Financial Instruments

1. Unit 1
I. Financial Instruments
Expected questions.
1. What Is a Financial Instrument?
2. What are the various types of Financial Instruments?
3. What are the various types of asset classes of financial instruments?
4. Distinguish between cash and derivative instruments?
What Is a Financial Instrument?
Financial instruments are assets that can be traded, or they can also be seen as packages of
capital that may be traded. Most types of financial instruments provide efficient flow and
transfer of capital throughout the world’s investors. These assets can be in the form of cash, a
contractual right to deliver or receive cash or another type of financial instrument, or
evidence of one’s ownership in some entity.
Examples of financial instruments include stocks, exchange-traded funds (ETFs), bonds,
certificates of deposit (CDs), mutual funds, loans, and derivatives contracts, among others.
KEY TAKEAWAYS
 A financial instrument is a real or virtual document representing a legal agreement
involving any kind of monetary value.
 Financial instruments may be divided into two types: cash instruments and derivative
instruments.
 Financial instruments may also be divided according to an asset class, which depends
on whether they are debt-based or equity-based.
 Foreign exchange instruments comprise a third, unique type of financial instrument.
Understanding Financial Instruments
Financial instruments can be real or virtual documents representing a legal agreement
involving any kind of monetary value. Equity-based financial instruments represent
ownership of an asset. Debt-based financial instruments represent a loan made by an
investor to the owner of the asset. Foreign exchange instruments comprise a third, unique
type of financial instrument.
Types of Financial Instruments
Financial instruments may be divided into two types: cash instruments and derivative
instruments.
Cash Instruments
 The values of cash instruments are directly influenced and determined by the
markets. These can be securities that are easily transferable. Stocks and bonds are
common examples of such instruments.

2.  Cash instruments may also be deposits and loans agreed upon by borrowers
and lenders. Checks are an example of a cash instrument because they transmit
payment from one bank account to another.
Derivative Instruments
 The value and characteristics of derivative instruments are based on the vehicle’s
underlying components, such as assets, interest rates, or indices.
 An equity options contract—such as a call option on a particular stock, for
example—is a derivative because it derives its value from the underlying shares. The
call option gives the right, but not the obligation, to buy shares of the stock at a
specified price and by a certain date. As the price of the underlying stock rises and
falls, so does the value of the option, although not necessarily by the same
percentage.
 There can be over-the-counter derivatives or exchange-traded derivatives. OTC is a
market or process whereby securities—which are not listed on formal exchanges—
are priced and traded.
Types of Asset Classes of Financial Instruments
Financial instruments may also be divided according to an asset class, which depends on
whether they are debt-based or equity-based.
Debt-Based Financial Instruments
Debt-based instruments are essentially loans made by an investor to the owner of the asset.
Short-term debt-based financial instruments last for one year or less. Securities of this kind
come in the form of Treasury bills (T-bills) and commercial paper. Bank
deposits and certificates of deposit (CDs) are also technically debt-based instruments that
credit depositors with interest payments.
Exchange-traded derivatives exist for short-term, debt-based financial instruments, such as
short-dated interest rate futures. OTC derivatives also exist, such as forward rate agreements
(FRAs).
Long-term debt-based financial instruments last for more than a year. Long-term debt
securities are typically issued as bonds or mortgage-backed securities (MBS). Exchange-
traded derivatives on these instruments are traded in the form of fixed-income futures and
options. OTC derivatives on long-term debts include interest rate swaps, interest rate caps
and floors, and long-dated interest rate options.
Equity-Based Financial Instruments
Equity-based instruments represent ownership of an asset. Securities that trade under the
banner of equity-based financial instruments are most often stocks, which can be either
common stock or preferred shares. ETFs and mutual funds may also be equity-based
instruments.
Exchange-traded derivatives in this category include stock options and equity futures.

