To buy groceries you would go to a Supermarket or Grocery shop which offers you product varieties to suit your home requirements. So you end up investing in products to make your life comfortable and the shopkeeper is able to generate revenue. In the same way, to shop for financial instruments investors go to the capital market. They purchase these instruments to maximize their wealth. The company issuing these financial instruments is able to raise funds to meet its financial needs. There are a variety of financial instruments of the capital market that offer flexibility to the purchaser to opt for the options that best suit them. These financial markets and instruments cater to different types of investors, with different risk appetites.
Table of Contents
What is Capital Market?
A capital market is a market to buy and sell financial instruments. A company may raise capital to meet its long terms funding needs by selling its financial instruments to the investors. The company intends to raise money by selling the financial instruments of the capital market while the investors intend to buy these with the objective of maximizing their wealth in the long term. These markets are inclusive of equity and debt. These markets are further bifurcated into 2 Markets depending upon the types of financial instruments traded.
- Primary Market
It is the known as market of new issues. The company sells freshly issued financial instruments for the first time in this market. The intention is to raise capital to meet long-term funding needs for the company. The investors intend to hold these securities to gain through capital appreciation resulting from the futuristic higher market prices. IPOs are also launched in the primary market.
- Secondary Market
It is the market for already issued or existing financial instruments. The intention here for the companies is to raise funds by selling their existing securities in the market to meet financial needs. For investors, the intention is to purchase these securities with the objective of maximizing their returns. Stock exchanges represent a secondary market where already listed securities are traded. Thus IPOs once listed in the primary market are traded in the secondary market.
Types of Instruments of Capital Market
Both the Primary and Secondary market offers varieties of financial instruments to meet the diverse needs of the investors. There are different types of instruments of Capital market available to invest as below:
- Equity Shares – Equity shares may be issued by the company to raise long-term finance. Equity shares give the right to its owner to share in the profits of the company (dividends) and to vote at general meetings of the company. These shares might be issued at par, at a premium, or at a discount. It is one of the most popular instruments of the capital market to raise funds. Raining IPOs this year are the result of the issue of equity shares by the company to raise funds.
- Preference Shares – These shares carry preferential rights as compared to equity shares. The holder of these shares will get the dividends and repayment of any of their dues in the event of winding up of the company prior to the equity shareholders. However, they are not allowed to vote at general meetings of the company. They are offered a fixed percentage of dividend, unlike the equity shareholders who take full advantage of high dividends on a profit year and no dividends on a loss-making year. Lesser risk comes with fixed income. These instruments of the capital come with different features and types like:
- Cumulative preference shares – The dividends are accumulated from loss-making years to be paid when the company turns profitable again.
- Non-cumulative preference shares – No accumulation of dividends takes place in the loss-making years of the company.
- Participating preference shares – The shareholders enjoy a share in the surplus profits earned by the company in the case of liquidation.
- Non-Participating preference shares – The shareholders do not enjoy a share in the surplus profits earned by the company in the case of liquidation.
- Redeemable preference shares – These shares are redeemed at a fixed rate and specified date.
- Fully convertible cumulative preference shares – These shared can be fully converted to equity shares after a specified time and specified period.
- Preference shares with warrants attached
Each of these preference shares comes with different benefits and limitations to suit the needs of different types of investors.
- Debentures – These instruments carry fixed or floating obligations to pay to the debenture holders. It is considered as a loan given by the investor to the company to meet its financial needs in return for a stable interest income. A fixed-rate of interest needs to be paid to them even before paying any dividend to the other shareholders. Even in the event of winding up of the company they will have preferential rights to claim their due before others. Since they are least risky, thus the return offered to the holders is comparatively lesser. These are loan instruments of the capital market.
- Bonds – They are similar to debentures, as they are also considered as a loan given by the investor to the company to meet its financial needs for a stipulated time period. It is a highly secured financial instrument usually issued by a company or government. The holders of bonds are called bondholders. They carry preferential rights of paying fixed rates of interest to the bondholders even before any dividend or interest is paid to debenture holders or other shareholders. Thus, they are least risky, thus offering a comparatively lower interest income than a debenture offers. These are also debt instruments of the capital market.
