Capital Market Instruments are ways through which firms and financial institutions can raise capital through Primary and Secondary Markets. A strong capital market is a necessary condition for a country's industrial and commercial development. The capital market is a central coordinating and directing mechanism for the free and balanced flow of financial resources into a country's economic system. The study of the capital market instruments is essential to reap the full benefits of this long term capital. Capital market instruments are an important topic for the UPSC IAS Exam Economy Syllabus.

What is a Capital Market?

• A capital market is a marketplace for medium and long-term investments.
• All organisations, institutions, and instruments that provide long-term and medium-term funds are included in the capital market.
• It does not include instruments or institutions that provide short-term financing (up to one year).
• The Capital Market in India is regulated by SEBI.
• Primary and secondary markets make up capital markets.
• New securities are issued and sold in primary capital markets. The secondary market is where investors trade previously issued securities.
• The stock market and the bond market are the two most common capital markets.

Types of Capital Market Instruments

Indian Depository Receipt

• An IDR is a financial instrument that allows a foreign company to raise funds in India.
• In an IDR, a foreign company issues shares to an Indian Depository, which then issues depository receipts (IDR) to Indian investors.
• An Overseas Custodian would hold the real shares underlying the IDRs and authorise the Indian Depository to issue the IDRs.
• IDRs are denominated in Rupees. It reflects a stake in a certain number of the Issuing Company's underlying equity shares. Deposited Shares are the name for these shares.

Global Depository Receipt

• A Global Depositary Receipt (GDR) is a bank certificate that symbolises shares in a foreign company, with the shares being held by a foreign branch of an international bank.
• GDRs are traded on a variety of exchanges because they are considered negotiable certificates.
• In the international market, GDR transactions have lower associated costs than alternative mechanisms used by investors to trade foreign securities.

Participatory Notes

• Participatory Notes are Overseas Derivative Instruments with Indian stocks as underlying assets that allow foreign investors to invest in Indian stock exchanges without having to register with SEBI.
• Participatory notes are not traded on Indian stock exchanges and are sold in a directory to foreign investors who purchase them through the FII to dodge taxes and regulations.

Inter Corporate Deposits Market

• Inter Corporate Deposits (ICDs) are unsecured short-term loans from one corporation to another.
• These corporations must be registered under the Companies Act 1956.
• A company with excess funds would lend to another company in need of money.

Collective Investment Scheme

• A system offered by a company under which the contributions made by the investors are pooled and used with the goal of receiving profits, income, produce or property is known as a Collective Investment Scheme (CIS).
• Under the Securities Laws (Amendment) Act 2014, when a corpus amount of Rs 100 crore or more is gathered from investors, it is referred to as a Collective Investment Scheme.

Alternate Investment Funds

• AIFs are any privately pooled investment fund (whether from Indian or foreign sources) in the form of a trust, a company, a body corporate, or a Limited Liability Partnership, as defined by the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
• As a result, venture capital funds, hedge funds, private equity funds, commodity funds, debt funds, infrastructure funds, and other AIFs are included in the definition.

REITs

• REITs or Real estate investment trusts are investment instruments that allow developers to profit from revenue-generating real estate while also allowing investors or unitholders to invest in these assets without really owning them.
• The goal of REITs is to make real estate investment more accessible.
• Both the stressed-developer and the high-net-worth investor can benefit from REITs.

InvITs

• Infrastructure investment trusts (InvITs) are investment instruments that enable developers to monetize revenue-generating infrastructure assets while allowing investors or unitholders to invest in them without actually owning them.
• The goal of InvITs is to make infrastructure investment more accessible.
• Both the stressed-developer and the high-net-worth investor can benefit from InvITs.

Mutual Funds

• A mutual fund is a collection of money from people who pool their money to invest in stocks, bonds, and other short-term investments.
• Individuals and institutions both invest in mutual funds.
• This fund is typically administered by a fund manager who collects fees from investors in exchange for looking after their investments.

Hedge Funds

• Hedge funds are pools of money that invest in both short and long positions, buy and sell stocks, engage in arbitrage, and trade bonds, currencies, convertible securities, commodities, and derivative products in order to generate higher returns with lower risk.

Venture Capital

• The funding by wealthy investors who like to put their money into businesses that have long-term growth potential is called venture capital.
• The people who invest such money are called venture capitalists.
• Venture Capitalists typically obtain ownership in the new company in exchange for their support, which is common in the form of preferred stock.

Angel Investor

• A wealthy individual who agrees to invest in a small startup company with limited access to money is known as an angel investor.
• Angel investors are usually entrepreneurs who are friends or relatives of the individual who is beginning the business.

Private Equity

• Private equity is a type of alternative investment that involves money that isn't traded on a public exchange.
• Private equity funds and investors invest directly in private enterprises or engage in buyouts of publicly traded companies, culminating in the delisting of public stock.

Hundi

• The Hundi is a medieval Indian financial instrument used in trade and credit transactions.
• According to RBI, "a Hundi is an unconditional order in writing made by a person directing another to pay a certain sum of money to a person named in the order.

Chit Funds

• A chit fund is a form of savings plan in which a certain number of people donate money in installments over a set period of time.
• Depending on the form of the chit fund, each subscriber is entitled to a reward sum determined by lot, auction, or tender.
• Typically, the prize is equal to the total amount of contributions minus a discount, which is then given as a dividend to subscribers.

Qualified Institutional Placements

• Qualified Institutional Placements enable an Indian-listed firm to raise funds from domestic markets without having to file any pre-issue documents with market regulators.
• According to the SEBI, companies can only raise money by issuing securities.
• The Securities and Exchange Board of India (SEBI) enacted this rule to prevent enterprises from relying on foreign financing.

