INSTRUMENTS OF CAPITAL MARKETS

Equity Instruments

A. Equity Shares

• How It Works: Equity shares represent partial ownership in a company. When a company needs to raise capital for expansion, new projects or to pay off debts it issues shares to public through an Initial Public Offering (IPO). Investors buy these shares becoming part-owners.
  After the IPO shares are traded in the secondary market. Shareholders can earn through:
  • Dividends: A portion of company profits distributed to shareholders.
  • Capital Gains: Profit from selling shares at a higher price than purchase price.
• Key Features:
  • Ownership: Shareholders are part-owners of company.
  • Voting Rights: They can vote on important company matters (e.g. electing directors).
  • Dividend Income: Not fixed & depends on company performance.
  • Transferability: Can be bought& sold in secondary markets like NSE, BSE.
  • Residual Claim: In case of liquidation shareholders are paid after debt holders & preference shareholders.
• Regulations:
  • Regulated by SEBI (Securities and Exchange Board of India).
  • Companies Act, 2013 governs corporate governance, disclosures etc.
  • Listing requirements from stock exchanges (e.g. minimum public shareholding norms).
• Advantages: High potential for capital appreciation, Voting rights and influence in company decisions, Liquidity through stock exchanges.
• Disadvantages: High risk due to market volatility, No guaranteed dividends, Last priority in case of liquidation.
• Types of Equity Shares:
  • Ordinary Shares: Standard voting rights.
  • Differential Voting Rights (DVR): Fewer voting rights but higher dividends.
  • Bonus Shares: Free shares issued from company profits.
  • Rights Shares: Offered to existing shareholders at a discount.
• Real-World Example: LIC IPO (2022): India’s then largest IPO raising ₹21,000 crores. Over 6 million retail investors participated.

B. Preference Shares

• How It Works: Preference shares are hybrid instruments offering a fixed dividend prioritized over equity shareholders. However they typically lack voting rights. They are suitable for investors seeking stable returns with lower risk compared to equity shares.
• Key Features:
  • Fixed Dividends: Paid before equity shareholders.
  • Priority in Liquidation: Paid after debt holders but before equity holders.
  • Limited Voting Rights: Only in specific cases like non-payment of dividends.
  • Convertible Option: Some can be converted into equity shares.
• Regulations:
  • Governed under the Companies Act, 2013.
  • SEBI’s Issue of Capital and Disclosure Requirements (ICDR) regulations apply.
• Advantages: Stable income through fixed dividends, Higher priority in asset distribution, Lower risk than common equity.
• Disadvantages: Limited/no voting rights, Less capital appreciation potential, Fixed returns may be lower than equity gains.
• Types of Preference Shares:
  • Cumulative: Unpaid dividends accumulate and are paid later.
  • Non-Cumulative: No accumulation of unpaid dividends.
  • Convertible: Can be converted into equity shares after a certain period.
  • Non-Convertible: Cannot be converted into equity.
  • Participating: Shareholders may receive additional dividends if the company performs exceptionally well.
• Real-World Example: Tata Steel’s Preference Shares: Issued to raise funds with a fixed dividend payout to reduce reliance on debt.

C. Indian Depository Receipts (IDRs)

• How It Works: IDRs are financial instruments allowing foreign companies to raise funds from Indian investors without being listed on Indian exchanges directly. A foreign company issues shares to an Indian depository, which then issues IDRs to Indian investors.
• Key Features:
  • Issued in INR: No foreign exchange risk for Indian investors.
  • Ownership: Represents underlying shares of a foreign company.
  • Tradable: Can be bought/sold on Indian stock exchanges.
  • Dividend Distribution: In INR after conversion from foreign currency.
• Regulations:
  • Governed by SEBI (IDR) Regulations, 2004.
  • RBI’s Foreign Exchange Management Act (FEMA) guidelines apply.
• Advantages: Exposure to foreign companies without opening foreign accounts, No direct foreign investment compliance needed for Indian investors, Potential for global diversification.
• Disadvantages: Limited liquidity compared to domestic shares, Currency conversion risks for dividend payouts, Regulatory complexities for issuing companies.
• Types:
  • Standard IDRs: Represent regular equity shares.
  • Sponsored IDRs: Issued in collaboration with the foreign company.
• Real-World Example: Standard Chartered PLC’s IDR (2010): The first IDR issued in India raising over ₹2,500 crores.

D. Global Depository Receipts (GDRs)

• How It Works: GDRs are certificates issued by international banks representing shares of foreign companies. Indian companies use GDRs to raise capital from global investors. GDRs are traded on international exchanges like the London Stock Exchange.
• Key Features:
  • International Fundraising: Enables companies to tap into global capital markets.
  • Denominated in Foreign Currencies: Usually in USD or Euros.
  • Convertible: Can be converted into underlying equity shares.
  • Dividend Payments: In foreign currency.
• Regulations:
  • Governed by SEBI (Issue of Capital and Disclosure Requirements).
  • FEMA and RBI regulations for foreign transactions.
• Advantages: Access to international capital, Diversified investor base, Enhanced global visibility for companies.
• Disadvantages: Exchange rate risks, Higher regulatory compliance, Listing and administrative costs.
• Types:
  • Rule 144A GDRs: For qualified institutional buyers in the US.
  • Regulation S GDRs: For investors outside the US.
• Real-World Example: Infosys GDR Listing (1999): Helped Infosys raise substantial global capital expanding its international footprint.

E. Qualified Institutional Placements (QIPs)

• How It Works: QIPs allow publicly listed companies to raise capital quickly by issuing equity shares or convertible securities to Qualified Institutional Buyers (QIBs) like mutual funds, insurance companies & foreign institutional investors.
• Key Features:
  • Fast Fundraising: Minimal regulatory procedures compared to public issues.
  • Targeted Investors: Only available to QIBs.
  • Flexible Pricing: Based on market conditions.
  • No SEBI Pre-Approval: Faster execution compared to FPOs (Follow-on Public Offers).
• Regulations:
  • Introduced by SEBI in 2006 under ICDR regulations.
  • Companies must be listed on recognized Indian stock exchanges.
• Advantages: Faster access to capital, No need for extensive documentation like IPOs, Cost-effective compared to international fundraising options.
• Disadvantages: Only institutional investors can participate, Potential dilution of existing shareholders’ equity, May impact stock price if large volumes are issued.
• Real-World Example: Bharti Airtel’s QIP (2020): Raised over ₹7,500 crores to strengthen its balance sheet amid increased competition in the telecom sector.

