Financial markets and instruments

In short

A financial market is any arrangement — an exchange, a dealer network or an electronic platform — where surplus units (savers) transfer funds to deficit units (governments, companies, households) in exchange for financial instruments. Instruments are the contracts traded there: short-term debt (T-bills, CPs, CDs), long-term debt (G-secs, debentures, bonds), ownership claims (equity and preference shares) and pooled or hybrid claims (REITs, InvITs, convertibles). The markets perform six functions — mobilising savings, price discovery, liquidity, risk transfer, lowering transaction cost and signalling information — under SEBI (securities), RBI (money market, government securities, foreign exchange) and IFSCA (GIFT City). In India this is the single most examined area in B.Com finance papers and the core of banking, broking, treasury, investment-banking and research interviews (SBI/ICICI/HDFC, NSE, BSE, NSDL, CDSL, CRISIL, ICRA, Zerodha, Kotak Securities, Motilal Oswal, Edelweiss).

Explained

Structure and classification of financial markets

• Money market vs capital market: money market deals in debt of original maturity up to one year, is wholesale, largely OTC and RBI-regulated; capital market deals in instruments above one year (and in equity, which has no maturity) and is SEBI-regulated.
• Primary vs secondary market: the primary market creates new securities and the money reaches the issuer; the secondary market only transfers existing securities between investors — the issuer receives nothing but gains liquidity and a visible price.
• Debt vs equity vs hybrid: debt gives a contractual claim (fixed return, prior charge, no ownership); equity gives a residual claim (variable return, voting rights, last in liquidation); hybrids blend both.
• Cash (spot) vs derivatives market: cash markets settle the asset itself; derivative markets trade contracts whose value is derived from it.
• Exchange-traded vs OTC: exchanges are order-driven, anonymous, standardised and centrally cleared (novation by a clearing corporation); OTC trades are bilaterally negotiated, customised and carry counterparty risk.
• Organised vs unorganised: banks, NBFCs, exchanges and mutual funds form the organised sector; indigenous bankers, moneylenders and chit funds the unorganised one.
• Legal framework: SCRA 1956 (recognition of exchanges, definition of "securities"), SEBI Act 1992, Depositories Act 1996, Companies Act 2013 (Ch. III — prospectus and allotment), RBI Act 1934, Government Securities Act 2006, FEMA 1999; SEBI regulations — ICDR 2018 (issues), LODR 2015 (listing obligations), PIT 2015 (insider trading), SAST 2011 (takeovers).

Money market instruments

• Call / notice / term money: uncollateralised interbank borrowing — call is overnight, notice 2–14 days, term 15 days to 1 year; the weighted average call rate (WACR) is RBI's operating target and stays within the LAF corridor.
• Treasury Bills: zero-coupon sovereign promissory notes of 91, 182 and 364 days, issued at a discount to ₹100 face value by RBI auction (uniform or multiple price), minimum ₹10,000 and multiples; no default risk, eligible for SLR. Cash Management Bills are the same thing with maturity under 91 days for temporary cash mismatches.
• Commercial Paper (CP): unsecured promissory note of highly rated corporates, NBFCs and all-India financial institutions; 7 days to 1 year, minimum ₹5 lakh and multiples, issued at a discount, must carry a minimum credit rating (A3 or better) and be held in demat form.
• Certificate of Deposit (CD): negotiable term deposit receipt issued by banks (7 days to 1 year) and select FIs (1–3 years), minimum ₹5 lakh; transferable, unlike an ordinary FD, but cannot be bought back before maturity except as permitted.
• Repo and reverse repo: sale of securities with an agreement to buy back at a fixed price — economically a collateralised loan; the difference is the repo interest. TREPS (triparty repo on CCIL, which replaced CBLO in 2018) is now the largest overnight money-market segment. RBI's LAF repo/SDF/MSF set the floor and ceiling for short-term rates (policy repo rate was 5.50% in mid-2025 — always quote the current rate).
• Commercial bills and bankers' acceptances: trade bills drawn on a buyer, accepted and then discounted or rediscounted with a bank — the oldest but thinnest Indian segment.
• Features common to the segment: large denominations, high safety, high liquidity, no formal exchange — dealt over NDS-Call, F-TRAC and broker screens.

