Chapter 1 Functions of the Financial System: The services that are provided to a person by the various Financial Institutions including banks, insurance companies, pensions, funds, etc. constitute the financial system. Given below are the features of the Indian Financial system: • It plays a vital role in the economic development of the country as it encourages both savings and investment • It helps in mobilising and allocating one’s savings • It facilitates the expansion of financial institutions and markets • Plays a key role in capital formation • It helps form a link between the investor and the one saving • It is also concerned with the Provision of funds The financial system of a country mainly aims at managing and governing the mechanism of production, distribution, exchange and holding of financial assets or instruments of all kinds. There are four main components of the Indian Financial System. This includes: 1. Financial Institutions 2. Financial Assets 3. Financial Services 4. Financial Markets Let’s discuss each component of the system in detail. 1. Financial Institutions The Financial Institutions act as a mediator between the investor and the borrower. The investor’s savings are mobilised either directly or indirectly via the Financial Markets. The main functions of the Financial Institutions are as follows: • A short term liability can be converted into a long term investment • It helps in conversion of a risky investment into a risk-free investment • Also acts as a medium of convenience denomination, which means, it can match a small deposit with large loans and a large deposit with small loans 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. Further, Financial Institutions can be classified into three categories: • Regulatory – Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc. • Intermediates – Commercial banks which provide loans and other financial assistance such as SBI, BOB, PNB, etc. • Non Intermediates – Institutions that provide financial aid to corporate customers. It includes NABARD, SIBDI, etc. 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 have been discussed briefly below: • 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 (Electronically generated) 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 Services provided by Asset Management and Liability Management Companies. They help to get the required funds and also make sure that they are efficiently invested. 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 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. 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 – Designed to finance the long term investment, the Capital market deals with transactions which are taking place in the market for over a 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 – Mostly dominated by Government, Banks and other Large Institutions, the type of market is authorised for small-term investments only. It is a wholesale debt market which works on low-risk and highly liquid instruments. 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 Debt Capital Debt Capital is the money that a company raises through borrowing from individuals or institutions, and they must repay the entire amount after a specific time interval. They are a cheaper and low-risk alternative for getting finances when compared to equity capital. Debt Capital is either secured or unsecured. Secured Debt is a loan that the company takes by pledging its assets. It allows the lender to sell that asset and recover its money if it does not repay within a fixed duration. Unsecured Debt is a borrowing made by the company without pledging any assets as security. There are three kinds of Debt Capital – Term Loans, Debentures and Bonds. Here is a brief description of the three terms: • Term Loans – Banks provide Term Loans to companies at a fixed/floating interest rate (according to the loan agreement). These secured loans have a fixed repayment schedule. • Debentures – Debenture is a debt instrument issued by a company to the general public. They can be secured or unsecured, and the principal amount is repayable after a fixed time interval. • Bonds – A bond is a fixed income instrument issued by the government or a company to the general public. They have a fixed date of maturity post which the issuer pays back the principal amount to the investor along with interest. What is Equity Capital? Equity Capital is the total amount of funds invested by the owners in their business. The equity of a company gets divided into several units, and each unit is called a share. The owners can sell some of these shares to the general public to raise funds. The shares are of two types – Equity shares and Preference shares. Here is a brief description of the two terms: • Equity Shares – These are ordinary shares of a company that the owners sell in the open market. Investors purchase these shares and become stakeholders in the organisation with ownership rights. They hold voting rights to select the company’s management. They get a percentage of the company’s profits, but only after preference shareholders get their dividend. • Preference Shares – Preference shares allow shareholders to receive dividends before equity shareholders. They are entitled to a fixed rate of compensation whenever the company declares a dividend. They also have the right to claim repayment of capital if the company dissolves. Differences between Debt and Equity Capital The main differences between Debt and Equity Capital are as follows: Debt Capital Equity Capital Definition Debt Capital is the borrowing of funds from individuals and organisations for a fixed tenure. Equity capital is the funds raised by the company in exchange for ownership rights for the investors. Role Debt Capital is a liability for the company that they