MSc Financial Markets Course Overview

M.SC.,ACCOUNTING AND FINANCE-2022
FINANCIAL MARKETS AND INSTITUTIONS
COURSE CODE-ACFN551-CREDIT-2HR
CHAPTER-ONE
OVERVIEW OF THE FINANCIAL SYSTEM
PROF. DR. CHINNIAH ANBALAGAN
PROFESSOR OF M.SC., ACCOUNTING & FINANCE
COLLEGE OF BUSINESS AND ECONOMICS
SAMARA UNIVERSITY, ETHIOPIA, EAST AFRICA
EMAIL ID: DR.CHINLAKSHANBU@GMAIL.COM

CHAPTER -ONE
OVERVIEW OF THE FINANCIAL SYSTEM
1. INTRODUCTION TO FINANCIAL SYSTEM
• Definition
• Basic features of financial system
• Participants in financial system
2. FINANCIAL MARKET
3. FINANCIAL INSTRUMENTS
• Money market instruments
• Capital market instruments
• Hybrid instruments
• Derivative market instruments
• Foreign exchange market instruments
• International financial market instruments
4. FUNCTION OF FINANCIAL MARKETS

1. INTRODUCTION TO FINANCIAL SYSTEM
• Definition of Financial System
A financial system is a set of institutions, such as banks,
insurance companies, and stock exchanges, that permit
the exchange of funds.
Financial systems exist on firm, regional, and global
levels.
Borrowers, lenders, and investors exchange current
funds to finance projects, either for consumption or
productive investments, and to pursue a return on their
financial assets.
The financial system also includes sets of rules and
practices that borrowers and lenders use to decide
which projects get financed, who finances projects, and
terms of financial deals

Understanding the Financial System
• Like any other industry, the financial system can be organized
using markets, central planning, or some mix of both.
• Financial markets involve borrowers, lenders, and investors
negotiating loans and other transactions.
• In these markets, the economic good traded on both sides is
usually some form of money: current money (cash), claims on
future money (credit), or claims on the future income potential
or value of real assets (equity). These also include derivative
instruments.
• Derivative instruments, such as commodity futures or stock
options, are financial instruments that are dependent on an
underlying real or financial asset's performance. In financial
markets, these are all traded among borrowers, lenders, and
investors according to the normal laws of supply and demand.
• In a centrally planned financial system (e.g., a single firm or
a command economy), the financing of consumption and
investment plans is not decided by counterparties in a
transaction but directly by a manager or central planner.

Basic Features Of Financial System
• Financial systems are multidimensional. Four
characteristics are of particular interest for
benchmarking financial systems:
• Financial Depth,
• Access,
• Efficiency, And
• Stability.
• These characteristics need to be measured for
financial institutions and markets.

The Basic Financial System
• In a global view, financial systems include
–the international monetary fund,
–Central banks,
–Government treasuries and
–Monetary authorities,
• The world bank, and major private international
banks.

Functions of Financial system
• Financial Markets have different roles to play
which include
• Price Determination,
• Funds Mobilization,
• Risk Sharing,
• Easy Access,
• Liquidity,
• Capital Formation and reduction in
transaction costs and
• Provision of the required information, etc.

Functions of Financial Markets

The Parts to the Financial System
1. Money
Money is used as a medium to buy goods & services. It also is a standard
unit of measurement and acts as a store of value. However, money may
not be a good store of value since it loses value with inflation.
2. Financial Instruments
Financial Instruments are formal obligations that entitle one party to
receive payments or a share of assets from another party. Examples of
tradable financial instruments include loans, stocks, bonds.
3. Financial Markets
A Financial Market is a place or network where financial instruments can
be sold quickly & cheaply.
4. Financial Institutions
Financial Institutions are firms that connect borrowers and lenders,
provide savers and borrowers access to financial instruments & markets.
There are two types of Financial Markets – the primary market and the
secondary market.
5. Central Banks
Central Banks are large financial institutions that handle government
finances, they regulate the supply of money, and they serve as banks to
commercial banks.

Participants in financial system
• The major participants in the money market are
• Commercial Banks,
• Governments,
• Corporations,
• Government-sponsored Enterprises,
• Money Market Mutual Funds,
• Futures Market Exchanges,
• Brokers And Dealers, And
• The Federal Reserve.

Participants of Financial Markets

Major Financial Markets Participants

3 Participants In The Financial System
• A financial system is a system that allows the
exchange of funds between financial market
participants such as
• lenders,
• investors, and
• borrowers

4 Types Of Market Participants
• There are four kinds of participants in a
derivatives market:
• Hedgers,
• Speculators – Risk Taker and Investors
• Arbitrageurs, and
• Margin (Border) traders.

2. FINANCIAL MARKET
• Financial Markets include any place or system
that provides buyers and sellers the means to
trade financial instruments, including bonds,
equities, the various international currencies,
and derivatives.
• Financial markets facilitate the interaction
between those who need capital with those who
have capital to invest.