3. Foreign Exchange Instruments
Foreign exchange (forex, or FX) instruments include derivatives such as forwards, futures,
and options on currency pairs, as well as contracts for difference (CFDs).
Currency swaps are another common form of forex instrument. In addition, forex traders
may engage in spot transactions for the immediate conversion of one currency into another.
Examples of financial instruments include stocks, exchange-traded funds (ETFs), mutual
funds, real estate investment trusts (REITs), bonds, derivatives contracts (such as options,
futures, and swaps), checks, certificates of deposit (CDs), bank deposits, and loans.
Eg: They include futures, forwards, and options contracts that use a commodity as the
underlying asset.
II. Financial Markets
Expected questions.
1. What is a financial market?
2. Distinguish between money market and capital markets.
3. Who are the participants in the financial market? Describe their role.
4. Explain how a financial security or asset is created in the financial market.
5. “Capital formation is takes place in the primary market”. Explain.
Indian financial markets are a complex and dynamic system that plays a vital role in the
country's economy. They bring together investors and businesses, providing a platform for
capital to flow from those with excess to those with a need. The Indian financial market is
made up of a variety of markets, including the stock market, the bond market, the derivatives
market, the foreign exchange market, and the money market.
Financial intermediation is the process of bringing these two groups together. It is an
essential part of the Indian financial market, and it helps to ensure that capital is allocated
efficiently.
Structure of Financial Markets in India
This is popularly referred to as financial intermediation and exists at the core of the Indian
economy; bringing investors and businesses together in a symbiotic relationship. Here is what
it consists of.b
The Banking System
Indian banking has a multi-tier structure. The Reserve Bank of India is the regulator of the
banking system and the monetary authority. Its functions include licensing banks and

4. regulation for a strong and stable banking system. RBI is the note-issuing authority and
banker to the government and acts as a lender of last resort to the other banks. It also acts as a
controller of credit in the monetary system. On the banking front there are PSU banks, private
banks; cooperative banks, small finance banks etc. and they combine to define the Indian
banking system.
Indian Securities Market
The securities market provides an institutional framework for efficient flow of capital in the
economy. Capital markets converts saving into investments for the investor and it converts
business pedigree into funding for the businesses. This basic arrangement in the securities
markets enables flow of capital from households to business, in a regulated institutionalised
framework.
The securities market include equities, index futures, index options, stock futures, stock
options, long term bonds, medium term bonds, short term bonds, money market securities,
equity funds, debt funds, hybrid funds, structured products, REITS, INVITs etc. Security
markets are an important for raising money for corporates and institutions and also for
investors to allocate their money.
Indian Commodities Market
Commodity market facilitates transactions between buyers and sellers of commodities. These
commodities are broadly dividend into four categories viz. agricultural commodities, precious
metals, industrial metals and energy products (oil and gas). Commodities can be traded in
India in the spot market (for immediate delivery) or in the futures market (for delivery), or in
the futures market (not for delivery) or in the options (so as to devolve into commodity
futures). Commodity markets are essentially used by industries, traders, importer and
exporters to hedge the commodity price risk
Foreign Exchange Market or Forex Market
This is where the currencies are exchanged and there are traders, arbitrageurs, speculators and
hedgers in these markets. Globally, the forex trading market is the largest compared to other
asset classes. The growth of international trade made it necessary to be able to determine the
relative value of currencies given the differences in their purchasing power. The need for
exchanging one currency to another for settling trades in goods and services brought about
foreign exchange risk and that created a robust forex market. India has had the rupee forward
market offered by banks for a long time, but that is offered by banks only against actual
exposure. Today, it is possible to also trade currency pairs in the currency derivatives

