Chapter 1: Concept of Investment

Introduction- Investment: Attributes, Economic vs. Financial Investment, Investment and speculation, Features of a good
investment, Investment Process. Financial Instruments: Money Market instruments, Capital Market Instruments and Derivatives.

Introduction:
Investment is the strategic allocation of resources with the aim of generating future returns. It encompasses various asset classes
like stocks, bonds, real estate, and crypto currencies, each carrying unique risks and rewards. Successful investment requires
understanding market dynamics, risk management, and adapting to changing economic and regulatory landscapes.

Meaning

Investment refers to the act of using money or capital to acquire assets or items of value with the expectation of generating
income or profit in the future. This could involve purchasing stocks, bonds, real estate, or other financial instruments, or investing
in starting or expanding a business. The ultimate goal of investment is to increase wealth or generate a return on the invested
capital over time.

Definition

Donald E. Fischer and Ronald J. Jordan Financial investment is the allocation of money to assets that are expected to yield some
gain over a period of time.

Investment objectives/Need:

 To meet financial goals set by investors.

 They guide investment decisions and strategies, risk tolerance and time horizon
 Common investment objectives include
 wealth accumulation
 income generation
 retirement planning
 education funding
 legacy planning
 Short-term goals
 Tax planning

Attributes of Investments / Features of Investment

1. Return on Investment (ROI): ROI measures the gain or loss generated from an investment relative to its cost. It's expressed
as a percentage and indicates the profitability of an investment. A positive ROI means the investment has generated profit, while a
negative ROI signifies a loss.
 Example: Suppose you invest ₹10,000 in a mutual fund and after one year, the value of your investment grows to ₹11,000.
Your ROI would be (₹11,000 - ₹10,000) / ₹10,000 = 0.10 or 10%.

2. Risk: Risk refers to the uncertainty of returns associated with an investment. It encompasses various factors such as market
volatility, economic conditions, regulatory changes, and company performance. Understanding risk is crucial for investors to
assess the potential downside of an investment and make informed decisions to manage or mitigate risk.
 Example: Investing in small-cap stocks listed on the Bombay Stock Exchange (BSE) can be riskier than investing in
government bonds issued by the Reserve Bank of India (RBI). Small-cap stocks may offer higher returns but come with higher
volatility and risk of loss.

3. Liquidity: Liquidity measures how easily an investment can be converted into cash without significantly impacting its price.
Highly liquid investments, such as stocks and bonds traded on major exchanges, can be quickly bought or sold with minimal price
disturbance. In contrast, investments like real estate or private equity may have lower liquidity, requiring more time and effort to
sell.

4. Time Horizon: Time horizon refers to the length of time an investor expects to hold onto an investment before needing to
liquidate it. It varies based on individual financial goals and risk tolerance. Short-term investments typically have a time horizon
of one year or less, while medium-term investments range from one to five years, and long-term investments extend beyond five
years.
 Example: If you're investing in a Public Provident Fund (PPF) for your child's education, your time horizon might be 15
years. However, if you're investing in a fixed deposit for a vacation next year, your time horizon would be shorter.

5. Diversification: Diversification involves spreading investments across different asset classes, industries, and geographic
regions to reduce risk. By diversifying, investors can minimize the impact of poor performance in any single investment on their
overall portfolio. This strategy helps balance risk and return potential, improving the likelihood of achieving long-term financial
goals.

6. Tax Considerations: Tax considerations involve understanding the tax implications of investment decisions on returns.
Factors such as capital gains tax, dividend tax, and tax-deferred accounts can significantly impact after-tax returns. Investors may
employ tax-efficient strategies to minimize taxes and maximize their net returns.
 Example: Investing ₹ 1,00,000 in Fixed Deposit (FD) earns taxable interest at your income tax slab rate, potentially
reducing returns.Investing the same amount in Equity Linked Savings Scheme (ELSS) mutual funds allows you to claim
deductions up to ₹1,50,000 under Section 80C of the Income Tax Act, potentially saving taxes while offering growth potential.

