Financial instruments in India
A financial instrument is
a claim against a person or an institution for payment, at a future date, of a
sum of money and/or a periodic payment in the form of interest or dividend. Securities
and other financial products are called as financial instruments. Different
types of financial instruments can be designed to suit the risk and return preferences
of different classes of investors. They enable investors to hold a portfolio of
different financial instruments to diversify risk.
Classification of Financial
Financial instruments can
be classified as follows:
on how they are issued:
They may be primary or
These securities are
directly issued by ultimate borrowers of funds to the ultimate savers. Primary
securities are also called as direct securities.
Equity, preference , debt
and various combinations come under primary securities
They can be classified as
common shares, preference shares
Common share specifies
that the issuer pays the investor an amount based on income earnings, if any,
after settling the obligations arising from firm’s debt instruments which is
required to be paid first to investors.They carry voting rights for the owners.They
are permanent in nature.They are transferable.
value /par value of a share: It is the internally set value
given to the share when it is first issued and has no relationship to the
market price.It remains constant during the life of the period.
An equity shareholder is
entitled to a share of the company’s profits through the payment of an annual
dividend, the amount of which is in proportion to the shareholder’s holding in
the company. Dividends are not guaranteed, and a company can decide not to pay
a dividend or to distribute only lesser amount.In India companies are asked to
state the dividend on a per share basis to ensure better transperancy.When
buying shares, an investor may expect to make a profit on the resale of those
shares. This profit is called capital gain.The price of the share depends on
many factors like
Performances of the company
The market’s evaluation of its performance
The economic situation
Relevant sector risk and company specific
These are shares of a company’s stock which give limited ownership and a
fixed amount of dividends that are paid before common stock
dividends are issued.Dividends
are paid only in years of profit.Preference shareholders
generally don’t have any voting rights in the company
shares exist as long as the companies exist.They are not repayable or redeemable similar to common shares.
Redeemable: The face value is
returned to the share holders after maturity.They have fixed maturity.
Callable: The issuing company
has the right to buy back these shares at a certain price on a certain date.
Convertible:These type of
preference shares can be converted to company’s common stock at a pre-defined conversion
ratio after a certain period.The owners of preference shares can realize
substantial gains by converting their shares.
The type of financial instrument in
which are undertaken to pay the investor (buyer) a regular amount as interest
plus repay the initial amount borrowed is called a debt instrument. The
interest amount which is required to be paid by the issuer is fixed
contractually.Therefore, this type of instrument is usually called fixed income
Features of a
Debt istruments usually carry
a fixed rate of interest commited by the issuer.This rate is called as
Company has to pay interest
whether they make profits or not.
Debt securities are
tradable.The person can hold it until maturity or sell it prior to maturity and
make a capital gain (or loss)
Holders of debt instruments
are not owners of the company .They are its creditors.The creditors may demand
collateral to secure their investment.In this case the instrument is called as
a secured debt,else it is unsecured debt.
The face value of a debt
instrument defines the amount to be repaid on maturity.
of debt securities based on maturity:
Long term debt-instruments-Bonds and Debentures:
used to raise money for longer duration (more than one year)
The issuer of
the bond promises to pay the bondholder typically a fixed amount of interest
each year for a fixed time period.At the end of that time period (the maturity
date) the issuer promises to pay the bondholder the face value of the bond.
It is a long
term debt security
Coupon rate of a bond:
interest rate committed by the issuer at the time security is first issued is
called coupon rate.Coupon payment can be quarterly or semi annual or annual.
Zero coupon bond or discount bond: It is issued at a discount
rate to face value and is redeemed at face value.
Issuer of bonds:The issuer
is a corporation or government(state or central)
by the Central government in India are called as GOI securities or G-secs (also
known as Gilts)
The coupon on
G-sec is paid every 6months( semi-annual coupon)
It is an
unsecured debt instrument which is backed by only the creditworthiness and
reputation of the company and not by physical assets and collateral.
rate is higher than that of bonds as debentures are more riskier.
issue bonds and debentures which are
Short term debt instruments-Money market instruments:
used to raise money for short duration (less than one year).The money market
1. Treasury bills: These are debt securities backed by government so
considered virtually default risk- free.
