Financial market in India
List of Contents
- Financial Economics
- Financial system
- Financial markets
- Money Market
- Capital Market
- Financial Market -Stock exchange
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Economics is the study of scarcity. Do you think we would still need to study or teach economics if we had an unlimited number of resources available to us?
Similarly, there would have been no need for financial economics if every one of us had access to unlimited amounts of money (finance).
It is the study of the use and distribution of resources (money instead of goods and services) in the financial markets.
The entire financial system is made up of the following three elements:
- Financial Markets
- Financial Instruments
- Financial Institutions
In this article, we shall focus on financial markets and financial market instruments.
In an economy, some will have a surplus while others will be suffering from a deficit. This surplus & deficit can be of any kind but in financial economics, we shall assume this to be related to money.
- Consider a person Mr A who wants to open a factory. He needs Rs 10 Crore for it. But has only 5 Crore with him. So, what does he do?
- Should he go door to door asking for money? That’s just not feasible. So, he decides to borrow.
- Now, consider another person Mr B. He has surplus money of Rs 1 Cr with him. Similarly, like him there are thousands of other people who have surplus money with them.
- Mr A wants to borrow money and people like Mr B have that kind of money to lend. All good, but how does Mr A find out about such people who would be willing to lend him money!
- This function is performed by a market where borrowers and lenders meet each other. It is like a supermarket but not for goods and services but for money.
- In this market, surplus money is channeled from those who have it i.e., lenders to those who need it i.e., borrowers.
Following five types of lenders and borrowers exist,
- Government of India
- Big businesses
Thus, financial market, like all other markets is a place where buying and selling take place, but instead of the usual things like goods, merchandise, etc, money and other financial assets are traded.
Types of financial markets
A financial market is of two types –
- Money Market
- Capital Market
Note: There can be one more type of classification of financial market –
- Organized financial market – regulated and controlled by any regulatory body like RBI. This organized market can be further divided into the following two categories:
- Money Market
- Capital Market
- Unorganized financial market – unregulated and not governed by any laws. Private moneylenders etc come under this category
In a money market, short term financial assets that are close substitutes of money are sold & bought (for 364 days or less)
- Close substitutes mean those financial assets that can be quickly converted to cash with minimum transaction cost
- Short-term financial assets mean maturity period is less than a year. Examples include treasury bills, certificates of deposit, etc.
- This market is characterised by buying and selling of products with high liquidity (easily convertible to cash) and short-maturity (less than a year)
In simplest of terms, the money market fulfills borrowing and lending needs of less than a year.
Types of maturity
Borrowing and lending can be done for various time periods within 365 days. On the basis of these we define few terms:
- Call money or overnight call money – Here lending and borrowing is done on an overnight basis i.e., 1 day
- Notice money – Time period here is b/w 1 – 14 days (i.e., 2 to 13 days)
- Term money – Time period here is b/w 14 – 365 days (i.e., 15 to 364 days)
We know if we need to borrow or lend money for the short term then we can approach the money market and the tools used to achieve this are referred to as money market instruments.
Types of money market instruments
- Treasury Bills
- Commercial bills
- Certificate of Deposit (CD)
- Commercial Paper (CP)
- Banker’s acceptances
- Bills of exchange
- Money market mutual funds
- Repurchase agreements (Repos)
Let us discuss these instruments, one by one.
Treasury Bills (T-Bills)
T-Bill is a type of government security. Hence, before knowing about T-Bills, it is extremely important that you know all about government securities.
Let us understand the idea behind the word ‘security’ itself.
Here is a simple example:
- You and Ram are best friends.
- Suddenly one day, Ram comes to you and asks for 1 lakh rupees as a loan. He promises to return it after a period of 2 months.
- Although his offer is interesting, you are still not sure about giving him 1 lakh because of his current financial situation.
- Seeing your hesitation, he not only promises to return the principal but also pay an interest of 10% meaning at the end of 2 months he will be returning 1 lakh 10 thousand.
