Financial Markets & Instruments

Classification 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 OTC

Indian 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
MFs

Some Products
Depository Receipts

ADRs and GDRs

Traded like shares
Low transaction costs
Three levels of listing for ADRs
International diversification

Some 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 NAVs

Public 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

International comparison
NSE ranks 1st in no. of
trades in equity
India ranked in top 20
countries with most
traded volumes
India ranked in top 15
countries with highest
market cap

Market Activities
Average Monthly Turnover at BSE and NSE in 2013-14
(Rs. Billion)

Spot

Derivative

Spot

Derivative

NSE

2314.56

32213.11

85%

81%

BSE

422.22

7632.32

15%

19%

Trading Pace at NSE 300 trades per sec.

Roughly 150 shares per trade; 45,000 shares per

sec

Market Activities
Derivative Trades at BSE and NSE in 2013-14
Index

Stock

Index Futures Options

Stock Futures Options

BSE

1.01%

98.14%

0.79%

0.06%

NSE

7.41%

73.75%

12.01%

6.83%

Market Activities
Table 10: Industry Wise Distribution of Turnover and Market Capitalisation of NIFTY firms on 26-Mar-2010

AUTOMOBILES
BANKS
CEMENT AND CEMENT PRODUCTS
IT & ITES
CONSTRUCTION
FMCG
ENGINEERING
Financial
PHARMACEUTICALS
POWER
Oil & Gas
METALS
TELECOMMUNICATION
Source: NSE

Value (Rs Crores)

% Weight
Market Cap
Traded value Market Cap Traded value
75087
1001.34
5.25%
15.73%
246902
1129.6
17.28%
17.74%
36466
81.3
2.55%
1.28%
191531
455.66
13.40%
7.16%
20468
417.64
1.43%
6.56%
100043
323.71
7.00%
5.08%
154674
446.59
10.82%
7.01%
87132
243.7
6.10%
3.83%
34752
133.2
2.43%
2.09%
62702
316.22
4.39%
4.97%
239897
832.38
16.79%
13.07%
124923
720
8.74%
11.31%
54332
264.98
3.80%
4.16%
1428909
6366.32
100.00%
100.00%

Market Activities
Table 12: Trading Frequency on NSE & BSE
NSE

BSE

No. of co.s
available

% of

No. of

No. of securities Traded to

Month/Yearfor trading traded

available

securities % of Traded to
Listed

traded

Listed

Feb-10

1,342

1,328

98.96

8,118

2,955

36.40

Jan-10

1,338

1,320

98.65

8,086

2,890

35.74

Dec-09

1,303

1,297

99.54

8,176

2,894

35.40

Nov-09

1,292

1,276

98.76

8,127

2,877

35.40

Oct-09

1,291

1,280

99.15

8,167

2,876

35.22

Sep-09

1,287

1,265

98.29

8,098

2,790

34.45

Source: BSE,NSE and SEBI

Volatility
Table 15: Performance of Sectoral Indices- Average Daily Volatility (%)
S&P

S&P

S&P

Finance

S&P

S&P

Month/

CNX

CNX

CNX IT

CNX

CNX

Year

Nifty

FMCG

Petro-

Phar-

(Nifty

chemi-

maceu-

50)

cals

ticals

Jul-07

1.16

1.24

1.36

1.94

1.42

0.85

Aug-07

2.06

1.64

1.88

3.24

2.08

1.37

Sep-07

1.06

0.89

1.49

1.86

1.26

0.79

Oct-07

2.46

1.70

1.69

4.41

2.62

1.30

Nov-07

1.72

1.89

1.82

2.77

2.12

1.06

Dec-07

1.67

1.11

1.91

2.32

2.14

1.37

Jan-08

3.29

3.41

2.77

5.10

4.86

2.92

Feb-08

2.46

2.20

2.71

3.34

2.64

1.52

Mar-08

3.06

1.82

3.46

5.69

3.70

1.96

Apr-08

1.28

1.34

2.50

1.73

2.90

-0.95

May-08

1.21

1.42

1.66

2.00

2.37

0.93

Jun-08

1.91

1.48

2.24

2.76

3.35

1.36

Average

1.95

1.68

2.12

3.10

2.62

1.21

Source: ISMR 2008 and IISL(India Index Services & Product Ltd.).

