Money Market and Foreign Exchange Market [Finance Notes for AHSEC Class 12 2024 Exam]

Money Market and Foreign Exchange Market
[Finance Notes for AHSEC Class 12 2024 Exam]

OBJECTIVE QUESTIONS (1 mark)

1. What is a financial market? Mention its components. 2008, 2013

Ans: It refers to a market which creates and exchanges financial assets and credit instruments such as cheques, bills, bonds, deposits etc. It is divided into two parts: Money market and capital market.

2. What are financial assets?

Ans: It refers to the financial instruments or securities. For e.g. shares, debentures, treasury bills, commercial paper etc.

3. What is floatation cost?

Ans: The expenditure incurred in issuing the securities is called floatation cost.

4. What is a zero coupon bond?

Ans: It is a financial instrument for which no interest is paid but is issued at a discount redeemable at par.

5. Name two buyers of Commercial paper.

Ans: a) Banks b) Insurance companies.

6. What is meant by “Near Money?”

Ans: All very short term securities are called near money for e.g. marketable securities.

7. What type of trade-off function is performed by the money market?

Ans: The money market establishes a balance between short term financial supply and short term financial demand.

8. Name the instruments that are traded in money market.                        2013

Ans: Call money, Commercial Papers, Certificates of deposits, Bills of exchange.

9. Name the institutions operating in the money market.

Ans: Central Bank, Commercial banks, Non-bank financial institutions.

10. What is price rigging?

Ans: It refers to the manipulation of prices of the securities by agents/company for their own profits.

11. Give some examples of Primary assets and secondary assets.

Ans: Primary assets include shares, debentures and bonds and secondary assets include mutual funds, bank deposit, insurance etc.

Q.1. What is money market (99, 02, 05, 10, 15,)? Explain its nature and functions.     2017, 2020, 2022

Ans: Money market is a place where money and short term financial assets which are close substitutes of money are traded. It mainly deals in cash or near money or liquid assets of short-term nature. It also deals in treasury bills (TBs), Commercial bills, Commercial paper (CP), ADRs, GDRs, Call and Short money market etc.

According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government."

From the above explanation, we can say that money market is a market for short term funds meant for use for a period of one year or less. The major participants of money market consist of the government, commercial banks, Life insurance companies, Mutual funds, Non-banking finance companies, stock exchange brokers etc.

Features of Money Market: The salient features of money market are as follows:  2020

a)       Flow of short-term funds: The money market brings together the lenders who have surplus funds for short-term and the borrowers who are in need of short-term funds.

b)      No fixed geographical location: There is no fix geographical location of money market. Different name is given to money market located in different areas.

c)       Participants: The major participants of money market consist of the government, commercial banks, Life insurance companies, Mutual funds, Non-banking finance companies, stock exchange brokers etc.

d)      Instruments:  It deals in money or instruments which are a close substitute of money such as treasury bills (TBs), Commercial bills, Commercial paper (CP), ADRs, GDRs, Call and Short money market etc.

e)      Sub-markets or components: Money market consists of many sub-markets such as call money market, collateral loan market, acceptance market, bill market, treasury bills market etc.

f)        Reasonable access: Money market provides reasonable access to users of short-term funds to meet their requirements on reasonable terms or rates of interest.

g)       Source of working capital: Money market constitutes a major source of working capital finance for borrowers.

Functions of Money Market

The major functions of money market are given below:

(a)    Economic Development: The money market helps in economic development of a country by providing short term funds to both public and private institutions without any discrimination.

(b)    Funds for government: Money market helps the government in borrowing short term funds at very low interest rate. This can be done by issuing treasury bills.

(c)     Return on idle funds: Money market helps the lenders to earn return on their idle or surplus funds for short period.

(d)    Implementation of Monetary Policy: Money market helps in implementing monetary policy of the central bank of any country.

(e)    Mobilisation of funds: The money market helps in transferring funds from one sector to another. The development of trade, commerce and industry depends on the mobilisation of financial resources.

(f)      Connecting link between various financial market: Money market acts as a connecting link between all the segments of financial market like capital market, foreign exchange market etc.

Q.2. Explain the role of Money market.

Ans: Role and of Money Market

A well-developed money market is essential for a modern economy. Though, historically, money market has developed as a result of industrial and commercial progress, it also has important role to play in the process of industrialization and economic development of a country. Importance of a developed money market and its various functions are discussed below:

1. Financing Trade: Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade.

2. Financing Industry: Money market contributes to the growth of industries in two ways:

(a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc.

(b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market.

3. Profitable Investment: Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity.

4. Self-Sufficiency of Commercial Bank: Developed money market helps the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market.

5. Help to Central Bank: Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank.

Money market helps the central bank in two ways:

(a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy,

(b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy.

