MFS intro

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Course Objective

To make students aware of variousaspects of a financial system likebanking, insurance, mutual funds, capital

markets, portfolio management etc. To provide students with an

understanding of various trading andsettlement regulations in both domesticas well as international markets

To enable students to apply theoreticalknowledge into the real world

To enable students to apply various skillslike information technology, accountingetc. to develop analytical skills in financial

services To develop an ability to access and

assimilate information and updateknowledge in financial markets.

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Course outline

Introduction to the Financial system

Financial services provided by Banks

Trading and settlement in stock markets

Mutual fund schemes and comparison of

mutual funds

Merchant banking, book building, initial

public offer (IPO)

Insurance plans, Unit linked Insurance

plans (ULIP), schemes in insurance

International financial markets

Issue of ADR and GDR

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Financial System Definition

A system is a set of interrelated parts working together to

achieve some purpose

A financial system is a set of complex or closely connected

or inter mixed institutions, agents, practices, markets,

claims and so on in any economy. It can therefore be defined as

that part of the economy which includes all the

institutions involved in moving savings from savers

(households and firms) to borrowers, and in

transferring, sharing, and insuring risks;

it includes financial institutions / intermediaries like

banks, insurance organizations, unit trusts/ mutualfunds markets, bond markets, and the stock market

which collect capital from savers/investors and

distribute them to the entrepreneurs / productive

enterprises

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Constituents of a financial

System

Components of financial systems

Formal systems

Financial institutions

Financial markets Financial instruments

Informal systems

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Basic functions of financial

systems

Financial systems are of crucial significance to capitalformation which in turn is indispensable for economicgrowth

Process of capital formation involves three distinct

although interrelated activities Savings ability by which claims to resources are set

aside and become available for other purposes

Finance The activity by which resources are assembledfrom domestic savings or obtained from abroad, orspecially created usually as bank deposits or notes andthen placed in the hands of investors

Investments The activity by which resources arecommitted to production

There are three types of economic units

Saving surplus units

Savings deficit units

Neutral units

If capital formation has to take place savings must be

transferred from saving surplus units to savings deficitunits.

Financial systems act as a link between savers andinvestors and thereby aid capital in capital formation

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Role of financial intermediaries

Indirect finance refers to the flow of savings from thesavers to entrepreneurs through intermediary financialinstitutions like mutual funds, insurance companies etc.

Financial intermediaries come in between the ultimateborrowers and ultimate lenders in the savings

investment process Financial intermediaries play a vital role in economic

development via the capital formation process. Theirrelevance to the flow of savings is derived from what iscalled transmutation effect that is the ability to convertcontracts with a given set of features into contracts withdifferent features.

Financial intermediaries provide services formobilization of savings as well as their channelization

Services provided under mobilization of savings are Convenience

Divisibility

maturity

Lower risk

Expert management

Economics of scale

Financial intermediaries play a crucial role in theeconomic development by directing savings in tune withdevelopmental priorities

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Financial intermediaries

Important intermediaries operating in thefinancial markets include; investment bankers,

underwriters, stock exchanges,

registrars, depositories, custodians,

portfolio managers,

mutual funds,

financial advertisers, financial consultants,

primary dealers, satellite dealers,

Though the markets are different, theremay be a few intermediaries offering theirservices in more than one market e.g.

underwriter. However, the servicesoffered by them vary from one market toanother.

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FINANCIAL INTERMEDIATION

Intermediary Market RoleStock Exchange Capital Market Secondary Market to

securitiesInvestment Bankers Capital Market, Credit Market Corporate advisory services,

