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CHAPTER - II
INTRODUCTION TO FINANCIAL MARKETS

I. INTRODUCTION:
A significant component of the Indian Financial System is the
financial markets. They function as facilitating organisations in the savings-
investment process. The Financial markets are in the forefront in developing
economics. Efficient financial markets are a sine qua non for speedy
economic development. The vibrant financial market enhances the
efficiency of capital formation. This market facilitates the flow of savings
into investment vis-a-vis capital formation. Dr. Khan has opined that, "A
variegated financial market can appeal to the security, motivation and other
such aspects of savers and attracts more savings by the creation of an array
of attractive financial assets. It also tends to promote the development
financial structure. The role of the financial markets in the financial system
is quite unique. The relevance of the financial markets in the financial
system is not merely quantitative but also supportive. Thus, the financial
markets bridge one set of financial intermediaries with another set of
players. Well-developed financial markets diversify resource mobilisation
channels and enlarge the range of financial services. More importantly,
under appropriate conditions financial markets can provide long-term
finance to government and large business firms. The role of financial
markets assumes greater importance in the modern economy. Financial
markets perform an important function of channellising surplus funds from
savers to those who are short of funds, thereby contributing to higher
production and efficiency in the economy. In the wake of increased degree
of globalisation, financial markets facilitate across border movements of
funds from the countries tacking profitable avenues for investments to
 48

countries providing higher returns. Another crucial role of financial market

is the pricing and management of economic and financial risks. Financial
markets also ply a crucial role in the transmission of monetary policy,
impulses developed and stable financial markets also enable central banks to
use market-based instruments of monetary policy to target monetary
variables more effectively. Thus, the financial markets through their
linkages with the real economy, enhance the levels of output and
employment. They act as a conduit through which funds are transferred from
the savers to users. Financial markets facilitate the buying and selling of
financial instruments, also called financial assets or financial securities.
Efficient Financial Markets indicate the economy's ability to take advantage
of profitable opportunities. Financial markets in fact reflect the risk
perceptions and reward of millions of individual investors from pension
funds, banks, hedge funds and healthy individuals to businessmen wanting
to raise money borrowers of home loans and pensioner s looking for ways to
invest in their nest eggs. To a large extent Financial markets hold up a
mirror to the economy. The equilibrium in financial markets is usually
determined by assuming that there would be perfect competition, and by
using the well-known tool of supply and demand. Financial markets are said
to be perfect when:-
(a) a large number of savers and investors operate in markets
(b) the savers and investors are rational
(c) all operators in the market are well-informed and information is
freely available to all of them
(d) there are no transaction costs
(e) the financial assets are infinitely divisible
(f) the participants in markets have homogeneous expectations, and
(g) there are no taxes
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II. CHARACTERISTICS OF FINANCIAL MARKETS:

There are various characteristics of Financial Markets which may be

summed up as follows :

(i) Financial Markets are characterised by a large volume of

transactions and the speed with which financial resources move
from one market to another.

(ii) There are various segments of Financial Markets such as stock

markets, bond markets, primary and secondary segments,
wherever themselves decide when and where they should invest
money.

(iii) There is scope for instant arbitrage among various markets and
types of instruments.

(iv) Financial Markets are highly volatile and susceptible to panic and
distress selling as the behaviour of a limited group of operators
can get generalised.

(v) Markets are dominated by financial intermediaries who take

investment decision as well as risks on behalf of their depositors.

(vi) Negative externalities are associated with financial markets. A

failure in any one segment of these markets may affect other
segments, including non-financial markets.

(vii) Domestic financial markets are getting integrated with worldwide

financial markets. The failure and vulnerability in a particular
domestic market can have international ramification. Similarly
problems in external markets can affect the functioning of
domestic markets. In view of the above characteristics, financial
markets need to be closely monitored and supervised.
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III. FUNCTIONS OF FINANCIAL MARKETS:

The primary function of the Financial Markets is to facilitate the

transfer of funds from surplus sectors (lenders) to deficit sectors (borrower).
Financial Markets perform the essential economic function of channeling
funds from households, firms and governments that have saved surplus funds
by spending less than their income to those that have a shortage of funds
because they wish to spend more than their income. Financial markets
perform various functions such as:

(a) Enabling economic units to exercise their time preference,

(b) Separation, distribution, diversification and reduction of risk,

(c) Efficient payment mechanism
(d) Providing information about companies which spurs investors to
make inquiries themselves and keep track of the companies
activities with a view to trading in their stock efficiently.
(e) Transmutation or transformation of financial claims to suit the
preferences of both savers and borrowers.
(f) Enhancing liquidity of financial claims through trading in
securities and
(g) Providing portfolio management services.

