The Instruments of Capital Market, as the devices of the Capital Market, are integral for channeling capital between investors and borrowers. Various types of Capital Market Instruments, including equity, debt, derivatives among others, facilitate the mobilization and allocation of long-term funds. Understanding them is essential for developing a grasp of the Capital Market in particular and the Indian Financial Market in general. This article of NEXT IAS aims to study in detail various Instruments of Capital Market, including Shares, Bonds, Derivatives, Mutual Funds, Exchange Traded Funds (ETFs), Instruments of Foreign Investments, and other related concepts.
What is Capital Market?
- Capital Market refers to that part of the broader financial market which provides a market for borrowing and lending of medium and long-term funds, above 1 year.
- Thus, the capital market caters to the borrowing needs for medium to long term projects and investments.
- Because of the long maturity period, the Capital Market facilitates the mobilization and allocation of long-term funds.
Its Structure, Major Participants, Major Instruments, and other aspects can be studied in our detailed article on the Capital Market.
About Instruments of Capital Market
The phrase “Instruments of Capital Market” refers to various types of financial tools used within the capital market. They include financial securities and derivatives that serve as mediums through which capital is raised, invested, and traded. These instruments, collectively, facilitate the flow of money among the participants of the capital market, such as investors, companies, and government entities, among others.
Types of Capital Market Instruments
Various instruments used in the capital market for making and raising investments can be, broadly, classified into the following types:
- Share or Stock
- Debt Instruments
- Derivatives
- Mutual Funds
- Exchange Traded Funds (ETFs)
- Instruments of Foreign Investments
Each types of capital market instruments has been discussed in detail in the sections that follow.
Share or Stock
- Share or Stock refers to securities issued by a company that represents a portion of the ownership of a company.
- The capital of a company is divided into shares. Each share forms a unit of ownership of the company and is offered for sale in order to raise capital for the company.
- When an investor purchases a share or stock, it, essentially, means acquiring a stake in the company’s assets and earnings.
- The company pays a dividend to the shareholders as a return on their investment.
- Thus, the shareholders receive dividends, and not interest, as a return from the company.
- There are, primarily, 2 types of Shares.
Equity Shares or Common Shares
- Equity Shares give their holders a share in the earnings/profits of the company as well as voting rights.
- The dividends paid to the holders of equity shares are not fixed but depend on the company’s performance.
- Thus, they receive dividends if the company earns profit, but have to bear the loss if the company incurs a loss.
- Equity shareholders are considered the real owners of the company.
Preference Shares
- Preference Shares give their holders only a share in the earnings/profits of the company, but no voting rights.
- The dividends paid to the holders of preference shares are fixed.
- Thus, they have an entitlement to a fixed amount of dividend like that of interest on a loan given.
- Preference Shares are named so because in case the company is winding up, these shares have the preferential right to get back the capital paid, before Equity Shareholders.
- Preference shares are further classified into 2 types:
Cumulative Preference Shares
Cumulative Preference Shares are those Preference Shares whose dividend, if not paid in a particular year by the company due to loss or any other reasons, gets accumulated and is paid in the next year or after.
Non-Cumulative Preference Shares
Non-Cumulative Preference Shares are those Preference Shares whose dividend, if not paid in a particular year by the company due to loss or any other reasons, does not get accumulated and is foregone.
Debt Instruments
- Debt Instruments are tools through which issuers borrow money from investors.
- Unlike equity securities, holders of debt instruments do not have ownership rights.
- Thus, debt instruments are like a loan from the investor to the issuer. The issuer agrees to pay a specified rate of interest during the life of the bond and to repay the principal amount on a specified date.
- The issuer of a debt instrument is liable to pay interest on the capital borrowed through the instruments, regardless of profit or loss.
