FINANCIAL MARKETS AND SERVICES

Module - I

INDIAN FINANCIAL SYSTEM- AN OVERVIEW

An efficient, articulate and developed financial system is indispensable for the rapid economic growth of any country/ economy. However, their institutional structure, operating policies, regulatory/legal framework differ widely, and are largely influenced by the prevailing politico-economic environment. The liberalization/deregulation/globalization of the Indian economy since the early nineties has had important implications for the future course of development of the financial system/sector.

The evolution of the Indian financial system falls, from the viewpoint of exposition, into three distinct phases:

1. Pre-Independence Period

2. Between 1951 and the mid-eighties reflecting the imperatives of planned economic growth and

3. After the early nineties responding to the requirements of liberalized/deregulated/globalised economic environment

Phase I: Pre-Independence

The organization of the Indian financial system before independence had a close resemblance with the theoretical model of a financial organization in a traditional economy, as formulated by R.L.Bennett. A traditional economy, according to him, “is one in which the per capita output is low and constant”. According to L.C.Gupta: “The principal features of the pre-independence industrial financing organization are the closed-circle character of industrial entrepreneurship; a semi- organized and narrow industrial securities market, devoid of issuing institutions and the virtual absence of participation by intermediary financial institutions in the long-term financing of the virtual absence of participation by intermediary financial institutions in the long-term financing of the industry. As a result, the industry had very restricted access to outside saving. The fact that the industry had no easy access to the outside savings is another way of saying that the financial system was not responsive to opportunities for industrial investment. Such a financial system was clearly incapable of sustaining a high rate of industrial growth of new and innovating enterprises.

Phase II: 1951 to Mid-Eighties

In pursuance of the broad economic and social aims of the state to secure economic growth with social justice as enshrined in the Indian Constitution, under the Directive Principles of state policy, the scheme of planned economic development was initiated in 1951.

With the adoption of mixed economy as the pattern of industrial development, in which a complementary role was conceived for the public and private sectors, there was a need for an alignment of the financial mechanism with the priorities laid down by the government’s economic policy.

The main elements of the financial organization in planned economic development could be categorized into four broad groups:

i. Public/government ownership of financial institutions,

ii. Fortification of the institutional structure,

iii. Protection to investors and

iv. Participation of financial institutions in corporate management.

i) Public Ownership of Financial Institutions

One aspect of the evolution of the financial system in India during this phase was the progressive transfer of its important constituents from private ownership to public control.

Nationalization: The nationalization of the Reserve Bank of India (RBI) in 1948 marked the beginning of the transfer of important financial intermediaries to Government control. This was followed in 1956 by the setting up of the State Bank of India (SBI) by taking over the then Imperial Bank of India. In the same year, 245 life insurance companies were nationalized and merged into the state-owned monolithic Life Insurance Corporation of India (LIC).

RBI 1948

SBI 1956 (take-over of Imperial Bank of India)

LIC 1956 (Merges of over 250 Life Insurance Companies)

Banks 1969 (14 major banks with Deposits of over Rs. 50Crs nationalized)

1980 (6 more Banks)

Insurance 1972 (General Insurance Corp. GIC by New India, Oriental, united and National)

New Institutions: in addition to nationalization, the control of public authorities on the sources of credit and finance led to the creation of a battery of new institutions in the public sector. A number of powerful special-purpose financial institutions designated as development banks/development finance institutions/term-lending institutions were set up. Another step of considerable significance was the creation of an investment trust organization-the Unit Trust of India-in the public sector. Thus, the public sector occupied a commanding position in the industrial financing system in India, that is, virtually the entire institutional structure was owned and owned and controlled by the Government.

ii) Fortification of Institutional Structure

The most significant element in the emergence of a fairly well developed financial system in India during the second phase was the strengthening of its institutional structure. The fortification of the institutional structure of the Indian financial system was partly the result of modification in the structure and policies of the existing financial institutions.

Development Banks: They grew into a massive source of industrial finance, and as the most important supplier of capital during the period under reference; they could be appropriately designated as the backbone of the system of industrial financing in India. The structure of development banking consisted of both all India as well as state- level institutions.

The IFIC (Industrial Finance Corporation of India) was established to give medium and long-term credit to industrial enterprises in circumstances where normal banking accommodation was inappropriate, or recourse to the capital issue method impracticable, thus envisaging the role of a gap-filler. State Financial Corporation’s (SFC’s), were organized to assist the small/medium enterprises.

The establishment of the Industrial Credit and Investment Corporation of India (ICICI) Ltd, in 1995 represented a landmark in the diversification of development banking in India

The most important event in the sphere of development banking in India took place in 1964, when the IDBI was established as a subsidiary of the Reserve Bank of India. It was delinked from the Reserve Bank of India in 1976 and was converted into a holding company. At the state level, the machinery of the State Industrial Development Corporations (SIDCs)/State Industrial Investment Corporations (SIICs) were geared up to meet the financial needs. The Industrial reconstruction Corporation of India (IRCI) Ltd was jointly set up by the IDBI, banks and LIC to look after the rehabilitation of the sick mills. It was renamed as the Industrial Reconstruction Bank of India (IRBI) in 1984. It was converted into a full-fledged public financial institution (PFI) and was renamed as the Industrial Investment Bank of India (IIBI) in 1997. Finally, another institutional innovation was the setting up of the Small Industrial Development Bank of India (SIDBI) as a subsidiary of the IDBI, for fostering the development of small and medium enterprises.

Life Insurance Corporation of India: Another development in the direction of fortifying the structure of the industrial financing organization in India during this phase was the coming into being of the Life Insurance Corporation (LIC) in 1956, as a result of the amalgamation of 245 life insurance companies into a single monolithic state- owned institution. The setting up of the LIC was a notable feature in the evolution of the post-1951 organization of industrial financing in India because it transferred an important savings institution from private to public ownership.

The LIC emerged as the single largest reservoir of long –term savings in India.

Unit Trust of India: The establishment of the Unit Trust of India (UTI) in 1964 was the culmination of a long overdue need of the capital market in India. The objective of setting up the UTI was to enable the small investors to share in industrial prosperity, through indirect holding of equities, and to mobilize the saving of the relatively small investors.

