Capital & Money Markets
The financial system of a country is divided into the money market, which deals in short-term funds of up to one year, and the capital market, which deals in long-term funds. Together they channel the savings of households into productive investment. In India the capital market is regulated by the Securities and Exchange Board of India, and the money market operates under the overall control of the Reserve Bank of India. This topic is important for examinations because it combines institutions, instruments, market terminology and regulation. These notes cover the role of the regulator, the stock exchanges and their indices, the difference between primary and secondary markets, the main money market instruments and the meaning of depository and derivative terms.
The regulator: SEBI
The Securities and Exchange Board of India was established in 1988 as a non-statutory body and became a statutory authority in 1992 under the SEBI Act. Its headquarters is in Mumbai. The main role of SEBI is to protect the interests of investors, to promote the development of the securities market and to regulate the market and its intermediaries, including stock exchanges, brokers, merchant bankers, mutual funds and depositories. In other words, SEBI is the watchdog of the capital market, while the Reserve Bank regulates the money market, banking and currency. SEBI also regulates foreign portfolio investment and takes action against unfair practices such as insider trading and price manipulation.
Stock exchanges and their indices
A stock exchange is an organised market where securities are bought and sold. The Bombay Stock Exchange, founded in 1875, is the oldest stock exchange in Asia, and the National Stock Exchange, established in 1992, is a modern electronic exchange. The two best known indices of the Indian market are the Sensex of the BSE and the Nifty 50 of the NSE. The Sensex is made up of thirty actively traded and financially sound companies and has a base year of 1978-79 with a base value of one hundred. The Nifty 50 consists of fifty companies, has a base year of 1995 and a base value of one thousand. An index is a barometer of the market, because its movement summarises the direction in which share prices in general are moving.
Primary and secondary markets
The primary market is the market for new issues, where a company raises capital directly from investors by issuing securities. When a company offers its shares to the public for the first time, it is called an initial public offering, or IPO, and a subsequent public issue by an already listed company is called a follow-on public offer, or FPO. The secondary market is where already issued securities are traded among investors, and the stock exchanges are the main secondary market. The primary market transfers savings to industry; the secondary market provides liquidity, that is, the ability to convert securities into cash, and it does not directly add to the capital of the company. A share represents ownership in a company and carries a variable dividend, while a debenture is a loan to the company that carries a fixed rate of interest and must be repaid, and debenture holders are creditors rather than owners.
Money market instruments
The money market deals in short-term instruments and is used by banks, financial institutions, corporates and the government to manage temporary surpluses and deficits. Treasury bills are short-term instruments issued by the government through the Reserve Bank and are issued for eighty-eight, one hundred and eighty-two and three hundred and sixty-four days in India. Call money is very short-term borrowing, usually for one day, between banks. A repo is an agreement to sell securities with a commitment to repurchase them, and it is a way for banks to borrow against securities. Commercial paper is an unsecured promissory note issued by large creditworthy corporates to raise short-term funds, and a certificate of deposit is a negotiable receipt of deposit issued by a bank or financial institution. A credit default swap is a derivative instrument that provides protection against the risk of default of a borrower.
Derivatives, mutual funds and depositories
A derivative is a financial contract whose value is derived from an underlying asset such as a share, an index, a commodity or a currency, and its main purpose is to transfer or hedge risk. Common derivatives are futures, options and swaps. A mutual fund pools the savings of many investors and invests them in a diversified portfolio under professional management, and the Association of Mutual Funds in India, or AMFI, is the industry body for the sector. A depository holds securities in electronic form, and India has two main depositories, the National Securities Depository Limited and the Central Depository Services Limited, of which the former was the first. When securities are held in electronic form it is called dematerialised, or DEMAT, form, and it has largely replaced the old practice of holding physical certificates.
