INTRODUCTION TO

FINANCIAL ECONOMICS
Financial Intermediation (FI)

▪ Intermediation between lenders and borrowers.

▪ Facilitating the transfer of funds from those
that wish to save (surplus agents) to those that
wish to borrow (deficit agents)
▪ Catering to the needs of borrowers and
lenders
Eg. Banks collect funds through deposits and
lend out through loans to borrowers
Why do we need FI?

▪ Problems with direct lending between lenders to

borrowers
• Inefficient
• Requires double coincidence of wants
• Requires a sort of contract which needs negotiation
• Time consuming for both lenders and borrowers
• Exposure to default risk for lender
Role of financial intermediary

1. Provision of a payment mechanism:

Intermediaries like commercial banks facilitate
payments by non-cash means like cheques, credit cards,
electronic transfers

Provision of an effective payment mechanism is

important for the health of the modern economy
2. Maturity transformation
The process of converting short term liabilities into
longer term assets
Savers/ investors wish to redeem their surplus funds at
relatively short period
Borrowers require funds for a longer period
3. Risk transformation
An FI can reduce the risk exposure for the lenders
It pools funds from various surplus agents then lends to
many deficit agents
4. Liquidity provision
Savers require high degree of liquidity at short notice
at low cost.
FI offers access to their funds, although penalties are
applied if savings are withdrawn before the
deposit reaches maturity
5. Reduction of contracting, search and information
costs
FI provides a convenient place for business for both
borrowers and lenders
Surplus agents do not have time, skill, and resources to
find prospective borrowers
FIs reduce the search, contracting and information
costs thereby reducing the costs and risks for savers
and borrowing costs for deficit agents
 A financial system: set of institutions,
instruments, and markets which foster savings
and channels them to their most efficient use

