Grade 12 Business Studies

Subject: Business Studies

Notes on Chapter 10.1 Financial Markets
1. Financial Market

• A Financial Market is a market for the creation and exchange of financial assets.
• A business is part of an economic system that consists of two main sectors -
households which save funds and business firms which invest these funds.
• A financial market helps to link the savers and the Investors by mobilizing funds
between them. In doing so it performs the 'Allocative Function'. It allocates or directs
funds available for investment into their most productive Investment opportunity.
• The process by which the allocation of funds is done is called financial
intermediation.
• Financial markets exist wherever a financial transaction occurs.
• Financial transactions could be in the form of creation of financial assets such as the
initial issue of shares and debentures by a firm or the exchange of existing financial
assets like equity shares, debentures and bonds.

2. Consequences of Allocative Function

• When the Allocative function is performed well, two consequences follow:

• The rate of return offered to the households would be higher. Scarce resources are
allocated to those firms which have the highest productivity for the economy.

3. Alternative Mechanisms of Allocation of Funds

There are two major alternative mechanisms through which allocation of funds can be done:

1) Banks: Households can deposit their surplus funds with banks, who in turn could lend
these funds to business firms.

2) Financial Markets: Households can buy the shares and debentures offered by a business
using financial markets.
 Functions of Financial Markets
Financial Market play an important role in the allocation of scarce resources in an economy
by performing the following four important functions:

Allocative Function -

• Mobilization of Savings and Channelling Them into the Most Productive Uses: A
financial market facilitates the transfer of savings from savers to investors.
• It gives savers the choice of different Investments and thus helps to channelize
surplus funds into the most productive use.

Facilitating Price Discovery:

• In the financial market, households are suppliers of funds and business firms
represent the demand.

• The Interaction between the forces of demand and supply helps to establish a price
for a financial asset being traded in the financial market.

Providing Liquidity to Financial Assets:

• Financial markets facilitate easy purchase and sale of financial assets.

• Financial markets provide liquidity to financial assets so that they can be easily
converted into cash whenever required. Holders of assets can readily sell their
financial assets through the mechanism of the financial market.
Reducing the Cost of Transactions:

• Financial markets provide valuable Information about securities being traded in the
market.
• It helps to save time, effort and money that both buyers and sellers of a financial
asset would have to otherwise spend to try and find each other.

The financial market is thus a common platform where buyers and sellers can meet for the
fulfillment of their individual needs.

5. Types of Financial Markets

Financial market has been divided into two markets based on the period of their
dealing/trading in securities.

1. Money Market
2. Capital Market
a. Primary Market
b. Secondary Market

Money Market

What is the Money Market?

The money market is a part of the financial system where people and organizations trade
financial products that have short lifespans, usually less than a year. These products are
known as securities. The main goal of the money market is to help manage short-term
borrowing and lending, making sure that there is enough money available and that it's safe
to lend and borrow. Here's a more detailed breakdown:

What is traded in the money market?

Short-term financial products:

These are things like Treasury bills, commercial paper, and certificates of deposit. They are
designed to be paid back quickly, usually within a year.
Purpose of the money market:

Managing short-term needs: It helps people and businesses who need to borrow money for
a short period and those who want to lend their money for a short time.

Providing liquidity: Liquidity means having easy access to cash. The money market ensures
that there is always enough cash available for those who need it.

Ensuring safety: The products traded in the money market are generally considered safe
because they are short-term and usually issued by trustworthy entities like governments or
large corporations.

Key Features of the Money Market:

1. Dealing in Short-term Funds:

Short-term Funds: These are financial products, such as loans or securities, that must be
repaid within a year. Examples include Treasury bills (T-bills) and commercial paper.

Close Substitutes for Money: These short-term funds can be easily converted into cash.
Because they are very liquid (easy to buy and sell), they act like cash or are almost as good
as having cash.

2. Dealing in Actively Traded Financial Instruments:

Financial Instruments: These are products like loans, bonds, or securities that are used
in financial transactions. In the money market, these instruments are usually:

Low Risk: They are considered safe investments, meaning there’s a low chance of losing
money.

Unsecured: They are not backed by physical assets (like property), which means there is
no collateral.

Short-term Debt Instruments: They need to be repaid quickly, usually within a year.
Actively Traded: These instruments are frequently bought and sold, making them easy to
trade and convert into cash.

3. Having No Physical Location:

No Physical Location: Unlike stock markets, which have a specific place where trading
happens (like the New York Stock Exchange), the money market does not have a physical
location.

