INDIAN FINANCIAL SYSTEM

CHAPTER 3: FINANCIAL INSTRUMENTS AND SERVICES

INTRODUCTION
Financial instruments are essential tools in financial markets, connecting investors and businesses to
support economic activity. Widely used to raise capital, manage risk, and invest in future growth, they
play a critical role in enabling financial transactions and supporting economic stability. As the financial
landscape evolves, these instruments continue to adapt, meeting diverse investment needs and fostering
innovation in finance.

MEANING
A financial asset is an asset whose value is derived from a contractual claim, such as bank
deposits, bonds, and stocks. Financial assets are usually more liquid than other tangible assets, such as
real estate, and may be traded on financial market.
A financial instrument is a claim, against a person or an institution, for the payment of a sum of
money and/or a periodic payment in the form of interest or dividend, at a specified future date.

IMPORTANCE OF FINANCIAL INSTRUMENTS

Financial instruments are crucial for the functioning and growth of the economy. Here are key reasons
why financial instruments are important:

 Capital Formation: Financial instruments allow companies and governments to raise funds for
expansion, innovation, and infrastructure development, which are essential for economic growth.
 Risk Management: Instruments such as bonds and insurance contracts help investors and
businesses protect against various risks, providing financial stability.

 Liquidity Provision: Many financial instruments, particularly in secondary markets, provide

liquidity, making it easier for investors to buy and sell assets and convert them into cash when
needed.

 Diversification: Different financial instruments help investors spread out risk across their
portfolios, which can improve returns. By investing in various types of assets, investors are
better protected against losses in any single investment.

 Income Generation: Financial instruments like bonds and dividend-paying stocks provide
regular income to investors, supporting savings and wealth-building over time.

 Market Efficiency: They enhance the efficiency of financial markets by reflecting information
about companies, economies, and investor sentiment, leading to fairer asset pricing.

Overall, financial instruments are vital in creating a dynamic and flexible financial system that
supports investment, growth, and economic development.

TYPES OF FINANCIAL INSTRUMENTS

Financial instruments can be broadly classified into money market instruments, which are short-term
debt securities, and capital market instruments, which are long-term investments like stocks and bonds.

MONEY MARKET INSTRUMENTS

1. Treasury Bill:
A Treasury bill (T-bill) is a short-term debt security issued by RBI on behalf of the Central
government to raise funds. T-bills are sold at a discounted price and sold at their face value, the
difference between the purchase price and the face value is the investor’s return. They have
maturities of a few days up to one year, and they are considered one of the safest investments
because they are backed by the government’s credit. There are three types of treasury bills namely:
● 91 Days Treasury Bill
● 182 Days Treasury Bill
● 364 Days Treasury Bill

2. Certificate of deposits:
Certificate of deposits are short-term instruments issued by the commercial bank and other
development financial institution. They are unsecured and negotiable. The maturity period
of certificate varies from 1 day to 270 days.

3. Calls and short notice money:

Call money refers to money given for a very short period. It may be taken for a day or overnight.
Surplus funds of commercial bank and other institution are usually given as call money. Banks are
the borrowers and as well as lender for call funds. Another version of call money is notice money
can be provided for a period up to 14 days.

4. Commercial paper:

Commercial papers are the short-term promissory notes issued by reputed companies with good
credit standing and sufficient tangible assets. Commercial paper can be issued for maturities
between minimum of 7 days and maximum of up to from the data of issued commercial paper are
normally issued by insurance companies, public utilize etc. it is normally issued at a discount are
repaid at face value.

5. Repurchase agreement:
Repurchase agreement is a money market instrument which enables collateral short-term borrowing
and lending through sale purchase operation. Under repo, a holder of securities sells them to
investor with an agreement to re-purchase it at a predetermined date and rate. It is a collateral
lending and the cost of transaction is called as repo rate.

