Financial system in India P2

Financial system in India have different types of instruments which are discussed as below

Major instruments of Capital market

1.Shares-

• A company’s capital is divided into small equal units of a finite number. Each unit is known as a share.

• In simple terms, a share is a percentage of ownership in a company or a financial asset

Types of Shares-

It is generally of 2 types-

A.Preference shares

B.Equity Shares

A.Preference shares

• In this the shareholders receive dividends on the highest priority, and also companies return their capital before ordinary shareholders when undergoing liquidation.

It has following features-

• Steady  income.

• No voting rights.

• No assured return.

• Less risk.

It is further divided as follows-

Convertible and Non convertible-

• Which can and can not be converted into equity shares respectively.

Redeemable and Irredeemable- 

• Which can be refunded before any period of time is called redeemable and vice versa for irredeemable.

B.Equity Shares

• Equity shares refer to shares that are only paid dividends when there are profits remaining after the fixed rate of dividends has been paid to preference shareholders.

It has following features-

• Right to vote in companies board or management.

• No charge on assets.

• Higher risks.

• They are costly.

• Permanent capital.

It is further divided as follows-

Rights shares- 

• When shares are given to already existing share holders.

Bonus Shares -

• Bonus shares are issued by companies to shareholders as a means of providing additional equity without any monetary compensation in the form of dividends.

Sweet equity shares- 

• Companies can issue shares to its employees and directors as a means of compensation, usually when they perform excellently is known as sweet equity shares

2.Debentures-

• Debentures are a type of debt instrument that large companies use to raise funds from the market. They typically have medium to long-term maturity dates and offer a fixed rate of interest to investors who purchase them.

It is divided as follows-

A.Convertible Debentures-

• Which can be easily converted into Shares and it can be fully convertible or Partially convertible.

B.Non convertible Debentures-

• Which can not be converted into shares.

C.Mortgage Debenture- 

• A mortgage debenture is a type of debenture that is secured by a specific asset. If the borrower fails to repay the loan, the debenture holders can recover their dues by selling that particular asset.

D.Redeemable and Irredeemable- 

• Which can be refunded before any period of time is called redeemable and vice versa for irredeemable.

Debentures has following features-

• It gives fixed returns depending on Rate of interest on which company has borrowed the money.

• Debenture holders are called as Creditors of the company.

• They have no voting rights ion the company.

• Paying interest on a debenture is considered a charge against profit, which makes it tax deductible.

• Even if a company incurs a loss, they are still obligated to pay interest on their debenture.

• Because of this obligation, debenture holders do not bear any risk.

Difference Between Shares and Debentures-

3.Mutual Funds-

• A mutual fund is a collection of funds that is professionally managed by a fund manager to invest in various securities, including stocks, bonds, money market instruments, and other assets.

• They are  operated by professional money managers.

Net Assets Value- 

• The NAV or Net Asset Value represents the total market value of a fund's holdings in shares, bonds, and securities on a specific day.

• The fees that mutual funds charge are regulated and limited by the Securities and Exchange Board of India (SEBI).

Types of Mutual Funds-

A.Classification on the Basis of Structure

Open Ended Mutual Fund-

• An open-end fund is a type of mutual fund that is accessible for purchase and sale on any business day of the year.

Closed Ended Mutual Fund-

• A closed-end fund has a fixed maturity date and is only available for subscription during the initial offer period.
• The units of a closed-end fund can only be redeemed upon reaching maturity.

B.Based on Assets they are classified as follows-

Equity Funds-

• These are funds that invest in equity stocks/shares of companies and have high risk and high return.

Debt Funds-

• Debt funds refer to investment funds that focus on debt instruments, such as government bonds, company debentures, and other fixed-income assets.

Money Market Funds- 

• Money market funds invest in liquid instruments such as T-Bills and CPs.

• They are a safe investment option for individuals seeking moderate returns on their surplus funds.

• These funds provide an opportunity to park surplus funds for immediate use.

Balanced or Hybrid Funds- 

• These are funds that invest in a mix of asset classes and can have combination of both Debenture and Equity.

