Financial Markets

Financial Market/system
A financial market /system is a market/system in which financial
assets (securities) such as stocks and bonds can be purchased
or sold.
Financial markets/systems facilitate the flow of funds and
thereby allow financing and investing by households, firms, and
government agencies.
Financial markets/systems transfer funds from those who have
excess funds to those who need funds.

Money Markets vs. Capital markets

Financial markets that facilitate transfer of debt instruments
with less than a year to maturity (short term debt instruments)
are classified as Money markets
Financial markets that facilitate transfer of instruments (debt
and equity) with more than a year to maturity (mid/long term
instruments) are classified as Capital markets.

Types of Assets
Tangible Assets
Value is based on physical properties
Examples include buildings, land, machinery

Intangible Assets
Claim to future income (Cash flows)

Debt vs. Equity

Debt Instruments
Fixed payments, preference in claim, no-ownership
Eg: Bank loans, Government bonds, Corporate bonds, Municipal
bonds, Foreign bond
Equity Claims
Non-fixed residual payments (except in preferred stock),
ownership
Eg: Common stock, partnership share, Preferred stock

Financial Assets & Financial

Are financed by issuing
Markets
Assets
Tangible (Land, Building) Assets
Intangible (FD, Share, Bonds,
Insurance) Assets

Demand for assets

Product Market

Factor Market

Investment Assets Contingent Claim (ins,Opt)

Tradable Shares, Bonds

Non-tradable (FD)

Intermediated (Exchange Traded)

Auction

Over the counter (negotiated)

Equity

Debt

Debt

Equity

Equity

Debt

Role of Financial Assets

To transfer funds from surplus to deficiency
Cash Funds
Surplus of funds

Deficiency of funds
Financial Claims/Assets

To transfer funds to redistribute the unavoidable risk associated with the

C.F. generated by the tangible assets among those seeking and those
providing the funds
Investment type Investors
Equity

B 60%

C 20%
FI 20%
Debt

FI
Bank
Working Capital

FI

Bank

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Price of Financial Asset and

Risk
The price or value of a financial asset is
equal to the present value of all expected
future cash flows.
Expected rate of return based on the
expected Cash Flows
Risk of expected cash flow
Purchasing power risk or inflation risk
Default or credit risk
Exchange rate or currency risk
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Role of Financial Markets

Determine price or required rate of return
of asset.
Provide liquidity.
Reduce transactions costs, which consists
of search costs and information costs.

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Classification of Financial
Markets
Debt vs. equity markets
Money market vs. capital market
Primary vs. secondary market
Cash or spot vs. derivatives market
Auction vs. over-the-counter vs.
intermediated market

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Financial Market
Participants
Households
Intermediaries and Business units
Central/Federal, state, and local
governments
Regulators (RBI, SEBI, IRDA)
Supranationals (IMF, WB, ADB)

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Globalization of Financial
Markets
Deregulation or liberalization of financial
markets
Technological advances
Increased institutionalization

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Classification of Global
Financial Markets
InternalMarket
(alsocallednational
market)

DomesticMarket
MSFTonNYSE

ExternalMarket
(alsocalledinternational
market,offshoremarket,
andEuromarket)
MSFTSellingEurodenominated
bondsacrossEuropeancountries

ForeignMarket
INFYonNYSE

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Motivation for Using Foreign

Markets and Euromarkets
Limited fund availability in internal
market
Reduced cost of funds in overseas
markets
Diversifying funding sources
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Financial Intermediaries
and Financial Innovation

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Types of Regulation
Disclosure regulation
Financial activity regulation
Regulation of financial institution
Regulation of foreign participation
Banking and monetary regulation

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Regulators in India
RBI Banking sector and microfinance
SEBI - Capital Markets
FMC Commodity derivatives

IRDA Insurance
Pension Fund Regulatory and
Development Authority
One integrated market regulator proposal

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Types of Financial
Intermediaries
Deposit accepting Commercial Banks/Post offices
Payment Banks
Investment and Merchant banks
FIs
MFs
Insurance firms
NBFC
Micro Finance Firms
Hedge Funds
.
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Services of Financial
Intermediaries
Transforming Financial Assets
Exchanging Financial Assets on Behalf
of Customers
Exchanging Financial Assets on Own
Account
Assisting in the Creation of Financial
Assets
Providing Investment Advice
Managing Portfolios
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Role of Financial
Intermediaries
Providing Maturity
Intermediation
Reducing Risk Through
Diversification
Reducing Costs of Contracting
and Information Processing
Providing a Payments
Mechanism
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Asset/Liability
Management
Spread and Non-Spread
Businesses
Nature of Liabilities
Amount of cash outlay
Timing of cash outlay

