Indian Financial System PDF

Indian Financial
System
For B Com Honours Degree Course of
University of Calcutta
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Sujatra Bhattacharyya
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Assistant Professor and Head of Department of Economics

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Maharaja Srischandra College

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Features of
Figures The
Improvement in standard of living Economic stabilization Assistance in implementing
government policy
chapters contain
numerous well-
Improvement in payment mechanism Financial system Transfer mechanism
labelled figures and
flowcharts to enhance
the assimilation of the
Proper selection of portfolio Other functions topics.
Fig. 1.6 Functions of a financial system
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Tables
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Table 1.2 Differences between fund-based financial services and fee-based financial services
Basis of Difference Fund-based Services Fee-based Services
The chapters contain
Nature They provide funds to the business units to meet They provide advisory services to their clients and
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numerous detailed their requirements charge fees against their services
tables to support Risk These institutions provide funds and reduce risks They only provide advisory services
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Objective The main objective is the provision of capital Their main objective is provision of various
the text. technical, financial, and project-related advices
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Remuneration They earn interest on capital They earn fees against their advices
Example Hire-purchase and leasing companies, insurance Merchant banking, portfolio consultancy, issue
services, bill discounting, etc management, etc
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GLOSSARY Glossary Every

Banking intermediaries directly participate in the payment mechanism and various transactions. They together can create money or credit. chapter contains a
Capital market is that part of financial market, which deals with the long-term claims and, like money market, ensures the flow of funds from
surplus to deficit units.
glossary of key words
Direct finance refers to a financial system where savings are directly channelized into investments through the financial market without any with definitions to
intervention of financial intermediaries such as insurance organizations, mutual funds, and other financial institutions.
Fee-based services refer to the specialized services provided by some professionally managed institutions against requisite fees. These recapitulate important
services mainly imply technical and financial advices.
Finance is referred to be the mainstay of the economy as it is adequately required to perform various economic activities such as
terms.
development of infrastructure, creation of employment opportunities, economic development, and establishment of industries.
Financial institutions refer to the institutions that act as intermediaries in the transfer of funds from surplus to deficit units and, thus, mobilize
savings in the economy.
Financial instruments or assets, which are heterogeneous in nature, refer to the legal claims associated with a future cash flow.
Financial intermediaries refer to institutions that facilitate the process of transfer of fund from fund providers to fund seekers and, thus,
mobilize the savings.
Financial market refers to a centre that provides the facilities of sale and purchase of financial claims and services.
Financial non-intermediaries do not work as a medium between fund providers and fund seekers. They do not accept any deposit from the
general public. They actively take part in the business and sometimes invest in the proper sector
Financial regulators refer to institutions that generally try to protect the interest of the investors and maintain the financial discipline of the
market.

the Book
Solved CU QPs
and Model QPs Solved Question Papers
The book contains
solutions to last INDIAN FINANCIAL SYSTEM ((2017))
three years’
university question Model Question Papers )XOO0DUNV
papers, as well as Group-ASET-1

two model question
papers for students 1. What is financial system? State the components of a financial system. 2+3
Group-A
to get a feel of s. We can defi
Ans. fine financial system as a combination of various complex and mutually interdependent
examinations. financial savers
a rs and investors
ancial activities which also acts as connecting link between save n estors to fulfi
inv fil a certain and
fulfil
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1. Discuss the importance of financial intermediary in the financial system. 5
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OR Distinguish between banking and non-banking financial intermediary. 5
2. What are the functions of ICICI in Indian financial market? 5
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OR State the importance of SFC in the development of small-scale industries. 5
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Question Bank
Question Bank
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The book contains

a question bank of
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Chapter 1 The Indian Financial System solved model questions

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and answers to help

the students prepare
1. Define financial system. What is the significance of the financial system?
for examinations.
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A financial system is an integral part of the economy. It plays a pivotal role in the overall economic growth
of a nation. We can define financial system as a combination of various complex and mutually interdepend-
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ent financial activities that also acts as connecting link between savers and investors to fulfil a certain and
predetermined objective. The financial system acts as an intermediary, which ensures the flow of funds from
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surplus to deficit units. The financial system performs its basic activities through the components and involves
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MULTIPLE CHOICE QUESTIONS

1. A financial system ensures the flow of funds from 4. In which of the following eras, the Indian financial system
(a) Investors to savers was characterized by a lack of financial innovation?
MCQs and (b) Savers to investors (a) Post-liberalization phase
Exercises (c) Investors to government (b) In the mid-1960s
(d) Government to financial institutions (c) In pre-1951
Each chapter EXERCISES
2. Which one of the following is not termed as a financial (d) In between 1950 and 1980
contains a set regulator?
1. Define a financial system. Mention its significance and
5. UTI was established in
9. What are the functions of financial services institutions in a
(a) RBI (b) SEBI (a) 1956 (b) 1948
of MCQs and (c) IDBI
functions.
(d) IRDA (c) 1964
financial system?
(d) 1960
2. Write a brief note on the financial system of a country. 10. Define financial regulator. What is the role of the regulators
review questions 3. Which one of the following is not recommended by the 6. Banking institutions
3. Explain the role of finance briefly. in the financial system?
Narasimham Committee? (a) Are capable of creating credit
for self-evaluation. 4. Show how the fund flows from surplus to deficit units 11. Discuss the different types of finance in a financial system.
(a) Restructuring of the banking system (b) Accept deposit directly from public
through a financial system? 12. Discuss the organizational structure of the Indian financial
(b) Abolition of dual control system over banks (c) None of the above
5. What are the components of a financial system? system with examples.
(c) Removal of licensing (d) Both (a) and (b)
6. Explain the significance of financial intermediary. 13. Distinguish between
(d) Interest rate regulation
7. Discuss the role of financial institutions in the financial (i) Banking and non-banking institutions
system. (ii) Fund-based and fee-based financial services
8. What is the relevance of a financial market in a financial (iii) Financial intermediary and non-intermediary
system?

Preface
Financial system is closely interlinked with economic development. Basically economic development indicates
both qualitative and quantitative aspects. Economists and financial experts relentlessly try to determine the
impact of the changes in the financial indicators on economic activities. Some serious efforts have been made
to assess the impact of financial activities on capital formation and economic development. The various the-
oretical and empirical findings are suggestive of significant effects of financial indicators on economic devel-
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opment. However, these financial indicators are not the only ones to affect economic growth. Actually they
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have a considerable amount of influence over the factors of economic development. Thus it is often believed
that a strong and sound financial system acts as a catalyst to economic development. It enhances the standard
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of living of the people as well as ensures the well-being of the population.
One important aspect of the financial system is its capability to encourage the rate of savings and invest-
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ment in the economy. An ideal and efficient financial system has the capability of filling the gap between
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investment and savings potential of the economy and thereby, mobilizing the savings. The specialty of the
financial system is that it not only initiates investment but also directs the investible fund into the productive
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sectors of the economy. This definitely leads to greater possibilities of economic development. On the other
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hand, the economic development of a nation increases the efficiency of the financial system. Thus we observe
some sort of complementarity between a financial system and economic development.
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India is one of the emerging developing nations which is expected to be a superpower in the near future.
The recent development in the nation owes significantly to the financial sector reforms since 1991, when the
country adopted the strategy of liberalization, privatization, and globalization. Naturally the robust growth
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of the economy is a matter of interest among the economists and financial experts. The book Indian Financial
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System comprises various financial aspects of Indian economy and presents a detailed idea about the oper-
ations in the financial market. The Indian financial system is now going through a phase of alterations and
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introduction of new techniques, rules, and regulations. This is a part of the strategy of turning the Indian
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financial system compatible with the financial systems of the developed nations. The financial sector reforms
are going to change the financial habits of the population. The government puts emphasis on the digitaliza-
tion of the financial transactions. A combination of all these changes and the existing traditional modes make
the Indian financial system an interesting one. This has motivated me to write a book on the Indian financial
system in a lucid manner so that it is easily comprehensible to the students.
ABOUT THE BOOK

This book is mainly designed for the third year students of B Com (Hons) course under University of Calcutta.
Apart from this, the book will also be useful for the students pursuing commerce course in graduation in other
universities. The students of professional courses will also find the necessary materials and inputs from the
book which will meet their requirements. Above all, the young researchers in this field can gather the basic
and preliminary ideas and information from this book.
The objective of the book is to make the readers aware of the various aspects of the Indian financial
system and financial market operations. The book provides theoretical knowledge of the components of the
financial system with appropriate examples. As an author I have made an effort to provide the readers what

Preface vii
are not available in the existing books. Besides, I have tried to explain the contents of the chapters in a lucid
manner for the benefit of the students. Thus we are hopeful that this book will not merely be an addition to
the already existing corpus in this field, but will also be able to create a unique and separate identity due to
its special features.
The key features of the book are as follows:
• The book clearly mentions the learning objectives at the beginning of the chapters which will enable the
students to be focused.
• The chapters are written in a simple lucid style so that the students can independently extract the matters
for their use.
• The contents are prepared with the objective of providing conceptual understanding and logical expla-
nations to the students.
• One of the most important features of the book is the simple diagrammatic representation of most of
the subject matter through figures and flow charts.
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• Current and latest data are incorporated in the subject matter for better understanding of the trends of
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various macroeconomic indicators.
• Some topics are accompanied by graphical representation so that the students can grasp the subject
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matter conveniently.
• All chapters end with multiple choice questions and review questions which will help the students apply
the concepts learnt in the chapters.
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• The detailed summary and glossary at the end of every chapter will help the students in a quick under-
standing of the contents and subject matter.
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• The important and extremely relevant portions of the subject matter are highlighted so that the students
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can focus on them.

