FINANCIAL MARKETS

UNDERSTANDING DOCUMENT FOR BROKERAGE INDUSTRY AND SECURITIES MARKETS

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Brokerage Industry - Commonly used terminologies: Broker: Broker is an agent who arranges trades for his clients, in return for a commission. Brokers are used for trading by individual clients because: Brokers can solve clearing and settlement problems at a lower cost than the clients themselves can Brokers can often access exchanges and clients who may otherwise be inaccessible to the party placing the order Brokers are considerably more experienced when it comes to trading than an average investor Brokers can find easily the parties willing to trade than individual clients Brokers are better negotiators than individual clients Brokers can represent clients in the market at a time when the client may be unable to represent himself Brokers also help their clients to determine as to which dealer is offering the best quotes at a particular point in time Brokers also handle order exposure better. This means that a trader with a large order would not like to expose it all at once to the market, since it will have a large market impact. This is particularly important for traders who have a reputation for being well informed and generally place large trades. Dealer: Dealers maintain an inventory of assets and stand ready to buy and sell at any point in time. Thus dealers unlike brokers have funds that are tied up in the asset. A dealer effectively takes over the trading problem of the client. If a client is seeking to sell, the dealer will buy the asset from him in the hope of selling it later at a higher price. If a client is seeking to buy, the dealer will sell the asset in the hope of being able to replenish his inventory at a lower price. Dealers have to be expert traders. In the U.S. dealers specialize in particular segments of the market like T-bills, Commercial Paper etc. Bid and Ask: The price at which a dealer is willing to acquire an asset will obviously be less than the price at which he is willing to sell the same asset. The price at which a dealer is willing to buy is called the bid The price at which he is willing to sell is called the ask The difference between the two prices is their profit margin and is called the bidask spread

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Settlement Agents: Settling entails the payment of cash by the purchaser and the delivery of securities by the seller. The job of a settlement agent is to receive the cash from one party and the securities from the other, ensure that the amounts are in order, and pass the cash/securities to the counterparty. The largest settlement agent in the US is the NSCC, which is not surprising since clearing and settlement are related functions. In practice settlement is made very efficient by ensuring settlement on a net basis. What this means is that the buys and sells for each client will be netted into a net security position All money credits and debits will be netted into a net money position and only these net positions will be settled. For net settlement to work most efficiently, all traders must use the same settlement agent. The netting process significantly reduces the number of required transactions. Settlement Terminology: Normal-way settlement in the US occurs 3 business days after the day of trade. This is called T+3 settlements. I.e. Exchange of cash for securities takes place 3 business days from the day of the trade. There are also special settlements like cash settlements. Cash settlement means that the trade is cleared and settled on the day of trade itself. Depositories and Custodians: These entities hold cash and securities on behalf of their clients. They facilitate the settlement process by quickly transferring cash and securities to settlement agents upon receiving instructions from the traders. The largest depository in the world is the Depository Trust Company (DTC), which holds nearly 20 trillion dollars in assets. Margin: To enable the broker gauge the ability of his client to buy or sell securities, the clients will have to deposit a collateral or performance guarantee with their brokers prior to the execution of their trades. This is known as Margin. (There also exist credit agencies, which provide on demand, information about the credit histories of individuals.) When a client places a buy order but fails to pay for the stock, the broker will liquidate the margin and use the proceeds to settle the trade. The losses if any will be debited to the clients account. Similarly if a client sells a security and fails to deliver, the broker will borrow it from someone else to settle the trade. He will then liquidate the clients assets to settle his debts.

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Clearing House: The clearinghouse is an entity that undertakes the clearing and settlement activities for all the trades placed on the exchange. Now every broker will not have a credit relationship with the clearinghouse. Only certain brokers called clearing members will have such a facility. So what this means is that all the trades must be routed through a clearing member. Clearing Agents: When a trade occurs, either on the exchange floor, or over the telephone, both parties will make a record of the terms of the trade and the identity of the counterparty. Before the trade is settled, the two records must be compared to ensure that the facts and figures tally. This is called clearing. Clearing agents are entities, which match and verify records, in order to confirm that both the parties have agreed on the same terms and conditions. If the records match, the trade is said to clear and can then be settled. If there is a discrepancy, it will be reported to the traders who will then try and resolve the problem. Trades with discrepancies are called DKs (Dont Knows). In the futures markets they are called out trades. The largest clearing agency in the US is the National Securities Clearing Corporation (NSCC). Clearing is a very important exercise in the context of conventional manual exchanges. In electronic systems, the orders are matched by the computer, which contains all the required information about the orders. Consequently clearing becomes a trivial exercise. Introducing Brokers: Thus if an investor places an order with a broker who is not a clearing member, he in turn must route the order through a clearing member. Brokers who route orders in this fashion are called Introducing Brokers. Subscribers: These days, there are cases where the broker will allow a client direct access to an electronic order routing system. When these systems in turn connect to an automated order execution system, the client is effectively given an opportunity to trade directly. Clients who are given such access are called subscribers. However even in these cases the responsibility to settle the trade ultimately lies with the broker who is providing such access. Monitoring the Market: Traders who use limit orders and stop orders would be required to watch the market closely in order to modify or cancel their orders if required. However many traders cannot do this in practice, and consequently entrust this task to their brokers.

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Structure of a Brokerage Firm: The activities of a brokerage firm can be broken into three broad categories: Front-Office Operations All activities that involve client contact take place in the front office. o These tasks include the soliciting and taking of orders; execution of trades; and provision of investment advice. o Brokers solicit order flow by advertising and by calling prospective clients. o They also provide potential clients with extensive investment information and research inputs, to induce them to trade. o Sales Brokers are front office staff whose primary function is to interact with clients. They work in the Sales & Trading department of the firm. o Floor Brokers are employees who arrange trades on the exchange and on the trading floor of the firm, if the firm itself were to operate a trading platform. This division of a brokerage firm is called Floor Operations. o Large brokerage firms have a Corporate Finance department whose staff is engaged in distributing large stock and bond offerings made by companies. o These personnel work closely with Sales Brokers Back-Office Operations The back-office clears and settles all trades; maintains accounts, produces research reports; and creates and operates information systems. o Brokerage firms use computerized accounting systems to keep track of their accounts, and to clear and settle trades. o Most small firms and some large firms buy such systems off the shelf. o Some of the larger brokerage houses however use proprietary systems. o In some cases it is because these firms have special needs, which readymade systems cannot satisfy. o In other cases it is simply because an in house system had been developed, before the advent of sophisticated off the shelf systems. Proprietary Operations Proprietary operations include cash and risk management; and speculative deals on account of the firm itself. Street Name Securities: Traders often choose to allow brokers or depositories to hold securities on their behalf. Such securities are said to be held in Street Name. o In these cases, where a broker holds the security on behalf of the client, the broker is the legal owner. o The client only has a corresponding relationship in his account.

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o When a security is held in Street Name, the broker has certain responsibilities thrust on him. Firstly he must collect interest or dividends payments from the issuing firms, and credit them to the proper client accounts. o He must keep track off and handle corporate re-organizations such as name changes, splits/reverse splits, bonus issues, mergers, acquisitions, and liquidations. o He must also ensure that the issuers of securities can at all times communicate with the beneficial owners of the securities, namely the clients. o Such activities are overseen by the Corporate Reorganizations Department of the brokerage firm. Communication protocols used in Trading Industry: The software industry has developed certain communications protocols that enable systems developed by different vendors to interact with each other. The protocols allow traders to route orders and transmit related information in standard formats that can be interpreted by any FIX or OFE based system. Financial Information eXchange (FIX) protocol - Primarily serves institutional traders Open Financial Exchange (OFE) protocol - Essentially for Internet based retail traders. Margin Trading: Brokers often extend credit to clients, to other brokers, and to dealers. A client may have insufficient funds to buy securities and may consequently seek to borrow a part of the required amount. This is called Margin Trading. Short Selling: Brokers may seek to sell a security that he does not own, in which case he will need to borrow a security. This is called Short Selling. The broker must carefully evaluate all credit relationships to avoid potential losses. The Credit Manager of the firm undertakes this task. Margin Department/Compliance Department: A brokerage firm will have a Compliance Department or what is known as a Margin Department. This department is entrusted with the task of ensuring that the firm and its clients comply with all applicable regulations. Stock lending and borrowing comes into the picture where short sales are involved. A broker may lend a share or arrange for a share to be lent to a client or another broker for undertaking a short sale. Or else he may borrow a share from a client or another broker to enable his client to short sell.

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Employees who handle such activities are a part of the Margin Department or the Stock Loan Department.

Risk Management: The Risk Manager is required to monitor all activities of the firm to ensure that risks do not become unmanageable. The specific roles are: o To ensure that management is aware of all financial and legal risks o To ensure that adequate controls are in place to prevent rogue traders from creating unauthorized positions o To ensure that the concerned employees understand the financial ramifications of all proprietary trades. o To ensure that proper credit appraisal of potential clients is undertaken. Account Opening: The minimum information necessary to open an account with an NYSE member firm includes: o Full Name o Address Residential and Business (if any) o Telephone Number o Social Security or TIN (taxpayer identification number) o Employment Details o Marital Status o An acknowledgement that the client is of legal age Investment Objectives: Every client must provide a statement of purpose listing the goal of the account/. The Possible goals include: o Preservation of capital o Earning of income o Earning of tax-free income o Capital gains o Speculation o Hedging o The broker and the client should reach an agreement on how the goals ought to be indicated, to avoid potential legal disputes Options Trading: Accounts set up for trading listed options require additional information regarding: o Income o Liquid Net Worth o Total Net Worth o Investment experience with regards to stocks, bonds, and options

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Prospective customers must also acknowledge receipt of the Options Clearing Corporation Disclosure Document. This describes the risks inherent in options trading in detail. Option traders must sign and return an `options agreement within 15 days of the account being opened.