7. Volatility: Volatility measures the degree of variation in an investment's price over time. Highly volatile investments
experience frequent and significant price fluctuations, while less volatile investments have more stable prices. Investors must
assess their risk tolerance and investment objectives to determine their comfort level with volatility.

8. Inflation Protection: Inflation protection refers to an investment's ability to preserve purchasing power over time, despite
inflationary pressures. Assets like real estate, commodities, and inflation-linked bonds tend to provide protection against inflation
by either maintaining or increasing in value as prices rise.
 Example: Investing in real estate properties in growing cities like Bangalore or Mumbai can provide inflation protection.
Property values tend to appreciate over time, helping investors preserve their purchasing power.

9. Transparency: Transparency refers to the clarity and accessibility of information about an investment. Transparent
investments provide investors with comprehensive data regarding performance, fees, risks, and other relevant factors.
Transparency fosters trust and confidence among investors and enables them to make well-informed investment decisions.
 Example: Index funds like Nifty 50 ETFs provide transparency as they track the performance of the Nifty 50 index.
Investors can easily access information about the index constituents and their weights.

10. Sustainability: Sustainability involves considering environmental, social, and governance (ESG) factors in investment
decisions. Sustainable investing aims to generate positive societal and environmental impacts alongside financial returns.
Investors may evaluate companies based on their ESG practices and incorporate sustainability criteria into their investment
strategies.

Economic Investment vs Financial Investment

Meaning of Economic investments

Economic investments refer to expenditures made with the intention of enhancing the productive capacity of a country or region.
These investments are aimed at increasing the overall output and efficiency of the economy. Examples include investments in
infrastructure, technology, education, and healthcare.
Economic investments are critical for fostering long-term growth and development. They contribute to the creation of jobs,
improvement of living standards, and expansion of the economy’s productive capabilities. Governments often play a significant
role in promoting economic investments through policies and initiatives aimed at infrastructure development and innovator

Meaning of Financial investments

Financial investments involve the allocation of funds into assets with the expectation of generating income or appreciation in
value. These assets include stocks, bonds, mutual funds, real estate, and commodities. Profit motives and market dynamics
primarily drive financial investments.
Financial investments are more focused on wealth accumulation and capital appreciation. Investors seek opportunities to grow
their money through various financial instruments available in the market. The performance of financial investments is influenced
by factors such as interest rates, inflation, market volatility, and geopolitical events.
 Difference between economic investment and financial investment:
Basis Economic investment
Nature Economic investment involves the acquisition
of physical assets or goods that contribute to
the production of goods and services,
enhancing long-term productivity
Assets Economic investment typically involves
investments in tangible assets such as
machinery, equipment, infrastructure, and
technology.
Purpose The primary purpose of economic investment
is to increase productive capacity, enhance
efficiency, and foster economic growth.
Time Horizon Economic investments often have longer time
horizons and focus on generating sustainable
productivity gains over the long term
Risk and Return Economic investments may involve risks
related to technological obsolescence, market
demand, and regulatory changes, with returns
realized through increased productivity and
economic growth
Role in Economy Economic investment plays a vital role in
driving economic development, creating
employment opportunities, and improving
living standards by expanding productive
capacity and infrastructure
Investment and Speculation
Meaning of speculation
Speculation involves engaging in risky financial activities aimed at making quick profits by taking advantage of short-term price
fluctuations in assets like stocks, commodities, or currencies. It often lacks a thorough analysis of underlying fundamentals and
relies on market trends, technical analysis, or rumors. While it can yield high returns, speculation is associated with greater
uncertainty and risk compared to long-term investing.
Difference between Investment and Speculation:
Investment
1. Investment is the purchase of an asset or security to generate stable and
expected returns
2. Timeline of investments is long-term in nature
3. Nature of risks involved in investments varies from extremely low to
moderate
4. Investors usually use their own funds for investments
5. Investment is a prerogative of cautious and conservative investors
6. Investment involves a lot of study into the fundaments and the market
economics related to the particular stock or commodity, or asset
Financial investment
Financial investment involves allocating funds into
financial assets or securities with the expectation of
generating financial returns, focusing on wealth
accumulation and growth.
Financial investment involves investments in intangible
assets or financial instruments such as stocks, bonds,
mutual funds, and real estate investment trusts (REITs).
The primary purpose of financial investment is to generate
returns on invested capital, whether in the form of capital
appreciation, interest income, dividends, or rental income.
Financial investments may have varying time horizons
depending on investment objectives, ranging from short-
term to long-term, with a focus on achieving financial goals
within a specified timeframe
Financial investments entail risks such as market volatility,
interest rate fluctuations, and credit risk, with returns
generated through capital appreciation, interest income,
dividends, or rental income
Financial investment facilitates capital allocation, liquidity
provision, and risk management within the economy,
enabling investors to participate in financial markets and
access investment opportunities
Speculation
1. The speculation involves taking risky positions in the
market, usually against the market, and expecting to earn
substantial returns
2. Speculation is short-term in nature
3. The speculation involves high to extremely high levels of
risks
4. Speculators tend to use a lot of leverage and hence use
borrowed funds
5. Speculators tend to be careless and extremely aggressive
in their positions
6. The speculation involves technical analysis and is much
more based on behavioral analysis and individual opinion
 Features of a good investment

