CBSE Class 12 Business Studies Chapter 10: Financial Markets – Lecture, Revision, Notes, Explanation

Financial Markets

In this video series, I am covering the Business Studies subject from the CBSE Class XII syllabus. We will be following the standard NCERT textbook for the topics that we will discuss. This is the tenth video of the series, and we will cover the tenth chapter—Financial Markets from Part B of the subject.

Introduction

Let us start with the concept of financial markets. We have already discussed in the previous chapters that every business needs funds or money to finance both its assets and activities.

There are two sources of funds for any business:

1. Owners’ or Investors’ Funds: Money brought in by the owners of the business. In a company, this will be through equity share capital or preference share capital.
2. Borrowed Funds: Money borrowed by the business through loans, issuing debentures, accepting deposits from banks or financial institutions, or accepting deposits from the public.

What about the profits generated by the business itself? Can it be a source of finance? Yes—it can be. Technically, the profits generated by the business belong to the owners or the investors. So, profits that are not given out to the owners or the investors but retained by the business as reserves or retained earnings are also classified as owners’ or investors’ funds.

Savers and Investors

Next, let us talk about savers or investors. Most of us are savers because we save a part of our income—the surplus funds left over after our expenses are taken care of. Some people who have access to larger amounts of money may be investors.

The main difference between savers and investors is the risk that they are willing to take. A saver may typically have a smaller sum of surplus funds, so they don’t want to take unnecessary risk. They may invest in a bank fixed deposit, which will fetch a small amount of return.

An investor may have a large amount of funds and is willing to take higher risks by investing in shares, debentures, company deposits, or even give out loans to businesses. The higher the risk that a person is willing to take, the higher the returns that may be expected.

The Role of Financial Markets

Now you have businesses who need money, and you have savers and investors who need to invest their money to earn returns. This is where the financial markets come in. They are the medium that connects savers, investors, banks or financial institutions, and businesses.

Financial markets allocate or direct the savers’ or investors’ funds into the most productive investment opportunities. Here, banks and financial institutions are both financial markets and they are also investors.

As financial markets, they collect deposits from savers and provide loans to businesses who need money. So, banks perform an allocative function. As investors, banks may invest in companies as shareholders, which is also why some banks are called investment banks.

In a perfect world, where everyone has perfect information and takes perfect decisions, the financial markets can perform a ‘perfect allocative function’ where savers and investors get the highest possible rate of returns and financial resources are allocated to the most productive businesses. But in reality, perfect allocative function is very rare.

Banks and financial markets, which collect funds from savers and investors and provide it to businesses, perform the allocation of funds. This allocative function is also known as financial intermediation. So, banks and financial markets are called financial intermediaries.

As a saver, you have a choice of either investing your money in a bank fixed deposit or going through the financial market and directly investing in a business for higher returns at a higher risk.

If you deposit money in a bank, the bank will give you 7% interest and give the money as a loan to a business at, say, 13% interest—the difference is the bank’s profit. Businesses participating in the financial market want you to bypass the bank and directly invest with them as a shareholder, debenture holder, or depositor. They will have access to funds at a cheaper rate than a bank loan, and you as the investor will earn a higher rate of return than in a bank deposit because you are taking a greater risk.

So, here, banks and the financial markets are competitors or competing intermediaries because both are competing to attract your money.

A point to remember here is that ‘financial market’ is a generic term. Any platform or process which connects savers, investors, banks, financial institutions, and businesses is part of the financial market.

Definition of Financial Market

A financial market is a market for the creation and exchange of financial assets such as shares, debentures, and bonds.

Here, there are two processes:

1. Creation: The initial issue of financial assets from the business or the government to the original buyers or investors. This happens in the primary market.
2. Exchange: The subsequent sale, purchase, or exchange of financial assets. This happens in the secondary market.

For example, a company like Bajaj Housing Finance announces an IPO (Initial Public Offering) for its shares. A large number of people apply, but only a few people get the IPO allotment. Here, the company has created the financial assets (its shares) and allots them to the original buyers or investors. This is the creation process in the primary market.