Types of Financial Markets
1. Stock Markets
• Perhaps the most ubiquitous of financial markets are stock
markets. These are venues where companies list their shares
and they are bought and sold by traders and investors. Stock
markets, or equities markets, are used by companies to raise
capital via an Initial Public Offering (IPO), with shares
subsequently traded among various buyers and sellers in
what is known as a secondary market.
• Stocks may be traded on listed exchanges, such as the New
York Stock Exchange (NYSE) or Nasdaq, or else over-the-
counter (OTC).
• Most trading in stocks is done via regulated exchanges, and
these play an important role in the economy as both a gauge
of the overall health in the economy as well as providing
capital gains and dividend income to investors.

Conti…
2. Over-the-Counter Markets
An Over-The-Counter (OTC) market is a decentralized
market meaning it does not have physical locations, and
trading is conducted electronically—in which market
participants trade securities directly between two
parties without a broker.
While OTC markets may handle trading in certain stocks
(e.g., smaller or riskier companies that do not meet the
listing criteria of exchanges), most stock trading is done
via exchanges.
Certain derivatives markets, however, are exclusively
OTC, and so make up an important segment of the
financial markets. Broadly speaking, OTC markets and
the transactions that occur on them are far less
regulated, less liquid, and more opaque.

Conti…
3. Bond Markets
• A bond is a security in which an investor loans
money for a defined period at a pre-established
interest rate. You may think of a bond as
an agreement between the lender and borrower
that contains the details of the loan and its
payments. Bonds are issued by corporations as
well as by municipalities, states, and sovereign
governments to finance projects and operations.
The bond market sells securities such as notes and
bills issued by the United States Treasury, for
example. The bond market also is called the debt,
credit, or fixed-income market.

Conti…
4. Money Markets
• Typically the money markets trade in products with
highly liquid short-term maturities (of less than one
year) and are characterized by a high degree of safety
and a relatively low return in interest.
• At the wholesale level, the money markets involve
large-volume trades between institutions and traders.
• At the retail level, they include money market mutual
funds bought by individual investors and money
market accounts opened by bank customers.
• Individuals may also invest in the money markets by
buying short-term certificates of
deposit (CDs), municipal notes, or U.S. Treasury bills,
among other examples.

Conti…
5. Derivatives Markets
• A derivative is a contract between two or more parties
whose value is based on an agreed-upon underlying financial
asset (like a security) or set of assets (like an index).
Derivatives are secondary securities whose value is solely
derived from the value of the primary security that they are
linked to. In and of itself a derivative is worthless.
• Futures markets are where futures contracts are listed and
traded. Unlike forwards, which trade OTC, futures markets
utilize standardized contract specifications, are well-
regulated, and utilize clearinghouses to settle and confirm
trades. Options markets, such as the Chicago Board Options
Exchange (CBOE), similarly list and regulate options
contracts.
• Both futures and options exchanges may list contracts on
various asset classes, such as equities, fixed-income
securities, commodities, and so on.

Conti…
6. Forex Market
• The forex (foreign exchange) market is the market in
which participants can buy, sell, hedge, and speculate
on the exchange rates between currency pairs. The
forex market is the most liquid market in the world,
as cash is the most liquid of assets.
• The currency market handles more than $5 trillion in
daily transactions, which is more than the futures and
equity markets combined.
• As with the OTC markets, the forex market is also
decentralized and consists of a global network of
computers and brokers from around the world.
• The forex market is made up of banks, commercial
companies, central banks, investment
management firms, hedge funds, and retail forex
brokers and investors.

Conti…
7. Commodities Markets
• Commodities markets are venues where producers
and consumers meet to exchange physical
commodities such as agricultural products (e.g., corn,
livestock, soybeans), energy products (oil, gas, carbon
credits), precious metals (gold, silver, platinum),
or "soft" commodities (such as cotton, coffee, and
sugar). These are known as spot commodity markets,
where physical goods are exchanged for money.
• The bulk of trading in these commodities, however,
takes place on derivatives markets that utilize spot
commodities as the underlying assets. Forwards,
futures, and options on commodities are exchanged
both OTC and on listed exchanges around the world
such as the Chicago Mercantile Exchange (CME) and
the Intercontinental Exchange (ICE).

Conti…
8. Crypto currency Markets
• The past several years have seen the introduction and rise
of crypto currencies such as Bitcoin and Ethereum,
decentralized digital assets that are based on block
chain technology. Today, hundreds of crypto currency tokens
are available and trade globally across a patchwork of
independent online crypto exchanges. These exchanges host
digital wallets for traders to swap one crypto currency for
another, or for fiat monies such as dollars or euros.
• Because the majority of crypto exchanges
are centralized platforms, users are susceptible to hacks or
fraud. Decentralized exchanges are also available that
operate without any central authority. These exchanges
allow direct peer-to-peer (P2P) trading of digital currencies
without the need for an actual exchange authority to
facilitate the transactions. Futures and options trading are
also available on major crypto currencies.

