Class 12 Business Studies Notes Chapter 2 (Financial Markets) – Business Studies-II Book

Detailed Notes with MCQs of a very important chapter for your competitive exams – Financial Markets. Understanding how money flows through the economy is crucial, and this chapter lays the foundation. Pay close attention to the definitions, functions, and distinctions we discuss.

Chapter 2: Financial Markets - Detailed Notes for Government Exam Preparation

1. Concept of Financial Market

• Definition: A financial market is a marketplace where financial assets (like shares, debentures, bonds, derivatives, currencies, etc.) are created and exchanged.
• Core Function: It acts as an intermediary, linking savers (those with surplus funds) and borrowers/investors (those needing funds). It facilitates the transfer of funds from surplus units to deficit units.
• Mechanism: Performs the allocative function – directing funds into their most productive investment opportunities. It does this through the interplay of demand and supply, which helps in 'price discovery' for financial assets.

2. Functions of Financial Market

• (a) Mobilisation of Savings and Channeling them into the Most Productive Uses:
  • Connects savers and investors.
  • Provides avenues for savers to invest their surplus funds (e.g., buying shares/debentures).
  • Makes these funds available to businesses/governments who need them for investment.
  • Ensures funds flow towards activities offering higher potential returns.
• (b) Facilitating Price Discovery:
  • Prices of financial assets (like shares) are determined by the forces of demand and supply in the market.
  • Continuous interaction between buyers and sellers helps establish a market price.
  • This price reflects information available about the asset and the issuing entity.
• (c) Providing Liquidity to Financial Assets:
  • Financial markets allow investors to easily buy and sell their financial assets whenever they wish.
  • This converts assets into cash (liquidity) without significant loss of time or value (in an efficient market).
  • This ease of exit encourages investment.
• (d) Reducing the Cost of Transactions:
  • Markets provide a common platform, saving time, effort, and money for both buyers and sellers.
  • Information about securities is readily available, reducing search costs.

3. Classification of Financial Markets

Financial markets can be broadly classified into:

• A. Money Market:

  • Definition: Market for short-term funds/securities whose maturity period is up to one year.
  • Nature: Deals in assets that are close substitutes for money (highly liquid, low risk, unsecured, traded in large volumes).
  • Purpose: Meets temporary needs for cash (working capital) for businesses and fulfills short-term liquidity requirements for banks and governments.
  • Participants: RBI, Commercial Banks, Non-Banking Finance Companies (NBFCs), State Governments, Large Corporate Houses, Mutual Funds.
  • Location: No fixed geographical location; transactions conducted over phone, internet.
  • Instruments of Money Market:
    • (i) Treasury Bills (T-Bills):
      • Short-term borrowing instrument of the Government of India.
      • Issued by RBI on behalf of the Central Government.
      • Maturity: Less than one year (Currently issued in 91-day, 182-day, and 364-day variants).
      • Nature: Zero Coupon Bonds (issued at a discount, redeemed at par). The difference is the interest.
      • Safety: Highly safe (backed by Govt.).
      • Availability: Minimum amount of ₹25,000 and in multiples thereof.
    • (ii) Commercial Paper (CP):
      • Short-term, unsecured promissory note issued by large, creditworthy companies.
      • Maturity: 15 days to 1 year.
      • Purpose: Meet short-term funding needs, often for seasonal requirements or bridge financing (funding costs until long-term funds are raised).
      • Regulation: Governed by RBI guidelines.
    • (iii) Call Money:
      • Very short-term finance (maturity: 1 day to 15 days).
      • Mainly used by banks for inter-bank transactions to maintain their Cash Reserve Ratio (CRR).
      • Interest Rate: Call Rate (highly volatile, depends on demand/supply of funds).
    • (iv) Certificate of Deposit (CD):
      • Unsecured, negotiable instrument in bearer form.
      • Issued by: Commercial Banks and Development Financial Institutions (DFIs).
      • Maturity: Banks (91 days to 1 year); DFIs (1 year to 3 years).
      • Issued to: Individuals, corporations, companies during periods of tight liquidity when deposit growth is slow but credit demand is high.
      • Minimum Amount: Typically high (e.g., ₹1 Lakh).
    • (v) Commercial Bill (Trade Bill):
      • A bill of exchange used to finance the credit sales of firms.
      • Seller (drawer) draws the bill on the buyer (drawee) for the value of goods sold.
      • When accepted by the buyer, it becomes a marketable instrument.
      • Can be discounted with a bank if the seller needs funds before the due date. When a trade bill is accepted by a commercial bank, it is known as a commercial bill.