Commercial Banks: A beginning was made with the modification in the monetary and credit policies of the RBI in the form of instruments such as selective credit controls, moral suasion and other such macro-type controls to encourage the banks to reorient their operational policies to the finance for industry.

· Diversification in Forms of Financing: Since the mid- sixties, the commercial banks in India were officially encouraged to enter new forms of financing of which two deserve specific mention: (i) Term-lending and (ii) Underwriting of new issues of corporate securities by industrial enterprises. The lending banks were provided refinancing facilities against approved term loans from the Refinance Corporation of India (RCI) Ltd. Apart from term loans and underwriting of issue of capital, the banks also widened their range of financial assistance to the industry partly to direct subscription to the shares and debentures of the corporate enterprises and partly to their lending against such securities.

· Enlargement of Functional Coverage: The commercial banks were further directed to channelize their resources to small scale industries, exports and agriculture, i.e., the neglected (later priority and now directed) sectors of the Indian economy. RBI introduced a policy of granting additional rights to the banks to borrow to from it at concessional rates in case they increased the quantum of lending to the small industries. An important measure taken to facilitate credit for exports was the setting up of the Export Risk Insurance Corporation in1957. In 1964, it was renamed as the Export Credit and Guarantee Corporation (ECGC) Ltd.

· The important elements of the elaborate legislative code adopted by the Government are briefly recapitulated below:

· Companies Act: The enactment of the Companies Act, 1956 represented an important stage in the development of corporate enterprises in India. The Act made considerable changes in the matter of prospectus, allotment of shares, terms and conditions on which companies were floated, and the capital structure of companies.

· Securities Contracts (Regulation) Act: The Securities Contracts (Regulation) Act, 1956 provided for reforms in stock exchange trading methods and practices which were the subjects of controversy in the past. The scheme of regulation included the provision that only recognized stock exchanges will be permitted to function and that the Government was empowered to withdraw the recognition in the interest of the trade or in public interest.

· Monopolies and Restrictive Trade Practices Act: The Monopolies and Restrictive Trade Practices Act came into force from June 1, 1970 with the following objectives: (a) to ensure that the functioning of the economic system did not result in concentration of economic power and (b) To control such monopolistic and restrictive trade practices that were injurious to public welfare.

· Foreign Exchange Regulation Act: The Foreign Exchange Regulation Act (FERA), 1973, regulated foreign investment with the aim of diluting the equity holding in foreign companies. It was also a step in the direction of engendering confidence among the investing public in industrial securities.

iv) Participation in Corporate Management

A development of considerable significance in the Indian financial system in this phase of its evolution was the participation of the financial institutions in the management of the assisted concern. The problem, during the eighties, was the potential control of the public financial institutions over private industrial enterprises through their shareholding. There were numerous cases where the institutional equity holdings had become so large that the management’s tenure in office became dependent on their direct and indirect support. In several large companies, these institutions, particularly the LIC and the UTI, were able to exercise considerable pressure on the management by virtue of the voting powers they had, to secure board representation for themselves, and initiate other changes in the composition of the Board of Directors and in the appointment of the Chief Executive. Most companies needed to approach one or more financial institutions for underwriting or loan. In the Indian financial system between 1951 and the mid-eighties, an institutional structure with considerable strength and repute capable of supplying industrial capital to various enterprises in diverse forms was gradually built up. With setting up of a variety of newer institutions, the whole financial system had come under the ownership and control of public authorities so that the public sector occupied a commanding position in the distribution of credit and finance to private industrial enterprises in India.

Organizational Deficiencies

Certain weakness still persisted in the pre-1990 organization of the Indian financial system. These pertained to: i) Institutional structure, ii) Problem of small scale and new enterprises, iii) New issue market organization.

i) Institutional structure: The structure of Indian financial system was heavily dominated by the two categories of financial institutions:

a) Commercial banks, LIC, GIC, and UTI

b) Development finance institutions, namely, IDBI, IFCI, ICICI, SFC’s and so on

Since, the development banks provided most of the funds in the form of term loans, there was a preponderance of debt in the financial structure of industrial enterprises and the share of equity capital was both low and declining.

ii) Problem of Small and New Enterprises: Another weakness in the organization of the Indian financial system was its inability to meet the financing needs of small and new enterprises. The holdings in small enterprises did not fit into their investment requirements, because of the difficulty of administration and the lack of marketability. Apart from institutional obstacles, such enterprises also faced operational obstacles in terms of the prohibitively high cost of rising capital.

iii) New Issue Market Organization: The new issue market in India also suffered from serious institutional lacunae. There was practically no institutional arrangement for the origination of issue of capital. The underwriting facility to issue of capital, though fairly pervasive, was of limited complexion in the sense that it was synonymous with an amount of money which each underwriter was prepared to guarantee in case of unsatisfactory public response.

Phase III: Post-Nineties

The organization of the Indian financial system, since the mid-eighties in general, and the launching of the new economic policy in 1991 in particular, has been characterized by profound transformation. Major economic policy changes such as macro-economic stabilization, delicensing of industries, trade liberalization, currency reforms, reduction in subsidies, financial sector/capital market/banking reforms, privatization/disinvestments in public sector units, tax reforms and company law reforms in terms of simplifications and debureaucratisation were gradually implemented, and they have had far reaching impact on the structure of the corporate industrial sector in India.

The notable developments in the organization of the Indian financial system during this phase are briefly outlined below with reference to:

i) Privatization of financial institutions

ii) Reorganization of institutional structure

iii) Investor protection

i) Privatization of Financial Institutions

Practically the entire financial system was under the state ownership and control till the mid-eighties, steps were initiated during this phase to privatize important financial institutions. The IDBI and IFCI Ltd offered their equity to private investors. Private mutual funds have been set up under the guidelines prescribed by the SEBI. A number of private banks under RBI guidelines have also come into existence. With setting up of the Insurance Regulatory and Development Authority (IRDA), private insurance companies sponsored by both domestic and foreign promoters have re-emerged on the Indian financial scene. With the establishment of Pension Fund Regulation and Development Authority (PFRD) private entities are poised to enter nineties, has been dismantled in a phased manner mainly through the establishment of private financial institutions such as banks, mutual funds and insurance companies. This is, indeed, a revolutionary change in the organization of the Indian financial system.

ii) Reorganization of Institutional Structure

Apart from the entry of private financial institutions, the institutional structure of the Indian financial system has undergone an outstanding transformation to reflect the capital market orientation in its evolution.

