FINANCIAL MARKETS & REGULATIONS Assignment A Q: 1). What do you mean by Money Market and Money Market instruments?

Answer: Money market: is a market for short-term, high liquid debt securities with maturities of less than one year. It is a highly liquid market wherein securities are bought and sold in large denominations to reduce transaction costs. Call money market, certificates of deposit, commercial paper, and treasury bills are the major instruments of the money market. Money market is a very important segment of the financial system of a country. It is the market dealing in monetary assets of short term nature. Short term funds up to one year and financial assets that are close substitutes for money are dealt in the money market. The money market functions include: a) Money markets serve as an equilibrating force that redistributes cash balances in accordance with the liquidity needs of the participants. b) Money markets form a basis for the management of liquidity and money in the economy by monetary authorities. c) Money markets provide a reasonable access to the users of shortterm money for meeting their requirements at realistic prices. d) As it facilitates the conduct of monetary policy, money markets constitute a very important segment of the financial system. Money market Instruments are short-term, low risk, high liquid financial instruments such as treasury bills, call money, notice money, certificates of deposit, commercial paper etc. 1) Call Money: is money borrowed or lent on demand for a very short period. It is borrowed or lent for a day, and sometimes called as Overnight Money. Intervening holidays or weekends are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day is Call Money. 2) Notice Money: is money borrowed or lent for up to 14 days. No collateral security is required to cover these transactions. 2

3) Inter-Bank Term Money: are deposits of maturity beyond 14 days. The entry restrictions are the same as those for Call and Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days. 4) Treasury Bills: is a document by which the Government borrows money in the short term (up to one year). It is borrowing instruments of the union Government. The Government promises to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. 5) Certificate of Deposits (CDs): is a negotiable money market instrument and issued in dematerialized form or as a usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. CDs are similar to traditional term deposits but are negotiable and can be traded in the secondary market. 6) Commercial Paper (CP): is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. Q: 2). Answer: Depositories are organizations which hold securities of investors in electronic form at the request of the investors through a registered Depository Participant. It also provides services related to transactions in securities. In the Depository System, the securities of a shareholder are held in the electronic form by conversion of physical securities to electronic form through a process called 'dematerialization' (demat) of share certificates and facilitates transactions electronically without involving any share certificate or transfer deed. Depository system is playing a significant role in stock markets around the world and hence has become popular and prevalent in many advanced countries. Explain role of depositories.

Depository participants are associates of a depository through whom the investor will hold the beneficiary account of the investors to enable them to trade in dematerialized shares. The SEBI (Depository and Participants) regulations specify the eligibility requirements for a DP. Banks, financial institutions, brokers, custodians, R&T agents, NBFCs among others are eligible to become DPs. Apart from this, the DPs are required to have minimum net worth as specified by the regulations. Roles of Depository participants are as follow: 1) They are responsible for executing the investors directions on delivery and receipt of shares from their beneficiary account to settle the trades done on the secondary markets. 2) The Depository participants are Similar to brokers, who act on behalf of a client in the stock market they are also representatives in the depository system. 3) DP provides various services with regard to your holdings such as: a) b) c) d) Maintaining the securities account balances. Enabling surrender (dematerialization) and withdrawal (rematerialization) of securities to and from the depository. Delivering and receiving shares. Keeping updated with regard to status of holdings periodically.

Q: 3). What do you mean by Primary Market? Explain its objectives. Answer: Financial markets are the mechanism enabling participants to deal in financial claims. The markets also provide a facility in which their demands and requirements interact to set a price for such claims. Financial markets are classified as primary market and secondary market. Primary Market: It is the market where new issues of securities are offered to the investors. It deals in new issues. Primary market is a part of capital market meant for new issues. In other words, the primary market creates long-term instruments for borrowings. It is a market where securities are issued for the first time. For example, when StarTek, Inc. sold 4,370,000 new shares of its common stock in June 2004, it did so in the primary markets. In 2004, U.S. corporations issued bonds worth $5.5 2

