Financial Markets & InstrumentsClassification of Financial Markets Type of Claims Debt and Equity Maturity of Claims Money market and Capital market Issuance of Claims Primary and Secondary Timing of delivery Cash/spot and forward/future Organizational structure Exchange traded and OTCIndian Financial markets Five important domains of Indian Financial markets : Users of financial markets, Public equity markets, Government Securities markets, Derivative markets and, Commodity markets Equity Markets Types of Equity Securities Common Stock Preferred Stock Convertibles/Warrants Depository Receipts Rights MFsSome Products Depository Receipts ADRs and GDRs Traded like shares Low transaction costs Three levels of listing for ADRs International diversificationSome Products Mutual Funds Tax inefficient; liquidity needs; low returns for index tracking Cannot be shorted or margined Exchange Traded Funds Tax efficient; low portfolio turnovers Can be shorted or margined International diversification made easy Arbitrage trades and NAVsPublic Equity Market Dominated by National Stock Exchange (NSE) and Bombay stock Exchange (BSE) serve for more than 99% trading in equity market for spot and derivative contracts Respective broad market Indices to look for these exchanges are CNX NIFTY and BSE SENSEX Trading mechanism, clearing and settlement system stands at one of the best in the world NSE ranks 1stin no. of trades in equity India ranked in top 20 countries with most traded volumes India ranked in top 15 countries with highestmarket cap Trading Pace at NSE 300 trades per sec. Roughly 150 shares per trade; 45,000 shares per sec(Rs. Billion) SpotDerivative SpotDerivativeNSE 2314.56 32213.11 85% 81%BSE 422.22 7632.32 15% 19%Average Monthly Turnover at BSE and NSE in 2013-14Index FuturesIndex OptionsStock FuturesStock Options BSE 1.01% 98.14% 0.79% 0.06%NSE 7.41% 73.75% 12.01% 6.83%Derivative Trades at BSE and NSE in 2013-14Market Cap Traded value Market Cap Traded valueAUTOMOBILES75087 1001.34 5.25% 15.73%BANKS 246902 1129.6 17.28% 17.74%CEMENT AND CEMENT PRODUCTS 36466 81.3 2.55% 1.28%IT & ITES 191531 455.66 13.40% 7.16%CONSTRUCTION 20468 417.64 1.43% 6.56%FMCG 100043 323.71 7.00% 5.08%ENGINEERING 154674 446.59 10.82% 7.01%Financial 87132 243.7 6.10% 3.83%PHARMACEUTICALS 34752 133.2 2.43% 2.09%POWER 62702 316.22 4.39% 4.97%Oil & Gas 239897 832.38 16.79% 13.07%METALS 124923 720 8.74% 11.31%TELECOMMUNICATION 54332 264.98 3.80% 4.16%1428909 6366.32 100.00% 100.00%Source: NSEValue (Rs Crores) % WeightTable 10: Industry Wise Distribution of Turnover and Market Capitalisation of NIFTY firms on 26-Mar-2010Month/YearNo. of co.s available for tradingNo. of securities traded% of Traded to available ListedNo. of securities traded% of Traded to ListedFeb-10 1,342 1,328 98.96 8,118 2,955 36.40Jan-10 1,338 1,320 98.65 8,086 2,890 35.74Dec-09 1,303 1,297 99.54 8,176 2,894 35.40Nov-09 1,292 1,276 98.76 8,127 2,877 35.40Oct-09 1,291 1,280 99.15 8,167 2,876 35.22Sep-09 1,287 1,265 98.29 8,098 2,790 34.45Source: BSE,NSE and SEBINSE BSETable 12: Trading Frequency on NSE & BSES&P S&P S&P Finance S&P S&PMonth/ CNX CNX CNX IT CNX CNXYear Nifty FMCG Petro- Phar-(Nifty chemi- maceu-50) cals ticalsJul-07 1.16 1.24 1.36 1.94 1.42 0.85Aug-07 2.06 1.64 1.88 3.24 2.08 1.37Sep-07 1.06 0.89 1.49 1.86 1.26 0.79Oct-07 2.46 1.70 1.69 4.41 2.62 1.30Nov-07 1.72 1.89 1.82 2.77 2.12 1.06Dec-07 1.67 1.11 1.91 2.32 2.14 1.37Jan-08 3.29 3.41 2.77 5.10 4.86 2.92Feb-08 2.46 2.20 2.71 3.34 2.64 1.52Mar-08 3.06 1.82 3.46 5.69 3.70 1.96Apr-08 1.28 1.34 2.50 1.73 2.90 -0.95May-08 1.21 1.42 1.66 2.00 2.37 0.93Jun-08 1.91 1.48 2.24 2.76 3.35 1.36Average 1.95 1.68 2.12 3.10 2.62 1.21Table 15: Performance of Sectoral Indices- Average Daily Volatility (%)Returns VolatilityNSE 12.56% 27.27%BSE 13.96% 27.63%S&P 500 7.93% 20.27%FTSE 100 5.65% 19.46%NIKKEI 225 -1.11% 24.99%Table 16: Nominal Annual Returns and Volatilities(1 Jan 1995-31 Dec 2009)Source: ISMR 2008 and IISL(India Index Services & Product Ltd.).Market Quality Liquidity (Internal efficiency) Low transaction costs (spreads); depth; resilience; price continuity No. of participants; diversity of opinion; convenience and reliability Transparency (Informational efficiency) Accurate and timely (pre-trade and post-trade) information Trade Completion Settlement; counterparty riskMarket Types Quote-driven or dealers market Market making- price continuity; lack of natural liquidity; credit risk; brokers Order driven market Many players; competitive prices; illiquidity; order matching; anonymity Crossing N/Ws; Auctions Brokered market block trades Hybrid marketType of Trading Orders Market orders Price uncertainty; immediate execution Limit orders Execution uncertainty; fixed price Short sale orders Stop loss orders Stop loss sale Stop loss buyExecution Costs Explicit Costs Commissions; taxes; stamp duties; fees Implicit Costs Impact costs; opportunity costs; delay costsExecution Costs Bid-Ask spreads Quoted and effective spreads Price adjustment and impact costTime Quote Size Quote Size12:02 446.69 1500 446.81 170012:02 446.17 1650 447.01 155312:02 445.99 1445 447.62 1654Bid AskFixed Income Markets and Instruments Types of Securities Treasuries T-bills T-bonds Notes TIPS On-the-run/ off-the-run STRIPS coupon and principal Agency Issues PSU bonds; State Govt. bonds; MBS by Govt. agenciesTypes of Securities Corporate Securities Bonds/ debentures Medium-Term notes Structured notes Commercial papers Negotiable CDs Bankers acceptance ConvertiblesSources of Returns Coupon payments Principal with capital gain and loss Reinvestment of couponsPrice Quotations Accrued interest Dirty price Clean priceYield Measures Nominal Yield Current Yield Yield to Maturity (YTM) Bond Equivalent Yield (BEY) Effective Annual Yield (EAY) Yield to Call (YTC); Yield to First Call Yield to Put (YTP)Government securities markets Second largest in terms of market capitalization Due to large fiscal deficit, GoI has issued bond in significant numbers Outstanding amount of Government securities (internal liabilities) as on Mar 2014 stands at Rs. 54.68 trillion as compared to Rs. 4.87 trillion outstanding in 1994-95 Despite enormous volume,the market lacks basic features essential for a well developed and efficient market Despite high interest rate volatility introduction of key derivatives is sluggish Liquidity has been elusive throughout unlike the equity markets Participation is restricted to a few players hampers the speculations and hence the price discovery For overnight funds the call money market is a non-collateralized interbank dealer market For exchange traded repos- collateralized borrowing and lending obligations (CBLO) market the participation is not limited to the banks 91 GoI bonds outstanding, as on Sep 2012 There are no STRIPS and ZCBs in India Despite monetary policy not being well defined the outstanding stock shows securities as far as 30 years to maturity repressive Government intervention to hold such securitiesDerivativesDerivatives as Risk Transfer Vehicles Derivative contracts Derives value from some underlying asset Exchange traded Standardized Over-the-counter (OTC) CustomizedTypes of Derivatives Forward commitments Forward Contract Futures Contract Swaps Contingent claims Options Structured Instruments STRIPS; CMOs; CDOsForward Contracts Bilateral contract with obligations on BOTH side