Markets & Interest Rates

Financial Markets

• All entities need finance to run business• Financial markets - Platform that brings

together entities with surplus money and those that need money

• Different types – Assets backing, Risk, Return, Duration, etc.

Financial System

• Existence of a well organized financial system

• Promotes the well being and standard of living of the people of a country

• Money and monetary assets • Mobilize the saving • Promotes investment

Financial System

Financial System of any country consists of financial markets, financial intermediation and financial instruments or financial products

Suppliers of funds(Mainly households)Flow of financial services

Incomes , and financial claims

Seekers of funds (Mainly business firms

and government)

Flow of funds (savings)

Indian Financial System

Non- Organized Organize

d Money lenders

Local bankers

Traders

Landlords

Pawn brokers

Chit Funds

Regulators

Financial Institutions

Financial Markets

Financial services

Financial System

Savers Lenders Households Foreign Sectors

Investors Borrowers

Corporate Sector Govt.Sector

Un-organized Sector

Economy

Interrelation--Financial system & Economy

Organized Indian Financial System

Money Market Instrument

Capital Market Instrument

Forex Market

Capital Market

Money Market

Credit Market

Primary Market

Financial Instruments

FinancialMarkets

FinancialIntermediarie

s

Secondary Market

Regulators

Financial Markets• Mechanism which allows people to trade

• Affected by forces of supply and demand

• Process used

• In Finance, Financial markets facilitates

Why Capital Markets Exist• Capital markets facilitate the transfer of capital

(i.e. financial) assets from one owner to another.• They provide liquidity.

– Liquidity refers to how easily an asset can be transferred without loss of value.

• A side benefit of capital markets is that the transaction price provides a measure of the value of the asset.

Role of Capital Markets• Mobilization of Savings & acceleration of Capital

Formation• Promotion of Industrial Growth• Raising of long term Capital• Ready & Continuous Markets• Proper Channelisation of Funds• Provision of a variety of Services

Indian Capital Market

Market Instruments Intermediaries

Primary Secondary

Equity DebtHybrid

Regulator

•Brokers •Investment Bankers •Stock Exchanges•Underwriters

SEBI

Players

Corporate Intermediaries Banks/FI FDI /FIIIndividual

Capital Market Instruments

ADR / GDR

Equity Debt

EquityShares

PreferenceShares

Debentures Zero coupon bonds

Deep DiscountBonds

Hybrid

Money Market• Market for short-term money and financial assets

that are near substitutes for money.

• Short-Term means generally period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost

Money Market

• It is a place for Large Institutions and government to manage their short-term cash needs

• It is a subsection of the Fixed Income Market

• It specializes in very short-term debt securities

• They are also called as Cash Investments

Defects of Money Market• Lack of Integration

• Lack of Rational Interest Rates structure

• Absence of an organized bill market

• Shortage of funds in the Money Market

• Seasonal Stringency of funds and fluctuations in Interest rates

• Inadequate banking facilities

Money Market Instruments

• Treasury Bills

• Commercial Paper

• Certificate of Deposit

• Money Market Mutual Funds

• Repo Market

Segment Issuer Instruments

Government

Central Government

Zero Coupon Bonds, Coupon Bearing Bonds, Capital Index Bonds, Treasury Bills.

Public Sector

Government Agencies / Statutory Bodies

Govt. Guaranteed Bonds, Debentures

Public Sector Units PSU Bonds, Debenture, Commercial Paper

Private Corporate Debentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-Corporate Deposits

Banks Certificate of Deposits, Bonds Financial Institutions Certificate of Deposits, Bonds

Financial Institutions

• Financial intermediariesCommercial banksInvestment banksMutual fundsInsurance/Pension funds

• Direct TransfersCompany / Government as borrower and Saving households

Cost of Money

• There is no free lunch• There is cost to money

Stocks – DividendDebt – Interest

• Factors affecting cost of money– Return– Risk– Time duration– Inflation

INTEREST RATE A FUNCTION OF SUPPLY&DEMAND

• INTEREST RATE – ALLOCATION OF CAPITAL

• COMPETITION FOR CAPITAL ALLOCATION

• INTEREST RATE – TOOL FOR INVESTMENT DECISIONS

Illustration• Market A vs Market BCost of capital 10% 12%

Demand for fund deccreases – Interest rates will decline

Supply tightened due to monetary policy – Interest rates will increase

Markets A & B are interdependent

Risk premium = 12% - 10% = 2%. If demand for fund decreases, supply will shift to Market B as risk premium is 4 % (12% - 8%)

Market A supply will decrease which will increase interest rate again before balancing at 2% risk Premium

INTEREST RATE DETERMINANTS

• Expected rate of return = Real risk free rate + Inflation premium + Default risk premium + Liquidity premium + Maturity risk premium

• The Nominal risk free rate of interest = Real risk free rate + IP

FACTORS AFFECTING DEMAND/SUPPLY

• Monetary Policy• Fiscal Policy• Foreign Trade Balance• Business Activity

INTEREST RATES VS STOCK PRICES

• INTEREST RATES AFFECT PROFITABILITY• INTEREST RATES ALTERS ECONOMIC

ACTVITIY• CHOICE OF BOND VS STOCK BASED ON

INTEREST RATES

Thankyou