Financial instrumentsin IndiaAfinancial instrument is a claim against a person or an institution for payment,at a future date, of a sum of money and/or a periodic payment in the form of interestor dividend. Securities and other financial products are called as financialinstruments. Different types of financial instruments can be designed to suitthe risk and return preferences of different classes of investors.
They enableinvestors to hold a portfolio of different financial instruments to diversifyrisk.Classification ofFinancial instruments Financialinstruments can be classified as follows:Based on how they are issued:Theymay be primary or secondary securities.PrimarysecuritiesThesesecurities are directly issued by ultimate borrowers of funds to the ultimatesavers. Primary securities are also called as direct securities.
Equity,preference, debt and various combinations come under primary securitiesEquity instruments:Theycan be classified as common shares, preference sharesCommon shares/stock:Commonshare specifies that the issuer pays the investor an amount based on incomeearnings, if any, after settling the obligations arising from firm’s debtinstruments which is required to be paid first to investors. They carry votingrights for the owners. They are permanent in nature. They are transferable.Face value /par value of a share:It is the internally set value given to the share when it is first issued andhas no relationship to the market price .It remains constant during the life ofthe period.Dividend:Anequity shareholder is entitled to a share of the company’s profits through thepayment of an annual dividend, the amount of which is in proportion to theshareholder’s holding in the company.
Dividends are not guaranteed, and acompany can decide not to pay a dividend or to distribute only lesser amount. InIndia companies are asked to state the dividend on a per share basis to ensurebetter transparency. When buying shares, an investor may expect to make aprofit on the resale of those shares. This profit is called capital gain. Theprice of the share depends on many factors like· Performances of thecompany· The market’s evaluationof its performance· The economic situation· Relevant sector riskand company specific riskPreferenceshares:These are shares of a company’s stock which givelimited ownership and a fixed amount of dividends that are paid beforecommon stock dividends are issued.
Dividends are paid only in years of profit. Preference shareholders generally don’t have any votingrights in the companyTypes of preference shares:· Perpetual: Perpetual preference shares exist as long as the companiesexist.They are not repayable orredeemable similar to common shares.· Redeemable: The face value is returned to the share holders after maturity.Theyhave fixed maturity.· Callable: The issuing company has the right to buy back these shares at acertain price on a certain date.
· Convertible: These type of preference shares can be converted to company’scommon stock at a pre-defined conversion ratio after a certain period.Theowners of preference shares can realize substantial gains by converting theirshares.Debtinstruments:The type of financialinstrument in which are undertaken to pay the investor (buyer) a regular amountas interest plus repay the initial amount borrowed is called a debt instrument.The interest amount which is required to be paid by the issuer is fixedcontractually. Therefore, this type of instrument is usually called fixedincome instrument.
Features of a Debt instrument:· Debt instrumentsusually carry a fixed rate of interest committed by the issuer. This rate iscalled as ‘coupon’.· Company hasto pay interest whether they make profits or not.· Debtsecurities are tradable. The person can hold it until maturity or sell it priorto maturity and make a capital gain (or loss)· Holders ofdebt instruments are not owners of the company .They are its creditors. Thecreditors may demand collateral to secure their investment.
In this case theinstrument is called as a secured debt, elseit is unsecured debt.· The facevalue of a debt instrument defines the amount to be repaid on maturity.Classification of debt securities based on maturity:Long termdebt-instruments-Bonds and Debentures:These are used to raise money for longer duration (more than oneyear)Bonds:The issuer of the bond promises to pay the bondholder typically afixed amount of interest each year for a fixed time period.At the end of thattime period (the maturity date) the issuer promises to pay the bondholder theface value of the bond.It is a long term debt securityCoupon rate of a bond:The original interest rate committed by the issuer at the timesecurity is first issued is called coupon rate. Coupon payment can be quarterlyor semi-annual or annual.
Zero coupon bond or discount bond: It is issued at a discount rate to face value and is redeemed atface value.Issuer of bonds: The issuer is a corporation or government (state or central)GOI securities:Bonds issued by the Central government in India are called as GOIsecurities or G-secs (also known as Gilts)The coupon on G-sec is paid every 6months (semi-annual coupon)Debentures:It is an unsecured debt instrument which is backed by only the creditworthinessand reputation of the company and not by physical assets and collateral.The coupon rate is higher than that of bonds as debentures aremore riskier.Companies can issue bonds and debentures which are convertible(fully/partly) non-convertibleShort term debtinstruments-Money market instruments:These are used to raise money for short duration (less than oneyear).The money market instruments are:1. Treasurybills: These are debt securities backed by government so considered virtually defaultrisk- free.
