INDIAN FINANCIAL SYSTEM ( Reference e-book for BBA / B.Com)

 

 

 

 

COURSE TITLE: INDIAN FINANCIAL SYSTEM

 

 

Topic

Module – 1: CONCEPT OF FINANCIAL SYSTEM Formal and informal financial systems, Functions of financial system, Nature and Role of financial institutions and financial markets, Financial system and the economy

Module – II: MONEY MARKET Emerging Structure of Indian Money Market; Instruments of Money Market; Money Mutual Funds — An Overview and 1213I's Regulatory Guidelines; Commercial Banks — Role in Industrial Finance and Working Capital Finance.

Module – III:  CAPITAL MARKET Concept, Structure and Functions of Capital Market; Primary Market- Instruments of Issue and Methods of Flotation; Secondary Market — Concept, Market Players, trading System and Settlement.

Module – IV: INSTITUTIONAL STRUCTURE INDIAN FINANCIAL INSTITUTION: Development Banks- FCLICICI, Sits and IDBI: Investment Institutions —UTI and other Mutual Funds; Insurance Organization- Life Insurance Corporation of India, SEI31: Scope and Functions, Objectives of SEBI.

Module – V: FINANCIAL PRODUCTS Leasing, Hire Purchase, Factoring and Forfeiting. CREDIT RATING Meaning, Functions, Importance. DERIVATIVES: Basic Introduction

 

 

Books References:

1.     Machiraju, ‘Indian Financial System’ – Vikas Publishing House, 2nd Edition, 2002.

2.     Varshney P.N., & Mittal D.K., ‘Indian Financial System’, Sultan Chand & Sons, New Delhi. 2002.

3.     Verma J.C., ‘Venture Capital Financing in India’, Sage, New Delhi, 1997.

4.      Sadhale H., ‘Mutual Funds in India’, Sage, New Delhi, 1997.

 

 

Module I: The Financial System Concept

1.1 A Brief Overview of the Financial System
A financial system is a collection of organizations, tools, marketplaces, and regulations that make it easier for investors to receive money from savers. By attracting surplus funds and directing them toward profitable investments, it guarantees the effective distribution of resources within an economy.

1.2 The Financial System's Elements

1. Financial Institutions: These comprise banking and non-banking organizations like: o Banks (like HDFC Bank and State Bank of India); o Development Financial Institutions (like NABARD and SIDBI); o Insurance Companies (like LIC and ICICI Prudential).
o Mutual funds (such as HDFC AMC and SBI Mutual Fund)
2. Financial Markets: o Money Market: Deals with short-term securities (less than a year), such as call money and Treasury Bills.
o Capital Market: Handles long-term securities, such as bonds and equity shares.
3. Financial Instruments: Certificates of Deposit, Debentures, Shares, and Commercial Paper are a few examples.
4. Financial Services: o Consists of investment banking, leasing, factoring, and credit rating services.

1.3 The Difference Between Formal and Informal Financial Systems:

Aspect	Formal Financial System	Informal Financial System
Definition	Institutionalized system regulated by government and central bank.	Non-institutional system with no formal regulation or supervision.
Examples	Banks, insurance companies, stock markets, NBFCs, etc.	Moneylenders, friends and family, local cooperatives, chit funds.
Regulatory Authority	Regulated by bodies like RBI (India), SEBI, central banks.	No formal regulatory authority. Based on trust and social norms.
Documentation	Extensive documentation and legal formalities required.	Minimal or no documentation.
Interest Rates	Generally lower and regulated.	Often higher and arbitrary, depending on lender.
Access to Services	May be difficult for low-income groups without proper documents.	Easily accessible to people without formal paperwork or credit history.
Transparency	High transparency; audited and reported.	Low transparency; transactions are often unrecorded.
Legal Protection	Borrowers and lenders are protected by law.	Little or no legal protection.
Cost of Borrowing	Lower, due to regulation and competition.	Higher, due to risk and lack of oversight.
Purpose	Long-term development, economic growth, investment.	Short-term needs, emergency funds, small business support.

 

1.4 The financial system's functions

1. Savings Mobilization: Promotes saving with financial products such as mutual funds and deposits.
2. Capital Formation: Facilitates the conversion of savings into investments.
3. Payment system facilitation: permits transactions through RTGS, NEFT, UPI, and other methods.
4. Risk Management: Derivatives and insurance aid in the control of monetary risks.
5. Information Production: Disclosures, research reports, and credit ratings help with decision-making.

1.5 Financial Institutions' Function

Banks: Provide loans, take deposits, and encourage financial inclusion through programs like the Jan Dhan Yojana.
DFIs: Offer long-term funding to industries such as MSMEs and agriculture.
Insurance companies: Reduce monetary risk (LIC's term plans, for example).
Mutual funds: These invest in diversified portfolios by pooling the savings of individual investors.

1.6 Financial Markets' Role
Primary market : New securities are issued by the primary market. For instance, LIC IPO
Secondary Market: Facilitates trading in already-issued securities. For instance, stock shares are traded on the NSE and BSE.
Creation of Liquidity: By allowing investors to sell securities in the market, confidence and involvement are raised.

1.7 The Financial System and Economic Growth
A strong financial system fosters the following: effective capital allocation; innovation and entrepreneurship; employment creation; and economic stability and expansion.
For instance, post-1991 financial sector liberalization allowed for the expansion of the private sector and increased GDP growth.

 

Multiple-choice Questions
1. What is a component of the official financial system?
i) Commercial Bank       ii) Friends and Family                  iii) Moneylender             iv) Chit Fund

2. Savings deposits, short-term loans, long-term securities, and daily transactions are all dealt with by the capital market.
2. The financial system plays a crucial role in:

i) producing goods         ii ) encouraging savings               iii) offering subsidies    iv) Tax Collection

Fill in the blanks
1. The …………………market deals in short-term financial instruments. (Money)
2. Mutual funds, banks, and insurance companies are examples of ……………………….institutions. (Financial Institutions)
3. …………………………………….makes it easier to buy and sell already-issued securities. (secondary market)

Short-answer questions
1. Define  financial system in India. (Hint: A fund-raising and allocation network)
2. List two ways that formal and informal financial systems differ from one another. (Hint: Transparency and regulation)
3. What constitutes a financial system's essential elements? (Hint: Markets, Institutions, Instruments, Services)
 
Long-answer questions
1. Describe how financial institutions contribute to the growth of the economy. (Hint: capital allocation and mobilization through banks, insurance, and DFIs.)
2. Explain a financial system's operations using pertinent Indian examples. The following is a hint: payment facilitation, risk management, and mobilization.

Case Study based Questions
An entrepreneur named Ramesh intends to start a manufacturing company. In addition to seeking an investment option for his idle funds, he needs funding and wants insurance for plant machinery.
Q1: Which banks should he contact to obtain funding?
Q2: How can he control risk?
Q3: Make a recommendation for an investment vehicle for his  idle funds 

 

 

 

 

Module II: Money Market

2.1 Overview of the Indian Currency Market
In India, the money market is a section of the financial market where short-term loans and borrowings of money occur, typically for a maximum of one year. Because it gives banks, financial institutions, and corporations liquidity, it is an essential part of the Indian financial system. One of the main players in money market regulation is the Reserve Bank of India (RBI).

2.2 The Indian Money Market's Structure

2.3 Money Market Instruments:

Instrument	Issuer	Tenure	Example
Treasury Bills (T-Bills)	Indian Government	91, 182, and 364 days	T-Bill for 91 days
Commercial Papers (CPs)	Businesses (Corporates)	7 days to 1 year	Reliance Industries' CP
Certificates of Deposit (CDs)	Banks	7 days to 1 year	ICICI Bank’s 1-year CD
Call/Notice Money	Financial Institutions and Banks	1 to 14 days	SBI’s overnight borrowing
Repo/Reverse Repo	Banks and Reserve Bank of India (RBI)	1 to 7 days	RBI’s repo operations

2.4 Mutual funds that invest in the money market (MMMFs)
Mutual funds that invest in money market instruments are known as MMMFs.

For investors with extra money, they provide a short-term, low-risk investment option.
Important characteristics include:

• High liquidity

• Safer but lower returns

 • SEBI regulated

SEBI guidelines:
• There should be no lock-in period;

 • NAV is reported daily;

• At least 80% of assets should be in money market instruments.

Example: SBI Magnum Instant Cash Fund, for instance

 

2.5 Commercial Banks' Function in the Money Market
A. Industrial Finance: Term loans are given by banks to businesses so they can start up and grow. One example is the expansion of Tata Steel's plant.
B. Working Capital Finance: Banks provide short-term loans to cover operational expenses like purchasing raw materials and paying employees.
• For instance, MSMEs can purchase inventory with financing from HDFC Bank.