Types of Accounts: Almost all customers related securities transactions take place in either a cash account or in a margin account. In addition brokers/dealers transact significant business with each other through house accounts. Investment advisors, mutual funds, and other institutions use omnibus accounts. It allows institutions to make large single transactions, which can then be allocated to various sub-accounts. Futures contracts are executed through special accounts that are set up for this purpose. Futures accounts are regulated by the rules of the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). These accounts require more detailed financial disclosure since trading in derivatives is inherently riskier. Cash Accounts: A trader can buy or sell any security on a cash and carry basis. I.e. if the purchase is paid for in full, or if adequate funds exist in the account, then cash account transaction can be put through. The securities traded may be stocks, bonds, mutual funds, warrants, or options. Customers will receive a written confirmation from their broker that payments are due within 3 business days, in the case of T+3 settlements. If the client fails to pay, the broker will liquidate the position, and impose a 90day block or freeze on the account. Margin Accounts: Margin accounts are used to gain leverage through the use of borrowed funds, and for executing short sales. Margin customers have to sign a margin agreement also called a customers agreement or a hypothecation agreement. The margin agreement pledges the customers securities as collateral for the margin loans extended by the broker. The agreement may also contain a stock-loan consent form, which allows the broker to lend the margined securities of his clients to other clients for short sales, and arbitrage transactions. Margin customers have to be provided with a copy of the Federal Truth-inlending agreement, which describes how the broker will compute interest. Truth-in-lending Act:

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The U.S. Congress passed this Act more correctly known as the Consumer Credit Protection Act in 1968. It is firstly about truthful disclosure of the terms of a loan. But beyond that, it defines and prohibits extortionate credit practices. The Act puts restrictions on the possible seizure of the wages of a borrower to settle his debts. It also leads to the creation of a National Commission on Consumer Finance to oversee enforcement of the law. The Act requires lenders to provide significant information about credit contracts, in easily understood terms, so that a potential borrower can make an intelligent decision. It also provides certain rights to a consumer. Viz. Lenders, who fail to conform to the Act, can be sued. The Act requires lenders to disclose the Annual Percentage Rate of interest (APR) that is being charged on the loan. Lenders must disclose the total dollar cost associated with granting a loan known as the Finance Charge which is the sum of all the charges that are required to be paid by the consumer in order to secure the loan. These additional charges may include credit investigation fees, insurance premia etc. Since every lender has to quote his APR based on the same method of computation, it makes it easier for the consumer to shop around.

Street Name Stocks: Securities in a margin account are held in street name. This is done so as to facilitate the transfer and pledging of such securities. This is because the broker has a lien on such securities as long as there is a debit balance in the account. Consequently, if a client fails to respond to a payment request, the broker can liquidate or transfer the shares without obtaining his signature. Thus when securities are held in street name, the customers name will not be on the share certificate and nor will it be known to the issuer. In such cases, therefore the brokerage firm is the registered owner or owner of record. The customer is considered to be the beneficial owner. This is because all dividend and interest payments, and other reports issued by the issuer will be received and forwarded to the client by the broker. Holding of securities in street name offers certain advantages to clients. o Firstly it simplifies the transfer process. o Secondly it reduces the risk of the securities being lost or stolen, for the broker performs the safekeeping functions. o When the client wants to sell all it requires a mere phone call. o Neither signatures, nor signature verifications, are required.

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Joint Accounts: Two or more individuals may share joint interests in the same share account. The most common joint accounts are known as `joint tenants with rights of survivorship shown as JTWROS or JTROS on trade confirmations or account statements. This is nothing but an `either or survivor provision. Married couples commonly use such accounts. The major advantage of course is that in the event of death of one party, the asset goes directly to the surviving tenant. Another type of arrangement is called `tenancy in common. In this case, each partys ownership is clearly delineated and is independent of the property of others. They can achieve economies of scale leading to lower commissions. Secondly all the parties need to deal with only one trade confirmation per trade, a single periodic account statement, and more importantly need to go through only one broker. In case of a death of a joint member, remaining members can either claim their respective portions or go their separate ways, or else they can set up a new tenancy jointly. Transfer on Death Registration: TOD is actually a form of registration and is not an account type. It however offers certain features, which make many investors, prefer it to a joint account. In this kind of an arrangement the owner of the securities can designate a beneficiary to receive the securities upon his death. Advisory Accounts: Some customers lack the knowledge, time, or inclination to manage their investments. They therefore seek the services of a professional money manager, investment advisor, or counselor. Such facilities can be availed of from a number of sources. These include: o Bank Trust Departments o Large National Advisory Firms o Smaller Specialized Advisory Firms o Investment Counseling Subsidiaries of Major Securities Firms Having chosen an advisor, the client will sign a limited power of attorney or trading authorization in his favor. The advisor can then trade without consulting the client. The customer is liable for all transactions costs and advisor fees. Large advisors give a lot of business to brokers and consequently can command lower commissions.

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Discretionary Accounts: This is an alternative approach to fund management. The customer in such cases will sign a trading authorization in favor of a registered representative of a brokerage firm. Some firms have separate registration account agreements for this purpose. However there is a potential conflict of interest between the client and the registered representative. This is because the brokers representative gets no management fee. On the contrary his compensation is based on the volume of trading activity in the account. Since the representative does not need permission to trade, it is always possible for a client to level allegations of excessive trading subsequently. Such charges may or may not be justified. Another criticism is that brokers use such accounts as dumping grounds for unsuccessful IPOs. Thus there is a lot of potential for regulatory and legal problems. Many brokers either prohibit such accounts or else restrict them to carefully screened customers. They also ensure that their senior personnel handle such accounts. DRIPs: Some corporations offer their shareholders the option of reinvesting their dividends in additional shares of stock. In these cases, shareholders can directly purchase additional stocks from the issuing firm without using the services of a broker. This is known as a Dividend Reinvestment Plan (DRIP). To be eligible for a dividend reinvestment plan, most firms require that the shareholder purchase his original shares from a brokerage house. Once the investor has acquired some shares of the firm, he can subsequently enroll in a DRIP. Brokerage houses provide advice to investors regarding the choices available with regard to DRIPs. There are two types of DRIPs: Offering pre-existing or old shares: o In the first types of a DRIP there is a trustee who will purchase shares in the secondary market. The objective of acquiring the shares is to enable their re-issuance to DRIP members. o The shareholders will get the additional shares at the market price. o However, in order to encourage shareholders to participate, the companies will often offer to cover the commissions and fees. Offering new shares: o In the second type of a DRIP, the shareholders receive newly issued shares directly from the firm.

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o The company has the power to decide whether or not the shares should be issued at a discount to the prevailing market price. o Some companies offer discounts of up to 5%. Discounts are offered because the firm saves the costs of going through an investment banker. The primary goal of the issuing firm in such cases is to induce repeated investments by existing shareholders. DRIPs are popular because by offering a DRIP, a company can raise capital inexpensively. DRIPs also provide stability for the companys stock price by offering perpetual demand for shares as new dividends continue to be declared. The issuer also has the flexibility of increasing or decreasing the availability and benefits of the DRIP, depending on the amount of capital required to be raised. DRIPs also enable firms to conserve cash, which would otherwise have to be paid out as dividends. Finally these plan help build shareholder loyalty. Investors too stand to benefit. An investor will usually save brokerage fees or will be offered other discounts that a corporation will provide at the time of issuing shares. DRIPs give them the option of purchasing shares in a company that they trust, and that too by investing small amounts regularly. Shareholders will have to open a separate account with each sponsor of a DRIP, if they seek to participate. Transactions can be accomplished by mail or by automatic checking account debits. Some companies charge a small brokerage fee and a service charge per transaction. Others charge a one-time enrollment fee and/or transactions fees. Many companies require a minimum starting investment of $ 1,000. Periodic investments may also have to be of a prescribed minimum or more.

Revenues: Commissions (Primary source of revenue) Payment for orders Interest on cash balances Margin interest on loans Underwriting fees M&A consulting fees Security lending fees Commissions: In most countries commissions are negotiable. There are however countries where government or exchange regulations specify fixed commission rates that a broker must charge.

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Until 2003, the minimum commission in Hong Kong was 0.25% of the trade value. Deep discount brokers charge the least. However they provide only the bare minimum by way of service. Full service brokers charge the maximum, but offer value-added services and advice. Discount and deep discount brokers specify standard commission schedules. They may even offer additional discounts to their best clients. The commission schedule provided by a full service broker is usually just list prices, analogous to the rack rate quoted by a hotel. Very few clients will pay the list price. The regular clients can negotiate substantially lower rates. Full service brokers are increasingly charging a flat fee for the accounts that they advise. This fee covers: o All trading commissions o Investment research fees o Portfolio management fees o Account maintenance fees In the absence of a flat fee, the client would have to pay separately for each service. Clients are happy because this system takes away the incentive for the broker to churn the account. Churning refers to inducing trades primarily to benefit from commissions. The typical flat fee is 1 to 3 percent of the total value of the account, and is negotiable. Fixed fee accounts are also known as wrap accounts because all commissions and expenses are wrapped in a single fee. Institutional brokers in the U.S. typically charge a fixed price per share traded. The average price is 5-6 cents per share, but it can range from 1-12 cents per share. In most countries, however, institutional brokers base their commissions on the size of the transaction. In almost all countries the rates are negotiable. The rate may vary depending on: o The size of the trade o The difficulty of arranging it o The soft dollars that it generates Institutional clients sometimes get volume discounts based on the total volume traded during a month, quarter, or year. Most NYSE/NASD member firms establish a rate schedule and revise it periodically. The smaller brokerage firms generally wait for changes from industry leaders like Merrill Lynch or Salomon Smith Barney before adjusting their own rates. The rates inevitably favor larger transactions over smaller ones.

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The brokerage house will share the commission with the registered representative who is handling the client. The principle is the same. For a large transaction, the representative may receive 25-50% of the gross commissions earned by the firm. But for smaller trades the payout will be less and may even be nil. Thus representatives lack an incentive to handle small investors who are perceived as unprofitable. Institutional investors on the other hand witness fierce competition for their business. There are cases where large institutions are charged no commission. The loss in such cases can be justified by the perceived gains from liquidity and order flow. Brokerage houses welcome greater liquidity because most of them are dual traders. However, it is not as if institutions have been the sole beneficiaries of deregulation. Retail customers too have benefited. Prior to deregulation, the fixed commission structure was subsidizing retail customers at the expense of institutional clients. Thus when rates were deregulated, retail clients witnessed a sharp increase in rates. This lead to the evolution of Discount Broking.