6. Bankers acceptance:
It is the short term instrument issued by a firm that is guaranteed by a commercial bank. In other
word it is a document promising future payment guaranteed by a commercial bank. The party
issuing a bankers acceptance pays a fees to the bank for its guarantee.
7. Commercial bills or bill of exchange:

It is a bill containing an unconditional order. The bills is signed by the drawer directing a certain
sum of money to the drawer directing a certain person (drawer) to pay a certain sum of money to
the bearer of the instrument at a fixed time is future or on demand it is an important document in
commercial transaction, the bill is discounted by commercial bank.

CAPITAL MARKET INSTRUMENTS

1. Equity shares:
Equity shares are also known as ordinary shares or Common Shares. The holders of these shares are
the real owners of the company. Equity shares holders are paid Dividend after paying the Preference
shareholders. They may not receive any return if there are no profits. Equity share capital cannot be
redeemed during the lifetime of a company.

2. Preference Share:
Preference shares, or preferred stock, are a type of equity that pays a fixed dividend and gives
shareholders priority over common shareholders when it comes to getting paid in case of
liquidation. They usually do not have voting rights, making them a safer investment option for
those looking for stable returns.

3. Deferred Shares:
The shares which are issued to the founder or promoters are called deferred or founder share. For
such shares the right to receive profits of a company is deferred that is postponed till all other
shareholders receive dividend. Presently no public co can issue deferred shares.

4. Sweat Equity:
They are equity shares issued by a company to its employees as a reward for their contribution
towards a company’s growth. It is termed as sweat equity because it is earned by hard work of the
employees. The purpose of issue is to ensure more loyalty and participation of the employees.

5. Debentures:
A debenture is a type of debt instrument issued by companies to raise capital. It is not secured by
physical assets or collateral. Debentures promise to pay interest and principal to the debenture
holders. Companies issue debentures to investors, and these investors become creditors of the
company.

6. Bonds:
A bond issued by a company is a debt security that the company uses to raise capital from
investors. When an investor buys a bond, they are lending money to the company, and in return,
the company promises to pay interest and return the principal amount when the bond matures.

FINANCIAL SERVICES

The Indian financial services industry has undergone a metamorphosis since1990. Before its
emergence the commercial banks and other financial institutions dominated the field and they met the
financial needs of the Indian industry. It was only after the economic liberalisation that the financial
service sector gained some prominence. Now this sector has developed into an industry.
 In fact, one of the world’s largest industries today is the financial services industry.

Financial service is an essential segment of financial system. Financial services are the foundation of
a modern economy. The financial service sector is indispensable for the prosperity of a nation.

Meaning of Financial Services

In general, all types of activities which are of financial nature may be regarded as financial services.
In a broad sense, the term financial services means mobilisation and allocation of savings. Thus, it
includes all activities involved in the transformation of savings into investment.
Financial services refer to services provided by the finance industry. The finance industry consists of
a broad range of organisations that deal with the management of money. These organisations include
banks, credit card companies, insurance companies, consumer finance companies, stock brokers,
investment funds and some government sponsored enterprises.

Financial services may be defined as the products and services offered by financial institutions for the
facilitation of various financial transactions and other related activities.

Features of financial services

 Intangibility: Financial services cannot be physically touched or owned; they represent a promise
of value, like insurance or investment returns.

 Customization: They can be tailored to meet the specific needs of individuals or businesses,
allowing for personalized financial planning and investment strategies.\

 Risk and Uncertainty: Financial services involve inherent risks, such as fluctuating investment
values or the uncertainty of future events in insurance.

 Regulation: The industry is heavily regulated to protect consumers and ensure market stability,
with oversight from various regulatory bodies.

 Technology Integration: Many financial services now use technology, such as online banking
and mobile payments, to improve accessibility and efficiency.

Importance of financial services

1. Facilitates Savings and Investments: Financial services encourage individuals and businesses to
save and invest, helping to build wealth over time. This is crucial for achieving personal financial
goals and funding future needs.