Multiple-choice Questions Assessment

1. The following entities issue Treasury Bills:

a)Commercial banks    b)Corporation                  c)Indian government    d)SEBI

2. Among these, which one is a money market instrument?
a) Debentures b) Equity Shares             c) Commercial Paper   d) Real Estate

Fill in  the Blanks :
1. The RBI's overnight lending rate is …………………….(Repo Rate )
2. Companies issue …………………..a type of short-term debt instrument.( Commercial Paper)
3. The money market deals in securities with maturities under ………………………... (One year)

Questions with Short Answers
1. Describe the money market. (Hint: The market for short-term loans and borrowing)
2. Name two Indian money market instruments. (Hint: CPs, CDs, T-Bills)
3. How does SEBI regulate MMMFs? (Hint: Investor protection, disclosures, and asset allocation)

Questions with Long Answers
1. Use a diagram to illustrate the Indian money market's structure. (Hint: Parts that are organized and parts that are not.)
2. Using examples, go over the main money market instruments in India. (Hint: call money, CD, T-Bills, and CP.)
________________________________________
Question Based on a Case Study
 MedCare Ltd. a pharmaceutical company, requires short-term funding in order to import German raw materials. The finance manager is debating whether to borrow money through the call money market or issue a commercial paper.
Q1: What is the better choice, and why?
Q2: What dangers are connected to CP?
Q3: In what ways can MMMFs serve as a substitute for unused funds in the company's treasury?

 

 

 

 

Module III: Capital Market

 3.1 An Overview of the Capital Market

Capital market is a part of financial market that makes it easier for governments and businesses to raise long-term capital . It makes it possible for financial securities like bonds, preference shares, debentures, and equity share to be issued and traded. Economic development in India depends on the Indian capital market because it gives businesses and investors a place for financial intermediation.


3.2 The Capital Market Structure
There are two main categories of the capital market:
1. Primary Market (New Issue Market): This is where initial capital raising for new securities takes place.
2. Secondary Market (Stock Market): An exchange between investors for already-issued securities.

3.3 Capital Market Functions:

1.        Long-term Fund Mobilization.

2.        Effective Capital Allocation.

3.        Wealth Creation for Investors.

4.        Supports Industrial Growth.

5.        Secondary Market Liquidity.

6.        Risk Distribution Among Investors

3.4 Primary Market:

The Primary Market—also known as the new issue market (NIM)—is a segment of the capital market where new securities are issued and sold for the first time. It facilitates capital raising by companies, governments, or public sector institutions through the issuance of equity shares, preference shares, debentures, and bonds.

 

In the primary market, the issuer receives the funds directly from investors, enabling it to raise capital for purposes such as business expansion, new projects, or debt repayment.

Key Features of the Primary Market:

1. Involves fresh issue of securities (not previously traded).
2. Capital raised goes directly to the issuing entity.
3. Securities are issued to the public through various methods of flotation.
4. No trading activity occurs here—unlike the secondary market.
5. Regulated in India by SEBI (Securities and Exchange Board of India).

Functions of the Primary Market:

1. Capital Formation: Helps channel household and institutional savings into productive investment.
2. Direct Investment Route: Investors become shareholders or creditors of the issuing firm.
3. Economic Development: Facilitates the funding of industries, leading to job creation and GDP growth.
4. Investor Allocation: Offers a route for investors to invest in newly established or expanding firms.

Methods of Raising Capital in the Primary Market:

Method	Description	Example
Public Issue (IPO/FPO)	Offering securities to the public via a prospectus	LIC IPO (2022)
Private Placement	Securities offered to a select group of investors (institutions, HNIs)	Bonds issued by Indian Railways Finance Corp
Rights Issue	Offered to existing shareholders in proportion to holdings	Reliance Industries rights issue (2020)
Preferential Allotment	Shares issued to select individuals/groups at a pre-determined price	Adani Group's preferential allotments

 

Process of an Initial Public Offering (IPO):

          I.               Board Approval: Company’s board approves raising capital via IPO.

        II.               Appointment of Merchant Bankers: Registered intermediaries prepare the prospectus and regulatory documents.

      III.               Draft Red Herring Prospectus (DRHP): Filed with SEBI for review.

     IV.               Book Building Process: Price discovery based on investor bids.

       V.               Allotment of Shares: Based on oversubscription, shares are allotted to investors.

     VI.               Listing on Stock Exchange: Shares are listed on NSE/BSE for secondary trading.

 

 

Example (from Indian Financial Market):

• LIC IPO (2022): One of India’s largest public issues, raising over ₹21,000 crore.
• Zomato IPO (2021): A tech-driven company raised ₹9,375 crore through the primary market, showing the rise of new-age companies.

Difference between Primary and Secondary Market:

Basis	Primary Market	Secondary Market
Nature of transaction	First-time issue of securities	Resale of existing securities
Issuer receives funds	Yes (directly from investors)	No (between investors)
Price discovery	By issuer or book-building process	Determined by market forces
Regulation	SEBI regulations for new issues	Stock exchange regulations

 

3.5 Secondary Market: Overview, Market Participants, and Trading Framework

The Secondary Market, also known as the stock market or aftermarket, is a segment of the capital market where existing securities (such as equity shares, debentures, bonds, etc.) are traded among investors. Unlike the primary market, in the secondary market, the issuing company does not receive any funds; instead, securities are exchanged between investors.

The secondary market plays a vital role in providing liquidity, marketability, and valuation to financial instruments. It facilitates continuous price discovery based on demand and supply dynamics.

Importance of the Secondary Market

1. Liquidity to Investors: Investors can sell their holdings whenever required.
2. Continuous Price Discovery: Reflects real-time valuation of companies.
3. Encourages Investment: As investors are assured of an exit route.
4. Efficient Allocation of Capital: Resources shift from low to high-performing assets.
5. Corporate Governance Pressure: Listed companies are subject to scrutiny by analysts and investors.

Types of Secondary Markets in India

Type	Description	Example
Equity Market	Trading in shares of listed companies	BSE, NSE
Debt Market	Trading in bonds, debentures, government securities	NSE Bond Platform, RBI Retail
Derivatives Market	Futures and options trading based on underlying assets	NSE F&O Segment
Currency Market	Trading in currency futures	NSE, BSE
Commodity Market	Trading in agri, metals, energy commodities	MCX, NCDEX

Market Participants in Secondary Market

Participant Type	Role in the Market	Example
Retail Investors	Individuals investing personal funds	Common stock investors
Institutional Investors	Entities investing large funds for members/clients	LIC, SBI Mutual Fund
Foreign Portfolio Investors (FPIs)	Overseas entities investing in Indian equities/debt	Vanguard, BlackRock
Brokers/Sub-Brokers	Registered intermediaries who execute trades	Zerodha, Angel One
Market Makers	Provide liquidity by continuously quoting buy/sell prices	Proprietary desks of brokers
Clearing Corporations	Ensure smooth settlement of trades	NSCCL (NSE), ICCL (BSE)
Stock Exchanges	Platforms for buying/selling of securities	BSE, NSE
Regulator	Protect investor interest and regulate market functioning	SEBI

 

Trading Framework in India

India’s secondary markets are highly organized and technology driven. Trading takes place on electronic platforms provided by stock exchanges such as NSE (National Stock Exchange) and BSE (Bombay Stock Exchange).

Pre-Trading Process:

• Account Opening: Investors must open a Demat Account with a Depository Participant (DP).
• KYC Compliance: Submission of identity and address proofs.
• Broker Selection: Registered broker with SEBI must be appointed.

 

 

 

Trading Mechanism:

Phase	Activity
Order Placement	Buy/sell orders placed through broker’s platform
Matching Orders	Matching of buy and sell orders in real time
Trade Execution	Automatic trade confirmation on price match
Order Types	Market Order, Limit Order, Stop Loss, etc.

 

Note: Trades on NSE and BSE occur from 9:15 AM to 3:30 PM (Monday to Friday).

3.6 The Mechanism of Settlement

Settlement Process:

1. T+1 Rolling Settlement: Trades executed today are settled the next working day.
2. Depositories Involved: NSDL and CDSL transfer securities electronically.
3. Clearing Corporation Role: Ensures that both funds and securities are exchanged smoothly.

Settlement Cycle Example:

1. Trade Date (T) → Monday
2. Settlement Date (T+1) → Tuesday

 

Regulation of Secondary Market

• SEBI: Ensures fair practices, transparency, investor protection.
• Stock Exchanges: Enforce listing and compliance norms.
• Depositories (NSDL/CDSL): Secure holding and transfer of securities.