C.Classification on the Basis of Investment Goals-

Growth funds-

• In this case the money is invested primarily in equity stocks with the purpose of providing capital appreciation

Income funds- 

• In this, The money is invested primarily in fixed-income instruments e.g. bonds, debentures etc. with the purpose of providing capital protection and regular income to investors

Tax-Saving Funds (ELSS)- 

• ELSS (Equity-Linked Saving Scheme) Funds are mutual funds that invest predominantly in equity shares. One of the benefits of investing in these funds is that they offer tax deductions under the Income Tax Act.

Bonds

• Bonds are financial instruments that allow borrowers to raise funds from the public for a specific period of time.

• A bond represents a loan from an investor to a borrower, typically with fixed interest payments.

• Bonds can be issued by governments, corporations, or other organizations looking to finance their operations or projects.

Terms Related to Bonds

Issue Date-

• The date of issue for bonds is the starting point from which the accrual of interest begins.

Coupon Rate-

• The coupon rate is the interest rate that a company agrees to pay to investors who buy its bonds when they are issued. This rate is legally binding and determines the amount of interest payments that bondholders will receive.

Face Value-

• The face or par value of the bond is the price of a bond repayable at maturity.

• This price may differ from the bond price prevailing in the secondary market.

Yield-

• Yield means the return investor gets from the bond.

Issuers of Bonds-

• Bonds can be issued by Government or companies.

• Bonds issued by Government are less risky and provides fixed return to the investor.

• Bonds issued by company have high return and high risk involved.

Different types of Bonds

1.Fixed-rate Bonds- 

• Fixed-rate bonds are a type of investment where the coupon rate remains constant throughout the tenure of the bond.

2.Floating-rate Bonds- 

• Floating-rate bonds are a type of investment where the coupon rate changes over time.

• This means that the interest rate paid to the bondholder is not fixed and may fluctuate during the bond's lifespan.

3.Zero Coupon Bonds- 

• Zero coupon bonds are a type of bond in which the issuer does not pay any interest to the investor during the term of the bond. Instead, the investor receives only the principal amount of the bond upon its maturity. These bonds are commonly referred to as "zero-coupon bonds."

4.Perpetual bonds- 

• Perpetual bonds are a type of debt security that has no maturity date.

• Unlike traditional bonds, the issuer does not have to repay the principal amount to the bondholders.

• Instead, the bondholders receive regular coupon payments for an indefinite period of time, hence the name "perpetual."

• Perpetual bonds are often issued by companies or governments as a way to raise capital without the pressure of repaying the principal amount.

5.Bearer Bonds -

• Bonds which do not carry the name of the bond holder and anyone who possesses the bond certificate can claim the amount.

6.Inflation index bonds-

• Inflation index bonds are a type of bond designed to mitigate the effects of inflation on the face value and coupon payments.

• The principal amount is adjusted based on inflation, while coupon payments are made on the adjusted principal amount.

• In India, inflation index bonds are linked to the Wholesale Price Index (WPI) and are issued for a period of 10 years.

• The minimum investment amount for these bonds is Rs. 5000.

7.Masala Bonds

• Masala bonds refer to a type of bonds that are issued outside of India, but are denominated in Indian Rupees instead of the local currency.

• The first Masala bond was issued by the World Bank- backed IFC in November 2014.

• These bonds are converted at market value on the day the transactions are settled.

Eligibility of Masala bonds -

• Several Indian companies have raised money by selling masala bonds.

• Countries that are members of the Financial Action Task Force (FATF) and the International Organization of Securities Commissions are eligible to issue masala bonds.

• The eligibility for these bonds is restricted to individuals who are citizens of nations that are members of the Financial Action Task Force (FATF), and no other individuals are eligible to obtain them.

• These bonds may be purchased by members of regional and international financial organizations that include India

Maturity Period of Masala Bonds-

• Minimum Maturity period in it is 3 years.

Benefits of Masala Bonds-

• Masala Bonds provide a way for foreign investors to invest in the domestic market, even if they lack access through FII or FPI.

• For borrowers, issuing Masala Bonds is advantageous because the cost of funds is cheaper, and they can be issued at an interest rate below 7%.

• There is no currency risk for companies issuing these bonds, as the depreciation of the rupee is not a concern.

• It is important to note that the money raised through these bonds has specific limitations on where it can be invested.

Financial Action Task force

• In 1989, the G7 established an intergovernmental organization with the goal of creating policies to combat money laundering and protecting certain interests. This organization is commonly known as FATF.

Members of FATF-

• As of 2021, FATF has 37 countries as full members.

