What are Fnanca markets

Fnanca market s a market where nanca nstruments are exchanged

or traded and
heps n determnng the prces of the assets that are traded n and s aso
caed the prce
dscovery process.
1. Organzatons that factate the trade n nanca products. For e.g. Stock
exchanges
(NYSE, Nasdaq) factate the trade n stocks, bonds and warrants.
2. Comng together of buyer and seers at a common patform to trade
nanca products
s termed as nanca markets, .e. stocks and shares are traded
between buyers and
seers n a number of ways ncudng: the use of stock exchanges;
drecty between
buyers and seers etc.
Fnanca markets may be cassed on the bass of
types of cams - debt and equty markets
maturty - money market and capta market
trade - spot market and devery market
deas n nanca cams - prmary market and secondary market

Indan Fnanca Market conssts of the foowng markets:

Capta Market/ Securtes Market
o Prmary capta market
o Secondary capta market
Money Market
Debt Market


Prmary capta market- A market where new securtes are bought and sod
for the rst
tme

Types of ssues n Prmary market
Inta pubc oher (IPO) (n case of an unsted company),
Foow-on pubc oher (FPO),
Rghts oher such that securtes are ohered to exstng sharehoders,
Preferenta ssue/ bonus ssue/ OIB pacement
Composte ssue, that s, mxture of a rghts and pubc oher, or
oher for sae
(oher of securtes by exstng sharehoders to the pubc for subscrpton).

Dherence between
Prmary market Secondary market
Deas wth new securtes Market for exstng securtes, whch are
aready sted
Provdes addtona capta to ssuer
companes
No addtona capta generated. Provdes
qudty to exstng stock


Leadng stock exchanges:

Bombay Stock Exchange Lmted
o Odest n Asa
o Presence n 417 ctes and towns n Inda
o Tradng n equty, debt nstrument and dervatves
Natona Stock Exchange
New York Stock Exchange NYSE)
NASDAO
London Stock Exchange

Functons of Stock Exchanges
Lqudty and marketabty of securtes
Far prce determnaton
Source of ong-tern funds
Heps n capta formaton
Reects genera state of economy

Bascs of Stock Market Indces:

A stock market ndex s the reecton of the market as a whoe. It s a
representatve of
the entre stock market. Movements n the ndex represent the average
returns obtaned
by the nvestors. Stock market ndex s senstve to the news of:
Company specc
Country specc
Thus the movement n the stock ndex s aso the reecton of the expectaton
of the
future performance of the companes sted on the exchange

Index Cacuaton:
Step 1: Cacuate the weghtage of each scrp
Weghtage = (Mcap t / tota market cap)*100

Step 2: Vaue of ndex
n
_ {Mcap t * Weght t }/ W b
I=1

Where;
Mcap t = market cap of scrp "" at tme "t"
= prce of the share * number of outstandng shares
W b = Sum of a the market cap of a the scrps n the ndex durng the base
year

Settement cyces:

Settement s the process whereby the trader who has made purchases
of scrp makes
payment and the seer seng the scrp devers the securtes. Ths
settement process s
carred out by Cearng Houses for the stock exchanges. The Cearng House
acts ke an
ntermedary n every transacton and acts as a seer to a buyers and buyer
to a seers.

Capta market and money market:
Fnanca markets can broady be dvded nto money and capta market.
Money Market: Money market s a market for debt securtes that pay oh n
the short term
usuay ess than one year, for exampe the market for 90-days treasury bs.
Ths market
encompasses the tradng and ssuance of short term non equty debt
nstruments ncudng
treasury bs, commerca papers, bankers acceptance, certcates of
deposts, etc.
Capta Market: Capta market s a market for ong-term debt and equty
shares. In ths
market, the capta funds comprsng of both equty and debt are ssued and
traded. Ths
aso ncudes prvate pacement sources of debt and equty as we as
organzed markets
ke stock exchanges. Capta market ncudes nanca nstruments wth more
than one
year maturty
Sgncance of Capta Markets
A we functonng stock market may hep the deveopment process n
an economy
through the foowng channes:

1. Growth of savngs,
2. Emcent aocaton of nvestment resources,
3. Better utzaton of the exstng resources.

In market economy ke Inda, nanca market nsttutons provde the avenue
by whch
ong-term savngs are mobzed and channeed nto nvestments.
Condence of the nvestors n the market s mperatve for the growth and
deveopment of the market. For
any stock market, the market Indces s the barometer of ts performance and
reects the
prevang sentments of the entre economy. Stock ndex s created to provde
nvestors
wth the nformaton regardng the average share prce n the stock market.
The ups and
downs n the ndex represent the movement of the equty market. These
ndces need to
represent the return obtaned by typca portfoos n the country.

Generay, the stock prce of any company s vunerabe to three types of
news:

Company specc
Industry specc
Economy specc

An a share ndex ncudes stocks from a the sectors of the economy and
thus cances
out the stock and sector specc news and events that ahect stock prces,
(aw of portfoo
dverscaton) and reect the overa performance of the company/equty
market and the
news ahectng t.