 

How an Investor Buys Shares in the Secondary Market ( Sample Example)

Steps:

1. Opens Demat and Trading account with Broking Company (e.g. Zerodha).
2. Searches Infosys stock symbol on NSE or BSE .
3. Places a limit buy order for ₹1,500 per share.
4. Order matches, trade is executed.
5. Shares credited to his Demat account by next day.

 

Execution of the Trade – Purchase through Trading Terminal

1. Investor Action: The investor logs into the trading platform (e.g., Zerodha, ICICI Direct) and places an order to buy or sell securities like shares, bonds, or derivatives.
2. Order Routing: The order is routed to the stock exchange (BSE or NSE) through the broker’s terminal.
3. Order Matching: The exchange uses an electronic order book to match buy and sell orders on a price-time priority basis.
4. Trade Confirmation: Once a match is found, the trade is executed, and a trade confirmation is generated in real-time.

Example: Ravi buys 100 shares of Infosys at ₹1,500 per share via NSE. The trade is matched and confirmed on the exchange platform.

 

Clearing of Trade: Obligations Calculated by the Clearing House

After trade execution, the transaction enters the clearing phase, where the clearing corporation (like NSCCL for NSE or ICCL for BSE) steps in.

          I.               Trade Netting: The clearing house calculates the net obligations of each trading member. For instance, if a broker has multiple buys and sell orders, only the net amount of securities and funds is computed.

        II.               Obligation Statement: The clearing corporation issues an obligation report, stating how much money and how many securities are to be delivered or received.

Dispute Resolution

In case of any trade-related mismatches or grievances, SEBI and the stock exchanges provide a structured dispute resolution mechanism.

1. Investor Grievance Redressal Mechanism (IGRM): Allows investors to lodge complaints against brokers or exchanges.
2. Arbitration Mechanism: If the issue persists, it is referred to an arbitration panel for resolution, especially in case of default or trade mismatch.
3. Stock Exchanges’ Role: Exchanges like NSE/BSE offer an online redressal platform (e.g., SCORES by SEBI).

Money and Securities Transfers – Settlement on T+1 Basis

1. Settlement Day: The trade executed on day T is settled on the next working day, i.e., T+1.
2. Funds Transfer: The buyer's bank account is debited, and the seller’s account is credited with the sale proceeds.
3. Securities Transfer: The seller's Demat account is debited, and the buyer's Demat account is credited with the securities.
4. Depositories Involved: NSDL (National Securities Depository Ltd.) and CDSL (Central Depository Services Ltd.) facilitate this electronic transfer.

End-to-End Trade Process

Step	Description
Trade Execution	Order placed and matched via trading terminal (e.g., NSE NOW, BSE Bolt)
Clearing Obligations	Net obligations calculated by NSCCL/ICCL
Dispute Resolution	Grievance redressal through SEBI/stock exchange arbitration
Settlement (T+1)	Funds and securities are exchanged through banks and depositories

 

Sample Example :

1. On Monday, Ravi buys 100 shares of TCS.
2. The trade is executed and confirmed on NSE.
3. On Tuesday (T+1), his Demat account is credited with 100 shares, and funds are debited from his bank account.
4. NSCCL ensures both buyer and seller obligations are fulfilled.
5. If any issue arises (e.g., shares not credited), Ravi can file a complaint via SEBI SCORES portal.

 

3.7 Post-1991 Reforms in the Indian Capital Market

Major Post-1991 Reforms

Establishment and Empowerment of SEBI (1992)

1. The Securities and Exchange Board of India (SEBI) was granted statutory powers through the SEBI Act, 1992.
2. SEBI became the apex regulator to protect investor interests and regulate intermediaries, disclosures, insider trading, and unfair trade practices.

Introduction of Electronic Trading System

1. Replaced the open outcry system with screen-based trading in stock exchanges.
2. Introduced in NSE (1994) and later in BSE.

Formation of National Stock Exchange (NSE)

1. Established in 1992 as a modern, technology-driven exchange.
2. Brought nationwide trading, better liquidity, and lower transaction costs.
3. NSE became the first exchange to offer a fully automated screen-based electronic trading system.

 

 

Dematerialization and Establishment of Depositories

1. Establishment of NSDL (1996) and CDSL (1999) enabled electronic holding and transfer of securities through Demat accounts.
2. Eliminated risks related to physical certificates (e.g., theft, loss, forgery).

 

Introduction of Derivatives Trading (2000)

1. SEBI permitted trading in equity derivatives, starting with index futures.
2. Expanded to options and stock futures later.

Reforms in IPO Process

1. Shifted from fixed-price mechanism to book-building method.
2. Made disclosures and prospectus requirements more stringent.

 

 T+1 Rolling Settlement

• Settlement cycle reduced from T+5 to T+1 (Trade Day + 1 Day) by 2023.
• Ensured faster transfer of securities and funds.

 

Regulation of Intermediaries

1. Compulsory registration and regulation of brokers, merchant bankers, mutual funds, credit rating agencies, etc., by SEBI.
2. Introduced capital adequacy norms, code of conduct, and surveillance mechanisms.

 

Foreign Portfolio Investment (FPI) Reforms

1. Simplified entry norms for Foreign Institutional Investors (FIIs).
2. Introduced FPI route in 2014 to consolidate and rationalize regulations.

 

Corporate Governance and Investor Protection

1. SEBI issued Listing Obligations and Disclosure Requirements (LODR) for better corporate disclosures.
2. Strengthened norms related to related party transactions, independent directors, and minority shareholder rights.

 

Impact of Post-1991 Reforms

Area	Pre-Reform	Post-Reform
Regulatory Framework	Weak and fragmented	Strong SEBI-led framework
Trading Mechanism	Manual/open outcry	Electronic screen-based trading
Security Transfer	Paper-based, time-consuming	Dematerialized, instant transfer
Market Access	Limited to metros	Pan-India online access
Investor Protection	Minimal	Robust grievance redressal
Market Participation	Institutional participation limited	Surge in retail and institutional investors

 

 

Platforms for Online Trading (NSE, BSE)

National Stock Exchange (NSE)

The National Stock Exchange of India Limited (NSE) was established in 1992 and became operational in 1994. It was the first exchange in India to offer a fully automated, screen-based electronic trading system, which revolutionized the way securities were traded.

Key Features of NSE:

1. NEAT (National Exchange for Automated Trading) platform allows order matching in real-time using the order-driven method.
2. Equity, derivatives, debt, ETFs, and mutual funds are traded on the platform.
3. Provides nationwide access through internet-based trading terminals.
4. Facilitates real-time price discovery and fast trade execution.

 Bombay Stock Exchange (BSE)

The Bombay Stock Exchange (BSE) is Asia’s oldest stock exchange, established in 1875. It adopted electronic trading in 1995 with the introduction of BOLT (BSE Online Trading) system.

Key Features:

• Offers trading in equities, derivatives, currency, debt instruments, mutual funds, and SME platforms.
• BSE StAR MF is India's largest online mutual fund platform.
• Supports mobile trading apps, API-based trading, and integrated dashboards for retail and institutional investors.

 

 

 

 

 

 

Advantages of Online Trading Platforms:

Feature	Benefit
Speed	Instantaneous execution of orders
Transparency	Live quotes, charts, and order book view
Accessibility	Pan-India and NRI access
Security	Two-factor authentication and encryption
Cost Efficiency	Lower brokerage and transaction charges
Analytical Tools	Research reports, screeners, portfolio analytics

 

 

Measures for Protecting Investors in Indian Capital Market

Investor protection is a cornerstone of a sound financial system. In India, the Securities and Exchange Board of India (SEBI), as the capital market regulator, plays a pivotal role in ensuring that investors are not misled, exploited, or subjected to unfair practices. Investor protection measures aim to safeguard retail and institutional investors from fraud, misrepresentation, and unethical practices in the securities market.

1.Regulatory Framework by SEBI

           i.               Listing Obligations and Disclosure Requirements (LODR):

• Mandates listed companies to disclose all material information promptly.
• Ensures transparency in financial results, shareholding patterns, board composition, and corporate governance.

         ii.               Prohibition of Insider Trading Regulations:

• Prevents misuse of non-public price-sensitive information (UPSI) by insiders such as directors, employees, etc.
• Mandatory disclosure of trades by insiders.

       iii.               Takeover Regulations:

• Ensures fairness and transparency when an entity acquires a substantial stake in a listed company.
• Mandates open offers to protect the interest of minority shareholders.

 

2. Investor Protection Fund (IPF)

Established by stock exchanges (NSE, BSE) and regulated by SEBI, the Investor Protection Fund compensates investors who suffer losses due to default by registered brokers.