- You are still hesitant because words mean nothing. So, you ask him to give his promise in writing. This will act as security. In case, after 2 months Ram decides to abscond with the money then you’ll have proof that he took your money.
- Now, you understand what is a security instrument. It’s just a piece of paper in which the borrower promises to pay back the amount loaned to him with or without interest.
- If this paper is issued by the RBI on behalf of the government then it is called government security (g-sec)
- G-Secs carry practically no risk of default and, hence, are called risk-free gilt-edged instruments.
- The term is of British origin. Back then it referred to the debt securities issued by the Bank of England on behalf of His/Her Majesty’s Treasury, whose paper certificates had a gilt edge.
- Gilt means gold or something that resembles gold laid on a surface.
Note: Trust in a security issued by the government will be highest since it is backed by the government itself.
In the above example,
- Suppose instead of Ram, the government asks Rs 1 Lakh from you. It issues a g-sec to you in which it is written that whosoever holds this security will be paid Rs 1 Lakh 5 thousand after 2 months i.e., the government is paying just 5% interest instead of Ram who is ready to pay 10%.
- To whom shall you prefer to give your money, government or Ram?
- Obviously, to the government because although the interest is less, you are sure that government will not run away with your money. Trust in government-issued security is the highest. Hence, they are considered risk-free.
Note: Securities are generally of three types:
- Debt – In these, the one who takes a loan or debt agrees to repay it after a fixed duration along with some or no interest, like government securities, T-bills, etc.
- Equity – Money is loaned in this case too but it also offers ownership rights like shares of a company
- Hybrid (have features of both debt & equity)
Bill: Now, security (issued by the RBI on behalf of the government), when it needs money for less than 365 days, is termed as Bill.
So, what is a T-Bill exactly?
When bills are issued at a discounted price they are known as T-Bills. Discounted price means the security would be issued at a discount instead of a face value.
- For example: Consider security having a face value of Rs 100. Issued at a discount this security would be sold at an amount less than 100 Rs. Now, if it is sold at 90 Rs then there is a 10% discount.
These are presently issued in three formats –
- 91-day T-bills
- 182-day T-bills
- 364-day T-bills
- These bills can be purchased by individuals, firms, institutions, banks, and trusts.
- These bills are zero-risk since they are backed by the government itself
- Treasury bills are zero-coupon securities and pay no interest. Instead, they are issued at a discount and redeemed at the face value at maturity.
- Example: a 91-day Treasury bill of ₹100/- (face value) may be issued at say ₹ 90, that is, at a discount of say, ₹10 and would be redeemed at the face value of ₹100/-. The return to the investors is the difference between the maturity value or the face value (that is ₹100)
- T-Bills can also be kept under SLR requirements.
- Statutory Liquidity Ratio or SLR is a minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold, or other securities
- Government securities issued for more than 365 days are termed as bonds and when these bonds are issued at discounted prices then they are called zero-coupon.
- As security of a maturity period of more than 365 days cannot be issued under the money market so such securities are issued under the capital market. Therefore, bills and bonds can be defined in one another way.
- Government securities issued in the money market are termed as Bills whereas government securities issued in the capital market are termed as bonds.
- T-Bills are debt security while shares are a type of equity security
Certificate of Deposit (CD)
It is a negotiable unsecured (without any collateral) money market instrument. It is issued in a dematerialized (electronic) form or as a Usance Promissory Note against funds deposited at a bank or other eligible financial institution for a specified time period.
- Regulated by: the Reserve Bank of India (RBI)
- CDs can be issued by
- Scheduled commercial banks (excluding Regional Rural Banks and Local Area Banks)
- Select All-India Financial Institutions (FIs) that are permitted by RBI to raise short-term resources within the limit fixed by RBI.
- Maturity period:
- Banks: The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, from the date of issue.
- Financial Institutions (FIs): FIs can issue CDs for a period not less than 1 year and not exceeding 3 years.
- This is an exception because under the money market, financial assets are bought & sold for less than a year but here the time period is beyond 1 year extending up to 3 years.
- These are similar to Fixed Deposits but are negotiable and tradable.
