Financial Markets - I

Unit – 12
Prof. Anil Kumar
Monetary Policy
• Instruments
• Open Market Operations: Buying/selling of securities
• Cash Reserve Ratio: Specified amount of bank deposits which banks are required
to keep with the RBI in the form of reserves or balances
• Statutory Liquidity Ratio: All financial institutions have to maintain a certain
quantity of liquid assets with themselves at any point in time of their total time
and demand liabilities
• Bank Rate Policy: They are interest charged by the RBI for providing funds and
loans to the banking system
• Credit Ceiling: RBI issues prior information or direction that loans to the
commercial bank will be given up to a certain limit
Goals
• Maintain price stability while still pursuing the goal of economic growth
• Legal basis for the flexible inflation targeting framework’s implementation
• Determine the inflation target once every five years
• Promotion of saving and investment
• Managing business cycles
• Controlling imports and exports
• Aggregate demand regulation
• Employment generation
• Helping infrastructure development
Targets
• There are three target variables for monetary policy
• Money Supply: According to Friedman – money supply should be
allowed to grow steadily at the rate of 3 to 4 per cent per year for a
smooth growth of the economy and to avoid inflationary and
recessionary tendencies
• Availability of Credit and Interest Rates:
Economists call them as Money market conditions which refer to short
term interest rates and the banking system’s free reserves.
 REAL INTEREST RATES NOMINAL INTEREST RATES
Meaning
The real rates are accustomed to considering the monetary waves or the The nominal interest rate is the least difficult rate that doesn’t take into
financial ripples brought about by economic inflation. consideration economic inflation.
Also Known as
The real interest rate is additionally called an actual interest rate. The other name for the nominal interest rate is the coupon rate.
Formula
Real Rate = Nominal Rate – Inflation Nominal Rate = Real Rate + Inflation
Economic Inflation
The rate of real interest is fixed in view of levels of economic inflation. The nominal interest rate is fixed without the impact of economic inflation.
Stability
Adaptability and flexibility are the components of the real interest rate. Strength and stability are the elements of the nominal interest rate.
Adjustment
The real interest rate can be a negative measure assuming that specific The nominal interest rate can never be a negative measure.
circumstances prevail.
Amount
Typically, the interest is low in the real interest rate. Generally, the interest is high in nominal interest rate.
Example
The deposit rate is 2% p.a. on an Rs.1,000 venture or an investment, and the A deposit rate is 2% p.a. on an Rs. 1,000 speculation or investment. The financial
economic inflation rate is 3%. The real rate return the financial backer will backer figures, he will get Rs. 200 as interest in nominal terms.
acquire is 2% – 3% = – 1%. The return in the wake of considering the rate of
economic inflation is negative.
Money Market
• It is a short term financial assets having liquidity of one year or less
are traded on stock exchanges.
• There are variety of instruments traded in the money market which
includes treasury bills, certificates of deposit, commercial paper,
repurchase agreements
• Reserve Bank controls the interest rate of various instruments in the
money market
• Money market can be defined as a market for financial assets that are
near substitutes for money
Objectives
• Provides borrowers short term funds at a reasonable price
• It also enables lenders to turn their idle funds into an effective
investment
• Helps to regulate the level of liquidity in the economy
• Money market helps organizations to have the necessary funds to
meet their working capital requirements
• Provides an opportunity for the banks to park their surplus funds
Importance
• Maintains a balance between the supply of and demand for the
monetary transactions done in the market
• Enables funds for businesses to grow
• Aids in the implementation of monetary policies
• Helps develop trade and industry in the country
• Short term interest rates influence long term interest rates
• Helps in the functioning of the banks
• Also responsible for controlling inflation
Advantages & Disadvantages
• Advantages:
• Higher liquidity
• No lock in period
• Rate of return on a money market is marginally higher
• Disadvantages:
• Rate of interest does not account for the increasing inflation in the
economy
• Mutual funds offer a higher return on investment over the long term
Characteristics
• It has no fixed geographical location
• It is a market for short term financial needs
• It’s a primary players
• Main money market instruments are Treasury bills, commercial
papers, certificate of deposits, call money
• Highly liquid
• Most of them provides fixed returns
Types of Money Market
• Treasury Bills
They have varying short-term maturities. These instruments are issued at a discount and
repaid at pat at the time of maturity
• Commercial Bills
Works more like the bill of exchange. Businesses issue them to meet their short-term
money requirements
• Certificate of Deposit
It is a negotiable term deposit accepted by commercial banks. It is usually issued through a
promissory note
• Commercial Paper
Serves as an alternative to borrowing from a bank. Period ranges from 15 days to 1 year.
• Call Money
Helps to manage day-to-day cash flows. Interest rates in the market are market driven and
hence highly sensitive to demand and supply
Gilt edged Securities
• It is used in India for the Government securities like central government
loans and state government loans because they carry no risk
• RBI Issues government securities amount at a fixed interest returns
• Short term government securities are Treasury bills
• Long term government securities are known as government bonds or dated
securities
• Features: They have zero income default, there is high rate of return, there
is cent per cent liquidity
Commercial Banks
• Commercial banks are profit-based institutions that offer financial
services like loans, deposits and electronic transfer of funds etc.
• Functions: Primary and Secondary functions
Primary Function Secondary function
Accepting deposits Providing locker facilities
Saving deposits Dealing in foreign exchange
Fixed deposits Exchange of securities
Current deposits Discounting bills of exchange
Providing loans Bank as an agent
Credit creation Platform for e-transaction
Cash and short term credit
Types of Commercial Banks
• Public Sector Banks
State-owned by the corresponding government. RBI creates operating
guidelines for the public sector banks
• Private Sector Banks
They are registered as companies with limited liabilities.
• Foreign banks
They operate overseas within a foreign nation. These are essential for
the economic development of a nation
Co-operative Banks
• It is a small sized, financial entity, where its members are the owners and
customers of the bank
• Main motto ‘no profit-no loss’
• Features:
• They work on the principle of one person, one vote
• Farmers can avail agricultural loans on minimum interest rates
• Provides easy and accessible loans and credit benefits in the rural areas
• Annual profit earned is spent on financial reserves
History
• Cooperative credit societies act 1904 was the first step taken for the
cooperative society and introduced to the cooperative societies act of
1912
• Post-independent India, central committee for cooperative training
(1953) was set up by RBI for establishing co-operative training centres
• Rural credit survey committee was set up 1954
• From 1950s cooperative banks had started extending their reach to
the public in both rural and urban areas
Advantages & Disadvantages
Advantages:
• They provide aid to the rural population by granting loans and credits
• They do not seek huge profits and believe in mutual help
• Interest rate on deposits is high and on loans is low
• Help the farmers by providing them agricultural credits to but basic products like fertilizer,
seeds etc
Disadvantages:
• To lend money, they need investors which are tough to find
• They have been enjoyed by rich landowners
• They are not equally developed across the country
• With new types of banks opening up, these banks are facing the risk of losing their
customers
Insurance
• It is some form of protection from any possible financial losses
Functions:
• Provides reliability
• Protection
• Pooling of risk
• Legal requirements
• Capital formation
Principles of Insurance
• Utmost good faith
• Insurable interest
• Indemnity
• Subrogation
• Contribution