Capital market instruments

• Equity shares: permanent capital, dividends at the board's discretion, residual claim, one-vote-per-share; variants include DVR (differential voting rights), sweat equity, ESOP shares and bonus shares (free, capitalised from reserves). A split or bonus changes share count, not business value; a buy-back returns cash, so it reduces share count and net worth together.
• Preference shares: fixed dividend, prior claim over equity, normally non-voting (voting revives if dividend is unpaid for two years); cumulative/non-cumulative, redeemable (maximum 20 years under the Companies Act; 30 for infrastructure), convertible/non-convertible, participating.
• Debentures and corporate bonds: secured/unsecured, convertible (FCD/PCD)/non-convertible (NCD), redeemable, registered/bearer; listed NCDs need a debenture trustee, a Debenture Redemption Reserve where required, and a credit rating. AT1 and Tier-2 bonds of banks are perpetual/long-dated and loss-absorbing — written down in resolution (as in the Yes Bank episode).
• Government securities (G-secs): dated central securities (up to 40 years), State Development Loans, floating-rate bonds, inflation-indexed bonds, STRIPS (cash flows stripped into zero-coupon pieces) and Sovereign Gold Bonds (no fresh tranches have been issued since February 2024). Traded on NDS-OM, cleared by CCIL, held in SGL/CSGL, and open to individuals through RBI Retail Direct.
• Other instruments: ADRs/GDRs and FCCBs for overseas fund-raising, masala bonds (rupee-denominated, offshore), zero-coupon and deep-discount bonds, securitised debt / pass-through certificates, covered bonds, municipal bonds (Pune, Indore, Ahmedabad issues), REITs (Embassy, Mindspace, Brookfield, Nexus) and InvITs (IRB, IndiGrid, PowerGrid), and warrants.
• Risk ranking (low to high): T-bills and G-secs → AAA PSU bonds → AA/A corporate NCDs → preference shares → equity → unrated/unlisted paper.

Primary market: how an issue is made

1. Decide route: public issue (IPO/FPO), rights issue to existing shareholders, private placement, preferential allotment, QIP (listed companies, to qualified institutional buyers), OFS (promoter sells on the exchange), bonus (no cash raised).
2. Appoint intermediaries: merchant banker (lead manager), registrar (RTA), underwriters, bankers, legal counsel; for debt, a trustee and rating agency.
3. Eligibility and disclosure: ICDR 2018 lays down either a profitability/net-tangible-asset route (Reg 6(1)) or the book-built-only route for companies without that track record (Reg 6(2)); a DRHP goes to SEBI for observations, then RHP and prospectus with the RoC.
4. Pricing: book building (price band with cap no more than 20% above the floor; investors bid; cut-off price discovered) or fixed price. Anchor investors may take up to 60% of the QIB portion.
5. Allocation (book-built, Reg 6(1)): QIB ≤ 50%, Non-institutional ≥ 15%, Retail ≥ 35%; under Reg 6(2) it is QIB ≥ 75%, NII 15%, RII 10%. Retail oversubscription is allotted by lottery of minimum lots.
6. Application and listing: ASBA is compulsory — money is only blocked in the bank account; retail applications up to ₹5 lakh use the UPI mandate. Listing and trading must begin within T+3 days of issue closure (shortened from T+6 in 2023). Minimum public shareholding after listing is 25%.
7. Post-issue: basis of allotment, refunds/unblocking, credit of shares to demat, lock-in of promoter contribution (20% of post-issue capital), and continuous disclosure under LODR.
8. SME platforms (BSE SME, NSE Emerge) allow smaller issues with lighter norms and a mandatory market maker.