Debt Instruments

Debt instruments are financial tools used by governments, corporations or financial institutions to raise capital from investors. In return they promise to repay principal amount along with periodic interest (coupon payments).

A. Bonds

• How It Works: A bond is a loan from an investor to an issuer (like a company or government). The issuer agrees to:
  • Pay interest (called a coupon) at regular intervals.
  • Repay principal (face value) on a specified maturity date.

Investors earn through: Fixed/Variable Interest Payments or Capital Gains (if sold before maturity at a higher price)

• Key Features:
  • Face Value: principal amount (e.g., ₹1,000).
  • Coupon Rate: interest rate paid (e.g., 7% annually).
  • Maturity Date: date the principal is repaid.
  • Yield: actual return based on the bond’s price & interest.
  • Credit Rating: Indicates issuer’s creditworthiness (e.g. AAA, BBB).
• Regulations:
  • Corporate Bonds: Regulated by SEBI.
  • Government Bonds: Regulated by RBI under the Government Securities Act, 2006.
  • Listed bonds follow SEBI’s Listing Obligations and Disclosure Requirements (LODR).
• Advantages: Predictable income through fixed interest, Lower risk than equities (especially government bonds), Priority over equity in case of liquidation.
• Disadvantages: Interest rate risk: bond prices fall when interest rates rise, Credit/default risk: issuer may fail to repay, Lower returns compared to equities in the long run.
• Types of Bonds:
  • Government Bonds: Issued by central/state governments.
  • Corporate Bonds: Issued by companies.
  • Convertible Bonds: Can be converted into equity shares.
  • Zero-Coupon Bonds: Sold at a discount no periodic interest.
  • Perpetual Bonds: No maturity date; pays interest indefinitely.
• Real-World Example: Sovereign Gold Bonds (SGBs): Used to be Issued by RBI on behalf of the Government of India offering 2.5% interest annually plus gold price appreciation.

B. Debentures

• How It Works: A debenture is an unsecured debt instrument (no collateral) where companies borrow money from investors with a promise to pay interest & return the principal at maturity. It relies on the issuer’s creditworthiness.
• Key Features:
  • Fixed Interest Rate: Regular interest payments.
  • No Collateral: Backed by the issuer’s credit rating.
  • Transferable: Can be traded in debt markets.
  • Maturity Period: Short to long-term (1 to 10 years typically).
• Regulations:
  • Governed by the Companies Act, 2013.
  • SEBI regulates publicly listed debentures.
  • Trust Deed Requirement: A trustee is appointed to protect investors’ interests.
• Advantages: Higher interest rates than secured bonds, Flexible terms & maturities, No dilution of ownership (unlike equity).
• Disadvantages: Higher risk due to lack of collateral, Credit risk if issuer’s financial condition worsens, Sensitive to interest rate changes.
• Types of Debentures:
  • Convertible Debentures: Can be converted into equity shares.
  • Non-Convertible Debentures (NCDs): Cannot be converted into shares; offer higher interest rates.
  • Secured Debentures: Backed by company assets.
  • Unsecured Debentures: No collateral backing.
• Real-World Example: Tata Capital Financial Services NCDs: Offering interest rates of 8-9% annually, popular among retail investors for fixed income.

C. Commercial Papers (CPs)

• How It Works: Commercial Papers are short-term unsecured promissory notes issued by corporations to meet short-term funding needs like working capital. They are typically issued at a discount & redeemed at face value.
• Key Features:
  • Short-Term Maturity: 7 days to 1 year.
  • Unsecured: No collateral, issued based on credit rating.
  • Issued at Discount: No interest payments; difference between issue price & face value is the return.
  • High Denomination: Usually issued in multiples of ₹5 lakhs.
• Regulations:
  • Regulated by RBI under RBI Act, 1934.
  • Only companies with a strong credit rating can issue CPs.
• Advantages: Lower cost of borrowing for companies compared to bank loans, High liquidity for investors, Attractive returns for short-term investors.
• Disadvantages: Not suitable for retail investors due to high denominations, Higher risk if issuer faces financial trouble, Limited secondary market liquidity.
• Real-World Example: Reliance Industries CP Issuance (2021): Raised ₹4,000 crores for working capital needs at attractive discount rates.

D. Certificates of Deposit (CDs)

• How It Works: Certificates of Deposit are time deposits issued by banks to raise funds. Investors deposit a lump sum for a fixed period earning a predetermined interest rate.
• Key Features:
  • Fixed Tenure: Ranging from 7 days to 1 year (for banks) & up to 3 years (for financial institutions).
  • Issued in Demat or Physical Form: Tradable in secondary market.
  • Higher Interest Rates: Compared to regular savings accounts.
  • Minimum Investment: Typically ₹1 lakh & in multiples thereof.
• Regulations:
  • Regulated by RBI under Negotiable Instruments Act, 1881.
  • Only scheduled commercial banks & certain financial institutions can issue CDs.
• Advantages: Safe investment with assured returns, Higher interest than savings accounts, Flexible tenure options.
• Disadvantages: Limited liquidity compared to stocks & bonds, Penalty for early withdrawal, Fixed returns: no benefit from rising interest rates.
• Real-World Example: HDFC Bank CDs: Frequently issued to manage liquidity offering competitive interest rates compared to fixed deposits.

