FINANCIAL

SERVICES
 Overview
• Financial Institutions; Financial Markets;
Financial Instruments & Services
• Organized and unorganized sectors
• Major players like ICICI; IDBI; HDFC; L&T; Birla
Sunlife; TATA Capital; Reliance Capital
• Highly linked to the macro policy decisions
• Financial Services sector growing ~ 8.5%
 Financial Services
• Very loosely defined
• Generally means
“Services rendered by banking & non-banking
finance companies regulated by the RBI,
insurance companies regulated by IRDA, and
other entities regulated by SEBI”
 Financial Sector Reforms
• Initiated in 1991
• Accelerate economic growth and eradicate
poverty
• Addressed
– Dominance of public sector in industrial sector
– Discretionary controls on industrial investments
– Trade and exchange controls
– Limited foreign investments
– Public ownership & regulation of financial sector
 Key Constituents
• RBI
• Commercial Banks – Public & Private
• Developmental Finance Institutions – IDFC; GSFC
• Insurance Companies – Life & General
• Public sector institutions – POSB; NABARD; NHB;
SIDBI
• Mutual Funds – UTI & Others
• NBFCs – HDFC; Shriram Finance
• Asset Reconstruction Companies
• Capital Market Intermediaries
• Credit Information Companies – ICRA; CARE
 RBI

• The Apex (Central) Bank

• Regulates Monetary Policy
• Prints Money
• Lender of the last resort
• Government’s banker
• Regulatory authority for banks
 Commercial Banks
• Business under Companies Act, 1956
• Carry out business of ‘banking’ as per Banking
Regulation Act.
• Segregation
– Nationalized Banks
– SBI & Associate Banks
– Regional Rural Banks
– Foreign Banks
– Other Indian Private Banks
 DFI
• Financial Institutions with mixed ownership
• Long term financial needs of industrial sector
• Centrally or state controlled
 Insurance Companies
• Traditionally dominated by LIC & GIC
• GIC has 4 fully owned subsidiaries
• New entrants since liberalization
• IRDA is the regulating authority
• Current segmentation
– Life Insurance
– General Insurance
– Health Insurance
– Re-insurance
 Public Sector Institutions
• Post Office Savings Bank
• National Bank for Agriculture and Rural
Development
• National Housing Bank
• Export Import Bank of India
• Small Industries Development Bank of India
 Mutual Funds
• Originated with UTI in 1963
• Regulated and monitored by SEBI
• Private players involved since liberalization of
1990s
• Managed through trusts – sponsors; trustees;
AMC and custodians
 NBFC
• Registered under Companies Act
• Governed by RBI
• Regulations different from banks
• Classification
– Asset Finance Company
– Investment Company
– Loan Company
 ARC
• Asset Reconstruction Companies
• Securitization and Reconstruction of Financial
Assets and Enforcement of Security Interest Act,
2002 (SARFAESI)
• ARCIL etc.
• Recreate stressed and doubtful assets
 Capital Market Intermediaries
• Custodian of Securities
• Depositories
• Merchant Bankers
• Portfolio Managers
• Collective Investment Schemes
• Stock Brokers
• Underwriters
• Other Intermediaries
 Credit Agencies
• Registered with RBI
• Credit Information Companies (Regulation) Act,
2005
• Primarily rate credit/debt of companies and
corporations
• National and International players
 Video
• The following video outlines the genesis of the
global financial crisis of 2007-08 originating in
the US.
• Includes various elements of the Financial
Services space.
• Shows the inter-connectedness of the industry.
• Terminology used is U.S. based but easy to
understand globally.
 Processing
1. Identify and list down various financial services