Issue of securitiesUnderwriters Capital Market, Money

Market Subscribe to unsubscribedportion of securitiesRegistrars, Depositories,

Custodians Capital MarketIssue securities to the

investors on behalf of the

company and handle share

transfer activityPrimary Dealers SatelliteDealers Money Market Market making ingovernment securitiesForex Dealers Forex Market Ensure exchange ink

currencies

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Functions of Financial

Institutions and Markets

Assemble funds

Allocate capital

Interest rates and prices of financial instruments

Quantities to borrowers and lenders

Absorb risk Analyse and disseminate expensive and financial

information

Risk of debt and equity issues and issuers

Valuation of debt and equity

Valuation of derivatives

Volumes of debts and equities Ownership of debts and equities

Monitor primary issuer performance

Distribute Primary Securities

Investigate issuers of debts and equities as to their futureperformance

Underwrite securities i.e. guarantee a price for the

security issue and accept the risk of security issue Wholesale distribution of security to underwriters and

dealers

Retail distribution of securities through a sale to the openmarket via brokers and dealers

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Functions of Financial Institutions

and Markets (cont.)

Provide for secondary market for primary,

secondary and derivative securities. The

secondary market is the market for

outstanding securities where most tradingtakes place

Intermediate between the preferences of

primary security issuers and ultimate

savers Other functions

Maturity intermediation

Reducing risk via diversification

Reducing the cost of contracting and

information processing Providing a payment mechanism

Asset / Liability management

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Relationship between financial

system and economic growth

Existence of financial system facilitates economic

activity and growth.

Markets, institutions and instruments are the

prime movers of economic growth. Financial system diverts savings to productive

uses, it helps to increase output of the economy

Helps accelerate the volume and rate of savings

by providing diversified range of financial

instruments and services

Makes innovation least costly and most profitable

thereby enabling a faster economic growth

Financial system is useful in evaluating assets,

increasing liquidity and producing and spreading

information

Economic growth in turn develops financial

system as they increase trading activities and

develop new risk management products to keep

pace with growth

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system and economic growth (cont.)

Financial markets represent deep end of thefinancial system; deeper the system, greater thestability and resilience. A well developed moneyand govt. securities market helps the Central

Bank to conduct monetary policy effectively withthe help of market based instruments

The financial system plays an important role indisciplining and guiding management ofcompanies leading to sound corporategovernance

The domestic financial system when linked tointernational financial system, increases capitalflow with the help of financial markets. This linkreduces risk through portfolio diversification andhelps in accelerating economic growth

There is a symbiotic relationship between

financial system and economic growth. Asophisticated and sound financial accelerateseconomic growth and the financial system in turndevelops more with economic growth

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system and economic growth

Market frictions Information costs

Transactions cost

Financial markets and intermediaries

Financial market Functions (Services)

Liquidity

Risk diversification

Rapid information

Corporate control

Savings mobilisation

Channels to growth

Capital accumulation Technological innovations

Economic Growth

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Financial institutions

Banking institutions

Scheduled Commercial Banks

Public Sector Banks

Private Sector Banks

Foreign Banks

Regional rural Banks

Scheduled Co-operative

Non banking institutions

Non Banking Financial Companies

Development Financial Institutions

All India Financial Institutions ( IDBI, IFCI, IIBI,

NABARD,SIDBI, NHB etc)

State Level institutions ( SFCs, SIDCs)

Other Institutions (DICGC,ECGC)

Mutual Funds

Public

Private

Insurance and housing finance companies

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Financial Markets

A Financial Market can be defined as the market in whichfinancial assets are created or transferred. As against a realtransaction that involves exchange of money for real goods orservices, a financial transaction involves creation or transfer ofa financial asset. Financial Assets or Financial Instrumentsrepresents a claim to the payment of a sum of money

sometime in the future and /or periodic payment in the form ofinterest or dividend.

Money Market- The money market ifs a wholesale debtmarket for low-risk, highly-liquid, short-term instrument. Fundsare available in this market for periods ranging from a singleday up to a year. This market is dominated mostly bygovernment, banks and financial institutions.

Capital Market - The capital market is designed to finance

the long-term investments. The transactions taking place inthis market will be for periods over a year.

Forex Market - The Forex market deals with the multicurrencyrequirements, which are met by the exchange ofcurrencies. Depending on the exchange rate that isapplicable, the transfer of funds takes place in thismarket. This is one of the most developed and integratedmarket across the globe.