E. Treasury Bills (T-Bills)

• How It Works: Treasury Bills are short-term debt instruments issued by Government of India to meet temporary funding needs. They are issued at a discount & redeemed at face value.
• Key Features:
  • Short-Term Maturity: 91, 182 or 364 days.
  • Risk-Free: Backed by government’s credit.
  • No Interest Payments: Return comes from discount to face value.
  • Highly Liquid: Traded actively in money market.
• Regulations:
  • Issued by the RBI on behalf of Government of India.
  • Governed under Government Securities Act, 2006.
• Advantages: Virtually risk-free, High liquidity: easy to buy/sell, Attractive for conservative investors.
• Disadvantages: Low returns compared to corporate bonds, No regular interest payments, Not ideal for long-term investments.
• Real-World Example: 91-Day T-Bills (2023): Yielded around 6.5% popular among mutual funds & institutional investors for parking short-term surplus funds.

Hybrid Instruments

Hybrid instruments combine features of both equity & debt offering investors benefits of both while allowing issuers flexibility in raising capital. They can provide fixed income like debt instruments & potential for capital appreciation like equity.

A. Convertible Debentures

• How It Works: A convertible debenture is a type of long-term debt issued by a company that can be converted into equity shares after a specified period. Investors receive interest like regular debentures until conversion.
• Key Features:
  • Conversion Option: Can be converted into shares at a pre-determined ratio.
  • Interest Payments: Until conversion holders receive interest (coupon).
  • Conversion Period: Specified in terms (e.g. after 5 years).
  • Conversion Price: Fixed or based on market conditions.
• Regulations:
  • Governed by Companies Act, 2013.
  • SEBI regulations apply for listed debentures.
  • Issuers must disclose conversion terms clearly in offer documents.
• Advantages: Fixed income until conversion, Potential for capital gains if the company’s stock performs well, Lower interest rates compared to non-convertible debentures (due to equity upside).
• Disadvantages: Dilution of ownership post-conversion, Complex valuation due to hybrid nature, Risk of loss if the share price falls after conversion.
• Types of Convertible Debentures:
  • Fully Convertible Debentures (FCDs): Entire principal converts into shares.
  • Partially Convertible Debentures (PCDs): A portion converts into equity rest remains as debt.
  • Optionally Convertible Debentures (OCDs): Investor has option to convert or not.
• Real-World Example: Tata Motors OCDs (2020): Issued to raise capital allowing investors to convert into equity based on company performance.

B. Warrants

• How It Works: A warrant gives holder right (but not obligation) to buy company’s shares at a specific price (strike price) within a certain timeframe. It’s like a long-term stock option.
• Key Features:
  • Strike Price: Predetermined price to buy the shares.
  • Expiration Date: Valid for several years longer than options.
  • No Voting Rights: Warrants don’t represent ownership until exercised.
  • Tradable: Can be bought/sold in secondary markets.
• Regulations:
  • Regulated by SEBI for listed companies.
  • Disclosure of terms mandatory in offer documents.
  • Pricing Guidelines: Governed under SEBI (Issue of Capital and Disclosure Requirements) Regulations.
• Advantages: Potential for significant capital gains if share prices rise, Flexibility to exercise or sell in the secondary market, Useful for companies to raise funds without immediate dilution.
• Disadvantages: High risk: if stock price doesn’t rise above the strike price warrants become worthless, No dividend or voting rights until exercised, Dilution of equity when warrants are exercised.
• Types of Warrants:
  • Equity Warrants: Right to buy shares.
  • Covered Warrants: Issued by financial institutions, not companies.
  • Detachable Warrants: Can be traded separately from the original bond/share.
• Real-World Example: Reliance Industries Warrants (2019): Issued as part of a rights issue allowing investors to subscribe to shares at a future date at a fixed price.

C. Preference Shares

• How It Works: Preference shares are equity shares that have preferential rights over common shares regarding dividend payments & repayment of capital during liquidation. They are a hybrid of debt & equity due to fixed dividends.
• Key Features:
  • Fixed Dividend: Paid before dividends to common shareholders.
  • Preference in Liquidation: Priority over equity holders if the company winds up.
  • No Voting Rights: Typically unless dividends are unpaid for a certain period.
  • Redeemable/Non-Redeemable: Some preference shares can be bought back by the company.
• Regulations:
  • Governed by the Companies Act, 2013.
  • SEBI guidelines for listed preference shares.
  • Dividend distribution governed by company profits.
• Advantages: Stable income through fixed dividends, Priority over equity shareholders during liquidation, Convertible options for potential capital gains.
• Disadvantages: No voting rights in most cases, Fixed returns: no benefit from company’s high growth, Risk of non-payment if the company faces financial issues.
• Types of Preference Shares:
  • Cumulative Preference Shares: Unpaid dividends accumulate.
  • Non-Cumulative Preference Shares: No accumulation of unpaid dividends.
  • Convertible Preference Shares: Can be converted into equity.
  • Participating Preference Shares: Entitled to additional profits after fixed dividends.
• Real-World Example: Tata Steel Preference Shares: Issued to raise funds with fixed dividend commitments offering stable returns to investors.

D. Hybrid Mutual Funds

• How It Works: Hybrid mutual funds invest in a mix of equity, debt & sometimes commodities to balance risk & return. They provide diversification within a single investment.
• Key Features:
  • Asset Allocation: Mix of stocks, bonds & other securities.
  • Diversification: Reduces risk through varied exposure.
  • Dynamic Rebalancing: Fund managers adjust allocations based on market conditions.
  • Income and Growth: Combines capital appreciation from equity & regular income from debt.
• Regulations:
  • Regulated by SEBI under Mutual Fund Regulations.
  • Fund houses must disclose asset allocation strategy in Scheme Information Documents (SIDs).
• Advantages: Diversified risk across asset classes, Suitable for conservative & moderate investors, Professional fund management.
• Disadvantages: Management fees reduce returns, Market volatility affects both debt & equity portions, Limited control over asset allocation for investors.
• Types of Hybrid Funds:
  • Aggressive Hybrid Funds: Equity-heavy (65-80%) for higher growth.
  • Conservative Hybrid Funds: Debt-heavy (75-90%) for stability.
  • Balanced Funds: Equal allocation between equity and debt.
  • Dynamic Asset Allocation Funds: Flexible allocation based on market conditions.
• Real-World Example: HDFC Balanced Advantage Fund: Popular hybrid fund dynamically adjusting equity-debt mix to optimize returns while managing risk.

