Capital Market Instruments

and Financial Innovation

Ann May Chacko

Asst.Professor
Department of Economics
Mount Carmel College ,Bangalore
Financial innovation

 Financial innovation is a continuous,

dynamic process that entails the
creation and subsequent popularization
of new financial instruments, as well as
new financial technologies, institutions,
and markets.
Types of Financial Innovation
 Financial system/institutional innovations: Such innovations can effects the financial sector as
a whole, relate to changes in business structures, to the establishment of new types of financial
intermediaries, or to changes in the legal and supervisory framework. Important examples include
the use of the group mechanism to retail financial services, formalizing informal finance systems,
reducing the access barriers for women, or setting up a completely new service structure.
 Process innovations: Such innovations cover the introduction of new business processes leading to
increased efficiency, market expansion, etc. Examples include office automation and use of
computers with accounting and client data management software.
 Product innovations: Such innovations include the introduction of new credit, deposit, insurance,
leasing, hire purchase, and other financial products. Product innovations are introduced to respond
better to changes in market demand or to improve the efficiency of product markets.
 Technology driven financial innovation: Advancements in Information Technology have
facilitated a number of innovations, such as new methods of underwriting securities, Assembling
portfolios of stocks, New markets for securities, New means of executing security transactions, Many
new forms of derivatives have been made possible because business people could have some
confidence in the methods of pricing and hedging the risks of these new contracts. Various forms of
innovations such as new risk management systems and measures, on-line retirement planning
services and new valuation techniques were clearly facilitated by both intellectual and information
technology innovations.
Some of the innovative financial instruments used in the Indian Financial Market
are explained as follows:
 1)Triple Option Convertible Debentures (TOCD): First Issued by Reliance Power Limited with an issue size of
Rs. 2,172 Cr. There was no outflow of interest for first five years, Equity increase was in phases. There is No put
option to investors and no takeover threat. It reduced dependence on the financial institutions. The expenses for
floating the issue was just 2.62% of the issue size which was very less when compared to the 10-12% for a
general public issue.
 2)Deep Discount Bonds: The investor got a tax advantage and could eliminate the re-investment risk. From the
issuer's point of view also, the issue cost was saved as it involved no immediate service cost and lower effective
cost. The refinancing risk was also eliminated.
 3)Floating Rate Notes: First issued by Tata Sons with a floor rate of 12.5% and a cap of 15.5% and a reference
rate of 364 T-Bill yield, which was 9.85% at the time of issue. The investors would get a minimum return of the
floor rate and the maximum return was the cap rate. They would get higher than floor rate depending upon the
fluctuations in the reference rate.
 4)Zero Coupon Bonds: It did not involve any annual interest on the bonds. But it had a higher maturity value on
the initial investment for a particular time period.
 5)Convertible and Zero Coupon Convertible Bonds: Similar to the zero coupon bonds except that the
effective interest was lower because of the convertibility.
 6)Inflation linked bonds: Inflation linked bonds (ILB) securities give an opportunity to market participants and
investors to hedge against inflation. The coupon (interest rate) of ILB is fixed but the underlying principal would
move in tandem with the inflation levels in the country. At redemption of the securities the higher of the value
(adding inflation) thus arrived or face value is paid off. Banks and Financial Institutions usually buy wholesale and
create retail market for such securities. With right access retail investor can easily buy such securities to protect
himself from inflation
 For Investors in general, inflation linked bonds would provide distinct advantages:
  
