Financial Markets

  • Introduction to Money Markets

    • Liquidity mismatch often occurs in the short run as cash inflows and outflows rarely synchronize. It is important to manage the same carefully, to avoid liquidity crisis in case of deficit and idle funds that do not bear interest in case of surplus.
    • The money market is a formal financial market that deals with short-term fund management. It involves high volumes and is dominated by a relatively small number of players, namely: Governments, central banks, banks, financial institutions, corporates, mutual funds, foreign institutional investors, discount houses, acceptance houses and market makers (primary dealers).
    • Repo transactions are popular mechanisms to deploy/borrow short-term funds in the money market, by selling securities to another party with an agreement to buyback the same at a later date.
    • The main risks associated with money market instruments/investments are: Market risk, Interest rate risk, Reinvestment risk, Default risk, Inflation risk, Currency risk and Political risk.
    • The main money market securities in the US market are: Government securities (T-bills), municipal notes, federal agency securities, call loan market, repos and reverses, certificates of deposit, Eurodollar deposits and Eurodollar CDs, Yankee CDs, loan participations, bankers' acceptances, commercial papers, Euro commercial papers in Europe and commercial bills.
    • The main objectives of the monetary policy are: Price stability and economic growth. The most critical factors in a monetary policy are: Money supply, Interest rate stability and Exchange rate stability.
    • Monetary contraction can be resorted to control inflation, by adopting one of the following measures: Increase the statutory reserves (CRR and SLR), undertake repo transactions or go in for open market operations.
    • The RBI controls the money market in India by adopting the following measures: Changes in CRR, changes in SLR, open market operations, reduction in bank and repo rates.
    • The main objectives of the primary dealers are: Enhance liquidity of the money market, become underwriters and market makers for government securities, activate the secondary market for government securities and aid the RBI in open market operations.
    • Subsidiaries of nationalized banks, FIs and security business companies can become primary dealers, if they have a minimum of Rs.50 crore as net owned funds. Subsidiaries of Flls can become primary dealers subject to permission from the FIPB.
    • The RBI extends the following support to the PDs: Liquidity support, permission to borrow and lend in the market, access to current and subsidiary general ledger accounts, repos and refinance, permission to raise funds through commercial papers and permission to transfer funds from one center to the other.

     

    Call Money Market

    • The call money market is the part of the money market where the surplus funds of the banks are traded on a daily basis. Borrowers use funds to match short-term mismatches of assets and liabilities and to match the CRR requirements. This market is a measure of the liquidity of the overall money market.
    • All private sector, public sector and co-operative banks, term lending institutions, insurance companies and mutual funds participate in this market. Primary dealers, DFHI and STCI can participate only in the local call money markets.
    • Interest paid on call loans is known as call rates and is calculated on a daily basis.
    • Call money markets are located in the cities that have the major stock exchanges in India, namely, Mumbai, Kolkata, Delhi, Chennai and Ahmedabad. Mumbai has the largest market in India.
    • The RBI acts as a regulator of the call money market, but neither borrows nor lends to it. It uses repos and open market operations to control the market.
    • An efficient call money market should be less volatile and provide an opportunity to the players to transact at comparatively stable rates of interest.

     

    Treasury Bills

    • Treasury bills are issued by the governinent to raise short-tenn funds in the money market. They are a major portion of the borrowings of the Government of India.
    • The investors in T-bills include: Banks (to meet their SLR requirements), primary dealers, financial institutions (for primary cash management), insurance companies, provident funds (as per the investment guidelines), non-banking finance companies, corporations, Flls, state governments and individuals (to a very minor extent).
    • Ad hoc T-bills are issued in favor of the RBI when the government needs to replenish the cash balances and to provide temporary surpluses to state governments and foreign Central Banks. These are not available to the public.
    • 91 -day T-bills are auctioned weekly on Fridays and payment in respect to the allotments is made on Saturdays.
    • The auction for and 364-day is held weekly on Wednesdays and payment in respect to the allotments is made on Thursdays.
    • T-bills are important market instruments in the US, where the minimum denomination is $10,000 and in multiples of $5,000 thereof. The American T-bills are mainly classified as 'regular-series T-bills' and 'irregular-series T-bills'.
    • Regular-series of 13-week, 26-week and 52-week maturities are issued weekly or monthly while irregular-series are issued for a special cash need of the treasury.
    • The US T-bills are sold in auctions and issued at a discount to face value.