• India became an Observer at FATF in 2006. Since then, it had been working towards full-fledged membership.

• On June 25, 2010 India was taken in as the 34th country member of FATF.

• Indonesia is the only observer country of FATF and 28 international organisations are its observers

The FATF Secretariat

• It is located at the OECD headquarters in Paris.

• The Secretariat supports the substantive work of the FATF membership and global network.

Grey and Black Lists of the FATF-

Grey List-

• The Grey List comprises of nations that are deemed as safe havens for facilitating terrorist financing and money laundering.

Black List-

• The Black List includes Non-Cooperative Countries or Territories (NCCTs) that support terror funding and money laundering activities and it includes Iran, North Korea and Myanmar

Consequences of being in the FATF grey list-

• Economic sanctions from IMF, World Bank, ADB.

• Problem in getting loans from IMF, World Bank, ADB and other countries.

• Reduction in international trade.

• International boycott.

Derivatives-

• Derivatives are financial products that derive their value from underlying assets. These instruments can be classified into four main categories: futures, forwards, options, and swaps.

• The main purpose of entering into derivative contracts is to earn a large amount of profits by contemplating the underlying asset's value in the future.

Types of Derivatives

1.Forward Contracts

• Forward contracts mean two parties come together and enter into an agreement to buy and sell an underlying asset set at a fixed date and agreed on a price in the future.

• Forward contracts do not require any collateral as they are self-regulated.

• It is a customized contract and have high risk involved in it.

• They are self Regulated.

• In this the settlement is done on Maturity basis.

2.Future Contacts-

• Future contracts are comparable to forward contracts.

• They entail an agreement between two parties to buy or sell an underlying asset at a pre-determined price on a future date.

• The counterparty risk in futures contracts is low due to the standardized nature of the contract.

• Future contracts have a fixed size, and their regulation is done by the stock exchange because they are standardized.

• Settlements for future contracts can be made on a daily basis.

3.Options Contracts

• An Option contract gives the right but not an obligation to buy/sell the underlying assets.

Sub types-

Call option -

• A call option is a type of financial contract where the purchaser is granted the right, but not the obligation, to buy an underlying asset at a predetermined price.

Put option-

• The buyer has all the right but not obligation to sell an underlying asset at a fixed price while entering the contract.

4.Swap Contracts

• Swap contracts are complex agreements.

• Such contracts are usually private agreements made between two parties.

• The parties agree to exchange their cash flow in the future according to a predetermined formula.

Offshore Derivative Instruments

1.Participatory notes/P- Notes-

• Participatory notes, also known as P-Notes, are offshore derivative instruments used to make investments in shares listed in the Indian stock market from outside India.

• These notes are particularly popular among foreign high net worth individuals, hedge funds, and other investors who wish to invest in Indian markets without being registered with SEBI.

• P-Notes allow investors to bypass some of the regulatory requirements that would otherwise apply to foreign investments in Indian markets.

• They are issued by brokers and Financial Investment Institutions registered with SEBI and they have to mandatorily report their PN issuance status to SEBI for each quarter

Advantages of P-Notes-

Anonymity -

• Investors who choose to invest in participatory notes are not obligated to register with SEBI. In contrast, all foreign institutional investors (FIIs) must register. This arrangement allows significant hedge funds to conduct their activities without revealing their identity.

Ease of trading- 

• Participatory notes make trading easy due to their similarity to contract notes that can be transferred through endorsement and delivery.

Tax saving- 

• Certain entities utilize participatory notes to route their investments and benefit from the tax laws of specific countries.

Disadvantages of P-notes

• Due to anonymous nature of these notes the sources of investments are not known.

• P-notes are being used in Money Laundering by wealthy Indians.

• Some of the individuals use it to evade capital gain tax in in India

Regulations-

• They are regulated by SEBI.

• To curb black money, restrictions on P-Notes have been tightened.

• In May 2016, SEBI extended KYC and anti-money laundering norms to PN subscribers.

• In April 2014, SEBI banned unregulated entities in foreign countries (Category III FPIs in India) from subscribing P-Notes.

• FIIs cannot issue PNs to non-resident Indians (NRIs) and must provide an undertaking to that effect.

