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Key Financial Markets Traded

1.
Key Financial Markets Traded
The first chapter is a very gentle introduction to the different types of financial instruments
traded in the United States of America. It mainly is a collection of functions and definitions of
financial instruments in general. We also briefly set the scene for some of the later chapters by
classifying the types of markets these products trade along with the classification of the
products themselves. Depending on your background, you can choose to read the chapter
thoroughly or skim through. We have written this chapter to be informative rather than
instructive.

Introduction
Before, we discuss about the types of financial instruments, let us first discuss why do financial
markets exist? What are the benefits of having financial markets to the society?
Financial Markets like any other markets are there to facilitate the exchange of goods, the good
here being value. The value of each financial product may be different for different people.
Due to this disagreement in value some of the people are buyers and some are sellers of this
value. Financial Markets facilitate these transactions by connecting the buyers and the sellers.
This value can be in the form of value of equity in the company, value of a particular commodity,
or value of one currency with respect to the other currency. The other very subtle reason for
existence of financial markets is to connect the issuers and borrowers of securities to those who
wish to purchase those securities. For example, a company may want to issue shares to raise
capital or a country may want to issue debt to build its roads and infrastructure, in such a
situation it can go to financial markets to raise funds by issuing debt or equity. We have
introduced two major categories of financial instruments Debt and Equity. We will define these
and many more, later in this chapter. To sum up the discussion of existence of financial markets
it is worth mentioning that financial markets exist for three major reasons. Firstly, to connect the
investors and lenders to issuers and borrowers respectively, Secondly, to help nations build
infrastructure and other developmental activities and finally to better position companies and
businesses to take bigger challenges and projects and hence drive innovation and industrial
development. There are various other uses and functions of financial markets and products
which will be clear as we discuss each of the products in this chapter.
As we discussed above, Equity and Debt are the two major instruments of value, we will from
now formally classify them asset classes. Together with Commodities and FOREX, they
constitute the four major asset classes in financial markets. Although market structures differ by
asset class which is the discussion of this book, all of them share some common characteristics
of market structure on a broader scale. This can be classified as Primary or Secondary Markets,
OTC or Exchange traded and Cash or Derivatives market. We will leave the discussion for the
former two structures later, but it is worth mentioning the Cash or Derivatives market at this

Key Financial Markets Traded


point to continue the discussion.
Cash or Derivatives Market
Cash Markets provide actual ownership of the asset to participants in the financial markets. A
Cash market is traded for immediate (within the allowed settlement period which can be
different for different product) delivery or possession of asset. A Derivatives Market on the other
hand gives the holder either an obligation or choice to buy or sell an asset at some future point
in time. Derivatives market has financial contracts that derive their value from the underlying in
the Cash market.

Equities (Stocks) Markets:


Although Equities Markets may consist of variety of instrument type: Common stock and
Preferred stock are two most prevalent types. There are other types of stocks traded in the
United States of America, namely ADR or ETF which vary significantly from the common stock
in terms of underlying risk and product formation dynamics.
Belgium boasted a stock exchange as far back as 1531, in Antwerp. Brokers and moneylenders
would meet there to deal in business, government and even individual debt issues. It is odd to
think of a stock exchange that dealt exclusively in promissory notes and bonds, but in the 1500s
there were no real stocks. There were many flavors of business-financier partnerships that
produced income like stocks do, but there was no official share that changed hands.
Trading stocks can be compared to gambling in a casino, where you are betting against the
house, so if all the customers have an incredible string of luck, they could all win.

Stock represents the residual asset of the company that would be due to stockholders after
discharge of all senior claims such as secured and unsecured debt. Stockholders equity cannot
be withdrawn from the company in a way that is intended to be detrimental to the companys