Discount Brokers: These firms started out as small no-frills players. But some of them like Charles Schwab and Fidelity Investment have grown large enough to be comparable with the big full service brokerage houses. Such brokers offer the same services or attractions to all their clients. In most cases they do not offer their own research. Many simply offer Standard and Poors reports on major companies. Fidelity is an exception. In 1997 it established an agreement with Salomon to offer its institutional research. In return Fidelity agreed to provide Salomon with access to its customers for marketing new equity issues. In a discount brokerage house, the registered representative is merely an order taker. He is forbidden by firm policy to make any kind of investment recommendation. The representatives pay is not linked to the solicitation of new business or to active trading and it is much lower than that of a representative working with a full service firm. Deep Discount Brokers: These firms charge even less as compared to discount brokers. But they usually require a minimum number of trades annually and/or a large account balance.

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Soft Commissions: In an unregulated market a broker obtains greater order flow by lowering his commissions and trying to offer better services. In a price regulated market the only choices are: Offer better service Or offer other things of value Before deregulation brokers gave institutional clients many free services. The services took many forms. o They provided investment research o They gave away accounting systems; communications systems; computing systems; and provided staff training. o Clients were given marketing incentives such as: o Tickets to major sporting events o All expense paid trips to investment conferences in exotic locations o In return clients paid high commissions. To promote fairness in the systems, that is, to ensure that the services provided were commensurate with the value of business, they created a system of soft dollar accounting. Under this scheme, a client earned one soft or notional dollar for a certain amount of hard dollars spent by way of commissions. These soft dollars could then be used to procure services from the broker. They could even be used to procure services from third parties via brokers. The soft dollar system allowed brokers to compete for business despite the fixed commissions. A more aggressive broker would simply gift away soft dollars more easily. Clients benefited from the competition and by way of lower net trading costs. The soft dollar system basically undermined the concept of fixed brokerage commissions and hastened deregulation. But the abolition of the fixed commission regime has not lead to the end of the soft dollar system. In fact, the use of soft dollars has increased after deregulation. According to the SEC the total value of research paid for with soft dollars exceeded US dollars 1 billion in 1998. In fact to obtain such soft dollars, many institutional traders, and willing pay much higher commissions than they would otherwise have had to pay for trade execution. In 1998 soft dollar brokers offered 1 dollar of soft dollar services on an average, for every 1.7 dollars received by way of hard dollar commissions. The reason for popularity of Soft dollars is that mutual funds find this system to be attractive. When an investment fund pays hard dollars for expenses other than trading commissions, the cost appears as an expense in the books of accounts. Trading commissions, however, even though they are paid for with hard dollars do not show up as direct expenses in the books of account. Instead they have a financial impact on the net price at which the fund buys or sells shares. Page 15 of 52

Commissions will raise purchase prices, and lower sales proceeds. Many investors prefer to invest in funds with a low expense ratio. Thus many funds prefer to pay for services with soft dollars in order to create an illusion that costs are being managed more effectively.

Directed Brokerage & Commission Recapture: Many institutional investment sponsors direct their investment advisors to use the services of specific brokers. The sponsors thus create direct brokerage relationships to support specific brokers. For instance, political considerations force many state and municipal pension funds to use in-state brokers. Pension plans at times negotiate commission recapture agreements with brokers to whom they direct orders. These agreements require the broker to return to the sponsor some of the commissions that are paid. These recaptured commissions may reflect volume discounts or may simply be rebates. State and municipal plan sponsors use this money to pay for investment consulting services for which they would otherwise have no budget. According to the Employment Retirement Income Security Act (ERISA), trustees of private pension plans in the U.S have to treat commissions as assets of the fund. Thus if they were to recapture any commissions they would have to return them to the fund. Thus private pension plans generally do not negotiate such recapture agreements. Interest Income: Some times brokers lend a part of the money that is required by an investor to buy securities. This is called Margin Trading. In such cases the broker will charge interest on the margin loan. The rate of interest is based on the broker call money rate. This is the rate at which a broker can borrow from another broker. Brokers also earn interest on the cash that is deposited with them by their clients. But this is largely offset by the interest that they are required to pay to their clients on such balances. But in the net the broker will still make money. Some brokers will not pay interest on the clients cash balance. And there are others who will pay only if the balance were to exceed a certain minimum figure. Short Interest Rebate: When a trader wants to short sell a security his broker must have the security ready for delivery to the buyer. Thus before a broker accepts an order to short sell, he will first determine if the security is available.

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In practice the broker will usually have securities that he is holding in street name. If so, he can deliver these securities. If not he must borrow the securities from someone else. When the broker delivers a security that he holds in street name, he will not pass on the proceeds to the short seller. He will keep the cash as collateral in order to ensure that the short seller is able to repurchase the security. Thus the broker can invest the proceeds from the short sale, and will earn interest income on the same. If the broker is forced to borrow the security to facilitate the short sale, he must deposit the sale proceeds plus about 2% more with the lender to collateralize the loan. The lender of the stock can invest this money and earn interest on it. Since the market for lending securities is competitive, lenders will pay the borrowing brokers interest on the cash collateral in order to solicit business. This interest is called Short Interest Rebate. The short interest rate is based on a benchmark such as LIBOR minus a small borrowing fee. The borrowing fee would depend on the availability of the security. Securities, which are difficult to borrow, are said to be on special. The borrowing fees for them are higher. The interest that a broker earns directly or indirectly on the proceeds from a short sale can be a very significant source of revenue. Large clients and professional traders demand that their brokers rebate some of the interest earned on the proceeds of the short sale. This kind of an interest payment is also called a short interest rebate. Retail brokers however, generally refuse to pay short interest rebates to their clients as a matter of firm policy.

Security Lending Fees: A broker who holds securities in street name will often lend them for short sales. In return he will get securities lending fee. The fee would depend on the demand for short positions and the availability of the shares. Money Markets Features of the Market: It is a market for instruments with an original time to maturity of one year or less. It is a wholesale market. Instruments are: Highly Liquid Short Term Debt Securities Not for small investors.

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However they can participate indirectly through MMMFs. The money market facilitates large-scale transfer of funds. For most banks except the Bank of America, fund requirements usually exceed deposits. For smaller state and local banks, deposits usually exceed fund requirements. It helps parties to adjust liquidity imbalances. Corporations and institutions with temporary surpluses can transfer them to corporations and institutions with short-term needs.

The Federal Reserve: The Federal Reserve is the central bank of the United States. It consists of 12 member banks located in the following cities. o Boston o New York o Philadelphia o Cleveland o Richmond o Atlanta o Chicago o St. Louis o Minneapolis o Kansas City o Dallas o San Francisco Open Market Operations: The money market is where the Federal Reserve carries out open-market operations. The term refers to the buying and selling of Treasury securities by the FED in the secondary market. This is done to regulate the money supply and influence interest rates. In order to increase the money supply, the FED will buy Treasury securities. To decrease the money supply, it will sell Treasury securities. The decision to undertake such operations is taken by the Federal Open Market Committee (FOMC). The Federal Reserve of New York implements it. Features of Trading: Because of the large volumes involved, skill and expertise in trading are of the utmost importance. Most traders specialize in narrow segments of the market. The market is bound by a strict code of honor.

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 T-Bills:

Billions of dollars worth of business is conducted over the phone, and no one reneges. The market is relatively unregulated and therefore highly innovative. They are short-term debt instruments issued by the U.S. Treasury. They are devoid of credit risk. They are highly liquid. Bills with original terms to maturity of 13 weeks, 26 weeks, and 52 weeks are regularly issued. 13 week and 26 week bills are issued every week. One-year bills are issued once a month. The most recently issued securities are called On-The-Run securities. These are highly liquid. Instruments issued earlier are called Off-The-Run securities. They tend to be less liquid. These are zero coupon securities. That is, they are issued at a discount from the face value. The yield that is quoted for bills is a discount yield. Such yields are used to calculate the difference between the face value and the price to be paid.

Calculation of the Discount: For all calculations involving money market instruments the year is assumed to have 360 days. Let us use the following symbols: V = Face Value Tm = Days to Maturity d = Quoted Yield Dollar Discount: D = d x V x Tm/360 Rate of Return: The rate of return if the bill is purchased at this price will be greater than the quoted yield. Bankers Acceptances (BAs): In international trade when goods are exported the exporter will draw up a Draft or a bill of exchange. A Draft is an instrument that instructs the importer to pay the amount mentioned upon presentation. A Draft may be a Sight Draft or a Time Draft. Sight Drafts: In such cases the importer has to pay for the goods on sight of the draft. His bank will not release the shipping document until he pays.

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Such transactions are known as Documents against Payment transactions.

Time Drafts: These are also known as Usance Drafts. The bank will release the shipping documents in such cases as soon as the importer accepts the draft by signing on it. The importer need not pay immediately. In other words the exporter is offering him credit for a period. When the importer accepts a draft it becomes a Trade Acceptance. Letters of Credit (LCs): Most international transactions are backed by LCs. An LC is a written guarantee given by the importers bank to honor any drafts or claims for payment presented by the exporter. LC based transactions are more secure. Shipments under an LC can be on the basis of a sight draft or a time draft. LC Based Transactions: In the case of a sight draft the importers bank will pay on presentation. In the case of a time draft it will accept it by signing on it. A draft that is accepted by a bank is called a Bankers Acceptance. It is obviously more marketable than a trade acceptance. The Market for BAs: In the U.S. there is an active secondary market for BAs. They are short term zero coupon assets which are redeemed at the face value on maturity BAs with a face value of 5MM USD are considered to constitute a round lot. Once a BA is issued the exporter can get it discounted by the accepting bank. o That is he can sell it for its discounted value. Or he can sell it to someone else in the secondary market. The credit risk involved in holding a BA is minimal. This is because it represents an obligation on the part of the accepting bank. In addition it is also a contingent obligation on the part of the exporter. o That is if the bank fails to pay, the holder has recourse to the exporter who is the drawer of the draft

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Commercial Paper (CP): Commercial Paper is a short-term unsecured promissory note. Unsecured means that the loan is not backed by a pledge of assets. Thus it is backed only by the liquidity and earning power of the borrower. CP markets are wholesale because the denominations are large. For a large credit worthy issuer CP issues offer low cost alternatives to a bank loan. Unlike T-Bills CPs carry a risk of default. o Consequently investors demand higher yields. Sale of Paper: Most paper is sold through dealers who buy it from the issuer and resell it mainly to banks. They get a fee for this. Dealers also provide advice on what rate to offer on newly issued paper. Dealers also undertake to buy unsold paper. Large and regular issuers of paper often employ their own sales force. Rating of Commercial Paper: Paper is rated by one or more of the following main rating agencies in the U.S. o Moodys o Standard and Poor o Duff and Phelps o Fitch Credit Rating: Agencies are paid by the issuers of paper. A good rating makes it easier and cheaper to borrow However rating agencies always look at the issue from the perspective of a potential investor. This is because their credibility is based on their track record from the standpoint of accuracy. Evaluation Criteria: Rating agencies use the following criteria. Strong management. Good position for the company in a well established industry. Good earnings record. Adequate liquidity. Ability to borrow to meet both anticipated and unanticipated needs. Repurchase Agreements (Repos): In a Repo transaction a borrower of securities sells them to the lender at a price with a promise to buy it back subsequently at a higher price. Sometimes the securities are bought back at the same price, in which case interest is explicitly calculated and paid.

