Capital Market and Securities Laws · Basics of Capital Market

Capital Market Instruments: Equity, Debt and Derivatives Explained

Updated 11 October 2026 · Fact-checked

Capital market instruments are the securities issued and traded to raise or invest long-term funds. They fall into equity (equity and preference shares), debt (debentures and bonds), derivatives (contracts whose value depends on an underlying asset) and pooled instruments such as mutual fund units. Answer by defining, classifying, then comparing rights, risk and return.

Understand Capital Market Instruments

A capital market instrument is a financial claim that a company, government or fund issues to raise long-term money, and that investors can hold or trade. Each instrument gives the holder a different bundle of rights, risk and return.

Start with the split between ownership and lending. Equity shares make you an owner. You get dividend only if the company declares it, you have voting rights, and you share in profits and residual assets on winding up. Risk is highest, and so is the possible reward.

Preference shares sit between equity and debt. Holders get a dividend at a fixed rate ahead of equity holders, and are repaid before equity holders on winding up. They usually have no ordinary voting rights, except in the situations the Companies Act, 2013 allows. They can be cumulative or non-cumulative, participating or non-participating, convertible or non-convertible, and redeemable. Under the Companies Act, 2013 preference shares must be redeemable; irredeemable preference shares cannot be issued.

Debentures and bonds are debt. The holder is a lender, not an owner. The issuer pays interest and repays principal. Debentures can be secured or unsecured, convertible or non-convertible, redeemable, and registered or bearer. In common use, bonds are the term for debt issued by governments, public sector bodies and financial institutions, while debentures are issued by companies. The terms overlap, so say how you are using them.

Derivatives are contracts whose value is derived from an underlying such as shares, an index, a currency or a commodity. The main types are forwards, futures, options and swaps. Futures and options are traded on stock exchanges; forwards and swaps are mostly over the counter. They are used for hedging, speculation and arbitrage. Under the SCRA, 1956, the definition of securities includes derivatives. Mutual fund units represent a proportionate share in a pooled portfolio managed by a professional fund manager and are also treated as securities.

Key rules to remember

Instrument classification: Capital market instruments = Equity + Debt + Derivatives + Pooled (mutual fund units); Use this as the frame for any 'explain the instruments' question.
Order of claim on winding up: Secured creditors and debt ahead of preference shareholders; preference shareholders ahead of equity shareholders; Equity is the residual claim. Do not state this order without noting that statutory priorities in winding up also apply.
Equity vs preference return: Equity: variable dividend, only if declared. Preference: fixed-rate dividend, paid before equity; Preference dividend is fixed but still depends on distributable profits.
Debt return: Debenture or bond holder: fixed or agreed interest + principal on maturity; Interest is a charge on the company and is payable whether or not it earns profit.
Derivative value: Value of derivative = f(price of underlying asset); Main types: forwards, futures, options, swaps.

How to solve Capital Market Instruments questions

Most questions ask you to explain, classify or compare instruments. Use one structure for all of them.

1Read the verb: define, classify, distinguish, or discuss. It decides your layout.
2Open with a one-line definition of the instrument or the market segment.
3Classify the instrument into its types, naming each type briefly.
4For a comparison, pick fixed heads: ownership, return, voting, risk, repayment, and claim on winding up.
5Add the legal anchor where relevant, such as the Companies Act, 2013 for shares and debentures or the SCRA, 1956 for the definition of securities.
6Add one Indian example, such as a listed company's equity shares or a government security.
7Close with a short conclusion that states the main difference or use.

Quickest way: Own, lend, hedge, pool

When to use it: Use when you have only a few minutes and must cover all instruments in a short note.

Own: equity shares (variable return, voting, residual claim).
Between: preference shares (fixed dividend, priority, limited voting).
Lend: debentures and bonds (interest and repayment, creditor status).
Hedge or speculate: derivatives (futures, options, forwards, swaps).
Pool: mutual fund units (shared portfolio, professional management).
For each, write return, risk and rights in one line.

