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Unit 1: Indian Financial System

financial instruments or securities, are intangible assets inasmuch as their value is a claim to Notes
future cash.
Equity shares, preference shares, corporate bonds, government security are examples of financial
assets. The entity that offers future cash flows is called the issuer of the financial assets and the
owner of the financial assets is called the investor.

Financial assets exist in an economy because the savings of various individuals, business firms,
and governments during a period of time differ from their investment in real assets (physical
assets). If savings equaled investment in real assets for all economic units in an economy over a
period of time, there would be no external financing and no financial assets. A financial asset is
created only when the investment of an economic unit in real assets exceeds its savings, and it
finances this excess by borrowing or issuing equity securities. Of course, another economic unit
must be willing to lend. In the economy as a whole, savings-surplus economic units provide
funds to savings deficit units and this exchange of funds is evidenced by pieces of paper
representing a financial asset to the holder and a financial liability to the issuer.
Wide range of financial instruments with varying maturity denominations, claims to income
and assets and controlling power are traded in financial markets so as to cater to the diverse
needs of both the supplier of funds and those who need them. Thus, there may be short-term as
well as long-term financial assets. Among short-term instruments, Commercial bills, Treasury
bills, Negotiable certificates of deposits, Commercial paper, Eurodollars are the important
ones.

Commercial Bills represent an important short-term financial instrument that arises out of
commercial transactions. When a buyer is unable to make the payment immediately, the seller
may draw a bill upon him payable after a certain period. The buyer accepts the bills and returns
to the seller who either retains till the due date or gets it discounted from some bank to get cash.
Treasury Bills are the most popular instrument used by the government to raise funds. They are
direct obligations of the government and are almost risk free. They have maturities ranging
from three months to one year. Financial institutions, corporations and individuals buy these
securities from liquidity and safety of principal.

Notes The yields on Treasury bills and bonds are market determined and the market is
both active and liquid.

Negotiable Certificate of Deposit (CD) is a special type of time deposit of a commercial bank.
Negotiable CDs typically have maturities of one to twelve months and are issued in
denominations ranging from $1,00,000 to $1million. CDs are sold only by the largest and most
creditable banks and have a very low default risk.
A Commercial Paper is the unsecured promissory notes with a fixed maturity, usually, between
seven days and three months, issued in bearer form and on a discount basis. Commercial paper
is typically issued by corporations and finance companies. The default risk of commercial paper
is quite low because only well-established business firms can sell it. It is marketed through a
handful of dealers or it may be issued directly to the issuing firm.
Eurodollars are a relatively new instrument. They are nothing more than U.S. dollar denominated
liabilities of foreign banks or offices of U.S. banks located in foreign countries. Eurodollars are
traded in Europe. American firms and banks can borrow in this market. Business firms usually
borrow to finance their international operations. Banks use Eurodollars to make domestic loans
and investment. The loans are generally from one month to six months, and transaction sizes are
typically $10 million.

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