Financial Market: CBSE Class 12 Business Studies (NCERT Chapter 10)

Understanding the Financial Market and its Functions

A financial market is a marketplace where financial assets like shares, debentures, bonds, and currencies are created and exchanged. It acts as a critical link between savers and borrowers. Savers have excess funds, while businesses and governments need funds for investment. The financial market facilitates this transfer, ensuring that idle funds are put to productive use. This process, known as the allocative function, is the market's most important role. It ensures that funds are channelled towards projects that offer the highest potential returns, thus promoting economic efficiency and growth. Beyond allocation, financial markets also provide liquidity to financial assets, meaning they can be easily converted into cash. They also help in price discovery by determining the price of securities through the interaction of demand and supply. Lastly, by providing a platform for trading, they reduce the cost of transactions, saving time, effort, and money for both buyers and sellers.

Money Market vs. Capital Market: A Core Distinction

Worked Example: Treasury Bills (T-Bills)

• Concept: Treasury Bills are short-term borrowing instruments issued by the Reserve Bank of India (RBI) on behalf of the Central Government to meet its short-term fund requirements. They are issued at a discount to their face value and redeemed at par (face value). The difference between the issue price and the redemption value represents the interest earned by the investor. They are also known as Zero Coupon Bonds.

  Worked Example:
  Suppose the Government of India issues a 91-day Treasury Bill with a face value of ₹25,000. An investor, say a commercial bank, buys it for ₹24,600.

  Step 1: Identify the given values.

  • Face Value (Redemption Value) = ₹25,000
  • Issue Price (Purchase Price) = ₹24,600

  Step 2: Calculate the discount (interest earned).
  The discount is the difference between the face value and the issue price.
  Discount = Face Value - Issue Price
  Discount = ₹25,000 - ₹24,600 = ₹400

  Step 3: Understand the transaction.
  The investor pays ₹24,600 today and receives ₹25,000 from the RBI after 91 days. The ₹400 earned is the return on the investment. T-Bills are considered one of the safest investments as they are backed by the sovereign guarantee of the government.

The Process of Trading on a Stock Exchange

1. Step 1: Selection of a Broker and Opening Accounts — First, an investor must select a SEBI-registered stockbroker. To trade, three accounts are essential: a Demat Account (to hold shares in electronic form), a Trading Account (to place buy/sell orders), and a Bank Account (for fund transfers).
2. Step 2: Placing the Order — The investor instructs the broker to buy or sell a specific number of shares of a company at a particular price. For example, 'Buy 100 shares of Reliance Industries at ₹2900 or less'. This can be done online through a trading platform or over the phone.
3. Step 3: Order Execution — The broker's computer system sends the order to the stock exchange. The exchange's matching engine finds a corresponding sell order. Once a match is found at the specified price, the order is executed, and a trade confirmation slip is sent to the investor.
4. Step 4: Settlement (T+2 Days) — This is the final stage where the actual transfer of shares and money happens. India follows a T+2 rolling settlement cycle. This means the trade is settled within two working days after the trade day (T). On T+2, the broker receives money from the buyer and transfers it to the seller, and simultaneously, receives shares from the seller's Demat account and transfers them to the buyer's Demat account.

Exam Tip: Scoring High on SEBI's Functions

Questions on the functions of the Securities and Exchange Board of India (SEBI) are very common in board exams. To score well, don't just list the functions; categorize them correctly into three types. For your exam, remember at least two examples for each category:

1. Protective Functions (Protecting Investors):

• Prohibition of fraudulent and unfair trade practices like price rigging.
• Controlling insider trading and imposing penalties for such practices.

1. Developmental Functions (Developing the Market):

• Promoting training of intermediaries of the securities market.
• Facilitating trading through electronic means (e.g., promoting online trading and Demat accounts).

1. Regulatory Functions (Regulating the Business):

• Registration of brokers, sub-brokers, and other players in the market.
• Conducting inquiries and audits of stock exchanges and intermediaries.

Practice Questions with Solutions

• Q: A company needs a large amount of funds (approx. ₹200 crores) for its expansion and diversification plans, which are expected to yield returns after 3-4 years. Which financial market should it approach and why? Also, name two instruments it could use.
  A: Step 1: Identify the nature of the fund requirement. The company needs a large amount of funds for a long-term purpose (expansion with returns after 3-4 years).
  Step 2: Match the requirement with the correct market. The Capital Market deals with long-term funds (more than one year), whereas the Money Market deals with short-term funds (less than one year).
  Step 3: Conclude the market and suggest instruments. The company should approach the Capital Market. Two instruments it could use are Equity Shares and Debentures.
  Final Answer: The company should approach the Capital Market because its fund requirement is for a long-term duration. The Capital Market specializes in providing long-term finance for businesses. Two suitable instruments would be Equity Shares and Debentures.

• Q: A company issued a 182-day Treasury Bill with a face value of ₹50,000 for ₹48,000. Calculate the yield for the investor.
  A: Step 1: Identify the given values. Face Value (FV) = ₹50,000. Issue Price (IP) = ₹48,000. Period = 182 days.
  Step 2: Calculate the discount (interest earned). The interest is the difference between the face value and the issue price. Interest = FV - IP = ₹50,000 - ₹48,000 = ₹2,000.
  Step 3: Calculate the rate of return (yield) for the period. Yield = (Interest / Issue Price) 100. Yield = (₹2,000 / ₹48,000) 100 = 4.167% for 182 days.
  Final Answer: The yield for the investor over the 182-day period is approximately 4.167%.

• Q: An investor can sell her shares in a company anytime she wants through the stock exchange, which provides her with cash. Which function of the financial market is being highlighted here?
  A: Step 1: Analyze the situation described. The investor is able to easily convert her shares (a financial asset) into cash.
  Step 2: Recall the functions of a financial market. The functions include Mobilisation of Savings, Price Discovery, Providing Liquidity, and Reducing the Cost of Transactions.
  Step 3: Match the situation to the correct function. The ability to easily convert an asset into cash without much loss in value is known as liquidity.
  Final Answer: The function of the financial market being highlighted is 'Providing Liquidity to Financial Assets'. The stock exchange acts as a ready market where securities can be bought and sold, ensuring they can be converted to cash when needed.

• Q: A director of a company has knowledge of an upcoming merger that will likely cause the company's share price to increase significantly. Before this news is made public, he buys a large number of shares in his wife's name. Which malpractice is this, and which function of SEBI aims to prevent it?
  A: Step 1: Identify the action. A person with confidential, price-sensitive information is using it for personal gain in the stock market.
  Step 2: Name the malpractice. This practice is known as 'Insider Trading'. It is illegal and unethical as it gives an unfair advantage to the person with the private information.
  Step 3: Identify the relevant SEBI function. SEBI's role is to protect investors and ensure a fair market. Preventing such malpractices falls under its Protective Functions.
  Final Answer: The malpractice committed is Insider Trading. The 'Protective Function' of SEBI aims to prevent such activities by controlling insider trading and imposing heavy penalties.

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