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It is collateralized loan because it is backed by the underlying securities. From the perspective of the borrower, such a deal is a Repo. From the perspective of the lender, it is a Reverse Repo. Investors do reverse repos because they want a better return on cash that is temporarily idle.

Types of Repos: Most repos are done on an overnight basis. Typically a dealer will locate a corporation or MMMF, which has funds to invest overnight. Some dealers may also undertake long-term speculative positions, which consequently need to be financed for longer periods. o Such repos are called Term Repos and carry a higher rate of interest. Collateral for Repos: Most repos are collateralized by government securities. Sometimes other money market instruments like commercial paper and BAs may be used. Credit Risk: In practice both he borrower and the lender are subject to credit risk. If interest rates rise sharply, the value of the collateral will decline and the lender will be vulnerable. o In this case, if the borrower were to go bankrupt, the lender will be left with assets, which may be worth less than the loan amount. If interest rates decline the value of the collateral will rise. o Now if the lender goes bankrupt, the borrower will be left with an amount that is less than the market value of the securities. There is no strategy, which will reduce the risk for both the parties. o Increasing protection for one means enhanced risk for the other. The lender can ask for margin. What this means is that he can lend less than the market value of the assets. But this will increase the risk for the borrower. The borrower can ask for reverse margin. That is, he can ask the lender to lend more than the market value of the securities. But this will increase the risk for the lender. In practice it is the lenders who receive margins. This is because they are parting with cash, which is the more liquid of the two assets. Thus the market value of the collateral will exceed the loan amount. The excess is called a Haircut.

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Haircuts: The size of the haircut would depend on: The maturity of the collateral. Its liquidity. Its price volatility. The term to maturity of the Repo Creditworthiness of the borrower. Market Risk and Marking to Market: Market risk is the risk that the value of the collateral may decline. To reduce market risk, the collateral must be periodically marked to market. That is the market value of the security should be checked to see if it is adequately in excess of the loan amount. o If not more collateral should be asked for. o Or else a partial return of cash must be demanded. Negotiable Certificates of Deposit: A CD is an instrument issued by a bank in return for a time deposit. The term negotiable indicates that there is an active secondary market where these deposit receipts can be bought and sold. A CD can have any maturity in excess of 30 days. Most CDs have maturities ranging from one to three months. CDs: CDs are interest-bearing instruments and not discount instruments. o So to get a certificate with a face value of $100,000 one has to actually deposit $100,000. CDs pay interest on an Actual/360 basis.

Yields on CDs: These are a function of demand and supply. o CDs are not risk less because the issuing bank could fail. o For the issuing bank, the effective cost of the CD is greater than the quoted rate of interest because of reserve requirements and insurance premia. Derivatives: These are assets whose demand is based on, or derived from, the demand for an underlying asset. The underlying assets could be stocks, bonds, physical assets, stock market indices, or foreign currencies. Derivative securities, more appropriately termed as derivative contracts, are assets, which confer the investors who take positions in them with certain rights or obligations.

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They owe their existence to the presence of a market for an underlying asset or portfolio of assets, which may be considered as primary securities. Consequently such contracts are derived from these underlying assets, and hence the name. Thus if there were to be no market for the underlying assets, there would be no derivatives.

Broad Categories of Derivatives: Forward Contracts Futures Contracts Options Contracts Swaps For Options, the derivative categories are: o Futures Options Options contracts which are written on futures contracts o Compound options Options contracts which are written on options contracts o Swaptions Options on Swaps Forward Contract: A forward contract is an agreement between two parties that calls for the delivery of an asset on a specified future date at a price that is negotiated at the time of entering into the contract. Unlike a conventional transaction, no money changes hands when a forward contract is negotiated. When the contract expires, the goods will be delivered and the money will be paid in return. A forward contract is an Over-the-Counter or OTC contract. This means that the terms of the agreement are negotiated individually between the buyer and the seller. Every forward contract has a buyer and a seller. The buyer has an obligation to pay cash and take delivery on the future date. The seller has an obligation to take the cash and make delivery on the future date. Futures Contract: A futures contract too is a contract that calls for the delivery of an asset on a specified future date at a price that is fixed at the outset. It too imposes an obligation on the buyer to take delivery and on the seller to make delivery. Thus it is essentially similar to a forward contract. Futures contracts are however traded on organized futures exchanges, just the way common stocks are traded on stock exchanges.

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The features of such contracts, like the date and place of delivery, and the quantity to be delivered per contract, are fixed by the exchange.

Options: An options contract gives the buyer the right to transact on or before a future date at a price that is fixed at the outset. It imposes an obligation on the seller of the contract to transact as per the agreed upon terms, if the buyer of the contract were to exercise his right. Consequently there are two types of options Calls and Puts. A Call Option gives the holder the right to buy/acquire the asset. A Put Option gives the holder the right to sell the asset. If a call holder were to exercise his right, the seller of the call would have to make delivery of the asset. If a put holder were to exercise his right, the seller of the put has an obligation to buy the asset. The buyers of both call and put options have to pay a price to acquire the option from the sellers. This called the Option Price or Premium. If the right is subsequently exercised the call/put holder will pay/receive a price per unit of the underlying asset. This is called the Strike or Exercise Price. Longs and Shorts: The buyer of a forward, futures, or options contract is known as the Long. A trader who owns an asset is said to have a Long position. People with long positions will gain if prices rise subsequently and will lose if they subsequently fall. Thus those desirous of taking long positions attempt to buy low and sell high. The seller of a forward, futures, or options contract, is known as the Short. A trader is said to have a short position when he has sold an asset that was not owned by him. In such cases he has to eventually buy the asset and return it to the investor who lent it to him to facilitate the sale. The hope is that prices would have declined by then. When a person with a short position re-acquires the asset, he is said to be `covering his position. The objective of a short seller is to sell high and buy low. In the case of options, a Short is also known as the Option Writer. Comparison of Futures/Forwards versus Options: Instrument Nature of Longs Commitment Nature of Shorts Commitment

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Forward/Futures Contract Call Options

Obligation to buy

Obligation to sell

Right to buy

Obligation to sell

Put Options

Right to sell

Obligation to buy

Swaps: A swap is a contractual agreement between two parties to exchange specified cash flows at pre-defined points in time. There are two broad categories of swaps: o Interest Rate Swaps and o Currency Swaps. Interest Rate Swaps: In the case of these contracts, the cash flows being exchanged represent interest payments on a specified principal, which are computed using two different parameters. For instance one interest payment may be computed using a fixed rate of interest, while the other may be based on a variable rate such as LIBOR. These are called fixed floating Swaps. There are also floating floating Swaps where both the interest payments are computed using two different variable rates For instance one may be based on the LIBOR and the other on the Prime Rate of a country. Obviously a fixed-fixed swap will not make sense. Since both the interest payments are denominated in the same currency, the actual principal is not exchanged. This principal is known as a notional principal. Also, once the interest due from one party to the other is calculated, only the difference or the net amount is exchanged. LIBOR: The most common benchmark is the London Interbank Offer Rate or LIBOR. LIBOR is the rate at which a Eurobank is willing to lend to another Eurobank. Commercial loans made on a floating basis are priced at LIBOR plus a spread. The spread would depend on the credit worthiness of the borrower. Currency Swaps: These are also known as cross-currency swaps. In this case the two parties first exchange principal amounts denominated in two different currencies. Each party will then compute interest on the amount received by it as per a pre-defined yardstick, and exchange it periodically.

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At the termination of the swap the principal amounts will be swapped back. In this case, since the payments being exchanged are denominated in two different currencies, we can have fixed-floating, floating-floating, as well as fixed-fixed swaps.

Deregulation of the Brokerage Industry: On 1 May 1975, fixed brokerage commissions were abolished in the U.S. Subsequently, brokers and clients were given the freedom to negotiate commissions while dealing with each other. In October 1986, fixed commissions were eliminated in London, and in 1999 Japan deregulated its brokerage industry. Also, from February 1986, the LSE began admitting foreign brokerage firms as full members. The objective of the entire exercise was to make London an attractive international financial market, which could effectively compete with markets in the U.S. Why Use Derivatives: Derivatives have many vital economic roles in the free market system. Firstly, not every one has the same propensity to take risks. Hedgers consciously seek to avoid risk, while speculators consciously take on risk. Thus risk re-allocation is made feasible by active derivatives markets. In a free market economy, prices are everything. It is essential that prices accurately convey all pertinent information, if decision making in such economies is optimal. How does the system ensure that prices fully reflect all relevant information? It does so by allowing people to trade. An investor, whose perception of the value of an asset differs from that of others, will seek to initiate a trade in the market for the asset. If the perception is that the asset is undervalued, there will be pressure to buy. On the other hand if there is a perception that the asset is overvalued, there will be pressure to sell. The imbalance on one or the other side of the market will ensure that the price eventually attains a level where demand is equal to the supply. When new information is obtained by investors, trades will obviously be induced, for such information will invariably have implications for asset prices. In practice it is easier and cheaper for investors to enter derivatives markets as opposed to cash or spot markets. This is because; the investor can trade in a derivatives market by depositing a relatively small performance guarantee or collateral known as the margin.