• B. Capital Market:

  • Definition: Market for medium-term and long-term funds/securities (maturity period more than one year).
  • Nature: Includes all facilities and institutional arrangements for borrowing and lending term funds. Deals in both debt and equity instruments.
  • Purpose: Finances long-term investments (fixed assets, expansion projects).
  • Participants: Financial institutions, banks, corporate entities, foreign investors, retail investors.
  • Instruments: Shares (equity & preference), Debentures, Bonds, Mutual Funds, etc.
  • Types of Capital Market:
    • (i) Primary Market (New Issue Market):
      • Deals with the issue of new securities by companies for the first time.
      • Funds directly flow from savers to the issuing company.
      • Purpose: Setting up new projects, expansion, diversification, modernization.
      • Methods of Floatation in Primary Market:
        • Offer through Prospectus: Most common method; company invites public subscription through an issue document (prospectus) providing details about the company and the issue.
        • Offer for Sale: Securities are offered for sale to the public not directly by the company, but through intermediaries like issuing houses/stock brokers who buy the whole lot from the company.
        • Private Placement: Allotment of securities by a company to institutional investors and some selected individuals, rather than to the public. Cost-effective, quicker.
        • Rights Issue: Offer of new shares to existing shareholders in proportion to their existing holding. Shareholders have the 'right' to subscribe or renounce it.
        • e-IPOs (Electronic Initial Public Offers): Issuing securities through the online system of the stock exchange. Requires registering with SEBI-registered brokers/banks.
    • (ii) Secondary Market (Stock Exchange / Stock Market):
      • Market for the purchase and sale of existing securities.
      • Provides liquidity and marketability to already issued securities.
      • Securities are traded between investors; the company is not directly involved.
      • Location: Specific physical location or electronic platform.
      • Functions of Stock Exchange:
        • Providing Liquidity and Marketability to Existing Securities.
        • Pricing of Securities (through demand & supply).
        • Safety of Transaction (transactions occur within a regulatory framework).
        • Contributes to Economic Growth (channeling savings into productive investments).
        • Spreading of Equity Cult (educating public about investing).
        • Providing Scope for Speculation (within legal limits, aids liquidity).
        • Acts as an Economic Barometer (reflects the state of the economy).

4. Distinction between Capital Market and Money Market

5. Stock Exchange

• Definition: An institution providing a platform for the buying and selling of existing securities.
• Key Terms:
  • Broker: A member of the stock exchange who buys/sells securities on behalf of investors/speculators.
  • Depository: An institution (like NSDL, CDSL) holding securities in electronic (dematerialized) form on behalf of investors. Acts like a bank for securities.
  • Depository Participant (DP): An agent of the Depository (e.g., Banks, Brokers) through whom investors interact with the Depository.
  • Demat Account: An account opened by an investor with a DP to hold securities in electronic form.
  • Trading Account: An account with a broker used to place buy/sell orders.
  • Dematerialisation: Process of converting physical share certificates into electronic form.
  • Rematerialisation: Process of converting electronic holdings back into physical certificates.

6. Trading Procedure on a Stock Exchange (Screen-Based Trading)

• (a) Selection of a Broker: Choose a SEBI-registered broker to trade through. Enter into a Broker-Client agreement, provide PAN, address proof, etc.
• (b) Opening Demat Account: Open a Demat account with a Depository Participant (DP) to hold securities electronically.
• (c) Placing the Order: Instruct the broker (online, phone, etc.) specifying the security, quantity, and price (market price or limit price).
• (d) Executing the Order: Broker connects to the stock exchange online, matches the best bid (buy price) and offer (sell price). Order is executed electronically when prices match. Trade Confirmation Slip issued to the investor.
• (e) Settlement: The crucial final stage.
  • Currently follows T+1 rolling settlement cycle (as of Jan 2023, phased implementation completed). This means the trade is settled (funds paid, securities delivered) one business day after the trade day (T).
  • Broker makes payment to the exchange (pay-in day); Exchange delivers shares/payment to the broker (pay-out day).
  • Broker credits investor's Demat account with shares (if bought) or account with money (if sold) within 24 hours of the pay-out day.