 It allows investors to hedge the purchasing power (inflation) risk. The capital is inflation risk protected
and the income (coupon) can be structured that way too.
 Inflation linked bonds universally are regarded as a separate asset class & would provide
diversification benefits to a portfolio due to its negative co relation with returns from traditional asset
classes.
 Such bonds provide positive risk reward relationship too.
 Inflation linked bonds are effective vehicle for hedging risks for institutional investors, where the long
term liabilities are inflation linked or linked to future wage levels or banks who face the inflation risk
on their assets side due to their GOI Bond holdings.
 Access of FIIs to the inflation linked bonds can allow them to hedge their inflation risks in India which
are currently expressed in the currency markets. The USD/INR (currency) volatility can hence come
down hence.
 7)Secured Premium Notes (SPNs): First issued by TISCO in July, 1992. These financial
instruments were secured against the assets of the company but the investors had to pay a premium
over the market price for these types of instruments.
 8)Pension Funds: International experience shows that pension funds have indeed provided the
much-needed boost to the development of corporate debt markets both in terms of demand for
corporate bonds as also liquidity apart from improving the market microstructure. Pension funds
have also been major stimulators of financial innovation as they have directly or indirectly supported
product innovation by supporting the development of asset backed securities, structured finance,
derivative products and so on. Pension fund presence in the bond market is likely to increase the
availability of long term funds in the market, which in turn will improve the asset liability mismatch
that often arises in projects with long gestation periods.
 9)Economy growth futures: This is a unique type of futures contract that can be raised in India as
in this there should be an index which measures the economy growth and futures can be predicted
on the underlying growth. In this there should be a hypothetical index created on the basis of growth
of an economy. It can be measured on the growth 3, 6, 9, 12 months. Every quarter the growth can
be measured and compared with future contract. Based on the conditions prevailing in the economy
and also the world scenario should be predicted and accordingly the moment of the future contract
can be decided.
 10)Credit Derivatives: Credit derivatives are over the counter financial contracts. They are usually
defined as "off-balance sheet financial instruments that permit one party (beneficiary) to transfer
credit risk of a reference asset, which it owns, to another party (guarantor) without actually selling
the asset". It, therefore, "unbundles" credit risk from the credit instrument and trades it separately
 Types of Credit
Derivatives

Credit Default Swaps Credit-Linked Note (CLN) Credit Linked Deposits (CLDs)
(CDS)
 Credit Default Swaps (CDS): CDS have grown rapidly in the credit risk market since their
introduction in the early 1990s. It is believed that current usage is but a small fraction of what
it will ultimately represent in the credit risk markets. In particular, the CDS market will become
as central to the management of credit risk as the interest rate swap market is to the
management of market risk.
 Credit-Linked Note (CLN): CLN market is one of the fastest growing areas in the credit
derivatives sector. It is, a combination of a regular note (bond or deposit) and a credit-option.
Since it is a regular note with coupon, maturity and redemption, it is an on-balance sheet
equivalent of a credit default swap. Under this structure, the coupon or price of the note is
linked to the performance of a reference asset. It offers borrowers a hedge against credit risk
and investors a higher yield for buying a credit exposure synthetically rather than buying it in
the publicly traded debt.
 Credit Linked Deposits (CLDs): CLD are structured deposits with embedded default
swaps. Conceptually they can be thought of as deposits along with a default swap that the
investor sells to the deposit taker. The default contingency can be based on a variety of
underlying assets, including a specific corporate loan or security, a portfolio of loans or
securities or sovereign debt instruments, or even a portfolio of contracts which give rise to
credit exposure. If necessary, the structure can include an interest rate or foreign exchange
swap to create cash flows required by investor.
 11)Weather Derivatives: A weather derivative contract may be termed as a financial weather
dependent contract whose payoff will be determined by future weather events. The settlement value of
these weather events associated with a particular instrument is determined from a weather index,
expressed as values of a weather variable measured at a stated location at a particular time. These
derivatives are financial instruments that can be used by organizations or individuals to reduce the risk
associated with adverse or unexpected weather outcomes. The difference from other derivatives is that
the associated asset (rain/temperature/snow) has no direct value to price the weather derivative.
Weather Derivatives can be an important tool to hedge against losses occurring from uncertain
weather conditions and can help reduce the impact of adverse weather on a company's profitability.
 12)Mortgage Backed Securities (MBS): A type of asset-backed security that is secured by a
mortgage or collection of mortgages. These securities must also be grouped in one of the top two
ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are
similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and
authorized financial institution. When you invest in a mortgage-backed security you are essentially
lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend
mortgages to its customers without having to worry about whether the customers have the assets to
cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment
markets. This type of security is also commonly used to redirect the interest and principal payments
from the pool of mortgages to shareholders. These payments can be further broken down into different
classes of securities, depending on the riskiness of different mortgages as they areclassified under the
MBS. However, the long-term tenure of MBS and the lack of liquidity in the secondary market
discourage investors from getting actively involved in the market. Also home loans in India get pre-paid
or re-priced, thus exposing the structures to significant interest rate risk and leading to higher credit
enhancement requirements.
 12)Indian Depository Receipts (IDR): After the success of American Depository Receipts and
Global Depository Receipts the Indian regulatory body, SEBI also allowed foreign companies to raise
capital in India through INDIAN DEPOSITORY RECEIPTS (IDRs). IDRs can be understood as a mirror
image of well-known ADRs/GDRs. In an IDR, foreign companies issue the shares to an Indian
Depository, which would, issue Depository Receipts to investors in India. The Depository Receipts
would be listed on Indian stock exchanges and would be freely transferable. The actual shares of the
IDRs would be held by an Overseas Custodian, who shall authorize the Indian Depository to issue the
IDRs. The Overseas Custodian must be a foreign bank having business in India and needs approval
from the Finance Ministry for acting as a custodian while the Indian Depository needs to be
registered with the SEBI.
 Issuers Eligibility Criteria 
 Must have an average; turnover of US$ 500 million during the previous 3 financial years.
 Must have capital and free reserves which must aggregate to at least US$100 million.
 Must be making a profit for the previous 5 years and must have declared a dividend of 10% in each
such year.
 The pre issue debt-equity ratio must be not more than 2:1.
 Must be listed in its home country.
 Must not be prohibited by any regulatory body to issue securities.
 Must have a good track record with compliance with securities market regulations.
 Must comply with any additional criteria set by SEBI
 IMPLICATIONS OF INNOVATION ON FINANCIAL MARKETS:
  
