Financial market instruments can be divided into two parts i.e., Money market Instrument and Capital Market instrument. Money market instruments consist of Treasury bills, call money, certificate of deposit, commercial bills, and commercial paper, whereas capital market instruments consist of non-security market and security market. In this article, we will study financial market Instruments, which are important for UPSC Examination.

There are various types of financial instruments available in the market, such as:

Money Market Instruments

• Treasury Bills - Treasury bills are money market instruments issued by the Government of India in the form of a promissory note with a future repayment guarantee. Funds collected through such tools are typically used to meet the government's short-term needs, thereby reducing a country's overall fiscal deficit.
• Call Money - Call money is any type of short-term, interest-bearing loan that the borrower must repay immediately if the lender demands it. Call money allows banks to earn interest on their excess funds, which is known as the call loan rate. Brokerage firms typically use call money for short-term funding needs.
• Certificate of Deposit - A certificate of deposit is a straightforward and widely used savings vehicle offered by banks and credit unions. When a depositor buys a certificate of deposit, they agree to leave a certain amount of money at the bank for a set period of time, such as a year.
• Commercial Bills - Commercial bills are unsecured, short-term debt issued by a corporation, which is frequently used to finance short-term liabilities and inventory. Meanwhile, a Treasury bill (T-Bill) is a type of short-term debt backed by the United States government that has a maturity of less than one year.
• Commercial paper - Commercial paper is a money-market security issued by large corporations to obtain funds to meet short-term debt obligations (such as payroll) and is backed only by an issuing bank or company promise to pay the face amount on the maturity date specified on the note.

Government Securities

• Treasury Bills (T- Bills)- Only the Indian central government issues Treasury bills, also known as T-bills.
• These are short-term money market products, which means that they have a maturity of less than one year.
• Treasury bills are currently available in three maturities: 91 days, 182 days, and 364 days.
• Cash Management Bills (CBM)- CMBs are a relatively new financial instrument in India. They were launched by the Indian government and the Reserve Bank of India in 2010.
• CMBs are zero-coupon instruments that look a lot like Treasury bills. The only difference between the two forms of government securities is the maturity time.
• Cash Management Bills (CMBs) are ultra-short-term investment options with maturity periods of less than 91 days.
• Dated G-secs- Dated G-Secs are another sort of government security available in India. G-Secs, unlike T-bills and CMBs, are long-term money market securities with a wide range of tenures, starting at 5 years and running up to 40 years.
• The interest rate on these instruments, often known as the Coupon rate, is either set or variable.
• State Development Loans (SLD)- SDLs are issued solely by Indian state governments to support their activities and meet their budgetary demands, as the name implies.
• These resemble dated G-Secs in appearance. The only difference between these two lies in the fact that SDLs are issued by the state government while G-secs are issued by the Central Government.

Capital Market Instruments

There are three types of capital market instruments

• Pure Instruments – They are pure and don't have anything in common. Shares, bonds, and debentures are examples of pure instruments.
  • Shares - A share is a unit of ownership in a corporation or a financial asset. Shareholders are investors who own stock in a company.
  • Bonds - A bond is a loan made by an investor to a borrower, such as a corporation or the government. The borrower uses the funds to fund its operations, while the investor earns interest on his or her investment. A bond's market value can fluctuate over time.
  • Debentures - A debenture is a marketable security (a type of investment) issued by a company or organization to raise funds for long-term operations and growth. Because it is a type of debt capital, it is recorded as debt on the issuing company's balance sheet.
• Hybrid instruments – They have a combination of characteristics, such as a bond and an equity investment.
• Derivatives – These instruments have no intrinsic value and are derived from one or more financial assets. Futures and options are two examples of derivatives.
  • Futures -Futures are financial derivative contracts that bind the parties to trade an asset at a predetermined future date and price. Regardless of the current market price at the expiration date, the buyer or seller must purchase or sell the underlying asset at the set price.
    • Physical commodities or other financial instruments are examples of underlying assets. Futures contracts specify the amount of the underlying asset and are standardized to allow trading on a futures exchange. Futures contracts can be used for hedging or trading.
  • Options - An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (such as a stock or index) at a specified price on or before a specified date (listed options are all for 100 shares of the particular underlying asset). An option, like a stock or bond, is a security that represents a legally binding contract with clearly defined terms and properties.