• The book also comprises solved CU question papers of the last three years and two model questions
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which will benefit the students immensely.

• At the end of the book a Question Bank has been introduced which comprises around 60 solved ques-
tions, collected from different university examinations. This will provide guidance to the students on how
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to construct answers to the questions.

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CONTENTS
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This book is comprised of 10 chapters which present the Indian financial system in a detailed manner.
Chapter 1 deals with the basics of the financial system and its components. It mainly focuses on the activ-
ities of financial intermediaries and also provides description about the structure of Indian financial system
and its recent changes.
Chapter 2 provides a fair idea about money and banking. Here, I have explained the different variations of
money, structure, and functions of the commercial banks and finally the functions and monetary policies of
Reserve Bank of India (RBI) and the recent changes.
Chapter 3 illustrates the objectives and functions of development banks like IFCI, IDBI, ICICI, NABARD,
SFC, EXIM Bank, etc. and focuses on the operational activities of them.
Chapter 4 covers other financial institutions like LICI, GICI, and UTI. The chapter not only focuses on
the objectives and functions of these institutions but also discusses their activities after liberalization. Besides
this, the chapter provides information about mutual funds and IRDA.
Chapter 5 explains the interest rate structure of the economy and differentiates gross and net interest. It
shows the methods of determination of equilibrium rate of interest and also identifies the reasons for the
differential interest rate.

viii Preface
Chapter 6 gives an overview of the financial markets by mentioning different financial instruments and
derivative techniques like forward, future, and options.
Chapter 7 focuses on the features, functions, and different types of money market. It further discusses call
money market in detail and informs about the money market reforms after liberalization.
Chapter 8 provides detailed analyses of features, functions, divisions, and participants of capital market.
The chapter clearly distinguishes the features of primary and secondary market and also discusses every
aspect of the stock exchange.
Chapter 9 shows the protection measures for the investors and provides remedies to the investors’ griev-
ances. It assesses the role of SEBI, court, and media in protecting the interest of the investors.
Chapter 10 describes the details of financial services. In this chapter the merchant banks and the credit
rating agencies are analysed. It also provides a detailed view of the objectives and activities of the merchant
banks and the credit rating agencies.
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ACKNOWLEDGEMENTS
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I have received active support and motivation from a number of persons for writing this book. My parents
have always been there to inspire me throughout this long journey. I am grateful to my teachers who taught
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me the basics of the subject. The support I have received from my elder brother Mr Dipra Bhattacharya,
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my sisters-in-law Aishee and Writi, and my in-laws is fabulous. My wife Prof. Debashree Bhattacharya has
not only helped me focus only on the writing by sharing the entire burden at home singlehanded but also
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rendered assistance to prepare the content. My student Prof. Sucharita Bhattacharyya of Barasat College
has actively participated in preparing study material by investing her time and hard work affectionately. My
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student Prof. Soumya Mukherjee of Maharaja Manindrachandra College has also helped me in different
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publication-related matters.
I am also indebted to my supervisors Prof. Arup Mitra of Institute of Economic Growth, New Delhi, and
Dr Asim Karmakar, my Principal Dr Shyamal Kumar Chakraborty, Prof. Sidhdhartha Majumdar of City
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College, and Prof. Asis Sana of University of Calcutta for continuous guidance and advice. Prof. Biswajit
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Chatterjee of Jadavpur University, Prof. Santanu Ghosh of Maulana Azad College, and Dr Indrani Saha of
Sri Sikhshayatan College have always encouraged me to pursue this sort of work. My colleagues of Maharaja
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Srischandra College are as usual cooperative and I should name Prof. Soma Sengupta, Dr Sunanda Ray, Dr
Sonali Banerjee, Debjani Kundu, Anindita Bhattacharyya, Debasis Mukherjee, Bidyut Sarkar, Dr Asim Das,
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Dr Avijit Chakraborty, Dr Debasree De, Sara Basu, Prof. Pradip Mukherjee, Prof. Prabir Dutta, Sarita Mal,
and Amrita Kundu for their tremendous support. The teachers of the Department of Commerce—Arup Kr
Bhattacharya, Dr Supti Kotal, Krishnapada Dash, Sreya Basu, Debjani Kundu, and Camellia Sarkar have
also motivated me a lot during this project. Supriya Bhattacharyya has provided relevant advice and inputs in
constructing the subject matter. Nabarun Bhattacharyya, Kuntal Mitra, Amit Ray, and Sudipta Bhattacharyya
were always present with their extended hands of cooperation, technical support, and motivation throughout
the journey. Prof. Debjani Lahiri of our college and Mita Dutta, the educator at Dakshineswar Sri Sri Sarada
Devi Balika Vidyamandir have also rendered their assistance in preparing the course material.
My heartfelt thanks and gratitude to those friends who helped me, choosing to remain invisible themselves.
I am also extremely grateful to the editorial and sales teams of Oxford University Press for their patience
and inspiration which boosted me to complete the project finally.
Feedback and suggestions for improving the future editions are always welcome and can be sent to the
author at [email protected].
Sujatra Bhattacharyya

Contents
Features of the Book iv

Preface vi
Road Map to Indian Financial System xiv
1. The Indian Financial System 1 2.4 Functions of Money 33

2.5 Money Supply and Money Demand 34
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1.1 Finance 1
2.6 Different Measures of Money Supply in
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1.1.1 Role of Finance 1
India 35
1.2 Financial System 2
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2.7 Indian Banking System 36
1.2.1 Role or Significance of the
2.7.1 Features of the Indian Banking
Financial System 3
System 36
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1.2.2 Functions of a Financial
2.7.2 Types of Banks in India 38
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System 4
1.2.3 Components of a Financial 2.7.3 Structure of the Banking System
in India 40
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System 6
1.2.4 Classification of Financial 2.7.4 Weakness of the Indian Banking
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Institutions 13 System 41
2.7.5 Remedial Measures Adopted to
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1.3 Types of Finance 16

1.3.1 Rudimentary Finance 16 Remove the Weaknesses of the
1.3.2 Direct Finance 17 Indian Banking System 42
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1.3.3 Indirect Finance 18 2.8 Commercial Banks 44

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1.4 Structure of Indian Financial System 19 2.8.1 Functions of Commercial

1.4.1 Phase 1: Pre-1951 or Pre-planning Banks 44
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Era 20 2.8.2 Importance of Commercial

1.4.2 Phase 2: 1951 to Late 1980s 21 Banks 46
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1.4.3 Phase 3: Post-1990 or Post- 2.8.3 Credit Creation by Commercial

liberalization Era 22 Bank 47
1.5 Organizational Structure of the Indian 2.9 High-powered Money 50
Financial System 24 2.10 Money Multiplier 51
1.5.1 Financial Institutions 24 2.11 The Reserve Bank of India 52
1.5.2 Financial Markets 24 2.11.1 Origin 53
1.5.3 Financial Instruments 25 2.11.2 Organization and the
1.5.4 Financial Services 25 Management of the RBI 53
1.5.5 Financial Regulators 25 2.11.3 Objectives of the RBI 54
1.6 Reform or Changes in the Indian 2.11.4 Functions of the RBI 55
Financial Sector 26 2.11.5 Instruments of Credit Control 58
2.11.6 Monetary Policy 64
2. Money and Banking System 32 2.11.7 Evaluation of Monetary Policy of
2.1 Introduction 32 RBI in India 66
2.2 Origin and Evolution of Money 33 2.11.8 The Monetary Policy
2.3 Definition of Money 33 Committee 67

x Contents
3.6.1 Introduction 95
3. Development Banks 72
3.6.2 Current Status of NABARD 95
3.1 Introduction 72 3.6.3 Capital Structure of
3.2 Definition of Development Bank 73 NABARD 95
3.2.1 Objective of Development
3.6.4 Share Holding Pattern of
Bank 73
NABARD 95
3.2.2 Role/Functions of Development
3.6.5 Management of NABARD 96
Banks 75
3.6.6 Objectives of NABARD 97
3.3 Industrial Finance Corporation of India
3.6.7 Functions of NABARD 97
(IFCI) 76
3.7 Export–Import Bank of India
(EXIM Bank) 100
3.3.2 Current Status of IFCI 77
3.3.3 Capital Structure of IFCI 77
3.7.2 Objectives of EXIM Bank 100
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3.3.4 Share Holding Pattern IFCI 77
3.7.3 Role/Functions of EXIM
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3.3.5 Management of IFCI 78
Bank 101
3.3.6 Objectives of IFCI 78
3.8 State Finance Corporation (SFC) 101
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3.3.7 Role/Functions and Operating
Policies of IFCI 80 3.8.1 Introduction 101
3.8.2 Objectives of SFC 102
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3.3.8 Subsidiary Functioning 82
3.8.3 Role/Functions of SFC 102
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3.4 Industrial Development Bank of India
(IDBI) Limited 83 3.9 Small Industries Development Bank of
India (SIDBI) 103
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3.4.2 Current Status of IDBI Bank 3.9.1 Introduction 103
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Limited 83 3.9.2 Objectives of SIDBI 104