trillion, and more than 240 companies came to market for the first time with initial public offerings worth $34 billion. The Primary Market consists of arrangements, which facilitate the procurement of long term funds by companies by making fresh issue of shares and debentures. Companies make fresh issue of shares and debentures at their formation stage and, if necessary, subsequently for the expansion of business. It is usually done through private placement to friends, relatives and financial institutions or by making public issue. In any case, the companies have to follow a well-established legal procedure and involve a number of intermediaries such as underwriters, brokers, etc. who form an integral part of the primary market. The main objectives of primary markets are: 1) To provide mechanism for establishing new productive assets and expanding those existing. 2) To stabilize the demand for and supply of productive assets. 3) To facilitate the procurement of long term funds by companies by making fresh issue of shares and debentures. Q: 4). What is Monetary Policy? Explain its objectives,

tools and targets in detail. Answer: Monetary policy is the process by which the central bank or monetary authority of a country controls the supply of money, availability of money, and the cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy rests on the relationship between the rates of interest in an economy and the total supply of money. It uses a variety of tools to control one or both of these, to influence outcomes like economic growth, lower inflation, exchange rates with other currencies and unemployment. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy. Expansionary policy increases the total supply of money in the economy, and the contractionary policy decreases the total money supply. Expansionary policy is used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money 2

supply, or decreases the interest rate. Furthermore, monetary policies are described as accommodative, if the interest rate set by the central monetary authority is intended to create economic growth, neutral, if it is intended neither to create growth nor combat inflation, or tight if intended to reduce inflation. Within almost all modern nations, special institutions have the task of executing the monetary policy such as the Bank of England, the European Central Bank, Reserve Bank of India, and the Federal Reserve System in the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. Monetary Policy Objectives: The main objectives of the monetary policy are as following; 1) 2) 3) 4) 5) Price Stability. Exchange Stability. Increase in Capital Accumulation. Higher Employment Level. Increase in Rate of Economic Growth

The monetary policy is operated through the instruments of credit control. These instruments are: 1) 2) 3) 4) 5) 6) 7) 8) 9) Bank rate policy. Open market operations. Reserve requirements. Rationing of credit. Margin requirements. Consumers selective credit control. Direct action, moral persuasion and publicity. Increasing interest rates by fiat. Reducing the monetary base.

All have the effect of contracting the money supply; and, if reversed, expand the money supply. During inflation, the measures are taken to decrease the supply of money in circulation and during deflation; the supply of money is increased by adopting the above methods. The monetary policy has the following effects on the economy; 1) It brings the desirable changes in the price level. 2

2) It helps to maintain foreign exchange reserves at a desirable level. 3) It creates more employment opportunities because the central bank can encourage the commercial banks to provide more loans to the sectors where more persons can be employed. 4) It can affect the rate of economic growth. This policy can facilitate more effective use of the resources of the country. Limitations of Monetary Policy Objectives of monetary policy cannot be achieved successfully due to the following limitations: 1) Commercial banks do not cooperate fully with the central bank. 2) Money market is not properly organized. 3) Some of the financial institutions are not under the control of the central bank. Some of Monetary policy tools are as follow: 1) Monetary base: Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base. 2) Reserve requirements: The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier. 3) Discount window lending: Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply. 4) Interest rates: The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. This rate has significant effect on other market interest rates, but there is no perfect relationship. By raising the interest rates under its control, a monetary 2

authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply. 5) Currency board: A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation. Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or gold. The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. 2

A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Monetary policy targets include: 1) Inflation targeting: Monetary policy targets to keep inflation under a particular definition such as Consumer Price Index, within a desired range. This is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. 2) Price level targeting: Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move. 3) Monetary aggregates: This is based on a constant growth in the money supply. It focuses on monetary quantities. This approach was refined to include different classes of money and credit (M0, M1 etc). This approach is also called monetarism. 4) Fixed exchange rate: This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation. 5) Gold standard: The gold standard is a system in which the price of the national currency is measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. The selling of gold is very important for economic growth and stability. This might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index". Q: 5). Explain theories which decide level of interest rate in any economy. Answer:

