Elaborate Notes
MONEY MARKET INSTRUMENTS
The money market is a segment of the financial market where short-term borrowing and lending occur with a maturity of up to one year. It deals in near-money assets and is crucial for managing the short-term liquidity needs of governments, banks, and corporations. The Reserve Bank of India (RBI) is the principal regulator of the money market in India.
-
Certificate of Deposit (CDs):
- A Certificate of Deposit is a negotiable, short-term, unsecured promissory note issued by a bank or financial institution (FI) at a discount to its face value. It was introduced in India in 1989 on the recommendations of the Vaghul Committee to widen the range of money market instruments and give investors greater flexibility.
- Issuers: CDs are issued by all Scheduled Commercial Banks (excluding Regional Rural Banks and Local Area Banks) and select All-India Financial Institutions (e.g., NABARD, SIDBI, EXIM Bank) that have been permitted by the RBI.
- Maturity Period: For commercial banks, the maturity period for CDs ranges from 7 days to 1 year. For Financial Institutions, it ranges from 1 year to 3 years. This short-term nature makes them an ideal instrument for parking surplus funds for a brief period.
- Investors: All resident individuals, corporations, trusts, and funds can invest in CDs. Non-Resident Indians (NRIs) can also subscribe to CDs, but only on a non-repatriable basis.
- Denomination and Form: To broaden the investor base and align with market practices, the RBI has stipulated the minimum denomination. As per current RBI guidelines, the minimum amount for a single CD is ₹5 lakh, and it must be issued in multiples of ₹5 lakh thereafter. CDs can now only be issued in a dematerialized (Demat) form, which enhances transparency, security, and ease of transfer. This move away from physical certificates was part of broader financial market reforms to improve efficiency.
-
Commercial Bills:
- A commercial bill is a bill of exchange used to finance the credit sales of firms. It is a short-term, negotiable, and self-liquidating instrument.
- Genesis (Trade Bill to Commercial Bill): When a seller of goods (drawer) draws a bill on the buyer (drawee) for the value of goods delivered, it is known as a trade bill. The buyer accepts the bill, promising to pay the amount at a specified future date. This trade bill becomes a commercial bill when a commercial bank “accepts” it or discounts it. Bank acceptance lends credibility to the bill, making it more marketable.
- Discounting and Rediscounting: The holder of a commercial bill can get immediate payment by ‘discounting’ it with a commercial bank. The bank pays the holder an amount less than the face value of the bill, with the difference (discount) representing the interest for the period until maturity. These banks can, in turn, get these bills ‘rediscounted’ by the RBI or other financial institutions to meet their own liquidity needs. The rediscounting facility by the RBI acts as a tool of monetary policy to influence liquidity in the system. The maximum allowed maturity period for these bills is typically 90 days.
-
Call Money:
- The call money market is the most liquid segment of the money market. It is an inter-bank market where banks borrow from and lend to each other for very short periods, typically ranging from one day (overnight) to 14 days, to manage their day-to-day cash requirements.
- Purpose: Banks primarily use this market to maintain their mandatory reserve requirements, such as the Cash Reserve Ratio (CRR), with the RBI. A bank with a temporary surplus of funds can lend to a bank with a temporary deficit.
- Participants: Scheduled Commercial Banks, Co-operative Banks (excluding Land Development Banks), and Primary Dealers are the main participants in this market.
- Call Rate: The interest rate at which these short-term funds are borrowed and lent is known as the call money rate. This rate is highly volatile and serves as a sensitive indicator of the liquidity conditions in the banking system. It is determined by the demand for and supply of short-term funds.
TYPES OF BONDS
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).
-
Zero-Coupon Bonds:
- Unlike conventional bonds that pay periodic interest (coupons), a zero-coupon bond does not make any periodic interest payments during its tenure.
- Mechanism: It is issued at a significant discount to its face value (or par value) and is redeemed at the face value upon maturity. The investor’s return is the difference between the purchase price (the discounted price) and the face value received at maturity.
- Example: A 10-year zero-coupon bond with a face value of ₹1,00,000 might be issued for ₹60,000. The investor pays ₹60,000 upfront, receives no interest payments for 10 years, and gets back ₹1,00,000 at maturity. The implicit return is the ₹40,000 gain. These are also known as deep-discount bonds.
