2Amity CampusUttar PradeshIndia 201303ASSIGNMENTSPROGRAM: BFIASEMESTER-II

Subject Name: FINANCIAL MARKETS & REGULATIONSStudy COUNTRY: SOMALIARoll Number (Reg. No.): BFIA01512010-2013019Student Name: MOHAMED ABDULLAHI KHALAFINSTRUCTIONS

a) Students are required to submit all three assignment sets.ASSIGNMENT DETAILS MARKSAssignment A Five Subjective Questions 10Assignment B Three Subjective Questions + Case Study 10Assignment C Objective or one line Questions 10

b) Total weight-age given to these assignments is 30%. OR 30Marksc) All assignments are to be completed as typed in word/pdf.d) All questions are required to be attempted.e) All the three assignments are to be completed by due dates andneed to be submitted for evaluation by Amity University.f) The students have to attach a scanned signature in the form.

Signature : _________________________Date: 08. Jan. 2012( ) Tick mark in front of the assignments submitted

Assignment A Assignment B Assignment C

3FINANCIAL MARKETS & REGULATIONSAssignment A

Q: 1). What do you mean by Money Market and Money Marketinstruments?

Answer:Money market: is a market for short-term, high liquid debt securities withmaturities of less than one year. It is a highly liquid market whereinsecurities are bought and sold in large denominations to reducetransaction costs. Call money market, certificates of deposit, commercialpaper, and treasury bills are the major instruments of the money market.Money market is a very important segment of the financial system of acountry. It is the market dealing in monetary assets of short term nature.Short term funds up to one year and financial assets that are closesubstitutes for money are dealt in the money market.The money market functions include:

a) Money markets serve as an equilibrating force that redistributescash balances in accordance with the liquidity needs of theparticipants.

b) Money markets form a basis for the management of liquidity andmoney in the economy by monetary authorities.

c) Money markets provide a reasonable access to the users of short-term money for meeting their requirements at realistic prices.

d) As it facilitates the conduct of monetary policy, money marketsconstitute a very important segment of the financial system.

Money market Instruments are short-term, low risk, high liquid financialinstruments such as treasury bills, call money, notice money, certificatesof deposit, commercial paper etc.1) Call Money: is money borrowed or lent on demand for a very shortperiod. It is borrowed or lent for a day, and sometimes called asOvernight Money. Intervening holidays or weekends are excluded for thispurpose. Thus money, borrowed on a day and repaid on the next workingday is Call Money.2) Notice Money: is money borrowed or lent for up to 14 days. Nocollateral security is required to cover these transactions.

43) Inter-Bank Term Money: are deposits of maturity beyond 14 days.The entry restrictions are the same as those for Call and Notice Moneyexcept that, as per existing regulations, the specified entities are notallowed to lend beyond 14 days.4) Treasury Bills: is a document by which the Government borrowsmoney in the short term (up to one year). It is borrowing instruments ofthe union Government. The Government promises to pay a stated sumafter expiry of the stated period from the date of issue (14/91/182/364days i.e. less than one year). They are issued at a discount to the facevalue, and on maturity the face value is paid to the holder. The rate ofdiscount and the corresponding issue price are determined at eachauction.5) Certificate of Deposits (CDs): is a negotiable money marketinstrument and issued in dematerialized form or as a usance PromissoryNote, for funds deposited at a bank or other eligible financial institutionfor a specified time period. CDs are similar to traditional term depositsbut are negotiable and can be traded in the secondary market.6) Commercial Paper (CP): is a note in evidence of the debt obligationof the issuer. On issuing commercial paper the debt obligation istransformed into an instrument. CP is thus an unsecured promissorynote privately placed with investors at a discount rate to face valuedetermined by market forces. CP is freely negotiable by endorsement anddelivery.

Q: 2). Explain role of depositories.

Answer:Depositories are organizations which hold securities of investors inelectronic form at the request of the investors through a registeredDepository Participant. It also provides services related to transactions insecurities.In the Depository System, the securities of a shareholder are held in theelectronic form by conversion of physical securities to electronic formthrough a process called 'dematerialization' (demat) of share certificatesand facilitates transactions electronically without involving any sharecertificate or transfer deed.Depository system is playing a significant role in stock markets around theworld and hence has become popular and prevalent in many advancedcountries.

5Depository participants are associates of a depository through whom theinvestor will hold the beneficiary account of the investors to enable them totrade in dematerialized shares.The SEBI (Depository and Participants) regulations specify the eligibilityrequirements for a DP. Banks, financial institutions, brokers, custodians,R&T agents, NBFCs among others are eligible to become DPs. Apart fromthis, the DPs are required to have minimum net worth as specified by theregulations.Roles of Depository participants are as follow:

1) They are responsible for executing the investors directions ondelivery and receipt of shares from their beneficiary account to settlethe trades done on the secondary markets.

2) The Depository participants are Similar to brokers, who act onbehalf of a client in the stock market they are also representatives inthe depository system.

3) DP provides various services with regard to your holdings such as:a) Maintaining the securities account balances.b) Enabling surrender (dematerialization) and withdrawal

(rematerialization) of securities to and from the depository.c) Delivering and receiving shares.d) Keeping updated with regard to status of holdings periodically.