have to pay back within a fixed tenure. Equity Capital is an asset for the company that they show in the books as the entity’s funds. Duration Debt Capital is a short term loan for the organisation. Equity Capital is a relatively longer-term fund for the company. Status of the Lender A debt financier is a creditor for the organisation. A shareholder is the owner of the company. Types Debt Capital is of three types: Equity Capital is of two types: • Term Loans • Equity Shares • Debentures • Preference Shares • Bonds Risk of the Investor Debt Capital is a low-risk investment Equity Capital is a high-risk investment Payoff The lender of Debt Capital gets interest income along with the principal amount. Shareholders get dividends/profits on their shares. Security Debt Capital is either secured (against the surety of an asset) or unsecured. Equity Capital is unsecured since the shareholders get ownership rights. Conclusion Companies need financing regularly to run their operations successfully. There are several differences between Debt and Equity Capital, but companies need both these instruments to raise funds. Return Determination Low borrowing rates encourage more borrowing and less saving, while higher rates encourage less borrowing and more saving. The equilibrium rate is when market participants like individuals, businesses, and governments are willing and able to borrow meets the rate at which other participants are willing and able to lend. These rates differ for different types of borrowing, depending on the differences in risk, liquidity, andtime to maturity of the security. The following rules can be applied in normal market conditions: • • • The higher the risk, the higher the rate. The lower the liquidity, the higher the rate. The higher the time to maturity, the higher the rate. The following list of different types of assets and markets gives a broad overview of each asset or market. Financial Assets These include securities (like stocks and bonds), derivative contracts, and currencies. Real Assets These include tangible assets like real estate, equipment, commodities, and other physical assets. Debt and Equity An entity that issues debt promises to repay the borrowed money via interest and principal payments. An equity security represents ownership of the entity. The company is not obligated to pay dividends to equity holders. Private and Public Publicly traded securities are traded on exchanges or through securities dealers and are regulated. Private securities do not trade on public exchanges. They are often illiquid and not heavily regulated. The value of a derivative is “derived” from an underlying asset. For example, a call option on the NIFTY 50 index derives its value from the level of the NIFTY 50 index. The index is the underlying asset. The underlying asset can be based on equities, equity indexes, debt, debt indexes, or other financial contracts. Index derivatives are cash-settled contracts. The underlying assets of a physical derivative are assets like gold, oil, wheat, sugar, etc. Markets for immediate delivery are referred to as spot markets. For example, if you want to buy a currency right now, you will buy it in the spot market for currencies. Forwards, futures, and options contracts provide for the future delivery of physical and financial assets. If you buy an option, then you have the right, but not the obligation, to buy or sell an asset at a predetermined price at a future date. If you sell an option, you have the obligation but not the right to deliver the asset when the buyer exercises the option. Primary Markets and Secondary Markets The primary market is the market for newly issued securities. It is called an issue when the security is sold to the secondary market. The security can then trade in the secondary market. For example, Zomato has entered the secondary market with an IPO. They have listed their shares on the BSE and NSE, which are now available to investors and traders. Money Markets and Capital Markets Debt securities with less than one year of maturity trade-in money markets. Longer-term debt securities and equity securities with no specific maturity date trade in capital markets. Traditional Investments and Alternative Investments Traditional investments include debt and equity. Alternative investments include hedge funds, private equity funds, commodities, real estate, collectables, gemstones, leases, and equipment. It is more difficult to value such assets, and they may trade at discounts. They do not necessarily trade frequently, and so they are less liquid. They are subject to less disclosure (in the case of hedge funds or private equity funds), so they require more due diligence. Bonds are usually regarded as long-term fixed-income securities, while notes are usually regarded as intermediate-term fixed-income securities. They can also be classified by issuer: • • • Companies: Usually issue commercial paper. These are short-term debt instruments. Governments: May issue bills (short-term) or bonds (long-term). Banks: Usually issue certificates of deposit (CDs). A repurchase agreement (repo) is an agreement between two parties where the borrower sells a highquality asset (collateral security) and has the right and the obligation to repurchase it (at a higher price)in the future depending on the interest rate of the repo agreement. This is usually done to get some immediate liquidity. These agreements can range from overnight borrowing to short-term borrowing. If an investor can exchange debt security for a specified number of equity shares of the issuing company, it is called convertible debt. The debtholder has the right but not the obligation to “convert” their debt to equity if the market conditions are favorable. Equity Securities These represent ownership of the issuing entity in