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What are Financial Instruments?

Financial instruments are financial contracts of different natures made between institutional units. These comprise the full range of financial claims and liabilities between institutional units, including contingent liabilities like guarantees, commitments, etc.

A financial asset is defined as any contract from which a financial claim may derive for one party and a financial liability or participation in equity for another.

Financial instruments can exist only between two institutional units. Where financial instruments are compounded, i.e. represent a set of several instruments, for compilation of statistics there will be a need to distinguish them into separate instruments so that each of them includes only a single pair of institutional units.

Financial assets are contracts that do not contain contingency, i.e., irrespective of any conditions, generate financial claims having demonstrable value over which ownership rights are enforced, individually or collectively, and from which economic benefits can be derived by using or holding them.

The concept of financial instruments is wider than the concept of financial assets as defined in the System of National Accounts, 1993.

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Concept of Financial Instruments

Financial instruments refer to those documents which represent financial claims on assets. Financial asset refers to a claim to the repayment of a certain sum of money at the end of a specified period together with interest or dividend.

Examples are Bill of Exchange, Promissory Notes, Treasury Bills, Government Bonds, Deposit Receipt, Shares, Debenture, etc. Financial instruments can also be called financial securities. Financial securities can be classified into:

1. Primary or Direct Securities
2. Secondary or Indirect Securities
3. Short-Term Securities
4. Medium-Term Securities
5. Long-Term Securities

Primary or Direct Securities

These are securities directly issued by the ultimate investors to the ultimate savers, e.g. shares and debentures issued directly to the public.

Secondary or Indirect Securities

These are securities issued by some intermediaries called financial intermediaries to the ultimate savers, e.g. Unit Trust of India and mutual funds issue securities in the form of units to the public, and the money pooled is invested in companies.

Again these securities may be classified on the basis of duration as follows:

Short-Term Securities

These securities are those which mature within a period of one year. For example, the Bill of Exchange, the Treasury Bill, etc.

Medium-Term Securities

These securities are those which have a maturity period ranging between one and five years like Debentures maturing within a period of 5 years.

Long-Term Securities

These securities are those which have a maturity period of more than five years. For example, Government Bonds generally mature after 10 years.

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Characteristics of Financial Instruments

1. Most of the instruments can be easily transferred from one hand to another without many cumbersome formalities.
   
   
2. They have a ready market i.e., they can be bought and sold frequently, and thus trading in these securities is made possible.
   
   
3. They possess liquidity, i.e., some instruments can be converted into cash readily. For instance, a bill of exchange can be converted into cash readily by means of discounting and rediscounting.
   
   
4. Most of the securities possess security value, i.e., they can be given as security for the purpose of raising loans.
   
   
5. Some securities enjoy tax status, i.e., investments in these securities are exempted from Income Tax, Wealth Tax, etc., subject to certain limits.
   
   
6. They carry risk in the sense that there is uncertainty with regard to payment of principal or interest or dividend as the case may be.
   
   
7. These instruments facilitate future trading so as to cover risks due to price fluctuations, interest rate fluctuations, etc.
   
   
8. These instruments involve fewer handling costs since the expenses involved in buying and selling these securities are generally much less.
   
   
9. The return on these instruments is directly in proportion to the risk undertaken.
   
   
10. These instruments may be short-term or medium-term or long-term depending upon the maturity period of these instruments.

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Innovative Financial Instruments

In recent years, innovation has been the key word behind the phenomenal success of many financial service companies and it forms an integral part of all planning and policy decisions. This has helped them to keep in tune with the changing times and changing customer needs.

Accordingly, many innovative financial instruments have come into the financial market in recent times. Some of them have been discussed hereunder:

1. Commercial Paper
2. Treasury Bill
3. Certificate of Deposit
4. Inter-Bank Participation (IBPs)
5. Zero Interest Convertible Debenture/Bonds
6. Deep Discount Bonds
7. Index-Linked Guilt Bonds
8. Option Bonds
9. Secured Premium Notes
10. Medium Term Debentures
11. Variable Rate Debentures
12. Non-Convertible Debentures with Equity Warrants
13. Equity with 100% Safety Net
14. Cumulative Convertible Preference Shares
15. Convertible Bonds
16. Debentures with ‘Call’ and ‘Put’ Feature
17. Easy Exit Bond
18. Retirement Bond
19. Regular Income Bond
20. Infrastructure Bond
21. Carrot and Stick Bonds
22. Convertible Bonds with a Premium Put
23. Debt with Equity Warrant
24. Dual Currency Bonds
25. ECU Bonds (European Currency Unit Bonds)
26. Yankee Bonds
27. Flip-Flop Notes
28. Floating Rate Notes (FRNs)
29. Loyalty Coupons
30. Global Depository Receipt (GDR)