Development/ Public Financial Institutions (DFIs/PFIs):

In financing of industry by these institutions in the traditional form of rupee/ foreign currency term loans for project finance, underwriting, direct description, lease financing, and so on, they also started providing core working capital to industry. The term-lending institutions was the growing focus on non-fund based financial activities/services such as merchant banking and project counseling, portfolio management services, mergers and acquisition, and so on. The pattern of financing of the development banks, which consisted predominantly of funds from the Government and the RBI, was progressively geared to accessing the capital market through issue of capital to the public, issue of innovative floating interest rate bonds, and other types of bonds without Government guarantee.

Commercial Banks: In the context of the changed perspective in terms of the deregulated/liberalized/globalised economic environment, the post-1991 era of Indian banking is characterized by prudential/viable/profitable banking. By the mid-nineties, a geographically wide and functionally diverse banking system had emerged as reflected in the phenomenal branch expansion especially in the rural and semi-urban and unbanked areas, phenomenal growth in deposits, and increase in the share of the priority sector in total bank lending. But there was a decline in productivity and efficiency of the banking system and a serious erosion of its profitability with implication of its viability itself. Therefore, the Narsimhan Committee was set up which had examined the second generation of reforms in terms of three broad interrelated issues: (i) Action that should be taken to strengthen the foundation of the banking system, (ii) Streamlining procedures, upgrading technology and human resource development and, (iii) Structural changes in the system.

Non-Banking Financial Companies (NBFCs): The NBFCs constitute a significant element of the organization of the financial system. They broaden the range of financial services. The important fund/asset based activities of NBFCs are equipment leasing, hire-purchase, bills discounting, loan or investment, venture capital, house finance, factoring and forfeiting, stock broking, merchant banking and so on. Their fee based or advisory services include issue management, portfolio management, corporate counseling, loan or lease syndication, merger and acquisition and so on.

Mutual Funds: A remarkable development in the reorientation of the Indian financial system in the post 1991 years is reflected in the structural growth of mutual funds industry. The present structure comprises of domestic mutual funds sponsored by the UTI, bank subsidiaries, insurance organizations, private sector with foreign collaboration and foreign institutional investors. They offered a wide variety of schemes focusing on income, growth, tax savings, insurance- linkage and special categories like children and senior citizens, sector-specific, money market mutual’s to suit the investment requirement of the heterogeneous category of investors.

Securities or Capital Market: From being a marginal institution in the mid- eighties, the securities market has emerged as the most important mechanism for allocating resources in the economy during this period. The structure of both the segments of the market-primary or new and secondary or stock exchange- has witnessed significant changes. The secondary market which represented an institutional mechanism that was inadequate, non-transparent, hardly regulated and rarely geared to investors’ protection till the early nineties, has also witnessed notable developments. A few stock exchanges, dominated by the Bombay Stock Exchange (BSE Ltd. now) provided the trading platforms for the secondary market transactions.

Money Market: Till the early nineties, the money market in India had narrow base and a limited number of participants, which was restricted to the banks and the LIC and UTI. In the post-1990 period and particularly in the context of a deregulated economic environment, a sophisticated and articulate money market has emerged in the country. A notable development had been the emergence of specialized institutions, namely, Primary Dealers (PDs), and money market mutual funds (MMMFs). Alongside activating the existing instruments through a modification in the procedures, deregulated of interest rates and enlargement of participants, a number of inter-related sub-markets, namely Call or notice market, Commercial bills market, T-bills market, Commercial papers (CPs) market, Certificates of deposits (CDs) market, and Repo market. There are also indications of a trend towards an integration of the forex and the money market.

Protection of Investors: Securities and Exchange Board of India

The securities market witnessed a spectacular growth, both in terms of its ability to mobilize resources and to allocate it with some efficiency. The corporate sector has come to rely on the securities market increasingly, to finance its long term requirements of fund. To help sustain this growth investors’ right must be fully protected, trading mal-practices must be prevented and structural and inadequacies of the market must be removed.

The Capital Issues (Control) Act was repealed in 1992 and the Office of the Controller of Capital Issues (CCIs) was abolished. The Securities and Exchange Board of India (SEBI) was set up in April 1988 and acquired a statutory status in 1992. It has emerged as an autonomous and independent statutory body with a definite mandate which requires it to: (i) protect the interest of the investors in securities; (ii) promote the development of securities market; and (iii) regulate the securities market. The SEBI prohibits fraudulent and unfair trade practices, including insider trading. In order to ensure investor protection and to safeguard the integrity of the markets there is a comprehensive surveillance system.

CAPITAL MARKET

Definition: “By capital market, I mean the market for all the financial instruments, short term and long term, as also commercial, industrial and Government paper”.

- H.T.Parkekh

Meaning: It is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long term securities which have a maturity period of above one year.

Functions:

a) It deals in long term and medium term funds.

b) It is concerned with the transfer of long term and medium term funds from investing parties and commercial enterprises.

c) It facilitates large scale mobilization of savings and financial resources.

d) It helps in procuring foreign capital for the quicker economic development of a country.

e) It facilitates acceleration of capital formation.

f) It provides profitable investment opportunities to the small savers and investors.

g) It ensures effective allocation of mobilised financial resources among projects which yield highest returns or which contribute to balanced economic development.

h) It ensures ready and continuous market for long term funds.

Capital market may be divided into three namely:

· Industrial securities market

· Government securities market

· Long term loans market

I. Industrial Securities Market

It is a market for industrial securities like Equity shares, Preference shares and Debentures or bonds. It is a market where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be subdivided into two. They are:

i. Primary Market or New issue Market

ii. Secondary Market or Stock Exchange

Primary Market: It is a market for new issues or new financial claims. Hence, it is also called New Issue market. The Primary market deals with those securities which are issued to public for the first time. Here, the borrowers exchange new financial securities for long term funds.