 Financial market is market where financial

assets are traded. It can be organized or
unorganized. Unorganized markets include
money lenders and traders which are not
controlled by RBI
Types of financial market
 The financial markets that facilitate the transfer of funds
based upon the maturity of securities can be classified
into two-
 Money Market
 Those financial markets that facilitates the flow of short
term funds (with maturities of one year or less) are
known as money market.
 It is a constant flow of cash between governments,
corporations, banks, and financial institutions, borrowing
and lending for a term as short as overnight and no
longer than a year.
 Borrowers tap it for the cash they need to operate from
day to day. Lenders use it to put spare cash to work.
 Capital market:
 Those financial markets that facilitates the flow of
long term funds are known as capital market.
 The capital market is geared toward long-term
investing. Companies issue stocks and bonds to raise
money to grow their businesses. Investors buy them
to share in that growth.
 The money market is less risky than the capital
market while the capital market is potentially more
rewarding.
Primary vs Secondary market
 Money market securities are debt securities that have a
maturity of one year or less. They have relatively high
degree of liquidity due to their short maturities and because
they have a active secondary market. Whether referring to
money market securities or capital market securities, it is
necessary to distinguish between transaction between
primary and secondary market
 Primary markets facilitate the issuance of new securities.
 Secondary markets facilitates the trading of existing
securities which allows for a change in the ownership of
securities.
 Primary market transition provide funds to the initial issuers
of securities. Secondary market do not
 The issuance of new corporate stock or new
treasury securities is a primary market transaction.
 While the sale of existing corporate stock or
treasury securities holding by one investor to
another is a secondary market transaction.
 An important feature of securities that are traded in
secondary market is liquidity which is the degree to
which securities can easily be liquidated (sold) without a
loss of value.
 Some securities have an active secondary market
meaning that there are many willing buyers and sellers
of the security at a given point in time.
 Investor prefers liquid securities so that they can easily
sell the security whenever they want. If security is illiquid
investors may not be able to sell the securities at a
large discount just to attract a buyer.
 During the credit crisis in 2008-09, investors were
less willing to invest in many debt securities because
they were concerned that these securities may
default, meaning investors would not receive the
interest and principals payment as expected.
 As the investors reduced their investment, the
secondary market some debt securities become
illiquid. Thus investors who were holding these
securities could not easily sell them.
Money Market Instruments
 1. Treasury Bills:
 This instrument is issued by Reserve Bank of India on
behalf of the Central Government for fulfilling short
term requirements of funds. They are issued at discount
and are paid at par.
 Issue in primary auction is conducted by RBI on behalf
of the government
 This difference between the issue and the redemption
price is the interest payable.
 The Treasury Bills are treated to be the safest
instruments with no risk at all or having Zero risk
Type of bill periodicity Day of auction
91 days weekly Every Wednesday
182 days fortnightly Alternate
Wednesday
364 days fortnightly Alternate
Wednesday
with no 182 days
T-bill auction
 Suppose a T.Bill having face value of Rs. 100/- is sold for Rs.
97.85 for a specified period the purchaser shall get Rs.
100/- on the maturity of the bill. The benefit of the purchaser
is the margin amount of purchasing and redeeming the bill. In
the above case it may be Rs. 100 -Rs. 97.85 = Rs. 2.15.
 For example, suppose an investor purchases a 108 days
Treasury bill for Rs. 138,000 having face value of Rs. 1, 50,
000. On maturity, he receives Rs. 1, 50,000. The difference of
Rs. 12, 000 in the issue and redemption price is the interest
received by him.
 (In fact during the financial crises faced by the British
Government in India Treasury Bills were introduced in the
early 20th century say about 1917 to provide financial help
to the than government and the practice is continuing till date.)
 2. Commercial Paper:
 Commercial Paper (CP) is a short term unsecured promissory
note with maturity period of 15 days to one year. Since it is
unsecured, it is issued by the large and creditworthy companies
to meet their short term fund requirements primarily for
working capital requirements, maintaining inventory and other
type of short term liabilities.
 Commercial papers are frequently traded in the secondary
market as promissory notes (a signed document containing a written promise
to pay a stated sum to a specified person or the bearer at a specified date or on
demand) and can be freely transferred in demat form.
 Although they are unsecured but risk remains minimum because
of the goodwill and backing of highly rated corporates.
 Introduced in India in 1990 with a view to provide an additional money
market instrument to provide a source of funds to corporate at cheaper
rate of interest in comparison to commercial banks.
 Main thing is these are issued by private companies and are unsecured. But
because issuing company have very high credit ratings these are easy
bought by those having surplus funds. Being short term instruments, these
are beneficial to both seller and the buyer.
 For example, if company has sold its products worth Rs. 10 lacs with credit
period of 3 month. The company shall be getting money after a period of
three months. But because of certain exigency they require the said money
immediately. Instead of taking a loan from bank on higher rate of interest
it can issue a commercial paper in the form of unsecured promissory note at
a discount of certain percentage say 5 % of the face value of Rs. 10 lacs
to be matured after a period of 3 months. In this way they shall get the
funds instantly to meet it exigency and the buyer will earn interest of Rs.
50000/- over a period of 3 months.
 3. Certificate of Deposits:
 Certificates of deposit (CD) are issued by commercial banks and
financial institutions to the individuals, corporations and companies. They
are unsecured and negotiable. Such instruments are usually issued by
banks when they have a tight liquidity position because of slow growth
of bank deposits but the demand for credit is high.
 (CD) is an agreement between the depositor and the bank where a