Q: 3). What do you mean by Primary Market? Explain itsobjectives.

Answer:Financial markets are the mechanism enabling participants to deal infinancial claims. The markets also provide a facility in which theirdemands 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 areoffered to the investors. It deals in new issues. Primary market is a part ofcapital market meant for new issues. In other words, the primary marketcreates long-term instruments for borrowings. It is a market wheresecurities 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 inthe primary markets. In 2004, U.S. corporations issued bonds worth $5.5trillion, and more than 240 companies came to market for the first timewith initial public offerings worth $34 billion.

6The Primary Market consists of arrangements, which facilitate theprocurement of long term funds by companies by making fresh issue ofshares and debentures. Companies make fresh issue of shares anddebentures at their formation stage and, if necessary, subsequently for theexpansion of business. It is usually done through private placement tofriends, relatives and financial institutions or by making public issue. Inany case, the companies have to follow a well-established legal procedureand 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 andexpanding 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, toolsand targets in detail.

Answer:Monetary policy is the process by which the central bank or monetaryauthority 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 objectivesoriented towards the growth and stability of the economy.Monetary policy rests on the relationship between the rates of interest inan economy and the total supply of money. It uses a variety of tools tocontrol 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 acontractionary policy. Expansionary policy increases the total supply ofmoney in the economy, and the contractionary policy decreases the totalmoney supply. Expansionary policy is used to combat unemployment in arecession by lowering interest rates, while contractionary policy involvesraising interest rates to combat inflation. A policy is referred to ascontractionary if it reduces the size of the money supply or raises theinterest rate. An expansionary policy increases the size of the moneysupply, or decreases the interest rate. Furthermore, monetary policies aredescribed as accommodative, if the interest rate set by the centralmonetary authority is intended to create economic growth, neutral, if it is

7intended neither to create growth nor combat inflation, or tight if intendedto reduce inflation.Within almost all modern nations, special institutions have the task ofexecuting the monetary policy such as the Bank of England, theEuropean Central Bank, Reserve Bank of India, and the Federal ReserveSystem in the United States, the Bank of Japan, the Bank of Canada orthe Reserve Bank of Australia. In general, these institutions are calledcentral banks and often have other responsibilities such as supervising thesmooth operation of the financial system.Monetary Policy Objectives:The main objectives of the monetary policy are as following;

1) Price Stability.2) Exchange Stability.3) Increase in Capital Accumulation.4) Higher Employment Level.5) Increase in Rate of Economic Growth

The monetary policy is operated through the instruments of credit control.These instruments are:

1) Bank rate policy.2) Open market operations.3) Reserve requirements.4) Rationing of credit.5) Margin requirements.6) Consumers selective credit control.7) Direct action, moral persuasion and publicity.8) Increasing interest rates by fiat.9) 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 todecrease the supply of money in circulation and during deflation; thesupply 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) 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 thesectors where more persons can be employed.

84) It can affect the rate of economic growth. This policy can facilitatemore effective use of the resources of the country.

Limitations of Monetary PolicyObjectives of monetary policy cannot be achieved successfully due to thefollowing 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 changingthe size of the monetary base. This directly changes the total amount ofmoney circulating in the economy. A central bank can use open marketoperations to change the monetary base. The central bank would buy/sellbonds in exchange for hard currency. When the central bankdisburses/collects this hard currency payment, it alters the amount ofcurrency in the economy, thus altering the monetary base.2) Reserve requirements: The monetary authority exerts regulatorycontrol over banks. Monetary policy can be implemented by changing theproportion of total assets that banks must hold in reserve with thecentral bank. Banks only maintain a small portion of their assets as cashavailable for immediate withdrawal; the rest is invested in illiquid assetslike mortgages and loans. By changing the proportion of total assets to beheld as liquid cash, the Federal Reserve changes the availability ofloanable funds. This acts as a change in the money supply. Centralbanks typically do not change the reserve requirements often because itcreates very volatile changes in the money supply due to the lendingmultiplier.3) Discount window lending: Many central banks or financeministries have the authority to lend funds to financial institutions withintheir country. By calling in existing loans or extending new loans, themonetary authority can directly change the size of the money supply.4) Interest rates: The contraction of the monetary supply can beachieved indirectly by increasing the nominal interest rates. This rate hassignificant effect on other market interest rates, but there is no perfectrelationship. By raising the interest rates under its control, a monetaryauthority can contract the money supply, because higher interest ratesencourage savings and discourage borrowing. Both of these effects reducethe size of the money supply.5) Currency board: A currency board is a monetary arrangement thatpegs the monetary base of one country to another, the anchor nation. As

9such, it essentially operates as a hard fixed exchange rate, whereby localcurrency in circulation is backed by foreign currency from the anchornation at a fixed rate. Thus, to grow the local monetary base anequivalent amount of foreign currency must be held in reserves with thecurrency board. This limits the possibility for the local monetaryauthority to inflate or pursue other objectives.

