Banking and Financial Service Unit 2

UNIT-II
FINANCIAL SYSTEM
Introduction to financial system:
Introduction to Financial System The economic scene in the post-independence period has seen
a sea change; the end result being that the economy has made enormous progress in diverse
fields. There has been a quantitative expansion as well as diversification of economic activities.
The experiences of the 1980s have led to the conclusion that to obtain all the benefits of greater
reliance on voluntary, market-based decision-making, India needs efficient financial systems.
The financial system is possibly the most important institutional and functional vehicle for
economic transformation. Finance is a bridge between the present and the future and whether
it be the mobilisation of savings or their efficient, effective and equitable allocation for
investment, it is the success with which the financial system performs its functions that sets the
pace for the achievement of broader national objectives.
Significance and Definition
The term financial system is a set of inter-related activities/services working together to achieve
some predetermined purpose or goal. It includes different markets, the institutions, instruments,
services and mechanisms which influence the generation of savings, investment capital
formation and growth.
Van Horne defined the financial system as the purpose of financial markets to allocate savings
efficiently in an economy to ultimate users either for investment in real assets or for
consumption.
Christy has opined that 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."
From the above definitions, it may be said that the primary function of the financial system is
the mobilisation of savings, their distribution forindustrial investment and stimulating capital
formation to accelerate the process of economic growth.
Financial System – Meaning, Functions and Services
A financial systemis a network of financial institutions, financial markets, financial
instruments and financial services to facilitate the transfer of funds. The system consists of
savers, intermediaries, instruments and the ultimate user of funds. The level of economic
growth largely depends upon and is facilitated by the state of financial system prevailing in the
economy. Efficient financial system and sustainable economic growth are corollary. The
financial system mobilizes the savings and channelizes them into the productive activity and
thus influences the pace of economic development. Economic growth is hampered for want of
effective financial system. Broadly speaking, financial system deals with three inter-related
and interdependent variables, i.e., money, credit and finance.
The financial system provides channels to transfer funds from individual and groups who have
saved money to individuals and group who want to borrow money. Saver (refer to the lender)
are suppliers of funds to borrowers in return with promises of repayment of even more funds
in the future. Borrowers are demanders of funds for consumer durables, house, or business
plant and equipment, promising to repay borrower funds based on their expectation of having

higher incomes in the future. These promises are financial liabilities for the borrower-that is,
both a source of funds and a claim against the borrower’s future income.
Services Provided by the Financial System
1. Risk Sharing: Financial system provides risk sharing by allowing savers to hold many
assets. It also means financial system enables individuals to transfer risk. Financial
markets can create instruments to transfer risk from savers to borrowers who do not like
uncertainty in returns or payments to savers or investors who are willing to bear risk.
The ability of the financial system to provide risk sharing makes savers more willing to
buy borrowers’ IOUs. This willingness, in turn, increases borrowers’ ability to raise
funds in the financial system.
2. Liquidity: The second service that financial system provides for savers and borrowers
is liquidity, which is the ease with which an asset can be exchanges for money to
purchase other assets or exchanges for goods and services. Most of the savers view the
liquidity as a benefit. If an individual need their assets for their own consumption and
investment, they can just exchange it. Liquid assets allow an individual or firm to
respond quickly to new opportunities or unexpected events. Bonds, stocks, or checking
accounts are created by financial assets, which have more liquid than cars, machinery
and real estate.
3. Information: The third service of financial system is collection and communication of
information or we can say that it is the facts about borrowers an expectations about
returns on financial assets. The first informational role the financial system plays is to
gather information. That includes finding out about prospective borrowers and what
they will do with borrowed funds. Another problem that exists in most transactions is
asymmetric information. This means that borrowers posses information about their
opportunities or activities that they don’t disclose to lenders pr creditors and can take
advantage of this information. The second informational role that financial system plays
is communication of information. Financial markets do that job by incorporating
information into the prices of stocks, bonds, and other financial assets. Savers and
borrowers receive the benefits of information from the financial system by looking at
asset returns. As long as financial market participants are informed, the information
works its way into asset returns and prices.
Functions of a financial system:
Functions and Role of financial system

1. Pooling of Funds,
2. Capital Formation,
3. Facilitates Payment,
4. Provides Liquidity,
5. Short and Long Term Needs,
6. Risk Function,
7. Better Decisions,
8. Finances Government Needs,
9. Economic Development.
1. Pooling of Funds
In a financial system, the Savings of people are transferred from households to business
organizations. With these production increases and better goods are manufactured, which
increases the standard of living of people.
2. Capital Formation
Business require finance. These are made available through banks, households and different
financial institutions. They mobilize savings which leads to Capital Formation.
3. Facilitates Payment
The financial system offers convenient modes of payment for goods and services. New
methods of payments like credit cards, debit cards, cheques, etc. facilitates quick and easy
transactions.
4. Provides Liquidity
In financial system, liquidity means the ability to convert into cash. The financial market
provides the investors the opportunity to liquidate their investments, which are in instruments
like shares, debentures, bonds, etc. Price is determined on the daily basis according to the
operations of the market force of demand and supply.
5. Short and Long Term Needs
The financial market takes into account the various needs of different individuals and
organizations. This facilitates optimum use of finances for productive purposes.
6. Risk Function
The financial markets provide protection against life, health and income risks. Risk
Management is an essential component of a growing economy.
7. Better Decisions
Financial Markets provide information about the market and various financial assets. This helps
the investors to compare different investment options and choose the best one. It helps in
decision making in choosing portfolio allocations of their wealth.
8. Finances Government Needs
Government needs huge amount of money for the development of defense infrastructure. It
also requires finance for social welfare activities, public health, education, etc. This is supplied
to them by financial markets.
9. Economic Development
India is a mixed economy. The Government intervenes in the financial system to influence
macro-economic variables like interest rate or inflation. Thus, credits can be made available to
corporate at a cheaper rate. This leads to economic development of the nation.

