Introduction to Financial System.pdf

CHAPTER 1 : INTRODUCTION TO FINANCIAL SYSTEM 1.1 FINANCIAL SYSTEM A. Financial System – An Overview:  The financial system is possibly the most important institutional and functional vehicle for economic transformation.  A 'financial system...

CHAPTER 1 : INTRODUCTION TO FINANCIAL SYSTEM 1.1 FINANCIAL SYSTEM A. Financial System – An Overview:  The financial system is possibly the most important institutional and functional vehicle for economic transformation.  A 'financial system' is a framework that permits the trading of funds between borrowers, lenders, and investors.  A financial system consists of individuals like borrowers and lenders and institutions such as banks, stock exchanges and insurance companies that work at the national and international levels to permit the exchange of funds. Institutions in the financial system include everything from regional banks to government treasures and stock exchanges.  The services that are provided to a person by the various Financial Institutions including banks, insurance companies, pensions, funds, etc. constitute the financial system.  It gives investors the ability to grow their wealth and assets, thus contributing to economic development.  financial system operating at corporate, national, and international levels are governed by different government policies and specific set of rules  It serves different purposes in an economy, such as working as payment systems, providing savings options, bringing liquidity to financial markets, and protecting investors from unexpected financial risks.. B. Definition of Financial System:  According to Christy, the objective of the financial system is to ―supply funds to various sectors and activities of the economy in ways that promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desires‖.  According to Robinson, the primary function of the system is ―to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth‖. C. Features of the Financial system Given below are the features of the Financial system:  It helps in mobilising and allocating one‘s savings  It helps form a link between the depositors and investors.  Plays a key role in capital formation  It plays a vital role in the economic development of the country as it encourages both savings and investment  Financial system promotes efficient allocation of financial resources for socially desirable and economically productive purposes.  It facilitates the expansion of financial institutions and markets 1.2 FUNCTIONS OF FINANCIAL SYSTEM A. Introduction: A financial system functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. It helps in borrowing and lending when needed. A financial system allows its participants to prosper and reap the benefits. In simpler words, it will circulate the funds to different parts of an economy. B. Functions of Financial System 1. Payment System – An efficient payment system allows businesses and merchants to collect money in exchange for their products or services. The financial systems offer a very convenient mode of payment for goods and services. Payments can be made with cash, checks, credit cards, and etc. are the easiest methods of payment system in the economy; they also drastically reduce the cost and time of transactions. 2. Savings – Financial system helps to pool the Public savings from individuals and businesses and invest the same in business and companies. Borrowers can use them to fund new projects and increase future cash flow, and investors get a return on investment in return. Similarly the funds are in the hands of the producers, resulting in better goods and services and an increase in society's living standards. When savings flow declines, however, the growth of investment and living standards begins to fall.  3. Liquidity – The financial markets provide the investor with the opportunity to liquidate their investments. It thus allows for easy buying and selling of assets when needed. That is why one always prefers to store funds in financial instruments like stocks, bonds, debentures, etc. which provides the degree of liquidity. 4. Risk Management – The financial system provide protection against life, health, and income risks. These are accomplished through the sale of life, health, and property insurance policies. Overall, it provides immense opportunities for the investor to hedge himself/herself against or reduce the possible risk involved in various instruments. 5. Government Policy – Governments attempt to stabilize or regulate an economy by implementing specific policies to deal with inflation, unemployment, and interest rates. So, for example, the federal or central bank indulges in several cuts in CRR and tries to decrease the interest rates and increase the availability of credit at cheaper rates to the corporates. 1.3 EVOLUTION OF FINANCIAL SYSTEM – PRE AND POST INDEPENDENCE The India Financial System falls into 3 different phases :  Phase I- Pre Independence upto 1951  Phase II- Post Independence 1951  Phase III- Post 1991  A. Phase I- Pre Independence up to 1951 The structure of Indian Financial System during the Pre Independence Era was that of a traditional economy. The main features of the financial system pre 1951 was that of a closed economy consisting of :  Semi organized Securities Market.  Closed circle Industrial Entrepreneurship  Restricted access to foreign savings  Absence of financial institutions in long term industrial financing. B. Post Independence upto 1990’s During the post independence period there has been a significant growth in the Indian Financial System in terms of quantitative indicators as well as in diversification and innovations. This period was the progressive transfer of its important constituents from private ownership to public ownership. An overview of the development of the Indian Financial System in the post independence period up to 1990‘s are as under : 1. Nationalization of Banks & Insurance Sector  The post 1951 phase was a landmark era in the history of Indian Financial System with the nationalization of RBI and SBI in 1956  In 1969, 14 major commercial banks were brought under direct control of government of India. The nationalisation of LIC and GIC was yet another historical measure. 2. Development Banks / Institutions  The govt created a wide range of new institutions in the public sector. The institutions were created to cater to the financial needs of industries and between them covered the whole range of Industry.  The public sector occupied a commanding position in the industrial financing system in India ex ; SIDBI, IFCI, IDBI, UTI etc.  3. Investors Protection During this period, there were gross mismanagement of companies, corporate frauds and abuses which results in loss of public confidence in corporate securities market. To restore investor faith and confidence, the government adopted drastic measures such as :  The companies Act, 1956  The Capital Issues Act, 1947  Securities Contracts Act, 1956  Monopolies & Restrictive Trade practices Act, 1970  Foreign Exchange Regulation Act, 1973 C. Post – The New Industrial Policy 1991 The declaration of the New Industrial Policy witnessed a profound transformation in the Indian Financial System. The notable developments in the Indian Financial System during this phase are :  Privatization of Financial Institutions.  Re-organisation of existing financial structure.  Protection of Investors.  Adequacy of Capital Structure.  Review of Supervisory Arrangement.  Improve Efficiency, Effectiveness and Competitiveness. 1.4 LIMITATIONS/WEAKNESS OF FINANCIAL SYSTEM After the introduction of planning, rapid industrialization has taken place. It has in turn led to the growth of the corporate sector and the government sector. In order to meet the growing demand of the government and Industries, many innovative financial instruments have been introduced. The Indian financial system is now more developed and integrated today than what it was few years ago. Yet it suffers from some weaknesses. Following are the weakness of Indian financial system. 1. Govt Interference The Indian Financial System is all time politicised by excessive government intervention. This leads to virtual lack of freedom for the banks, financial institutions, financial markets etc. to enhance productivity and efficiency, greater degree of autonomy should be ensured. 2. Lack of Coordination: There are a large number of FIs. Most of the vital FIs are owned by the government. At the same time, the government is also the controlling authority of these institutions. In these circumstances, the problem of coordination arises. 3. Monopolistic Market Structures: In India, some FIs are so large that they have created a monopolistic market structure of financial system. For instance, almost entire life insurance business is in the hands of LIC of India. So large structures could delay development of financial system of the country itself. 4. Inactive and Erratic Capital Market: The Indian capital market is not strong and dependable. Because of regular scams and frauds, general public is not having faith in the Capital Markets. The weakness of the capital market is a serious problem in Indian financial system. 5. Lack of Professionalism One of the drawback of Indian Financial System has been caused due to unprofessional management. Absence of work culture, inadequate internal controls, and insufficient delegation of authority has caused competitive inefficiency. 6. Lack of Direction The effectiveness of the financial system lies in rendering efficient and timely services limited delegation of authority, excessive regulation by govt and stringent controls have given rise to lack of direction in Indian Financial System. 7. Lack of Operational flexibility It is said that the functional autonomy is a pre requisite for operational flexibility of financial system to achieve improved performance in terms of productivity, efficiency and profitability. Due to tight regulation and strict controls by govt, there is lack of operational flexibility in Indian Financial System. 8. Excessive Regulation One of the issues in the Indian Financial System is that of over regulation. If every aspect of the system is subject to control and approval, then the financial system loses its innovative character which obstructs the growth.  CHAPER 2- STRUCTURAL REFORM OF INDIAN FINANCIAL SYSTEM 2.1 STRUCTURE OF INDIAN FINANCIAL SYSTEM A. Introduction:  The Indian financial system is a complex network of financial institutions, markets, instruments, and services that facilitate the flow of funds between savers and investors. The Indian Financial System is made up of various components that work together to facilitate the flow of funds between savers and investors. The structure of the Indian financial system can be broadly divided into two parts: the organized sector and the unorganized sector.  The organized sector includes formal financial institutions such as banks, insurance companies, NBFCs, mutual funds, stock exchanges, and pension funds. These institutions are regulated by the Reserve Bank of India (RBI) and other regulatory bodies such as the Securities and Exchange Board of India (SEBI), the Insurance Regulatory and Development Authority of India (IRDAI), and the Pension Fund Regulatory and Development Authority (PFRDA).  