Markets and Financial Instruments
Efficient transfer of resources from those having idle resources to others who have a pressing need for them is achieved through financial markets. Stated formally, financial markets provide channels for allocation of savings to investment. These provide a variety of assets to savers as well as various forms in which the investors can raise funds and thereby decouple the acts of saving and investment. The savers and investors are constrained not by their individual abilities, but by the economy’s ability, to invest and save respectively. The financial markets, thus, contribute to economic development to the extent that the latter depends on the rates of savings and investment.
The financial markets have two major components:
- Money market
- Capital market.
The Money market refers to the market where borrowers and lenders exchange short-term funds to solve their liquidity needs. Money market instruments are generally financial claims that have low default risk, maturities under one year and high marketability.
The Capital market is a market for financial investments that are direct or indirect claims to capital. It is wider than the Securities Market and embraces all forms of lending and borrowing, whether or not evidenced by the creation of a negotiable financial instrument. The Capital Market comprises the complex of institutions and mechanisms through which intermediate term funds and long-term funds are pooled and made available to business, government and individuals. The Capital Market also encompasses the process by which securities already outstanding are transferred.
Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level. Let’s look at how commodity derivatives differ from financial derivatives.
Difference between Commodity and Financial Derivatives: The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying is concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.
TYPES OF INVESTMENT AVENUES
Before starting with the deep discussion on financial markets, we must know in a broad sense about the types of investment avenues available in these markets. In other words knowing the alternative financial instruments that are bought and sold in these markets. When a person has more money than he requires for current consumption, he would be coined as a potential investor. The investor who is having extra cash could invest it in assets like stock or gold or real estate or could simply deposit it in his bank account. All of these activities in a broader sense mean investment. Now, lets define investment.
HOW DO YOU DEFINE INVESTMENT?
We can define investment as the process of, “sacrificing something now for the prospect of gaining something later”. So, the definition implies that we have four dimensions to an investment – time, today’s sacrifice and prospective gain. Can we think of Some Transactions, which will qualify as “Investments” as per Our Definition!
- In order to settle down, a young couple buys a house for Rs.3 lakhs in Bangalore.
- A wealthy farmer pays Rs.1 lakh for a piece of land in his village.
- A cricket fan bets Rs.100 on the outcome of a test match in England.
- A government officer buys ‘units’ of Unit Trust of India worth Rs 4,000.
- A college professor buys, in anticipation of good return, 100 shares of Reliance Industries Ltd.
- A lady clerk deposits Rs.5, 000 in a Post Office Savings Account.
- Based on the rumor that it would be a hot issue in the market in no distant future, our friend John invests all his savings in the newly floated share issue of Fraternity Electronics Ltd., a company intending to manufacture audio and video magnetic tapes to start with, and cine sound tapes at a later stage.