Market
Money Market:
Definition: Money market basically refers to a section of the financial market where financial
instruments with high liquidity and short-term maturities are traded. Money market has become
a component of the financial market for buying and selling of securities of short-term
maturities, of one year or less, such as treasury bills and commercial papers.
Over-the-counter trading is done in the money market and it is a wholesale process. It is used
by the participants as a way of borrowing and lending for the short term.
Description: Money market consists of negotiable instruments such as treasury bills,
commercial papers. and certificates of deposit. It is used by many participants, including
companies, to raise funds by selling commercial papers in the market. Money market is
considered a safe place to invest due to the high liquidity of securities.
It has certain risks which investors should be aware of, one of them being default on securities
such as commercial papers. Money market consists of various financial institutions and dealers,
who seek to borrow or loan securities. It is the best source to invest in liquid assets.
The money market is an unregulated and informal market and not structured like the capital
markets, where things are organised in a formal way. Money market gives lesser return to
investors who invest in it but provides a variety of products.
Withdrawing money from the money market is easier. Money markets are different from
capital markets as they are for a shorter period of time while capital markets are used for longer
time periods.
Salient Features of Money Market
 It is a wholesale market, as the transaction volume is large.

 Trading takes place over the telephone, after which written confirmation is done by way
of e-mails.
 Participants include banks, mutual funds, investment institutions and Central Banks.
 There is an impersonal relationship between the participants in the money market, and
so, pure competition exists.
 Money market operations focus on a particular area, which serves a region or an area.
On the basis of the market size and needs, the area may differ.
Importance of Money Market:
The money market meets the short-term requirements of the borrowers and provides liquid ity
to the lenders. These markets therefore provide information for monetary policy formulation
and management.
The Reserve Bank of India occupies a strategic position in the money market by changing the
level of liquidity in the economy through open market operations and by regulating the access
of the banks to its accommodation.
It is for this reason that development of a money market itself becomes an important monetary
regulation measure. Money markets are not merely a channel for transferring short-term funds
from savers to investors, but also provide information on the underlying conditions of supply
and demand.
More importantly, they are essential for moving from quantity based to market-based
instruments of monetary management. There is, therefore, an urgent need for deepening and
broad-basing the market for debt instruments and Govt. dated securities. Institutional support
should be provided wherever needed.
Objectives of Money Market:
The objectives of the money market are to implement the monetary policy of the country.
Monetary policy has three main objectives — growth, equity and price stability. The objective
of the monetary policy in the first decade of planning was the revival of traditional weapons of
monetary control.
In the second decade, the emphasis shifted to economic growth and control of money supply.
During the 70’s and 80’s faster economic growth and price stability assumed importance. The
credit policy on the other hand, has been evolved to meet the credit needs of the developing
economy and on the other hand, to keep in check inflationary prices. This policy has come to
be known as “controlled expansion”.
In addition the monetary policy takes care of promotional aspects such as:
(i) Monetary integration of the country,
(ii) Directing credit flow according to policy priorities,
(iii) Assisting in mobilisation of the savings of the community,
(iv) Promotion of capital formation and
(v) Maintain an appropriate structure of relative prices and demand containment.
When the balance of payments situation acquired crisis dimension in mid 1990-91 the RBI
through its monetary and credit policy measures aimed at import compression and demand
containment. Since then the focus of monetary policy has changed in consistent with a
comprehensive package of stabilisation and structural reforms measures initiated in mid-1991.
Functions of Money Market:
The nature of money market reveals the functions of the money market.

Now we can list down such functions precisely:
1. A money market by providing profitable investment opportunities for short-term surplus
funds helps to enhance the profit of financial institutions.
2. A money market enhances the amount of liquidity available to the entire country.
3. A well-developed money market helps to avoid wide seasonal fluctuations in the interest
rates.
4. A well-developed money market, through quick transfer of funds from one place to another,
helps to avoid the regional gluts and stringencies of funds.
5. By providing various kinds of credit instruments suitable and attractive for different sections,
a money market augments the supply of funds.
6. A well organised money market is essential for the successful operation of the central bank-
ing policies.
Limitations of Money Market:
Unlike other well developed capital markets, Indian capital market has not developed in that
manner. The capital market has become almost synonymous with equity market. The debt
market which is many time bigger than equity market, in developed countries like USA, UK
and Japan has hardly developed in India. The Govt. securities market is confined only to banks
and institutions and to some extent to provident funds.
The second major requirement for the development of a healthy capital market is the presence
of active bond dealers who not only act as intermediaries but also markets in the debt Indian
debt market lacks depth as it does not have resourceful mature dealers in debt in instrument.
Instruments of Money market
What is Call Money Market?
The call money market is an essential part of the Indian Money Market, where the day-to-day
surplus funds (mostly of banks) are traded. The money market is a market for short-term
financial assets that are close substitutes of money. The most important feature of a money
market instrument is that it is liquid and can be turned into money quickly at low cost and
provides an avenue for equilibrating the short-term surplus funds of lenders and the
requirements of borrowers.
The loans are of short-term duration varying from 1 to 14 days, are traded in call money
market. The money that is lent for one day in this market is known as "Call Money", and if it
exceeds one day (but less than 15 days) it is referred to as "Notice Money". Term Money
refers to Money lent for 15 days or more in the Inter Bank Market.
Banks borrow in this money market for the following purpose:
 To fill the gaps or temporary mismatches in funds
 To meet the Cash Reserve Ratio(CRR) & Statutory Liquidity Ratio(SLR) mandatory
requirements as stipulated by the RBI
 To meet sudden demand for funds arising out of large outflows.
Thus call money usually serves the role of equilibrating the short-term liquidity position of
banks
Participants in the Call Money Market:

