Financial Market refers to the system consisting of financial institutions, financial instruments, regulatory bodies, and organisations. It facilitates the flow of debt and equity capital. Banks, Development Financial Institutions (NABARD, SIDBI, IDBI, etc.), and Non- Banking Financial Institutions form Financial Institutions.
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Financial Instruments are shares, bonds, debentures, etc.
Main functions of the financial market
The main functions of the financial market.
(a) It provides facilities for interaction between the investors and the borrowers.
(b) It provides pricing information resulting from the interaction between buyers and sellers in the market when they trade the financial assets.
(c) It provides security to dealings in financial assets.
(d) It ensures liquidity by providing a mechanism for an investor to sell the financial assets.
(e) It ensures a low cost of transactions and information.
Financial markets consist of two major segments:
- Money Market: The market for short term funds
- Capital Market: The market for long and medium-term funds.
There are two types of Capital Flow –
This is an important topic for UPSC 2021 exam.
Financial Market (UPSC Notes):- Download PDF Here
According to the RBI, “The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders.
It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government.”
Functions of Money Market
- To maintain the balance between the demand and supply for money when it comes to short-term money-related transactions(monetary equilibrium)
- To promote economic growth. The money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc.
- To provide help to Trade and Industry. The money market provides adequate finance to trade and industry. Similarly, it also provides the facility of discounting bills of exchange for trade and industry.
- To help in implementing Monetary Policy. It provides a mechanism for the effective implementation of the monetary policy.
- To help in Capital Formation. The money market makes available investment avenues for the short term period. It helps in generating savings and investments in the economy.
Features of Money Market
The money market provides non-inflationary sources of finance to the government. It is possible by issuing treasury bills to raise short loans. However, this does not lead to increases in prices.
Money Market consists of all the organizations and institutions which deal or facilitate dealings in short term debt instruments. These institutions include RBI, commercial banks, cooperative banks, non-banking financial companies like LIC, GIG, UTI, and special institutions like Discount and Finance House of India (DFHI). The important money market instruments or securities (financial assets) are as follows.
The capital market is the market for medium and long term funds. It consists of all the financial institutions, organizations, and instruments which deal with lending and borrowing transactions of over one-year maturity.
Types of Capital Market
|It issues security for the first time.
Example- Initial public offer and
follow on public offer.
|Existing securities are bought and sold.|
|Firms issue shares to the public.||One investor sells it to another investor.|
|Price is fixed by the firms.||Price is fixed based on demand and supply.|
|Firms raise money for long-term investments.||Companies benefit from the secondary markets.|
|There is no specific geographical location.||There is no specific geographical location.|
|Security & Exchange Board of India (SEBI) is the regulator for this market.||SEBI is the regulator of this market as well.|
Difference between Money Market & Capital Market
|Money Market||Capital Market|
|Deals with short-term financial transactions. (up to 1 year)
Net lenders are people.
Firms borrow to invest money to buy raw materials. This is a short-term transaction. This is called working capital finance.
|Deals with medium and long-term financial transactions. Medium 1-5 yrs.
Long Term Over 5 years
|Working capital finance.||Promotes capital formation.|
|Works only with bonds. Example: Commercial papers, commercial bills, treasury bills, etc.||Deals with both bonds and equity. Example: Debentures, shares, etc.|
|Deals with high volume transactions.||Deals with all value transactions.|
|Only banks are there.||All Financial Institutions are there.|
|The general public does not participate much in the Money market.||The general public also participates significantly|
|The Prime regulator is RBI.||The Prime regulator is SEBI, IRDA, PFRDA (Pension Fund Regulatory Authority)|
Major Terminologies – Financial Market
Treasury Bills: They are promissory notes issued by the RBI on behalf of the government as a short term liability and sold to banks and the public. The maturity period ranges from 14 to 364 days. They are the negotiable instruments, i.e. they are freely transferable. No interest is paid on such bills but they are issued at a discount on their face value. You can read in detail about Treasury Bill – Definition, Types & Its Use on the page link provided here.
Commercial Bills: They are also called Trade Bills or Bills of Exchange. Commercial bills are drawn by one business firm to another in lieu of credit transactions. It is a written acknowledgment of the debt by the maker directing to pay a specified sum of money to a particular person. They are short-term instruments generally issued for 90 days. These are freely marketable. Banks provide working capital finance to firms by purchasing the commercial bills at a discount; this is called ‘discounting of bills’.
Commercial Paper (CP): The CP was introduced in 1990 on the recommendation of the Vaghul Committee. A commercial paper is an unsecured promissory note issued by a corporate with a net worth of at least Rs 5 crore to the banks for short term loans. These are issued at discount on face value for a period of 14 days to 12 months. These are issued in multiples of Rs 1 lakh subject to a minimum of Rs 25 lakh. Further information on Commercial Paper (CP) can be checked on the linked page.
Certificate of Deposit (CD): The CD was introduced in 1989 on the recommendation of the Vaghul Committee. These are issued by banks against deposits kept by individuals and institutions for a period of 15 days to 3 years. These are similar to Fixed Deposits but are negotiable and tradable. These are issued in multiples of Rs. 1 lakh subject to a minimum of Rs 25 lakh.
Discount and Finance House of India Ltd.: DFHI was set up as a subsidiary of RBI in 1988 on the recommendation of the Vaghul Committee. Its objective is to stimulate activity in the money market by providing liquidity to the money market instrument. It buys bills and short term securities from banks and financial institutions thereby developing a secondary market in them. DFHI was set up as a subsidiary of RBI in 1988 on the recommendation of the Vaghul Committee. It buys bills and short term securities from banks and financial institutions thereby developing a secondary market in them.
Read about the Difference between Primary market and Secondary Market on the linked page.
The Gilt-edged market refers to the market for government and semi-government securities, backed by the RBI. The term gilt-edged means ‘of the best quality’. It is known so because the government securities do not suffer from the risk of default and are highly liquid. The RBI is the sole supplier of such securities. These are demanded by commercial banks, insurance companies, provident funds, and mutual funds.
The gilt-edged market may be divided into two parts- the Treasury bill market and the government bond market. Treasury bills are issued to meet short-term needs for funds of the government, while government bonds are issued to finance long-term developmental expenditure.
UPSC aspirants should know the types of markets while preparing for GS-III of the UPSC Exam.
Financial Market (UPSC Notes):- Download PDF Here
Multiple Choice Question
Consider the following Statements
- The capital Market is the market for short term funds.
- One of the functions of the Money market is to maintain the balance between the demand and supply for money when it comes to short-term money-related transactions (monetary equilibrium).
- The Money market is the market for medium and long term funds.
- The Prime regulators of the Money market are the Securities Exchange Board of India (SEBI), Insurance Regulatory Development Authority (IRDA), Pension Fund Regulatory Development Authority (PFRDA)
Which of the following options is correct?
A) All the above-given statements are true.
B) Only Statements 1,2 and 3 are true.
C) Only Statements 1,2 and 4 are true.
D) None of the above-given statements are true.
Candidates can find the general pattern of the UPSC Civil Service Exam by visiting the IAS Syllabus page.