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On the contrary taking a long position in the spot market would entail paying the full price of the asset. Similarly it is easier to take a short position in derivatives than to short sell in the spot markets. In fact, many assets cannot be sold short in the spot market. Consequently new information filters into derivatives markets very fast. Thus derivatives facilitate Price Discovery. Because of the high volumes of transactions in such markets, transactions costs tend to be lower than in spot markets. This in turn fuels even more trading activity. Also derivative markets tend to be very liquid. That is, investors who enter these markets, usually find that traders who are willing to take the opposite side are readily available. This enables traders to trade without having to induce a transaction by making major price concessions. Derivatives improve the overall efficiency of the free market system. Due to the ease of trading, and the lower associated costs, information quickly filters into these markets. At the same time spot and derivatives prices are inextricably linked. Consequently, if there is a perceived misalignment of prices, arbitrageurs will move in for the kill. Their activities will eventually lead to the efficiency of spot markets as well. Finally derivatives facilitate speculation. And speculation is vital for the free market system.

Offsetting: What happens when a trader who has entered into a futures contract, desires to get out of his position without having to deliver or to accept delivery? He can simply offset by taking a counter-position in the same contract, on the floor of the futures exchange. (If a trader has taken a long position initially, taking a counter-position would entail going short subsequently and vice versa.) Margins: Let us first see as to why a margin is required. Since a futures contract imposes an obligation on both the parties, it is but logical that given a chance, one of the two parties would like to default on the expiration date, since it will not be in his interest to go through with the contract. The question is how can the clearinghouse guard itself against this eventuality? Remember it has provided a performance guarantee to both the parties, and unless it takes adequate precautions, it could be saddled with a loss. The protection technique is fairly simple. Estimate the potential loss for either party and collect it in advance.

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Since both the parties have an obligation, both can lose in principle. Consequently it is necessary to collect collateral from both the parties. Once the potential loss is collected from a party, there is no incentive to default. And even if the party that ends up on the losing side of the transaction were to fail to perform its obligations, the clearinghouse is in a position to take care of the interests of the other party. This is the crux of margining.

Marking to Market: Closely related to the system of margining is the concept of marking to market. What is marking to market? Now, the reason for collecting margins is to protect both the parties against default by the other party. The potential for default arises because a position once opened, can and invariably will lead to a loss for one of the two parties if that party were to comply with the terms of the futures contract. Now this loss will not simply arise all of a sudden at the time of expiration of the contract. As the prices in the market fluctuate from trade to trade, one of the two parties to an existing futures position will experience a loss while the other will experience a gain. The total loss or gain from the time of getting into a position, till the time the contract expires or is offset by taking a counter-position, whichever were to happen first, will be the sum of the these small losses/profits corresponding to each observed futures price in the interim. Marking to Market refers to the process of calculating the loss for one party, which implies a corresponding gain for the other, at specified points in time, with reference to the futures price that was prevailing at the time the contract was previously marked to market. When a futures contract is entered into, it will be marked to market for the first time at the end of that day. Subsequently, it will be marked to market everyday until either the position is offset or else the contract expires. Remember that both the parties have deposited a performance guarantee or collateral in their margin accounts. The amount of margin that is deposited when the contract is first entered into is called the Initial Margin. Margin Accounts: If a profit is made subsequently, the margin account will be credited, while if a loss is made, it will be debited. An increase in the balance in the margin account can be withdrawn by the investor. However the broker has to ensure that the balance in the account does not dip below a threshold level due to repeated losses.

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Otherwise the entire purpose of depositing margins will be defeated. This threshold is known as the Maintenance Margin. If the balance dips below this level, the trader will get a Margin Call asking for additional funds to be deposited, to take the balance back to the Initial Margin level.

Maintenance Margins: On many exchanges, a loss suffered by a party does not automatically manifest itself as a call for funds. The broker will fix a minimum threshold level for the balance in the margin account of the trader. This is called the Maintenance Margin. As long as the account balance remains above this level, the trader does not have to deposit any additional funds, not withstanding any losses that he may have suffered. However if the account balance were to dip below this level, the broker will issue a Margin Call. VaR: The whole purpose of margining is to remove the incentive to default by collecting an amount equal to the potential loss in advance. The pertinent question is therefore, How do we calculate the potential loss over a given time horizon? This is where the concept of Value at Risk or VaR comes in. The Value at Risk of a position is a statistical measure of the possible loss of value of a portfolio of assets over a specified time horizon. For instance, the 99% VaR of a portfolio over a one day horizon signifies that the portfolio is expected to suffer a loss exceeding the calculated VaR only with a probability of 1% over a one day horizon. This does not mean that the maximum loss that a portfolio can suffer from one day to the next is equal to the VaR. The maximum possible loss of value is always equal to the initial value of the portfolio, since, in principle, the value of the assets constituting the portfolio can go to a minimum of zero. A given measure of VaR is meaningless unless the corresponding probability level and time horizon are specified. Margins Calls & Variation Margin: The trader is expected to deposit enough funds to take the account balance back to the level of the Initial Margin, whenever he receives a Margin Call. The additional funds that are deposited are known as Variation Margin. Gross versus Net Margining:

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Clearinghouses collect margins through the brokers of the traders who have placed the orders. The margin collected by a clearinghouse is known as the Clearing Margin. The individual clients in turn will deposit margins with their respective brokers. While a broker may demand a greater margin than the amount stipulated by the clearinghouse, he certainly will not ask for less. However every broker is not authorized to collect margins.

FCMs: In the U.S. only a Futures Commission Merchant (FCM) is authorized to open an account on behalf of a client who wishes to trade. Opening and maintenance of an account entails the collection of margin money; the maintenance of balances in margin accounts; and the recording and reporting of all trading activities. Every broker need not be an FCM. A broker who merely facilitates a transaction by routing an order to an FCM is known as an Introducing Broker. Secondly every FCM is not a member of a clearinghouse. In other words, not every FCM is authorized to clear and settle trades with the clearinghouse. Members who are authorized to perform this function are called Clearing Members. Thus if you place an order with a non-clearing FCM, he must route the order through a clearing member. Every trader has to deposit margin with his FCM. However, an FCM may or may not have to deposit margins for every trade that is routed through him, with the clearinghouse. Whether he has to do so or not, would depend on whether the exchange uses Gross or Net Margining. Net Margining System: Consequently under this system, the clearinghouse will collect margin only for net difference between short and long positions the broker is having. The broker is responsible for guaranteeing performance from the standpoint of the remaining positions, which are actually short or long apart from the net value. Net margining is also known as Broker Level margining. In the case of net margining, traders have to carefully evaluate the integrity and creditworthiness of their brokers, for they cannot always rely on the clearinghouse to bail them out. Gross/Client Level Margining System:

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Under this system, the clearinghouse will ask the broker to deposit margin equivalent to all the 300 contracts that have been routed through him. Now if the shorts default, and the brokers go insolvent, the clearinghouse will have adequate resources to take care of all the 180 long positions. India has adopted a gross margining system. Gross margining provides greater safety but carries a higher economic price tag.

Trading Volume: Trading Volume refers to the number of contracts that are traded during a given period, usually a day. Every trade will consequently lead to an increase in the value recorded for the trading volume for that day. Open Interest: Open Interest refers to the number of open positions at any point in time. Obviously the number of open long positions will be equal to the number of open short positions. Consequently, we need to total up only one side of the market while calculating the open interest. Trading Volume vs. Open Interest: Every trade need not lead to an increase in the open interest. If both parties to a trade are increasing their respective positions, then open interest will rise. However, if in the process of trading, one of the parties is offsetting, and then open interest will remain unchanged. However, if the trade results in both parties offsetting their existing positions, then open interest will actually fall. A high trading volume indicates that the market was very liquid on that day. A high open interest on the other hand is a signal that liquidity on future days is likely to be high. Because, the higher the open interest, the greater is the potential for offsetting. The relationship between the spot price and the forward price at any point in time is a function of the carrying cost. Arbitrage: The inefficiencies in a system are overcome in practice by a process known as arbitrage. We will define arbitrage as the potential to make costless risk-less profits by simultaneously transacting in multiple markets. These opportunities cannot persist for long. As investors rush to buy shares in New York, the price on the NYSE will rise. As everyone starts selling shares in London the price on the LSE will fall.

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As people start selling pounds and buying dollars, the dollar will appreciate relative to the pound. Consequently equilibrium will be restored.

Cash and Carry Arbitrage: What would be the consequence if F > S + rS If so, an arbitrageur would borrow and buy the asset and go short in a forward contract to deliver at a future date. At the time of delivery he would receive F, return S + rS, which represent the loan plus interest, and pocket the difference. Such a strategy is called Cash and Carry Arbitrage. To rule it out, we require that F S rS F S (1+r) The rate of return obtained from a cash and carry arbitrage strategy is called the Implied Repo Rate. Thus cash and carry arbitrage is profitable only if the Implied Repo Rate exceeds the borrowing rate. We have seen that if F > S + rS then it can be exploited by an arbitrageur by going short in a forward contract. However, what if F < S + rS? This too represents an arbitrage opportunity. However to exploit it, one would have to take a long position in a forward contract. Under such circumstances, the arbitrageur would have to short sell the asset and invest the proceeds as the risk-less rate. He would have to simultaneously go long in a forward contract to reacquire the asset at a predetermined price. Such a strategy is called Reverse Cash and Carry Arbitrage. Synthetic T-Bill: A combination of a long position in the asset and a short position in the forward contract is equivalent to a long position in a Zero Coupon instrument. Such a Zero Coupon instrument is called a Synthetic T-Bill. Symbolically Spot Forward = Synthetic T-Bill The negative sign indicates a short position in the forward contract. Thus if we have a natural position in two out of the three assets, we can artificially create a position in the third. Short Sales:

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When an investor expects the market to go through a bull phase, or expects stocks to rise in value He will acquire stocks in anticipation of being able to sell them subsequently at a higher price The maxim is Buy Low and Sell High But what if an investor anticipates a bear phase? He would like to Sell High and Buy Low Short selling requires an investor to sell a stock that he does not own How can one sell something that one does not possess? The answer is simple, borrow the asset from someone and sell it In this case, borrow the shares from a broker and sell When an investor requests that a share be borrowed on his behalf and sold, the proceeds will be credited to his account. At some point in time he will have to actually buy the share in order to return it This is called Covering the Short Position Obviously the anticipation is that the share price will be lower when the short position is covered. If so, the investor will reap a profit If not, he will make a loss