The primary tool of monetary policy is open market operations. This entailsmanaging the quantity of money in circulation through the buying andselling of various credit instruments, foreign currencies or commodities. Allof these purchases or sales result in more or less base currency enteringor leaving market circulation.Usually, the short term goal of open market operations is to achieve aspecific short term interest rate target. In other instances, monetary policymight instead entail the targeting of a specific exchange rate relative tosome foreign currency or gold.The other primary means of conducting monetary policy include: (i)Discount window lending (lender of last resort); (ii) Fractional depositlending (changes in the reserve requirement); (iii) Moral suasion (cajolingcertain market players to achieve specified outcomes); (iv) "Open mouthoperations" (talking monetary policy with the market).The central bank influences interest rates by expanding or contracting themonetary base, which consists of currency in circulation and banks'reserves on deposit at the central bank. The primary way that the centralbank can affect the monetary base is by open market operations or salesand purchases of second hand government debt, or by changing thereserve requirements. If the central bank wishes to lower interest rates, itpurchases government debt, thereby increasing the amount of cash incirculation or crediting banks' reserve accounts. Alternatively, it can lowerthe interest rate on discounts or overdrafts (loans to banks secured bysuitable collateral, specified by the central bank). If the interest rate onsuch transactions is sufficiently low, commercial banks can borrow fromthe central bank to meet reserve requirements and use the additionalliquidity to expand their balance sheets, increasing the credit available tothe economy. Lowering reserve requirements has a similar effect, freeingup funds for banks to increase loans or buy other profitable assets.A central bank can only operate a truly independent monetary policy whenthe exchange rate is floating. If the exchange rate is pegged or managed inany way, the central bank will have to purchase or sell foreign exchange.These transactions in foreign exchange will have an effect on the monetarybase analogous to open market purchases and sales of government debt; ifthe central bank buys foreign exchange, the monetary base expands, and

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vice versa. But even in the case of a pure floating exchange rate, centralbanks and monetary authorities can at best "lean against the wind" in aworld where capital is mobile.Monetary policy targets include:1) Inflation targeting: Monetary policy targets to keep inflation undera particular definition such as Consumer Price Index, within a desiredrange. This is achieved through periodic adjustments to the CentralBank interest rate target. The interest rate used is generally theinterbank rate at which banks lend to each other overnight for cash flowpurposes.2) Price level targeting: Price level targeting is similar to inflationtargeting except that CPI growth in one year is offset in subsequentyears such that over time the price level on aggregate does not move.3) Monetary aggregates: This is based on a constant growth in themoney supply. It focuses on monetary quantities. This approach wasrefined 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 fixedexchange rate with a foreign currency. There are varying degrees of fixedexchange rates, which can be ranked in relation to how rigid the fixedexchange rate is with the anchor nation.5) Gold standard: The gold standard is a system in which the price ofthe national currency is measured in units of gold bars and is keptconstant by the daily buying and selling of base currency to othercountries and nationals. The selling of gold is very important foreconomic growth and stability. This might be regarded as a special caseof the "Fixed Exchange Rate" policy. And the gold price might beregarded as a special type of "Commodity Price Index".

Q: 5). Explain theories which decide level of interest rate inany economy.

Answer:Interest is the price paid for borrowing money. It is expressed as apercentage rate over a period of time. It is the price the borrowers mustpay to lenders to obtain the use of money for a period of time.There are many interest rates, and all are affected by certain underlyingeconomic conditions including supply of and demand for money. Whenthose conditions change, all rates change together. The equilibrium rate ofInterest is also determined by the forces of demand and supply in themarket.

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Economists have different theories in the forces assumed to be behind thesupply of and demand for money. Here are four of those theories: classicaltheory, liquidity preference theory, loanable funds theory, and rationalexpectations theory.

1) The Classical TheoryThis theory is associated with the names of Ricardo, Hume, Fisher andother classical economists. It is a static theory, and according to it the rateof interest is a real phenomenon in the sense that it is determined by thereal factors. It is the supply of savings and the demand for investment thatdetermine the equilibrium rate of The Interest. The classical theory focusedon household savings as the primary source of the supply of money andupon business investment as the primary demand. According to thistheory, households individuals and families change their level ofsavings as interest rates change. This is because they view interestearnings as a reward for deferring consumption. Households save morewhen rates rise and save less as rates fall.

2) Keynesian Theory (Liquidity Preference)The Keynesian theory was introduced by great economist John MaynardKeynes in the twentieth century in response to changes in the economicenvironment and to omissions of the classical theory. As the bankingsystem grew in importance, it was observed that banks, through theirmoney creation process, were important suppliers of money. In addition,time value of money theory was developed and the relationship betweeninterest rates and security prices became understood.This theory represents another extreme approach to the determination ofinterest rate. According to Keynes, interest rate is a purely monetaryphenomenon. This means that the rate of interest, at least in the shortrun, is determined by the monetary factors. It depends on the actions ofthe monetary authorities The central bank and the Government and onthe attitude of the economic units towards holding money as an alternativeto holding bonds. In other words, interest rate is determined by theinteraction between the supply of money and demand for it to hold in theeconomic system.The rate of interest is the reward offered to people to influence them tohold securities instead of cash. Cash is perfectly liquid and safe in thesense that there is no danger of physical deterioration or capital loss. Onthe other hand, securities can and do vary in value and, therefore, there isa 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

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risky securities. It arises or exists as a price or inducement for giving upliquidity of holding money in favour of holding securities.Keynes suggested that the primary reason individuals demanded moneywas their desire for liquidity, the ability to access their cash quickly andwithout loss.As interest rates rise, security prices will fall and investors will hold lesscash as they invest in the lower-priced securities. At very high interestrates, investors will hold little cash. High interest rates are thus thereward demanded by investors to surrender their liquidity.