Financial Markets Work
• A financial market is a place where firms and
individuals enter into contracts to sell or buy
a specific product such as a stock, bond, or
futures contract.
• Buyers seek to buy at the lowest available
price and sellers seek to sell at the highest
available price

Is Capital A Market?
• Capital market is a place where buyers and
sellers indulge in trade (buying/selling) of
financial securities like bonds, stocks, etc.
• The trading is undertaken by participants such
as individuals and institutions.
• Capital market trades mostly in long-term
securities.

Differences Between Capital Markets and the Stock Market
• The stock market is part of the capital market.
• The stock market deals only with equity capital, while
the capital market deals with equity and debt
instruments.
• The stock market exclusively works with corporations
regulated by the Securities Exchange Commission (SEC),
while the capital market extends beyond regulated
securities.
• The stock market doesn't have trades of any
government instruments, while the capital market
includes US treasuries and municipal bonds.
• The stock market deals only with simple shares of
equity, while the capital market also includes much
more sophisticated derivatives.

Derivative Products
• During the 1980s and 1990s, a major growth sector in financial
markets was the trade in so called derivatives.
• In the financial markets, stock prices, share prices, bond prices,
currency rates, interest rates and dividends go up and down,
creating risk. Derivative products are financial products that are
used to control risk or paradoxically exploit risk. It is also called
financial economics.
• Derivative products or instruments help the issuers to gain an
unusual profit from issuing the instruments. For using the help of
these products a contract has to be made. Derivative contracts are
mainly 4 types:
• Future
• Forward
• Option
• Swap

Future
• The Dutch pioneered several financial instruments and
helped lay the foundations of the modern financial
system.
• In Europe, formal futures markets appeared in
the Dutch Republic during the 17th century.
• Among the most notable of these early futures
contracts were the tulip futures that developed during
the height of the Dutch Tulipmania in 1636.
• The Dōjima Rice Exchange, first established in 1697
in Osaka, is considered by some to be the first futures
exchange market, to meet the needs
of samurai who—being paid in rice—needed a stable
conversion to coin after a series of bad harvests.

Conti…
• The Chicago Board of Trade (CBOT) listed the first-ever
standardized 'exchange traded' forward contracts in 1864,
which were called futures contracts.
• This contract was based on grain trading, and started a trend
that saw contracts created on a number of
different commodities as well as a number of futures
exchanges set up in countries around the world.
• By 1875 cotton futures were being traded in Bombay in India
and within a few years this had expanded to futures
on edible oilseeds complex, raw jute and jute goods
and bullion.
• In the 1930s two thirds of all futures was in wheat.
• The 1972 creation of the International Monetary
Market (IMM) by the Chicago Mercantile Exchange was the
world's first financial futures exchange, and
launched currency futures.
• In 1976, the IMM added interest rate futures on US treasury
bills, and in 1982 they added stock market index futures.

Conti…
• In finance, a futures contract (sometimes
called futures) is a standardized legal agreement to
buy or sell something at a predetermined price at a
specified time in the future, between parties not
known to each other.
• The asset transacted is usually
a commodity or financial instrument.
• The predetermined price the parties agree to buy
and sell the asset for is known as the forward price.
• The specified time in the future—which is when
delivery and payment occur—is known as
the delivery date.
• Because it is a function of an underlying asset, a
futures contract is a derivative product.

Forward Contract
• In finance, a forward contract or simply a forward is a non-
standardized contract between two parties to buy or sell an asset at a
specified future time at a price agreed on at the time of conclusion of
the contract, making it a type of derivative instrument.
• The party agreeing to buy the underlying asset in the future assumes
a long position, and the party agreeing to sell the asset in the future
assumes a short position. The price agreed upon is called the delivery
price, which is equal to the forward price at the time the contract is
entered into. The price of the underlying instrument, in whatever
form, is paid before control of the instrument changes.
• This is one of the many forms of buy/sell orders where the time and
date of trade is not the same as the value date where
the securities themselves are exchanged. Forwards, like other
derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to
take advantage of a quality of the underlying instrument which is time-
sensitive.

Conti…
• Suppose that Bob wants to buy a house a year from now. At
the same time, suppose that Alice currently owns a $100,000
house that she wishes to sell a year from now. Both parties
could enter into a forward contract with each other. Suppose
that they both agree on the sale price in one year's time of
$104,000 (more below on why the sale price should be this
amount). Alice and Bob have entered into a forward contract.
Bob, because he is buying the underlying, is said to have
entered a long forward contract. Conversely, Alice will have
the short forward contract.
• At the end of one year, suppose that the current market
valuation of Alice's house is $110,000. Then, because Alice is
obliged to sell to Bob for only $104,000, Bob will make a
profit of $6,000. To see why this is so, one needs only to
recognize that Bob can buy from Alice for $104,000 and
immediately sell to the market for $110,000. Bob has made
the difference in profit. In contrast, Alice has made a potential
loss of $6,000, and an actual profit of $4,000.