Interest is the price paid for borrowing money. It is expressed as a percentage rate over a period of time. It is the price the borrowers must pay to lenders to obtain the use of money for a period of time. There are many interest rates, and all are affected by certain underlying economic conditions including supply of and demand for money. When those conditions change, all rates change together. The equilibrium rate of Interest is also determined by the forces of demand and supply in the market. Economists have different theories in the forces assumed to be behind the supply of and demand for money. Here are four of those theories: classical theory, liquidity preference theory, loanable funds theory, and rational expectations theory. 1) The Classical Theory This theory is associated with the names of Ricardo, Hume, Fisher and other classical economists. It is a static theory, and according to it the rate of interest is a real phenomenon in the sense that it is determined by the real factors. It is the supply of savings and the demand for investment that determine the equilibrium rate of The Interest. The classical theory focused on household savings as the primary source of the supply of money and upon business investment as the primary demand. According to this theory, households individuals and families change their level of savings as interest rates change. This is because they view interest earnings as a reward for deferring consumption. Households save more when rates rise and save less as rates fall. 2) Keynesian Theory (Liquidity Preference) The Keynesian theory was introduced by great economist John Maynard Keynes in the twentieth century in response to changes in the economic environment and to omissions of the classical theory. As the banking system grew in importance, it was observed that banks, through their money creation process, were important suppliers of money. In addition, time value of money theory was developed and the relationship between interest rates and security prices became understood. This theory represents another extreme approach to the determination of interest rate. According to Keynes, interest rate is a purely monetary phenomenon. This means that the rate of interest, at least in the short run, is determined by the monetary factors. It depends on the actions of the monetary authorities The central bank and the Government and on the attitude of the economic units towards holding money as an 2

alternative to holding bonds. In other words, interest rate is determined by the interaction between the supply of money and demand for it to hold in the economic system. The rate of interest is the reward offered to people to influence them to hold securities instead of cash. Cash is perfectly liquid and safe in the sense that there is no danger of physical deterioration or capital loss. On the other hand, securities can and do vary in value and, therefore, there is a risk of incurring capital loss when securities are held rather than cash. Interest is the difference between the yield on safe money and the yield on risky securities. It arises or exists as a price or inducement for giving up liquidity of holding money in favour of holding securities. Keynes suggested that the primary reason individuals demanded money was their desire for liquidity, the ability to access their cash quickly and without loss. As interest rates rise, security prices will fall and investors will hold less cash as they invest in the lower-priced securities. At very high interest rates, investors will hold little cash. High interest rates are thus the reward demanded by investors to surrender their liquidity. 3) Loanable Funds Theory Both the classical and liquidity preference theories have major limitations. The classical theory is generally considered a long-run theory. It is not very good at explaining short-run rate movements since it is based on savings habits and investment productivity, factors that are believed to be slow in changing. By contrast, liquidity preference is seen as a short-run theory, unable to explain long-run interest rate trends, because it ignores (implicitly holds as constant) important macroeconomic variables such as income, investment, and price levels. In the 1960s and 1970s, a third theory, the loanable funds theory, was developed to provide a more general and comprehensive explanation of the base level of interest rates. This theory of interest rate determination is a dynamic theory opposed to the static nature of the classical theory. It also combines real and monetary factors as determinants of the rate of interest. Further, it takes a short run view of the process of interest rate determination in place of the secular or long run view taken by the classical theory. Once the dynamic assumptions are made regarding the creation of money and credit, the following two positions of classical interest theory necessarily need to be modified: 2

a) Though interest is paid in money terms on money loans and assets, the level of interest rate has nothing to do with the levels of money and prices. And b) The commercial banks are a mere conduit for the more efficient channeling of saving into the best investment outlets; they cannot affect the level of interest rate. The aggregate supply of loanable funds is the sum of the quantity supplied by the separate fund supplying sectors (e.g. households, business, governments, foreign agents). Similarly, aggregate demand for loanable funds is the sum of the quantity demanded by the separate fund demanding sectors. Whenever the rate of interest is set higher than the equilibrium rate, the financial system has a surplus of loanable funds. As a result, some suppliers of funds will lower the interest rate at which they are willing to lend and the demanders of funds will absorb the loanable funds surplus. In contrast, when the rate of interest is lower than the equilibrium interest rate, there is shortage of loanable funds in the financial system. 4) Rational Expectations Theory In recent years, concepts of market efficiency have been applied to interest rates. The rational expectations theory argues that the market for money displays the same efficiency often ascribed to the market for securities. Investors are rational in that they promptly and accurately assess the meaning of any newly received information which bears upon interest rates. Interest rates therefore reflect all publicly known information, are always at equilibrium levels, and change promptly as new information arrives. Rational expectations theory is the most general of all the explanations of the base level of interest rates. No underlying relationships are specified. No data are identified as particularly important. The theory simply states that if a piece of information is meaningful to financial market participants, they will promptly incorporate it into their analyses and it will just as quickly be reflected in interest rates.