that are illustrated in the video. In your view
what are the other services that can be included
here?
2. What were the key expectations of the ultimate
investors from the financial system?
3. What was the key role played by the investment
bankers in triggering the financial crisis in the
first place?
4. What are CDOs? How is risk managed under
these instruments?
Financial Markets Primer
 Market Beginnings…
• Financial markets are at work all around us
– Rupee reacting to the Chinese devaluation of Yuan
– The BSE Sensex struggling to regain highs
– Software firms loosing millions with derivatives
– Loans to get cheaper following rate cuts by RBI
• Markets have a long history and have been
around for a long time
• Markets have come a long way in recent past in
terms of variety and complexity
• Slow face-to-face dealing replaced by fast
networks
 What Do Markets Do??
• Financial markets take on various forms and
operate in diverse ways.
• In essence all of them serve the same basic
functions
– Price Setting
– Asset Valuation
– Arbitrage
– Raising Capital
– Commercial Transactions
– Investing
– Risk Management
• Price Setting
– The value of a commodity or stock / share or bond is
what someone is willing to pay for it. (MSP?)
– This is achieved through mechanism of price
discovery
– Determines relative value of different items based
upon prices
• Asset Valuation
– Market prices determine value of a firm or assets
owned by the firm
– Important to buyers and sellers and regulators as well
– e.g. Securities bought and held by an insurer against
claims and payouts, with a view to determine
solvency
• Arbitrage
– Especially observed in underdeveloped markets
– In essence this the difference in prices of currencies,
commodities or securities at different locations; eg
BSE & NSE
– Alternative viewpoint – manpower arbitrage in the
software development industry
– Ultimately prices move away from these divergences
and make the economy more efficient
• Raising Capital
– Achieved through a host of instruments – bonds;
shares;
– Businesses are prime customers – for adding
capacity; greenfield projects;
– Governments also access markets in order to raise
capital
– Capital required by individuals is also sourced here
• Commercial Transactions
– Markets also meet the ongoing finance needs of the
economy
– Trade related funding and financing
– Working capital requirement of firms
• Investing
– Used to deploy excess and spare funds to earn a
return
– Corporates use capital markets to manage treasury
operations
– Could be deployed across bond, share, money or
derivatives markets
– Also assist in accumulating assets for the future
– Returns through – Yield or Capital Gains
• Risk Management
– Primarily a function of the futures, options and other
derivative contracts
– Provide protection against many types of risks
– Critical in managing finances that have trans-border
exposures
– Allow attaching a price to risk, thereby allowing the
trading of risk
• Price Setting
– The value of a commodity or stock / share or bond is
what someone is willing to pay for it.
– This is achieved through mechanism of price
discovery
– Determines relative value of different items based
upon prices
 How big are the markets?
• Highly dynamic setting prevents any accurate
estimation
• Total capital market financing in 2011 was
approximately 6.5 t
• But traded nearly 180 t of capital in the same
year
• Excludes activities such as insurance
underwriting, trading in derivative and lending to
individuals
• Float between stock; bonds and loans
How big are the markets?