After the allotment, the shares are listed on a stock exchange, and because there are so many more people interested in buying the shares but did not get the original allotment, there is a huge demand in the market, and the prices of the shares quickly increase. The original allottees can sell their shares at a profit, and other investors can buy the shares. This is the exchange process in the secondary market. Later, these new buyers may again sell their shares, and others will buy them, so this buying and selling—the exchange—can happen indefinitely.

Types of Financial Markets

The term ‘financial markets’ includes all those markets where different types of financial products are bought, sold, or exchanged. These include:

• Capital Market: Where equity and some debt instruments like corporate bonds and debentures are issued and existing securities are traded among investors. The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) are examples.
• Money Market: Deals with short-term borrowing and lending, typically for periods less than a year. Instruments in the money market include Treasury Bills, Commercial Paper, Certificates of Deposit, and Repurchase Agreements (REPO).
• Debt Market: For short-term and long-term bonds with a maturity or tenure of more than one year.
• Other Markets: Markets for derivatives, forex, commodities, insurance and reinsurance-related products, mutual funds, private equity, venture capital, and Non-Banking Financial Companies (NBFCs) which provide various banking services without meeting the legal definition of a bank.

In the CBSE Class 12 syllabus, we will be discussing only about the capital markets and the money markets, and briefly touch upon debt markets.

Functions of Financial Markets

There are four main functions of financial markets:

1. Mobilization of Savings and Channeling Them into the Most Productive Uses: Facilitates the transfer of savings from savers to investors and also from savers and investors to businesses. Offers savers and investors a variety of saving and investment choices. Channels surplus funds into the most productive uses.
2. Facilitating Price Discovery: The interaction between people who have money and the businesses who want money helps in discovering the value of financial assets like bonds or debentures.
3. Providing Liquidity to Financial Assets: Financial markets provide liquidity by allowing the sale of different types of financial assets and converting them into cash.
4. Reducing the Cost of Transactions: Markets allow useful information about various financial securities to be collected, analyzed, and used by both buyers and sellers. By serving as a common platform, financial markets save time, effort, and money for all parties.

Classification of Financial Markets

Financial markets can be classified into:

• Money Market: Deals with financial instruments with a maturity of less than one year.
• Capital Market: Deals with instruments like equity shares which have no defined maturity and bonds and debentures with a maturity of more than one year.

Capital markets are divided into:

• Primary Market: Where the initial public offerings of shares are made or where bonds or debentures are originally issued.
• Secondary Market: Where the exchange of financial securities takes place after their initial issue in the primary market.

Money Market

The money market is a market for short-term funds dealing in monetary assets or financial securities with a maturity period of up to one year. These assets are close substitutes for money because they can be quickly converted into or traded for money and converted into cash.

Trades in the money market are low-risk, unsecured, and involve short-term debt instruments that are highly liquid. There is no specific physical location for money markets like a stock exchange; activities are conducted over the telephone and through the internet. There is active daily trading of these financial instruments in the money market.

The money markets help in raising short-term funds, meeting temporary shortages of cash, and fulfilling obligations such as working capital requirements or urgent payments. They also facilitate the deployment of excess funds, allowing temporary investment of surplus funds to earn returns.

The major participants in the money market are the Reserve Bank of India (RBI), various commercial banks, Non-Banking Finance Companies (NBFCs), state governments, large corporate houses, and mutual funds.

Capital Market

The capital market refers to the facilities and institutional arrangements through which long-term funds, both debt and equity, are raised and invested—that is, issued, bought, and sold.

Functions and Characteristics of Capital Markets

• Make the savings of the community available for various business enterprises and the public in general.
• Direct these savings into their most productive uses, leading to economic growth and development.
• Include development banks, commercial banks, and stock exchanges.

Importance of an Ideal Capital Market

• Finance available at reasonable costs.
• Facilitate the process of economic development through a well-functioning capital market.
• Development of an efficient financial system is seen as a necessary condition for economic growth of any country.

Essential Features for the Efficiency of Capital Markets

• Financial institutions should be sufficiently developed.
• Market operations must be free, fair, competitive, and transparent.
• Should deliver efficient information, minimize transaction costs, and allocate capital most productively.

