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Supplementary Note 1-CMM
Supplementary Note 1-CMM
Supplementary Note 1-CMM
Commercial Banks
A commercial bank is a type of financial institution that accepts deposits, offers checking
account services, makes business, personal, and mortgage loans, and offers basic financial
products like certificates of deposit (CDs) and savings accounts to individuals and small
businesses. A commercial bank is where most people do their banking, as opposed to an
investment bank.
Investment Banks
Investment banks specialize in providing services designed to facilitate business operations,
such as capital expenditure financing and equity offerings, including initial public offerings
(IPOs). They also commonly offer brokerage services for investors, act as market makers for
trading exchanges, and manage mergers, acquisitions, and other corporate restructurings.
Insurance Companies
Among the most familiar non-bank financial institutions are insurance companies. Providing
insurance, whether for individuals or corporations, is one of the oldest financial services.
Protection of assets and protection against financial risk, secured through insurance products, is
an essential service that facilitates individual and corporate investments that fuel economic
growth.
Brokerage Firms
Investment companies and brokerages, such as mutual fund and exchange-traded fund (ETF)
provider Fidelity Investments, specialize in providing investment services that include wealth
management and financial advisory services. They also provide access to investment products
that may range from stocks and bonds all the way to lesser-known alternative investments,
such as hedge funds and private equity investments.
A nonbank financial institution (NBFI) is a financial institution that does not have a full banking
license and cannot accept deposits from the public. However, NBFIs do facilitate alternative
financial services, such as investment (both collective and individual), risk pooling, financial
consulting, brokering, money transmission, and check cashing. NBFIs are a source of consumer
credit (along with licensed banks).
Mutual funds can be delineated along the nature of their investments. For example, some
funds make high-risk, high return investments, while others focus on tax-exempt securities. Still
others specialize in speculative trading (i.e. hedge funds), a specific sector, or cross-border
investments. Pension funds are mutual funds that limit the investor’s ability to access their
investment until after a certain date. In return, pension funds are granted large tax breaks in
order to incentivize the working public to set aside a percentage of their current income for a
later date when they are no longer amongst the labor force (retirement income).
Specialized sectoral financiers provide a limited range of financial services to a targeted sector.
For example, leasing companies provide financing for equipment, while real estate financiers
channel capital to prospective homeowners. Leasing companies generally have two unique
advantages over other specialized sectoral financiers. They are somewhat insulated against the
risk of default because they own the leased equipment as part of their collateral agreement.
Additionally, leasing companies enjoy the preferential tax treatment on equipment investment.
Other financial service providers include brokers (both securities and mortgage), management
consultants, and financial advisors. They operate on a fee-for-service basis. For the most part,
financial service providers improve informational efficiency for the investor. However, in the
case of brokers, they do offer a transactions service by which an investor can liquidate existing
assets.
Role in financial system
NBFIs supplement banks in providing financial services to individuals and firms. They can
provide competition for banks in the provision of these services. While banks may offer a set of
financial services as a package deal, NBFIs unbundle these services, tailoring their services to
particular groups. Additionally, individual NBFIs may specialize in a particular sector, gaining an
informational advantage. By this unbundling, targeting, and specializing, NBFIs promote
competition within the financial services industry.
Having a multi-faceted financial system, which includes non-bank financial institutions, can
protect economies from financial shocks and recover from those shocks. NBFIs provide multiple
alternatives to transform an economy's savings into capital investment, which act as backup
facilities should the primary form of intermediation fail.
However, in countries that lack effective regulations, non-bank financial institutions can
exacerbate the fragility of the financial system. While not all NBFIs are lightly regulated, the
NBFIs that comprise the shadow banking system are. In the run-up to the recent global financial
crisis, institutions such as hedge funds and structured investment vehicles, were largely
overlooked by regulators, who focused NBFI supervision on pension funds and insurance
companies. If a large share of the financial system is in NBFIs that operate largely unsupervised
by government regulators and anybody else, it can put the stability of the entire system at risk.
Weaknesses in NBFI regulation can fuel a credit bubble and asset overpricing, followed by asset
price collapse and loan defaults.
Credit Unions: These are the cooperative financial units which facilitate lending and borrowing
of funds to provide financial assistance to its members.
Stock Exchanges: The stock exchange facilitates the trading of securities and stocks, and in
every trading activity, it charges the brokerage from each party which is its profit.
Mutual Fund Companies: The mutual fund organizations club the amount collected from
various investors. These investors have identical investment objectives and risk-taking ability.
The funds are then collectively invested in the securities, bonds, and other investment options,
to ensure a capital gain in the long run.
