Financial Instruments in India: Types, Features, Classification & Long-Term Finance

Definition of Financial Instrument

A real or virtual document representing a legal agreement involving some sort of monetary value in today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity, for example.

Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments:

1. Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.
2. Derivative instruments are financial instruments which derive their value from the value and characteristics of one or more underlying entity such as an Asset an Index or an Interest Rate. They can be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

Instruments of Long-Term Finance

Long-term finance refers to funds required by a business for a period exceeding one year. These funds are used for purchasing fixed assets, expansion, modernization, and business growth.

Main Instruments of Long-Term Finance

1. Equity Shares

Equity shares represent ownership in a company.

Features:

• Shareholders are owners of the company. 
• Dividend is paid from profits. 
• Voting rights are available. 
• Permanent source of capital. 

Advantages:

• No compulsory dividend payment. 
• Increases creditworthiness. 
• Suitable for long-term projects. 

Disadvantages:

• Dilution of control. 
• Higher cost of capital. 

2. Debentures

Debentures are long-term debt instruments issued by companies.

Features:

• Fixed rate of interest. 
• Debenture holders are creditors. 
• Redeemable after a specific period. 

Advantages:

• No dilution of ownership. 
• Interest is tax deductible. 

Disadvantages:

• Fixed financial burden. 
• Risk during low profits. 

3. Term Loans

Term loans are loans obtained from banks or financial institutions for a fixed period.

Features:

• Repayment in installments. 
• Interest payable periodically. 
• Used for acquiring fixed assets. 

Advantages:

• Easy availability. 
• Flexible repayment terms. 

Disadvantages:

• Requires collateral security. 
• Interest burden continues. 

4. Convertible Debentures

Convertible debentures can be converted into equity shares after a specified period.

Features:

• Hybrid security. 
• Lower interest rate. 
• Conversion option available. 

Advantages:

• Attractive to investors. 
• Reduces cash outflow initially. 

Disadvantages:

• Future dilution of ownership. 

5. Warrants

Warrants give investors the right to purchase shares at a fixed price within a specified period.

Features:

• Right but not obligation to buy shares. 
• Issued along with bonds or debentures. 

Advantages:

• Helps companies raise additional funds. 
• Attractive investment option. 

Disadvantages:

• Share dilution if exercised. 

6. Zero Interest Debentures

These debentures do not carry regular interest.

Features:

• Issued at discount. 
• Redeemed at face value. 

Advantages:

• No periodic interest burden. 
• Useful for cash flow management. 

Disadvantages:

• Large payment at maturity. 

7. Deep Discount Bonds

These bonds are issued at a heavy discount and redeemed at face value.

Features:

• No regular interest payment. 
• Long maturity period. 

Advantages:

• Suitable for long-term investors. 
• Lower immediate cash burden. 

Disadvantages:

• No regular income to investors. 

8. Secured Premium Notes

Secured Premium Notes (SPNs) are secured debentures redeemable at a premium.

Features:

• Secured against company assets. 
• Premium paid at redemption. 

Advantages:

• Attracts investors due to premium benefit. 
• Enhances fund raising. 

Disadvantages:

• Higher redemption liability. 

Interpretation: Long-term finance instruments help businesses raise funds for expansion, modernization, and development. Each instrument has different features, risks, and benefits. Companies choose the most suitable source depending on cost, control, risk, and financial requirements.

Combining the above methods for categorization, the main instruments can be organized into a table as follows:

Asset Class	Securities	Other Cash	Exchange-Traded Derivatives	OTC Derivatives
Debt (Long Term) > 1 year	Bonds	Loans	Bond futures Options on bond futures	Interest rate swaps Interest rate caps and floors Interest rate options Exotic instruments
Debt (Short Term) ≤ 1 year	Bills (e.g., T-bills) Commercial paper	Deposits Certificates of deposit	Short-term interest rate futures	Forward rate agreements
Equity	Stock	N/A	Stock options Equity futures	Stock options Exotic instruments
Foreign Exchange	N/A	Spot foreign exchange	Currency futures	Foreign exchange options Outright forwards foreign exchange swaps Currency swaps

What are financial instruments and different types in India

Financial Instruments are nothing but legal agreement made between two or more in terms of cash, evidence of an entity, or a contract right to deliver, receive (cash/cheque/demand draft/bonds/bill of exchange/futures or option contract) is called a Financial Instrument. There are two main types of Financial Instruments available in India. They are Government Securities and Industrial Securities.

1. Government Securities (G-Sec): They are nothing but fixed income securities which cannot be fake and most widely trusted as under Government RBI control. Government Securities are issued by different categories of Government like State Government and Central Government, Local Municipalities/Corporations, Electricity Board and various sector wise investments to attract people to develop the core business. As this Securities are issued by Government the risk is very minimum and the interest rate also very minimum compares too many other private financial investment. The maturity period of the securities is different from five years to twenty years. The Central and State Governments generate money to increase Infrastructure, to generate new job opportunities and many other available to the resources in the state. The interest paid by these securities are fixed and paid every3-6months of a minimum. The biggest investor of these securities are commercial banks to safe their investment and corporate to see their fixed returns even though the interest rate is less, to maintain a certain percentage of Statutory Liquidity Ratio (SLR) as well as an investment. These securities are sold in the primary market mainly through the auction mechanism. The RBI notifies issue of a new tranche of securities. Prospective buyers submit their bids. The RBI decides to accept bids based on a cut off price. Government Securities are mainly bought by Institutional Investors. Insurance companies, provident funds, and mutual funds are the other large investors.
2. Industrial Securities: These are securities issued by the corporate sector to finance their long term and working capital requirements. The Major Instruments that fall under Industrial Securities are Equity shares, Preference Shares and Debentures.
3. Equity Shares: Equity Shares nothing but “high return risk” instrument. Equity shares don’t have any fixed return rate and thereby, no period of maturity. The company may or may not declare dividend on equity shares. Equity shares of major companies are traded on the stock exchanges. The major component of return to equity holders usually consists of market appreciation.
4. Preference Shares: Preference Shares carry a fixed rate of dividends. These carry a preferential right to dividends over the equity shareholders. This means that equity shareholders cannot be paid any dividends unless the preference dividend has been paid in full. Similarly on the winding up of the company, the preference shareholders get back their capital before the equity shareholders. In case of cumulative preference shares, any dividend unpaid in past years accumulates and is paid later when the company has sufficient profits. Now all preference shares in India are `redeemable’, i.e. they have a fixed maturity period. Thus, preference shares are sometimes called a `hybrid variety’ – incorporating features of debt as well as equity.
5. Call Money Market: The loans made in this market are of a short term in nature, overnight to a fortnight. This is commonly inter-bank market. Those banks which are facing a short in terms of cash deficit, borrow funds from the cash that have surplus funds in other banks. The rate of interest is market driven and depends on the liquidity position in the banking system.
6. Commercial Paper (CP) and Certificate of Deposits (CD): CPs is issued by the corporate to finance their working capital needs. These are issued for short term maturities. These are issued at a discount and redeemed at face value. These are unsecured and therefore only those companies who have a good credit standing are able to access funds through this instrument. The rate of interest is that the market driven and depends on the current liquidity position and the credit worthiness of the issuing company. The characteristics of CDs and CPs are similar except that CDs are issued by the commercial banks.