When it comes to making an investment, I prefer visiting banks as that is where I get financial advice and assistance from certified wealth management professionals. Visiting the bank has always been useful as bankers showcase all kinds of financial products. As a customer, this becomes easier to decide as you get to weigh the pros and cons of various financial instruments.
Let us assume that I work at a bank and am trying to impart financial literacy to investors looking out for the best of returns. By the end of this article, you would have a basic understanding of different financial instruments in the market.
Different Types Of Financial Instruments In The Market
A bond is a financial instrument which is termed as a debt instrument. It is a contract between the investor and the borrower ensuring that the investor gets a fixed amount of payment along with a fixed rate of interest after a certain period of time.
Bonds are usually issued by governmental institutions to raise capital from the public. The Corporate sector also issues bonds when it wishes to not go for any loans.
Types Of Bonds
There are various types of bonds available for investors to choose from.
Zero coupon bonds do not pay any interest to investors. Investors are given a discount on the par value, also known as the face value of the bond. In other words, the face value of the bond determines the value of the bond at maturity. When an individual chooses to invest in a zero coupon bond, he will be given a discount even if he receives the entire face value at maturity. The returns will be the difference between the face value at maturity and the cost of the bond at the beginning of the first year.
Convertible bonds are bonds that allow its bond holders to convert bonds into equities at some point in the future when the prices of the stock increase. This option is provided with the intent that the interest or coupon payment to the bond holder is comparatively less, which allows the company to pay only a little at its earlier stages. This conversion can be done even before the maturity of the bond.
Callable bonds have an embedded option which different from that of a convertible bond. This option is in favor of corporate organisations as these organisations can call back these bonds at any point in the future even before the bond matures. This scenario arises when the ratings of a company improve and borrowers are willing to buy bonds at a lower coupon rate. This is in consistence with the inverse relation between bond prices and interest rates.
On the contrary, a Puttable bond is a financial instrument which allows bond holders to put or sell the bond at any point in the future before it matures. This option allows the investors to sell the bond if they feel that the value of a bond is on a declining trajectory. Bond issuers offer this option to the investors in return for a lower coupon rate win order to attract more number of people.
Of all the financial instruments in the market, equities never seem to loose their charm. Let us have a look at the most basic concept that is central to the entire idea of investing in numerous companies. When there is a requirement for capital in any company; it could be for a new project or for an expansion or introduction of a new product, companies often raise capital through investors in the stock market.
For the investments that these investors make in the market, they get paid returns in the form of dividends. In simple terms,once the company raises capital, it utilizes this money to increase its market share and grow in the industry. Consistent and high returns result in an increase in the prices of the stocks of these companies.
The shareholders of that particular company are also termed as part owners as a small part of the ownership is granted to these investors. Equity can be traded as stocks in the stock market. There are two stock exchanges in India; the National Stock Exchange and the Bombay Stock Exchange.
A derivative security or derivative contract is a legal document that confers on the investors certain rights or obligations depending on the type of contract they hold. The name derivative suggests that it is an asset which is derived from an underlying asset known as the primary asset. There are different types of assets which can be listed as :
Forwards & Futures
A simple transaction between a buyer and seller consisting of an exchange of assets in return for money is known as a spot transaction. In the case of forwards and futures, the two parties agree to exchange assets at a pre decided price in the future. This puts an obligation on both the parties once they agree upon this deal. The major difference between futures and forwards is that, futures contracts are standardized whereas forwards contracts on the other hand are customized.
The terms standardization and customizations are with reference to the set of terms and conditions. But one thing common between the two is that the buyer is obliged to acquire the underlying asset at the negotiated point in time. Secondly, the seller is obliged to deliver the asset on the same date as above. The keyword “obligation” holds tremendous importance in a futures or a forwards contract.
We have emphasized on how both the buyer and the seller, have an obligation to deliver the assets for money. However, what differentiates an options contract is that this type of a contract removes any type of obligation. An options contract was financially engineered for the purpose of removing any financial obligation.