The most mportant use of an equty market ndex s as a benchmark for a
portfoo of
stocks. A dversed portfoos, beongng ether to reta nvestors or mutua
funds, use
the common stock ndex as a yardstck for ther returns. Indces are
usefu n modern
nanca appcaton of dervatves.

Capta Market Instruments - some of the capta market nstruments are:

Equty
Preference shares
Debenture/ Bonds
ADRs/ GDRs
Dervatves

Corporate securtes
Shares
The tota capta of a company may be dvded nto sma unts caed
shares. For
exampe, f the requred capta of a company s US $5,00,000 and s dvded
nto 50,000
unts of US $10 each, each unt s caed a share of face vaue US $10. A share
may be of
any face vaue dependng upon the capta requred and the number of shares
nto whch
t s dvded. The hoders of the shares are caed share hoders. The
shares can be
purchased or sod ony n ntegra mutpes.
Equty shares sgnfy ownershp n a corporaton and represent cam over the
nanca
assets and earnngs of the corporaton. Sharehoders en|oy votng rghts and
the rght to
receve dvdends; however n case of qudaton they w receve resduas,
after a the credtors of the company are setted n fu. A company may
nvte nvestors to subscrbe
for the shares by the way of:
Pubc ssue through prospectus
Tender/ book budng process
Oher for sae
Pacement method
Rghts ssue

Stocks
The word stock refers to the od Engsh aw tradton where a share n the
capta of the
company was not dvded nto "shares" of xed denomnaton but was
ssued as one
chunk. Ths concept s no more prevaent, but the word "stock"
contnues. The word
"|ont stock companes" aso refers to ths tradton.
Debt Instruments

A contractua arrangement n whch the ssuer agrees to pay nterest and
repay the
borrowed amount after a speced perod of tme s a debt nstrument.
Certan features
common to a debt nstruments are:
Maturty - the number of years over whch the ssuer agrees to meet the
contractua obgatons s the term to maturty. Debt nstruments are
cassed on
the bass of the tme remanng to maturty
Par vaue - the face vaue or prncpa vaue of the debt nstrument s caed
the
par vaue.
Coupon rate - agreed rate of nterest that s pad perodcay to the
nvestor and s
cacuated as a percentage of the face vaue. Some of the debt nstruments
may
not have an expct coupon rate, for nstance zero coupon bonds. These
bonds are
ssued on dscount and redeemed at par. Thus the dherence between the
nvestors nvestment and return s the nterest earned. Coupon rates may be
xed
for the term or may be varabe.
Ca opton - opton avaabe to the ssuer, speced n the trust ndenture,
to ca
n the bonds and repay them at pre determned prce before maturty. Ca
feature
acts ke a ceng f or payments. The ssuer may ca the bonds before the
stated
maturty as t may recognze that the nterest rates may fa beow the
coupon rate
and redeemng the bonds and repacng them wth securtes of ower coupon
rates
w be economcay beneca. It s the same as the prepayment opton,
where
the borrower prepays before schedued payments or sated maturty
o Some bonds are ssued wth ca protecton feature, .e they woud not be
caed for a speced perod of tme
o Smar to the ca opton of the ssuer there s a put opton for the nvestor,
to se the securtes back to the ssuer at a predetermned prce and date.
The nvestor may do so antcpatng rse n the nterest rates wheren the
nvestor woud qudate the funds and aternatvey nvest n pace of
hgher nterest
Debentures are qute often secured, that s, a securty nterest s created
on some
assets to back up debentures. There s no queston of any securty n
case of
shares.
Share hoders have a rght to attend and vote at the meetngs of the share
hoders
whereas debenture hoders have no such rghts.

Ouas debt nstruments
Preference shares
Preference shares are dherent from ordnary equty shares. Preference share
hoders have
the foowng preferenta rghts
() The rght to get a xed rate of dvdend before the payment of dvdend to
the equty
hoders.
() The rght to get back ther capta before the equty hoders n case of
wndng up of
the company.

Egbty norms for pubc ssue: ICDR Reguatons

IPO

Condtons for IPO: (a condtons sted beow to be satsed)
Net tangbe assets of 3 crore n each of the precedng 3 fu years, of whch
not
more than 50% are hed n monetary assets:
Track record of dstrbutabe prots for 3 out of the mmedatey
precedng 5
years:
Net worth of 1 crore n each of the precedng three fu years;
Issue sze of proposed ssue + a prevous ssues made n the same
nanca year
does not exceed 5 tmes ts pre-ssue net worth as per the audted baance
sheet of
the precedng nanca year;
In case of change of name wthn the ast one year, 50% of the revenue for
the
precedng 1 fu year earned by t from the actvty ndcated by the new
name.