Q.3. Explain the various Money market instruments. 

Ans: Money market is the short term security market. Following are the instruments dealt in money market.

a) Treasury bills: T-bills short term government security ranging from 14 days to 364 days issued by RBI on behalf of the government to meet its short-term financial needs. No fixed interest in payable on Treasury bills. Normally TBs are issued at the lowest interest rate agreed on competitive bidding. These bills are negotiable instruments and freely transferable.

b) Commercial Paper: Commercial papers are unsecured promissory notes issued by highly creditworthy companies to raise funds for short term. It usually has a maturity period of 15 days to one year. CPs are normally issued at a discount and redeemed at par.  The commercial banks and mutual funds are the main investors of commercial papers.

c) Call money and short notice money: Call money refers to money given for a very short period ranging from 1 day to 7 days. Surplus funds of the commercial banks and other institutions are usually given as call money. Banks are the borrowers as well as lenders for the call funds. If the loan is given for one day and can be called back on demand, it is called money at call but if the loan cannot be called back on demand and will require 3 days’ notice, it is called money at short notice. Money at short notice can be of maximum 14 days.

d) Certificate of deposit (CD): Certificate of deposit is a time deposit having a maturity period from 91 days to 12 months. CDs are issued only by a bank. It is a bearer certificate which is freely transferable and can be sold in secondary market. Banks are not allowed to discount these documents.

e) Commercial bills: These are the trade bills which are drawn at the time of credit sales by the Drawer (Supplier) and accepted by the Drawee (Debtor). It is an acknowledgment of debt normally having a maturity period of 90 days. It is a negotiable instrument and can also be endorsed from one person to another.  It can also be discounted with the bank before maturity.

Q.4. Write a brief note about the structure of Indian money market. What are its important constituents?

Ans: The Indian money market is composed of two categories of financial agencies:

a)       The Organised Sector: The sector contains will established financial instruments. The RBI at the apex is the lender of the money market and controls the banking sector. The scheduled and non-scheduled commercial banks in the private as well as public sector, foreign banks, post office savings bank and co-operative banks are parts of this sector.

b)      The Unorganised Sector: The unorganised sector contains agencies which have diverse policies, lack of uniformity and consistency in the lending business. It includes indigenous bankers, money lenders and chit funds. The indigenous bankers are known as shroffs, multanis, chettiars, etc. The unorganised sector lacks scientific organisation, being orthodox in approach, stagnant and ill-organised.

CONSTITUENTS/COMPOSITION OF INDIAN MONEY MARKET       2010, 2012, 2015, 2017, 2019

Following are the important components of the money market:

1.    Call Money Market: The call money market refers to the market for extremely short period, say one to seven days. These loans are repayable on demand or control. The borrowers are required to pay the loans as and when asked for. There is no demand for collateral securities on call money.

2.    Collateral loan market: Collateral loans are loans which are offered against collateral securities like stocks and bonds and the market is known as the collateral loan market. Collateral loan market is geographically most diversified.

3.    Acceptance market: Acceptance market refers to the market for banker’s acceptance involved in trade transactions. This market deals with banker’s acceptance which may be defined as a draft drawn by a business firm upon a bank and accepted by it. A banker is requiring to a certain sum of money to a particular party or to the bearer on a specific date both within India or abroad.

4.    Bill Market: It is a market in which short-term papers or bills are bought and sold. The most important types of short-term papers are the bills of exchange and the treasury bills. In bills of exchange market, trade bills and promissory note are traded and in treasury bills market, TBs issued by RBI on behalf of government are traded.

5.    Commercial Paper Market: CPs is negotiable short-term unsecured promissory notes with fixed maturities, issued by well rated companies generally sold on discount basis. Companies can issue CPs either directly to the investors or through banks / merchant banks (called dealers). These are issued for a fixed period of time at a discount to the face value and mature at par.

6.    Ready Forward Contract: It is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price.

Q.5. What are the characteristics of Developed money market?

Ans: Essential Characteristic of a Strong Money Market

In order to fulfill the objectives of money market, the money market should be fully developed and efficient. In every country of the world, some type of money market exists. Some of them are highly developed while others are not well developed. Prof. S.N. Sen has described certain essential features of a developed money market. They are as follows:

(i) Highly Organized Banking System: The commercial banks are the nerve centre of the whole money market. They are the principal suppliers of short-term funds. The commercial banks serve as vital link between the central bank and the various segments of the money market. Consequently, a well-developed money market and a highly organized banking system co-exist. In an underdeveloped money market, the commercial banking system is not fully developed.