The unorganized sector, on the other hand, includes informal financial intermediaries such as moneylenders, chit funds, and other unregulated entities that cater to the financial needs of the unbanked and underserved sections of society. B. Components of Indian Financial System 1. Financial Institutions  The Financial Institutions act as a mediator between the investor and the borrower. Financial institutions are intermediaries that mobilize savings and facilitate the allocution of funds in an efficient manner.  The best example of a Financial Institution is a Bank. People with surplus amounts of money make savings in their accounts, and people in dire need of money take loans. The bank acts as an intermediate between the two. The financial institutions can further be divided into two types:  Banking Institutions or Depository Institutions – This includes banks and other credit unions which collect money from the public against interest provided on the deposits made and lend that money to the ones in need.  Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds and brokerage companies fall under this category. They cannot ask for monetary deposits but sell financial products to their customers. 2. Financial Assets The products which are traded in the Financial Markets are called Financial Assets. Based on the different requirements and needs of the credit seeker, the securities in the market also differ from each other. Some important Financial Assets are :  Call Money – When a loan is granted for one day and is repaid on the second day, it is called call money. No collateral securities are required for this kind of transaction.  Notice Money – When a loan is granted for more than a day and for less than 14 days, it is called notice money. No collateral securities are required for this kind of transaction.  Term Money – When the maturity period of a deposit is beyond 14 days, it is called term money.  Treasury Bills – Also known as T-Bills, these are Government bonds or debt securities with maturity of less than a year. Buying a T-Bill means lending money to the Government.  Certificate of Deposits – It is a dematerialised form for funds deposited in the bank for a specific period of time.  Commercial Paper – It is an unsecured short-term debt instrument issued by corporations. 3. Financial Services The main aim of the financial services is to assist a person with selling, borrowing or purchasing securities, allowing payments and settlements and lending and investing. The financial services in India include:  Banking Services – Any small or big service provided by banks like granting a loan, depositing money, issuing debit/credit cards, opening accounts, etc.  Insurance Services – Services like issuing of insurance, selling policies, insurance undertaking and brokerages, etc. are all a part of the Insurance services  Investment Services – It mostly includes asset management  Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part of the Foreign exchange services 4. Financial Markets The marketplace where buyers and sellers interact with each other and participate in the trading of money, bonds, shares and other assets is called a financial market. The financial market can be further divided into four types:  Capital Market – Capital market is market for long term securities. it is a market for long term borrowing and lending, i.e. more than one year. The capital market can further be divided into three types: (a)Corporate Securities Market (b)Government Securities Market (c)Long Term Loan Market  Money Market – Money market is market for short term securities. it is a market for short term borrowing and lending, i.e. more than less than year. The money market can further be divided into two types: (a) Organised Money Market (b) Unorganised Money Market  Foreign exchange Market – One of the most developed markets across the world, the Foreign exchange market, deals with the requirements related to multi-currency. The transfer of funds in this market takes place based on the foreign currency rate.  Credit Market – A market where short-term and long-term loans are granted to individuals or Organisations by various banks and Financial and Non-Financial Institutions is called Credit Market.  2.2 INTERNATIONAL FINANCIAL INSTITUTIONS A. Introduction:  Under the terms of the Bretton Woods Agreement, also known as the United Nations Monetary and Financial Conference, the World Bank and International Monetary Fund (IMF) were established simultaneously.  In December 1945, both organizations were formally established. The World Bank and International Monetary Fund are also known as the Bretton Wood Twins. The only requirement for a country to join the World Bank is that it must be an IMF member. B. World Bank  The World Bank is an international organization that provides financing, advice, and research to developing nations to help advance their economies.  The World Bank Group is an international partnership comprising 189 countries and five constituent institutions that works towards eradicating poverty and creating prosperity.  There is a special focus on developing and underdeveloped countries. The bank predominantly acts as an organization that attempts to fight poverty by offering developmental assistance to middle- and low-income countries.  The World Bank are headquartered in Washington, D.C  The five development institutions under the World Bank Group are: o IBRD- International Bank for Reconstruction and Development - provides loans, credits, and grants. o IDA- International Development Association - provides low- or no interest loans to low-income countries. o IFC- The International Finance Corporation - provides investment, advice, and asset management to companies and governments. o MIGA- Multilateral Guarantee Agency- insures lenders and investors against political risk such as war. o ICSID- International Centre for the Settlement of Investment Disputes - settles investment-disputes between investors and countries.   Functions of the World Bank o It helps the war-devasted countries by granting them loans for reconstruction. o It helps the poor countries increase their economic growth, reducing poverty and a better standard of living. o It helps the underdeveloped countries by granting development loans. o It also provides loans to various governments for irrigation, agriculture, water supply, health, education, etc. o It promotes foreign investments to other organizations by guaranteeing the loans. o It provides economic, monetary, and technical advice to the member countries for any of their projects. o It encourages the development of of-industries in underdeveloped countries by introducing the various economic reforms. C. The International Monetary Fund (IMF)  The International Monetary Fund (IMF) is an international organization that promotes global economic growth and financial stability, encourages international trade, and reduces poverty around the world.  The International Monetary Fund (IMF) is based in Washington, D.C. The organization is currently composed of 190 member countries, each of which has representation on the IMF's executive board in proportion to its financial importance.  Functions of IMF o It maintain stability and prevent crises in the international monetary system, the IMF conducts surveillance of national, regional, and global economic and financial developments. o It provides advice to its 190 member countries, encouraging them to adopt policies that foster economic stability, reduce their vulnerability to economic and financial crises, and raise living standards. o It also serves as a forum where its global membership can discuss the national, regional, and global consequences of their policies. o It makes financing temporarily available to member countries to help them address balance of payments problems i.e. when they find themselves short of foreign exchange to meet their payments to other countries.  2.3 FINANCIAL SECTOR REFORMS IN INDIA A. Need for Financial Sector Reforms  After independence India inherited a colonial legacy that was full of various social and economic deprivations.  In order to achieve various economic goals, the government resorted to increased borrowings at concessional rates which lead to weak and underdeveloped financial markets in India.  The nationalization of banks increased government control and decreased the role of market forces in the financial sector.  Increased bureaucratic control, issues of red-tapism increased the non- performing assets.  Turbulent international events such as the war in the Middle East and the fall of the USSR increased the pressure on the Foreign Exchange Reserves of India. B. Narasimham Committee Report (1991)  It was established to give reforms pertaining to the financial sector of India including the capital market and banking sector. On the basis of recommendations of Committee report reforms took place in Banking sector, debt market and foreign exchange market market. C. Reforms in the Banking Sector  Reduction in CRR and SLR has given banks more financial resources for lending to the agriculture, industry and other sectors of the economy.  The system of administered interest rate structure has been done away with and RBI no longer decides interest rates on deposits paid by the banks.  Allowing domestic and international private sector banks to open branches in India, for example, HDFC Bank, ICICI Bank, Bank of America, Citibank, American Express, etc.   Issues pertaining to non-performing assets were resolved through Lok adalats, civil courts, Tribunals, The Securitisation And Reconstruction of Financial Assets and the Enforcement of Security Interest (SARFAESI) Act.  The system of selective credit control that had increased the dominance of RBI was removed so that banks can provide greater freedom in giving credit to their customers. D. Reforms in the Debt Market  The 1997 policy of the government that included automatic monetization of the fiscal deficit was removed resulting in the government borrowing money from the market through the auction of government securities.  Borrowing by the government occurs at market-determined interest rates which have made the government cautious about its fiscal deficits.  Introduction of treasury bills by the government for 91 days for ensuring liquidity and meeting short-term financial needs and for benchmarking.  To ensure transparency the government introduced a system of delivery versus payment settlement. E. Reforms in the Foreign Exchange Market  Market-based exchange rates and the current account convertibility was adopted in 1993.  The government permitted the commercial banks to undertake operations in foreign exchange.  Participation of newer players allowed in rupee foreign currency swap market to undertake currency swap transactions subject to certain limitations.  Replacement of foreign exchange regulation act (FERA), 1973 was replaced by the foreign exchange management act (FEMA), 1999 for providing greater freedom to the exchange markets.  Trading in exchange-traded derivatives contracts was permitted for foreign institutional investors and non-resident Indians subject to certain regulations and limitations.  