Spot–forward Parity
• For liquid assets ("tradeables"), spot–forward parity
provides the link between the spot market and the
forward market. It describes the relationship between
the spot and forward price of the underlying asset in a
forward contract. While the overall effect can be
described as the cost of carry, this effect can be broken
down into different components, specifically whether
the asset:
• pays income, and if so whether this is on a discrete or
continuous basis
• incurs storage costs
• is regarded as
– an investment asset, i.e. an asset held primarily for
investment purposes (e.g. gold, financial securities);
– or a consumption asset, i.e. an asset held primarily for
consumption (e.g. oil, iron ore etc.)

Conti…
• Investment assets
• For an asset that provides no income, the relationship
between the current forward ({displaystyle F_{0}}) and spot
({displaystyle S_{0}}) prices is
• {displaystyle F_{0}=S_{0}e^{rT}}where {displaystyle r} is the
continuously compounded risk free rate of return, and T is
the time to maturity. The intuition behind this result is that
given you want to own the asset at time T, there should be
no difference in a perfect capital market between buying the
asset today and holding it and buying the forward contract
and taking delivery. Thus, both approaches must cost the
same in present value terms. For an arbitrage proof of why
this is the case, see Rational pricing below.
• For an asset that pays known income, the relationship
becomes:
• Discrete: {displaystyle F_{0}=(S_{0}-I)e^{rT}}
• Continuous: {displaystyle F_{0}=S_{0}e^{(r-q)T}}

Conti…
Consumption assets
Consumption assets are typically raw material commodities which are
used as a source of energy or in a production process, for
example crude oil or iron ore. Users of these consumption commodities
may feel that there is a benefit from physically holding the asset in
inventory as opposed to holding a forward on the asset. These benefits
include the ability to "profit from" (hedge against) temporary shortages
and the ability to keep a production process running, and are referred
to as the convenience yield. Thus, for consumption assets, the spot-
forward relationship is:
Discrete storage costs: {displaystyle F_{0}=(S_{0}+U)e^{(r-y)T}}
Continuous storage costs: {displaystyle F_{0}=S_{0}e^{(r+u-y)T}}
where {displaystyle y%p.a.} is the convenience yield over the life of
the contract. Since the convenience yield provides a benefit to the
holder of the asset but not the holder of the forward, it can be
modelled as a type of 'dividend yield'. However, it is important to note
that the convenience yield is a non cash item, but rather reflects the
market's expectations concerning future availability of the commodity.

Conti…
• Cost of carry
• The relationship between the spot and forward
price of an asset reflects the net cost of holding (or
carrying) that asset relative to holding the forward.
Thus, all of the costs and benefits above can be
summarised as the cost of carry, {displaystyle c}.
Hence,
• Discrete: {displaystyle F_{0}=(S_{0}+U-I)e^{(r-y)T}}
• Continuous: {displaystyle
F_{0}=S_{0}e^{cT},{text{ where }}c=r-q+u-y.}

Option(finance)
In finance, an option is a contract which conveys to its
owner, the holder, the right, but not the obligation, to
buy or sell an underlying asset or instrument at a
specified strike price on or before a specified date,
depending on the style of the option.
Options are typically acquired by purchase, as a form of
compensation, or as part of a complex financial
transaction.
Thus, they are also a form of asset and have
a valuation that may depend on a complex relationship
between underlying asset value, time until
expiration, market volatility, and other factors.
Options may be traded between private parties in over-
the-counter (OTC) transactions, or they may be
exchange-traded in live, orderly markets in the form of
standardized contracts.

Option Trading
• Exchange-Traded Options
• Exchange-traded options (also called "listed options") are a
class of exchange-traded derivatives. Exchange-traded
options have standardized contracts, and are settled through
a clearing house with fulfillment guaranteed by the Options
Clearing Corporation (OCC). Since the contracts are
standardized, accurate pricing models are often available.
Exchange-traded options include:
• Stock options
• Bond options and other interest rate options
• Stock market index options or, simply, index options
and
• Options on futures contracts
• Callable bull/bear contract

Over-the-Counter Options
• Over-the-counter options (OTC options, also called
"dealer options") are traded between two private
parties, and are not listed on an exchange. The
terms of an OTC option are unrestricted and may
be individually tailored to meet any business need.
In general, the option writer is a well-capitalized
institution (in order to prevent the credit risk).
Option types commonly traded over the counter
include:
• Interest rate options
• Currency cross rate options, and
• Options on swaps or swaptions.

Exchange Trading
• The most common way to trade options is via standardized
options contracts that are listed by various futures and
options exchanges. Listings and prices are tracked and can be
looked up by ticker symbol. By publishing continuous, live
markets for option prices, an exchange enables independent
parties to engage in price discovery and execute transactions.
As an intermediary to both sides of the transaction, the
benefits the exchange provides to the transaction include:
• Fulfillment of the contract is backed by the credit of the
exchange, which typically has the highest rating (AAA),
• Counterparties remain anonymous,
• Enforcement of market regulation to ensure fairness
and transparency, and
• Maintenance of orderly markets, especially during fast
trading conditions.