IV. CLASSIFICATION OF FINANCIAL MARKETS:

There are various classifications of Financial Markets in the economy
as according to the instruments being traced in those markets and also
according to the people working and the period of the instruments being
traded in those Financial Markets. The Financial Market may be classified as
Government Securities market and Corporate Securities market. The
Government securities market in India has two segments i.e. the primary
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market and secondary market. The primary market consists of the issuers
of securities, the central and state government, while the buyers include
commercial banks, primary dealers, financial institutions and insurance
companies. The secondary market includes commercial banks, financial
institutions, insurance companies, provident funds, trusts, mutual funds and
the Reserve Bank of India. On the basis of the type of instruments traded the
financial market for corporate securities may be classified as capital market
and money market. The capital market is a market for long-term funds and
the securities traded in the capital market are equity shares, preference shares,
debentures and bonds. The capital market is further divided into primary and
secondary markets. The primary market provides funds to the enterprises for
starting new organisation or for their expansion/diversification. The
secondary market is a market for existing securities. It is also known as stock
market or stock exchange, and provides an institutional mechanism for the
purchase and sale of securities that have already been issued. If the securities
traded in a financial market are short-term securities, such a financial market
is known as money market. A debt market is a financial market for debt
securities such as debentures, bonds and commercial paper. The Financial
Market that provides a mechanism or a system for trading long term securities
such as equity shares which have been already issued is called the stock
market. The Financial Markets may also be classified as organised market
and unorganised (informal) markets. The organised markets are the market
governed by certain explicit rules, regulations and statutes. The unorganised
markets are those that are not governed by prescribed rules and regulations.
V. MONEY MARKET
Introduction:
Money market is a very important segment of the Indian Financial
System. It is the market for dealing in monetary assets of a short-term nature.
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Short term funds up to one year and for financial assets that are close
substitutes for money are dealt in the money market. Money market
instruments have the characteristics of liquidity (quick conversion into
money), minimum transaction cost and no loss in value. Money market
performs the crucial role of providing an equilibrating mechanism to even out
short-term liquidity and in the process, facilitate the conduct of monetary
policy short-term surpluses and deficits are evened out. The Money Market is
the major mechanism through which the Reserve Bank influences liquidity
and the general level of rates of interest. The money market is a market for
financial assets that are close substitutes for money. It is a market instruments
having a maturity period of one or less than one year. It is a market for
overnight to short-term funds and for short-term money and financial assets
that are close substitutes for money. "Short-term" in the Indian context,
generally means a period upto one year and “close substitute for money”
denotes any financial asset that can be quickly converted into money with
minimum transaction cost and without any loss in value. The major
participants in the market are the commercial banks, the other financial
intermediaries, large corporates and the Reserve Bank of India (RBI).
Need of the money market:
The existence of an efficient money market is a precondition for the
development of a government securities market and a forward, swaps and
futures is also supported by a liquid money market as the certainty of prompt
cash settlement is essential for such transactions. The government can achieve
better pricing on its debt as it provides access to a wide range of buyers. The
need for money market arises because the immediate cash needs of
individuals, corporations and governments do not necessarily coincide with
their receipts of cash. In general, a money market, provides an investment
opportunity that generates a higher rate of interest than holding cash, but it is
also very liquid and has relatively low default risk.
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Features of money market:

The developed money markets bear certain distinct features as

compared to other market which may be summed up as follows :
(i) A developed commercial banking system: In a developed money
market not only the banking system should be well developed and
organised but the public should also have banking habits. These two
things are complementary. The commercial banks are the most
important suppliers of short-term funds and their policy pertaining to
loans, advances and investment would have its impact and investment
would have its impact on the entire money market. S.N. Sen in his book
'Central Banking in Underdeveloped Money Market' rightly calls them
"the nucleolus of the whole money market". Thus for any developed
money market, the foremost feature is well coordinated and well
integrated commercial banking system.

(ii) Presence of a central bank: In a developed money market there is

always an apex Central Bank. It means the Central Bank is both dejure
and defacto the head of money and banking authority. A Central Bank
is the lender of the last resort which means that the member banks can
borrow from the Central Bank during emergency and due to this reason
the Central Bank is also termed as the guardian of the money market.
According to Prof. Sen, "It provides the ultimate liquidity without
which a money market cannot function efficiently." It is correctly
stated that a strong Central Bank is as necessary a characteristic of the
money market as the heart in the human body.

(iii) Sub-markets: A developed money market has the most developed and
sensitive sub-market. The money market is a group of various sub-
markets each dealing in loans of various maturities. There will be
markets for call loans, the collateral loans, acceptances, foreign
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exchange, bills of exchange and treasury bills. If these sub-markets are

non-existent or there is less responsiveness to small changes in the
interest and discount rates, it means that under no circumstances a
money market may be developed. There must be a large number of
dealers and bidders in different sub-markets. According to Prof. S.V.
Sen, "The larger the number of submarkets, the broader and more
developed will be the structure of the money market." But besides it,
the sub-markets must be integrated with each other.