3.9.3 Role/Functions of SIDBI 104
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3.4.3 Capital Structure of IDBI Bank

Limited 84
3.4.4 Shareholding Pattern of IDBI
4. Other Financial Institutions 108
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Bank Limited 84 4.1 Financial Institutions 108

4.2 Insurance 109
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3.4.5 Management of IDBI Bank

Limited 85 4.2.1 Importance or Needs of Insurance/
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3.4.6 Objectives of IDBI Bank Insurance Organizations 110

Limited 86 4.3 Life Insurance Corporation of India
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3.4.7 Functions of IDBI Bank (LICI) 112

Limited 87 4.3.1 Introduction 112
3.5 Industrial Credit and Investment 4.3.2 Organizational Set Up of
Corporation of India (ICICI) LICI 112
Bank Ltd 89 4.3.3 Objectives of LICI 112
3.5.1 Introduction 89 4.3.4 Functions of LICI 115
3.5.2 Current Status of ICICI 89 4.3.5 Total Investment of LICI in
3.5.3 Capital Structure of ICICI 90 2015–2016 118
3.5.4 Share-holding Pattern of 4.3.6 Investments of LICI as on 31 March
ICICI 90 2016 (In Rupees Billion) 118
3.5.5 Management of ICICI 90 4.4 General Insurance Corporation of India
3.5.6 Objectives of ICICI 91 (GICI) 118
3.5.7 Functions and Operating Policies 4.4.1 Introduction 118
of ICICI 92 4.4.2 Organizational Structure of the
3.6 National Bank for Agriculture and Rural GICI 119
Development (NABARD) 95 4.4.3 Objectives of the GICI 120

Contents xi
4.4.4 Functions of GICI 121 5.3 Basic Functions of Interest 145

4.5 Reforms in the Insurance Sector 5.4 Types of Interests 145
and the Evolution of Insurance 5.4.1 Gross Interest 145
Regulatory Development Authority 5.4.2 Net Interest 146
(IRDA) 123 5.5 Nominal and Real Interest Rate 147
4.5.1 Recommendations of the 5.6 Relationship between Short-term and
Committee 124 Long-term Interest Rates 147
4.6 Insurance Regulatory Development 5.7 Determinants of Interest Structure/
Authority (IRDA) 125 Factors Affecting Interest Rate
4.6.1 Management of IRDA 126 Structure 147
4.6.2 Objectives of the Formation of 5.8 Theories on Term Structure of Rate of
IRDA 126 Interest 149
4.6.3 Powers and Functions of 5.8.1 The Expectations Theory 150
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IRDA 126 5.8.2 Liquidity Premium Theory 151
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4.7 Unit Trust of India 127 5.8.3 Market Segmentation
4.7.1 Origin and History of the Theory 151
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Evolution of UTI 127 5.9 Differential Interest Rate: Causes
4.7.2 Organizational Set Up of of Variations or Differences in the
UTI 128
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4.7.3 Management of UTI 128 5.9.1 Difference in Pure Interest 152
4.7.4 Objectives of UTI 128 5.9.2 Difference in Gross Interest
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4.7.5 Functions of UTI 131 Rate 153

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4.7.6 Progress of Unit Trust of 5.10 Theories of Determination of Rate of

India Since its Inception: Interest 154
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The Rise and Fall of the 5.10.1 Classical Theory of Interest Rate

US-64 Schemes 132 Determination 154
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4.7.7 Recovery Phase and 5.10.2 Loanable Fund Theory 156

Recent Changes in the 5.10.3 Liquidity Preference
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Organizational Structure of Theory 158

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UTI 135 5.10.4 Hicks–Hansen Theory 161

4.7.8 Some Mutual Funds of 5.11 Relationship between Interest Rate and
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UTI 137 Economic Progress 162

4.8 Mutual Funds 137 5.12 Administered Interest Rate and Market-
4.8.1 Introduction 138 determined Interest Rate 162
4.8.2 Organization of Mutual 5.13 Interest Rate Structure in Indian
Funds 138 Economy—Recent Changes in the
4.8.3 Types of Mutual Funds 139 Interest Rate Structure of India 163
4.8.4 Advantages of Mutual 5.13.1 Phase 1 (1948–1960) 163
Funds 139 5.13.2 Phase 2 (1960–1985) 163
4.8.5 Disadvantages and Limitations of 5.13.3 Phase 3 (1985–2000) 164
Mutual Funds 141 5.13.4 Phase 4 (2000 onwards) 165
4.8.6 Calculation of Net Asset Value
(NAV) 141 6. An Overview of
Financial Markets in India 173
5. Interest Rate Structure 144 6.1 Introduction 173
5.1 Introduction 144 6.2 Features of the Indian Financial
5.2 Concept of Interest 144 Market 173

xii Contents
6.3 Classification of Financial Markets in 7.9.3 Discount Houses in India 210

India 175 7.9.4 Role and Functions of
6.3.1 Money Market 175 DFHI 210
6.3.2 Capital Market 177 7.10 Money Market Reforms and Recent
6.3.3 Foreign Exchange Market 178 Trends in the Money Market 211
6.3.4 Derivative Market 179 7.10.1 Narasimham Committee
6.4 Regulators of Indian Financial Recommendations 211
Market 184 7.10.2 Reform Measures in the Indian
6.4.1 Central Government 185 Money Market 211
6.4.2 Reserve Bank of India 185
6.4.3 Company Law Board 185 8. Capital Market 216
6.4.4 Security and Exchange Board of 8.1 Concepts and Definition 217
India (SEBI) 185 8.2 Features of Capital Markets 217
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6.4.5 Insurance Regulatory 8.3 Funtions of Capital Market 218
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Development Authority 186 8.4 Structure of Capital Market 220
8.5 Participants or Constituents of Capital
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7. Money Market 189 Market 220
7.1 Introduction 189 8.6 Indian Capital Market 222
7.2 Money Market—Concept and
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Significance 189 Growth of Indian Capital
7.3 Participants in the Money Market 190 Market 222
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7.4 Conditions for Developed Money 8.6.2 Nature and Features of the Indian
Market 190 Capital Market 223
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7.5 Importance/Functions of the Money 8.6.3 Capital Market Reforms in

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Market 192 India 225

7.6 Indian Money Market 193 8.7 Securities Market 227
7.6.1 Structure and Participants of 8.7.1 Primary/New Issue
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Indian Money Market 193 Market 228

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7.6.2 Features or Characteristics of 8.7.2 Secondary Market 241

Indian Money Market 195
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7.6.3 Limitations of the Indian Money 9. Investors’ Protection 277

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Market 197 9.1 Introduction 277

7.7 Money Market Instruments 199 9.2 Need and Importance of Investors’
7.7.1 Treasury Bill Market 199 Protection 278
7.7.2 Commercial Bill Market 200 9.3 Investors’ Grievances Regarding Stock
7.7.3 Certificate of Deposit Exchange Dealings in India 279
(CD) 201 9.3.1 Unethical and Illegal
7.7.4 Commercial Paper Market 202 Activities 279
7.7.5 Repo and Reverse Repo 203 9.3.2 Illegitimate Speculation 280
7.7.6 Call Money Market 203 9.3.3 Unnecessary Delay in Refund of
7.8 Acceptance House 208 Excess Application Money 280
7.8.1 Importance/Functions of 9.3.4 Inadequate Protection Measures
Acceptance House 208 for Investors 280
7.9 Discount House 208 9.3.5 Abnormal Delay in Transmission
7.9.1 Features of Discount House 209 of Share Certificates 280
7.9.2 Importance and Functions of 9.3.6 Lopsided Growth 281
Discount House 209 9.3.7 Excessively Slow Progress 281

Contents xiii
9.3.8 Inadequate and Short Trading 10.2.4 Non-preserving or

Hours 281 Concomitant 304
9.3.9 Oligopolistic Nature of Share 10.2.5 Information Technology
Market 281 Based 304
9.3.10 Ill-developed Debenture 10.2.6 Innovation Prone 304
Market 282 10.2.7 Advisory in Nature 304
9.3.11 Unfavourable for Small 10.2.8 Professionally Managed 304
Investors 282 10.3 Types of Financial Services 305
9.3.12 Payment Crisis 282 10.3.1 Fund-based Financial
9.3.13 High Volatility 282 Services 305
9.3.14 Lack of Depth 283 10.3.2 Fee-based Financial
9.3.15 Manipulation in Price 283 Services 305
9.3.16 Insider Trading 283 10.4 Merchant Banks 306
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9.4 Grievance Redressal Cell in Stock 10.4.1 Origin of Merchant
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Exchanges 285 Banking 307
9.4.1 Objectives and Functions of 10.4.2 Evolution of Merchant Banking
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Grievance Redressal Cell 285 in India 307
9.5 Securities and Exchange Board of India 10.4.3 Nature and Features of Merchant
(SEBI) 287
y Banks 308
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9.5.1 Organization and 10.4.4 Functions of Merchant
Structure 287 Banks 309
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9.5.2 Objectives of SEBI 288 10.4.5 Role and Importance of Merchant

9.5.3 Role and Functions of Banks 311
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SEBI 290 10.4.6 SEBI Guidelines Regarding

