatory requirements and expectations to support policyholder and creditor © The Institute of Chartered Accountants of India  1.16 1.16 FINANCIAL SERVICES AND CAPITAL MARKETS protection, giving due regard to the need to allow institutions to compete effectively. As healthy companies are in the best position to protect policyholders and creditors, OSFI is aware of the impact of its requirements and expectations on competition domestically and internationally. Insurance regulators in other jurisdictions pursue similar goals but with different legislative and policy tools and with different economic experiences and conditions. OSFI considers the pace, scope and impact of reforms while renewing the regulatory framework ensures that we can incorporate best practices, and limit – to the extent practical – unintended consequences and an uneven playing field. (Source: Office of the Superintendent of Financial institutions, Canada) (d) Pension Fund Regulatory and Development Authority (PFRDA): The objective of PFRDA is to be a model Regulator for promotion and development of an organized pension system to serve the old age income needs of people on a sustainable basis. Pension systems throughout the world have been under scrutiny over the last couple of decades. Numerous reforms have been carried out to tackle the sustainability and adequacy of pension arrangements in the face of the rising global demographic challenge. Outside India: The main law which governs the establishment, maintenance, and termination of pension plans in the United States is the Employee Retirement Income Security Act (ERISA). Prudential supervision of Australian pension funds started in 1993.The objective of the regulation regarding superannuation aimed at reducing the riskiness of superannuation investments, dealing with retirement incomes policy, equal treatment of members and various other matters. (iv) Administrative authorities to facilitate the financial market (a) Association of Mutual funds of India (AMFI): The Association of Mutual Funds of India (AMFI) is dedicated to developing the Indian Mutual Fund Industry on professional, healthy and ethical lines and to enhance and maintain standards in all areas with a view to protecting and promoting the interests of mutual funds and their unit holders. AMFI, the association of SEBI registered mutual funds in India of all the registered Asset Management Companies, was incorporated on August 22, 1995, as a non-profit organization. As of now, all the 42 Asset Management Companies that are registered with SEBI are its members. © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.17 1.17 Roles of AMFI  It is an advisory body for mutual funds.  It represents Mutual Fund (MF) industry before the Government.  All Asset Management Companies (AMCs) are members of AMFI.  It gives information about all the Mutual Fund schemes on its website.  It is also responsible for framing code of conduct and ethics for AMCs. The Mutual Fund Dealers Association of Canada (MFDA) is the national self-regulatory organization (SRO) that oversees mutual fund dealers in Canada. The MFDA was established in mid-1998 at the initiative of the Canadian Securities Administrators (CSA) in response to the rapid growth of mutual funds in Canada in the late 1980s from $40 billion to $400 billion and recognition by the CSA that the mutual fund industry and investors would benefit from more effective regulation and oversight. As an SRO, the MFDA is responsible for regulating the operations, standards of practice and business conduct of its members and their representatives with a view to enhancing investor protection and strengthening public confidence in the Canadian mutual fund industry. (b) Foreign Exchange Dealers Association of India (FEDAI): Foreign Exchange Dealers Association of India (FEDAI) was set up in 1958 as an Association of banks dealing in foreign exchange in India (typically called Authorised Dealers - ADs) as a self-regulatory body and is incorporated under Section 25 of The Companies Act, 1956. Its major activities include framing of rules governing the conduct of inter-bank foreign exchange business among banks vis-à-vis public and liaison with RBI for reforms and development of forex market. Internationally, forex dealers provide online trading services to allow individuals to speculate on rapidly changing foreign exchange rates. Forex Dealer Members (FDMs) are regulated in the United States by the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA), as well as by national and local regulatory bodies where they conduct business. (c) Fixed Income Money Market and Derivative Association of India (FIMMDA) The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an association of Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers, and Insurance Companies was incorporated as a Company under section 25 of the Companies Act, 1956 on June 3rd, 1998. FIMMDA is a voluntary market body for the bond, money, and derivatives markets. © The Institute of Chartered Accountants of India  1.18 1.18 FINANCIAL SERVICES AND CAPITAL MARKETS FIMMDA has members representing all major institutional segments of the market. The membership includes Nationalized Banks such as State Bank of India, its associate banks and other nationalized banks; Private sector banks such as ICICI Bank, HDFC Bank, IDBI Bank; Foreign Banks such as Bank of America, ABN Amro, Citibank, Financial institutions such as IDFC, EXIM Bank, NABARD, Insurance Companies like Life Insurance Corporation of India (LIC), ICICI Prudential Life Insurance Company, Birla Sun Life Insurance Company and all Primary Dealers. The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. It’s headquarter is in New York City, and has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions. (d) Association of Investment Bankers of India (AIBI) In the early 1990s, the merchant banking industry in India witnessed a phenomenal growth with over 1500 merchant bankers registered with SEBI. To ensure the wellbeing of the industry and for promoting healthy business practices, it became necessary to set up a Self- Regulatory Organization within the industry. This led to the birth of the Association of Investment Bankers of India (AIBI). AIBI was promoted to exercise overall supervision over its members in the matters of compliance with statutory rules and regulations pertaining to merchant banking and other activities. AIBI was granted recognition by SEBI to set up professional standards, for providing efficient services and to establish standard practices in merchant banking and financial services. AIBI, in consultation with SEBI, is working towards improving the compliance of statutory requirement in a systematic manner. AIBI's primary objective is to ensure that its members render services to all its constituents within an agreed framework of ethical principles and practices. It also works as a trade body promoting the interests of the industry and of its members. (Source www.aibi.org.in) Internationally, International Association of Investment Bankers (IAIB) since its inception in 1994 has leveraged its collective expertise, best practice knowledge, industry insights, and global reach to assist clients in executing mergers, acquisitions, divestitures, and strategic partnerships. Its