What is a promissory note?
- When a person gives a promise in writing to pay a certain sum of money unconditionally to a certain person or according to his order the document is called is a promissory note.
- A promissory note does not require any acceptance because the maker of the promissory note himself promises to make the payment.
- It can be negotiable or non-negotiable
- Negotiable means creditor can ask the debtor to pay the amount to a third party instead of him
- It is a legal instrument defined under the Negotiable Instruments Act 1881. As per the act, a promissory note is defined
- an instrument in writing (not being a banknote or a currency note), containing an unconditional undertaking signed by the maker, to pay a certain sum of money only to or to the order of a certain person (amount can be paid to a third party other than the creditor)
- Promissory note payable to the bearer is illegal as per RBI
- Payable to the bearer means amount to be paid to whosoever holding the promissory note
- Parties involved:
- Debtor/Maker/Promisor – one who issues the note
- Creditor/Acceptor/Promisee – to whom the note is issued
- Types of promissory note: There can be many types of promissory notes, like
- On Demand: money has to be given when demanded by the creditor
- Usance: a future date of payment is mentioned
- Interest bearing: Interest is applicable
- Interest-free: No interest
Commercial Bills/Bills of exchange
These bills, unlike the T-Bills, are issued by financial institutions, firms, or businesses in exchange for goods sold or purchased.
- Bill of exchange: According to the Negotiable Instruments Act 1881, a bill of exchange is defined as an instrument in writing containing an unconditional order (Note, that in case of a promissory note there was an unconditional promise but here there is an unconditional order because here the person who has given money is ordering the person to whom money is given to return his money at a specified date), signed by the maker (creditor), directing a certain person to pay a certain sum of money only to, or to the order of a certain person
- Types: On-demand & Usance
Commercial Paper (CP)
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
- It was introduced in India in 1990 with a view to enable high rated corporate borrowers to diversify their sources of short-term borrowings. Also, to provide an additional way for investors to invest.
- Subsequently, primary dealers and all-India financial institutions were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations
- CP is always issued at a discount to face value
- Issued by: Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are eligible to issue CP.
- Eligibility requirements for companies to issue CP: A corporate is eligible to issue CP provided –
- the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 Crore
- company has been sanctioned working capital limit by bank/s or all-India financial institution/s; and
- the borrowal account of the company is classified as a Standard Asset by the financing bank/s/ institution/s.
- Credit rating is required to be able to issue CP from rating agencies like CRISIL, ICRA, FITCH, or any such rating agency as specified by RBI
- Maturity period: CP can be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue. However, the maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid
BA is a time draft or bill of Exchange drawn on and ‘accepted’ by a bank as its commitment to pay a third party
- Time draft: It is a document acknowledging a promise to make a payment after a specific period
- Bills of exchange: It has been discussed earlier in the article.
Money market mutual funds
These funds are a collective pool of savings of various investors who wish to make money via their savings.
- Regulated by: Securities Exchange Board of India (SEBI)
- These funds invest in high-quality liquid instruments such as treasury bills (T-Bills), repurchase agreements (Repos), commercial papers, and certificates of deposit.
Repurchase agreements (Repos)
- Repo acts as an instrument of borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed
- Under Repo, securities are sold & funds are borrowed.
- Banks do the repo transactions with RBI when they need funds on short notice.
- The rate at which RBI lends them funds is termed as Repo Rate.
- RBI uses Repo Rate (and Reverse Repo Rate) to control the money supply. When it wants to lower the money supply it raises the Repo Rate & similarly when it wants to increase the money supply it reduces the Repo Rate.
- Reverse Repo acts as an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed (lent).
- Under Reverse Repo, securities are bought and funds are lent.
- Unlike a stock exchange, a money market is not one specific place but a system consisting of many participants like RBI, Scheduled commercial banks, etc.
- Money market instruments are traded wholesale so any individual investor cannot purchase them in terms of standard units. Their trading is done through a certified stockbroker or through a money market mutual fund. For example One of the ways you can invest in the money market is via a SIP (Systematic Investment Plan)
After the money market, now let’s discuss another type of financial market i.e., the capital market.