Credit Market- Credit market is a place where banks, FIs andNBFCs purvey short, medium and long-term loans tocorporate and individuals.

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Financial Markets (contd.)

Capital Market Equity

Primary Public issues

Private placement Domestic International

Secondary NSE, BSE, OTCI, ISE, Regional Stockexchanges

Derivatives Exchange traded - Futures and options

Index,

Stock

Debt Private Corporate

PSU Bond

Government securities market Primary, Secondary

Money Market Treasury Bills,

Call Money Market

Commercial bills

Commercial Papers

Certificates of deposits Term money

Primary Segment

Secondary Segment

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Money Market Instruments

1. Call /Notice-Money Market

Call/Notice money is the money borrowed or lent ondemand for a very short period. When money is borrowedor lent for a day, it is known as Call (Overnight) Money.Intervening holidays and/or Sunday are excluded for this

purpose. Thus money, borrowed on a day and repaid onthe next working day, (irrespective of the number ofintervening holidays) is "Call Money". When money isborrowed or lent for more than a day and up to 14 days, itis "Notice Money". No collateral security is required tocover these transactions.

2. Inter-Bank Term Money

Inter-bank market for deposits of maturity beyond 14 days

is referred to as the term money market. The entryrestrictions are the same as those for Call/Notice Moneyexcept that, as per existing regulations, the specifiedentities are not allowed to lend beyond 14 days.

3. Treasury Bills.

Treasury Bills are short term (up to one year) borrowinginstruments of the union government. It is an IOU of theGovernment. It is a promise by the Government to pay a

stated sum after expiry of the stated period from the dateof issue (14/91/182/364 days i.e. less than one year). Theyare issued at a discount to the face value, and on maturitythe face value is paid to the holder. The rate of discountand the corresponding issue price are determined at eachauction.

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(contd.)

4. Certificate of Deposits

Certificates of Deposit (CDs) is a negotiablemoney market instrument issued indematerialised form or as a Usance Promissory

Note, for funds deposited at a bank or othereligible financial institution for a specified timeperiod. CDs can be issued by

scheduled commercial banks excluding RegionalRural Banks (RRBs) and Local Area Banks (LABs);and

select all-India Financial Institutions that have beenpermitted by RBI to raise short-term resourceswithin the umbrella limit fixed by RBI. Banks havethe freedom to issue CDs depending on theirrequirements. An FI may issue CDs within theoverall umbrella limit fixed by RBI, i.e., issue of CDtogether with other instruments viz., term money,

term deposits, commercial papers andintercorporate deposits should not exceed 100 percent of its net owned funds, as per the latestaudited balance sheet.

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(contd.)

5. Commercial Paper

CP is a note in evidence of the debt obligation ofthe issuer. On issuing commercial paper the debtobligation is transformed into an instrument. CP is

thus an unsecured promissory note privatelyplaced with investors at a discount rate to facevalue determined by market forces. CP is freelynegotiable by endorsement and delivery. Acompany shall be eligible to issue CP provided

the tangible net worth of the company, as per the

latest audited balance sheet, is not less than Rs. 4crore;

the working capital (fund-based) limit of thecompany from the banking system is not less thanRs.4 crore and

the borrowal account of the company is classifiedas a Standard Asset by the financing bank/s.

The minimum maturity period of CP is 7 days. Theminimum credit rating shall be P-2 of CRISIL orsuch equivalent rating by other agencies.

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(contd.)

Capital Market Instruments

The capital market generally consists ofthe following long term period i.e., more

than one year period, financialinstruments; In the equity segment Equityshares, preference shares, convertiblepreference shares, non-convertiblepreference shares etc and in the debt

segment debentures, zero coupon bonds,deep discount bonds etc.

Hybrid Instruments

Hybrid instruments have both thefeatures of equity and debenture. This

kind of instruments is called as hybridinstruments. Examples are convertibledebentures, warrants etc.

