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The Financial System. Dr. Ram Chandra Rai Sr. professor(Financial Management) Railway Sraff College Vadodara . Constituents of a Financial System. Surplus Units Deficit Units Financial Markets Financial Intermediaries. Financial System. Surplus Units: Households, corporates

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the financial system

The Financial System

Dr. Ram Chandra Rai

Sr. professor(Financial Management)

Railway Sraff College


constituents of a financial system
Constituents of a Financial System
  • Surplus Units
  • Deficit Units
  • Financial Markets
  • Financial Intermediaries
financial system

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

financial markets
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
other markets
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
money market and capital market
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?
Money Market

Government, banks and financially sound companies

Capital Market

Government, companies, financial intermediaries and investors in general

financial instruments
Money Market (maturity

< 1 year)

Call and Notice Money

Treasury Bill


Commercial Paper

Certificate of Deposit

Inter-bank Term Money

Inter-bank Participation Certificate

Bill of Exchange


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
other long term sources
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

features of some capital market instruments
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
equity shares
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
preference shares
Stated dividend

Ordinarily, no voting right

Dividend may be missed

Subordinate to debentures

Preference shares
types of debentures bonds
Types of debentures / bonds
  • Floating-rate (Indexed)
  • Deep discount including zero-coupon
  • Convertible
  • Income
what accounts for yield differentials among bond issues
What accounts for yield differentials among bond issues?
  • Default Risk (Indicator: Credit Rating)
  • Maturity
  • Call proviso
  • Convertibility
  • Marketability
  • Tax features
what are structured debt obligations
What are Structured Debt Obligations?
  • Debt securities that bear special features which enhance the investment quality of the instruments.
financial intermediaries
Financial Intermediaries
  • Banks
  • Term-lending institutions
  • Mutual Funds
  • Pension and Provident Funds
  • Insurance Companies
  • Specialized institutions
investment policies of financial intermediaries
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
complexities for firms that operate internationally
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
some aspects of international capital markets
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
features of the eurocurrency markets
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
some international capital market instruments
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)