Most common instruments traded in the capital market

Introduction

Capital market instruments ensure a seamless flow of funds in an economy. They transfer surplus funds from investors to those in need of capital for expansion and therefore help in the balanced growth of the economy by promoting investments and savings.

The capital market has two parts—primary and secondary markets. Companies issue securities for the first time through the Initial Public Offering (IPO) on primary markets. While the trade of already issued securities happens on the secondary market. The buy and sell of capital market instruments are done in exchange for monetary value.

There are several instruments traded in the capital market. The common ones are as follows:

Stocks

Stock is a capital market instrument issued by companies to raise capital. It is also known as equity share. Investment in company stocks gives you ownership and voting rights in the company. The partial ownership in the company extends until you sell the shares in the secondary market or the company liquidates. Also, you become a partner in the company’s profits and losses, and the returns are offered as dividends.  The increase in the share value depends on the organisation’s performance which impacts the investor’s return. Considered a high-risk instrument, equity generates higher returns than other instruments in the capital market in the past.

Preference shares

Preference shares are the shares that get preference in case of dividend payment or liquidation payouts. It means the company has to pay dividends or payouts to preference shareholders before equity shareholders. However, preference shareholders do not enjoy voting rights in the company. Preference shares are typically not traded in the secondary market like equity shares. The types of preference shares include:

• Redeemable: The issuing organisation can redeem the preference shares by choosing buyback at a later stage.
• Irredeemable: A company can redeem the irredeemable shares only when it liquidates.
• Convertible: An investor can convert these preference shares into equity after a specific time.

According to the Companies Act, 2013, Indian companies cannot issue irredeemable preference shares. Instead, they can issue redeemable shares that must be redeemed within 20 years of their issue.

Debt

Governments and companies issue debt instruments to finance capital-intensive projects. Issued on primary or secondary markets, debt is a form of borrowing with no ownership rights in the organisation. The debt instruments usually have limited tenure, after which the issuing entity has to return the principal amount. The interest payments are made annually, semi-annually, quarterly or monthly. Debt instruments include municipal, government and corporate bonds/debentures. The investments in debt are considered less-risky than equity. However, the default risk may be higher if the financial health of the issuing company is not good. So, you must invest in debt instruments after analysing the financial status of the issuing organisation.

Derivatives

Derivatives are capital market instruments that derive their value from an underlying asset. The underlying assets can be bonds, stocks, metals, commodities, currency, etc. The trade of these instruments is based more on speculation, however these can also be used for hedging and arbitrage purpose as well. Thus, considered more volatile and riskier than equity, derivatives are suitable for experienced investors in the financial market. Derivatives are traded on the secondary market, and the common ones in India are:

• Future contracts
• Options contract

Exchange-traded funds (ETFs)

ETFs are capital market instruments where many investors pool their resources to invest in bonds, equity or gold. Having features of both shares and mutual funds, most ETFs are registered with the Securities and Exchange Board of India (SEBI). Like mutual funds, ETFs are beneficial for investors looking to invest in an index, a basket of stocks or a commodity.

Foreign exchange instruments

The foreign exchange instruments are traded on the foreign market. They consist of derivatives and currency agreements. The currency agreements are further categorised into:

• Currency futures
• Currency swaps
• Currency options

Conclusion

Apart from the above-discussed instruments, the capital market trades in many other products. Understanding the features of different capital market instruments is essential for an informed decision. As an investor, you must also assess your financial goals, current financial condition and risk appetite before picking an investment tool. After this, you can open a trading account through a registered broker to trade in the capital market.