Transactions Over Phone or Internet: Trading is done through phone calls or online
platforms. This allows for quick and efficient transactions.

4. Meeting the Temporary Needs of the Participants:

Temporary Needs: Sometimes, businesses or financial institutions need money for a

short period to cover immediate expenses or cash flow gaps.

Raising Short-term Funds: The money market helps them borrow money for a short
time, usually less than a year.

Managing Cash Shortages: If a company or bank doesn’t have enough cash temporarily,
they can borrow from the money market to meet their needs.

Earning Returns on Excess Funds: If a company has extra money that it doesn’t need
immediately, it can lend this money in the money market to earn interest until the funds are
needed.

5. Major Participants:
The money market is utilized by various entities for different purposes related to short-term
financial needs. Here's a detailed look at who uses the money market and why:

1. Businesses

Purpose:
Managing Cash Flow: Businesses often experience delays between paying for supplies
and receiving payment from customers. To bridge this gap, they may need to borrow money.

Operational Expenses: Covering day-to-day operational costs such as payroll, inventory,

and utilities when immediate cash isn't available.

How They Use It:

Issuing Commercial Paper: Large companies can issue commercial paper, which is a
type of short-term unsecured promissory note, to raise funds quickly.

Short-Term Loans: Smaller businesses might take short-term loans from banks or other
financial institutions to cover immediate expenses.

2. Governments

Purpose:

Managing Budget Deficits: Governments might need to borrow money to cover budget
deficits or to manage cash flow discrepancies.

Funding Immediate Needs: Paying for infrastructure projects, social services, or other
expenditures that require immediate funding but are expected to be covered by future tax
revenues.

How They Use It:

Issuing Treasury Bills (T-Bills): Governments issue T-Bills, which are short-term
securities, to raise funds. Investors buy these T-Bills and the government promises to pay
back the principal amount plus interest in a short period (typically from a few days to a
year).

Repurchase Agreements (Repos): Governments might also engage in repos, where

they sell securities with an agreement to buy them back at a higher price at a later date.
3. Banks and Financial Institutions

Purpose:

Managing Liquidity: Banks need to maintain a certain level of cash to meet withdrawal
demands and regulatory requirements. The money market provides a way to quickly adjust
their cash levels.

Short-Term Investments: Banks and financial institutions can invest excess funds in
short-term securities to earn returns while keeping the funds accessible.

How They Use It:

Interbank Lending: Banks often lend to each other overnight or for a few days to balance
their reserves. This is known as the interbank lending market.

Certificates of Deposit (CDs): Banks issue CDs, which are short-term deposits, to attract
funds from investors. These CDs offer a fixed interest rate and have a set maturity date.

Money Market Mutual Funds: Financial institutions create money market mutual
funds, where they pool money from many investors to buy short-term securities. This
provides investors with a safe place to park their money while earning a small return.

4. Other Entities

Purpose:

Short-Term Investment Needs: Other entities, such as insurance companies, pension

funds, and large non-profit organizations, might use the money market to manage their
short-term investment needs.

How They Use It:

Investing in Money Market Instruments: These entities might invest in various

money market instruments to ensure they have liquid and safe investments that can be
easily converted to cash when needed.
Summary

The money market is a critical component of the financial system, providing a platform for
businesses, governments, banks, and other entities to manage their short-term financial
needs efficiently. By using short-term securities, these entities can ensure they have the
liquidity necessary to operate smoothly, cover immediate expenses, and make short-term
investments safely.

Types of Instruments in the Money Market:

1. Treasury Bill (T-Bill)

Explanation:

A T-Bill is like a loan you give to the government for a short time, usually less than a year.
Instead of paying you interest, the government sells the bill at a lower price than what it's
actually worth, and you get the full amount back when it's due.

Example:

You lend ₹10,000 to the government for 6 months. They sell you a T-Bill for ₹9,800. After 6
months, they give you back ₹10,000. Your profit is ₹200.

2. Commercial Paper

Explanation:

Commercial paper is like a short-term loan a company takes out to cover its expenses
quickly. Instead of going to a bank, the company borrows from investors for a short time.
They pay back the loan with a little extra as profit.

Example:

A company needs ₹5 million urgently. It offers investors a deal: lend us ₹5 million now, and
we'll give you ₹5.1 million back in 3 months. Investors make ₹100,000 profit.
3. Call Money

Explanation:

Call money is like a quick, short-term loan between banks. If one bank needs money
urgently, it can borrow from another bank just for a day or two.