2. Certificateof deposits: These are issued by bank or a financial institutuion to raisemoney ,similar to fixed deposits3. Commercialpapers: These are unsecured debt instruments of large denomination issued by acorporation to raise money.As with other debt securities, the holders of these instrumentsare exposed to most of the general risks and particularly interest rate risk,liquidity and credit spread risk.Secondary securities· Time depositsTime deposits are money deposits that cannot be withdrawn for acertain period unless a penalty is paid.
When the term is over it can be withdrawn,or it can be held for another term. The longer the term the better the yield onthe money.· Mutual fundsMutual fund is a mechanism for pooling the resources from theinvestors and investing funds in securities. This is done in accordance withobjectives as disclosed in offer document.The performance of a mutual fund scheme is reflected in its netasset value (NAV) which is disclosed on daily basis in case of open-endedschemes and on weekly basis in case of close-ended schemes. Net Asset Value isthe market value of the securities held by the scheme.It varies on day-to-daybasis.
· Insurance policiesIt is an agreement in which insureragrees to pay a given sum of money upon the happening of a event contingentupon duration of human life in exchange of the payment of a consideration. Theperson who guarantees the payment is called Insurer, the amount given is calledPolicy Amount, the person on whose life the payment is guaranteed is calledInsured or Assured. The consideration is called the Premium.
The documentevidencing the contract is called Policy. Derivative instrumentsA derivative instrument is a financial contract whose payoffstructure is determined by the value of the underlying asset. The underlyingasset can be commodity, security, interest rate, share price index, oil price,currency (exchange rate) in circulation, precious metals or the likeTypes of derivatives:1) Forward contractsA forward contract obligesits purchaser to buy a given amount of a specified asset at some stated time inthe future at the forward price2) Future contractsFutures contracts are created and traded on organized futuresexchanges. Buyers and sellers of future contracts do not deal directly witheach other but with a clearinghouse3) Options An option is a derivative security that gives the buyer (holder)the right, but not the obligation, to buy or sell a specified quantity of aspecified asset within a specified time period4) Swaps A swap is a derivative contract through which twoparties exchange financial instruments.
Examples of swaps are interest rateswaps and currency swaps. “Financial instruments in USThe financial system of the United States of America (US)constitutes the banking system, nonbank financial institutions and financialmarkets. The US Congress introduces legislation relating to financial services,and regulators at federal and state levels issue rules and regulationsgoverning the practices of the industry.
Equity instrumentsEquities are shares that represent part of ownership of abusiness. The different types of equities are stocks, preferred stocks and warrants(Warrants are securities that give the holder the right, but not theobligation, to buy a certain number of securities at a certain price before acertain time).The US equities markets comprise several stock exchanges.
The mostimportant of them are l in New York City: the New York Stock Exchange (NYSE)and the American Stock Exchange (AMEX). Stocks not listed on a formal exchangeare traded in the over-the-counter (OTC) market. The OTC market includes theNational Association of Securities Dealers Automated Quotation system (Nasdaq)and the National Market system (NMS). Securities markets are regulated by theSecurities and Exchange Commission (SEC).Debt InstrumentsBonds Bonds are debt securities with maturities of longer than one yearand must be registered with the SEC. The Securities and Exchange Commission(SEC) maintains the integrity of the securities markets and protects investorsfrom frauds. Bonds can be issued bygovernments or by private sector companies.
Asset-backed Securities Asset-backed securities are classified into mortgage-backedsecurities and non-mortgage securities1) Mortgage-backed securities give investors the right to interest payments from many mortgageloans. Examples of mortgage-backed securities are· Fannie Maes:Fannie Maes areissued by the Federal National Mortgage Association, a publiclyowned, federally sponsored corporation that provides liquidity to the financialsystem by buying mortgages from the institutions that originate them, and allowsthem to relend the funds.· Ginnie Maes:Ginnie Maes are securities issued by mortgage bankers.These are issued underthe guidance of the Government National Mortgage Association which facilitatesgovernment mortgage lending.· FreddieMacs: Freddie Macs are issued by the Federal Home Loan Mortgage Corporation(FHLMC). FHLMC packages the individual mortgages they buy into pools (groups ofsimilar types of mortgages with similar rates and maturities) and sell them toinvestors as debt securities· Farmer Macs:Farmer Macs are pass-throughs of mortgages on farms and rural homes. TheFederal Agricultural Mortgage Credit Corporation, a shareholder-owned companyestablished by the US government, securitizes both agricultural mortgages andloans guaranteed by the US Department of Agriculture, some of which are notmortgages.
