Financial Markets and

Instruments
PGDM III
International Management Institute Bhubaneswar
2021
Financial System – Functions and Roles
 A financial system comprises a range of financial institutions,
financial instruments and financial markets which interact to facilitate
the flow of funds through the financial system.

 Another important function – implement monetary policy of the

central banks
What are financial instruments?

This is the financial instrument

Various financial instruments
• 1. Equity
• 2. Debt
• 3. Derivatives
• The financial markets have two major components:
• 1. The Money Market
• 2. The Capital Market

• The Money market refers to the market where borrowers and lenders exchange short term funds to meet their
liquidity needs.
• Money market instruments are generally financial claims that have low default risk, maturities under one year
and high marketability.
Structure of money and capital markets
Money market participants and instruments
 The Capital market is a market for financial investments that are direct
or indirect claims to capital.
 Comprises the complex of institutions and mechanisms through which
intermediate term funds and long-term funds are pooled and made
available
 The Capital Market also encompasses the process by which securities
already outstanding are transferred.
• The Primary and Secondary markets – components of the capital
market

• The Primary market – new issues (IPOs)

• The Secondary market – listed securities
 The Banking System - Functions

 Deposits (savings, current, FDs, RDs)

 Lending (Overdraft, loans)
 Banking System
in India

Scheduled Non-banking
Reserve Bank of Regional Rural
Commercial Financial
India Banks
Banks Companies
 RBI
• The Reserve Bank of India (RBI) is the central bank of India, established
on April 1, 1935, under the Reserve Bank of India Act. 

• The main purpose of the RBI is to conduct consolidated supervision of the

financial sector in India, which is made up of commercial banks, financial
institutions, and non-banking finance firms.

• It also frames implements the monetary policy – inflation targeting, growth

• Awards license for banking activities
• The RBI also manages all forex under the Foreign Exchange
Management Act of 1999.
Monetary Policy and its tools
• https://indianexpress.com/article/business/economy/rbi-reserve-bank-o
f-india-monetary-policy-committee-december-2020-meeting-outcome-
key-announcements-7091164/

• Monetary policy is the process by which the monetary authority of a

country, generally the central bank, controls the supply of money in
the economy by its control over interest rates in order to maintain 
price stability and achieve high economic growth

• Announced every alternate month (next due in February 2021)

 Tools (or instruments)

• 1. Cash Reserve Ratio (CRR)

• 2. Statutory Liquidity Ratio (SLR)
• 3. Open Market Operations (OMO)
• 4. Repo and Reverse Repo Rate
CRR
• Cash reserve ratio is a certain percentage of bank deposits
 which banks are required to keep with RBI in the form of
reserves or balances.

• No interest is payable to the banks

• Acts as a safety cushion

• 3% (as on December 21, 2020)

 SLR

• These assets have to be kept in non-cash form such as G-secs,

precious metals, approved securities like bonds

• Provides additional safety net

• The SLR instruments have the least risk

• 18% (as on December 21, 2020)

Repo and Reverse Repo
• Repo rate is the rate at which RBI lends to its clients generally against
government securities.
• Reduction in repo rate helps the commercial banks to get money at a
cheaper rate and increase in repo rate discourages the commercial
banks to get money as the rate increases and becomes expensive. 
• The reverse repo rate is the rate at which RBI borrows money from the commercial
banks.

• The increase in the repo rate will increase the cost of borrowing and lending of the banks
which will discourage the public to borrow money and will encourage them to deposit.

• 3.35% (as on December 21, 2020)

• Repo and reverse repo together constitute Liquidity Adjustment Facility (LAF)
Open Market Operations (OMOs)
• This refers to buying and selling of government securities by RBI to
regulate short-term money supply.

