Financial Markets | CBSE Class 12 Business Studies Notes

This note covers the financial market and its allocative function, the four functions of a financial market, how financial markets are classified, the money market and its instruments, the capital market and how it differs from the money market, the primary market and the methods of floating new issues, the secondary market, the stock exchange and its functions, screen-based trading and settlement, dematerialisation and depositories, and the Securities and Exchange Board of India (SEBI).

What is a financial market?

A business needs finance for working capital, such as payments for raw materials and salaries, and for fixed capital, such as buying machinery or a building or expanding capacity. It raises these funds from various sources through financial markets.

Idea Cellular (which merged with Vodafone India in 2018 and is now Vodafone Idea Limited), for example, decided to enter the Indian capital market for its needs of expansion.

How does a financial market link savers and investors?

An economic system has two main sectors: households, which save funds, and business firms, which invest these funds. A financial market links the savers and the investors by mobilising funds between them.

In doing so it performs the allocative function: it directs the funds available for investment into their most productive investment opportunity. When this is done well, the rate of return offered to households is higher, and scarce resources go to the firms with the highest productivity for the economy.

What is financial intermediation?

Funds can be allocated via banks or via financial markets. Households can deposit surplus funds with banks, which lend them to business firms. Alternatively, households can buy the shares and debentures offered by a business through financial markets.

The process by which funds are allocated is called financial intermediation. Banks and financial markets are competing intermediaries, and households choose where to place their savings.

Definition: A financial market is a market for the creation and exchange of financial assets. It exists wherever a financial transaction occurs, such as the initial issue of shares and debentures by a firm, or the purchase and sale of existing shares, debentures and bonds.

Four drawings form a circle: business firms (a factory) at the top, financial markets (exchange buildings) on the right, household savers (a man with a briefcase marked "Rs." beside a house) at the bottom, and banks on the left.

Arrows run from household savers to both banks and financial markets. Pairs of opposite arrows link banks with business firms, and business firms with financial markets.

Reference: NCERT Class 12 Business Studies figure "Financial System"

What are the functions of a financial market?

Financial markets help to allocate scarce resources in an economy by performing four important functions.

1. Mobilisation of savings and channelling them into the most productive uses: A financial market transfers savings from savers to investors. It gives savers a choice of investments and so channels surplus funds into the most productive use.
2. Facilitating price discovery: In the financial market, households are the suppliers of funds and business firms represent the demand. Their interaction helps to establish a price for the financial asset being traded.
3. Providing liquidity to financial assets: Financial markets make it easy to buy and sell financial assets, so that they can be converted into cash whenever required.
4. Reducing the cost of transactions: Financial markets provide valuable information about securities. This saves the time, effort and money that buyers and sellers would otherwise spend trying to find each other.

The financial market is thus a common platform where buyers and sellers meet to fulfil their individual needs.

How are financial markets classified, and what is the money market?

Financial markets are classified on the basis of the maturity of the instruments traded in them. Instruments with a maturity of less than one year are traded in the money market. Instruments with a longer maturity are traded in the capital market.

A tree chart has "Financial market" at the top, branching into "Money market" and "Capital market". The capital market branches into "Primary market" and "Secondary market", and each of these branches into "Debt" and "Equity".

Reference: NCERT Class 12 Business Studies chart "Classification of Financial Markets"

Definition: The money market is a market for short-term funds which deals in monetary assets whose period of maturity is up to one year. These assets are close substitutes for money.

Low-risk, unsecured, short-term and highly liquid debt instruments are issued and actively traded in it every day. It has no physical location; it works over the telephone and through the internet. It lets short-term funds be raised for temporary cash shortages, and excess funds be deployed temporarily to earn returns.

Its major participants are the Reserve Bank of India (RBI), commercial banks, non-banking finance companies, state governments, large corporate houses and mutual funds.

What are the main money market instruments?

What is a treasury bill?

A treasury bill is an instrument of short-term borrowing by the Government of India, maturing in less than one year.

Also known as zero coupon bonds, treasury bills are issued by the RBI on behalf of the Central Government, in the form of a promissory note. They are highly liquid, with an assured yield and negligible risk of default.

They are issued at a price lower than their face value and repaid at par. The difference is the interest, called the discount. They are now issued in three tenors: 91, 182 and 364 days.

