What is Financial Instrument?
A financial instrument is a tradable asset of any kind. Financial instruments are key components of the modern financial market system as they allow efficient flow of capital through the global financial market place. Financial instruments have some monetary value attached to them thus can be traded for other financial instruments or can be redeemed for cash.
A very common example of a financial instrument is a fixed deposit receipt, which can be traded for obtaining loans from banks or can be enchased as the need be. Other financial instruments include share certificates, bond certificates, debt, equity, treasury bills, etc.
Table of Content
Money as a Medium of Exchange
Money has three properties that make it desirable for use it as a medium of exchange. Money provides:
- A Means of Payment: Money is an accepted unit of exchange for goods and services or for the satisfaction of obligations, such as debt, because it is standardised into specific units with specific values. Thus, it is much easier to exchange it for another good.
- A Unit of Account: It can be used to price goods and services, and allows the easy comparison of prices.
- A Store of Value: Money has to be relatively scarce and the supply of new money must be controlled. Any increase in money supply must be gradual and should expand with the economy. Increase in the total quantity of money would reduce the value of money, which is a direct cause of inflation.
Money acts as is a medium of exchange in the process of investment. It is through money that an exchange takes place. Every investment can be reduced to a monetary value, which helps the investor in deciding whether to make an investment or not. Therefore, money is the driving force for all the investment decisions.
Stocks and Bonds
Stocks and bonds are the two main classes of financial instruments investors use in their portfolios. Stocks offer an ownership in the stake of an organization, while bonds are similar to loans made to an organisation. In general, stocks are considered riskier and more volatile than bonds. However, there are many different kinds of stocks and bonds, with varying levels of volatility, risk and return.
There are many differences between a stock and a bond, which are shown in Table:
| Kind of Instrument | Bonds | Stocks |
|---|---|---|
| Meaning | A bond is a debt security, in which an issuer owes the holders a debt and is obliged to repay the principal and interest. | A stock capital is raised by a corporation or jointstock company through the issuance and distribution of shares. |
| Centralisation | Bond markets, unlike stock markets do not have a centralised exchange or trading system. | Stock markets have a centralised exchange or trading system. |
| Holders | Bond holders are in core lenders to the issuer. | The stock holders own a part of the issuing company. |
| Participants | Investors, Speculators, Institutional Investors | Market maker, Floor trader, Floor broker |
| Issued By | Bonds are issued by public sector authorities, credit institutions, companies and supranational institutions. | Stocks are issued by corporations or joint-stock companies. |
| Owners | Bondholders | Stockholders/shareholders |
What is Debt Instruments?
A debt instrument is a document that serves as a legally enforceable evidence of debt and the promise of its timely repayment. In general, two terms are used for denoting a debt instrument. These terms are bonds and debentures. Bonds are used for debt instruments issued by the Central and State Governments and Public Sector Undertakings (PSUs).
They are issued to an individual or organisation against a collateral or security. On the other hand, debentures are the debt instruments that are issued to an individual or organisation by a private sector company without any collateral.
Debt market is basically a wholesale market wherein the trading of securities takes place between the big institutional investors. These investors include banks, financial institutions, mutual funds, provident funds, etc. In India, the debt market is basically segmented into three categories, i.e., government securities, Public Sector Units (PSU) bonds, and corporate securities.
The National Stock Exchange (NSE) began its trading operations in June, 1994 by enabling the Wholesale Debt Market (WDM) of the Exchange. This segment deals in providing a trading platform for a wide range of fixed income securities, which are:
- Central Government Securities: Government securities include dated securities issued by the Central and State governments, which are free from default risk and provide reasonable returns.
- Treasury Bills (T-Bills): These are short-term debt obligations backed by the government with a maturity of less than one year.
- State Development Loans (SDLs): These are issued by the State governments, and the Reserve Bank of India coordinates the process of selling these securities. Every state can issue securities up to a certain limit per year.
- Bonds Issued by Public Sector Undertakings (PSUs): These are issued by central PSUs and sold on private placement basis to the targeted investors at market-determined interest rates.
- Floating Rate Bonds (FRBs): These are debt instruments that have a variable interest rate.
- Zero-Coupon Bonds (ZCBs): These are debt instruments that do not pay interest but are traded at deep discount rates offering profit at maturity when the bonds are redeemed for full face values.