 Financial innovations have a direct impact on the financial markets. It majorly impacts the asset
prices, international price relationships, and market behaviour. The major implications of innovations
in financial markets are as under:
 Lower transaction costs
 More liquidity
 Diversification of risk
 More competition in financial markets
 Increased opportunities for making investment
 More financial product to select for investment
 International markets relationships and capital mobility
 Greater integration of international markets
 Significant impact of changes in currency rates and exchange rates
The rising expectations of the middle-class, widening income and wealth inequalities between the haves and have-
nots, require efficient initiatives from Government and corporate to attract and accommodate the funds available.
So, the role of the financial innovations in the present financial system of today should be properly understood to
reduce the complexities and take full advantage of these innovations.
  Capital Market
  important part of Indian financial system .
 to meet long term financial needs usually more than one year or more .
 Companies like manufacturing , infrastructure power generation and governments which need funds
for longer duration period  raise money from capital market.
 Individuals and financial institutions who have surplus fund and want to earn higher rate of interest
usually invest in capital market .

 Functions of capital market

1)Link between Savers and Investors:

2)Encouragement to Saving:Capital Formation:
3)Promotes Economic Growth:
4)Stability in Security Prices:
5)Assists to Government :
6)Benefits to Investors:(Liquidity of Investment,Hedge against inflation, Higher Return, Collateral,
Flexibility, Tax advantage )
  Components of Capital Market:
 Capital market can be classified into two;
 Primary market
 Secondary market.

Primary market is the market where the securities are issued for the first time. It is the primary
market in which the companies issue their securities.
Secondary market is the market for already issued (second hand) securities. Secondary market
enables the further buying and selling of issued securities.