E. Perpetual Bonds (AT-1 Bonds)

• How It Works: Perpetual bonds also known as Additional Tier-1 (AT-1) bonds are debt instruments with no maturity date. They pay interest indefinitely unless the issuer chooses to call (repurchase) them.
• Key Features:
  • No Maturity Date: Interest paid forever unless called by the issuer.
  • Callable: Issuer can redeem after a specific period.
  • High Yield: Offers higher interest rates due to higher risk.
  • Loss-Absorbing: In case of financial stress issuer can skip payments or write down the principal.
• Regulations:
  • Issued by banks to meet capital adequacy requirements under Basel III norms.
  • Regulated by RBI in India.
  • Disclosure norms under SEBI for listed bonds.
• Advantages: High-interest payouts compared to regular bonds, No maturity pressure on issuers, Helps banks strengthen their capital base.
• Disadvantages: High risk: can be written off during a crisis (e.g. YES Bank AT-1 bond write-off in 2020), Interest payments are discretionary for issuers Limited liquidity in secondary markets.
• Real-World Example: YES Bank AT-1 Bonds (2020): Investors faced losses when RBI allowed the write-off of these bonds during the bank’s financial crisis.

Derivatives Instruments

Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, interest rates or currencies. They are widely used for hedging risks, speculation & arbitrage opportunities.

A. Futures Contracts

• How It Works: A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price on a specific future date. These contracts are traded on exchanges like the NSE or BSE in India.
• Key Features:
  • Standardization: Contracts are standardized in terms of quantity, quality, expiration.
  • Margin Requirements: Both parties must maintain a margin to manage default risks.
  • Mark-to-Market (MTM): Profits & losses are settled daily.
  • Leverage: Traders can control large positions with a small amount of capital.
• Regulations:
  • Regulated by SEBI in India under SEBI (Futures & Options) Regulations.
  • Trading occurs on regulated exchanges like NSE, BSE, MCX.
  • Margin requirements & risk management norms are strictly enforced.
• Advantages: Hedging against price fluctuations (e.g., commodities, currencies), High liquidity due to standardized contracts, Leverage can amplify gains.
• Disadvantages: High risk due to leverage: losses can exceed initial investments, Requires constant monitoring because of daily MTM settlements, Complexity for beginners due to technical requirements.
• Types of Futures:
  • Equity Futures: Based on individual stocks or indices.
  • Commodity Futures: For commodities like gold, oil or wheat.
  • Currency Futures: For foreign exchange rate movements.
  • Interest Rate Futures: Based on interest rate movements.
• Real-World Example: Crude Oil Futures Crash (April 2020): US oil futures went negative for the first time due to oversupply & low demand during the COVID-19 pandemic.

B. Options Contracts

• How It Works: An options contract gives buyer right (but not the obligation) to buy or sell an asset at a specified price within a certain timeframe. The seller (writer) is obligated to fulfill the contract if the buyer exercises the option.
• Key Features:
  • Call Option: Right to buy an asset at a specified price.
  • Put Option: Right to sell an asset at a specified price.
  • Premium: Buyer pays a fee (premium) to the seller for the option.
  • Strike Price: Price at which the asset can be bought or sold.
  • Expiry Date: The date the option contract expires.
• Regulations:
  • Governed by SEBI for listed options.
  • Traded on exchanges like NSE’s F&O segment.
  • Strict margin requirements for writers (sellers) to manage risk.
• Advantages: Limited risk for buyers (only the premium is at risk), Potential for high returns with small initial investments, Flexibility to hedge or speculate.
• Disadvantages: Complex pricing mechanisms (requires understanding of Greeks like Delta, Gamma etc.), Premiums can become worthless if the option expires out of money, Unlimited risk for sellers of options (especially uncovered calls).
• Types of Options:
  • American Options: Can be exercised anytime before expiry.
  • European Options: Can only be exercised on the expiry date.
  • Index Options: Based on stock indices like Nifty 50.
  • Stock Options: Based on individual company shares.
• Real-World Example: GameStop Options Frenzy (2021): Retail investors used call options to drive up the stock price leading to a short squeeze against hedge funds.

C. Forward Contracts

• How It Works: A forward contract is a customized agreement between two parties to buy or sell an asset at a future date for a price agreed upon today. Unlike futures forwards are traded over the counter (OTC) meaning they are private contracts without standardized terms.
• Key Features:
  • Customization: Tailored to the needs of parties involved (amount, date, terms).
  • OTC Trading: No exchange involvement: higher counterparty risk.
  • No Daily Settlement: Profits/losses are realized only at contract maturity.
  • Flexible Terms: Can be structured around non-standard assets.
• Regulations:
  • Regulated by Reserve Bank of India (RBI) for currency forwards.
  • Other forwards are generally unregulated due to OTC nature but governed by contractual law.
• Advantages: Complete flexibility in terms & conditions, Effective for hedging specific business risks (e.g., exporters locking in forex rates), No upfront costs unless there’s a margin requirement.
• Disadvantages: High counterparty risk due to lack of clearinghouse, Limited liquidity compared to standardized futures, Difficult to exit positions before maturity.
• Types of Forwards:
  • Currency Forwards: To hedge foreign exchange risk.
  • Commodity Forwards: For agricultural products, metals etc.
  • Interest Rate Forwards: To lock in future interest rates.
  • Equity Forwards: Based on stock prices.
• Real-World Example: Currency Forwards for Exporters: Indian exporters often use forward contracts to lock in USD/INR rates to avoid currency fluctuations affecting revenue.