Sources: Bank for International Settlements;

World Federation of Exchanges
Trends – Int. Capital Markets

Source: Bank for International Settlements

 Long Term Trends
• Increased financial-market activity over last few
decades
• Four main factors responsible
1. Lower inflation
2. Pensions
3. Stock and bond market performance
4. Risk management
 Rise of Formal Markets
• Important attributes of successful markets
– Liquidity
– Transparency
– Reliability
– Legal Procedures
– Suitable investor protection and regulation
– Low transaction costs
 Forces of Change
• Capital markets have been shaped in recent
times by:
– Technology
– Deregulation
– Liberalization
– Consolidation
– Globalization
 Some players…
• Individual Investors
• Institutional Investors
– Mutual Funds
– Hedge Funds
– Insurance Companies
– Pension Funds
– Algorithmic Traders
– Others
 Programmed Learning
1. What is the link between arbitrage and market
efficiency?
2. How have the availability of risk instruments
impacted the development of financial
markets?
3. Capital can be raised using bonds, equity or
loans. What factors will decide the usage of
each option?
4. What could be the key difference between
mutual and hedge funds?
 Market Types
• Foreign Exchange Markets
• Money Markets
• Bond Markets
• Equity Markets
• Futures and Options Markets
• Derivatives Markets
• Commodity Markets
 Money Markets
• Involves corporations, financial institutions ,
investors and governments
• Deals with flow of short-term capital
• Money markets have expanded in recent past at
expense of banks (disintermediation)
• Deregulation and ease of moving money
electronically has supported trend
• Low cost of raising money for short-term and
irregular cash flows
 Money Markets…
• Money markets could also involve deployment
into other currencies
• However this brings in additional risk (forex)
• Hence usually limited to home currencies
 Money Markets…
• Money markets – web of connected borrowers
and lenders
• Central bank policies determine short-term
interest rate
• Array of treasuries – company & govt. – around
• Invest unneeded cash as safely and profitably as
possible
• Borrow when necessary when needed at lowest
possible cost
 Money Markets…
• Money-market instruments in circulation
worldwide
– 2001 - $ 6 trillion
– 2008 - $ 14 trillion
– 2012 - $13 trillion
• Money-market investors are very risk averse
• Freezing of ‘money markets’ drove economies
into recession
 What do Money Markets do…?
• No precise definition of money markets
• Generally applied to buying and selling of debt
instruments maturing in one year or less
• Related to the bond market (long-term) but with
different objectives – profits v/s cash
management
• Well developed money-market supports
development of long-term securities
 Investing in Money Markets…
• Short-term instruments unattractive to small
investor
• Investments through funds, rather than buying
individual securities
• Retail and institutional versions of funds
• Reduce investors’ search costs and risks
• Cost of intermediation lower than banks
• Spreads are few basis points
 Investing in Money Markets…
• Institutional Investors
– Trading departments at Banks and investment
institutions
– Mutual Funds – for flexibility in redemption
– Pension Funds & Insurers for same reason
– Dominant portion of the money-market operations
Money Market Dynamics…
 Money / Capital Markets
Money Markets Capital Markets
Maturity of 1 year or less More than 1 year
Instruments
Risks Less More and varied

