What are Financial Instruments?
Financial Instruments are legally binding agreements between two or more parties involving monetary value. They may represent cash, evidence of ownership in an entity, or a contractual right to deliver or receive money or financial assets (such as cash, cheques, demand drafts, bonds, bills of exchange, futures, or options).
Definition of a Financial Instrument
A financial instrument is a real or virtual document that represents a legal agreement involving monetary value. In today’s financial marketplace, financial instruments are generally classified into three categories:
- Equity Instruments – Represent ownership in an asset (e.g., common shares, preferred shares).
- Debt Instruments – Represent a loan made by an investor to an asset owner (e.g., bonds, debentures).
- Foreign Exchange Instruments – Represent agreements involving currency exchange and form a unique category.
Categories of Financial Instruments Based on Form
Financial instruments can also be classified by their form cash instruments and derivative instruments:
- Cash Instruments Cash instruments have values that are directly influenced by market conditions. They are further divided into:
- Securities: Easily transferable instruments, such as stocks and bonds.
- Other Cash Instruments: Includes loans and deposits, where transfer requires mutual agreement between the borrower and the lender.
- Derivative Instruments Derivative instruments derive their value from the performance or characteristics of one or more underlying entities, such as an asset, index, or interest rate. They can be categorized into:
- Exchange-Traded Derivatives: Standardized contracts traded on regulated exchanges.
- Over-the-Counter (OTC) Derivatives: Customized contracts traded directly between two parties outside formal exchanges.
Instruments of Long-Term Finance
- Shares Equity instruments representing ownership in a company. Shareholders receive dividends and have voting rights depending on the share type.
- Debentures Long-term debt instruments issued by companies to borrow funds. Debenture holders receive fixed interest and are creditors of the company.
- Term Loans Medium to long-term loans provided by financial institutions, repayable over a fixed schedule. These are typically used for capital expenditure and expansion.
- Convertible Debentures Debt instruments that can be converted into equity shares after a specified period. They offer the benefits of fixed interest initially and potential ownership later.
- Warrants Financial instruments giving the holder the right (but not the obligation) to purchase shares at a predetermined price within a specific period.
- Zero Interest Debentures (ZIDs) Debentures issued at a discount and redeemed at face value, carrying no periodic interest. Investors gain through the price difference.
- Deep Discount Bonds Long-term bonds issued at a substantially discounted price and redeemed at their full face value, resulting in significant capital appreciation for investors.
- Secured Premium Notes (SPNs) Long-term instruments secured by the company’s assets. They are issued with detachable warrants and offer redemption premium instead of regular interest.
Combining the above methods for categorization, the main instruments can be organized into a table as follows:
|
Asset
Class |
Securities |
Other
Cash |
Exchange-Traded
Derivatives |
OTC
Derivatives |
|
Debt (long term > 1 yr) |
Bonds |
Loans |
Bond futures Options on bond futures |
Interest rate swaps Interest rate caps and floors Interest
rate options Exotic instruments |
|
Debt (short term ≤ 1 yr) |
Bills (e.g., T-bills) Commercial paper |
Deposits Certificates of deposit |
Short-term interest rate futures |
Forward rate agreements |
|
Equity |
Stock |
N/A |
Stock options Equity futures |
Stock options Exotic instruments |
|
Foreign Exchange |
N/A |
Spot foreign exchange |
Currency futures |
Foreign exchange options Outright forwards foreign
exchange swaps Currency swaps |
Financial Instruments Types in India
In India, financial instruments broadly fall under two categories:
- Government Securities
- Industrial (Corporate) Securities
1. Government Securities (G-Secs)
Government Securities are fixed-income instruments issued and backed by the Central Government, State Governments, and other government bodies such as municipal corporations or electricity boards.
Key Features
- Considered one of the safest investments due to sovereign backing.
- Offer low but stable interest rates.
- Have maturities ranging from 5 to 20 years.
- Interest is paid semi-annually (every 3 or 6 months).
- Used by governments to raise funds for infrastructure development and public welfare.
Who invests in G-Secs?
- Commercial banks (for SLR maintenance)
- Insurance companies
- Provident funds
- Mutual funds
- Large institutional investors
How are they issued?
Government securities are issued through the auction process conducted by the Reserve Bank of India (RBI). Investors place bids, and RBI accepts them based on a cut-off price.
2. Industrial Securities (Corporate Securities)
These instruments are issued by companies to meet long-term or working capital requirements.
The main types are:
- Equity Shares
- Preference Shares
- Debentures
3. Equity Shares
Equity shares are considered high-risk, high-return instruments. They represent ownership in a company.
Characteristics
- No fixed return or maturity period
- Dividends are not guaranteed
- Returns mainly come from capital appreciation
- Traded on stock exchanges
- Carry voting rights (in most cases)
4. Preference Shares
Preference shares offer a fixed rate of dividend and priority over equity shareholders.
Characteristics
- Preferential right to receive dividends
- Priority in repayment during winding up
- Cumulative preference shares accumulate unpaid dividends
- All preference shares in India today are redeemable (fixed maturity)
- Act as a hybrid instrument (combining features of equity and debt)
5. Call Money Market
The call money market deals with very short-term loans ranging from overnight to 14 days. It is mainly an inter-bank market.
Key Features
- Banks with cash deficits borrow from banks with surplus liquidity
- Interest rates are market-driven, based on overall liquidity
- Plays a crucial role in maintaining short-term liquidity in the banking system
6. Commercial Paper (CP) and Certificates of Deposit (CD)
Commercial Paper (CP)
- Short-term, unsecured promissory notes issued by companies
- Used to finance working capital requirements
- Issued at a discount and redeemed at face value
- Only companies with strong credit ratings can issue CPs
Certificates of Deposit (CD)
- Similar to CPs but issued by commercial banks
- Fixed maturity and interest rate
- Also issued at a discount and redeemed at face value
Both CP and CD interest rates depend on:
- Market liquidity
- Creditworthiness of the issuer
FAQ's
How are financial instruments classified?
They are mainly classified by form (cash instruments vs derivatives) and by nature such as equity instruments (like shares), debt instruments (like bonds), and foreign exchange instruments.
What are cash instruments?
Cash instruments have values directly influenced by market conditions. Examples include stocks, bonds, loans, and deposits.
What are the main types of long-term financial instruments?
Long-term instruments include shares, debentures, term loans, convertible debentures, warrants, zero-interest debentures, and deep discount bonds.
What are government securities (G-Secs)?
Government securities are fixed-income instruments backed by the Government of India, usually considered safe investments with stable returns
What are corporate or industrial securities?
These are financial instruments issued by companies to raise funds for business operations. They include equity shares, preference shares, and corporate bonds.
What is the call money market?
The call money market is a very short-term loan market (overnight to 14 days) where banks borrow and lend surplus funds among themselves.
What is a commercial paper (CP)?
A commercial paper is an unsecured short-term promissory note issued by companies to finance short-term working capital needs.
Practical Insight: This article gives a clear and simple overview of different types of financial instruments in India, explaining what they are and how they work from equity and debt securities to government and short-term instruments like commercial paper and certificates of deposit so readers can better understand where money can be invested or managed.
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