Example:

Bank A needs ₹1 million for a day. Bank B lends it at a small interest. At the end of the day,
Bank A pays back the ₹1 million plus a little extra as interest.

4. Certificates of Deposit (CDs)

Explanation:

CDs are like savings accounts, but you promise not to touch the money for a certain time. In
return, the bank gives you a better interest rate.

Example:

You put ₹100,000 in a CD for a year. The bank promises to pay you 6% interest. After a year,
you get your ₹100,000 back plus ₹6,000 as profit.

5. Commercial Bill

Explanation:

Commercial bills are like IOUs used in business deals. When a company buys goods on
credit, it promises to pay the seller later. The seller can then get immediate cash by showing
this IOU to a bank and getting a slightly smaller amount.

Example:

A company buys goods for ₹1 million on credit. It promises to pay in 3 months. The seller
takes this promise to a bank, which gives them cash now, but a little less than ₹1 million as
profit.
what is iou?

An IOU, short for "I Owe You," is a written acknowledgment of a debt. It's essentially a
promise to repay borrowed money or to fulfill a certain obligation. When someone gives
you an IOU, they're saying they owe you something, whether it's money, goods, or a favor.
IOUs are informal and typically used between friends, family members, or in small business
transactions. They may not have the legal weight of a formal contract but can still be
considered binding depending on the circumstances.

Capital Market

Meaning of Capital Market

• The capital market is a financial market where long-term securities, such as stocks
and bonds, are bought and sold.
• It provides a platform for companies, governments, and other entities to raise long-
term funds by issuing securities.
• The market encourages the public to invest their savings into productive ventures,
thus contributing to the economy's growth.
• There are two main segments within the capital market: the primary market (where
new securities are issued and sold for the first time) and the secondary market
(where existing securities are traded among investors).

Features of Capital market

1. It deals in Long-term Securities:

• The capital market focuses on long-term investments, which typically last more than
one year.
• It includes stocks (equity securities) that represent ownership in a company, and
bonds (debt securities) that represent a loan made by an investor to a borrower.
2. It satisfies the Long-term Financial Requirement:

• It provides necessary funds for large-scale projects and investments that need time
to mature and produce returns.
• Governments use the capital market to fund infrastructure projects, while companies
use it to expand operations and innovate.

3. It performs Trade-off Functions:

• The capital market facilitates the matching of supply (those who have funds to invest)
and demand (those who need funds).
• This function ensures that financial resources are allocated efficiently, supporting
economic stability and growth.

4. It helps in Capital Formation:

• The capital market plays a crucial role in the process of capital formation, which is
the accumulation of savings into productive investments.
• When people invest their money, they earn profits, which can be reinvested, creating
a cycle of investment and growth in the economy.

5. It helps in Creating Liquidity:

• Liquidity refers to how quickly an asset can be converted into cash without
significantly affecting its value.
• The capital market provides a platform where investors can easily buy and sell
securities, thus ensuring liquidity.
 Distinction between Capital Market and Money Market

Basis of
Difference Capital Market Money Market

Involves a variety of participants Mainly involves the Reserve Bank of

including financial institutions, banks, India (RBI), banks, financial
companies, foreign investors, and the institutions, and finance
Participants general public. companies.

Uses long-term investment tools such as Uses short-term investment tools like

equity shares (stocks), preference shares, call money, treasury bills,

debentures (a type of bond), and other commercial bills, commercial

Instruments bonds. papers, and certificates of deposit.

Investments can be made with smaller Typically requires larger amounts for
Investment amounts of money, such as ₹10, ₹100, investment, such as a minimum of
Outlay etc. ₹1 crore for call money.

Focuses on investments that are held for Focuses on investments that are
the medium to long term, often several held for a very short term, ranging
Duration years. from one day to one year.

Highly liquid market where it is easy

Not all securities are easily sold for cash. to sell securities and get cash

Only those that are actively traded have quickly due to formal arrangements
Liquidity good liquidity. ensuring liquidity.

Safer investments with lower risk.

Generally riskier. There’s a higher chance The institutions and companies
that investors might not get back their issuing these instruments have a
Safety principal amount or expected returns. lower risk of defaulting.
 Basis of
Difference Capital Market Money Market

Offers higher potential returns, but with

higher risk. Investors might earn more, Offers lower returns, but with lower
but they also face a greater chance of risk. Investors earn less, but their
Expected Return losing money. investment is safer.