(iv) Near money-assets : In a developed money market, there is a large

quantity and variety of financial instruments such as bills of exchange,
treasury bills, promissory notes, short dated government bonds etc.. If
the numbers of near money assets are more, the money market will be
more developed.
(v) Availability of ample resources : Another feature of the developed
money market is the availability of ample resources. A developed
money market has easy access to financial resources from both within
and without the country. It is the availability of cheap facilities for the
remittance of funds from one place to another, which has resulted in
raising the resources.
(vi) Integrated interest rate structure : Another feature of developed
money market is that it has an integrated interested rate structure. The
interest rates which prevail in the different sub-markets must be
integrated interest rate structure. The interest rates which prevail in the
different sub-markets must be integrated with each-other. It is due to
this structure of interest rates that the Central Bank can exercise control
on the functioning of the money market.
(vii) Other factors: There are many other factors which are responsible for
the development of a money market. The contributory factors are
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volume of international trade, bills of exchange, great industrial

development, stable political condition, economic crisis, boom,
depression, war, absence of discrimination etc.

Thus the aforesaid are the various distinct features that are beared by a
developed money market as compared to the other markets and any features
stated above if are found missing indicates a less developed money market.
An under developed money market is a stumbling block in the way of
monetary authority and also a block in the efficient development of the
Financial System of the country.

Definition of money market:

J.M. Culberston, in his book "Money and Banking", has defined money
market as "a network of markets that are grouped together because they deal in
financial instruments that have a similar function in the economy and are to
some degree substitutes from the point of view of holders. The instruments of
the money market are liquid assets; interest bearing debts that mature within a
short period of time or callable on demand.” Geoffrey Crowther in his book "An
outline of Money", has stated "Money Market is a collective name given to the
various forms and institutions that deal with the various grades of near money.”

The money market, in a nutshell, is a short term credit market. It deals

in assets of relative liquidity such as treasury bills, bills of exchange, short
term government securities, etc.. The Reserve Bank of India 'Functions and
Working' describes money market as 'the centre for dealings, mainly short
term character, in monetary assets; it meets the short term requirements of
borrowers and provides liquidity or cash to the lenders. It is the place where
short term surplus investible funds at the disposal of financial and other
institutions and individuals are bid by borrowers, again compromising
institutions and individuals and also government itself."
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S.N. Sen, in his book "Central Banking in underdeveloped Money

Market", has aptly stated that the short term money market is “the place
where the strain on the banking system is first felt in periods of pressure, and
it is the place where ease in the banking system is first felt in periods of
monetary superfluity." The money market is thus a reservoir of short term
funds. It is a region where short term fund are bought and sold through
telephone or mail. Funds are borrowed in the market for a short period
ranging from a day to six months or less than one year. The assets which are
used as credit instruments are known as "near money assets".

Structure of the money market:

The structure of Money Market can be illustrated as below :

Money Market

Components/ Institutions Instruments

Submarkets

1. Components or sub markets of money market: The money market is

not homogeneous in character. This is a loosely organised institution
with a number of divisions and sub-divisions. Each particular division
or sub-division deals with a particular type of credit operation. All the
sub-markets deal in short-term credit. The following are the important
constituents or sectors of money market.

(a) Call Money Market

(b) Collateral Loan Market

(c) Acceptance Market

(d) Bill market

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(a) Call money market: It refers to the market for very short period.
Bill brokers and dealers in Stock Exchange usually borrow
money at call from the commercial banks. These loans are given
for a very short period not exceeding seven days under any
circumstances, but more often from day-to-day or for overnight
only i.e. 24 hours. Call loan is an important constituent of the
Money Market.
(b) Collateral loan market: It is another specialised sector of the
Money market. The loans are generally advanced by the
commercial banks to private parties in the market. The collateral
loans are backed by the securities, stocks and bonds. The
collateral securities may be in the form of some valuable, say
government bonds which are easily marketable and do not
fluctuate much in prices.
(c) Acceptance market: Acceptance market refers to the market for
banker's acceptances involved in trade transactions. The market
where the bankers acceptances are easily sold and discounted is
known as the acceptance market.
(d) Bill market: It is a market in which short term papers or bills are
bought and sold. The important types of short-term papers are :
(i) Bills of Exchange
(ii) Treasury Bills

2. Institutions of money market: The institutions of money markets are

those which deal in lending and borrowing of short term funds. The
Central Bank, Commercial Banks, Acceptance Houses, Non-Banking
Financial Intermediaries, Brokers, etc. are the major institutions of
money markets.
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a) Central bank: The Central Bank plays a vital role in the money
market. It is the monetary authority and is regarded as an apex
institution. The Central Bank is the controller and the guardian of the
money market.

b) Commercial banks: These are the back bone of the Money Market and
are one of the major constituents. These banks use their short term
deposits for financing trade and commerce for short periods.

c) Acceptance houses: The acceptance houses and the bill brokers are the
main institutions dealing in the bill market. They function as
intermediaries between importers and exporters, and between lenders
and borrowers in the short period.

d) Non-banking financial intermediaries: In addition to commercial

Banks, there are non-banking financial intermediaries which resort to
lending and borrowing of short-term funds in the money market.

e) Bill brokers: Bill brokers are the intermediaries who act as

intermediaries between the borrowers and lenders by discounting bills
of exchange at a small rate of commission. These are more active in an
under developed money market.