It is a market in which lending or borrowing is done for a period of more than 365 days.
- The capital market is characterized by long term financial assets like bonds, debentures, etc.
- This market is critical for our economy because it provides the financial resources required for the long-term sustainable development of the economy.
- Most projects which result in real tangible benefits i.e., infrastructural projects at the ground level require long-term finance, like a building of roads, setting up of new industries, etc. The capital market fulfills this important responsibility.
- The capital market consists of development banks, commercial banks, and stock exchanges.
- Indian Capital Markets are regulated and monitored by the Ministry of Finance, The Securities and Exchange Board of India (SEBI), and RBI.
Types of capital market
Capital market is generally of two types:
- Primary market
- Secondary market
In this market, securities are issued for the first time
- The investors in this market are banks, financial institutions, insurance companies, mutual funds, and individuals.
It deals with the buying and selling of existing or previously issued securities.
- This market is also known as the stock market or stock exchange
Case 1: Shares are issued for the first time
- Suppose you want to start a company and require funds of around 100 Crore. The duration for which you need these funds is more than a year so you’ll have to go to the capital market.
- Now, you can’t find a single investor having this huge amount of money. So, you decide to borrow from investors all over India by dividing 100 Crore into 10 Crore shares meaning each share is worth Rs 10 each. (Take your time to process this info)
- Share is just a piece of paper
- The task becomes easier as now one person can buy a share in your company for as low as 10 Rs.
- Assume that a person buys 1 Crore shares (Rs 10 Crore) in your company. This person will have 10% ownership of the company.
- Most aspirants are confused as to what a share actually is. As per the above example, the share is simply the smallest unit into which a company’s capital is divided.
- Ownership of shareholders is decided by how many shares they are holding in a company. A person who holds 50% shares will have 50% ownership in a company.
- Also note that shareholders are also paid dividends i.e., a share in company profits as per their shareholding
- If your company is issuing shares for the first time then it shall do so in the primary market. Issuing of shares for the first time is done by an IPO (Initial Public Offering)
Case 2: Reselling of shares
- Now, consider a case where a friend of yours who purchased 10 Crore shares in your company wants to sell them further.
- Can he do so?
- He can, but he can do so only in the secondary market, not in the primary market.
- In the secondary market, selling and buying of existing securities (debt & equity both) takes place.
- One important distinction b/w primary and secondary market is that in a primary market only buying of securities takes place whereas in a secondary market both buying and selling of securities takes place.
We hope you are clear about the types of capital markets. Now, like money market instruments, we also have capital market instruments. Let us discuss these.
Capital market instruments
Capital market instruments are of three types:
- Pure instruments: These include shares, bonds, debentures. They do not share features of one another. They are pure.
- Hybrid instruments: They have a combination of features like a combination of bond & equity
- Derivatives: These instruments have no value of their own but derive their value from one or more financial assets. Some examples of derivatives include futures and options
Let’s discuss few major ones.
We discussed shares in the example above. In that example, you wanted to start a company and needed 100 Crore. So, you issued shares and raised the required capital.
Shares are units into which the total share capital of a company is divided. One share is the smallest unit of the entire share capital.
- Persons holding shares are termed, shareholders.
- Shareholders are paid dividends (a share in profit) by a company. For example: if you deposit money into a bank in form of a Fixed Deposit you get some interest. Similarly, on buying shares of a company, shareholders are given shares in the profits called a dividend
- Shares are of two types:
- Equity shares: It is also known as an ordinary share. Through these shares, the company raises capital for its business.
- As per the Companies Act, 1956, an equity share is a share that is not a preference share.
- Equity shares grants ownership to the shareholder proportional to the amount of shareholding
- Equity shareholders have voting rights.
- Dividends to equity shareholders depend on the profit and company policy.