2. Risk Management: They provide various insurance products that protect against financial losses
due to unforeseen events, like accidents or natural disasters. This helps individuals and businesses
manage uncertainty and secure their financial future.

3. Economic Growth: Financial services play a vital role in the economy by providing businesses
with the capital they need to grow and expand. This leads to job creation and overall economic
development, benefiting society as a whole.

4. Liquidity: They ensure that individuals and businesses can easily convert their assets into cash
when needed. This liquidity is essential for managing day-to-day expenses and emergencies
without financial strain.
 5. Financial Planning and Advisory: Financial services offer expert advice and planning
assistance, helping clients make informed decisions about their finances. This guidance is
important for navigating complex financial situations and achieving long-term stability.

6. Access to Credit: They provide individuals and businesses with access to loans and credit,
allowing for immediate purchases and investments that might otherwise be out of reach. This
access fosters growth and innovation, driving economic progress.

TYPES OF FINANCIAL SERVICES

Financial services can be broadly classified into:
I. Fund based services
II. Fee based services

I. FUND BASED SERVICES:

Fund-based services are financial services where a bank or financial institution provides money or
access to assets to clients. This can include giving loans, allowing clients to use assets like equipment
through leasing, or investing money in stocks and bonds. The institution uses its own funds for these
services, earning income from interest, fees, or gains. Fund-based services are essential in banking and
finance, as they help businesses and individuals access capital or assets they need to operate or grow.

List of Fund based services:

 Leasing: Leasing is an arrangement where a leasing company (the lessor) allows a customer (the lessee)
to use an asset such as equipment, vehicles, or property, for a specific period in exchange for regular
payments. The leasing company retains ownership of the asset, while the lessee gains the right to use it.
At the end of the lease term, the lessee may have options like renewing the lease, buying the asset, or
returning it to the leasing company. This setup allows the lessee to access and benefit from assets
without the need for a large initial investment.

 Hire Purchase: Hire purchase is an arrangement where a buyer agrees to pay for an asset, such as a
vehicle or equipment, in installments over a set period. The buyer makes an initial down payment at the
start of the agreement, and the remaining balance is paid in regular installments. The service provider
(seller or finance company) retains ownership of the asset until the full amount is paid off. Once the
final payment is made, ownership of the asset transfers to the buyer.

Difference between leasing and Hire Purchase

Aspect Leasing Hire Purchase

Ownership Ownership remains with the lessor Ownership transfers to the buyer only
(leasing company) throughout the after all payments are made.
lease term.
Usage The lessee can use the asset but does The buyer can use the asset and
not own it. eventually owns it after completing
payments.
Initial Payment Generally no large initial payment is Requires an initial down payment at
made, just regular lease installments. the start of the agreement.
 Flexibility at end At the end of the lease term, the lessee The buyer automatically owns the
may return, buy, or renew the lease. asset after completing the payment,
with no return option.
Asset The lessor typically maintains the asset. The buyer is responsible for the
Maintenance maintenance of the asset.

 Insurance services: Insurance services refer to financial products provided by insurance companies that
offer protection against financial loss or risk. In exchange for regular payments, called premiums, an
insurer agrees to compensate the policyholder for certain types of loss, damage, or liability. This service
can cover various areas, such as health, life, property, or vehicle, and helps individuals or businesses
manage risks by providing financial security in times of need.

 Bill Discounting: Bill discounting is a financial service where a business sells its bills receivable to a
bank or financial institution at a discount before the payment due date. This allows the business to
receive immediate cash flow instead of waiting for customers to pay their bills. The bank then collects
the full amount from the customer when the bill is due. Essentially, it helps businesses manage their
cash flow by converting future payments into immediate cash.

 Consumer Credit: Consumer credit refers to the borrowing of money by individuals to purchase goods
and services with the agreement to repay the amount over time, typically with interest. It includes
various types of credit, such as credit cards, personal loans. This allows consumers to make purchases
immediately and pay for them in installments rather than in full upfront.