D. Swaps

• How It Works: A swap is a financial contract where two parties exchange cash flows or financial instruments over time. The most common type is an interest rate swap where fixed interest payments are exchanged for floating rates.
• Key Features:
  • Exchange of Cash Flows: Based on predetermined conditions (e.g. fixed for floating interest rates).
  • OTC Nature: Privately negotiated allowing customization.
  • Long-Term Contracts: Swaps often last several years.
  • No Initial Cash Flow: Except for notional adjustments in some cases.
• Regulations:
  • In India, regulated by the RBI for interest rate & currency swaps.
  • Global oversight from entities like the International Swaps & Derivatives Association (ISDA).
• Advantages: Tailored risk management for interest rates, currencies etc, No upfront capital required (unlike options), Flexibility in structuring deals.
• Disadvantages: Counterparty risk due to OTC nature, Complexity in pricing and managing risks, Limited transparency compared to exchange-traded derivatives.
• Types of Swaps:
  • Interest Rate Swaps: Exchange fixed-rate interest for floating-rate interest.
  • Currency Swaps: Exchange principal and interest payments in different currencies.
  • Commodity Swaps: Exchange cash flows based on commodity price fluctuations.
  • Credit Default Swaps (CDS): A form of insurance against credit default.
• Real-World Example: 2008 Financial Crisis (Credit Default Swaps): CDS contracts played a major role during the subprime mortgage crisis leading to massive financial institution failures.

Derivatives Market Statistics (India & Global):

• India:
  • NSE is largest derivatives exchange globally by the number of contracts traded.
  • Index Options: Account for over 80% of derivative volumes in India.
  • Commodity Derivatives: MCX dominates with gold, crude oil, natural gas being top traded commodities.
• Global:
  • Global Derivatives Market Size (2023): Estimated at over $1 quadrillion (notional value).
  • Leading Players: CME Group, ICE, Eurex, LSE.

Alternative Investment Instruments

Alternative investments differ from traditional assets like stocks, bonds or cash. They include private equity, hedge funds, real estate, commodities & more. These assets often have complex structures, limited liquidity & higher risk-return profiles attracting sophisticated investors.

A. Hedge Funds

• How It Works: A hedge fund is an actively managed investment fund that pools capital from accredited investors or institutions to generate high returns using diverse strategies—long/short equity, leverage, derivatives, arbitrage, etc.
• Key Features:
  • Flexible Strategies: Can invest in stocks, bonds, currencies, real estate, derivatives.
  • Leverage: Uses borrowed capital to amplify returns.
  • High Fees: Follows a “2 & 20” model: 2% management fee & 20% performance fee.
  • Restricted Access: Available only to high-net-worth individuals (HNIs) or institutional investors.
• Regulations:
  • In India regulated under SEBI (Alternative Investment Funds) Regulations, 2012.
  • Classified as Category III AIFs (for complex trading strategies).
  • Global hedge funds have lighter regulations compared to mutual funds.
• Advantages: Potential for high returns through aggressive strategies, Flexibility to hedge against market downturns, Diversification beyond traditional asset classes.
• Disadvantages: High fees reduce net returns, Lack of transparency compared to mutual funds, Illiquidity: lock in periods before investors can withdraw money.
• Types of Hedge Funds:
  • Global Macro Funds: Bet on macroeconomic trends globally.
  • Event-Driven Funds: Exploit events like mergers, bankruptcies or acquisitions.
  • Long/Short Equity Funds: Take long positions in undervalued stocks & short overvalued ones.
  • Quant Funds: Use mathematical models & algorithms for trading.
• Real-World Example: Bridgewater Associates: The world’s largest hedge fund with over $150 billion in AUM known for macroeconomic strategies.

B. Private Equity (PE)

• How It Works: Private equity involves investing directly in private companies (not listed on stock exchanges) or buying out public companies to make them private. PE firms aim to improve company performance & sell at a profit after a few years.
• Key Features:
  • Long-Term Investment: Holding periods of 5–7 years.
  • Active Management: PE firms often influence company strategy, operations, governance.
  • Capital Commitment: Investors commit large sums with capital drawn over time.
  • Exit Strategies: Includes IPOs, mergers, acquisitions or secondary sales.
• Regulations:
  • In India regulated by SEBI (AIF) Regulations, 2012 under Category II AIFs.
  • Disclosure requirements around fundraising, investments & exits.
• Advantages: High potential returns compared to public markets, Control over portfolio companies allows strategic growth, Less affected by public market volatility.
• Disadvantages: Illiquid: capital is locked for years, high risk due to business failures or poor management decisions, Limited access for retail investors.
• Types of Private Equity:
  • Venture Capital (VC): Invests in early-stage startups.
  • Growth Capital: For expanding mature businesses.
  • Leveraged Buyouts (LBOs): Acquiring companies using debt.
  • Distressed Investments: Buying undervalued or bankrupt companies to turn them around.
• Real-World Example: Blackstone Group: One of the largest PE firms globally managing over $1 trillion in assets with investments across real estate, tech, healthcare.

C. Real Estate Investment Trusts (REITs)

• How It Works: REIT is a company that owns, operates or finances income-generating real estate. Investors can buy shares of REITs on stock exchanges earning returns from rental income and property appreciation.
• Key Features:
  • Regular Income: Must distribute 90% of taxable income as dividends.
  • Liquidity: Public REITs are traded like stocks.
  • Diversification: Exposure to commercial properties (offices, malls, data centers).
  • Tax Efficiency: Often tax-exempt at the corporate level if income is distributed.
• Regulations:
  • In India, governed by SEBI (REIT) Regulations, 2014.
  • Minimum investment: ₹10,000–15,000 (recent SEBI updates).
  • Requires diversified property holdings to reduce risk.
• Advantages: Regular dividend income, Diversified real estate exposure without owning property, Inflation hedge as property values rise over time.
• Disadvantages: Sensitive to interest rate changes (affecting property values), Market risks if real estate demand drops, Limited capital appreciation compared to direct property investments.
• Types of REITs:
  • Equity REITs: Own & operate income-generating properties.
  • Mortgage REITs (mREITs): Invest in real estate debt and mortgages.
  • Hybrid REITs: Combine both equity & mortgage investments.
• Real-World Example:
  Embassy Office Parks REIT (India): India’s first listed REIT managing over 42 million sq. ft. of office spaces with clients like Google and Microsoft.