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Financial Instruments/

Assets/Securities

Equity / Ordinary shares

Debentures

Preference shares

Innovative instruments Issued by companies

Participating debentures

Convertible debentures with options

Third party convertible debentures

Convertible debentures redeemable at premium

Debt equity swaps

Secured premium notes with detachable warrants

Zero coupon convertible notes

Non convertible debentures with detachable equity

warrants

Zero interest fully convertible debentures

Fully convertible debentures with interest

Warrants

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Innovative instruments contd.

Issued by Financial institutions

Floating rate bonds

Zero coupon bonds / Deep discount bonds

Easy exit bond with a floating interest rate

Easy exit bonds with floating interest rates

Regular income bonds

Retirement bonds

Set up liquid bonds

Growth bonds

Index bonds

Capital gains bonds

Encash bonds

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Opportunities of the 21st Century

New technology Proliferation of new services

Development of new market areas

Reduction of operational costs

Globalization

Growth of international financial institutions Increased competition for customers and markets

Specialized niches for boutique firms

Continuing Consumer Concerns Bigger is not necessarily better (service)

Security of personal financial information Identity theft

Damaging credit reports Bad management of large financial institutions can lead

to: Loss of funds

Loss of credit

Widespread negative economic impact

Financial Assets versus Real Assets A financial asset is a contract that offers a promise of payment (or

the option to receive payment) in the future from the party thatissued the contract. Examples include securities, loans, etc.

Real assets are those assets expected to provide benefits basedon their fundamental qualities. Examples include inventory, realestate, etc.

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Differences between Financial

Institutions and Non-financial Firms

Depository

Institutions

Non-financial

Firms

Assets

Most assets are

financial assets

Most assets are

real assets

Financing

of the firm

High financial

leverage is normal

and advantageous

Moderate financial

leverage is normal;

high is dangerous

Asset

LiquidityVery High More moderate

Liability

LiquidityQuite High More moderate

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Types of Financial Institutions

Depository Institutions1

Commercial banks Thrift institutions

Savings & loan

associations

Savings banks

Credit unions

Non-Depository

Institutions Finance companies

Contractual

intermediaries Pension funds

Insurance

companies

Investment

companies

Mutual fundmanagement

companies

Real estate

investment trusts

(REITs)

Securities firms

Securities brokers Investment banks

Government-

sponsored

enterprises

1Depository institutions take

deposits and make loans.

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Depository Institutions

Depository Institutions

are financial institutions that take deposits andmake loans

control the largest proportion of financial assets.

Depositors are protected from loss of funds bydeposit insurance via quasi-federal agencies

Builds depositors confidence in financial system

Provides another level of regulatory oversight

Commercial Banks Banks hold primarily securities and loans as

assets

Banks have been the primary source of short-termand intermediate-term loans

Their loan portfolio is the most diversified andcredit risk is their largest risk

Banks major source of funds are customerdeposits

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Depository Institutions (contd)

Thrift Institutions

Savings and loan associations (S&Ls) andsavings banks traditionally rely on savingsdeposits as sources of funds.

S&Ls have expanded beyond their traditionalrole as mortgage suppliers.

Savings banks resemble S&Ls, but they havemore diversified asset bases.

Credit Unions (CUs)

CUs are not-for-profit organizations

CUs are subject to a common bondrequirement and cannot make commercialloans

CUs have aggressively stretched commonbond boundaries, becoming more like banksby offering credit cards and other investmentservices

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Finance Companies

Finance companies provide

Loans to businesses and consumers who can notqualify for bank loans

Provide liquidity to businesses by financing their mostliquid assets (accounts receivable)

Loans at higher interest rates than banks

Major sources of funds include

Loans from commercial banks

Selling commercial paper and bonds

Contractual Intermediaries Operate under formal agreements with

policyholders or pensioners who entrust their fundsto these firms.

Provide financial vehicles for

Risk management

Retirement savings

Defined contribution retirement plans have largelyreplaced defined benefit plans

Assets are primarily long term investments

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Investment Companies

Investment companies include mutual funds,money market funds, and REITs

Provides professional management of diversified

portfolios to individual investors Economies of scale offer the benefits of:

professional management

reduced costs

reduced risk exposure within large, diversifiedportfolios.