Types of Options
• Options can be classified in a few ways.
• According to the option rights
– Call options give the holder the right—but not the
obligation—to buy something at a specific price for a
specific time period.
– Put options give the holder the right—but not the
obligation—to sell something at a specific price for a
specific time period.
• According to the underlying assets
– Equity option
– Bond option
– Future option
– Index option
– Commodity option
– Currency option
– Swap option

Other Option Types
• Another important class of options, particularly in the U.S.,
are
• employee stock options, which are awarded by a company to
their employees as a form of incentive compensation.
• Other types of options exist in many financial contracts, for
example real estate options are often used to assemble large
parcels of land, and prepayment options are usually included
in mortgage loans. However, many of the valuation and risk
management principles apply across all financial options.
• Option styles
– Options are classified into a number of styles, the most common
of which are:
– American option – an option that may be exercised on any
trading day on or before expiration.
– European option – an option that may only be exercised on
expiry. These are often described as vanilla options.

Conti…
• Other styles include:
– Bermudan option – an option that may be exercised
only on specified dates on or before expiration.
– Asian option – an option whose payoff is determined
by the average underlying price over some preset time
period.
– Barrier option – any option with the general
characteristic that the underlying security's price must
pass a certain level or "barrier" before it can be
exercised.
– Binary option – An all-or-nothing option that pays the
full amount if the underlying security meets the
defined condition on expiration otherwise it expires.
– Exotic option – any of a broad category of options that
may include complex financial structures.

The Largest Financial Market In The World
• The foreign exchange market
• The foreign exchange market or forex
market is the market where currencies are
traded.
• The forex market is the world's largest
financial market where trillions are traded
daily.
• It is the most liquid among all the markets in
the financial world.

3. FINANCIAL INSTRUMENTS
A. Money Market Instruments
B. Capital Market Instruments
C. Hybrid Instruments
D. Derivative Market Instruments
E. Foreign Exchange Market Instruments
F. International Financial Market
Instruments

A. Money Market Instruments
• The money market is referred to as dealing in debt
instruments with less than a year to maturity
bearing fixed income.
• Money Market is a financial market where short-
term financial assets having liquidity of one year or
less are traded on stock exchanges.
• The securities or trading bills are highly liquid. Also,
these facilitate the participant’s short-term
borrowing needs through trading bills.
• The participants in this financial market are usually
banks, large institutional investors, and individual
investors.

Conti…
• There are a variety of instruments traded in the
money market in both the stock exchanges, NSE
and BSE.
• These include treasury bills, certificates of deposit,
commercial paper, repurchase agreements, etc.
Since the securities being traded are highly liquid
in nature, the money market is considered as a
safe place for investment.

Importance of Money Markets in the Economy
• The money market plays a very significant role in
the economy.
• It allows a variety of participants to raise funds. It
offers liquidity to both the investors and the
borrowers.
• And hence maintaining a balance between the
demand and supply for money.
• Thus facilitating the development and growth of
the economy.

Objectives
• Below are the main objectives of the money market:
• Providing borrowers such as individual investors, government,
etc. with short-term funds at a reasonable price. Lenders will
also have the advantage of liquidity as the securities in the
money market are short-term.
• It also enables lenders to turn their idle funds into an effective
investment. In this way, both the lender and borrower are at a
benefit.
• RBI regulates the money market. Therefore, in turn, helps to
regulate the level of liquidity in the economy.
• Since most organizations are short on their working capital
requirements. The money market helps such organizations to
have the necessary funds to meet their working capital
requirements.
• It is an important source of finance for the government sector
for both national and international trade. And hence, provides
an opportunity for the banks to park their surplus funds.

Types of Money Market Instruments in India
• 1. Treasury Bills
• T-bills are one of the most popular money market
instruments. They have varying short-term
maturities. The Government of India issues it at a
discount for 14 days to 364 days.
• These instruments are issued at a discount and
repaid at par at the time of maturity. Also, a
company, firm, or person can purchase TB’s. And
are issued in lots of Rs. 25,000 for 14 days & 91 days
and Rs. 1,00,000 for 364 days.

Conti…
• 2. Commercial Bills
• Commercial bills, also a money market instrument,
works 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.
• 3. Certificate of Deposit
• Certificate of deposit or CD’s is a negotiable term
deposit accepted by commercial banks. It is usually
issued through a promissory note.

Conti…
• 4. Commercial Paper
• Corporates issue CP’s to meet their short-term
working capital requirements. Hence serves as an
alternative to borrowing from a bank. Also, the period
of commercial paper ranges from 15 days to 1 year.
• The Reserve Bank of India lays down the policies
related to the issue of CP’s. As a result, a company
requires RBI‘s prior approval to issue a CP in the
market. Also, CP has to be issued at a discount to face
value. And the market decides the discount rate.
• Denomination and the size of CP:
• Minimum size – Rs. 25 lakhs
• Maximum size – 100% of the issuer’s working capital

Conti…
• 5. Call Money
• It is a segment of the market where scheduled
commercial banks lend or borrow on short notice
(say a period of 14 days).
• In order to manage day-to-day cash flows.
• The interest rates in the market are market-driven
and hence highly sensitive to demand and supply.
• Also, the interest rates have been known to
fluctuate by a large % at certain times.