Common mistakes in Capital Market Instruments

Calling preference shareholders creditors of the company.
Their dividend is fixed, so they look like lenders.
Fix: They are shareholders. They have priority in dividend and capital repayment but are not creditors. Debenture holders are the creditors.
Saying preference dividend is guaranteed.
Students focus on the word fixed.
Fix: Say it is payable at a fixed rate, but only out of distributable profits. Cumulative shares carry forward unpaid dividend.
Treating debentures and bonds as completely different.
Textbooks use the words separately.
Fix: Both are debt instruments. Note the usual usage difference and that the terms often overlap.
Describing derivatives as only a tool for speculation.
News coverage highlights trading losses.
Fix: State three uses: hedging, speculation and arbitrage. Name futures, options, forwards and swaps.
Listing types without distinguishing them.
Students memorise names but not features.
Fix: Give a one-line feature for each type, for example cumulative means unpaid dividend carries forward.

Worked examples

Example 1

Distinguish between equity shares and preference shares.

Show the solution

Define: equity shares carry ownership with a residual claim; preference shares carry priority in dividend and capital repayment.
Dividend: equity dividend is variable and declared only if the company decides; preference dividend is at a fixed rate and paid before equity.
Voting: equity holders have full voting rights; preference holders have limited voting rights as the Companies Act, 2013 permits.
Repayment: on winding up, preference capital is repaid before equity; equity is paid from what remains.
Redemption: preference shares must be redeemable under the Companies Act, 2013; equity capital is not redeemed in the normal course.
Risk and return: equity carries higher risk and higher potential return; preference carries lower risk and a steadier return.

Answer: Equity shares give ownership, variable dividend, full voting and a residual claim. Preference shares give a fixed-rate dividend and priority in repayment but limited voting. Equity suits investors seeking growth; preference suits those seeking steadier income.

Example 2

What are derivatives? Explain their types and uses in the capital market.

Show the solution

Define: a derivative is a contract whose value depends on the price of an underlying asset such as shares, an index, a currency or a commodity.
Legal point: the definition of securities under the SCRA, 1956 includes derivatives.
Types: forwards (customised contracts to buy or sell later at a fixed price), futures (standardised exchange-traded forwards), options (right but not obligation to buy or sell) and swaps (agreements to exchange cash flows).
Trading venue: futures and options are traded on recognised stock exchanges; forwards and swaps are mostly over the counter.
Uses: hedging against price risk, speculation on price moves and arbitrage between markets.
Conclude that derivatives help manage risk but need regulation because of leverage.

Answer: A derivative is a contract deriving value from an underlying asset. Its main types are forwards, futures, options and swaps. It is used for hedging, speculation and arbitrage, and it is a security under the SCRA, 1956.

Exam tips

Comparison questions score best with fixed heads such as return, voting, risk and repayment, written as short paragraphs or bullets.
Always name the legal source: Companies Act, 2013 for shares and debentures, SCRA, 1956 for securities and derivatives.
Give the types of each instrument with a one-line feature, because examiners reward classification.
Write a one-line conclusion; the answer format expects provision, analysis and conclusion.
Link this topic with the primary market, secondary market and derivatives provisions in the SCRA chapters.

Practice questions from Basics of Capital Market

Capital Market Instruments in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital Market Instruments: frequently asked questions

What is the difference between equity shares and preference shares?

Equity shareholders are owners with variable dividends, full voting rights and a residual claim. Preference shareholders get a fixed-rate dividend and priority in repayment, but have limited voting rights. Preference shares must be redeemable under the Companies Act, 2013.

What are the types of debentures?

Debentures can be secured or unsecured, convertible or non-convertible, redeemable, and registered or bearer. Convertible debentures can turn into equity shares on stated terms. Mention the feature of each type in your answer.

What are derivatives in the capital market?

Derivatives are contracts whose value is derived from an underlying asset such as shares, an index, a currency or a commodity. The main types are forwards, futures, options and swaps. They are used for hedging, speculation and arbitrage.

Are mutual fund units capital market instruments?

Yes. A unit gives you a proportionate share in a pooled portfolio managed by a professional fund manager. Mutual fund units are treated as securities and are regulated by SEBI.