1. Meaning, characteristics and types of derivatives?

I. Meaning:
Derivatives are financial contracts whose value is dependent on an underlying asset or group of
assets. The commonly used assets are stocks, bonds, currencies, commodities and market indices.
The value of the underlying assets keeps changing according to market conditions. The basic
principle behind entering into derivative contracts is to earn profits by speculating on the value of
the underlying asset in future. Imagine that the market price of an equity share may go up or down.
You may suffer a loss owing to a fall in the stock value. In this situation, you may enter a derivative
contract either to make gains by placing accurate bet. Or simply cushion yourself from the losses
in the spot market where the stock is being traded.
II. Characteristics:

 Derivatives have a maturity or expiration date after which they become worthless or
automatically terminate.
 A derivative is usually constructed by adding and combining basic components,
specifications, triggers and contingencies in order to create a desired pay-off pattern.
 Derivatives are powerful leverage tools. The value of a derivative can move exponentially
relative to the value of its underlying.
 There is no limit on number of units transacted in the derivative market because there are
not physical assets to be transacted.
 The derivative market is quite liquid and transaction can be effected easily.

III. Types:

The four major types of derivative contracts are options, forwards, futures and swaps.

 Options
Options are derivative contracts which gives the buyer a right to buy/sell the underlying asset at
the specified price during a certain period of time. The buyer is not under any obligation to exercise
the option. The option seller is known as the option writer. The specified price is known as strike
price. You can exercise American options at any time before the expiry of the option period.
European options, however, can be exercised only on the date of expiration date.

 Futures
Futures are standardised contracts which allow the holder to buy/sell the asset at an agreed price
at the specified date. The parties to the future contract are under an obligation to perform the
contract. These contracts are traded on the stock exchange. The value of future contracts are
marked-to-market everyday. It means that the contract value is adjusted according to market
movements till the expiration date.

 Forwards
Forwards are like futures contracts wherein the holder is under an obligation to perform the
contract. But forwards are unstandardised and not traded on stock exchanges. These are available
over-the-counter and are not marked-to-market. These can be customised to suit the requirements
of the parties to the contract.

 Swaps
Swaps are derivative contracts wherein two parties exchange their financial obligations. The cash
flows are based on a notional principal amount agreed between both the parties without exchange
of principal. The amount of cash flows is based on a rate of interest. One cash flow is generally
fixed and the other changes on the basis of a benchmark interest rate. Interest rate swaps are the
most commonly used category. Swaps are not traded on stock exchanges and are over-the-counter
contracts between businesses or financial institutions.

2. Capital Market and instruments of capital market?

Capital markets are venues where savings and investments are channeled between the suppliers
who have capital and those who are in need of capital. The entities who have capital include retail
and institutional investors while those who seek capital are businesses, governments, and people.

Capital markets are composed of primary and secondary markets. The most common capital
markets are the stock market and the bond market.

Capital markets seek to improve transactional efficiencies. These markets bring those who hold
capital and those seeking capital together and provide a place where entities can exchange
securities.

Instruments:

Debt Instruments

A debt instrument is used by either companies or governments to generate funds for capital-
intensive projects. It can obtained either through the primary or secondary market. The relationship
in this form of instrument ownership is that of a borrower – creditor and thus, does not necessarily
imply ownership in the business of the borrower. The contract is for a specific duration and interest
is paid at specified periods as stated in the trust deed* (contract agreement). The principal sum
invested, is therefore repaid at the expiration of the contract period with interest either paid
quarterly, semi-annually or annually. The interest stated in the trust deed may be either fixed or
flexible. The tenure of this category ranges from 3 to 25 years. Investment in this instrument is,
most times, risk-free and therefore yields lower returns when compared to other instruments traded
in the capital market. Investors in this category get top priority in the event of liquidation of a
company.

When the instrument is issued by:

 The Federal Government, it is called a Sovereign Bond;

  A state government it is called a State Bond;

 A local government, it is called a Municipal Bond; and

 A corporate body (Company), it is called a Debenture, Industrial Loan or Corporate Bond

2. Equities (also called Common Stock)

This instrument is issued by companies only and can also be obtained either in the primary market
or the secondary market. Investment in this form of business translates to ownership of the
business as the contract stands in perpetuity unless sold to another investor in the secondary
market. The investor therefore possesses certain rights and privileges (such as to vote and hold
position) in the company. Whereas the investor in debts may be entitled to interest which must be
paid, the equity holder receives dividends which may or may not be declared.

The risk factor in this instrument is high and thus yields a higher return (when successful). Holders
of this instrument however rank bottom on the scale of preference in the event of liquidation of a
company as they are considered owners of the company.

3. Preference Shares

This instrument is issued by corporate bodies and the investors rank second (after bond holders)
on the scale of preference when a company goes under. The instrument possesses the
characteristics of equity in the sense that when the authorised share capital and paid up capital are
being calculated, they are added to equity capital to arrive at the total. Preference shares can also
be treated as a debt instrument as they do not confer voting rights on its holders and have a dividend
payment that is structured like interest (coupon) paid for bonds issues.

Preference shares may be:

 Irredeemable, convertible: in this case, upon maturity of the instrument, the principal sum
being returned to the investor is converted to equities even though dividends (interest) had
earlier been paid.

 Irredeemable, non-convertible: here, the holder can only sell his holding in the secondary
market as the contract will always be rolled over upon maturity. The instrument will also
not be converted to equities.

 Redeemable: here the principal sum is repaid at the end of a specified period. In this case
it is treated strictly as a debt instrument.

Note: interest may be cumulative, flexible or fixed depending on the agreement in the Trust Deed.