Commercial Paper

A paper is a short-term negotiable money market instrument. It has the character of an unsecured promissory note with a fixed maturity of 3 to 6 months. Banking and non-banking companies can issue this for raising their short-term debt. It also carries an attractive rate of interest.

Commercial papers are sold at a discount from their face value and redeemed at their face value. Since its denomination is very high, it is suitable only for institutional investors and companies.

Treasury Bill

A treasury bill is also a money market instrument issued by the Central Government. It is also issued at a discount and redeemed at par. Recently, the Government has come out with short-term treasury bills of 182-day bills and 364-day bills.

Certificate of Deposit

The scheduled commercial banks have been permitted to issue certificates of deposit without any regulation on interest rates. This is also a money market instrument and unlike a fixed deposit receipt, it is a negotiable instrument and hence it offers maximum liquidity.

As such, it has a secondary market too. Since the denomination is very high, it is suitable mainly for institutional investors and companies.

Inter-Bank Participation (IBPs)

The scheme of inter-bank participation is confined to scheduled banks only for a period ranging between 91 days and 180 days. This may be “with risk” participation or “without risk” participation. However, only a few banks have so far issued IBPs carrying an interest rate ranging between 14 and 17 percent per annum. This is also a money market instrument.

Zero Interest Convertible Debenture/Bonds

As the very name suggests, these instruments carry no interest till the time of conversion. These instruments are converted into equity shares after a period of time.

Deep Discount Bonds

There will be no interest payments in the case of deep discount bonds also. Hence, they are sold at a large discount to their nominal value. For example, the Industrial Development Bank of India issued in February 1996 deep discount bonds.

Each bond has a face value of Rs. 2,00,000 and was issued at a deeply discounted price of Rs.5300 with a maturity period of 25 years. Of course, provisions are there for early withdrawal or redemption in which case the deemed face value of the bond would be reduced proportionately. This bond could be gifted to any person.

Index-Linked Guilt Bonds

These are instruments having a fixed maturity. Their maturity value is linked to the index prevailing as of the date of maturity. Hence, they are inflation-free instruments.

Option Bonds

These bonds may be cumulative or non-cumulative as per the option of the holder of the bonds. In the case of cumulative bonds, interest is accumulated and is payable only on maturity. But, in the case of a non-cumulative bond, the interest is paid periodically. This option has to be exercised by the prospective investor at the time of investment.

Secured Premium Notes

These are instruments that carry no interest for three years. In other words, their interest will be paid only after 3 years, and hence, companies with high capital-intensive investments can resort to this type of financing.

Medium Term Debentures

Generally, debentures are repayable only after a long period. But, these debentures have a medium-term maturity. Since they are secured and negotiable, they are highly liquid. These types of debt instruments are very popular in Germany.

Variable Rate Debentures

Variable rate debentures are debt instruments. They carry a compound rate of interest, but this rate of interest is not a fixed one. It varies from time to time in accordance with some pre-determined formula as we adopt in the case of Dearness Allowance calculations.

Non-Convertible Debentures with Equity Warrants

Generally, debentures are redeemed on the date of maturity but these debentures are redeemed in full at a premium in installments as in the case of anticipated insurance policies. The installments may be paid at the end of the 5th, 6th, 7th, and 8th year from the date of allotment.

Equity with 100% Safety Net

Some companies make “100% safety net” offer to the public. It means that they give a guarantee to the issue price. Suppose, the issue price is Rs.40/- per share (nominal value of Rs.10/ – per share), the company is ready to get it back at Rs.40/- at any time, irrespective of the market price.

That is, even if the market price comes down to Rs.30/- there is a 100% safety net and hence the company will get it back at Rs.40/-.