     

    Commercial Paper (CP)

    • Commercial Papers (CPs) are short-term unsecured usance promissory notes issued at a discount to face value by reputed corporates with high credit rating and strong financial background.
    • CPs are open to individuals, corporates, NRls and banks, but the NRIs can invest on non-repatriable/non-refundable basis. Flls have also been allowed to invest their short-term funds in CPs.
    • The features of CPs are: They do not originate from specific trade transactions like commercial bills. They are unsecured, involve much less paper work and have very high liquidity.
    • CPs can be direct paper if issued directly to the investors by the corporate or dealer paper if issued through an intermediary/merchant banker. CPs are usually placed with the investors by issuing and paying agents.
    • The main reasons for poor development of the CPs market are: restricted entry of corporates, tendency to issue CPs only if the total cost is lower than the PLR of banks, high minimum investment of individual investors and no tax benefits.
    • The main features of CPs in US are: high liquidity and safety, high quality instruments negotiable by endorsement and delivery, issued in multiples of $1,000 as bearer documents at a discount to the face value. They are unsecured by nature and tailored to the user requirement as far as maturity period is concerned.
    • Two types of CPs exist in the US such as direct paper (issued directly by the corporates and large banks) and dealer paper (issued by the dealers on behalf of their corporate clients).
    • The innovations in the American CP market are: master note (financial paper issued by finance companies to bank trust departments with interest pooled by the investors), medium-term notes (unsecured obligation papers with maturity of 9-10 months issued by investment grade corporations at fixed rate) and asset-backed commercial papers (packages of pooled loans or credit receivables with rates of interest and placed with a special purpose entity).

     

    Certificates of Deposit (CDs) 

    • Certificates of Deposit (CDs) are usance promissory notes, negotiable and in marketable form bearing a specified face value and number. Scheduled commercial banks and the major financial institutions can issue CDs.
    • Individuals, corporates, trusts and NRls are the main investors in CDs (on non-repatriable basis).
    • The features of CDs are: it is a title document to a time deposit, riskless, liquid and highly marketable, issued at a discount to face value, being part of the time liabilities of banks, either in registered or bearer form, freely transferable by endorsement and delivery. It does attract stamp duty.
    • The benefits of issuing CDs to the banks are: interest can be determined on a case to case basis, there is no early maturity of a CD, rates are more sensitive to call rates.
    • To the investors the benefits of subscribing to CDs are: it is a better way of deploying short-term funds as higher yield is offered, secondary market liquidity is available and repayment of interest and principal is assured.
    • CDs are the largest money market instruments traded in dollars. They are also issued by either banks or depository institutions, mostly in bearer form enabling trading in the secondary market.
    • Individuals, corporates and other bodies also buy the CDs in the US.
    • CDs have undergone various innovations: Asian dollar CDs, jumbo CDs, yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising rate CDs and foreign index CDs, all have different features. Many more innovations are expected in this upcoming market.

     

    Bill Financing

    • Monetary policy refers to the use of the official instruments under the control of the Central Bank of the country to regulate the availability, cost and use of money and credit.
    • The bank standard rate is the rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchases.
    • A bill of exchange has been defined as an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the instrument.
    • The specific features of a negotiable instrument are: there must be three parties to the exchange, namely drawer, drawee and payee, the instrument must be in writing, containing an order (not a request) to a certain person to pay, unconditionally, a certain sum of tender legal money, duly signed by the drawer and presented to the drawee for acceptance. It should also have date, number, place and other considerations found in the bills of exchange.
    • Bills of exchange can be classified as demand or usance bills, documentary or clean bills, D/A or D/P bills, inland or foreign bills, supply bills or government bills or accommodation bills.
    • The RBI has instructed banks to restrain from rediscounting bills outside the consortium of banks and initially discounted by finance companies and merchant bankers. Further, discounting should be only for the purpose of working capital/credit limits and for the purchase of raw materials/inventory. Accommodation bills are not to be discounted under any circumstances.