Customized contracts; no regulation practically Have zero value at inception to either party Buy or sell a specific quantity of an asset, at a set price, on a specific date in the future No upfront payments usually Counterparty risk is always there ( no clearing houses) Buyer long forward position Seller short forward positionForward ContractsExamples Underlying - 90 day T-bill, Rs. 1000 FV Term of the contract 30 days from now Contract Price at delivery Rs.990 Party A buyer; Party B seller Settlement price Rs. 995 What are the payoffs??? Counter party risk Deliverable or Cash settled Deliverable: Party A pays Rs. 990, gets the T-bill Party B incurs a loss of Rs 5 Cash: Party A receives Rs. 5 No exchange of T-bill If A wishes, he can buy at Rs. 995 (Rs. 990 of his own and + Rs. 5 from B)Forward ContractsExamples A portfolio manager desires to generate $10 mn 100 days from now from a portfolio very similar to composition of S&P index. He gets a quote of 525.2 on a notional amount of $10mn in a short position in a 100-day forward contract. If index at settlement turns out to be 535.7, calculate the payoffs for managers? What if it is 519.95? Manager is already LONG his own portfolio Needs to take an offsetting SHORT position in SIMILAR asset If S&P is 537.5 Gain in S&P Index= 2% Manager thus LOSES 2% in S&P short contract If S&P is 519.95 Loss in S&P Index = 1% Manager thus GAINS 1% in S&P short contractForward ContractsForward Rate Agreements (FRAs) Forward contract to borrow/lend money at a certain rate at some future date Settled in cash, but no actual loan is made at settlement date Borrower long Lender - shortForward ContractsExamples Consider an FRA: Expires/settles in 30 days Based on $1mn notional Based on 90-day LIBOR (add-on rate) Reference forward rate is 5% Actual at expiry turns out to be 6% What is the cash settlement? Who pays? After 30 days LIBOR turns out to be 6%. Borrower contracted to borrow at 5% (implicitly) Gain to borrower Payments of interest to be made at the end of the period (after 90 day from the loan initiation) Payments will be after 120 days after contract initiation (30+120) Payments if made after 30 days instead of 120 days from initiation of contract=$24632500 $ 000 , 000 , 136090%) 5 % 6 ( X X Payoffs)36090 % 61 (2500XPVForward ContractsExamples Currency forward party A agrees to exchange a certain amount of currency X for a certain amount of currency Y at a future date Fortune Inc. expects to receive EUR 50 mn three months from now and enters into a cash settlement currency forward to exchange these euros for dollars at USD 1.23 per euro. If market rate turns out to be USD 1.25 per euro at settlement, what are the payoffs for Fortune? Fortune is already LONG in EUR 50 mn Needs an offsetting position to hedge Takes SHORT position to sell EUR 50 mn at 1.23 LONG position gains if asset price increase SHORT position gains if asset price increase EUR appreciated increased in price relative to USD Fortune Gains in LONG but loses EQUAL amount in SHORT position EUR 50 mn X 1.23 = 61.5 mn USD Will get this contracted amount if contract was on DELIVERY in exchange of EUR 50 mn Will PAY (50X1.25=62.5) -61.5 mn = 1 mn USD to counterparty if on CASH basisFutures Market & Contracts Standardized contracts; mostly exchange traded Specifies quality, quantity of goods at specific dates and mode of delivery Cash or deliverable Have zero value at inception No counterpart risk (clearing house) Margin as performance guarantee Govt. regulates futures market Purchaser long Seller - shortMargins in Futures Market Money deposited by both long and short with clearing member Futures settle on daily basis marking to market