7. Securities and Exchange Board of India (SEBI)

• Establishment: Established as an administrative body in 1988. Given statutory powers through the SEBI Act, 1992, on April 12, 1992.
• Reason for Establishment: Protect the interests of investors and regulate the securities market, curb malpractices (price rigging, insider trading, delays, etc.) prevalent before its formation.
• Role: Regulator of the securities market in India.
• Objectives:
  • Protection: Protect the rights and interests of investors.
  • Prevention: Prevent trading malpractices.
  • Regulation & Development: Regulate stock exchanges and intermediaries, and develop a code of conduct.
• Functions of SEBI:
  • (i) Regulatory Functions:
    • Registering brokers, sub-brokers, merchant bankers, etc.
    • Registering collective investment schemes (Mutual Funds).
    • Regulating stock brokers, portfolio exchanges, underwriters, merchant bankers.
    • Regulating takeover bids by companies.
    • Calling for information, undertaking inspections, conducting inquiries and audits.
    • Levying fees.
    • Prohibiting fraudulent and unfair trade practices.
    • Prohibiting insider trading.
  • (ii) Developmental Functions:
    • Training intermediaries of the securities market.
    • Conducting research and publishing information useful to market participants.
    • Undertaking measures to develop the capital markets (e.g., promoting screen-based trading, demat).
  • (iii) Protective Functions:
    • Prohibition of fraudulent and unfair trade practices.
    • Controlling insider trading and imposing penalties.
    • Undertaking steps for investor protection.
    • Promotion of fair practices and code of conduct in the securities market.

Multiple Choice Questions (MCQs)

1. The market for securities with a maturity period of less than one year is known as:
   a) Capital Market
   b) Primary Market
   c) Money Market
   d) Secondary Market

2. Which of the following is NOT an instrument of the Money Market?
   a) Treasury Bills
   b) Commercial Paper
   c) Debentures
   d) Certificate of Deposit

3. Treasury Bills are issued by:
   a) Commercial Banks
   b) Large Creditworthy Companies
   c) Reserve Bank of India (on behalf of the Government)
   d) State Governments

4. The process of holding securities in an electronic form is called:
   a) Rematerialisation
   b) Private Placement
   c) Dematerialisation
   d) Allotment

5. SEBI was granted statutory powers in the year:
   a) 1988
   b) 1991
   c) 1992
   d) 1995

6. The market where existing securities are bought and sold is called:
   a) Primary Market
   b) Money Market
   c) Commodity Market
   d) Secondary Market

7. Which function of the financial market helps in determining the price of securities through demand and supply?
   a) Mobilisation of Savings
   b) Providing Liquidity
   c) Reducing Cost of Transactions
   d) Facilitating Price Discovery

8. 'Call Money' is primarily used by which institutions to meet short-term fund requirements, often for CRR maintenance?
   a) Large Corporations
   b) Mutual Funds
   c) Commercial Banks
   d) Stock Brokers

9. Which method of floatation involves offering new shares to existing shareholders?
   a) Offer through Prospectus
   b) Private Placement
   c) Rights Issue
   d) e-IPO

10. The settlement cycle currently followed in Indian stock exchanges for equities is:
    a) T+3
    b) T+2
    c) T+1
    d) T+0 (Same day)

Answer Key:

1. c) Money Market
2. c) Debentures (It's a Capital Market instrument)
3. c) Reserve Bank of India (on behalf of the Government)
4. c) Dematerialisation
5. c) 1992
6. d) Secondary Market
7. d) Facilitating Price Discovery
8. c) Commercial Banks
9. c) Rights Issue
10. c) T+1 (Note: T+2 was the long-standing norm, but T+1 is the current standard after phased implementation completed in Jan 2023. Be aware exam questions might still refer to T+2 if based on older material, but T+1 is the correct current practice).

Study these notes thoroughly. Focus on the distinctions, functions, instruments, and the role of SEBI. Good luck with your preparation!