membership is composed of established boutique investment banks from around the world whose primary focus is advising middle market and emerging growth companies. As a highly collaborative group, they hold monthly conference calls and gather twice each year to review creative transaction structures and current market dynamics, as well as to share perspectives © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.19 1.19 on important industry issues. Through these efforts, they can offer their clients a truly differentiated advisory service that leverages the significant transaction experience and domain expertise of their member firms. The International Association of Investment Bankers (IAIB) is an affiliation of investment banking firms from Europe, North America, Australia, and Asia, working together to broaden their reach and leverage their expertise within the global marketplace. Since 1994, the IAIB member firms have utilized this network to offer their clients worldwide access to providers of capital, advisory services and acquirers and sellers of businesses. With this capability, member firms can provide substantial added value to their clients beyond that typically offered by purely domestic advisors. (Source www.iaib.org) 4. INDIAN FINANCIAL MARKET SCENARIO The Indian economy is a developing one and so is the Indian financial market ecosystem. The market is well regulated by SEBI, along with other regulators. The pace of development, in terms of systems and enablers, has been quite fast. Though we are yet to catch up with developed markets like the USA on many parameters, it is because we are still a developing economy. Let us look at the components of the Indian financial market: Source: Google to http://practicemock.com/blog/lic-aao/insurance-financial-market-awareness-indian-financial-system/ © The Institute of Chartered Accountants of India  1.20 1.20 FINANCIAL SERVICES AND CAPITAL MARKETS 4.1 Money Market Instruments The money market is the market for financial assets that are close substitutes for money. It is the market for instruments ranging from one day deployment e.g., call money market to a few months, but upto or less than one year. 4.1.1 Treasury Bills Treasury Bills (T-Bills) are short term instruments issued by the Central Government with maturities in less than one year. Their purpose remains the same as Dated Securities (i.e., regular Government Securities), but they are intended more to be meeting the short-term funding needs of the Central Government. Currently, the Central Government issues T Bills of 91-day, 182-day and 364-day maturity. Since T Bills have a maturity of less than one year, they are a money market instrument. 4.1.2 Cash Management Bills These are a short-term instrument issued by the Government of India and meant to specifically meet temporary cash flow mismatches of the Government. These instruments have a maturity of less than 91 days. Further, they are issued at a discount to par value (in zero-coupon securities). CMBs have similar characteristics as Treasury Bills. 4.1.3 Call Money, Notice Money, and Term Money These are the terms used for short-term borrowing and lending operations between Banks and sometimes with and between Primary Dealers. The difference between the three is in their tenure of lending. Call money is for overnight deployment i.e., one day, notice money is two to fourteen days and term money is for a tenure fifteen days and longer. 4.1.4 Certificate of Deposits (CDs) CDs are issued by banks for short-term funding needs. Usually, banks issue CDs when credit pick- up is higher than bank deposit growth. CDs save on operational costs of the Bank as these take place in bulk. Issued for 3, 6 and 12 months maturity. Also, issued at a discount and redeemed at par. © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.21 1.21 4.1.5 Commercial Papers (CPs) CPs are issued by corporates (mostly NBFCs), primary dealers and all-India financial institutions (other than Banks), as a source of short-term finance. In a way CDs and CPs are similar, difference being CDs are issued by Banks and CPs are issued by corporates. Issued at a discount to face value and contains higher risk and yield than T-Bills. 4.1.6 Repurchase Agreements These are short-term loans in which two parties agree to sell and repurchase the same security. When considering a transaction from the seller's point of view, it is called a repo, and when considering it from the buyer's point of view, it is called a reverse repo. Only transactions in Central Government dated securities, Treasury bills, state development loans, and GOI special securities like oil bonds that have been approved by the RBI may be conducted through Repo or Reverse Repo between parties that have received RBI approval. 4.2 Capital Market The capital market provides support to corporates for raising resources. The Securities and Exchange Board of India (SEBI), along with the Reserve Bank of India are the regulatory authorities for Indian securities market, to protect investors and improve the microstructure of capital markets in India. There are two components of capital market, primary and secondary. In primary markets, companies, governments, or public sector institutions can raise funds through bond issues. In the primary market, the investor directly buys shares / bonds of a company. In secondary markets, the shares / bonds are bought and sold by the customers. On the platforms provided by Exchanges like NSE or BSE, investors buy and sell instruments like stocks and bonds through brokers / sub-brokers. 4.2.1 Indian Capital Market scenario (Equity Market) The market capitalization to Gross Domestic Product (GDP) ratio shows to what extent the market is assigning a value to the listed corporates against the GDP of the economy. The perspective is the current value against the historical average. The stock market capitalization-to-GDP ratio is also known as the Buffett Indicator, after legendary investor Warren Buffett, who popularized its use. This measures the total value of all listed shares divided by GDP. © The Institute of Chartered Accountants of India  1.22 1.22 FINANCIAL SERVICES AND CAPITAL MARKETS 113.332 103.803 94.824 88.788 78.893 76.448 77.368 72.886 69.608 69.020 61.190 62.707 Source: www.ceicdata.com The chart above shows that investments in, and discounting of future earnings growth of Indian companies has been moving up during the FY 2011 to 2022 represented by the increase in the ratio of market capitalization to GDP. However, earnings growth of companies has not kept pace with the increase in valuations given by the market, as indicated in the chart above. If EPS does not grow as much and price goes up, the market valuation, as represented by P/E ratio, moves to the higher side. Source: PhillipCapital India Research The P/E ratio, calculated on the basis of forward or expected EPS, has moved to the higher side. © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.23 1.23 4.2.2 Historical Returns from Equity Returns from the equity market have been volatile. The following chart shows returns from Sensex since inception on a rolling basis. Annual rolling means returns of every one year calculated every year, three-year rolling return means returns over past three years, calculated every year, and