Margin Trading: The term Margin Trading refers to the purchase of shares by borrowing a fraction of the required amount Short Selling too is a form of Margin Trading the difference is that instead of cash, shares are being borrowed Consequently, short selling in the U.S is governed by Regulation T (Reg T), the same regulation that governs margin trading Thus when a share is sold short, the seller must deposit at least 50% of the sale proceeds as collateral, in addition to the proceeds from the short sale A short position is inherently more risky than a long position acquired on the margin When one buys an asset on the margin, the maximum possible loss is equal to the purchase price of the share When a stock is bought on the margin the broker will tolerate losses till the maintenance margin level is reached If the investor fails to respond the position will be liquidated and the funds due to the broker will be recovered The balance will be refunded to the investor Short sales entail finite profits and infinite losses That is profits are capped at 100%, while losses are unbounded Short Sale undoubtedly contributes positively to the functioning of the free market system It provides liquidity and helps drive down the prices of overvalued stocks to realistic levels The Uptick Rule:

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The SEC, NYSE, and NASD have rules that prevent short selling unless the sale is at a price that is higher than the last different price That is, the trade must be on an Uptick or on a zero Uptick The objective is to prevent short sales in a declining market, because sustained short selling under such conditions, can cause markets to crash

Implied Reverse Repo Rate: The cost of borrowing funds using a reverse cash and carry strategy is called the Implied Reverse Repo Rate. Reverse cash and carry arbitrage is profitable only if the Implied Reverse Repo Rate is less than the lending rate. The No-Arbitrage Condition: In order to rule out cash and carry arbitrage, we require that F S (1+r) In order to rule out reverse cash and carry arbitrage we require that F S (1+r) Hence to rule out both forms of arbitrage it must be the case that F = S (1+r) Futures or Options? Futures contracts lock in the price at which the hedger can buy or sell the asset. When a futures contract is entered into, the futures price is set in such a way that the value of the contract to both the parties is zero. Thus neither party need pay to get into a futures position. Options however give protection on one side, while permitting the hedger to benefit from favorable price movements on the other side. In the case of an option, whether it is a call or a put, the buyer has to pay a price to the writer at the outset, in order to acquire the right. This price is called the Option Price or the Option Premium. This amount cannot be recovered if the buyer were to decide not to exercise the option subsequently. Exercise Price: The exercise price is what the option holder has to pay per unit of the asset, if he decides to exercise the option. Speculating With Futures: The advantage of speculating with futures is that the entire value of the asset need not be paid in order to acquire a long position. All that the speculator has to do is to deposit the required margin. Secondly, because of the high volumes of transactions involved, transactions costs are much lower in futures markets. Bulls and Bears:

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A person who anticipates that the market will move up is a Bull. He can speculate by either going long in futures, or by buying call options. An investor who anticipates that the market will fall is called a Bear. A Bear can speculate by going short in futures or by buying put options.

Options: Options are by design different from forward and futures contracts. The buyer of the options contract is called the Holder or the Long, and he has a right. The seller of the contract is called the Writer or the Short and he has an obligation. Options contract, which can be exercised only at the time of expiration, are called European options. Contracts, which can be exercised at any time, up to, and including the time of expiration are called American options. Most exchange-traded options are American. Option Price or Premium: This is the cost of acquisition of the option. It is payable by the buyer to the writer at the outset. Thus unlike in the case of a forward or a futures contract, the long has to pay the short to get into an options contract. Strike Price/Exercise Price: This is the price payable per unit of the underlying asset, if a call option is exercised by the holder. It is the price receivable per unit of the underlying asset, if a put option is exercised by the holder. Thus when the buyer of an options contract pays the option premium, he merely acquires the right to transact. If he subsequently decides to go through with the transaction, he must pay to acquire the underlying asset in the case of call options. Or else he must be paid when he delivers the underlying asset in the case of put options. Expiration date: This is the point in time after which the contract becomes null and void. It is the only point in time at which a European option can be exercised. It is the last point in time at which an American option can be exercised Profit Bounds: For a call holder the maximum profit is unlimited, since theoretically, there is no upper bound on the price of the asset. Thus if the call is exercised: = (ST X) C, which has no upper bound. ST is the stock price, X is the exercise price and C is the premium.

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If the call is not exercised: = -C

For a call writer the maximum profit is the option premium. This is because the best thing that can happen from his standpoint is that the holder does not exercise, and he consequently gets to retain the entire premium. Thus if the call is not exercised: = C. If the call were to be exercised the writer has to deliver a share, whose price is theoretically unbounded, at the exercise price. That is: = C (ST X) Thus the maximum possible loss for a call writer is infinite. For a put writer the maximum possible profit is the premium. This is because the best thing that can happen to him is that the option is not exercised. His loss if the put is exercised is: = P (X ST) which has a lower bound of (P X) = -(X-P) Thus both calls and puts are Zero Sum Games. One mans profit is always another mans loss.

Exchange Trade and OTC Options: Exchange traded options were introduced for the first time by the Chicago Board Options Exchange (CBOE) in 1973. Until then options were only traded Over the Counter. OTC options are customized, in the sense that the exercise price, the expiration date, and the contract size are negotiated between the buyer and the seller. Exchange traded options are however standardized like futures contracts. That is the allowable exercise prices and expiration dates are specified by the exchange. Individual buyers and sellers can incorporate any of the allowable exercise prices and expiration dates into their agreements, but cannot design their own contracts. The contract size too is specified by the exchange. Advantages of Exchange Trade Options: The advantage of standardization is that volumes tend to be high and transactions costs tend to be low. Secondly because of high volumes, these markets tend to be liquid. Also standardized option contracts can be offset by taking counterpositions, without necessarily involving the original counter-party. Counter Positions:

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Taking a counter-position means that if you have originally bought a call/put, you now sell an identical call/put. By identical we mean that the offsetting contract should be on the same asset, and have the same exercise price and time to expiration. Similarly if you have sold a call/put, you would now have to buy an identical call/put in order to offset.

OTC Markets: The OTC market is dominated by institutional investors. Contracts are entered into privately by large corporations, financial institutions, and sometimes even governments. When buying an OTC option you have to be either familiar with the creditworthiness of the writer or else seek a guarantee. Nevertheless OTC markets always carry an element of credit risk. They do offer certain advantages however. Firstly terms and conditions like expiration dates and exercise prices can be tailored to the specific needs of the two parties. Often the contract may be on an asset on which an exchange traded contract is not available. Since the market is private, neither the public nor other investors need to know about the transaction taking place. However, seeking privacy need not mean that an illegal activity is taking place. The OTC market is unregulated. Consequently government approval is not required to design new types of contracts. FLEX Options: Their disadvantages not withstanding, customized contracts have an appeal particularly for institutional investors. For many institutions, exchange designed contracts are often inadequate and they desire their freedom to create their own contracts. Traditionally, an institution in need of a tailor-made contract has had to seek out another like minded institution like a commercial bank that is seeking to write an option with similar features. Of late, in response to competition the exchanges have been making an effort to grab a slice of the growing OTC market. Both FLEX and E-FLEX options are cleared by the clearinghouse. Money ness: Let us denote the current stock price by St and the exercise price by X. If St > X, the call option is said to be in the money. Example: St = 110; X = 100 If St < X the call option is said to be out of the money. Example: St = 90; X = 100

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If St = X the call option is said to be at the money. Example: St =100; X = 100 For put options, if St > X, the option is said to be out of the money. Example: St = 110; X = 100 If St < X, the put option is said to be in the money. If St = X, the put option is said to be at the money. If St is very close to X, both call and put options are said to be near the money. Obviously, an option, whether a call or a put will exercised only if it is in the money.

Long Term Equity Anticipation Securities or LEAPS: In addition both the CBOE and the Amex offer long term options with up to two years to maturity called Long Term Equity Anticipation Securities or LEAPS. Option Class: All contracts on a given stock, which are of the same, type that is calls or puts, are said to constitute an Option Class. For instance all the calls that are available on IBM at a point in time, irrespective of their strike price or the expiration date, would be said to constitute an Option Class. Options Series: All the contracts in a given class, that is, the Call Class or the Put Class, and which have the same exercise price and the same expiration date, are said to constitute an Options Series. Thus all call options contracts on XYZ stock with X = 75 and expiring in June 2003 would constitute an Options series. Cash Settlement: Cash settlement is used for Index options globally. So if an index option is exercised the holder will receive the difference between the current index value and the exercise price, in the case of call options. In the case of puts, the holder will receive the difference between the exercise price and the current index level, from the writer. Equity: Equity shares or shares of common stock represent ownership in a business enterprise. When an investor subscribes to the issue of shares by a company he becomes a part owner of the business. Ownership of shares entitles an investor to dividends paid by the firm. The rate of dividends is not fixed neither is it contractually guaranteed.

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However good companies try to keep dividends at steady levels to avoid sending wrong signals to the outside world. A firm will however not pay out its entire profits for the year as dividends. A fraction of the profits for the year will be reinvested in the company. This is known as `Retained Earnings. If a firm is forced to declare bankruptcy, then the shareholders are entitled to the residual value of the business, after the claims of the other creditors are fully settled. Equity shares never mature, in the sense that they have no expiry date. This is because when a firm is created, it comes into existence with the assumption that it will last forever. Shareholders are given voting rights. They can vote on various issues at the Annual General Meetings of companies, including the election of the board of directors. Not all shares carry voting rights, however. There are categories of non-voting shares, and shares with restricted voting rights.

Debt Securities: Debt instruments are financial claims issued by borrowers to the lenders of funds. The ownership of a debt security does not constitute part ownership of a business venture. It is merely an IOU. Issuers of debt promise to pay interest at periodic intervals, and to repay the principal at maturity. Long term debt securities (with a time to maturity of one year or more) issued by the government or by corporations, are called Bonds or Debentures. In the US a debenture is a bond for which no collateral has been specified. In India the terms are often used interchangeably. In the US the Treasury Department issues long term bonds called Treasury Bonds or T-bonds. Companies and governments also issue short term debt instruments (with a time to maturity at the time of issue of one year or less). Examples include Commercial Paper and T-bills. Commercial Paper is issued by corporations to meet Working Capital requirements. T-bills are issued by the Treasury Department and have a maturity of either 13, 26, or 52 weeks. The Treasury also issues medium term debt (with maturities ranging from 1 to 10 years) called T-notes. These are otherwise similar to T-bonds. Terminology often differs across countries. T-notes in Australia, for instance, correspond to T-bills in the U.S. Interest payments on debt securities are contractually guaranteed. That is, they are not a function of the profits made by a firm. Consequently all interest payments have to be made, before dividends can be paid to equity shareholders.