Comparison of Capital Markets and Money Markets

Primary Markets and Secondary Markets

Primary Market (New Issues Market)

• Deals with new securities being issued for the first time.
• Facilitates the transfer of investible funds from savers to entrepreneurs or businesses.
• Helps in establishing new enterprises or expanding existing ones through the issuance of securities.
• Investors involved include banks, financial institutions, insurance companies, mutual funds, and individuals.
• Forms of capital raised: equity shares, preference shares, debentures, loans, deposits.
• Purposes for raising funds: setting up new projects, expansion, diversification, modernization, mergers, and takeovers.

Secondary Market (Stock Market or Stock Exchange)

• Marketplace for the purchase and sale of existing securities.
• Helps investors disinvest and allows new investors to enter the market.
• Provides liquidity and marketability for existing securities, allowing them to be easily converted into cash.
• Contributes to economic growth by funding the most productive investments through divestment and reinvestment.
• Regulated by the Securities and Exchange Board of India (SEBI) to ensure transparency and fairness.

Comparison of Primary and Secondary Markets

Stock Exchange

A stock exchange is a platform where investors buy and sell securities such as shares and bonds through brokers who execute trades on behalf of the investors. Stocks are exchanged at specific, regulated locations known as stock exchanges.

If we look at the process of how an Initial Public Offering (IPO) works, it starts when a company offers its shares to the public for the first time. Many investors may apply, but only a limited number of shares are allotted. After the IPO, the shares get listed on a stock exchange like the Bombay Stock Exchange (BSE) or the National Stock Exchange (NSE).

Once listed, the transactions take place between the original shareholders and new investors. Later, these new investors can also sell their shares to others, creating a continuous cycle of buying and selling, which all happens within the stock exchange or the secondary market.

Functions of the Stock Exchange

1. Providing Liquidity and Marketability to Existing Securities: Creates a continuous market where people can buy and sell securities anytime, ensuring securities or money don’t get stuck.
2. Pricing of Securities: Prices are driven by demand and supply, providing a live pricing mechanism for both buyers and sellers.
3. Safety of Transactions: Tightly regulated with strict membership rules, ensuring fair and safe deals.
4. Contributing to Economic Growth: Helps channel savings into more productive investments, driving capital formation and economic growth.
5. Spreading of Equity Culture: Plays a role in educating people about investments, promoting wider share ownership, and ensuring new issues are well-regulated.
6. Providing Scope for Speculation: Allows a certain level of healthy speculation to ensure liquidity and price stability in the market.

Trading and Settlement Process in Stock Exchanges

Trading has moved from the exchange floor to an online, screen-based electronic trading system. All buying and selling of shares and debentures are managed through computer terminals that are directly connected to the main stock exchange servers.

Process Flow

1. Selection of Broker and Agreement: Investor approaches a registered broker and enters into an agreement, providing necessary KYC details.
2. Opening Demat and Bank Accounts: If not already available, the investor opens a demat account and a suitable bank account.
3. Placing an Order: Investor places an order with the broker to buy or sell shares, providing clear instructions.
4. Matching of the Order: Broker’s system connects to the stock exchange to match the buy or sell order and best price available.
5. Execution of Order: When the shares can be bought or sold at the mentioned price, the order is executed electronically.
6. Issue of Contract Note: Broker issues a contract note to the investor within 24 hours of the trade execution.
7. Settlement (Pay-in Day): Buyer pays in the money to the broker, and the seller delivers the shares to the broker’s account.
8. Settlement (Pay-out Day on T+2): Exchange delivers the shares and makes payment to the buyers and sellers’ brokers respectively.
9. Delivery of the Shares: Broker delivers the shares in demat form to the investor’s demat account.

Advantages of Electronic Trading Systems

• Transparency: Complete transparency by allowing everyone to see the prices of all securities in real-time.
• Efficient Information Flow: Instant availability of information on prices and market developments.
• Operational Efficiency: Reduces the time, cost, and risk involved in transactions.
• Accessibility: Participation in the stock market from anywhere.
• Single Trading Platform: Centralized trading platform ensuring smooth operations and unified access.

Dematerialization, Depository Participants, and Depositories

Dematerialization: The process of converting physical share certificates into electronic format held in a demat account.

Purpose and Benefits

• Shift to electronic trading and settlement through electronic book entry.
• Eliminates problems associated with physical shares such as theft, forgery, and delays in transfers.

