Financial Market

You gave me money I gave you a piece of paper (security)

The place where we did this business is called financial market.

If I had promised to pay back money in less than 1 year (=short

term loan) , this will be called Money Market

If I had promised to pay back money after long time like 10-20
years (=long term loan) , this will be called a CAPITAL MARKET.

Players in Capital Market (diagram)

Subparts of capital market.

As said above, when I take long term loan = its capital market.

When initially I took money from you and give you piece of paper
= this is PRIMARY market. *

But after sometime, you need the money while Im going to pay
back after 10 years.

So you borrow 100 Rs from another guy and give that piece of
paper (=security) to that guy. And tell him to recover the money from
Mrunal = you traded my security. This is SECONDARY MARKET
(Sharemarket / BSE/NSE etc)
(*this primary market will be discussed in another article) our current article
deals only with capital market.)
Its the job of SEBI to control both Primary & Secondary Capital market in
India. (detailed article about SEBI,BSE,&NSE is coming soon.)
As you saw on above diagram that Govt. is also a player in capital market.
So,

Why does Government issue securities?

Suppose Im the Govt.

My expenses are more than my income

= Im in deficit (gap)
Ive following options to cover that deficit
1. Increase tax rates (income tax, VAT, import duties)
But this will make people unhappy and theyll not vote for me in next
election
2. Print more money
But this will create inflation= again unhappy people= less votes.
3. Borrow from international institution (world bank / IMF)
But if I borrow too much, Ill have to play by their tunes regarding Kashmir,
Copenhagen, WTO-Doha.
4. Borrow from people within India
This sounds safer!

So Ill issue securities. (When you issue for the first time = youre
in primary market.)

keep in mind that Govt. does this for short term deficits. (its like I
need money in October 2010 but youre going to pay income tax in
March 2011 so Ill use this trick to cover my money needs.)

Govt. generally plays only in the primary market.

When you give me your money and receive that piece of paper
(security) = you can be certain that Im going to pay back and wont
run away like Ashok Jadeja. After all Im the Government. And I pay
good profits.

thats why Govt. securities are called Gilt-Edged securities

How does this thing work?

As I decided to issue security in primary market, but that doesnt

mean Ill send my peon/clerk/Secretary to the primary market with bag
full of papers (security) and sell it like vegetables.

I give my piece of papers (security / treasury bills) to RBI- theyll

give me the money and then RBIs men will sell it in the primary
market. = RBI is Govt.s debt manager.*

*Security Paper= Im going to pay money after some time. = Im in

your debt. And RBI managers my security papers so theyre my debt
manager.

Separate debt Management office.

Ok so now you know that RBI is Govt.s debt manager. But

consider this

RBIs main job = maintain liquidity (=money supply) in market

via monetary policy (=CRR,Repo etc crap)

But, When RBI sells Govt. securities in primary market, and give
the money to Govt. = money supply flow is interrupted = liquidity is
drying = harder to get loans

= conflict of interest.

Thats why many people are calling for separate Public debt
Management office and relieve RBI from this duty.
Ok now ,final part in this article-As we saw, there are 2 types of capital
market : Primary and secondary. but

Why do we need Secondary market?

Gives Exit Route

Im going to return money to you after 10 years. So your hands are

tied you cant recover it from me until next 10 years, so what if you
needed money in emergency? Youve secondary market so youll sell
my security to someone else and recover the money. Otherwise,

In the absence of a secondary market, many of the investors

would probably not agree to supply capital (money) in the primary
market because they would not have an exit route for their investment.

Gives Price information

By active trading by millions of investor, you get price information regarding
the securities.

This price information is used to judge

1. the corporate performance (share prices)
2. performance of the Government
3. economy (through interest rates on Government debt).
4. facilitating value-enhancing control activities (mergers &
acquisitions) and
5. enabling implementation of incentive-based management
contracts (employee stock options).

Issues & Securities,

1. If I write on a piece of paper saying anyone who gives me 100 Rs.,
Ill give him 120 rupees after 6 months = this is public issue
2. If you give me 100 Rs. And take that paper- then that paper
becomes the security
Keep in mind that The 100 Rs you give to me or the 120 Rs. Ill give to you
after 6 months- that is NOT Security. That Piece of paper is the security.

Technical definition

Security means a formal declaration that documents a fact of

relevance to finance and investment gives the holder a right to receive
interest or dividends.

Security means A guarantee that an obligation will be met

Shares, debentures.

Theyre also securities of one type. You must be knowing about them already
so just in brief-1. If for your 100 rs, I give you a limited ownership in my company
and promise to give you the share from my profit = this is share
2. But if I say that, Ill give you 15 Rs. Every year no matter I get any
profit / not = this is debenture.

Derivatives / Stock Market Derivatives

you gave me 100 Rs and I gave you a paper saying Ill payback
120 Rs. (=Mrunals security paper)

there is another guy named Mitul who, same way borrowed 100
Rs. And gave you another paper saying hell pay you 120 Rs after 6
months. (Mituls security paper.)

Now you need money before 6 months, so you write on a new

paper, anyone who gives me 220 Rs, Ill give him 240 Rs. Worth
Security papers of Mrunal and Mitul.

that new paper you crated is again a security but it doesnt have
direct-money attached with it instead, it derives its value from the
security papers for Mrunal and Mitul. So your new paper is called
Derivatives
lets now deviate from our articles topic for a while to learn a few
things related to recession from above talk.

Mortgage, Asset bubble & derivatives

You give me 100 Rs. And I give you paper saying if I dont pay
back, you can take away my house

this is mortgage. But again this is also one kind of security paper

Now youre a big bank, so youve plenty of such mortgage papers

because you give loans to lot of people. (even to those who cant
afford to pay back the loan)

Then you repack those mortgage papers (security ) and make a

new security paper anyone who gives me 500 Rs. Ill give him
mortgage papers of 5 houses = this is derivative product.

Suppose 3 guy bought such derivative papers and after few

months, he repacks them- makes another derivative product and sell it
to 4 guy.

Such papers are one sort of asset (because you can get money
from someone using it.)

but as you can see, you did not create any new asset youre just
keep reselling same stuff over and over to different people. So youre
blowing a bubble

After few months, I refuse to pay money, and tell the 4 guy to
take away my home. But the prices in reality sector are low so even if
you sell my home you cant recover your 100 Rs. = this is toxic
asset / NPA = non-performing asset and your asset bubble is burst
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