so on. Year Sensex Rolling 1 Rolling 3 Rolling 5 Rolling 10 Rolling Rolling 20 End (1) YR Growth YR YR YR 15 YR YR Growth Growth Growth Growth Growth (2) (3) (4) (5) (6) (7) (8) Mar-79 100 Mar-80 129 29% Mar-81 173 35% Mar-82 218 26% 30% Mar-83 212 -3% 18% Mar-84 245 16% 12% 20% Mar-85 354 44% 18% 22% Mar-86 574 62% 39% 27% Mar-87 510 -11% 28% 19% Mar-88 398 -22% 4% 13% Mar-89 714 79% 8% 24% 22% Mar-90 781 9% 15% 17% 20% Mar-91 1168 50% 43% 15% 21% Mar-92 4285 267% 82% 53% 35% Mar-93 2281 -47% 43% 42% 27% Mar-94 3779 66% 48% 40% 31% 27% Mar-95 3261 -14% -9% 33% 25% 24% Mar-96 3367 3% 14% 24% 19% 22% Mar-97 3361 0% -4% -5% 21% 20% Mar-98 3893 16% 6% 11% 26% 21% © The Institute of Chartered Accountants of India  1.24 1.24 FINANCIAL SERVICES AND CAPITAL MARKETS Mar-99 3740 -4% 4% 0% 18% 20% 20% Mar-00 5001 34% 14% 9% 20% 19% 20% Mar-01 3604 -28% -3% 1% 12% 13% 16% Mar-02 3469 -4% -2% 1% -2% 14% 15% Mar-03 3049 -12% 15% -5% 3% 15% 14% Mar-04 5591 83% 16% 8% 4% 15% 17% Mar-05 6493 16% 23% 5% 7% 15% 16% Mar-06 11280 74% 55% 26% 13% 16% 16% Mar-07 13072 16% 33% 30% 15% 8% 18% Mar-08 15644 20% 34% 39% 15% 14% 20% Mar-09 9709 -38% -5% 12% 10% 6% 14% Mar-10 17528 81% 10% 22% 13% 12% 17% Mar-11 19445 11% 8% 12% 18% 12% 15% Mar-12 17404 -10% 21% 6% 18% 12% 7% Mar-13 18836 8% 2% 4% 20% 11% 11% Mar-14 22386 19% 5% 18% 15% 13% 9% Mar-15 27957 25% 17% 10% 16% 12% 11% Mar-16 25342 -9% 10% 5% 8% 14% 11% Mar-17 29621 17% 10% 11% 9% 15% 11% Mar-18 32969 11% 6% 12% 8% 17% 11% Mar-19 38673 17% 15% 12% 15% 14% 12% Mar-20 29468 -24% 0% 1% 5% 11% 9% Probability of Gain 27/41 32/39 34/37 31/32 27/27 22/22 Source: HDFC Mutual Fund How to read it? Return of 29% from March 1979 to March 1980 means over a holding period of one year. Then it goes on like this every year. Return of 30% from March 1979 to March 1982 means over a holding © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.25 1.25 period of 3 years, annualized. Similarly, the same pattern will be followed for other 3-year holding periods. Conclusion: On a one-year holding period basis, returns were positive in 25 out of 38 years, hence the probability of positive return is 25/38. Over 10-year holding periods, it is positive in 28 out of 29 years, hence over a long holding period probability of positive return is 28/29. Over 15 and 20 year holding periods, it is always positive. 4.2.3 Bond Market The Government and corporates issue bonds / debentures for raising resources. The market capitalization concept is not used in the bond market as the market price is not much different from the face value of instruments. To gauge the size of the market, we will look at the outstanding quantum of securities. The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures. The most important advantage of investing in bonds is that it helps diversify and grow your money. Debt or Bond can be defined as a loan for which an investor is the lender. The issuer of the bond pays the investor interest (at a predetermined rate and schedule) in return for the funding. The maturity date refers to the date on which the issuer has to repay the principal to the investor. When an investor invests money via equity, he becomes an owner in the corporation. In case of debt, the investor becomes a creditor to the issuing entity. To build a diversified and stable portfolio, investing in debt securities is a must since it assures fixed income. Amount outstanding % of total Amount outstanding as on as on 31 Dec. 2015 Dec. 2015 (` Cr) (` Cr) G Secs 45,19,205 51 1,00,33,518.106 (as on Dec. 4, 2023) SDLs 14,51,236 16 95,77,920 (as on Oct. 2023) T Bills 4,25,648 5 1,00,65,404.70 (24 Nov. 2023) Total Sovereign 63,96,089 72 No added the numbers above as the dates are different Corporate Bonds 19,11,226 22 44,16,320 (Sept. 2023) CPs 3,08,109 4 3,64,999.65 (April 30, 2022) CDs 2,06,559 2 201427.56 (April 22, 2022) © The Institute of Chartered Accountants of India  1.26 1.26 FINANCIAL SERVICES AND CAPITAL MARKETS Total Corporate 24,26,294 28 No added the numbers above as the dates are different Total 88,22,383 100 Source: RBI, SEBI As we observe from the chart above, the outstanding quantum of Government Securities, both Centre and States, have been going up steadily. This is in line with the GDP growth of the country and increase in size of Government budgets. The Central Government is the major issuer of securities in the bond market. Corporate bonds and Commercial Papers have also been increasing steadily, in line with the growth of the corporate sector. This is another means of raising resources for them, apart from Bank loans. Money market instruments like Treasury Bills and Certificates of Deposit have not increased much as these are means of short-term funding. CPs have increased in quantum as the major issuers are NBFCs; NBFCs require money as that is their input and output. 4.2.4 Subscribers to Government Securities Source: RBI © The Institute of Chartered Accountants of India  INTRODUCTION TO FINANCIAL MARKETS 1.27 1.27 TEST YOUR KNOWLEDGE Multiple Choice Questions (MCQs) 1. The derivatives market deals in contracts whose value is based on the market value of the asset being traded, called the …………. (a) Forwards (b) Futures (c) Options (d) Underlying 2. Which among the following is not a function of Financial Markets? (a) puts savings into more productive use (b) determines the price of securities (c) makes financial assets risky and liquid (d) lowers the cost of transactions 3. Which among the following is the primary stakeholder in the financial market? (a) Merchant Bankers (b) Brokers (c) Underwriters (d) Companies 4. The ………… make their profit on the difference in price between what they paid before the IPO and when the shares are offered to the public. (a) Underwriters (b) Merchant Bankers (c) Brokers (d) Custodians © The Institute of Chartered Accountants of India  1.28 1.28 FINANCIAL SERVICES AND CAPITAL MARKETS 5. ………… is a voluntary market body for the bond, money, and derivatives markets. (a) AMFI (b) FIMMDA (c) AIBI (d) FEDAI Theoretical Questions 1. What do you understand by financial markets? Discuss the importance of financial markets. 2. Explain briefly the various service providers in financial markets. 3. Discuss the important objectives of SEBI and make a brief comparison to its compatriot in USA. 4. Explain briefly the various administrative authorities to facilitate the financial market. ANSWERS/SOLUTIONS Answers to the MCQ based Questions 1. (d) 2. (c) 3. (d) 4. (a) 5. (b) Answers to the Theoretical Questions 1. Please refer to paragraph 1.2 2. Please refer to paragraph 3 3. Please refer to paragraph 3.(iii) 4. Please refer to paragraph 3.