Financial products are of the following types. Depending on the risk appetite, objectives and the type of investment analysis an investor is comfortable with, he or she can choose which type of instruments to invest in.
1. Fixed Income Products
Fixed Income products are debt type products. These products assure a near fixed type return to the investor. As an example, if you put money into a bank’s fixed deposit and bank assures you an interest rate of 5% per annum, then this is an example of a Fixed Income product. The holders of these fixed income type securities are also usually senior in the entitlement of cash flows of the issuer/company. This means that in case the issuer/company runs into any financial trouble, its cash balances will be first used to pay those who own the Fixed Income instruments of the company. Because of this senior entitlement, these products are considered to be safer than equity type products as equity type products have a more junior entitlement to the issuer/company’s cash balances. Because of this lower risk, the returns from these instruments are generally lower than the returns generated by equity instruments. Banks typically provide this type of Fixed Income capital to individuals and companies in an economy. There are some other specialist companies too that provide this type of capital in some cases.
Fixed income products include well known products such as Fixed Deposits, Home loans, car loans to more complex versions such as Non-Convertible debentures and corporate loans.
2. Listed Equity products
An ‘equity’ product provides entitlement to a profit share in a certain business or asset. Example, a Common Stock in a company will provide share in the profits of a company. The concept of equity stretches to all assets. As an example, many people own homes wherein the mortgage has already been paid out completely – this basically means that the individual owns 100% equity of house. Generally, when people say ‘equity’ colloquially, they refer to listed equities of companies.
What do we mean by listed equities? – As companies grow, they need equity capital to fund the expansion since too much fixed income capital requires constant servicing of interest commitments. When companies are small, they raise equity capital from Venture Capital funds. Then, as the companies get larger, they raise capital from Private Equity funds. Finally, when companies become very large, they have to raise capital from large institutions as well as general public as there is no other source of capital that can provide so much equity capital easily. After raising capital from the general public and other large investors the company’s shares ‘list’ on Stock Exchanges. This is because there are so many daily transactions of buying and selling of these shares that an exchange provides an orderly location for the conduct and price discovery of these transactions in a regulated framework. In addition, given the size of these companies, they are relatively safer to invest in as compared to smaller companies. Regulators do a thorough check before ensuring any company can list on exchanges.
Investment strategies in equities are of a wide variety – an investor can simply buy securities and hold them for the long run. Other investment strategies can be more advanced such as using mathematical models to buy and sell securities after few minutes.
Investors can either buy listed equities of companies directly or invest in Mutual Funds. Mutual funds are pools of capital that are invested in a diversified manner across several listed equities.
3. Mezzanine products
Mezzanine products are those that have characteristics of Fixed Income and Equity products, that is, they have debt and equity type components. Usually they are designed in a manner wherein the investor gets a certain interest and if the company does very well, then an additional upside profit share payout. These types of instruments are also called ‘Structured Products’ and are usually available to High Net Worth Individuals only.
4. Alternative Investments
Fixed Income and Listed Equity products are among the largest asset classes in the world. However, in recent years, other financial instruments have gained popularity as global financial markets have evolved. In earlier years, most investment activities were focused on publicly listed equities and fixed income products. However, in recent years – financial products related to unlisted companies – called Private Equity or Private Debt have emerged as large asset classes. Most alternative investment products require a significant investment amount and therefore these products have typically been invested into by High Net Worth Individuals either directly or through Private Equity funds or Private Debt funds.
5. Angel investing
Angel investing deals with investing in early stage companies. This type of investing can be done by directly investing into a startup or by investing into a Venture Capital fund. This category can also be considered to be part of ‘Alternative Investing’ as described above.
6. Real Estate
Real Estate is a large asset class globally. Individuals can take exposure to this asset class by directly purchasing a residential/commercial/warehousing/industrial property. Real Estate globally has been a popular asset class because of its tangible nature and the emotional comfort it provides to an owner who resides in it. Alternatively, investors can also take exposure to publicly traded products called ReITs (Real Estate Investment Trusts) and even to Real Estate focused funds that are managed by experts. Real Estate prices in the long term, grow in line with GDP growth rates of the location.
7. Derivatives
Derivatives include products such as options, futures, swaps, warrants, etc. These products provide the option or the obligation to purchase/sell another financial instrument at some point in the future at a pre-agreed price. As an example, a call option on Sensex having specifications: ‘Exercise Price: INR 40000, Exercise date: 31 June 2020’ may be sold for INR 25. This would mean the buyer of the Call Option has the right to purchase one quantity of Sensex from the call option seller by paying the seller INR 40000. In case the price of Sensex on 31st March 2020 is INR 41000, the Call Option holder will ‘exercise’ the option and pay INR 40000 to the call option seller thereby getting one quantity of Sensex at a price lower than the prevailing market price (INR 41000). This will result in a profit of 1000 for the call option holder – after factoring in the price that he paid for obtaining the option, the net profit is INR 975. On the other hand, if the price of Sensex falls to INR 39000, the call option holder will consider it unviable to exercise the option and let the option expire – his loss in this case is the price that was paid for the option, i.e., INR 25. Derivatives are complex instruments- they are used for hedging as well as for speculation by investors. Derivatives provide high risk – high return investment opportunities.
8. Commodity markets
These markets trade prices of widely used agricultural commodities, industrial metals and precious metals. Many businesses that use these commodities for their manufacturing or trading require the use of these commodity futures to hedge against adverse price movement. Speculators participate in these markets to profit by predicting price movements. Investors are attracted to these products because these products trade usually on global factors rather than only local factors thereby protecting against some specific risks. The other attractive feature is that investment products of Commodities provide high leverage. These products also trade on exchanges such as MCX or NCDEX.
9. Currency markets
This is the largest traded market globally. Similar to commodity markets, these products are used by companies and organizations that need to hedge exposure to adverse movements in currencies. Speculators participate in these markets to trade the price movements. These products usually provide the largest leverage, trade 24 hours and price drivers are usually macro-economic developments. These products also trade on exchanges like NSE and BSE.
Disclaimer: Vitspan does not provide any investment related, tax related or financial advice. The information presented is done so without considering the investment objectives, risk profile, or economic circumstances of any reader or investor. The information presented may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the potential loss of principal. Please consult your financial advisor prior to making investment related decisions.