proportionate to the amount invested. They include: • • Common stock: This is a “residual claim” on a company’s assets. Interest on debt and dividends on preferred stock are paid before dividends to common stockholders (if any dividends are paid at all). Common stockholders also have the last claim to a company’s assets if the company liquidates (i.e., debtholders and preferred stocks have a higher priority of claims). However, common stockholders have voting rights. Preferred stock: These securities pay scheduled dividends, and this schedule does not • usually change. Preferred stockholders are paid dividends before common stockholders but after interest payments on debt. Warrants: These are similar to options. They give the holder the right to buy a company’s equity shares (usually common stock) at a fixed price before the warrant expires. How are shareholders rewarded? Buyback A share buyback is another way companies can return excess profits shareholders by using cash to buy back shares from the public. Typically, buying back shares signals that the company is optimistic about the prospect of the business and thinks that the market is undervaluing the share price. But be wary: sometimes, management executes share buyback because their compensation is tied to share price performance or because a significant portion of their compensation is in the form of equity. This can create a distorted alignment of incentives where management initiates share buyback to hit their targets or inflate their compensation. If a company conducts share buyback when its share price is overvalued, it is essentially paying more than it should for its own shares. This can reduce the company’s ability to invest in new projects, pay dividends, or weather future economic downturns. As a result, the share price eventually falls, and shareholders lose value in their investments. Compared to dividends, share buybacks are a more flexible way to redistribute cash to investors. As mentioned, dividends are sticky because cancelling or reducing them can negatively impact the share price. In contrast, share buybacks can be deployed by management on an as-needed basis. Management can be more opportunistic when doing share buyback. Dividend A dividend is the distribution of a company's earnings to its shareholders and is determined by the company's board of directors. Dividends are often distributed quarterly and may be paid out as cash or in the form of reinvestment in addi-onal stock. Dividends must be approved by the shareholders by vo-ng rights. Although cash dividends are common, dividends can also be issued as shares of stock. Various mutual funds and exchange-traded funds (ETFs) also pay dividends. A dividend is a reward paid to the shareholders for their investment in a company’s equity, and it usually originates from the company's net profits. Though profits can be kept within the company as retained earnings to be used for the company’s ongoing and future business activities, a remainder can be allocated to the shareholders as a dividend. Bonus Issue A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free additional shares to existing shareholders. For example, a company may give one bonus share for every five shares held. Companies issue bonus shares to attract further investment and reward shareholders. Bonus issues increase a company’s outstanding shares but not its market capitaliza-on. Companies usually fund a bonus issue through profits or existing share reserves. The issuance of bonus shares is not taxable; however, shareholders must still pay capital gains tax if they sell them for a net gain. A company allocates bonus issues according to each shareholder’s stake. Bonus shares do not dilute shareholders’ equity because they are issued in a constant ratio that keeps the relative equity of each shareholder the same as before the issue. For example, a three-for-one bonus issue entitles each shareholder three shares for every one that they hold before the issue. A shareholder with 1,000 shares receives 3,000 bonus shares (1,000 × 3 ÷ 1 = 3,000). Rights Issue A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. This type of issue gives existing shareholders securities called rights. With the rights, the shareholder can purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price. Companies most commonly issue a rights offering to raise additional capital. A company may need extra capital to meet its current financial obligations. Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money. However, not all companies that pursue rights offerings are in financial trouble. Even companies with clean balance sheets may use rights issues. These issues might be a way to raise extra capital to fund expenditures designed to expand the company's business, such as acquisitions or opening new facilities for manufacturing or sales. If the company is using the extra capital to fund expansion, it can eventually lead to increased capital gains for shareholders despite the dilution of the outstanding shares as a result of the rights offering. Several investors invest in one fund. A separate investment manager manages this fund on behalf of the investors. Investors will receive their share of the profits from the fund after managers have been paid. Mutual funds: Several investors may invest in the same mutual fund scheme and thereby provide money for fund managers. These fund managers will then invest the money according to the investment policy of the mutual fund scheme. Investors receive units, and the value of the underlying investments determines the net asset value (NAV) of these units. Investors can buy these units from the fund (open-end funds) or in the secondary market (closed-end funds). Hedge funds: Investors in a hedge fund are called the limited partners (LP), and the