SEP- Name of the Program:

BACHELOR OF COMMERCE (REGULAR)

Course Code: 1.4
Name of the Course: INDIAN FINANCIAL SYSTEM
Unit – 3: Financial Instruments and Services 12
Financial Instruments- Meaning, importance & types
Equity Shares – Meaning and features.
Preference shares – Meaning, features and types
Debentures – Meaning, feature and types

Financial Services- Meaning, importance, and types of Financial Services – Fund based
services and Fee based services – Meaning, features and types Specialized Financial
Services- Meaning, features and types of Leasing, Factoring, Forfeiting, Credit Rating and
Venture Capital.

Financial Instruments:
Financial instruments are assets or contracts that represent a claim to a future stream of
income or assets. They are used for various purposes like raising capital, managing risk, and
ensuring liquidity in financial markets. They can be categorized into different types, depending
on their characteristics and purpose.

Importance of Financial Instruments:

1. Facilitating Capital Flow: Financial instruments enable companies and governments to raise
funds by connecting those who have capital (investors) with those who need capital
(borrowers).

2. Risk Management: Instruments like derivatives (futures, options, swaps) help investors and
businesses to hedge against various risks, such as interest rate changes, currency
fluctuations, and price volatility.

3. Liquidity Provision: They provide a mechanism for investors to quickly convert assets into
cash, ensuring that liquidity is maintained in the market.

4. Investment Diversification: Financial instruments allow investors to diversify their portfolios

across different asset classes, spreading and managing risks.

5. Income Generation: They provide opportunities for investors to earn returns in the form of
interest, dividends, or capital gains, depending on the type of instrument.

6. Price Discovery: Financial instruments, especially those traded on exchanges, help

determine the fair market price of assets through the forces of supply and demand.

7. Economic Growth: By facilitating efficient capital allocation, financial instruments support

investment in businesses and infrastructure, thus contributing to overall economic growth.

Types of Financial Instruments:

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1. Equity Instruments: Represent ownership in a company and provide potential returns
through dividends and capital appreciation. Equity holders have a Surplus claim on assets in
case of liquidation.

a. Equity Shares (Common Stocks): Shareholders are part-owners of the company, with voting
rights and a share in the company’s profits. Dividends are paid at the Option of the company.

b. Preference Shares: Shareholders receive fixed dividends before equity shareholders and
have a higher claim on assets during liquidation. However, they typically do not have voting
rights.

2. Debt Instruments: Represent a loan from investors to borrowers, typically providing fixed
returns through interest payments. They are less risky than equity but offer limited upside
potential.

a. Bonds: Long-term debt securities issued by companies or governments to raise capital.

Bondholders receive regular interest payments and the principal amount upon maturity.

b. Debentures: Unsecured debt instruments that rely on the creditworthiness of the issuer.
They pay fixed interest and have a maturity period.

c. Commercial Papers: Short-term unsecured promissory notes issued by companies to meet

short-term liquidity needs. They are usually issued at a discount to face value.

d. Certificates of Deposit (CDs): Time deposits issued by banks with a fixed interest rate and
maturity date, offering a secure way for investors to earn interest over a short to medium-term
period.

3. Derivative Instruments: Financial contracts whose value is derived from underlying assets
like stocks, bonds, or commodities. They are mainly used for hedging risks or for speculative
purposes.

a. Futures: Standardized contracts to buy or sell an asset at a predetermined price on a

specific future date. Commonly used to hedge against price changes.

b. Options: Contracts that give the buyer the right (but not the obligation) to buy or sell an
asset at a set price within a specified time frame. Options come in two types: calls (buy) and
puts (sell).

c. Swaps: Agreements between two parties to exchange cash flows or financial instruments.
Common types include interest rate swaps and currency swaps, often used to manage
financial risks.

4. Hybrid Instruments: Combine characteristics of both equity and debt instruments, offering
flexibility and potential conversion into equity.

a. Convertible Bonds: Debt instruments that can be converted into a predetermined number of
equity shares after a certain period. They offer fixed interest payments

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b. Convertible Preference Shares: Preference shares that can be converted into equity shares
at a specified time and conversion rate. They provide fixed dividends with the potential for
equity conversion in the future.