If the ssuer does not satsfy any of the condton sted above, ssuer may
make IPO
by satsfyng the foowng:

1. Issue through book budng
sub|ect to aotment of 50% of net
oher to pubc to OIB fang
whch fu subscrpton mones to
be refunded




O
R
15% of the cost of the pro|ect to 2. Mnmum post-ssue face vaue
capta of the ssuer s 10 crores

O
R
Issuer to provde market-makng for 2
yrs from the date of stng of the
speced securtes

Promoters contrbuton:
o Cannot be ess than 20% of the post ssue capta
o Maxmum not dened, but n vew of the requred mnmum pubc oher as
per Rue 19 (2) (b) of Securtes Contracts Reguatons, promoters
contrbuton pus any rm aotments cannot exceed 90% or 75% of the ssue
sze as the case may be (see beow).
Mnmum Pubc oher: By pubc oher s meant the securtes beng
ohered to
pubc by advertsement, excusve of promoters contrbuton and rm
aotments.
o Rue 19(2)(b) of the Securtes Contracts (Reguatons) Rues, 1957 requres
that the mnmum pubc oher shoud be 25% of tota ssued securtes shoud
be ohered to pubc through advertsement.
o However, a ower pubc oher of 10% s aowed f the foowng condtons
are satsed:
The mnmum pubc of
mnmum aocaton of 60% to OIBs.
Frm aotment/ reservatons: Sub|ect to the mnmum pubc oher norms,
ssuers
are free to make reservatons on compettve bass (as dened herenafter)
and/or rm
aotments (as dened herenafter) to varous categores of persons for the
remanng
part of the ssue sze.

Frm aotment: Ths mpes aotment on a rm bass n pubc ssues by an
ssung
company. Speced Categores for Frm aotment n pubc ssues can be
made to the
foowng:
1. Indan and Mutatera Deveopment Fnanca Insttutons
2. Indan Mutua Funds
3. Foregn Insttutona Investors (ncudng non resdent Indans and
overseas
corporate bodes)
4. Permanent / reguar empoyees of the ssuer company - maxmum 10 % of
tota
proposed ssue amount
5. Schedued Banks
6. Lead Merchant Banker- sub|ect to a ceng of 5 % of the proposed ssue.

FPO

Promoters contrbuton:
o In case of FPO, the promoters shoud ensure partcpaton ether to the
extent
of 20% of the proposed ssue or ther post-ssue share hodng must be to the
extent of 20% of the post ssue capta. Requrement to brng n contrbuton
from promoters sha be optona for a company sted on a stock exchange
for at east 3 years and havng a track record of dvdend payment of
3 years
mmedatey precedng the year of ssue.
o As for maxmum promoters contrbuton, Rue 19 (2) (b) stated above sha
be appcabe.
o Partcpaton by promoters n excess of above sha be treated as
preferenta
aotment, to whch preferenta aotment rues w be appcabe. As
for
preferenta aotment rues, see Notes under sec. 81.
Net Pubc oher:
o The mnmum net pubc oher sha be as per Rue 19 (2) (b) - see above..
Frm aotment / reservatons:
o The ssuer companes are free to make reservatons on compettve bass
(as
dened above) and/or rm aotments to varous categores of persons
enumerated above, for the remanng ssue sze, that s, after
consderng
promoters contrbuton and pubc oher..
o The reservaton on compettve bass may aso be made for reta ndvdua
sharehoders (RIS). For meanng of the term RIS, see under categores
of
nvestors beow.

Composte Issue

Promoters contrbuton:
o promoters have opton to contrbute ether 20% of the proposed ssue or
20%
of post ssue capta
o the rght ssue component to be excuded whe computng the post-
ssue
capta
Others:
o The rght ssue component to be ohered to the exstng sharehoders
o Except the above, the rues of aotment under IPO as above sha appy

Ouaed Insttutona Pacement

Another cass of ssue, not beng a rghts ssue, whch cas for resouton
under sec. 81
(1A).
Condton for ssue-
The equty shares of the same cass were sted on a stock
exchange havng
naton-wde tradng termnas for a perod of at east one year as on the date
of
ssuance of notce for ssue of shares to OIBs
The ssue shoud not voate the prescrbed mnmum pubc
sharehodng
requrements speced by the stng agreement.

Reservaton
Mnmum of 10 percent of speced securtes ssued sha be aotted to
mutua
funds.
In case the mutua funds do not agree to take shares ssued under ths
chapter,
such shares may be aotted to other OIBs. However, no aotment sha
be made under ths chapter, ether drecty or
ndrecty, to any OIB beng a promoter or any person reated to promoters.

Wthdrawa of bd not permtted.- Investors sha not be aowed to wthdraw
ther bds
after the cosure of ssue.

Number of aottees.-
mnmum number of aottees sha not be ess than:
o Two, where the ssue sze s ess than or equa to Rs. 250 crores;
o Fve, where the ssue sze s greater than Rs. 250 crores.
No snge aottee sha be aotted more than 50% of the ssue sze.

Restrctons.-
Amount rased through the proposed pacement + a prevous pacements
made n
the same nanca year sha not exceed ve tmes the net worth of the ssuer
as
per the audted baance sheet of the prevous nanca year.
Lock-n-perod of one year from the date of aotment, except when
sod on a
recognsed stock exchange.


