Financial Market Instruments and Innovative Debt Instruments - 1 | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

An individual has various options to invest money through different financial instruments available in the market. These instruments serve as channels for investment, acting as means to achieve financial goals. The financial market serves as a hub where millions of investors worldwide converge to trade a wide array of financial instruments. Any asset with capital value that can be traded in the market qualifies as a financial instrument. In India, prominent financial instruments traded in the stock market include shares, stocks, bonds, derivatives, mutual funds, and cheques. However, investing in financial instruments carries inherent financial risks, and trading in them is done at the buyer's own risk. This unit aims to provide an overview of financial instruments, covering their concept, types, functions, associated risks, and regulatory mechanisms in the financial instruments market.

Concept and Features of Financial Instruments

• Financial instruments are intangible assets expected to yield future benefits in the form of claims to future cash flows. They represent tradable assets embodying legal agreements or contractual rights evidencing monetary value or ownership interests. Financial instruments are typically traded in financial markets, where their prices are determined by market forces.
• These instruments can be categorized into two types: cash instruments and derivative instruments, or based on asset class as debt instruments or equity instruments. A third category comprises foreign exchange instruments. Debt and equity instruments are distinguished based on the type of claim they represent. Debt instruments entail a fixed amount owed to the holder and can be short-term (less than one year) or long-term (with a tenure exceeding one year). In contrast, equity instruments obligate the issuer to pay the holder only if profits are earned after debt payments. Common examples of equity instruments include common stock or partnership shares, while some securities, such as preferred shares and convertible bonds, exhibit characteristics of both categories.

Foreign Exchange

Foreign exchange instruments constitute a distinct category. Cash-based foreign exchange instruments include spot foreign exchange, while exchange-traded derivatives comprise currency futures, and over-the-counter derivatives encompass foreign exchange options and outright forwards.

Functions, Importance and Participants in Financial Instruments

• Financial instruments are traded in financial markets, serving three major economic functions: price discovery, liquidity provision, and reduction of transaction costs. Price discovery occurs as transactions between buyers and sellers determine the price of traded assets. This process signals how funds will be allocated among those seeking to lend or invest and those in need of funds, raising capital through the issuance of financial instruments.
• Liquidity provision allows investors to sell financial instruments, representing the ability to sell an asset at its fair market value at any time. Without liquidity, investors would be compelled to hold onto financial instruments until conditions permit their sale or until the issuer is contractually obligated to repay them.
• The reduction of transaction costs occurs when financial market participants incur the costs associated with trading financial instruments. In market economies, institutions and instruments with the lowest transaction costs tend to survive.
• Secondary markets offer liquidity and marketability to existing securities, providing investors with a readily available market to sell shares or debentures. These markets facilitate price discovery through the interplay of buy and sell orders, along with ongoing research and news interpretation. Market prices offer immediate information about issuing companies to all participants due to strict disclosure requirements mandated by exchanges.
• Secondary market trading data is used to create benchmark indices, serving as indicators of economic strength and market capitalization valuation. It facilitates effective governance by enabling changes in corporate control through takeovers, mergers, buyouts, and restructuring activities.
• While there are numerous financial instruments available, each serves the purpose and meets the needs of different investors. For risk-averse investors, investing in the bond market may be preferable to equities. Similarly, investing in the currency market depends on the investor's preferences and objectives, with some businesses opting for currency investments to manage import and export transactions.

The secondary market comprises various participants:

• Investors who buy and sell shares among themselves, providing liquidity and wealth creation in stock markets.
• Market infrastructure institutions including stock exchanges, clearing corporations, and depositories, which handle transaction execution, clearing, and settlement processes.
• Custodians, institutional intermediaries holding funds and securities on behalf of large investors like banks, insurance companies, mutual funds, and foreign portfolio investors (FPIs).
• Depository Participants facilitating electronic holding, transfer, and pledge of securities, as well as corporate actions on holdings.
• Members of stock exchanges or brokers, acting as intermediaries between the exchange and investors, facilitating trading both conceptually and operationally.

Issuers, including companies and other entities, list their securities on stock exchanges, including equity shares, corporate bonds, debentures, and government securities (G-Secs and treasury bills), subject to specific eligibility criteria.

