Capital markets play a vital role in the economic development of any country by facilitating the flow of funds from investors to businesses. The capital market instruments allow investors to trade securities, derivatives, and commodities with varying levels of liquidity, risk, and returns.
But how does one ensure that these capital markets are not manipulated and transparent to investors?
What are some of the features of capital markets that help both businesses and investors?
Features of Capital Markets
Capital markets help determine the fair value of financial instruments based on market demand and supply forces. This allows investors to make informed decisions about buying and selling securities and ensures that the market remains efficient and transparent.
Allocation of Capital
Capital markets help allocate capital to the most deserving entities based on their creditworthiness, risk profile, and growth potential. This ensures that capital is used efficiently and effectively, leading to optimal returns for investors and economic growth for businesses and the country.
Now comes the question of the types of capital market instruments that exist today and how one can exchange these instruments to ensure returns from the markets.
Capital market instruments
In India, several capital market instruments are available for trading, and we can broadly classify them into equity, debt, derivatives, and commodities. Let's dive deeper to understand each of these instruments in detail.
Equity instruments are the most common type of capital market instruments, also known as stocks or shares, representing ownership in a company. When an investor buys a share of a company's stock, they become a shareholder, which means they own a portion of the company's assets, profits, and losses.
In India, the two leading exchanges that offer equity instruments for trading are the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
We can further classify equity instruments into:
- Common Stocks: These are the most common type of equity instruments, where the shareholder has voting rights in the company's affairs and receives dividends based on the company's profits.
- Preferred Stocks: These equity instruments offer fixed dividends to shareholders and are generally less risky than common stocks. Its stockholders receive a fixed dividend payment, typically higher than the dividend paid to common stockholders.
- American Depository Receipts (ADRs): ADRs are a type of financial instrument representing ownership of a company's shares and trading on a U.S. stock exchange. Often, Non-U.S. companies use ADRs to raise capital from U.S. investors. It provides an opportunity to invest in non-U.S. companies without dealing with the administrative and regulatory complexities of investing in foreign stock exchanges.
- Global Depository Receipt (GDR): GDRs are financial instruments representing ownership of a company's shares and are traded on an international stock exchange. It provides an opportunity to invest in a company's shares without dealing with the administrative and regulatory complexities of investing in a foreign stock exchange. Investing in companies in different countries and regions is a way to diversify portfolios.
Debt instruments are securities that represent a debt owed by the issuer to the holder. When an investor buys a debt security, they lend money to the issuer, who promises to repay the principal amount with interest. Big companies and governments can borrow money from lots of people. It is less risky than equity instruments but offers lower returns.
The NSE and BSE offer a separate platform for trading in debt securities called the Wholesale Debt Market (WDM).
We can further classify debt instruments can into:
- Bonds: Bonds are debt instruments companies, governments, or financial institutions use to raise capital.
When you buy a bond, you are lending money to the issuer, who promises to pay you back the principal amount plus interest on a specified date. They typically have a fixed interest rate and maturity date, which means the issuer must repay the principal amount on the maturity date.
- Debentures: They are similar to bonds as they are debt instruments companies and governments issued to raise capital. However, unlike bonds, debentures are unsecured, meaning any specific asset does not back them. Instead, debentures are backed only by the issuer's general creditworthiness.
- Treasury bills: Treasury bills, or T-bills, are short-term debt instruments issued by the government to raise funds for short-term financing needs. Governments typically issue T-bills with maturities of 4, 8, 13, 26, or 52 weeks.
As the government backs T-bills, they are considered one of the safest investments available. They also offer relatively low yields compared to other debt instruments but can be a good option for investors looking for a short-term, low-risk investment.
A derivative is a financial instrument that derives its value from an underlying asset or group of assets. They are often used as a tool for hedging or managing risk, as they allow investors to take positions on the future price movement of an asset without owning the asset itself. For example, a farmer might use a derivative contract to lock in a price for their crops in advance to protect against price fluctuations.
The NSE and BSE offer a separate platform for trading in derivatives called the Futures and Options (F&O) segment.
Derivative Instruments can be further classified into:
- Futures: Futures are a type of derivative contract that obligates the buyer to purchase an underlying asset (such as a commodity, currency, or stock index) at a predetermined price and date in the future. It's like saying, "I promise to buy ten apples from you for $1 each next month." This way, you know exactly how much you'll pay for the apples, even if the price goes up or down.
- Options: Options are contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price and date in the future. The buyer pays a premium to the seller for this right and can choose to exercise the option if it becomes profitable. It's like saying, "I have a coupon that lets me buy ten apples from you for $1 each, but I don't have to use it if I don't want to." This way, you can choose whether to buy the apples at the special price or not, depending on what the cost is in the future
- Swaps: Swaps are contracts in which two parties agree to exchange cash flows based on a specified underlying asset or interest rate. For example, one company might have a lot of debt with a fixed interest rate, while another might have a lot of debt with a variable interest rate. They could agree to swap cash flows so that the first company pays a fixed rate to the second company, and the second company pays a variable rate to the first company. This way, both companies can manage their interest rate risk more effectively.
Commodity instruments are securities that represent physical goods, such as gold, silver, crude oil, and agricultural products. Traders use commodity instruments to gain exposure to commodity prices without owning the physical asset. The commodity instruments available for trading in India include futures and options contracts.
In India, commodity instruments can be traded on two major exchanges
- Multi Commodity Exchange (MCX): The MCX is the largest commodity exchange in India, offering futures contracts on commodities such as gold, silver, crude oil, natural gas, copper, and more.
- National Commodity and Derivatives Exchange (NCDEX): The NCDEX is a commodity exchange that offers futures contracts on agricultural commodities such as wheat, soybean, chana, castor seeds, and more.
A brief overview of exchanges in India
The capital market offers various instruments for investors to trade in. The capital market allows investors to earn returns on their investments, contributing to their financial well-being. However, investing in capital market instruments involves risk and requires careful consideration of an investor's risk appetite, financial goals, and investment horizon.
By understanding the different types of capital market instruments available for trading, investors can make informed investment decisions and build a diversified portfolio to achieve their financial goals.