 Venture Capital: Venture capital is a type of funding provided by investors to startups and small
businesses with high growth potential. In exchange for their investment, venture capitalists typically
receive equity (ownership) in the company. This funding helps businesses develop, expand, and scale,
often in industries like technology, healthcare, or innovation, where the potential for high returns exists
but the risks are also significant.

II. FEE BASED SERVICES:

Fee based services refers to services that are provided for a specific fee. In this context, professionals or
businesses charge clients for their expertise or assistance, such as in consulting, tutoring or assistance or
financial advice. Clients pay based on the services they receive according to their needs.

List of Fund based services:

 Stock Broking: Stock broking is the act of buying and selling stocks (shares) and other securities on
behalf of clients. A stockbroker is a professional or firm that executes these trades on the stock market
for individual or institutional investors. Stockbroking services may also include investment advice,
portfolio management, and market research, helping clients make informed decisions on their
investments. Stock brokers charge fees for their services, typically in the form of brokerage fees or
commissions.

 Debt restructuring: Debt restructuring is the process of modifying the terms of an existing debt to
make it easier for the borrower to manage. This may involve changing the payment schedule, reducing
the interest rate, or even decreasing the principal amount owed. Debt restructuring is typically done to
avoid default and to make repayment more feasible for the borrower, often during financial distress.
Debt restructuring typically involves fees for services, legal advice, and administrative processes.

 Credit rating: Credit rating to an assessment or evaluation that indicates the creditworthiness of an
individual or organisation. It reflects how well they are likely to repay their loans or financial
obligations. Credit rating agencies such as CRISIL, ICRA, CARE prepare these ratings, which prepare
 these ratings, which help financial institutions in making decisions about lending or issuing credit cards.
A higher credit rating means the borrower is considered reliable, while a lower credit rating indicates a
higher risk.

 Merchant Banking: Merchant banking refers to specialized financial services provided by merchant
banks or financial institutions that primarily cater to companies and large institutions. These services
include underwriting, loan services, fundraising through issuing securities, financial advisory, mergers
and acquisitions, and private equity investments. Merchant Bankers charge fee for the service provided.

 Issue Management: Issue management services provided by financial institutions or investment banks
assist companies in issuing securities, such as stocks or bonds, to raise capital. These services support
companies throughout the entire process, from planning and regulatory compliance to the actual
issuance and post-issuance activities. These services also help companies navigate market conditions,
attract investors, and ensure the securities are priced and structured in a way that maximizes their appeal
and raises the necessary capital efficiently.

 Underwriting of shares: Underwriting services refer to the process by which financial institutions, such
as banks or finance companies, assess and assume the risk of issuing securities, loans. In the context of
securities, underwriting involves evaluating the risk of a company's stock or bond offering, setting the
price, and agreeing to buy and sell the securities to investors. Essentially, underwriters take on the risk
of financial products in exchange for a fee or commission.

DIFFERENCE BETWEEN FUND BASED AND FEE BASED SERVICES

Feature Fund-Based Services Fee-Based Services

Nature of Service Provides direct funds or assets to No direct funds or assets; only
clients, such as loans, investments, advisory, facilitation, or
or leasing. transaction-based services.
Revenue Source Generates income from interest and Generates income through fees for
returns on investments or assets services
Risk Exposure Higher risk due to potential loan Lower risk, as it does not involve
defaults and market fluctuations capital deployment
Income Stability Variable, affected by economic More stable, as fees are typically
conditions and interest rates fixed or commission-based
Example Leasing, Hire Purchase, Consumer Stock Broking, Credit rating, Issue
Credit. management.

