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Capital Market Instruments: Definition and Types Research Team | Posted On Tuesday, January 08,2019, 03:32 PM

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Capital Market Instruments: Definition and Types



What is capital market?

Capital market which is also known as the securities market is a trading market that garners capital from the investors and makes them available to companies and the government for development of projects. The capital market includes the bond market and the stock market among others. The capital market consists of development bank, commercial banks and stock exchanges.

SEE ALSO: Guide to the Stock Market for a First Timer

What are capital market instruments?

There are two types of instruments that are traded in the capital market. They are as follows:

  • Bonds:  bonds are basic debt securities that are traded in the capital market. Companies issue bonds to raise capital as investors subscribe to them. Issuing bonds helps the company raise capital for the growth and expansion of the business at cheaper rates than banks and lending institutions. The bond issuer pays interest and returns the principal at the end of the duration. The government also issues bonds to raise money for government projects.
  • Stocks: stocks are the right of ownership in a Company. The buyer of the shares is known as a shareholder. Investors buy and sell shares over a stock exchange like NSE and BSE.

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SEE ALSO: Basics of Stock Exchanges and Stock Trading

Capital Market Instruments

Capital market instruments primary role:

The capital market plays a major role in the growth of the economy. It allows transfer of funds from people who have surplus money or seek higher returns for an investment in companies. The primary role of the capital market is as follows:

  • The capital market enables the transfer of funds from entities with surplus funds to those who require it.
  • The capital market promotes investments and savings.
  • The capital market facilitates a balanced economic growth. 

SEE ALSO: How To Invest In Stock Market With Little Money?

Types of capital market:

The capital market can be divided into two parts:

  • Primary market:  The primary market is also known as the new issues market. It deals with new securities being issued for the first time. The function of Primary market is to facilitate the transfer of investible funds to entrepreneurs, seeking to establish new enterprises or to expand existing ones, through the issue of securities for the first time. The investors in this market are banks, financial institutions, insurance companies, mutual funds and HNIs. 
  • Secondary market: The secondary market is also known as the stock market. It is a market for the purchase and sale of existing securities. It helps existing investors sell their securities and fresh investors enter the market. It also provides liquidity and marketability to existing securities.

Equity instruments:

An equity instrument offers ownership rights in a firm, like a share certificate. Equity instruments are generally issued to company shareholders and are used to fund the business. Some of the most common forms of equity instruments include common stock and preferred stock.

Common stocks:

These are the stocks that allow the investors gain a sizable amount of profit through raising prices of shares and dividend payments. It is equity ownership that allows the holders of this stock to enjoy voting rights on corporate matters. However, in case the company suffers heavy losses and ends up bankrupt, the holders of the common stock are the last ones to get their money back after creditors, bondholders, and holders of preferred stock.

Preference shares:

Preferred stock also represents owning a share of the company. Preferred stock pays a predetermined dividend, whereas the dividends paid to common shareholders tend to vary according to the company's fortunes.

Dividends on preferred stock are often larger than common stock. Holders of preferred stock do not get to vote on company matters. If a company's assets are liquidated, the preferred stockholders get to redeem their shares before the holders of the common stock, giving them a better chance at getting at least part of their money back

Cumulative preferred stocks:

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. It means unpaid dividend on such shares is accumulated till it is paid off in full.

Non-cumulative preferred stocks:

Non-cumulative preference shares are those types of preference shares, which have the right to get fixed rate of dividend out of the profits of the current year only. They do not carry the right to receive arrears of dividends. If a company fails to pay dividend in a particular year, then it need not to be paid out of future profits.

Participating preferred stocks:  

Participating preferred stock is preferred stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of liquidation. This form of financing is used by private equity investors and venture capital firms.

Convertible preferred stocks:

Convertible preferred stocks refer to a kind of preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date.

Debt instruments:

Debt instrument is a paper or electronic obligation that enables the issuing party to raise funds by promising to repay the lender according to the terms of a contract. The debt instrument provides fixed and higher returns than bank fixed deposits. Examples of debt instruments are bonds, debentures, leases, certificate, bills of exchange and promissory notes.

Hybrid instruments:

A hybrid instrument is a type of financial security that combines two or more different financial instruments.  Hybrid securities are a group of securities that combine the characteristics of securities, debt and equity. Hybrid instruments are designed as debt-type instruments with exposure to equities market. Examples of hybrid instruments include convertible bonds, preferred stocks, equity default swaps and structured notes linked to an equity index. 

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