2. Certificate of deposits:These are issued by bank or a financial
institutuion to raise money,similar to fixed deposits
3. Commercial papers:These are unsecured debt instruments of large
denomination issued by a corporation to raise money.
As with other
debt securities, the holders of these instruments are exposed to most of the
general risks and particularly interest rate risk, liquidity and credit spread
· Time deposits
are money deposits that cannot be withdrawn for a certain period of time unless
a penalty is paid. When the term is over it can be withdrawn or it can be held
for another term.The longer the term the better the yield on the money.
· Mutual funds
is a mechanism for pooling the resources from the investors and investing funds
in securities .This is done in accordance with objectives as disclosed in offer
performance of a mutual fund scheme is reflected in its net asset value (NAV)
which is disclosed on daily basis in case of open-ended schemes and on weekly
basis in case of close-ended schemes. Net Asset Value is the market value of
the securities held by the scheme.It varies on day-to-day basis.
· Insurance policies
It is an
agreement in which insurer agrees to
pay a given sum of money upon the happening of a particular event contingent
upon duration of human life in exchange of the payment of a consideration. The
person who guarantees the payment is called Insurer, the amount given is called
Policy Amount, the person on whose life the payment is guaranteed is called
Insured or Assured. The consideration is called the Premium. The document
evidencing the contract is called Policy.
instrument is a financial contract whose payoff structure is determined by the
value of the underlying asset. The underlying asset can be commodity, security,
interest rate, share price index, oil price, currency (exchange rate) in
circulation, precious metals or the like
1) Forward contracts
A forward contract obliges
its purchaser to buy a given amount of a specified asset at some stated time in
the future at the forward price
2) Future contracts
Futures contracts are created and traded on organized futures
exchanges. Buyers and sellers of future contracts do not deal directly with
each other but with a clearinghouse
An option is a derivative security that gives the buyer (holder)
the right, but not the obligation, to buy or sell a specified quantity of a
specified asset within a specified time period
A swap is a derivative contract through which two
parties exchange financial instruments.Examples of swaps are interest rate
swaps and currency swaps.
Financial instruments in
system of the United States of America (US) constitutes the banking system ,
nonbank financial institutions and financial markets.The US Congress introduces
legislation relating to financial services, and regulators at federal and state
levels issue rules and regulations governing the practices of the industry.
shares that represent part ownership of a business enterprise. There are
different types of equities, namely, stocks, preferred stocks and warrants(Warrants are
securities that give the holder the right, but not the obligation, to buy a
certain number of securities at a certain price before a certain time).
equities markets comprise several stock exchanges. The most important are
located in New York City: the New York Stock Exchange (NYSE) and the American
Stock Exchange (AMEX). Stocks not listed on a formal exchange are traded in the
over-the-counter (OTC) market which includes the National Association of
Securities Dealers Automated Quotation system (Nasdaq) and the National Market
system (NMS). Securities markets are regulated by the Securities and Exchange
debt securities with maturities of longer than one year and must be registered
with the SEC. The Securities and Exchange Commission (SEC) protects investors
and maintains the integrity of the securities markets. Bonds may be issued by governments or by
private sector companies.
securities are classified into mortgage-backed securities and non-mortgage
securities give investors the right to interest
payments from a large number of mortgage loans. Examples of mortgage-backed
Fannie Maes: Fannie Maes are
securities issued by the Federal National Mortgage Association, a publicly
owned, federally sponsored corporation that provides liquidity to the financial
system by buying mortgages from the institutions that originate them, thus
allowing them to relend the funds
Ginnie Maes: Ginnie Maes are
securities issued by mortgage bankers, under the auspices of the Government
National Mortgage Association, to facilitate government mortgage lending.
Freddie Macs: Freddie Macs are
issued by the Federal Home Loan Mortgage Corporation (FHLMC). FHLMC packages
the individual mortgages they buy into pools (groups of similar types of
mortgages with similar rates and maturities) and sell them to investors as debt
Farmer Macs: Farmer Macs are
pass-throughs of mortgages on farms and rural homes. The Federal Agricultural
Mortgage Credit Corporation, a shareholder-owned company established by the US
government, securitizes both agricultural mortgages and loans guaranteed by the
US Department of Agriculture, some of which are not mortgages.