(iv) © The Institute of Chartered Accountants of India CHAPTER 2 IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS LEARNING OUTCOMES After going through the chapter student shall be able to understand:  Credit Policy of RBI  Fed Policy  Inflation Index, CPI, WPI, etc. © The Institute of Chartered Accountants of India  2.2 FINANCIAL SERVICES AND CAPITAL MARKETS CHAPTER OVERVIEW Impact of Various Policies of Financial Markets Meaning Objectives Credit Policy of RBI Analytics Operating Procedure Instruments About Fed System Fed Policy Tools Fed Policy Impact on Global Financial Market Quantitative Easing Concept and Cost Inflation Index Computation Classification of Items Consumer Price Index Issues relations to CPI Wholesale Price Introduction and Differences Index between CPI and WPI © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.3 2.3 1. CREDIT POLICY OF THE RESERVE BANK OF INDIA (RBI) 1.1 Meaning of Credit Policy The credit policy is basically a plan of action executed by the Reserve Bank of India (RBI)on behalf of the Government of India to control and regulate the demand for and supply of money with the public and the flow of credit i.e. money into the economy. It refers to the use of credit policy instruments which are at the disposal of central bank to regulate the availability, cost and use of money and credit to promote economic growth, price stability, optimum levels of output and employment, balance of payments equilibrium, stable currency, or any other goal of government’s economic policy. 1.2 Objectives of Credit Policy The various objectives of Credit Policy are as follows: (i) Maintenance of Price Stability–One of the foremost responsibilities of RBI is to control inflation and maintain the stability of prices. For this RBI uses interest rates as a tool to maintain inflation at its desired levels. If the RBI feels that the inflation is high, then it increases the interest rates to curb demand in the overall market & to tune the credit growth in economy which in turn leads the inflation to cool down. Similarly, if RBI feels the inflation is too low and wishes to increase inflation then it either reduces the interest rates or pumps in money in the system by different means to increase the demand in the economy and in turn increases the inflation. (ii) Achieving Economic Growth – It is also one of the most important objectives of the Credit Policy of RBI. The purpose is to achieve economic growth through various means which will be discussed later. In fact, the primary objective is to maintain a judicious balance between maintenance of price stability and achieving economic growth. So, achieving economic growth is not a direct objective. GDP growth and job creation is primarily the government function. Credit policy is primarily targeted to keep inflation in check and maintain sufficient liquidity in the system which will spur demand and leads to economic growth. (iii) Exchange Rate Stability – The aim is to maintain exchange rate stability, so the imports are cheaper, and exporters increase their exports and earn precious foreign exchange. If RBI finds that the Dollar is appreciating, and INR is depreciating, and it wants to support INR from further depreciation then it will take measures that will allow more dollar inflow in the system thereby appreciating the rupee, and thus, supporting INR. For example, allowing banks temporarily to raise © The Institute of Chartered Accountants of India  2.4 FINANCIAL SERVICES AND CAPITAL MARKETS fresh Foreign Currency Non-Resident Bank i.e., FCNR(B) and Non-Resident External (NRE) deposits for a limited period. (iv) External Balance of payment equilibrium – The balance of payment is basically economic transactions of the residents of a country with the rest of the world during a given period of time. When we add up all the demand for foreign currency and all the sources from which it comes, these two amounts are necessarily equal and thus the overall account of the balance of payments necessarily balance or must always be in equilibrium. (v) Adequate flow of credit to productive sectors – It is the responsibility of the Central Bank to ensure that regular, easy, and smooth availability of money to the needy sectors of the economy is rendered on a continuous basis. This will help the industry to pump in the required money to boost their production. This will automatically increase employment as the companies will hire more people to enhance their capacity. This in turn will lead to a higher standard of living for the people. (vi) Maintaining a moderate structure of interest rates to enhance investments – The RBI plays an important role in the management of the rate of interest. And the fate of many industries depends upon the interest rate policy pursued by the Central Bank. They expect that interest rates be reduced so that loans can be available at a cheaper rate. On the other hand, in case of inflation, the general perception is to increase the rate of interest. Therefore, the RBI evaluates the pros and cons of its every prospective decision and decides if interest rate policy is to be pursued. Hence, the role of RBI is to tread on a cautious path. People expect that inflation shall be contained and stay within a reasonable limit so that goods and services are available to them in a cheap manner. At the same time, people expect that unemployment should be reduced and more and more jobs should be available. So, a tradeoff is required between controlling inflation and rising unemployment. 1.3 Analytics of Credit Policy There are basically four different mechanisms through which monetary policy influences the price level and the national income. These are: (i) Interest Rate Channel – Interest rates increase the cost of capital and real cost of borrowing for firms with the result that they cut back on their investment expenditure. Similarly, general public facing the heat of high interest rates cut back on their purchase of homes, cars, air-conditioners and other goods. So, a decline in aggregate demand results in the decline in aggregate output and goods. On the other hand, a decrease in interest rates has the opposite effect of a decrease in cost of capital of firms and cost of borrowing for households. © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.5 2.5 (ii) Exchange Rate Channel – Appreciation of the domestic currency makes domestically produced goods more expensive as compared to foreign-produced goods. The reason is that import from countries outside India will become cheaper and it will make the goods produced in India dearer in comparison. This will cause the net export to fall (because expensive good produced in India will have to be sold at a higher price and it will find few takers outside India). Consequently, domestic output and employment will also fall. On the other hand, as the rupee depreciates, exports become more profitable, because the exporter earns more rupees for exchanging dollar. On the other hand, imports become expensive as the importer needs to pay more rupees for the dollars billed. Industries linked to exports like pharma and IT benefit with depreciation, whereas those industries linked to imports (or having vital components of their product imported) must bear higher input cost, which is ultimately passed on to the end users. (Source: Financial Express) China used the strategy to devalue their currency “Yuan” and keep the exports profitable for local vendors and thereby infusing jobs and growth in their country. (iii) Quantum Channel (relating to money supply and credit) – Two things are worth mentioning in this regard – the bank lending (credit) channel and the balance sheet channel. Credit channel operates by altering the access of firms and households to bank credit. Most business organizations depend on bank loans for their borrowing needs. To restrict the flow of credit in times of inflation, the RBI sells government securities to commercial