A) Mutual Funds:

The unit trust of mutual fund is a special type of managed pooled portfolio financial
company that sells shares/units/stocks to the public to obtain its resources, and it invests the savings
so mobilized in large, diversified, and sound portfolio of equity shares, bonds, money market
instrument, etc. A mutual fund is pure intermediary which performs a basic function of buying and
selling securities on behalf of its unit holders, which the latter also can perform but not as easily,
conveniently, economically and profitably. The liabilities of mutual funds, in nature, are formally
almost identical with their assets1. Unit trust is obligated to buy back units whenever an investor
wants to sell them. The schemes floated by mutual fund can be classified into two categories

Open Ended Funds(OEFs)

When the units are sold and redeemed everyday. It is said to be open ended because its
funds expand and contract continuously with the passage of time. There is no ceiling on the amount
the investors can invest in these funds; they also have the right to sell the units back to MFs
whenever they choose, and MFs are legally bound to repurchase those units. An investor will
generally purchase shares in the fund directly from the fund itself rather than from the existing
shareholders.

Close Ended Funds (CEFs)

CEFs on the other hand, do not sell any additional units after the sale of a fixed number of
units at the initial or inception stage, during a fixed period of time when the issue is open for
subscription. New shares are rarely issued after the fund is launched. Typically an investor can
acquire shares in a closed-end fund by buying shares on a secondary market from a broker or other
investors as opposed to an open ended fund where all transactions eventually involve the fund
company creating new shares.
The CEFs have fixed time duration for their operation; i.e. shares are not normally
redeemable for cash or securities until the fund liquidates. Their corpus or capitalization remains
fixed or intact till their redemption, the date of which is fixed and declared at the time of issue itself.
MFs enable small investors to obtain “high return-low risk” combination from their indirect
holding of equities and other assets. The activities of the MFs have significantly diversified the
portfolio of financial assets to choose from. The SEBI is the Regulatory Authority for MFs.
UTI invests a major part of its funds in private corporate securities. The deposits with banks
as well as companies, call deposits, term loans, government securities and so on are its other assets.

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B) The Call Money Market

The call money market is the market for very short term funds with maturity period varying
between one day to a fortnight. These loans are repayable on demand and at the option of either the
lender or the borrower; they are highly liquid, their liquidity being exceeded only by cash.
Commercial banks and cooperative banks are major participants on both the supply and demand
sides of this market. Therefore, it is also referred as inter-bank call market.
The volume of call loans depend on the extent of deposit accrual2, buoyancy of the stock
market, increase in the demand for loans for industrial and commercial purpose, the possibility of
quick investment or liquidation of government securities, treasury bills, and other short term
investment. Demand for call money tends to broaden in December, March, June, i.e., when
1
Unlike other financial institutions whose liabilities and assets differ sharply in their nature, unit trust issues
claims(units) which have, like its assets(equity stock), claim on a proportionate part of the portfolio.
2
Increase in bank deposits with banks, other things being equal, would induce banks to explore possibilities of
investment. So supply of call loans will increase when there is an increase in deposits.
quarterly advance tax payments are to be made. The policy of the RBI in respect of its loans to
banks and implementation of the reserve ratio requirements is another important factor having a
bearing on the banks decision to borrow on the call market3.
The call money market is mainly located in big industrial and commercial centres like
Mumbai, Kolkata, Chennai, Delhi and Ahmadabad.
The rate of interest in the call market - call rate - in India was market determined till 1973.
Subsequently, it was subjected to a ceiling fixed by the Indian Banks Association during 1973-
1989. With effect from 1 May 1989, the ceiling on the call rate was withdrawn. As a result call rate
has been freely determined by market force since1989. The call rates differ at different centres.
After the removal of ceiling, the volatility of call rates has increased over the years. The
extreme volatility of the call rates could be attributed to factors such as; a) the large amount of
borrowings by banks on certain dates to meet CRR requirements and sharp reduction in the demand
when the demand for call money once CRR needs are met, b) over exceeded credit positions of
some banks, c) sudden withdrawal of funds by institutional lenders to meet their business needs, d)
illiquidity in money market4 over exceeded credit position of some banks. The RBI has been
introducing many measures5 to stabilize the call rate.