Difference between Debt Instruments and Shares
| Basis of Difference | Debt Instruments | Shares |
|---|---|---|
| Meaning | Securities issued to borrow money from investors, without offering any share in ownership rights. | Securities issued by a company that represents a portion of the ownership of a company. |
| Type | Debt is the borrowed fund | Equity is an owned fund. |
| Term | Debt can be kept for a limited period and should be repaid after the expiry of that term. | Equity can be kept for a long period. |
| Risk | Risk is lower than Equity | Risk involved here is higher than in the Debt |
| Forms | Can be in the form of loans, debentures, and bonds | Equity can be in the form of shares and stock. |
| Security | Debt can be secured or unsecured. | Equity is always unsecured. |
Types of Debt Instruments
Based on their risk profiles, and other characteristics, there are various types of debt instruments. The main types of debt securities used in the Capital Market are discussed in the sections that follow.
Bonds
- Bond is a type of debt instrument that represents a loan from an investor (lender) to an issuer (borrower).
- Thus, when an investor purchases a bond, it, essentially, means giving a loan to the issuer of the bond
- Just as in the case of a loan, the issuer of the Bond pays the bondholder
- Interest at regular intervals (also called the Coupon Payment), and
- Principal Amount (also called the Face Value) on the bond’s maturity date.
- The effective return paid by a bond is called the Yield of Bond or the Bond Yield.
- For example, if someone buys a bond of Face Value 100 and gets Coupon Interest of 10 for a year, then the Yield of Bond is 10% ((10/100)x100)
- They are generally considered a safer investment compared to Shares or Stocks, primarily because they provide steady income through fixed interest payments.
- Based on the issuers, there are various types of Bonds as discussed below.
Government Bonds
- Government Bonds refer to bonds issued by national governments or lower levels of government.
- At the national level, these government bonds are known as “sovereign” debt and are backed by the ability of a nation to repay through taxation of its citizens and to print currency.
- Government Bonds are one of the two types of Government Securities (G-Secs).
- One other type of Government Securities (G-Secs) is Treasury Bills, which have a maturity period of less than 1 year and hence are Money Market instruments.
Municipal Bonds
- Municipal Bonds are debt securities issued by a state, municipality or county to finance civic projects.
- They are aimed to meet the financial needs of the Urban Local Bodies (ULBs) or the Municipalities.
- Municipal bonds were first issued in India in 1997, 5 years after the 74th Constitutional Amendment constitutionalized the Urban Local Bodies (ULBs).
- The growth of the municipal bond market is critical for India’s large cities and towns to upgrade their creaking infrastructure.
- However, as of now, the Municipal Bond market in India is not much developed, primarily because of their non-tradability and lack of regulatory clarity.
Corporate Bonds
- Corporate Bonds are issued by corporations to raise capital. As compared to Government Bonds, Corporate Bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government.
- Corporate Bonds are, primarily, of 2 types:
Convertible Bonds
- Convertible Bonds are those bonds that can be converted into a predefined number of stocks as and when required by the investor.
- In other words, they are, essentially, a bond with a stock option hidden inside.
Non-Convertible Bonds
Non-convertible bonds refer to those bonds which cannot be converted into stocks.
Impact Bonds
- Impact Bonds are a form of contractual agreement between Investors and an implementation agency wherein the investors pay money to the implementation agency only if it is able to achieve the pre-determined empirically verifiable social indicators.
- Of late, Impact bonds have become an innovative method of financing social projects related to Education, Health, etc.
- Some popular examples of Impact Bonds include – USAID’s Utkrisht Bond, World Bank’s Women’s Livelihood Bonds, etc.
Green Bonds
- Green Bonds are a type of debt securities, specifically designed to finance projects that have a positive environmental impact.
- Green Bonds are similar to Corporate Bonds. However, the proceeds of such Bonds are exclusively used for financing green projects such as renewable energy projects, projects to mitigate the impact of climate change, reducing the emission of fossil fuels, etc.
Masala Bond
- Masala Bond is a term used to refer to a financial instrument through which Indian entities raise money from overseas markets in Indian Rupees.
- In other words, Masala Bonds are essentially rupee-denominated bonds issued by Indian entities outside India.