SPECIALISED FINANCIAL SERVICES

Specialized financial services refer to specific services offered by companies established specifically to
provide those services. These firms have expertise in particular financial areas, and they focus on
meeting unique needs or handling complex financial transactions that regular banks might not cover.
Examples include companies dedicated to leasing, factoring, forfeiting, credit rating, venture capital.
Following are some of the specialised financial services:

 Leasing:
Leasing is an arrangement where a leasing company (the lessor) allows a customer (the lessee) to use
an asset such as equipment, vehicles, or property, for a specific period in exchange for regular
payments. The leasing company retains ownership of the asset, while the lessee gains the right to use
it. At the end of the lease term, the lessee may have options like renewing the lease, buying the asset,
 or returning it to the leasing company. This setup allows the lessee to access and benefit from assets
without the need for a large initial investment.

Features of leasing:
 Ownership Retention: The lessor retains ownership of the asset, while the lessee only has the
right to use it for a specified period.
 Periodic Payments: The lessee makes regular payments to the lessor throughout the lease term.
 Fixed Lease Term: The lease is for a specific duration, after which the lessee may return or
purchase the asset.
 Maintenance Responsibility: Maintenance responsibilities are typically defined in the lease
agreement, with either the lessor or lessee being responsible.
 Flexibility: At the end of the lease, the lessee may have options to buy the asset, renew the lease,
or return it.

In conclusion, leasing provides businesses with flexible access to assets without full ownership, along
with defined responsibilities and end-of-term options that meet various operational needs.

Types of Leases:

 Operating Lease: A short-term lease where the lessee rents an asset for a period shorter than its
useful life. The lessor retains ownership, and the lessee typically has the option to return the asset
at the end of the lease term.

 Finance Lease (Capital Lease): A long-term lease where the lessee assumes most of the risks and
rewards of ownership, often with an option to purchase the asset at the end of the lease term. A
finance lease is usually structured so that the lease term covers a significant portion of the asset's
useful life, making it similar to a loan for purchasing the asset.

Feature Operating Lease Finance Lease

Ownership Lessor retains ownership of the Lessee assumes most risks and
asset. rewards of ownership.
Lease Term Short-term Long-term
Maintenance & Lessor is usually responsible for Lessee typically assumes
Risk maintenance and risks. maintenance and ownership risks.

 Sale and Leaseback: A financial arrangement where a company sells an asset to a leasing
company and then immediately leases it back, allowing the company to continue using the asset
while freeing up capital. This arrangement provides the company with immediate cash flow from
the sale of the asset, while still allowing it to retain operational use of the asset without the
burden of ownership.

 Leveraged lease: It is a lease where the lessor borrows a significant portion of the cost of the
asset from a lender and uses the lease payments from the lessee to repay the loan, while
transferring the risk of asset usage to the lessee. This type of lease allows the lessor to acquire
the asset with minimal upfront capital and share the financial risk with the lessee.

 Factoring:
 Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to
a third party, known as a factor, at a discount. This allows the business to receive immediate
cash instead of waiting for customers to pay. The factor then collects the payments directly
from the customers. Factoring helps businesses improve cash flow and manage working capital
more effectively.

Features of Factoring:

 Sale of Receivables: A business sells its accounts receivable (invoices) to a factoring

company at a discount, receiving immediate cash.
 Advance Payment: The factor typically advances a percentage (usually 70-90%) of the
invoice value upfront, with the remainder paid once the customer settles the debt.
 Collection Responsibility: The factor assumes responsibility for collecting payments
from the business’s customers, handling the accounts receivable management.
 Risk Sharing: Factoring can be with or without recourse. In with recourse factoring,
the business is liable to buy back unpaid invoices, while in without recourse
factoring, the factor assumes the risk of non-payment.
 Improved Cash Flow: Factoring provides businesses with quick access to working
capital, improving cash flow and liquidity by reducing the time spent waiting for
payments.

These features make factoring a useful tool for businesses needing immediate cash or looking
to offload their credit management responsibilities.