Functions:

a) It is concerned with long term funds or capital.

b) Securities are issued by industrial and commercial companies directly to investors.

c) It transfers resources from savers to the users.

d) Funds raised in the primary market are utilized by the issuing companies for investment on fixed capital i.e., fixed assets

e) It does not cover long term loans from financial institutions.

f) It promotes capital market formation directly.

Secondary Market: It is a market for secondary sale of securities. Such shares are quoted in the stock exchange and it provides a continuous and a regular market for buying and selling of securities.

Relationship between Primary market and Secondary market:

· Both the markets together constitute the capital market which is an integral part of the economy of the country.

· New securities first placed in the primary market are then disposed off subsequently in the secondary market.

· Since the stock exchange help in continuous purchase and sale of securities, many new issues are placed.

· Both markets move in the same direction and are dependent on each other.

· Both are susceptible to the influence of environmental conditions.

Differences between Primary and Secondary Market:

Primary Market

i. New issues of securities are dealt in primary market.

ii. Securities are exchanged between companies and investors.

iii. It promotes capital formation directly.

iv. Securities are only bought by the investors from companies, and they are not sold.

v. The prices of securities dealt in primary market are determined by the management of issuing companies.

vi. Securities are issued to investors for the first time.

Secondary Market

i. Existing securities are dealt in secondary market.

ii. Securities are exchanged between investors.

iii. It promotes capital formation indirectly.

iv. Securities are bought and sold.

v. The prices of securities are dealt in the secondary market determined by the demand for the supply of securities

vi. Securities can be bought and sold any number of times.

Instruments of Capital Market

Some of the common Primary and Secondary Market Instruments:

· Equity Shares

· Preference Shares

· Deferred share

· Debentures

· Hybrid Securities

· Bonds

· Derivatives

Equity Shares:

· Equity is the residual interest in the Net Asset i.e. (Assets - Liabilities)

· It represents permanent ownership capital of a Company which cannot be redeemed in its lifetime.

· Equity includes reserves and surplus.

· Equity Shares holders have right vote in all resolutions at the meetings and have control over the functioning of the Company.

· They have a claim on profit of a Company.

· The Equity Shares Holders have liability limited to the value of Shares purchased.

· Equity Shares possess an unlimited potential for Dividend and price appreciation bearing the risk on the other hand.

Preference Shares:

Preference Shares capital means the part of Share Capital of the Company which fulfills both the conditions:

1. Carries preferential rights in respect of dividend at fixed rate

2. Has preferential right in respect of repayment of capital at the time of winding up.

Generally they do not have any voting rights but can vote on the matters directly relating to their rights.

Types of Preference Shares:

1. Cumulative preference Shares - They carry the right to accumulate dividends as arrivers if the Company fails to pay dividend in particular year (all preference Shares are always presumed to be cumulative unless the contrary is stated in AOA or in terms of issue).

2. Non- Cumulative Preference Shares - Such Shares do not carry the right to accumulate dividend to subsequent years.

3. Redeemable Preference Shares - The paying back of capital is called redemption. Capital received on such Shares is repayable after expire of prescribed time (not greater than 20 years).

4. Irredeemable Preference Shares - The capital is not repayable during life time of the Company but repayable only on the date of winding up (however currently no Company can issue irredeemable preference Shares).

5. Participating preference Shares - They participate in surplus profit over and above the fixed rate of dividend (such excess profit is distributed after certain percentage of dividend has been paid to Equity Shares holders also).

6. Non-Participating preference Shares:-They are entitled only to a fixed rate of Dividend and do not participate in surplus profit.

7. Convertible Preference Shares - They have right of conversion in to Equity Shares.

8. Non-Convertible Preference Shares - They have no right of conversion in to Equity Shares. It may be noted that if AOA is silent, all preference Shares are deemed to be non convertible preference Shares.

Deferred Shares:

· A method of stock payment to directors and executives of a company through the deposit of shares into a locked account. The value of these shares fluctuates with the market and cannot be accessed by the beneficiary for the purpose of liquidation until they are no longer employees of the company.

· A share generally issued to company founders that restricts their receipt of dividends until dividends have been distributed to all other classes of shareholders

· Subordinate to all other classes of common and preferred stock, these shares are last in line when a company goes bankrupt and liquidates all assets.

· These are different from phantom stocks because they don't allow for payment in cash. Also, rather than actual deposits of securities, companies sometimes maintain bookkeeping entries of cash equaling an offsetting security position. When the executive or director leaves the company, the cash is converted into stocks at market value.

· No longer commonly used, these shares provided its holders with large dividend payouts only after all other classes of shareholders are paid. Holders of deferred shares had access to all the remaining profits after all obligations were met.

Debentures:

· The term Debenture is derived from Latin term “Debere” meaning “to Owe”. So literally, debenture means a document acknowledging a debt.

· It is a debt security issued by a Company usually on a medium or long term (i.e. 7 to 10 yrs).

· As per companies act 1956, “Debentures” includes debenture stoke, bonds and any other security of a Company whether constituting a charge on the asset of the Company or not (secured or unsecured).

· The Company agrees to pay interest which is a charge against profit.

· Holders have no voting rights and can generally transfer their debentures.

· After the maturity debt are redeemed at par or at premium by the issuer.

· The issuing Company needs to take compulsory credit rating from approved agencies.

· There are no restrictions for issue of debentures at a discount.

· Interest is payable even if there is no profit.

Types of Debentures:

1. Registered Debentures

2. Unregistered or Bearer Debentures

3. Secured Debentures

4. Unsecured Debentures

5. Redeemable Debentures

6. Irredeemable Debentures

7. Convertible Debentures

8. Non-convertible Debentures

Registered Debentures:-Registered Debentures are those debentures in respect of which the names of debenture holders are entered in the register of debenture holders kept by the Company and payment of interest and repayment of principle amount are made only to those person whose names are recorded in the register of debenture holder.