Instruments Treasury Bills, CDs Shares, bonds, etc

etc.
Finance Short term Long term

Relation with Direct Indirect

Central Bank
 Money Markets Instruments
• Call / Notice Money
• Inter-bank Term Money
• Inter-bank Participation Certificate
• Inter-corporate Deposit
• Treasury Bills
• Commercial Bills
• Certificate of Deposits
• Commercial Paper
• Bankers’ Acceptance
• Government Agency Notes (//local)
• Interbank Loans
 Call / Notice Money
• Forms core of the Money Market Operations
• Confined generally to inter-bank business
• Mainly on an overnight basis
• Small portion of notice money business on 14
day basis
 Inter-bank Term Money
• Originally exclusively for the commercial & co-
operative banks
• Now open to All India DFIs
• Permitted to borrow for 3-6 months
• Borrowing limits set by RBI
• Interest rates are market driven
• Predominantly a 90-day market
 Inter-bank Participation Certificate
• Short-term instruments
• Even-out short term liquidity in banking system
• Issued under an underlying advance, classified
standard and aggregate amount of participation
in any account time issue
 Inter-corporate Deposit
• Outside purview of regulatory framework
• Corporates park short-term surplus funds
• Interest rates determined by market
• Predominantly a 90 day market
 Treasury Bills
• Short-term promissory notes
• Issued by Government
• Issued at discount for 14 days to 364 days
• Assists in dynamic asset-liability management
• 14, 28, 91 and 364 day TBs have been introduced
• Available on auction basis
• Amount to be auctioned is pre-announced
• Cut-off rate of discount and issue-price
determined at auction
 Commercial Bills
• Commercial bills arising out of genuine trade
transactions i.e. credit transactions
• Negotiable and self-liquidating paper
• Written order from creditor to debtor, to pay a
certain sum to certain person, after a creation
period
• Always drawn for a short period between 3-6
months
 Certificate of Deposits
• Negotiable term-deposits
• Accepted by commercial banks from bulk
depositors at market rates
• Can be issued at discount to face value
• Tenor ranges from 3 months to 1 year
• Minimum of 5 lacs to single investor
 Commercial Paper
• Unsecured debt instrument in form of
promissory note
• Issued by highly rated corporate borrowers
• Used to fund ongoing business activities
• Issued either directly or via dealer bank
• Generally issued at market determined discount
• Tenors ranging between 15 days and 1 year
 Bankers’ Acceptance
• Promissory note issued by non-financial firm to
bank for a loan
• Bank resells note in MM at a discount
• Bank guarantees payment to buyer
• Usually a maturity of less than 6 months
 Govt. Agency Notes
• Issued by National Govt. agencies
• Issued by Local Govt. agencies
• Manage irregular cash flows
 …Debt Securitization
• Retail – Wholesale – Retail conversion of loans
• Transform loans into negotiable instruments
tradable in secondary markets
• Can be structured to fund large and long-term
projects
 …MMMF
• Primarily meant for individual investors
• NRIs can invest on non-repatriable basis
• Funds raised to be invested exclusively in money
market instruments
• No guaranteed minimum rate of return
• Minimum lock-in 46 days
 Repurchase Options
• Borrower places with lender certain acceptable
securities against funds received and agrees to
reverse the transaction on a pre-determined
future date at agreed interest cost.
• No fixed period prescribed; generally 14 days -
1 year
• Interest is market determined
• These keep markets highly liquid
• Commercial Banks; FIs; Brokers; DFHI
• Repo transactions limited to TBs
 Programmed Learning
1. How are the investment objectives different for
the money and bond markets?
2. Efficient money markets help even long-term