Features
• It can be called as a collection of the market. Its
main feature is liquidity. All the submarkets, such as
call money, notice money, etc. have close
interrelation with each other. This helps in the
movement of funds from one sub-market to
another.
• The volume of traded assets is generally very high.
• It enables the short-term financial needs of the
borrowers. Also, it deals with investments that have
a maturity period of 1 year or less.
• It is still evolving. There is always a possibility of
adding new instrument

Maturity
• The maturity in respect of money market instruments means
the time period within which the securities will mature. This is
generally less than a year in case of money market instruments.
• What is the yield on security?
• In simple words, the yield is the interest rate earned by investing
securities It can be calculated by the below formula:
• Yield = (Face value – Sale value)/sale value* (days or months in
a year/period of discount)*100
• Let’s understand the above with the help of an example:
• Face value or amount of issue – Rs. 100
Period – 6 months
Discount rate – 10%
Discount – 100*(6/12)*(10/100) = Rs. 5
• By using the above formula for yield we get
• Y = (100-95)/100*(12/6)*100
= 10%

Money Market VS Stocks Market
Particulars Money Market Instruments Stocks
Maturity of the
instruments
The money market
instruments carry a maturity
period of less than a year.
However tradable in
the short term,
stocks create wealth
creation when
invested for a
number of years.
Financing
needs
These instruments are used to
fund the short-term needs of
the borrower.
Used for long-term
fund requirements.
Types of
instruments
It has instruments like T-bills,
certificate of deposits, inter-
bank call money, etc.
It’s a stock of an
independently listed
company
Degree of risk Risk is comparatively lower
due to the short-term
maturity period
Risk is higher.

Money Market Funds
• Money market mutual funds, MMMFs are highly
liquid open-ended dent funds generally used for
short term cash needs.
• The money market fund deal only in cash and
cash equivalents with an average maturity of an
year with fixed income
• The fund manager invests in money market
instruments like treasury bills, commercial
paper, certificate of deposits, bills of exchange
etc.

Factors Determine Interest Rates Of
Money Market Instruments
• Currently, the interest rate is dependent on the market
forces of demand for; and supply of short term money.
• Fiscal deficit, for example, occurs when the
government expenditure is more than government
revenue.
• To fund this deficit, the government requires money
which in turn leads to borrowing by the government
and hence influencing the interest rates.
• In other words, the higher the fiscal deficit more will
be the money required by the government.
• Hence, it will lead to an increase in interest rates

Purpose of the Money Market
• Money market maintains liquidity in the market.
• RBI uses money market instruments to control liquidity.
• It finances short term needs of the government and economy.
• Any business or organization can borrow money at short notice
for a short term.
• Helps in utilizing surplus funds in the market for a short term
to earn an additional return.
• It channelizes savings to investments.
• Assists in mobilizing funds from one sector to another with the
utmost transparency
• Guides in devising monetary policies.
• The current money market conditions are the result of
previous monetary policies.
• Hence it acts as a guide for devising new policies regarding
short term money supply.

B. Capital Market Instruments
• Capital market is a broad term used to describe
the in-person and digital spaces in which various
entities trade different types of financial
instruments.
• These venues may include the stock market, the
bond market, and the currency and foreign
exchange markets.

Instruments of Capital Market
• The instruments traded (media of exchange) in
the capital market are:
• Debt Instruments. A debt instrument is used
by either companies or governments to
generate funds for capital-intensive projects.
• Equities (also called Common Stock)
• Preference Shares.
• Derivatives.

The Functions of the Capital Market
1. It is the best medium of finance for companies and offers different modes
of investment avenues to all investors which encourage building capital.
2. The main functions of the capital market are:
3. The capital market acts as the link between the investors and savers.
4. It helps in facilitating the movement of capital to more productive areas to
boost the national income.
5. It boosts economic growth.
6. It helps in the mobilization of savings for financing long term investment.
7. It facilitates the trading of securities.
8. It reduces transaction and information cost.
9. It helps in quick valuations of financial instruments.
10. Through derivative trading, it offers hedging against market risks.
11. It helps in facilitating transaction settlement.
12. It improves the effectiveness of capital allocation.
13. It provides continuous availability of funds to the companies and
government.

Types of Capital Market
• Capital Market can be divided into Primary Market
and the Secondary Market:
• 1. Primary Market
• The primary market is a new issue market that
mainly deals with the issues of new securities.
• It is a place where the trading of financial
instruments is done for the first time also known
as Initial Public Offer (IPO).

