NISM Series II-A · Chapter 1: Introduction to Securities

L1 · Foundation

Introduction to Securities

How a business funds itself through equity or debt, the four bases on which capital is classified, the features of equity capital — limited liability, ownership and voting, liquidity, perpetuity and uncertain pay-outs — the features of debt capital and how a bond or a bank loan is defined, and the hybrid instruments that combine both.

14 min read · Worth 3% of the paper · Written from pages 14–19 of the official NISM workbook · Updated 17 September 2026

What this chapter covers

Chapter 1 carries 3 marks out of 100 — 3% of the paper.

LEARNING OBJECTIVES: After studying this chapter, you should know about: Concept of Equity and Debt · Features and Benefits of Equity Capital · Features and Benefits of Debt Capital · Features of Hybrid Instruments

1.1 Equity and debt — the two ways a business is funded

A firm that requires money to conduct its operations can fund its requirements through: Contribution by owners (either in form of loan or equity) · Contribution from outsiders (either in form of loan or equity)

Note that both sources can supply either kind of capital. An owner can lend to his own company; an outsider can buy shares in it.

How a business grows into this: businesses are typically created by promoters, who bring in the initial funds, to start and nurture a business. Later as the business grows in size, the need for money can be met by additional funds brought in by the owner(s) or contributions from outsiders (public).

And the investor faces the mirror-image choice: an investor has a choice of owning a business by contributing to equity capital or lending to a business as debt capital.

Own it, or lend to it. That single distinction runs through this whole chapter.

The four bases of classification

Capital used in running a business can be primarily classified based on:

The contributors of funds The period for which money is contributed The cost of the funds to the firm The rights that accrue to the contributors of the funds

Four bases — contributor, period, cost, rights.

Contributors. Fund brought in by promoters and owners of the business is called equity capital. Equity capital can be brought in at the start of a business or at a later date as the business grows. Equity capital also can be contributed by outside investors. To enable such contribution, the business offers equity shares to outside investors, who become shareholders.

Funds brought in as loan is called debt capital. Those that contribute debt capital are called as lenders to the business. Lenders can be individuals or institutions including banks. To enable such lending, a business issues debt instruments to investors, or obtains term loans by mortgaging the assets of the company.

Two routes to debt — issue instruments to investors, or take a term loan against the company's assets.

Time Period. The period for which capital is brought in may vary. Equity capital cannot be taken out of the firm unless the firm is liquidated. Such capital is for perpetuity.

Debt has to be repaid by the company after a certain period. The period of repayment may be short-term (less than one year) or long-term (more than one year and may go up to even 30 years or more) and is decided at the time such funds are brought in.

Short-term is less than one year; long-term is more than one year and can run to thirty or more.

Cost of Capital. The business has to pay a price for using equity or debt capital. The cost may be fixed at the time the money is brought in and may constitute an obligation for the company. Debt instruments usually pay a periodic interest.

And the rate need not be a single number: the rate of interest may be pre-determined or the method by which the rate will be determined, as in the case of floating rate bonds and inflation indexed bonds, will be described upfront.

Either the rate itself or the method of arriving at it is fixed in advance.

By contrast: the cost of capital may vary depending on the earnings of the company, as is the case with equity capital.

Where both appear in the accounts: both debt and equity are reflected in the liability side of the balance sheet indicating "source of funds". A company must carefully decide the mix of debt and equity to be used in the business.

Rights of the Contributors. The contributors of capital enjoy certain rights and obligations depending upon the type of capital that they have brought in. Equity investors enjoy rights such as ownership and voting rights and rights to share the profits of the company. Debt investors have the right to receive periodic interest and return of the capital on the expiry of the fixed period. The contributors of debt capital may have their rights secured against the assets of the company.

1.2 Features of equity capital

Those who contribute equity capital to the company, buy equity shares, when they are issued by the company. They are called equity shareholders of the company.

Limited Liability

Equity capital is issued with limited liability. This means, if the creditors to a business are not able to recover their dues, equity shareholders will not be asked to pay up. The liability of equity shareholders in a company is limited to their contribution made to its equity capital, or on any amount unpaid which they have agreed to pay.

Note the second limb — a shareholder who has agreed to pay more than he has actually paid remains liable for that unpaid amount, and no further.

Ownership Rights

Equity represents ownership of the company. Equity shareholders are owners of the company in portion of the shares held.