- Equity shares are traded in the stock market
- They are a higher risk instrument since returns are directly linked to the company’s profit and share price
- They have ownership and control in the company like voting rights
- Preference shares: The keyword here is ‘preference’. Shareholders of preference shares are given preference over equity shareholders over two things:
- Distribution of dividend: They receive dividends first and only after that equity shareholders are paid dividends. Usually, preference shares have a fixed rate of dividend.
- Right to company’s assets in case of bankruptcy: When a company is liquidated its assets are sold and shareholders are to be paid. In this case, also, preference shareholders are paid first.
- These shares offer a fixed dividend so they are not traded in a stock market. Profits are not decided as per-share price. The share price of a company can go up and down the return to preference shareholders is pre-decided and fixed. Hence, they are a lesser risk and fixed return type of instrument.
- They have no voting rights in a company
- Although they have ownership in the company, they cannot be part of its management.
- The preference share option is generally not available to retail investors like us. They are generally taken up by wealthy individuals, financial institutions, venture capitalists, etc.
What if I want to start a company but I am not interested in issuing shares! An immediate question that might come to you is this – Why would you not want to issue shares? What’s the problem?
The problem is ownership.
As you might have seen above, in the case of equity I would have to share ownership with others and I don’t want that. I want to raise money but I also want to keep all the shareholding to myself i.e., no dilution of ownership.
So, I resort to raising money via taking a loan from a bank.
But even that is not working out for me as a bank has too many conditions and formalities. So, where should I go now?
Fear not. There is another way of raising money without any of the above hassles. This is done via bonds.
Note: While shares are categorized as equity security, bonds are categorized as debt security.
Let’s discuss bonds.
A bond is a debt instrument in which an investor (you) loans money to an entity (typically corporate or government) that borrows the funds for a defined period of time at a variable or fixed interest rate.
- Bonds are used by companies (corporate bonds), municipalities, states, and sovereign governments to raise money to finance a variety of projects and activities.
- Corporate bonds are high risk, high return while government bonds (g-sec) are low risk, low return.
- Owners of bonds are debtholders, or creditors, of the issuer meaning the one who is loaning money (you) will be called a lender/Creditor, and the one who is taking the money (government, company, etc) will be the borrower/
- A bond is a fixed interest instrument meaning a fixed interest is paid to the bondholder. If a company has issued bonds that it is liable to pay you a fixed amount of interest no matter the value of its share price.
- Remember, in the case of shareholders their profits were depending on the share price but not in the case of bondholders.
- This means a bond is less risky than a share but, it also means that chance of high profit is more in shares.
- Also, bondholders are given first preference (over and above both equity and preference shareholders) on the assets sold in case the company goes bankrupt.
- Equity is most risky, preference shares are less risky and bonds are least risky in terms of investment.
- G-secs, as discussed above, is also a type of bond. When issued for,
- a short term (less than a year) they are known as – T-Bills
- a long term (one year or more) they are termed as – Government bonds or dated securities
- G Secs pays interest at a fixed rate of interest.
- In India, the Central Government issues both, treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs).
- Investors buy bonds at face value (the price of a bond) or a principal amount that is returned at the end of a fixed period. Borrowers give interest payments to bondholders at a fixed rate or at a variable rate.
- Face value is different from the market value of a bond.
- Coupon rate: It is the interest rate paid on a bond
- Tenure: Time period after which a bond matures
- Bonds usually fall into two categories:
- Secured bonds: These bonds are backed by an underlying asset and in case the company defaults i.e., fails to repay the principal and interest at the end of maturity of a bond then bondholders can stake a claim to the underlying assets
- Unsecured bonds: Bonds that are not backed by any underlying asset are called unsecured bonds.
- It is the rate of returns realized on a bond i.e., the rate of interest of a bond. Bond yield doesn’t include the principal amount. For example, A bond sold by the government for 300 Rs @ 10% for 10 years will result in a bond yield of Rs 30 every year for 10 years.
- Let us understand this with an example:
- The government issues bonds to borrow from the market.
- We already know that a bond is just a piece of paper on which it is written that government shall pay the interest plus the principal, to the purchaser at the end of a specific time period.