Liquidity Concerns
Regulations and Taxation
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Nature of Liabilities of
Financial Institutions
Amount of Cash
Outlay

Timing of Cash
Outlay
Known

Type II

Known
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Known

Uncertain

Type III

Uncertain

Known

Type IV

Uncertain

Uncertain

Liability Type
Type I

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Concerns of Regulators
Credit Risk
Settlement Risk
Counterparty Risk
Liquidity Risk
Market Liquidity Risk
Funding Liquidity Risk

Market Risk
Operational Risk
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Financial Innovation
Market broadening instruments
Risk management Instruments
Arbitraging instruments and processes

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Motivations for financial

innovations
Increased volatility of Interest rates, inflation,
equity prices and exchange rates
Advances in computer and telecommunication
technologies
Greater sophistication and educational training
among professional market participants
Financial intermediary competition
Incentives to get around existing regulations
and tax laws
Changing global patterns of financial wealth
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Asset securitization as a financial

innovation (Off Balance Sheet
Financing)

Event: Purchase of a home on a loan (home

mortgage)
Commercial
Bank Accepts
deposits and uses the fund
to finance the loan
Commercial Bank then Issues
Securities Backed by such
Home Loans
To improve the credit Quality the Commercial
Bank can obtain credit risk insurance from an
insurance for these securitized loans

the commercial bank can then sell the right

to service these loans to another company
which specializes in loan servicing
The commercial bank can then use the
services of another firm to distribute these
securities to investors through sale. 29

Benefits of securitization
To Investors
Diversification and reduced cost of funding
Management of regulatory capital
Generation of servicing fee income
Management of interest rate volatility
Benefits to investors: liquidity; lower credit risk;
diversification
Benefits to borrower: low cost
Implications of securitization for financial markets
Social benefits
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Derivatives as financial
innovation
Derivative securities are those assets the value of which are
derived from value of the underlying assets
Futures/forward contracts are buy/sell obligations that
must be fulfilled at maturity.
Options contracts are rights, not obligations, to either
buy (call) or sell (put) the underlying asset at the maturity.
Swapis a derivative in which two counterparties exchange
cash flows of one party'sfinancial instrument for those of
the other party'sfinancial instrument.
Synthetic is the term given to financial instruments that
are created artificially by simulating other instruments with
different cash flow patterns.

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Spot market
Market where buy/sell of an identified
asset is carried out for a price for
immediate delivery

Forwards contracts

Forwards contract: These are customized contracts of sale of identified

underlying for delivery on a future date at a predetermined place for a
predetermined price.
These are margin based positions and therefore create leveraged risk
exposure. Actual payment/delivery is made at the time of maturity.
Forward contracts are not much liquid due to its customized structure.
Are traded through OTC mechanism
Used by firms (sellers and buyers) to hedge against price or rate risk
Interest rates, Commodities, Exchange rates

Futures contracts

Futures contract: These are Standardized contracts of sale of identified underlying for delivery on
a future date (usually 3 months) at a predetermined place (delivery location) for a predetermined
price. These contracts are exchange listed for trading and the market is regulated by FMC (India).

These are margin based positions and therefore create leveraged risk exposure.

Actual payment/delivery is usually not made as most of the positions are closed by squaring off.

A new contract is created every month in the same underlying with same specifications to create
a chain of contracts where each expiring after the same contract term (usually 3 months).

Liquidity in futures contracts varies from contract to contract. Near Month (expiring contracts) are
more liquid than the far month contract.

For liquid contracts (index based) volume is much higher compared to underlying.

Are new futures products are created by exchanges which lists its contract for trading through
exchange mechanism

Standardization specifications are defined by the exchange

Contracts are traded through till it approaches the expiry date

If positions are not squared off, just before the expiry (delivery window) open interest need to
provide for their part of the consideration for a delivery based transaction

Used by firms (sellers and buyers) to hedge against price or rate risk

Discovery of futures prices are expected to bring price stability

Contracts are usually available in Commodities, Equity, Index (MCX, NCDEX, NSE, BSE)