Key Financial Markets Traded


creditors.
A holder of stock (a shareholder) has a claim to a part of the corporation's assets and
earnings. In other words, a shareholder is an owner of a company. Ownership is determined by
the number of shares a person owns relative to the number of outstanding shares. For example,
if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that
person would own and have claim to 10% of the company's assets.
Stocks are the foundation of nearly every portfolio. Historically, they have outperformed most
other investments over the long run.
When you own a share of a stock, you are a part owner in the company with a claim on
every asset and every penny in earnings. Individual stock buyers rarely think like owners, and
it's not as if they actually have a say in how things are done.
Common Stock
Common shareholders are owners of the corporation. Holders of common stock exercise
control by electing a board of directors and voting on corporate policy. Common stockholders
are on the bottom of the priority ladder for ownership structure. In the event of liquidation,
common shareholders have rights to a company's assets only after bondholders, preferred
shareholders and other debt holders have been paid in full. In the U.K., these are called
"ordinary shares"
If the company goes bankrupt, the common stockholders will not receive their money
until the creditors and preferred shareholders have received their respective share of the
leftover assets. This makes common stock riskier than debt or preferred shares. The upside to
common shares is that they usually outperform bonds and preferred shares in the long run as
they are entitled to the profits of the company.
Preferred Stock
A class of ownership in a corporation that has a higher claim on the assets and earnings
than common stock i.e. preferential treatment is called Preferred stock. Preferred stock
generally has a dividend that must be paid out before dividends to common stockholders and
the shares usually do not have voting rights.
The precise details as to the structure of preferred stock are specific to each corporation.
However, the best way to think of preferred stock is as a financial instrument that has
characteristics of both debt (fixed dividends) and equity (potential appreciation) also known as
"preferred shares".
There are certainly pros and cons when looking at preferred shares. Preferred
shareholders have priority over common stockholders on earnings and assets in the event of
liquidation and they have a fixed dividend (paid before common stockholders), but investors
must weigh these positives against the negatives, including giving up their voting rights and less

Key Financial Markets Traded


potential for appreciation.

(Strumpf, Dan. "U.S. Public Companies Rise Again." The Wall Street Journal. 5 Feb. 2014.)
The number of companies traded on major U.S. stock exchanges rose by 92 last year,
taking the count of U.S.-listed companies to 5,008 at year-end, according to data provided by
the World Federation of Exchanges, a trade association.

Key Financial Markets Traded

Top 10 Stock Exchanges(By market capitalization) in the world:


Rank

Exchange

Country

1
2
3
4

New York Stock Exchange


NASDAQ
Japan Exchange Group
Euronext

London Stock Exchange

United States
United States
Japan
Netherlands France
Belgium Portugal
United Kingdom
Italy
China

Market
Cap($Billion)
18,779
6,683
4,485
3,504

Trade
Volume(Billion)
11,299
8,739
4,011
1443

3,396

1,890

3,146

1,093

2,869
2,204
1,913
1,716

2,920
1,008
3,677
1,095

Hong Kong Stock


Exchange
7
Shanghai Stock Exchange
China
8
TMX Group
Canada
9
Shenzhen Stock
China
10
Deutsche Bourse
Germany
Data from "world federation of exchanges" September 2014

An important point to discuss here or may be for any instrument in the financial markets will be:
How these instruments come to the markets? How are they available for trading? Where are
they traded? Who trades these instruments? Many more such details about each instrument
are inevitable. These questions are answered in details in the future chapters, but we will touch
upon some of the details here for completion.
Here we describe the second important classification of the financial market structure i.e.
Primary Markets and Secondary Markets.
Primary Markets
The Primary markets are the place where creation of securities takes place. These Markets
create a mechanism where companies and governments can access funds from investors and
their intermediaries. Basically these markets provide the initial point of inception for the
securities. There are various methods by which each instrument may be introduced in the
primary markets and the method of raising funds. Some of these methods may be Underwriting,
Auctions etc.
Secondary Markets
The Secondary markets are the place that does not raise money for corporations or
governments but they facilitate the function of transferring the ownership of securities from one
owner to the other. The function is promoted by the activity which we call Trading. The
securities are traded at trading venues for example, Exchanges like NYSE or CME. The
secondary market structure is further subdivided into different types of buyers and sellers,