Difference between a Debenture and a Bond
There are different types of Bonds to cater to the needs of different types of investors:
- Corporate Bonds – Investment Grade
- Corporate Bonds – Junk Bonds
- Foreign Bonds
- Treasury Bonds
- Municipal Bonds
- Zero-coupon Bonds
|Issue by companies and governments
|Issued only by companies
|Riskier compared to Bonds
|First Priority in terms of payment
|Second Priority in terms of payment
|Longer date of maturity as compared to Debentures
|Usually, short term maturity but maybe long-term depending on the case
|Lower interest rate
|Comparatively higher interest rate
- Global Depository Receipts or GDRs
It is a bank certificate issued in more than one country for shares in a foreign company.
Basically, GDRs are receipts for shares in a foreign-based company. These shares are held by a foreign branch of an international bank. GDRs are emitted by banks, who purchase the shares of the foreign companies and deposit them in their accounts. Thus, these shares are traded as domestic shares but are offered for sale globally through various branches of the bank. This is a derived version of instruments of the capital market.
GDRs are in the form of a depository receipt or a certificate created by an overseas depository bank outside India and issued to non-resident investors against the issue of ordinary shares. GDRs allow companies in Europe, Asia, and the United States to offer shares across the markets in the world. Among the Indian companies, Reliance Industries Ltd was the first company to raise capital through the GDR issue.
- American Depository Receipt or ADRs
ADR is a stock that trades in the United States, representing a specified number of shares in a foreign corporation. ADRs are bought and sold in the American markets just like any regular stocks, are issued or sponsored in the United States by a bank or a brokerage firm. It was introduced in the United States in 1927, as a result of the complexities involved in buying shares in foreign countries and the difficulties associated with the exchange rates and pricing fluctuations. Thus, to overcome these problems the United States purchases the bulk of shares from a company bundles them into groups, and reissues them on either the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX) or in Nasdaq. In return, the foreign company must provide detailed financial information to the sponsor bank. The depositary bank sets the ratio of United States ADRs per home country share. This ratio can be anything less than or greater than 1. Majority of ADRs range between $10 to $100 per share. These instruments of capital market stemmed to solve the existing issues.
A “Derivative” is an instrument whose value is derived from another security or economic variable. The dependence of the derivative’s value on other prices or variables makes it an excellent vehicle for transferring risk. These derivatives are bought and sold in the capital market. Below are different types of derivatives devised to hedge risk based on the needs of different investors
- Forward Contract – In a forward contract the buyers agree to pay cash at a later date when the seller delivers the goods. The price is decided upon at the time of entering into the contract. Usually, no money changes hands when forward contracts are entered into, but sometimes one or both parties may like to ask for some initial, good faith deposit to ensure that the contract is honored.
- Futures Contract – A futures contract is a standardized contract between two parties where one of the parties commits to sell and the other to buy, a stipulated quantity of a commodity, currency, security, index, or some other specified item at an agreed price on a given date in the future.
- Options – Option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. An option to buy is called a CALL OPTION and the option to sell is called a PUT OPTION.
- Warrants – Warrants are long-term options with 3 to 7 years of expiry. Warrants are issued by companies, as means of raising finance with no obligations of paying dividends or paying interest income. They are like call options on the stock of issuing firms.
- Swaps – Swaps are customized arrangements between parties to exchange one set of financial obligations for another as per the terms of the agreement. Major types of swaps are
- Currency swaps
- Interest rate swaps
- Bond swaps
- Coupon swaps
- Debt equity swaps
- Swaptions – A combination of swaps and options is called Swaptions. They become operative after the expiry of the options. Instead of having calls, and puts, Swaptions have receiver swaptions (an option to receive fixed rate while paying floating rate) and a payer swaption (an option to pay fixed rate while receiving floating rate). Basically, it is an option to entitle the holder the right to enter into or cancel a swap at a future date.
These derivatives are highly leveraged instruments of the capital market.
Functions of Capital Market
Below are the functions of the Capital Market:
- Mobilize long terms savings to finance long term investments
- Provide risk capital in the form of equity to business owners
- Make better use of productive assets
- Lower the cost of transactions as well as reduce wastages
- Optimal use of resources
- Efficient dissemination of information
- Enable valuation of financial instruments
- Helps in hedging risk
- Direct flow of funds into productive use through savings and investments
- Facilitate liquidity
According to the depositories data, foreign portfolio investors, or FPIs, invested 13,536 crore rupees into equities and 8,339 crore rupees in the debt segment. This resulted in a net investment of 21,875 crore rupees in the Indian capital markets in the month of September.
Let us know about any instruments of the capital market apart from those listed above!