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9.6 Company Law Board (CLB) 293 Merchant Bank Activities 314
9.6.1 Power of CLB 294 10.5 Credit Rating 319
9.6.2 Functions of CLB 295 10.5.1 Concepts of Credit Rating 319
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9.6.3 National Company Law Tribunal 10.5.2 Origin of Credit Rating 321
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(NCLT) 295 10.5.3 Objectives of Credit

9.7 Role of Judiciary in Investors’ Rating 322
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Protection 296 10.5.4 Functions of Credit

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9.8 Role of Media in Investors’ Rating 323

Protection 297 10.5.5 Importance/Advantages of Credit
Rating 325
10. Financial Services 303 10.5.6 Limitations of Credit
10.1 Introduction 303 Rating 326
10.2 Features of Financial Services 303 10.5.7 Procedure of Credit
10.2.1 Non-tangible 304 Rating 327
10.2.2 Customized Service 304 10.5.8 SEBI Guidelines for Credit
10.2.3 Ever-changing 304 Rating Agencies 330
10.5.9 Profile of Rating Agencies 332
Question Bank 342

Solved Question Papers 433
Model Question Papers 447
About the Author 450

Road Map to Indian Financial System
MODULE 1
Unit Topic Details Chapter
Unit I Financial System Meaning and significance; Role of finance in an economy; Components (instruments, 1
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markets, etc.); Kinds of finance – Rudimentary finance, direct and indirect finance;
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Role of financial intermediaries; The structure of Indian financial system
Unit II Money and Indian Functions; Alternate measures to money supply in India – Their different 2
Pr
Banking System components; Commercial banks – Importance and functions; Structure of
commercial banking system in India; Distinction between commercial and central
y
bank; Credit creation process of commercial banks; High powered money – meaning
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and uses – Concept of money multiplier
The Reserve Bank of India: Functions; Instruments of monetary and credit control;
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Main features of monetary policy since independence
Unit III Development Banks Concept of development banks, and their needs in Indian financial system – 3
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Differences with commercial banks – Major development banks and their functions
(IFCI, IDBI, ICICI, EXIM Bank, SIDBI, SECs, NABARD)
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Unit IV Other Financial Introduction; Life Insurance Corporation of India, General Insurance Corporation of 4
Institutions India, Unit Trust of India
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Unit V Interest Rate Meaning – gross and net interest rate – their difference; Nominal and real interest 5
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Structure rate – their difference; Differential interest rate, Causes of variation of interest rate,
relationship between interest rate and economic progress; Administered and market-
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determined interest rate; Recent changes in interest rate structure in India

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MODULE 2
Unit Topic Details Chapter
Unit I Overview An Overview of Financial Markets in India 6
Unit II Money Market Concept; Structure of Indian money market, Acceptance houses; Call money market; 7
Recent trends of Indian money markets
Unit III Capital Market Concept; Security market, Primary and secondary markets – Functions and role; 8
Functionaries of stock exchanges – Brokers, sub-brokers, jobbers, consultants,
institutional investors, and NRIs
Unit IV Investor’s Protection Grievances concerning stock exchange dealings and their removal, Grievance 9
redressal cell in stock exchanges; Role of the SEBI; Company Law Board, Judiciary
and media
Unit V Financial Services Merchant banking – Functions and roles; SEBI guidelines; Credit rating – concept & 10
types, functions and limitations; Profile of Indian rating agencies

CHAPTER
6
An Overview of
Financial Markets in India
Learning Objectives
After studying this chapter, you should be able to
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• understand the features, roles, and classifications of the financial market
• identify the variations in the organized and unorganized financial market
• recognize the features and functions of the foreign exchange market
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• explain the features of the derivatives
• classify the different derivatives
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• understand the concepts and features of forward, future, options, and swaps
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• distinguish between forward and future, future and options, and call option and put option
• identify the regulators of the Indian financial market
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6.1 INTRODUCTION
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Financial market refers to a centre that provides the facilities of sale and purchase of financial claims and ser-
vices. The individuals, financial institutions, corporations, and government trade in this market either directly
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or indirectly through brokers and dealers. If we want to analyse the financial market of a nation, then initially,
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we should concentrate on the various financial markets of that nation, various financial institutions operating
on those markets, and the financial instruments and services available in those markets.
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The financial market generally plays a vital role in transferring funds of the surplus units into the produc-
tive sectors of the economy. Thus, this market is involved in proper channelization of savings, which in turn
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leads to the capital formation and economic development. Allocation of funds into the productive sectors of
the economy implies a growth in the national income (Fig. 6.1).
6.2 FEATURES OF THE INDIAN FINANCIAL MARKET

The effectiveness of financial system is one of the main determinants of the economic development. However,
the efficacy of the financial system hugely depends on the working capacity of the financial market. In that
sense, financial market plays a vital role in the balanced economic development of the nation. The basic
essence of financial market cannot be properly understood without analysing the features of the financial
market. Hence, it will be convenient for the readers if we will discuss the features of financial market in the
following way
1. Coexistence of organized and unorganized segments Indian financial market is character-
ized by the coexistence of organized and unorganized segments. The organized financial market com-
prises commercial banks, cooperative banks, and development banks. The regulators in this segment are

174 Indian Financial System
Financial markets
Foreign exchange
Money markets Capital markets Derivative markets
markets
Organized Unorganized
1. Call money
2. Commercial bill
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3. Treasury bill
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Equity Debit
4. Commercial paper
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5. Certificate of deposit
6. Repo and reverse repo
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Primary Secondary
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Forward Future Option Swap

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Call option Put option

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or
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Currency swap Interest rate swap Debt-equity swap

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Fig. 6.1 Financial market
Reserve Bank of India (RBI), Security and Exchange Board of India (SEBI), etc. Conversely, the par-
ticipants in the unorganized segment are beyond the control of the regulators. The rural moneylenders
occupy a significant portion of unorganized market.
2. Insufficient participation In India, the per capita income is low, which leads to a low rate of savings
and investment. The low rate of savings is responsible for insufficient participation of investors in the
financial market.
3. Mobilization of savings The financial market acts as the medium in the process of transfer of funds
from savers to investors. Indian financial market also ensures flow of funds from savers to the productive
sectors of the economy.
4. Presence of regulatory bodies The Indian financial market comprises both money and capital
market, which are regulated by some institutions such as Ministry of Finance, RBI, SEBI, Insurance
Regulatory and Development Authority (IRDA), and National Company Law Tribunal (NCLT).

An Overview of Financial Markets in India 175
5. Faulty banking network In India, most of the scheduled commercial banks are interested to estab-
lish their branches in the urban areas for profit motive. Hence, the number of banks in the rural areas is
very limited. This leads to an unbalanced development in the banking sector.
6. Inefficient capital market The efficiency of the Indian capital market is not up to the mark. Before
the adoption of the new economic policy in 1991, the capital market was ill-developed. However, after the
adoption of new economic policy, there were a lot of positive changes in the capital market. Foreign cap-
ital was flown to Indian capital market. Thus, there was an improvement but was definitely insufficient.
7. Limited coordination Since a significant portion of the financial market in India is characterized by
unorganized segment, there was clearly a lack of coordination between the different units of the Indian
financial market.
8. Lopsided development The financial markets in India are not equally developed in different
regions. The financial markets are fragmented, and accordingly, the coordination among them is not so
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strong. Thus, the Indian financial market is characterized by lopsided development.
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9. Parallel economy In India, besides the conventional economy, we observe a parallel economy where
the transactions occur without any specific rules and regulations. This leads to the generation of unac-
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counted or black money in the financial system.
10. Paucity of financial instruments As the financial market in India is not that vast, the possibility of
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introducing new financial markets is very limited. Though, after 1991, when the new economic policy
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was adopted, some measures were taken to develop the capital market. Some new financial instruments
are introduced in recent times also. However, there is a long way to travel, as still we have a very limited
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usage of the financial instruments compared to the other developed nation of the world.
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11. Huge corruptions and scam The Indian financial market experienced huge corruptions and scams.
The scams related to Harshad Mehta and Ketan Parekh destroyed the faith of investors on the financial
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market. Government of India established SEBI in 1992 to prevent the malpractices specifically in the
Indian financial market.
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However, the financial market in India helps to develop the financial system, assists in the process of capital
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formation, helps in transaction, and plays an important part in increasing the volume of trade. Apart from
this, an efficient financial market leads to creation of new job opportunities in India.
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6.3 CLASSIFICATION OF FINANCIAL MARKETS IN INDIA

We can classify the Indian financial market into the following categories:
(i) money market (ii) capital market
(iii) foreign exchange market (iv) derivative market
Many financial experts classify the Indian financial market in a different way, and a few considered the
derivative market as a part of the Indian capital market. However, we have considered derivative market as
a separate part since it is not only related to equity but also to currency and commodity. Now, we will briefly
explain the different parts of the Indian financial market briefly, because most of these components will be
discussed in a broader way in the subsequent chapters.
6.3.1 Money Market

The financial market that deals with short-term securities and claims (with a period of maturity of 1 year or
less) is known as money market. Indian money market plays a significant role in the economic system as it effi-
ciently ensures the transfer of funds from savers to investors. The short-term surpluses of the fund providers

are channelized into the hands of fund seekers. Here, the short term refers to the time period between 1 day
and 1 year. The main instruments for the short-term transactions in this market are bank draft, cheques, bill
of exchange, and pay-orders.
Indian money market can be subdivided into
(i) organized money market (ii) unorganized money market
6.3.1.1 Organized money market

The part of money market where financial transactions occur according to proper regulations and norms
is known as organized money market. In India, the organized money market comprises RBI, nationalized
commercial banks, cooperative banks, insurance organizations, development banks, mutual funds, etc. There
is a close interlinkage among the various units of this market, and, hence, the components of this market are
organized and compact. Indian organized money market comprises:
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1. Call money market The part of the money market where day-to-day transactions of surplus funds
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occur is known as call money market. This market provides short-term funds, and the time of repayment
varies from 1 to 14 days. Call money has the maximum liquidity and considered as a very safe loan.
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In India, the scheduled commercial banks, discount and finance house of India, and many primary deal-
ers participate in this market. The other financial institutions and mutual funds can only provide loans in
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this market. The call money market basically meets the temporary crisis of funds and protects the cash
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reserve ratio of the banks. In India, the call money market is very much controlled and narrow. The entry
is restricted, and, hence, there are a number of borrowers in the market but the number of lenders is
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very few. That is why the participants in this market do not get any active market. However, the situations
have changed after 1985 where committees of both Chakraborty and Bhagal recommended increasing
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the activity of the call money market.

