What are the Most Common Instruments Traded in the Capital Market?

The capital market is a key segment of the financial market, serving as a channel for the transfer of funds from one entity to another.

The capital market can be divided into two – a primary market, where companies issue stocks for the first time, and a secondary market that trades old or existing securities. These securities, termed capital market instruments, are bought and sold in exchanges for certain monetary considerations. 

There are different kinds of instruments traded in the capital market, both primary and secondary, here is what you should know about these instruments. 

What are Capital Market Instruments? 

Instruments of capital market are the certificates or documents that act as evidence of investment. There are a number of instruments traded in the capital market, here are the most common ones:

Shares

Shares, also known as stocks or equities, are issued by the companies. An investment into a share or equity of a company translates to acquiring a part of its ownership. In addition, this contract of ownership through equity stands in perpetuity until it is sold to investors in the secondary market or when the company is liquidated. 

Know that, through equity investment, investors hold certain privileges and rights in the enterprise issuing equity, including voting rights. An equity holder also receives returns in the form of dividends. Also, depending on the performance or the operations of the company, the value of the equity increases (when additional investment comes in) or decreases (when there is an exit of investors).

That said, though the returns from a share are relatively higher among other capital market instruments, the risks are higher as well. 

Investors can invest in these instruments either in the primary (IPO) or secondary market.

Debt Instruments

Corporations, as well as governments, raise funds for capital-intensive projects by issuing a debt instrument. As a result, this type of instrument leads to the formation of a borrower-creditor relationship. Therefore, unlike equities, holders of debt instruments do not possess any ownership in the issuing entity. 

Moreover, the contract stands valid for a particular tenure, say, from three years to 25 years. Interest, mentioned at the time of bond subscription, is paid out periodically on an annual, quarterly, or semi-annual basis. An investor’s principal amount invested is repaid when the contract period expires.

The table below further elaborates on these capital market instruments:

In the event of a company’s liquidation, investors of its debt instruments are considered a top priority. Note that while the risk is lower when compared to investment in shares, debt instruments are not completely risk-free. Additionally, investment in debt instruments involves lower levels of risk. The risks depend on the issuing body. If a company is already in bad financial health and is raising money by issuing bonds, one should be alert, even if the interest rate is high. 

One can obtain debt instruments either in the primary market or the secondary market.

Derivatives

These instruments are derived from other securities that are known as underlying assets. Though the level of associated risk, function, and price of a derivative depends on its underlying assets, it is very volatile and comes with higher risks than equities.

Moreover, these instruments are unpredictable and largely speculation-oriented. Some of the common derivative instruments in India are:

• Commodities or Exchange Traded Funds
• Swap Contracts
• Options Contracts
• Future Contracts
• Forwards Contracts

Individuals can invest in derivatives in the secondary market.

Preference Shares

These are the shares that have preferential rights in a company, in terms of dividend payment or pay-out in case of liquidation. In simpler words, this implies that a business has to first pay its preference shareholders first.

Only after their payment, the company can pay its equity shareholders, especially in terms of dividends. 

So, preference shares have a few similarities with debt instruments. But these shareholders, unlike equity shareholders, don’t have any voting rights. But, preference shareholders receive a timely (usually guaranteed) return on investment which makes up for this shortcoming. If interest rates increase, their fixed dividend can dwindle. 

Moreover, preference shares can be of several types, they include:

• Redeemable Preference Shares: The issuing company can redeem these preference shares by opting for a buy-back at a later stage. 

• Irredeemable Preference Shares: These can only be redeemed if their issuing company liquidates itself. 

• Convertible Preference Shares: These can be converted into equity shares after a certain period of time. 

It is important to note that as per the Companies Act, 2013, companies in India cannot issue irredeemable preference shares. Rather, they must issue redeemable preference shares, which need to be redeemed within a period of 20 years of issuance.

Individuals can buy preference shares of a publicly-traded enterprise in the same manner as they purchase common shares. These can be acquired in either the primary or secondary market.