JAIIB IE and IFS Paper-1 Module-D Unit 1 : Financial Markets

JAIIB Paper 1 (IE and IFS) Module D Unit 1 : Financial Markets (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 1 (Indian Economy & Indian Financial System) includes an important topic called “Financial Markets”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 1 (IE and IFS) Module D (FINANCIAL PRODUCTS AND SERVICES ) Unit 1 : Financial Markets, Aspirants must go through this article to better understand the topic, Financial Markets and practice using our Online Mock Test Series to strengthen their knowledge of Financial Markets. Unit 1: Financial Markets

What is a Financial Market? 

Any financial system

Financial market refers in an abstract way to the purchase and sale transactions of a commodity and the formation of its price. Used in this way, the term refers to the countless decisions made by producers of a commodity (the supply side of the market) and consumers of a commodity (the demand side of the market), which  taken together, determine the price of the commodity.

Segments Of Financial Markets

The financial market has a number of different segments. While commonly, these markets are stated to consist of money market, foreign exchange market, capital market and insurance market, when studied  more granularly, as stated earlier, there are additional segments like credit market and derivatives market.  Hence, the financial markets can be understood of consisting of the following segments: 

Credit Market 

The major institutional purveyors of credit in India are banks (commercial, cooperative and differentiated banks) and non-banking financial institutions, i.e., non-banking financial companies (NBFCs). The noninstitutional or unorganised sources of credit include moneylenders, indigenous bankers and sellers for trade credit.

An important aspect of the credit market is its term structure, viz.,

• Short-term credit,
• Medium-term credit, and
• Long-term credit.

While banks and NBFCs predominantly cater to short-term needs, Financial Institutions provide mostly medium and long-term funds.

Money Market 

Money markets perform the crucial role of providing a conduit for equilibrating short-term demand for and supply of funds, thereby facilitating the conduct of monetary policy. The money market instruments mainly comprise:

• Call money,
• Certificates of deposit,
• Treasury bills,
• Other short-term government securities transactions, such as, repos,
• Bankers’ acceptances/commercial bills,
• Commercial paper, and
• Inter-corporate funds. While inter-bank money markets and central bank lending via repo operations or discounting provide liquidity for banks, private non-bank money market instruments, such as commercial paper provide liquidity to the corporate sector.

Debt Market

• The debt market consists, largely, of government securities and to a smaller extent, corporate bonds.
• A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or a State Government. It is a document of the Government’s debt obligation. Long term securities are also issued by State Governments and these are called State Development Loans (SDLs).
• Companies raise funds for longer period say 5 years or 10 years, through issue of a typical long-term debt instruments, known as Corporate Bonds. A company which is engaged in infrastructure projects may issue debentures as a source of long-term funds.

Foreign Exchange Market 

• The foreign exchange market consists of banks (Authorised Dealers), customers and Reserve Bank of India. The forex market in India developed, practically, only after 1978. Prior to 1978, banks were permitted to conduct only merchant transactions and their cover operations.
• They were also required to keep their positions ‘square’ or ‘near-square; at all times during the day. It was in the year 1978 that banks were permitted by RBI to take trading positions and they were also required to maintain a ‘square’ or ‘near-square’ position only at the end of the day, and throughout the day.

Derivatives Market

A derivative is a financial instrument: 

• Whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the ‘underlying’);
• That requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and
• That is settled at a future date.

Capital Market 

• Capital market is a market for long-term equity and debt. In this market, capital funds comprising of both equity and debt are issued and traded.
• This also includes private placement sources of debt and equity as well as organised markets, like stock exchanges.
• In common parlance, capital market may be understood as the market for long-term funds. The capital market provides long-term debt and equity finance for the government and the corporate sector.

Insurance Market 

• In an increasingly competitive economy, the need for insuring against risks is well recognised. In India, the insurance industry is broadly classified into life insurance and non-life insurance business.
• In the early days, life insurance business had been undertaken by the Life Insurance Corporation of India (LIC) and the non-life insurance by the General Insurance Corporation (GIC) and its four subsidiaries. In the wake of financial liberalisation during the early ’nineties, the Committee on Reform of the Insurance Sector (Chairman: Shri R. N. Malhotra) recommended in 1994, the opening up of the insurance sector to private participation and the institution of a separate regulatory and development authority.
• Accordingly, the Insurance Regulatory and Development Authority (IRDA) Act was enacted in the year 1999, and a separate Insurance Regulatory and Development Authority was set up.

Mutual Fund 

• Mutual Fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.
• A fund established in the form of a trust to raise monies through the sale of units to the public or a section of the public under one or more schemes for investing in securities, including money market instruments.
• SEBI regulates Mutual Funds, though mutual funds also have formed a self-regulatory body in the form of Association of Mutual Funds of India (AMFI), which is an industry body of mutual funds.