5. segment of the stock exchange. The USDINR pair is, obviously, the most popular and
extensively traded currency pair.
Indian Insurance Market
Insurance business in India is regulated by the Insurance Regulatory and Development
Authority (IRDA) of India. It regulates life and non-life insurance activities in India.
Insurance is all about sharing of risk. Broadly, there are 3 sub categories in insurance viz. life
insurance, non-life insurance and re-insurance. Insurance in India is still fairly
underpenetrated. For long the insurance business was dominated by the government owned
companies but that has changed over the last 20 years with the entry of private players.
Indian Pension Market
Much of the Indian population is still outside the formal retirement benefit cover provided by
the government and its associated organisations, and companies covered under the
Employees Provident Fund Organisation (EPFO). In provident fund contribution, a portion of
the employers’ contribution is earmarked to provide pension under the Employee Pension
scheme. Some private companies may provide Superannuation plans and privately sponsored
pension plans to their employees. The National Pension System (NPS) is a defined
contribution pension scheme now applicable to government employees, where the employee
and the government make matching contributions to a fund of the employee’s choice,
managed by licensed fund managers.
What role do participants play in the securities market?
Here are the key intermediaries in the securities market and the role that they play.
 Stock Exchanges provide the infrastructure for trading in securities that have been
issued at prices that reflect its current value and also helps discover a fair value for the
stock. It also provides liquidity to the investors when they require funds. Stock
exchanges appoint clearing and settlement agencies and clearing banks to handle
clearing and settlement of securities.
 Depository participants facilitate investors to hold and transact in securities in
dematerialised form. They service customers on behalf of one of the depositories;
NSDL or CDSL. Demat has gone a long way to make the Indian stock market system
clean and transparent.
 Custodians work with institutional investors and hold securities and manage bank
accounts on behalf of institutional investors. They manage the transactions pertaining

6. to delivery of securities and money after a trade is made through the broker, and also
keeps the accounts of securities and money.
 Stockbrokers are registered trading members of stock exchanges. They sell new
issuance of securities to investors. They put through the buy and sell transactions of
investors on stock exchanges.
 Investment Bank’s activities include advisory for business expansions, project
financing, mergers and acquisition, investment valuation, among others, new issue
management etc. Commercial Banks provide banking services of taking deposits,
providing credit and enabling payment services. They provide efficient cash
management for businesses.
 Insurance Companies provide service of insuring life, property and income against
unexpected and large charge. Life insurance companies deal with insuring the life of
individuals while general insurance covers health, motor, travel and other areas,
where a sudden large expense can derail the financial situation of a household or
business. Insurance companies use channels such as individual and corporate agents,
brokers, and banks to sell their products. Given the large resources mobilized by
insurance companies by way of premiums, they are an important source of long-term
funding for government and businesses.
 Pension Funds take contributions from eligible individuals and invest these funds
according to the directions of the contributors to create a retirement corpus. These
funds provide different options for investment of the contribution, such as debt, equity
or a combination. Investors select the type of fund and these are long term retirement
funds.
 AMCs and Portfolio Managers are investment specialists who manage a portfolio of
securities and other assets. Against this portfolio, these asset managers either issue
units or PMS accounts to create wealth over the long run.
 Investment Advisers and distributors help investors to make a choice of securities that
they can buy based on an assessment of their needs, time horizon return expectation
and ability to bear risk. The idea is to work towards a long term financial plan.
Organized and Unorganized Market
An organized market is a formal financial market that operates under rules, regulations and
guidelines set by regulatory authorities such as Securities Exchange Board of India, Reserve
Bank of India, Insurance Regulatory Authority, Mutual Fund Regulations, and Central
Government Policies.

7. Unorganized market is an informal market that operates without any standardization and
control of any regulatory authority. In India it is operated by moneylenders and traders. There
are high rates of interest and it operates mainly in rural areas. Such informal markets also
exist in urban areas and they are outside the purview of government control.
ORGANIZED AND UNORGANIZED MARKET
Organized Market Unorganized Market
A market operating with rules and
regulations.
Non-standardized procedures. Variable rates of
interest and transactions.
Control of a recognized controller ex; SEC. No control on transactions as no rules operate.
It is a formal recognized market like New
Issue Market and Stock Exchange.
It is operated by money lenders and traders. It is
also called an informal market.
Institutions play an important role in
collection of savings of people in the
intermediation process.
There is no large institution but there are some
chit funds and lotteries in operation in an
informal manner. Rates of interest are exorbitant.