Assignment B Q: 1). What do you mean by Financial System? Explain in detail. Answer: Financial System is a popularly known term consisting of two sub terms, namely; Finance and System. In order to understand better the term Financial System we have to define each of these sub terms. Firstly, the term "finance" in its simplest meaning is equivalent to 'Money'. In other words most people perceive finance and money interchangeable. But finance exactly is not money; it is the source of providing funds for a particular activity. Thus public finance does not mean the money with the Government, but it refers to sources of raising revenue for the activities and functions of a Government. Finance is the study and practice of how money is raised and used by organizations. It is a discipline concerned with determining value and making decisions. The finance function allocates resources, which includes acquiring, investing, and managing resources. Secondly, the word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. Financial system is a group of interrelated and interacting institutions in the economy that help to match one persons saving with another persons investment. The term financial system is a set of inter-related activities/services working together to achieve some predetermined purposes or goals. It includes different markets, institutions, instruments, services and mechanisms which influence the generation of savings, investment, capital formation and economic growth. Van Horne defined the financial system as the purpose of financial markets to allocate savings efficiently in an economy to ultimate users either for investment in real assets or for consumption. Christy has opined that the objective of the financial system is to "supply funds to various sectors and activities of the economy in ways that 2

promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desires." According to Robinson, the primary function of the system is "to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth." From the above definitions, it may be said that the primary function of the financial system is the mobilization of savings, their distribution for industrial investment and stimulating capital formation to accelerate the process of economic growth. A financial system provides services that are essential in a modern economy. The use of a stable, widely accepted medium of exchange reduces the costs of transactions. It facilitates trade and therefore, specialization in production. A financial system plays a vital role in the economic growth of a country. It intermediates with the flow of funds between those who save a part of their income to those who invest in productive assets. It mobilizes and usefully allocates scarce resources of a country. A financial system is a complex well integrated set of sub systems of financial institutions, markets, instruments and services which facilitates the transfer and allocation of funds, efficiently and effectively. The financial system is possibly the most important institutional and functional vehicle for economic transformation. Finance is a bridge between the present and the future and whether it be the mobilization of savings or their efficient, effective and equitable allocation for investment, it is the success with which the financial system performs its functions that sets the pace for the achievement of broader national objectives. The formal financial system consists of these four segments or components: Financial Institutions, Financial markets, financial instruments and financial services. Financial Institutions: Financial Institutions are intermediaries that mobilize savings and facilitate the allocation of funds in an efficient manner.

Financial institutions can be classified as banking and non banking financial institutions. Banking institutions are creators of credit while nonbanking financial institutions are purveyors of credit. Financial Markets: Financial markets are the mechanism enabling participants to deal in financial claims. The markets also provide a facility in which their demands and requirements interact to set a price for such claims. The main organized financial markets are money market and capital market. The first is market for short term securities while the second is a market for long term securities with the maturity period of one year or more. Financial markets are also classified as primary, market and secondary market. The primary market deals in new issues of securities, and the secondary market deals for trading in outstanding or existing securities. Financial Instrument: is a claim against a person or an institution for the payment at a future date a sum of money and/or a periodic payment in the form of interest or dividend. Financial securities may be primary or secondary securities. Primary securities are also termed as direct securities as they are directly issued by the ultimate borrowers of the funds to the ultimate savers. Examples of primary or direct securities include equity shares and debentures. Secondary securities are also referred to as indirect securities, as they are issued by financial intermediaries to the ultimate savers. Bank deposits, mutual fund units, and insurance policies are secondary securities. Financial instruments differ in terms of marketability, liquidity, reversibility, type of options, return, risk and transaction costs. Financial instruments help the financial markets and the financial intermediaries to perform the important role of channelizing funds from lenders to borrowers. Financial Services: Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, credit-rating, and so on. Financial services rendered by the financial intermediaries bridge the gap between lack of knowledge on the part of investors and increasing sophistication of financial instruments and markets. These financial services are vital for creation of firms, industrial expansion, and economic growth. Before investors lend money, they need to be reassured that it is safe to exchange securities for funds. This reassurance is provided by the financial regulator who regulates the conduct of the market, and 2