Functions Of Financial Markets

The following are the functions of financial markets:

• Price Determination
• Funds Mobilisation
• Liquidity
• Risk sharing
• Easy Access
• Reduction in transaction costs and provision of the Information
• Capital Formation

Price Determination 

• Financial markets perform the function of price discovery for the different financial instruments which are traded between the buyers and the sellers on the market.
• The prices at which the financial instruments are traded in the financial market are determined by the market forces, i.e., demand and supply in the market. Accordingly, financial markets provide the vehicle by which, the prices are set for both financial assets which are issued newly and for the existing stock of the financial assets.

Funds Mobilisation

• Along with the determination of the prices at which the financial instruments are traded in the financial markets, the required return out of the funds invested by the investor is also determined by participants, in the market.
• The motivation for persons seeking the funds is dependent on the required rate of return, which is demanded by the investors.
• It is this function of the financial market, that determines how the funds which are available from the lenders or the investors will get allocated among the entities that are in need of the funds or raise the funds by means of issuing financial instruments in the financial market.  Hence, in this manner, financial markets contribute to the mobilisation of the savings of the investors.

Liquidity 

• The liquidity function of financial markets provides an opportunity to the investors to sell their financial instruments at their fair value prevailing in the market at any time, during the working hours of the market.
• In case there is no liquidity in the financial market, then the investor will have to forcibly hold the financial securities or the financial instrument, until the conditions arise in the market for selling those assets or the issuer of the security is obligated contractually to pay for the same, i.e., at the time of maturity in debt instrument.

Risk sharing 

• Financial markets perform the function of the risk-sharing, as the entities which are undertaking the investments are different from the persons who have invested their savings in that entity.
• With the help of financial markets, the risk is transferred from the entity which undertakes the investments to those investors, who have provided funds for making those investments.

Accessibility 

• Industries require investors for raising funds and the investors require the industries for investing their savings and earning the returns from them. Hence, financial markets bring together potential buyers and sellers, which helps them in saving their time and money, in finding the suitable investment avenues.

Reduction in Transaction Costs and Provision of the Information 

• Investors requires various types of information while buying and selling securities, and for obtaining the same, time and money is required.
• However, financial markets help in providing all types of information, without the requirement of spending any money by individual investors. In this way, the financial markets reduce the cost of the transactions.

Capital Formation 

• Financial markets provide the channel through which, the new savings flow into the economy and this aids in capital formation.

Price Discovery

• Price discovery, also referred to as the price discovery mechanism or price discovery process, is a very important aspect of all financial markets. It is a method for determining the price of an asset through interactions between buyers and sellers.
• Price discovery enables buyers and sellers to set the market prices of tradable assets. This is because the mechanisms of price discovery set out what sellers are willing to accept, and what buyers are willing to pay. As a result, price discovery is concerned with finding the equilibrium price that facilitates the greatest liquidity for that asset.

There are a number of factors which determine the levels of price discovery. These include: 

• Supply and demand
• Attitudes to risk
• Volatility
• Available information
• Market mechanisms

Supply and Demand 

• Supply and demand are the two greatest factors, which determine an asset’s price and which in turn, dictate how crucial price discovery mechanisms are for traders.

Attitudes to Risk

• A buyer or seller’s attitude to risk can greatly affect the level, at which, a price is agreed between two market participants.
• For instance, if the buyer is willing to take on the risk of a fall in price, for the potential reward of a large rise in price, they might be willing to pay a little more, in order to secure their exposure to a market.

Volatility 

• Volatility is linked to risk, but they are not the same. Volatility is one of the main factors which determines whether a buyer chooses to enter or not in any particular market.
• Some traders actively seek out volatile markets as they offer the potential for larger profits. However, they could also incur larger losses.

Available Information 

• The amount of information available to both buyers and sellers can determine the levels at which, they are willing to buy or sell. For example, buyers may wish to wait for key market announcements – such as the outcome of RBI meetings – to be made public, before determining whether they wish to buy or not.
• In turn, these meetings and their outcome could increase demand or reduce supply, which means that asset prices might change in line with any changes that are highlighted in these market announcements.

Price Discovery Example

• In the Chart below, demand is decreasing as supply is increasing. Typically, this means an asset’s price will fall. As the graph shows, the two lines representing demand and supply eventually cross, representing a level at which both buyers and sellers agree is the fair market price for an asset.
• As a result, the asset will begin to trade at this level until there is a shift in the levels of supply and demand, which will require another period of price discovery.

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