Investments by Non- resdent Investors

Provsons about nvestments by non-resdents, non resdent Indans,
overseas bodes
corporates and other foregn nvestors are made by the RBI n
pursuance of FEMA
provsons. An overvew s as foows:

Foregn nvestment s freey permtted n amost a sectors n Inda. Under
Foregn Drect
Investments (FDI) Scheme, nvestments can be made by non-resdents
n the shares /
convertbe debentures of an Indan Company under two routes;
Automatc Route; and
Government Route.

Dervatves
What are dervatves? A dervatve pcks a rsk or voatty n a
nanca asset,
transacton, market rate, or contngency, and creates a product the vaue of
whch w
change as per changes n the underyng rsk or voatty. The dea s that
someone may
ether try to safeguard aganst such rsk (hedgng), or someone may take the
rsk, or may
engage n a trade on the dervatve, based on the vew that they want to
execute. The rsk
that a dervatve ntends to trade s caed underyng.

A dervatve s a nanca nstrument, whose vaue depends on the
vaues of basc
underyng varabe. In the sense, dervatves s a nanca nstrument that
ohers return
based on the return of some other underyng asset, .e the return s derved
from another
nstrument.
The best way w be take exampes of uncertantes and the
dervatves that can be
structured around the same.
Stock prces are uncertan - Lot of forwards, optons or futures contracts
are based
on movements n prces of ndvdua stocks or groups of stocks.
Prces of commodtes are uncertan - There are forwards, futures and
optons on
commodtes.
Interest rates are uncertan - There are nterest rate swaps and futures.
Foregn exchange rates are uncertan - There are exchange rate
dervatves.
Weather s uncertan - There are weather dervatves, and so on.

Dervatve products ntay emerged as a hedgng devce aganst
uctuatons n
commodty prces, and commodty nked dervatves remaned the soe
form of such
products for amost three hundred years. It was prmary used by the farmers
to protect
themseves aganst uctuatons n the prce of ther crops. From the tme t
was sown to
the tme t was ready for harvest, farmers woud face prce uncertantes.
Through the use
of smpe dervatve products, t was possbe for the farmers to partay or
fuy transfer
prce rsks by ockng n asset prces.

From hedgng devces, dervatves have grown as ma|or tradng too.
Traders may
execute ther vews on varous underyngs by gong ong or short on
dervatves of
dherent types.
Fnanca dervatves:
Fnanca dervatves are nanca nstruments whose prces are derved from
the prces
of other nanca nstruments. Athough nanca dervatves have
exsted for a
consderabe perod of tme, they have become a ma|or force n nanca
markets ony
snce the eary 1970s. In the cass of equty dervatves, futures and
optons on stock ndces have ganed more popuarty than on ndvdua
stocks, especay among
nsttutona nvestors, who are ma|or users of ndex-nked dervatves.
Even sma nvestors nd these usefu due to hgh correaton of the popuar
ndces wth
varous portfoos and ease of use.

DERIVATIVES PRODUCTS
Some sgncant dervatves that are of nterest to us are depcted n the
accompanyng
graph:

Ma|or types of dervatves
Dervatve contracts have severa varants. Dependng upon the market n
whch
they are traded, dervatves are cassed as 1) exchange traded and 2) over
the counter.
The most common varants are forwards, futures, optons and swaps.
Forwards:
A forward contract s a customzed contract between two enttes,
where
settement takes pace as a specc date n the future at todays
predetermned prce.
Ex: On 1 st |une, X enters nto an agreement to buy 50 baes of
cotton for 1 st
December at Rs.1000 per bae from Y, a cotton deaer. It s a case of a
forward contract
where X has to pay Rs.50000 on 1 st December to Y and Y has to
suppy 50 baes of
cotton.
Optons:
Optons are of two types - ca and put. Cas gve the buyer the rght but not
the
obgaton to buy a gven quantty of the underyng asset, at a gven prce on
or before a
gven future date. Puts gve the buyer the rght, but not the obgaton to se
a gven
quantty of the underyng asset at a gven prce on or before a gven date.
Warrants:
Optons generay have maturty perod of three months, ma|orty of optons
that
are traded on exchanges have maxmum maturty of nne months. Longer-
traded optons
are caed warrants and are generay traded over-the-counter.
Leaps:
The acronym LEAPS means Long-term Equty Antcpaton Securtes. These
are
optons havng a maturty of up to three years.
Baskets:
Basket Optons are currency-protected optons and ts return-proe s
based on
the average performance of a pre-set basket of underyng assets. The
basket can be
nterest rate, equty or commodty reated. A basket of optons s made
by purchasng
dherent optons. The payout s therefore the addton of each ndvdua
opton payout
Swaps:
Swaps are prvate agreement between two partes to exchange cash ows
n the
future accordng to a pre-arranged formua. They can be regarded as
portfoo of forward
contracts. The two commony used Swaps are
) Interest Rate Swaps: - A nterest rate swap entas swappng ony the
nterest
reated cash ows between the partes n the same currency.
) Currency Swaps: - A currency swap s a foregn exchange agreement
between
two partes to exchange a gven amount of one currency for another and after
a
speced perod of tme, to gve back the orgna amount swapped.