-
Masala Bonds:
- These are Rupee-denominated bonds issued by Indian entities in overseas markets. The term ‘Masala Bond’ was coined by the International Finance Corporation (IFC), a part of the World Bank Group, to evoke the Indian culture and cuisine, similar to ‘Dim Sum bonds’ (Chinese Renminbi-denominated) and ‘Samurai bonds’ (Japanese Yen-denominated).
- Historical Context & Rationale: Before their introduction, Indian companies borrowing from abroad had to issue bonds in foreign currencies (like USD, EUR). This exposed them to currency exchange risk. If the Indian Rupee depreciated against the foreign currency, the cost of servicing and repaying the debt in Rupee terms would increase. Masala Bonds transfer this currency risk from the Indian borrower to the foreign investor, as the principal and interest are denominated in Rupees.
- First Issuance: The IFC was the first to issue Masala Bonds in November 2014, raising funds to finance private sector infrastructure projects in India. This paved the way for Indian corporates to tap global financial markets without taking on currency risk.
-
Inflation-Indexed Bonds (IIBs):
- IIBs are debt instruments that protect investors from the risk of inflation. The principal and/or interest payments are adjusted periodically to reflect the changes in a specific inflation index, most commonly the Consumer Price Index (CPI) or Wholesale Price Index (WPI).
- Evolution in India: The first attempt in India was the issuance of Capital Index Bonds (CIBs) in 1997. These CIBs offered inflation protection only on the principal amount at the time of redemption, while the interest payments (coupons) were paid on the face value and were not inflation-adjusted.
- Modern IIBs: The current form of IIBs, reintroduced by the RBI, provides inflation protection to both the principal and the interest payments. The principal value is adjusted for inflation, and the fixed coupon rate is then applied to this inflation-adjusted principal. This ensures that the investor’s real return (nominal return minus inflation) is protected.
-
Foreign Currency Convertible Bonds (FCCBs):
- An FCCB is a hybrid financial instrument that is essentially a bond with an embedded equity option.
- Characteristics: It is issued by an Indian company in a foreign currency (e.g., USD) and is subscribed to by non-resident investors. It carries a fixed interest rate (coupon). The key feature is that it gives the bondholder the option to convert the bond into a pre-determined number of equity shares of the issuing company at a specified future date.
- FDI/ECB Treatment:
- As long as the FCCB is held as a bond and not converted, it is treated as a debt obligation and is part of the country’s External Commercial Borrowings (ECB).
- When the investor chooses to convert the bond into shares, it becomes an equity investment and is counted towards Foreign Direct Investment (FDI).
- Implications: For the investor, it offers the safety of a debt instrument (fixed returns) with the potential upside of an equity investment if the company’s stock performs well. For the issuing company, it is an attractive way to raise foreign capital at a lower interest rate compared to a standard bond. However, conversion leads to equity dilution, meaning the ownership stake of existing shareholders decreases.
-
Negative Yield Bonds:
- A negative yield bond is a debt instrument where the investor, upon holding the bond to maturity, receives a total amount that is less than the purchase price. In effect, the investor is paying the issuer to hold their money.
- Context: This seemingly irrational phenomenon occurs during periods of extreme economic stress, deflationary pressures, or flight-to-safety. Investors, particularly large institutional ones, may be willing to accept a small, certain loss on a highly secure government bond (like German Bunds or Japanese Government Bonds) rather than risk a larger, uncertain loss in more volatile assets like equities or corporate bonds. Central bank policies, such as quantitative easing and negative policy rates, can also push bond yields into negative territory.
CAPITAL MARKET
The capital market is the part of the financial system concerned with raising capital by dealing in long-term financial instruments like shares, debentures, and bonds.
-
Share:
- A share represents a unit of ownership in a company. The total capital of a company is divided into a number of these units. Shareholders are the owners of the company.
- Equity Shares:
- These are the primary source of finance for a company and represent true ownership.
- Voting Rights: Equity shareholders have the right to vote in the company’s Annual General Meetings (AGMs) and participate in major corporate decisions.
- Return: Their return is not fixed. They receive a dividend, which is a portion of the company’s profits, only after all other obligations (including payments to debenture holders and preference shareholders) have been met. The dividend is not assured and depends on the company’s profitability and policy. They are the residual claimants on the company’s assets in case of liquidation.
- Risk: They bear the highest risk as their capital is the last to be repaid in case of winding up, but they also stand to gain the most if the company performs well (through dividends and capital appreciation).
- Preference Shares:
- These shares carry certain preferential rights over equity shares.
- Fixed Dividend: They are entitled to a fixed rate of dividend before any dividend is paid to equity shareholders.