CHAPTER 3- FINANCIAL MARKETS 3.1 CAPITAL MARKET A. Introduction: The market where investment instruments like bonds, equities and mortgages are traded is known as the capital market. The primal role of this market is to make investment from investors who have surplus funds to the ones who are running a deficit. B. Types of capital market There are two types of capital market: 1. Primary market, 2. Secondary market 1. Primary Market  It is that market in which shares, debentures and other securities are sold for the first time for collecting long-term capital. This market is concerned with new issues. Therefore, the primary market is also called NEW ISSUE MARKET.  In a primary issue, the securities are issued by the company directly to investors.  The company receives the money and issues new security certificates to the investors.  It Is Related With New Issues.It Has No Particular Place.It Has Various Methods of Float Capital.  Following are the methods of raising capital in the primary market: i) Public Issue ii) Offer For Sale iii) Private Placement iv) Right Issue v) Electronic-Initial Public Offer. 2. Secondary Market Secondary market deals with the exchange of prevailing or previously-issued securities among investors. Once new securities have been sold in the primary market, an efficient manner must exist for their resale. Secondary markets give investors the means to resell/ trade existing securities. Issuing companies play no part in the secondary market. Examples of secondary markets are New York Stock Exchange (NYSE), London Stock Exchange (LSE), Bombay Stock Exchange (BSE). C. Importance of Capital market 1. Raising capital for business. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business. 2. Mobilizing savings The key function of the primary market is to facilitate capital growth by enabling individuals to convert savings into investments. 3. Provide fund to govt. It provides a channel for the government to raise funds from the public to finance public sector projects. Government can raise capital through sale of Treasury bonds. 4.Control liquidity: Open market operation to effect monetary policy of the government i.e control of excess liquidity in the economy. 5. FDI It is a vehicle for direct foreign investment. Foreign investors invest in stock market by FDI and portfolio investment. 6. Global Investments The primary market enables business expansion and growth for domestic and foreign companies. International firms issue new stocks and raise fund from international market in foreign currency.  3.2 Money Market A. Introduction Money Market is a financial market borrowing and lending takes place for short time period. In money market, short-term financial assets having liquidity of one year or less are traded on stock exchanges. The market offers very high liquidity as the assets can easily convert into cash. The money market is categorized into organized and unorganized sectors. An organized sector - is one that operates under the legal framework of a country, while the unorganized sector does not adhere to any legal framework. In the money market, the organized sector includes banks, financial institutions, and other regulated entities, whereas the unorganized sector consists of unregulated entities such as money lenders, chit funds, and other informal financial intermediaries. B. Instruments of Money Market 1. Commercial Bills Commercial bills, also a money market instrument, work more like the bill of exchange. Businesses issue them to meet their short-term money requirements. These instruments provide much better liquidity. As the same can be transferred from one person to another in case of immediate cash requirements. 2. Call Money Call money is one of the most liquid instruments. The validity is generally one working day. Banks can face shortfalls that can be solved by borrowing through call money. In contrast, those with surplus cash can invest in other banks through call money. Borrowing and lending take place at the call rate. 3. Treasury Bills T-bills are issued by a country‘s central bank on behalf of its government. The government often raises funds through Treasury Bills that provide quick money. In the money market, it is considered one of the safest investments due to the government backing. They don‘t offer an income Interest T-bills are issued at a discount and redeemed at par. The tenure of T-bills is generally from 14 days to 364 days. 4. Commercial Papers (CPs) Companies generally use commercial papers to fund their short-term working capital needs, such as payment of accounts receivables, inventory purchases, etc. However, these are unsecured in nature. CPs are issued at a discount, and therefore, they don‘t come with separate interests. the period of commercial paper ranges from 15 days to 1 year. 5. Certificate of Deposits (CDs) A certificate of deposit is a type of time deposit with the bank. Only a bank can issue a CD. Like all other time deposits, CDs also have a fixed maturity date and cannot be withdrawn before maturity. The duration of these varies between 3 months to 1 year. 3.3 Commodity Market A. Introduction to Commodity Market  A commodity market is a marketplace for buying, selling, and trading raw materials or primary products. It is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar.  A commodities exchange is an exchange where various commodities and derivatives are traded. Most commodity markets across the world trade in agricultural products and other raw materials and contracts based on them. These contracts can include spot prices, forwards, futures and options on futures. B. Types of Commodities Commodities which are traded in commodity market are often split into two broad categories: hard and soft commodities. 1. Hard commodities include natural resources that must be mined or extracted. It includes  Precious metals: Gold, platinum, copper, silver, etc.  Energy: Crude oil, Natural gas, gasoline, etc.  2. Soft commodities are agricultural products or livestock. It icludes—  Agriculture: Soybeans, wheat, rice, coffee, corn, salt, etc.  Livestock and meat: Live cattle, pork, feeder cattle, etc. C. Role of commodities market In India Realizing the importance of the commodities market in India, the role of the commodities market in India is pivotal to the country‘s growth and safeguarding the interest of its citizens. The market plays its role through the following factors: 1. Food Security: The commodities market in India plays a crucial role in ensuring that the suppliers of commodities are protected against falling prices. They can utilize the commodities futures contracts to lock in a price that they think is apt for their products. It ensures that there will be an adequate supply of commodities throughout the country. 2. Better agriculture infrastructure: Within the commodities market, farmers suffer at the hands of inadequate post- harvest infrastructure. Even though they produce a high quantity of commodities, the lack of adequate warehousing, transport, etc., forces them to suffer losses. Commodities market offers profits to farmers, brokers, intermediaries, and customers. Thus, attracting investments in the agriculture sector in the hope of better long-term profits. 3. An organized platform: Before the commodities market, the farmers or the suppliers of commodities only relied on middlemen to sell their products. It forced them to take whatever amount the middlemen offered. However, today, the commodity market ensures that they can utilize an organized platform to trade their commodities and realize an adequate price.  4. A new asset class: The role of the commodities market is not limited to farmers or suppliers but extends to offer a new asset class for investors seeking profits. By trading in commodities, they can hedge against losses from other asset classes, diversify their portfolio, while helping in the overall growth of the commodity sector in India. 5. Mitigates Volatility: This is one of the most important roles of the commodity market in India. It helps protect the originator of the risk and results in the overall distribution of the risk exposure. For example, a jewellerycan sell a gold futures contract to avoid any rise in the gold prices in the upcoming months. However, the same futures contract can be bought by an investor with the intention that the gold prices will rise in the future. Through the contract, the risk gets distributed and mitigates a high level of volatility. D. Traders in a Commodity Market The players in the commodity derivatives market can be classified into two major categories – Hedgers & Speculators 1. Hedgers Risk givers or hedgers refer to those who have a risk due to physical exposure to the commodity, and are looking to pass on their risk by taking a sell or buy position on Stock Exchange. Any change in the price level does not affect the rate at which respective commodities are traded in the market. 2. Speculators Investors aiming to generate substantial profits from trade in the commodity market are termed as speculators. A prediction regarding the direction of movement of market prices are assumed by such individuals before signing a futures contract, and depending upon accuracy of market forecast, positive or negative returns can be realised, subject to spot prices.  3.4 Derivatives Market A. Introduction  The derivatives market is a financial market where various types of derivatives instruments are bought and sold.  It serves as a platform for participants to manage risk, speculates on price movements, and gain exposure to different asset classes. B.Contracts in Derivative Markets: 1. Forward contract A forward contract is a private agreement between the buyer and seller to exchange the underlying asset for cash at a particular date in the future and at a certain price. On the settlement date, the contract is settled by physical delivery of asset in consideration for cash. Settlement date, quality, quantity, rate and the asset are fixed in the forward contract. Such contracts are traded in a decentralized market, i.e. Over the counter (OTC) where the terms of the contract can be customized as per the needs of the parties concerned. The buyer in a forward contract is considered as long, and his position is assumed as long position while the seller is called short, holds a short position. When the price of the underlying asset rises and is more than the agreed price, the buyer makes a profit. But if the prices fall, and is less than the contracted price the seller makes a profit. Example: Aman wants to sell grain at the current rate of Rs.26, but he feels that the grain prices might fall in the coming months due to certain conditions. So, he decides to sign a forward contract with a grocery shop. According to the contract, Aman will sell grains after three months at Rs 26. If the price of grain falls below Rs.26, Aman will not incur any loss. However, if grain prices rise, Aman will only receive the price stated in the contract. 2. Future contract  A binding contract which is executed at a later date is a future contract.  It is an exchange-traded contract of the standardized nature where two parties, decides to exchange an asset, at an agreed price and future specified a date for delivery and payment.  A future contract is a standardized in terms of the quantity, date, and delivery of the item.  The buyer holds long position while the seller holds a short position in this contract.  