Secondary market: trading, clearing and settlement

• Exchanges: NSE and BSE are the national exchanges (plus MSEI; MCX and NCDEX for commodities). Trading is on an electronic, order-driven limit order book with price-time priority; there are no floor jobbers.
• Order types and controls: market, limit, stop-loss, IOC; circuit filters (2/5/10/20%) on scrips, index-wide circuit breakers at 10/15/20%, and ASM/GSM surveillance frameworks.
• Clearing and settlement: the clearing corporation (NSE Clearing, ICCL) becomes the central counterparty; securities settle in T+1 rolling settlement (fully implemented January 2023), with an optional T+0 same-day cycle being extended scrip by scrip since 2024. Funds and securities move through clearing banks and depositories; shortfalls go to auction.
• Depositories: NSDL and CDSL hold securities in dematerialised form through depository participants; all listed trading is compulsorily demat. ISIN identifies each security.
• Participants: retail investors, HNIs, domestic institutions (mutual funds, insurers, EPFO/NPS), FPIs (registered with SEBI, routed under FEMA), AIFs, proprietary traders, market makers, custodians and credit rating agencies (CRISIL, ICRA, CARE, India Ratings, Acuité — scale AAA down to D).
• Indices: Sensex (30 stocks, BSE) and Nifty 50 (NSE) are free-float market-capitalisation-weighted; free float excludes promoter and strategic holdings. SEBI classifies the top 100 companies by full market cap as large-cap, 101–250 mid-cap, 251 onwards small-cap.
• Market efficiency: the efficient market hypothesis — weak form (past prices already in price, so technical analysis cannot earn abnormal returns), semi-strong (all public information, so fundamental analysis on public data cannot), strong (even private information). Insider trading and front-running are therefore prohibited under SEBI PIT 2015 and PFUTP 2003.

Bond mathematics, yields and risk

• Inverse relation: a bond's price moves opposite to market yield, because the coupon is fixed; price = present value of coupons + redemption value.
• Par, premium, discount: YTM = coupon rate → price = face value; YTM > coupon → discount; YTM < coupon → premium.
• Yield measures: nominal (coupon) yield, current yield (coupon/price, ignores capital gain and time), YTM (IRR of holding to maturity, assumes reinvestment at YTM), YTC for callable bonds, holding-period return for an actual sale.
• Clean vs dirty price: dirty (settlement) price = clean price + accrued interest since the last coupon.
• Duration: Macaulay duration is the PV-weighted average time to cash flows (in years); modified duration measures percentage price change per 1% change in yield; convexity corrects the curvature. Longer maturity and lower coupon mean higher duration and more interest-rate risk.
• Yield curve: plot of yield against maturity — normal (upward), flat or inverted; explained by expectations, liquidity-premium and market-segmentation theories; the G-sec curve is the benchmark for pricing all rupee debt (corporate yield = G-sec yield + credit spread).
• Risks: interest-rate (price) risk, reinvestment risk (opposite direction to price risk — immunisation balances the two), credit/default risk, liquidity risk, inflation risk, call and currency risk.

Key points

• Financial market - mechanism transferring funds from savers to users through tradable instruments; functions are savings mobilisation, price discovery, liquidity, risk transfer, lower transaction cost, information signalling.
• Money market - debt up to 1 year, wholesale, OTC, RBI-regulated: call money, T-bills, CP, CD, repo/TREPS, commercial bills.
• Capital market - over 1 year plus equity, SEBI-regulated: shares, debentures, bonds, G-secs, REITs/InvITs.
• Primary market - issuer receives funds (IPO, FPO, rights, QIP, private placement); secondary market - only transfers ownership and provides liquidity and price.
• T-bill - zero-coupon sovereign paper of 91/182/364 days sold at discount on ₹100 face value; no default risk, SLR-eligible.
• CP vs CD - CP is issued by corporates/NBFCs (unsecured, rating-gated); CD by banks; both minimum ₹5 lakh, demat, discounted.
• Repo - collateralised borrowing dressed as sale-and-repurchase; repo interest = difference in the two legs; TREPS is the main overnight market.
• Book building - price discovered inside a band whose cap is ≤ 20% above the floor; anchor investors take up to 60% of the QIB quota.
• ASBA/UPI - application money is blocked, not debited; mandatory for public issues, with UPI mandate for retail up to ₹5 lakh.
• Settlement - equities settle T+1 (since January 2023), with optional T+0 being phased in; the clearing corporation is the central counterparty.
• Depository - NSDL/CDSL hold demat securities through DPs under the Depositories Act 1996; ISIN identifies each security.
• Free-float index - Sensex and Nifty weight each stock by market cap of shares actually available for trading, scaled by a base divisor.
• Bond price-yield rule - price falls when yield rises; premium when YTM < coupon, discount when YTM > coupon, par when equal.
• Current yield vs YTM - current yield uses only the coupon and price; YTM is the IRR including capital gain or loss and timing.
• Duration - PV-weighted average life; modified duration gives the approximate % price fall for a 1% yield rise; higher for low-coupon, long-maturity bonds.
• Credit spread - corporate yield minus G-sec yield of the same maturity; widens with lower rating and weaker liquidity.
• EMH - weak, semi-strong and strong forms; the basis for banning insider trading (SEBI PIT Regulations 2015).
• Key statutes - SCRA 1956, SEBI Act 1992, Depositories Act 1996, Companies Act 2013, Government Securities Act 2006; regulators SEBI, RBI, IRDAI, PFRDA, IFSCA.