- The interest is always paid on the face value of the bond.
- Let us suppose a friend of yours purchases a bond of Rs 30 @10% yearly, from the government.
- It means the government will be liable to pay an interest of Rs 3 (yearly) to the borrower. Bond yield, in this case, is 10%
- Hence, bond yield changes only when a bond is traded in the secondary market. If a bond will not be traded, then its yield will stay the same.
- Now, consider a situation in which your friend needs money immediately and decides to sell his bond. This selling (and purchasing) of the bond will be done in the secondary market. Remember, this market has many sellers and buyers of the bonds. Depending upon whether there are more sellers or more buyers, there can be two cases:
- Case 1: More sellers -> Bonds are in large supply
- Now, if there are many sellers of the bonds in the secondary market as compared to the buyers, your friend here will face a situation where the buyer will be the king.
- Your friend will have to sell his bond at a lower price than the price for which he purchased it (because there are other sellers who want their bonds to be sold). Let us assume that he sells it at Rs 20 to a buyer.
- Keep in mind that the buyer here shall continue to get the interest of Rs 3 as promised initially by the government as interest is calculated on the face value of the bond i.e., Rs 30 in this case. This means that the buyer will get an interest of Rs 3 on a bond worth Rs 20 while your friend was getting the same interest on a higher price of Rs 30.
- Clearly, the buyer will gain here as he is getting an interest of 15% (as Rs 3 is 15% of Rs 20 while it was 10% of Rs 30)
- In the above case, the bond price went down (from Rs 30 to Rs 20) while bond yield increased (from 10% to 15%)
- Hence, when bond prices go down, bond yield goes up
- Now, seeing the increased bond yield, more and more buying of the bonds will ensue, leading to an increased demand of the bonds and we already know that a quantity in increased demand will command a higher price.
- So, an increased demand will propel the bond prices up thereby leading to a reduction in bond yield, which will further lead to reduction in demand.
- For the case where there are more buyers in the secondary market you can simply reverse the scenario. Try it on your own!
Here is another example to better understand how bond yield is affected by overall condition of an economy.
Impact of an economic slowdown on bond yield
We have already discussed that,
- Government bonds are low risk & low return investments. They are the safest avenues to invest money because they are backed by government with only one downside that they don’t offer much return. So, an investor looking for high return won’t usually invest in them unless there are some major reasons.
Now, consider a scenario where the world is suffering from a recession, global economy is reeling under low growth rates and the future too is looking bleak. What kind of sentiment this entire picture paint for an investor?
Obviously, in such circumstances, an investor, instead of high returns, would simply be looking to invest his money in a safe avenue which safeguards his investment. At this point he won’t be concerned about the low interest. So, where shall he invest his money?
Yes. You guessed it right.
In the government securities.
Similarly, there would be other investors like him, looking to invest their money in government securities. This would lead to an increased demand for g-secs in the market.
The safest g-secs in the world right now are those offered by USA due to its government’s high credibility. So, global investors will buy US government securities while domestic investors will start buying Indian government securities.
Now, what happens when there is an increased demand for something?
Its price shoots upward. Similarly, in this case too price of the g-secs will rise.
And we already know what happens when bond price goes up. It leads to a fall in the bond yield.
- So, a fall in bond yield, amongst many other things, can also indicate slowdown in the economy.
Major factors impacting bond yield
The major factors affecting the yield is the
- Monetary policy of the Reserve Bank of India, especially the course of interest rates: A fall in interest rate results in increased bond prices and vice versa. A rise in bond yields means interest rates in the monetary system have fallen, and the returns for investors (those who invested in bonds and govt securities) have declined.
- When RBI increases the repo rate
- Fiscal position of the government and its borrowing programme: If the government wants to borrow more, then it will have to issue more bonds, leading to an excess of bonds in the bond market which will decrease the bond prices and bond yield will go up.