Key Financial Markets Traded


brokers, dealers, broker / dealer which will be covered in depth in further chapters.
This brings us to our third and important classification due to difference in type of trading venues
Exchange Traded and Over the Counter (OTC)
Exchange Traded and OTC Markets
The securities in the secondary market where the trading venue is an organized exchange are
called Exchange traded instruments. The important terminology here is organized. In fact, the
study of trading which takes place at organized exchanges is described as Market
Microstructure by Larry Harris in his book titled Trading and Exchanges: Market Microstructure
for practitioners. The securities that trade without any intermediary exchange to facilitate the
transaction are called OTC traded instruments.
We shall now discuss other types of Equities and discuss about various instruments in Cash as
well as Derivatives Segment.
American Depositary Receipt (ADR)
Introduced to the financial markets in 1927, an American depositary receipt (ADR) is a
stock that trades in the United States but represents a specified number of shares in a foreign
corporation. ADRs are bought and sold on American markets just like regular stocks, and are
issued/sponsored in the U.S. by a bank or brokerage.
The stocks of most foreign companies that trade in the U.S. markets are traded as
American Depositary Receipts (ADRs). Each ADR represents one or more shares of foreign
stock or a fraction of a share. If you own an ADR, you have the right to obtain the foreign stock it
represents, but U.S. investors usually find it more convenient to own the ADR. The price of an
ADR corresponds to the price of the foreign stock in its home market, adjusted to the ratio of the
ADRs to foreign company shares. (SEC.gov)

Key Financial Markets Traded

Manish. "American Depositary Receipts (ADRs) - Finance Train." Finance Train 05 Nov.
2014.
A negotiable certificate issued by a U.S. bank representing a specified number of shares
(or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in
U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help
to reduce administration and duty costs that would otherwise be levied on each transaction.
This is an excellent way to buy shares in a foreign company while realizing any
dividends and capital gains in U.S. dollars. However, ADRs do not eliminate the currency and
economic risks for the underlying shares in another country. For example, dividend payments in
euros would be converted to U.S. dollars, net of conversion expenses and foreign taxes and in
accordance with the deposit agreement. ADRs are listed on either the NYSE, AMEX or
NASDAQ as well as OTC.

Exchange Traded Fund(ETF)


A security that tracks an index or a basket of assets like an index fund, but trades like a

Key Financial Markets Traded


stock on an exchange is called an ETF. ETFs experience price changes throughout the day as
they are bought and sold.
In less than 20 years, exchange-traded funds (ETFs) have become one of the most
popular investment vehicles for both institutional and individual investors. Often promoted as
cheaper, and better, than mutual funds, ETFs offer low-cost diversification, trading and arbitrage
options
for
investors.
Now with over $1 trillion assets under management, new ETF launches number from several
dozen to hundreds, in any particular year. ETFs are so popular that many brokerages offer free
trading in a limited number of ETFs to their customers.
Because it trades like a stock, an ETF does not have its net asset value (NAV)
calculated every day like a mutual fund does.Think of an ETF as a mutual fund that trades like a
stock. Just like an index fund, an ETF represents a basket of stocks that reflect an index such
as the S&P 500. An ETF, however, isn't a mutual fund; it trades just like any other company on
a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end
of each trading day, an ETF's price changes throughout the day, fluctuating with supply and
demand. It is important to remember that while ETFs attempt to replicate the return on indexes,
there is no guarantee that they will do so exactly. It is not uncommon to see a 1% or more
difference between the actual index's year-end return and that of an ETF.
By owning an ETF, you get the diversification of an index fund as well as the ability to
sell short, buy on margin and purchase as little as one share. Another advantage is that the
expense ratios for most ETFs are lower than those of the average mutual fund. When buying
and selling ETFs, you have to pay the same commission to your broker that you'd pay on any
regular order. One of the most widely known ETFs is called the Spider (SPDR), which tracks the
S&P 500 index and trades under the symbol SPY.

Mutual Funds

Stocks
ETF

Key Financial Markets Traded

Derivatives
Derivatives markets have become more and more important in the finance world. It has
become necessary for finance people to know how these markets work, and how they can be
used, and what determines there price. Derivatives are instruments that derive its value from an
underlying. This underlying instrument can be Equities, Commodities, Bonds or even another
Derivative.

