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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
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
(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.
Exchange
Country
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3
4
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
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,
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.
Mutual Funds
Stocks
ETF
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
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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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
American option
Bermudan option
Asian option
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Binary option
Exotic option
Vanilla option
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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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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1. To replicate a $1
Million investment in the
security, the fund enters
into a swap agreement
for that "notional"
amount with a bank
Collateral manager
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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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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