Angel investor and Venture Capital Fund

Angel Investor

• An angel investor, also known as a business angel, angel funder, private investor, or seed investor, is a high net worth individual who invests capital in a start-up or businesses.

• Angel investors typically invest in exchange for convertible debt or ownership equity in the business.

• Angel investors often provide not only financial support, but also expertise, experience, and connections to help the start-up succeed.

• Angel investors differ from venture capitalists in that they invest their own money rather than institutional funds, and typically invest in early-stage companies with lower capital needs.

Venture capital (VC) -

• It is an individual or group that invests money into high-risk startups.

Difference between Angel investor and Venture capitalist

• An angel investor works alone, while venture capitalists are part of a company.

• Angel investors only invest in early-stage companies.

• Venture capitalists Pools money from funds, foundations, corporations, and insurance companies, to invest while Angel investor use their own money.

• Venture capitalists can invest very high amount but mostly angel investors do not invest very high amount

Real Estate Investment Trust (REIT) and Infrastructure Investment Trusts (InVITs)

1.Real Estate Investment Trust (REIT)-

• It was Launched in 2014.

• REITs invest in properties like warehouses, apartments, corporate offices, data centres, shopping malls, etc.

• REITs are similar to mutual funds.

• The main objective of REITs is to create regular income and capital appreciation.

• REITs own their real estate through long-term leases or freehold ownership, which makes them safe from political and regulatory threats.

2.Infrastructure Investment Trusts (InVITs)

• It was also Launched in 2014.

• InvITs (Infrastructure Investment Trusts) aim to increase private investment in infrastructure and encourage more retail investors to participate in the sector.

• These trusts invest in various infrastructure projects, including transmission, roadways, environmental initiatives, renewable energy, and more.

• Large trading lot size and higher unit price of InvITs, make them less liquid.

Important one liner and short questions and answers on Financial system in India.

What are the main instruments of the Capital market?

The main instruments of the Capital market are shares, debentures, and mutual funds.

What are shares?

Shares are small equal units of a company's capital. Each unit represents a percentage of ownership in the company or financial asset.

What are the types of shares?

Shares are generally of two types: preference shares and equity shares.

What are preference shares?

Preference shares are shares where shareholders receive dividends on the highest priority, and companies return their capital before ordinary shareholders when undergoing liquidation.

What are the features of preference shares?

The features of preference shares are steady income, no voting rights, no assured return, and less risk.

What are the types of preference shares?

Preference shares can be convertible and non-convertible, redeemable and irredeemable.

What are equity shares?

Equity shares refer to shares that are only paid dividends when there are profits remaining after the fixed rate of dividends has been paid to preference shareholders.

What are the features of equity shares?

The features of equity shares are the right to vote in companies' board or management, no charge on assets, higher risks, costly, and permanent capital.

What are the types of equity shares?

The types of equity shares are rights shares, bonus shares, and sweet equity shares.

What are debentures?

Debentures are a type of debt instrument that large companies use to raise funds from the market. They typically have medium to long-term maturity dates and offer a fixed rate of interest to investors who purchase them.

What are the types of debentures?

Debentures can be convertible and non-convertible, mortgage debenture, and redeemable and irredeemable.

What are the features of debentures?

The features of debentures are fixed returns depending on the rate of interest on which the company has borrowed the money, debenture holders are called creditors of the company, they have no voting rights in the company, and interest payment is tax-deductible.

What are mutual funds?

Mutual funds are a collection of funds that are professionally managed by a fund manager to invest in various securities, including stocks, bonds, money market instruments, and other assets.

What is the net asset value (NAV)?

The net asset value (NAV) represents the total market value of a fund's holdings in shares, bonds, and securities on a specific day.

What are the types of mutual funds?

Mutual funds can be classified on the basis of structure as open-ended and closed-ended mutual funds, and on the basis of assets they are classified as equity funds, debt funds, money market funds, and balanced or hybrid funds.

What is an open-ended mutual fund?

An open-ended fund is a type of mutual fund that is accessible for purchase and sale on any business day of the year.

What is a closed-ended mutual fund?

A closed-end fund has a fixed maturity date and is only available for subscription during the initial offer period.

What are equity funds?

Equity funds are funds that invest in equity stocks/shares of companies and have high risk and high return.

What are debt funds?

Debt funds refer to investment funds that focus on debt instruments, such as government bonds, company debentures, and other fixed-income assets.