intermediaries to protect the investors interests. The Reserve Bank of India regulates the money market and Securities and Exchange Board of India (SEBI) regulates capital market. Q: 2). What do you understand by capital market? Discuss

capital market instruments. Answer: Capital market: is a market for long-term debt instruments with the maturity period of more than one year. It is composed of borrowers and lenders and the rate of interest is determined by the demand for and supply of capital forces. The Capital market is a market for securities with maturity greater than one year including intermediate and long term notes, bonds, and stocks. The long term capital takes two forms: Equities or ordinary shares and fixed interest capital like preference share capital or debentures. The purpose of capital market is: To mobilize long term savings to finance long term investments. Provide risk-capital in the form of equity to entrepreneurs. Encourage broader ownership to productive assets. Provide liquidity with a mechanism enabling the investor to sell financial assets. 5) Lower the costs of transactions and information. 6) Improve the efficiency of capital allocation through a competitive pricing mechanism. 1) 2) 3) 4) Capital markets can be classified into primary and secondary markets. The primary market is meant for new issues and the secondary market is a market where outstanding issues are traded. In other words, the primary market creates long-term instruments for borrowings, whereas the secondary market provides liquidity through the marketability of these instruments. The secondary market is also known as the stock market. The capital market consists of the following instruments: 1) 2) 3) 4) 5) Stock Exchange. Investment Trusts. Insurance Companies. Hire Purchase Companies. Building Societies. 2

6) Pension Funds. 7) Commercial Banks.

Q: 3). Answer:

Discuss all the participants in a stock market.

A stock market which is also known as equity market is a public body in which a free network of economic transactions occurs. It is not a physical facility or secret body. It is the place for the trading of stock or shares of company and its derivatives at an agreeable price. These shares and derivatives are securities that are listed on a stock exchange. Participants in the stock markets The participants in a stock market process are: Investors, Intermediaries and Companies. 1) Investors Investors come to the stock exchange to buy and sell securities. SEBIs regulations permit Resident investors, Non-resident Indians, Corporate bodies, Trusts, FIIs who are registered with SEBI, among others, to invest in stock markets in India. Foreign citizens and overseas corporate bodies are prohibited from investing in Indian securities markets. Investors cannot directly trade on the stock market. They have to go through intermediaries called brokers. Brokers are members of the stock exchange. The investors have to open a trading account with the broker. They are required to comply with the Know your Customer (KYC) norms. This seeks to establish the identity and bona-fides of the investor. Investors will also need to open a beneficiary account with a depository participant (DP) to be able to trade in dematerialized securities. This account will hold the shares which the investor will buy and sell. Once the formality of account opening is done, investors can put through their transactions through their brokers terminal. The trades have to be settled, i.e. securities delivered/received and funds paid out/received, according to the settlement schedule (currently T+2) decided by the exchange. Investors have to give instructions to the DP to transfer 2

securities from their account to that of the broker who is also a clearing member. Or give standing instructions to receive securities if they have bought shares. Similarly, they have to ensure that funds are available in their bank account to settle for shares they have bought.

2) Brokers Intermediaries in the secondary market process include brokers and depository participants. Brokers are members of a stock exchange who are alone authorized to put through trades on the stock exchange. Brokers may be individuals or institutions who are registered with SEBI and meet the respective stock exchanges eligibility criteria for becoming a member of the exchange. The stock exchange will specify minimum eligibility requirements such as base capital to be collected from the member brokers which are in line with SEBIs regulations on the same. The exposure that a broker can take in the market will be a multiple of the base capital that is deposited with the exchange. 3) DPs Depository participants are associates of a depository through whom the investor will hold the beneficiary account of the investors to enable them to trade in dematerialized shares. The SEBI (Depository and Participants) regulations specify the eligibility requirements for a DP. Banks, financial institutions, brokers, custodians, R&T agents, NBFCs among others are eligible to become DPs. Apart from this, the DPs are required to have minimum net worth as specified by the regulations. This could range from Rs 10 Crore for R&T agents who are DPs to Rs 50 Crore for NBFCs. The DPs are responsible for executing the investors directions on delivery and receipt of shares from their beneficiary account to settle the trades done on the secondary markets.