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C) Treasury Bill
A treasury note is a kind of bill or promissory note issued by the government of the country
to raise short term funds. In theory they were issued to meet temporary needs for funds of govt,
arising from temporary excess of expenditure over receipts. In practice they have become a
permanent source of funds. Every year more treasury bills are sold than retired. Treasury bills are
highly liquid because there cannot be a better guarantee of repayment than the one given by the govt
and because the Central Bank of the country is always willing to purchase or discount them. The
important qualities of treasury bills are : the high liquidity, absence of risk of default, assured yield,
eligibility for inclusion in statutory liquidity ratio(SLR) and negligible capital depreciation.

Types of treasury bills:

91- day Treasury bill, 182-day Treasury, 364-day Treasury bill and two types of 14 day treasury
bills6.

Now all types of treasury bills are sold through auctions. With the introduction of auction
system, interest rates of all types of TBs are being determined by the market forces.
The 91-day TBs are purchased by the RBI, commercial banks, states govts and other
approved bodies, and financial institutions like LIC and UTI. The other TBs are purchased by
foreign banks in India, Indian scheduled banks, National Co-operatives Development Organization,
financial institution, joint stock companies etc.
The TBs market in India is very narrow and underdeveloped. They offer very low rate of
return and banks prefer to invest in govt securities to earn higher income.

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3
When banks have liberal access to on cheap terms to the discount window of the RBI, they need to resort to the call
money market will be less. On the other hand, in the period of restrictive monetary policy, banks would attempt to
utilize their resources among themselves more efficiently.
4
Banks invest fund in govt bonds, securities etc. in order to maximize earnings from the fund management but with no
buyers in markets, these instruments become illiquid.
5
money market support, enhancing govt securities refinancing etc.
6
91 and 182 treasury bills have been discontinued from 1 Aril 1997 and 1 April 1992 respectively
D) Commercial Paper(CPs) and Certificate of Deposits(CDs)
CPs and CDs are two new money market instruments introduced in India.

CPs are a finance paper like TBs. They are unsecured 7, negotiable, short-term promissory
notes with fixed maturity. They are safe and highly liquid; they are believed to be one of the highest
quality instruments available from the private sector.
They are issued in large denominations by the leading, nationally reputed high rated and
credit worthy large manufacturing and financial companies in the public as well as private sector.
CPs are mostly issued to finance current transactions, and seasonal and intrim needs for
funds. They are rarely issued to finance fixed assets and permanent working capital.
Any person, bank, company and NRI can invest in CPs.
The maturity period of CPs can vary from 30 days to 6 months.
Interest rates on CPs are market determined. The cost of CP finance is lower than or
comparable to that of bank credit.

CDs are marketable receipts in bearer or registered form of funds deposited in banks for
specified period at a specified rate of interest. They are transferable, negotiable, short term, fixed
interest bearing, maturity dated, highly liquid and riskless money market instruments. CDs can be
issued to individuals, corporations, trusts, funds, associations and NRIs.
The maturity period of CDs varies between three months to one year.
The rate of interest is also market determined and it is more attractive than that on bank
deposits.

Both primary and secondary markets for CPs and CDs are as yet underdeveloped in India.
The size of the CDs market is much bigger than that of the CPs market. The amount and interest
rates on both CDs and CPs have been subject to a high degree of both intra-year and inter –year
fluctuations.

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E) The Discount Market

The efficiency, stability, and minimization of the risk of insolvency of financial institutions
and banks require institutions, arrangements, and services for the best liquidity management in
financial markets. That is, the participants in the money market must be in a position to command
liquidity in times of need or crisis. Traditionally, central banks in all countries have been helping
the money market in this context by providing discounting and refinance facilities. Banks borrow
funds temporarily at the discount window of the Central Bank; they are permitted to borrow or are
given the privilege of doing so from the Central Bank against certain types of eligible paper
(collateral), such as the commercial bill or treasury bill, which the Central Bank stands ready to
discount for the purpose of financial accommodation to banks. The Central Bank is the ultimate
source of funds to the money markets.
The term, ‘discounting’ now is referred to lending not only against bills of exchange but also
in the form of direct loans and advances.
In different countries, various institutional arrangements have been made which, in addition
to the Central Bank, help to provide and smoothen liquidity flows in the money markets. In India,
institutions such as IDBI, NABARD< EXIM Bank, SIDBI, and NHB play an important role in the
discount market.