- Index Bonds: These are bond for which payment of interest on the principal is related to a specific price index, generally the consumer price index. This helps in protecting investors by guarding them from changes in the underlying index.
- Commercial Papers (CPs): These are unsecured, short-term debt instruments issued by a firm, mainly for financing accounts receivables, inventories and meeting short-term liabilities.
- Certificates of Deposit (CDs): It is a promissory note issued by a bank. CDs are term deposits that restrict holders from withdrawing funds on demand.
- Corporate Debentures: These are debt instruments raised by various firms to raise capital and like bonds, the debentures too, are documented as agreement.
- SLR and Non-SLR Bonds issued by Financial Institutions (FIs): Banks invest in bonds issued by the government and notified by the RBI as qualifying for Statutory Liquidity Ratio (SLR) to meet the prescribed ratio. On the other hand, banks are also allowed to invest in various non-SLR instruments such as stocks and bonds issued by public and private sector companies.
- Bonds issued by Foreign Institutions and Units of Mutual Funds (MFs): A bond issued by a foreign institution in a different country, denominated in the currency of the country where the bond is issued.
To further encourage wider participation of the retail investors, the Retail Debt Market (RDM) segment was started on January 16, 2003. This segment offers a nationwide, order-driven, screen-based trading system in government securities.
All the above mentioned debt instruments have some similar features, which are discussed as follows:
- Maturity: It is the date on which the borrower has agreed to repay the principal amount to the lender.
- Coupon: It is the periodic interest paid on a bond by the borrower (the issuer of bond) to the lender (the individual who purchased the bond).
- Coupon Rate: It is the rate at which interest is paid to the lender. The coupon rate is calculated as a percentage of the par value of a bond.
- Principal: It is the amount at which a bond is purchased by an individual or organisation. Principal is the par value or face value of the bond.
- Interest: It is the amount paid by a borrower to the lender in return of the amount borrowed for a specific period of time. Interest on a debt instrument is payable annually, quarterly, or monthly on the face value of the bond.
- Face Value: It is the value of the bond mentioned on the bond certificate.
What is Derivatives?
Derivative can be referred to as a financial instrument whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a predetermined manner. The underlying asset could include equity, forex, commodity, etc. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices in the present. The price of a derivative is determined by the spot price of wheat.
The Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines derivative to include the following:
- A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security
- A contract, which derives its value from the prices, or index of prices, of underlying securities.
Derivatives are securities under the SC(R)A and therefore their trading is governed by the regulatory framework under the SC(R)A. Derivatives can be of several types.
Some of the commonly used derivatives are:
- Forwards: It is a derivative wherein one party agrees to sell the asset at a fixed price and the other party agrees to buy the asset at that price on a pre-specified date in future.
- Futures: It is similar to the forward derivative with a difference that the size of the shares and their quality is predefined. In addition, futures contract are traded at stock exchanges like NSE and BSE while forward contract is traded in the FOREX market. future contract is a standardised contract that is written by a clearing house while a forward contract is written by the parties involved in the contract itself.
- Options: It is a derivative in which the owner has a right to buy (also called the call option) or sell (also called the put option) an asset; but he does not have any obligation to buy or sell the asset.
- Swaps: It is a derivative in which two parties exchange cash over a period of time based on the value of underlying asset, exchange rates, interest rates, etc. Swaps are generally of two types, currency swaps and interest rate swaps.
Currency swaps are the one in which exchange of cash takes place in different currencies between two parties and the cash includes both the principal and the interest amount. On the other hand, in interest rate swap, the interest associated with the cash flow is exchanged between two parties in the same currencies.
In derivative markets, there are three types of participants:
- Hedgers: They are the individuals or organisations that predict risks in the future and use derivative instruments for reducing this risks.
- Speculators: These are the individuals or organisations that want to earn money from the fluctuations the occur in the financial markets.
- Arbitrageurs: These are the individuals or organisations that earn money by taking advantage of dissimilarity in the prices of assets and securities in different markets.
Although both speculators and arbitrageurs want to earn money from the loopholes or fluctuations in the market, there is a difference in the approach of the two. Arbitrageurs of study the different markets and their behaviour and then decide to invest in some markets. On the other hand, speculators do not analyse the market and invest in it on the bases of general market trends and tips circulating in the market.