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2. Commercial bill market The market in which we observe the transactions of commercial bills is
known as the commercial bill market. Now, commercial bills refer to the bills against which the industrial
and business concerns receive short-term loans from the commercial banks. These short-term loans are
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received to meet the requirement of the circulating capital.

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The commercial bills involve three parties such as drawer or bill-preparer, drawee or bill-subscriber, and
payee. The commercial bills are in the written form, which should be signed for authenticity. Generally,
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the use of commercial bills enhances the size of goods market, provides liquidity, and expands credit
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facilities. It is transferable and legally authenticated.

3. Treasury bill market Treasury bill refers to a commercial bill or a financial instrument issued by
the central bank on behalf of the government to meet the short-term liquidity problem. The market in
which the transactions of the treasury bills occur is known as treasury bill market. In India, RBI has the
power to issue the treasury bills. However, prior to 1950, the state governments also accumulate funds
through the treasury bills. Treasury bills are very useful in bridging the gap of the fiscal deficits.
The treasury bills are basically liquid in nature, which involve a very low transaction cost. Since it is
issued by the government, the risk associated is minimal. On the basis of the tenure, the treasury bills are
of four types—14-, 91-, 182-, and 364-day T-bills.
Although treasury bills have numerous advantages, still the Indian T-bill market is ill-developed. Even
after 1991, when most of the restrictions are withdrawn, the T-bill market failed to reach its optimum
level in India.
4. Certificate of deposit market Certificate of deposits that are issued by the commercial banks
and development financial institutions in bearer forms refer to the short-term and unsecured negotia-
ble instruments. The market in which they are traded in exchange is known as certificate of deposit
market.

Certificate of deposit was introduced in India in June 1989. The commercial banks accept the term-de-
posits by issuing this type of certificates. This certificate is transferable in nature whose tenure varies from
15 days to 1 year. The minimum amount deposited is fixed at `100,000.
5. Commercial paper market The commercial paper, that is negotiable in nature, implies a short-
term promissory note issued by the big and highly rated companies. The market that deals with commer-
cial papers is known as commercial bill market. These are issued by the companies to raise the short-term
fund required for working capital. The commercial papers are unsecured and can be exchanged.
Commercial papers are used in India since 1990. An individual, an institution, a company, or a bank can
invest in commercial papers. Generally, the tenure varies from 7 days to 1 year, and the minimum amount
required for investment is `5 million. In India, the commercial paper market plays a significant role.
6. Repo and reverse repo Repo and reverse-repo are one of the latest inclusions in the money market,
which are compatible with the recent diversifications in the financial market in India. All these diversifi-
cations actually strengthen the financial markets of India.
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Repo or repurchase agreement is the transaction in which a financial institution or a bank receives funds
immediately by selling securities with an agreement to repurchase the same at a specified pre-determined
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price after a specific time period. Hence, repo is applicable only if there is a short-term crisis of funds.
Conversely, in case of reverse repo, a financial institution or a bank purchases a security with an agree-
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ment to sell it back on a specific date at a pre-determined price.
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Apart from the above-mentioned components, the mutual funds and inter-bank participation certificates are
also notable, which will be discussed elaborately in the subsequent chapters.
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6.3.1.2 Unorganized money market

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The part of the money marker where all the transaction occurs without any regulations or norms is known as
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unorganized money market. In the unorganized market, there is a very weak linkage among the various units.
In India, the unorganized market occupies a significant portion of the money market. Often, their activities
are beyond the control of RBI.
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The important components of the unorganized financial market in India are local moneylenders, rural
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moneylenders, chit funds, business person, shroffs, etc. The organized sectors are not interested to operate
in the rural economy due to low profit potential. Hence, the unorganized sector grabs the opportunities of
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investing in the rural economy of India. Naturally, the lending rate is very high in the rural sector, which leads
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to a considerable amount of exploitation of the rural mass. The economic development varies inversely with
the presence of unorganized sector in the economy.
6.3.2 Capital Market

The financial market that deals with the long-term claims and like money market ensures the flow of funds
from surplus to deficit units is known as capital market. This market provides long-term finance (with a period
of maturity of more than 1 year) to the trade, industry, and commerce. It is different from the money market
on the basis of the period of maturity of the financial assets.
In India, capital market is mainly constituted by investment trust (such as UTI), insurance companies
(LICI and GICI), specialized financial institutions (such as IFCI, IDBI, and ICICI), and security market.
The capital market can be subdivided into
(i) equity market or security market (ii) debt market
Few experts considered derivative market as a part of capital market, but since it involves capital, commod-
ities, and currency, we have considered the derivative market as a separate and distinguished portion of the
capital market.

6.3.2.1 Equity market

It refers to capital market that deals with shares and debentures of various joint stock companies. The equity
market in India can be subdivided into:
1. Primary or new issue market The financial market that deals with new financial claims or securi-
ties is known as primary market. As this part of financial market deals with new securities, it is known as
‘new issue market’. In the primary market, the securities issued by corporate or government come into
the hand of owner.
2. Secondary market The financial market that deals with the already existing or new securities is
known as secondary market. Thus, in the secondary market, existing securities are sold and purchased.
Secondary market is also known as ‘stock market’ or ‘aftermarket’. This market has the capability of
providing liquidity to the securities issued in the primary market.
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6.3.2.2 Debt market
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Debt market essentially indicates the bond market. The debt market occupies a major portion of the financial
market, and actually, it covers more than the equity market in terms of volume. The debt market can be clas-
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sified as corporate debt market, government securities market, and public sector undertaking bond market.
This market is able to maintain the liquidity of the financial market. It provides finance to government for
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developmental activities. However, the principal function of this market is to channelize the surplus fund of
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the savers to the productive sectors of the economy.
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6.3.3 Foreign Exchange Market

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Foreign exchange market refers to a market in which domestic currency or claims are exchanged for foreign
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currencies. In an open economy, foreign exchange market has a vital role to play. It refers to a centre where
we observe the transactions between buyers and sellers of foreign exchange. In other words, it is the market in
which currency of one nation is exchanged for the currency of the other nation (Fig. 6.2).
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6.3.3.1 Features of the foreign exchange market

The basic features of foreign exchange markets are
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1. International transactions The transactions of one nation with other nations are known as inter-
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national transactions. The foreign exchange market is the centre of international transactions.
International transaction
Currency of one nation is
exchanged for currency of Round the clock functions
another nation Voluminous transactions
Lower trading cost
Sufficient liquidity
Arbitrage hedging
Foreign exchange market Features
speculation
High transparency
Big players’ market
Worldwide presence
Transaction of foreign Exchange rate fluctuations
exchanges
Emerging activities
Fig. 6.2 Foreign exchange market

2. Round the clock functions Except for the weekends, foreign exchange market is open 24 hours a
day. It should be noted that it is the only market that is always open except for the weekends.
3. Huge volume of transactions The foreign exchange market is characterized by the presence of a
number of big players. Thus, the volume of transactions executed in forex market is huge.
4. Lower trading costs The trading cost in the forex market is comparatively low. So, it is possible for
the small, individual investors to make a considerable amount of profit from various transactions.
5. Liquidity Owing to the presence of numerous big players in the market, the transactions are volumi-
nous. This leads to sufficient liquidity in this market.
6. Transparency Transparency in the forex market implies the free access to the trading information.
The players in the forex market have the full access to the data and relevant information, which are nec-
essary to perform a profitable transaction. In that sense, forex market is extremely transparent.
7. Big players’ market The big and reputed banks and the governments of different countries par-
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ticipate in the foreign exchange market as the players. Hence, forex market is known as the big players’
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market.
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8. Worldwide presence As the forex market is present in every nation, it can be said that they are
located everywhere in the world geographically. This is naturally a unique feature of the forex market.
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9. Exchange rate fluctuations Since the demand and supply conditions in the foreign exchange mar-
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ket are continuously changing, the market is characterized by exchange rate fluctuations.
10. Emerging activities The fluctuations in the exchange rate of the forex market give birth to some
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activities or professions namely arbitrage, speculation, and hedging. Arbitrage refers to the buying of a
currency from the financial centre where it is cheap and simultaneously selling of it where it is expensive.
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Hedging implies covering or minimizing the risk. Conversely, speculation is the deliberate assumption of
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the risk associated with fluctuations in the exchange rate.