Types of Financial Instruments

• Financial instruments can be categorized into three main types: cash instruments, derivative instruments, and foreign exchange instruments. Additionally, they can be classified based on asset classes into equity-based or debt-based instruments. Foreign exchange instruments constitute a unique category separate from debt and equity.
• Another classification divides financial instruments into two categories: Complex and Non-complex. Complex instruments require specialized knowledge for successful trading, with derivatives being a commonly traded type. Non-complex instruments, such as shares, debt securities, and certain investment funds, can be traded without extensive specialist knowledge.
• Cash instruments are valued directly by the markets and include securities that are readily transferable, as well as loans and deposits requiring agreement between borrower and lender for transfer.
• Derivative instruments, such as options and forward exchange contracts, derive their value from underlying assets and are known as "derivatives" because their value is derived from underlying assets or liabilities. These instruments include futures and options, which are used to manage various risks.
• Options contracts grant the holder the right, but not the obligation, to buy or sell the underlying asset at a specified date and price. Futures contracts involve agreements between parties to buy or sell specific quantities of the underlying asset at a predetermined price on a future date.

Individual financial instruments include:

Bonds: Long-term debt instruments obligating the issuer to repay the holder the principal amount plus interest over a specified period. Bonds can be government bonds, corporate bonds, or municipal bonds.

• Exotic derivatives: Customized derivative products more complex than standard options.
• Loans: Funds lent by individuals, organizations, or entities to others, with the recipient liable to repay the principal amount plus interest.
• Treasury bills (T-bills): Short-term debt instruments issued by governments, known for their liquidity.
• Deposits: Savings and current accounts held in banks or post offices, offering guaranteed returns.
• Cash and Cash Equivalents: Highly liquid investments convertible into cash within three months, including treasury bills and money market funds.
• Certificate of Deposits (CDs): Fixed-income financial instruments issued by financial institutions, similar to fixed deposits (FDs) but freely negotiable.

Foreign exchange instruments include currency swaps, foreign exchange options, and swaps related to currency exchange rates.

• Mutual funds pool investors' money to invest in various financial instruments, offering diversification, professional management, and regulatory oversight. They can be categorized by structure (open-ended or closed-end) or by investment objective (growth funds, income funds, balanced funds, etc.).
• Mutual funds in India are popular due to low initial investment requirements and risk diversification. They are regulated by the Securities and Exchange Board of India (SEBI) and offer various schemes tailored to investors' needs, including tax-saving schemes, sector funds, and index funds.

Shares and other equity-related instruments

• Equity represents ownership in a company, with shares in a limited company granting the holder a portion of the company's share capital. Shareholders have the right to vote at general meetings, with their voting power often corresponding to the number of shares owned. Dividends, if distributed, are contingent on the company's profits and are not guaranteed. Equity shares provide permanent capital to the firm and cannot be redeemed during the company's existence. During liquidation, equity shareholders have a claim to their capital after all other obligations are met.
• Shares are traded on stock markets, and their prices are influenced by various factors such as company performance, market evaluation, economic conditions, sector risks, and company-specific risks. In India, share trading is actively conducted on stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).

Primary market activities involve the trading or subscription of newly issued shares, primary capital certificates, and bonds. Various types of primary issues include:

• Public issue: Securities are offered to the general public.
• Private placement: Securities are issued to select investors, diluting existing shareholders' voting rights.
• Preferential issue: Securities are issued to identified investors.
• Qualified Institutional Placement (QIP): Securities are issued to institutional investors exclusively.
• Rights and Bonus issues: Existing shareholders receive additional shares based on their holdings, with bonus issues being funded from share premium reserves.

Share prices are primarily influenced by a company's prospects and future profitability. Market participants' analyses and assessments of a company's potential for earnings growth, as well as external factors like economic conditions and technological advancements, impact share prices. Financial market participants may hold varying opinions on future share price movements, with earnings being a significant factor driving stock prices. Market turnover, or the volume of shares traded, also affects share prices. Shares with high turnover and good liquidity allow for large trades without significant price impact and typically have narrower bid-ask spreads.

The Nature of Risks Associated with Specific Financial Instruments

All financial instruments inherently carry a degree of risk, even those considered low-risk may entail some level of uncertainty. The specific risks associated with each financial instrument depend on various factors, including its issuance or structure. Each structured product has its unique risk profile, but certain risks may apply cumulatively, increasing the overall risk for the investor.