Main Functions of The Primary Market
• Origination: Origination refers to the
examination, evaluation, and process of new
project proposals in the primary market. It begins
before an issue is presented in the market with
the help of commercial bankers.
• Underwriting: Underwriting firms ensure the
success of new issues that guarantee minimum
subscription. When the issue remains unsold
then it is bought by the underwriters.
• Distribution: For the success of the issue
generally the brokers and dealers who are in
direct contact with investors are given the job of
distribution.

2. Secondary Market
• The secondary market is another type of capital
market where trading takes place for existing
securities.
• It is known as the stock market where the
securities are bought and sold by the investors.
• Let us discuss the main functions of the
secondary market:
• It regularly informs about the value of security.
• It offers liquidity to the investors for their assets.
• It involves continuous and active trading.
• It provides a marketplace where the securities
are traded.

C. Hybrid Instruments
• Hybrid Securities are financial instruments that
have mixed characteristics of two or more
different financial instruments like stocks or
bonds.
• These are defined under Section 2 (19A) of the
Companies Act, 1956 as “any security which has
the character of more than one type of security,
including their derivatives” These are hence called
as ‘hybrids’ because they have mixed
characteristics of both equity and debt.

Advantages and Disadvantages of
Hybrid Securities
• Advantages
• Higher yield: Hybrid securities are generally placed
subordinate in the capital structure and hence offer a high
rate of return than senior debt.
• Less volatility in market price: Hybrid securities have less
volatility in the market because they pay a regular, pre-
determined, distribution of market returns.
• Diverse nature: Hybrid securities are, as mentioned above,
not bound by any strict definition of either equitable
securities or debt securities and hence can diversify the
overall risk portfolio while again, guaranteeing attractive
returns and hence, improving a firm’s risk profile.
• Disadvantages
• Complicated: Investing through hybrid securities is considered
more complicated than investing through equity or bond
securities.

Types of Hybrid Securities
• While there can be many types of hybrid
securities, for the purpose of this article, we are
only going to deal with the 5 most popular ones
such as:-
• Convertible Bond
• Preferred Shares
• Mezzanine Financing
• Toggle Notes
• Warrants

D. Derivative Market Instruments
• A derivative is an instrument whose value is
derived from the value of one or more underlying,
which can be commodities, precious metals,
currency, bonds, stocks, stocks indices, etc. Four
most common examples of derivative instruments
are Forwards, Futures, Options and Swaps.
• A derivative is a financial instrument whose value
changes in relation to changes in a variable, such
as an interest rate, commodity price, credit rating,
or foreign exchange rate. There are two key
concepts in the accounting for derivative

Purpose of derivative instrument
• Derivatives are financial contracts whose
value is linked to the value of an underlying
asset. Correctly identifying and they are
complex financial instruments that are used
for various purposes, including hedging.
• Hedging provides a sort of insurance cover to
protect against losses from an investment.

Advantages of Derivatives
• Hedging risk exposure
• Underlying asset price determination
• Market efficiency
• Access to unavailable assets or markets

Disadvantages of Derivatives
• High risk
• Speculative features
• Counter-party risk Counter-party risk

E. Foreign Exchange Market Instruments
• Foreign exchange market users use different instruments to
keep away from loss risks. These instruments are
derivatives that are used to arbitrage or hedge the
exchange rate risk arising from forex transactions. Five
major forex instruments,
• 1. Spot contracts
• Spot contracts are the contract of exchanging currencies,
securities, and commodities at the price of the settlement
date. If the arrangement is conducted at the transaction
date exchange rate, which is known as spot rate contracts.
It involves the immediate purchase and sale of currencies,
securities, and commodities. It is suitable for short-term
arrangements.

Conti…
• For example, the gold price on 01/04/20XX is
$2,000. If the customer has a desire to purchase
the gold @ $2,000 he can enter into spot
contracts and take instant physical delivery of
gold.
• Characteristics of spot contracts
• Immediate physical delivery.
• Only cash involved transactions.
• Takes less time to finish the arrangement.

Conti…
• 2. Forward contracts
• A forward contract is an agreement of buying or selling of
particular asset on a mentioned future date at the specified
rate.
• Here future dates may be longer-term (more than 12
months).
• Forward contracts are foreign exchange derivatives. It is
utilized by players to restrict the risk of exchange rate
uncertainty.
• Forward contracts take place over the counter, two parties
sit across and negotiate the quantity, quality, cost, and date
of the transaction.
• Forward contracts should be used to fix specific rates on
the date of agreement to keep away from currency floating
risks.

Conti…
• For example, a buyer X and a seller Y agree to do
trade in 10 tons of gold on 31 December 2015 at
$25,000 per ton. Here $25,000 per ton is the
forward price of 31 December 2015 gold. Once
the contract has been entered into, buyer X is
obliged to pay $250,000 on 31 December 2015
and take delivery of 10 tons of gold. Same way
seller Y is obliged to accept the $250,000 on 31
December 2015 and give 10 tons of gold in
exchange.