2) Non-mortgage securities are asset backed securities which give owners the right to income
from other assets. Examples of non-mortgage securities are credit card
securities, home equity loans, automotive loans, manufactured-housing
securities, student loans, stranded-cost securities and other novel types of
asset-backed securities. There is no government regulator or SRO to regulate
the asset-backed securities industry.
Municipal Securities: Municipal securities are debt securities such as bonds and notes
issued by states, cities and counties or their agencies to help financing
public projects. Municipal securities are regulated by the Municipal Securities
Rulemaking Board (MSRB).
Money market instruments:
These are debt instruments with maturities of one year or less and
provide liquidity for investors to obtain or lend funds on a short-term basis.
These instruments include
Commercial paper: short-term
debt obligation of a private-sector firm or a governmentsponsored corporation.
Bankers’ acceptances: Bankers’ acceptances are promissory notes
issued by a non-financial firm to bank for a loan.
Treasury bills: T-bills, are
securities issued by national governments with a maturity of one year or less.
Government agency notes:
Government agency notes are short-term debt notes issued by national government
agencies or government-sponsored corporations
Local government notes: Local
government notes are short-term debt notes issued by state, provincial or local
governments or by agencies of these governments
Interbank loans: Interbank loans are loans extended from one
bank to another
Time deposits: Time deposits
are interest-bearing bank deposits that cannot be withdrawn without penalty
before a specified date. They are also called certificates of deposit (CDS).
It is an
agreement to buy or sell a standard amount of a specific commodity in the
future at a certain price. There are two forms of future contracts
1) Commodity futures concern agricultural products, metals, energy and transport.
2) Financial futures include interest-rate futures, currency futures, stock-index
futures, share-price futures, etc.
contracts that give the holder the right, but not the obligation to either buy
or sell a stipulated commodity at a specified price on or before the expiration
date. The most widely traded types of options are equity options, index
options, interest-rate options, commodity options and currency options.
Futures Trading Commission (CFTC) is an independent agency with the mandate to
regulate commodity futures and option markets in the US.
India initiative started by our honourable Prime Minister Mr.Narendra Modi is
one of the necessary steps needed for our economy to compete with the
digitalization transition going on around the world and aims to close the gap
by fostering investment in digital infrastructure, improving digital literacy,
and increasingly providing online services to citizens. This initiative brings
transparency, better control, better job opportunities, it also provides an
ease of access to the people and an upward movement in their quality of life.
Impact of digitization on financial instruments in India:
At first,there were many
problems due to paper shares.There was a need of system that would make buying
and selling of shares easier.
Therefore in 1996, the Indian
parliament passed the Derivatives act, which allowed online transaction of
shares, thus making it much easier for the broker and investor.
Online trading is
basically the act of buying and selling financial products through an online
trading platform. These platforms are normally provided by internet based
brokers and are available to every single person who wishes to try to make
money from the market.
In the new online trading
system, an investor must open a demat account with one of the Stock Brokers to
start trading online.A demat account is a must for an investor to trade online.
Advantages of trading online:
1) Easier and convenient way to own shares
2) Lesser printing and distribution costs
3) It increases the efficiency of the registrars and transfer agents
4) Zero stamp duty on transfer of shares
5) Increased safety than paper shares ,no scope for fake
signatures, delay, thefts, etc.
6) Lesser paperwork for transfer of securities(Immediate
7) Less transaction cost
8) No “odd” problems. Even a single share can be sold.
9) No need for the investor to contact the companies
10) No need of notifying the companies.
11) Automatic credit in demat
12) Both equity and debt
instruments can be held by a demat account
13) Better facilities for communication
14) Timely service to shareholders and investors
The disadvantages of online
trading are mentioned below:
1) Poor investment
choices due to quick decision making
2)There is no personal relationship
between a professional broker and an online trading account holder, thus
leaving the investor on his own to make choices of the right shares.
3)Users who are not familiar
with the ins and outs of the basics of brokerage software can make mistakes
which can prove to be a costly affair.
4)This is like any other
financial strategy, where your commitment to online trading takes research and
dedication to make sure by yourself that everything is up to par. You have to
take time out to do your own research where you will have to overcome a great
learning curve to make some money from online trading a possibility.