 Important Financial Instruments in Capital Market:
I)Shares:
 According to the Companies Act 1956, ‘a share is the share in the share capital of a company’. It is a
portion of capital which is divided among number of people. It is a unit of ownership interest in a
corporation and offered for sale. Shares are of two types, Preference shares and Equity shares.
Preference shares: Preference shares are those, which enjoy the following two preferential rights:
 Dividend at a fixed rate or a fixed amount on these shares before any dividend on equity shares.
 Return of preference share capital before the return of equity share capital at the time of winding up of
the company.
Preference shares also have a right to participator in part in excess profits left after been paid to equity
shares, or has a right to participate in the premium at the time of redemption. But these shares do not
carry voting rights.
Following are the major types of preference shares.
1)Cumulative Preference Shares: When unpaid dividends on preference shares are treated as arrears
and are carried forward to subsequent years, then such preference shares are known as cumulative
preference shares.
Non-cumulative Preference Shares: Non-cumulative preference shares are those type of preference
shares, which have right to get fixed rate of dividend out of the profits of current year only. They do
not carry the right to receive arrears of dividend.
2)Redeemable Preference Shares: Those preference shares, which can be redeemed or repaid after
the expiry of a fixed period are known as redeemable preference shares.
 Non-redeemable Preference Shares: Those preference shares, which cannot be redeemed during
the life time of the company, are known as non-redeemable preference shares. The amount of such
shares is paid at the time of liquidation of the company.
3) Participating Preference Shares: Those preference shares, which have right to participate in any
surplus profit of the company after paying the equity shareholders, in addition to the fixed rate
oftheir dividend, are called participating preference shares.
Non-participating Preference Shares: Preference shares, which have no right to participate on the
surplus profit of the company are called non-participating preference shares.
4)Convertible Preference Shares: Those preference shares, which can be converted into equity
shares at the option of the holders after a fixed period according to the terms and conditions of their
issue, are known as convertible preference shares.
Non-convertible Preference Shares: Preference shares, which are not convertible into equity shares,
are called non-convertible preference shares.
 II)Equity shares (Ordinary shares or Common shares):
 Equity shares are the ordinary shares of a company which have no preferential rights. They are the shares
representing the ownership interest. Equity shares give their holders the power to share the earnings in the
company as well as a vote in the Annual General Meetings of the company. Such a shareholder has to share
the profits and also bear the losses incurred by the company. Equity share holders are the real owners of the
company.
Types of Equity shares
 Rights Shares: it’s a type of dividend of subscription rights to buy additional securities in a company
made to the company's existing security holders. When the rights are for equity securities, such as shares, in
a public company, it is a non-dilutive pro rata way to raise capital. Rights issues are typically sold via a
prospectus or prospectus supplement. With the issued rights, existing security-holders have the privilege to
buy a specified number of new securities from the issuer at a specified price within a subscription period. In a
public company, a rights issue is a form of public offering
 Bonus Share: It is a free share of stock given to current shareholders in a company, based upon
the number of shares that the shareholder already owns While the issue of bonus shares increases the total
number of shares issued and owned, it does not change the value of the company. Although the total number
of issued shares increases, the ratio of number of shares held by each shareholder remains constant.
 Blue chip shares: A Blue chip shares means that the shares issued by blue chip companies. Blue Chip
Company is very strong financially, with a solid track record of producing earnings and only a moderate
amount of debt. It also has strong name in its industry with dominant products or services. The blue chip
shares qualified as a high-quality and usually high-priced stock. It has high price because of public confidence
in company's long record of steady earnings.
 III)Debenture / Bond :
 A debenture is an acknowledgement of the debt of the Company. It is a long term debt instrument
yielding a fixed rate of interest issued by a company. A debenture is like a certificate of loan or debt
evidencing the fact that the company is liable to pay a specified amount with interest. Debenture is
not secured by the physical asset of the company. Debenture holders are the creditors of the
company and hence they have no voting right in the company.
 Bonds are the debt instruments secured by the physical asset of the company. In some countries,
the term denture is used interchangeably with ‘bond’.
(If a company needs funds for extension and development purpose without increasing its
share capital, it can borrow from the general public by issuing certificates for a fixed
period of time and at a fixed rate of interest. Such a loan certificate is called a
debenture. Debentures are offered to the public for subscription in the same way as for
issue of equity shares. Debenture is issued under the common seal of the company
acknowledging the receipt of money.
Various types of debentures are as follows
 Convertible Debentures: These are those debentures which can be converted into equity shares. These
debentures have an option to convert them into equity or preference shares at the stated rate of exchange
after a certain period.
Non-Convertible Debentures: These are those debentures which cannot be converted either into equity
shares or preference shares. They may be secured or unsecured. Non-convertible debentures are normally
redeemed on maturity period which may be 10 or 20 years.
 Redeemable Debentures: These debentures are issued by the company for a specific period only. On the
expiry of period, debenture capital is redeemed or paid back.
 Irredeemable Debentures: These debentures are issued for an indefinite period which is also known as
perpetual debentures. The debenture capital is repaid either at the option of the company by giving prior
