Capital and Money Markets: Capital Market Instruments | Management Optional Notes for UPSC PDF Download

Introduction

A capital market serves as a platform for raising long-term funds through securities, including debt or equity, by business enterprises and governments. Unlike short-term funds obtained from other markets like the money market, the capital market provides financing for periods exceeding one year. Distinguished by its breadth, the capital market offers a diverse range of financial instruments. While equity and preference shares, fully convertible debentures (FCDs), non-convertible debentures (NCDs), and partly convertible debentures (PCDs) remain prevalent, innovative instruments continue to emerge, such as debentures bundled with warrants, participating preference shares, zero-coupon bonds, and secured premium notes.

Secured Premium Notes (SPN)

• SPN is a secured debenture redeemable at a premium, accompanied by a detachable warrant redeemable after a specified notice period, typically four to seven years. Holders of SPN warrants have the option to apply for and receive equity shares, subject to full payment of the SPN. During a lock-in period, no interest is paid on the invested amount. 
• After this period, SPN holders can sell back the notes to the company at par value, foregoing interest/premium. Alternatively, if retained, holders receive the principal amount along with interest/premium in installments as determined by the company. Conversion of detachable warrants into equity shares must occur within the specified timeframe.

Deep Discount Bonds

• These bonds are sold at a significant discount from their par value and typically carry no coupon rate or lower coupon rate compared to similar fixed-income securities with comparable risk profiles. 
• Deep discount bonds cater to the long-term funding needs of issuers and investors seeking deferred returns, often featuring lengthy maturities of 25-30 years. For instance, IDBI issued deep discount bonds for Rs. 1 lakh, repayable after 25 years, at a discounted price of Rs. 2,700.

Equity Shares with Detachable Warrants

• Warrants, securities issued by companies, grant holders the right to purchase a specified number of shares at a predetermined price within a defined period. These warrants are independently listed on stock exchanges and traded separately. 
• Often attached to bonds or preferred stock, warrants serve as incentives for issuers, allowing them to offer lower interest rates or dividends. Companies like Essar Gujarat, Ranbaxy, and Reliance have issued such instruments.

Fully Convertible Debentures with Interest

• These are debt instruments that undergo full conversion into equity shares within a specified timeframe. Conversion may occur in one or multiple phases. During the debt phase, investors receive interest payments. 
• However, once conversion takes place, interest payments cease on the converted portion. In cases where project finance is raised through Fully Convertible Debentures (FCDs), investors continue to earn interest even during the project implementation phase. Upon project completion, investors can benefit from profit participation through share price appreciation and dividend payments.

Equipref

Equipref refers to fully convertible cumulative preference shares divided into two parts: Part A and Part B. Part A automatically converts into equity shares upon allotment without any application by the allottee. Part B, on the other hand, can either be redeemed at par or converted into equity shares after a lock-in period, at the investor's discretion, at a price 30% lower than the average market price.

Sweat Equity Shares

• "Sweat equity" denotes equity shares granted to employees on favorable terms to acknowledge their contributions. Typically, employees receive options to purchase company shares, thereby becoming partial owners and participating in profits alongside their salaries. This practice boosts employee morale and incentivizes them to strive towards the company's objectives. 
• According to the Companies Act, sweat equity shares are equity shares issued to employees or directors at a discount or in exchange for non-cash consideration, such as intellectual property rights or value additions.

Tracking Stocks

• Tracking stocks are securities issued by a parent company to monitor the performance of a specific subsidiary or business line, without entitling holders to assets of either the division or the parent company. 
• They are sometimes referred to as "designer stock." By issuing tracking stocks, a parent company segregates the revenues and expenses of the relevant division from its financial statements, often to separate a subsidiary's high-growth segment from a larger parent company facing losses. Despite this separation, the parent company and its shareholders retain control over the subsidiary's operations.

Disaster Bonds

• Also known as Catastrophe or CAT Bonds, Disaster Bonds are high-yield debt instruments typically linked to insurance and intended to raise funds in the event of a catastrophe. They contain special provisions stating that if the issuer, typically an insurance or reinsurance company, incurs losses from a predefined catastrophe, the issuer's obligation to pay interest and/or repay principal may be deferred or forgiven entirely. 
• For instance, Mexico issued $290 million in catastrophe bonds under a World Bank program, with Goldman Sachs Group Inc. and Swiss Reinsurance Co. managing the sale. These bonds pay investors unless a specified earthquake or hurricane triggers a transfer of funds to the Mexican government.

Mortgage-Backed Securities (MBS)

• MBS represents a form of asset-backed security, functioning as a debt obligation representing claims on cash flows from mortgage loans, primarily those related to residential properties. These securities derive their value from the principal and payments associated with the underlying mortgage loans. The payments are categorized into different classes of securities based on the risk profile of the mortgages included in the MBS.
• Mortgage originators utilize MBS to replenish their investments and introduce new instruments for market fundraising, offering economic efficiency and effectiveness. It facilitates the conversion of assets into funds, allowing financial companies to save on asset maintenance costs and overheads, thereby enhancing profit margins. Various types of Mortgage-Backed Securities include Commercial Mortgage-Backed Securities (CMBS), Collateralized Mortgage Obligations (CMOs), and Stripped Mortgage-Backed Securities.

Global Depository Receipts/American Depository Receipts (GDRs/ADRs)

GDRs and ADRs are negotiable certificates held in one country's bank representing a specific number of shares of a stock traded on an exchange in another country. They facilitate share trading, particularly for companies from emerging or developing markets. While their prices closely track related shares, GDRs and ADRs are traded and settled independently of the underlying shares. These depository receipts provide an indirect means for companies to list on foreign stock exchanges, enabling NRIs and foreign nationals to invest in Indian companies without directly engaging with the complexities of the Indian financial market.