D. Commodities (Physical & Derivatives)

• How It Works: Commodities are basic goods like gold, oil, wheat or natural gas that can be traded. Investments can be made by directly purchasing physical commodities or through commodity futures & ETFs.
• Key Features:
  • Tangible Assets: Involves physical goods with global demand.
  • Hedging Tool: Protects against inflation & currency risks.
  • Global Influence: Prices influenced by geopolitical events, supply-demand dynamics, weather conditions.
• Regulations:
  • In India regulated by SEBI and traded on exchanges like MCX (Multi Commodity Exchange).
  • Internationally regulated by CFTC (Commodity Futures Trading Commission) in the US.
• Advantages: Inflation hedge especially with gold & oil, Diversification from traditional financial assets, High liquidity in global commodity markets.
• Disadvantages: High volatility due to market & political factors, Requires storage/security for physical commodities, Prone to speculative bubbles (e.g., oil price crashes).
• Types of Commodities:
  • Precious Metals: Gold, silver, platinum.
  • Energy: Crude oil, natural gas, coal.
  • Agricultural: Wheat, corn, coffee.
  • Industrial Metals: Copper, aluminum, zinc.
• Real-World Example: 2022 Energy Crisis: Crude oil prices surged to over $120 per barrel after the Russia-Ukraine war affecting global markets.

E. Structured Products

• How It Works: Structured products are pre packaged investments that combine derivatives with traditional assets like bonds or equities. They are designed to meet specific risk return objectives often with capital protection features.
• Key Features:
  • Customization: Tailored to investor goals: capital protection, income generation or growth.
  • Embedded Derivatives: Linked to market indices, interest rates or currencies.
  • Fixed Maturity: Typically 3–5 years.
  • Capital Protection: Some offer 100% principal protection if held to maturity.
• Regulations:
  • In India regulated under SEBI (Issue of Capital and Disclosure Requirements) Regulations.
  • Banks issuing structured products are overseen by RBI.
• Advantages: Tailored for specific investment goals, Capital protection in many cases, Potential for higher returns compared to traditional fixed-income products.
• Disadvantages: Complexity: hard to understand for average investors, Limited liquidity as they’re not always traded on exchanges, Counterparty risk if the issuer defaults.
• Types of Structured Products:
  • Equity-Linked Notes (ELNs): Returns linked to stock indices.
  • Capital-Protected Notes: Guarantee principal repayment with market linked returns.
  • Credit-Linked Notes: Returns dependent on credit events of specific entities.
• Real-World Example: Credit Suisse’s Structured Products: Popular among HNIs in Europe offering exposure to complex strategies with downside protection features.

Alternative Investments Market Statistics:

• Global AUM (2023):
  • Private Equity: ~$12 trillion
  • Hedge Funds: ~$4 trillion
  • REITs: ~$3 trillion
  • Commodities Market: Over $20 trillion globally
• India’s AIF Industry (2023):
  • AIFs (Alternative Investment Funds): Managing over ₹7 lakh crore (~$85 billion).
  • Growing at a CAGR of 20–25% annually due to rising HNI participation.

F. Cryptocurrencies and Digital Assets

• How It Works:
  Cryptocurrencies are digital or virtual currencies that use blockchain technology for secure, decentralized transactions. Popular cryptocurrencies include Bitcoin (BTC), Ethereum (ETH), and Ripple (XRP). Investors can buy, hold or trade these assets on crypto exchanges.
• Key Features:
  • Decentralization: No central authority; transactions verified via blockchain.
  • Volatility: Prices can fluctuate significantly within short periods.
  • Limited Supply: For example Bitcoin has a maximum supply of 21 million coins.
  • Transparency: Publicly verifiable ledger of transactions.
• Regulations:
  • In India regulated under Crypto Tax Regime (Budget 2022) with a 30% tax on gains & 1% TDS on transactions.
  • Globally regulations vary: strict in China, evolving in the US (SEC)& more favorable in countries like Singapore.
• Advantages: Potential for high returns in bull markets, 24/7 trading without market holidays, Growing adoption in payments, DeFi (Decentralized Finance) & NFTs.
• Disadvantages: High price volatility leading to potential losses, Regulatory uncertainty in many countries, Vulnerable to cyber threats like hacking.
• Types of Digital Assets:
  • Cryptocurrencies: Bitcoin, Ethereum.
  • Stablecoins: USDT, USDC (pegged to fiat currency).
  • NFTs (Non-Fungible Tokens): Unique digital collectibles or art.
  • DeFi Tokens: Uniswap (UNI), Aave (AAVE) used in decentralized finance protocols.
• Real-World Example: Bitcoin Rally (2021): Bitcoin surged from $29,000 to $69,000 in less than a year driven by institutional adoption & inflation fears.

G. Art, Antiques, and Collectibles

• How It Works: Investments in art, antiques, rare coins, vintage cars, luxury watches or collectibles are considered alternative assets. Returns are generated through appreciation over time & auction sales.
• Key Features:
  • Tangible Assets: Physical often irreplaceable items with intrinsic value.
  • Emotional Appeal: Investors may also buy for personal enjoyment.
  • Long-Term Horizon: Value increases gradually based on rarity and demand.
  • Non-Correlated Asset: Performance often unrelated to stock or bond markets.
• Regulations:
  • No formal regulations globally; transactions often governed by auction house standards.
  • In India subject to capital gains tax when sold.
• Advantages: Unique diversification from financial markets, Potential for significant appreciation especially rare items, Prestige associated with owning iconic art or collectibles.
• Disadvantages: Illiquidity: finding right buyer can take time, High transaction fees (auction house commissions), Risk of forgery or authenticity issues.
• Types of Collectibles:
  • Fine Art: Paintings by Picasso, MF Husain or Banksy.
  • Vintage Cars: Classic Ferraris, Lamborghinis.
  • Rare Coins & Stamps: Historical or limited-edition pieces.
  • Luxury Items: Patek Philippe watches, Hermès handbags.
• Real-World Example: Leonardo da Vinci’s “Salvator Mundi” sold for $450 million at a Christie’s auction in 2017 becoming then the most expensive artwork ever sold.