1. Solid Fundamentals: A good investment often involves assets with strong underlying fundamentals, such as a sound business
model, healthy financials, and a competitive advantage in the market.

2. Potential for Growth: A good investment offers the potential for capital appreciation or growth over time. This can be driven
by factors such as increasing revenues, expanding market share, or favorable industry trends.

3. Diversification: A good investment helps diversify a portfolio, spreading risk across different asset classes, sectors, or
geographic regions. Diversification can help mitigate losses during market downturns and enhance long-term returns.

4. Liquidity: A good investment is relatively liquid, meaning it can be easily bought or sold without significantly impacting its
price. High liquidity ensures investors can access their funds when needed, providing flexibility and minimizing transaction
costs.

5. Risk-Adjusted Returns: A good investment offers attractive returns relative to the level of risk involved. Investors should
assess risk-adjusted returns by considering factors such as volatility, downside protection, and correlation with other assets in
their portfolio.

6. Transparency: A good investment provides transparent and readily available information about its performance, fees, and
underlying assets. Transparency allows investors to make informed decisions and understand the risks associated with the
investment.

7. Stability and Consistency: A good investment demonstrates stability and consistency in performance over time. While all
investments experience fluctuations, those with a track record of delivering steady returns and weathering market cycles are
often considered more reliable.

8. Tax Efficiency: A good investment minimizes tax liabilities and maximizes after-tax returns. Tax-efficient investments may
offer benefits such as capital gains deferral, tax-free growth, or preferential tax treatment on income.

9. Alignment with Investment Objectives: A good investment aligns with the investor's financial goals, time horizon, and risk
tolerance. Whether the objective is wealth accumulation, income generation, or capital preservation, the investment should
support these goals effectively.

10.Adaptability: A good investment is adaptable to changing market conditions, economic trends, and investor preferences.
Flexibility in adjusting investment strategies or reallocating assets allows investors to capitalize on opportunities and manage
risks effectively.

Investors identify investments that fit their individual needs and preferences while optimizing their overall investment portfolio.

Investment Process
The investment process refers to the systematic approach that investors follow to identify, analyze, and manage investment
opportunities with the goal of achieving their financial objectives. While specific investment processes may vary depending on
individual preferences, risk tolerance, and investment goals,

Key stages in Investment process are:

1. Goal Setting: The first step in the investment process is to define investment objectives and establish clear financial goals.
These goals may include wealth accumulation, retirement planning, education funding, or preservation of capital. Setting
specific, measurable, achievable, relevant, and time-bound (SMART) goals helps investors align their investment strategies
with their long-term financial aspirations.

2. Risk Assessment: Investors need to assess their risk tolerance, which is their ability and willingness to withstand fluctuations
in the value of their investments. Risk tolerance depends on factors such as investment time horizon, financial resources,
 income stability, and emotional temperament. Understanding risk preferences helps investors select investment strategies
and assets that align with their risk tolerance and financial goals.