- Situation of the global economy
- Inflation (you can link it to how RBI uses monetary policy tools like repo rate to control inflation)
Issue of the rising bond yields
You must have heard recently that rising bond yields on g-secs in US & India have triggered concern over the negative impact on other asset classes, especially stock markets, and even gold.
- The yield on 10-year bonds (g-secs issued for 10 years) in India moved up from the recent low of 5.76% to 6.20% in line with the rise in US yields
Why there is a concern regarding increasing bond yields?
It’s mainly due to the following factors:
- A rising bond yield means investors will start buying g-secs and take their money out of the equity markets
- Rising bond yield also means that cost of borrowing capital will increase for companies because an investor will like to loan his money to the government (g-sec) instead of a company (corporate bond)
- When bond yields rise in the US, foreign portfolio investors move out of Indian equity market (share market). Also, it has been seen that when the bond yield in India goes up, it results in capital outflows from equities and into debt.
Debentures are also a method of raising capital via debt.
- It is a long-term debt instrument issued by private sector companies
- Debentures are not backed by any specific security instead the credit of the company issuing the same is the underlying security. Hence, unsecured bonds are termed as debentures
- Many investors prefer debentures since they offer higher rate of interest than bonds
- Debenture holders do not get any voting rights
In simplest of terms, a derivative is anything that derives its value from some other underlying asset. On its own, a derivative has no value. Now, a more technical definition would be:
- It is security derived from an underlying asset (underlying asset can be a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security)
- It can also be defined as a contract that derives its value from the prices, or index of prices, of underlying securities
- Forward/Futures contract: Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date.
- Generally, the underlying asset in futures are commodities like grains, oil, etc.
- Futures contracts are traded on exchange while Forward contracts are directly between seller & buyer. Hence, forward is also called as Over The Counter (OTC) transaction.
- Future contracts cannot be customized as per the needs of the parties involved while forwards can be customized.
- Options contract: Options Contract is a type of Derivatives Contract that gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period.
- Options are also traded on the stock exchange
- SEBI regulates the derivatives market in India
Financial Market -Stock exchange
It is a place for buying and selling of securities of listed companies. Exchanges can be a physical location or an electronic trading platform.
Major stock exchanges in India:
There are many stock exchanges in India but we shall only discuss the two most important ones.
- Bombay Stock Exchange (BSE)
- National Stock Exchange (NSE)
Bombay Stock Exchange
It was established in 1875 and is the oldest and first stock exchange of Asia and was formerly known by the name of –The Native Share & Stock Brokers Association.
National Stock Exchange
NSE was incorporated in 1992. It was recognized as a stock exchange by SEBI in April 1993 and commenced operations in 1994. It was the first exchange in India to provide fully computerized electronic trading.
Stock market index
Performance of companies listed on a stock exchange is measured via a stock market index.
- There are around 5000 companies listed on BSE while NSE has around 1600. It’s impossible to measure performance of every company listed on an exchange. Hence, the concept of an index is employed wherein performance of select few top performing companies is tracked.
- Index is based on market capitalisation (m-cap) of only few selected companies
- Remember that one company can be listed on multiple exchanges.
- Share price * no of issued shares = M-cap of a company
- Example: If a company has issued 10 Crore shares with a value of Rs 10 per share then its m-cap = 100 Crore
- This also means that if share price of a company increases then overall m-cap will increase. Shares are traded in secondary market so share price fluctuates daily.
- If no of shares of a company are increasing then it means business is expanding and the company is witnessing growth
- Hence, an index reflects the performance of the underlying companies and of the overall economy. If they perform well then index is high and if they perform poorly then index reflects that.
- But, do remember that sometimes index can also be dictated by market sentiment. For eg: People might start buying shares of a company based on some rumor or political event. This can lead to artificial increase in the share price of a company due to increased demand. Increase share price will reflect an increased m-cap and an increased m-cap will result in a higher value of sensex.
- Two major stock indices are:
- SENSEX (Sensitive + Index): This index comprises of 30 companies
- NIFTY (National + fifty): This index comprises of 50 companies
We hope you are now clear with the basics of financial market.
If you still have any doubts then be sure your queries below.