Discount and Finance House in India(DFHI)

7
They are backed only by the general credit standing of the issuing company.
 DFHI was set up in April 1988 as a specialized institution to operate in the discount market.
DFHI is a joint stock company owned by the RBI, public sector banks, and financial institution.
It plays a development as well as stabilizing role in the India money market. It aims at smoothening
liquidity imbalances by developing active primary and secondary markets in all money markets
instruments8.
DFHI has enabled a) corporate entities to invest their short term surplus gainfully and to
liquefy whenever necessary, and b) banks and financial institutions to earn an income by investing
their money for short periods, and also to raise short term money without liquidating their
investment.
The DFHI has an access to the RBI refinance facility in quite a liberal measure. The RBI has
been providing substantial resources to the banking system through DFHI.

Securities Trading Corporation of India(STCI)

In 1994, another institution, namely the STCI was set up with a view to promote good
secondary markets for debt instruments; it is supposed to function as a market maker at the long end
of the govt dated securities market.

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Government Securities

A Government security is a tradable instrument issued by the Central Government or the State
Governments. It acknowledges the Government’s debt obligation. 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). In India, the Central Government
issues9, treasury bills, bonds or dated securities and special rupee securities10. Government securities carry
practically no risk of default and, hence, are called risk-free or gilt-edged instruments.

The supply of government securities stem from the issue of government marketable debt. These
securities are issued by the Central government, state government and semi government authorities which
include local government authorities like city corporations, municipalities etc.

Unique and Important Financial Instrument

a) Two of the major techniques of monetary control of the Central Bank – open market operations 11 and
statutory liquidity ratio – are closely connected with the dynamics of the market for this instrument.

b) helpful in implementing the fiscal policy of the government.

c) It is also easier to obtain loans against the collateral of these securities from the RBI and other
institutions.

d) As the RBI can issue currency against the backing of Central government bonds, they constitute the
ultimate source of liquidity in the economy.

8
DFHI deals with TBs, commercial bills, CDs CPs, call and notice money and government securities.

9
the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs)
10
The special rupee securities are treated as a part of internal floating debt of the government. They are non negotiable
and non interest bearing claims.
11
The buying and selling of government securities in the open market in order to expand or contract the amount of
money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of
securities do the opposite.
 e) Secure : as it is a claim on the government which guarantees the certainty of both income and capital.
That is why it is called “gilt edged” security or stock. They are free of default or credit risk, which
leads to reduction in market risk12, and an increase in liquidity in their case.

f) certainty of capital value not only at maturity but also prior to maturity.

Denomination

a) The government securities are normally issued in the denomination of Rs 100 or 1000.

a) The rate of interest is relatively lower because of their being liquid and safe. It was maintained at a
low level to minimize the cost of servicing public debt.

b) Market expansion: because of regulations, statutory or otherwise under which financial institutions
are required to invest a certain proportion of their investible funds in these securities.

Interest

A) The interest on govt securities is payable half yearly.

B) Income in the form of interest on investments is exempt from income tax to a limit. But as
individuals do not normally invest in these securities, savings in tax liability does not seem to be an
important motivation behind investment in them.

Liquidity

Securities of different authorities differ in respect of the extent to which they possess these attributes.
Securities of state govt and semi govt are less liquid than Central govt securities.

There is no need to underwriting or guaranteeing the sale of central and state govt securities. The
securities of semi govt agencies, however may need to be underwritten. They are also guaranteed by
the state govt for repayment of the principal and the payment of interest.

Forms of Government Securities

There are three forms of Central and state government securities:

a) inscribed stock or stock certificates13, b) promissory notes, c) bearer bond14

Bearer bonds are not issued in India and stock certificates are not very popular with investors.