1. Compensation is subject to certain limits.
2. Covers unpaid obligations in case the brokerage firm becomes insolvent or fails to pay after trade execution.

 

3. SEBI Complaints Redress System (SCORES)

SCORES is an online platform where investors can lodge complaints against listed companies, brokers, mutual funds, and depositories.

• Complaints are monitored and resolved within stipulated timelines.
• Investors can track the status and escalate if not satisfied.

Example: If a shareholder does not receive dividend or refund in an IPO, the issue can be reported on SCORES.

 

4. T+1 Settlement Cycle

SEBI has shortened the settlement cycle from T+2 to T+1, meaning trades are settled within one working day after the transaction date.

• Reduces settlement risk.
• Ensures faster transfer of securities and funds to investors.

 

5. ASBA (Application Supported by Blocked Amount)

ASBA is a facility used during IPOs and other public issues where investor funds are blocked in their bank account until the shares are allotted.

• Eliminates the risk of refunds.
• Prevents misuse of funds during IPO oversubscription.

 

6. Investor Education and Awareness

SEBI conducts financial literacy campaigns and sponsors investor awareness programs through:

• Recognized Investor Associations.
• School and college workshops.
• Online learning modules and YouTube videos in multiple languages.

Example: SEBI’s “Securities Market Awareness Campaign” educates first-time investors about scams and red flags.

 

7. KYC and Anti-Money Laundering Measures

• Mandatory Know Your Customer (KYC) norms for all investors.
• PAN linkage ensures traceability and reduces fraudulent entries.
• Prevention of money laundering by reporting large or suspicious transactions.

 

8. Investor Charter (2021)

SEBI introduced a unified Investor Charter across intermediaries to improve transparency and service quality.

Rights of Investors:

• Fair treatment and confidentiality.
• Access to accurate and timely information.
• Quick grievance redressal.

Duties of Intermediaries:

• Transparent fees and charges.
• Timely execution of trades and communication.
• Record maintenance and compliance.

 

9. Risk Management Systems

• Stockbrokers and intermediaries must maintain minimum net worth and margin requirements.
• Use of surveillance mechanisms to identify suspicious trading patterns.
• Circuit filters to prevent excessive volatility.

 

10. Whistleblower Mechanism

SEBI offers monetary incentives and anonymity to individuals who report insider trading, fraudulent practices, or corporate governance violations under the SEBI (Prohibition of Insider Trading) Regulations, 2015.

 

3.8 SEBI's Function in the Capital Market:

The Securities and Exchange Board of India (SEBI) is the statutory regulatory body established under the SEBI Act, 1992. It plays a critical role in maintaining transparency, integrity, and investor confidence in the Indian capital market. Below is a breakdown of the core regulatory functions highlighted in your content:

Regulates Capital Market Intermediaries

SEBI supervises and regulates various intermediaries who operate within the capital market ecosystem. These include:

• Stock brokers and sub-brokers
• Merchant bankers
• Portfolio managers
• Depositories and depository participants
• Mutual fund houses and registrars
• Credit rating agencies

Purpose: To ensure that intermediaries are compliant with SEBI’s rules and maintain ethical and professional standards in their operations.

Example: SEBI mandates brokers to maintain capital adequacy norms and perform periodic disclosures.

 

Authorizes Rights Issues and Initial Public Offerings (IPOs)

SEBI plays a central role in regulating the primary market, especially when companies issue securities for the first time or raise additional capital.

• IPO (Initial Public Offering): Before a company can go public, SEBI must approve its Draft Red Herring Prospectus (DRHP).
• Rights Issue: SEBI oversees the process to ensure that existing shareholders are treated fairly.

Objective: Ensure full disclosure, transparency, and protection of retail investors during public offerings.

Example: During LIC’s IPO in 2022, SEBI ensured that all investor categories were given fair access and the offer documents disclosed all material risks.

 

Prevents Fraud and Insider Trading

SEBI enforces strict rules under the SEBI (Prohibition of Insider Trading) Regulations, 2015 and SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003.

• Insider Trading: Trading in a company’s securities by someone with unpublished price-sensitive information (UPSI) is strictly prohibited.
• Market Manipulation: SEBI takes action against false or misleading statements, circular trading, or price rigging.

Recent Example: SEBI banned individuals and entities from trading who were involved in pump-and-dump schemes using fake stock tips on social media.

 

Encourages Investor Education

SEBI has initiated several programs to educate investors about financial products, risks, and rights. Its goal is to build an informed investor base and promote long-term participation in the capital market.

1. Workshops and Seminars across Tier II and III cities
2. SCORES Portal: To help investors file and track complaints
3. Digital Literacy: YouTube videos, courses, and booklets in regional languages

 

Sample Example: SEBI Bans Front-Running in Mutual Funds

Front-running is a malpractice where an intermediary or insider trades securities based on advance knowledge of large transactions that will affect the price.

Recent Case: SEBI took strict action by banning mutual fund distributors and fund managers from front-running, after discovering that they had misused internal trade information to profit from future price movements.

 

Multiple-choice Questions Assessment

1. What market is used to issue new securities?
a) Forex Market               b) Primary Market          c) Derivatives Market    d) Secondary Market

2. The bonus is intended for:

a) new investors             b) SEBI officials               c) the government          d) current shareholders.

3. Which of the following best describes how the Indian capital market is governed?
a) RBI                                  b) NABARD                       c) IRDAI                             d) SEBI

Fill in the blanks

1. The procedure known as ………………….. is used to convert tangible shares into electronic form. (Dematerialization )
2. The NSE uses the …………………. trading  system. (NEAT)
3. …………….term instruments are traded on the capital market. (Long)

Short-answer questions

1. Describe the capital market. (Hint: Long-term securities market)
2. Describe two ways that the primary and secondary markets differ from one another

3. Name any two financial instruments. (Hint: Debentures and Equity)

Long-answer questions
1. Describe the Indian capital market's composition and operations. (Hint: liquidity, capital mobilization, primary and secondary markets)
2. How are new issues of securities floated in the primary market? (Hint: private placement, rights, bonus, IPO)

Case Study Based Question:

ABC Pvt. Ltd., a new company in the electric vehicle market, wants to raise ₹500 crore in order to grow. They are thinking of doing a private placement or an IPO.

Q1: What are each method's benefits and drawbacks?
Q2: What kind of regulatory clearances are required?
Q3: How will the secondary market increase the company's value if it is listed?

 

Module IV: Institutional Structure

4.1 Overview
Development banks are specialized financial institutions established to provide long-term capital for projects that are crucial to economic development but may not be adequately served by commercial banks due to their high risk, long gestation periods, or low profitability in the short run.

Unlike commercial banks, development banks do not accept deposits from the public. Instead, they raise funds from government support, international financial institutions, and bond markets. They aim to promote industrial growth, infrastructure development, agriculture, and regional development, especially in underdeveloped areas.

Characteristics of Development Banks

1. Project-based Financing: Provide finance for capital-intensive projects with long gestation periods.
2. Sector-Specific Focus: Targeted financing for sectors like agriculture, MSMEs, infrastructure, and heavy industries.
3. Government Support: Most development banks are supported or owned by the government.
4. Non-commercial Objectives: Primary goal is economic development, not profit maximization.

4.2 India's Development Banks

a) Industrial Development Bank of India (IDBI)

1. Established in 1964 under the IDBI Act.
2. Objective: To provide financial assistance for industrial development in India.
3. Functions:

Ø  Direct financial assistance through loans and equity subscription.

Ø  Indirect assistance by refinancing loans extended by other institutions.

Ø  Promotional activities like entrepreneurship development and technical consultancy.

Example: IDBI has supported infrastructure projects like power generation, telecom, and industrial estates.

 

b) Industrial Finance Corporation of India (IFCI)

1. Set up in 1948 as the first development financial institution in India.
2. Objective: To provide medium and long-term credit to industrial undertakings.
3. Activities include:

Ø  Project finance

Ø  Structured finance

Ø  Corporate advisory services

 

 

c) Small Industries Development Bank of India (SIDBI)

1. Established in 1990 as a subsidiary of IDBI, now an independent institution.
2. Objective: Promotion, financing, and development of Micro, Small and Medium Enterprises (MSMEs).
3. Offers:

Ø  Refinance to banks and NBFCs lending to MSMEs.

Ø  Direct loans for expansion and modernization.

Ø  Support for innovation and technology upgradation.

Example: SIDBI’s role in implementing the Stand-Up India and Credit Guarantee Fund Scheme.

---

d) National Bank for Agriculture and Rural Development (NABARD)

1. Established in 1982 following the recommendations of the Sivaraman Committee.
2. Objective: To provide and regulate credit for agricultural and rural development.
3. Functions:

Ø  Refinance credit for rural infrastructure.