4. Derivatives
These are instruments that derive from other securities, which are referred to as underlying assets
(as the derivative is derived from them). The price, riskiness and function of the derivative depend
on the underlying assets since whatever affects the underlying asset must affect the derivative. The
derivative might be an asset, index or even situation. Derivatives are mostly common in
developed economies.

Some examples of derivatives are:

 Mortgage-Backed Securities (MBS)

 Asset-Backed Securities (ABS)
 Futures
 Options
 Swaps
 Rights
 Exchange Traded Funds or commodities

Of all the above stated derivatives, the common one in Nigeria is Rights where by the holder of an
existing security gets the opportunity to acquire additional quantity to his holding in an allocated
ratio.

*Note: a Trust Deed is a document that states the terms of a contract. It is held in trust by the
Trustee.

3. Money Market

Money Market can be understood as the market for short term funds, wherein lending and
borrowing of funds varies from overnight to a year. It is an important part of the financial system
that helps in fulfilling the short term and very short-term requirements of the companies, banks,
financial institution, government agencies and so forth.

Salient Features of Money Market

 It is a wholesale market, as the transaction volume is large.

 Trading takes place over the telephone, after which written confirmation is done by way of e-
mails.
 Participants include banks, mutual funds, investment institutions and Central Banks.
 There is an impersonal relationship between the participants in the money market, and so, pure
competition exists.
 Money market operations focus on a particular area, which serves a region or an area. On the
basis of the market size and needs, the area may differ.
There are five major segments of money market which are Certificate of Deposits (CD),
Commercial Paper, Swaps, Repo and Government treasury securities.
 Money Market Instruments
In this market, only those financial instruments are traded which are immediate substitutes for
money, which includes:

1. Call/Notice Money: When the money raised or borrowed on demand for a very short term which
ranges from one day to 14 days, then it may be called as notice money, and when it exceeds 14
days it is termed as call money.
2. Treasury Bills: These are short term, negotiable financial assets issued by the central bank, on
behalf of the government, for overcoming liquidity shortfalls.
3. Commercial Bills: A commercial bill is a negotiable, self-liquidating instrument that is less risky
in nature. When goods are bought on credit, these bills improve the liability to make payment at
the specified date.
4. Commercial Paper: It alludes to an unsecured promissory note, issued by large and creditworthy
companies, at a discount on its face value and redeemable at its face value.
5. Certificate of Deposit: It is an unsecured, negotiable financial instrument which a bank and
financial institution issues to individuals, corporation, trust, funds etc. at a discount on its face
value and its maturity vary from 15 days to one year.

The financial assets dealt in the money market possess high liquidity, low transaction cost, less
risky and no loss in value. And so, it acts as a whole sale debt market for such instruments.

Functions of Money Market

The three basic functions of money market are:

 It provides a balancing tool for equating the demand for and supply of short term funds.
 It provides a centre for the intervention of central bank, for controlling liquidity and general
interest rate level.
 It provides a proper reach to the suppliers and users of the short term funds, to fulfil their
requirements, at a reasonable market clearing price.

4. ADR & GDR

American Depository Receipts (ADRs) is a way of trading non-U.S. stocks on the U.S.
exchange. Say Indian companies who are willing to raise funds from the U.S. can do so by
issuing shares on American Stock exchange.

However, the issuance of ADR is governed by the rules and regulations as laid down by the
regulator SEC (Securities and Exchange Commission). The Indian Companies will have to
maintain accounts as per the American Standards.The Indian companies cannot directly list
their equity shares on the international stock exchange. So in order to overcome this problem;
the companies give shares to an American bank. These American banks in return for those
 shares provide receipts to the Indian companies. The companies raise funds by providing those
ADR receipts in American share market.

GDRs are similar to ADRs except the fact that it is listed on an exchange outside the U.S. and
helps the issuer to raise funds simultaneously in different markets i.e. it allows the foreign firms
to trade on the exchange outside its home country.

These shares are held by a foreign bank who provides depository receipts to these companies in
return for the shares. Generally, GDR stands for 10 equity shares of the underlying firm.

They are usually listed on London or Luxembourg stock exchange and even on the newer
exchanges including Singapore Stock exchange.

Difference between ADR and GDR

 American Depository Receipt (ADR) is a depository receipt which is issued by a US

depository bank against a certain number of shares of non-US company stock. Whereas
Global Depository Receipt (GDR) is a depository receipt which is issued by the
international depository bank, representing foreign company’s stock.
 Foreign companies can trade in US stock market, through various bank branches with the
help of ADR. Whereas GDR helps foreign companies to trade in any country’s stock
market other than the US stock market.
 ADR is issued in America while GDR is issued in Europe.
 ADR is listed in American Stock Exchange i.e. New York Stock Exchange (NYSE)
whereas GDR is listed in non-US stock exchanges like London Stock Exchange or
Luxembourg Stock Exchange.
 ADR can be traded in America only while GDR can be traded in all around the world.
 ADR Market is more liquid as compared to GDR market
 Investor’s participation is more in ADR as compared to GDR
 ADR market is a retail investor market whereas GDR’s market is institutional one.
 ADR’s disclosure agreements are more onerous as compared to GDR.

5. Call and put option.

Call and put options are derivative investments, meaning their price movements are based on
the price movements of another financial product, which is often called the underlying. A call
option is bought if the trader expects the price of the underlying to rise within a certain time
frame. A put option is bought if the trader expects the price of the underlying to fall within a
certain time frame. Puts and calls can also be written/sold, which generates income but gives
up certain rights to the buyer of the option.