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 authorize 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.

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Global Depository Receipt

• A Global Depositary Receipt (GDR) is a bank certificate that symbolizes 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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 recognized entity outside India.

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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.

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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.

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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.

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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 percent or more of the stock.

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Conclusion

A financial instrument is a physical or virtual document that represents a legal agreement with monetary value. Financial instruments provide the necessary equity and funds for a firm or the government to raise funds to meet its expenses. However, Indian financial markets are not well developed as compared to the emerging economies due to the poor exposure and the masses staying out of it.

FAQs

Q1: What are financial market instruments?

Q2: What are the main types of financial market instruments?

Q3: How do stocks differ from bonds?

Q4: What role do derivatives play in financial markets?

Q5: Why are financial market instruments important for the economy?

MCQs

1. Which of the following is NOT a type of financial market instrument?

a) Stocks

b) Bonds

c) Real estate

d) Derivatives

2. What is the primary purpose of bonds?

a) Ownership stake in a company

b) Loan to a company or government

c) Speculation on asset prices

d) Currency exchange

3. Derivatives can be used for which of the following purposes?

a) To acquire ownership in a company

b) To hedge against risks

c) To convert currencies

d) To buy physical assets

4. Which instrument represents ownership in a corporation?

a) Bond

b) Stock

c) Option

d) Future

5. Which of the following is considered a primary market instrument?

a) Exchange-traded funds (ETFs)

b) Initial Public Offerings (IPOs)

c) Mutual funds

d) Options contracts

GS Mains Questions and Model Answers

Q1: Discuss the significance of financial market instruments in the Indian economy.

Answer: Financial market instruments play a crucial role in the Indian economy by facilitating capital formation, providing liquidity, and enabling risk management. They allow businesses to raise funds for expansion through equity and debt instruments, while investors can diversify their portfolios to manage risks. The growth of financial instruments also enhances market efficiency, contributing to economic stability and growth. Moreover, they provide a framework for price discovery and resource allocation, which is essential for a vibrant economy.

Q2: Analyze the impact of derivatives on risk management in financial markets.

Answer: Derivatives are pivotal for risk management as they provide tools for hedging against adverse price movements in underlying assets. By allowing investors to lock in prices or offset potential losses, derivatives enhance financial stability for businesses and individuals alike. They facilitate speculation, which can lead to increased market liquidity, but also carry inherent risks, as they can amplify losses if not used wisely. Understanding their impact is vital for regulators and market participants to ensure the integrity of financial markets.

Q3: Evaluate the role of government regulations in the functioning of financial market instruments.

Answer: Government regulations play a significant role in ensuring the integrity, transparency, and stability of financial markets. They establish guidelines for trading practices, disclosure requirements, and capital adequacy, which protect investors and maintain market confidence. Regulations prevent fraud, reduce systemic risks, and promote fair competition among market participants. However, excessive regulation may stifle innovation and market efficiency. Striking a balance between oversight and market freedom is crucial for the healthy functioning of financial market instruments.

Previous Year Questions on Financial Market Instruments

1. UPSC CSE 2021

Question: "Discuss the evolution and significance of financial market instruments in the context of India's economic development."

Answer: Financial market instruments in India have evolved significantly since independence, reflecting changes in economic policy and market dynamics. Initially dominated by traditional banking, the introduction of stocks, bonds, and derivatives marked a shift towards a more diversified financial ecosystem. Their significance lies in facilitating capital flows, enhancing liquidity, and enabling effective risk management. The growth of these instruments supports infrastructure development and drives economic growth, while also providing investors with various opportunities. A robust regulatory framework is essential to maintain market stability and investor confidence.

2. UPSC CSE 2019

Question: "Examine the challenges faced by financial market instruments in India."

Answer: Financial market instruments in India face several challenges, including regulatory hurdles, lack of investor awareness, and market volatility. The complexity of derivatives and their misuse during financial crises has led to increased scrutiny and regulation, which can hinder market growth. Additionally, low financial literacy limits participation in markets, restricting capital inflow. Market volatility can deter investors, leading to fluctuations in instrument values. Addressing these challenges through education, effective regulation, and fostering a conducive investment environment is crucial for enhancing the effectiveness and stability of financial market instruments in India.