3. Instruments of the money market: The following are the major

instruments that are available in the Money Market.

(a) Commercial bills: Commercial Bills or Bills of Exchange

popularly known as bill is a written instrument containing an
unconditional order. The bill is signed by the drawers, directing a
certain person to pay a certain sum of money only to, or order of a
certain person, or to the bearer of the instrument at a fixed time in
future or on demand. Once the buyer signifies his acceptance on
the bill itself it becomes a legal document.
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(b) Treasury bills: The Treasury Bill on the other hand, is the short-
term government security, usually of the duration of 91 days, sold
by the Central Bank on behalf of the government. There is no
fixed rate of interest payable on the T-bills. These are sold by the
Central Bank on the basis of competitive bidding.

(c) Call and short notice money: Call Money refers to a money
given for a very short-period. It may be taken for a day or
overnight but not exceeding seven days in any circumstances.
Surplus funds of the commercial banks and other institutions are
usually given as call money.

(d) Certificate of deposits: These are marketable receipts in bearer or

registered form of funds deposited in a Bank for a specified period
and at a specified rate of interest.

(e) Commercial papers: These are short-term usance promissory

notes issued by reputed companies with good credit standing and
having sufficient tangible assets. These are unsecured and are
negotiable by endorsement and delivery.

(f) Repurchase agreement (REPO): It is an important instrument in

the developed money markets. It enables smooth adjustment of
short-term liquidity among varied categories of market
participants. It is much safer than call money market operations as
it is backed by collaterals.

(g) ADR's & GDR's: American Depository Receipts (ADR's) are the
fore runners of Global Depositing Receipts (GDRs). These are the
instruments in the nature of depository receipt or certificate. These
instruments are negotiable and represent publicly traded, local
currency equity shares issued by non-American company.
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(h) Collateralised borrowing and lending obligation (CBLO): The

Clearing Corporation of India Limited (CCIL) launched a new
product- Collateralised Borrowing and Lending Obligation
(CBLO) in 2003 to provide liquidity to non-bank entities hit by
restrictions on access to the call money market.
Significance/functions of money market:
The importance or the functions of money market may be explained as
below:
(a) Economic development: The money market provides short-term
funds to both public and private institutions who are in need of
money to finance their capital needs.
(b) Profitable investment: The aim of the commercial banks to put
their reserves into productive channels is to maximise profits. The
excess reserves of the Banks are invested in near money assets.
(c) Borrowings by the government: The money market helps the
government in borrowing short-term funds at very low interest
rates.
(d) Importance for central bank: If the money market is well-
developed, the Central Bank implements the monetary policy
successfully. It is only through the money market that the Central
bank can control the banking system and thus contribute to the
development of trade and commerce.
(e) Mobilisation of funds: The money market helps in transferring
funds from one sector to another.
(f) Self Sufficiency of commercial banks : In case of the prevalence
of a developed money market the commercial banks need not
borrow from the Central Bank.
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(g) Savings and investment: Another point of importance of the

money market is that it helps in promoting liquidity and safety of
financial assets. By doing so it can help in encouraging saving and
investment which ultimately helps in equitable allocation of
resources.

VI. THE INDIAN MONEY MARKET:

The money market in India is divided into the formal (organised) and
informal (unorganised) segments. One of the greatest achievements of the
Indian financial system over the last 50 years has been the decline in the
relative importance of the informal segment and increasing presence and
influence of the formal segment. Upto the mid-1980, money market was
characterised by lack of depth, small number of instruments and strict
regulation on interest rates. The money market consisted of the inter-bank call
market, treasury bills, commercial bills and participation certificates. Several
steps were taken in the 1980s and 1990s to reform and develop the money
market. The reforms in the money market were initiated in the latter half of
the 1980s. A committee to review the working of the monetary system under
the chairmanship of Sukhamoy Chakravorthy was set up in 1985. It
underlined the need to develop money market instruments. As a follow-up,
the Reserve Bank set-up a working group on the money market under the
chairmanship of N. Vaghul which submitted its report in 1987. This
committee laid the blue print for the institution of a money market. Based on
its recommendations, the Reserve Bank initiated a number of measures. The
Government again set-up a high level committee in August 1991 under the
Chairmanship of M. Narasimhan (the Narsimhan Committee) to examine all
aspects relating to structure, organisation, functions, and procedures of the
financial system. The committee made several recommendations for the
development of the money market. The Reserve Bank accepted many of its
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recommendations. The development and profile of the money market has