3) Loanable Funds TheoryBoth the classical and liquidity preference theories have major limitations.The classical theory is generally considered a long-run theory. It is not verygood at explaining short-run rate movements since it is based on savingshabits and investment productivity, factors that are believed to be slow inchanging. 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 asincome, investment, and price levels. In the 1960s and 1970s, a thirdtheory, the loanable funds theory, was developed to provide a more generaland comprehensive explanation of the base level of interest rates.This theory of interest rate determination is a dynamic theory opposed tothe static nature of the classical theory. It also combines real andmonetary factors as determinants of the rate of interest. Further, it takes ashort run view of the process of interest rate determination in place of thesecular or long run view taken by the classical theory.Once the dynamic assumptions are made regarding the creation of moneyand credit, the following two positions of classical interest theorynecessarily need to be modified:

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 moneyand prices. And

b) The commercial banks are a mere conduit for the more efficientchanneling of saving into the best investment outlets; they cannotaffect the level of interest rate.

The aggregate supply of loanable funds is the sum of the quantity suppliedby the separate fund supplying sectors (e.g. households, business,governments, foreign agents). Similarly, aggregate demand for loanable

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funds is the sum of the quantity demanded by the separate funddemanding sectors.

Whenever the rate of interest is set higher than the equilibrium rate, thefinancial system has a surplus of loanable funds. As a result, somesuppliers of funds will lower the interest rate at which they are willing tolend and the demanders of funds will absorb the loanable funds surplus.In contrast, when the rate of interest is lower than the equilibrium interestrate, there is shortage of loanable funds in the financial system.

4) Rational Expectations TheoryIn recent years, concepts of market efficiency have been applied to interestrates.The rational expectations theory argues that the market for moneydisplays the same efficiency often ascribed to the market for securities.Investors are rational in that they promptly and accurately assess themeaning of any newly received information which bears upon interestrates. Interest rates therefore reflect all publicly known information, arealways at equilibrium levels, and change promptly as new informationarrives.Rational expectations theory is the most general of all the explanations ofthe base level of interest rates. No underlying relationships are specified.No data are identified as particularly important. The theory simply statesthat if a piece of information is meaningful to financial marketparticipants, they will promptly incorporate it into their analyses and it willjust as quickly be reflected in interest rates.

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Assignment BQ: 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 todefine 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 aparticular activity. Thus public finance does not mean the money with theGovernment, but it refers to sources of raising revenue for the activitiesand functions of a Government.Finance is the study and practice of how money is raised and used byorganizations. It is a discipline concerned with determining value andmaking decisions. The finance function allocates resources, which includesacquiring, investing, and managing resources.Secondly, the word "system", in the term "financial system", implies a setof 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 inthe economy that help to match one persons saving with another personsinvestment.The term financial system is a set of inter-related activities/servicesworking together to achieve some predetermined purposes or goals. Itincludes different markets, institutions, instruments, services andmechanisms which influence the generation of savings, investment, capitalformation and economic growth.Van Horne defined the financial system as the purpose of financialmarkets to allocate savings efficiently in an economy to ultimate userseither for investment in real assets or for consumption.Christy has opined that the objective of the financial system is to "supplyfunds to various sectors and activities of the economy in ways that promotethe fullest possible utilization of resources without the destabilizing

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consequence of price level changes or unnecessary interference withindividual desires."According to Robinson, the primary function of the system is "to provide alink between savings and investment for the creation of new wealth and topermit portfolio adjustment in the composition of the existing wealth."From the above definitions, it may be said that the primary function of thefinancial system is the mobilization of savings, their distribution forindustrial investment and stimulating capital formation to accelerate theprocess of economic growth.A financial system provides services that are essential in a moderneconomy.The use of a stable, widely accepted medium of exchange reduces the costsof transactions. It facilitates trade and therefore, specialization inproduction.A financial system plays a vital role in the economic growth of a country. Itintermediates with the flow of funds between those who save a part of theirincome to those who invest in productive assets. It mobilizes and usefullyallocates scarce resources of a country. A financial system is a complexwell integrated set of sub systems of financial institutions, markets,instruments and services which facilitates the transfer and allocation offunds, efficiently and effectively.The financial system is possibly the most important institutional andfunctional vehicle for economic transformation. Finance is a bridgebetween the present and the future and whether it be the mobilization ofsavings or their efficient, effective and equitable allocation for investment,it is the success with which the financial system performs its functionsthat sets the pace for the achievement of broader national objectives.