Securities Firms Provide retail brokerage services including buying

and selling stocks, bonds, and other financialassets for customers

Make a market in financial securities by buying andselling the same securities themselves

Sell investment banking services including thecreation and issuance of new securities (individualpublic offerings or IPOs)

Provide financial consulting services

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Industry Differences

Major differences exist between financialinstitutions in their

Asset and liability distributions

Services offered to the public

Riskiness of invested funds

Legal structure

There are significant differences in the lawsregulating their operations and governmentagencies acting as regulators.

Economic Functions of financial Institutions Intermediation (transfer of funds, securities) Reduced transactions and information costs

Liquidity For markets

For individual parties (companies or individuals)

Information and contacts

Transfer of risk Creation of financial instruments

Creation of money

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Primary versus Secondary

Securities and Markets

For securities

Primary (direct) securities are claims against

individuals, governments, and nonfinancial

firms. Secondary (indirect) securities are financial

liabilities of financial institutions.

For Markets

Primary markets: Securities are initially offered

(IPO) and issuing party receives the funds Secondary markets: Outstanding securities

are traded from one holder to another and

issuing party receives no funds.

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Primary and Secondary

Securities

Primary Securities Secondary Securities

Commercial Loans Savings Deposits

Mortgage Loans Transaction Deposits

Consumer Loans Certificates of Deposit

Government Bonds Insurance Policyholders

Reserves

Corporate Bonds Mutual Fund Shares

Corporate Common

Stock

Pension Fund Reserves

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Financial Intermediation Benefits

Reduction of transactions and information costs

Information and Search Costs

Portfolio Selection and Denomination Costs

Monitoring Costs

Risk Management Costs Maturity Intermediation and Liquidity

Exchange of securities with different characteristics

Transfer of risk

Search Costs

Financial institutions provide ways to identify entities with

excess funds and those needing funds. This identification by financial institutions eliminates the

need for individual lenders and borrowers to find oneanother.

Portfolio Selection Costs

Investors may wish to invest in financial assets in differentdollar amounts, with different maturities, or with different

risk levels from the financial liabilities borrowers wish toissue.

Financial institutions issue secondary securities tolenders, and then repackage funds in forms attractive toborrowers.

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Financial Intermediation Benefits

(contd.)

Monitoring Costs Asymmetric information exists when managers have one

set of information and investors have a different set ofinformation.

Managers are generally better informed about their firmsprospects, so they generally have a better set ofinformation.

Information asymmetry gives rise to monitoring costs -ongoing expenses incurred by investors to gatherinformation so they can intervene if borrowers financialsituations change.

Risk Management Costs Investors can avoid the risk of a single party defaulting on

its obligations by holding shares in a mutual fund

Insurance companies can pool premiums and provide riskmanagement at much lower cost Banks provide letters of credit that guarantee payment by

other parties, reducing risk Investment and commercial banks provide instruments

that can protect against interest rate and foreignexchange risk

Maturity Intermediation and Liquidity

Banks accept small amounts from small investors asdeposits and transform them into longer-term loans

Banks borrow short-term (from depositors) and lendlonger-term

Checks, credit cards, electronic payments, and bank wirescan be used to make payments in lieu of cash

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The Changing Role of Financial

Institutions in the Technological Age

New risks with technology Societal Concerns

Serving the community Services for the unbanked Community Reinvestment Act

Accounting & Ethical Concerns Enron Arthur Anderson Investment bankers providing false information Mutual fund management practices Corporate Governance Scandals

Financial Institution Management Who sets objectives?

Stockholders versus stakeholders

Normative versus positive theory approach

Agency theory

Customer needs

Regulations providing limits

What is the goal of the firm?

Economic Value Added (EVA) A goal for risk-profitability management

Measures profitability after Long term debtholders earn their return

Stockholders and other investors earn their return

Can be used for individual capital allocation decisions

Documents

MFS intro