FUTURES, FORWARDS AND OPTIONS
An opton s dherent from futures n severa ways. At practca eve, the
opton buyer
faces an nterestng stuaton. He pays for the optons n fu at the tme t s
purchased.
After ths, he ony has an upsde. There s no possbty of the optons
poston
generatng any further osses to hm. Ths s dherent from futures, where
one s free to
enter, but can generate huge osses. Ths characterstc makes optons
attractve to many
market partcpants who trade occasonay, who cannot put n the tme to
cosey montor
ther futures poston.
Buyng put optons s ke buyng nsurance. To buy a put opton on
Nfty s to buy
nsurance whch remburses the fu amount to whch Nfty drops beow the
strke prce
of the put opton. Ths s attractve to traders, and to mutua funds creatng
"guaranteed
return products".



FORWARDS
A forward contract s an agreement to buy or se an asset on a speced date
for a
speced prce. One of the partes to the contract assumes a ong poston
and agrees to
buy the underyng asset on a certan speced future date for a certan
speced prce.
The other party assumes a short poston and agrees to se the asset on the
same date for
the same prce, other contract detas ke devery date, prce and quantty
are negotated
bateray by the partes to the contract. The forward contracts are
normay traded
outsde the exchange.
The saent features of forward contracts are:
They are batera contracts and hence exposed to counter-party rsk
Each contract s custom desgned, and hence s unque n terms of
contract sze,
expraton date and the asset type and quaty.
The contract prce s generay not avaabe n pubc doman
On the expraton date, the contract has to be setted by devery of the
asset, or
net settement.

The forward markets face certan mtatons such as:
Lack of centrazaton of tradng
Iqudty and
Counterparty rsk
FUTURES
Futures contract s a standardzed transacton takng pace on the futures
exchange. Futures market was desgned to sove the probems that exst n
forward
market. A futures contract s an agreement between two partes, to buy or
se an asset at
a certan tme n the future at a certan prce, but unke forward contracts,
the futures
contracts are standardzed and exchange traded To factate qudty n the
futures
contracts, the exchange speces certan standard quantty and quaty of the
underyng
nstrument that can be devered, and a standard tme for such a settement.
Futures exchange has a dvson or subsdary caed a cearng house that
performs the specc
responsbtes of payng and coectng day gans and osses as we as
guaranteeng
performance of one party to other. A futures' contract can be ohset pror to
maturty by
enterng nto an equa and opposte transacton. More than 99% of futures
transactons are
ohset ths way.

Yet another feature s that n a futures contract gans and osses on each
partys poston
s credted or charged on a day bass, ths process s caed day settement
or markng
to market. Any person enterng nto a futures contract assumes a ong or
short poston,
by a sma amount to the cearng house caed the margn money

The standardzed tems n a futures contract are:
Ouantty of the underyng
Ouaty of the underyng
The date and month of devery
The unts of prce quotaton and mnmum prce change
Locaton of settement




FUTURES TERMINOLOGY
1. SPOT PRICE: The prce at whch an asset trades n the spot market.
2. FUTURES PRICE: The prce at whch the futures contract trades n the
futures
market.
3. CONTRACT CYCLE: The perod over whch a contract trades. The ndex
futures
contracts on the NSE have one month, two months and three months expry
cyces
that expres on the ast Thursday of the month. Thus a contract whch s to
expre
n |anuary w expre on the ast Thursday of |anuary.
4. EXPIRY DATE: It s the date speced n the futures contract. Ths s the ast
day
on whch the contract w be traded, at the end of whch t w cease to exst.
5. CONTRACT SIZE: It s the quantty of asset that has to be devered under
one
contract. For nstance, the contract sze on NSEs futures market s 200
Nftes.
6. BASIS: In the context of nanca futures, bass can be dened as
the futures
prce mnus the spot prce. There w be dherent bass for each devery
month, for each contract. In a norma market, bass w be postve; ths
reects that the
futures prce exceeds the spot prces.
7. COST OF CARRY: The reatonshp between futures prce and spot prce can
be
summarzed n terms of what s known as the cost of carry. Ths measures the
storage cost pus the nterest pad to nance the asset ess the ncome
earned on
the asset.
8. INITIAL MARGIN: The amount that must be deposted n the margn
account at
the tme when a futures contract s rst entered nto s known as nta
margn.
9. MARK TO MARKET: In the futures market, at the end of each tradng day,
the
margn account s ad|usted to reect the nvestors gan or oss dependng
upon
the futures cosng prce. Ths s caed Markng-to-market.
10. MAINTENANCE MARGIN: Ths s somewhat ower than the nta
margn.
Ths s set to ensure that the baance n the margn account never
becomes
negatve. If the baance n the margn account fas beow the
mantenance
margn, the nvestor receves a margn ca and s expected to top up the
margn
account to the nta margn eve before tradng commences on the next day.
Stock futures contract