Unregistered or Bearer Debentures:-In this case the names of the holder of debentures are not entered in the register of debenture holders maintained by the Company and payment of interest and repayment of principle amount are made to the bearer or holder of these debenture.

Secured Debentures - Mortgage is the other name for the Secured Debentures. These Debentures are secured by a charge on the asset of the Company. The charge may be fixed or specify or a floating charge. If the charge is on some fixed or specific immovable property of the Company, it is called a fixed charge. Same way if the charge is not on any specific immovable property of the Company but on the assets of the Company in general, then it’s called a floating charge.

Unsecured Debentures - Simple, Naked are the other names of unsecured debentures. These are the Debentures which are issued with the mere promise to pay the interest and to repay the principle without any charge on the asset of the Company.

Redeemable Debentures:-Redeemable Debentures are those Debentures which are repayable on a certain date or after a specified period.

Irredeemable Debentures - The term Irredeemable Debentures does not mean that these debentures are not be repaid at all. It only means that there is no time specified or fixed for the repayment of the Debentures. They are repaid at the time of liquidation.

Convertible Debentures - These Debenture are in which an option is given to the holders to convert their debentures into preference or equity Shareswholly or partly after a specified period. These have become more popular these days.

Non-convertible Debentures - These Debenture are not convertible into preference or equity Shares at the option of the Debenture holder. It may be noted that unless the Debenture are specifically issued as convertible all Debenture are non-convertible.

Hybrid Securities:

· Securities which have both the characteristics of Securities and Equity Shares.

· Generally they are issued as a debt security which after certain number of years converted into an Equity Shares.

· Convertible debenture is an example for Hybrid Securities.

· Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share.

· A hybrid security is structured differently and while the price of some securities behaves more like fixed interest securities, others behave more like the underlying shares into which they convert.

Examples

· A convertible bond is a bond (i.e. a loan to the issuer) that can be converted into common shares of the issuer. A convertible bond can be valued as a combination of a straight bond and an option to purchase the company's stock.

· An income security is a hybrid between a stock and a bond. The bond portion pays interest, and the stock portion pays dividends. Income securities are popular in Canada.

· A PIK loan may carry a detachable warrant (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) – the loan is the debt (Bond), while the warrant is the equity.

Bonds:

· Certificates that represent money a government or corporation has borrowed from other entities. Loans can be raised from public by issuing Bonds by Public Ltd Companies.

· It is a marketable long term debt security which the issue is obliged to repay with coupon (interest)

· Bonds have a maturity period after which it is redeemed by issuer

· Holders do not have a equity stake, they are only lenders to the issuing company

· Bonds have to be rate by specialized credit rating agencies

· They are more secure than debentures but carry lower interest rates

· Bonds are normally issued in different denominations ranging from Rs. 100 to 1000 and carry different rates of coupon

· Bonds are either secured or unsecured

· From investor point of view Bonds offer a more attractive prospect than preference Shares.

Types of Bonds:

1. Deep discount/ Zero-coupon Bonds – It is a form of zero-interest Bond. These Bonds are sold at a discounted value and on maturity face value is paid to the investors. In such Bonds, there is no interest payout during lock-in period. It is sold by the issuing Company at a discount. The difference between the discounted value and face value represents the interest to be earned by the investor on such Bonds.

2. Double Option Bonds - These have been recently issued by the IDBI. The face value of each Bond is Rs. 5000/- the Bond carries an interest at 15% per annum compounded half yearly from the date of allotment. The Bond has the maturity period of 10 yrs.

3. Option Bonds - These are cumulative and non-cumulative Bonds, where interest is payable on maturity or periodically. Redemption premium is also offered to attract investor. These are recently issued by ICICI & IDBI.

4. Inflation Bonds - These Bonds are in which interest rate is adjusted for Inflation. Thus, the investor gets interest which is free from effect of inflation. For example, if the interest rate is 11% and the inflation is 5% the investor will earn 16% meaning there by that the investor is protected again inflation.

5. Floating Rate Bond - As the names suggest is Bond where the interest rate is not fixed and it is allowed to float depending upon the market condition. This has become more popular as a money market instrument and has been successfully issued by financial institution like IDBI, ICICI etc.

6. Junk Bond -A colloquial term for a high-yield or non-investment grade bond.

Junk bonds are so called because of their higher default risk in relation to investment-grade bonds. Junk bonds are risky investments, but have speculative appeal because they offer much higher yields than safer bonds.

7. Putable bond :-

Retractable bond is other name of it.

The holder of the putable bond has the right, but not the obligation, to demand early repayment of the principal.

This type of bond protects investors: if interest rates rise after bond purchase, the future value of coupon payments will become less valuable. Therefore, investors sell bonds back to the issuer and may lend proceeds elsewhere at a higher rate

8. Callable bond:-A callable bond (also called redeemable bond) is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity.

On the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price

9. Guaranteed Bond - A debt security that offers a secondary guarantee that interest and principal payment will be made by a third party, should the issuer default due to reasons such as insolvency or bankruptcy. A guaranteed bond can be municipal or corporate, backed by a bond insurer, a fund or group entity, or a government authority.

International Instruments:

Some of the Financial Instruments dealt with in the international market are briefly described below:

1. Euro Bond - These are the debt instruments which are not denominated in the currency if the country in which they are issued. E.g., A Yen note floated in Germany, such Bonds are generally issued in a bearer form rather than as registered Bond and in such case they do not contain the investor names or the country of their origin.

2. Foreign Bonds - These are the debt instruments issued by Foreign Government. Such Bonds are exposed to default risk, especially they the Corporate Bonds. These Bonds are denominated in the currency of the Country where they are issued, however incase these Bonds are issued in a Currency other than the investors home currency. They are exposed to exchange rate risk.

3. Fully Hedged Bonds - As mentioned above in Foreign Bonds the risk of Currency fluctuation exists. These Bonds eliminate the risk by selling in forward markets the entire stream of principle and interest payment.

4. Foreign Euro Bonds - In domestic capital markets of various countries the Bonds issues refer to above are know by different names, such as Yankee Bonds in US, Swiss Frances in Switzerland, Bulldogs in UK.