2) Non-mortgage securities are asset backed securities which give owners the right to incomefrom other assets. Examples of non-mortgage securities are credit cardsecurities, home equity loans, manufactured-housing securities, student loans,stranded-cost securities and other novel types of asset-backed securities.There is no government regulator for regulation of the asset-backed securitiesindustry.
MunicipalSecurities: Municipal securities aredebt securities issued by states, cities and countries or their agencies tohelp financing public projects. Municipal securities are regulated by theMunicipal Securities Rulemaking Board (MSRB). Moneymarket instruments:These are debt instruments with maturities of one year or less (shortterm) and provide liquidity for investors to obtain or lend funds for ashort-term. These instruments include· Commercialpaper: Short-term debt obligation of a private-sector firm or a government sponsoredcorporation.
· Bankers’acceptances: Bankers’ acceptances arepromissory notes issued by a non-financial firm to bank for a loan.· Treasurybills: T-bills, are securities issued by national governments with a maturityof one year or less. · Governmentagency notes: Government agency notes are short-term debt notes issued bynational government agencies or government-sponsored corporations· Localgovernment notes: Local government notes are short-term debt notes issued bystate, provincial or local governments or by agencies of these governments· Interbank loans: Interbank loans are loans extended from onebank to another · Timedeposits: Time deposits are interest-bearing bank deposits that cannot bewithdrawn without penalty before a specified date. They are also calledcertificates of deposit (CDS).Future contracts and options:Future contracts It is an agreement to buy or sell a standard amount of a specificcommodity in the future at a certain price.
There are two forms of futurecontracts1) Commodity futuresconcern agricultural products, metals, energy and transport. 2) Financial futuresinclude interest-rate futures, currency futures, stock-index futures,share-price futures, etc.OptionsOptions are contracts that give the holder the right, but not theobligation to either buy or sell a stipulated commodity at a specified price onor before the expiration date.
The most widely traded types of options areequity options, index options, interest-rate options, commodity options andcurrency options.The Commodity Futures Trading Commission (CFTC) is an independentagency with the mandate to regulate commodity futures and option markets in theUS.” Impact of digitization on financial instruments in IndiaOnline trading:At first, there weremany problems due to paper shares. There was a need of system that would makebuying and selling of shares easier.Online trading isbasically the act of buying and selling financial products throughan online trading platform. These platforms are normally provided byinternet based brokers and are available to every single person who wishes totry to make money from the market.
In the new online tradingsystem, an investor must open a demat account with one of the stock brokers tostart trading online. A demat account is a must for an investor to tradeonline. Advantages of trading online:1) Easier and convenient way to own shares2) Lesser printing and distribution costs3) It increases the efficiency of the registrars and transfer agents4) Zero stamp duty on transfer of shares5) Increased safety than paper shares, no scope for fakesignatures, delay, thefts, etc.6) Lesser paperwork for transfer of securities (Immediatetransfer)7) Less transaction costs8) No “odd” problems. Even a single share can be sold.
9) No need for the investor to contact the companiesimmediately.10) No need of notifying the companies.11) Automatic credit in demataccounts12) Both equity and debtinstruments can be held by a demat account13) Better facilities for communication14) Timely service to shareholders and investorsThe disadvantages ofonline trading are as follows:1) Poor investmentchoices due to quick decision making2)There is no personal relationshipbetween a professional broker and an online trading account holder.3)Users who are notfamiliar with the basics of brokerage software can make mistakes which canprove to be a costly affair.Impact of technologyadvancements on financial industry in USDigital MortgageShifting customerpreferences, regulations and alternative lending platforms are forcingtraditional mortgage business models to adopt technology at much faster pace.The growth of companies like Prosper and Lending Club are examples of havingcrossed billion dollars in origination transactions. Without putting their owncapital at risk, they have provided a market place for lenders and borrowers tomeet and surpass even the best rates.
Features of digitalmortgage:· If amortgage provider can clearly explain product options and loan terms online, itwill reduce the time taken to process loans. These processes help to deliver excellentcustomer experience and create differentiation in this large market.· Everyborrower has the option of choosing a better lender based on a superior userexperience, which makes every transaction more crucial.