Ø  Promote rural credit institutions like cooperative banks and RRBs.

Ø  Supervise rural financial institutions.

 
4.3 Investment Institutions — UTI and Other Mutual Funds

Investment institutions are financial intermediaries that mobilize the savings of investors and channel them into a diversified portfolio of financial assets. They play a key role in capital formation, market development, and financial inclusion, especially for retail investors who lack the expertise or time to invest directly in capital markets.

Unit Trust of India (UTI)

a) Establishment and Background

• Formed in 1964 under the Unit Trust of India Act, 1963, UTI was India's first mutual fund.
• Sponsored by the Reserve Bank of India and later came under IDBI.
• Objective: To mobilize household savings and promote investment in capital markets by offering a low-risk, diversified investment vehicle.

b) Role and Contributions

Ø  Pioneered the concept of mutual funds in India.

Ø  Popularised the idea of small-ticket investments with schemes like Unit Scheme 1964 (US-64) – the first and most popular scheme in Indian mutual fund history.

Ø  Played a critical role in Expanding the investor base

Ø  Channelling retail savings into equity and debt markets

Ø  Supporting public sector disinvestment programs

 

c) Structural Reforms

In 2002, following the US-64 crisis, UTI was bifurcated into:

          I.               UTI Mutual Fund – regulated by SEBI, operating like any other mutual fund.

        II.               Specified Undertaking of UTI (SUUTI) – managed the assured return schemes and government obligations.

 

Mutual Funds in India

A mutual fund is a financial intermediary that pools money from multiple investors and invests in diversified securities like equities, bonds, or money market instruments. Each investor owns units proportional to their contribution.

Types of Mutual Funds

Type	Features
Equity Funds	Invest in stocks; suitable for long-term growth.
Debt Funds	Invest in government securities, bonds, etc.; lower risk.
Hybrid Funds	Mix of equity and debt investments.
Liquid Funds	Invest in short-term money market instruments; high liquidity.
Index Funds	Mirror a specific stock index like Nifty or Sensex.
ELSS (Equity Linked Saving Schemes)	Tax-saving with lock-in of 3 years.

 

4.4 Insurance Companies

Concept of Insurance

Definition: “Insurance is a contract in which a person (the insured) pays a premium to an insurance company (the insurer) to receive financial protection or reimbursement against specific potential losses or risks.”

Insurance is a financial arrangement that provides protection against risk or unforeseen loss. It works on the principle of risk pooling — many individuals pay a premium to create a fund, from which losses incurred by any member of the pool are compensated. Insurance thus promotes financial security and stability.

Classification of Insurance

Insurance in India is broadly classified into two categories:

A. Life Insurance

Life insurance provides financial compensation upon the death or survival of the insured for a specified period. It is primarily used for income protection, savings, and wealth transfer.

Common Life Insurance Products:

Ø  Term Insurance: Offers pure life cover for a fixed term.

Ø  Endowment Plans: Combine insurance with savings.

Ø  Unit Linked Insurance Plans (ULIPs): Investment-cum-insurance product.

Ø  Pension/Annuity Plans: Provide income post-retirement.

B. Non-Life Insurance (General Insurance)

Non-life insurance covers losses other than life, such as health, assets, and liability risks. These are usually annual contracts.

Types of Non-Life Insurance:

Ø  Health Insurance: Covers medical expenses (e.g., Ayushman Bharat).

Ø  Motor Insurance: Covers damage to vehicle and liability (mandatory in India).

Ø  Fire Insurance: Protects against fire-related damages.

Ø  Marine Insurance: Covers goods in transit by sea or air.

Ø  Crop Insurance: Government-supported insurance for farmers (e.g., PMFBY).

Difference between Life Insurance and Non-Life Insurance

Basis	Life Insurance	Non-Life Insurance
Coverage	Human life	Assets, liabilities, health
Tenure	Long-term	Usually one year
Claim Event	Death or survival of insured	Event like accident, hospitalization, fire
Examples	LIC term plan, ICICI ULIP	Star Health, New India Assurance, HDFC Ergo

 

 

 Major Insurance Companies in India

A. Life Insurance Corporation of India (LIC)

The Life Insurance Corporation of India (LIC) is the largest and oldest life insurance organization in India. It was established in 1956 under the LIC Act, 1956, following the nationalization of 245 private life insurance companies operating at the time.

Objectives of LIC

Ø  To spread life insurance as a means of social security and financial protection.

Ø  To mobilize long-term savings from households and channel them into productive investments.

Ø  To act as a trustee of policyholders’ money, ensuring safety and returns.

Functions and Role of LIC

Function	Description
Insurance Coverage	Provides life insurance policies like term plans, endowment plans, ULIPs, and pensions.
Capital Formation	Invests large corpus from premiums into infrastructure, government securities, and capital markets.
Social Welfare	Provides insurance in rural and economically weaker sections via micro-insurance.
Financial Inclusion	Operates across semi-urban and rural areas, promoting insurance literacy.

 

B. Private Life Insurance Companies

Ø  HDFC Life Insurance

Ø  ICICI Prudential Life

Ø  SBI Life Insurance

Ø  Max Life Insurance

C. Major General Insurance Companies

• Public Sector:

Ø  New India Assurance

Ø  United India Insurance

Ø  Oriental Insurance

Ø  National Insurance Company

• Private Sector:

Ø  ICICI Lombard General Insurance

Ø  HDFC Ergo

Ø  Bajaj Allianz

Ø  Reliance General Insurance

D. Health Insurance Specialists

Ø  Star Health and Allied Insurance

Ø  Niva Bupa

Ø  Care Health Insurance

4.5 Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) is the apex regulatory body of the Indian capital market. It was established in 1988 and given statutory powers through the SEBI Act, 1992. It functions under the Ministry of Finance, Government of India.

SEBI has jurisdiction over:

Ø  Stock exchanges (e.g., BSE, NSE)

Ø  Listed companies

Ø  Market intermediaries (brokers, merchant bankers, mutual funds, etc.)

Ø  Investor protection and education

Ø  Regulation of corporate disclosures and insider trading

 

Functions of SEBI

A. Regulatory Functions

Ø  Registering and regulating stockbrokers, sub-brokers, merchant bankers, portfolio managers, etc.

Ø  Regulating mutual funds and venture capital funds.

Ø  Framing rules for takeover of companies, buybacks, and delisting.

B. Developmental Functions

Ø  Promoting fair practices and transparency in the securities market.

Ø  Conducting investor education and awareness programs.

Ø  Facilitating online trading systems and modern surveillance tools.

C. Protective Functions

Ø  Prohibiting fraudulent and unfair trade practices.

Ø  Regulating insider trading (trading based on unpublished price-sensitive information).

Ø  Taking disciplinary actions against violators.

 

Objectives of SEBI

Objective	Explanation
Investor Protection	Ensure that investors are not cheated and are given timely, accurate information.
Market Efficiency	Enhance transparency, reduce delays, and promote online systems (e.g., T+1 settlement).
Regulation of Market Intermediaries	Ensure ethical conduct and compliance from brokers, funds, and companies.
Promote Healthy Capital Formation	Facilitate fundraising through IPOs, bonds, rights issues, etc., with adequate disclosures.

 

 

 

 SEBI’s Major Reforms and Initiatives

Ø  SME Exchange & Start-up Platform: Helping smaller companies raise capital efficiently.

Ø  Investor Grievance Redressal System (SCORES): Digital portal for complaints.

Ø  Real-time Surveillance Mechanism: Detects abnormal trading patterns instantly.

Ø  Mandatory KYC and PAN linkage: For transparency and prevention of money laundering.

Ø  Online Disclosure Systems: Simplifying compliance via portals like SEBI Intermediary Portal and Listing Disclosure Portal.

 

 

4.6 Reserve Bank of India(RBI)

The Reserve Bank of India (RBI) is the central bank of India, established on 1st April 1935 under the RBI Act, 1934. Initially privately owned, it was nationalized in 1949, and since then it has operated as a statutory body wholly owned by the Government of India.

RBI plays a crucial role in regulating the monetary and financial system of the country. It is known as the banker’s bank, the currency-issuing authority, and the chief regulator of the Indian financial system.

Objectives of the RBI

Ø  To maintain price stability and ensure adequate flow of credit to productive sectors.

Ø  To manage the country’s currency and foreign exchange reserves.

Ø  To regulate and supervise banks and financial institutions.

Ø  To promote financial inclusion and a robust payment system.