It includes an intermediary (clearance house, a division of a stock exchange) between two parties. Because each party collaborates with the clearing house that monitors the transaction, the default risk that may seem too troublesome in a contract is drastically decreased in a future contract.  Example: Aman and Rashmi are two individual parties. Aman is an iron producer, and Rashmi owns a business that frequently requires iron. Rashmi agrees to trade a certain amount of iron (say, 90 kg), and both parties agree to a fixed price (say, 400/kg) for trading the iron on a future date. The future contract will be executed through stock exchange at the agreed-upon price at the delivery time, irrespective of the market price at the expiration date. 3. Options  Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.  Each options contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.  Types of Options 1. Call Option  A call option is a type of options contract that gives the holder the right, but not the obligation to buy the asset at the agreed-upon strike price before the expiration date.  Investors buy calls when they believe the price of the underlying asset will increase and sell calls if they believe it will decrease.  The call option can be bought by the investor by paying a premium upfront to the seller, also called the Options writer.  The option holders, therefore, make a profit if the value of the asset rises in the future. This is because the call option allows them to buy the asset at a much lower price and then sell in the market for its current higher price.  For example, suppose you purchase a call option for stock at a strike price of Rs 200 and the expiration date is in two months. If within that period, the stock price rises to Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to make a profit of Rs 240-200 = Rs 40. 2. Put Option  A put option is a type of options contract that gives the options holders the right, but not the obligation to sell the asset at the set strike price any time before the expiration date.  Investors buy puts when they believe the price of the underlying asset will decrease and sell puts if they believe it will increase. If the value of the asset falls in the future, the call option gives holders the choice to sell the asset at the agreed-upon higher price, thereby minimising overall risk.  For example, let‘s assume you purchase a put option for stock at a strike price of Rs 200 and the expiration date is in a month. If within that period, the stock price falls to Rs 180, you can still choose to sell the stock at Rs 200. On the other hand, if the price of the stock rises above Rs 200, you can choose between exercising the contract or not. 4. Swap  Swap refers to an exchange of one financial instrument for another between the parties concerned. This exchange takes place at a predetermined time, as specified in the contract, usually through an intermediary like a financial institution.  Under the Swaps agreement, one party exchanges fixed cash flows in return for floating cash flows exchanged by the other counterparty.  Swaps can be used to hedge risk of various kinds which includes interest rate risk and currency risk. Currency swaps and interest rates swaps are the two most common kinds of swaps traded in the market.  A swap is not standardised and does not trade on public stock exchanges, and it is not common for retail investors to engage in a swap. Rather, swaps are over- the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties. Since they are traded over-the-counter, the terms of the swap contract are negotiated and customised to the needs of both parties.  As a result of swaps occurring on the over-the-counter market, the swap contracts are considered risky because of the counterparty risk where one party can default on the payment. Example of Swap:  The two parties enter into an interest rate swap agreement in which party B will make monthly payments to party A of MIBOR+1% on the notional principal amount of INR 10 lakhs for 3 years. At the same time, party A will make monthly payments to party B of 7% every month on the same notional amount for 3 years. This is a standard interest rate swap, where the notional principal amount of INR 10 lakhs remains the same.  Assume that in the following month, the MIBOR rises to 6.5%. In this case, party B will receive a fixed payment of 7%. However, party A will receive the new MIBOR +1%, i.e. 7.5% on the principal amount. This way, party A will benefit if the interest rate rises.  3.5 Foreign exchange market A. Introduction  The foreign exchange market is over a counter (OTC) global marketplace that determines the exchange rate for currencies around the world. This foreign exchange market is also known as Forex, FX, or even the currency market. The participants engaged in this market are able to buy, sell, exchange, and speculate on the currencies.  These foreign exchange markets are consisting of banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers, and investors. B. Features of Foreign Exchange Market 1. High Liquidity The foreign exchange market is the most easily liquefiable financial market in the whole world. This involves the trading of various currencies worldwide. The traders in this market are free to buy or sell the currencies anytime as per their own choice. 2. Market Transparency There is much clarity in this market. The traders in the foreign exchange market have full access to all market data and information. This will help to monitor different countries‘ currency price fluctuations through the real-time portfolio. 3. Dynamic Market The foreign exchange market is a dynamic market structure. In these markets, the currency values change every second and hour. 4. Operates 24 Hours The Foreign exchange markets function 24 hours a day. This provides the traders the possibility to trade at any time. C. Functions of Foreign Exchange Market The various functions of the Foreign Exchange Market are as follows:  Transfer Function: The basic and the most obvious function of the foreign exchange market is to transfer the funds or the foreign currencies from one country to another for settling their payments. The market basically converts one‘s currency to another.  Credit Function: The FOREX provides short-term credit to the importers in order to facilitate the smooth flow of goods and services from various countries. The importer can use his own credit to finance foreign purchases.  Hedging Function: The third function of a foreign exchange market is to hedge the foreign exchange risks. The parties in the foreign exchange are often afraid of the fluctuations in the exchange rates, which means the price of one currency in terms of another currency. This might result in a gain or loss to the party concerned. D. Participants in a Foreign Exchange Market The participants in a foreign exchange market are as follows:  Central Bank: The central bank takes care of the exchange rate of the currency of their respective country to ensure that the fluctuations happen within the desired limit and this participant keeps control over the money supply in the market.  Commercial Banks: Commercial banks are the channel of forex transactions, which facilitates international trade and exchange to its customers. Commercial banks also provide foreign investments.  Traditional Users: The traditional users consist of foreign tourists, the companies who carry out business operations across the globe.  Traders and Speculators: The traders and the speculators are the opportunity seekers who look forward to making a profit through trading on short-term market trends.  Brokers: Brokers are considered to be the financial experts who act as a sure intermediary between the dealers and the investors by providing the best quotations.  CHAPTER 4: FINANCIAL INSTITUTION 4.1 Introduction  Financial institutions are the economic entities that help individuals and businesses with several financial services, enabling them to deposit, save, invest, and manage their monetary resources.  Central banks, commercial banks, investment entities, credit unions, mutual fund companies, insurance companies, etc., are some of the widely available financial institution types.  They also offer consultation services to consumers who seek advice on the pros and cons of making a particular investment.  These institutions are strictly regulated by national authorities to keep the financial structure and market active and efficient. 4.2 Types of Financial Institutions I. Banking Financial Institutions Banking financial institutions are in the business of taking deposits from the public and making loans. In addition, they provide other services such as investment banking, foreign exchange, and safe deposit boxes. These institutions are heavily regulated by governments to protect consumers and ensure that the banking system is stable. 1. Central Bank The Reserve Bank of India is the central bank of our country. the central bank of the country may also be known as the banker‘s bank as it provides assistance to the other banks of the country and manages the financial system of the country, under the supervision of the Government. 2. Cooperative Banks These banks are organised under the state government‘s act. They give short term loans to the agriculture sector and other allied activities.The main goal of Cooperative Banks is to promote social welfare by providing concessional loans. 3. Commercial Banks A commercial bank is a financial institution that accepts money from individuals and businesses and provides loans to those in need. They offer services such as loans, savings, certificates of deposits, bank accounts, bank overdrafts, etc., to their customers. These organizations earn money by granting loans to individuals and gaining interest on loans. Business loans, house loans, personal loans, car loans, and education loans are the different types of loans offered by commercial banks.The commercial banks can be further divided into three categories: a. Public sector Banks – A bank where the majority stakes are owned by the Government or the central bank of the country. b. Private sector Banks – A bank where the majority stakes are owned by a private organization or an individual or a group of people. 4. Foreign Banks Banks that are headquartered in a different country but have operations in India. They play a significant role in the Indian banking sector by providing competition, improving services, and attracting foreign investment. 5. Regional Rural Banks (RRB) These are special types of commercial Banks that provide concessional credit to agriculture and rural sector. RRBs are joint ventures between the Central government (50%), State government (15%), and a Commercial Bank (35%). 6. Specialized Banks Certain banks are introduced for specific purposes only. Such banks are called specialized banks. These include:  Small Industries Development Bank of India (SIDBI) – provide financial assistance to small industries or businesses with modern technology and equipment.  EXIM Bank – EXIM Bank stands for Export and Import Bank, which provide financial assistance for exporting or importing goods from foreign.  National Bank for Agricultural & Rural Development (NABARD) – provide financial assistance for rural, handicraft, village, and agricultural development,.  