• If RBI wants to induce liquidity or more funds into the system, it will
buy government securities and inject funds, and if it wants to curb the
amount of money out there, it will sell these to banks, thereby
reducing the amount of cash that banks have. 
 Business of banks

• Loans and advances – (Term loans, WC loans, overdrafts, housing

loans, personal loans..)
• Receives funds as deposits from public (savings, current, FDs)
• Provides ancillary services – insurance, MFs
Profitability source – the net interest margin

• NIM = Interest received (-) Interests paid

• Interest received on loans and advances
• Interest paid on deposits
 Problems of Indian banking – non performing
assets (npa)

• Money or assets provided by banks to companies as loans sometimes

remain unpaid by borrowers. This late or non-payment of loans is
defined as Non-Performing Assets (NPA). They are also termed as bad
assets.
• In India, the RBI monitors the entire banking system and, as defined by
the country’s central bank, if for a period of more than 90 days, the
interest or installment amount is overdue then that loan account can be
termed a Non-Performing Asset.
 NPA Classification

• 1. Standard Assets
• 2. Substandard Assets
• 3. Doubtful Assets
• 4. Loss Assets
• A stress test conducted by the Reserve Bank of India suggests that the
Covid-19 crisis could push Indian banks’ gross bad loans to their highest in
nearly two decades.

In a “very severe stressed scenario”, the gross non-performing assets of the

banking sector could rise to as high as 14.7% of total loans by March 2021,
(RBI FSR)
Reasons
1. Economic recession
2. Business cycles
3. Poor governance in companies
4. Stress in MSME, agriculture
5. Willful defaults
Raising ST Capital

Money market is a market for short-term loan or financial assets. 

• 1. Treasury Bills
• 2. Commercial Paper
• 3. Certificate of Deposit
• 4. Repurchase Agreements
• 5. Banker’s Acceptance
• 6. Money Market Mutual Funds
• 7. Collateralized Borrowing and Lending Obligation (CBLO)
• 8. Call/Notice/Term Money.
1. Treasury Bills
Treasury bills or T-bills, which are money market instruments, are short term debt
instruments issued by the Government of India and are presently issued in three
tenors, namely, 91 day, 182 day and 364 day. 

Treasury bills are zero coupon securities and pay no interest. 

They are issued at a discount and redeemed at the face value at  maturity.

For example, a 91 day Treasury bill of Rs.100(face value) may be issued at say Rs.
98.20, that is, at a discount of say, Rs.1.80 and would be redeemed  at the face
value of Rs.100
•  Sale of T-bills happen through yield based auction

=

In the previous example, issue price was Rs 98.20 issued for 91 days,
so its quote will be 7.35%
The 91-day bills are issued weekly while the 182-day and 364-day bills
are issued bi-weekly.
2. Commercial Paper
Commercial Paper (CP) is an unsecured money market instrument
issued in the form of a promissory note.

It was introduced in India in 1990.

t was introduced in India in 1990 with a view to enabling highly rated

corporate borrowers to diversify their sources of short-term
borrowings
Corporates, primary dealers (PDs) and the All-India Financial Institutions
(FIs) are eligible to issue CP.

A corporate would be eligible to issue CP provided –

• a. the tangible net worth of the company, as per the latest audited
balance sheet, is not less than Rs. 4 crore
• b. company has been sanctioned working capital limit by bank/s or all-
India financial institution/s; and
• c. the borrowal account of the company is classified as a Standard Asset
by the financing bank/s/ institution/s.
 The issuers shall have to obtain credit rating before the issuance of
the CP

CP can be issued for maturities between a minimum of 7 days and a

maximum of up to 1 year from the date of issue.

CP can be issued in denominations of Rs.5 lakh or multiples thereof.

https://www1.nseindia.com/products/content/debt/corp_bonds/cb
m_sett_data_archives.htm
Certificate of Deposits
Certificate of Deposit (CD) is issued in dematerialized form or against
funds deposited at a bank or other eligible financial institution for a
specified time period.

CDs can be issued by

(i) scheduled commercial banks {excluding Regional Rural Banks and
Local Area Banks};
(ii) select All-India Financial Institutions (FIs) that have been permitted by
RBI to raise short-term resources within the umbrella limit fixed by RBI.
Minimum amount of a CD should be Rs.1 lakh and in multiples of Rs 1 lakh
thereafter

CDs can be issued to individuals, corporations, companies (including banks

and PDs), trusts, funds, associations, etc.

All OTC trades in CDs shall necessarily be cleared and settled under DVP
(Delivery Vs Payment) mechanism through the authorised clearing houses
{National Securities Clearing Corporation Limited (NSCCL), Indian Clearing
Corporation Limited (ICCL) and MCX Stock Exchange Clearing Corporation
Limited (CCL)} of the stock exchanges.
CDs are transferable, the physical certificates may be presented for
payment by the last holder. 