The workbook's own illustration: if a company has an issued and paid-up capital of Rs.10 crore made up of 1 crore shares of Rs.10 each, and an investor owns 10 lakh equity shares, such investor owns 10 percent of the company.

Ten lakh out of one crore shares is one-tenth.

Voting: equity shareholders have the right to participate in the management of the company. They can do this through voting rights. Each equity share carries one vote. Major decisions of the company require resolutions to be passed, which have to be voted by a majority.

One share, one vote.

Residual profits: equity capital entitles its contributors to participate in the residual profits of the company. After meeting all expenses and provisions, profit that remains in the books belongs to equity shareholders. This is generally distributed to the shareholders in the form of dividends.

"Residual" is the key word. Everyone else is paid first; whatever remains belongs to the shareholders.

Liquidity

Equity shares are first issued by a company to the public through a process called the Initial Public Offer (IPO). IPOs are made in primary market. The money raised in an IPO is used by the company for its business activities and reflected in the balance sheet of the company.

After IPO, the shares are listed on the stock exchanges, where they can be traded between one investor to another. This is called the secondary market. Such transactions do not result in change in the capital structure of the company. Secondary market provides liquidity to the investors.

The distinction that matters: money raised in the primary market reaches the company; a secondary market trade only moves shares from one investor to another, and do[es] not result in change in the capital structure of the company.

Perpetuity

Equity capital is for perpetuity. It cannot be redeemed and the company does not have an obligation to repay it. In special situations, a company may buy-back its own shares from the shareholders. Such shares shall be extinguished by the company.

Buy-back is the exception, and the shares bought back are extinguished — not held as an asset.

Uncertain Pay-outs

Shareholders enjoy return in the form of dividends paid by the company and may also benefit by the appreciation in share price. The investors can book capital gains by selling their shares in secondary market at a price higher than the acquisition price. If share price goes down, this may result in capital loss.

And nothing is promised: there is no guarantee of dividends or capital appreciation on equity capital. Thus, the returns from equity are uncertain.

Two forms of return — dividend and capital appreciation — neither guaranteed.

1.3 Features of debt capital

Debt capital refers to the borrowings of a company. Those that contribute debt capital are lenders or creditors of the company. Debt capital implies regular return and security for the investor. For the company there is an obligation to make periodic interest payments and to repay the capital on maturity.

One transaction, two perspectives — regular return and security for the investor, obligation for the company.

How it is raised: debt is raised by companies either by issuing securities such as debentures, bonds and commercial papers to the lenders or by taking a loan from a bank or financial institution. The terms at which the borrowing is being made, are mentioned in the document (or certificate) that represents the debt.

Period: debt is raised by the company for a fixed period after which it has to be repaid. The period of borrowing will vary depending upon the need of the company.

What sets the interest rate: the interest rate or coupon rate of a bond/ debenture depends on the risk of default associated with the company issuing such securities. Thus credit rating of the debt security by SEBI registered Credit Rating Agency forms an important factor while investing in such securities.

Default risk drives the coupon — which is why credit rating matters, and why Chapter 3 devotes a section to it.

Secured and unsecured: debt securities/ loans have differential rights such as secured or unsecured. A secured loan is one where lenders have a right against the assets of the company if the company fails to pay interest and/or return the principal amount borrowed. Unsecured loan is one where such rights do not exist. Debt instruments may be listed on a stock exchange.

How each is defined

A bond or debenture will be defined by:

Face value Interest rate (also called coupon rate) and Frequency of interest payment Date of Maturity/ Redemption Other Rights of Bondholders (secured / unsecured)

A loan from a Bank or Financial Institution will be defined by:

Amount of the Loan Interest Rate and Frequency of Payment Nature of Loan (Term Loan, overdraft limit, bill discounting etc.) Repayment Conditions and Time Line (As Negotiated between Borrower and Lender) Other Rights of Lender (secured / unsecured)

Four elements for a bond, five for a loan. The differences are instructive: a bond has a face value and a fixed date of maturity, while a loan has an amount and repayment conditions... as negotiated between borrower and lender.

A bond is a standardised instrument; a loan is a negotiated contract.

1.4 Hybrid structures

Companies may raise capital in a form that combines the features of both debt and equity. These are called hybrid instruments.