banks and the public and squeeze money from them. This makes the firms which are dependent on bank loans cut back on their spending on investment. This will diminish aggregate output and employment following a reduction in money supply. Now, we shall look at how the balance sheet channel works. The direct effect of monetary policy on the balance sheet is that it will show the interest cost and increase in payments through loan repayments. An indirect effect is that the same increase in interest rate works to reduce the capitalized value of the firm’s fixed assets. This will also raise the company’s cost of capital and consequently, precipitate a reduction in production and output. (iv) Asset Price Channel – The standard asset price channel indicates that changes in credit policy effects output, employment, and inflation. An increase in interest rates in debt securities makes them more attractive to investors than equity. This leads to a fall in the share prices which resulted in the consequent fall in consumption, production, and employment. These also affect the overall financial wealth of the investors. © The Institute of Chartered Accountants of India  2.6 FINANCIAL SERVICES AND CAPITAL MARKETS 1.4 Operating Procedure and Instruments The operating framework of monetary policy refers to how the various aspects of monetary policy are implemented. These aspects are briefly explained as below: Choosing the operating target –The operating target to the variable (for e.g. inflation) that monetary policy can influence with its actions. Choosing the intermediate target - (e.g. economic stability) is a variable which central bank can hope to influence to a reasonable degree. Choosing the policy instruments -The credit policy instruments are the various tools that a central bank can use to influence money market and credit conditions and pursue its monetary policy objectives. The day-to-day implementation of monetary policy by central banks through various instruments is referred to as ‘operating procedures’. 1.5 The instruments of Credit Policy The various credit policy instruments are explained in the following paragraphs: (i) Cash Reserve Ratio (CRR): Cash reserve ratio is the amount which the commercial banks must maintain as cash deposit with the Reserve Bank of India. An important thing to note here is that commercial banks do not get any interest from RBI on CRR. RBI may increase the CRR if it thinks that there is large amount of money supply in the economy. Conversely, it will decrease the CRR if it is of the opinion that inflation is in control and the industry needs a monetary boost up. The reduction in CRR will provide more money in the hands of commercial banks which will pass it on to industry. More money in the hands of industry will boost production, consumption, and employment. (ii) Statutory Liquidity Ratio (SLR): Statutory Liquidity Ratio is the amount which commercial banks must keep it with itself. So, SLR is the amount of money which banks must always keep in its custody. SLR is also a very powerful tool to control liquidity in the economy. To encourage industries to boost up their production, SLR may be decreased to put more money in the hands of commercial banks. An increase in SLR is used as an inflation control measure to control price rise. Maintenance of CRR and SLR are a part of what is known as the ‘Fractional Reserve System’ in Central Banking. Fractional Reserves are a part of the wider Quantitative Monetary Policy. (iii) Liquidity Adjustment Facility (LAF): Under this facility, the commercial banks can borrow from RBI through the discount window against the collateral of securities like commercial bills, © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.7 2.7 treasury bills or other eligible papers. Currently, the RBI provides financial accommodation to the commercial banks through repos/reverse repos under the LAF. Repo transaction is defined as an instrument through which commercial banks borrow from RBI. So, it is basically borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. In other words, repo is a money market instrument, which enables collateralized short- term borrowing and lending through sale/purchase operations in debt instruments. Source: https://www.assignmentpoint.com/business/finance/repurchase-agreement-definition.html Reverse Repo transaction, on the other hand, is an instrument through which RBI borrows from commercial banks by giving them securities. So, reverse repo is defined as an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent. (iv) Margin Standing Facility (MSF): Margin Standing Facility announced by the Reserve Bank of India (RBI) in its Monetary Policy, 2011-12 refers to the facility under which scheduled commercial banks can borrow additional amount of overnight money from the central bank over and above what is available to them through the LAF facility up to a limit at a penal rate of interest. The minimum amount which can be assessed through MSF is ` 1 crore and more will be available in multiples of ` 1 crore. The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility on which the rates are lower compared to the MSF. (v) Market Stabilization Scheme: Under the market stabilization scheme, the Government of India borrows from the RBI and issues treasury bills/dated securities for absorbing excess liquidity from the market arising from large capital inflows. Now, with the introduction of Liquidity Adjustment Facility (LAF) i.e. Repo and Reverse Repo mechanism, bank rate has become dormant as an instrument of monetary policy. © The Institute of Chartered Accountants of India  2.8 FINANCIAL SERVICES AND CAPITAL MARKETS The bank rate has been aligned to the Marginal Standing Facility (MSF) rate and therefore, as and when the MSF rate changes alongside policy repo rate changes, the bank rate also changes automatically. Now, bank rate is used only for calculating penalty on default in the maintenance of Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). (vi) Open Market Operations: Open Market Operation is basically a tactic employed by the RBI to control the liquidity in the economic system. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby reducing excess rupee flowing in the Indian economy. Similarly, when there is a tight liquidity situation in the economy RBI will buy securities from the market, thereby releasing money (rupee) into the system. Maintaining short-term liquidity is very important because if it is not maintained then the short term money market rates (MIBOR) will be impacted, which will have its impact on short term lending and borrowings. (vii) Focusing Banks to promote lending to a particular sector: RBI may change the category of the sector in which it wants more lending to be done by commercial banks. For example, in can include the sector in and as priority sector or it can include a particular sector under the definition of infrastructure to promote more funding in that sector. Furthermore, infrastructure status helps easier access to Institutional credit and reduction in cost of borrowing. 2. FED POLICY 2.1 About the Federal Reserve System The Federal Reserve System is the Central Bank of the United States. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest. The Federal Reserve: conducts the nation's monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy; promotes the stability of the financial system and seeks to minimize and contain systematic risks through active monitoring and engagement in the U.S. and abroad; promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole; fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S. dollar transactions and payments; and © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.9 2.9 promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations. 2.2 Fed Policy Tools The techniques or tools employed by the US Federal Reserve as a part of Fed Policy have been discussed in brief in the following paragraphs. The purpose of the Fed Policy tools is more or less the same as employed by the Reserve Bank of India which has been discussed in detail in the preceding paragraphs. (i) Open Market Operations: It is the purchase and sale of securities in the open market by a central bank that are key tools used by the Federal Reserve in the implementation of monetary policy. (ii) The Discount Rate: The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured. Under the primary credit program, loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities. (iii) Reserve Requirements: Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. (iv) Interest on Required Reserve Balances and Excess Balances: The Federal Reserve Banks pay interest on required reserve balances and on excess reserve balances. The interest rate on required reserves (IORR rate) is determined by the Board and is intended to effectively eliminate the implicit tax that reserve requirements used to impose on depository institutions. © The Institute of Chartered Accountants of India  2.10 FINANCIAL SERVICES AND CAPITAL MARKETS (v) Overnight Reverse Repurchase Agreement Facility: When the Federal Reserve conducts an overnight RRP, it sells a security to an eligible counterparty and simultaneously agrees to buy the security back the next day. (vi) Term Deposit Facility: Funds placed in and thereby drain reserve balances from the banking system. (Source: www.federalreserve.gov) 2.3 Fed Funds Rate and its impact on Global Financial Market The Fed Funds Rate is the interest rate at which the top US banks borrow overnight money from common reserves. All American banks are required to park a portion of their deposits with the Federal Reserve in cash, as a statutory requirement. Fed fund rate gives the direction in which US interest rates should be heading at any given point of time. If the Fed is increasing the interest rates, lending rates for companies and retail borrowers will go up and vice versa. In India, hike in repo rate may not impact the countries outside India. On the other hand, US interest rates matter a lot to global capital flows. Some of the world’s richest institutions and investors have their base in the USA. They constantly compare Fed rates with interest rates across the world to make their allocation decisions. Any changes in the Fed Fund Rates impact the domestic borrowing market to a large extent. For instance, if the Fed rates go up, it will make the RBI hesitant in cutting rates at that time. The reason is that if RBI cut rates it will lead to heavy pullout of foreign investors from the Indian bond market. Further, US interest rates matter to foreign stock investors in India also. The reason is zero or near zero returns on safe investments in the US. But, if the Fed rates go up, it may lead to mass exodus of foreign investors from the Indian Stock Market because higher returns in the form of interest is available there. 2.4 Quantitative easing (QE) It is a monetary policy strategy used by central banks like the Federal Reserve. With QE, a central bank purchases securities to reduce interest rates, increase the supply of money and drive more lending to consumers and businesses. The goal is to stimulate economic activity during a financial crisis and keep credit flowing. What is Quantitative Easing (QE)? When a central bank decides to use QE, it makes large-scale purchases of financial assets, like government and corporate bonds and even stocks. This relatively simple decision triggers powerful © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.11 2.11 outcomes: The amount of money circulating in an economy increases, which helps lower longer- term interest rates. This lowers the cost of borrowing, which spurs economic growth. By buying longer maturity securities, a central bank is aiming to lower longer-term market interest rates. Contrast this with one of the main tools used by central banks: Interest rate policy, which targets shorter-term market interest rates. When the Federal Reserve adjusts its target for the federal funds rate, it’s seeking to influence the short-term rates that banks charge each other for overnight loans. The Fed has used interest rate policy for decades to keep credit flowing and the U.S. economy on track. When the fed funds rate was cut to zero during the Great Recession, it became impossible to reduce rates further to encourage lending. Instead, the Fed deployed QE and began purchasing mortgage- backed securities (MBS) and Treasuries to keep the economy from freezing up. Central banks like the Fed send a strong message to markets when they choose QE. They are telling market participants that they’re not afraid to continue buying assets to keep interest rates low. How Does Quantitative Easing Work? Quantitative easing works by making large-scale asset purchases. In response to the coronavirus pandemic, for example, the Fed has begun purchasing longer-maturity Treasuries and commercial bonds. For example: Here’s how the simple act of buying assets in the open market changes the economy (mostly) for the better: The Fed buys assets. The Fed can make money appear out of thin air—so-called money printing— by creating bank reserves on its balance sheet. With QE, the central bank uses new bank reserves to purchase long-term Treasuries in the open market from major financial institutions (primary dealers). New money enters the economy. As a result of these transactions, financial institutions have more cash in their accounts, which they can hold, lend out to consumers or companies, or use to buy other assets. Liquidity in the financial system increases. The infusion of money into the economy aims to prevent problems in the financial system, such as a credit crunch, when available loans decrease or the criteria to borrow money drastically increase. This ensures the financial markets operate as normal. © The Institute of Chartered Accountants of India  2.12 FINANCIAL SERVICES AND CAPITAL MARKETS Interest rates decline further. With the Fed buying billions worth of Treasury bonds and other fixed income assets, the prices of bonds move higher (greater demand from the Fed) and yields go lower (bondholders earn less). Lower interest rates make it cheaper to borrow money, encouraging consumers and businesses to take out loans for big-ticket items that could help spur economic activity. Investors change their asset allocations. Given the now-lower returns on fixed income assets, investors are more likely to invest in higher-returning assets—like stocks. As a result, the overall stock market could see stronger gains because of quantitative easing. Confidence in the economy