 Forfaiting:
Forfaiting is a financial arrangement where an exporter sells its medium- to long-term
receivables (such as promissory notes or bills of exchange) to a forfeiter at a discount, in
exchange for immediate cash. In this process, the forfeiter takes on the risk of non-payment,
freeing the exporter from credit risk and allowing them to improve cash flow. Forfaiting is
commonly used in international trade, as it provides exporters with quick access to funds while
transferring the risk of collection to the forfeiter.

Features of Forfaiting:

 Sale of Receivables: The exporter sells its medium- to long-term receivables to a

forfaiter in exchange for immediate cash.
 Non-Recourse Financing: Forfaiting is generally non-recourse, meaning the forfaiter
assumes the full risk of non-payment, and the exporter has no liability if the importer
defaults.
 Fixed Interest Rate: Forfaiting typically involves a fixed discount rate, so the exporter
knows the exact amount they will receive, regardless of interest rate fluctuations.
 Large Transactions: Forfaiting is usually used for larger transactions in international
trade, often with payment terms ranging from six months to seven years.
 Transfer of Collection Responsibility: The forfaiter takes on responsibility for
collecting payments from the importer, freeing the exporter from managing the debt.
 Forfaiting is an attractive option for exporters as it improves cash flow, reduces credit risk, and
simplifies collection on international sales.

 Credit rating:
Credit rating to an assessment or evaluation that indicates the creditworthiness of an individual or
organisation. It reflects how well they are likely to repay their loans or financial obligations.
Credit rating agencies such as CRISIL, ICRA, CARE prepare these ratings, which prepare these
ratings, which help financial institutions in making decisions about lending or issuing credit cards.
A higher credit rating means the borrower is considered reliable, while a lower credit rating
indicates a higher risk.

Features of credit rating:

 Assessment of Creditworthiness: Credit ratings evaluate an individual’s, company's, or

government’s ability to repay debts on time, providing insight into their financial health.
 Rating Scale: Ratings are represented on a standardized scale (e.g., AAA, BBB, etc.) to
indicate the level of risk, with higher ratings suggesting lower risk and vice versa.
 Objective and Independent: Credit rating agencies conduct an unbiased, independent
evaluation based on financial data, industry trends, and economic factors.
 Risk Indicator for Investors: Credit ratings serve as a risk indicator, helping investors
make informed decisions about lending or investing in rated entities or securities.
 Regular Monitoring and Updates: Credit ratings are periodically reviewed and adjusted
based on changes in the entity’s financial situation or market conditions to maintain
accuracy.

Credit ratings play a critical role in financial markets by fostering transparency and helping
lenders and investors assess the risk associated with different borrowers or investments.

 Venture Capital:
Venture capital is a type of funding provided by investors to startups and small businesses with
high growth potential. In exchange for their investment, venture capitalists typically receive
equity (ownership) in the company. This funding helps businesses develop, expand, and scale,
often in industries like technology, healthcare, or innovation, where the potential for high returns
exists but the risks are also significant.

Features of Venture Capital:

 Equity Investment: Venture capitalists (VCs) provide funding in exchange for equity,
gaining ownership stakes in high-growth potential startups.
 High Risk, High Return: Venture capital focuses on early-stage companies, accepting
high risks in exchange for potentially high returns.
 Active Involvement: VCs often take an active role in guiding the company, offering
expertise, mentorship, and strategic advice.
 Long-Term Investment Horizon: Venture capital investments are typically held for
several years until the startup matures or achieves a liquidity event (e.g., IPO or
acquisition).
  Exit Strategy: VCs aim for a profitable exit, usually through a public offering or
acquisition, to realize returns on their investments.

Venture capital plays a vital role in supporting innovative startups with both capital and
industry expertise to drive growth.

In conclusion, financial services play a crucial role in supporting economic growth by providing
essential services like capital access, risk management, and investment guidance, enabling
individuals, businesses, and governments to achieve financial stability, drive innovation, and foster
sustainable development.