Insurance Companies: These companies provide insurance policies to the individuals and
business entities to secure them against accident, death, risk, uncertainties and default. For this
purpose, they accept deposits in the form of premium, which is pooled into profitable
investments to gain returns. The insured person can claim the money in case of any mishap as
per the agreement.
Financial Advisers or Brokers: The investment brokers also collect the funds from various
investors to invest it in the securities, bonds, equities, etc. The financial advisers even provide
guidance and expert opinions to the investors.
Investment Bankers: These banks specialize in services like initial public offerings (IPO), other
equity offerings, proving for mergers and acquisitions, institutional client’s broker services,
underwriting debts, etc. As a result of constant mediation, between the investor or public and
the companies issuing securities.
Escrow Companies: It is a third party acting as an intermediary and responsible for getting all
the conditions fulfilled at the time of loan provided by one party to the other for the real estate
mortgage.
Pension Funds: The government entities initiate a pension fund. A certain amount is deducted
from the salary of the employees each month. This collected sum is then invested in different
schemes to gain profits. The investor’s fund is returned with interest after their retirement.
Building Societies: These financial intermediaries are similar to the credit unions, owned and
facilitating mortgage loans and demand deposits to its members.
Collective Investment Schemes: Under this scheme, the various investors with common
investment objective come together to pool their funds and collectively invest this amount into
a
profitable investment option. Later they distribute the interest among themselves as per the
agreement.
The main components of capital market are: 1. Primary Market 2. Secondary Market
1. Primary Market (New Issue Market):
Primary market is also known as new issue market. As in this market securities are sold for the
first time, i.e., new securities are issued from the company. Primary capital market directly
contributes in capital formation because in primary market company goes directly to investors
and utilizes these funds for investment in buildings, plants, machinery etc. The primary market
does not include finance in the form of loan from financial institutions because when loan is
issued from financial institution it implies converting private capital into public capital and this
process of converting private capital into public capital is called going public. The common
securities issued in primary market are equity shares, debentures, bonds, preference shares
and other innovative securities.
In secondary market companies get no additional capital as securities are bought and sold
between investors only so directly there is no capital formation but secondary market indirectly
contributes in capital formation by providing liquidity to securities of the company.
If there is no secondary market then investors could get back their investment only after
redemption period is over or when company gets dissolved which means investment will be
blocked for a long period of time but with the presence of secondary market, the investors can
convert their securities into cash whenever they want and it also gives chance to investors to
make profit as securities are bought and sold at market price which is generally more than the
original price of the securities.
This liquidity offered by secondary market encourages even those investors to invest in
securities who want to invest for small period of time as there is option of selling securities at
their convenience.
In the secondary market, securities that have already been sold in the primary market are then
bought and sold at later dates. Investors can purchase these bonds from a broker, who acts as
an intermediary between the buying and selling parties. These secondary market issues may be
packaged in the form of pension funds, mutual funds, and life insurance policies—among many
other product structures.
Government Bonds
National-issued government bonds (or Treasuries) entice buyers by paying out the face
value listed on the bond certificate, on the agreed maturity date, while also issuing periodic
interest payments along the way. This characteristic makes government bonds attractive to
conservative investors.
Municipal Bonds
Municipal bonds—commonly abbreviated as "muni" bonds—are locally issued by states, cities,
special-purpose districts, public utility districts, school districts, publicly-owned airports and
seaports, and other government-owned entities who seek to raise cash to fund various
projects.
Mortgage-Backed Bonds
These issues, which consist of pooled mortgages on real estate properties, are locked in by the
pledge of particular collateralized assets. They pay monthly, quarterly, or semi-annual interest.
Commodity market
A commodity market is a marketplace for buying, selling, and trading raw materials or primary
products. There are currently about 50 major commodity markets worldwide that facilitate
trade in approximately 100 primary commodities.
Commodities are often split into two broad categories: hard and soft commodities. Hard
commodities include natural resources that must be mined or extracted—such as gold, rubber,
and oil, whereas soft commodities are agricultural products or livestock—such as corn, wheat,
coffee, sugar, soybeans, and pork.
Investors can gain exposure to commodities by investing in companies that have exposure to
commodities or investing in commodities directly via futures contracts.
Stock market
A stock market is a place where investors go to trade equity securities, such as common stocks,
and derivatives—including options and futures. Stocks are traded on stock exchanges. Buying
equity securities, or stocks, means you are buying a very small ownership stake in a company.
While bondholders lend money with interest, equity holders purchase small stakes in
companies on the belief that the company performs well and the value of the shares purchased
will increase.