These different types of financial instruments serve various purposes, offering a range of risk-
return profiles and investment opportunities for different types of investors.

Equity Shares:

Meaning: Equity shares, also known as common shares, represent a form of ownership in a
company. Holders of equity shares are called shareholders and they are entitled to a portion of
the company's profits (dividends) and have voting rights in the company’s decision-making
processes. However, they bear a higher risk compared to other types of securities because
they are the last to be repaid in case of liquidation.

Features:

1. Ownership Rights: Equity shareholders are part-owners of the company, with a Surplus claim
on the company's assets and income. This means that after all liabilities are settled,
shareholders have a claim on the remaining assets.

2. Voting Rights: Equity shareholders have the right to vote on key company matters, including
the election of the board of directors, mergers, and acquisitions. This allows them to have a
say in the company's management.

3. Dividends: Shareholders may receive dividends, which are a share of the company's profits.
However, dividends are not guaranteed and are usually paid at the discretion of the company’s
board of directors, depending on profitability.

4. Potential for Capital Appreciation: Equity shares offer the potential for capital appreciation
if the company performs well, leading to an increase in the share price. This can result in
significant capital gains for shareholders.

5. Surplus Claim: In the event of the company's liquidation, equity shareholders have a claim
on the company's assets after all debts and obligations have been settled. However, they are
last in line to be paid, after debenture holders and preference shareholders.

6. High Risk, High Reward: Equity shares are considered high-risk investments due to their
price volatility, but they also have the potential for high returns, making them attractive for
long-term investors.

Preference Shares:

Meaning: Preference shares are a type of equity that gives shareholders preferential rights
over common shareholders in terms of dividend payments and capital repayment during
liquidation. Preference shareholders receive fixed dividends before any dividends are paid to
equity shareholders. However, they typically do not have voting rights, except in specific
situations.

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Features:

1. Fixed Dividend: Preference shareholders are entitled to receive a fixed dividend before any
distribution of profits to equity shareholders. This makes them more stable compared to equity
shares.

2. Priority in Liquidation: In the event of liquidation, preference shareholders have a higher

claim on the company's assets than equity shareholders but rank below debt holders.

3. No Voting Rights: Generally, preference shareholders do not have voting rights in the
company’s affairs, except in matters directly affecting their interests.

4. Convertible or Non-Convertible: Some preference shares can be converted into equity shares
after a certain period, while others cannot.

5. Redeemable or Perpetual: Preference shares can be redeemable, meaning they are

repurchased by the company after a specified period. Perpetual preference shares, on the
other hand, do not have a maturity date.

Types:

1. Cumulative Preference Shares: If the company fails to pay dividends in any year, the unpaid
dividends accumulate and are paid in subsequent years before any dividends are paid to equity
shareholders.

2. Non-Cumulative Preference Shares: Unpaid dividends do not accumulate. If the company

does not declare a dividend in a particular year, preference shareholders cannot claim those
dividends in the future.

3. Convertible Preference Shares: These shares can be converted into equity shares after a
specific time and at a predetermined rate.

4. Non-Convertible Preference Shares: These shares cannot be converted into equity shares
and remain as preference shares throughout their life.

5. Participating Preference Shares: These shares allow the shareholders to participate in the
company’s surplus profits after a fixed dividend has been paid.

6. Non-Participating Preference Shares: Shareholders are entitled only to a fixed dividend and
do not share in any additional profits of the company.

Debentures:

Meaning: Debentures are a type of debt instrument issued by companies to raise long-term
funds. They are essentially a loan made by investors to a company, which the company agrees
to repay with interest. Debenture holders are considered creditors of the company and receive
fixed interest payments at regular intervals.

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Features:
1. Fixed Interest Rate (Coupon): Debenture holders receive a fixed interest rate, known as the
coupon rate, regardless of the company's profitability.