Thus, foreign exchange market enables the players to perform international transactions. Its transparency
and round the clock function increase the volume of transactions and trade. Evidently, the presence of a
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strong forex market strengthens the financial market of a nation.

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6.3.4 Derivative Market

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Financial derivative is treated as an integral part of the financial market in these days. It is a well-known
fact that the financial market is quite volatile, and, hence, the investors have to take the possibility of risk
into consideration for every transaction. This calls for the introduction of the concept of derivative. The
derivatives become the most modern financial instruments for minimizing the risk. These instruments
are known as ‘derivatives’ because they derive their values from some underlying assets such as agricul-
tural commodities, shares, currencies, gold, silver, and other commodities. Hence, it is evident that the
derivative techniques can be applied in capital, commodity, and foreign exchange markets.
Thus, derivatives are defined as written contracts between two different parties, which have no
intrinsic value of its own, but it is derived from the underlying assets such as currencies, commodities,
and gold. The risk-averse people interact with the risk-lovers through derivatives, and the common
place of interaction between them is known as derivative market. In this context, derivatives act as
risk-shifting instrument (Fig. 6.3).
6.3.4.1 Features of derivatives

Derivatives have the following features:
• It is an important financial instrument, which is used to reduce the market risk.

• It has no intrinsic value of its own—its value is derived from underlying assets such as commodity, currency, and
capital.
• Derivatives involve low transaction costs and raise liquidity in the financial system.
• Sometimes, derivatives assist the traders as they predict the market movements.
• The presence of derivatives in the financial market strengthens the composition and depth of the market.
• Derivatives in the financial market are used for hedging and speculation.
• Derivatives are traded globally that indicates their popularity in the financial market.
• The types of derivatives are forward, future, options, swaps, and warrants.
6.3.4.2 Classification of derivatives

The popular types of derivatives that are used in the financial market are
• forward contracts • options
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• future contracts • swaps
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We will briefly explain these different derivative techniques of the financial market.
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1. Forward contracts
The derivative contract where a buyer and a seller are agreed to exchange a commodity or instru-
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ment for cash at a pre-determined price at a pre-determined date, agreed upon today, is known as
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forward contract.
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The stipulated or the pre-determined price is known as forward price.
Let on 15 August 2016, company A makes an agreement with company B, that on 15 November 2016, it
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will buy 2 kg of gold at `2.5 million/kg. Let on 15 November, the market price (also known as spot price)
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of per kilogram gold becomes `30 million which implies a gain of (2 × 30 million − 2 × 25 million) or
`10 million for the buyer. If the contract is cash-settled, then the seller will just pay the profit, that is
`10 million to the buyer rather than giving him 2 kg of gold.
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a) Features of forward contract The salient features of the forward contracts are:
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i. Customized contract The contract between buyer and seller is made according to their mutual
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decisions. The contract is customized in the sense that it can vary from parties to parties depend-
ing on mutual decision-making, which serves the needs of both the parties.
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Customized and
Written contract between Forward
OTC contract
two different parties
Low transaction cost Standardized and exchange
based contract
Predict market movements Future
Call
Derivatives Types
Contractual agreement with
Strengthen the depth of the Options right but no obligation
market
Increase liquidity Put
Value is derived from the Customized contracts to
underlying assets Swap exchange cash flow
Fig. 6.3 Derivative market

ii. Settlement of future transactions In this type of contract, the agreement is made for a transaction in
future while the future price and date of transaction are agreed upon today.
iii. Associated risk Naturally, the parties involved in the forward contract are exposed to risk during
the validity of the contract.
iv. Settlement The contract is settled at its date of expiry, when one of the parties make profit in
terms of cash or other assets. The forward contracts can be settled by physical delivery of the
asset or cash settlement at the date of expiry or delivery date.
v. Vast applicability The forward contract can be observed in foreign exchange market, capital
market, or commodity market, which shows its vastness and wide acceptability.
vi. Bilateral The forward contract is bilateral in nature, which involves a buyer and a seller. The
agreements about pre-determined price, delivery date, etc. are negotiated bilaterally by the par-
ties involved.
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vii. Absence of direct cost One of the reasons for the popularity of the forward contract is the absence
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of direct cost in this agreement. In case of a cash settlement, the buyer or seller has to pay only
the cash difference between agreed upon price and spot price. There is no exchange of money
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between the parties at the time of making the contract.
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viii. Over-the-counter trade Forward contracts trade over the counter. Trading of forward contracts on
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any recognized stock exchange is not familiar.
2. Future contracts A future contract refers to a standardized contract between two parties to purchase
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or sell an asset at a specified time in future for a certain price agreed by the parties involved. It is often
termed as a special type of the forward contract, which is standardized in nature and exchange traded.
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The price agreed upon is known as future price.

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a) Features of future contract The future contract has the following features:
i. Standardized in nature The future contracts are standardized in nature. It is characterized
by few standardized specifications such as date and month of delivery, quantity, and price
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quotations.
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ii. Liquidity Future contracts are highly liquid in nature, which makes it popular in the financial
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market.
iii. Period of contract The period of future contracts generally varies from 3 to 21 months.
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iv. Exchange traded Unlike forward contracts, future contracts are standardized and exchange
traded. This implies future contracts are traded on the exchange subject to the specific rules and
regulations of the exchange.
v. Presence of margin payments The future contract is characterized by the margin requirements.
Margin money should be paid by both buyers and sellers.
vi. Limited number of contracts The number of contracts is limited in case of future contracts. It is
generally limited between 4 and 12 in a year (Table 6.1).
3. Options
An option refers to a contractual agreement that ensures a right, but not the obligation, to buyer or
the seller to buy (in a call option) or to sell (in a put option) a specific instrument at a per-determined
price (which is known as strike price) on or before the specified date in the future.
The maker of the option is known as option writer and the holder of the option as option buyer. The
holder of the options has to pay the price of the options, which is known as ‘premium’. The premium is
determined by the expected variance in price in future, market liquidity, rate of interest, dividend, etc.

Table 6.1 Distinction between forward and future contracts

Basis of Difference Forward Future
Definition It is a derivative contract where the traders It refers to a standardized contract that is traded in
make an agreement to exchange goods for future at exchange. It provides an assurance by the
cash at a pre-determined future date and at a exchange authority to trade a security, good, or currency
stipulated price agreed upon today at a pre-determined date at a price agreed upon today
Nature of transactions They are OTC contracts They are exchange traded
Delivery Generally, a single delivery date Generally, a range of delivery dates
Liquidity No liquidity Highly liquid
Credit risk They involve credit risk They do not involve credit risk.
Margin No margin requirements Both buyer and trader have to pay margin money
Risk of counterparty Exists Non-existent
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Regulation Generally traded in an unregulated market Financial regulators regulate the transactions
Contract price Not disclosed publicly Publicly disclosed
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Settlement of date They are settled in the maturity date They can be settled on or before maturity date
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Profit or loss It is realized when the contract matures sit It is realized on daily basis
It should be noted that, if the option buyer does not exercise the option, then he/she will only lose the
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amount of premium.
a) Features of option The option is an important derivative technique practiced all over the world
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including India. The salient features of the options are:

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i. Transaction right The options provide the opportunities to buy and sell some underlying assets
such as securities, currencies, and commodities. It is only exercisable by the option holder.
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ii. No obligation Though the option holder has the right to buy or sell the underlying assets such as
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securities, commodities, and currencies, there is complete absence of obligation. In case of huge
losses, the holder will not exercise the option and, instead, only pay the premium prices.
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iii. Strike price/exercise price

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The price at which the transactions of underlying assets have been performed is known as
the strike price. It is also known as the ‘exercise price’.
iv. Time limit European option can be exercised only on the date of maturity. However, American
option can be exercised any time prior to the maturity date or in the maturity date.
v. Types of options The options are of two types call options and put options. In case of call
options, the holder has the right to purchase the assets if market price is greater than strike price.
Conversely, in case of put option, the holder has the right to sell the assets if market price falls
below the strike price.
vi. Difference from shareholder An option holder and share holder is completely different from each
other in terms of various rights. The shareholders enjoy voting rights, dividends, etc. An option
holder has no such rights.
b) Types of option As we have mentioned earlier, options are of two types call option and put option.
i. Call option Call options offer the right (not obligation) to the investor or option holder, to pur-
chase the underlying assets such as commodity, currency, or securities by a specified date or
before at a certain price. If the option holder exercises his right, then the seller has the obligation

to fulfil the contract. An investor opts for call if he/she expects that market price will go above
the strike price.
We can explain the process of call option through the following example. Let the listing price of
the share X in the share market be `100. The premium price per share is determined at `20.
Let an investor or the option holder purchase a call option to buy 100 shares at `250 after 3
months. Now, let the spot/market price becomes `350 after 3 months. Here, the option holder
will definitely exercise his right by paying `25,000 to the seller. Here, his/her net gain will be
[(spot/market price - strike price) - premium price] × no of shares, that is `[(350 − 250) − 20]
× 100 = `8000. However, if after 3 months, the market price of X falls to `75, then naturally,
the option holder will not exercise his/her option to avoid the possible loss, as he/she has no
obligation. In that case, he/she has to pay only the premium price, that is `20 × 100 = `2000.
Thus, his/her maximum loss will be the premium price.
ii. Put option Put option offers the right (not obligation) to the investor or option holder to sell the
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underlying assets such as currency, commodity, and securities by a certain date at a pre-deter-
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mined price. If the option holder exercises his right, then the buyer has the obligation to fulfil
the contract. An investor opts for put if he/she expects that spot or market price will fall below
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the strike price.
We can illustrate this fact through the following example. Let the listing price of the share Y in
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the share market is `100. The premium price per share is determined at `20. Let an investor or
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the option holder purchases a put option to sell 100 shares at `250 after 3 months. Now, let the
spot/market price becomes `150 after 3 months. Here, the option holder will definitely exercise
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his right and sell these 100 shares for `250. Here, his/her net gain will be [(strike price - spot/
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market price) - premium price] × no of shares, that is `[(250 − 150) − 20] × 100 = `8000.
However, if after 3 months, the market price of share of company Y rises to `350, then natu-
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rally the option holder will not exercise his/her option to avoid the possible loss, as he/she has no
obligation. In that case, he/she has to pay only the premium price, that is `20 × 100 = `2000.
Thus, his/her maximum loss will be the premium price (Tables 6.2 and 6.3).
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4. Swaps
Swaps are defined as the customized contracts between two parties to exchange cash flow in the
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future on the basis of a pre-determined formula. It is a type of financial instrument concerned with
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exchange mechanism.
Table 6.2 Distinctions between call option and put option