It s a contractua agreement to trade n stock/ shares of a company on a
future date. Some
of the basc thngs n a futures trade as speced by the exchange are:
Contract sze
Expraton cyce
Tradng hours
Last tradng day
Margn requrement

Advantages of stock futures tradng

Investng n futures s ess costy as there s ony nta margn money to be
deposted
A arge array of strateges can be used to hedge and specuate, wth
smaer cash
outay there s greater qudty

Dsadvantages of stock futures tradng

The rsk of osses s greater than the nta nvestment of margn money
The futures contract does not gve ownershp or votng rghts n the equty
n
whch t s tradng
There s greater vgance requred because futures trades are marked to
market
day INDEX DERIVATIVES
Index dervatves are dervatve contracts that has ndex as the underyng.
The
most popuar ndex dervatves contract s ndex futures and ndex optons.
NSEs market
ndex - the S&P CNX Nfty are exampes of exchange traded ndex futures.
An ndex s a broad-based weghted average of prces of seected
consttuents that
form part of the ndex. The rues for constructon of the ndex are dened by
the body
that creates the ndex. Tradng n stock ndex futures was rst ntroduced by
the Kansas
Cty Board of Trade n 1982.

Advantages of nvestng n stock ndex futures
Dverscaton of the rsks as the nvestor s not nvestng n a partcuar
stock
Fexbty of changng the portfoo and ad|ustng the exposures to
partcuar
stock ndex, market or ndustry

OPTIONS
An opton s a contract, or a provson of a contract, that gves one
party (the
opton hoder) the rght, but not the obgaton, to perform a speced
transacton wth
another party (the opton ssuer or opton wrter) accordng to the speced
terms. The
owner of a property mght se another party an opton to purchase the
property any tme
durng the next three months at a speced prce. For every buyer of an
opton there must
be a seer. The seer s often referred to as the wrter. As wth
futures, optons are
brought nto exstence by beng traded, f none s traded, none exsts;
conversey, there s
no mt to the number of opton contracts that can be n exstence at any
tme. As wth
futures, the process of cosng out optons postons w cause contracts to
cease to exst,
dmnshng the tota number.
Thus an opton s the rght to buy or se a speced amount of a
nanca
nstrument at a pre-arranged prce on or before a partcuar date.
There are two optons whch can be exercsed:
Ca opton, the rght to buy s referred to as a ca opton.
Put opton, the rght to se s referred as a put opton.

OPTION TERMINOLOGY
1. INDEX OPTION: These optons have the ndex as the underyng. Some
optons are European whe others are Amercan. European stye optons
can be exercsed ony on the maturty date of the opton, whch s known
as the expry date. An Amercan stye opton can be exercsed at any tme
upto, and ncudng, the expry date. It s to be noted that the dstncton
has nothng to do wth geography. Both type of the opton are traded a
over the word
2. STOCK OPTION: Stock optons are optons on ndvdua stocks. A
contract gves the hoder the rght to buy or se shares at the
speced
prce. 3. BUYER OF AN OPTION: The buyer of an opton s the one who
by
payng the opton premum buys the rght but not the obgaton to exercse
the optons on the seer/wrter.
4. WRITER OF AN OPTION: The wrter of a ca/put opton s the one who
receves the opton premum and s thereby obged to se/buy the asset f
the buyer exercsed on hm.
5. STRIKE PRICE: The prce speced n the opton contract s known as the
strke prce or the exercse prce.
6. IN THE MONEY OPTION: An n the money opton s an opton that
woud ead to a postve cash ow to the hoder f t was exercsed
mmedatey. A ca opton on the ndex s sad to be n-the-money (ITM)
when the current ndex stands at a eve hgher than the strke prce (.e.
spot prce> strke prce). If the ndex s much hgher than the strke prce,
the ca s sad to be deep ITM. In the case of a put, the put s ITM f the
ndex s beow the strke prce.
7. AT THE MONEY OPTION: An at the money opton s an opton that
woud ead to zero cash ow to the hoder f t were exercsed
mmedatey. An opton on the ndex s at the money when the current
ndex equas the strke prce(.e. spot prce = strke prce).
8. OUT OF THE MONEY OPTION: An out of the money(OTM) opton
s an opton that woud ead to a negatve cash ow for the hoder f t
were exercsed mmedatey. A ca opton on the ndex s out of the
money when the current ndex stands at a eve ower than the strke
prce(.e. spot prce < strke prce). If the ndex s much ower than
the
strke prce, the ca s sad to be deep OTM. In the case of a put, the put s
OTM f the ndex s above the strke prce.
9. INTRINSIC VALUE OF AN OPTION: The opton premum can be
broken down nto two components - ntrnsc vaue and tme vaue. The
ntrnsc vaue of a ca s the ITM vaue of the opton that s f the ca s
OTM, ts ntrnsc vaue w be zero.
10. TIME VALUE OF AN OPTION: The tme vaue of an opton s the
dherence between ts premum and ts ntrnsc vaue. Usuay maxmum
tme vaue exsts when the opton s ATM. The onger the tme to
expraton, the greater s an optons tme vaue, or ese equa. At
expraton, an opton shoud have no tme vaue.