The textbook gives the minimum amount as ₹25,000 in multiples of ₹25,000; the RBI now accepts bids from ₹10,000, in multiples of ₹10,000.

Worked example 1: interest on a treasury bill. An investor buys a 91 days treasury bill with a face value of ₹1,00,000 for ₹96,000 and holds it until maturity. What interest does the investor earn?

Answer: At maturity the investor receives ₹1,00,000. Interest = ₹1,00,000 − ₹96,000 = ₹4,000, which is the discount on the bill.

What is commercial paper?

Commercial paper is a short-term, unsecured promissory note, negotiable and transferable by endorsement and delivery, with a fixed maturity period.

Large and creditworthy companies issue it to raise short-term funds at lower rates of interest than market rates, as an alternative to bank borrowing. The textbook gives its usual maturity as 15 days to one year.

Under the RBI's present directions it can be issued for 7 days to one year, in multiples of ₹5 lakh and only in dematerialised form, and NBFCs and All-India Financial Institutions can issue it as well as companies. It is sold at a discount and redeemed at par.

Worked example 2: bridge financing. A company needs long-term finance to buy machinery. To raise funds in the capital market it must first pay floatation costs such as brokerage, commission, printing of applications and advertising. How can it meet these costs?

Answer: It can raise funds through commercial paper, which matures within a year (7 days to one year under the RBI's current directions), and use them to pay the floatation costs. This is called bridge financing.

What is call money?

Call money is short-term finance repayable on demand, with a maturity of one day to fifteen days, used for inter-bank transactions.

Banks must maintain a minimum cash balance called the cash reserve ratio, which the RBI changes from time to time. Banks borrow call money from each other to maintain it.

In the RBI's present terms, overnight borrowing is call money and borrowing for 2 to 14 days is notice money, and only banks and primary dealers take part in this market.

The interest rate on call money is the call rate. It is highly volatile, varying from day to day and even hour to hour. When call rates rise, commercial paper and certificates of deposit become cheaper in comparison, so banks raise funds from these sources.

What are certificates of deposit and commercial bills?

Certificates of deposit (CDs) are unsecured, negotiable, short-term instruments, described in the textbook as being in bearer form, issued by commercial banks and development financial institutions to individuals, corporations and companies.

Under the RBI's present directions they are issued only in dematerialised form, for 7 days to one year and in multiples of ₹5 lakh.

They can be issued in periods of tight liquidity, when deposit growth is slow but demand for credit is high.

A commercial bill is a short-term, negotiable, self-liquidating bill of exchange used to finance the credit sales of firms.

The seller (drawer) draws the bill and the buyer (drawee) accepts it, making it a marketable trade bill that can be discounted with a bank. A trade bill accepted by a commercial bank is a commercial bill.

What is the capital market?

Definition: The capital market refers to the facilities and institutional arrangements through which long-term funds, both debt and equity, are raised and invested.

Through its channels, the savings of the community are made available for industrial and commercial enterprises and the public in general, and directed into their most productive use. It consists of development banks, commercial banks and stock exchanges.

An ideal capital market is one where finance is available at reasonable cost. A well-functioning capital market facilitates economic development; in fact, the development of the financial system is seen as a necessary condition for economic growth.

Financial institutions should be sufficiently developed, and market operations should be free, fair, competitive and transparent. The capital market should also deliver information efficiently, minimise transaction costs and allocate capital most productively.

The capital market has two parts: the primary market and the secondary market.

How does the capital market differ from the money market?

Individual investors may transact in the secondary money market but do not normally do so. Small unit values in the capital market help individuals with small savings to invest.

The money market is safer because of the short duration and the financial soundness of its issuers: mainly the government, banks and highly rated companies. In the capital market, companies may fail to perform as projected, and promoters may defraud investors.

Capital market returns are generally higher, and the possibility of earnings is higher when securities are held for longer. Equity shares offer scope for capital gains, and in the long run shareholders share a company's prosperity through high dividends and bonus issues.

What is the primary market, and how are new issues floated?

The primary market, or new issues market, deals with new securities issued for the first time. It transfers investible funds from savers to entrepreneurs who set up new enterprises or expand existing ones. Its investors are banks, financial institutions, insurance companies, mutual funds and individuals.

A company can raise capital here in the form of equity shares, preference shares, debentures, loans and deposits, for new projects, expansion, diversification, modernisation, mergers and takeovers.