2. Maturity Period: Debentures come with a specific maturity period, after which the company
is obligated to repay the principal amount to the debenture holders.

3. Security: Debentures can be secured or unsecured:

4. Secured Debentures: Backed by the company's assets as collateral, providing an additional

layer of security for investors.

5. Unsecured Debentures: Not backed by collateral, making them riskier for investors.

6. No Voting Rights: Debenture holders do not have voting rights in the company’s affairs since
they are creditors rather than owners.

7. Priority in Repayment: Debenture holders have a priority claim over equity and preference
shareholders in the event of the company’s liquidation, meaning they are paid first from the
company’s assets.

Types:

1. Convertible Debentures: These can be converted into equity shares of the company after a
certain period, offering investors the potential for capital appreciation.

2. Non-Convertible Debentures (NCDs): These remain debt instruments throughout their tenure
and cannot be converted into equity shares.

3. Secured Debentures: They are backed by specific assets of the company, providing a
guarantee of repayment to debenture holders.

4. Unsecured Debentures: Not backed by any assets, making them a higher-risk option
compared to secured debentures.

5. Redeemable Debentures: These are repaid by the company after a specified period, either at
a fixed date or upon demand by the debenture holder.

6. Substitute Debentures: They do not have a maturity date and pay interest indefinitely until
the company chooses to repay the principal.

7. Zero-Coupon Debentures: These do not pay regular interest but are issued at a discount to
their face value. The difference between the issue price and the face value is the return to the
investor upon maturity.

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Financial Services:

Meaning: Financial services refer to a broad range of services provided by financial institutions
that support individuals, businesses, and governments in managing their finances. These
services facilitate the flow of capital and funds in the economy and play a crucial role in
financial stability and growth.

Importance of Financial Services:

1. Economic Growth: Financial services facilitate savings, investments, and the allocation of
resources, contributing significantly to the overall economic growth.

2. Encourages Savings: Financial services encourage people to save through various

instruments like fixed deposits, mutual funds, and insurance products, which contribute to
capital formation.

3. Risk Management: Financial services, such as insurance, help in managing risks and
uncertainties by providing coverage against potential financial losses.

4. Credit Availability: By providing loans, credit cards, and other forms of credit, financial
services support businesses in expanding their operations and individuals in meeting their
consumption needs.

5. Investment Opportunities: They offer diverse investment avenues, such as stocks, bonds,
and mutual funds, enabling investors to earn returns and diversify their portfolios.

6. Liquidity Management: Financial services enable companies to manage their cash flow and
maintain liquidity through services like factoring and leasing.

Types of Financial Services:

Financial services are broadly categorized into:

1. Fund-Based Services
2. Fee-Based Services

1. Fund-Based Services: Fund-based services involve financial institutions directly using their
funds to offer services such as loans, leases, and investments. They generate income through
interest, dividends, or asset appreciation.

Features:
1. Direct Deployment of Funds: Financial institutions directly use their own capital or funds to
provide services like loans, leasing, and investments. This direct involvement means the
institution's money is at risk until the borrower repays or the investment matures.

2. Interest or Dividend Income: The primary source of income for fund-based services is
through interest (on loans or advances) or dividends (from equity investments). For example,
banks earn interest on the loans they provide to businesses or individuals.

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3. Risk Exposure: Fund-based services involve a higher risk as the institution's capital is
exposed to market fluctuations, defaults, or changes in the creditworthiness of the borrower.
The success of these services is often dependent on the economic environment and the credit
risk of borrowers.

4. Asset-Based Transactions: In fund-based services, transactions often involve tangible or

intangible assets like property (in the case of loans or mortgages), equipment (in leasing), or
accounts receivables (in factoring). The assets can serve as collateral to secure the funds
provided.

5. Long-Term Engagement: These services often involve long-term commitments, such as the
tenure of a loan or the duration of a lease agreement. This long-term engagement impacts the
institution’s balance sheet, making capital management crucial for maintaining liquidity.