The formal financial system consists of these four segments orcomponents: Financial Institutions, Financial markets, financialinstruments and financial services.Financial Institutions are intermediaries that mobilize savings andfacilitate the allocation of funds in an efficient manner.Financial institutions can be classified as banking and non bankingfinancial institutions. Banking institutions are creators of credit while non-banking financial institutions are purveyors of credit.

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Financial Markets are the mechanism enabling participants to deal infinancial claims. The markets also provide a facility in which theirdemands and requirements interact to set a price for such claims. Themain organized financial markets are money market and capital market.The first is market for short term securities while the second is a marketfor long term securities with the maturity period of one year or more.Financial markets are also classified as primary, market and secondarymarket. The primary market deals in new issues of securities, and thesecondary market deals for trading in outstanding or existing securities.Financial Instrument: is a claim against a person or an institution for thepayment at a future date a sum of money and/or a periodic payment inthe form of interest or dividend.Financial securities may be primary or secondary securities. Primarysecurities are also termed as direct securities as they are directly issued bythe ultimate borrowers of the funds to the ultimate savers. Examples ofprimary or direct securities include equity shares and debentures.Secondary securities are also referred to as indirect securities, as they areissued 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. Financialinstruments help the financial markets and the financial intermediaries toperform the important role of channelizing funds from lenders toborrowers.Financial Services: Financial intermediaries provide key financial servicessuch as merchant banking, leasing, hire purchase, credit-rating, and soon. Financial services rendered by the financial intermediaries bridge thegap between lack of knowledge on the part of investors and increasingsophistication of financial instruments and markets. These financialservices are vital for creation of firms, industrial expansion, and economicgrowth.Before investors lend money, they need to be reassured that it is safe toexchange securities for funds. This reassurance is provided by thefinancial regulator who regulates the conduct of the market, andintermediaries to protect the investors interests. The Reserve Bank ofIndia regulates the money market and Securities and Exchange Board ofIndia (SEBI) regulates capital market.

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Q: 2). What do you understand by capital market? Discusscapital market instruments.

Answer:Capital market: is a market for long-term debt instruments with thematurity period of more than one year. It is composed of borrowers andlenders and the rate of interest is determined by the demand for andsupply of capital forces. The Capital market is a market for securities withmaturity greater than one year including intermediate and long termnotes, bonds, and stocks.The long term capital takes two forms: Equities or ordinary shares andfixed interest capital like preference share capital or debentures.The purpose of capital market is:

1) To mobilize long term savings to finance long term investments.2) Provide risk-capital in the form of equity to entrepreneurs.3) Encourage broader ownership to productive assets.4) 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.Capital markets can be classified into primary and secondary markets. Theprimary market is meant for new issues and the secondary market is amarket where outstanding issues are traded. In other words, the primarymarket creates long-term instruments for borrowings, whereas thesecondary market provides liquidity through the marketability of theseinstruments. The secondary market is also known as the stock market.The capital market consists of the following instruments:

1) Stock Exchange.2) Investment Trusts.3) Insurance Companies.4) Hire Purchase Companies.5) Building Societies.6) Pension Funds.7) Commercial Banks.

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Q: 3). Discuss all the participants in a stock market.

Answer:A stock market which is also known as equity market is a public body inwhich a free network of economic transactions occurs. It is not a physicalfacility or secret body. It is the place for the trading of stock or shares ofcompany and its derivatives at an agreeable price. These shares andderivatives are securities that are listed on a stock exchange.Participants in the stock marketsThe participants in a stock market process are: Investors, Intermediariesand Companies.

1) InvestorsInvestors 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 corporatebodies are prohibited from investing in Indian securities markets.Investors cannot directly trade on the stock market. They have to gothrough intermediaries called brokers. Brokers are members of the stockexchange. 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 depositoryparticipant (DP) to be able to trade in dematerialized securities. Thisaccount will hold the shares which the investor will buy and sell.Once the formality of account opening is done, investors can put throughtheir transactions through their brokers terminal. The trades have to besettled, i.e. securities delivered/received and funds paid out/received,according to the settlement schedule (currently T+2) decided by theexchange. Investors have to give instructions to the DP to transfersecurities from their account to that of the broker who is also a clearingmember. Or give standing instructions to receive securities if they havebought shares. Similarly, they have to ensure that funds are available intheir bank account to settle for shares they have bought.

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2) BrokersIntermediaries in the secondary market process include brokers anddepository participants. Brokers are members of a stock exchange who arealone authorized to put through trades on the stock exchange. Brokersmay be individuals or institutions who are registered with SEBI and meetthe respective stock exchanges eligibility criteria for becoming a member ofthe exchange.The stock exchange will specify minimum eligibility requirements such asbase capital to be collected from the member brokers which are in linewith SEBIs regulations on the same. The exposure that a broker can takein the market will be a multiple of the base capital that is deposited withthe exchange.

3) DPsDepository participants are associates of a depository through whom theinvestor will hold the beneficiary account of the investors to enable them totrade in dematerialized shares.The SEBI (Depository and Participants) regulations specify the eligibilityrequirements for a DP. Banks, financial institutions, brokers, custodians,R&T agents, NBFCs among others are eligible to become DPs. Apart fromthis, the DPs are required to have minimum net worth as specified by theregulations. This could range from Rs 10 Crore for R&T agents who areDPs to Rs 50 Crore for NBFCs.The DPs are responsible for executing the investors directions on deliveryand receipt of shares from their beneficiary account to settle the tradesdone on the secondary markets.