Loans / Premature Payment

Banks/FIs cannot grant loans against CDs. Banks/FIs cannot buy-back
their own CDs before maturity. No premature cancellation of the CD is
allowed.
Repurchase agreement (Repo)
A repurchase agreement (repo) is a form of short-term borrowing for
dealers in G-secs.

In the case of a repo, a dealer sells government securities

to investors, usually on an overnight basis, and buys them back the
following day at a slightly higher price. 

Overnight repo is the term of loan is 1 day; if it is more than 1 day –

term repo
 An illustration
• Issue Price = Face value – interest
• And
• Interest = Face value × repo-rate × Repo term (in days)/360

• Say a dealer wants to purchase Rs 10 m worth of bonds. Either he can use his own funds
or borrow from a bank or can use a repo
• Under repo, he finds a client who has excess cash of Rs 10 m. The dealer can enter into
repo agreement with the client to sell the bond on an overnight basis to repurchase the
bond at face value.
• The overnight repo rate is 6.75%. What will be the issue price?
Letter of Credit (LC)
A letter of credit is a document that guarantees the buyer’s payment
to the sellers.
It is Issued by a bank and ensures the timely and full payment to the
seller.
A letter of credit is issued against a pledge of securities or cash.
Used for international trade
Post the PNB LC scam, RBI has tightened regulations to issue LCs
Gilt edged securities market
A Government Security (G-Sec) is a tradeable instrument issued by
the Central Government or the State Governments

Such securities are short term (usually called treasury bills, with
original maturities of less than one year) or long term (usually called
Government bonds or dated securities with original maturity of one
year or more).
 • Dated G-Secs
• Dated G-Secs are securities which carry a fixed or floating coupon
(interest rate) which is paid on the face value, on half-yearly basis.
Generally, the tenor of dated securities ranges from 5 years to 40
years.
Coupon : 7.17% paid on face value
Name of Issuer : Government of India
Date of Issue : January 8, 2018
Maturity : January 8, 2028
Coupon Payment Dates : Half-yearly (July 08 and January 08) every year
Minimum Amount of issue/ sale : ₹10,000
In case, there are two securities with the same coupon and are
maturing in the same year, then one of the securities will have the
month attached as suffix in the nomenclature

E.g. 6.05% GS 2019 FEB, would mean that G-Sec having coupon 6.05%
that mature in February 2019 along with the other similar security
having the same coupon. 
Types of G-Secs
• i) Fixed Rate Bonds – These are bonds on which the coupon rate is
fixed for the entire life (i.e. till maturity) of the bond. Most
Government bonds in India are issued as fixed rate bonds.
• ii) Floating Rate Bonds (FRB) – FRBs are securities which do not have
a fixed coupon rate. Instead it has a variable coupon rate which is re-
set at pre-announced intervals (say, every six months or one year).
• iii) Inflation Indexed Bonds (IIBs) - IIBs are bonds wherein both
coupon flows and Principal amounts are protected against inflation.
• Government of India through RBI issued IIBs (linked to WPI) in June
2013
How are the G-Secs issued?
G-Secs are issued through auctions conducted by RBI through e-
KUBER electronic platform
The Reserve Bank of India conducts auctions usually every
Wednesday to issue T-bills of 91day, 182 day and 364 day tenors
Settlement for the T-bills auctioned is made on T+1 day i.e. on the
working day following the trade day.
Money Market MFs
• Money market mutual funds (MMF) invest in short-term debt
instruments, cash, and cash equivalents that are rated high quality

• Safe or investment with minimal to low risk.

• These funds are open-ended in the debt fund category and deal only in
cash or cash equivalents.

• The fund manager invests in high-quality liquid instruments such as

treasury bills (T-Bills), repurchase agreements (Repos), commercial
papers, and certificates of deposit
• Those individuals with low-risk appetite having their surplus cash
parked in a savings bank account can invest in money market funds.

