INTRODUCTION TO

FINANCIAL MARKET
AND DERIVATIVES

INTRODUCTION TO FINANCIAL
MARKET
Financial Market is a channel through which financial assets are exchanged.
Money Markets markets that trade debt instruments with maturities of up to one year.
e.g. Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements,
and bankers acceptances.
Capital Markets markets that trade equity and debt instruments with maturities of more than
one year.
e.g. Stocks, bonds,.
Primary Markets markets in which corporations raise funds through new issues of securities,
such as stocks and bonds.
e.g. May be first-time issues by firms initially going public, the sale of additional new shares of
an already publicly traded firm, or first time debt issuances.
Secondary Markets markets in which existing securities are traded.
Organized Exchanges physical meeting place and communication facilities are provided for
members to conduct their transactions.

INTRODUCTION TO FINANCIAL
MARKET
Trading process
Deal

Buyers and
sellers locate
one another
and agree on
price
Usually take
place on
organize
exchange
(NYSE, London
Stock
Exchange,
Shanghai Stock

Clear

Clearinghouse
match the
buyers and
sellers and
keeping track off
their obligations
and payments.
DTCC & NSCC
clear and settle
stock and bond
trade.
CME Clearing &
ICE Clear U.S.

Settle

Maintain Records

Buyers and
Once the trade
sellers must
are complete
deliver in the
ownership
required period
records are
of time the cash
updated.
or securities
necessary to
satisfy their
obligation.
With derivatives trade one party may have to
pay in future. Derivatives clearinghouse
typically interpose itself in the transaction and
becoming buyers/sellers . This is known as

RISK-SHARING
In business world, changes in commodity prices, exchange rates, and interest rates are the
potential risks. Surging oil price can wiped out airlines profits. Farmers face the possibly fall of
the price of her crop.
Insurance market a formal risk sharing arrangement.
Premium paid to buy insurance and the collected premium are available to help buyers with
mishaps and the lucky buyers will loss their premium.
Even insurers need to share risks, where they use reinsurance market to buy from reinsurers
insurance against large claims. The risks are spread.
Reinsurers share risks by issuing catastrophe bonds (bonds that the issuer need not repay if
there is a specified event such as large earthquake. Bondholders willing to accept earthquake
risk can buy these bonds in exchange of greater interest payments on the bond if no
earthquake.
Diversifiable risk- unrelated to other risk, it has no significant if many investors share a small
piece of this risk.

WHAT IS DERIVATIVES?
Derivatives are financial instruments whose values
depend on the market price of another assets.
Examples: Forwards, futures, options, swaps, warrants

WHY ENTER DERIVATIVES

MARKET?

Risk Management- to mitigate/alter risk and protect profits

For example, a European investor purchasing shares of an American company off of an
American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while
holding that stock. To hedge this risk, the investor could purchase currency futures to lock in
a specified exchange rate for the future stock sale and currency conversion back into Euros.
Every form of insurance is a derivative- if incidents occur, insurance is valuable and if nothing
happen it is not.
Speculation- Investment vehicle for market makers. Investors make profit if the value of the
underlying asset moves the way they expect. (profit from market fluctuation)
Reduce transaction cost- trading derivatives might result in lower transaction cost than
actually trading stocks and bonds. (e.g. in option trading investors have to pay only certain
agreed premium to have control over 100 shares)
Regulatory arbitrage- to get around regulatory limitations, accounting regulations and taxes.
(e.g. to achieve economic of scale of stock while maintaining physical possession of the stock.

Buying Financial Assets

Ask price/Offer price the price at which the dealer offers to sell a security.
Bid price The price at which a dealer buy a security
Bid-ask spread- the difference between the bid price and the ask price
Transaction fee commission pay to the broker
Market order Instruction to trade a specific quantity of asset immediately at
the best price that is currently available
Limit order- Instruction to trade a specific quantity of asset at a specified or
better price

BUYING FINANCIAL ASSETS

Example 1
Suppose XYZ is bid at $49.75 and offered at $50, and the commission is $15. If
you buy 100 shares and sell immediately. How much is the profit/loss?

Buy => ($50 x 100) + $15 = $5015

Sell => ($49.75 x 100) - $15 = $4960
Loss = $5015 - $4960 = $55

SHORT SELLING
A transaction in which an investor borrows a security , sells it and then
return it at a later date to the lender.

WHY SHORT-SALE?
Speculation Investors make profit if the price of the stock goes down
Financing Another way to borrow money and frequently use as a form of financing. Very
common in bond market
Hedging Offset the risk of owning the stock or derivative on the stock

* Dividends received are paid to the lender and short-seller is tax deductible

SHORT SELLING
Example 2:
Mr. Jay believes that thestockof XYZ Corp. will fall in the future. He calls his broker and asks
him to find 100 shares of XYZ that he (Mr. Jay) can borrow for ashort sale. XYZ's current price is
$25 per share. Mr. Jay receives acashinflow of $2,500 after he sells the shares he has
borrowed.
Scenario 1:
Two weeks later, the price has indeed dropped, and shares of XYZ now trade for $20 each.
He spends $2,000 to repurchase the shares and returns the shares to the person he borrowed
them from.
Mr. Jays profiton the trade is $500 ($2,500 received from thesale of the stock minus $2,000
paid to repurchase the stock).
Scenario 2:
The shares had risen to $27 during hisholding period.
He would have lost $200 ($2,500 received from the sale of the stock minus $2,700 paid to

TUTORIAL
Derivatives Market (THIRD EDITION) Robert L . McDonald
Q1.4, Q1.6,Q1.7, Q1.14