 

Functions of the Reserve Bank of India

The functions of RBI can be classified into traditional (central banking) and developmental roles:

Traditional (central banking) Function:

A. Monetary Authority : RBI formulates and implements monetary policy to control inflation and ensure liquidity. It uses tools like:

Ø  Repo Rate

Ø  Reverse Repo Rate

Ø  Cash Reserve Ratio (CRR)

Ø  Statutory Liquidity Ratio (SLR)

Ø  Open Market Operations (OMO)

Example: In response to COVID-19, RBI reduced the repo rate to boost liquidity.

 

 

B. Issuer of Currency

Ø  Sole authority for the issuance of currency notes in India (except ₹1 notes and coins issued by the Government of India).

Ø  Ensures adequate supply and quality of currency through a currency management system.

Note: The ₹500 and ₹2000 notes were demonetized and remonetized under RBI supervision in 2016.

 

C. Custodian of Foreign Exchange

Ø  Manages India’s foreign exchange reserves.

Ø  Regulates the foreign exchange market under FEMA, 1999.

Ø  Maintains exchange rate stability and facilitates trade and investment.

Example: RBI intervenes in the forex market to prevent excessive volatility of the rupee.

 

D. Regulator and Supervisor of the Financial System

Ø  Grants licenses to banks and NBFCs.

Ø  Prescribes capital adequacy norms (e.g., Basel III compliance).

Ø  Monitors the health of the financial system through inspections and audits.

Ø  Ensures customer protection and risk management in banks.

Recent Example: RBI cancelled licenses of non-compliant cooperative banks to safeguard depositors’ money.

 

E. Banker to the Government

Ø  Manages the banking requirements of Central and State Governments.

Ø  Handles public debt, disbursements, and treasury operations.

Ø  Issues government bonds and conducts borrowing programs.

Example: RBI conducted auctions of G-Secs (Government Securities) for Union Budget financing.

 

F. Banker’s Bank

Ø  Provides liquidity support to commercial banks via LAF (Liquidity Adjustment Facility).

Ø  Acts as a clearinghouse for interbank settlements.

 

G. Promoter of Financial Inclusion and Development

Ø  Promotes rural and priority sector lending.

Ø  Encourages the expansion of banking services in underserved areas.

Ø  Supports institutions like NABARD, SIDBI, and NHB.

Example: The Pradhan Mantri Jan Dhan Yojana (PMJDY) was actively supported by RBI for increasing financial access.

 

Developmental Function:

Ø  Conducts research and publishes reports like the Financial Stability Report, Monetary Policy Report, etc.

Ø  Promotes digital payment ecosystems (e.g., UPI, Bharat QR).

Ø  Supervises innovations in fintech and payment banks.

 

Recent Reforms and Initiatives by RBI

Initiative	Description
Digital Rupee Pilot	Launched in 2022 as a Central Bank Digital Currency (CBDC)
PCA Framework	Strengthened rules for weak banks under Prompt Corrective Action
RBI Innovation Hub	Fosters innovation in financial services
Account Aggregator System	Facilitates secure and consent-based data sharing

 

Assessment:

Multiple-choice Questions
1. Which organization helps MSMEs in India?
a) NABARD                       b) SIDBI              c) IRDAI              d) UTI

2. The main activities of LIC are:

 a) trading in mutual funds         b) life insurance             c) stock broking             d) trading in derivatives.

3. SEBI oversees:
a)Regulation of currency                                          b) setting insurance premiums  

c) capital market regulation                                    d)money printing

Fill in the  the Blanks
1. In 1956, ……………………………. was founded to provide life insurance in India. (LIC)
2. In India, mutual funds are governed by  ……………………………………………………( SEBI)
3. The investment firm that started the US-64 scheme is …………………………….. (UTI)

 

Short Answer Questions
1. Name two Indian development banks. (SIDBI, IFCI)
2. How does SEBI contribute to investor protection? (Hint: Regulates, keeps an eye on fraud, and instructs.)
3. Describe the two purposes of mutual funds. (Hint: Diversifying your portfolio and pooling savings.)

Long  Answer Questions
1. Explain the key functions and significance of SEBI in regulating and developing the Indian capital market. (Hint: Discuss its role in investor protection, market development, and regulatory oversight.)

2. Discuss how development banks contribute to economic development in India.
(Hint: Highlight their role in sector-specific financing and provision of long-term capital for infrastructure and industrial growth.)

Case Study Based Question

Priya, a salaried professional and first-time retail investor, has recently received a bonus of ₹5 lakhs. She wants to invest in a safe mutual fund scheme that offers reasonable returns. Along with this, she plans to purchase a term insurance policy to secure her family’s future. Being financially aware, Priya is also exploring the idea of entering the stock market in the future. However, she is cautious and wants to ensure her investor rights are protected, and she operates within a regulated and transparent financial system.

 

Questions:

1.Which financial institutions or organizations can guide Priya in choosing and investing in mutual funds? (Hint: Consider the role of AMCs like SBI Mutual Fund, HDFC AMC, and the regulatory oversight by SEBI.)

 

2.Which insurance provider should Priya consider for her term insurance, and what factors should she evaluate before selecting one? (Hint: Refer to public insurers like LIC and private players like ICICI Prudential, with a focus on claim settlement ratio, premium, and coverage.)

 

3.In what ways does SEBI help ensure that Priya’s investments in the capital market are secure, fair, and transparent?(Hint: Discuss SEBI’s role in regulating intermediaries, preventing fraud, mandating disclosures, and promoting investor education.) 

 

 

 

 

 

 

 

Module V: Financial Products

 5.1 Leasing :  Leasing is a contractual arrangement where the owner of an asset (lessor) allows another party (lessee) to use the asset for a specific period in return for periodic lease rentals.

Types of Leasing:

1. Operating Lease

2.Financial Lease

 

Operating Lease : An Operating Lease is a short-term leasing arrangement where the ownership, risk, and maintenance responsibilities remain with the lessor (the owner of the asset). The lessee (the user) pays for using the asset for a limited period and returns it after the lease term.

Key Features:

Ø  Duration: Short-term (usually much shorter than the useful life of the asset).

Ø  Risk & Reward: Retained by the lessor.

Ø  Maintenance: Lessor is responsible for maintenance and repairs.

Ø  Cancellation: Lease can usually be cancelled by the lessee with notice.

Example :

Ø  Jet Airways leasing aircraft from foreign companies for 5–6 years without transferring ownership is a typical example of an operating lease.

Ø  Retail sector: Brands lease display equipment for festive seasons or events.

Financial Lease : A Financial Lease (also called Capital Lease) is a long-term leasing arrangement in which the lessee assumes the risks and rewards of ownership, including maintenance and obsolescence. Although the lessee doesn’t legally own the asset, the lease is structured to cover nearly the entire useful life of the asset.

Key Features:

Ø  Duration: Long-term and often non-cancellable.

Ø  Risk & Reward: Transferred to the lessee.

Ø  Maintenance: Lessee is responsible for maintenance and insurance.

Ø  Ownership Option: May include a bargain purchase option at the end of the lease.

Example :

Ø  Tata Motors leasing commercial vehicles to transport firms through Tata Capital.

Ø  A manufacturing company leasing heavy machinery (e.g., CNC machines) under a financial lease agreement for 10 years.

 

Difference Between Operating and Financial Lease

Feature	Operating Lease	Financial Lease
Duration	Short-term	Long-term
Ownership	Retained by lessor	May transfer to lessee at end (indirectly)
Risk & Maintenance	Lessor bears	Lessee bears
Cancellation	Generally cancellable	Non-cancellable
Balance Sheet	Often off-balance sheet (old rules)	On-balance sheet
Suitable For	Seasonal or temporary use of asset	Long-term business needs

 

5.2 HIRE PURCHASE :  A system in which the buyer takes possession of goods by paying an initial down payment and pays the remaining amount in instalments. Ownership is transferred only after the final payment.

Example: Buying a car from Mahindra Finance on a hire purchase agreement.

Key Features:

Ø  Instalment payments

Ø  Ownership after final payment

Ø  High cost due to interest

Difference: Leasing vs Hire Purchase

Criteria	Leasing	Hire Purchase
Ownership	Stays with lessor	Transfers after final payment
Risk & Maintenance	By lessee (financial lease)	By buyer
Down payment	May or may not	Generally required

 

5.3 FACTORING : Factoring is a financial transaction where a business sells its accounts receivables (invoices) to a third party (factor) at a discount to improve liquidity.

Types of Factoring:

Ø  Recourse Factoring

Ø  Non-recourse Factoring

 

 

Recourse Factoring: In recourse factoring, the seller of the receivables (usually a business) remains liable for non-payment by the customer. If the debtor (customer) does not pay the amount due, the factor has the right to recover the unpaid amount from the business that sold the receivable.