notice to that effect or at the winding up of the company. The interest is regularly paid on these debentures.
The principal amount is repayable only at the time of winding up of the company. However, the company may
decide to repay the principal amount during its lifetime.
 Fully Convertible debentures: A type of debt security where the whole value of the debenture is
convertible into equity shares at the issuer's notice. The ratio of conversion is decided by the issuer when the
debenture is issued. Upon conversion, the investors enjoy the same status as ordinary shareholders of the
company.
Partially convertible debentures: are the debentures part of which can be converted into equity at a price
and the time specified by the issuer at the time of issuing such instruments. It may also be defined as a
financial instrument that may be converted into a different security of the same company under various
specified conditions. The option of this conversion may sometimes be optional, i.e. at the discretion of the
investor or sometimes it may be compulsory as well. Generally, in these types of financial instruments no
cash is involved.
 Primary Market
 It is also called New Issue Market.
 It is the market where securities are issued for the first time. These
securities are never traded before elsewhere.
 Both new companies and existing companies approach primary
market for raising capital.
 The main function of primary market is to facilitate transfer of funds
from willing investors to the entrepreneurs setting up new
business or diversification, expansion or modernisation of existing
business.
 A new issue market is of paramount importance for economic growth
and industrial development as it supplies necessary long term
capital.
 Though the functions of primary market are so different from that of
secondary market, the sentiments in the secondary market do affect
the primary market activities.
 Primary market Intermediaries
A number of intermediaries play a critical role in the process of issue of new securities.
 They are,
 Merchant bankers/lead managers:
it is an institution that extends a number of services in connection with issue of capital.
Their services include management of security issues, portfolio management services,
underwriting of capital issues, credit syndication, financial advice and project counselling
etc.
It has now made mandatory that all public issues should be made by merchant bankers
acting as lead managers.
 Underwriters:
underwriter guarantee that the securities offered for the public will be subscribed if it is not
subscribed by the public.
It is an insurance to the issuing company against the failure of issue.
In case, the public fails to subscribe, the underwriter will have to take them up and pay for
them.
They charge a commission called underwriting commission for their service. It should not
exceed 5 percent in case of shares and 2.5 percent for debentures.
 Bankers to an issue:
Banker to an issue accepts applications and application money, refund application money
after allotment and participate in the payment of dividend by companies.
No banker can act as a banker to an issue unless it possesses a registration with SEBI.
SEBI grants registration only when it is satisfied that the bank has enough infrastructure,
communication and data processing facilities and requisite man power to discharge such
duties.
The banker is required to maintain documents and records relating to the issue for a period of 3
years.
It is also required to furnish information to the SEBI regarding the number of applications
received, number of issues for which it has acted as a banker to an issue, date on which
applications from investors were forwarded to registrar of issue, date and amount of
refund to investors etc
 Registrar to an issue:
It is an intermediary who performs the function of collecting application from investors
(through bankers), keeping record of applications, keeping record of money received from
investors, assisting companies in allotment and helping despatch of allotment letters,
refund orders etc.
 Share transfer agents:
They maintain the record of holders of securities on behalf of companies and deals with all
activities connected with transfer or redemption of securities.
 Debenture trustees:
A debenture is an instrument of debt issued by the company acknowledging its obligation to repay the
sum along with an interest.
In the case of public issue of debentures, there would be a large number of debenture holders on the
register of the company.
As such it shall not be feasible to create charge in favour of each of the debenture holder.
A common methodology generally adopted is to create Trust Deed conveying the property of the
company.
A Trust deed is an arrangement enabling the property to be held by a person or persons for
the benefit of some other person known as beneficiary.
It has been made mandatory for any company making a public/rights issue of debentures to appoint
one or more debenture trustees before issuing the prospectus or letter of offer and to obtain their
consent which shall be mentioned in the offer document.
 Brokers to an issue:
Brokers are the persons who procure subscriptions to issue from prospective investors
spread over a larger area.
A company can appoint as much number of brokers as it wants.
 Portfolio managers:
Portfolio construction, formulation of investment strategy, evaluation and regular
monitoring of portfolio is an art that requires skill and high degree of expertise.
Any person whopursuant to a contract or arrangement with a client, advises or directs or undertakes on
behalf of the client [whether as a discretionary portfolio manager or otherwise(adviser)] the
management or administration of a portfolio of securities or the funds of the client, as the case may
be is a portfolio manager.
Different Kinds of Issue
 Every Company needs funds for its business.
 Funds requirement can be for short term or for long term.
 To meet short term requirements, they may approach banks, lenders & may even accept fixed
deposits from public/shareholders.
 To meet its long term requirements, funds can be raised either through loans from lenders, Banks,
institutions or through issue of capital.
 Capital can be raised through private placement of shares, public issue, right issue etc.
 Public Issue :
 Public issue means raising funds from public.
 The main purpose of the public issue, amongst others, is to raise money through public and get its
shares listed at any of the recognized stock exchanges in India.