As the RBI guideline, the participants in call/notice money market currently include scheduled
commercial banks (excluding RRBs), Development Financial Institutions,Co-operative
banks (other than Land Development Banks) and Primary Dealers (PDs), both as borrowers
and lenders.
Interest Rate:
Eligible participants are free to decide on interest rates in call/notice money market. Calculation
of interest payable would be based on the methodology given by the Fixed Income Money
Market and Derivatives Association of India (FIMMDA).
Note: FIMMDA is an association of Commercial Banks, Financial Institutions and Primary
Dealers. It is a voluntary market body for the bond, Money and Derivatives Markets.
There are five major segments of money market which are Certificate of Deposits (CD),
Commercial Paper, Swaps, Repo and Government treasury securities.
Advantages of Call Money Market
In India, commercial banks play a dominant role in the call loan market. They used to borrow
and lend among themselves and such loans are called inter-bank loans. They are very popular
in India. So many advantages are available to commercial banks. They are as follows:
 High Liquidity: Money lent in a call market can be called back at any time when
needed. So, it is highly liquid. It enables commercial banks to meet large sudden
payments and remittances by making a call on the market.
 High Profitability: Banks can earn high profiles by lending their surplus funds to the
call market when call rates are high volatile. It offers a profitable parking place for
employing the surplus funds of banks temporarily.
 Maintenance Of SLR: Call market enables commercial bank to minimum their
statutory reserve requirements. Generally banks borrow on a large scale every reporting
Friday to meet their SLR requirements. In absence of call market, banks have to
maintain idle cash to meet5 their reserve requirements. It will tell upon their
profitability.
 Safe And Cheap: Though call loans are not secured, they are safe since the participants
have a strong financial standing. It is cheap in the sense brokers have been prohibited
form operating in the call market. Hence, banks need not pay brokers on call money
transitions.
 Assistance To Central Bank Operations: Call money market is the most sensitive
part of any financial system. Changes in demand and supply of funds are quickly
reflected in call money rates and give an indication to the central bank to adopt an
appropriate monetary policy. Moreover, the existence of an efficient call market helps
the central bank to carry out its open market operations effectively and successfully.
Drawbacks of Call Money
The call market in India suffers from the following drawbacks:
 Uneven Development: The call market in India is confined to only big industrial and
commercial centers like Mumbai, Kolkata, Chennai, Delhi, Bangalore and Ahmadabad.
Generally call markets are associated with stock exchanges. Hence the market is not
evenly development.
 Lack Of Integration: The call markets in different centers are not fully integrated.
Besides, a large number of local call markets exist without any integration.
 Volatility In Call Money Rates: Another drawback is the volatile nature of the call
money rates. Call rates very to greater extant indifferent centers indifferent seasons on
different days within a fortnight. The rates very between 12% and 85%. One can not
believe 85% being charged on call loans.

Commercial Paper
What is a Commercial Paper?
A commercial paper is an unsecured promissory note issued with a fixed maturity by a
company approved by RBI, negotiable by endorsement and delivery, issued in bearer form and
issued at such discount on the face value as may be determent by the issuing company.
Features of Commercial Paper
1. Commercial paper is a short-term money market instrument comprising usance
promissory note with a fixed maturity.
2. It is a certificate evidencing an unsecured corporate debt of short term maturity.
3. Commercial paper is issued at a discount to face value basis but it can be issued in
interest bearing form.
4. The issuer promises to pay the buyer some fixed amount on some future period but
pledge no assets, only his liquidity and established earning power, to guarantee that
promise.
5. Commercial paper can be issued directly by a company to investors or through
banks/merchant banks.
Advantages of Commercial Paper
 Simplicity: The advantage of commercial paper lies in its simplicity. It involves hardly
any documentation between the issuer and investor.
 Flexibility: The issuer can issue commercial paper with the maturities tailored to match
the cash flow of the company.
 Easy To Raise Long Term Capital: The companies which are able to raise funds
through commercial paper become better known in the financial world and are thereby
placed in a more favourable position for rising such long them capital as they may, form
time to time, as require. Thus there is in inbuilt incentive for companies to remain
financially strong.
 High Returns: The commercial paper provides investors with higher returns than they
could get from the banking system.
 Movement of Funds: Commercial paper facilities securitization of loans resulting in
creation of a secondary market for the paper and efficient movement of funds providing
cash surplus to cash deficit entities.
Commercial Paper in India
In India, on the recommendations of the Vaghul working Group, the RBI announced on 27th
March 1989, that commercial paper will be introduced soon in Indian money market. The
recommendations of the Vaghul Working Group on introduction of commercial paper in Indian
money market are as flowers:
1. There is a need have limited introduction of commercial paper. It should be carefully
planned and the eligibility criteria for the issuer should be sufficiently rigorous to ensure
that the commercial paper market develops on healthy lines.
2. Initially, access to the commercial paper market should be registered to rated companies
having a net worth of Rs. 5 cores and above with good dividend payment record.
3. The commercial paper market should function within the overall discipline of CAS.
The RBI would have to administer the entry on the market, the amount if each issue the
total quantum that can be raised in a year.
4. Ni restriction be placed on the commercial paper market except by way of minimum
size of note. The size of single issue should not be less than Rs. 1 core and the size of
each lot should not be less than Rs. 5 lakhs.
5. Commercial paper should be excluded from the stipulations on insecure advances in
the case of banks.