🏦 How It Works:

1. Business sells goods/services to a customer on credit.
2. Business assigns the invoice to a factor.
3. Factor pays around 80-90% of invoice value upfront.
4. If the customer fails to pay, the factor recovers the amount from the business.

📌 Example: Let’s say an Indian textile exporter sells fabric worth ₹10 lakhs to a buyer in Europe and avails recourse factoring from SBI Global Factors. If the European buyer defaults, SBI Global Factors will recover the amount from the exporter.

✅ Advantages:

Ø  Lower cost compared to non-recourse factoring.

Ø  Easier to obtain, especially for small businesses.

Ø  Factor may still handle collection and credit monitoring.

❌ Disadvantages:

Ø  Risk of bad debts remains with the seller.

Ø  May strain finances if customer defaults.

Ø  Limited protection against insolvency of the debtor.

 

 

Non-Recourse Factoring:  In non-recourse factoring, the factor bears the risk of non-payment by the customer due to insolvency or financial inability to pay. Once the receivable is sold, the business has no further liability.

🏦 How It Works:

1. Business sells goods/services and assigns the invoice to the factor.
2. Factor pays advance (usually lower, around 70-85%).
3. If the customer defaults due to insolvency, the factor absorbs the loss.

📌 Example: An Indian SME exports machinery to a buyer in the U.S. and opts for non-recourse factoring from Export Credit Guarantee Corporation of India (ECGC)-backed factor. If the U.S. buyer goes bankrupt, the factor absorbs the loss, not the Indian exporter.

✅ Advantages:

Ø  Complete protection from bad debts due to insolvency.

Ø  Ideal for exporters dealing with high-risk clients or countries.

Ø  Better financial planning as future losses are covered.

 

❌ Disadvantages:

Ø  More expensive due to risk borne by the factor.

Ø  Not all receivables may qualify (only creditworthy debtors).

Ø  Stricter credit checks and documentation.

 

🔄 Key Differences Between Recourse and Non-Recourse Factoring

Feature	Recourse Factoring	Non-Recourse Factoring
Risk of Non-payment	On the business (seller)	On the factor
Cost	Lower	Higher
Liability	Seller liable for bad debts	Factor bears loss due to insolvency
Credit Protection	No	Yes
Availability	More common, easier to get	Less common, stricter criteria
Advance Rate	80–90%	70–85%

 

 

5.4 FORFAITING :  Forfaiting is a form of export financing in which an exporter sells its medium to long-term receivables (such as bills or promissory notes) to a forfaiter (usually a financial institution or bank) at a discount, on a non-recourse basis, in exchange for immediate cash.

In simple words, the exporter gets paid immediately and transfers the risk of collection, default, or political instability to the forfaiter.

 

🔄 How Forfaiting Works – Step-by-Step

1. Exporter sells goods to a foreign buyer on deferred payment terms (e.g., 6 months to 5 years).
2. Exporter approaches a forfaiter (bank or specialized institution) to discount the receivables.
3. Forfaiter pays the exporter upfront (after deducting the discount/interest).
4. The forfaiter collects the payments from the importer as per the agreed schedule.
5. Even if the importer defaults, the exporter is not liable (non-recourse).

 

🌍 Example: An Indian engineering company exports machinery worth ₹10 crore to a buyer in Africa with a 3-year payment term.

          I.               The exporter doesn’t want to wait 3 years to receive full payment.

2. It approaches EXIM Bank of India, which agrees to forfait the bills.
3. EXIM Bank pays ₹9 crore now (after discount) and later collects the full ₹10 crore from the African buyer over 3 years.
4. If the buyer fails to pay, the Indian company faces no loss—the bank bears the risk.

 

📈 Key Features of Forfaiting

Feature	Description
Risk Transfer	Exporter transfers credit and political risk to forfaiter
Non-recourse	Forfaiter cannot ask exporter for repayment if buyer defaults
Immediate Cash Flow	Exporter gets instant payment, improves working capital
Used in	Medium to long-term international trade deals
Instruments	Bills of exchange, promissory notes, letters of credit (LCs)
Tenure	Usually from 180 days to 7 years
Currency	Often in foreign currency (USD, Euro, etc.)

 

✅ Advantages of Forfaiting for Exporters

Ø  Immediate cash without waiting for credit period to end.

Ø   No risk of buyer default or country risk.

Ø   Improves balance sheet by removing receivables.

Ø   Simplifies documentation and administration.

Ø   No impact of interest rate fluctuations (fixed discounting).

 

❌ Disadvantages / Limitations

Ø  Higher cost due to risk premium and discounting charges.

Ø  Requires guarantees or letters of credit from reputed banks.

Ø  Applicable mainly in international trade, not local/domestic.

 

 Forfaiting vs. Factoring – Key Differences

Basis	Forfaiting	Factoring
Scope	Used in international trade	Used in domestic and international
Tenure	Medium to long-term (180 days to years)	Short-term (30–180 days)
Recourse	Always non-recourse	Can be recourse or non-recourse
Type of Receivables	Specific bills or promissory notes	All accounts receivable
Used By	Mostly exporters	Domestic and export businesses

 

5.5 CREDIT RATING :  Credit rating is the evaluation of the creditworthiness of a borrower or debt instrument by a rating agency.

Rating Agencies in India:

Ø  CRISIL

Ø  ICRA

Ø  CARE Ratings

Functions of Credit Rating:

1. Assess credit risk of companies and instruments.
2. Helps investors make informed decisions.
3. Aids companies in accessing capital.

Importance:

1. Enhances transparency
2. Reduces information asymmetry
3. Helps in pricing of debt instruments

Example: CRISIL AAA rating given to sovereign bonds or blue-chip companies like Reliance.

Rating Scale (Illustrative):

• AAA: Highest safety
• AA: High safety
• A: Adequate safety
• BBB: Moderate safety

 

 

 

 

 

 

 

5.6 DERIVATIVES(  Basic Introduction only)

Derivative is a financial instrument whose value is derived from an underlying asset such as stocks, bonds, commodities, currencies, interest rates, or market indices. It is not an asset itself, but a contract between two parties that is based on the price movement of the underlying asset.

Examples of Underlying Assets:

Ø  Stock (e.g., Infosys, Reliance)

Ø  Commodity (e.g., Gold, Crude Oil)

Ø  Currency (e.g., USD/INR)

Ø  Index (e.g., Nifty 50)

Ø  Interest Rates (e.g., 10-year government bond yield)

 

📌 Key Features of Derivative :

1. It derives its value from another asset.
2. Used for hedging (risk management), speculation, and arbitrage.
3. Traded on exchanges (like NSE, BSE) or over the counter (OTC).
4. Helps manage future price uncertainties.

 

 TYPES OF DERIVATIVES :  Derivatives are primarily of four types.

          I.               Forward Contracts

        II.               Futures Contracts

      III.               Options Contracts

     IV.               Swaps

 

 i. Forward Contracts : A  forward contract is a private agreement between two people or businesses to buy or sell something at a fixed price on a future date.It helps to lock in a price today to avoid uncertainty about the price in the future.

📌 Example:  Imagine a small wheat farmer named Ramesh who is preparing for his harvest in three months. He is worried that by the time the wheat is ready, the market price might fall, and he won’t get a good return. On the other hand, a local bakery owned by Meera depends on wheat for baking bread and biscuits. She is concerned that wheat prices might go up in the next few months, which would increase her costs.

To protect themselves from this uncertainty, Ramesh and Meera enter into a forward contract. They agree that Meera will buy 1,000 kg of wheat from Ramesh at a fixed price of ₹25 per kg, to be delivered three months later. That means, no matter what the market price of wheat is after three months—whether it goes up to ₹30 or falls to ₹20—Meera will pay ₹25,000 to Ramesh, and Ramesh will deliver the wheat as promised.

Through this simple agreement:

Ø  Ramesh, the farmer, is protected from a fall in wheat prices.

Ø  Meera, the bakery owner, is protected from a rise in wheat prices.

This is how a forward contract works—by giving both parties price certainty and helping them plan better for the future.

 

 

ii. Futures Contracts : A futures contract is a standardized agreement traded on a regulated exchange to buy or sell an asset at a predetermined price on a specific future date. Both parties are obligated to fulfill the contract. The exchange ensures safety through a margin system and daily settlement.

 

📌 Example: Stock Futures traded at NSE

Aman ( investor) believes that the stock price of Infosys Ltd. will rise over the next month. He decides to buy a stock futures contract on Infosys at the NSE as per details given below:

Stock	Infosys Ltd.
Lot size (as per NSE)	300 shares
Futures Price (Current)	₹1,500 per share
Expiry Date	Last Thursday of the month (say, 27th June)
Total Contract Value	₹1,500 × 300 = ₹4,50,000
Margin Required (say 20%)	₹90,000 (approx.)