Zero-Coupon Bond
- Zero-Coupon Bond is also known as Discount Bond.
- It is a type of debt security that, unlike regular bonds, doesn’t pay regular interest. Instead, it’s sold at a discount to its face value (maturity value), and at its maturity, face value is paid to its holder.
- Thus, the return of the Masala Bond holder comes from the difference between the purchase price and the face value received at maturity.
Inflation Indexed Bond
- Inflation Indexed Bond is a special type of debt security, designed to protect investors from the negative effects of inflation.
- Unlike regular bonds, it provides a constant return, irrespective of the level of inflation.
Debentures
- Debentures are a type of debt instrument just like Bonds that represents a loan from an investor (lender) to an issuer (borrower). However, unlike bonds, which are usually secured by specific assets of the issuer, debentures are typically unsecured.
- As they are not backed by any security, Debentures are considered riskier than Bonds.
Difference between Bonds and Debentures
| Parameters | Bonds | Debentures |
|---|---|---|
| Meaning | A bond is a financial instrument showing the indebtedness of the issuing body towards its holders | A debt instrument used to raise long-term finance is known as Debentures. |
| Collateral | Yes, Bonds are generally secured by Collateral | Debentures may be Secured or Unsecured by a collateral |
| Interest Ratio | Low | High |
| Issued By | Government Agencies, financial institutions, corporations, etc. | Companies |
| Payment | Accrued | Periodical |
| Owners | Bond-Holders | Debenture-Holders |
| Risk Factor | Low | High |
| Priority in repayment at the time of liquidation | First | Second |
Derivatives
- Derivative is a financial contract between two parties (buyer and seller) that derives its value/price from one or more underlying assets and/or securities such as shares, bonds, commodities, etc.
- The buyer agrees to purchase the underlying asset(s) from the seller on a pre-specific date at a pre-specific price.
- Derivates are named so because their values are derived from fluctuations in the underlying assets.
- Since the underlying assets in derivative contracts are bought/sold at a pre-agreed price, they reduce future price fluctuations and uncertainties.
- Thus, they help in hedging the risks and hence are used as risk-hedging instruments.
- Some common forms of derivatives used in the capital market are as follows:
- Forward Contracts
- Future Contracts
- Options
- Swaps
Forward Contracts
- A Forward Contract is an agreement between two parties – a buyer and a seller – to buy or sell something at a future date at a price agreed upon today.
- The pre-agreed price is called the Strike Price.
- Forward contracts are typically traded Over-The-Counter (OTC), meaning they are negotiated directly between the two parties involved, rather than on a centralized exchange.
- Thus, they are unregulated.
Future Contracts or Futures
- Future Contracts are also called Futures.
- Similar to Forward Contracts, a Future Contract is an agreement between two parties – a buyer and a seller – to buy or sell something at a future date at a price agreed upon today.
- The pre-agreed price is called the Strike Price.
- Unlike forward contracts, futures contracts are traded on organized exchanges.
- Thus, they are regulated.
Difference between Forward Contracts and Future Contracts
Though similar in nature, Forward Contracts and Future Contracts (Futures) differ in various respects as can be seen below.
| Forward Contracts | Future Contracts (Futures) |
|---|---|
| Traded Over-The-Counter (OTC), thus are unregulated. | Traded on organized exchanges, thus are regulated. |
| Settled only once – at the end date of the contract. | Changes in the price of the underlying asset are settled on a daily basis. |
Options
- An Option is a contract between two parties – a buyer and a seller – that gives the holder of the contract the right, but not obligation, to buy or sell something at a future date at a price agreed upon today.
- Thus, unlike Forward Contracts and Future Contracts (Futures), there is no obligation on the holder of the contract to perform the contract.
- The pre-agreed price is called the Strike Price.
- The person who writes the option is the seller of the option and is denoted as the “Option Writer”. The person who buys and holds the option is called the “Option Holder”.