6. Commercial paper would not be tied to any transaction and the maturity period may be
7 days and above but not exceeding six months, backed up if necessary by a revolving
underwriting facility of less than three years .
7. The using company should have a net worth of net less than Rs. 5 cores, a debt quality
ratio of not more than 105, current ratio of more than 1033, a debt servicing ratio closer
to 2, and be listed on the stock exchange.
8. The interest rate on commercial paper would be market dominated and the paper could
be issued at a discount to face value or could be interest bearing.
9. Commercial paper should not be subject to stamp duty at the time of issue as well as at
the time transfer by endorsement and delivery.
On the recommendations of the Vaghul Working Group, the RBI announced on 27th March,
1989 that commercial paper will be introduced soon in Indian money market. Detailed
guidelines were issued in December 1989, through non-Banking companies (acceptance of
Deposits through commercial paper) Direction, 1989 and finally the commercial papers were
instructed in India from 1st January, 1990.
RBI Guidelines on Commercial Paper Issue
The important guidelines are:
1. A company can issue commercial paper only if it has:
1. A tangible net worth of not less than Rs. 10croes as per the latest balance sheet;
2. Minimum current ratio of 1.33:1,
3. A fund based working capital limit of Rs. 25 crores or more.;
4. A debt servicing ratio closer to 2;
5. The company is listed on a stock exchange;
6. Subject to CAS discipline;
7. It is classified under Health Code no. 1 by the financing banks;
8. The issuing company would need to obtain p1 from CRISIL;
2. Commercial paper shall be issued in multiples of Rs. 25 lakhs but the minimum amount
to be invested by a single investor shall be Rs. 1 crore.
3. The commercial paper shall be issued for minimum maturity period of 7 days and the
maximum period of 6 months from the date of issue. There will be no grace period on
maturity.
4. 0the aggregate amount shall not exceed 20% of the issuer’s fund based working capital.
5. The commercial paper is issued in the form of usince promissory notes, negotiable by
endorsement and delivery. The rate of discount could be freely determined by the
issuing company. The issuing company has to bear all flotation cost, including stamp
duty, dealers, fee and credit rating agency fee.
6. The issue of commercial paper cannot be underwritten or co-opted in any manner.
However, commercial banks can provide standby facility for redemption of the paper
on the maturity date.
7. Investment in commercial paper can be made by any person or banks or corporate
bodies registered or incorporated in India and un-incorporated bodies too. Non-resident
Indians can invest in commercial paper on non-repatriation basis.
8. The companies issuing commercial paper would be required to ensure that the relevant
provisions of the various statutes such as companies Act, 1956, the IT At, 1961 and the
Negotiable Instruments Act, 1981 are complied with.
Procedure and Time Frame Doe Issue Commercial Paper
1. Application to RBI through financing bank or leader of consortium bank for working
capital facilities together with a certificate from credit rating agency.
2. RBI to communicate in writing their decision on the amount of commercial paper to be
issued to the leader bank.
3. Issue of commercial paper to be completed within 2 weeks from the date of approval
of RBI through private placement.

4. The issue may be spread shall bear the same maturity date.
5. Issuing company to advise RBI through the bank/leader of the bank, the amount of
actual issue of commercial paper within 3 days of completion of the issue.
Commercial Bill Markets or Discount Markets
A Commercial Bill arises out of a genuine trade transaction. A bill of exchange is an important
commercial bill which is drawn by the seller on the buyer for the amount due to him. The
maturity period of bill may vary from three to six months. Commercial Bills may be of the
following types.
Types of Commercial Bill Markets or Discount Markets in India
a. Demand and usance bills.
b. Inland and foreign bills
c. Clean and documentary bills.
d. Indigenous Bills; and
e. Accommodation and Supply Bills.
1. Demand Bills and Usance Bills
A demand bill is one in which no time of payment is specified. So, demand bills are payable
immediately when they are presented to the drawee.
Usance bill is otherwise known as time bill. It is payable after the expiry of time specified
therein. The time for payment is determined according to the trade custom or usage in practice.
2. Clean bills and documentary bills
Bills that are accompanied by documents of title to goods are called Documentary bills.
Examples for documentary bills are railway receipt, lorry receipt, bill of lading, etc.
Documentary bills can again be classified into D/A bills and D/P bills.
The documents accompanying D/A bills have to be delivered to the drawee immediately after
the acceptance of the bill. In this sense, the D/A bill becomes a clean bill immediately after
delivery of documents.
In the case of D/P bills, the documents have to be handed over to the drawee only against
payment. Clean bills are drawn without accompanying any document.
3. Inland bills and foreign bills
Bills that are drawn and payable in India on a person who is resident in India are called Inland
bills. Bills that are drawn outside India and are payable either in India or outside India are
called foreign bills.
4. Indigenous bills
The drawing and acceptance of indigenous bills are governed by native custom or usage of
trade. Indigenous bills are used by indigenous bankers to raise or remit money or finance inland
trade. These are popularly known as “hundis”. Hundis are known by various names such as
Shahjog, Namjog, Jokhani, Termainjogidarshani, Dhanijog and so on.
5. Accommodation bills and supply bills
Accommodation bills are those which do not arise out of genuine trade transactions. In the case
of accommodation bills, a person accepts the bill to help the other person to meet his financial
obligations. Generally, these bills are not accompanied by any document of title to goods.
Banks discount such accommodation bills and money is paid to the bank on the due date.
Supply bills are generally drawn on the Government departments by contractors or suppliers
for the goods supplied to them. The peculiar feature of the supply bills is that they are neither
accepted by the Government departments nor accompanied by documents of title of goods.
However, commercial banks lend to the holder of supply bills by creating a charge on them.