predetermined amount of money is fixed for a specific time period
 The Certificate of Deposit is issued in dematerialised form i.e. issued
electronically and may automatically be renewed if the depositor fails
to decide what to do with the matured amount during the grace period
of 7 days
 It also restricts the holder from withdrawing the amount on demand or
paying a penalty, otherwise. When the Certificate of Deposit matures,
the principal amount along with the interest earned is available for
withdrawal
 Features of Certificate of Deposit
 Before we invest in a certificate of deposit, it is necessary that we are entirely aware
of what this money market instrument is all about-
 Eligibility: Not all institutions or banks are allowed to issue Certificates of Deposit and
not every individual or organization can purchase one. There are certain conditions laid
down by the RBI that allow the purchase of CDs
 Maturity Period: A Certificate of Deposit issued by the commercial banks can have a
maturity period ranging from 7 days to 1 year. For financial institutions, it ranges from
1 year to 3 years
 Minimum investment amount– A CD can be issued to a single issuer for a minimum of
Rs.1 Lakh and its multiples
 Transferability: Certificates that are available in Demat forms must be transferred
according to the guidelines followed by Demat securities. While
dematerialised/electronic certificates can be transferred by endorsement or delivery
 Non-availability of loan: Since these instruments do not have any lock-in period, banks
do not grant loans against them. In fact, banks cannot even buy back certificates of
deposit before maturity
Eligibility
 The Reserve Bank of India has laid down the following
specifications for the lenders and investors of the certificate of
deposit-
 Scheduled commercial banks or financial institutions in India that have been
granted the permission by RBI can issue certificates of deposit
 CDs can only be issued to individuals, companies, fund houses, and such
 Co-operative banks and regional rural banks cannot issue these certificates
 It must be noted that CDs can be issued to Non-Residential Indians (NRIs)
 However, banks and financial institutions cannot provide loans against the
certificate of deposit. Moreover, banks cannot buy their own CDs prior to the
latter’s maturity
 As per RBI, banks are bound to maintain the statutory liquidity ratio (SLR) and
cash reserve ratio (CRR) on the price of a certificate of deposit
Difference Between CD vs FD
 There is no major difference between a certificate
of deposit and a fixed deposit. They are one and
the same. Fixed deposits are even referred to as
CDs or time deposits by certain banks. They come
with the same term period, a minimum requirement
for a deposit, and high-interest rates compared to
traditional savings accounts. One difference is that
CDs are freely negotiable while FDs are not.
Difference between CD vs Commercial
Paper
 There are two glaring differences between commercial
paper and a CD.
 The first is who can issue them. A CD is issued by
financial institutions and banks. Commercial papers are
issued by primary dealers, large corporations and All-
India Financial Institutions.
 The second difference is the minimum amount of
deposit. A certificate of deposit requires a minimum
investment of ₹1 lakh and thereafter permits multiples
of it. A commercial paper, on the other hand, is issued
for investments of at least ₹5 lakhs and in multiples of
₹5 lakh, thereafter.
Difference between Drawee & Drawer
 The person who draws the bill is called the drawer. He gives the
order to pay money to the third party. The party upon whom the bill
is drawn is called the drawee. He is the person to whom the bill is
addressed and who is ordered to pay. He becomes an acceptor
when he indicates his willingness to pay the bill.
 Suppose, you are working in a Company. At the end of month,
Company pays you salary through Cheque. You go to bank to
encash cheque. Bank will deduct money from company’s bank
account and will deposit to your bank account. Here you see that
your company directed bank to deduct money from its bank account
and deposit to your bank account. Here, Bank is “Drawee”, your
company which issued cheque is “Drawer”, and you, who receive
money through bank, is Payee.
4. Commercial Bills:
 Commercial Bill are issued by the seller (drawer) on the
buyer (drawee) for the sale value of goods delivered
by him.
 These bills are of 30days, 60days or 90 days
maturity.
 When the seller are in need of funds , he sends the bill
to the buyer and then the buyer accepts the bill by
signing it and promise to pay on the due date .
 The seller also go to the bank for acceptance of bill but
the bank charges the commission from drawer and
promise to make the payment if the buyer default.
 Once this process is accomplished, the seller can sell it in
the market. This way a commercial bill becomes a
marketable investment.
 Like treasury bills, commercial bills also have a
market of their own. The latter bills are issued by
firms engaged in business. Generally, they are of
three- month maturity. They are like postdated
cheques drawn by sellers of goods on the buyers of
goods for value received.
 An example of typical bill of exchange
 In the above example, Bhagat Ram is the drawer of the bill and Mohan Lal is the drawee.
The former has sold the latter goods worth Rs. 50,000 on three- month credit. The seller
may, however, need cash now. So he draws a bill and sends it to the buyer for acceptance.
The latter, in acknowledgement of his responsibility to make payment on the due date,
writes ‘accepted’ on the bill, or arranges to get the bill accepted on his behalf by his bank
 The bank charges acceptance commission and assumes responsibility of making the
payment if the drawee defaults. Once the bill has been so accepted, it becomes a
marketable instrument. On receipt, the drawer can now sell it in the market for cash.
Again, a bank normally comes into picture. The drawer goes to his bank and gets the bill
discounted.
 This simply means that he sells it for cash to the bank, which pays him the face value of the
bill, less collection charges and interest on the amount for the remaining life of the bill. The
rate of interest charged is known as the discount rate on bills. At the time of selling the bill,
the seller (drawer) endorses the bill in favour of the buying bank.
 This makes him liable to meet the bill at maturity should the drawee (or his ‘accepting’
bank) fail to do so. Thus, the buying bank is protected against the risk of default. If need
be, this bank can later sell the bill to some other bank or get it rediscounted with the RBI.
 bills are a very important device for providing short-term finance to trade and industry
 5. Call Money/Notice Money/Term money market