debt markets develop. Your views.
3. Why do banks need to borrow and lend in the
short-term money markets?
4. How did the ‘freeze’ in money-markets
contribute to the financial crisis?
 Debt Markets
• Collectively with Equity Markets drive the Capital
Markets
• Two key components
– Government Securities
– Bonds
• Mirrored growth of other financial markets in
recent past
• However taken backseat in India due to various
reasons
Debt Securities Outstanding ($T)
 Rapid Growth…
• Large budget deficits, funded by bond issuance
• Intended to stimulate economies
• Extremely low long-term interest rate (India??)
• Emerging economies could borrow cheap –
domestically and internationally
 Government Securities
• Tradable instrument issued by Central or State
governments
• Short-term -Treasury Bills
• Long-term -Govt. Bonds; dated securities
• Practically no risk of default; hence risk-free gilt-
edged instruments
• Also issues savings instruments – Savings bonds;
NSC
 …Government Securities
• Special securities – oil bonds; FCI bonds; fertilizer
bonds; power bonds etc.
• Issued by RBI on behalf of govt.
• Proceeds used to meet expenditure
commitments.
• Generally fixed maturity and fixed coupon
– E.g. 8.24% GOI 2018
 Features
• Issued at face value
• No default risk – sovereign guarantee
• High liquidity – tradable in secondary markets
• Interest payment on hly basis on face value
• No TDS
 Features
• Demat form
• Rate and tenor fixed at issuance
• Redeemed at face value
• Maturity from 91 days to 30 years
• Qualify as SLR investments
 Risk Management
• Practically no default risk
• Market risk
• Reinvestment risk
• Liquidity risk
 Bond Markets
• Makes up the composite capital market
• Bedrock of the Debt Markets
• BOND – contract, agreement or guarantee
• Generally classified as fixed-income securities
• Traditionally considered low-risk defensive
vehicles – changing profile
• Aimed at preserving capital in unsettled markets
• Debt securities; entitle owner to receive interest
+ principal, without ownership or control
 Advantage BONDs
1. Minimizing Financing Costs
2. Matching Revenue & Expenses
3. Promoting Intergenerational Equity
4. Controlling Risk
5. Avoiding short-term financial constraints
 Bond Types
• Zero Coupon Bond
• Convertible Bond
• Bearer Bond
• Registered Bonds
• Term Bonds
 …Bond Types
• Serial Bonds
• Puttable Bonds
• Callable Bonds
• Exchangeable Bonds
• Fixed Rate Bonds
 …Bond Types
• High Yield Bonds
• Mortgage Bonds
• Subordinated Bonds
• Guaranteed Bonds
• Perpetual Bonds
 …Bond Types
• Global Bonds
• Easy Exit Bonds
• Option Bonds
• Double Option Bonds
• Floating Rate Bonds
• Inflation Bonds
 Bond Issuers
• National Governments
• Local Governments
• Corporations
• Securitisation vehicles
 Bond Issuance
• Underwriters to issue
• Primary Dealers
• Interest rate swaps
• Interest Rate setting
• Bond distribution
 Bond Properties
• Maturity
– 1-5 yrs short term
– 5-10 yrs medium term
– 10 + yrs long term
• Coupon
– Stated as percentage of price at issuance
– Does not change after issuance
 Risk Rating
• Issues rated by private rating agencies
• Investigate
– Issuers ability to service bonds
– Financial strength
– Intended use of funds
– Political and regulatory environment
– Potential economic changes
• Proprietary rating system
• Provides estimation of default risk
 Bond Properties
• Current yield
– Effective interest rate @ current market price
– Annual rupee coupon interest / Current price
• Yield to maturity
– Annual rate received if held to maturity
– Includes capital gains/losses on redemption
• Duration
– Half the total payment due over bond’s remaining life
– Present value of future payments adjusted
– Higher yields usually translate into shorter duration
Risk Rating
Price / Yield Curve
 Equity Markets