grows. Through QE, the Fed has reassured markets and the broader economy. Businesses and consumers may be more likely to borrow money, invest in the stock market, hire more employees, and spend more money—all of which helps to stimulate the economy. The Downsides of QE Implementing QE comes with potential downsides, and its impact is not universally beneficial to everyone in the economy. Here are some of the dangers: (i) QE May Cause Inflation The biggest danger of quantitative easing is the risk of inflation. When a central bank prints money, the supply of dollars increases. This hypothetically can lead to a decrease in the buying power of money already in circulation as greater monetary supply enables people and businesses to raise their demand for the same amount of resources, driving up prices, potentially to an unstable degree. (ii) QE Isn’t Helpful for Everyone, May Cause Asset Bubbles Some critics question the effectiveness of QE, especially with respect to stimulating the economy and its uneven impact for different people. Quantitative easing can cause the stock market to boom, and stock ownership is concentrated among Americans who are already well-off, crisis or not. By lowering interest rates, the Fed encourages speculative activity in the stock market that can cause bubbles and the euphoria can build upon itself so long as the Fed holds on to its policy. So, this is basically a confidence game; market participants think the Fed has their back and as long as they do, there’s limited fear. (iii) QE May Cause Income Inequality A final danger of QE is that it might exacerbate income inequality because of its impact on both financial assets and real assets, like real estate. It has benefited those who do well when asset prices go up. © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.13 2.13 This potential for income inequality highlights the Fed’s limitations. An expert said in this regard that the central bank doesn’t have the infrastructure to lend directly to consumers in an efficient way, so it uses banks as intermediaries to make loans. “It is really challenging for the Fed to target individuals and businesses that are hardest hit by an economic disruption, and that is less about what the Fed wants to do and more about what the Fed is allowed to do. (Source: www. forbes.com) 3. COST INFLATION INDEX (CII) Cost Inflation Index is a measure of inflation that is used for computing long-term capital gains on sale of capital assets. It is prescribed by the central government every year and useful in the calculation of the indexed value of capital assets. It helps a taxpayer in computing the actual long- term gain or loss on selling of capital assets and allows the taxpayer to factor the impact of inflation on the cost of their assets. To calculate the indexed cost of acquisition we must divide the Cost Inflation Index or CII for year in which asset is sold by the Cost Inflation Index or CII for a year in which asset is bought, then multiplied with the purchase price of the asset to arrive at the indexed cost of acquisition which is the actual or true cost used at the time of tax computation. Since the government levies a tax on such transactions, the owner would be required to pay a large amount as tax. To avoid paying a large sum towards tax, the purchase price of the asset can be indexed to show the asset’s value as per its current value, considering inflation by increasing its value. In this manner, the profit derived from the sale would be lower, thus reducing the tax on capital gains. Thus, indexation helps the actual value of the asset to reflect at its present market rates, considering the reduction in its value due to inflation. When selling an asset, the purchase price is referred to as the indexed cost of acquisition. The cost inflation index (CII), therefore, is the indexed price that the asset is purchased at. The CII for a particular year is fixed by the government and released before the accounting year ends, for the purpose of tax computation. Computation of Cost Inflation Index Cost Inflation Index (CII) = CII for the year the asset was transferred or sold / CII for the year the asset was acquired or bought. The above formula for the computation of CII has been explained with the help of an example: © The Institute of Chartered Accountants of India  2.14 FINANCIAL SERVICES AND CAPITAL MARKETS Example Suppose you purchased a house for ` 25 lakhs in Jan 2005 and sold it for ` 70 lakhs in Jan 2015. Your profit or capital gain is ` 45 lakhs. The CII for the year the apartment was bought in is 406. The CII for the year the apartment was sold is 1081. Now, the cost inflation index = CII for the year the asset was transferred or sold / CII for the year the asset was acquired or bought = 1081/406 = 2.66 While computing tax, CII is multiplied with the purchase price to arrive at the indexed cost of acquisition. This is the actual cost of the assets. Therefore, the indexed cost of acquisition = 25, 00,000 X 2.66 = ` 66,50,000 And the long term capital gain = sale value of the asset- indexed cost of acquisition = 70,00,000 – 66,50,000 = ` 3,50,000 The tax liability if you use the indexation method is charged at 20 percent. The tax liability will be 20% X 3,50,000 = ` 70000. If you do not use the indexation method, the tax is payable at 10% on the capital gain. The capital gain in this case is sale price of the apartment – cost of acquisition = 70,00,000 – 25,00,000 = `45,00,000. The capital gains tax is 10% x 45,00,000 = `4,50,000. Therefore, when indexation benefit is taken, it helps you in saving taxes. It helps you adjust the purchase price of the house with the current market prices. 4. CONSUMER PRICE INDEX (CPI) A Consumer Price Index (CPI) is designed to measure the changes over time in the general level of retail prices of selected goods and services that households purchase for the purpose of consumption. Such changes affect the real purchasing power of consumers’ income and their welfare. The CPI measures price changes by comparing, through time, the cost of a fixed basket of commodities. The basket is based on the expenditures of a target population in a certain reference period. Since the basket contains commodities of unchanging or equivalent quantity and quality, the index reflects only pure price. Traditionally, CPI numbers were originally introduced to provide a measure of changes in the living costs of workers, so that their wages could be compensated to the changing level of prices. However, over the years, CPIs have been widely used as a macroeconomic indicator of inflation, and as a tool by Government and Central Bank for targeting inflation and © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.15 2.15 monitoring price stability. CPI is also used as deflators in the National Accounts. Therefore, CPI is considered as one of the most important economic indicators. Given the many uses of CPIs, it is unlikely that one index can perform equally satisfactory in all applications. Therefore, there is a practice of compiling several CPI variants for specific purposes. Each index should be properly defined and named to avoid confusion. The purpose of CPI should influence all aspects of its construction. 