6. Profitability Tied to Interest Rate Movements: The profitability of fund-based services is

closely linked to interest rate fluctuations in the market. For example, if interest rates rise, the
cost of funds increases, which can reduce margins unless adjusted in loan pricing.

Types of Fund-Based Services:

1. Loans and Advances: Banks provide loans to businesses and individuals, earning interest
over time.

2. Leasing: A lease is an agreement where the owner (lessor) allows another party (lessee) to
use an asset for a specified period in return for periodic payments.

3. Hire Purchase: A method where the buyer acquires the asset through installment payments,
gaining ownership only after paying the final installment.

4. Factoring: The sale of accounts receivable to a third party (factor) at a discount for
immediate cash flow.

5. Forfeiting: A form of factoring where exporters sell their international receivables at a

discount to a forfeiter, receiving immediate cash.

6. Venture Capital: Financial investment in start-ups and small businesses with high growth
potential in exchange for equity or ownership stake.

2. Fee-Based Services:

Meaning: Fee-based services are those where financial institutions provide services for a fee
or commission without directly involving their funds. Income is generated through service
charges, consultancy fees, commissions, and other charges.

Features:-

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1. Income Generation Through Fees and Commissions: Revenue is earned by charging fees or
commissions for services rendered, such as advisory, brokerage, or consultancy services.
2. Minimal Risk Exposure: Institutions do not deploy their own funds, which means lower
exposure to credit risks or market fluctuations compared to fund-based services.

3. Transaction-Based Income: Earnings are linked to specific transactions, like stock trades,
mergers, or investment advice, allowing scalability through volume.

4. Focus on Expertise and Advisory Roles: Services rely heavily on professional knowledge and
expertise in areas like investment advisory, portfolio management, and financial consulting.

5. Diversification of Services: Institutions often offer a wide range of services, such as

insurance advisory, credit rating, and wealth management, creating multiple revenue streams.

6. Client Relationship: Building trust and maintaining strong relationships with clients is
crucial, as the quality of service and personalized advice leads to long-term engagements and
repeat business.

Types of Fee-Based Services:

1. Investment Advisory Services: Providing advice on investment opportunities, portfolio

management, and wealth management.

2. Underwriting: Guaranteeing the purchase of securities issued by companies during IPOs for
a fee.

3. Credit Rating Services: Evaluating the creditworthiness of companies or financial

instruments, helping investors make informed decisions.

4. Stock Broking: Assisting clients in buying and selling securities in the stock market.

5. Insurance Advisory Services: Offering advice on selecting appropriate insurance products

for risk coverage.

Specialized Financial Services:

Specialized financial services cater to specific financial needs of businesses and individuals.
They offer tailored solutions that go beyond traditional banking services, focusing on niche
areas like leasing, factoring, forfeiting, credit rating, and venture capital. Each of these
services addresses unique aspects of financial requirements, providing flexibility and solutions
to various business challenges. Here’s an in-depth look into each of these services:

1. Leasing Leasing is a contractual arrangement in which the lessor (owner) permits the
lessee (user) to use an asset for a specified period in exchange for periodic payments (lease
rentals). At the end of the lease period, the asset either reverts back to the lessor, or the
lessee may have the option to purchase it.

Features:

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1. Ownership vs. Usage: The lessor retains ownership of the asset while the lessee gets the
right to use it.
2. Fixed Tenure: Lease agreements have a fixed duration, typically medium to long-term.

2. Lease Rentals: The lessee makes regular payments, known as lease rentals, which are
considered operating expenses.

3. Tax Benefits: Lessees often enjoy tax benefits as lease payments are tax-deductible.

4. Leftover Value: At the end of the lease, the asset may have a Leftover value, which the
lessor can recover.

Types of Leasing:

1. Operating Lease: Short-term lease where the lessor bears the risk of obsolescence and
maintenance.

2. Finance Lease: Long-term lease where the lessee bears most of the risks and rewards of
ownership, often akin to purchasing the asset.

