Financial Markets, Instruments & Derivatives
This chapter covers the instruments that fill the money and capital markets mapped in this subject's first chapter, and the derivative contracts built on top of them. F&M rewards knowing precisely what each instrument does and who typically uses it, not just its name.
1. Government securities — the risk-free anchor
Government securities (G-secs) are debt instruments issued by the central or state government to fund the fiscal deficit, and because sovereign default risk is treated as negligible for a country borrowing in its own currency, G-sec yields serve as the risk-free benchmark against which every other domestic debt instrument is priced.
Treasury bills (T-bills) are short-term G-secs (91-day, 182-day, and 364-day maturities), issued at a discount to face value rather than carrying a coupon — the investor's return comes entirely from the difference between the discounted purchase price and the face value received at maturity, not from periodic interest payments.
Dated government securities carry longer maturities (from just over a year to 40 years) and pay a fixed or floating coupon, and the yield on the 10-year benchmark G-sec is the figure most commonly quoted in financial media as "the bond market's" reading of the economy's interest-rate and inflation outlook.
2. Money-market instruments beyond G-secs
Commercial Paper (CP) is an unsecured, short-term promissory note issued by highly-rated corporates to raise working-capital funds directly from the market, typically at a lower cost than a bank loan — its availability is effectively restricted to corporates with a strong enough credit rating that investors will accept an unsecured instrument.
Certificates of Deposit (CDs) are the bank-issued mirror of commercial paper: a negotiable, unsecured, short-term deposit instrument issued by a bank at a discount, allowing the bank to raise bulk short-term funds — the key structural similarity between CP and CDs is that both are discount instruments with no periodic coupon, unlike a dated bond.
The call money market is the shortest-tenure market of all — overnight to a few days — where banks lend to and borrow from each other to manage day-to-day liquidity mismatches, and the interest rate prevailing in this market (the call rate) is one of RBI's closest-watched indicators of short-term liquidity conditions in the banking system.
3. Equity and debt in the capital market
Equity shares represent ownership in a company and carry a residual claim on profits (dividends are discretionary, not guaranteed) and on assets in liquidation (paid only after all creditors, including debenture-holders, are settled).
Debentures and bonds represent a company's or government's debt, carrying a fixed or floating coupon and a defined maturity — debenture-holders rank above equity shareholders in a liquidation, which is why debt is generally considered lower-risk than equity for the same issuer.
4. Derivatives — risk transfer, not risk creation
A derivative is a contract whose value is derived from an underlying asset (a stock, index, currency, commodity, or interest rate), and the three principal types are futures, options and swaps.
| Instrument | Structure | Obligation |
|---|---|---|
| Futures | Standardised exchange-traded contract to buy/sell an asset at a set price on a future date | Both parties are obligated to transact |
| Options | Contract giving the buyer the RIGHT (not obligation) to buy (call) or sell (put) at a set price | Buyer has a right, not an obligation; seller (writer) is obligated if the buyer exercises |
| Swaps | Agreement to exchange cash flows (e.g., fixed-rate for floating-rate interest) over time | Both parties exchange agreed cash flows |
Hedging and speculation use the identical instruments for opposite purposes, and F&M scenario questions specifically test whether a candidate can tell them apart. Hedging uses a derivative to REDUCE existing risk exposure a party already holds — an exporter buying a currency forward to lock in a future exchange rate on real receivables.
Speculation uses the same instrument to take on NEW risk in pursuit of profit from a price view — a trader buying futures purely betting on a price rise, with no underlying exposure to offset.
Worked Examples
Example 1. Why do T-bills carry no coupon payment, and where does the investor's return come from?
T-bills are issued at a discount to face value; the investor's return is the difference between the discounted purchase price and the face value received at maturity, with no periodic coupon in between.
Example 2. What is the structural similarity between Commercial Paper and Certificates of Deposit?
Both are unsecured, short-term, discount instruments (no periodic coupon) — CP is issued by highly-rated corporates, CDs by banks.
Example 3. An exporter expects to receive US dollars in three months and buys a currency forward to lock in today's exchange rate for that future receipt. Is this hedging or speculation?
Hedging — the exporter already has a real, existing currency exposure (the future dollar receivable) and is using the derivative to reduce the risk of adverse exchange-rate movement, not to create a new speculative position.
Example 4. A trader with no underlying commodity exposure buys crude oil futures purely betting prices will rise. Is this hedging or speculation?
Speculation — the trader has no existing exposure to offset; the position is taken purely to profit from an anticipated price movement.
Example 5. In an options contract, does the buyer of a call option have an obligation to exercise it?
No — the buyer holds the RIGHT, not the obligation, to buy the underlying at the set price; only the option writer (seller) is obligated to perform if the buyer chooses to exercise.
Example 6. In a liquidation, who is paid first — a debenture-holder or an equity shareholder?
The debenture-holder — debt-holders (including debenture-holders) rank above equity shareholders, who hold only a residual claim paid after all creditors are settled.
Example 7. What does the call money market's interest rate (the "call rate") indicate to RBI?
Short-term liquidity conditions in the banking system — it reflects how easily or expensively banks can borrow overnight funds from each other, making it one of RBI's closest-watched short-term liquidity indicators.
Summary
Government securities anchor the domestic yield curve as the risk-free benchmark, splitting into short-term discount T-bills and longer-maturity, coupon-bearing dated securities, with the 10-year G-sec yield serving as the most commonly cited market read on interest-rate and inflation expectations.
Commercial Paper and Certificates of Deposit are the corporate and bank equivalents of short-term discount instruments, while the call money market handles the shortest-tenure interbank liquidity management, its rate closely watched by RBI. Equity carries a residual, discretionary claim; debentures/bonds carry a fixed, senior claim — debt ranks above equity in liquidation.
Derivatives (futures, options, swaps) exist primarily to transfer risk, and the same instrument can be used for hedging (reducing an existing exposure) or speculation (taking on new risk for profit) — F&M questions specifically test whether a candidate can classify a given scenario correctly between the two.