“It is usually agreed that casinos

should, in the public interest, be
inaccessible and expensive. And
perhaps the same is true of Stock
Exchanges.”
- John Maynard Keynes
 Equity Markets
• Equity = ownership
• Shares representing part ownership of a business
enterprise
• Exemplified by part ownership of early
temporary business
• Rapid progression in India over last three
decades
• Evolved into efficient avenues of raising capital
• Best performing asset class over the long term
 Prominent Equity Markets
Market capitalisation, $bn

US 21,149
Japan 4,222
China 4,038
UK 3,603
Euronexta 3,037
India 2,966
Hong Kong 2,873
Canada 2,010
Germany 1,617
Switzerland 1,362
Australia 1,182
Brazil 1,152
Korea 1,146
OMX Nordic Exchangeb 1,077

Spain 983
Share Turnover ($bn)
 Equity Markets
• Main function is raising capital for productive
purposes
• Fund raising options
– Loans
– Bonds
– Securitisation
– Venture Capital
– Equity
 Types of Equity
• Common stock or ordinary shares
– Voting rights
• Preferred stock
– Cumulative
– Non-cumulative
• Convertible preferred stock
– Converted to common stock
• Warrants
– Rights issue
 Equity Issuance
• Issuing shares
– Initial ownership with individuals / VCs
– Regulatory requirements (time / profit)
• Flotation
– Selling shares to public
– Leverage new opportunities
– Spin-offs
– Exit option for founders / VCs
– Compensate employees
– Divestment process of Govt.
 Equity Issuance
• Private offering
– Placement with private investors
– Hedge funds; HNIs
– Requires lower disclosures
– Lock-in may be prescribed
• Secondary offering
– FPOs
– Issued by company or large investors
– Additional shares issued to increase capital
– Leads to dilution
 Flotation Process
• Registration with securities regulator
• Legal and regulatory compliance
• Issuance of prospectus (red herring)
• List past performance & future prospects
• Float handled by investment bank
– Underwriting basis
– Best-effort basis
• Price band discovery
• Retail & Institutional options
 The IPO
• Favoured avenue for the retail investor
• Intense competition in up-swings – bunched-up
• Price fluctuation on listing
• Instances of price rigging
• Contrasting recent IPOs
– Indigo v/s Coffee Day
 Buy-backs
• Go private
• Boost current share price
• Return excess capital to shareholders
• Use in employee compensation programs
• Reduce operational expenses – dealing with
minority shareholders
• Take advantage of tax considerations
 Factors – share prices
• Theoretical v/s actual share price
• Earnings
• Cashflows
• Dividends
• Asset value
• Analysts’ recommendations
• Inclusion in an index
 Factors – share prices
• Interest rates
• Bond returns
• General economic news
• Fads
• Stock-splits
• Market efficiency
 Key Numbers
• Price / earnings ratio (P/E)
• Beta
• Return on equity (ROE)
• Return on capital (ROC)
• Value Added
 Top Exchanges
Exchange No. of Companies Listed
Bombay Stock Exchange 5191
Toronto Stock Exchange 3970
BME Spanish Exchanges 3200
London Stock Exchange 2767
NASDAQ 2577
New York Stock Exchange 2339
Tokyo Stock Exchange 2304
Australian Stock Exchange 2056
Korea Exchange 1784
National Stock Exchange of India 1665
Hong Kong Exchanges 1547
Shenzhen Stock Exchange 1540
Euronext 1073
Shanghai Stock Exchange 954
Market Cap as % of GDP
 Off-Market Trading
• Result of technological & regulatory changes
• For sophisticated market players
• Dark pools
– Institutional investors
– Large orders
– Secrecy
• Internalisation
– Retail investors
– Small orders
– Fulfilled by wholesale brokers without market
Emerging Markets
 Measuring Market Performance
• Basic two price measures
• Averages
• Indexes
 Trading Shares
• Market order
• Limit order
• Stop order
• Day order
 Institutional Trading
• Block trades
• Basket trades
• Program or algorithmic trades
• Short sales
Futures & Options Markets
 Managing Risk
• Essential functions of financial markets
• Risk is linked to time
• F&O markets protect against risk of constant
price changes
• Agreements to buy or sell assets in the future at
certain prices or under certain conditions
• F&O contracts v/s Forward contracts
• Managing risk; Speculation; Trading
 Market Evolution
• F&O markets are outgrowths of commodity mkts
• Commodity markets
– Have existed for a very long time
– Help set prices
– Match buyers and sellers
• Cannot prevent loss of value over time or
prevent variation in prices
• F&O markets can help lock these prices
• Transition from one-off to standardized contracts
 Commodity characteristics
“ Commodities are physical goods, but not all
physical goods are commodities”

• Can be stored for long (unlimited) periods

• Value depends heavily on measurable physical
attributes & physical location
• Commodities with same physical attributes and
same physical location are fungible
• Participants – producers, users or intermediaries
 Why trade F&O?
• Features
– Do not represent long-term investments
– No income potential; no interest or dividend
• Hedging
– Used to offset specific risks
– Hedgers decide to take certain risks and avoid others
• Speculation
– Profiting from changes in prices of contracts
– Speculation increases liquidity in markets
 Leading F&O Exchanges
Exchange F&O Contracts traded (m)

CME Group, US 2890

Eurex, Germany/Switzerland/US 2291
National Stock Exchange of India 2010
NYSE Euronext, US/UK/FR/NL/B/P 1951
Korea Exchange 1835
BM&F Bovespa, Brazil 1636
Chicago Board Options Exchange, US 1134
Nasdaq OMX Group, US/DK/SV/SU 1115
Moscow Echange 1062
Multi Commodity Exchange of India 960
 Futures Contracts
• Deal between two investors
• Unknown and unaware about motives
• Contract is a derivative
• Price and terms derived from underlying asset
• Contract can be created anytime
 Types of Contracts
• Two basic categories
– Commodity futures
• Based on bulk commodities
• Known as physicals
– Financial futures
• Popularised by floating exchange rates
• Deregulation of interest rates
• Trading volumes exceed commodity futures
 Trading Futures
• Market orders
• Limit orders
• Market-if-touched orders
• All-or-none orders
• Fill-or-kill orders
 Contract Terms
• Contract contains specification of transaction
– Contract size
– Quality
– Delivery date
– Price limits
– Position limits
– Settlement
 Leading Futures Contracts
Contract Exchange No. Traded (m)