5. Euro Convertible Zero Bonds - These Bonds are structured as a convertible Bond. No interest is payable on the Bonds. But the conversion of Bonds takes place on maturity at a pre-determined price.Usually there is a 5 years maturity period and they are treated a deferred equity issue.

6. Euro Bonds with equity warrants - These Bonds carry a coupon rate determined market rates. The warrants are detachable. Pure Bonds are traded at a discount.

Derivative Instruments

· Derivatives are financial instruments whose value depend on the value of some underlying asset

· The underlying assets can be shares, commodities, interest rates, Index etc..

· Derivatives contract provides risk hedging mechanism in variety of ways

· The transaction are settled by offsetting /squaring transactions in the same derivative

· The difference in value is settled in cash

· Derivatives are only secondary market instruments

· Various participants are hedgers, speculators and arbitrageurs

Types of derivatives

Derivatives can be classified into different groups as follows:

· Commodity and financial derivatives

· Basic and complex derivatives

· Exchange traded and OTC derivatives

Financial derivatives

· Forwards

· Futures

· Options

· Swaps

Forwards

· It is an agreement between two parties to buy and sell an asset at a futures date at a price agreed today.

· Forward contracts are common in agricultural products

· There is no standard form, it differs according to the suitability and requirements of the parties involved

· These cannot be transferred hence not trade in stock exchanges –OTC derivatives

· Both the parties to the forward have an obligation to perform

Problems of forward contracts:

· Forwards are not standardized which results in excessive flexibility and generality

· Cannot be traded in stock exchanges so highly illiquid

· Counter party risk is high, hence unreliable

Futures

· It is a financial security issued by an organized exchange to buy or sell underlying assets at an agreed price.

· The agreed upon price is called “futures price”

· Futures contracts are standardized and exchange traded

· Buying a future is “going long” and selling is “going short”

· Future price=spot price +cost of carrying

· The obligation of buyer or seller is to the clearing house in fulfilling the contract

· The clearing house takes margin which eliminates default to some extent

Option

· It is an agreement that gives the option buyer the right but not the obligation to purchase or sell the underlying asset at a specified price by or before a fixed date in future

· Buyer of an option at a price is called holder of an option

· Price at which an option is brought is called premium

· The seller of an option for a premium is called the writers

· The price specified in the contract is striking or exercise price

· Kinds of option : call option , put option , American option , European option

Swaps

· It can be defined as the exchange as the exchange of one stream of future cash flow with another stream of cash flow with different characteristics

· It is an agreement between two parties to exchange cash flow & no principal is exchanged

· Swaps are of 2 types -: currency swaps & interest rate swaps

· Currency swap is an agreement to exchange currencies at a specified exchange rate

· Interest rate swap is an agreement whereby one party exchange one set of interest payments for another

· Swaps are executed through an intermediary who connects the needs of two parties

MONEY MARKET

A well organised money market is the basis for an effective monetary policy. The smooth functioning of money market ensures the flow of funds to the most important uses. The money market is a market for overnight to short-term funds, and for short term money and financial assets that are close substitutes for money. “Short-term”, in the Indian context, generally means a period up to one year; “close substitute for money” denotes any financial asset that can be quickly converted into money with minimum transaction cost and without loss in value.

Meaning of Money Market: The term money market refers to the institutional facilities or arrangements available for borrowing and lending of short term funds. In other words, the money market comprises of all the facilities for borrowing and lending money for a short period. Thus, money market refers to money for short term funds.

Definition of Money Market: According to G. Crowther, “The money market is the collective name given to the various firms and institutions that deal in the various grades of near-money”.

According to the Reserve Bank of India the money market, “is the centre for dealings, mainly of a short term character, in money assets; it meets the short term requirements of most of the borrowers and provides liquidity or cash to the lenders. It is the place where short term surplus investible funds at the disposal of the financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also the government.”

Features of Money Market:

The few most important features of money market are as follows:

1. Short period: In the money market the operations (raising and development of funds) are for a short duration (normally up to one year), in the capital market they are for longer durations/periods

2. Source of working capital: As a corollary, the money market is the institutional source of working capital to the industry, the focus of the capital market being on financing fixed investments.

3. Large number of participants: Moreover, there are large numbers of participants in the money market. In fact, the larger the number of participants, the greater is the depth of the market.

4. Wholesale market: In addition, the money market is a wholesale market. The volume of funds/financial assets representing the money traded in the market is very large, which underscores the needs for the skilled professional operators.

5. Same day settlement: Also, unlike the other markets (exchanges), trading in the money market in conducted on the telephone, followed by the written confirmation from both the borrowers and the lenders.

6. Flexibility: Due to greater flexibility in the regulatory framework, there is a greater scope for innovative dealings..

7. Sub-markets: Finally the money market consists of a number of interrelated sub-markets such as the call market, the commercial bill (bill) market, the Treasury bill market, the commercial paper market, the certificates of deposit market and so on.

The important functions of money market are as follows:

1. It provides an outlet to commercial banks and non banking financial companies to park their short-term funds.

2. It provides funds for industry, trade and commerce.

3. It supplies short-term funds to the government.

4. It facilitates successful functioning of the central bank.

5. It helps in the development of the capital market.

Difference between Money Market and Capital Market:

Money Market

Capital Market

1. Market for short term loans.

2. Deals in near money assets.

3. Includes commercial banks.

4. Loans maximum for 6

Months.

5. Transactions in short term

Instruments.

6. Arranges small amount of

Funds.

7. Funds supplied for working

Capital.

8. Rate of interest generally high.

1. Market for long term loans.

2. Deals in shares and

Debentures.

3. Includes share market too.

4. Loans for long Period.

5. Deals in long term

Instruments.

6. Arranges large amount of

Funds.

7. Funds supplied for fixed

Capital.