The primary function of the stock market is to bring buyers and sellers together into a fair,
regulated, and controlled environment where they can execute their trades. This gives those
involved the confidence that trading is done with transparency, and that pricing is fair and
honest. This regulation not only helps investors, but also the corporations whose securities are
being traded. The economy thrives when the stock market maintains its robustness and overall
health.
Just like the bond market, there are two components to the stock market. The primary market
is reserved for first-run equities: initial public offerings (IPOs) will be issued on this market. This
market is facilitated by underwriters, who set the initial price for securities. Equities are then
Derivative market:
Just like shares, Derivatives are also traded in stock exchanges.
Derivatives are a type of security, whose value is derived from an underlying asset.
These underlying assets can be stocks, bonds, commodities or currency.
The popularity of derivative can easily be understood by daily turnover in the derivative
segment on the exchange, which is much higher than turnover in the cash segment on
the same exchange.
Derivatives can either be exchange-traded or traded over the counter (OTC).
Exchange refers to the formally established stock exchange wherein securities are
traded and they have a defined set of rules for the participants.
Use of Derivatives:
Derivative contracts like futures and options trade freely on exchanges and can be employed to
satisfy a variety of needs which includes the following-
b) Transfer of risk
This is the most important use of derivative which helps in transferring risk from risk-averse
people to a risk-seeking investor.
a) Hedgers
These are traders who wish to protect themselves from the risk or uncertainty involved in price
movement.
For example, you can enter into an options contract (a part of the derivative strategy) by
paying a small price or premium and reduce your losses.
Moreover, it would help you benefit whether or not the price falls. This is how you can hedge
your risk and transfer it to someone who is willing to take the risk.
b) Speculators
They are extremely high-risk seekers who anticipate future price movement in the hope of
making large and quick gains.
c) Arbitrageurs
Arbitrage is a low-risk trade which involves buying of securities in one market and simultaneous
selling it in another market. This happens when same securities are trading at different prices in
two different markets.For instance, say the cash market price of a share is Rs 100 and it is
trading at Rs 110 per share on the futures market. An arbitrageur observes the same and
bought 50 shares @ Rs 100 per share in the cash market and simultaneously sells 50 shares
@Rs 110 per share, thus gaining Rs 10 per share.
Since swaps are complex instruments which we cannot trade in the stock market, so we’ll focus
on the first three.
a) Forward contracts
They are customized contractual agreements between two parties where they agree to trade a
particular asset at an agreed upon price and at a particular time in future.
b) Futures contracts
These are standardized version of the forward contract which takes place between two parties
where they agree to trade a particular contract at a specified time and at an agreed upon price.
c) Options
It is an agreement between a buyer and a seller which gives the buyer the right but not the
obligation to buy or sell a particular asset at a later date at an agreed-upon price.
Lending and borrowing in the money market is for the short-term. In the capital market,
investors lend and borrow securities for medium term to long-term.
Participants
Usual participants in the money market are central banks, commercial banks, mutual funds,
financial institutions and chit funds. Capital market, on the other hand, involves stock
brokers, retail investors, mutual funds, underwriters, insurance companies and stock
exchanges.
Instruments
Popular instruments in the money market are commercial papers, T-bills, call money,
promissory notes and so on. Capital markets typically deal in bonds,
debentures, preference shares and so on.
Structure
Capital markets are more formal than the money market. Compared to capital markets, money
markets are more informal. Also, capital markets are more organized than the money market.
Classification
There are two types of capital markets – Primary Market and Secondary Market. There is
no such classification in the money market.
Liquidity
Since money market deals with short-term instruments, it is more liquid. Capital market deals in
medium to long-term time frame, thus liquidity is less.
Risk Factor
Money market usually involves less risk as the market is liquid and funds are for the short-
term. Due to long-term maturity and comparatively less liquidity, the risk in the capital market
is more.
Purpose
It helps borrowers to meet their short-term funding requirements. Due to its long-term
nature, the capital market works more towards stabilizing the economy by mobilizing the
savings.
Returns
Since the time duration is short and the risk is less, returns in the money market are also less.
Return in the capital market is more as the investment is for more duration.
Relevance to Economy
Money market helps to boost liquidity in an economy. Capital market, on the other hand,
converts savings into productive investments.
Maturity Period
Money market instruments have a max maturity period of one year. In the capital market, there is
no specified maturity period for the instruments, but it is always more than a year.
Relation with Country’s Central Bank
Money market and Central bank work closely with each other. Central bank’s policies
influence the working of the capital markets, but there is no direct relation between the two.
As you now know that the primary function of both markets is to ensure an adequate level of
funding. Which market (money market vs capital market) does investor access depend on
their funding needs and time duration they want the funds for.1–3