What may happen is that the value of the underlying asset may rise or fall in the future. Therefore, these contracts protect the interests of investors and at the same time also gives them the chance to earn from arbitrage opportunities.
There are many types of options contracts but let us discuss about the simple types of contract which are commonly know as vanilla contracts. These are “calls” and “puts”.
A call option allows an investor to purchase an asset at a pre-determined price when the value of the asset rises. Therefore, the holder of such an option hopes to get the value of the asset soar. One important thing to note is that if the value of the asset falls below the pre determined price then the buyer is not obliged to purchase that asset as he may choose to “exercise” his call option.
A put option on the other hand allows an investor to sell the underlying asset at a pre-determined price if the value falls in future. Basically, the holder of a put option hopes for the value of the underlying asset to plummet. This is totally opposite from the reference point of a call option.
Interest Rate Swaps
This is a very unique type of derivative contract that involves swapping of cash flows between two parties such that the net cash flow remains unchanged but the parties involved experience a relative difference in their bank statements.
This can be explained with a simple situation. Let is assume that any given commodity, say apples are being sold at INR 100 per kg in city A. The same apples are being sold at INR 10 per kg in city B. Another commodity, say oranges, are being sold at for INR 10 in city A whereas it costs INR 100 in city B. Now with the help of an intermediate party, two individuals living in city A and B respectively would come in contact. It would be pretty obvious that Individual 1 residing in city A who wishes to have apples would purchase oranges whereas individual 2 residing in city B who wants to have oranges would purchase apples.
The amount the two individuals have spent so far is INR 10. They would swap the two commodities and hence would get what they wanted in the first place. The intermediary would want some commission in return, say INR 5 from each party. Therefore, instead of spending rupees 100 on apples in city A and rupees 100 in city B, the two parties spent rupees 15 each and came to an agreement to swap the underlying assets. This is analogical to the interest rate swaps when it comes to payment of installments in banks for loan.
Mortgage Backed Securities
The term mortgage refers to the contract between a borrower and a lender in which the borrower deposits a collateral in the form of an illiquid asset.
The term illiquid asset refers to the fact that the underlying asset holds monetary value implicitly. This could be in the form of a house or even a vehicle. A mortgage is in itself an illiquid asset which restricts the circulation of capital.
Therefore, lenders pool such mortgages and issue debt securities to initiate the mobilization of capital. These debt securities are issued and backed by collaterals which the lender holds. Hence, the securities for which the borrower ensures periodic installments so as to retire the debt is termed as mortgage backed securities. The process of converting an illiquid asset into liquid marketable securities is known as securitization.
Foreign Exchange Market
At a time when countries around the world started establishing themselves, there was an advent of a global economy. To incorporate trade and trade related transactions, the foreign exchange market came into being. This market is one of the oldest markets that exists.
The FOREX market determines the value of currencies around the world. Investors buy and sell currencies that might rise or fall in value. There is no central institution which facilitates the trading. Trading occurs through a network of different institutions which run for 24 hours a day. This is unlike the stock market.
With minimal amount of regulations, the forex market attracts investors from all avenues with a caveat. This ensures that arbitrage opportunities are diminished instantly. The value of currencies are always given relative to another currency which is contrary to the representation of values of stocks. In fact, the value of currencies depend on various factors such as monetary policies, imports and exports and political stability.
Now that we have an overview of the different kinds of financial instruments in the market, Investments can be thought of as a way of systematically managing and growing savings by different ways of capital generation. Investors can definitely see promising returns if they have a focused long term investment plan. It is also important for investors to know the different kinds of financial instruments which are available in the market.
We all look at diversification of investment portfolios and gradual amplification of returns on a long term basis as the main goal. Financial Literacy should be leveraged for investors to fully utilise and take advantage of different financial instruments in the market.
This article is authored by Abhishek Katti. He is a graduate of technology from NIT Allahabad. He writes about topics such as economy, financial planning, investments and wealth management.
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