8. Rate of interest generally low.

Money Market Instruments:

1. Call/Notice Money Market: The component of the money market in India deals with the (borrowed and lent) overnight/one-day (call) money and notice money for period up to 14 days. It primarily serves the purpose of balancing the short-term liquidity position of banks. The call money market is a market for short term funds repayable on demand and with maturity period varying from one day to a fortnight. When money is borrowed/lent for a day, it is known as call money. When money is borrowed/lent for more than a day and up to 14 days, it is known as notice money. No collateral security is required to cover these transactions. It is basically an over-the-counter (OTC) market without the intermediation of brokers. Call money is required by banks to meet their CRR requirement.

2. Treasury bills: Treasury bills of the Central Government have been issued since the inception of the Bank. They were issued for 91 days. The sales were occasionally suspended. Treasury bills are claim against the government. They are negotiable securities and since they can be rediscounted with the Bank they are highly liquid. Their other features are:

· Absence of default risk

· Easy availability

· Assured yield

· Low transaction cost

· Eligibility for inclusion in the securities for SLR purposes and

· Negotiable capital depreciation

There were 14 days, 91 days and 364 days treasury bills in vogue in 1997. They are not issued in scrip form. The purchases and sales are affected through the Subsidiary General Ledger Account.

3. Term Money Market: The term money market in India has been dormant. The factors that have inhibited the development of term money market are statutory pre-emption on interbank liabilities, regulated interest rate structure, high degree volatility in the call money rates, availability of sector specific refinance, cash credit system of financing, absence of Asset Liability management practices among banks and inadequate development of money market instruments. RBI has gradually removed most of the constraints in the past decade. The volume of transactions has picked up in response to policy measures to develop the market segments.

4. Certificate of Deposits (CD): CDs are similar to the traditional term deposits but are negotiable and can be traded in the secondary market. It is often a bearer security and there is a single payment, principal and interest, at the end of the maturity period. The bulk of the deposits have very short duration of 1.3 or 6 months. For long term CDs there is a fixed coupon or a floating rate coupon. For CDs with floating rate coupons, the life of CD is subdivided into sub periods of usually 6 months. Interest is fixed at the beginning of each period and is based on LIBOR or US Treasury Bill rate or prime rate.

In India Certificate of deposits are being issued since 1989, by banks, either directly to the investors or through the dealers. CDs are documents of title to time deposits with banks. CDs are marketable or negotiable short- term instruments in bearer form and are known as Negotiable Certificates of Deposit.

5. Commercial Paper: Commercial Paper was introduced in January 1990, to enable highly-rated corporate borrowers to diversify their sources of short-term borrowings and also provide an additional instrument to the investor. The guidelines issued by the RBI regulating the issue of commercial paper apply to all non-financial companies.

Issue of commercial paper: Commercial paper can be issued by a company whose,

I. Tangible net worth (paid up capital plus free reserve) is not less than Rs.5 crores;

II. Fund-based working capital limits are not less than Rs.4 crores;

III. Shares are listed on a stock exchange.

6. Commercial Bill Market: Trade bills are drawn by the seller (drawer) on the buyer (drawee) for the value of goods delivered to him. Commercial banks as a part of the working capital limits grant a component for discounting such bills. Normally, 20 percent margin is kept and the trade bill when presented by the constituent enjoying working capital credit limits along with bill limit component, the bank discounts the bill and credits the proceeds to his account. These bills can be for 30 days, 60 days or 90 days depending on the credit extended in the industry to which the constituent belongs. Interest is charged for the time it takes to collect the bill.

7. Money Market Mutual Funds: Money Market Mutual Funds (MMMFs) enable small investors to participate in the money market. The investors can realise through MMMFs, market-related yield.

The MMMFs can be set up by scheduled commercial banks and public financial institutions. They are allowed to be set up as a separate entity in the form of Trust. Only individuals can subscribe to MMMFs. The minimum lock-in period is 15 days. There should be no guarantee of minimum return. Reserve requirements will not apply to MMMFs.

The portfolio of MMMFs consists of short-term money market instruments. Investors can obtain a yield close to money market rates by investing in MMMFs.

MMMFs are also permitted to offer cheque writing facility to investors. MMMFs were brought within the purview of SEBI regulations. Banks and FIs were required to seek clearance from RBI for setting up MMMFs.

8. Repos/ Reverse Repos: Repo/ reverse repo is a transaction in which two parties agree to sell and repurchase the same security. The seller sells specified securities, with an agreement to repurchase the same at a mutually decided future date and price. Likewise, the buyer purchases the securities, with an agreement to resell the same to the seller on an agreed date and at a predetermined price. The same transaction is repo from the view point of the seller of the securities and reverse repo from the view point of the buyer of the securities.

9. RBI Repos: With the objectives of improving short-term management of liquidity in the system and to even out interest rates in the call/notice money market, Reserve Bank of India has been undertaking repos (through auctions) since December 1992. Only banks and institutions having current account and SGL Account with RBI at Mumbai were eligible to participate in the repos auctions. The repos were described to be in the form of sale of dated government securities by the RBI for very short periods with a confirmed buy-back provision. Shorter period repos provide greater maneuverability to Reserve Bank in deciding the quantum of liquidity to be absorbed and the repo rate depending upon demand and supply conditions.

FINANCIAL SERVICES

Financial services constitute an important component of the financial system. Financial services, through the network of elements such as financial institutions, financial markets and financial instruments, serve the needs of individuals, institutions and corporate.

Types of Financial Services

i. Asset / Fund based financial services and

ii. Non-fund / Fee based financial services

i) ASSET / FUND BASED FINANCIAL SERVICE

This involves provision of funds against assets, bank deposits, etc. Fund based income comes mainly from interest spread (the difference between the interest earned and interest paid), lease rentals, income from investments in capital market, real estate, etc.

Various Asset/Fund Based Services:

· Underwriting - The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt). The word "underwriter" is said to have come from the practice of having each risk-taker write his or her name under the total amount of risk that he or she was willing to accept at a specified premium. New issues are usually brought to market by an underwriting syndicate in which each firm takes the responsibility (and risk) of selling its specific allotment.

· Money Market - A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers, acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

· Equipment leasing - A lease is an agreement under which a company or a firm acquires a right to make use of a capital asset like machinery, on payment of a prescribed fee called “rental charges” for a long-term.

