Financial Markets

Main Idea

Financial markets provide an organised system for creating, exchanging and regulating financial assets such as shares, debentures, bonds and treasury bills. They transfer savings from individuals and institutions to businesses and governments requiring funds. The money market serves mainly short-term financing needs, whereas the capital market supports medium-term and long-term finance. Stock exchanges facilitate regulated trading, while SEBI protects investors and regulates the securities market.

Key Concepts and Definitions

• Financial Market: A market where financial assets such as shares, bonds, debentures and short-term instruments are created and traded.
• Money Market: A market for short-term funds and financial instruments with a maturity period generally not exceeding one year.
• Capital Market: A market for raising and investing medium-term and long-term funds through instruments such as equity shares, preference shares, debentures and bonds.
• Primary Market: The market where new securities are issued to investors for the first time, enabling companies or governments to raise fresh funds.
• Secondary Market: The market where existing securities are bought and sold among investors, usually through stock exchanges.
• Treasury Bill: A short-term government security issued at a discount and repaid at its face value on maturity.
• Commercial Paper: An unsecured short-term promissory note issued by financially strong companies to raise funds.
• Certificate of Deposit: A negotiable short-term instrument issued by banks and eligible financial institutions against deposited funds.
• Commercial Bill: A short-term bill of exchange used to finance credit sales and trade transactions.
• Call Money: Very short-term borrowing and lending, generally for one day, mainly among banks and financial institutions.
• Repo Rate: The rate at which the central bank lends short-term funds to commercial banks against approved securities.
• Reverse Repo Rate: The rate at which the central bank borrows short-term funds from commercial banks by providing securities.
• Stock Exchange: An organised and regulated market where listed securities are bought and sold according to established rules.
• Listing: The admission of a company's securities for trading on a recognised stock exchange.
• Broker: A registered intermediary who buys or sells securities on behalf of investors.
• Dematerialisation: The conversion of physical share certificates into electronic form.
• Depository: An institution that holds securities electronically and facilitates their transfer and settlement.
• SEBI: The Securities and Exchange Board of India, which regulates the securities market and protects investors.
• Investor Protection: Measures that ensure fair treatment of investors, truthful information, safe transactions and action against market abuse.
• Liquidity: The ease with which a financial asset can be converted into cash without a significant loss in value.

Supporting Arguments and Evidence

• Financial markets improve economic efficiency by transferring funds from surplus units, such as savers, to deficit units, such as businesses and governments. Their main functions include mobilising savings, facilitating price discovery, providing liquidity, reducing transaction costs and allocating funds.

• The money market supports short-term liquidity requirements. Its instruments are generally short-term and highly liquid, including treasury bills, commercial paper, certificates of deposit, commercial bills, call money and repos. By contrast, the capital market supports medium-term and long-term investment through equity shares, preference shares, debentures, bonds and government securities.

• The primary market, also known as the new issue market, deals with newly issued securities and enables companies or governments to raise fresh funds. The secondary market does not directly provide new funds to the issuing company; instead, it provides liquidity and marketability to existing securities. These markets are therefore connected: the primary market creates securities, while the secondary market provides liquidity and price information.

• Stock exchanges provide a continuous and regulated market for securities. They determine prices through demand and supply, ensure liquidity, encourage savings, promote fair dealing and support economic growth. Securities generally have to be listed, transactions must follow standard procedures and trades must be settled through recognised systems.

• Financial intermediaries support the operation of markets. Brokers execute transactions on behalf of investors, while depositories hold securities electronically and facilitate their transfer and settlement. Dematerialisation reduces paperwork, delays, forgery and the risk of losing physical share certificates.

• SEBI was established as a non-statutory body in 1988 and became a statutory body under the SEBI Act, 1992. Its objectives are to protect investors, promote the development of the securities market and regulate its functioning. SEBI regulates stock exchanges, brokers, merchant bankers, mutual funds, depositories and other market intermediaries.

• SEBI promotes investor protection by requiring adequate and accurate disclosure by companies, preventing unfair trade practices and insider trading, and encouraging investor education. Regulation is necessary because financial markets may be affected by fraud, misleading information, insider trading and other unfair practices.

• The return on a discounted instrument can be calculated using the relationship:

Return or gain = Face value − Purchase price

The approximate holding-period return percentage is:

Return percentage = (Gain ÷ Purchase price) × 100

• The market price of a security is influenced by demand and supply, expected returns, risk, interest rates, company performance and general economic conditions. Higher expected returns are usually associated with higher risk; therefore, investors should assess both risk and return before investing.

• The central bank influences money-market liquidity through the repo rate, reverse repo rate, bank rate, cash reserve requirements and open-market operations. Changes in these instruments affect the availability and cost of short-term funds.

What to Remember

Financial markets connect savers with businesses and governments that require funds. The money market meets short-term needs through highly liquid instruments, while the capital market supports medium-term and long-term finance. Primary markets issue new securities, secondary markets provide liquidity, stock exchanges enable organised trading, and SEBI promotes fair, transparent and investor-oriented regulation.