Factors ahectng vaue of optons - you woud understand ths whe usng the
vauaton technques, but the terms are ntroduced beow:

Prce - vaue of the ca opton s drecty proportonate to the change n the
prce
of the underyng. Say for exampe
Tme - as optons expre n future, tme has an ehect on the vaue of the
optons.
Interest rates and Voatty - n case where the underyng asset s a bond
or
nterest rate, nterest rate voatty woud have an mpact on the opton
prces.
The statstca or hstorca voatty (SV) heps measure the past prce
movements of the stock and heps n understandng the future voatty of
the
stock durng the fe of the opton


Commodty Dervatves

Commodty Dervatves are the rst of the dervatves contracts that emerged
to hedge
aganst the rsk of the vaue of the agrcutura crops gong beow the cost of
producton.
Chcago Board of Trade was the rst organzed exchange, estabshed n 1848
to have
started tradng n varous commodtes. Chcago Board of Trade and Chcago
Mercante
Exchange are the argest commodtes exchanges n the word

It s mportant to understand the attrbutes necessary n a commodty
dervatve contract:

a) Commodty shoud have a hgh shef fe - ony f the commodty has
storabty,
durabty w the carrers of the stock fee the need for hedgng aganst the
prce
rsks or prce uctuatons nvoved
b) Unts shoud be homogenous - the underyng commodty as dened
n the
commodty dervatve contract shoud be the same as traded n the cash
market to
factate actua devery n the cash market. Thus the unts of the
commodty
shoud be homogenous
c) Wde and frequent uctuatons n the commodty prces - f the prce
uctuatons
n the cash market are sma, peope woud fee ess ncentvsed to
hedge or
nsure aganst the prce uctuatons and dervatves market woud be
of no
sgncance. Aso f by the nherent attrbutes of the cash market of
the
commodty, the cash market of the commodty was such that t woud
emnate
the rsks of voatty or prce uctuatons, dervatves market woud be
of no
sgncance. Takng an oversmped exampe, f an nvestor had purchased
100
tons of rce @ Rs. 10/ kg n the cash market and s of the vew that the prces
may
fa n the future, he may short a rce future at Rs. 10/ kg to hedge aganst the
fa
n prces. Now f the prces fa to Rs. 2/ kg, the oss that the nvestor makes n
the cash market may be compensated by squarng of the short
poston thus
emnatng the rsk of prce uctuatons n the commodty market

Commodty dervatve contracts are standardzed contracts and are
traded as per the
nvestors needs. The needs of the nvestor may be nstrumenta or
convenence,
dependng upon the needs, the nvestor woud trade n a dervatve product.
Instrumenta
rsks woud reate to prce rsk reducton and convenence needs woud
reate to
exbty n trade or emcent cearng process.

Commodty Dervatves n Inda

Commodty dervatves n Inda were estabshed by the Cotton Trade
Assocaton n
1875, snce then the market has suhered from qudty probems and severa
reguatory
dogmas. However n the recent tmes the commodty trade has grown
sgncanty and
today there are 25 dervatves exchanges n Inda whch ncude four natona
commodty
exchanges; Natona Commodty and Dervatves Exchange (NCDEX), Natona
Mut-Commodty Exchange of Inda (NCME), Natona Board of Trade
(NBOT) and Mut
Commodty Exchange (MCX)

NCDEX
It s the argest commodty dervatves exchange n Inda and s the
ony commodty
exchange promoted by natona eve nsttutons. NCDEX was
ncorporated n 2003
under the Companes Act, 1956 and s reguated by the Forward Market
Commsson n
respect of the futures tradng n commodtes. NCDEX s ocated n Mumba

MCX
MCX s recognsed by the government of Inda and s amongst the
words top three
buon exchanges and top four energy exchanges. MCXs headquarter s n
Mumba and
factates onne tradng, cearng and settement operatons for the
commodotes futures
market n the country.

Over the Counter Dervatves (OTC Dervatves)
Dervatves that are prvatey negotated and not traded on the stock
exchange are caed
OTC Dervatves.
Interest Rate Dervatves (IRD)
In the OTC dervatves segment, nterest rate dervatves (IRDs) are easy the
argest and
therefore the most sgncant gobay. In markets wth compex rsk
exposures and hgh
voatty Interest Rate Dervatves are an ehectve too for management of
nanca
rsks. In IRDs, the partes are tryng to trade n the voatty of nterest rates.
Interest
rates ahect a whoe spectrum of nanca assets - oans, bonds, xed ncome
securtes,
government treasures, and so on. In fact, changes n nterest rates have
ma|or macro
economc mpcatons for varous economc parameters - exchange rates,
state of the
economy, and thereby, the entre spectrum of the nanca sector.