2. Factoring: Factoring is a financial service where a business sells its accounts receivable
(invoices) to a third-party (factor) at a discount. This provides immediate cash flow to the
business, while the factor takes on the responsibility of collecting payments from the debtors.

Features:

1. Immediate Cash Flow: Businesses can convert their receivables into cash quickly, improving
liquidity.

2. Risk Transfer: The factor assumes the credit risk of the receivables, depending on whether
it’s a recourse or non-recourse arrangement.

3. Discounted Rate: The factor purchases the invoices at a discounted price, which serves as
their fee.

4. Collection Services: The factor often provides collection services, reducing the
administrative burden on the business.

5. Credit Management: Factors may assist in evaluating the creditworthiness of a business’s

customers, helping in better credit control.

Types of Factoring:

1. Recourse Factoring: The business must buy back unpaid invoices if customers default.

2. Non-Recourse Factoring: The factor assumes the risk of non-payment, relieving the business
from the risk of bad debts.

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3. Forfeiting: Forfeiting is a financial service where an exporter sells their medium to long-term
receivables (promissory notes or bills of exchange) to a forfeiter at a discount. It is primarily
used in international trade to receive immediate cash against future payments from the
importer.

Features:
1. Non-Recourse Financing: The forfeiter assumes all risks of non-payment, providing a
guarantee to the exporter.

2. Cash Flow Improvement: Exporters receive immediate payment, improving their liquidity.
Focus on International Trade: It is specifically used for financing export transactions with
extended credit terms.

3. No Currency Risk: Exporters can avoid foreign exchange risks as they receive payment in
their home currency.

4. High Discount Rates: Forfeiting can involve higher discount rates due to the risks taken by
the forfeiter.

Types of Instruments Used:

Promissory Notes: Written promises by the importer to pay a specified amount at a future date.
Bills of Exchange: Drafts drawn by the exporter on the importer, accepted by the importer.

4. Credit Rating: Credit rating is an assessment of the creditworthiness of a borrower,

whether an individual, corporation, or sovereign entity. It evaluates the ability of the borrower
to meet its debt obligations and reflects the likelihood of default.

Features:

1. Objective Evaluation: Credit ratings are based on a thorough analysis of financial

statements, economic conditions, and qualitative factors.

2. Grades and Symbols: Ratings are expressed in symbols like AAA, AA, A, etc., representing
different levels of credit risk.

3. Non-Static Nature: Credit ratings can change based on the borrower’s financial condition
and external economic factors.

4. Impact on Borrowing Costs: A higher credit rating often means lower interest rates, as it
indicates lower risk for lenders.

5. Regulatory Use: Credit ratings are used by regulators, banks, and investors to assess the
risk levels associated with debt instruments.

Types of Credit Rating:

1. Corporate Rating: Assessment of companies’ creditworthiness.

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2. Sovereign Rating: Evaluation of a country’s ability to meet its debt obligations.
3. Instrument Rating: Specific to debt instruments like bonds, evaluating the risk of the
instrument itself.

5. Venture Capital: Venture capital is a type of private equity financing provided by investors to
startups and small businesses with high growth potential. Venture capitalists invest in
exchange for equity or ownership stake, taking on higher risk with the hope of significant
returns.

Features:
1. Equity Financing: Venture capitalists provide funds in exchange for equity in the company,
meaning they become partial owners.

2. High Risk, High Return: Venture capital is risky as it is invested in unproven businesses, but
it aims for high returns through the growth of the startup.

3. Active Participation: Venture capitalists often take an active role in the management of the
business, providing mentorship and strategic guidance.

4. Long-Term Investment: Typically, venture capital is a long-term investment, with investors

looking for an exit strategy through an IPO or acquisition.

5. Stage-Based Funding: Investments are often made in stages, such as seed funding, early-
stage funding, and later-stage funding, based on the startup’s growth and needs.

Types of Venture Capital:

1. Seed Capital: Initial funding for developing a business idea and early-stage prototypes.

2. Early-Stage Capital: Funds for starting operations and expanding the business model.

3. Growth Capital: Investment for scaling up operations, marketing, and product expansion.

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