changed in the nineties. A basic objective of money market reforms in the
recent years has been to facilitate the introduction of new instruments and
their appropriate pricing. The Reserve Bank has endeavoured to develop
market segments which exclusively deal in specific assets and liabilities as
well as participants. Accordingly the call/notice money market is now a pure
inter-bank market. In order to ensure systematic stability, prudential limits on
exposures to the call money market have been imposed. Standing liquidity
support to Banks from the Reserve Bank and facilities for exceptional
liquidity support have been rationalised. The various segments of the money
market have integrated with the introduction and successful implementation
of the Liquid Adjustment Facility (LAF) in June, 2000. The Negotiated
Dealing System (NDS) & Clearing Corporation of India Ltd. (CCIL) have
improved the functioning of money markets. They have facilitated a speedier
conversion of notice/call money market into a pure inter-bank money market
and enabled the growth of a buoyant repo market outside the LAF.

VII. CAPITAL MARKET

Introduction:

A good-capital market is an essential pre-requisite for industrial and

commercial development of a country. Credit is generally, required and
supplied on short-term and long-term basis. The money-market caters to the
short-term needs only. The long-term capital needs are met by the capital
market. Capital market is a central coordinating and directing mechanism for
free and balanced flow of financial resources into the economic system
operating in a country. The development of a good capital market in a country
is dependent upon the availability of savings, proper organisation of its
constituent units and the entrepreneurship qualities of its people.
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Meaning and concept:

The term capital market refers to the institutional arrangements for

facilitating the borrowing and lending of long-term funds. In the widest sense
it consists of a series of channels through which the savings of the community
are made available for industrial and commercial enterprises and public
authorities. A Capital Market may be defined as an organised mechanism for
effective and efficient transfer of money capital or financial resources from
the investing parties, i.e. individuals or institutional savers to the
entrepreneurs (individuals or institutions) engaged in industry or commerce in
the business either be in the private or public sectors of an economy. It is the
market for financial assets that have long or indefinite maturity. It is basically
composed of those who demand funds (borrowers) and those who supply
funds (lenders).

Definition of capital market:

It is an organised market mechanism for effective and efficient transfer

of money capital or financial resources from the investing class (a body of
individual or institutional savers) to the entrepreneur class (individual or
institutions engaged in industry business or service) in the private and public
sectors of the economy. In a very broad sense, it includes the market for
short-term funds. H.T. Parikh has referred to it as, "By Capital Market, I mean
the market for all the financial instruments, short-term and long-term as also
commercial, industrial and government paper."

In the words of Goldsmith, "the capital market of a modern economy

has two basic functions: first the allocation of savings among users and
investment; second the facilitation of the transfer of existing assets, tangible
and intangible among individual economic units." Grant defines capital
market in abroad sense as "a series of channels through which the savings of
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the community are made available for industrial and commercial enterprises
and for public authorities. It embraces not only the system by which the
public takes up long-term securities directly or through intermediaries but
also the elaborate network of institutions responsible for short-term and
medium-term lending." From the above definitions, it may be deducted that
the capital market is generally understood as the market for long-term funds.
The capital market provides long-term debt and equity finance for the
government and the corporate sector. By making long term investments
liquid, the capital market mediates between the conflicting maturity
preference of lenders and borrowers. The capital market also facilitates the
dispersion of business ownership and the reallocation of financial resources
among corporations and industries.
Role and functions of capital market:
The Capital Market plays a vital role in providing liquidity and
investment instruments. It fosters economic growth in various ways such as
by augmenting the quantum of savings and capital formation and through
efficient allocation of capital, which, in turn, raises the productivity of
investment. It also enhances the efficiency of a financial system diverse
competitors vie with each other for financial resources. The domestic capital
market can help financial stability by reducing currency mismatches. The
capital market also provides an alternative means of long-term resources for
development. It improves economic efficiency by generating market
determined interest rates that reflect the opportunity costs of funds at different
maturities.
Capital Market performs various important functions in the Financial
System of any country. The various functions of an efficient capital market
may be summed up as follows:
(i) Mobilise long-term savings to finance long-term investments.
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(ii) Provide risk capital in the form of equity or quasi-equity to

entrepreneurs.
(iii) Encourage broader ownership of productive assets.
(iv) Provide liquidity with a mechanism enabling the investor to sell
financial assets.
(v) Lower the costs of transactions and information.
(vi) Improve the efficiency of capital allocation through a competitive
pricing mechanism.
(vii) Disseminate information efficiently for enabling participants to
develop an informed opinion about investment, disinvestment,
reinvestment, or holding a particular financial asset.

(viii) Enable quick valuation of financial instruments — both equity

and debt.

(ix) Provide insurance against market risk or price risk through

derivative trading and default risk through investment protection
fund.

(x) Enable wider participation by enhancing the width of the market

by encouraging participation through, networking institutions and
associating individuals.

(xi) Provide operational efficiency through simplified transaction

procedures, lowering settlement timings and lowering transaction
costs.