CASE STUDY Security Scam in India-1991 In April 1992, press reports indicated that there was a shortfall in the Government Securities held by the State Bank of India. Investigations uncovered the tip of an iceberg, later called the securities scam, involving misappropriation of funds to the tune of over Rs. 3500 Crores8. The scam engulfed top executives of large nationalized banks, foreign banks and financial institutions, brokers, bureaucrats and politicians: The functioning of the money market and the stock market was thrown in disarray. The tainted shares were worthless as they could not be sold. This created a panic among investors and brokers and led to a prolonged closure of the stock exchanges along with a precipitous drop in the price of shares. Soon after the discovery of the scam, the stock prices dropped by over 40%, wiping out market value to the tune of Rs. 100,000 crores. TIle normal settlement process in government securities was that the transacting banks made payments and delivered the securities directly to each other. The broker's only function was to bring the buyer and seller together. During the scam, however, the banks or at least some banks adopted an alternative settlement process similar to settlement of stock market transactions. The deliveries of securities and payments were made through the broker. That is, the seller handed' over the securities to the broker who passed them on to the buyer, while the buyer gave the cheque to the broker who then made the payment to the seller. There were two, important reasons why the broker intermediated settlement began to be used in the government securities markets: The brokers instead of merely bringing buyers and sellers together stfu1:ed taking positions in the market. They in a sense imparted greater liquidity to the markets. When a bank wanted to conceal the fact. That it was doing a Ready Forward deal, the broker came in handy. The broker provided contract notes for this purpose with fictitious counterparties, but arranged for the actual settlement to take place with the correct counterparty. This allowed the broker to lay his hands on the cheque as it went from one bank to another through him. The hurdle now was to find a way of crediting the cheque to his account though it was drawn in favour of a bank and was crossed account payee. It is purely a matter of banking custom that an account payee cheque is paid only to the payee mentioned on the cheque. In fact, privileged (Corporate) customers were routinely allowed to credit account payee cheques in favour of a bank into their own accounts to avoid clearing delays; thereby reducing the interest lost on the amount. The brokers thus found a way of getting hold of the cheques as they went from one bank to another and crediting the amounts to their accounts. This effectively transformed an RF into a loan to a broker rather than to a 2

bank. But this, by itself, would not have led to the scam because the RF after all is a secured. Loan and a secured loan to a broker is still secured. What was necessary now was to find a way of eliminating the security itself. Three routes adopted for this purpose were: Some banks (or rather their officials) were persuaded to part with cheques without actually receiving securities in return. A simple explanation of this is that the officials concerned were bribed and/or negligent. Alternatively, as long as the scam lasted, the banks benefited from such an arrangement. The management of banks might have been sorely tempted to adopt this route to higher profitability. The second route was to replace the actual securities by a worthless piece of paper - a fake Bank Receipt (BR). A BR like an IOU has only the borrower's assurance that the borrower has the securities which can/will be delivered if/when the need arises. The third method was simply to forge the securities themselves. In many cases, PSU bonds were represented only by allotment letters rather than certificates on security paper. However, it accounted for only a very small part of the total funds misappropriated. During the scam, the brokers perfected the art of using fake BRs to obtain unsecured loans from the banking system. They persuaded some small and little known banks - the Bank of Karad (BOK) and the Metropolitan Cooperative Bank (MCB) - to issue BRs as and when required. These BRs could then be used to do RF deals with other banks. The cheques in favour of BOK were, of course, credited into the brokers' accounts. In effect, several large banks made huge unsecured loans to the BOK/MCB which in turn made the money available to the brokers. Questions: Q: 1). Explain flaws in regulation which gives scope to scam-1991 and how that scam helps in improvement of regulations. Answer:

Q: 2).