- Priority in Repayment: In the event of the company’s liquidation, their capital is repaid before that of the equity shareholders.
- No Voting Rights: Typically, preference shareholders do not have voting rights in the company’s general meetings, except in matters that directly affect their interests.
-
Debentures:
- A debenture is a medium- to long-term debt instrument used by large companies to borrow money at a fixed rate of interest. It is a formal acknowledgement of a loan by the company.
- Security: Debentures issued by a company are generally unsecured, meaning they are not backed by any specific asset or collateral. Their security depends on the overall creditworthiness and reputation of the issuing company.
- Rights: Debenture holders are creditors of the company, not owners. Therefore, they do not have any voting rights. They receive a fixed interest payment, which is a charge against the company’s profits (i.e., it must be paid even if the company makes a loss).
- Convertible Debentures: These debentures can be converted into equity shares of the company after a specified period and at a pre-determined price. They offer the investor the safety of a debt instrument with the potential for capital appreciation.
- Non-Convertible Debentures (NCDs): These are regular debentures that cannot be converted into equity shares and are redeemed at maturity.
DERIVATIVES
A derivative is a financial contract whose value is derived from the value of an underlying asset.
-
Concept: The underlying asset can be stocks, bonds, currencies, commodities (gold, oil, agricultural products), or even market indices (like Nifty 50 or Sensex). The primary purpose of derivatives is to manage (hedge) price risk and to speculate on future price movements. Derivative trading is essentially trading in the forward market, where contracts are for future dates and prices. They are contracts between two or more parties.
-
Trading Platforms: Derivatives can be traded either Over-The-Counter (OTC), which are private, customized contracts between two parties, or on an exchange, which offers standardized, transparent, and regulated trading.
-
Forwards:
- A forward contract is a customized, bilateral agreement to buy or sell an underlying asset at a specified price on a future date.
- Characteristics: Being private contracts (OTC), their terms (quantity, quality, date) are negotiable between the two parties. This flexibility is an advantage. However, they are not traded on exchanges, which leads to a lack of liquidity and exposes the parties to counterparty risk (the risk that the other party will default on the agreement).
- Example: A farmer agrees to sell 100 quintals of onions to ITC three months from now at a pre-agreed price of ₹10/kg. This locks in the price for both parties, protecting the farmer from a price drop and ITC from a price rise. This is a form of contract farming.
-
Futures:
- A futures contract is similar to a forward contract but with crucial differences. It is a standardized legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future.
- Characteristics: Futures are traded on organized exchanges (e.g., Multi Commodity Exchange (MCX) for commodities, National Stock Exchange (NSE) for financial derivatives). Standardization (in terms of quantity, quality, maturity date) and exchange trading make them highly liquid. The exchange’s clearinghouse acts as a counterparty to all trades, thereby eliminating counterparty risk.
-
Option:
- An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (the strike price) on or before a certain date (the expiration date). For this right, the buyer pays a premium to the seller (writer) of the option.
- Put Option: Gives the holder the right to sell the underlying asset at the strike price. An investor would buy a put option if they expect the price of the asset to fall.
- Call Option: Gives the holder the right to buy the underlying asset at the strike price. An investor would buy a call option if they expect the price of the asset to rise.
Prelims Pointers
- Certificate of Deposit (CDs):
- Issued by: Scheduled Commercial Banks (except RRBs, LABs) and select Financial Institutions.
- Maturity: 7 days to 1 year for Banks; 1 to 3 years for FIs.
- Minimum amount: ₹5 lakh and in multiples thereof.
- Form: Issued only in dematerialized (Demat) form.
- Commercial Bill: A trade bill becomes a commercial bill when accepted or discounted by a commercial bank. Maximum period is typically 90 days.
- Call Money:
- An inter-bank market for short-term lending and borrowing.
- Period: Overnight to 14 days.
- Purpose: Primarily to meet CRR requirements.
- The interest rate is called the Call Money Rate.
- Zero-Coupon Bond: Does not pay periodic interest; issued at a discount and redeemed at face value.
- Masala Bonds:
- Rupee-denominated bonds issued in overseas markets.
- Currency risk is borne by the foreign investor, not the Indian issuer.
- First issued by the International Finance Corporation (IFC) in 2014.
- Inflation-Indexed Bonds (IIBs):
- Provide protection against inflation for both principal and interest payments.
- The earlier version, Capital Index Bonds (CIBs) of 1997, protected only the principal.