Convertible Debentures

Convertible debentures pay interest like any other debt instrument till the date of maturity. On maturity, the debt is converted into equity shares. The terms of conversion, such as the number of equity shares that each debenture will be converted into and the price at which the conversion will take place are mentioned at the time of the issue of the debt instrument.

Debt while it runs, equity at the end — with the conversion terms settled at issue, not at maturity.

Who gains what: they are beneficial to a company as there is no cash outflow on maturity. The lender is benefitted if the conversion is below the prevailing market price of the share.

The company saves the repayment; the investor gains if he receives shares worth more than the conversion price.

Preference Shares

Preference shares resemble debt instruments because they offer pre-determined rate of dividend. However, they do not have a fixed maturity period or a right over the assets of the company. They have a preference in the payment of dividend over ordinary equity shares and in the return of capital, if the company is wound up.

Debt-like in the fixed rate; equity-like in the absence of maturity and of any charge on assets.

And the "preference" is twofold — ahead of equity in the payment of dividend, and ahead of equity in the return of capital, if the company is wound up.

The sample questions confirm that equity capital is for perpetuity from the company's point of view; that equity gives returns as both dividend and capital appreciation; that the interest a company pays on debt depends on its default risk; that it is false that debt capital is always raised for short-term periods; and that preference shares are a hybrid security.

Think of it like this

Owning the shop or lending to the shopkeeper

Two people put a lakh of rupees into the same shop. One becomes a part-owner; the other lends. Everything else follows from that choice.

An investor has a choice of owning a business by contributing to equity capital or lending to a business as debt capital.

The part-owner has no promise of anything. Equity capital entitles its contributors to participate in the residual profits of the company. After meeting all expenses and provisions, profit that remains in the books belongs to equity shareholders. If the shop does well he takes the surplus; if it does badly he takes nothing. There is no guarantee of dividends or capital appreciation on equity capital. Thus, the returns from equity are uncertain.

The lender has a promise. Debt capital implies regular return and security for the investor. For the company there is an obligation to make periodic interest payments and to repay the capital on maturity.

But the lender's upside is capped at that promise. However well the shop does, he receives his interest and his principal, nothing more.

The part-owner can also vote. Equity shareholders have the right to participate in the management of the company. They can do this through voting rights. Each equity share carries one vote. The lender cannot; he has a contract, not a say.

And the money behaves differently over time. Equity capital cannot be taken out of the firm unless the firm is liquidated. Such capital is for perpetuity. Whereas debt has to be repaid by the company after a certain period, whether short-term (less than one year) or long-term (more than one year and may go up to even 30 years or more).

If the shop fails, the order of payment reverses the order of reward. The lender may have security — a secured loan is one where lenders have a right against the assets of the company — while the shareholder is last in line, protected only by limited liability, which means that if the creditors to a business are not able to recover their dues, equity shareholders will not be asked to pay up.

Risk and reward move together. The owner bears the uncertainty and takes the residue; the lender takes certainty and forgoes the upside.

Primary market fills the company's pocket; secondary market only changes whose pocket the share is in

When a builder sells a new flat, the money reaches the builder. When that flat is later resold, the builder receives nothing. Shares work the same way.

That is the primary market — the company receives the money.

Note that last sentence carefully. However many crores of shares change hands on the exchange in a day, the company's issued and paid-up capital is exactly the same in the evening as it was in the morning.

So what does the secondary market do for anyone? Secondary market provides liquidity to the investors.

And that liquidity is what makes the primary market work. An investor will part with money for a perpetual instrument — equity capital is for perpetuity. It cannot be redeemed and the company does not have an obligation to repay it — only because he knows he can sell it to someone else.

It is also where one of the two forms of equity return is realised: the investors can book capital gains by selling their shares in secondary market at a price higher than the acquisition price. If share price goes down, this may result in capital loss.

The company's only route back is exceptional: in special situations, a company may buy-back its own shares from the shareholders. Such shares shall be extinguished by the company.

Extinguished, not held — the shares cease to exist, which reduces the capital.

This distinction underlies much of the rest of this workbook. Chapters 7 to 10 deal with public offers and the primary market; Chapter 14 deals with secondary market transactions; and the R&T agent works at the point where both meet the investor's records.

A hybrid borrows a little from each side

A sofa-cum-bed is neither only a sofa nor only a bed. Hybrid securities are built the same way.

Companies may raise capital in a form that combines the features of both debt and equity. These are called hybrid instruments.