What are the methods of floatation?

1. Offer through prospectus: The most popular method. The company invites subscription from the public through a prospectus advertised in newspapers and magazines. The issue may be underwritten, must be listed on at least one stock exchange, and its prospectus must follow the Companies Act and SEBI disclosure and investor protection guidelines.
2. Offer for sale: The company sells securities en bloc at an agreed price to intermediaries such as issuing houses or stock brokers, who resell them to the public. In today's public issues the term usually means existing shareholders selling some of their shares to the public, so that part of the money goes to them and not to the company.
3. Private placement: Securities are allotted to institutional investors and some selected individuals. This raises capital more quickly than a public issue, and suits companies that cannot afford the expenses of one.
4. Rights issue: A privilege given to existing shareholders to subscribe to a new issue on the company's terms and conditions. They get the 'right' to buy new shares in proportion to the shares they already hold.
5. e-IPOs: The company issues capital through the online system of a stock exchange, under an agreement with the exchange. This is an initial public offer (IPO).

How does an e-IPO work?

SEBI-registered brokers are appointed to accept applications and place orders. The company appoints a registrar to the issue with electronic connectivity to the exchange.

It can apply for listing on any exchange other than the one through which it offered its securities. The lead manager coordinates all the activities among the intermediaries connected with the issue.

Today, bids for a public issue are placed online, investors pay through ASBA, which blocks the amount in their bank account until allotment, and individual investors can pay through UPI for bids of up to ₹5 lakh. Shares must be listed within three working days of the issue closing (T+3).

Worked example 3: identifying the market. Life Insurance Corporation of India (LIC) subscribed 70% of Hindustan Aeronautics' ₹4,200-crore initial public offering. Which market is this, and explain any two other methods of floatation in it.

Answer: The primary market, because an initial public offering of ₹4,200 crore is a new issue of securities to investors, of which LIC took 70%.

Other methods include offer through prospectus, where the company invites the public to subscribe through an advertised prospectus; offer for sale, where securities are sold en bloc at an agreed price to intermediaries who resell them to the public; private placement, where securities are allotted to institutional investors and some selected individuals; and rights issue, where existing shareholders are offered new shares in proportion to their holdings.

What is the secondary market, and how does it differ from the primary market?

The secondary market, also called the stock market or stock exchange, is a market for the purchase and sale of existing securities. It lets existing investors disinvest and fresh investors enter, and gives existing securities liquidity and marketability.

Through disinvestment and reinvestment, it channels funds towards the most productive investments. Securities are traded, cleared and settled within SEBI's regulatory framework, and trading terminals make stock exchanges accessible from anywhere in the country.

Note: The two markets are linked. An efficiently functioning stock exchange creates a conducive climate for an active and growing primary market.

What is a stock exchange, and what are its functions?

A stock exchange is an institution that provides a platform for buying and selling existing securities, turning a security into money and vice versa. It helps companies raise finance, gives investors liquidity and safety, and enhances the creditworthiness of companies.

Definition: Under the Securities Contracts (Regulation) Act, 1956, a stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying and selling or dealing in securities.

What does a stock exchange do?

1. Providing liquidity and marketability to existing securities: Its basic function is creating a continuous market where securities are bought and sold, so investors can disinvest and reinvest.
2. Pricing of securities: Prices are set by demand and supply through constant valuation, giving instant information to buyers and sellers.
3. Safety of transactions: Membership is well regulated and dealings are well defined under the existing legal framework, so investors get a safe and fair deal.
4. Contributing to economic growth: Disinvestment and reinvestment channel savings into their most productive avenues, leading to capital formation.
5. Spreading of equity cult: It can widen share ownership by regulating new issues, improving trading practices and educating the public about investments.
6. Providing scope for speculation: It provides scope, within the law, for speculation in a restricted and controlled manner. A certain degree of healthy speculation is generally accepted as necessary for liquidity and price continuity.

A stock market index is a barometer of market behaviour, measuring market sentiment through a representative set of stocks. The BSE SENSEX and the NSE NIFTY are important Indian indices.

The SENSEX, launched in 1986, is made up of 30 of the most actively traded stocks.

Its members are reviewed from time to time, so the companies in it change, and it has been weighted by free-float market capitalisation since September 2003.

How does screen-based trading work?

Trading is now done through an online, screen-based electronic trading system: all buying and selling of shares and debentures happens through a computer terminal.