- Foreign Currency Convertible Bonds (FCCBs):
- A hybrid instrument: debt that is convertible into equity.
- Issued by Indian companies in foreign currency to non-residents.
- Considered External Commercial Borrowing (ECB) until conversion.
- Counted under Foreign Direct Investment (FDI) after conversion.
- Negative Yield Bond: A bond where the purchase price is higher than the maturity value, resulting in a negative return for the investor.
- Equity Shares: Represent ownership, have voting rights, and receive variable dividends.
- Preference Shares: Receive a fixed dividend, have priority in payment over equity holders, but typically have no voting rights.
- Debentures: Debt instruments with a fixed rate of interest; holders are creditors, not owners, and have no voting rights.
- Derivative: A financial contract whose value is derived from an underlying asset.
- Forwards: Customized, bilateral (Over-The-Counter) derivative contracts with counterparty risk.
- Futures: Standardized, exchange-traded derivative contracts with no counterparty risk due to the clearinghouse.
- Option: A contract giving the right, but not the obligation, to buy or sell an asset.
- Call Option: Right to buy.
- Put Option: Right to sell.
Mains Insights
-
Role of Money and Capital Markets in the Economy:
- Money Market (Liquidity Management): The money market is the bedrock of short-term liquidity management for the entire financial system. Instruments like Call Money, CDs, and Commercial Bills enable banks and corporations to efficiently manage their temporary cash surpluses and deficits. A well-functioning money market is essential for the effective transmission of the RBI’s monetary policy. The call money rate, for instance, is a key indicator that the central bank monitors to gauge systemic liquidity.
- Capital Market (Capital Formation): The capital market channels savings from households and other surplus units to corporations and governments for long-term productive investments. Instruments like shares and debentures are crucial for financing infrastructure, industrial expansion, and innovation, thereby driving economic growth and job creation.
-
Masala Bonds: Internationalization of the Rupee and Risk Mitigation:
- Cause-Effect: The primary cause for introducing Masala Bonds was the significant currency risk faced by Indian corporations borrowing in foreign currency. A depreciating Rupee would inflate their debt servicing costs. The effect of Masala Bonds is the transfer of this risk to foreign investors, making foreign borrowing safer for Indian entities.
- Broader Implications: Masala Bonds contribute to the gradual internationalization of the Indian Rupee by increasing its role in global financial markets. They also help deepen the Indian bond market and provide an alternative channel for financing India’s large infrastructure needs.
- Debate: While beneficial, the success of Masala Bonds depends on the appetite of foreign investors to bear the Rupee’s exchange rate risk. In times of high currency volatility, attracting investment through this route can be challenging.
-
Derivatives: A Tool for Hedging or a Source of Systemic Risk?
- Hedging Perspective: Derivatives are indispensable tools for risk management. For example, an exporter expecting payment in USD can use a currency forward to lock in an exchange rate, protecting them from Rupee appreciation. Similarly, a farmer can use a futures contract to lock in a price for their crop, ensuring price stability. This reduces business uncertainty and encourages investment.
- Speculation and Systemic Risk: The same instruments can be used for speculation. While speculation provides liquidity to the market, excessive and unregulated speculation can lead to asset bubbles and extreme volatility. The 2008 Global Financial Crisis was exacerbated by complex and opaque derivatives (like Credit Default Swaps), highlighting how these instruments can create and spread systemic risk across the global financial system.
- Regulatory Challenge: For regulators like SEBI in India, the key challenge is to create a framework that allows for the legitimate use of derivatives for hedging and price discovery while curbing excessive speculation that could destabilize the market.
-
Corporate Finance and Investor Rights (Equity vs. Preference vs. Debentures):
- Corporate Governance Angle: The distinction between different types of shares and debentures is central to corporate governance. Equity shareholders, as the true owners, have voting rights and influence over the management, but they also bear the ultimate risk. Debenture holders are creditors with a right to fixed interest but no say in management.
- Conflict of Interest: This structure can lead to conflicts. Management might undertake risky projects that could offer high returns to equity holders but increase the risk of default for debenture holders. The rights assigned to each class of investors are designed to balance these interests.
- Equity Dilution: Instruments like FCCBs and Convertible Debentures introduce a dynamic element. While they provide cheaper capital initially, their conversion can lead to equity dilution, which can be detrimental to the interests of existing equity shareholders if not managed properly. This highlights the continuous negotiation of control and ownership within a corporate structure.