 

Stock Futures Example – Infosys (Lot Size = 300 Shares)

Particulars	Scenario 1: Price Rises 📈	Scenario 2: Price Falls 📉
Futures Buy Price	₹1,500	₹1,500
Futures Sell Price on Expiry	₹1,550	₹1,450
Difference (Sell - Buy)	₹50 Profit	₹50 Loss
Lot Size (NSE Standard)	300 shares	300 shares
Total Gain / Loss	₹50 × 300 = ₹15,000 ✅	₹50 × 300 = ₹15,000 ❌
Initial Margin Paid (Approx. 20%)	₹90,000	₹90,000
Return on Margin Capital	₹15,000 ÷ ₹90,000 = 16.67%	₹15,000 loss on ₹90,000 = -16.67%

 

 

 

 

Key Points about Stock Futures:

Ø  Stock futures on NSE are standardized contracts with fixed lot sizes.

Ø  Trader is obligated to buy/sell on expiry unless they square off before that.

Ø  Margin money is required, which gives leverage (only a fraction of full value is paid upfront).

Ø  Profit or loss depends on movement of the stock price.

 

iii. Options Contracts : An option gives the right but not the obligation to buy (Call option) or sell (Put option) an asset at a certain price before or on a specific date.

Use of Option Contracts

Ø  Hedging risk in stock prices

Ø  Speculation on market movements

Ø  Portfolio protection (using puts)

 

Types of Options Contracts: There are two main types of options:

a)Call Option

Ø  Gives the buyer the right (but not the obligation) to buy an asset at a fixed price (called strike price) before or on the expiry date.

Ø  Buyer pays a premium to buy this right.

Ø  Used when the buyer expects the price to rise.

 

CALL OPTION EXAMPLE (Stock: Infosys) Contract Details:

 

Type	Call Option
Strike Price	₹1,500
Lot Size	300 shares
Premium Paid	₹20 per share
Total Premium Paid	₹6,000 (₹20 × 300)
Expiry	End of the month

 

 

 

 

 

 

Call Option  Scenarios :

Particulars	Scenario 1: Price Rises	Scenario 2: Price Falls
Spot Price at Expiry	₹1,550	₹1,450
Strike Price	₹1,500	₹1,500
Option Type	Call Option	Call Option
Profit per share	₹50 (₹1,550 - ₹1,500)	₹0 (not exercised)
Net Profit (after Premium)	₹50 - ₹20 = ₹30 × 300 = ₹9,000 ✅	Loss of ₹6,000 premium ❌

 

b)Put Option

Ø  Gives the buyer the right (but not the obligation) to sell an asset at a fixed price before or on expiry.

Ø  Buyer pays a premium for this right.

Ø  Used when the buyer expects the price to fall.

 

PUT OPTION EXAMPLE (Stock: Infosys) : Contract Details:

Type	Put Option
Strike Price	₹1,500
Lot Size	300 shares
Premium Paid	₹25 per share
Total Premium Paid	₹7,500
Expiry	End of the month

 

Put Option Scenarios :

Particulars	Scenario 1: Price Falls 📉	Scenario 2: Price Rises 📈
Spot Price at Expiry	₹1,450	₹1,550
Strike Price	₹1,500	₹1,500
Option Type	Put Option	Put Option
Profit per share	₹50 (₹1,500 - ₹1,450)	₹0 (not exercised)
Net Profit (after Premium)	₹50 - ₹25 = ₹25 × 300 = ₹7,500 ✅	Loss of ₹7,500 premium ❌

 

 

 

 

 

Summary of Options

Type	Market Expectation	Maximum Loss	Maximum Gain
Call Option	Price will rise	Limited to premium paid	Unlimited (if price rises high)
Put Option	Price will fall	Limited to premium paid	Limited (till price = 0)

 

 

iv. Swaps : A swap is a financial agreement between two parties to exchange cash flows or liabilities over a period of time. The main goal is to manage risk, reduce cost, or take advantage of market conditions. Swaps are customized contracts and usually traded over-the-counter (OTC)—i.e., not on exchanges.

 

Summary Table: Use of Swaps

Use of Swap	Type of Swap Used	Who Uses It?	Purpose
Hedge against interest rate risk	Interest Rate Swap	Companies, Banks	Convert floating to fixed (or vice versa)
Hedge currency fluctuations	Currency Swap	Exporters, MNCs	Lock in exchange rates
Reduce cost of borrowing	Interest or Currency Swap	Corporates	Access lower effective interest rates
Speculation	Interest/Currency/Commodity	Traders, Funds	Profit from rate or price movements
Balance cash flows (ALM)	Interest Rate Swap	Banks	Match assets & liabilities

 

 

Customized

Most Types of Swaps

Here are the most common types of swaps:

Type of Swap	What is Exchanged	Used For
1. Interest Rate Swap	Fixed interest rate ↔ Floating interest rate	To manage interest rate risk
2. Currency Swap	Interest & principal in one currency ↔ another	To hedge currency risk in international trade
3. Commodity Swap	Fixed price of a commodity ↔ floating price	To manage commodity price risk
4. Credit Default Swap	Credit risk of a borrower is transferred	To protect against default

 

 

Interest Rate Swap – Two Scenarios Table

Particulars	Scenario 1: MCLR Rises to 8.5% (Floating = 9.5%)	Scenario 2: MCLR Falls to 7.5% (Floating = 8.5%)
Company A's Loan Type	Floating (MCLR + 1%) = 9.5%	Floating (MCLR + 1%) = 8.5%
Company B's Loan Type	Fixed = 9%	Fixed = 9%
Swap Agreement	A pays 9% fixed to B; B pays floating (M+1%) to A	A pays 9% fixed to B; B pays floating (M+1%) to A
Actual Payment by A to Bank	₹9.5 lakh	₹8.5 lakh
Payment A Receives from B (Floating)	₹9.5 lakh	₹8.5 lakh
Payment A Makes to B (Fixed)	₹9 lakh	₹9 lakh
A’s Net Interest Cost	₹9 lakh ✅	₹9 lakh ❌
B’s Net Interest Cost	₹9.5 lakh ❌	₹8.5 lakh ✅

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✅ Summary:

Ø  When interest rates rise, Company A benefits because it locked into a lower fixed rate.

Ø  When interest rates fall, Company B benefits as it effectively pays a lower floating rate.

Ø  The swap allows each company to tailor their interest payments to their risk preferences or market expectations.

 

 

 

 

 

Summary Table of Derivatives

Type of Derivative	Market	Nature	Example
Forwards	OTC	Customized	Exporter locks USD-INR rate at ₹83
Futures	Exchange-traded	Standardized	Buys Nifty Futures at 22,000
Options	Exchange/OTC	Right, not obligation	Buys Call Option on Reliance @ ₹2,500
Swaps	OTC	Exchange of cash flows	Interest rate swap between banks

 

 

 

Assessment – Module V

MCQs

1. In a hire purchase agreement, ownership is transferred:
• a) Immediately
• b) On down payment
• c) After last instalment ✅
• d) Never
2. Which of the following is a credit rating agency in India?
• a) SBI
• b) SEBI
• c) CRISIL ✅
• d) LIC
3. Factoring is mainly used to:
• a) Buy machinery
• b) Finance receivables ✅
• c) Pay dividends
• d) Get term loans

 

Fill in the Blanks

1. _________ is the process of selling receivables to a third party for instant cash. (Answer: Factoring)
2. _________ contracts are traded on exchanges and are standardized. (Answer: Futures)
3. _________ rating indicates the highest level of creditworthiness. (Answer: AAA)

 

Short Answer Questions

1. What is the difference between leasing and hire purchase? (Hint: Ownership transfer, risk, duration)
2. Define credit rating and name two Indian agencies. (Hint: CRISIL, ICRA)
3. List any two applications of derivatives. (Hint: Hedging, speculation)

 

Long Answer Questions

1. Explain the concept of factoring and forfeiting with examples. (Hint: Domestic vs Export, duration, recourse)
2. Discuss the significance of credit rating in capital markets. (Hint: Risk assessment, investor trust)
3. Write a detailed note on financial derivatives and their types. (Hint: Forward, futures, options, swaps)

 

Case Study Based Question

Case: An Indian export firm dealing in textiles is struggling with delayed payments from European buyers. It also plans to hedge currency risk due to volatility in the euro.

• Q1: Which financial product can help them get immediate funds from receivables?
• Q2: What tool can they use to hedge against forex risk?
• Q3: How can credit rating of the exporter improve their market reputation and lending terms?