(xii) Develop integration among real and financial sectors, equity and
debt instruments, long-term and short-term funds, long-term and
short-term interest costs, private and government sectors and
domestic and external funds.
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(xiii) Direct the flow of funds into efficient channels through

investment, disinvestment and re-investment.

Objectives and importance of capital market:

An efficient Capital Market is a pre-requisite of economic
development. An organised and well developed Capital Market operating in a
free market economy, (i) ensures best possible coordination and balance
between the flow of savings on the one hand and the flow of investment
leading to capital formation on the other; (ii) directs the flow of savings into
most profitable channels and thereby ensures optimum utilisation of financial
resources. Thus, an ideal capital market is one where finance is used as a
hand-maid to serve the needs of industry. The importance of capital market
can be briefly summarised as follows:
(i) The Capital Market serves as an important source for the
productive use of the economy's savings. It mobilises the savings
of the people for further investment and thus avoids their wastage
in unproductive uses.
(ii) It provides incentives to savings and facilitates capital formation
by offering suitable rates of interest as the price of capital.
(iii) It provides an avenue for investors, particularly the household
sector to invest in financial assets, which are more productive than
physical assets.
(iv) It facilitates increase in production and productivity in the
economy and thus, enhances the economic welfare of the society.
Thus it facilitates "the movement of stream of command over
capital to the point of highest yield" towards those who can apply
them productively and profitably to enhance the national income
in the aggregate.
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(v) The operations of different institutions in the Capital Market

induce economic growth. They give quantitative and qualitative
directions of the flow of funds and bring about rational allocation
of scare resources.
(vi) A healthy capital market consisting of expert intermediaries
promotes stability in values of securities representing capital
funds.
(vii) Moreover, it serves as an important source for technological
upgradation in the industrial sector by utilising the funds invested
by the public.
Structure of capital market:
The structure of any capital market is composed of the sources of
demand for and supply of long-term capital. In the organised sector of capital
market demand for long-term capital comes from corporate enterprises, public
sector enterprises, government and semi-government institutions. The sources
of supply of funds comprise individual investors, corporate and institutional
investors, investment intermediaries, financial institutions, commercial banks
and government. The unorganised sector of the Capital Market consists of
indigenous bankers and private money lenders.
Components of capital market:
The Capital Market basically comprises of the Primary Capital Market
and the Secondary Capital Market. The Capital Market may also defined as
comprising of the New Issue Market or Primary Market, Stock Market or
Secondary Market and also the Financial Institutions. Primary Market refers
to the long-term flow of funds from the surplus sector to the government and
corporate sector (through primary issues) and to banks and non-banking
financial intermediaries (through secondary issues).
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Secondary Capital Market is a market for outstanding securities. An

equity instrument, being an eternal fund provides an all time market while a
debt instrument with a defined maturity period, is traded at the secondary
market till maturity. Unlike primary issues in the primary market which result
in capital formation, the secondary market facilitates only liquidity and
marketability of outstanding debt and equity instruments. Thus the
constituents of the Capital Market comprises of development banks,
specialised financial institutions, investment institutions, state level
development banks, mutual funds, lease companies, financial service
companies, commercial banks and other specialised institutions setup by
Development Banks for the growth of Capital Market.
VIII. HISTORY OF THE INDIAN CAPITAL MARKET
The history of the capital market in India dates back to the eighteenth
century when the East India Company securities were traded in the country.
Until the end of the nineteenth century, securities trading was unorganised
and the main trading centres were Bombay (now Mumbai) and Calcutta (now
Kolkata). Of the two, Bombay was the chief trading centre wherein bank
shares were the major trading stock. During the American Civil War (l860-
61), Bombay was an important source of supply for cotton. Hence, trading
activities flourished during the period, resulting in a boom in share prices.
This boom, the first in the history of the Indian capital market, lasted for
nearly half a decade. The bubble burst on July 1, 1865, when there was a
tremendous slump in share prices.
Trading was at that time limited to a dozen brokers; their trading place
was under a banyan tree in front of the Town Hall in Bombay. These stock
brokers organised an informal association in 1875 – the Native Shares and
Stock Brokers Association, Bombay. The stock exchanges in Calcutta and
Ahmedabad, also industrial and trading centres, materialised later. The
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Bombay Stock Exchange was recognised in May 1927 under the Bombay
Securities Contracts Control Act, 1925.

The capital market was not well-organised and developed during the
British rule because the British government was not interested in the
economic growth of the country. As a result, many foreign companies
depended on the London capital market for funds rather than on the Indian
capital market.

In the post-independence era also, the size of the capital market

remained small. During the first and second five year plans, the government's
emphasis was on the development of the agricultural sector and public sector
undertakings. Public sector undertakings were healthier than private
undertakings in terms of paid-up capital but their shares were not listed on the
stock exchanges. Moreover, the Controller of Capital Issues (CCI) closely
supervised and controlled the timing, composition, interest rates, pricing,
allotment, and floatation costs of new issues. These strict regulations
demotivated many companies from going public for almost four and a half
decades.

