We took a look at the players in the financial markets earlier. Let us now look at the Financial Instruments these players have. They can be braodly classified into
Ø Government securities and
Ø Industrial securities
Government Securities (G-Sec):
In India G- Secs are issued by the Central Government, State Governments and Semi Government Authorities such as municipalities, port trusts, state electricity boards and public sector corporations. The Central and State Governments raise money through these securities to finance the creation of new infrastructure as well as to meet their current cash needs. Since these are issued by the government, the risk of default is minimal. Therefore, interest rates on these securities often serve as a benchmark for the level of interest rates in the economy. Other issuers may price their offerings by `marking up' this benchmark rate to reflect the credit risk specific to them.
These securities may have maturities ranging from five to twenty years. These are fixed income securities, which pay interest every six months. The Reserve Bank of India manages the issues of the securities. These securities are sold in the primary market mainly through the auction mechanism. The RBI notifies issue of a new tranche of securities. Prospective buyers submit their bids. The RBI decides to accept bids based on a cut off price.
The G -secs are primarily bought by the institutional investors. The biggest investors are commercial banks who invest in G-secs to meet the regulatory requirement to maintain a certain percentage of Statutory Liquidity Ratio (SLR) as well as an investment vehicle. Insurance companies, provident funds, and mutual funds are the other large investors. The Primary Dealers perform the function of market makers through buying and selling activities.
The Government of India also borrows short term funds for up to one year. This is through the issue of Treasury Bills which are sold at a discount to the face value and redeemed at the full face value.
Industrial Securities:
These are securities issued by the corporate sector to finance their long term and working capital requirements.
The Major Instruments that fall under Industrial Securities are
• Debentures,
• Preference Shares And
• Equity Shares.
Debentures
Debentures have a fixed maturity and pay a fixed or a floating rate of interest during their lifetime. The company has an obligation to pay interest and the principal amount on the due dates regardless of its profitability position. The debenture holders are not members of the company and do not have any say in the management of the company. Since these carry a predefined rate of return, there is no scope for any major capital appreciation. However, in case of fixed rate debentures, their market price moves inversely with the direction of interest rates. The debenture issues are rated by the professional credit rating agencies regarding the payment of interest and the repayment of the capital amount. Apart from the `plain vanilla' variety of debentures (periodic payment of interest during their currency and repayment of capital on maturity), a number of variations have been devised. For example, zero coupon bonds are issued at a discount to their face value and redeemed at the full face value. The difference constitutes return for the investor.
Preference Shares
Preference Shares carry a fixed rate of dividends. These carry a preferential right to dividends over the equity shareholders. This means that equity share holders cannot be paid any dividends unless the preference dividend has been paid in full. Similarly on the winding up of the company, the preference share holders get back their capital before the equity share holders. In case of cumulative preference shares, any dividend unpaid in past years accumulates and is paid later when the company has sufficient profits. Now all preference shares in India are `redeemable', i.e. they have a fixed maturity period. Thus, preference shares are sometimes called a `hybrid variety' – incorporating features of debt as well as equity.
Equity Shares
Equity Shares are regarded as high return high risk instruments. These do not carry any fixed rate of return and there is no maturity period. The company may or may not declare dividend on equity shares. Equity shares of major companies are traded on the stock exchanges. The major component of return to equity holders usually consists of market appreciation.
Call Money Market:
The loans made in this market are of a short term nature – overnight to a fortnight . This is mostly inter-bank market. Those banks which are facing a short term cash deficit, borrow funds from the cash surplus banks. The rate of interest is market driven and depends on the liquidity position in the banking system.
Commercial Paper (CP) and Certificate of Deposits (CD) :
CPs are issued by the corporates to finance their working capital needs. These are issued for short term maturities. These are issued at a discount and redeemed at face value. These are unsecured and therefore only those companies who have a good credit standing are able to access funds through this instrument. The rate of interest is market driven and depends on the current liquidity position and the creditworthiness of the issuing company.
The characteristics of CDs are similar to those of CPs except that CDs are issued by the commercial banks.