Earlier, in the open outcry system, brokers struck deals on the floor of the stock exchange, shouting out prices and selling shares to the highest bidder. Trading has now shifted from the floor to the broker's office.

Every broker, as a member of the exchange, has a terminal connected to the exchange's main computer.

The broker feeds in the shares and price, and the software executes the deal when a matching order is found from a counter party, at the best bid and offer price. Unmatched orders stay on screen for matching during the day.

What are the advantages of screen-based trading?

1. It ensures transparency, as participants see the prices of all securities in real time.
2. It passes on information efficiently, helping to fix prices efficiently.
3. It makes operations efficient, reducing time, cost and risk of error.
4. People across the country, and even abroad, can trade through brokers without knowing each other, which improves the liquidity of the market.
5. It provides a single trading platform, as all trading centres transact at the same time on one computerised exchange.

Shares may be held in physical form, or in an electronic book entry form called the dematerialised form.

What are the steps in trading and settlement of securities?

Note: Trades on Indian stock exchanges settle on a T+1 rolling basis, since the phased move from T+2 to T+1 was completed on 27 January 2023, so pay-in and pay-out fall on the first working day after the trade day (T).

The steps below follow the textbook, which describes the earlier T+2 cycle, so read "T+2" in them as the earlier settlement day.

1. The investor approaches a registered broker (or the broker's authorised person, since SEBI discontinued the separate sub-broker category after March 2019), signs a broker-client agreement and a client registration form, and the broker opens a trading account in the investor's name.
2. The investor opens a demat account, or beneficial owner (BO) account, with a depository participant (DP), and a bank account for cash transactions.
3. The investor places an order stating the number of shares and the price. The broker issues an order confirmation slip.
4. The broker goes online, connects to the stock exchange and matches the share and the best price available.
5. When the order is executed electronically, the broker issues a trade confirmation slip.
6. Within 24 hours of the trade, the broker issues a contract note.
7. The investor pays cash for shares bought or delivers shares sold on the pay-in day, which, in the earlier cycle, came before the T+2 day.
8. The settlement cycle was T+2 on a rolling settlement basis, with effect from 1 April 2003, so the deal was settled and finalised on the T+2 day. It has been T+1 since the move completed on 27 January 2023.
9. In the earlier cycle, on the T+2 day, the pay-out day, the exchange delivered the shares or made payment to the other broker; it now does so on T+1. The broker pays the investor within 24 hours of the pay-out day.
10. The broker can deliver shares directly to the investor's demat account, once the investor instructs his DP to take delivery.

Note: SEBI also permits optional same-day (T+0) settlement, introduced in March 2024 for a limited set of shares. T+1 remains the standard settlement cycle.

What does the client registration form ask for?

It asks for the PAN number (mandatory), date of birth and address, educational qualification and occupation, residential status (Indian or NRI), bank account details, depository account details, the name of any other broker with whom the investor is registered, and a client code number.

Why is the contract note important?

The contract note shows the number of shares, the price, the date and time of the deal and the brokerage charges. It is legally enforceable and helps settle disputes between investor and broker. It carries the Unique Order Code number that the exchange assigns to each transaction.

Across the top, marked transaction day (T), a buying investor sends a "buy order" and a selling investor a "sell order" to their brokers.

A double-headed arrow between the brokers is labelled "Order match on exchange", and each broker returns a "contract note".

An arrow leads down through an exchange building to "Files of obligation downloaded by clearing members (NSDL/CDSL)", then to pools marked "Transfer to the pool account of clearing houses" at T+1 (the "Backend process").

On each side, arrows marked "T+2 settlement" run between the investor and the boxes "Transfer to the pool account of the broker", one set pointing down and one pointing up, and dotted arrows join these boxes across the bottom.

Reference: NCERT Class 12 Business Studies trade flow chart, which shows the earlier T+2 cycle

Worked example 4: the steps after opening accounts. Lalita wants to buy shares of Akbar Enterprises through her broker Kushvinder. She already has a demat account and a bank account for securities transactions. What are the next steps?

Answer: Following the textbook's earlier T+2 cycle (pay-in and pay-out now fall on T+1): (1) She places an order stating the number of shares and the price, and gets an order confirmation slip.