Methods of Public Issue:

 Public issue may be an Initial Public Offering (IPO) or Further/Follow on Public Offering
(FPO).
 During the IPO or FPO, the company offers its shares to the public either at fixed price or offers a
price range, so that the investors can decide on the right price.
 The method of offering shares at a fixed price is called Fixed Price Public Issue and
 the method of offering shares by providing a price range is called as book building
method.
 Initial Public Offering :
 It is the first time issue of securities to the public.
 The promoters of the companies after complying the with the guidelines of SEBI and the
Companies Act ask the public at large to subscribe to their shares so that they can generate
capital.
 It may be done through prospectus or Offer for Sale(Securities issued to a issue house
and they sell securities to the public by issuing advertisement called OFS)
 Public issue through offer for sale is not popular in India.

Further (Follow on) Public Offering :

If an already listed company makes the issue of securities after IPO, it is called Follow on
Public Offering.
If an existing company again intends to raise capital from the general public after IPO, it can again
make a public issue called FPO.
It is a supplementary issue made by a company once it is listed and established on the
stock exchange.
 Book Building
 Book building refers to the process of generating and recording investor demand for shares
during an Initial Public Offering (IPO), or FPO during their issuance process, in order to
support efficient price discovery.
 A price range (Price Band) is specified in the offer document with a floor price (Minimum
price).
 Based on the demand and supply of the shares, the final price is fixed.
 The lowest price in the price range is known as the floor price and the highest price in the
price range is known as cap price.
 The price at which the shares are allotted is known as cut off price.
 Usually, the issuer appoints a major investment bank to act as a major securities
underwriter or book-runner.
 Book-runner/Lead manager/Syndicate manager is the underwriter/investment bank who
manage the book building process
 Right Issue:
 It is an issue of rights to a company's existing shareholders that entitles them to buy
additional shares directly from the company in proportion to their existing holdings, within
a fixed time period.
 In a rights issue, the shares are generally offered at a discount to the current market price.
 Rights are often transferable, allowing the holder to sell them on the open market.
Bonus Issue (Gift shares):
 It is an issue of additional shares to shareholders of a company instead of paying dividend.
 These are company's accumulated earnings which are not given out in the form of
dividends, but are converted into free shares.
 Fully paid new shares are issued to shareholders in proportion to their holdings.
 For example, the company may give one bonus share for every five shares held.
Private Placement:
 Issue of securities (by a listed company) to a selected group of investors not exceeding 49
is called Private Placement.
 Investors involved in private placements are usually large banks, mutual funds, insurance companies
and pension funds.
 Private placement is the opposite of a public issue, in which securities are made available for
sale on the open market.
Following categories of issue can also be included in Private placement.
1)Preferential Allotment:
 It is a type of Private placement by unlisted companies.
 Preferential Allotment is the process by which allotment of securities is done on a preferential
basis to a select group of investors such as directors, existing shareholders etc.
2)Qualified Institutions Placement (QIP) :
 It is also part of private placement (by Listed companies).
 It is the issue of securities to Qualified institutional Buyers (QIB) in terms of the
provisions of the Issue of Capital & Disclosure Requirements (ICDR) of SEBI.
3)Employees Stock Option Scheme (ESOS) –
 A stock option scheme granted to specified employees of a company is called Employee
Stock Option Scheme.
 ESOS carry the right, but not the obligation, to buy a certain amount of shares in the
company at a predetermined price.