However, certain risks are specific to individual financial instruments, arising from factors unique to those assets rather than general market risks. Here are some of the key risks associated with specific financial instruments:

• Equities/Shares: Investment in shares poses risks related to dividend payments and potential loss of capital. Listing shares on a regulated market does not ensure their liquidity. Company-specific risk involves underperformance or adverse events affecting the company's financial instruments, while industry-specific risk pertains to negative events impacting an entire sector.
• Bonds: Bondholders face credit spread risk and interest rate risk, with bond prices moving inversely to interest rate changes. Default risk and liquidity risk are also pertinent. High yield bonds, with lower credit ratings, offer higher coupons to compensate for increased risk.
• Counterparty Risk: This risk arises when a debtor fails to repay debt on time, considering factors such as the debt amount, probability of default, and potential recovery in case of default.
• Derivatives: Derivatives exhibit diverse risk profiles based on product structure and classification. Market risk encompasses exposure to changes in market parameters. The gearing effect, influenced by underlying asset price movements, is a critical risk in derivative investments.

General Types of Risks Associated with All Financial Instruments:

• Economic Risk: Economic fluctuations impact financial instrument prices and exchange rates, requiring investors to adjust their portfolios accordingly.
• Credit Risk: Credit-financed investments carry additional risks, including the potential for collateral value fluctuations and issuer default.
• Market Risk: Fluctuations in market factors affect financial instrument prices, encompassing changes in interest rates, exchange rates, and commodity prices.
• Legal/Political Risk: Unclear or changing laws and regulations, along with government interventions, may impact securities.
• Exchange Rate Risk: Currency fluctuations can affect the value of foreign currency-denominated financial instruments.
• Liquidity Risk: The ability to buy or sell financial instruments at market prices may be compromised due to illiquidity.
• Psychological Risk: Market sentiment and rumors can influence price volatility, independent of company fundamentals.
• Force Majeure: Unforeseeable events beyond human control, like natural disasters, can impact financial market operations.

Each financial instrument carries its unique set of risks, necessitating thorough understanding and risk management by investors.

Regulation of Financial Instruments

• A variety of financial instruments are traded on regulated markets, such as stock exchanges. These include shares, primary capital certificates, bonds, treasury bills, certain fund units, and various financial derivatives. Trading activities are facilitated by securities firms utilizing the trading system. Price data for these financial instruments are regularly disseminated through the market's websites, newspapers, and other media outlets.
• Only shares issued by public limited companies or similar foreign entities can be listed on regulated markets, including stock exchanges. Specific criteria regarding the company's size, business history, ownership dispersion, and disclosure of financial statements and other pertinent information must be met.

Regulatory guidelines govern the public issuance of shares, encompassing various key regulations such as:

• Mandating a minimum of 3 and maximum of 10 working days for a public issue to remain open.
• Allowing investors to submit applications during this period.
• Permitting investors participating in book-built issues to revise their bids within the specified timeframe.
• Requiring companies conducting a public issue to establish agreements with all depositories.
• Providing the option for companies to have their initial public offerings (IPOs) graded by a SEBI-registered credit rating agency.

Secondary markets operate under the regulatory framework outlined by SEBI regulations. Stock exchanges are empowered by SEBI to oversee aspects of regulation concerning trading, membership, and listing. While we have previously delved into SEBI's role in earlier units (1 and 2) in more depth, the discussion of regulation in this unit aims to maintain continuity and comprehension.

Conclusion

• A financial instrument constitutes a tangible or digital document embodying a legal agreement among individuals or parties, representing a monetary value. These instruments, categorized as intangible assets, are anticipated to yield future benefits in the form of claims to forthcoming cash flows, each possessing distinctive characteristics. They can be generated, traded, settled, or altered in accordance with the requirements of the involved parties.
• Various types of financial instruments exist, broadly classified into two categories: derivative instruments and cash instruments. Derivatives derive their value from an underlying asset. Additionally, they can be categorized based on asset classes, encompassing commodities, shares, bonds, derivatives, or forex, and further subdivided into complex or non-complex instruments.
• Investment funds encompass hedge funds and mutual funds, which enable investors to pool their resources under the guidance of a specialist known as the fund manager. Typically, the fund manager assumes responsibility for making investment decisions on behalf of the investors.
• Market risk, also known as the risk of adverse changes, pertains to fluctuations in the price of the underlying instrument. Generally, the potential for investment gains in a financial instrument is accompanied by the risk of losses, which vary among different instruments. Despite past performance, the future performance of an investment is not guaranteed, contingent upon factors such as economic trends. Consequently, price declines, leading to investor losses, remain a possibility.