3. Asset Allocation: Asset allocation involves determining the optimal mix of asset classes (e.g., stocks, bonds, cash, real
estate) within an investment portfolio based on investors' financial goals, risk tolerance, and investment horizon. Asset
allocation is a critical driver of portfolio performance and risk management, as it allows investors to diversify across
different asset classes to reduce overall portfolio risk while potentially enhancing returns.

4. Security Selection: Once asset allocation targets are established, investors select specific securities or investments within
each asset class. This may involve conducting fundamental analysis to evaluate individual stocks, bonds, mutual funds,
exchange-traded funds (ETFs), or other investment vehicles. Investors consider factors such as valuation, financial
performance, growth prospects, industry trends, and macroeconomic conditions when selecting securities.

5. Tax Considerations: Consider the tax implications of your investment decisions, including capital gains taxes, dividend
taxes, and tax-deferred or tax-exempt investment accounts

6. Portfolio Construction: Portfolio construction involves combining selected securities into a diversified investment portfolio
that reflects the desired asset allocation and risk-return profile. Investors aim to achieve a balance between risk and return by
allocating assets across different asset classes, geographic regions, industries, and investment styles. Portfolios may be
actively managed or passively managed (e.g., index funds) based on investors' preferences and investment objectives.

7. Monitoring and Rebalancing: The investment process does not end with portfolio construction but requires ongoing
monitoring and periodic rebalancing to ensure that the portfolio remains aligned with investors' objectives and risk
tolerance. Monitoring involves tracking portfolio performance, market trends, and changes in economic conditions.
Rebalancing involves periodically adjusting asset allocation to maintain target weights as asset values fluctuate over time.

8. Review and Adjustments: Regular review of investment portfolios allows investors to evaluate performance against goals,
assess the effectiveness of investment strategies, and make necessary adjustments based on changing market conditions or
life circumstances. Investors may update their investment plans, goals, or risk tolerance as needed to adapt to evolving
financial situations or investment opportunities.

Financial instrument
A financial instrument refers to any type of asset that can be traded by investors in financial markets; they are contracts or
documents that act as a financial asset to one organisation and a liability to another. They serve as investment vehicles, enabling
individuals, businesses, and governments to raise capital, manage risk, and transfer assets. Examples of financial instruments
include stocks, bonds, derivatives, commodities, currencies, options, futures contracts, and swaps etc. These instruments have
various characteristics, such as maturity dates, interest rates, payment schedules etc

Financial market
Financial Market is a market that creates and exchanges financial assets. This market serves as a link between the savers and
borrowers, by transferring the capital or money from those who have a surplus amount of money to those who are in need of
money or investment.

Functions of Financial Markets

 1. Facilitation of Price Discovery: The price of anything instruments upon two factor that is demand and supply in the market.
Hence, the demand and supply of financial securities and assets help decide the price of different financial securities.

2. Mobilisation of Savings and Channelising the Savings into the most Productive Uses: As the financial markets act as a
link between the savers and investors, it transfers savers’ savings to the most productive and appropriate investment
opportunities.

3. Providing Liquidity to Financial Assets: Financial Markets provides the savers and investors with a platform to convert the
securities into cash, as they easily sell and buy the financial securities in this market

4. Reduction of the Cost of Transaction: Investors and companies have to collect information regarding financial securities
before investing in them, which can be very time-consuming. The financial markets help these investors and companies by
providing them with all information regarding financial securities including its price, availability, and cost.

Classification of Financial Market

Capital Market:

A capital market is a financial market in which long-term debt (more than a year) or equity-backed securities are bought and sold.
It channels the wealth of savers to those who can put it to long-term productive use, such as companies or governments making
long-term investments. Financial regulators like Securities and Exchange Board of India (SEBI), oversee capital markets to
protect investors against fraud, among other duties.
Some of the common instruments of a capital market are debentures, shares, bonds, public deposits, mutual funds, etc.