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CASE STUDYSecurity Scam in India-1991In April 1992, press reports indicated that there was a shortfall in theGovernment Securities held by the State Bank of India. Investigationsuncovered the tip of an iceberg, later called the securities scam, involvingmisappropriation of funds to the tune of over Rs. 3500 Crores8. The scamengulfed top executives of large nationalized banks, foreign banks andfinancial institutions, brokers, bureaucrats and politicians: Thefunctioning of the money market and the stock market was thrown indisarray. The tainted shares were worthless as they could not be sold. Thiscreated a panic among investors and brokers and led to a prolongedclosure of the stock exchanges along with a precipitous drop in the price ofshares. Soon after the discovery of the scam, the stock prices dropped byover 40%, wiping out market value to the tune of Rs. 100,000 crores. TIlenormal settlement process in government securities was that thetransacting banks made payments and delivered the securities directly toeach other. The broker's only function was to bring the buyer and sellertogether. During the scam, however, the banks or at least some banksadopted an alternative settlement process similar to settlement of stockmarket transactions. The deliveries of securities and payments were madethrough the broker. That is, the seller handed' over the securities to thebroker who passed them on to the buyer, while the buyer gave the chequeto the broker who then made the payment to the seller. There were twoimportant reasons why the broker intermediated settlement began to beused in the government securities markets: The brokers instead of merelybringing buyers and sellers together stfu1ed taking positions in themarket. They in a sense imparted greater liquidity to the markets. When a bank wanted to conceal the fact. That it was doing a ReadyForward deal, the broker came in handy. The broker provided contractnotes for this purpose with fictitious counterparties, but arranged for theactual settlement to take place with the correct counterparty. This allowedthe broker to lay his hands on the cheque as it went from one bank toanother through him. The hurdle now was to find a way of crediting thecheque to his account though it was drawn in favour of a bank and wascrossed account payee. It is purely a matter of banking custom that anaccount payee cheque is paid only to the payee mentioned on the cheque.In fact, privileged (Corporate) customers were routinely allowed to creditaccount payee cheques in favour of a bank into their own accounts toavoid clearing delays; thereby reducing the interest lost on the amount.The brokers thus found a way of getting hold of the cheques as they wentfrom 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 abank. But this, by itself, would not have led to the scam because the RFafter all is a secured. Loan and a secured loan to a broker is still secured.

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What was necessary now was to find a way of eliminating the securityitself.Three routes adopted for this purpose were: Some banks (or rather their officials) were persuaded to part withcheques without actually receiving securities in return. A simpleexplanation of this is that the officials concerned were bribed and/ornegligent. Alternatively, as long as the scam lasted, the banks benefitedfrom such an arrangement. The management of banks might have beensorely tempted to adopt this route to higher profitability. The second route was to replace the actual securities by a worthlesspiece of paper - a fake Bank Receipt (BR). A BR like an IOU has only theborrower's assurance that the borrower has the securities which can/willbe delivered if/when the need arises. The third method was simply to forge the securities themselves. In manycases, PSU bonds were represented only by allotment letters rather thancertificates on security paper. However, it accounted for only a very smallpart of the total funds misappropriated. During the scam, the brokersperfected the art of using fake BRs to obtain unsecured loans from thebanking system. They persuaded some small and little known banks - theBank of Karad (BOK) and the Metropolitan Cooperative Bank (MCB) - toissue BRs as and when required. These BRs could then be used to do RFdeals with other banks. The cheques in favour of BOK were, of course,credited into the brokers' accounts. In effect, several large banks madehuge unsecured loans to the BOK/MCB which in turn made the moneyavailable 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:Some of the flaws in the regulation that gave the scope of 1991 scam areas following:

a) Misappropriation of funds by top executives of large nationalizedbanks, foreign banks and financial institutions, brokers,bureaucrats and politicians.

b) Throwing in a disarray of the functioning of the money market andthe stock market

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c) Tainting of shares that were worthless(they could not sold)d) Creation of panic among investors and brokers leading to a

prolonged closure of stock exchanges, along with a sudden drop inthe price of shares.

e) Banks adopting an alternative settlement process similar tosettlement of stock market transactions.

f) Deliveries of securities and payments were made through thebrokers

Regulation improvement1) Ensuring that an account payee cheque is paid only to the payee

mentioned on the cheque.2) Allowing privileged (corporate) customers to credit account payee

cheques in favour of a bank into their own accounts to avoidclearing delays (thus reducing interest lost on the amount).

Q: 2). Explain roles and responsibilities of brokers and how thatwas being violated in that scam and what actions should be taken byregulatory bodies to avoid these kinds of frauds.