(ii) Presence of a Central Bank: The Central Bank acts as the banker’s bank. It keeps their cash reserves and provides them financial accommodation in difficulties by discounting their eligible securities. The central bank is the leader, guide and controller of the money market. In an underdeveloped money market, the central bank is in its infancy and not in a position to influence the money market.

(iii)Availability of Proper Credit Instruments: It is necessary for the existence of developed money market a continuous availability of readily acceptable negotiable securities such a bills of exchange, treasury bills etc. in the market. There should be a number of dealers in the money market to transact in these securities. Availability of negotiable securities and the presence of dealers and brokers in large numbers to transact in these securities are needed for the existence of a strong money market.

(iv) Existence of Sub-markets: The number of sub-markets determines the development of a money market. The larger the number of sub-markets, the broader and more developed will be the structure of money market.

(v)  Ample Resources: There must be availability of sufficient funds to finance transactions in the sub-markets. These funds may come from within the country and also from foreign countries.

(vi) Existence of Secondary Market: There should be an active secondary market in these instruments.

(vii) Demand and Supply of Funds: There should be a large demand and supply of short-term funds. It presupposes the existence of a large domestic and foreign trade. Besides, it should have adequate amount of liquidity in the form of large amounts maturing within a short period.

Q.6. What are the characteristics/Defects of Indian money market?                        2016, 2022

Ans: The distinguishing features of Indian money market are given below:             2007, 2009, 2011

1.       Existence of Unorganised Money Market: The Indian money market is dichotomized into organised and unorganised sectors. Existence of unorganised market is the major defect of Indian money market because such organised markets are not under the control of RBI.

2.       Lack of co-ordination: The Indian money market may be characterized as loose and unbalanced because there is no co-ordination between the organised and unorganised sectors.

3.       Disparity in interest rates: The rate of interest charged by the commercial banks, co-operative banks and financial institutions for the same kind of loan may be different. This was mainly due to lack of mobility of funds from one segment to another.

4.       Different lending policies: There is a wide divergence not only in the structure of interest rates, but also in the lending policies of the different financial institution.

5.       Inadequate control by the RBI: The RBI has inadequate control over the functioning of unorganised sector of the Indian money market.

6.       Instability and inelasticity: The instable and inelastic Indian money market acts as a great hindrance to the rapid economic development of the country.

7.       Lack of proper bill market: Indian traders prefer Hundies, rather than draw of bills of exchange. The reason for this is that there is no proper bill market or discount market for short term bills of exchange.

8.       No Banker’s acceptance: There is no development of banker’s acceptance or acceptance of credit by the banks in India.

9.       Banking gap: Banking facilities are inadequate in villages of India. Large commercial banks have a largely urban orientation in India.

10.   Seasonal diversity of Indian money market: Seasonal diversity is also a big problem of Indian money market. October to June is a very busy period for money market because of festive season and product of crops but the remaining period is not so busy.

Q.7. Discuss about the institutions participating in the Indian Money Market.    2012, 2013, 2015, 2017

Ans: Major Participants in the Indian Money Market is given below:

1) The Central Government: The Central Government is an issuer of Government of India Securities (G-Secs) and Treasury Bills (T-bills). These instruments are issued to finance the government as well as for managing the Government’s cash flow. T-bills and G-Secs are issued by RBI on behalf of the government to meet its short-term financial needs.

2) Commercial Banks: Commercial banks are major participants in money market. Certificate of deposits are issued by banks in money market. Then invest in government securities to maintain their statutory liquidity ratio. They also participate in call and term markets both as lenders and borrowers.

3) Life Insurance Companies: Life Insurance Companies (LICs) invest their funds in G-Sec, Bonds or short term money market instruments. They have certain pre-determined thresholds as to how much they can invest in each category of instruments.

4) Mutual Funds: Mutual funds also invest their funds in money market and debt instruments. The proportions of the funds which they can invest in any one instrument vary according to the approved investment pattern declared in each scheme.

5) Non-banking Finance Companies: Non-banking Finance Companies (NBFCs) invest their funds in debt instruments to fulfill certain regulatory requirements as well as to invest their surplus funds. NBFCs are required to invest 15% of their net worth in bonds which fulfill the SLR requirement.

Q.8. What are the similarities between capital market and money market? Also Distinguish between Capital market and Money market.        09, 12, 14, 15, 2016, 2019

Ans: Every firms, individuals and institutions need finance for its expansion and day to day operating activities. Financial needs may be of two types – short term or long term. Based on these needs, financial markets are divided into two categories:

a) Money market – Market for short term funds (2012, 2017)

b) Capital market - Market for long term funds     (2013, 2016)

Similarities between Money Market and Capital Market:

1. Parts of Financial Markets: Both the money market and the capital market are integral parts of the broader financial market system. Money market is a market for short term funds and capital market is a market for long term funds.