Denton of IRDs
Interest Rate Dervatves (IRD) are dervatves where the underyng rsk
nterest rates.
Hence, dependng on the type of the transacton, partes ether swap nterest
at a xed or
oatng rate on a notona amount, or trade n nterest rate futures, or engage
n forward
rate agreements. As n case of a dervatves, the contract s mosty
setted by net
settement, that s payment of dherence amount.

Types:
The basc IRDs are smpe and mosty qud and are caed vana products,
whereas
dervatves beongng to the east qud category are termed as exotc
nterest rate
dervatves. Some vana products are:
1) Interest Rate Swaps
2) Interest Rate Futures
3) Forward Rate Agreements
4) Interest rate caps/oors

Interest Rate Swaps - These are dervatves where one party
exchanges or swaps the
xed or the oatng rates of nterest wth the other party. The nterest rates
are cacuated
on the notona prncpa amount whch s not exchanged but used to
determne the
quantum of cashow n the transacton. Interest rate swaps are
typcay used by
corporatons to typcay ater the exposure to uctuatons on nterest rates
by swappng
xed rate obgatons for oatng and vce-a-versa or to obtan ower rates of
nterest than
otherwse avaabe.

Interest rate swaps can be a) xed-for-xed rate swap, b) xed-for-oatng
rate swap, c)
oatng-for-oatng rate swap and so on. As the names suggest nterest rates
are beng swapped, ether n the same currency or dherent currency and
there coud be as many
customzed varatons of the swaps, as desred.

Ths can be further expaned smpy. For nstance f there are two
borrowers n the
market where Borrower A has borrowed at a xed rate but wants a
oatng rate of
nterest and Borrower B has borrowed wth oatng and wants a xed rate of
nterest. IN
such a scenaro they can swap ther exstng nterest rates wthout any
further borrowng.
Ths woud make the transacton of the two borrowers ndependent of
the underyng
borrowngs. For nstance f a company has nvestments wth a oatng rate of
nterest of
4.7% and can obtan xed nterest rate of 4.5% then the company may enter
nto a xed-
for-oatng swap and earn a prot of 20 bass ponts.

Forward Rate Agreements (FRAs) - These are cash setted for ward contracts
on nterest
rate traded among nternatona banks actve n the Eurodoar market.

These are contracts between two partes where the nterest rates are to be
pad/ receved
on an obgaton at a future date. The rate of nterest, notona amount and
expry date s
xed at the tme of enterng the contract and ony dherence n the
amount s pad/
receved at the end of the perod. The prncpa s caed notona
because whe t
determnes the amount of payment, actua exchange of prncpa never takes
pace. For
nstance f A enters an FRA wth B and receves a xed rate of
nterest say 6% on
prncpa, say P for three years and B receves oatng rate on P. If at the end
of contract
perod of C the LIBOR rate s 6.5% then A w make a payment of
the dherenta
amount, (that s .5% on the prncpa P) to B. The settement mechansm can
be further
expaned as foows:

For nstance at a notona prncpa of USD 1 mon where the borrower buys
an FRA
for 3 months that carres an nterest rate of 6% and the contract run s 6
months. At the
settement date the settement rate s at 6.5%. Then the settement
amount w be
cacuated n the foowng manner:

Settement amount = |(Dherence between settement rate and agreed
rate)*
contract run* prncpa amount|/|(36,000 or 36500) + (settement
rate*contract
perod)|
That s, n the above probem
Settement amount = |(6.5-6)*180*USD 1 mon|/|36,000 + (6.5%* 90)
(Note: 36,000 s used for currences where the bass of cacuaton s
actua/360
days and 36,500 s used for currences where the bass of cacuaton of
nterest s
actua/365 days)

Interest Rate Caps/Foors: Interest rate caps/oors are bascay
hedgng nstruments
that can gve the nvestor both benets of xed rate nterest and uctuatng
rate nterest.
The person provdng an nterest rate cap s the protecton seer. The seer
assures the
borrower or the buyer that n case of hgh voatty n the nterest rates, f
nterest rate
moves beyond the cap the borrower w be pad amount beyond the
cap. In case the
market rates do not go beyond the cap mt, the seer need not pay
anythng to the borrower. In such a stuaton as ong as the nterest rates are
wthn the cap mt borrower
en|oys the oatng rates and f rates move above the cap mt he w be
compensated
wth the requste amount by the protecton seer and the borrower w pay
xed to the
capped rate of nterest. The same s the case when a person enters a Interest
Rate Foor
transacton.

In case of Interest Rate Cap transacton the borrower s expects the market
nterest rates
to go up n the future and hedge aganst the movement of the market rates.
Interest Rate
Caps/Foors transactons are deay of one, two, ve or ten years and the
desred eve of
protecton the buyer seeks are 6%, 8% or 10%.