- A Premium Price is paid by the Option Holder to the Option Writer to gain the right, but not obligation, to perform the contract.
- Options are traded on organized exchanges.
- Thus, they are regulated.
- Based on the type of right available to the holder of the contract, there are two types of Options – Call Option and Put Option.
Call Option
A Call Option is a type of Option that gives the Option Holder the right to ‘buy’ the underlying asset at a certain pre-agreed price at a pre-agreed date.
Put Option
A Put Option is a type of Option that gives the Option Holder the right to ‘sell’ the underlying asset at a certain pre-agreed price at a pre-agreed date.
Difference between Call Option and Put Option
| Call Option | Put Option |
|---|---|
| Gives the Option Holder the right, but not the obligation, to ‘buy’ the underlying asset. | Gives the Option Holder the right, but not the obligation, to ‘sell’ the underlying asset. |
| Usually, it is preferred when the prices of the underlying assets are expected to rise in the future. | Usually, it is preferred when the prices of the underlying assets are expected to fall in the future. |
Swaps
- A Swap is a contract between two parties for exchange of pre-agreed cash flows of two different financial instruments.
- Swaps are generally used to manage risks related to fluctuations in the interest rates and market value of currencies. Thus, there are two major types of swaps – Interest Rate Swaps and Currency Swaps.
Interest Rate Swaps
- An Interest Rate Swap (IRS) is a specific type of swap agreement that is used to exchange cash flows based on interest rates.
- They involve swapping only the interest rates-related cash flows between the parties in the same currency, which may be on account of a fixed or floating rate of interest.
- They are generally used to manage the risks related to fluctuations in interest rates.
Currency Swaps
- A Currency Swap is a type of swap agreement where two parties exchange cash flows denominated in different currencies.
- They entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
- They are generally used to manage the risks related to changes in the market value of a currency.
Currency Derivatives
- A Currency Derivative is a contract between the seller and buyer, whose value is derived from the currency value in the market or the currency exchange rate.
- It entails that two currencies may be exchanged at a future date at a stipulated exchange rate, irrespective of the exchange rate prevailing on the day of exchange.
Mutual Funds
- A Mutual Fund collects money from investors and invests the money, on their behalf, in stocks, bonds, and other securities.
- Thus, a Mutual Fund is, basically, a mediator that brings together a group of people and invests their money.
- Each investor who gives his/her money to the Mutual Fund owns shares in the Mutual Fund, which represent a portion of the holdings of the fund.
- The managers of the Mutual Fund charge a small fee from the investors for managing the fund on their behalf.
- Mutual funds can be broadly classified into three categories based on the asset classes they invest in.
Equity Funds
Equity mutual funds invest primarily in stocks and equity-oriented instruments, such as shares of the listed companies.
Debt Funds
Debt mutual funds invest in fixed-income instruments like government securities, corporate bonds, treasury bills, money market instruments, etc.
Hybrid Funds
These are mutual funds that invest in more than one type of asset class, including equity as well as debt.
Exchange Traded Funds (ETFs)
- An Exchange Traded Fund (ETF) is a basket of marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
- Exchange Traded Funds (ETFs) combine the features of Mutual Funds as well as Stocks.
- Similar to a mutual fund, an ETF holds a collection of underlying investments, which can be stocks, bonds, commodities, or a combination of these.
- Similar to Stocks and unlike Mutual Funds, ETFs are traded on an exchange and experience price changes throughout the day as they are bought and sold.