Formulas and examples

Example 1 — 91-day T-bill yield. A 91-day T-bill of ₹100 face value is bought at auction for ₹98.35.

• Discount = 100 − 98.35 = ₹1.65.
• Yield = (1.65 / 98.35) × (365/91) × 100 = 0.016777 × 4.01099 × 100 = 6.73% p.a.
• Reverse check: P = 100 / (1 + 0.0673 × 91/365) = 100 / 1.016779 = ₹98.35. ✔

Example 2 — bond price, current yield and YTM. A ₹1,000 face value bond pays an 8% annual coupon, redeemable at par in 3 years; the market yield for similar risk is 9%.

• Coupon C = ₹80. Discount factors at 9%: 0.91743, 0.84168, 0.77218 (annuity factor = 2.53129).
• Price = 80 × 2.53129 + 1,000 × 0.77218 = 202.50 + 772.18 = ₹974.69 (a discount, since YTM > coupon).
• Current yield = 80 / 974.69 × 100 = 8.21%.
• Approximate YTM = [80 + (1,000 − 974.69)/3] / [(1,000 + 974.69)/2] = (80 + 8.44) / 987.35 = 8.96%, close to the true 9%.

Example 3 — duration and interest-rate risk of the same bond.

• PV of cash flows: year 1 = 80/1.09 = 73.39; year 2 = 80/1.1881 = 67.34; year 3 = 1,080/1.29503 = 833.96; total = 974.69. ✔
• Macaulay D = (1×73.39 + 2×67.34 + 3×833.96)/974.69 = (73.39 + 134.67 + 2,501.87)/974.69 = 2,709.93/974.69 = 2.78 years.
• Modified duration = 2.78/1.09 = 2.55. If yields rise 50 bp, price falls ≈ 2.55 × 0.005 = 1.28%, i.e. to about ₹962.3.

Example 4 — cost of commercial paper. A company issues 91-day CP of ₹5,00,00,000 face value and receives ₹4,90,00,000.

• Discount = ₹10,00,000. Yield to investor = (10,00,000/4,90,00,000) × (365/91) × 100 = 0.020408 × 4.01099 × 100 = 8.19% p.a.
• If issue expenses (rating, IPA, stamp) are ₹1,00,000, net proceeds = ₹4,89,00,000 and effective cost = (11,00,000/4,89,00,000) × 4.01099 × 100 = 9.02% p.a.

Example 5 — free-float index. Base free-float market cap = ₹2,500 crore, base index = 100. Current data:

• Index = (7,500 / 2,500) × 100 = 300. Weight of B in the index = 3,000/7,500 = 40%, although by full market cap A and C are larger — free float, not size, drives index weight.

Example 6 — holding-period return. Shares bought at ₹250, dividend of ₹6 received, sold at ₹284 after 10 months.

• HPR = (284 − 250 + 6)/250 × 100 = 40/250 × 100 = 16% for 10 months.
• Annualised = (1.16)^12/10 − 1 = 19.5%; simple scaling (16% × 12/10 = 19.2%) is slightly lower because it ignores compounding — always state which convention is used.