· Venture Capital - Venture capital (VC) is financial capital provided to early- stage, high-potential, high risk, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, software, etc.

· Insurance Services - Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as premium.

· Hire Purchase - Hire purchase is a mode of financing the price of the goods to be sold on a future date. In a hire purchase transaction, the goods are let on hire, the purchase price is to be paid in installments and hirer is allowed an option to purchase the goods by paying all the installments.

Non-Fund Based/Fee Based Financial Service

Fee based financial services are those services wherein financial institutions operate in specialized fields to earn a substantial income in the form of fees or dividends or brokerage on operations.

Fee based income does not involve much risk. But, it requires a lot of expertise on the part of a financial company to offer such fee-based services Examples ◦ Corporate advisory services ◦ Bank guarantees ◦ Merchant banking ◦ Issue management ◦ Loan syndication ◦ Credit rating ◦ Stock Broking ◦ M & A, Capital restructuring, etc. Non-fund based services are also called Services in form of Advices.

· Merchant banking ◦ A merchant banker is a financial intermediary who helps to transfer capital from those who possess it to those who need it. ◦ Merchant banking includes a wide range of activities such as management of customer securities, portfolio management, project counseling and appraisal, underwriting of shares and debentures, loan syndication, acting as banker for the refund orders, handling interest and dividend warrants

· Project counseling - Project counseling services may be rendered independently or maybe, it relates to project finance and broadly covers the study of the project and offering advisory assistance on the project viability and procedural steps for its implementation broadly including following aspects:- general review of the project ideas/ project profile, advice on procedural aspects of project implementation, review of technical feasibility of the project on the basis of the report prepared by own experts r by the outside consultants, selecting Technical consultancy Organization (TCO) for preparing project reports and market survey, or review of the project reports or market survey report prepared by the TCO, preparing project report form financial angle, and advice and act on various procedural steps including obtaining government consents for implementation of projects. This assistance can include obtaining of the following approvals/licenses/permission/grants etc form the govt. agencies viz. letter of intent, industrial license and DGTD registration and government approval for foreign collaboration.

· Portfolio Management - refers to the professional management of securities and other assets also referred to as "asset management" and "wealth management." Portfolio management includes a range of professional services to manage an individual's and company's securities, such as stocks and bonds, and other assets, such as real estate.  The management is executed in accordance with a specific investment goal and investment profile and takes into consideration the level of risk, diversification, period of investment and maturity (i.e. when the returns are needed or desired) that the investor seeks. In cases of sophisticated portfolio management, services may include research, financial analysis, and asset valuation, monitoring and reporting. The fee for portfolio management services can vary widely among management companies.  In terms of structure, fees may include an asset-based management fee, which is calculated on the basis of the asset valuation at the beginning of the service.  Since this fee is guaranteed to the manager, it is typically a lower amount.  Alternatively, the fee may be tied to profits earned by the portfolio manager for the owner.  In such cases, the risk-based fee is usually much higher.

· Loan syndication

· Similar to consortium financing.

· Taken up by the merchant banker as a lead manager

· It refers to a loan arranged by a bank called lead manager for a borrower who is usually a large corporate customer or a government department.

· It also enables the members of the syndicate to share the credit risk associated with a particular loan among them selves

· Credit rating

· Evaluates the credit worthiness of a debtor, especially a business (company) or a government

· It is an evaluation made by a credit rating agency of the debtor’s ability to pay back the debt and the likelihood of default

· Some credit rating agencies; ICRA, CRISIL, S&P, Moody’s and so on

· Corporate Advisory Service

Business advisory services involves advises about current and future business prospects of a client, with the aim of advancing their business or company. This service is used by all types of businesses and includes examining the legal, tax, finance, market and risk factors involved to start up a business or making new changes to the existing business. Business advisory services are given by organizations with experience in company formation.

· Bank Guarantees

Bank Guarantee is a contract to perform the promise or discharge the liability of a third person in case of his default. IndusInd Bank sanctions Bank Guarantee limit to facilitate issue of guarantees on behalf of its clients. Various types of guarantees offered are – financial, performance, bid bond, tenders, customs, etc. Our guarantees are well accepted. Our overseas correspondent bank alliances also enable us to issue guarantees overseas for participation in global tenders, etc.

· Issue management

Project issues must be identified, managed and resolved throughout the project in order for the project to be successful. Issue management plays an important role in maintaining project stability and efficiency throughout the project lifecycle. It addresses obstacles that can hinder project success and/or block the project team from achieving its goals. These obstacles can include such factors as differences of opinion, situations to be investigated, emerging or unanticipated responsibilities. The purpose of issue management is to identify and document these issues and to resolve them by reviewing and carefully considering all relevant information

· Mergers and Acquisitions

Others Services

· Credit cards: A card issued by a financial company giving the holder an option to borrow funds, usually at point of sale. Credit cards charge interest and are primarily used for short-term financing. Interest usually begins one month after a purchase is made and borrowing limits are pre-set according to the individuals credit rating. Card holders normally must pay for credit card Purchases within 30 days of purchase to avoid interests and/or penalties.

· Debit cards: An electronic card issued by a bank which allows bank clients access to their account to withdraw cash or pay for goods and services. This removes the need for bank clients to go to the bank to remove cash from their account as they can now just go to an ATM or pay electronically at merchant locations. This type of card, as a form of payment, also removes the need for checks as the debit card immediately transfers money from the clients account to the business account

· Smart cards: A smart card, typically a type of chip card, is a plastic card that contains an embedded computer chip–either a memory or microprocessor type– that stores and transacts data. This data is usually associated with either value, information, or both and is stored and processed within the cards chip. The card data is transacted via a reader that is part of a computing system. Systems that are enhanced with smart cards are in use today throughout several key applications, including healthcare, banking, entertainment, and transportation

· Safe lockers: Strong storage container maintained in the vault area of a bank and rented to bank customers for safekeeping of valuables. These boxes are said to be impervious to fire, flood, and theft, and their contents are covered by the banks insurer. Access to individual boxes is secured through two different keys: one kept by the customer, the other by the bank.

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