financial 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 interest
or dividend. Securities and other financial products are called as financial
instruments. Different types of financial instruments can be designed to suit
the risk and return preferences of different classes of investors. They enable
investors to hold a portfolio of different financial instruments to diversify
instruments can be classified as follows:
Based on how they are issued:
may be primary or secondary securities.
securities are directly issued by ultimate borrowers of funds to the ultimate
savers. Primary securities are also called as direct securities.
preference, debt and various combinations come under primary securities
can be classified as common shares, preference shares
share specifies that the issuer pays the investor an amount based on income
earnings, if any, after settling the obligations arising from firm’s debt
instruments which is required to be paid first to investors. They carry voting
rights 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 and
has no relationship to the market price .It remains constant during the life of
equity shareholder is entitled to a share of the company’s profits through the
payment of an annual dividend, the amount of which is in proportion to the
shareholder’s holding in the company. Dividends are not guaranteed, and a
company can decide not to pay a dividend or to distribute only lesser amount. In
India companies are asked to state the dividend on a per share basis to ensure
better transparency. When buying shares, an investor may expect to make a
profit on the resale of those shares. This profit is called capital gain. The
price of the share depends on many factors like
Performances of the
The market’s evaluation
of its performance
The economic situation
Relevant sector risk
and company specific risk
These are shares of a company’s stock which give
limited ownership and a fixed amount of dividends that are paid before
common stock dividends are issued.Dividends are paid only in years of profit. Preference shareholders generally don’t have any voting
rights in the company
Types of preference shares:
Perpetual: Perpetual preference shares exist as long as the companies
exist.They are not repayable or
redeemable similar to common shares.
Redeemable: The face value is returned to the share holders after maturity.They
have fixed maturity.
Callable: The issuing company has the right to buy back these shares at a
certain price on a certain date.
Convertible: These type of preference shares can be converted to company’s
common stock at a pre-defined conversion ratio after a certain period.The
owners of preference shares can realize substantial gains by converting their
The type of financial
instrument in which are undertaken to pay the investor (buyer) a regular amount
as 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 fixed
contractually. Therefore, this type of instrument is usually called fixed
Features of a Debt instrument:
usually carry a fixed rate of interest committed by the issuer. This rate is
called as ‘coupon’.
to pay interest whether they make profits or not.
securities are tradable. The person can hold it until maturity or sell it prior
to maturity and make a capital gain (or loss)
debt instruments are not owners of the company .They are its creditors. The
creditors may demand collateral to secure their investment.In this case the
instrument is called as a secured debt, else
it is unsecured debt.
value of a debt instrument defines the amount to be repaid on maturity.
Classification of debt securities based on maturity:
debt-instruments-Bonds and Debentures:
These are used to raise money for longer duration (more than one
The issuer of the bond promises to pay the bondholder typically a
fixed amount of interest each year for a fixed time period.At the end of that
time period (the maturity date) the issuer promises to pay the bondholder the
face value of the bond.
It is a long term debt security
Coupon rate of a bond:
The original interest rate committed by the issuer at the time
security is first issued is called coupon rate. Coupon payment can be quarterly
or semi-annual or annual.
Zero coupon bond or discount bond: It is issued at a discount rate to face value and is redeemed at
Issuer of bonds: The issuer is a corporation or government (state or central)
Bonds issued by the Central government in India are called as GOI
securities or G-secs (also known as Gilts)
The coupon on G-sec is paid every 6months (semi-annual coupon)
It is an unsecured debt instrument which is backed by only the creditworthiness
and reputation of the company and not by physical assets and collateral.
The coupon rate is higher than that of bonds as debentures are
Companies can issue bonds and debentures which are
Short term debt
instruments-Money market instruments:
These are used to raise money for short duration (less than one
year).The money market instruments are:
bills: These are debt securities backed by government so considered virtually default
of deposits: These are issued by bank or a financial institutuion to raise
money ,similar to fixed deposits
papers: These are unsecured debt instruments of large denomination issued by a
corporation to raise money.
As with other debt securities, the holders of these instruments
are exposed to most of the general risks and particularly interest rate risk,
liquidity and credit spread risk.
Time deposits are money deposits that cannot be withdrawn for a
certain 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 on
Mutual fund is a mechanism for pooling the resources from the
investors and investing funds in securities. This is done in accordance with
objectives as disclosed in offer document.
The performance of a mutual fund scheme is reflected in its net
asset value (NAV) which is disclosed on daily basis in case of open-ended
schemes and on weekly basis in case of close-ended schemes. Net Asset Value is
the market value of the securities held by the scheme.It varies on day-to-day
It is an agreement in which insurer
agrees to pay a given sum of money upon the happening of a event contingent
upon duration of human life in exchange of the payment of a consideration. The
person who guarantees the payment is called Insurer, the amount given is called
Policy Amount, the person on whose life the payment is guaranteed is called
Insured or Assured. The consideration is called the Premium. The document
evidencing the contract is called Policy.
A derivative instrument is a financial contract whose payoff
structure is determined by the value of the underlying asset. The underlying
asset can be commodity, security, interest rate, share price index, oil price,
currency (exchange rate) in circulation, precious metals or the like
Types of derivatives:
A forward contract obliges
its purchaser to buy a given amount of a specified asset at some stated time in
the future at the forward price
Futures contracts are created and traded on organized futures
exchanges. Buyers and sellers of future contracts do not deal directly with
each other but with a clearinghouse
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 a
specified asset within a specified time period
A swap is a derivative contract through which two
parties exchange financial instruments. Examples of swaps are interest rate
swaps and currency swaps.