Explain roles and responsibilities of brokers and how

that was being violated in that scam and what actions should be 2

taken by regulatory bodies to avoid these kinds of frauds. Answer:

Assignment C Q: 1). The organized financial system comprises the following subsystems: I. Banking system II. Cooperative system III. Development Banking system IV. Money markets V. Financial companies/institutions. a) I, II, and III above b) I, II, III and IV above c) I, III, IV and V above d) I, II, III, IV, V (). Q: 2). The formal financial system consists of segments:

a) Financial Institutions, Financial markets, financial instruments and financial services (). b) Financial Institutions, Financial markets and financial instruments. c) Financial markets, financial instruments and financial services. d) Financial markets, financial instruments, financial derivatives and financial services. Q: 3). Financial institutions can be classified as banking and non banking financial institutions. a) True (). b) False Q: 4). The main organized financial markets in a country are normally: a) b) c) d) Q: 5). a) b) c) d) Money market and capital market (). Money market and debt market. Money market and equity market. Money market and derivative market. Examples of primary or direct securities include _________. Mutual fund and Insurance policies Insurance policies and Bank deposits Bank deposits and Insurance policies Equity shares and debentures (). 2

Q: 6). The Reserve Bank of India regulates the _______ and Securities and Exchange Board of India (SEBI) regulates _________. a) b) c) d) Money market, capital market (). Capital market, Money market Money market and debt market. Money market and derivative market.

Q: 7). Secondary securities are also referred to as indirect securities, as they are issued by financial intermediaries to the ultimate savers. _______________ are secondary securities. a) b) c) d) Mutual fund, equity shares and Insurance policies Insurance policies, Bank deposits and Mutual fund (). Bank deposits, equity shares and Insurance policies Bank deposits, Mutual fund and debentures.

Q: 8). Interest rates are typically determined by the supply of and demand for ___________in the economy. a) b) c) d) Commodities Money () Manpower Technology

Q: 9). If the economic growth of an economy picks up momentum, then the demand for money tends to________, putting upward pressure on interest rates. a) b) c) d) Go down Stabilize Go up () None of the above

Q: 10). Inflation is a ______ in the general price level of goods and services in an economy over a period of time. a) b) c) d) Rise () Fall Stabilization None of the above

Q: 11). Which of the following are examples of a primary market transaction? 2

a) A company issues new common stock (). b) An investor asks his broker to purchase 1,000 shares of Microsoft common stock. c) An investor sells his shares. d) All of the statements above are correct. Q: 12). a) b) c) d) Q: 13). When the price of a bond is above face value: The yield to maturity is below the coupon rate (). The yield to maturity will be above the coupon rate. The yield to maturity will equal the current yield. The yield to maturity will equal the coupon rate. Which of the following statements is most true? a) Yield to maturity is equal to the coupon rate if the bond is held to maturity. b) Yield to maturity is the same as the coupon rate. c) Yield to maturity is the same as the coupon rate if the bond is purchased for face value. d) Yield to maturity is the same as the coupon rate if the bond is purchased for face value and held to maturity (). Q: 14). ___________, __________ or _________ means the sum mentioned in the capital clause of Memorandum of Association. a) b) c) d) Nominal, issued or registered capital Nominal, authorized or paid up capital Nominal, paid up or registered capital Nominal, authorized or registered capital ().

Q: 15). _____________ means that part of the issued capital at nominal or face value which has been subscribed or taken up by purchaser of shares in the company and which has been allotted. a) b) c) d) Q: 16). I. II. III. IV. Paid up capital Issued capital Subscribed Capital Called Up Capital (). Three theories about the determination of rate of Interest are: The classical theory The loanable funds theory The Keynesian theory The Vogels theory 2

a) b) c) d) Q: 17).

I, II, and III () II, III and IV I, III and IV I, II, III, IV Financial markets and institutions

a) Involve the movement of huge quantities of money. b) Affect the profits of businesses. c) Affect the types of goods and services produced in an economy. d) Do all of the above (). Q: 18). The _____________ is the monetary authority of India, and also acts as the regulator and supervisor of commercial banks. a) b) c) d) SEBI (Securities and exchange board of India) RBI (Reserve Bank of India) () SBI (State bank of India) CBI (Central Bank of India)

Q: 19). Based on how interest is computed, interest rates are classified into _____________ and ____________. a) b) c) d) Fixed, floating Short term , Long term Simple, compound (). Long term, short term, medium term