(2) Kushvinder matches the share and best price online. (3) On execution he issues a trade confirmation slip, and (4) within 24 hours a contract note. (5) She pays cash on the pay-in day, before T+2.

(6) On T+2, the pay-out day, the exchange delivers the shares to Kushvinder, and (7) he can deliver them directly to her demat account, once she instructs her DP to take delivery in her beneficial owner account.

What are dematerialisation and depositories?

Definition: Dematerialisation is the process in which securities held by an investor in physical form are cancelled and the investor is given an electronic entry or number, so that the securities are held as an electronic balance in an account.

For this, the investor opens a demat account with an organisation called a depository. All IPOs are now issued in dematerialised form, and more than 99% of turnover is settled by delivery in demat form.

SEBI first made demat settlement mandatory in certain select securities and, since 1 April 2019, shares of listed companies can be transferred only in demat form.

Physical certificates may still be held, but they must be dematerialised before they can be transferred.

What were the disadvantages of holding securities in physical form?

Physical share certificates and debentures suffered from theft, fake or forged transfers, transfer delays and paperwork. Electronic book entry settlement was adopted mainly to eliminate these problems.

Why is the demat form convenient?

A demat account works just like a bank account. Shares can be transferred like cash, all trades settle through a single account, and demat securities can be pledged or hypothecated for loans.

There is no danger of loss, theft or forgery. Electronic holdings can even be reconverted into physical certificates, called rematerialisation.

How does the demat system work?

1. A depository participant (DP), such as a bank, broker or financial services company, is identified.
2. An account opening form and documents (PAN card details, photograph and, in the textbook's list, a power of attorney) are completed. Since 2022 the power of attorney has been replaced by an optional Demat Debit and Pledge Instruction, which a broker cannot insist on.
3. The physical certificate is given to the DP with a dematerialisation request form.
4. For shares applied for in a public offer, DP and demat account details are given, and allotted shares are credited automatically.
5. To sell through a broker, the DP is instructed to debit the account with the shares.
6. The broker instructs his DP to deliver the shares to the stock exchange.
7. The broker receives payment and pays the seller.
8. In the textbook's earlier T+2 cycle, all this was completed within 2 days. It is now completed on a T+1 settlement basis.

What are depositories and depository participants?

Just as a bank keeps money in safe custody, a depository keeps securities in electronic form for investors. It is a technology-driven electronic storage system with no paperwork, and settles transactions faster through book entries.

India has two depositories. The National Securities Depository Limited (NSDL), the first, was promoted by the IDBI, UTI and the National Stock Exchange. The Central Depository Services Limited (CDSL), the second, was promoted by the Bombay Stock Exchange and the Bank of India.

Both work through depository participants, intermediaries electronically connected to the depository who maintain investors' demat accounts. Financial institutions, banks, clearing corporations, stock brokers and non-banking finance corporations may become DPs.

A stepped pyramid has SEBI at the apex, labelled "Regulator".

Below are the depositories, labelled NSDL (NSE) and CDSL (BSE), then depository participants, labelled "Bank, Financial Institution, Broker eligible as per SEBI".

A side label on a lower band reads "Gateway to access Trading Terminal: Transact, track market move and manage fund". The base is labelled "Investors demat account".

Reference: NCERT Class 12 Business Studies pyramid figure

What is SEBI, and what does it do?

The Securities and Exchange Board of India (SEBI) was set up by the Government of India on 12 April 1988 as an interim administrative body, under the overall administrative control of the Ministry of Finance, to promote the orderly and healthy growth of the securities market and to protect investors.

It got statutory status on 30 January 1992 through an ordinance, later replaced by the Securities and Exchange Board of India Act, 1992.

Why was SEBI set up?

The capital market grew tremendously in the 1980s, with rising public participation. This led to malpractices such as self-styled merchant bankers, unofficial private placements, price rigging, unofficial premium on new issues, non-adherence to the Companies Act, violation of stock exchange rules and listing requirements, and delays in delivering shares.

These eroded investor confidence. The Government and the stock exchanges were rather helpless in redressing investors' problems because the existing law lacked proper penal provisions, so a separate regulatory body was set up.

What is SEBI's purpose?

SEBI aims to create an environment for efficient mobilisation and allocation of resources through the securities markets, and to stimulate competition and encourage innovation. This environment serves the three groups that make up the market.

What are the objectives of SEBI?