Table 16: Nominal Annual Returns and Volatilities

(1 Jan 1995-31 Dec 2009)

Volatility
12.56%
27.27%
13.96%
27.63%
7.93%
20.27%
5.65%
19.46%
-1.11%
24.99%

Returns
NSE
BSE
S&P 500
FTSE 100
NIKKEI 225

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 risk

Market 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 market

Type 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 buy

Execution Costs
Explicit Costs

Commissions; taxes; stamp duties; fees

Implicit Costs

Impact costs; opportunity costs; delay costs

Execution Costs
Bid-Ask spreads
Bid
Time
12:02
12:02
12:02

Quote
446.69
446.17
445.99

Ask
Size
1500
1650
1445

Quote
446.81
447.01
447.62

Quoted and effective spreads

Size
1700
1553
1654

Price adjustment and impact cost

Fixed 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. agencies

Types of Securities
Corporate Securities

Bonds/ debentures
Medium-Term notes
Structured notes
Commercial papers
Negotiable CDs
Bankers acceptance
Convertibles

Sources of Returns
Coupon payments
Principal with capital gain and loss
Reinvestment of coupons

Price Quotations
Accrued interest
Dirty price
Clean price

Yield 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

Shortcomings
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

Short term G-sec market

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

Long term G-sec market

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
securities

Derivatives

Derivatives as Risk Transfer Vehicles

Derivative contracts

Derives value from some underlying asset

Exchange traded
Standardized

Over-the-counter (OTC)
Customized

Types of Derivatives
Forward commitments
Forward Contract
Futures Contract
Swaps

Contingent claims
Options

Structured Instruments
STRIPS; CMOs; CDOs

Forward 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 position

Forward Contracts
Examples

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 Contracts
Examples
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 contract

Forward Contracts
Forward 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 - short

Forward Contracts
Examples
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)
90
X 1,000,000 $2500
360 days instead
30

Payoffs (6% 5%) X

Payments if made after

from initiation of contract
PV

2500
6% X 90
(1
)
360

=$2463

of 120 days

Forward Contracts
Examples
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 basis

Futures 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 - short

Margins 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 leverage

Futures Contracts
Examples
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 margin

Day
Required Deposit Price/Kg. Daily Changes Gain/Loss Balance
0 (purchase)
750
2
0
0
750
1
0
1.98
-0.02
-500
250
2
500
1.99
0.01
250
1000
3
0
1.98
-0.01
-250
750

Futures Contracts
Examples
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 = $1750

Futures Contracts
Examples
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 = $20000

Option 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 DELIVERY

Basic 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) Put

Option 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 underlying

Option Contracts
Examples

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 = 110

Option Contracts
Examples

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
Out of money > 110
At the money = 110

Option Contracts
Examples

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. 6200

Types of Options
Financial Options:

Equity {Index (cash settlement)and stocks}

Bonds
Interest rates
Currency

Options on Futures
Commodity Options

Swap 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 mostly

Swap Contracts
Examples
Fixed-for-floating loan 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 3rd year

Payments from Floating payer to Fixed payer

At the end of 1st year:

=(8%-8%) X 100000 = Rs. 0

At the end of 2nd year:

=(8.5%-8%) X 100000 = Rs. 500

At the end of 3rd year:

(7.5%-8%) X 100000 = -Rs. 500

Swap Contracts
Examples

Types of Swaps
Currency
Interest rate
Equity

Structured 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 risk

Inverse Floaters
Contract rates :

(Reference floating)
Risk levered instruments

Commodity 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)

Market activities
(Rs.Crore)

Average daily turnover in Commodities market for February 2009 & 2010

Pariculars
2009-10
2008-09
2009-10
Total value of trade
35,507.96
21,194.85
Total value of trade in Bullion
15,980.61
12,892.01
Total value of trade in Agri Commodities
4,504.74
2,678.16
Total value of trade in other Commodities
15,022.61
5,624.67

2008-09
100.00%
45.01%
12.69%
42.31%

100.00%
60.83%
12.64%
26.54%

Source : FMC

Table 5 :Monthly Volumes on the Top Commodity Exchanges, Jan 2010

Volume (Rs
Billion)
Market
Popular contracts
5626.97
MCX, Bombay
Copper, gold, silver, crude oil, zinc
878.23
NCDEX, Bombay
Jeera, pepper, guar seed, channa, soy oil
NMCE, Ahmedabad
Pepper, rubber, gold, zinc, aluminium
339.79

Market activities
Table 3: Top 15 Futures on Physical Commodities: Average Daily Value of Trading for Feb 2010
Exchange
Traded value
Avg Trading/day % of Total
1 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 : FMC

Regulation
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

Regulation
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