The Financial System

1. The Financial System Dr. Ram Chandra Rai Sr. professor(Financial Management) Railway Sraff College Vadodara

2. Constituents of a Financial System • Surplus Units • Deficit Units • Financial Markets • Financial Intermediaries

3. Financial System Surplus Units: Households, corporates Deficit Units: Individuals, Governments, Corporates Financial Markets: Vast forum where surplus units, deficit units and financial intermediaries forge linkages through financial instruments Financial Intermediaries: Intermediate, i.e., borrow from surplus units and lend to deficit units at terms acceptable to both sides

4. Money Market Funds are borrowed or lent for periods less than one year Facilitates adjustments to short-term liquidity positions Capital Market Funds are borrowed or lent for periods exceeding one year Typically associated with capital expenditures Financial Markets

5. Other markets • Foreign exchange markets: Spot and forward transactions • Derivatives Markets: Standardized contracts at exchanges, e.g., Options and Futures, and customized contracts over-the-counter, e.g., forwards and swaps

6. Money Market and Capital Market • Both Money Market and Capital Market have a primary and a secondary segment. • The primary segment refers to transactions by which securities are originated. • The secondary segment refers to trading in securities, which were issued earlier. Thus, Stock Markets are a part of the secondary segment of the Capital Market • A way to distinguish between the two is by asking: Who is the seller?

7. Money Market Government, banks and financially sound companies Capital Market Government, companies, financial intermediaries and investors in general Participants

8. Money Market (maturity < 1 year) Call and Notice Money Treasury Bill Repos Commercial Paper Certificate of Deposit Inter-bank Term Money Inter-bank Participation Certificate Bill of Exchange ICDs / FCDs Capital Market (maturity > 1 year) Government Securities (“Gilts) Corporate debentures/bonds Preference shares Equity shares Warrants (sweetener) --------------------------------------- GDR/ADR, Foreign Bonds, Foreign Currency Convertible Bonds Financial Instruments

9. Other long-term sources • Leasing (and Hire-purchase too) are important long-term sources of funds • Forms of Leasing: Direct Lease: Financial and Operating Lease Sale and Leaseback

10. Features of some capital market instruments • Debentures / Bonds • Long-term debt instrument • Coupon: Fixed or floating • Yield: the return to an investor and the actual cost to the issuer • Life: Certain • Voting rights: No • Priority of claim on earnings and assets • Deed of trust, i.e., indenture • Less expensive source of funds, because of lower risk to investors and also the tax shield • A good rating is desirable

11. Equity shares • Represent a residual ownership interest • Dividends may not be paid • Bear voting rights • Most expensive source of finance (high risk and no tax shield) • Equity capital facilitates borrowing

12. Stated dividend Ordinarily, no voting right Dividend may be missed Subordinate to debentures Preference shares

13. Types of debentures / bonds • Floating-rate (Indexed) • Deep discount including zero-coupon • Convertible • Income

14. What accounts for yield differentials among bond issues? • Default Risk (Indicator: Credit Rating) • Maturity • Call proviso • Convertibility • Marketability • Tax features

15. What are Structured Debt Obligations? • Debt securities that bear special features which enhance the investment quality of the instruments.

16. Financial Intermediaries • Banks • Term-lending institutions • Mutual Funds • Pension and Provident Funds • Insurance Companies • Specialized institutions

17. Investment Policies of Financial Intermediaries • Banks: prefer liquid assets and hence lend mostly short-term to businesses • Term-lending institutions: advance loans of around 5-7 years to businesses • Mutual Funds: invest in a portfolio of assets, depending upon the objective • Pension Funds: primary vehicle of retirement saving, hence risk-averse • Insurance Companies: high emphasis on safeguarding principal • Specialized institutions: cater to a specific segment

18. Complexities for firms that operate internationally • Revenues/Profits/Assets may be measured in different currencies • Differing legal requirements, e.g., tax laws, depreciation rules and government controls • Institutional restrictions: Ability to raise capital is restricted by the types of markets and institutions • Major dimension of foreign operations: Multiple currencies

19. Some aspects of International Capital Markets • Eurocurrency Market: International market in bank deposits and loans residing outside of the domestic currency, e.g., Eurodollar deposits --- dollar deposits held in a country other than the U.S. • LIBOR: London Inter-bank Offer Rate; Average of rates at which a group of London-based banks are prepared to lend Eurocurrencies to one another • LIBOR is an important benchmark rate

20. Features of the Eurocurrency Markets • No reserve requirements • No interest rate regulations or caps • No withholding taxes • No deposit insurance requirements • No regulations influencing credit allocation decisions • Less stringent disclosure requirements

21. Some international capital market instruments • Foreign Bonds: Bonds that are issued in a domestic market by a foreign borrower and denominated in the domestic currency, e.g., Yankee Bonds, Bulldog Bonds and Samurai Bonds • Eurocurrency Bonds: Long-term debt securities that are denominated in a currency other than the currency of the country in which they are issued • Note Issuance Facility: An arrangement for obtaining medium-tem financing by issuing short-term notes which are rolled over • Foreign Currency Convertible Bonds: Bonds denominated in a foreign currency which are convertible into equity shares • Global Depositary Receipts: A negotiable instrument that represents a certain number of shares of a foreign-based company (ADR: American Depositary Receipt)