Its overall objective is to protect investors' interests and to promote the development of, and regulate, the securities market.

1. To regulate stock exchanges and the securities industry to promote their orderly functioning.
2. To protect the rights and interests of investors, particularly individual investors, and to guide and educate them.
3. To prevent trading malpractices and balance self-regulation by the securities industry with statutory regulation.
4. To regulate and develop a code of conduct and fair practices by intermediaries such as brokers and merchant bankers, making them competitive and professional.

What are the functions of SEBI?

SEBI was given the twin task of regulation and development of the securities market, along with protective functions.

Glossary

• Financial market — A market for the creation and exchange of financial assets, which exists wherever a financial transaction occurs.
• Allocative function — A financial market's role in directing funds available for investment into their most productive investment opportunity.
• Financial intermediation — The process by which funds are allocated from savers to business firms, through banks or through financial markets.
• Money market — A market for short-term funds dealing in monetary assets with a maturity of up to one year.
• Treasury bill — A short-term borrowing instrument of the Government of India, issued by the RBI at a discount and repaid at par.
• Commercial paper — A short-term, unsecured promissory note issued by large, creditworthy companies, for 7 days to one year under the RBI's current directions (the textbook gives 15 days to one year).
• Call money — Inter-bank finance repayable on demand, with a maturity of one day to fifteen days; its interest rate is the call rate.
• Capital market — The facilities and institutional arrangements through which long-term funds, both debt and equity, are raised and invested.
• Primary market — The new issues market, which deals with new securities being issued for the first time.
• Secondary market — The stock market, where existing securities are bought and sold, giving them liquidity and marketability.
• Contract note — A legally enforceable document issued by the broker within 24 hours of a trade, giving its details and brokerage.
• Dematerialisation — Cancelling physical securities and giving the investor an electronic entry, so they are held as an electronic balance.
• Depository participant — An intermediary, electronically connected to a depository, that maintains investors' demat accounts and is their contact point.

Common errors and misconceptions

• Misconception: The money market is a particular place where short-term funds are traded. Correct: It has no physical location and works over the telephone and through the internet.
• Misconception: Investors can buy and sell securities in the primary market. Correct: Only buying takes place in the primary market; both buying and selling take place on the stock exchange.
• Misconception: A company receives money whenever its shares are traded on the stock exchange. Correct: In the secondary market, investors trade with each other and the company is not involved at all.
• Misconception: Treasury bills pay interest at regular intervals. Correct: They are zero coupon bonds, issued below face value and repaid at par; the difference, the discount, is the interest.
• Misconception: The money market is riskier than the capital market. Correct: The money market is generally much safer, because of short durations and financially sound issuers.
• Misconception: The contract note is only an informal receipt. Correct: It is legally enforceable and helps settle disputes between the investor and the broker.
• Misconception: SEBI has been a statutory body since 1988. Correct: It began in 1988 as an interim administrative body and got statutory status on 30 January 1992.

Exam-style questions with model answers

Q1. Name the document in online trading that is legally enforceable and helps settle disputes between the investor and the broker. [1 mark]

1. The contract note. The broker issues it within 24 hours of the trade being executed, and it carries the Unique Order Code number assigned by the stock exchange.

Q2. What is a treasury bill? [2 marks]

1. A treasury bill is an instrument of short-term borrowing by the Government of India, maturing in less than one year.
2. It is issued by the RBI on behalf of the Central Government as a zero coupon bond, below its face value, and repaid at par.

Q3. "Money market is essentially a market for short-term funds." Discuss. [3 marks]

1. It deals in monetary assets with a maturity of up to one year, which are close substitutes for money.
2. Its instruments, such as treasury bills, commercial paper, call money and certificates of deposit, are low-risk, unsecured, short-term and highly liquid.
3. It meets temporary shortages of cash and lets excess funds earn returns for short periods.

Q4. State the four functions of a financial market. [4 marks]

1. Mobilisation of savings: transferring savings from savers to investors and into the most productive use.
2. Price discovery: the interaction of households (supply of funds) and firms (demand) sets the price of a financial asset.
3. Liquidity: financial assets can be easily bought, sold and converted into cash.
4. Lower transaction costs: information about securities saves buyers and sellers time, effort and money.