• https://www.etmoney.com/mutual-funds/debt/money-market/58
  Amount of one currency that is convertible
into another - Forex rate or exchange rate
The Forex
Market: https://economictimes.indiatimes.com/mar
FOREX kets/forex

Rates
 The Forex Market
Foreign currencies and their volatility is an important consideration in
corporate finance
The relative change in the value of foreign currency vis-à-vis the native
country’s currency in which the firm is based is a source of major
concern
This is called as forex risk or currency risk
Major trading currencies - $, ¥, £, €
 Exchange Rate Quote Conventions

 Direct and Indirect

Direct Indirect

No. of units of a local currency No. of units of a foreign currency

exchangeable for a unit of foreign currency exchangeable for a unit of local currency

Rs 71/$ $0.01408/ Rs
Market for settlement of a foreign transaction within 2 business
days

Because of the domination of $, most of the spot quotes are in

USD
In India, forex trading is primarily an OTC Market, wherein trades
are conducted between two known counterparties.
There are two distinct segments of OTC foreign exchange market –
Interbank Market and Merchant Market

The SPOT Market

 Interbank market is the market between banks where dealers quote
prices at the same time for both buying and selling the currency. 

Forex trading is permitted in INR-related currency pairs viz. USDINR,

GBPINR, JPYINR, EURINR.
In India, OTC market is open from 9:00 AM to 5:00 PM.

However, for merchants the market is open from 9:00 AM to 4:30 PM

and the last half hour is meant only for interbank dealings for banks to
square off excess positions. 

The settlement in the OTC spot market happens by actual delivery of

currency.
 The RBI on January 7, 2020 said that select banks in India can offer
forex rates to Indian clients beyond the inter-bank market hours

Read more at:

https://economictimes.indiatimes.com/markets/forex/forex-news/rbi-a
llows-24x7-forex-mkt-ops-via-select-banks/articleshow/73133131.cms?
utm_source=contentofinterest&utm_medium=text&utm_campaign=cp
pst
Allows Indians to hedge their foreign exchange risks at any time of the
day.
 The Bid-Ask Rate
Dealers in the forex market quote two prices

One at which they are ready to buy (BID) and another at which ready to
sell (ASK)

https://in.investing.com/currencies/usd-inr

The difference is called as the bid-ask spread

 As per the quote in the previous slide:
Bid Rate for Rs/USD = Rs 71.1650
Ask rate for Rs/USD = Rs 71.1750

It means the dealer is willing to sell dollar at 71.1750 and purchase

them at 71.1650
The spread is = 71.1750 - 71.1650 = 0.0100 = 1 basis point
 The convention to quote forex is 4 decimals

 The change of 0.0001 or 1 point is called as a Pip

 For instance Rs 71.1650 changes to Rs 71.1651, the pip is 1 point

Cross Rates
A cross rate is an exchange rate of two currencies expressed in a third
 different currency, such as the exchange rate between the euro and the yuan
 expressed in yen.

Foreign exchange traders often use the term to refer to currency quotes that
do not involve the U.S. dollar, regardless of what country the quote is provided
in.
 For example:
1 USD = ¥ 123.25
1 £ = USD 1.4560
1 INR = USD 0.014
Then what will be the rate of INR in yen terms?
FOREX Risks and instruments to hedge
 Forex fluctuations pose a major risk for international trades

 A trader expects $ 1million to be received after 1 month from now.

The existing rate is Rs 71/ $. The rupee appreciates to Rs 70.56 on the
date of delivery. Then his loss will be (71-70.56) × $ 1 million = Rs
440,000

Similarly, an importer may lose if Rs depreciates against $

Forex risk hedging instruments
• 1. Currency Forward Contracts
• 2. Currency Futures Contracts
• 3. Currency Swaps
1. Currency Forward Contracts
 An agreement to buy and sell an underlying asset (forex here) at a
pre-agreed price and date

A currency forward is essentially a customizable hedging tool that

does not involve an upfront margin payment. 

The other major benefit of a currency forward is that its terms are not
standardized and can be tailored to a particular amount and for any
maturity or delivery period, unlike exchange-traded currency futures.
However, a currency forward has little flexibility and represents a
binding obligation, which means that the contract buyer or seller
cannot walk away if the “locked in” rate eventually proves to be
adverse.

The mechanism for computing a currency forward rate is

straightforward, and depends on interest rate differentials for
the currency pair 
For example, assume a current spot rate for the INR of US$1 = Rs 71.1560, a one-
year interest rate for interest rate of 4 percent, and one-year interest rate for US
dollars of 1.5 percent.

After 1 year, 1 $ is 1× (1.015) = $ 1.015

and Rs will be 71.156 × (1.04) = Rs 74.0022
Put simple, after 1 year, $1 = Rs 72.9085

Thus, 1 year forward rate today is $1 = Rs 72.9085