External Commercial Borrowings

• External Commercial Borrowings (ECB) are debts taken on by an eligible entity in India from external sources for strictly commercial purposes, i.e. from any recognised entity outside India.

Credit Default Swap

• A credit default swap (CDS) is a financial derivative that allows one investor to "swap" or balance their credit risk with that of another.
• To hedge against default, the lender purchases a credit default swap (CDS) from another investor who offers to reimburse the lender if the borrower defaults.

Infrastructure Debt Funds

• Infrastructure Debt Funds (IDFs) are financial entities that direct money into the infrastructure industry.
• Domestic and offshore institutional investors can invest through units and bonds issued by the IDFs, which are sponsored by commercial banks and NBFCs in India.

Inflation Indexed Bonds

• Inflation-Indexed Bonds (IIBs) are government-issued bonds that guarantee a steady yield regardless of the amount of inflation in the economy.
• Inflation-Indexed Bonds are designed to provide a hedge and protect investors against macroeconomic risks in a given economy.

CPSE ETF

• The CPSE Exchange Traded Fund, which works like a mutual fund, is made up of scrips of 10 CPSEs that are listed on stock exchanges and traded like shares.
• Central Public Sector Enterprises (CPSEs) are businesses in which the Central Government or other CPSEs own 51 per cent or more of the stock.

Importance of Capital Market

• It ensures the best coordination and balances possible between the flow of savings on the one hand and the flow of investment leading to capital formation on the other.
• It directs the flow of savings into the most profitable channels, ensuring the most efficient use of financial resources.
• Due to the capital market, national savings are mobilised or concentrated for economic development.
• It aids the mobilisation and import of foreign capital and investment to supplement the required financial resources deficit in order to maintain the expected rate of economic growth.

Conclusion

The ability of a country to develop a good capital market is determined by the availability of savings, the proper organisation of its constituent units, and the entrepreneurial qualities of its people. The capital market is the mechanism that directs these savings into investment or productive use. The capital market distributes resources among alternative uses. It is necessary as it bridges the gap between those who save a portion of their income and those who want to invest it in productive assets.

FAQs

MCQs

1. Which of the following is a capital market instrument?

A) Treasury Bill
B) Commercial Paper
C) Equity Share
D) Certificate of Deposit

2. What is a hybrid instrument in the capital market?

A) An instrument with features of both equity and debt
B) A short-term debt instrument
C) A government security
D) A derivative instrument

3. Which regulatory body oversees capital market instruments in India?

A) Reserve Bank of India (RBI)
B) Securities and Exchange Board of India (SEBI)
C) Ministry of Finance
D) Insurance Regulatory and Development Authority (IRDA)

4. Which of the following is NOT a characteristic of capital market instruments?

A) Long-term financing
B) High liquidity
C) Higher returns compared to money market instruments
D) Used by companies and governments to raise funds

5. Which of the following is an example of a pure capital market instrument?

A) Convertible Debenture
B) Equity Share
C) Treasury Bill
D) Commercial Paper

GS Mains Questions and Model Answers

Q1: Discuss the role of capital market instruments in the economic development of a country.

Answer: Capital market instruments, such as equity shares, bonds, and debentures, play a pivotal role in a country's economic development. They facilitate the mobilization of long-term funds from investors to businesses and governments, enabling the financing of infrastructure projects, industrial expansion, and technological advancements. By providing a platform for raising capital, these instruments support entrepreneurship, job creation, and overall economic growth. Additionally, they offer investment opportunities to individuals and institutions, contributing to wealth generation and financial inclusion.

Q2: Explain the differences between pure, hybrid, and derivative capital market instruments with suitable examples.

Answer: Capital market instruments are categorized into pure, hybrid, and derivative instruments:

Each category serves unique purposes, facilitating diverse investment and risk management strategies in the capital markets.

Q3: Analyze the importance of regulatory oversight in the functioning of capital market instruments, particularly in emerging economies.

Answer: Regulatory oversight in the capital markets ensures transparency, protects investors, and promotes market stability. In emerging economies, regulators like SEBI play a crucial role in establishing guidelines for issuing and trading capital market instruments, preventing market manipulation and fraud. This oversight builds investor confidence and attracts both domestic and foreign investments, fostering economic growth. Proper regulation also ensures that companies comply with ethical standards, contributing to the integrity and development of financial markets.

Previous Year Questions on Capital Market Instruments

1. UPSC CSE Prelims 2019:

Question: Which of the following is a primary function of capital market instruments?

A) Short-term borrowing
B) Raising long-term funds
C) Managing foreign exchange
D) Facilitating daily banking operations

Answer: (B)

Explanation: Capital market instruments are primarily used for raising long-term funds for companies and governments.

2. UPSC CSE Mains 2018 (GS Paper 3):

Question: "Examine the impact of capital market instruments on economic development and investment patterns in India."

Answer: Capital market instruments have significantly impacted India's economic development by channeling savings into productive investments. They provide a mechanism for raising long-term funds, supporting infrastructure and industrial projects. Equity and debt instruments enable companies to raise capital for expansion, while offering investors opportunities for wealth creation. Regulatory measures by bodies like SEBI ensure market integrity, attract foreign investments, and boost investor confidence, shaping India's investment landscape and fostering economic growth.

• Pure Instruments: These include equity shares and bonds, which represent ownership and debt, respectively.
• Hybrid Instruments: These combine features of both equity and debt, such as convertible debentures and preference shares.
• Derivative Instruments: These derive their value from underlying assets like stocks or commodities, including futures, options, and swaps.