 Call Money: The call money market (CMM) the

market where overnight (one day) loans can be
availed by banks to meet liquidity. Banks who seeks
to avail liquidity approaches the call market as
borrowers and the ones who have excess liquidity
participate there as lenders. Banks can access CMM
to meet their reserve requirements (CRR and SLR) or
to cover a sudden shortfall in cash on any particular
day.
 Notice money: If the bank needs funds for more
days, it can avail money through notice market.
Here, the loan is provided from two days to
fourteen days.
 Term Money: This market is exclusively for
commercial and cooperative banks in India, which
borrow and lend funds for a period of over 14
days and upto 90 days without any collateral
security at market-determined rates.
 6. Repo and Reverse Repo:
 When commercial banks approach the Reserve Bank of India for funds,
they’re charged a certain amount of interest. The rate at which RBI
lends these finances to commercial banks is called the repo rate.
 In this case, a repurchasing agreement is signed by both the parties,
stating that the securities will be repurchased on a given date at a
predetermined price.
 The repo rate in India is fixed and monitored by RBI. It allows the
central bank to control liquidity, money supply, and inflation level in the
country.
 To decrease the money supply in the economy, the RBI will hike up the
repo rate to discourage banks from borrowing funds. Similarly, if the
RBI wants to pump funds into the system, the may reduce the repo rate,
thus encouraging banks to go ahead and borrow funds.
 For instance, let’s assume the repo rate fixed by the RBI is 10% p.a. and
the amount borrowed by a bank from RBI is Rs.10,000. The interest rate
to be paid by the bank will be Rs.1,000.
 Reverse Repo:
 Reverse repo rate is the interest offered by the RBI to banks who
deposit funds into the treasury. For instance, when banks generate
excess funds, they may deposit the money in the central bank. This is a
much safer approach when compared to lending it to other companies
or account holders.
 The interest earned on the deposited funds is known as the reverse
repo rate.
 This is another financial instrument used by the RBI to control the supply
of money in the nation. In case the RBI is falling short on money, they
can always ask commercial banks to pitch in with funds and offer them
great reverse repo rates in return. This gives banks and other financial
institutions the opportunity to earn profit on excess funds.
 As an example, let’s assume the reverse repo rate is 5% p.a. A
commercial bank has deposited Rs.10,000 in the central bank. This
means, the commercial bank will earn Rs.500 p.a. as interest.
Policy Repo Rate : 4.00%
Reverse Repo Rate : 3.35%
 Since RBI is a very secure institution, banks will prefer
parking their money in RBI rather than giving loans to
businesses and individuals.
 Reverse repo rate is not kept high in order to avoid this
scenario. This will ensure that the commercial banks will have
sufficient funds to invest elsewhere or use as liquidity
thereby increasing the buying capacity of the people.
 Reverse repo rate is always lesser than repo rate so that the
flow of money should be there from RBI to commercial
banks. RBI doesn't want to keep all the money. The
commercial banks and businesses need the money so that the
economy has enough purchasing power.
Capital market instruments

It includes:
 Equity instruments

 Debt instruments (Bond/Debentures)

 Derivatives
EQUITY INSTRUMENTS
 An equity instrument offers ownership rights in a firm
 In the capital market equity is used as a source of
finance (capital)
 When the company wants to raise funds it can issue
common stock or preference shares.
 The main types of equity are :
Common stock:
 A security that represents ownership in a corporation
 When the company issue common stock they gives shareholder
to own some part of company ownership.
 Holders of common stock exercise control by electing a board
of director and voting on corporate policy.
 In the event of liquidation, common stockholder have rights to a
company's assets only after bondholder, preferred
shareholders and other debtholders have been paid in full.
 [Liquidation in finance and economics is the process of bringing a business to
an end and distributing its assets to claimants. It is an event that usually occurs
when a company is insolvent, meaning it cannot pay its obligations when they
are due.]
 If the company goes bankrupt, the common
stockholders will not receive their money until the
creditors and preferred shareholders have
received their respective share of the leftover
assets.
 This makes common stock riskier than debt or
preferred shares. The upside to common shares is
that they usually outperform bonds and
preferred shares in the long run.
Preference Shares
 The holder of preference share also own some
percentage of the company but cannot participate in
anything to the company.
 Holder of preference share has the claim of the
company asset and earning of the company .
 Normally has the first priority if there is any
dividend payment than common stock holder
 The main benefits to owning preference shares are
that the investor has a greater claim on the
company’s asset than common stockholders.
DEBT INSTRUMENTS
 A debt instrument is used by government or
organization to generate funds for longer duration
 The relation between person who invest in debt
instrument is of lender and borrower
 This gives no ownership right.
 A person receives fixed rate of interest on debt
instrument.
 A debt instrument is used by either companies or
governments to generate funds for capital-intensive
projects. It can obtained either through the primary or
secondary market.
TYPES OF DEBT INSTRUMENTS
There are many kinds of debt instruments among of
them are as follow:
 Bond

