One of the most common instrument that most of the general public invest in the stock market are shares. But there are more instruments other than shares that are traded heavily in the stock market. Like debentures, bonds, derivatives (futures, options). Debentures and bonds are considered safe and are good for long-term investing whereas derivatives are riskier and are only good for seasoned players of the market. All these products are explained briefly below:
Derivative is a contract or a product whose value is derived from the value of some other asset known as underlying. Derivatives are based on a wide range of underlying assets. These include:
Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc.
Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas etc.
Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses, etc.
Financial assets such as Shares, Bonds and Foreign Exchange.
Products in Derivatives Market
It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre‐decided on the date of the contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of the price of the underlying asset at the time of delivery. Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over‐the‐counter (OTC) contracts.
Let’s understand it with an example: Assume on March 9, 2017, you wanted to purchase a gold from goldsmith. The market price for gold on March 9, 2017, was ₹15,425 for 10 gram of gold and goldsmith agrees to sell you gold at that price. You paid him ₹15,425 for 10 gram of gold and took gold. This is a cash market transaction at a price (in this case ₹15,425) referred to as spot price.
Now suppose you do not want to buy gold on March 9, 2017, but only after 1 month. Goldsmith quotes you ₹15,450 for 10 grams of gold. You agree to the forward price for 10 grams of gold and go away. Here, in this example, you have bought forward or you are long forward, whereas the goldsmith has sold forwards or short forwards. There is no exchange of money or gold at this point in time. After 1 month, you come back to the goldsmith pay him ₹15,450 and collect your gold. This is a forward, where both the parties are obliged to go through with the contract irrespective of the value of the underlying asset (in this case gold) at the point of delivery.
In the above‐mentioned example, if on April 9, 2017, the gold trades at ₹15,500 in the cash market, the forward contract becomes favorable to you because you can then purchase gold at ₹15,450 under the contract and sell in cash market at ₹15,500 i.e. a net profit of ₹50. Similarly, if the spot price is 15,390 then you incur a loss of ₹60 (buy price – sell price).
A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Indeed, we may say futures are exchange-traded forward contracts.
An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While buyer of the option pays the premium and buys the right, writer/seller of the option receives the premium with an obligation to sell/ buy the underlying asset if the buyer exercises his right.
A swap is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula. Swaps are, broadly speaking, series of forward contracts. Swaps help market participants manage the risk associated with volatile interest rates, currency exchange rates, and commodity prices.
These are also the capital market instruments which are used to raise the medium and long-term capital funds in the public. These are the debt instruments which acknowledges a loan to the company and is executed under the common seal of the company and the deed shows the amount of loan and date of repayment.
Types of debentures:
On point of view of record:
- Registered Debentures: These debentures are registered with the company and the amount is payable only to those debentures holders whose names are registered with the company.
- Bearer Debentures: These debentures are not registered with the company, these are transferable merely by delivery and the debenture holder will get the interest.
On the basis of security:
- Secured or Mortgaged Debentures: These are secured by a charge on the assets of a company. The principal amount and the unpaid interest could be recovered by the holder out of the assets mortgaged by the company.
- Unsecured Debentures: They do not get any security in reference to the principal amount or unpaid interest. They are simple debentures.
On the basis of Redemption:
- Redeemable Debentures: They are issued for a fixed period and the principal amount is paid off only at the expiry of that period or at the maturity.
- Non-Redeemable Debentures: They are matured only after the liquidation or closing down or winding up of the company.
On the basis of convertibility:
- Convertible Debentures: These can be converted to shares after the expiry of the period i.e. on their maturity.
- Non- Convertible Debentures: These cannot be converted into shares on their maturity.
On the basis of priority:
- First Debentures: These are redeemed before other debentures.
- Second Debentures: These are redeemed after the redemption of the first debenture.
Bonds are the debt security where an issuer is bound to pay a specific rate of interest agreed as per the terms of payment and repay the principal amount at a later time. The bondholders are generally like a creditor where a company is obliged to pay the amount. The amount is paid on the maturity of the bond period. In India, there are several types of bonds available to investors, including ones that are only sold privately and a tax-savings bond that releases the investor of a tax burden.
Types of Bonds
Public Sector Undertaking or Government Bonds
PSU bonds are good for middle to long-term investing in the Indian bond market. PSU bonds are issued and backed by Government of India but they are usually sold on a private basis. In other words, the GOI targets investors themselves and offers the bonds to these investors at fixed rates.
These are more traditional bond instruments, which are offered by private corporations in India for terms that can last up to 15 years. Unlike the government bonds mentioned earlier, anyone can purchase a corporate bond. However, there is a higher risk of default and that can depend upon the corporation backing the bond, market conditions, the company’s industry and its investment rating. But the risk comes with a higher return on the investment.
Banks and other financial institutions bonds
These bonds are issued by banks or any financial institution. The financial market is well regulated and the majority of the bond markets are from this segment. However, care to be taken to consider the credit rating given by credit agencies before investing in these bonds. In case of poor credit rating, better to stay away from such bonds.
Tax Saving Bonds
In India, the tax saving bonds are issued by the Government of India for providing benefit to investors in the form of tax savings. Along with getting normal interest, the bondholder would get the tax benefit. Unfortunately, sales of these bonds ended in early 2018.
In India, all these bonds are listed in the National Stock Exchange and Bombay Stock Exchange, hence they can be easily liquidated and sold in the open market.