II. Nonbanking financial institution A nonbank financial institution (NBFI) is a financial institution that does not have a full banking license and cannot accept deposits from the public. However, NBFIs do facilitate alternative financial services, such as investment , risk pooling, financial consulting, brokering, money transmission, and check cashing. 1. Stock exchanges: The stock exchange reflects a marketplace where buyers and sellers engage in trading financial instruments like stocks and derivatives. It connects companies that need funding and investors who have excess funds to invest as an intermediary. 2. Insurance companies: Insurance companies provide various insurance policies like life insurance, home insurance, care insurance and other insurances designed to give financial protection to the customers. It pools policy holders‘ premiums and invests them in various investment vehicles like bonds and other money market instruments. 3. Mutual fund companies: Mutual funds these funds pool money from investors and invest it in a portfolio of stocks, bonds, and other assets. This enables individual investors to benefit from returns that they would not have earned had they invested independently. Mutual fund companies help clients with investment management. 4. Pension funds: A pension fund, also known as a superannuation fund provide retirement income for workers. Pension funds are pooled monetary contributions from pension plans set up by employers, unions, or other organizations to provide for their employees' or members' retirement benefits. The money is invested in stocks, bonds, and other assets. 5. Merchant banks /Investment Banks Investment banking helps individuals, organizations, governments, and other institutions raise capital and provide financial consultancy advice. They advise firms on mergers and acquisitions, fund raising, manage IPO of firms, underwrite new issues and facilitate demat trading. 6. Venture Capital Firms/ Companies These firms invest in early-stage companies with high growth potential.They provide finance and technical assistance to firms which undertake a business  project based on innovative ventures. They provide finance for the commercial application of new technology. 7. Private equity firms: A private equity firm is a type of investment firm. They invest in businesses with a goal of increasing their value over time and help them grow. Such firms make investments in private companies, or companies that aren't traded on the public stock market. They may also take the companies public. 8. Brokerage Firms A brokerage firm or company is a middleman who connects the buying and selling parties to facilitate the transaction. Once the transaction is completed, brokers receive both parties‘ brokerage (commission). Some brokerage companies also provide financial advice and act as consultants. 9. Financial advisors A financial advisor is an intermediary who provides financial services to clients. In most countries, financial advisors must undergo special training and obtain licenses before they can offer consultancy services. 10. Vulture Funds These funds buy stocks of companies which are nearing bankruptcy at a very low price. After purchasing such stocks they initiate the recovery process to increase the price of shares and sell it at a later point of time 11. Finance Companies (Loan Companies) Financial Institutions raise funds from the public for lending purpose. e.g. – Muthoot Finance, Cholamandalam 12. Micro Finance Institutions (MFI) Raise funds from the public for lending to weaker sections. In India, they mainly raise funds from banks. e.g. – Basix, Bandhan, SKS Micro Finance. 13. Leasing Companies They purchase equipment and machinery and provide the same to companies on a lease. These companies charge rent on these machineries which is similar to EMI 4.3 Roles Performed by Financial Institutions 1. Economic Growth of the Nation At the national level, financial institutions are subject to government regulation. They serve as an agent of the government and develop the country‘s economy. For instance, following government regulations, financial institutions may extend a selective credit line with lower interest rates to assist a struggling industry in resolving its problems. 2. Employment Creation Startups and small businesses can start their venture by seeking long and medium- term credit from these institutions. This will lead to the opening of new employment opportunities and economic growth. The business owners also have the option to take a loan against their existing property either for a new venture opening or for the expansion and diversification of an existing one. 3. Ensure Regional Balance The government set up financial institutes in rural and backward areas to help local people, small farmers, artisans, household workers, etc., with loans and credits. These institutions also provide government-approved schemes such as NABARD, Agricultural loans, interest at low rates to Self Health Groups (SGHs), etc., to help uplift these areas. 4. Intermediation Financial institutions act as intermediaries between savers and borrowers. They collect funds from individuals and businesses as deposits and then lend them to borrowers who need capital for various purposes, such as starting a business or purchasing a home. 5. Credit Provision Financial institutions extend credit to individuals and businesses through loans and credit lines. They evaluate the creditworthiness of borrowers, determine interest rates, and provide financial support for various needs, such as personal loans, mortgages, business loans, and working capital. 6. Investment Services Financial institutions offer investment services to help individuals and businesses manage and grow wealth. They provide access to investment products such as stocks, bonds, mutual funds, and other securities. They also offer advisory services to guide clients in making informed investment decisions. 7. Financial Advisory Financial institutions provide financial advisory services to individuals and businesses. They offer guidance on financial planning, retirement planning, tax planning, estate planning, and overall wealth management. They assist clients in making informed financial decisions based on their goals and risk tolerance. 8. Payment and Settlement Services Financial institutions facilitate payment transactions between individuals and businesses. They provide payment and settlement services such as processing electronic fund transfers, issuing credit and debit cards, and managing payment systems to enable smooth and secure transactions. 9. Risk Management Financial institutions assist individuals and businesses in managing financial risks. They provide insurance products, such as life insurance, health insurance, property insurance, and liability insurance, to protect against potential losses and unforeseen events. 10. Asset Management Financial institutions offer asset management services, where they manage investment portfolios on behalf of clients. They provide expertise in selecting investment options, diversifying portfolios, and monitoring market conditions to optimize returns and meet clients‘ financial goals.  CHAPTER 5 : FINANCIAL INSTRUMENT 5.1 What is a Financial Instrument?  A financial instrument is a legal contract between the parties who are a part of the transaction that holds a monetary value. The monetary assets can be traded, created, modified or settled as per the parties‘ requirements. In other words, any asset that holds capital and trades in the financial market can be termed a financial instrument. Basic examples of financial instruments are cheques, bonds, stocks.  For example, if a company were to pay cash for a bond, another party is obligated to deliver a financial instrument for the transaction to be fully completed. One company is obligated to provide cash, while the other is obligated to provide the bond. 5.2 Types of Financial Instruments There are typically three types of financial instruments: cash instruments, derivative instruments, and foreign exchange instruments. 1. Cash Instruments Cash instruments can easily be transferred and valued in the market. Also, market conditions directly influence the value of these financial instruments. The two types of cash instruments are –  Securities: This financial instrument has a monetary value and trade on the stock market. While purchasing security (share), it represents a part of the ownership of a publicly traded company on the stock exchange.  Deposits and Loans: Both are cash instruments because they represent monetary assets and bind both parties in a contractual agreement. 2. Derivative Instruments: Investments based on some underlying assets are known as derivatives. In general derivatives contracts promise to deliver underlying products at some time in the future or give the right to buy or sell them in the future. Types of derivative instruments are as follows:  Forward Contract: A forward contract gives the holder the obligation to buy or sell a certain underlying instrument at a certain date in the future at a specified price.  Futures Contract: Futures contracts are forward contracts traded on organized exchanges. A futures contract is a legally binding commitment to buy or sell a standard quantity at a price determined in the present (the futures price) on a specified future date.  Swaps: A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The cash amount of the payments exchanged is based on some predetermined principal amount.  Options: An option is a contract in which the option seller grants the option buyer the right to enter into a transaction with the seller to either buy or sell an underlying asset at a specified price on or before a specified date. 3. Foreign Exchange Instruments Foreign exchange instruments are financial instruments that are represented on the foreign market and primarily consist of currency agreements and derivatives. In terms of currency agreements, they can be broken into three categories.  Spot: A currency agreement in which the actual exchange of currency is no later than the second working day after the original date of the agreement. It is termed ―spot‖ because the currency exchange is done ―on the spot‖ (limited timeframe).  Outright Forwards: A currency agreement in which the actual exchange of currency is done ―forwardly‖ and before the actual date of the agreed requirement. It is beneficial in cases of fluctuating exchange rates that change often.  Currency Swap: A currency swap refers to the act of simultaneously buying and selling currencies with different specified value dates. 5.3 Classification of Financial Instruments: A. On the basis of Asset Classes 1. Debt-Based Financial Instruments Debt-based financial instruments are categorized as mechanisms that an entity can use to increase the amount of capital in a business. Examples include bonds, debentures, mortgages, Govt treasury bills, credit cards, and line of credits (LOC). They are a critical part of the business environment because they enable corporations to increase profitability through growth in capital. 