hedge fund itself is incorporated as a limited partnership. The fund manager is the general partner (GP), and they carry out investment decisions. Hedge funds can use various strategies, and they can even short sell assets (short sales are restricted for mutual funds or long-only funds). Hedge funds have high minimum investment amounts, so only investors with significant wealth and investment knowledge can directly gain exposure to hedge funds. Hedge funds usually use leverage, and their risk-return profile is amplified due to leverage. The general partners are compensated based on the total assets under management and performance-related fees Currencies Central banks like the RBI or the Federal Reserve issue currency of the domestic economy. Some currencies have a reserve currency status. These are held by governments and central banks all around the world. Reserve currencies change over a long period of time, and their status highly depends on how powerful or dominant that currency’s economy is in the context of the global economy. The U.S. dollar is the largest reserve currency, followed by the euro, the British pound, the Japanese yen, and the Swiss franc. Currencies trade in the spot market for immediate delivery and in forward markets for future delivery. Contracts A contract is an agreement between two parties that will fulfil their respective obligations at a future date. Financial contracts may be based on securities, currencies, commodities, or security indexes (portfolios). They include futures, forwards, options, swaps, and insurance contracts. Forwards This is an agreement to buy or sell an asset at a predetermined price in the future. For example, a forward contract to buy the U.S. dollar at the rate of Rs. 75.50 per dollar 1 month from now is an example of a currency forward. The party that is long the forward contract will buy the U.S. dollar, and the short party will sell the dollar. Forward contracts are not traded on exchanges or in dealer markets. They are usually customized contracts that are traded over the counter. Futures These contracts are similar to forward contracts, but they are standardized and regulated. The expiry of the contract, amount and characteristics of the underlying will all be regulated by an exchange. They are exchange-traded contracts and are more liquid than forwards contracts. Swaps One asset is swapped for another. For example, an interest rate swap is when one party that is paying a fixed rate of interest exchanges the fixed interest payments with the other party paying a floating rate of interest on various settlement dates. A currency swap involves taking a loan in one currency in exchange for loaning out another currency for a specified period of time. An equity swap involves exchanging the rate of the return on an equity index or portfolio for a fixed interest payment. Options The owner of an options contract has the right but not the obligation to buy or sell an asset at a specific exercise price at a specified time in the future. ● ● A call option gives the option buyer the right (but not the obligation) to buy an asset. A put option gives the option buyer the right (but not the obligation) to sell an asset. Sellers, or writers of options receive a premium when they sell the option. This is the price of the option. But writers have the obligation but not the right to sell (in the case of calls) or buy the asset (in the case of puts) if the buyer of the option exercises the option. Options on currencies, stocks, stock indexes, futures, swaps, and precious metals trade on exchanges. Dealers in the over-the-counter market also sell customized options contracts. Insurance Contracts These pay out a cash amount to the insurance holder if an unfavourable event occurs in the future. For example, an automobile insurance policy can protect against certain damages to the vehicle if the insurance policy covers it. Some insurance contracts can be traded, and they often have tax-advantaged payouts. Credit default swaps (CDS) are a form of insurance for fixed-income securities. They make a payment to the CDS holder if a debt issuer defaults on their bonds. Bond investors can therefore use them to hedge default risk. They can also be used by speculators who do not actually hold the underlying bonds. The CDS holder’s trade turns profitable when the issuer goes through more financial troubles than expected. Commodities Commodities trade in spot, forward, and futures markets. They include: ● Precious metals: Gold, silver. ● Industrial metals: Steel, copper, aluminium. ● Agricultural products: Wheat, sugar. ● Energy products: Oil, natural gas. ● Credits for carbon reduction. Futures and forward markets for commodities allow for both hedging positions and speculative trades. For example, an oil company may sell a specified amount of oil for a future price and hedge their downside risk, while a trader may simply speculate on the oil price (by using futures and options) without taking physical delivery of the oil. Real Assets These include real estate, equipment, and machinery. While such assets are useful for industrial uses, they are increasingly used for institutional investing through direct and indirect routes. The tax advantages of real assets provide incentives for high-net-worth investors or institutional investors. However, there is a trade-off because of the high management and maintenance costs. Additional due diligence is required because not all real assets are the same. For example, the housing aspect of real estate can vary from individual homes to apartment buildings. Each type is subject to different dynamics. Because of the investment's high value and specialized nature, a particular real asset may attract a limited number of investors. This makes these assets illiquid and difficult to value.