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Similarly in the event of bankruptcy, the claims of the bondholders have to be settled first. Consequently if a company defaults on a scheduled interest payment, or principal repayment, the bond holders can stake a claim on its assets. Debt securities can be `secured or `unsecured. Secured instruments are backed by pre-specified assets, which have been pledged as collateral. If the company is unable to honor its debt, these bond holders have a right over these assets. Debt instruments can be `Negotiable or `Non-negotiable. Negotiable instruments can be freely traded because they can be endorsed by one party to another. Non negotiable securities cannot be transferred. Examples include bank loans and bank time deposits.

Preferred Shares: They are a hybrid of debt and equity. They are promised a fixed rate of return like debt holders. But if the firm is unable to pay as promised then preferred shareholders cannot seek legal recourse. However until and unless their overdue dividends are paid the firm usually cannot pay dividends to equity holders. Dividends on preferred shares can be paid only after a company has made interest payments on its outstanding debt. In the event of liquidation, preferred shareholders get priority over equity shareholders. Pre-Tax versus Post-Tax Payments: Equity and preferred dividends are paid out of post-tax profits. However interest paid by the company on debt can be deducted from the profits while computing its tax liability. This reduces the tax burden for the firm or in other words gives it a `tax shield. Returns or Yields: In the case of equity shares, returns accrue in the form of dividends and/or capital gains/losses. If the subsequent selling price of an asset is greater than the original cost of acquisition, the profit is termed a capital gain. However, if the subsequent selling price is less, it gives rise to a capital loss. In the case of bonds, the investor gets returns by way of coupon payments and capital gains/losses. The interest rate paid by a bond is known as the coupon rate. Liquidity: Liquidity may be defined as follows: `It is the ability of market participants to transact quickly at prices that are close to the true or fair value of the asset.

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`It refers to the ability of buyers and sellers to discover each other quickly and without having to induce a transaction by offering a large premium or discount. In liquid markets there will always be plenty of potential buyers and sellers available. So traders will not be required to spend precious time and money in locating counterparties. If a market is liquid, large trades will not have a significant price impact. In the absence of liquidity, large purchase orders will send prices shooting up, while large sale orders will end up depressing prices substantially. Liquid markets in other words have a lot of depth. Securities, which trade in illiquid markets, are said to be thinly traded.

Underwriting: When a dealer underwrites an issue, he undertakes to buy that part of the issue, which remains unsubscribed if the issue is under subscribed. Underwriting helps in two ways. o Firstly it reduces the risk for the issuer. o Secondly it sends a positive signal to potential investors. This is because, in the case of an underwritten issue, a potential investor knows that the banker is willing to take whatever portion of the issue is left unsubscribed. An investment banker may not however like to take on the entire risk. Sometimes a group of investment bankers may underwrite an issue. This is called Syndicated Underwriting. The fee for underwriters in the U.S. is about 7% of the issue amount. Sometimes the bank may also be offered an option to buy additional shares at the original issue price. These options can become very valuable if the issue succeeds, for the stock price will then rise perceptibly. The underwriting fee compensates the investment bank for the sales effort as well as for the insurance service. Since a best efforts offer does not involve the insurance component, the corresponding fees and commissions tend to be lower. Underwriting fees are negotiated between the investment bank and the client. The fee is a function of the risks involved, and the amount of capital required to be deployed. Best Efforts: At times, an investment bank, instead of underwriting the issue may offer to sell it on a best efforts basis. That is, it will try and do everything to ensure that the issue is fully subscribed to. Devolvement Risk: Devolvement risk is the risk that the bank has to buy the unsold securities in the event of under subscription. Devolvement is a clear signal of negative market sentiments.

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It will lead to a loss for the investment banker because the acquired shares will inevitably have to be disposed off at a lower price.

GDRs and ADRs: Foreign equity is traded on international markets in the form of Depository Receipts (DRs). These are generally known as Global Depository Receipts (GDRs). In America they are known as American Depository Receipts (ADRs). ADR: It is a special share of foreign equity priced in U.S. dollars. It is essentially a depository receipt issued to American investors on the basis of shares issued by a foreign entity. Each receipt represents ownership of a specified number of securities that have been placed with a depository bank in the issuers country. ADRs can be a fraction, or a multiple, of the underlying foreign shares, packaged in a way so as to ensure that they trade at the appropriate price range in the U.S. The first ADR was created by J.P. Morgan in 1927. An ADR is akin to any domestic US security from the standpoints of clearing and settlement. They are traded on the NYSE, AMEX, NASDAQ, and OTC markets. In 1996, 13,655 Billion USD worth of DRs was raised through 80 public offerings by companies from 80 countries. There are four levels of ADRs in the U.S. They differ primarily with respect to the amount of information that is required to be provided to the investors. This of course has implications for the level of access granted to the U.S. capital market. Unsponsored ADRs are issued by depositories in the US in response to market demand. These issues are not initiated by the parent foreign company. Sponsored Level-I ADRs do not require compliance with U.S. GAAP, or disclosure beyond what is required in the home country. These can be traded on OTC markets in the U.S. and on some exchanges outside the U.S. Level-II ADRs can be traded on U.S. exchanges, but require financial statements conforming to U.S. GAAP, and disclosure in accordance with SEC regulations. Level-III ADRs require even more paperwork, but allow for the issuance and sale of new shares to raise equity capital in the U.S.market. Companies also have the option of selling sponsored ADRs to institutions via a private placement. Fungibility: Fungibility is defined as the ability to interchange with an identical item.

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One way fungibility means that a holder of an ADR in the US can sell the DR back to the depository and get the underlying foreign-currency denominated shares, which can then be sold in the foreign country. Two way fungibility means that foreign shares can be surrendered to the depository and DRs acquired in lieu. One way fungibility is less attractive from the standpoint of an American investor. It is because it has the potential to reduce liquidity and the floating stock of DRs.

Stock Market Indices: In order to study the performance of financial markets over a period of time, analysts track stock indices. There are many different ways of computing a stock market index. We will study three types of indices in detail. Price Weighted Indices Value Weighted Indices Equally Weighted Indices Price Weighted Index: (Example: Dow Jones Industrial Average DJIA) To calculate a price-weighted index, we need to sum up the prices of all the stocks, which have been chosen to constitute the index. This sum has to be then divided by a number called the `Divisor. We will also assume that we are standing on the base date. The base date is the date on which the value of the index is being computed for the first time. On the base date the value of the divisor can be set equal to any number. A logical choice would be the number of stocks constituting the portfolio. NOTE: We will continue to use the new divisor until any of the component stocks undergoes a split or a reverse split. Similarly if a company declares a stock dividend, or one company is replaced by another, we will once again have to change the divisor. One feature of a price weighted index is that a high price stock carries more weight than a low price stock Value Weighted Index: (Example: S&P 500) A value-weighted index is computed using the market values or market capitalization of the component stocks, instead of just their prices. Market Value is defined as: Market Price x # of shares outstanding. In the case of a value-weighted index, the importance of a particular stock would depend on its market value. Consequently, a given percentage change in the value of a large company (one with a higher market capitalization) will have a greater impact on the index, than a similar change in the value of a smaller company.

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Value Weighted Index = (1/Divisor) * (Total Market Capitalization of all stocks on the day) ---------------------------------------------------------------- * 100 (Total Market Capitalization of all stocks on base date) On the base date, the divisor is always assigned a value of 1.0. Unlike in the case of a price-weighted index, no change is required to be made to the divisor when there is a split/reverse split or when a stock dividend is announced. This is because, from a theoretical standpoint, the market capitalization of the stock concerned should remain unchanged. I.e. The decrease (increase) in price will be exactly compensated by the increase (decrease) in the number of shares outstanding.

Equally Weighted Index: Index (today) = Index (Yesterday) * (1/Total no. Of stocks) * (Price of all stocks as of today) -----------------------------------------(Price of all stocks as of yesterday) Index (today) = Index (Yesterday) * (1+ Average rate of return on all stocks between yesterday and today) Forming Mimicking Portfolios: To form a portfolio that tracks a price-weighted index, one has to buy an equal number of shares of every stock that constitutes the index. In order to mimic a value-weighted index, one has to invest a fraction of his wealth in each asset that corresponds to the ratio of the market capitalization of that particular asset to the total market capitalization of all the assets in the index. Finally, to form a portfolio which tracks an equally weighted index, one has to invest an equal dollar amount in each of the component stocks. Portfolio Rebalancing: A price-weighted portfolio has to be rebalanced on certain occasions if we want it to continue tracking the corresponding index. These events are: Stock Splits/Reverse Splits

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Stock Dividends Changes in composition Vale weighted portfolios have to be rebalanced only if there is a change in composition. However an equally weighted portfolio has to be balanced virtually every day. The only exception is the case where none of the component stocks has recorded a change in price as compared to the previous day.

Order: It is a trade instruction given to a broker or to an exchange. Orders are the fundamental building blocks of trading strategies. A proper order issued at the right time can: o Make the difference between a profitable trade and a costly trade. o It can at times even make a difference between a trade and no trade. Bid and Offer: When a trader wants to indicate that he wishes to buy a security, he will make a bid. When he wishes to convey that he is seeking to sell he will make an offer. When a dealer wishes to trade on his own account he will quote either a bid or an offer. Whereas if the dealer is trading on behalf of a client, he will convey the buy or sell order placed by the client to a broker or to an automated trading system. Bids and offers include information not just about the price, but also about the quantity sought to be transacted. This is known as the order size. The price specified in a buy order is called: the bid or the bidding price. The price specified in a sell order is called: the offer, offering, ask, or asking price. The highest bid price in the market is called the best bid. The lowest offer price in the market is called the best offer. The best bid and offer are also known as the Market Bid and Market Offer respectively. A Market Quotation often called a Best Bid and Offer (BBO) reports the best bid and offer in the market at a point in time. The best bid and offer available anywhere in the U.S. at a point in time is known as the National Best Bid and Offer (BBO). The difference between the best ask and the best bid is the bid-ask spread. It is also known as the inside spread, since it is observed within the market. In England the spread is often referred to as the touch. Once an order is accepted the price at which the trade is executed is known as the Trade Price. An order may not be released for trading as soon as it is submitted. In practice a broker may need to check whether a particular account is authorized to trade. Once an order is accepted, but before it is executed, it is known as a Working Order.

