UPSC Prelims 2024 Q44: ETFs, Currency Swaps & Financial Instruments

Consider the following:

1. Exchange-Traded Funds (ETF)

2. Motor vehicles

3. Currency swap

Which of the above is/are considered financial instruments?

  1. 1 only
  2. 2 and 3 only
  3. 1, 2 and 3
  4. 1 and 3 only

Answer: (d) 1 and 3 only

Statement-wise explanation

  • 1: correct — An Exchange-Traded Fund pools investors' money into a basket of assets such as index shares, gold or bonds. It issues units that are listed and traded on a stock exchange like shares, at prices close to the fund's net asset value. A unit is a claim on the fund's assets, so it is a financial asset for the holder. Indian law treats mutual fund units, which include ETF units, as 'securities' under the Securities Contracts (Regulation) Act, 1956, and SEBI regulates them. The government has also used ETFs as policy tools: the CPSE-based BHARAT 22 ETF in 2017, and in December 2019 the Bharat Bond ETF, India's first corporate bond ETF.
  • 2: incorrect — A motor vehicle is a physical, or real, asset. It is valuable because of its use, not because it is a contract that gives someone a claim on someone else. Under the accounting definition (Ind AS 32, para 11), a financial instrument is 'any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.' A car is not a contract and creates no matching liability for anyone. A car loan, a hire-purchase agreement or a motor insurance policy linked to the car can be a financial contract, but the vehicle itself is not.
  • 3: correct — A currency swap is a contract in which two parties exchange amounts of two currencies and agree to reverse the exchange later at set terms. Because it is a contract whose value depends on exchange rates, it is a financial instrument: specifically, a derivative. Central banks use bilateral swap arrangements to support each other's liquidity. One example is the RBI's SAARC Currency Swap Framework. Its 2024–27 version, announced by the RBI on 27 June 2024, has a ₹250 billion INR window and a US$2 billion USD/Euro window.

How to eliminate

Statement 1 is the easy one. An ETF is a 'fund' traded on an exchange, so it is clearly a financial product. It appears in three options, and the one option without it (2 and 3 only) is very unlikely to be the answer. That leaves '1 only', '1, 2 and 3' and '1 and 3 only'. Next, test the odd item. A motor vehicle is a physical good, not a claim on anybody, so '1, 2 and 3' is very unlikely. A 'swap' is by definition an agreement between two parties to exchange something, here currencies. That makes it a contract, and financial contracts are financial instruments. Remember this rule: a financial instrument is a contract that creates a financial asset for one party and a liability or equity claim against another. Real assets such as vehicles, land, machinery or gold bars are not, but contracts and units written on them are (a gold ETF, a car loan).

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Financial instrument vs real asset

Indian accounting standards (Ind AS 32, para 11) define a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. There are three parts to test: (1) a contract, (2) a financial asset for one party, and (3) a matching liability or equity claim for the other.

Item Type Financial instrument?
Shares, bonds, T-bills, G-secs Cash instruments (equity/debt) Yes
Mutual fund / ETF units Units of a collective investment scheme Yes
Futures, options, forwards, swaps Derivatives Yes
Bank deposit, loan Debt contract Yes
Car, house, machinery, gold bar Real/physical asset No
Car loan, motor insurance policy Contract linked to a real asset Yes

ETFs. An ETF is a fund whose units are listed on a stock exchange and trade throughout the day. Most mutual fund units are bought from or sold back to the fund house at the end-of-day NAV. ETFs can be equity, debt, gold or index-based. SEBI regulates them as mutual fund schemes. Government examples include BHARAT 22 (CPSE disinvestment, 2017) and the Bharat Bond ETF (2019).

Currency swaps come in two forms:

  • Market swaps: two parties exchange principal and/or interest in two currencies and reverse the exchange later. Firms and banks use them to hedge exchange-rate risk. The RBI also runs USD/INR buy-sell swaps with banks to manage rupee liquidity.
  • Central bank swap lines: two central banks agree to exchange currencies on request to meet short-term forex or balance-of-payments needs. Examples are the India–Japan bilateral swap arrangement (US$75 billion, 2018) and the RBI's SAARC framework (2024–27: ₹250 billion INR window plus US$2 billion USD/Euro window).

NCERT Concepts to Revise

  • Exchange-Traded Fund: Statement 1 asks whether a fund whose units trade on an exchange counts as a financial instrument.
  • Currency swap arrangement: Statement 3 turns on what a currency swap is: an agreement to exchange currencies between two parties.
  • Mutual fund: ETFs are a kind of mutual fund scheme, so knowing what a mutual fund unit represents helps judge Statement 1.
  • Net Asset Value: ETF units trade at prices close to NAV, which links each unit's value to the assets the fund holds.
  • Index fund: Most ETFs track an index passively, as index funds do; the two are easily confused in exams.
  • Gold ETF: A gold ETF shows the difference between holding a physical asset and holding a unit backed by it.

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