Mode of Issues

Role of Brokers and Dealers

The govt securities market is everywhere, including India is over-the-counter(OTC) market, where
there is one to one correspondent between buyer and sellers. But the role of the broker in the process of

12
The day-to-day potential for an investor to experience losses from fluctuations in securities prices.
13
Name of the holder is registered in the books of the Public Debt Office(PDO).
14
It differs from the more common types of investment securities in that it is unregistered – no records are kept of the
owner, or the transactions involving ownership. Whoever physically holds the paper on which the bond is issued owns
the instrument. This is useful for who wish to retain anonymity. Recovery of the value of a bearer bond in the event of
its loss, theft, or destruction is usually impossible.
marketing govt securities in India has been much more limited than in other because of the following
reasons:

a) From June 1978, RBI discontinued the practice of charging differential interest rate for the
purchase and sale of the central govt securities to enable banks to approach it directly instead of
through brokers.

b) The volume of floating stock is limited. Most of the investors who buy govt securities usually
hold them till maturity. Commercial banks can buy as much as they want, but they cannot sell
securities beyond a limit due to SLR requirements. All such factors have restricted the growth of the
secondary market.

b) The RBI acts as the biggest dealer through its OMOs. Continuous participation by the RBI in the
government securities market has resulted in the lack of growth of the institution of dealers.

d) Dealers need funds for their operations. Usually such funds are obtained from the commercial
banks in other countries. But the high cost of borrowing funds from banks compared with the low
yield on government securities has also inhibited the growth of the dealers in the market.

Purpose of Securities Issue:

a) Refunding, i.e., conversion or refinance of maturing securities. Refunding itself can be carried out
either by selling new securities for cash settlements and using the proceeds to retire old issues, or by offering
holders of maturing securities the right to exchange old securities for new one.

b) Advance refunding or reissue of securities that have not yet matured

c) cash financing

The objective of the conversion and the reissue of loans is to lengthen the maturity structure of govt debt, and
to reduce the volume of cash repayment of loans.

Two other activities carried out by RBI in the govt securities market are “grooming15” and “switches16”

Role of RBI

It is continuously in the market selling govt securities and buying them mostly in switch operations
and rarely for cash. Sometimes there are triangular switch transactions in which one investor’s sale or
purchase is matched by the purchase or sale transaction of another investor, the RBI being the middle party.
The RBI fixes an annual quota, based on the size of the bank for switch transactions of each bank from time
to time with a view to prevent banks from exclusive sales of low yielding securities to the RBI.

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Asset Securitization

15
Acquiring securities nearing maturity to facilitate redemption and making available on tap a variety of loans to
broaden the guilt edge market.
16
Purchase of one one security against the sale of another security as distinct from outright purchase or sale of security.
 The process through which an issuer creates a financial instrument by combining pool of
financial assets and then marketing repackaged instruments to investors. The process creates
liquidity by enabling smaller investors to purchase shares in a larger asset pool.

To understand ‘asset securitization’ we need to understand how it is different from

traditional system for financing the acquisition of assets, which called for one financial
intermediary, such as a depository institution/bank/insurance company.

Financial Intermediary Asset Securitization

Financial intermediaries stand between the lenders-
savers and the borrower-spenders and helps transfer
funds from one to the other; that is why it is called
indirect financing. A financial intermediary does this
by borrowing funds from the lender-savers and then
using these funds to make loans to borrower-spenders
(an example could be of a bank). A financial
intermediary works in the following way:
c) Originate a loan
d) Retain the loan in its portfolio of assets,
thereby accepting the credit risk associated
with the loan
e) Service the loan – collect payments and
provide tax or other information to borrower.
f) Obtain funds from public with which to
finance its assets.
Asset securitization means that more than one
institution may be involved in lending capital.
Consider loans for the purchase of automobiles. A
lending scenario can look like this
g) A commercial bank can originate automobile
loans
h) The commercial bank can issue securities
backed by these loans
i) The commercial bank can obtain credit risk
insurance for the pool of loans from a private
insurance company
j) The commercial bank can sell the right to
service the loans to another company that
specializes in the servicing of loans
k) The commercial bank can use the services of
a securities firm to distribute the securities to
individual investor.

In the case of asset securitization the commercial bank does not have to absorb the credit
risk and provide the funding. The largest part of the securitized assets market is the mortgage
backed securities market, where the assets collateralizing the securities are residential mortgage
loans.