A capital market is of two types, namely, Primary Market and Secondary Market.

a. Primary Market: A market in which the securities are sold for the first time is known as a Primary Market. It means
that under the primary market, new securities are issued from the company. Another name for the primary market is New
Issue Market. This market contributes directly to the capital formation of a company, as the company directly goes to
investors and uses the funds for investment in machines, land, building, equipment, etc.

b. Secondary Market: A market in which the sale and purchase of newly issued securities and second-hand securities are
made is known as a Secondary Market. In this market, a company does not directly issue its securities to the investors.
Instead, the existing investors of the company sell the securities to other investors. The investor who wants to sell the
securities and the one who wants to purchase meet each other in the secondary market, and exchange the securities for
cash takes place with the help of an intermediary called a broker.

Capital market Instruments

1. Equity stocks: Equities represent a stake in the company's ownership. The investor prefers them due to their ability to provide
higher returns over the long pull. They are highly volatile, which indicates that these instruments also have a downside. They are
categorized under risky assets.

Here are the key features of equity stocks:

 Provides part-ownership in the company.

 High liquidity enables the easy sale of shares in the market.
 Inherent volatility offers investors short-term gains based on price fluctuations.

Various types of stocks:

1. Common Stock: Common stock represents ownership in a corporation and typically grants shareholders voting rights at
shareholder meetings. It also entitles shareholders to a share of the company's profits in the form of dividends, though
dividends are not guaranteed and can vary.

2. Preferred Stock: Preferred stock is a type of equity security that usually does not have voting rights but has a higher
claim on assets and earnings than common stock. Preferred shareholders typically receive fixed dividends before
common shareholders and have priority in receiving assets in the event of liquidation.

3. Blue-chip Stocks: Blue-chip stocks are shares of large, well-established companies with a history of stable earnings and
dividends. These companies are typically leaders in their respective industries and are considered relatively stable and
reliable investments.

4. Small-cap, Mid-cap, and Large-cap Stocks: Stocks are often categorized based on market capitalization, which is the
total market value of a company's outstanding shares. Small-cap stocks have smaller market capitalizations, mid-cap
stocks have medium-sized market capitalizations, and large-cap stocks have larger market capitalizations.

5. Sector-specific Stocks: Stocks can also be classified based on the sector or industry in which the company operates,
such as technology, healthcare, financials, consumer discretionary, and energy, among others.

2. Debt securities: Debt instruments are securities issued by governments or corporates to raise money. Interest is paid on these
instruments at regular intervals. The principal amount is repaid at face value at the end of the contract period. The debt
instruments could be secured or unsecured.

a) Bonds are also known as fixed income instruments. Those are used by governments or companies to raise money by borrowing
from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the
investment, with interest, over a certain period of time.

Various types of bonds are corporate and government bonds. Those are rated by credit agencies to help determine the quality of
those bonds. These ratings are used to help assess the likelihood that investors will be repaid.

 Corporate bonds are debt instruments issued by a company to raise capital for initiatives like expansion, research and
development. The interest you earn from corporate bonds is taxable. But corporate bonds usually offer higher yields than
government or municipal bonds to offset this disadvantage.
 Municipal bonds are issued by a city, town or state to raise money for public projects such as schools, roads and
hospitals. Unlike corporate bonds, the interest you earn from municipal bonds is tax-free.

b) Debentures: A debenture is a type of loan, or a long-term debt instrument issued by a company or organisation to raise funds
from the public or institutional investors. It is essentially a form of loan that investors provide to the issuer, typically a
corporation, or government entity. In return, the issuer promises to repay the principal amount along with periodic interest
payments at a predetermined rate.

The different types of debentures are:

 a. Convertible debenture: A convertible debenture is a type of debt instrument that provides the holder with the option to
convert the debenture into equity shares of the issuing company after a specified period. This conversion feature allows
investors to benefit from potential capital appreciation if the company's stock price rises, thereby transitioning from
being creditors (debt holders) to shareholders.

b. Non-convertible debenture (NCD): Non-convertible debentures are debt instruments that cannot be converted into
equity shares. They remain as fixed-income securities throughout their tenure. NCDs offer investors regular interest
payments at a predetermined interest rate until the maturity date, providing a predictable income stream.

c. Redeemable debenture: Redeemable debentures are debentures that come with a specific maturity date. The issuer is
obligated to repurchase them from debenture holders at face value upon maturity. Investors receive both periodic interest
payments and the return of the principal amount upon maturity, which provides clarity on when the investment will be
repaid.

d. Irredeemable debenture (perpetual debenture): Irredeemable debentures, also known as perpetual debentures, do not
have a fixed maturity date. They continue indefinitely, and the issuer has no obligation to repurchase them. Investors
receive periodic interest payments, and the principal amount remains invested, with no specified date for redemption.
These debentures offer a perpetual income stream.