H. Infrastructure Investments

• How It Works: Infrastructure investments involve financing large-scale projects like roads, airports, power plants & telecom networks. Investors earn returns through usage fees, government payments or long-term lease agreements.
• Key Features:
  • Stable Cash Flows: Often backed by government contracts or monopolistic assets.
  • Inflation Protection: Revenues linked to inflation-adjusted tariffs.
  • Long-Term Horizon: Investments span 10–30 years.
  • High Capital Requirement: Suitable for institutional investors like pension funds.
• Regulations:
  • In India regulated under National Infrastructure Pipeline (NIP) & SEBI’s Infrastructure Investment Trusts (InvITs) framework.
  • Globally governed by Public-Private Partnership (PPP) models.
• Advantages: Predictable, long-term income streams, Lower correlation with market volatility, Essential nature of infrastructure reduces business risk.
• Disadvantages: High entry barriers due to capital intensity, Political and regulatory risks, especially in emerging markets, Illiquidity in direct infrastructure projects.
• Types of Infrastructure Assets:
  • Core Infrastructure: Roads, bridges, power plants.
  • Social Infrastructure: Hospitals, schools, public housing.
  • Digital Infrastructure: Data centers, telecom towers.
• Real-World Example: Brookfield Infrastructure Partners: A global leader managing assets worth over $75 billion in utilities, transport, data services.

I. Venture Capital (VC)

• How It Works: Venture capital funds invest in early-stage startups with high growth potential. VCs provide not just capital but also mentorship, strategic advice, industry connections.
• Key Features:
  • High-Risk, High-Reward: Many startups fail but successful ones offer exponential returns.
  • Equity Stakes: VCs receive ownership in the companies they fund.
  • Active Involvement: VC firms often guide business decisions & growth strategies.
  • Exit Through IPOs or Acquisitions: Profits are realized when startups go public or are acquired.
• Regulations:
  • In India regulated under SEBI (AIF) Regulations, 2012 as Category I AIFs.
  • Global VC activity monitored under private equity norms in the US & Europe.
• Advantages: Potential for 10x or even 100x returns, Exposure to disruptive technologies and new markets, Strong influence in shaping the company’s future.
• Disadvantages: High failure rate of startups, Illiquidity: capital locked until the exit event, Dilution risk in future funding rounds.
• Types of VC Funds:
  • Seed Capital: For idea-stage companies.
  • Early-Stage VC: For companies with initial traction but pre-profit.
  • Growth-Stage VC: For scaling operations and entering new markets.
• Real-World Example: Sequoia Capital: A leading VC firm that invested early in companies like Google, Apple, WhatsApp, Airbnb generating astronomical returns.

Summary of Financial Instruments

Primary Market Instruments

Instrument	How It Works	Key Features	Regulations	Advantages	Disadvantages	Types
Equity Shares	Represents ownership in a company; investors buy during IPO	Voting rights, dividends, capital gains	SEBI (India), SEC (US)	High returns, ownership rights	High risk, market volatility	Common, Preferred
Preference Shares	Fixed dividends, priority over equity in payouts	Fixed income, limited/no voting rights	Companies Act, SEBI	Stable income, priority in liquidation	Limited growth potential, less control	Cumulative, Non-cumulative, Convertible
Indian Depository Receipts (IDRs)	Foreign companies issue shares via Indian Depositories	INR-denominated, reflects foreign ownership	SEBI, RBI	Invest in foreign firms without forex risk	Limited liquidity, fewer options	Sponsored, Unsponsored
Global Depository Receipts (GDRs)	Foreign shares represented by bank certificates	Traded globally, accessible to international investors	SEBI, RBI	Global access, reduced forex risk	Regulatory complexities, currency risks	Rule 144A GDRs, Regulation S GDRs
Qualified Institutional Placements (QIPs)	Fundraising from Qualified Institutional Buyers (QIBs)	No pre-issue SEBI filings, quick capital raise	SEBI (Issue of Capital & Disclosure)	Fast process, cost-effective	Limited to QIBs, dilution of ownership	Equity QIPs, Debt QIPs
Debentures	Unsecured debt, fixed interest returns	Fixed maturity, interest payments	Companies Act, SEBI	Predictable income, tax benefits (for NCDs)	Credit risk, interest rate fluctuations	Convertible, Non-convertible
Bonds	Loan from investors to government/corporations	Fixed interest, maturity period	RBI (G-Secs), SEBI (Corp Bonds)	Low risk (govt bonds), steady income	Interest rate risk, inflation impact	Govt Bonds, Corporate Bonds, Municipal Bonds
External Commercial Borrowings (ECBs)	Indian firms borrow from foreign lenders	Lower interest rates, forex exposure	RBI’s ECB Framework	Global funds, competitive rates	Currency risk, regulatory approvals	Track I, Track II, Track III
Credit Default Swaps (CDS)	Derivative for protection against credit defaults	Risk transfer, speculative tool	RBI (India), ISDA (Global)	Risk mitigation, flexible	Complexity, counterparty risk	Single-name CDS, Index CDS
Convertible Debentures	Debt convertible into equity after a set period	Interest income + equity conversion potential	SEBI	Dual benefit (fixed income + growth)	Dilution of equity, conversion risks	Fully, Partially, Optionally Convertible
Warrants	Right (not obligation) to buy shares at a set price	Long-term option, traded on exchanges	SEBI	Leverage, potential high returns	High risk, no dividends until exercised	Equity Warrants, Covered Warrants