Advantages of Commercial Bills:
Commercial bill market is an important source of short-term funds for trade and industry. It
provides liquidity and activates the money market. In India, commercial banks lay a
significant role in this market due to the following advantages:
 Liquidity: Bills are highly liquid assets. In times of necessity, bills can be converted
into cash readily by means of rediscounting them with the central bank. Bills are self-
liquidating in character since they have fixed tenure. Moreover, they are negotiable
instruments and hence they can be transferred freely by a mere delivery or by
endorsement and delivery.
 Certainty of Payment: Bills are drawn and accepted by business people. Generally,
business people are used to keeping their words and the use of the bills imposes a strict
financial discipline on them. Hence, bills would be honored on the due date.
 Ideal Investment: Bills are for periods not exceeding 6 months. They represent
advances for a definite period. This enables financial institutions to invest their surplus
funds profitably by selecting bills of different maturities. For instance, commercial
banks can invest their funds on bills in such a way that the maturity of these bills may
coincide with the maturity of their fixed deposits.
 Simple Legal Remedy: In case the bills are dishonored, the legal remedy is simple.
Such dishonored bills have to be simply noted and protested and the whole amount
should be debited to the customer’s accounts.
 High and Quick Yield: The financial institutions earn a high quick yield. The discount
is dedicated at the time of discounting itself whereas in the case of other loans and
advances, interest is payable only when it is due. The discounts rate is also
comparatively high.
 Easy Central Bank Control: The central bank can easily influence the money market
by manipulating the bank rate or the rediscounting rate. Suitable monetary policy can
be taken by adjusting the bank rate depending upon the monetary conditions prevailing
in the market.
Operations in Commercial Bills Market:
From the operations point of view, the bill market can be classified into two viz.
 Discount Market
 Acceptance Market
Discount Market:
Discount market refers to the market where short-term genuine trade bills are discounted by
financial intermediaries like commercial banks. When credit sales are effected, the seller draws
a bill on the buyer who accepts it promising to pay the specified sum at the specified period.
The seller has to wait until the maturity of the bill for getting payment. But, the presence of a
bill market enables him to get payment immediately.
The seller can ensure payment immediately by discounting the bill with some financial
intermediary by paying a small amount of money called ‘Discount rate’ on the date of maturity,
the intermediary claims the amount of the bill from the person who has accepted the bill. In
some countries, there are some financial intermediaries who specialize in the field of
discounting.
For instance, in London Money Market there are specialise in the field discounting bills. Such
institutions are conspicuously absent in India. Hence, commercial banks in India have to
undertake the work of discounting. However, the DFHI has been established to activate this
market.
Acceptance Market:
The acceptance market refers to the market where short-term genuine trade bills are accepted
by financial intermediaries. All trade bills cannot be discounted easily because the paties to the
bills may not be financially sound. In case such bills are accepted by financial intermediaries

like banks, the bills earn a good name and reputation and such bills can readily discounted
anywhere. In London, there are specialist firms called acceptance house which accept bills
drawn by trades and import greater marketability to such bills. However, their importance has
declined in recent times. In India, there are no acceptance houses. The commercial banks
undertake the acceptance business to some extant.
Treasury Bills
Definition: Treasury Bills, also known as T-bills are the short-term money market
instrument, issued by the central bank on behalf of the government to curb temporary
liquidity shortfalls. These do not yield any interest, but issued at a discount, at its redemption
price, and repaid at par when it gets matured.
T-bills are the key segment of the financial market, which is utilised by the government to raise
short-term funds, for fulfilling periodic discrepancies between its receipts and expenditure .
The difference between the issue price and the redemption value indicates the interest on
treasury bills, called as a discount.
These are the safest investment instrument of its category, as the risk of default is negligible.
Further, the date of issue is predetermined, as well as the amount is also fixed.
Salient features of Treasury Bills
 Form: T-bills are issued either in physical form as a promissory note or dematerialised
form by crediting to Subsidiary General Ledger (SGL) Account.
 Eligibility: Individuals, firms, companies, trust, banks, insurance companies, provident
funds, state government and financial institutions are eligible to invest in treasury bills.
 Minimum Bid: The minimum amount of bid is Rs. 25000 and in multiples thereof.
 Issue price: T-bills are issued at a discount, but redeemed at par.
 Repayment: The repayment of the bill is made at par on the maturity of the term.
 Availability: Treasury bills are highly liquid negotiable instruments, that are available
in both financial markets, i.e. primary and secondary.
 Method of the auction: Uniform price auction method for 91 days T-bills, whereas
multiple price auction method for 364 days T-bill.
 Day count: The day count is 364 days, in a year, for treasury bills.
Besides this, other characteristics of treasury bills include market-driven discount rate, selling
through auction, issued to meet short-term mismatches in cash flows, assured yield, low
transaction cost, etc.
Types of Treasury Bills
At present there are three types of auctioned T-bills, which are:
1. 91 days T-bills: The tenor of these bills complete on 91 days. These are auctioned on
Wednesday, and the payment is made on following Friday.
2. 182 days T-bills: These treasury bills get matured after 182 days, from the day of issue,
and the auction is on Wednesday of non-reporting week. Moreover, these are repaid on
following Friday, when the term expires.
3. 364 days T-bills: The maturity period of these bills is 364 days. The auction is on every
Wednesday of reporting week and repaid on the following Friday after the term gets
over.
Treasury bills are backed by some advantages like no tax deducted at source, high liquidity and
trade-ability, zero risks of default, transparency, good return on investment and so on.
Advantages of treasury bills