Money Market:

A market for short-term funds that are meant to use for a period of up to one year is known as Money Market. In the general
case, the money market is the source of funds or finance for working capital. The transactions held in the money market involve
lending and borrowing of cash for a short term and also consist of the sale and purchase of securities with one year term or
securities which get paid back (redeemed) within one year. Some of the common instruments of the money market are Call
Money, Commercial Bills, T. Bills, Commercial Paper, Certificates of Deposits, etc.

Some of the Instruments of Money Market are:

1. Call Money: The money borrowed or lent on demand for a short period of time (generally one day) is known as Call
Money. The term of the call money does not include Sundays and other holidays. It is used mostly by banks. It means
that when one bank faces a temporary shortage of cash then the bank with surplus cash lends the former bank with
money for one or two days. It is also known as Interbank Call Money Market.

2. Treasury Bills (T. Bills): On behalf of the Government of India, Treasury Bills are issued by the Reserve Bank of India
(RBI). With the help of T. Bills, the Government of India can get short-term borrowings as they are sold to the general
public and banks. The Treasury Bills are freely transferable and negotiable instruments and are issued at a discount. As
Treasury Bills are issued by the Reserve Bank of India, they are considered the safest investments. The maturity period
of the Treasury Bills varies from 14 days to 364 days.

3. Commercial Bills: Commercial Bills also known as Trade Bills or Accommodation Bills are the bills drawn by one
organisation on another. Commercial Bills are the common instruments of the money market which are used in credit
sales and purchases. The maturity period of commercial bills is for short-term, generally of 90 days. However, one can
get the commercial bills discounted with the bank before the maturity period. The Trade Bills are negotiable and easily
transferable instruments.

4. Commercial Paper: An unsecured promissory note issued by private or public sector companies with a fixed maturity
period varying from 15 days to one year, is known as a Commercial Paper. It was for the first time introduced in India
in 1990. As this instrument is unsecured, it can be issued by companies with creditworthiness and good reputation. The
main investors of commercial papers are commercial banks and mutual funds.

5. Certificate of Deposits: A time or deposit that can be sold in the secondary market is known as a Certificate of
Deposits (C.D.). It can be issued by a bank only and is a bearer certificate or document of title. A Certificate of Deposits
is a negotiable and easily transferable instrument. The banks issue the Certificate of Deposits against the deposit kept by
the institutions and companies. The time period of a Certificate of Deposits ranges from 91 days to one year. The C.D.’s
 can be issued to companies, corporations, and individuals during a period of tight liquidity. It is that time when the
bank’s deposit growth is slow, but the credit demand is high.

Difference between capital market and money market

Basis Capital Market Money Market

Introduction Market which is concerned with the trading of Market that concerns with the trading of short term
long-term financial instruments financial instruments
Maturity Period Long Short
Related To Long term borrowings Short term debt
Market Type Formal Informal
Objective/Purpose Fulfill long term financial requirements Fulfill short-term financial need
Risk High Less
Return More Less
Instruments Bonds, equity shares, preference shares etc. Commercial paper, trade credit, promissory notes etc
Nature Of Instrument Heterogeneous Homogeneous
Convertible Into Cash Difficult Easy

Derivatives:

Derivatives are financial contracts whose value is based on the price movements of an underlying asset, such as stocks, bonds,
commodities, or market indices. They are used for hedging against risk, speculating on price changes, and managing investment
portfolios. Common types include futures contracts, options contracts, swaps, and forwards contracts.