Difference between Mutual Funds and Exchange Traded Funds (ETFs)
| Parameters | Mutual Funds | Exchange Traded Funds (ETFs) |
|---|---|---|
| Meaning | An investment fund where a number of investors pool their money together to invest in diversified securities. | The index fund, which tracks the index and is listed & traded in the financial market. |
| Disclosure of Holding | Holdings are disclosed on a quarterly basis. | Holdings are disclosed on a daily basis. |
| Disclosure of Expense Ratio | The average expense ratio of the mutual fund is higher than an ETF. | The average expense ratio of the ETFs is lower than Mutual Funds. |
| Trading Market | In a mutual fund, the buying and selling of shares proceed from the fund house. | Conversely, in ETF the trading is done between two investors in the secondary market. |
| Trade Price | The funds are traded on the Net Asset Value (NAV). | ETF is traded on quoted price rather than their NAV. |
| Tax Efficiency | Mutual funds are considered less tax-efficient than Exchange Traded Funds | Exchange Traded Funds are considered more tax efficient than mutual funds because due to frequent trading their capital gains tax is higher. |
| Requirement of Share Trading Account | In Mutual Funds, there is no requirement for a share trading account to buy a mutual fund. | As the ETF is traded in the stock market a share trading account is required to proceed with the transaction. |
| Brokerage | Brokerage is not paid in Mutual funds. | Brokerage is paid in ETFs. |
| Fractional Shares | Mutual Funds can be issued in a fraction. | ETFs cannot be sold in a fraction. |
| Management | Mutual Funds are actively managed by the fund managers, i.e. the assets are continuously bought and sold in order to outperform the market. | The ETF funds have passive management as they tend to match a specific index. |
Gold ETF
- Gold ETF stands for Gold Exchange Traded Fund.
- Gold ETF is a commodity ETF that consists of only one principal asset i.e. Gold.
- Generally, one unit of Gold ETF represents one gram of gold.
- Gold ETFs are traded in the stock exchange like usual stocks.
CPSE ETF
- CPSE ETF stands for Central Public Sector Enterprise Exchange Traded Fund.
- CPSE ETF pools shares of various Central Public Sector Enterprises (CPSEs) and offers them to investors in the form of a diversified equity investment product.
- CPSE ETF was created to help the Indian government in its initiative to disinvest some of its stake in various CPSEs.
Bharat-22 ETF
- Bharat 22 ETF comprises 22 stocks including Central Public Sector Enterprises (CPSEs), Public Sector Banks (PSBs), and Specified Undertakings of the Unit Trust of India (SUUTI).
- As compared to CPSE ETF, Bharat-22 ETF is more diversified, spanning six sectors –
- Basic materials (4.4%),
- Energy (17.5%),
- Finance (20.3%),
- FMCG (15.2%),
- Industrials (22.6%),
- Utilities (20%).
Instruments of Foreign Investments
There are various types of Capital Market Instruments that facilitate foreign investments in India. Major instruments of foreign investment in the capital market are discussed in the sections that follow.
Depository Receipts (DRs)
- A Depository Receipt (DR) is a financial instrument representing certain securities such as shares, bonds, etc, issued by a company/entity in a foreign jurisdiction.
- Securities of a firm are deposited with a domestic custodian in the firm’s domestic jurisdiction, and a corresponding “depository receipt” is issued abroad, which can be purchased by foreign investors.
- DRs constitute an important mechanism through which issuers can raise funds outside their home jurisdiction.
- Thus, they enable tapping foreign investors who otherwise may not be able to participate directly in the domestic market.
- Depending on the location of issue, Depository Receipts (DRs) are of two types – American Depository Receipts (ADRs) and Global Depository Receipts (GDRs).
American Depository Receipts (ADRs)
- ADRs are issued by an American Bank, acting as a custodian, that represent shares of a non-American company.
- They provide a way of trading non-USA stocks on the USA Exchange.
- For example, if an Indian company wants to raise funds from the US market, it gives its stocks to an American bank. In return for those stocks, the American Bank provides receipts to the Indian company. The company, then, raises funds by providing those ADR receipts in the American share market.
Global Depository Receipts (GDRs)
- They are similar to ADRs, but issued by a depositary bank outside the United States.
- They can be traded on stock exchanges around the world in various currencies, depending on the location of the depositary bank.
- They can be denominated in the foreign company’s home currency, USD, or the currency of the depositary bank’s location.