Where it is used

• Bank and NBFC treasuries: managing SLR portfolios of G-secs and T-bills, CD issuance, daily LAF/TREPS borrowing and lending, duration and AFS/HTM classification.
• Investment banking and merchant banking: DRHP drafting, due diligence, book building and anchor allocation for IPOs on NSE/BSE and SME platforms; QIPs and NCD private placements on the EBP platform.
• Broking, depository and RTA operations: Zerodha, Angel One, Kotak Securities (order management, margin, T+1 settlement), NSDL/CDSL and KFintech/Link Intime (demat, corporate actions, IPO allotment).
• Credit rating and research: CRISIL, ICRA, CARE, India Ratings assign CP/NCD ratings; equity research and fixed-income desks publish yield-curve and spread views.
• Corporate finance departments: choosing between CP, bank working capital and NCDs by comparing effective cost; investing surpluses in T-bills and liquid instruments.
• Regulatory, compliance and audit roles: SEBI LODR disclosures, insider-trading codes and trading windows, FPI custody reporting, and treasury audit in banks and insurers.

Interview questions

• Q: What is the difference between the primary and the secondary market? A: In the primary market new securities are created and the money goes to the issuer; the secondary market only transfers existing securities between investors, giving them liquidity and a market price.
• Q: Why does a bond's price fall when interest rates rise? A: The coupon is fixed, so when market yields rise the bond's cash flows are discounted at a higher rate and its present value — the price — falls.
• Q: A bond trades at a premium. What does that tell you about its YTM? A: Its YTM is below its coupon rate, because investors are paying more than face value to receive an above-market coupon.
• Q: Difference between a certificate of deposit and a fixed deposit? A: A CD is a negotiable, transferable money-market instrument in demat form with a minimum of ₹5 lakh and no premature withdrawal; an FD is a non-transferable bank contract that can usually be broken with a penalty.
• Q: What is repo and how does it differ from an outright sale? A: Repo is a sale of securities with a committed repurchase at a higher price on a fixed date — economically a secured loan; ownership returns to the seller, so it is accounted for as borrowing, not as a sale.
• Q: Why do Sensex and Nifty use free-float weighting? A: Only shares actually available for trading affect price discovery; weighting by free float stops closely held promoter companies from dominating the index.
• Q: What does ASBA achieve for an IPO investor? A: The application amount is merely blocked in the bank account and continues to earn interest; it is debited only to the extent of allotment, so no refund cycle is needed.
• Q: What is the difference between current yield and YTM? A: Current yield is coupon divided by price and ignores maturity; YTM is the internal rate of return including the capital gain or loss to redemption and the timing of cash flows.
• Q: Which bond is more sensitive to interest rates — a 10-year 5% coupon bond or a 10-year 9% coupon bond? A: The 5% coupon bond, because more of its value sits in the distant redemption payment, giving it a longer duration.
• Q: What is the settlement cycle for Indian equities today? A: T+1 rolling settlement for all stocks since January 2023, with an optional T+0 same-day cycle being extended scrip by scrip — the T+0 coverage is expanding, so quote the current scope.
• Q: How is a corporate bond's yield determined? A: It is the G-sec yield of matching maturity plus a credit spread reflecting rating, liquidity, security and tenor.
• Q: If markets are semi-strong efficient, what does that mean for an equity analyst? A: Analysing published information cannot consistently generate abnormal returns; value can only come from superior interpretation or faster processing, not from public facts alone.

Common mistakes

• Treating the secondary market as a source of funds for the company — it is not; only the primary market brings money to the issuer.
• Computing a T-bill or CP yield on face value instead of price, or using 360 days where Indian convention is 365.
• Confusing current yield with YTM, or quoting YTM for an instrument that will be sold before maturity (that is a holding-period return).
• Forgetting that the last bond cash flow includes the redemption value, so year n receives coupon + face value.
• Mixing up Macaulay duration (years) and modified duration (% per 1% yield change), and ignoring the minus sign in the price-change formula.
• Writing that CDs are issued by companies or CPs by banks, or quoting superseded facts as current — CBLO (replaced 2018), T+2 settlement (ended January 2023), fresh SGB tranches (none since February 2024).
• Describing free float as the total number of shares, which inflates index weights; it excludes promoter and strategic holdings.

Related topics

Sources of finance: equity, debt and hybrids · Derivatives: futures and options basics · Banking operations and the RBI · Mutual funds and personal investing · Time value of money · Mergers, acquisitions and valuation basics