 It is considered to have little or practically no risk attached. All things being equal, you
will definitely get your money back with the promised interest.
 They are very liquid (i.e. you can easily convert them to cash). Even before the full time
period elapses, you can always decide to go for your money at any time. This is however
not encouraged, unless you are in very desperate need of cash. Note that if you decide
to go for your money (i.e. sell your T’bills) before the time elapses, you will not be paid
the full interest promised. In order words, the investment will be discounted.
 No transaction cost is charged. Unlike other forms of investment where you are charged
a fee by the broker who purchases them for you, brokers do not charge you for
purchasing T’Bills for you.
Disadvantage of treasury bills
 The interest rates which are paid on T’bills are almost always lower than the other
investment options on the market. This however makes sense because one of the key
principles of investment is “the higher the risk, the higher the expected return”.
Certificate of Deposits:
A certificate of deposit is an agreement to deposit money for a fixed period with a bank that
will pay you interest. You can choose to invest for three months, six months, one year or five
years. You will receive a higher interest rate for the longer time commitment. You promise to
leave all the money, plus the interest, with the bank for the entire term.
In effect, you are lending the bank your money in return for interest. The CD is a promissory
note that the bank issues you. That's how banks acquire the cash they need to make loans. The
interest you receive is less than the pay earns for lending it out. That's how banks earn a profit.
But you earn a higher interest rate than you would for an interest-bearing checking account.
That because you can't withdraw the funds for the agreed-upon time.
Advantages of a CD
 Flexible Terms: The terms and the amounts that can be deposited into a CD are
flexible. If you are not willing to tie up your money for a long time, you can easily opt
for a shorter term. At the end of a CD term, you can renew that CD or start a new one.
 Safety: CDs that are available from a federally insured institution are generally insured
up to $250,000. This takes much of the risk out of the investment.
 BetterReturn Than Saving Accounts: Since the CD holder is not allowed to withdraw
money freely like savings account holders, a CD is often more valuable to the financial
institution. For this reason, the interest rate offered to a CD holder is higher than a
traditional savings account.
 Wide Selection: You can get a CD at various maturities and terms from different
financial institutions. Because of the diversity of CDs, investors can find a CD that
meets their individual needs.
 Fixed, Predictable Return: The investor can be sure about getting a specific yield at a
specific time. Even if the interest rates come down to a broader economy, the CD rate
will remain constant. You will be able to easily determine the rate at which your balance
will grow, thus making financial planning easy.
Disadvantages of a CD
 Limited Liquidity: The owner of a CD cannot access their money as easily as a
traditional savings account. To withdrawal money from a CD before the end of the term
requires that a penalty has to be paid. This penalty can be in the form of lost interest or
a principal penalty. To increase flexibility, the investor can create a CD Ladder, which

is composed of CDs with different maturity dates and terms. With a laddering strategy,
you have more options to access your CD savings at different intervals of time.
 Inflation Risk: CD rates may be lower than the rate of inflation. This means that your
money may lose its purchasing power over time if interest gains are outdone by inflation
rates.
With these advantages and disadvantages in mind, it is wise to consider that CD advantages
usually outweigh the disadvantages. CDs allow you to grow your savings without hassle. You
can easily compare different types of CDs with the help of online resources, and you can find
one that best suits your needs.
Summary of Certificates of Deposits
Certificates of Deposit (CD) are useful for people looking for a way to save money while
earning a relatively high interest. This not only helps you save money, but also earns you
interest without requiring any effort on your part. The disadvantages of CD’s are minor and
typically outweighed by their advantages.
Capital Market
Definition: Capital Market is used to mean the market for long term investments that have
explicit or implicit claims to capital. Long term investments refer to those investments whose
lock-in period is greater than one year.
In the capital market, both equity and debt instruments, such as equity shares, preference
shares, debentures, zero-coupon bonds, secured premium notes and the like are bought and
sold, as well as it covers all forms of lending and borrowing.
Capital Market is composed of those institutions and mechanisms with the help of which
medium and long term funds are combined and made available to individuals, businesses and
government. Both private placement sources and organized market like securities exchange are
included in it.
Functions of Capital Market
 Mobilization of savings to finance long term investments.
 Facilitates trading of securities.
 Minimization of transaction and information cost.
 Encourage wide range of ownership of productive assets.
 Quick valuation of financial instruments like shares and debentures.
 Facilitates transaction settlement, as per the definite time schedules.
 Offering insurance against market or price risk, through derivative trading.
 Improvement in the effectiveness of capital allocation, with the help of competitive price
mechanism.
Capital market is a measure of inherent strength of the economy. It is one of the best source of
finance, for the companies, and offers a spectrum of investment avenues to the investors, which
in turn encourages capital creation in the economy.
Types of Capital Market
The capital market is bifurcated in two segments, primary market and secondary market:
1. Primary Market: Otherwise called as New Issues Market, it is the market for the trading of
new securities, for the first time. It embraces both initial public offering and further public

offering. In the primary market, the mobilization of funds takes place through prospectus, right
issue and private placement of securities.
2. Secondary Market: Secondary Market can be described as the market for old securities, in the
sense that securities which are previously issued in the primary market are traded here. The
trading takes place between investors, that follows the original issue in the primary market. It
covers both stock exchange and over-the counter market.
Capital market improves the quality of information available to the investor regarding the
investment. Add to that, it plays a crucial role in encouraging the adoption of rules of corporate
governance, which backs the trading environment. It includes all the processes that help in the
transfer of already existing securities.
Debt Market:
A market that is involved in the trading of debt instruments such as government and corporate
bonds, as well as has an involvement with the trading of packaged loan products that are sold
to investors.
Debt Instruments are obligation of issuer of such instrument as regards certain future cash
flow representing Interest & Principal, which the issuer would pay to the legal owner of the
Instrument. Types of Debt Instruments are of different types like Bonds, Debentures,
Commercial Papers, Certificates of Deposit, Government Securities (G - Secs) etc. The
Government Securities (G-Secs) market is the oldest and the largest element of the Indian
debt market in terms of market capitalization, trading volumes and outstanding securities.
The G-Secs market plays a very important role in the Indian economy as it provides the
benchmark for determining the level of interest rates in the country through the yields on
the government securities which are treated as the risk-free rate of return in any economy.
The reserve Bank of India has allowed Primary Dealers, Banks and Financial Institutions
in India to do transactions in debt instruments among themselves or with non-bank clients.
Debt instruments provide fixed return known as coupon rate. Retail investors would have
a natural preference for fixed income returns and especially so in the present situation of
increasing volatility in the financial markets. Now, retail investors are also showing keen
interest in Debt Instruments particularly in the Central Government Securities (G-secs).For
an individual investor G-secs are one of the best investment options as there is zero default
risk and lower volatility.
What are Debt Capital Markets (DCM)?
Definition: A debt capital market (DCM) indicates a market in which companies and
government can raise funding through the trade of debt securities, including corporate bond,
government bonds, CDs, and so on.
What Does Debt Capital Market Mean?
What is the definition of debt capital market? Debt capital markets are responsible for
assisting companies and governments with raising debt from a pool of investors who are
seeking for funding opportunities. Raising debt is generally considered cheaper than raising
equity. For instance, borrowing $100,000 at an annual interest rate of 6% costs $6,000. Raising
equity for $100,000 would require giving up 20% of the company to the shareholders, i.e. a
cost of $20,000.
Debt capital is usually long-term capital with relatively low rates, and it goes towards
refinancing or restructuring existing debt or for a potential merger with another company. In
the United States, DCMs are regulated by the U.S. Securities and Exchange Commission
(SEC).
Example