US dollar/Indian rupee National Stock Exchange of India 620

US dollar/Indian rupee Multi-Commodity Exchange of India 551
Mini S&P 500 Chicago Mercantile Exchange 474
3-month eurodollar Chicago Mercantile Exchange 426
US dollar/Russian rouble Moscow Exchange 373
One-day interbank deposit BM&F Bovespa 341
Soy meal Dalian Commodity Exchange 326
DJ Euro Stoxx 50 Eurex 315
Euro-Bund Eurex 184
US 10-year Treasury Chicago Board of Trade 184
 Price Setting
• The quoted price
• Price movements
• Limits on price movements
• The spot price
• Term factor
 Commodity Futures
• Four main categories
• Agricultural futures
• Metals futures
• Energy futures
• Commodity related futures
 Financial Futures
• Interest rate futures
• Currency futures
• Stock-index futures
• Share-price futures
• Others
– Crop yield data
– Consumer price index
– Residential / commercial property prices
Trading volume – interest rate futures
Trading volumes currency futures
Trading volumes – stock index futures
 Clearance & Settlement
• Futures transaction requires buyer & seller
• Exchange facilitates trading and ensures solvency
• Clearing house matches trades
• Banking system ensures settlement
• Initial margin
• Marking to market
• Margin calls
• Delivery
 Trading Strategies
• Basis trading
• Dynamic hedging
• Index arbitrage
• Spreads
• Straddles
• Strips
 Options
• Initially considered to be dangerous
• Now premium instrument to manage risk
• Nearly $666 trillion worth of contracts traded in
2008
• Based on the price of some underlying
• Contracts have precisely defined underlying, a
standard size and variety of expiration dates
 Options
An option is a contractual agreement that gives
the option buyer the right, but not the
obligation, to purchase (in the case of a call
option) or to sell (in the case of a put option) a
specified instrument at a specified price at any
time of the option buyer’s choosing by or before
a fixed date in the future. Upon exercise of the
right by the option holder, an option seller is
obliged to deliver the specified instrument at the
specified price.
 Types of Options
• Equity options
• Index options
• Interest-rate options
– Bond options
– Yield options
• Commodity options
• Currency options
 Why Options Trading?
• Risk Management
• Hedging
• Leveraged speculation
• Arbitrage
• Income
Options
 Pricing Factors
• Intrinsic value
• Time value
• Volatility
• Delta
• Gamma
• Rho
• Vega
Foreign Exchange Markets
 Importance of Forex
• All prices expressed in units of currency
• Value of currency needs judging against an
external reference, most often other currencies
• Exchange rate becomes the fundamental price
• Determining relative values is role of forex
markets
• Forex markets directly influence foreign-trade
patterns, flow of international investment,
domestic interest and inflation rates.
Average Daily Turnover - $bn
 Forex Participants
• Exporters & Importers
– Global operators deal in multiple currencies
– Suppliers & workers paid in local currencies
– Eventually convert earnings into home currency
• Investors
– FDI
– Portfolio Investments
– Investments made in local currencies
– Conversion to home currency on repatriation
 Forex Participants
• Speculators
– Buy & sell currencies instead of business activity
– Anticipate changes in exchange rates
– Combined with short-term financial instruments
– Leading investment, Hedge funds & HFTs
• Governments
– Central banks trade currencies to control exchange
rates (intervention)
– Internationally focused sovereign wealth funds invest
foreign currencies as investments
Market Turnover – Daily average $bn
 Largest Exchanges - Futures
Exchange No. of Contracts Notional Value $bn