Example: Forwards and

Futures

Forward X enters into an agreement to Sell to Y gold 10gm 24c three month from now for INR
35000 for delivery at the Shop of Y situated on the Main Road, Ranchi.
Price 3 months from now
35000no one looses or benefits
Price >35000 Y benefits from the difference
Price <35000 X benefits from the difference
Futures Contract of Gold 24c for delivery at Mumbai warehouse three months from now is listed
on MCX. P is looking to buy the contract at INR35000 with the expectation that the prices of the
Gold will rise.
Q is ready to sell the contract at INR35000 with the expectation that the prices of the Gold
will fall. The both place order through their broker and transaction results into a buy and a
sell open positions. The exchange generally asks for a small margin money as a deposit to
cover the risk in price fluctuations.
Before the expiration of the contract, P and Q individually can close their open positions
by taking opposite positions (P can sell the contract and Q and buy the contract) and the
difference in the Buy and sell prices would result in loss/gain to both of them respectively.
If they do not close the position, P would need to pay the remaining amount of the price
and Q would need to Deposit 24c 10 gm gold in the Mumbai warehouse just before
expiration. The warehouse would then give the gold to P and price to Q (physical
delivery).

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Options contracts

Right to buy (call) or sell (put) the underlying (without an obligation to do so)
on (European) or on some schedule (Bermuda) or anytime on or before
(American) the maturity date a predetermined quantity for a predetermined
price (strike price).
Mostly exchange traded but can be OTC as well (exotic options having
custom specifications).
Price of this right is called Option Premium which has to be paid by the writer
of the option to the buyer of the option.
Such options contracts are being created each month for different underlying
by exchanges for different strike price for the same maturity
Contracts based on the strike price can be in the money, at the money and
out of the money
They are quite leveraged contracts
Positions are short or long and are mostly squared off before maturity.
Options value reflect the value of the right under the options contract.
Options are available on Equity, Index, Exchange rate, Interest Rate

Options

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Example:
Long Call (Strike Price 100; Option
premium 3)

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Long Call

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Short Call

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Short Call: Strike Price 100; Option

premium 2

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Long Put

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Short Put

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Swaps

A swap is a derivative in which two counterparties exchange cash flows of one

party's financial instrument for those of the other party's financial instrument. It
is entered into on a mutually beneficial basis and is expected to be costless.
Example A an Indian investor holds Infosys while B a US investor holds Microsoft.
A wants to have returns of Microsoft and B want to have return of Infosys. They
can enter a swap contract where A would be entitled for returns generated by
Bs holdings and vice versa.
Interest rate swap: Bank A has given a loan at 1%+LIBOR. Bank B has given loan
at 3%+Inflation. Bank B wants to exchange its exposure against 1%+LIBOR
whereas bank A wants to exchange its exposure against 3%+Inflation. Both can
enter a swap contract.
Currency swap: A UK based firm Company A wants loan in USD while a US firm
Company B wants a loan in BP. Both of them are likely to experience higher rates
of interest compared to a domestic company to the currency. Therefore they may
enter into a contract where Company A can take BP loan in UK and Company B
can take USD loan in US and both of them agree to exchange their respective
loan cash flows at a predetermined exchange rates. If exchange rate is USD 3 =
BP 2 then US company would need to take 1.5 times domestic denominated loan
compared to UK company.
Now consider that domestic loan in UK has a 3% interest rate whereas domestic
loan at US has a 4% interest rate. This implies that for BP 2 interest would be BP
0.06 and for USD 3 interest would be USD 0.12. Therefore both the parties would
make payment such that it is equal to the cost of borrowing of the other party in
the domestic country.

Swaps

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Synthetic
X wants to take a long position in a stock but does not
have the required amount to invest.
X can create a synthetic stock by purchasing acall
optionand simultaneously selling aput optionon the
same stock at the same strike price. The synthetic stock
would have the same cash flows as that of long position in
theunderlying security but with very low actual
investment.

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Role of Derivative
Instruments
Allows for risk management: Protect
against different types of investment
risks, such as purchasing power risk,
interest rate risk, exchange rate risk.
Advantages:

Lower transactions costs

Faster to carry out transaction
Greater liquidity
Allows for efficient price discovery

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Hedge Funds and financial

innovations

No single definition of hedge fund

Hedge is misleading
Wide range of trading strategies
Leverage, short selling, arbitrage, risk
control
Operate in all financial markets
Focus on absolute returns
Cater to sophisticated investors
Have lock-in period

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Types of Hedge Fund

Market directional hedge fund

Corporate restructuring hedge fund
Convergence trading hedge fund
Opportunistic hedge fund

Keep in mind they are high risk high expected

return category funds

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