Answer:Brokers are intermediaries in the secondary market process. They aremembers of the stock exchange who are authorized to put through tradeson the stock exchange. Brokers may be individuals or institutions who areregistered with SEBI and meet the respective stock exchanges eligibilitycriteria for becoming a member of the exchange.The stock exchange will specify minimum eligibility requirements such asbase capital to be collected from the member brokers which are in linewith SEBIs regulations on the same. The exposure that a broker can takein the market will be a multiple of the base capital that is deposited withthe exchange.All brokers are regulated by the Securities and Exchange Commission[SEC] and are required to meet certain standards when dealing withcustomers. Specifically, the Securities and Exchange Act of 1934 putsforth certain provisions that all brokers must adhere to. These provisionsare provided below:Duty of Fair Dealing: This includes the duty to execute orders promptly,disclosing material information (information that a brokers client would

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consider relevant as an investor), and charge prices that are in line withcompetitors.Duty of Best Execution: The broker has a responsibility to completecustomer orders at the most favorable market prices possible.Customer Confirmation Rule: The broker must provide the investor withcertain information, at or before the execution of the order (i.e. date, time,price, and number of shares, commission and other information).Disclosure of Credit Terms: At the time an account is opened, a brokermust provide the customer with the credit terms and, in addition, providecredit customers with account statements quarterly.Restriction of Short Sales: This rule bars an investor from selling anexchange-listed security that they do not own (in other words, sell a stockshort) unless the sale is above the price of the last trade.Trading During Offerings: the Rule 101 prohibits the broker from buyinga stock that is being offered during the "quiet period" one to five daysbefore and up to the offering.Restrictions on Insider Trading: Brokers have to establish writtenpolicies and procedures to ensure that employees do not misuse materialnonpublic (or inside) information.

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Assignment CQ: 1). The organized financial system comprises the following sub-

systems:I. Banking systemII. Cooperative systemIII. Development Banking systemIV. Money marketsV. Financial companies/institutions.a) I, II, and III aboveb) I, II, III and IV abovec) I, III, IV and V aboved) I, II, III, IV, V ().

Q: 2). The formal financial system consists of segments:a) Financial Institutions, Financial markets, financialinstruments and financial services ().b) Financial Institutions, Financial markets and financialinstruments.c) Financial markets, financial instruments and financialservices.d) Financial markets, financial instruments, financial derivativesand financial services.

Q: 3). Financial institutions can be classified as banking and nonbanking financial institutions.

a) True ().b) False

Q: 4). The main organized financial markets in a country arenormally:

a) Money market and capital market ().b) Money market and debt market.c) Money market and equity market.d) Money market and derivative market.

Q: 5). Examples of primary or direct securities include _________.a) Mutual fund and Insurance policiesb) Insurance policies and Bank depositsc) Bank deposits and Insurance policiesd) Equity shares and debentures ().

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Q: 6). The Reserve Bank of India regulates the _______ and Securitiesand Exchange Board of India (SEBI) regulates _________.

a) Money market, capital market ().b) Capital market, Money marketc) Money market and debt market.d) 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) Mutual fund, equity shares and Insurance policiesb) Insurance policies, Bank deposits and Mutual fund ().c) Bank deposits, equity shares and Insurance policiesd) Bank deposits, Mutual fund and debentures.

Q: 8). Interest rates are typically determined by the supply of anddemand for ___________ in the economy.

a) Commoditiesb) Money ()c) Manpowerd) Technology

Q: 9). If the economic growth of an economy picks up momentum,then the demand for money tends to________, putting upwardpressure on interest rates.

a) Go downb) Stabilizec) Go up ()d) None of the above

Q: 10). Inflation is a ______ in the general price level of goods andservices in an economy over a period of time.

a) Rise ()b) Fallc) Stabilizationd) None of the above

Q: 11). Which of the following are examples of a primary markettransaction?

a) A company issues new common stock ().b) An investor asks his broker to purchase 1,000 shares ofMicrosoft common stock.c) An investor sells his shares.

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d) All of the statements above are correct.Q: 12). When the price of a bond is above face value:

a) The yield to maturity is below the coupon rate ().b) The yield to maturity will be above the coupon rate.c) The yield to maturity will equal the current yield.d) The yield to maturity will equal the coupon rate.

Q: 13). Which of the following statements is most true?a) Yield to maturity is equal to the coupon rate if the bond is heldto 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 ispurchased for face value.d) Yield to maturity is the same as the coupon rate if thebond is purchased for face value and held to maturity ().

Q: 14). ___________, __________ or _________ means the sum mentionedin the capital clause of Memorandum of Association.

a) Nominal, issued or registered capitalb) Nominal, authorized or paid up capitalc) Nominal, paid up or registered capitald) Nominal, authorized or registered capital ().

Q: 15). _____________ means that part of the issued capital at nominalor face value which has been subscribed or taken up by purchaser ofshares in the company and which has been allotted.

a) Paid up capitalb) Issued capitalc) Subscribed Capitald) Called Up Capital ().