2. Equity-Based Financial Instruments Equity-based financial instruments are categorized as mechanisms that serve as legal ownership of an entity. Examples include common stock, convertible debentures, preferred stock, and transferable subscription rights.They help businesses grow capital over a longer period of time compared to debt-based but benefit in the fact that the owner is not responsible for paying back any sort of debt. A business that owns an equity-based financial instrument can choose to either invest further in the instrument or sell it whenever they deem necessary. B. On the basis of Market 1. Money Market Instruments: Money market instruments include call or notice money, caps and collars, letters of credit, forwards and futures, financial options, financial guarantees, swaps, treasury bills, certificates of deposits, term money, and commercial papers. 2. Capital Market Instruments: It includes equity instruments, receivables, payables, cash deposits, debentures, bonds, loans, borrowings, preference shares, bank balances, etc. 3. Hybrid Instruments: It includes warrants, dual currency bonds, convertible debt, equity-linked notes, convertible debentures, etc. C. On the basis of time period 1. Long-term financial instruments : Long-term financial instruments have a maturity period of more than one year. Long-term financial instruments include bonds, mortgages, and certain types of loans. 2. Short-term financial instruments Short-term financial instruments have a maturity period of less than one year. Short -term financial instruments include treasury bills, commercial paper, and short-term loans. 5.4 Advantages and Disadvantages of Financial Instruments: 1. Advantages  Liquid assets like cash in hand and other liquid assets are of great use for for the company to meet financial obligations associated with running a business or for dealing with financial contingencies.  Stakeholders often feel more secure in an organization that has employed more capital in its liquid assets or with a large amount of cash.   Financial instruments are essential for financing physical assets. It is made feasible by transferring money from physical assets with excess values to those with deficit values.  These sources like equity act as a permanent source of funds for an organization. Equity shares also allow an organization to have an open chance of borrowing and enjoy retained earnings. With equity shares, payment of dividends to equity holders is purely optional. 2. Disadvantages  Liquid assets like cash deposits, money market accounts, etc., might disallow organizations from making a withdrawal for months or years, too, or whatever is specified in the agreement.  If an organization wishes to withdraw the money before completing the tenure mentioned in the agreement, then the same might get penalized or receive lower returns.  High transactional costs are also a matter of concern for organizations dealing with or wishing to deal with financial instruments.  An organization must not over-rely on debts like principal and interest since these are supposed to be paid on a consequent basis.  Financial instruments like bonds payout return much less than stocks. Companies can even default on bonds.  Some financial instruments like equity capital are a Life-long burden for the company. Equity capital acts as a permanent burden in an organization. Equity capital cannot be refunded even if the organization has sufficient funds. However, as per the latest amendments, companies can buy back their shares for cancellation, but the same is subjected to certain terms and conditions. 5.5 Innovative Financial Instruments 1. Zero Coupon Bonds: There is no periodic interest payment and they are sold at a huge discount to the face value. Zero coupon bonds are sometimes convertible into equity on maturity which entails no outflow for the issuer, or into a regular interest bearing bond after a particular period of time. Companies such as Mahindra and Mahindra, HB Leasing and Finance have been pioneers in introducing these bonds in the Indian market. These bonds are the best options for individuals and institutional investors who look for safe and good returns and are ready to hold them till the bond matures. 2. Zero Coupon Zero Principal Bonds Markets are familiar with Zero Coupon Bonds (ZCBs), but zero coupons zero principal is an innovative instrument. These instruments will be issued by non-profit organisations, listed in the social stock exchange, and considered securities. This instrument can be bought and sold in the market, but the social enterprise will not return either a coupon or principal. 3. Deep Discount Bonds (DDBs) A deep discount bond is a zero coupon bond whose maturity is very high, say 15 years onwards and is offered at a discount to the face value. The Industrial Development Bank of India (IDBI) was the first financial institution to offer DDBs in 1992. The issuers have successfully marketed these bonds by luring the investor to become a ‗lakhpati‘ in 25 years. The issuer becomes free from intermittent cash flow problems and the funds can be deployed in infrastructure projects which involve long gestation periods. 4. Floating Rate Bonds The interest rate on these bonds is linked to a benchmark/anchor rate and is not fixed. It is a concept which has been introduced primarily to take care of the falling market or to provide a cushion in times of falling interest rates in the economy. It helps the issuer to hedge the loss arising due to interest rate fluctuations. In India,  the State Bank of India (SBI) was the first to introduce bonds with floating rates for retail investors. The SBI floating rate bonds were linked to the bank's term deposit rate which served as an anchor rate. The Treasury bill rate can also be the anchor rate. 5. Inverse Float Bonds Inverse float bonds are bonds carrying a floating rate of interest that is inversely related to short-term interest rates. The floating rate could be the Mibor (Mumbai inter-bank offer rate) or some other rate. If the Mibor falls, the return for the investor rises and vice versa. The actual rate payable on these bonds is arrived at by subtracting the floating rate from a fixed benchmark rate. Suppose the fixed benchmark rate is 12 per cent & the six-month Mibor is 6 percent, then the interest rate payable on these bonds is 6 per cent (12–6). These bonds enable investors to earn high returns in a low interest rate environment. 6. Perpetual Bonds They are debt instruments which do not have a maturity date. The investors receive a stream of interest payments for perpetuity. The bonds can be issued to retail investors with market making to ensure liquidity. In case of liquidation, holders of perpetual bonds are paid second last, after all other depositors and creditors but before equity shareholders. Being permanent in nature, they qualify as Tier I capital (i.e., equity and free reserves) of banks. 7. Municipal Bonds They are debt securities issued by the municipal corporation of a city to raise funds for financing their growing investment needs for a host of infrastructure projects. To fulfill the fund requirement of the municipality, SEBI is permitted to issue the municipal bond. Pune Municipal Corporation issued the first municipal bond in India in 2017. So far, fourteen municipal corporations have raised funds worth ₹ 2183.90 crores through issuing municipal bonds in India. 8. Green Bond Green Bond is an innovative instrument first issued by World Bank in 2008 to finance environment-friendly projects. In India, SEBI introduced the green bond issue framework in 2017. So far, 15 companies in India have issued green bonds under SEBI regulations and raised ₹ 4539 crores. 9. Non-convertible Debentures (NCDs) The holder of this instrument is given an option to buy a specific number of shares from the company at a predetermined price and time frame. There is a specific lock- in period after which the debenture holders have to exercise their option to apply for equities. If the option to apply for equities is not exercised, the unapplied portion of shares would be disposed of by the company at its liberty. Escorts, Bombay Dyeing, and Indian Rayon were among the early issuers of NCDs with warrants attached. 10. Fully Convertible Debentures (FCDs) with Interest (Optional) This instrument will not yield any interest for a specified short time period. After this period, FCD holders have the option to apply for equities at a ‗premium‘ for which no additional amount are payable and equity shares are issued in lieu of the interest. 11. Differential Shares Differential shares are shares with differential rights to voting and dividends. They are a class of shares which carry voting rights with varying rates of dividend. In fact, differential shares can be issued with no voting rights but high dividends or, with varying rights and dividends. If the voting right of the shareholder is taken away, the shareholder is compensated by higher returns. This concept originated in Canada and was highly successful. This concept was introduced in India through the Companies (Second Amendment) Act, 2000. 12. Securitized Paper Securitization is a process by which a company raises money by selling off its receivables. These receivables are sold off to cash-rich investors by converting them into securities. The receivables are sold at a discount to the investors which represent the yield.  CHAPTER 6: FINANCIAL SERVICES 6.1 Introduction:  In general, all types of activities which are of financial nature may be regarded as financial services. it includes all activities involved in the transformation of savings into investment.  Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are banks, credit card companies, insurance companies, consumer finance companies, stock brokerages, investment funds, and some government-sponsored enterprises. 6.2 Features of Financial Services 1. Intangibility Financial services are intangible in nature, unlike physical commodities. Financial institutions for selling their intangible product need to enhance their brand image by improving their service quality and create confidence amongst their clients. They have to focus on the quality of their services, which will give them credibility in the market. 2. Inseparability The service and service provider cannot be separated. The financial institutions and its customers cannot be separated from each other while producing and supplying of financial services as both the functions of financial service is done at the same time. 3. Perishable in nature These services are perishable in nature and cannot be store in advance as they need to be created and delivered to the target customers as per their requirements. Hence, financial institutions have to ensure proper synchronization between demand and supply. 4. Heterogeneity Financial services cannot be uniform for all clients. Services vary from customer to customer and cannot be standardized. Some services are targeted at individuals, while some are meant for institutions or companies. After analysing the needs of the clients, financial institutions offer customised financial services to the clients. 5. Customer-centric Financial services are customer-centric. The financial service industry is a customer- intensive and customer-focused industry. It needs high customer involvement. The financial services industry begins by identifying the needs of its customers. They have to remain in constant contact with their customers to understand their requirements and design products that cater to their specific demands. 