Cumulative Convertible Preference Shares

These instruments along with capital and accumulated dividend must be compulsorily converted into equity shares in a period of 3 to 5 years from the date of their issue, according to the discretion of the issuing company.

The main object of introducing it is to offer the investor an assured minimum return together with the prospect of equity appreciation. This instrument is not popular in India.

Convertible Bonds

A convertible bond is one which can be converted into equity shares at a pre-determined time neither fully nor partially. There are compulsory convertible bonds that provide for conversion within 18 months of their issue.

There are optionally convertible bonds that provide for conversion within 36 months. There are also bonds that provide for conversion after 36 months and they carry ‘call’ and ‘put’ features.

Debentures with ‘Call’ and ‘Put’ Feature

Sometimes debentures may be issued with the “Call” and “Put” features. In the case of debentures with a “Call feature”, the issuing company has the option to redeem the debentures at a certain price before the maturity date.

In the case of debentures with “Put features”, the company gives the holder the right to seek redemption at specified times at predetermined prices.

Easy Exit Bond

As the name indicates, this bond enables small investors to encash the bond at any time after 18 months of its issue and thereby paving the way for an easy exit. It has a maturity period of 10 years with a call option at any time after 5 years. Recently the IDBI has issued this type of bond with a face value of Rs.5000 per bond.

Retirement Bond

This type of bond enables an investor to get an assured monthly income for a fixed period after the expiry of the “wait period” chosen by him. No payment will be made during the “wait period”. The longer the waiting period, the higher will be the monthly income.

Besides these, the investor will also get a lump sum amount on maturity. For example, the IDBI has issued Retirement Bond 96 assuring a fixed monthly income for 10 years after the expiry of the wait period. This bond can be gifted to any person.

Regular Income Bond

This bond offers an attractive rate of interest payable half yearly with the facility of early redemption. The investor is assured of regular and fixed income. For example, the IDBI has issued Regular Income Bond 96 carrying 16% interest p.a. It is redeemable at the end of every year from the expiry of 3 years from the date of allotment.

Infrastructure Bond

It is a kind of debt instrument issued with a view to giving tax shelter to investors. The resources raised through this bond will be used for promoting investment in the field of certain infrastructure industries.

Tax concessions are available under Sec. 88, Sec. 54 EA and Sec. 54EB of the Income Tax Act. HUDCO has issued for the first time such bonds. Its face value is Rs. 1000 each carrying an interest rate of 15% per annum payable semi-annually. This bond will also be listed on important stock exchanges.

Carrot and Stick Bonds

Carrot bonds have a low conversion premium to encourage early conversion, and sticks allow the issuer to call the bond at a specified premium if the common stock is trading at a specified percentage above the strike price.

Convertible Bonds with a Premium Put

These are bonds issued at face value with a put, which means that the bondholder can redeem the bonds for more than their face value.

Debt with Equity Warrant

Sometimes bonds are issued with warrants for the purchase of shares. These warrants are separately tradable.

Dual Currency Bonds

Bonds that are denominated and pay interest in one currency and are redeemable in another currency come under this category. They facilitate interest rate arbitrage between two markets.

ECU Bonds (European Currency Unit Bonds)

These bonds are denominated in a basket of currencies of the 10 countries that constitute the European community. They pay principal and interest in ECUs or in any of the 10 currencies at the option of the holder.

Yankee Bonds

If bonds are raised in the U.S.A., they are called Yankee bonds and if they are raised in Japan, they are called Samurai Bonds.

Flip-Flop Notes

It is a kind of debt instrument that permits investors to switch between two types of securities e.g. to switch over from a long-term bond to a short-term fixed-rate note.

Floating Rate Notes (FRNs)

These are debt instruments that facilitate periodic interest rate adjustments.

Loyalty Coupons

These are entitlements to the holder of debt for two to three years to exchange into equity shares at discount prices. To get this facility, the original subscriber must hold the debt instruments for the said period.

Global Depository Receipt (GDR)

A global depository receipt is a dollar-denominated instrument traded on a stock exchange in Europe or the U.S.A. or both. It represents a certain number of underlying equity shares. Though the GDR is quoted and traded in dollar terms, the underlying equity shares are denominated in rupees.

The shares are issued by the company to an intermediary called the depository in whose name the shares are registered. It is the depository that subsequently issues the GDRs.

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FAQs About the Innovative Financial Instruments