Q: 20). Three theories about the determination of rate of Interest are:a) The classical theory, the loanable funds theory, The Keynesian theory (). b) The modern theory, the loanable funds theory, The Keynesian theory. c) The classical theory, the modern theory, The Keynesian theory. d) The classical theory, the loanable funds theory, the modern theory. Q: 21). Three theories about the term structure of Interest rates are:a) The Expectations Theory, Default Premium Theory, Market Segmentation Theory 2

b) Default Premium Theory, Liquidity Premium Theory, Market Segmentation Theory c) The Expectations Theory, Liquidity Premium Theory, Default Premium Theory d) The Expectations Theory, Liquidity Premium Theory, Market Segmentation Theory () Q: 22). The RBI performs a wide range of functions; particularly, it:-

I. Acts as the currency authority II. Controls money supply and credit III. Manages foreign exchange IV. Serves as a banker to the government V. Builds up and strengthens the country's financial infrastructure a) I, II, III, IV b) II, III, IV, V c) I to V () d) I, II, III, V Q: 23). By increasing ____________ , the RBI can reduce the funds available with the banks for lending and thereby tighten liquidity in the system. a) b) c) d) Statutory Liquidity Ratio Current Ratio Cash Reserve Ratio () Bank ratio

Q: 24). ________________ banks cater to the financing needs of agriculture, retail trade, small industry and self-employed businessmen in urban, semi-urban and rural areas. a) b) c) d) Co-operative () Scheduled commercial Foreign Private

Q: 25). Monetary policy is referred to as either being a _________ policy or a ____________ policy. a) b) c) d) Liberal, strict Expansionary, contractionary () Inflationary, deflationary Classical. Modern

Q: 26). Monetary policy is the process by which the central bank or monetary authority of a country controls the ________________. a) b) c) d) Supply of money () Demand of money Inflation Deflation

Q: 27). A monetary policy is referred to as __________ if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. a) b) c) d) Expansionary Contractionary () Inflationary Deflationary

Q: 28). The ____________ is a system in which the price of the national currency is measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. a) b) c) d) Stock trading Gold standard () Discount window lending Monetarism

Q: 29). Price level targeting is similar to ___________ except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move. a) b) c) d) Inflation targeting () Stock trading Discount window lending Monetarism

Q: 30). Money market is a very important segment of the financial system of a country. It is the market dealing in monetary assets of short term nature. a) b) c) d) Long term nature Medium term nature Short term nature () All the above 2

Q: 31). Yield to maturity (YTM) is a popular and extensively used method for computing the return on a _______ investment. a) b) c) d) Share Share & bond Futures & options Bond ()

Q: 32). Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior to the original maturity date, are called ________ bonds. a) b) c) d) Callable () Puttable Amortising Step up

Q: 33). An ________________ represents ownership in the shares of a foreign company trading on US financial markets. a) b) c) d) Global Depositary Receipt (or GDR) Treasury Bills Government Security( G-sec) American Depositary Receipt (or ADR) ()

Q: 34). External Commercial Borrowings (ECB) include: I. Commercial Bank Loans II. Buyers Credit III. Suppliers Credit IV. Securitized Instruments Such As Floating Rate Notes, Fixed Rate Bonds Etc. V. Credit From Official Export Credit Agencies a) I, II, III, IV b) II, III, IV, V c) I to V () d) I, II, III, V Q: 35). The credit risk of a borrower is evaluated by ____________. a) b) c) d) SEBI (Securities and exchange board of India) Stock Exchange RBI( Reserve Bank of India) Credit rating agencies ()

Q: 36). _________ risk denotes the risk of the value of an investment denominated in some other country's currency, coming down in terms of the domestic currency. a) b) c) d) Currency () Country Hedging Speculation

Q: 37). A _________is an entity which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. a) b) c) d) Stock exchange () Depository Company Credit rating agency variables impact the movement in

Q: 38). Various economic exchange rates such as:

I. Interest rates II. Inflation figures III. Balance of payment figures IV. GDP( Gross domestic product) a) I, II, III b) I, II, III, IV () c) II, III, IV d) I, III, IV Q: 39). Benefits of trading through a stock exchange: I. Best price II. lack of any counter-party risk III. Access to investor grievance and redressal mechanism a) I, II b) I, III c) II, III d) I, II, III () Q: 40). In a ____________ exchange, the three functions of ownership, management and trading are concentrated into a single Group. a) b) c) d) Mutual () Demutualised Neither a nor b Both a & b 2