6. Advisory Financial services can be of three types i.e. a fund based or a fee-based or both. In case of fee-based services, the advisory function is dominant. Issue management, registrar of issue, merchant banking, pricing of securities etc. are few examples of advisory financial services. 7. Information based Financial service industry is an information based industry. It involves creation, dissemination and use of information. Information is an essential component in the production of financial services. 8. Concomitant Production of financial services and delivery of these services have to be concomitant. Both these functions i.e. production of new and innovative financial services and supplying of these services are to be performed simultaneously. 9. Dominance of human element Financial services are dominated by human element. Thus, financial services are labour intensive. It requires competent and skilled personnel to market the quality financial products. They should have the necessary knowledge and be people-friendly and honest. The concept of a ‗relationship manager‘ has emerged in the banking sector recently. 10. Dynamism : Financial services are dynamic in nature. It changes in accordance with the varying needs of customers and the socio-economic environment. like disposable income, standard of living, level of education, etc. The financial services should be efficient so that the new services can be made by studying the future wants of the marker. 6.3 Types of Financial Services Financial services encompass a wide range of services provided by financial institutions, banks, investment firms, insurance companies, and other entities. The financial services industry is diverse and continually evolving to meet the changing needs of individuals, businesses, and the global economy. Here are some common types of financial services: 1. Banking Services: Banks offer a variety of services, including savings and checking accounts, loans (such as personal loans, mortgages, and business loans), credit cards, debit cards, ATM services, and online banking platforms. 2. Investment Services: Investment firms and brokerages provide services related to investing and wealth management. These services may include portfolio management, investment advisory services, trading of stocks, bonds, and other securities, retirement planning, and investment research. 3. Insurance Services: Insurance companies offer various types of insurance coverage to individuals and businesses. These include life insurance, health insurance, property and casualty insurance, auto insurance, liability insurance, and business insurance. 4. Asset Management: Asset management firms manage and administer investment portfolios on behalf of individuals, corporations, or institutions. They provide services such as portfolio diversification, asset allocation, investment research, and ongoing monitoring and reporting. 5. Financial Planning: Financial planning services involve helping individuals and businesses develop comprehensive financial plans. This includes evaluating current financial situations, setting financial goals, creating budgets, and providing strategies for savings, investment, retirement planning, and risk management. 6. Payment Services: These services facilitate the transfer of funds between individuals or entities. They include services such as electronic fund transfers, wire transfers, mobile payment solutions, online payment platforms, and issuing and processing of credit and debit cards. 7. Corporate and Investment Banking: Corporate and investment banks provide specialized services to corporations and institutional clients. These services include corporate finance, mergers and acquisitions, underwriting of securities, debt and equity financing, trade finance, treasury management, and financial advisory services. 8. Wealth Management: Wealth management services cater to high-net-worth individuals and families, offering comprehensive financial planning, investment management, estate planning, tax planning, and other services aimed at preserving and growing wealth. 9. Retirement Services: Retirement-focused services assist individuals in planning and managing their retirement funds. This includes retirement savings accounts, pension plans, annuities, and retirement income planning. 10. Foreign Exchange Services: Entities such as banks and currency exchange providers offer foreign exchange services, allowing individuals and businesses to convert one currency into another for travel, international trade, or investment purposes. 6.4 Roles of financial services Financial services play a crucial role in the global economy by facilitating the flow of funds and capital between individuals, businesses, and governments. These services are provided by various financial institutions, including banks, investment firms, insurance companies, and more that help manage, invest, save, and transfer funds. Here are some key roles of financial services: 1. Capital Allocation: Financial services help allocate capital efficiently by connecting savers and investors. People with surplus funds can deposit them in banks or invest in financial markets, while businesses and governments can access these funds to finance projects, expansion, or public services. 2. Risk Management: Financial institutions offer various tools and products to manage and mitigate risks. Insurance companies, for example, provide coverage against potential financial losses, while derivatives and hedging strategies help businesses and investors protect against market fluctuations. 3. Intermediation: Financial institutions, such as banks and credit unions, act as intermediaries between savers and borrowers. They collect funds from individuals and businesses in the form of deposits and then lend these funds to borrowers in the form of loans. This intermediation function helps allocate capital efficiently in the economy. 4. Payment Systems: Financial services include payment systems that facilitate transactions, making it easy for people and businesses to engage in economic activities. This includes credit cards, online banking, mobile payment apps, and more. 5. Wealth Management: Wealth management services help individuals and families grow and preserve their wealth. This can involve investment advisory services, estate planning, and tax optimization. 6. Savings and retirement planning: Financial services encourage individuals to save and plan for their future financial needs, including retirement. Services like retirement accounts, pension funds, and annuities help people build financial security and ensure a comfortable retirement. 7. Government Financing: Financial services help governments raise funds to finance public projects and services. They issue bonds and securities, manage debt, and implement fiscal policies to stabilize the economy. 8. Economic development: Access to financial services can promote economic growth by providing capital to entrepreneurs and businesses. Access to financing allows businesses to expand, invest in research and development, job creation, increased productivity, and innovation. 9. Financial Inclusion: Promoting access to financial services for underserved and marginalized populations is increasingly recognized as a critical role. Microfinance institutions and mobile banking services, for instance, help bring banking and financial services to those who were previously excluded. 10. International trade and investment: Financial services facilitate cross-border trade and investment by providing foreign exchange services, international payment systems, and access to global capital markets. They play a vital role in the globalization of economic activities. 6.5 Classifications of Financial Services A. Introduction  Fund-based and fee-based financial services are two broad categories of financial services offered by financial institutions. These categories are based on how financial institutions generate revenue and provide services to their clients.  Fund-based services typically involve a higher level of risk for the financial institution as they directly engage in lending and investment activities.  Fee-based services, on the other hand, are generally considered more stable and predictable in terms of revenue, as they are based on providing services and expertise rather than market fluctuations.  Many financial institutions offer a combination of both fund-based and fee-based services to diversify their income streams and serve a broader range of client needs. B. Fund-Based Financial Services: Fund-based financial services are those in which financial institutions use their own capital or funds to provide services to clients. These services typically involve the lending or investment of money, and the financial institution earns a return through the interest, dividends, or capital gains generated from these activities. Fund-based services include: 1. Lending Services: Banks and other financial institutions lend money to individuals and businesses, or governments, earning interest income on the loans they extend. This includes personal loans, mortgages, business loans, and more. 2. Asset Management: Asset management firms manage investment portfolios on behalf of clients. They earn fees and a percentage of the assets under management (AUM) as compensation. These services can include mutual funds, exchange-traded funds (ETFs), and other investment products.  3. Investment Banking: Investment banks may provide financing solutions to companies, including raising capital through equity and debt issuance. They earn fees for underwriting and advisory services. 4. Trading and Brokerage Services: Brokerage firms engage in trading stocks, bonds, commodities, and other financial instruments on behalf of clients or for their own accounts. They profit from the price differentials or commissions charged to clients for executing trades. 5. Depository Services: Banks and credit unions offer deposit accounts, such as savings accounts and certificates of deposit (CDs). They use the funds deposited by customers to make loans and investments, earning interest on these assets. C. Fee-Based Financial Services: Fee-based financial services generate income through fees charged for providing specific financial services and expertise. These fees are typically not directly tied to the amount of money managed but rather to the services rendered. Key examples of fee-based financial services include: 1. Financial Planning: Financial advisors and planners provide comprehensive financial planning services, including retirement planning, investment advice, and estate planning, for individuals and businesses. They charge clients fees for their expertise and recommendations. These fees can be hourly, flat-rate, or based on a percentage of AUM. 2. Asset Management Fees: Some asset managers charge clients a fixed fee or a percentage of AUM for managing their investments. This is distinct from fund-based asset management, where income is primarily derived from investment returns. 3. Wealth Management: Wealth management firms offer comprehensive financial services, including investment management, tax planning, and estate planning. They charge fees based on a percentage of assets under management (AUM). 