Q5. Distinguish between the primary market and the secondary market on any four bases. [4 marks]

1. Securities: new issues in the primary market; existing shares in the secondary market.
2. Parties: the company sells to investors in the primary market; investors trade with each other in the secondary market.
3. Buying and selling: only buying in the primary market; both in the secondary market.
4. Prices: decided by management in the primary market; set by demand and supply in the secondary market.

Q6. Distinguish between the capital market and the money market. [6 marks]

1. Participants: financial institutions, banks, companies, foreign and retail investors in the capital market; mainly institutions such as the RBI and banks in the money market.
2. Instruments: shares, debentures and bonds; against T-bills, commercial paper and certificates of deposit.
3. Investment outlay: small unit values and trading lots; against huge sums.
4. Duration: medium and long term; against a maximum of one year.
5. Liquidity: marketable but not always actively traded; against higher liquidity, with the DFHI (now part of SBI DFHI Limited) set up to provide a ready market.
6. Safety: riskier; against generally much safer, with minimum default risk.
7. Expected return: generally higher in the capital market.

Q7. Explain the steps in screen-based trading for buying and selling securities. [6 marks]

1. The investor signs a broker-client agreement and client registration form with a registered broker, who opens a trading account.
2. The investor opens a demat (BO) account with a DP and a bank account.
3. The investor places an order stating shares and price, and gets an order confirmation slip.
4. The broker goes online and matches the share and best price.
5. On electronic execution, the broker issues a trade confirmation slip.
6. Within 24 hours the broker issues a contract note.
7. On the pay-in day (before T+2 in the textbook's earlier cycle, now on T+1), the investor pays cash or delivers shares.
8. On the pay-out day (T+2 in the earlier cycle, now T+1), the exchange delivers shares or makes payment to the other broker, and the broker pays the investor within 24 hours.
9. Shares can be delivered directly to the investor's demat account.

Q8. Explain the functions of SEBI. [5 marks]

1. Regulatory functions: registration of brokers, sub-brokers (a category discontinued in 2018) and other market players; registration of collective investment schemes and mutual funds; regulation of stock brokers, portfolio managers, underwriters, merchant bankers and the business in stock exchanges; regulation of takeover bids; inspection, enquiries and audits of stock exchanges and intermediaries; levying fees; and exercising powers delegated under the Securities Contracts (Regulation) Act, 1956.
2. Development functions: training intermediaries, conducting research and publishing information useful to all market participants, and developing the capital markets by adopting a flexible approach.
3. Protective functions: prohibiting fraudulent and unfair trade practices such as misleading statements, manipulations and price rigging; controlling insider trading and imposing penalties; undertaking steps for investor protection; and promoting fair practices and a code of conduct.

Key takeaways

• A financial market links households that save with business firms that invest, directing funds into their most productive investment opportunity.
• Its four functions are mobilising savings, facilitating price discovery, providing liquidity to financial assets and reducing the cost of transactions.
• Instruments maturing in less than one year trade in the money market; longer-term instruments trade in the capital market.
• Money market instruments include treasury bills, commercial paper, call money, certificates of deposit and commercial bills.
• The capital market has a primary market for new issues and a secondary market, the stock exchange, for existing securities.
• New issues are floated through offer through prospectus, offer for sale, private placement, rights issue or e-IPO.
• Screen-based trading matches orders electronically, and trades are settled through demat accounts held with NSDL or CDSL through depository participants.
• SEBI, set up in 1988 and made statutory in 1992, protects investors and regulates and develops the securities market.

Test yourself

What is financial intermediation?

The process by which funds are allocated from savers to business firms, either through banks or through financial markets.

On what basis are financial markets classified?

On the maturity of the instruments traded: less than one year in the money market, longer in the capital market.

Why do banks use call money?

Banks borrow from each other through call money, repayable on demand, to maintain the cash reserve ratio.

What is bridge financing?

Using funds raised through commercial paper to meet the floatation costs of a long-term issue in the capital market.

How does a rights issue differ from private placement?

A rights issue offers existing shareholders new shares in proportion to their holdings; private placement allots securities to institutions and selected individuals.

What happens on the pay-out day?

The exchange delivers the shares or makes payment to the other broker on the pay-out day: T+2 in the textbook's earlier cycle, and T+1 now. The broker pays the investor within 24 hours of the pay-out day.

Name the two depositories in India.

National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL).

When did SEBI get statutory status?

On 30 January 1992, through an ordinance later replaced by the SEBI Act, 1992.