A convertible debenture is debt that turns into equity. Convertible debentures pay interest like any other debt instrument till the date of maturity. On maturity, the debt is converted into equity shares.

And nothing is left to be argued about later: the terms of conversion, such as the number of equity shares that each debenture will be converted into and the price at which the conversion will take place are mentioned at the time of the issue of the debt instrument.

Why a company likes it: they are beneficial to a company as there is no cash outflow on maturity. An ordinary debenture must be repaid in cash; this one is settled in shares.

Why an investor may like it: the lender is benefitted if the conversion is below the prevailing market price of the share. He receives shares worth more than the price at which he is deemed to have bought them.

A preference share leans the other way — it is equity that behaves like debt. Preference shares resemble debt instruments because they offer pre-determined rate of dividend.

But two debt features are missing: they do not have a fixed maturity period or a right over the assets of the company.

What they do have is priority: they have a preference in the payment of dividend over ordinary equity shares and in the return of capital, if the company is wound up.

Ahead of equity, behind debt — which is exactly what "hybrid" means in practice.

The sample question asks which of equity shares, preference shares and non-convertible debentures is a hybrid. Equity shares are pure equity; a non-convertible debenture is pure debt, since nothing converts; preference shares are the hybrid.

Chapter 4 takes this further, covering warrants, convertible debentures, depository receipts and foreign currency convertible bonds among the other securities an R&T agent will encounter.

Key terms in this chapter

Convertible debenture: A debenture paying interest like ordinary debt until maturity, at which point the debt converts into equity shares. The number of shares and the conversion price are stated at the time of issue. The company avoids a cash outflow at maturity; the investor gains if the conversion price is below the prevailing market price.
Coupon rate: The interest rate on a bond or debenture, which depends on the risk of default associated with the issuing company — making credit rating by a SEBI registered Credit Rating Agency an important factor for investors.
Debt capital: The borrowings of a company, contributed by lenders or creditors who may be individuals or institutions including banks. It implies regular return and security for the investor and an obligation on the company to pay periodic interest and repay the capital on maturity.
Elements of a bank loan: Amount of the loan; interest rate and frequency of payment; nature of the loan such as term loan, overdraft limit or bill discounting; repayment conditions and timeline as negotiated between borrower and lender; and other rights of the lender, secured or unsecured.
Elements of a bond: Face value; interest or coupon rate and frequency of interest payment; date of maturity or redemption; and other rights of bondholders, secured or unsecured.
Equity capital: Funds brought in by promoters and owners, or by outside investors who buy equity shares and become shareholders. It carries ownership and voting rights, entitles the holder to residual profits, is for perpetuity, and its cost varies with the company's earnings.
Hybrid instrument: Capital raised in a form that combines the features of both debt and equity — the workbook naming convertible debentures and preference shares.
Limited liability: The rule that if creditors cannot recover their dues, equity shareholders will not be asked to pay up — their liability being limited to the contribution made to equity capital, or to any amount unpaid which they have agreed to pay.
Perpetuity of equity: Equity capital cannot be redeemed and the company has no obligation to repay it; it cannot be taken out unless the firm is liquidated. In special situations a company may buy back its own shares, which are then extinguished.
Preference share: A share offering a pre-determined rate of dividend, resembling debt — but with no fixed maturity period and no right over the company's assets. It carries preference over ordinary equity shares both in the payment of dividend and in the return of capital if the company is wound up.
Primary market: The market in which a company first issues shares to the public, through an Initial Public Offer; the money raised is used by the company for its business activities and is reflected in its balance sheet.
Residual profits: What remains in the books after meeting all expenses and provisions — the profit belonging to equity shareholders, generally distributed to them in the form of dividends.
Secondary market: The stock exchanges on which listed shares are traded between one investor and another. Such transactions do not change the company's capital structure; their function is to provide liquidity to investors.
Secured and unsecured debt: A secured loan gives lenders a right against the assets of the company if it fails to pay interest or return the principal borrowed; an unsecured loan carries no such right.

Check you have understood it

The L1 test for this chapter has 6 questions. Score 60% to unlock L2 Application (worked numericals and scenarios) and then L3 Exam-Ready (NISM-style traps, timed, with this paper's real marking). Tests, the higher levels and full mock exams need a free account so we can track your progress.

Create a free account

Original explanatory writing based on the official NISM workbook for Series II-A, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

Something look wrong? Report it