Types of Financial Instruments available for Trading in the Capital Market

When we think about investing in the capital market, the first thing that comes to mind is stocks or equity investments. But the capital market has much more to offer than just stocks, and each instrument works in a different manner, having different characteristics.

In today’s blog post, we will give you an overview of different types of financial instruments in which one can invest or trade in the financial market.

What is a Financial Instrument?

A financial instrument is a financial contract that has monetary value, and it can be bought and sold on an exchange. A financial instrument represents ownership in an asset or has a contractual right between two or more parties. These instruments provide investors and traders with an option to invest in different ways to earn potential returns, manage risks, and participate in the capital market. Equity shares, bonds, debentures, mutual funds, and ETFs are the most commonly known instruments of capital market.

Importance of Financial Instruments in Capital Market

The key importance of financial instruments in the capital market is as follows:

1. Raising Capital: Whenever a company requires funds to expand its business, etc., they use financial instruments such as equity, bonds, debentures, etc.
2. Investment Opportunities: Financial instruments allow an investor to invest in multiple investment options according to their financial goals and risk profile.
3. Liquidity: As financial instruments can be bought and sold in the capital market, it provides flexibility to investors to convert their investments into cash.
4. Diversification of Portfolio: By investing in different financial instruments, one can reduce the risk in the portfolio. Different instruments have different risk and return characteristics.

Types of Financial Instruments Available for Trading in the Capital Market

Investors and traders have access to various stock market instruments, ranging from equity shares and bonds to mutual funds. Each instrument has a different risk-return profile.

Financial Instrument	What it Represents	Potential Return	Risk Level
Equity Shares	Ownership in a company	Capital appreciation and dividends	High
Bonds	Loan to an issuer	Interest income	Low to Moderate
Debentures	Corporate borrowing	Interest income	Moderate
Mutual Funds	Investment in a diversified portfolio	Depends on underlying assets	Varies
ETFs	Basket of securities traded on exchanges	Depends on underlying assets	Varies
Futures	Contract linked to an underlying asset	Depends on price movement	High
Options	Contract providing specific rights	Depends on price movement and strategy	High
REITs/InvITs	Exposure to real estate or infrastructure assets	Income and capital appreciation potential	Moderate to High

Overview of Types of Financial Instruments

1. Equity Shares

Equity shares are commonly known as stocks that represent ownership in a company in exchange for payment. Whenever an investor purchases equity shares, they become a partial owner of the company. They can potentially earn profit from capital appreciation and dividends. However, equity shares are highly volatile in nature and can move significantly during market downturns.

2. Preference Shares

These types of shares have preferential rights over equity shareholders. But these shareholders have limited voting rights when compared to equity shareholders. These shareholders get a fixed percentage of return over equity shareholders. Some preference shares get the option to convert into equity shareholders.

3. Bonds

It is a type of fixed-income security issued by banks, governments, and private companies. These are issued by institutions to borrow money from investors. Whenever an investor purchases a bond, they lend money to the issuer. The issuer, in return, agrees to pay interest and repay the principal amount according to bond terms.

4. Debenture

Debenture is another type of fixed income security issued by companies to raise capital. They do not provide ownership in the company; instead, investors act as creditors and receive regular interest payments.

5. Mutual Funds

A mutual fund is a financial instrument that pools money from investors, and a fund manager invests in a portfolio of different securities based on the investment objective. Mutual funds can invest in shares, bonds, government securities, etc. It can help investor in gaining exposure to a diversified portfolio.

6. Exchange Traded Funds

They are often known as ETFs, and it is traded on stock exchanges. They are similar to stocks and are traded on an exchange during trading hours, and an investor is required to have a demat and trading account. ETFs combine the diversification benefits of a fund with the flexibility of exchange-based trading. These are passive funds, and the fund manager tries to meet the returns of their underlying benchmark.

7. Future Contracts

A future contract is an agreement to buy or sell an underlying asset at a pre-defined price on a specific future date. The underlying assets in future contracts include stocks, indices, currencies, commodities, etc. These contracts are commonly used for hedging and trading purposes and are among the popular trading instruments available in the derivatives segment. However, futures contracts can be risky as they involve leverage, which may increase both potential gains and losses. 

8. Options Contracts

Options Contracts are the derivative instruments that derive their value from the underlying assets. There are two types of option contracts: call options and put options. Options are widely used trading instruments as well as for hedging and trading purposes, but it carries high risk. Options are very complex in nature. There are various concepts that one needs to understand, such as strike price, premium, expiry, etc.

9. REITs and InvITs

REITs and InvITs are commonly known as Real Estate Investment Trusts and Infrastructure Investment Trusts that allow investors to have exposure to income-generating real-estate and infrastructure assets without purchasing the underlying property. These can be considered an additional revenue source for portfolio diversification. 

Read Also: Money Market Instruments: Types, Features & Benefits

How to Choose the Right Financial Instruments 

To choose the right financial instruments, one can follow the steps mentioned below:

1. Defining Financial Goals: The first step is to define the financial objective for which one is investing. The goal can be long-term wealth creation, capital preservation, etc.
2. Risk Appetite: Investment in financial instruments carries certain risk. Hence, one should invest in financial instruments that match the risk profile of the investor.
3. Investment Horizon: Each financial instrument gives returns based on its ideal investment horizon. Long-term investors can consider investing in equities and mutual funds. Whereas short-term traders can opt for trading in derivatives, etc.
4. Cost: Investors must also consider the cost involved while investing in financial instruments. Buying and selling financial instruments involve brokerage costs, fund management fees, etc. 

Conclusion

On a concluding note, there are various capital market instruments in India in which one can invest and trade in the capital market. All these financial instruments have different characteristics, risks, and returns. Equity shares and equity mutual funds offer opportunities to create wealth in the long term, whereas debentures and bonds are suitable for parking short-term money with less risk. However, choosing financial instruments only based on returns is not advisable. Investors are advised to consider other factors such as their financial goals, risk appetite, and investment horizon before choosing any financial instruments. Along with this, it is advisable to consult your investment advisor before making any investments in financial instruments. 

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