Basis of Difference Call Option Put Option
Definition Call options offer the right (not obligation) to Put option offers the right (not obligation) to the
the investor or option holder, to purchase the investor or option holder to sell the underlying
underlying assets such as commodity, currency, or assets such as currency, commodity, and
securities by a specified date or before at a certain securities by a certain date at a pre-determined
price. price
Value Rises if value of underlying asset rises Decreases if value of underlying asset rises
Risk Buyer’s risk is restricted, but seller’s risk is Buyer’s risk is unlimited, but seller’s risk is
unlimited restricted
Right and obligation Provides a right to buy an underlying asset Provides an obligation to sell an underlying asset
Outlook The option holder remains optimistic in nature The trader remains pessimistic in nature
Link with stock market Direct relationship with stock market Inverse relationship with stock market

Table 6.3 Distinction between future and options

Basis of Difference Option Future
Definition An option is a contractual agreement that ensures a It refers to a standardized contract that is traded
right but not the obligation, buyer or the seller to buy in future at exchange. It provides an assurance by
or to sell a specific instrument at a pre-determined the exchange authority to trade a security, good, or
price (which is known as strike price) on or before currency at a pre-determined date at a price agreed
the specified date in the future upon today
Nature of Only the seller is required to execute the contract Both buyers and sellers are required to execute the
transactions contract
Maturity period Shorter period of maturity Longer maturity period
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Margin Only the seller has to pay the margin money Both buyer and trader have to pay margin money
Users Small traders with low risk Traders with high risk
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Policy Option holder can avoid trading if transaction is not Transaction in stipulated date is mandatory
profitable
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Swap technique is used in the conditions of changing rate of interest, undulating fluctuations in the
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foreign exchange rate, etc.

According to the financial experts, swaps are of three types:
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a) Currency swaps To minimize the risk associated with volatility of the currency rates, these
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types of swaps are used. It refers to the agreement where the currencies are exchanged at a certain
exchange rate. In other words, a currency swap or a cross-country swap refers to a foreign exchange
derivative between two institutions to exchange the principal and/or interest payments of a loan in
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one currency for equivalent amounts, in terms of net present value, in another currency (Wikipedia).
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b) Interest rate swaps (IRS) These indicate the arrangements interlinked to only the interest
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related cash flows between the different parties in the same currency. IRS implies a liquid financial
derivative instrument in which the two parties involved agree to exchange interest rate cash flows.
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This technique is used for both speculation and hedging.

c) Debt-equity swaps This refers to purchasing of a debt of a less-developed nation at a discount
to acquire the equities of that nation. This type of swap transaction enables a borrower to transform
the loans into equity.
Apart from these above-mentioned derivative techniques, some notable techniques are warrants, baskets,
Long-term Equity Anticipation Securities (LEAPS), etc.
6.4 REGULATORS OF INDIAN FINANCIAL MARKET

Financial system is the base of economic development. Hence, it is extremely important to review and eval-
uate the performance of the financial system. If there is any disparity between the actual performance and
targeted objective, then corrective measures are taken. In this context, regulation is very important. Financial
regulators take the responsibility of protecting the interest of the investors and maintaining financial disci-
pline in the financial market.
In recent times, Indian financial system is pretty organized, and it is regulated by some well-defined rules
and laws. Thus, we observe the following financial regulators in the financial market of India.

6.4.1 Central Government

Central government and Ministry of Finance regulate the financial market so that the protection of the
investors as well as the financial discipline of the market is ensured. After the independence, the central gov-
ernment opted for various steps to strengthen the financial market and tried to remove the different loopholes
of the Indian money and capital markets. The main focus was on the protection of investors’ investment.
Accordingly Capital Issue (Contract) Act, 1947; ESI Act, 1948; Banking Companies Act, 1949; Provident
Fund Act and Rules, 1952; Companies Act, 1956; Securities Contract (Regulation Act), 1956; Life Insurance
Corporation Act, 1956; SEBI Act, 1992; and IRDA Act, 1997, were passed. All these acts were passed to
regulate the financial marker properly.
According to Company Act, central government has the power to covert loans into shares in public
interest. Hence, the loans provided by LICI, IDBI, IFCI, NIDC, ICICI, etc. can be converted into shares in
public interest.
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Apart from this, the Ministry of Finance along with RBI have adopted various regulatory measures in
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the plan period. These measures were adopted to ensure the discipline of the financial market. Ministry of
Finance have a close look on the activities of the capital and money markets. In accordance with this, ministry
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of finance takes regulatory measures to remove the problems of the money and capital markets.
6.4.2 Reserve Bank of India

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RBI is the apex financial institution in the money market. Though RBI was established in 1935, it was not
able to exercise its power over the commercial banks. In 1949, when Banking Company Act was passed, RBI
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gained enormous power. It gained the power of controlling all the commercial banks in the financial system.
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To regulate the commercial banks in the system, RBI imposed various quantitative and qualitative control
measures in the system. The important quantitative control measures adopted by RBI are bank rate, open
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market operations, variable reserve ratio (i.e., cash-reserve ratio), and statutory liquidity ratio. The qualitative
control measure implies the selective credit control measures. In fact, since bank nationalization in 1969, the
regulating power of RBI in money market has increased significantly. RBI also has the power to control the
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authorized financial institutions.

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6.4.3 Company Law Board

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In Indian stock market, the existing shares of the companies are traded. Now companies are governed
through Company Act. Thus, Company Act has a close relationship with the share market. The Company
Act of 1956 was amended in 1963. In this amendment, it was mentioned that central government will
construct a separate board for regulation of companies whose name will be Board of Company Law
Administration or Company Law Board. Company Law Board was established in 1964. The basic objective
of the board was to ensure transparency in the company management. The board also tries to make the
company management free from corruption. As per New Companies Act, 2013, Company Law Board is
replaced by NCLT.
6.4.4 Security and Exchange Board of India (SEBI)

To remove the disturbances in the share market, the central government cancelled the Capital Issue (contract)
Act, 1947, in 1992. Gradually, SEBI became the principal regulatory institution of the capital market. All the
members and subsidiaries in the share market have to be registered under SEBI, and accordingly, they have
to obey the rules and regulations imposed by SEBI.
The capital market provides long-term finance to the industries. Hence, if the capital market is ill-man-
aged and not free from corruption, then this leads to an adverse effect on the economy. SEBI prevents the

corruptions in the capital market and, thus, strengthens the financial base of the nation. At the same time,
SEBI introduces code of conduct for the subsidiaries so that it can impose control over them.
6.4.5 Insurance Regulatory Development Authority

After the adoption of new economic policy in 1991, Government of India appointed Malhotra Committee to
undertake various reform measures in the insurance sector. According to the recommendations of Malhotra
Committee, Government of India focused on the regulation of insurance business and consequently intro-
duced IRDA Act. This act has the multiple objectives of regulation of insurer, settlement of disputes between
insurer and insured, integrated development of insurance sector, etc. Thus, IRDA was formed in 1999.
IRDA ensures improved insurance service and protects the interest of the investors. It has the power to
renew the registration and impose penal actions against the insurance companies if necessary. IRDA also has
the power to regulate the nature of the insurance companies. Thus, IRDA is empowered to impose various
regulatory measures in Indian insurance sector.
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SUMMARY
• Financial market refers to a centre that provides the facilities of sale and purchase of financial claims and services. The individuals, financial
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institutions, corporations, and government trade in this market either directly or indirectly through brokers and dealers.
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• Indian financial market is classified into money market, capital market, foreign exchange market, and derivative market.
• Money market is divided into organized and unorganized markets.
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• Indian money market comprises call money market, certificate of deposit market, and commercial paper market.
• The capital market is classified into equity market and debt market. Equity market is divided into primary and secondary markets.
iv
• In the foreign exchange market, currency of one nation is exchanged for the currency of another nation. Foreign exchange market facilitates
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international transactions, increases liquidity, and transparency.