Futures
Futures markets have formed in the middle ages. Originally they were used to
meet the needs of farmers and merchants.
A future contract is an agreement to buy or sell an asset at a certain time in the future for
a certain price. There are many exchanges throughout the world trading futures contracts. The
Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile
Exchange have merged to form the CME Group. Other large exchanges include NYSE
Euronext, Eurex, BM&FBOVESPA, and the Tokyo Financial Exchange.
Future exchanges allow people buy or sell assets in the future to trade with each
other. For Example:
"In September a trader in Chicago might contact a broker with instructions to buy
500 barrel of crude oil for December delivery. The broker would immediately communicate the
clients instructions to the Chicago Board of Trade. At about the same, another trader in Los
Angels might instruct a broker to sell 500 Barrel of crude oil for December delivery. These
instructions would also be passed on the Chicago Board of Trade. A price would be determined
and the deal would be done."
Futures can be used either to hedge or to speculate on the price movement of the
underlying asset. For example, a producer of corn could use futures to lock in a certain price
and reduce risk(hedge). On the other hand, anybody could speculate on the price movement of

Key Financial Markets Traded


corn by going long or short using futures
CBOT(The Chicago Board of Trade), established in 1848, is the oldest futures and
options exchange in the world. CBOT now offer futures contracts on many different underlying
assets, including corn, soybeans, soybean meal, soybean oil, oats, wheat, Treasury bonds, and
Treasury notes. More than 50 different options and futures contracts are traded by over 3600
CBOT members through open outcry and electronic trading. 36 years later CME(The Chicago
Mercantile Exchange) was established, it provding a market for butter and eggs. On July 12
2007, CBOT merged with the CME to form the CME Group.(CME,NYMEX, COMEX)

Options
There are two types of options Call option and Put option.
A call option gives the holder of the option the right to buy an asset by a certain date for
a certain price.
A put option gives the holder the right to sell an asset by a certain date for a certain
price.
The date specified in the contract is know as the expiration date or the maturity date.
The price specified in the contract is know as the exercise price or the strike price.
Option gives the holder the right to do something, that means the holder does not have
exercise the right. This methods distinguish between the future contracts from options."the
holder of a long futures contract is committed to buying an asset at a certain price at a certain
time in the future. By contrast, the holder of a call option has a choice as to whether to buy the
asset at a certain price at a certain time in the future. It costs nothing( except for margin
requirements) to enter into a futures contract. By contrast, an investor must pay an up-front
price, know as the option premium", for an options contract." written by John C. Hull. Also one
important difference between stocks and options is that stocks give you a small piece of
ownership in the company, while options are just contracts that give you the right to buy or sell
the stock at a specific price by a specific date. It is important to remember that there are always
two sides for every option transaction: a buyer and a seller. So, for every call or put option
purchased, there is always someone else selling it.
Jim Graham written in "Getting Acquainted With Options Trading" said Trading options is
more like betting on horses at the racetrack. There they use parimutuel betting, whereby each
person bets against all the other people there. The track simply takes a small cut for providing
the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer's
gain is the option seller's loss and vice versa: any payoff diagram for an option purchase must
be the mirror image of the seller's payoff diagram.
Premium is the price of an option. The buyer of an option cannot lose more than the
initial premium paid for the contract, no matter what happens to the underlying security. So the

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risk to the buyer is never more than the amount paid for the option. The profit potential, on the
other hand, is theoretically unlimited.
In return for the premium received from the buyer, the seller of an option assumes the
risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the
stock. Unless that option is covered by another option or a position in the underlying stock, the
seller's loss can be open-ended, meaning the seller can lose much more than the original
premium received.

Other Option types


There have many different kinds of option types
According to the underlying assets
Equity option
Bond option
Future option
Index option
Commodity option
Currency option

According to the trading markets

Exchange-traded options includes


Stock options

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Key Financial Markets Traded


Bond option and other interest rate options
Stock market index option or simply, index options
Options on futures contracts
Callable bull/ bear contract

Over the counter options includes


Interest rate options
Currency cross rate options
Options on swaps or swaptions

Another important class of options, particularly in the United States are employee stock
options, which are awarded by a company to their employees as a form of incentive
compensation. other types of options exist in many financial contracts, for example real estate
options are often used to assemble large parcels of land, and prepayment options are usually
included in mortgage loans. However, many of the valuation and risk management principles
apply across all financial options.
Option styles
European option

An option that may only be exercised


on expiration.

American option

An option that may be exercised on


any trading day on or before expiry.

Bermudan option

An option that may be exercised only


on specified dates on or before expiration.

Asian option

An option whose payoff is determined


by the average underlying price over some
preset time period.

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Barrier option

Any option with the general


characteristic that the underlying security's
price must pass a certain level or "barrier"
before it can be exercised.