1. Future Contracts: Futures indicate an agreement between parties for the purchase and delivery of assets at an agreed-upon
price in the future. The parties have the obligation to fulfill the commitment of trading the asset. These contracts are used to hedge
risk or for speculating on the price of the underlying assets. If the accepting party no longer wants the delivery of the product
agreed upon through the contract, they can sell it before expiration and keep the profit. Speculators can close their obligation of
either purchasing or delivering a commodity before the expiration of the contract with an offsetting contract. They can do so with
mutual agreement.

2. Swaps: Swap is a contract between two parties that agree to exchange cash flow or liabilities from two different financial
institutions. These are over-the-counter derivative products and are not traded over exchanges. Swaps occur between financial
institutions and businesses as per their convenience. Swaps are used to hedge currency risk and interest rate risk.

There are different types of swaps:

a. Interest Rate Swaps: This type of swap allows counterparties to exchange fixed and floating cash flows on interest-
bearing investments. Investors can switch the cash flow as per their requirement using interest rate swaps. Here, instead
of the principal amount, the interest payments are exchanged on ‘notional principal’. It converts one interest rate basis to
another rate basis to fixed interest.

b. Currency Swaps: In this agreement, the parties exchange the loan amount and interest in one currency for another
currency. At the inception of currency swap, principal amounts are exchanged at a spot rate. During the length of a
currency swap, each party has to pay interest on the swapped principal loan amount. Once the swap ends, principal
amounts are swapped back at either the pre-agreed rate or the prevailing spot rate. Through currency swaps, companies
can obtain foreign currency loans at better interest rates than directly through the foreign market.

c. Commodity Swaps: This financial derivative is a contract that occurs among companies that use raw materials for
producing finished goods and products. The two parties agree to exchange the cash flow that is dependent on the price of
an underlying commodity. Commodity producers and consumers can lock in the set price for a given commodity through
commodity swaps. These are not traded on an exchange but are customized deals executed outside of the formal
exchange without the supervision of an exchange regulator. Commodity swaps limit the risk for a given party within the
 swap. The party that is interested to hedge its risk against the volatility of a commodity price enters this swap. This party
accepts to pay or receive an agreed price throughout the agreement.

d. Credit Default Swaps: It is a financial derivative that allows investors to swap credit risk with another investor’s risk.
These contracts are maintained through an ongoing premium payment that is similar to the regular premiums due to the
insurance policy. Lenders purchase these swaps from those investors who agree to pay the lender in cases when the
borrower defaults on its obligations.

e. Zero-Coupon Swaps: This swap allows flexibility to one of the parties in swap transactions. The fixed rate of the swap
is paid in one lump sum once the contract reaches maturity. Since the payment is in lump sum, valuing zero-coupon
swap involves valuing present value of cash flows through the implied interest rate of zero-coupon bond.

3. Forward Contracts: Forward Contracts are agreed upon between two parties to buy and sell assets at pre-agreed prices on a
future date. They can be used for both hedging and speculation since the forward contract has non-standardized nature. These are
customizable financial derivatives that can be tailored to a particular commodity, price, and delivery date. They are over-the-
counter instruments that are not traded on exchanges. The settlement of forward contract can be done on either a cash or delivery
basis.

4. Option: Options are another type of financial derivative that allows its bearer to buy or sell underlying assets before the expiry
of the contract. These financial derivatives enhance the investor’s portfolio since options offer add-on leverage and protection.
The value of options is dependent on other asset prices. If a buyer wants to own an option, he will have to pay a premium. There
are two main types of options.

a. Call: Through the call option, the buyer holds the right to buy the underlying asset at strike price mentioned in the option
contract. It is, however, not an obligation. Based on the observation, investors make a decision to either sell or buy calls.
If the investor believes that the price of the underlying asset will increase, he buys the call. If the investor believes that
the price will decrease, then he will sell the call. In the call option, the buyer has to pay the full amount of the option
premium while entering the contract.

b. Put: These options allow buyers to sell the underlying asset at strike price as mentioned in the option contract. Similar to
the put option, there is no obligation. The seller of put option is obligated to buy the asset when put buyer exercise the
option. Based on the observation, investors make the decision to either buy or sell puts. If the price of asset increases, the
investor sells the put. If the price of underlying asset decreases, the investor buys the put.