 Government bond
 Corporate bond

 Convertible bond

 Debenture
Government bond
 A government bond is a debt security issued by a
government to support government spending and
obligations.
 Government bonds can pay periodic interest
payments called coupon payments.
 Government bonds issued by national governments
are often considered low-risk investments since the
issuing government backs them.
What is the difference between T-bills
& Government Bonds?
 Maturities less than 1 year are called T-bills and those more
than one year are called bonds.
 There are three T-bills variants, and they vary based on the
maturity period. They are 91 days, 182 days, and 364 days.
 T-bills do not carry an interest component, in fact, this is one
of the biggest differences between T-bills and Bonds. T-bills
are issued at a discount to their true (PAR) value and upon
expiry, its redeemed at its true value.
 Ex- Assume the true value (also called the Par value), is
Rs.100. This T-bill is issued to you at a discount to its par
value, Say Rs.97. After 91 days, you will get back Rs.100
and therefore you make a return of Rs.3.
 Bonds differ from T-bills on 2 counts. Bonds have long-dated
maturities and they pay interest twice a year.
corporate bond
 A corporate bond is a type of debt security that is
issued by a firm and sold to investors.
 The company gets the capital it needs and in return the
investor is paid a pre-established number of interest
payments at either a fixed or variable interest rate.
 When the bond expires, or "reaches maturity," the
payments cease, and the original investment is returned.
 Corporate bonds are typically seen as somewhat riskier
than government bonds, so they usually have higher
interest rates to compensate for this additional risk
Convertible bond
 A convertible bond pays fixed-income interest
payments but can be converted into a
predetermined number of common stock shares.
 The conversion from the bond to stock happens at
specific times during the bond's life and is usually at
the discretion of the bondholder.
 A convertible bond offers investors a type of hybrid
security that has features of a bond, such as interest
payments, while also having the option to own the
underlying stock.
 Debenture
 In corporate finance, a debenture is a medium- to long-
term debt instrument used by large companies to borrow
money, at a fixed rate of interest.
 A debenture is an unsecured bond. Essentially, it is a bond
that is not backed by a physical asset or collateral.
 Debentures typically are issued to raise capital to meet
the expenses of an upcoming project or to pay for a
planned expansion in business.
 A debenture is a type of bond. However, the term
debenture only applies to an unsecured bond. Therefore,
all debentures can be bonds, but not all bonds are
debentures. In business or corporate financing, unsecured
debentures are typically riskier requiring the payment of
higher coupons.
 A debenture is thus like a certificate of loan evidencing
the fact that the company is liable to pay a specified
amount with interest and although the money raised by
the debentures becomes a part of the company's
capital structure, it does not become share capital
 Debentures are freely transferable by the debenture
holder.
 Debenture holders have no rights to vote in the
company's general meetings of shareholders, but they
may have separate meetings or votes e.g. on changes
to the rights attached to the debentures
Types of Debenture
Convertible and Non-Convertible:
 Convertible debenture can be converted into equity shares
after the expiry of a specified period.
 On the other hand, a non-convertible debenture is those
which cannot be converted into equity shares.
difference between these two types of debentures
 a.) Interest Rate: Convertible debenture posses lesser
interest rate as the holder has advantage of converting
them into the company shares
 Whereas Nonconvertible debenture does not hold any
such advantage, so they usually come with higher interest
rate. Usually, nonconvertible debentures are treated little
risky then bonds and convertible debenture.
 b.) Risk: Convertible debenture comes with lesser risk than
nonconvertible debenture.
 When economy is in trouble and company is not able to pay
interest or defaults in making payment of interest then by
having convertible debenture you can convert your debenture
into the shares of the company.
 Usually shares trade at higher value than the convertible
debenture. After conversion, they act like any other shares and
can be traded in the market for either profit or to cut losses.
 Nonconvertible debenture hold higher risk as in the bad
market these debentures might get default.
 Holders have only one choice as to hold it till maturity and if
company defaults in making payment of debenture then this
directly shows the company is bankrupt.
GUIDELINES OF SEBI FOR THE ISSUE OF
DEBENTURES
 Debentures can be issued for the following
purposes:
 For starting new undertakings
 Expansion or diversification
 For modernization
 Merger/amalgamation which has been approved by
financial institutions
 Restructuring of capital
 For acquiring assets
 For increasing resources of long-term finance.
 Issue of debentures should not exceed more than 20% of gross
current assets and also loans and advances.
 Debt-equity ratio in issue of debentures should not exceed 2:1. But
this condition will be relaxed for capital intensive projects.
 Any redemption of debentures will not commence before 7 years
since the commencement of the company.
 For small investors for value such as Rs. 5,000, payments should be
made in one installment.
 With the consent of SEBI, even non-convertible debentures can be
converted into equity.
 A premium of 5% on the face value is allowed at the time of
redemption and in case of non-convertible debentures only.
 The face value of debenture will be Rs. 100 and it will be listed in
one or more stock exchanges in the country.