“Financial instruments in US
The financial system of the United States of America (US)
constitutes the banking system, nonbank financial institutions and financial
markets. The US Congress introduces legislation relating to financial services,
and regulators at federal and state levels issue rules and regulations
governing the practices of the industry.
Equities are shares that represent part of ownership of a
business. The different types of equities are stocks, preferred stocks and warrants
(Warrants are securities that give the holder the right, but not the
obligation, to buy a certain number of securities at a certain price before a
The US equities markets comprise several stock exchanges. The most
important 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 exchange
are traded in the over-the-counter (OTC) market. The OTC market includes the
National Association of Securities Dealers Automated Quotation system (Nasdaq)
and the National Market system (NMS). Securities markets are regulated by the
Securities and Exchange Commission (SEC).
Bonds are debt securities with maturities of longer than one year
and must be registered with the SEC. The Securities and Exchange Commission
(SEC) maintains the integrity of the securities markets and protects investors
from frauds. Bonds can be issued by
governments or by private sector companies.
Asset-backed securities are classified into mortgage-backed
securities and non-mortgage securities
Mortgage-backed securities give investors the right to interest payments from many mortgage
loans. Examples of mortgage-backed securities are
Fannie Maes areissued by the Federal National Mortgage Association, a publicly
owned, federally sponsored corporation that provides liquidity to the financial
system by buying mortgages from the institutions that originate them, and allows
them to relend the funds.
Ginnie Maes are securities issued by mortgage bankers.These are issued under
the guidance of the Government National Mortgage Association which facilitates
government mortgage lending.
Macs: Freddie Macs are issued by the Federal Home Loan Mortgage Corporation
(FHLMC). FHLMC packages the individual mortgages they buy into pools (groups of
similar types of mortgages with similar rates and maturities) and sell them to
investors as debt securities
Farmer Macs are pass-throughs of mortgages on farms and rural homes. The
Federal Agricultural Mortgage Credit Corporation, a shareholder-owned company
established by the US government, securitizes both agricultural mortgages and
loans guaranteed by the US Department of Agriculture, some of which are not
Non-mortgage securities are asset backed securities which give owners the right to income
from other assets. Examples of non-mortgage securities are credit card
securities, 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 securities
Securities: Municipal securities are
debt securities issued by states, cities and countries or their agencies to
help financing public projects. Municipal securities are regulated by the
Municipal Securities Rulemaking Board (MSRB).
These are debt instruments with maturities of one year or less (short
term) and provide liquidity for investors to obtain or lend funds for a
short-term. These instruments include
paper: Short-term debt obligation of a private-sector firm or a government sponsored
acceptances: Bankers’ acceptances are
promissory notes issued by a non-financial firm to bank for a loan.
bills: T-bills, are securities issued by national governments with a maturity
of one year or less.
agency notes: Government agency notes are short-term debt notes issued by
national government agencies or government-sponsored corporations
government notes: Local government notes are short-term debt notes issued by
state, provincial or local governments or by agencies of these governments
Interbank loans: Interbank loans are loans extended from one
bank to another
deposits: Time deposits are interest-bearing bank deposits that cannot be
withdrawn without penalty before a specified date. They are also called
certificates of deposit (CDS).
Future contracts and options:
It is an agreement to buy or sell a standard amount of a specific
commodity in the future at a certain price. There are two forms of future
concern agricultural products, metals, energy and transport.
include interest-rate futures, currency futures, stock-index futures,
share-price futures, etc.
Options are contracts that give the holder the right, but not the
obligation to either buy or sell a stipulated commodity at a specified price on
or before the expiration date. The most widely traded types of options are
equity options, index options, interest-rate options, commodity options and
The Commodity Futures Trading Commission (CFTC) is an independent
agency with the mandate to regulate commodity futures and option markets in the
Impact of digitization on financial instruments in India
At first, there were
many problems due to paper shares. There was a need of system that would make
buying and selling of shares easier.
Online trading is
basically the act of buying and selling financial products through
an online trading platform. These platforms are normally provided by
internet based brokers and are available to every single person who wishes to
try to make money from the market.
In the new online trading
system, an investor must open a demat account with one of the stock brokers to
start trading online. A demat account is a must for an investor to trade
Advantages of trading online:
1) Easier and convenient way to own shares
2) Lesser printing and distribution costs
3) It increases the efficiency of the registrars and transfer agents
4) Zero stamp duty on transfer of shares
5) Increased safety than paper shares, no scope for fake
signatures, delay, thefts, etc.
6) Lesser paperwork for transfer of securities (Immediate
7) Less transaction costs
8) No “odd” problems. Even a single share can be sold.
9) No need for the investor to contact the companies
10) No need of notifying the companies.
11) Automatic credit in demat
12) Both equity and debt
instruments can be held by a demat account
13) Better facilities for communication
14) Timely service to shareholders and investors
The disadvantages of
online trading are as follows:
1) Poor investment
choices due to quick decision making
2)There is no personal relationship
between a professional broker and an online trading account holder.
3)Users who are not
familiar with the basics of brokerage software can make mistakes which can
prove to be a costly affair.
Impact of technology
advancements on financial industry in US
preferences, regulations and alternative lending platforms are forcing
traditional mortgage business models to adopt technology at much faster pace.
The growth of companies like Prosper and Lending Club are examples of having
crossed billion dollars in origination transactions. Without putting their own
capital at risk, they have provided a market place for lenders and borrowers to
meet and surpass even the best rates.
Features of digital
mortgage provider can clearly explain product options and loan terms online, it
will reduce the time taken to process loans. These processes help to deliver excellent
customer experience and create differentiation in this large market.
borrower has the option of choosing a better lender based on a superior user
experience, which makes every transaction more crucial.