Foreign Currency Convertible Bonds (FCCBs)

• A convertible bond represents a hybrid financial instrument combining elements of both debt and equity. It entails regular coupon and principal payments, while offering bondholders the option to convert the bond into stock. FCCBs are issued in a currency different from the issuer's domestic currency.
• Investors benefit from the security of guaranteed bond payments while also having the opportunity to capitalize on significant appreciation in the company's stock value. The equity component of FCCBs enhances the bond's value, resulting in lower coupon payments for the issuing company, thus reducing its debt financing expenses.

Advantages:

• Certain companies, banks, governments, and sovereign entities may opt to issue bonds in foreign currencies due to the perceived stability and predictability of those currencies compared to their domestic currency.
• Issuers gain access to investment capital available in foreign markets.
• Companies can utilize FCCBs to enter foreign markets.
• FCCBs function as both debt and equity instruments, offering regular coupon and principal payments alongside the option for conversion into stock.
• FCCBs typically carry lower interest rates (30-50% lower than market rates) due to their equity component, making them a cost-effective debt option.
• Bond-to-stock conversion occurs at a premium to the market price, resulting in lower dilution of company stocks.

Advantages for Investors:

• Guaranteed bond payments provide investors with a secure investment option.
• Investors can capitalize on potential appreciation in the company's stock value.
• FCCBs are redeemable at maturity if not converted.
• The option for conversion into equity makes FCCBs easily marketable, particularly if there is capital appreciation.

Disadvantages:

• FCCBs expose issuers to exchange rate risk, as bond interest payments are payable in foreign currency. Therefore, FCCBs are preferred by companies with low debt-equity ratios and significant foreign exchange earnings.
• FCCBs contribute to increased debt and foreign exchange outflow in terms of interest payments.
• There is a risk of exchange rate fluctuations affecting both interest and principal payments if the bonds are not converted into equity. In the event of a decline in stock price, investors may opt for redemption rather than conversion, necessitating refinancing to fulfill redemption obligations, potentially impacting earnings.
• Until conversion, FCCBs remain classified as debt on the balance sheet.

Derivatives

A derivative is a financial instrument whose value and characteristics are dependent on an underlying asset, such as a commodity, bond, equity, currency, or index. Sophisticated investors utilize derivatives to manage risk associated with the underlying security, hedge against value fluctuations, or profit from periods of market inactivity or decline. Derivatives are often leveraged, meaning that even a slight movement in the underlying asset's value can result in a significant change in the derivative's value.

Derivatives are typically categorized based on several factors:

• The relationship between the derivative and its underlying asset (e.g., forward, option, swap).
• The type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, credit derivatives).
• The market in which they are traded (e.g., exchange-traded or over-the-counter).

Futures:

• Futures are financial contracts obligating the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price. These contracts specify the quality and quantity of the underlying asset and are standardized to facilitate trading on futures exchanges. 
• Some futures contracts require physical delivery of the asset, while others are settled in cash. Futures markets are known for their high leverage relative to stock markets.

Options:

• Options are financial derivatives representing contracts sold by one party (option writer) to another party (option holder). These contracts grant the buyer the right, but not the obligation, to buy (call) or sell (put) a security or financial asset at an agreed-upon price (the strike price) during a specified period or on a specific date (exercise date). 
• The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, whereas futures contract holders are obligated to fulfill the terms of their contracts.

Participatory Notes

• Participatory Notes, also known as "P-Notes," are financial instruments used by investors or hedge funds not registered with the Securities and Exchange Board of India (SEBI) to invest in Indian securities. 
• Indian-based brokerages purchase India-based securities and issue participatory notes to foreign investors, allowing them to benefit from dividends or capital gains from the underlying securities without registering with SEBI. The Reserve Bank of India (RBI) has sought to ban P-Notes due to difficulties in establishing beneficial ownership or the identity of ultimate investors.

Hedge Fund

• A hedge fund is an investment fund open to a limited range of investors that engages in a broader range of investment and trading activities in domestic and international markets. 
• Hedge funds typically pay a performance fee to their investment managers and employ various strategies, such as short selling, leverage, program trading, swaps, arbitrage, and derivatives, to seek high returns while mitigating risks. 
• Hedge funds are often structured as private investment partnerships with a high initial minimum investment requirement and relatively illiquid investment terms.

Fund of Funds

• A "fund of funds" (FoF) is an investment strategy in which a portfolio comprises other investment funds rather than directly investing in securities. This approach, also known as multi-manager investment, allows investors to achieve broad diversification and appropriate asset allocation across various fund categories within a single fund. 
• Fund of funds provide investors with exposure to a range of investment opportunities wrapped up in a single investment vehicle.

Exchange Traded Funds (ETFs)

• An Exchange Traded Fund (ETF) is a financial product traded on stock exchanges, similar to stocks, that holds assets such as stocks or bonds. ETFs typically trade at a price close to the net asset value of their underlying assets throughout the trading day. 
• Many ETFs are designed to track specific indices, such as the S&P 500 or MSCI EAFE, offering investors exposure to a diversified portfolio of securities in a single investment. They are often favored for their low costs, tax efficiency, and stock-like features. A single ETF can provide investors with access to a wide range of index funds, such as the NSE Nifty.

Gold ETF

• A Gold Exchange Traded Fund (ETF) is a type of financial instrument similar to a mutual fund, whose value is linked to the price of gold. The price of one unit of a gold ETF typically correlates closely with the price of one gram of gold. 
• As the price of gold increases, the value of the ETF is expected to rise proportionally. Gold ETFs are traded on major stock exchanges worldwide, including Zurich, Mumbai, London, Paris, and New York. Additionally, there are closed-end funds (CEFs) and exchange-traded notes (ETNs) available that aim to track the price of gold.