Q: 16). Three theories about the determination of rate of Interest are:I. The classical theoryII. The loanable funds theoryIII. The Keynesian theoryIV. The Vogels theorya) I, II, and III ()b) II, III and IVc) I, III and IVd) I, II, III, IV

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Q: 17). Financial markets and institutionsa) 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 alsoacts as the regulator and supervisor of commercial banks.

a) SEBI (Securities and exchange board of India)b) RBI (Reserve Bank of India) ()c) SBI (State bank of India)d) CBI (Central Bank of India)

Q: 19). Based on how interest is computed, interest rates areclassified into _____________ and ____________.

a) Fixed, floatingb) Short term , Long termc) Simple, compound ().d) 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, TheKeynesian theory ().b) The modern theory, the loanable funds theory, The Keynesiantheory.c) The classical theory, the modern theory, The Keynesian theory.d) The classical theory, the loanable funds theory, the moderntheory.

Q: 21). Three theories about the term structure of Interest rates are:-a) The Expectations Theory, Default Premium Theory, MarketSegmentation Theoryb) Default Premium Theory, Liquidity Premium Theory, MarketSegmentation Theoryc) The Expectations Theory, Liquidity Premium Theory, DefaultPremium Theoryd) 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 authorityII. Controls money supply and creditIII. Manages foreign exchange

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IV. Serves as a banker to the governmentV. Builds up and strengthens the country's financialinfrastructurea) I, II, III, IVb) II, III, IV, Vc) I to V ()d) I, II, III, V

Q: 23). By increasing ____________ , the RBI can reduce the fundsavailable with the banks for lending and thereby tighten liquidity inthe system.

a) Statutory Liquidity Ratiob) Current Ratioc) Cash Reserve Ratio ()d) Bank ratio

Q: 24). ________________ banks cater to the financing needs ofagriculture, retail trade, small industry and self-employedbusinessmen in urban, semi-urban and rural areas.

a) Co-operative ()b) Scheduled commercialc) Foreignd) Private

Q: 25). Monetary policy is referred to as either being a _________ policyor a ____________ policy.

a) Liberal, strictb) Expansionary, contractionary ()c) Inflationary, deflationaryd) Classical. Modern

Q: 26). Monetary policy is the process by which the central bank ormonetary authority of a country controls the ________________.

a) Supply of money ()b) Demand of moneyc) Inflationd) Deflation

Q: 27). A monetary policy is referred to as __________ if it reduces thesize of the money supply or increases it only slowly, or if it raises theinterest rate.

a) Expansionaryb) Contractionary ()

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c) Inflationaryd) Deflationary

Q: 28). The ____________ is a system in which the price of the nationalcurrency is measured in units of gold bars and is kept constant bythe daily buying and selling of base currency to other countries andnationals.

a) Stock tradingb) Gold standard ()c) Discount window lendingd) Monetarism

Q: 29). Price level targeting is similar to ___________ except that CPIgrowth in one year is offset in subsequent years such that over timethe price level on aggregate does not move.

a) Inflation targeting ()b) Stock tradingc) Discount window lendingd) Monetarism

Q: 30). Money market is a very important segment of the financialsystem of a country. It is the market dealing in monetary assets ofshort term nature.

a) Long term natureb) Medium term naturec) Short term nature ()d) All the above

Q: 31). Yield to maturity (YTM) is a popular and extensively usedmethod for computing the return on a _______ investment.

a) Shareb) Share & bondc) Futures & optionsd) Bond ()

Q: 32). Bonds that allow the issuer to alter the tenor of a bond, byredeeming it prior to the original maturity date, are called ________bonds.

a) Callable ()b) Puttablec) Amortisingd) Step up

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Q: 33). An ________________ represents ownership in the shares of aforeign company trading on US financial markets.

a) Global Depositary Receipt (or GDR)b) Treasury Billsc) Government Security( G-sec)d) American Depositary Receipt (or ADR) ()

Q: 34). External Commercial Borrowings (ECB) include:I. Commercial Bank LoansII. Buyers CreditIII. Suppliers CreditIV. Securitized Instruments Such As Floating Rate Notes, Fixed

Rate Bonds Etc.V. Credit From Official Export Credit Agenciesa) I, II, III, IVb) II, III, IV, Vc) I to V ()d) I, II, III, V

Q: 35). The credit risk of a borrower is evaluated by ____________.a) SEBI (Securities and exchange board of India)b) Stock Exchangec) RBI( Reserve Bank of India)d) Credit rating agencies ()

Q: 36). _________ risk denotes the risk of the value of an investmentdenominated in some other country's currency, coming down interms of the domestic currency.

a) Currency ()b) Countryc) Hedgingd) Speculation

Q: 37). A _________is an entity which provides "trading" facilities forstock brokers and traders, to trade stocks and other securities.

a) Stock exchange ()b) Depositoryc) Companyd) Credit rating agency

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Q: 38). Various economic variables impact the movement in exchangerates such as:I. Interest ratesII. Inflation figuresIII. Balance of payment figuresIV. GDP( Gross domestic product)

a) I, II, IIIb) I, II, III, IV ()c) II, III, IVd) I, III, IV

Q: 39). Benefits of trading through a stock exchange:I. Best priceII. lack of any counter-party riskIII. Access to investor grievance and redressal mechanisma) I, IIb) I, IIIc) II, IIId) I, II, III ()

Q: 40). In a ____________ exchange, the three functions of ownership,management and trading are concentrated into a single Group.

a) Mutual ()b) Demutualisedc) Neither a nor bd) Both a & b