2. Offer Investment Instruments: Both money market and capital market involve the buying and selling of financial instruments. But the nature of investments and maturity of these instruments are different in both the markets.

3. Market participants: Financial institutions, such as banks, insurance companies, mutual funds, brokerage firms, play essential roles in facilitating transactions in both markets.

4. Regulation: Both the markets are subject to statutory regulations to ensure transparency, fairness, and stability. Money market is regulated by RBI and capital market is regulated by SEBI.

5. Risk and Return: Investors in both markets face a trade-off between risk and return. Generally, higher returns come with higher risk, while lower-risk investments offer lower returns. Risk is lower in money market but in capital market risk is very high.

Difference between capital market and money market

Basis of  Distinction	Capital Market	Money Market
1)   Period	Capital market is a market for medium and long term funds.	Money market is a market for short term funds.
2)   Constituents	These include new issue market, stock market, stock brokers and intermediaries.	These include call money market, bill market and discounting market.
3)   Participants	Individual and institutional investors operate in the capital market.	Only the institutional investors operate in the money market.
4)   Instruments	The instruments in the capital market include shares, debentures, bonds etc.	Trade bills, certificate of deposits, commercial papers etc. are the instruments of money market.
5)   Liquidity	The instruments of capital market always take time to convert into cash.	The instruments of money market have very high degree of liquidity.
6)   Safety	Investments are unsecured due to high volatility in market.	Investments are safe as compared to capital market.
7)      Regulation	Capital market is primarily regulated by the Securities and Exchange Board of India (SEBI)	Money market is regulated by the Reserve Bank of India (RBI)

Q.9. Who are the Lenders and Borrowers of Indian Money Market?

Ans: Available in Our Mobile Application

Q.10. Write a brief note on foreign exchange market.    2011, 2012, 2016, 2020

Ans: Foreign exchange: Foreign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand.

Foreign Exchange Market: International transactions involve payments or receipts in currencies other than home currency of the trading countries. This results in the necessity for buying and selling of foreign exchange. The market in which currencies of different countries are bought and sold for one another is called the foreign exchange market. In other words, foreign exchange market is a market in which foreign exchange transactions take place.

According to Kindle berger, “Foreign exchange market it a place where foreign money is bought and sold”. 08, 09, 12

Features of Foreign Exchange Market

a. Foreign exchange market has no geographical location.

b. It is electronically linked network.

c. The trading in the foreign exchange market is done usually 24 hours a day by telephone, display monitors, telex, fax machines and other means of communication.

d. The exchange dealers are bound by an informal code of moral conduct.

e. More transactions are based on oral communications to start with; the written documents follow later on.

TYPES OF FOREIGN EXCHANGE MARKET

There are two foreign exchange markets:

a)       Retail market: In this foreign exchange market, the individuals and firms who require foreign currency can buy it and those who have acquired foreign currency can sell it.

b)      Interbank market: In this foreign exchange market, banks who require foreign currency can buy it and those who have acquired foreign currency can sell it.

DEALERS/PARTICIPANTS IN FOREGIN EXCHANGE MARKET: Important dealers in the foreign exchange market are the following:

a)       Banks: The banks dealing in foreign exchange have branches (called exchange banks) in different countries and maintain substantial foreign currency balances in these branches. These branches discount and sell foreign bills of exchange, issue bank drafts, make telegraphic transfers etc.

b)      Brokers: Banks use the services of foreign exchange brokers. Brokers act as intermediaries between the buyers and sellers of foreign exchange among banks.

c)       Acceptance houses: Acceptance house accept bills on behalf of their customers and thus help in remittance of funds.

d)      Central Banks: Central banks are the most official participants in the foreign exchange market. They enter the market both as buyers and sellers to prevent excessive fluctuations in the exchange rates.

FUNCTIONS OF FOREIGN EXCHANGE MARKET: Following are the important functions performed by the foreign exchange market:

a)       Facilitates transfer: The basic function of the foreign exchange market is to transfer purchasing power between countries i.e. to provide a platform whereby currency of one country is converted into currency of another country at the prevailing exchange rate.

b)      Facilitates credit: Foreign bills of exchange used in the international payments normally have maturity period of three to six months. The foreign exchange market performs the function of providing credit to promote foreign trade. Credit is provided on the basis of such foreign bills of exchange.

c)       Facilitates hedging: In a situation of exchange risks, the foreign exchange market performs hedging function. Hedging is the act of equating one’s assets and liabilities in a foreign currency to avoid the risk resulting from future exchanges in the value of foreign currency.

d)      Facilitates trade and investment: International trade and investment would not have been possible without the arrangements or mechanism for buying and selling foreign currency. The foreign exchange market is required to undertake import/export transactions.