Depository Participants (DPs)

• Act as intermediaries between investors and the depositories (NSDL or CDSL).
• Authorized to maintain accounts of dematerialized shares.
• Entities permitted to become DPs include financial institutions, banks, clearing corporations, stock brokers, and non-banking finance corporations.
• Provide key benefits through demat accounts such as greater speed, enhanced security, and ease of access.

Depositories

• Similar to a bank but for securities instead of money.
• Hold securities in electronic form on behalf of investors.
• Investors can open a securities demat account with a depository.
• Transactions are settled with greater speed and efficiency using a book-entry mode.
• Two depositories in India: NSDL (National Securities Depository Ltd.) and CDSL (Central Depository Services Ltd.).

Advantages of Holding Shares in Demat Form

• Convenience: Holding shares is similar to maintaining a bank account.
• Conversion Flexibility: Physical shares can be converted into electronic form (dematerialization) and vice versa (rematerialization).
• Ease of Transfer: Shares can be transferred to another account just like electronic cash.
• Security: Eliminates the risk of loss, theft, or forgery of share certificates.

Working of the Demat System

1. Select a Depository Participant (DP): Bank, broker, or financial services company.
2. Open a Demat Account: Complete the account opening form and submit required documentation.
3. Submit Physical Certificates for Dematerialization: Provide physical share certificates to the DP along with a dematerialization request form.
4. Applying for Shares in an IPO: Provide DP and demat account details when applying for shares; upon allotment, shares are credited to the demat account.
5. Selling Shares Through a Broker: Instruct DP to debit the demat account and authorize the transfer of shares to the broker.

Securities and Exchange Board of India (SEBI)

SEBI was founded by the Government of India on 12 April 1988 as an interim administrative body aimed at promoting orderly and healthy growth of the securities market and protecting investors. It was granted permanent statutory status on 30 January 1992 through the Securities and Exchange Board of India Act, 1992.

Objectives of SEBI

• Protect the Interests of Investors: Safeguard rights and interests, especially of individual investors; guide and educate investors.
• Promote Development of the Securities Market: Regulate stock exchanges and the securities industry for orderly functioning.
• Prevent Trading Malpractices: Achieve a balance between self-regulation by the securities industry and statutory regulation.
• Develop a Code of Conduct for Intermediaries: Regulate and promote fair practices among brokers, merchant bankers, etc.; make intermediaries competitive and professional.

Purpose and Role of SEBI

SEBI aims to create a facilitative environment for the securities market by establishing clear rules, regulations, and policy frameworks. It caters to:

• Issuers of Securities (Companies): Provides a fair and efficient platform to raise funds.
• Investors: Protects rights and interests; ensures clear and accurate information disclosure.
• Market Intermediaries: Maintains a competitive and professional market environment; ensures solid infrastructure for top-notch services.

Functions of SEBI

Regulatory Functions

1. Registration of Market Participants: Ensures that everyone who is part of the market is registered.
2. Regulation of Intermediaries and Markets: Keeps an eye on intermediaries and regulates business conduct in stock exchanges.
3. Regulation of Takeover Bids: Regulates company takeovers to ensure transparency and fair treatment of investors.
4. Information Gathering and Enforcement: Conducts inspections, inquiries, and audits to enforce rules.
5. Levying Fees and Charges: Authorized to levy fees and charges on market participants.
6. Exercise of Powers Delegated by the Government: Manages and regulates the securities markets in India under various acts.

Development Functions

1. Training of Intermediaries: Organizes training sessions to enhance skills and knowledge.
2. Conducting Research and Publishing Information: Regularly publishes valuable information for market participants.
3. Promoting the Development of Capital Markets: Introduces new policies and encourages new financial products.

Protective Functions

1. Prohibition of Fraudulent and Unfair Trade Practices: Prevents fraudulent activities and price manipulations.
2. Controlling Insider Trading: Imposes penalties on anyone caught using insider information.
3. Investor Protection Measures: Ensures proper disclosures and transparent communication.
4. Promotion of Fair Practices and Code of Conduct: Sets standards to ensure ethical behavior and professionalism.

Conclusion

With that, we can conclude this video. If you have any questions or feedback, post a comment below. I will see you in the next video.