Conti…
• 3. Options
• Options are exactly like a forward contract, parties can
exercise options on favorable terms. It is also a type of
forex derivative used to mitigate forex trading risks. It gives
the purchaser the right, but not a responsibility to transfer
any underlying asset, currencies, security, etc. at an agreed
cost on a specified date. Parties involved in the options are
called: option holders, option writers. Options have two key
attributes.
a. Call option
• It is a commitment that offers the purchaser the right, but
not responding to buy a particular number quantity of
assets from the seller of the option at a pre-determined
price on the specified date.

Conti…
b. Put option
• It is a commitment that offers the purchaser
the right, but not responding to sell a
particular number quantity of assets from
the seller of the option at a pre-agreed price
on the specified date.

conti…
• 4. Futures
• A futures contract is an arrangement between two agencies
that make one agent purchase an asset, financial instruments,
securities, currencies, and counterparty to sell an asset,
financial instrument, securities, and currencies at a fixed future
date. Futures requisite both the agencies in the arrangement
have balance in their margin account. Future contracts are a
derivative instrument that is used by investors to make huge
profits on their investments. Because vast investments are
always associated with high risk. CFD (Contract For Difference)
permits players to invest in the future market without the
physical movement of underlying assets.
• For example, buyer A and seller B enter into future contracts of
1,000 kilograms of corn at $10 per kg. The second-day price of
corn is $11. The price movement has led to a loss of $1,000 to
seller B, while A has gained the corresponding amount.

Conti…
• 5. Swaps
• Foreign Exchange Swaps is the agreement between two
agencies to exchange their revenue or cash flows from any
assets or liabilities, which is occurred during particular
intervals. Swaps are an exchange between two parties to
trade currencies for a pre-determined period of time.
Most interest rates are getting swapped between two
agencies. The majority of swaps are categorized into the
following groups:
• Interest rate swaps
• Commodity swaps
• Equity swaps
• Currency swap

Advantages of Foreign Exchange Market
• Trading in forex markets are flexible, since there is
no restriction on trading amount.
• Less costs, forex trading does not require much
costs. It only requires account in foreign exchange
market.
• Probability of making profits, many of the players
in FX market uses this wisely and make profits by
analyzing the price movement of trading assets,
currencies and securities.
• Forex market provide traders variety of trading
options as they can play with number of currency
pairs.

Factors influencing Foreign Exchange Market
• Inflation, variations in market position affects
currency rates.
• Political and economic environments.
• Country’s debt balances with foreign countries.
• Global trade affects country’s forex rate. In export
nation get money and in import nation became
liable to pay. If the nation’s export trade higher
than its import, it means the currency value of
country is increased.

F. International financial market
instruments
• The International Financial Market are financial
markets where individuals buy and sell foreign
assets such as stock, Bonds, currencies.
• Its also a place where institutions lay down rules.

Instruments of International Financial Markets

Money Market Instruments
• The money market is the securities market dealing
in short-term debt and monetary instruments.
Money market instruments are forms of debt that
mature in less than one year and are very liquid and
relatively risk free. Treasury bills make up the bulk
of the money market instruments.
• Commercial Paper
• Euro commercial Paper
• Certificate of Deposit
• Banker’s Acceptance

4. FUNCTION OF FINANCIAL MARKETS
• 1. The first function of financial market is liquidity:
• The financial market provides liquidity for tradable
assets by allowing for the purchase and sale of
securities. Investors can sell the asset at any
moment if they feel it is necessary to recoup their
investment.
• 2. Cost determination:
• Financial Markets assist in determining the capital
worth of securities by allowing market forces to
function on their own and determine the pricing of
a tradable asset.

Conti…
• 3. Platform
• Financial markets also provide as a venue for potential buyers
and sellers to meet, interact, agree, and deal. This feature of
the financial market not only saves interested parties a lot of
time and money, but it also makes trading easier.
• 4. Mobilization of Savings
• According to another equation, financial markets are aspects
in the global economy that reintroduce money into the
economy by allowing it to be used in the purchase and sale of
securities.
• 5. The Time Factor
• To be honest, it takes a lot of effort and time to operate in a
typical market where people trade. A financial market, on the
other hand, makes all of the information necessary for
trading financial assets available.

Advantages of functions of financial market
• The functions of the financial market provide investors
and companies operating in the financial market with
a variety of benefits. The following are some of the
benefits:
• It aids in the creation of an open and regulated system
for businesses to obtain substantial quantities of
capital from the market in order to operate.
• It serves as a conduit for potential investors’ savings to
pour into the economy. This will result in the
formation of capital in the country.
• It saves the parties’ time, effort, and money because
the traders do not have to devote their resources to
locating possible vendors or buyers of the securities.

Disadvantages of functions of financial markets
• The following are some of the limitations and
disadvantages of the financial market’s functions:
• There is no financial market function that can
determine a stock’s genuine intrinsic value.
Because of many macroeconomic considerations
such as taxation, etc., there is no actual intrinsic
value for a stock.
• The trader need a variety of information, which is
provided by the financial market. This information
must be accurate because the prices of the
securities are strongly reliant on informational
transparency to ensure that the right prices are
established by the market for the assets.

MSc Financial Markets Course Overview

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