Benefits from securitization:

A) Benefits to Issuers:
a) Diversification and reduced cost of funding: securitization of assets enables originators of
assets to broaden funding sources and often reduce funding.
b) Management of Regulatory Capital: Asset securitization can be used as tool to manage
risk based capital requirements.
c) Generation of servicing fee income: This is done by securitizing and selling the loans
while retaining the servicing. The servicing fee that is retained compensates the servicer for
providing the normal clerical, computational, and collection functions involved in receiving
payments from borrowers and remitting the proceeds to the paying agent for the securitized assets.
d) Management of Interest Rate Volatility: With respect to the management of interest rate
volatility, the securitization of assets fulfills a dual role. The dual role stems from the fact that the
institution can securitize assets that expose the institution to higher interest rate risk and retain
certain customized parts of the asset securitization transaction to attain an improved
asset/liability/position.
B) Benefits to Investor:
Securitization converts illiquid loans into securities with greater liquidity and reduced credit
risk. Credit risk is reduced because
b) Securities are backed by diversified pool of loans
c) Credit enhancement

C) Benefits to Borrower:
Because financial entity can securitize a loan it originates, or sell it to some entity that will
securitize it, the lender now has more liquid asset that it can sell if capital is needed. As market
matures, competition among originators should produce lower lending rate spreads in other loan
markets.

Securitization provides direct financing between borrowers and investors, short-circuiting

the traditional intermediaries. Pooling of assets reinforced by private credit enhancement reduces
credit risk to more acceptable levels for investors. Securitization serves a role similar to maturity
intermediation while shifting its risk to the lenders and denomination intermediation.

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Financial intermediation
Why are financial intermediaries and indirect finance so important in financial markets? To
understand this we need to understand the role of transaction costs and information costs in
financial markets:

C) Transaction Costs
The time and money spent in carrying out financial transactions are a major problem for people who
have excess funds to lend. Financial intermediaries can substantially reduce transaction costs
because they have developed expertise in lowering them and because their large sizes allows them
to take advantage of economies of scale, the reduction in transaction cost per dollar of transactions
as the size(scale) of transactions increases.

D) Risk Sharing
Financial intermediaries can help reduce the exposure of investors to risk – that is uncertainty about
the returns investors will earn on assets. Financial intermediaries will do this by risk sharing. Low
transaction costs for financial intermediaries allow them to do risk sharing at low costs, enabling
them to earn a profit on the spread between the returns they earn on risky assets and the payments
they make on the assets they have sold. This process of risk sharing is called asset transformation,
because in a sense risky assets are turned into safer assets for investors.

E) Asymmetric Information: Adverse Selection and Moral Hazard:

Because of asymmetric information one party does not know enough about the other party to make
accurate decisions. For example, a borrower has better information about the potential returns and
risks associated with the investment projects for which the funds are borrowed than the lender does.
Asymmetric information leads to the adverse selection17. Because there are chances of
adverse selection, lenders may decide not to make any loans even though there are good credit risks
as well in the marketplace.

17
Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an
undesirable outcome – the bad credit risk – are the one who most actively seek out a loan and thus most likely to be
selected.
 Moral hazard18 is the problem created by asymmetric information after the transaction
occurs. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide
that they would rather not make a loan.

F) Maturity and Denomination intermediation

Financial intermediaries acquire short term funds and grant loans with longer maturities.
This satisfies the objective of investors who want shorter term investments and borrowers who want
longer term funds; that is, the institution provides maturity intermediation although at their risk.
The amount of funds sought by borrowers is typically greater than any one individual
investor would be willing to lend. Financial intermediation makes large dollar loans to borrowers
and offer investors with smaller dollar denominations. They provide denomination intermediation,
transferring very large assets into quite divisible ones.

The problem created by adverse selection and moral hazard are an important impediment to
well functioning financial markets. Financial intermediaries can alleviate these problems.
With financial intermediaries in the economy, small savers can provide their funds to
trustworthy financial intermediaries, which in turn lends to the funds out either by making loans or
by buying securities such as stock or bonds. Successful financial intermediaries have higher
earnings on their investments because they are better equipped than individual to screen out good
from bad credit risk, thereby reducing losses due to adverse selection.

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18
Moral hazard in the financial markets is the risk(hazard) that the borrower might engage in activities that are
undesirable from the lenders point of view because they make it less likely that the loan will be paid back.