4.1 Classification of Items Classification is the first step in compiling the CPI because its sub-aggregates must be defined in such a way that expenditure weights and prices will relate precisely to the coverage of the sub- aggregates. It establishes a hierarchical framework from whose boundaries the representative items for inclusion in the index (and sometimes the outlets) will be defined and drawn. In a broad sense, classification is a procedure in which items are organized into categories based on information on one or more characteristics inherent to the items. In recent past, countries used their own distinct systems for classifying the range of products covered by their CPI. Most countries have now, however, moved to the international standard classification COICOP (Classification of Individual Consumption according to Purpose). To ensure better comparability with CPIs of other countries, it is desirable to have the classification of items synchronized with COICOP. At the same time, it is also important to make it relevant to the Indian context by making it comparable to groups and sub-groups being followed in the CPI series compiled in the country. Accordingly, all consumption items have been classified under various Groups, Categories, Sub-groups, and Sections. (Source: Ministry of Statistics and Programme Implementation) 4.2 Issues relating to Consumer Price Index (CPI) Some of the issues relating to Consumer Price Index (CPI) which have been in vogue for quite some times have been discussed in the following points in order to have a good glimpse of the actual impact of CPI to the consumers in India. (1) 90-95% of the index (CPI) is not affected by interest rates as the amount spent on household is not affected by the rate changes. This includes food products (covering 48% in index), housing or fuel expenses. These are fixed costs and had to be spent irrespective of the rate of inflation. (2) Concept of CPI does not make sense to the household. A 2% CPI does not seem convincing to a housewife who believes that prices of most of the commodities are on the higher side than that © The Institute of Chartered Accountants of India  2.16 FINANCIAL SERVICES AND CAPITAL MARKETS reflected by CPI. So, it is frustrating for the consumer who after every fall in rate of inflation finds that actual prices are on the much higher side. For example, prices of onions suddenly increase from ` 30 per kg. to ` 80 per kg. Similarly, the prices of Tur Dal increase from ` 40 per kg. to` 200 per kg in a very short span of time. However, prices came down slowly and then settled at ` 80-100 per kg. So, prices increase at a very fast rate but came down after taking a lot of time and that too, the reduced price is generally at a much higher level than the previous one, as explained in the previous sentence with the help of an example. (3) Lastly, a general view is that HRA allowance paid to Central Government employees would tend to raise inflation. However, if the government employee is residing in a government accommodation, HRA is automatically deducted from the pay slip of an employee. On the other hand, if an employee is not staying in government accommodation the amount in the pay slip will go up. Therefore, an increase in HRA may not translate into higher cost of living or higher retail demand. 5. WHOLESALE PRICE INDEX (WPI) The Wholesale Price Index (WPI) measures the average change in the prices of commodities for bulk sale at the level of early stage of transactions. The index basket of the WPI covers commodities falling under the three major groups namely Primary Articles, Fuel and Power and Manufactured products. (The index basket of the present 2011-12 series has a total of 697 items including 117 items for Primary Articles, 16 items for Fuel & Power and 564 items for Manufactured Products.) The prices tracked are ex- factory price for manufactured products, mandi price for agricultural commodities and ex-mines prices for minerals. Weights given to each commodity covered in the WPI basket are based on the value of production adjusted for net imports. WPI basket does not cover services. In India WPI is also known as the headline inflation rate. The base year of all India WPI has been revised from 2004-05 to 2011-12 by the Office of the Economic Advisor, Department of Industrial Policy and Promotion, Ministry of Commerce, and Industry. In India, Office of Economic Advisor (OEA), Department of Industrial Policy and Promotion, Ministry of Commerce and Industry calculates the WPI. The main uses of WPI are the following: © The Institute of Chartered Accountants of India  IMPACT OF VARIOUS POLICIES OF FINANCIAL MARKETS 2.17 2.17 (1) To provide estimates of inflation at the wholesale transaction level for the economy. This helps in timely intervention by the Government to check inflation, in essential commodities, before the price increase spill over to retail prices. (2) WPI is used as deflator for many sectors of the economy including for estimating GDP by Central Statistical Organisation (CSO). (3) WPI is also used for indexation by users in business contracts. (4) Global investors also track WPI as one of the key macro indicators for their investment decisions. Difference between Wholesale Price Index (WPI) and Consumer Price Index (CPI) WPI reflects the change in average prices for bulk sale of commodities at the first stage of transaction while CPI reflects the average change in prices at retail level paid by the consumer. The prices used for compilation of WPI are collected at ex-factory level for manufactured products, at ex-mine level for mineral products and mandi level for agricultural products. In contrast, retail prices applicable to consumers and collected from various markets are used to compile CPI. The reasons for the divergence between the two indices can also be partly attributed to the difference in the weight of the food group in the two baskets. CPI Food group has a weight of 39.1 per cent as compared to the combined weight of 24.4 per cent (Food articles and Manufactured Food products) in WPI basket. The CPI basket consists of services like housing, education, medical care, recreation etc. which are not part of WPI basket. A significant proportion of WPI item basket represents manufacturing inputs and intermediate goods like minerals, basic metals, machinery etc. whose prices are influenced by global factors, but these are not directly consumed by the households and are not part of the CPI item basket. Thus, even significant price movements in items included in WPI basket need not necessarily translate into movements in CPI in the short run. The rise or fall in prices at wholesale level spilled over to the retail level after a lag. Similarly, the movement in prices of non-tradable items included in the CPI basket widens the gap between WPI and CPI movements. The relative price trends of tradable vis a vis non-tradable is an important explanatory factor for divergence in the two indices in the short term. (Source: Arthapedia) © The Institute of Chartered Accountants of India  2.18 FINANCIAL SERVICES AND CAPITAL MARKETS TEST YOUR KNOWLEDGE Multiple Choice Questions 1. The US FED promotes the stability of the financial system and seeks to minimize and contain ………….. through active monitoring and engagement in the U.S. and abroad. (a) Credit risks (b) unsystematic risks (