Foreign portfolio investment and market conduct
Foreign portfolio investment, or FPI, refers to investment by foreign investors in Indian shares and debt securities through the securities market, and it is regulated by SEBI; it differs from foreign direct investment, which involves a lasting interest and management participation in a business. Insider trading is the buying or selling of securities by persons who possess confidential price-sensitive information not available to the public, and it is banned because it is unfair and damages investor confidence. The capital market also requires transparency disclosures so that all investors have access to the same material information at the same time.
Key facts at a glance
- SEBI was established in 1988 and became a statutory body in 1992.
- SEBI headquarters is in Mumbai; it regulates the capital market.
- The Reserve Bank of India regulates the money market.
- The Bombay Stock Exchange was founded in 1875 and is the oldest in Asia.
- The National Stock Exchange was established in 1992.
- The Sensex has 30 companies with base year 1978-79.
- The Nifty 50 has 50 companies with base year 1995.
- The primary market deals in new issues; the secondary market deals in existing securities.
- An IPO is the first public issue of shares; an FPO is a later public issue.
- A share gives ownership; a debenture is a loan giving a fixed interest.
- Money market instruments include treasury bills, call money, repos, commercial paper and certificates of deposit.
- Treasury bills are issued for 91, 182 and 364 days.
- A credit default swap protects against default risk.
- NSDL and CDSL are the two depositories; NSDL was the first.
- FPI is regulated by SEBI.
Quick revision points
- The money market is short-term and the capital market is long-term.
- SEBI protects investors and regulates the securities market.
- Indices are barometers of market sentiment.
- Debentures are debt and shares are equity.
- Treasury bills carry no default risk because they are government instruments.
- Depositories convert physical certificates into electronic form.
How to prepare this topic
- Memorise the years connected with SEBI, the BSE and the NSE.
- Learn the composition and base years of the Sensex and the Nifty 50.
- List the money market instruments with a one-line explanation of each.
- Practise distinguishing a share from a debenture and the primary market from the secondary market.
- Remember the two depositories and which came first.
- Understand derivatives and insider trading in simple words.
Common exam traps
- Saying SEBI was set up in 1992; it was established in 1988 and made statutory in 1992.
- Confusing the Sensex composition of 30 companies with the Nifty 50 of 50 companies.
- Mixing up the base years of the two indices.
- Thinking the secondary market raises fresh capital for companies; it does not.
- Treating a debenture and a share as the same thing.
- Calling CDSL the first depository when NSDL was the first.
Frequently Asked Questions
What is the difference between the money market and the capital market?
The money market deals in short-term funds, usually for a period of up to one year, and its instruments include treasury bills, call money, repos, commercial paper and certificates of deposit. The capital market deals in long-term funds and its instruments include shares, debentures and bonds. The money market is regulated by the Reserve Bank of India, while the capital market is regulated by SEBI.
What is the role of SEBI in the Indian securities market?
SEBI, the Securities and Exchange Board of India, protects the interests of investors, promotes the development of the securities market and regulates the market and its intermediaries. It was established in 1988 and obtained statutory powers in 1992. It regulates stock exchanges, brokers, mutual funds, depositories and foreign portfolio investment, and it acts against unfair practices such as insider trading.
What is the difference between the primary market and the secondary market?
The primary market is where securities are issued for the first time and the company receives the money raised, as in an initial public offering. The secondary market is where already issued securities are traded among investors, as on stock exchanges. The primary market channels savings into industry, while the secondary market provides liquidity to investors.
What is the difference between a share and a debenture?
A share represents ownership in a company and gives the holder a right to a dividend that varies with profits and a vote in the company. A debenture is a loan raised by the company and carries a fixed rate of interest that must be paid whether or not the company earns a profit. Shareholders are owners, whereas debenture holders are creditors of the company.
What are depositories and what is DEMAT form?
A depository holds securities in electronic form on behalf of investors, in the same way that a bank holds money. India has two main depositories, the National Securities Depository Limited and the Central Depository Services Limited, and NSDL was the first. When securities are held electronically they are said to be in dematerialised, or DEMAT, form, which is safer and easier to transfer than physical certificates.