In the l950s, Century Textiles, Tata Steel, Bombay Dyeing, National

Rayon, and Kohinoor Mills were the favourite scrips of speculators. As
speculation became rampant, the stock market came to be known as the satta
bazaar. Despite speculation, non-payment or defaults were not very frequent.
The government enacted the Securities Contracts (Regulation) Act in 1956 to
regulate stock markets. The Companies Act, 1956 was also enacted. The
decade of the 1950s was also characterised by the establishment of a network
for the development of financial institutions and state financial corporations.

The 1960s was characterised by wars and droughts in the country

which led to bearish trends. These trends were aggravated by the ban in 1969
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on forward trading and badla, technically called 'contracts for clearing'. Badla
provided a mechanism for carrying forward positions as well as for borrowing
hinds. Financial institutions such as LIC and G1C helped revive the sentiment
by emerging as the most important group of investors. The first mutual hind
of India, the Unit Trust of India (UTI) came into existence in 1964.

In the l970s, badla trading was resumed under the guise of `hand-
delivery contracts – a group.' This revived the market. However, the capital
market received another severe setback on July 6, 1974, when the government
promulgated the Dividend Restriction Ordinance, restricting the payment of
dividend by companies to 12 per cent of the face value or one-third of the
profits of the companies that can be distributed as computed under Section
369 of the Companies Act, whichever was lower. This led to a slump in
market capitalisation at the BSE by about 20 per cent overnight and the stock
market did not open for nearly a fortnight. Later came a buoyancy in the stock
markets when the multinational companies (MNC5) were forced to dilute
their majority stocks in their Indian ventures in favour of the Indian public
under FERA in 1973. Several MNCs opted out of India. One hundred and
twenty-three MNCs offered shares worth Rs. 150 crore, creating 1.8 million
shareholders within four years. The offer prices of FERA shares were lower
than their intrinsic worth. Hence, for the first time FERA dilution created an
equity cult in India. It was the spate of FERA issues that gave a real fillip to
the Indian stock market. For the first time, many investors got an opportunity
to invest in the stocks of such MNCs as Colgate, and Hindustan Lever
Limited. Then, in 1977, a little-known entrepreneur, Dhirubhai Ambani,
tapped the capital market. The scrip, Reliance Textiles, is still a hot favourite
and dominates trading at all stock exchanges.

The l980s witnessed an explosive growth of the securities market in

India, with millions of investors suddenly discovering lucrative opportunities.
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Many investors jumped into the stock markets for the first time. The
government's liberalisation process initiated during the mid-1980s, spurred
this growth. Participation by small investors, speculation, dcfaults, ban on
badla, and resumption of badla continued. Convertible debentures emerged as
a popular instrument of resource mobilisation in the primary market. The
introduction of public sector bonds and the successful mega issues of
Reliance Petrochemicals and Larsen and Toubro gave a new lease of life to
the primary market. This, in turn, enlarged volumes in the secondary market.
The decade of the 1 980s was characterised by an increase in the number of
stock exchanges, listed companies, paid-up capital, and market capitalisation.
The 1990s will go down as the most important decade in the history of
the capital market of India. Liberalisation and globalisation were the new
terms coined and marketed during this decade. The Capital Issues (Control)
Act, 1947 was repealed in May 1992. The decade was characterised by a new
industrial policy, emergence of the SEBI as a regulator of the capital market,
advent of foreign institutional investors, euro-issues, free pricing, new trading
practices, new stock exchanges, entry of new players such as private sector
mutual funds and private sector banks, and primary market boom and bust.
Major capital market scams took place in the 1990s. These shook the
capital market and drove away small investors from the market. The securities
scam of March 1992 involving brokers as well as hankers was one of the
biggest scams in the history of the capital market. In the subsequent years
owing to free pricing, many unscrupulous promoters, who raised money from
the capital market, proved to be flyby-night operators. This led to an erosion
in the investors' confidence. The M S Shoes ease, one such scam which took
place in March 1995, put a break on new issue activity.
The 1991-92 securities scam revealed the inadequacies of and
inefficiencies in the financial system. It was the scam which prompted a
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reform of the equity market. The Indian stock market witnessed a sea change
in terms of technology and market prices. Technology brought radical
changes in the trading mechanism. The Bombay Stock Exchange was subject
to nationwide competition by two new stock exchanges–the National Stock
Exchange, set up in 1994, and the Over the Counter Exchange of India, set up
in 1992. The National Securities Clearing Corporation (NSCC) and the
National Securities Depository Limited (NSDL) were set up in April 1995
and November 1996 respectively for improved clearing and settlement and
dematerialised trading. The Securities Contracts (Regulation) Act, 1956 was
amended in 1995-96 for introduction of options trading. Moreover, rolling
settlement was introduced in January 1998 for the dematerialised segment of
all companies. With automation and geographical spread, stock market
participation increased.