• Derivatives are defined as written contracts between two different parties, which have no intrinsic value of its own, but it is derived from the
underlying assets such as currencies, commodities, and gold. The derivatives reduce market risk and involve low transaction cost.
d
• In India, forward, future, options, and swaps are the main variations of the derivative.
• The derivative contract where a buyer and a seller are agreed to exchange a commodity or instrument for cash at a pre-determined price
or
at a pre-determined date, agreed upon today, is known as forward contract. It is OTC traded.
• A future contract is often termed as a special type of the forward contract, which is standardized in nature and exchange traded.
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• An option refers to a contractual agreement that ensures a right, but not the obligation, to buyer or the seller to buy (in a call option) or to
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sell (in a put option) a specific instrument at a per-determined price (which is known as strike price) on or before the specified date in the
future. The maker of the option is known as option writer and the holder of the option as option buyer. Options are of two types call option
and put option.
• Swaps are defined as the customized contracts between two parties to exchange cash flow in the future on the basis of a pre-determined formula.
• The regulators in the Indian financial market are central government, RBI, SEBI, IRDA, and company law board.
GLOSSARY
Call options offer the right (not obligation) to the investor or option holder, to purchase the underlying assets such as commodity, currency,
or securities by a specified date or before at a certain price.
Call money market is the part of the money market where day-to-day transactions of surplus funds occur. This market provides short-term
funds, and the time of repayment varies from 1 to 14 days.
Certificate of deposit market is the market that deals with certificate of deposits. Certificate of deposits, which are issued by the commercial
banks and development financial institutions in bearer forms, refer to the short-term and unsecured negotiable instruments.
Commercial bill market is the market in which we observe the transactions of commercial bills.
Commercial paper market deals with the commercial paper, which is negotiable in nature, and implies a short-term promissory note issued
by the big and highly rated companies.

Derivative market is the place of interaction between risk-averse people and risk-lovers through derivatives.
Equity market refers to that part of capital market that deals with shares and debentures of various joint stock companies.
Foreign exchange market refers to a market in which domestic currency or claims are exchanged for foreign currencies.
Forward contract is the derivative contract where a buyer and a seller are agreed to exchange a commodity or instrument for cash at a
pre-determined price at a pre-determined date, agreed upon today.
Future contract refers to a standardized contract between two parties to purchase or sell an asset at a specified time in future for a certain
price agreed by the parties involved.
Option refers to a contractual agreement that ensures a right, but not the obligation, to buyer or the seller to buy (in a call option) or to sell
(in a put option) a specific instrument at a per-determined price (which is known as strike price) on or before the specified date in the future.
Primary or new issue market is the financial market that deals with new financial claims or securities. As this part of financial market deals
with new securities, it is known as ‘new issue market’.
Put options offer the right (not obligation) to the investor or option holder to sell the underlying assets such as currency, commodity, and
securities by a certain date at a pre-determined price.
Repo or repurchase agreement is the transaction in which a financial institution or a bank receives funds immediately by selling securities
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with an agreement to repurchase the same at a specified pre-determined price after a specific time period.
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Reverse repo in this, a financial institution or a bank purchases a security with an agreement to sell it back on a specific date at a pre-de-
termined price.
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Secondary market is the part of the financial market that deals with the already existing or new securities. Thus, in the secondary market,
existing securities are sold and purchased. Secondary market is also known as ‘stock market’.
Swaps are defined as the customized contracts between two parties to exchange cash flow in the future on the basis of a pre-determined
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formula. It is a type of financial instrument concerned with exchange mechanism.
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Treasury bill market is the market in which the transactions of the treasury bills occur. Treasury bill refers to a commercial bill or a financial
instrument issued by the central bank on behalf of the government in order to meet the short-term liquidity problem. The market in which the
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transactions of the treasury bills occur is known as treasury bill market.

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MULTIPLE CHOICE QUESTIONS

1. In the call money market, time repayment varies from (b) It predicts the market movements
d
(a) 1–365 days (b) 1–14 days (c) It raises liquidity

(c) 1–21 days (d) 1–164 days (d) It reduces the transaction costs
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2. Commercial bills 8. The period of future contract generally varies from

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(a) Increases the size of goods market (a) 1–14 days (b) 3–21 days
(b) Provides liquidity (c) 3–21 months (d) 1–2 years
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(c) Expands credit facilities 9. Strike price in case of option is also known as
(d) All of the above (a) Shadow price (b) Equilibrium price
3. The treasury bills are issued by (c) Exercise price (d) Premium price
(a) Reserve bank of India 10. Which of the following cannot be regarded as a type of
(b) Commercial banks swap?
(c) Merchant banks (a) Currency swaps (b) Warrant swaps
(d) Development banks (c) Interest rate swaps (d) Warrant swaps
4. Which is not a type of treasury bills? 11. Forward contract involves
(a) 15 days (b) 91 days (a) Generally a single delivery date
(c) 182 days (d) 364 days (b) Liquidity
5. Certificate of deposit was introduced on India in (c) No credit risk
(a) 1991 (b) 1990 (d) Margin requirements
(c) 1989 (d) 1988 12. Which of the following is not a feature of the future
6. New issue market refers to contract?
(a) Commodity market (b) Primary market (a) They are exchange traded
(c) Secondary market (d) Stock market (b) Highly liquid
7. Which of the following is not a feature of the derivatives? (c) They involve credit risk
(a) It increases the market risk (d) Buyers and sellers have to pay margin money

13. Which of the following is not a feature of put option? 14. RBI was established in
(a) Buyer’s risk is unlimited but the seller’s risk is restricted (a) 1935 (b) 1940
(b) Provides an obligation to sell an underlying asset (c) 1937 (d) 1952
(c) The trader remains pessimistic in nature 15. IRDA was formed in
(d) Direct relationship with stock market (a) 1998 (b) 1999
(c) 2000 (d) 2001
EXERCISES
1. What do you mean by financial markets? 9. What are options? How do the options ensure profit for the
2. Define financial market. Mention its role and significance. option holder?
3. What is an equity market? What are its divisions? 10. What are the types of options? Discuss the features of the
4. Define derivatives. What are the features of a derivative? different types of options.
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5. Define foreign exchange market. How does the foreign 11. Distinguish between call options and put options.
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exchange market assist in the international transactions? 12. Distinguish between options and futures.
6. Define forward contract. What are the features of a forward 13. Discuss the uses and trading mechanism of forward
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contract? contract.
7. What do you mean by future contract? Discuss the features 14. Define swaps. What are its types? Discuss the features of
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of the same. swap.
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8. Distinguish between forward and future contracts.
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Indian Financial

Assistant Professor and Head of Department of Economics

Maharaja Srischandra College

© Oxford University Press. All rights reserved.

© Oxford University Press 2017

The moral rights of the author/s have been asserted.

First published in 2017

All rights reserved. No part of this publication may be reproduced, stored in

Typeset in Baskerville MT STD

Printed in India by Magic International (P) Ltd., Greater Noida

Cover image: greenaperture / Shutterstock

Third-party website addresses mentioned in this book are provided

by Oxford University Press in good faith and for information only.

© Oxford University Press. All rights reserved.

GLOSSARY Glossary Every

© Oxford University Press. All rights reserved.

papers, as well as Group-ASET-1

The book contains

Chapter 1 The Indian Financial System solved model questions

and answers to help

MULTIPLE CHOICE QUESTIONS

© Oxford University Press. All rights reserved.

ABOUT THE BOOK

© Oxford University Press. All rights reserved.

can focus on them.

which will beneﬁt the students immensely.

to construct answers to the questions.

© Oxford University Press. All rights reserved.

© Oxford University Press. All rights reserved.

Features of the Book iv

1. The Indian Financial System 1 2.4 Functions of Money 33

1.3 Types of Finance 16

1.3.3 Indirect Finance 18 2.8 Commercial Banks 44

1.4 Structure of Indian Financial System 19 2.8.1 Functions of Commercial

Era 20 2.8.2 Importance of Commercial

1.4.3 Phase 3: Post-1990 or Post- 2.8.3 Credit Creation by Commercial

© Oxford University Press. All rights reserved.

Limited 83 3.9.2 Objectives of SIDBI 104

3.4.3 Capital Structure of IDBI Bank

Bank Limited 84 4.1 Financial Institutions 108

3.4.5 Management of IDBI Bank

3.4.6 Objectives of IDBI Bank Insurance Organizations 110

3.4.7 Functions of IDBI Bank (LICI) 112

© Oxford University Press. All rights reserved.

4.4.4 Functions of GICI 121 5.3 Basic Functions of Interest 145

4.7.5 Functions of UTI 131 Rate 153

4.7.6 Progress of Unit Trust of 5.10 Theories of Determination of Rate of

The Rise and Fall of the 5.10.1 Classical Theory of Interest Rate

4.7.7 Recovery Phase and 5.10.2 Loanable Fund Theory 156

Organizational Structure of Theory 158

UTI 135 5.10.4 Hicks–Hansen Theory 161

UTI 137 Economic Progress 162

© Oxford University Press. All rights reserved.

6.3 Classification of Financial Markets in 7.9.3 Discount Houses in India 210

7.5 Importance/Functions of the Money 8.6.3 Capital Market Reforms in

Market 192 India 225

Indian Money Market 193 Market 228

7.6.2 Features or Characteristics of 8.7.2 Secondary Market 241

7.6.3 Limitations of the Indian Money 9. Investors’ Protection 277