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Market Order: A market order is an instruction to trade at the best price that is currently available in the market. Such an order is likely to be executed quickly but with execution price uncertainty. Impatient traders, and those wishing to be absolutely certain about execution, will favor such orders. Limit Orders: In the case of a limit order, a limit price is specified in addition to the quantity that is sought to be bought or sold. In the case of a buy order, the limit price is the maximum that the buyer is willing to pay. In the case of a sell order it is the minimum that he is willing to receive. One of the risks facing limit order traders is execution uncertainty. The more the price moves away from them, the greater will be their frustration since the odds of execution will get progressively reduced. The second risk is that they may trade, and subsequently regret it. This is called ex-post regret. This could happen if the price moves towards and through the limit price. The order will obviously get executed. But if the market moves in an adverse direction post-trade, the trader can make significant losses. Active & Passive Orders: An incoming order is known as an active order. The orders already present in the system when a new order enters are known as passive orders. The system will automatically try and match an active order with the existing passive orders. Priority Rules: The orders in the system are queued in accordance with certain rules. The first is the Price Priority rule. o A buy order with a higher limit price will get priority over other buy orders. o A sell order with a lower limit price will get priority over other sell orders. The second rule is the Time Priority rule. o If two buy orders have the same price, the order that comes in first will get a higher priority. o The same is true for sell orders.

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Matching: If the incoming order is a Market Buy order then the system will match it with the best passive sell order, which is the sell order with the lowest price. If the incoming order is a Market Sell order then the system will match it with the best passive buy order, which is the buy order with the highest price. Marketable Limit Orders: A marketable limit order is an order that can be executed on submission. Thus, the limit price of a marketable buy order will be greater than or equal to the best offer that is available. The limit price of a marketable sell order will be less than or equal to the best bid that is available. The reason to use marketable limit order is that, unlike in the case of a market order the execution price uncertainty is limited. The limit orders representing the best bid and offer are said to be at the market. The traders who have submitted these orders are said to make the market. When a trader submits an order, which improves the existing bid or offer, he is said to make a new market. So buyers make a new market when they raise the bid. Sellers make a new market when they lower the ask. Limit orders, which stand behind the best bid and offer, are said to be away from the market. A buy order is behind the market if its limit price is less than the best bid. A sell order is behind the market if its limit price is more than the best offer. Limit Orders as Options: A standing limit order is an offer of liquidity to other traders. It gives them an option to trade at the limit price. A limit sell order is a call option that gives other traders the right to buy. A limit buy order is a put option that gives other traders the right to sell. The specified limit prices are the exercise prices of the corresponding options. However although a limit order represents an option, it is not an options contract in the conventional sense. An options contract is an option to trade that is sold by a writer to a buyer in return for a price or premium. Limit orders however are the options, which are given away for free. In the sense that the traders who place such orders do not receive a premium. Besides there is no exclusive owner of the option on the other side. For any trader can exercise the option by placing a market order or a marketable limit order. Stop Orders: It is an instruction that stops an order from getting executed until the price reaches a pre-specified stop price.

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Traders attach these instructions when they wish to buy only after the price has risen to the stop price or only after it has fallen to the stop price. Such instructions can be attached to limit as well as market orders. In the case of stop sell orders the trigger price will be less than the best price that is available at the time of placing the order. In the case of a stop buy order, the trigger specified will be higher than the best price that was available at the time of submission of the order. In the case of both stop sell as well as stop buy orders, the investors are trying to cap their losses in the event of the market moving adversely against them. Thus stop orders are known as stop-loss orders.

Market-If-Touched (MIT) Orders: An MIT order gets activated when the price touches a pre-set barrier. A stop buy order will get activated only if the price were to rise and hit the trigger. Similarly, a stop sell order will get activated only if the price were to fall and hit the trigger. On the contrary an MIT buy order will get activated if the price were to fall and hit the trigger. Consequently the trigger prices for such orders will be below the best price that is currently available. Similarly, an MIT sell order will get activated only if the price were to rise and hit the trigger. Consequently the trigger prices for such orders will be above the best available market price. But doesnt this suggest that MIT orders are similar to limit orders. There is a crucial difference between an MIT order and a Limit order. On activation an MIT order will become a market order and will get executed at the best available price. A Limit order on the other hand can only trade at the limit price or better. Tick Sensitive Orders: Tick is the minimum price increment or variation observable in the market. In other words, it is the smallest amount by which two prices can differ. It is usually set by exchange regulations In the U.S. until 2000 the tick size was one-sixteenth of a dollar or 6.25 cents. Subsequently the system has been decimalized and tick size is now 0.01 dollars or one cent. The tick size on the Tokyo Stock Exchange is a function of the price. Price P 2000 Yen 2000 < P 3000 Tick Size 1 Yen 5 Yen

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3000 < P 30000 30000 < P 50000 50000 < P 100000 100000 < P 1000000 P 1000000

10 Yen 50 Yen 100 Yen 1000 Yen 10000 Yen

Traders classify prices by their relation to previous prices. A price is said to be on an up tick if it is higher than the last observed price. A price is said to be on a downtick if it is lower than the last observed price. If a price is equal to the last observed price it is said to be on a zero tick. Zero tick prices are further classified depending on the last different price observed. A price is said to be on a zero downtick if the last different price observed was higher. A price is said to be on a zero up tick if the last different price observed was lower. A trader who wants to condition his order on the last price change can submit a tick sensitive order. A buy downtick order can be filled only on a downtick or a zero downtick price. That is, the trade price must be lower than the last different price observed. Similarly, a sell up tick order can be filled only on an up tick or a zero up tick. That is, the trade price must be higher than the last different price observed. When a broker receives a tick sensitive order he will check to see whether it can be matched without violating the tick condition. If not, the order will be held in abeyance until a suitable opportunity was to arise. The tick condition ensures that tick sensitive orders do not have a market impact. For instance, a broker holding a buy downtick order cannot bid up prices to encourage sellers. He will have to wait until someone is willing to trade at a price lower than the last different price. Thus a tick sensitive order is a limit order with a dynamically changing limit price.

Market-Not-Held Orders: These are orders, which the broker is not required to fill immediately. This instruction, if specified, allows the broker to use his discretion while filling the order. Traders give such an instruction when they want the brokers to have the freedom to take strategic decisions. Brokers are usually better traders than their clients because they are more experienced, and more familiar with market conditions. However if the broker is given the freedom to wait till he gets a better price, there is a risk that he may eventually end up trading at a worse price. Page 50 of 52

In such cases the broker cannot be held responsible for failing to trade at a price, which subsequently looks attractive. In the case of a standard market order, however, the broker can be held accountable if he fails to trade when a suitable opportunity presents itself. The only way that a trader can express his displeasure in the case of market-notheld orders is by withholding future orders from the broker. Such orders are used when a trader wants to execute a large buy or sell transaction. To avoid a major market impact in such cases, traders will reveal only a small portion of their orders at a time.

Lot Size: The usual unit of trading is referred to as a Round Lot. Normally traders trade in multiples of a round lot. Anything less than a round lot is an odd lot. The definition of a round lot depends on the instrument being traded and the market on which it trades. On the American Stock Exchange, there is no standard lot size, and a trade can be for any number of shares. Most stock exchanges in the U.S. specify a round lot as constituting 100 shares. In Japan a round lot is equivalent to 1000 shares. Open & Good Orders: An order that that has not yet been executed or canceled is an open order. An order that is eligible for execution is a good order. All good orders by definition are open orders. But every open order need not be a good order. Consider an order placed on 1 July to buy a stock on or after 3 July. On 1 July the order is an open order. But is not a good order. Day Orders: A day order is valid only for the duration of the day on which it is entered. If it is not executed during the course of the day, then the system will automatically cancel it at the end of the day. As of 1999 the Stock Exchange of Singapore has been permitting only `good today limit orders. Every morning the Exchange opens with no outstanding orders carried over from the previous day. Good till Canceled Orders: Such orders will remain in the system until they are executed or canceled, whichever happens first. So if they are not executed on the day on which they are entered, they will be carried over to the next day and so forth. But obviously they cannot remain in the system indefinitely.

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The exchange will notify a maximum time period after which such orders will be automatically canceled. In order to ensure that traders do not forget such orders, many brokers provide their clients with a list of unfilled GTC orders at the end of every month. Some brokers cancel GTC orders after pre-specified time periods to avoid the cost of keeping track of sale orders. In the US GTC orders expire semi-annually unless canceled earlier. That is, they have a maximum validity of six months.

Good till Days Order: In the case of such orders, the investor has to specify the number of days for which the order can stay in the system unless it is executed. The number of days that can be specified obviously cannot exceed the time limit set for Good Till Canceled orders. Special cases of such orders are Good-this-week (GTW) orders and Good-thismonth (GTM) orders. Not all brokers will accept such orders because it requires then to keep track of expiration dates. Other types of Orders: Good-after-orders are activated or become valid only after a pre-specified date. Market-on-open orders can be filled only at the beginning of the trading session. Market-on-close orders can be filled only at the close of the trading session. All-or-nothing or all-or-none (AON) orders must be either filled all at once or else remain unexecuted. There are also trades with a minimum or none instruction. In such cases multiple trades can be used to fill an order. But each trade must be for a quantity that is greater than or equal to a specified minimum size. Such orders are also known as Minimum Acceptable Quantity (MAQ) orders. Spread Orders: It is a combination of two orders One to buy an instrument Another to simultaneously sell another instrument Spread orders may be market orders or limit orders. Limit Spread Orders: In the case of such orders the trader will specify a limit for the acceptable difference between the two prices. The limit will be specified as a premium on either the buy side or the sell side. Premiums: Sell Side Premium: If the trader wants to sell an instrument that is priced higher than the instrument that he seeks to buy, then the premium will be on the sell side. Such orders can be filled only if the difference between the sale and purchase prices is greater than or equal to the premium. Buy Side Premium: If the instrument that is sought to be purchased is priced higher than the one that the trader wishes to sell, then the premium will be on the buy side. Such an order can be filled only if the difference between the purchase price and the sale price is less than or equal to the premium.

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