Company ABC seeks to raise $100,000 in debt by issuing 20-year corporate bonds at an annual
interest of 6.25%. The company issues the bonds, and the interested investors are purchasing
the bonds in the capital market for $10,000 each, i.e. the bond’s par value. Unlike stockholders,
bondholders do not gain voting rights in the firm’s core decisions or rights to the firm’s future
earnings.
The company receives the par value of each bond with the obligation to compensate each
investor with the par value plus the annual interest of 6.25% at maturity. In case a bondholder
wants to sell the bond before maturity, he can do so in the DCMs.
DCMs are important because they determine the level of interest rates. High-interest rates
lower the consumer borrowing and spending as well as the business investment. Conversely,
when interest rates decline, consumer borrowing and spending tend to increase as consumers
feel more confident about the economy.
Derivative Market
A derivative contract is essentially a contract. The contract specifies that some future
commodity may be exchanged at a later date at a price fixed today. Notice the fact that the
agreement would basically be worthless if not for the time difference between the setting of
the price and the actual execution of the trade.
Since the price is set today, let’s say at $100 and the transaction takes place a month from now
when the price could be any amount greater or lower than $100, the derivative contract becomes
valuable. The derivative contract becomes a license to purchase commodities at below market
prices and book an immediate gain.
Therefore, the value of the contract is derived from the fluctuation in the price of an underlying
asset and hence the term derivatives to define these securities.
Modern day derivatives markets provide a mind-numbingly large number of options to the
buyers and sellers of such contracts. One can literally buy a derivative on anything. Obviously
assets like stocks, bonds and commodities form the basis of majority of these contracts.
However, there are derivatives available for people who would like to predict the amount of
rain or sunlight in a given time period at a given place!
The 4 Basic Types of Derivatives
Type 1: Forward Contracts
Forward contracts are the simplest form of derivatives that are available today. Also, they are
the oldest form of derivatives. A forward contract is nothing but an agreement to sell something
at a future date. The price at which this transaction will take place is decided in the present.
However, a forward contract takes place between two counterparties. This means that the
exchange is not an intermediary to these transactions. Hence, there is an increase chance of
counterparty credit risk. Also, before the internet age, finding an interested counterparty was a
difficult proposition. Another point that needs to be noticed is that if these contracts have to be
reversed before their expiration, the terms may not be favorable since each party has one and
only option i.e. to deal with the other party. The details of the forward contracts are privileged
information for both the parties involved and they do not have any compulsion to release this
information in the public domain.
Type 2: Futures Contracts
A futures contract is very similar to a forwards contract. The similarity lies in the fact that
futures contracts also mandate the sale of commodity at a future data but at a price which is
decided in the present.
However, futures contracts are listed on the exchange. This means that the exchange is an
intermediary. Hence, these contracts are of standard nature and the agreement cannot be

modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and
have pre-decided expirations. Also, since these contracts are traded on the exchange they have
to follow a daily settlement procedure meaning that any gains or losses realized on this contract
on a given day have to be settled on that very day. This is done to negate the counterparty credit
risk.
An important point that needs to be mentioned is that in case of a futures contract, they buyer
and seller do not enter into an agreement with one another. Rather both of them enter into an
agreement with the exchange.
Type 3: Option Contracts
The third type of derivative i.e. option is markedly different from the first two types. In the first
two types both the parties were bound by the contract to discharge a certain duty (buy or sell)
at a certain date. The options contract, on the other hand is asymmetrical. An options contract,
binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the
option. So, one party has the obligation to buy or sell at a later date whereas the other party can
make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.
There are two types of options i.e. call option and put option. Call option allows you the right
but not the obligation to buy something at a later date at a given price whereas put option gives
you the right but not the obligation to sell something at a later date at a given pre decided price.
Any individual therefore has 4 options when they buy an options contract. They can be on the
long side or the short side of either the put or call option. Like futures, options are also traded
on the exchange.
Type 4: Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the
participants to exchange their streams of cash flows. For instance, at a later date, one party may
switch an uncertain cash flow for a certain one. The most common example is swapping a fixed
interest rate for a floating one. Participants may decide to swap the interest rates or the
underlying currency as well.
Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts
are usually not traded on the exchange. These are private contracts which are negotiated
between two parties. Usually investment bankers act as middlemen to these contracts. Hence,
they too carry a large amount of exchange rate risks.
So, these are the 4 basic types of derivatives. Modern derivative contracts include countless
combinations of these 4 basic types and result in the creation of extremely complex contracts.
Relationship between Financial System and Economic growth
The development of any country depends on the economic growth the country achieves over a
period of time. Economic growth deals about investment and production and also the extent of
Gross Domestic Product in a country. Only when this grows, the people will experience growth
in the form of improved standard of living, namely economic development.
Role of financial system in economic development of a country
The following are the roles of financial system in the economic development of a country.
Savings-investment relationship
To attain economic development, a country needs more investment and production. This can
happen only when there is a facility for savings. As, such savings are channelized to productive
resources in the form of investment. Here, the role of financial institutions is important, since
they induce the public to save by offering attractive interest rates. These savings are
channelized by lending to various business concerns which are involved in production and
distribution.
Financial systems help in growth of capital market