Initial Margin to be deposited before any trades. Set for each type of underlying Maintenance margin minimum margin to be maintained in account Variation margin amount to be deposited to bring in balance at initial margin Margins are much lower as a percentage of the value of futures contract High leverageFutures ContractsExamples Consider a long position in five January Copper contract, each of which covers 5000 Kgs. Assume that the contract price is $2 per kg. and that each contract requires an initial margin deposit of $150 and a maintenance margin of $100. Compute the margin balance for this position after 2-cent decrease in price on Day 1, a 1-cent increase in price on day 2, and a 1-cent decrease in price on Day 3. Change of 1-cent per kg will cause=5000 x 0.01 = $50 per contract Total change = 5 x 50 = $250 each cent Total initial margin = 5 x 150 = $750 Total maintenance margin = 5 x 100 = $500 Minimum needs to be kept Will get a margin call if balance falls below maintenance marginDay Required Deposit Price/Kg. Daily Changes Gain/Loss Balance0 (purchase) 750 2 0 0 7501 0 1.98 -0.02 -500 2502 500 1.99 0.01 250 10003 0 1.98 -0.01 -250 750Futures ContractsExamples S&P 500 Index future. Multiplier is $250. A long position is taken at 1051 in stock index futures. The settlement value of Index is 1058. Calculate the payoffs for the party. LONG gains if underlying price increases Gain = (1058 1051) X $250 = $1750Futures ContractsExamples A long position in EUR with notional value of 1mn Euro at the rate of USD 1.23 per euro is taken. The next day Currencies traded at USD 1.21 per euro. What are the payoffs for the party? LONG loses if asset price decline Loss = (1.21 1.23) X 1mn EUR = $20000Option Contracts Right but no obligation to the buyer to enter into a transaction involving an underlying asset at a predetermined price Necessary obligation for seller to perform if exercised by the buyer Buyer pays a premium upfront to the seller of the option to acquire rights CASH or DELIVERYBasic Options Call Option: Right to purchase the underlying asset at predetermined price during(at) the specific period (date) American (European) Call Put Option: Right to sell the underlying asset at predetermined price during(at) the specific period (date) American (European) PutOption Combinations Long Call: The Buyer - has the right to buy the underlying asset Short Call: The Seller has the obligation to sell the underlying Long Put: The Buyer - has the right to sell the underlying asset Short Put: The Seller has the obligation to buy the underlyingOption ContractsExamples Underlying : ABCs stock, trading at Rs. 100 Call premium: Rs. 10 Strike price: Rs. 110 Expiration: 6 months from now Exercise price : Rs. 140 Calculate payoffs to the buyer and seller Payoffs to Buyer:= -10 + (140-110) = 20 Payoffs to Seller:=10+(110-140) = -20 Moneyness w.r.t. exercise prices: In the money >110 Out of money < 110 At the money = 110Option ContractsExamples Underlying : ABCs stock, trading at Rs. 100 Put premium: Rs. 10 Strike price: Rs. 110 Expiration: 6 months from now Exercise price : Rs. 90 Calculate payoffs to the buyer and seller Payoffs to Buyer:=-10+(110-90) = 10 Payoffs to Seller:= 10+(90-110) Moneyness w.r.t. exercise prices: In the money 110 At the money = 110Option ContractsExamples Underlying : NIFTY Index, trading at 4900 Call premium: Rs. 50 Strike price: 5000 Expiration: 6 months from now Exercise price : 5025 Multiplier: 250 Calculate payoffs to the buyer and seller Payoffs to Buyer:= -50 + (5025-5000)X250 = Rs. 6200 Payoff to Seller: = 50 + (5000-5025) X 250 = -Rs. 6200Types of Options Financial Options: Equity {Index (cash settlement)and stocks} Bonds