In the late- 1990s, Information Technology (IT) scrips dominated the

Indian bourses. These scrips included Infosys, Wipro, and Satyam. They were
a part of the favourite scrips of the period, also known as `new economy'
scrips, along with telecommunications and media scrips. The new economy
companies were knowledge intensive unlike the old economy companies that
were asset intensive.

The Indian capital market entered the twenty-first century with the
Ketan Parekh scam. As a result of this scam, badla was discontinued from
July 2001 and rolling settlement was introduced in all scrips. Trading of
futures commenced from June 2000, and Internet trading was permitted in
February 2000. On July 2, 2001, the Unit Trust of India announced
suspension of the sale and repurchase of its flagship US-64 scheme due to
heavy redemption leading to a panic on the bourses. The government's
decision to privatise oil PSUs in 2003 fueled stock prices. One big divestment
of international telephony major VSNL took place in early February 2002.
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Foreign institutional investors have emerged as major players on the Indian

houses. NSF has an upper hand over its rival BSL in tennis of volumes not
only in the equity markets hut also in the derivatives market.

It has been a long journey for the Indian capital market. Now the
capital market is organised, fairly integrated, mature, more global and
modernised. The Indian equity market is one of the best in the world in terms
of technology. Advances in computer and communications technology,
coming together on Internet are shattering geographic boundaries and
enlarging the investor class. Internet trading has become a global
phenomenon. Indian stock markets are now getting integrated with global
markets.

IX. CAPITAL MARKET INTERMEDIARIES:

A number of agencies called intermediaries play a critical role in the

process of issue of new securities. The major intermediaries of the capital
securities market include.

1. Merchant bankers/Lead managers

2. Underwriters

3. Bankers to an issue

4. Registrars to an issue

5. Share transfer agents

6. Debenture trustees

7. Portfolio managers

Merchant bankers/lead managers:

Merchant banker is an institution or an organisation which provides a
number of services including management of securities issues, portfolio
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management services, underwriting of capital issues, insurance, credit

syndication, financial advices and project counselling etc. They mainly offer
financial services for a fee. They are also different from the dealers, traders
and brokers of securities. It has become mandatory now that all public issues
should be managed by merchant banker(s) acting as the lead manager(s).

Underwriters:

Underwriting is an act of undertaking the guarantee by an underwriter

of buying the shares or debentures placed before the public in the event of
non-subscription. Underwriting in the context of a company means
undertaking a responsibility or giving a guarantee that the securities (shares
and debentures) offered to the public will be subscribed for. The firms which
undertake the guarantee are called `underwriters'. Underwriting is similar to
insurance in the sense that it provides protection to the issuing company
against the failure of an issue of capital to the public.
Bankers to an issue:
Bankers to an issue is an important intermediary who accepts
applications and application monies, collects all monies, refund application
monies after allotment and participates in the payment of dividends by
companies. They are subject to the rules and regulations framed by SEBI in
their regard.

Registrar to an issue and share transfer agent:

The Registrar to an issue is an intermediary who performs the functions

(i) Collecting applications from investors

(ii) Keeping a record of applications

(iii) Keeping record of money received from investors or paid to

sellers of shares
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(iv) Assisting the companies in the determination of basis of allotment

of shares

(v) Helping in despatch of allotment letter refund orders, share

certificates etc.

The Share Transfer Agents on the other hand maintain the record of
holders of securities or on behalf of the companies and deal with all activities
connected with the transfer/redemption of its securities. These are under the
control of SEBI and follow the rules made their under.

Debenture trustees:

The Regulations define a debenture trustee as a trustee of a trust deed

for securing any issue of debentures of a body corporate. Trust deed means a
deed executed by the company in favour of trustees named therein for the
benefit of the debenture holders.
Brokers to an issue:

Brokers are the person who procure subscriptions to issue from

prospective investors spread over larger area. A company can appoint as
many number of brokers as it wants.
Portfolio managers:
The SEBI Regulations define portfolio manager as any person who
pursuant to a contract or arrangement with a client, advises or directs or
undertakes on behalf of the client, the management or administration of a
portfolio of securities or the funds of the client.
X. DEPOSITORY SYSTEM AND DEMATERIALIZATION:
It is a system whereby the transfer and settlement of scrips take place
not through the traditional method of transfer deeds and physical delivery of
scrips but through the modern system of effecting transfer of ownership of
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securities by means of book entry on the ledgers or the depository without the
physical movement of scrips. The new system, thus, eliminates paper work,
facilitates automatic and transparent trading in scrips, shortens the settlement
period and ultimately contributes to the liquidity of investment in securities.
This system is also known as 'scripless trading system'.
Constituents of depository system:
There are essentially four players in the depository system:
(i) The Depository Participant
(ii) The Beneficial Owner/Investor
(iii) the Issuer
(iv) The depository