Any business requires two types of capital namely, fixed capital and working capital. Fixed
capital is used for investment in fixed assets, like plant and machinery. While working capital
is used for the day-to-day running of business. It is also used for purchase of raw materials and
converting them into finished products.
 Fixed capital is raised through capital market by the issue of debentures and shares.
Public and other financial institutions invest in them in order to get a good return with
minimized risks.
 For working capital, we have money market, where short-term loans could be raised by
the businessmen through the issue of various credit instruments such as bills, promissory
notes, etc.
Foreign exchange market enables exporters and importers to receive and raise funds for settling
transactions. It also enables banks to borrow from and lend to different types of customers in
various foreign currencies. The market also provides opportunities for the banks to invest their
short term idle funds to earn profits. Even governments are benefited as they can meet their
foreign exchange requirements through this market.
Government Securities market
Financial system enables the state and central governments to raise both short-term and long-
term funds through the issue of bills and bonds which carry attractive rates of interest along
with tax concessions. The budgetary gap is filled only with the help of government securities
market. Thus, the capital market, money market along with foreign exchange market and
government securities market enable businessmen, industrialists as well as governments to
meet their credit requirements. In this way, the development of the economy is ensured by the
financial system.
Financial system helps in Infrastructure and Growth
Economic development of any country depends on the infrastructure facility available in the
country. In the absence of key industries like coal, power and oil, development of other
industries will be hampered. It is here that the financial services play a crucial role by providing
funds for the growth of infrastructure industries. Private sector will find it difficult to raise the
huge capital needed for setting up infrastructure industries. For a long time, infrastructure
industries were started only by the government in India. But now, with the policy of economic
liberalization, more private sector industries have come forward to start infrastructure industry.
The Development Banks and the Merchant banks help in raising capital for these industries.
Financial system helps in development of Trade
The financial system helps in the promotion of both domestic and foreign trade. The financial
institutions finance traders and the financial market helps in discounting financial instruments
such as bills. Foreign trade is promoted due to per-shipment and post-shipment finance by
commercial banks. They also issue Letter of Credit in favor of the importer. Thus, the precious
foreign exchange is earned by the country because of the presence of financial system. The
best part of the financial system is that the seller or the buyer do not meet each other and the
documents are negotiated through the bank. In this manner, the financial system not only helps
the traders but also various financial institutions. Some of the capital goods are sold
through hire purchase and instalment system, both in the domestic and foreign trade. As a result
of all these, the growth of the country is speeded up.
Employment Growth is boosted by financial system
The presence of financial system will generate more employment opportunities in the country.
The money market which is a part of financial system, provides working capital to the
businessmen and manufacturers due to which production increases, resulting in generating
more employment opportunities. With competition picking up in various sectors, the service
sector such as sales, marketing, advertisement, etc., also pick up, leading to more employment
opportunities. Various financial services such as leasing, factoring, merchant banking, etc.,
will also generate more employment. The growth of trade in the country also induces
employment opportunities. Financing by Venture capital provides additional opportunities for
techno-based industries and employment.
Venture Capital
There are various reasons for lack of growth of venture capital companies in India. The
economic development of a country will be rapid when more ventures are promoted which

require modern technology and venture capital. Venture capital cannot be provided by
individual companies as it involves more risks. It is only through financial system, more
financial institutions will contribute a part of their investable funds for the promotion of new
ventures. Thus, financial system enables the creation of venture capital.
Financial system ensures Balanced growth
Economic development requires a balanced growth which means growth in all the sectors
simultaneously. Primary sector, secondary sector and tertiary sector require adequate funds for
their growth. The financial system in the country will be geared up by the authorities in such a
way that the available funds will be distributed to all the sectors in such a manner, that there
will be a balanced growth in industries, agriculture and service sectors.
Financial system helps in fiscal discipline and control of economy
It is through the financial system, that the government can create a congenial business
atmosphere so that neither too much of inflation nor depression is experienced. The industries
should be given suitable protection through the financial system so that their credit
requirements will be met even during the difficult period. The government on its part, can raise
adequate resources to meet its financial commitments so that economic development is not
hampered. The government can also regulate the financial system through suitable legislation
so that unwanted or speculative transactions could be avoided. The growth of black money
could also be minimized.
Financial system’s role in Balanced regional development
Through the financial system, backward areas could be developed by providing various
concessions or sops. This ensures a balanced development throughout the country and this will
mitigate political or any other kind of disturbances in the country. It will also check migration
of rural population towards towns and cities.
Role of financial system in attracting foreign capital
Financial system promotes capital market. A dynamic capital market is capable of attracting
funds both from domestic and abroad. With more capital, investment will expand and this will
speed up the economic development of a country.
Financial system’s role in Economic Integration
Financial systems of different countries are capable of promoting economic integration. This
means that in all those countries, there will be common economic policies, such as common
investment, trade, commerce, commercial law, employment legislation, old age pension,
transport co-ordination, etc. We have a standing example of European Common Market which
has gone to the extent of creating a common currency, representing several countries in
Western Europe.
Role of financial system in Political stability
The political conditions in all the countries with a developed financial system will be stable.
Unstable political environment will not only affect their financial system but also their
economic development.
Financial system helps in Uniform interest rates
The financial system is capable of bringing an uniform interest rate throughout the country by
which there will be balanced movement of funds between centres which will ensure availability
of capital for all kinds of industries.
Financial system role in Electronic development:
Due to the development of technology and the introduction of computers in the financial
system, the transactions have increased manifold bringing in changes for the all-round
development of the country. The promotion of World Trade Organization (WTO) has further
improved international trade and the financial system in all its member countries.

Banking and Financial Service Unit 2

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Banking and Financial Service Unit 2