4. Consulting and Advisory Services: Financial institutions and consultants offer specialized advice on various financial matters, such as mergers and acquisitions, risk management, and strategic financial planning, for a fee. 5. Insurance Brokerage: Insurance brokers assist clients in selecting insurance policies that suit their needs. They earn commissions from insurance companies for policies sold, which are indirectly paid by the client through premiums. 6. Legal and Estate Planning Services: Legal professionals and estate planners charge fees for services related to wills, trusts, and estate administration. Trust companies and estate planners charge fees for managing trusts and helping clients with estate planning.  CHAPTER 7: FINANCIAL REGULATORS 7.1 Meaning of Financial Regulators: Financial regulators are institutions or authorities established by governments to oversee and regulate financial markets and institutions within a specific jurisdiction. Their primary objective is to create a framework that promotes transparency, stability, and efficiency in the financial sector. These regulators play a critical role in safeguarding the interests of consumers, maintaining confidence in financial markets, and preventing fraud and misconduct. 7.2 Features of Financial Regulators: 1. Supervision and Regulation: Financial regulators supervise and regulate financial institutions and markets to ensure compliance with laws, regulations, and industry standards. They set rules and guidelines that govern the behavior and operations of financial entities. 2. Independence: Regulators are typically designed to operate independently from political interference to maintain their credibility and objectivity. 3. Consumer Protection: One of the key functions of financial regulators is to protect consumers and investors from unfair practices, fraud, and misrepresentation. They often establish rules for disclosure and transparency to help individuals make informed financial decisions. 4. Licensing and Authorization: Regulators grant licenses and authorizations to financial institutions, including banks, brokerage firms, and insurance companies, after evaluating their financial health, management, and compliance with regulatory requirements.  5. Enforcement: Regulators have the authority to enforce compliance with financial laws and regulations. They may investigate, penalize, or take legal action against entities or individuals that violate the rules. 6. Risk Assessment: Financial regulators continuously assess risks in the financial system, including credit risk, market risk, and operational risk. They develop and implement measures to mitigate these risks and ensure the safety of financial institutions and markets. 7. Transparency and Reporting: Regulators require financial institutions to provide regular reports and disclosures, enabling the public and investors to assess the financial health and performance of these entities. 8. Education and Outreach: Many financial regulators engage in educational initiatives and outreach programs to help consumers, businesses, and investors better understand financial products, risks, and regulatory requirement. 7.3 The Reserve Bank of India (RBI) The Reserve Bank of India (RBI) is the central banking institution of India. It plays a pivotal role in the country's financial and monetary system and is responsible for the regulation and supervision of the banking and financial sector. The Reserve Bank of India was established on April 1, 1935, in accordance with the provisions of the Reserve Bank of India Act, 1934. It was nationalized on January 1, 1949, after India gained independence. Here are some key points about the RBI: 1. Central Bank: The RBI is India's central bank and has the sole authority to issue currency notes and coins. The RBI manages the supply of currency in India. 2. Banker to the Government: The RBI acts as the banker to the central and state governments. It manages their accounts, conducts government transactions, and helps in raising funds through the issuance of government securities. 3. Banker's Bank: The RBI serves as the banker to other banks in India. It provides financial services to commercial banks, including maintaining their accounts and facilitating interbank transactions. 4. Monetary Policy: One of the primary functions of the RBI is to formulate and implement monetary policy in India. It uses various tools, including the repo rate, reverse repo rate, and cash reserve ratio (CRR), to control inflation and ensure price stability. 5. Regulation and Supervision: The RBI is responsible for regulating and supervising banks and financial institutions in India. It ensures that these entities follow prudential norms and maintain financial stability. 6. Foreign Exchange Management: The RBI manages India's foreign exchange reserves and formulates policies to promote and regulate foreign exchange transactions. It intervenes in the foreign exchange market to stabilize the rupee's exchange rate. 7. Developmental Role: The RBI plays a developmental role in the Indian economy by promoting financial inclusion, supporting agriculture and rural development, and encouraging banking in underserved areas. 8. Autonomy: While the RBI operates under the overall framework of government policies, it enjoys a considerable degree of autonomy in formulating and implementing monetary policy. The central bank's independence is crucial for maintaining credibility and stability. 7.4 The Securities and Exchange Board of India (SEBI) SEBI was established on April 12, 1992, as an autonomous regulatory body under the SEBI Act, 1992. The Securities and Exchange Board of India (SEBI) is the regulatory authority responsible for overseeing and regulating the securities and capital markets in India. Overall, the Securities and Exchange Board of India (SEBI) plays a pivotal role in regulating and developing the Indian securities market, ensuring investor protection, market integrity, and sustainable market growth. Its efforts are crucial in maintaining confidence in the Indian capital markets. Here are some key points to note about SEBI: 1. Regulatory Authority: SEBI is the primary regulatory authority for the securities market in India. It regulates various entities and activities in the market, including stock exchanges, stockbrokers, merchant banks, mutual funds, and foreign institutional investors (FIIs). 2. Investor Protection: One of SEBI's primary objectives is to protect the interests of investors in the securities market. It does so by promoting transparency, fairness, and accountability in market operations. 3. Investor Education: SEBI undertakes investor education initiatives to create awareness about investment risks and opportunities. It aims to empower investors with knowledge and information. 4. Securities Regulation: SEBI regulates the issuance and trading of securities, including equities, bonds, and derivatives. It approves public issues of securities, ensuring that companies adhere to disclosure and compliance norms. 5. Mutual Fund Regulation: SEBI regulates the mutual fund industry in India, including the registration and operation of mutual funds. It sets rules for the management and marketing of mutual funds.  6. Takeover Regulations: SEBI formulates and enforces takeover regulations, which govern the acquisition of shares and control of listed companies. 7. Insider Trading Regulations: SEBI has implemented stringent insider trading regulations to prevent the abuse of confidential information for personal gain. 8. Derivatives Market Regulation: SEBI regulates the derivatives market, including stock futures and options. It sets rules for the trading and settlement of derivative contracts. 9. Governance: SEBI is governed by a board of directors, including a Chairman. The board comprises government officials, financial experts, and market professionals. SEBI promotes good corporate governance practices among listed companies. 10. Autonomy: While SEBI operates within the framework of government policies, it enjoys a significant degree of autonomy in formulating and implementing regulations. This autonomy is essential for its effectiveness and impartiality. 7.5 Insurance Regulatory and Development Authority of India (IRDAI) The IRDAI was established on April 19, 2000, based on the recommendations of the Malhotra Committee, which was set up to examine and suggest reforms in the insurance sector. The insurance industry in India is regulated by the Insurance Regulatory and Development Authority of India (IRDAI), which is the primary regulatory body overseeing all insurance-related activities in the country. The regulatory framework for the insurance industry in India is designed to strike a balance between promoting the growth of the industry and protecting the interests of policyholders. It plays a crucial role in maintaining the integrity and stability of the insurance market in the country. Here's an overview of the regulatory framework for the insurance industry in India: 1. Regulatory Authority: IRDA is the regulatory authority for the insurance industry in India. It is responsible for regulating and supervising insurance companies, intermediaries, and other entities operating in the insurance sector. 2. Licensing and Registration: IRDA grants licenses and registrations to insurance companies, insurance brokers, agents, surveyors, and other entities involved in the insurance business. It ensures that these entities meet the necessary criteria and standards to operate in the industry. 3. Policyholder Protection: One of IRDA's primary functions is to protect the interests of policyholders. It does this by regulating the terms and conditions of insurance policies and ensuring that they are fair and transparent. 4. Promoting Innovation: While ensuring regulatory compliance, IRDA also encourages innovation in the insurance industry, allowing companies to develop new and innovative insurance products and distribution channels. 5. Product Approval: Insurance companies must seek approval from the IRDAI before launching new insurance products. The IRDAI reviews product features, pricing, and terms and conditions to ensure they are fair, transparent, and beneficial to policyholders. 6. Market Conduct Regulation: IRDA regulates the conduct of insurance companies and intermediaries to ensure that they adhere to ethical and fair practices in their dealings with policyholders and other stakeholders. 7. Investment Regulations: The IRDAI prescribes guidelines for the investment of insurance funds to safeguard policyholder interests. These guidelines define asset allocation limits, investment categories, and risk management practices. 8. Complaints and Grievance Redressal: The IRDAI has established mechanisms for policyholders to file complaints and seek resolution for grievances related to insurance companies and intermediaries IRDA facilitates the resolution of disputes between policyholders and insurance companies through mechanisms such as ombudsman offices and grievance redressal systems. 9. Consumer Awareness: IRDA promotes consumer education and awareness about insurance products and financial planning, helping policyholders make informed decisions. 10. Market Development: IRDA fosters the development and growth of the insurance market in India by creating a conducive regulatory environment. 7.6 Forward Markets