Foreign Currency Convertible Bond (FCCB)
- A Foreign Currency Convertible Bond (FCCB) is a type of convertible bond issued in a currency different than the issuer’s domestic currency.
- The term ‘Foreign Currency’, here, means that the money being raised by the issuing company is in the form of a foreign currency.
- The term ‘convertible’, here, they are, essentially, a bond, but offer the holder the option to convert them into a predetermined number of the issuer’s shares at specific times during the bond’s life.
Participatory Notes (P-Notes)
- Participatory Notes or P-Notes or PNs are financial instruments used by foreign investors, that are not registered with the Securities and Exchange Board of India (SEBI), to invest in Indian securities.
- Foreign Institutional Investors (FIIs) or Brokers, which are registered with the SEBI, issue Participatory Notes (P-Notes) to overseas investors willing to invest in the Indian stock market.
- P-Notes allow overseas investors who wish to invest in the Indian stock markets, without requiring them to register themselves with the SEBI and go through the hassles of scrutiny and KYC norms.
- Thus, P-Notes allow foreign investors to invest in the Indian market, while remaining anonymous.
- This is what makes P-Notes very popular amongst the FIIs.
- The anonymous nature of P-Notes means that investors remain beyond the reach of Indian regulators.
- This has led to concerns regarding these P-Notes being misused for the purpose of money laundering.
In summary, the instruments of capital market are diverse, each serving specific purposes for different types of investors and issuers. Understanding these capital market instruments is crucial for grasping the dynamics of the capital market as well as the financial system. As global financial markets evolve, these instruments play a vital role in ensuring economic stability and fostering growth.
Related Concepts
Dividends
- A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders.
- Dividends can be issued as cash payments, shares of stock, or other property.
Scrip Share
- It is the share given to existing shareholders without any charge.
- It is also known as Bonus Share.
Sweat Equity Shares
- Sweat Equity Shares refer to equity shares given to the company’s employees in recognition of their work.
- They allow the companies to reward their employees for their services.
Market Capitalization
Market capitalization is the aggregate valuation of the company based on its current share price and the total number of outstanding stocks.
Government Securities (G-Secs)
- A Government Security or G-Sec refers to a tradable instrument issued by the Central Government or the State Government.
- Being backed by the government, these securities are considered risk-free.
- G-Secs are, mainly, of 2 types
Treasure Bills (T-Bills)
- These are short-term Government Securities (G-Secs), with a maturity period of less than 1 year.
- Thus, they are Money Market instrument and not a Capital Market instrument.
- In India, only the Central Government can issue Treasury Bills (T-Bills).
- State Governments are not empowered to issue Treasury Bills (T-Bills).
Government Bonds or Dated Government Securities or Gilt-Edged Securities
- These are long-term Government Securities (G-Secs), with a maturity of more than 1 year.
- Thus, they are a Capital Market instrument and not a Money Market instrument.
- In India, both the Central Government and the State Governments can issue Government Bonds.
Hedge Fund
- A Hedge Fund is a type of investment fund that pools capital from accredited individuals or institutional investors and invests in a variety of assets,
- Thus, Hedge Funds are similar to Mutual Funds. However, as opposed to Mutual Funds, which collect funds from the public, in the case of the Hedge Fund, a handful of investors join together, pool their funds, and invest in different securities.
Alternate Investment Funds (AIFs)
- An Alternate Investment Fund (AIF) refers to any privately pooled investment fund that invests in a variety of investment avenues other than traditional stocks, bonds, and cash.
- These funds are typically pooled investment vehicles, similar to mutual funds or hedge funds, but they focus on alternative asset classes and investment strategies.
- AIFs are designed to provide investors with diversification options beyond conventional investments, aiming to reduce risk and enhance returns under different market conditions.
Venture Capital Funds (VCFs)
Venture Capital Funds (VCFs) are investment funds that manage money from different investors seeking to provide capital in startups and small- and medium-sized enterprises that have strong growth potential.
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