Interest rates Currency Options on Futures Commodity OptionsSwap Contracts Exchange of series of cash flows on periodic settlement dates over a period No upfront payments zero value at inception Notional exchanged in currency swaps Customized, not traded in secondary markets Unregulated largely Counterparty risk exist Involves large institutions mostlySwap ContractsExamples Fixed-for-floatingloan Plain Vanila Swap Underlying: Rs. 100,000 Party A: fixed payer at 8% for next 3 years Party B: floating rate payer at 1 year LIBOR initially at 8% Calculate the payoffs for A when 360-day LIBOR is 8.5% p.a. at the start of next year and 7.5% at the start of 3rdyearPayments from Floating payer to Fixed payer At the end of 1styear:=(8%-8%) X 100000 = Rs. 0 At the end of 2ndyear:=(8.5%-8%) X 100000 = Rs. 500 At the end of 3rdyear: (7.5%-8%) X 100000 = -Rs. 500Swap ContractsExamplesTypes of Swaps Currency Interest rate EquityStructured Notes STRIPS Zero coupon instruments extracted from conventional bonds Collateralized Mortgage Obligation (CMOs) Banks Securitization vehicles/agencies Investors (Tranches) Hedging of prepayment risk IO & PO CMOs Prepayment and interest rate riskInverse Floaters Contract rates : (Reference floating) Risk levered instrumentsCommodity Markets Began in 1875 with a cotton exchange Recently structural changes brought about by liberalization 24 exchanges listing futures in different commodities and 123 products listed Governed by the Forwards Contract Regulation Act (FC(R)A) and overseen by the Forward Markets Commission (FMC)(Rs.Crore)Pariculars 2009-10 2008-09 2009-10 2008-09Total value of trade 35,507.96 21,194.85 100.00% 100.00%Total value of trade in Bullion15,980.61 12,892.01 45.01% 60.83%Total value of trade in Agri Commodities 4,504.74 2,678.16 12.69% 12.64%Total value of trade in other Commodities15,022.61 5,624.67 42.31% 26.54%Source : FMCAverage daily turnover in Commodities marketfor February 2009 & 2010Market Popular contractsVolume (Rs Billion)MCX, Bombay Copper, gold, silver, crude oil, zinc 5626.97NCDEX, Bombay Jeera, pepper, guar seed, channa, soy oil 878.23NMCE, Ahmedabad Pepper, rubber, gold, zinc, aluminium 339.79Table 5 :Monthly Volumes on the Top Commodity Exchanges, Jan 2010Exchange Traded value Avg Trading/day % of Total1 Gold MCX 103641.97 9422.00 26.53%2 Silver MCX 63955.58 5814.14 16.37%3 Crude Oil MCX 49628.30 4511.66 12.71%4 Copper MCX 48457.16 4405.20 12.41%5 Zinc MCX 17963.32 1633.03 4.60%6 Nickel MCX 13723.45 1247.59 3.51%7 Lead MCX 13456.00 1223.27 3.45%8 Guar Seed NCDEX 12643.21 1149.38 3.24%9 Natural Gas MCX 9176.47 834.22 2.35%10 Soy Oil NCDEX 5829.72 529.97 1.49%11 Soy Bean NCDEX 5808.46 528.04 1.49%12 Gold ICEL 5295.55 481.41 1.36%13 R/M Seed NCDEX 3947.93 358.90 1.01%14 Chana NCDEX 3673.45 333.95 0.94%15 Copper ICEL 3282.10 298.37 0.84%Total Top 15 360482.678 92.29%All Contracts 390587.604 100.00%Source : FMCTable 3: Top 15 Futures on Physical Commodities: Average Daily Value of Trading for Feb 2010 Essential Commodities Act, 1955 (ECA) for spot markets ..provides power for the control of the production, supply and distribution of, and trade and commerce in certain commodities.. means that for same products there can be different pricing existing across states hamper arbitrage and true price discovery Forwards Contract Regulation Act, 1952 (FCRA) for derivative market Commodity futures trading was earlier governed by Department of Consumer Affairs, rather than the Ministry of Finance Only forward and futures are permitted in India for trading no options being traded Commodity with no physical underlying cannot be traded no such things like index futures and weather derivatives