Secondary Market Instruments

Instrument	How It Works	Key Features	Regulations	Advantages	Disadvantages	Types
Futures	Contract to buy/sell assets at a future date at a predetermined price	Standardized, traded on exchanges	SEBI (India), CFTC (US)	Hedging, speculation, leverage	High risk, margin requirements	Stock Futures, Index Futures
Options	Right (but not obligation) to buy/sell assets at a specific price	Call (buy) & Put (sell) options	SEBI, SEC	Hedging, flexible strategies	Time decay, complexity	American, European Options
Participatory Notes (P-Notes)	Offshore derivatives for foreign investors to invest in India	No SEBI registration required	SEBI	Ease of entry, quick investments	Lack of transparency, regulatory scrutiny	Equity-linked, Debt-linked P-Notes
Treasury Bills (T-Bills)	Short-term government securities, issued at discount	High liquidity, risk-free	RBI	Safe investment, short-term returns	Low returns, inflation risk	91-day, 182-day, 364-day T-Bills
Commercial Papers (CPs)	Short-term unsecured corporate debt	Issued at discount, high credit rating required	RBI	High returns (vs. T-bills), flexibility	Credit risk, limited secondary market	Asset-backed, Financial, Non-financial CPs
Inter-Corporate Deposits (ICDs)	Short-term unsecured loans between companies	Quick, flexible corporate funding	Companies Act	Higher returns than banks, flexibility	Default risk, unregulated	Call Deposits, Fixed Deposits

Collective Investment Instruments

Instrument	How It Works	Key Features	Regulations	Advantages	Disadvantages	Types
Mutual Funds	Pool money from investors to invest in diversified portfolios	Managed by professionals, diversified	SEBI (MF Regulations)	Diversification, liquidity	Management fees, market risks	Equity, Debt, Hybrid, Index Funds
Hedge Funds	Aggressive strategies like short-selling, leverage	High-risk, high-return, accredited investors only	SEBI (AIF Category III)	High returns potential	High fees, complex, illiquid	Long/Short, Event-Driven, Global Macro
Venture Capital (VC)	Investment in startups with growth potential	Equity stake, mentorship to founders	SEBI (AIF Category I)	High growth potential, early mover advantage	High risk of failure	Seed, Series A/B/C Funding
Private Equity (PE)	Buyouts of mature companies for restructuring and growth	Long-term investment, active management	SEBI (AIF Category II)	High returns, control over business	Illiquidity, long investment horizon	Growth Equity, Buyouts, Mezzanine
Angel Investors	Wealthy individuals investing in early-stage startups	Equity in exchange for capital and mentorship	Not heavily regulated, informal networks	Quick decisions, strategic guidance	High failure rates, dilution risks	Super Angels, Syndicates
Collective Investment Schemes (CIS)	Pooling funds for a common investment objective	Regulated if corpus exceeds ₹100 crores	SEBI (CIS Regulations)	Diversified exposure, managed funds	Fraud risks in unregulated schemes	Real Estate CIS, Agriculture CIS
Alternate Investment Funds (AIFs)	Private pooled funds investing in niche markets	Categorized into I, II, III	SEBI (AIF Regulations)	Flexibility, alternative strategies	High minimum investment, illiquid	VC Funds, PE Funds, Hedge Funds

Infrastructure & Real Estate Instruments

Instrument	How It Works	Key Features	Regulations	Advantages	Disadvantages	Types
Real Estate Investment Trusts (REITs)	Pool funds to invest in income-generating real estate	Regular income, traded like stocks	SEBI (REIT Regulations)	Liquidity, passive income	Market fluctuations, property risks	Equity REITs, Mortgage REITs
Infrastructure Investment Trusts (InvITs)	Similar to REITs but for infrastructure assets	Long-term stable returns from infra projects	SEBI (InvIT Regulations)	Stable income, tax benefits	Regulatory hurdles, interest rate risks	Public InvITs, Private InvITs
Infrastructure Debt Funds (IDFs)	Invest in debt of long-term infra projects	Long tenure, tax incentives	RBI, SEBI	Stable returns, infra exposure	Low liquidity, project risks	Mutual Fund IDFs, NBFC IDFs

Government Securities & Specialized Instruments

Instrument	How It Works	Key Features	Regulations	Advantages	Disadvantages	Types
Inflation-Indexed Bonds (IIBs)	Adjusts principal & interest based on inflation	Protects purchasing power	RBI	Inflation hedge, safe investment	Low real returns in deflationary periods	Capital-Indexed, Interest-Indexed
CPSE Exchange Traded Funds (CPSE ETFs)	ETF of Central Public Sector Enterprises	Diversified exposure to PSU stocks	SEBI	High dividend yield, tax efficiency	Market volatility, PSU-specific risks	Equity CPSE ETFs, Debt CPSE ETFs
Chit Funds	Traditional saving scheme via periodic contributions	Popular in informal sectors, regulated in some states	Chit Fund Act, State Laws	Flexible saving, credit facility	Fraud risks, lack of formal regulation	Auction Chits, Prize Chits
Hundis	Traditional credit instruments for trade finance	Historical usage in informal economy	Not formally regulated	Quick settlements in traditional markets	Legal enforceability issues	Darshani Hundi, Muddati Hundi

Practice Questions

Prelims Questions:

1. Consider the following:
   1. Exchange-Traded Funds (ETF)
   2. Motor vehicles
   3. Currency swap

Which of the above is/are considered financial instruments?

(a) 1 only
(b) 2 and 3 only
(c) 1, 2, and 3
(d) 1 and 3 only

Answer: (d) 1 and 3 only

2. With reference to Convertible Bonds, consider the following statements:
   1. As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
   2. The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: (a) 1 only

3. Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly?

(a) Certificate of Deposit
(b) Commercial Paper
(c) Promissory Note
(d) Participatory Note

Answer: (d) Participatory Note

UPSC Mains Questions:

1. Discuss the role of Real Estate Investment Trusts (REITs) in the Indian economy. How do they function, and what are their advantages and challenges?
2. Examine the significance of Alternative Investment Funds (AIFs) in diversifying investment portfolios in India. What are the different categories of AIFs, and how do they contribute to the financial market?
3. Analyze the impact of Exchange-Traded Funds (ETFs) on retail investment behavior in India. What are the advantages and potential risks associated with ETFs?