Binary option

An all-or-nothing option that pays the


full amount if the underlying security meets
the defined condition on expiration otherwise
it expires worthless.

Exotic option

Any of a broad category of options


that may include complex financial structures

Vanilla option

Any option that is not exotic.

The two basic well know options are American and European option. An American or
American-style option can be exercised at any time between the date of purchase and the
expiration date. Most exchange-traded options are American style and all stock options are
American style. A European, or European-style, option can only be exercised on the expiration
date. Many index options are European style.
When the strike price of a call option is above the current price of the stock, the call is
out of the money; when the strike price is below the stock's price it is in the money. Put options
are the exact opposite, being out of the money when the strike price is below the stock price
and in the money when the strike price is above the stock price.
Note that options are not available at just any price. Stock options are generally traded
with strike prices in intervals of $2.50 up to $30 and in intervals of $5 above that. Also, only
strike prices within a reasonable range around the current stock price are generally traded. Far
in- or out-of-the-money options might not be available.
All stock options expire on a certain date, called the expiration date. For normal listed
options, this can be up to nine months from the date the options are first listed for trading.
Longer-term option contracts, called LEAPS, are also available on many stocks, and these can
have expiration dates up to three years from the listing date.
Options officially expire on the Saturday following the third Friday of the expiration
month. But, in practice, that means the option expires on the third Friday, since your broker is
unlikely to be available on Saturday and all the exchanges are closed. The broker-to-broker
settlements are actually done on Saturday.
Unlike shares of stock, which have a three-day settlement period, options settle the next
day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option

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by the end of the day on Friday.

The largest exchange in the world for trading stock options is the Chicago Board Options
Exchange(CBOE)

Swaps
A swap is an agreement between two companies to exchange cash flows in the future.
The agreement defines the dates when the cash flows are to be paid and they way in which
they are to be calculated. Usually the calculation of the cash flows involves the future value of
an interest rate, an exchange rate, or other market variable.
A forward contract can be viewed as a simple example of a swap. Suppose it is Aug 1,
2014, an a company enters into a forward contract to buy $200 ounces of gold for $800 per
ounce in one year. The company can sell the gold in one year as soon as it is received. The
forward contract is therefore equal to a swap where the company agrees that on Aug 1, 2015, it
will pay $160.000 and receive $200*P. Where p is the market price of one ounce of gold on that
date.
If firms in separate countries have comparative advantages on interest rates, then a
swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while
another has access to a lower floating interest rate. These firms could swap to take advantage
of the lower rates.
(WEINBERG, ARI I. "'Swaps' Add a New Risk." The Wall Street Journal. Dow Jones &
Company,05 Nov. 2014.)
( Hull, John C. Fundamentals of Futures and Options Markets. Boston: Prentice Hall, 2011)

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Key Financial Markets Traded

1. To replicate a $1
Million investment in the
security, the fund enters
into a swap agreement
for that "notional"
amount with a bank

2. The fund deposits a


portion of that $1 million,
20% as collateral at a
third party and
segregates the
remainder as cash in its
portfolio.

5. Fund investors get


returns, for good or bad,
as if the fund had
owned the security
directly.

Collateral manager

4. If the security falls in


value the bank is paid
aand the fund posts
more collateral to get
back to 20%.

3. If the security rises in


value, the bank sends
money to collateral
manager and ultimately
to the fund.

Plain Vanilla
The most common type of swap is a"plain vanilla" interest rate swap. In this a
company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional

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Key Financial Markets Traded


principal for a number of years. In return, it receives interest at a floating rate on the same
notional principal for the same period of time.

LIBOR
The floating rate in most interest rate swap agreements is the London Interbank
Offered Rate(LIBOR), it is the rate of interest at which a bank is prepared to deposit money with
other banks that have a AA credit rating . One month, three month, six month and twelves
month LIBOR are commonly quoted in all major currencies.
A LIBOR quote by a particular bank is the rate of interest at which the bank is
prepared to make a large wholesale deposit with other banks. Large banks and other financial
institutions quote LIBOR for maturities up to 12 months in all major currencies.
A deposit with a bank can be regarded as a loan to that bank. A bank must therefore
satisfy certain creditworthiness criteria in order to be able to accept a LIBOR quote from another
bank and receive deposits from that bank at LIBOR. Typically it must have to have a AA credit
rating.

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