National Stock Exchange 631,266,655 597

of India
MICeZ/RTS, Russia 410,545,200 425
CME Group, US 203,302,545 25,203
Bolsa de Mercadorias & 85,120,548 4,272
Futuros, Brazil
Korea Exchange 54,506,045 551
Johannesberg SE 13,038,541 15
MexDer 9,841,497 99
ICE Futures 7,400,132 510
Global trading – daily average %
 Settlement
• At the retail level
• In futures and options
• Large trades in spot or derivatives
• Exposed to multiple risks as large volumes
involved
Factors of Change
 Managing Rates - Fixed
• The Gold Standard
– Metallic standard adopted by most countries
in mid 1800
– Money supply directly linked to gold reserves
– Notes and coins can be exchanged for gold
– Gold standard precluded devaluation
– Painful method of correcting current-account
imbalances
 Managing Rates - Fixed
• The Bretton Woods
– Alternative fixed-rate regime
– Based on foreign currencies + gold
– The IMF was created to facilitate balancing
– Special Drawing Rights were created
 Managing Rates - Fixed
• Pegs
– Pegged rate
– Hold value of currency constant in terms of
another currency
– Always subject to change
 Semi Fixed Systems
• Hybrid systems aimed at exchange-rate stability
• Also termed as a managed-float
• Types
– Bands
– Target Zones
– Pegs and Baskets
– Crawling peg
 Floating Rates
• Exchange rates not the target of monetary policy
• Central banks pursue other goals
• Rates move in tandem with market forces
• Floating rate now preferred over fixed
• However, most central banks do intervene from
time to time
• Enhanced economic activity linked to floating
rates
Trading the Forex Market
 Trading Currencies
• Four distinct sub-markets
– The Spot Market
– The Futures Market
– The Options Market
– The Derivatives Market
• Forward Contracts
• Foreign-exchange swaps
• Forward rate agreements
• Barrier options and collars
 Trading the Forex Market
• Traditionally the domain of large financial
institutions, corporates & central banks
• Now available to the retail investors due to
technology & communications
• Many brokerages offer services to individuals
• Spot trading not allowed by RBI
• Other features
 Features of trading
• There are many peculiar features of trading forex
– Daily fluctuations in currency value are very small
– Hence one of the least volatile financial markets
– Large amount of leverage is required by speculators
– Leverage can be as high as 250:1
– This is combined with deep liquidity
– Positions can be opened & closed rapidly or held for
longer times
– Currency prices linked to supply & demand
– Prices cannot be manipulated
 Risks and Benefits
• Advantages
– Large trades without affecting exchange rates
– Low margin requirements to operate
– Global nature of forex markets
– Limited number of traded instruments
• Risks
– Ultra-high leverage can be damaging
 Forex v/s Equity
Forex Equity
Limited number of traded Large number of traded
instruments stocks
Liquidity is always high Markets can freeze up
sometimes
Possible to make gains on Difficult to make gains in a
both sides falling market
Very low margin High margin requirements
requirements
Low expenses Higher expenses
 Features of trading
• Majority trade amongst seven pairs
• “the majors”
– EUR/USD - “euro”
– USD/JPY - “gopher”
– GBP/USD - “cable”
– USD/CHF - “swissie”
• “commodity pairs”
– AUD/USD - “aussie”
– USD/CAD - “loonie”
– NZD/USD - “kiwi”
 Reading the Quotes
• Currencies quoted in relation to another
currency
– E.g. while determining the exchange between U.S.
Dollar and the Indian Rupee, forex quote will look like

USD/INR=67.50

– This is considered a currency pair

– Base currency & quote or counter currency
– Base currency always = 1 unit
 Reading the Quotes
• Direct Currency Quote
– The domestic currency is the quoted currency
– The foreign currency is the base currency
– E.g. USD/INR; 67.50 USD/INR
– Most quotes in the spot market are direct with USD
as base
• Indirect Currency Quote
– The domestic currency is the base currency
– The foreign currency is the quoted currency
– E.g. INR/USD; 0.0148 INR/USD
 Other Terms
• Cross Currency
– Quotes without USD as one of the components
– E.g. EUR/GBP ; EUR/CHF ; EUR/JPY
– Not as actively traded as the majors
• Lots and mini-lots
 Other Terms
• Bid and Ask
– Bid price (buy) and Ask price (sell)
– In relation to the base currency
– E.g. USD/INR = 67.5000/50
– While buying, ask price is amount for one unit of
base currency
– While selling, bid price is amount of currency that will
be obtained for one unit of base currency
– Transaction is always conducted in base currency
 Other Terms
• Spreads and Pips
– Difference between bid and ask price
– Measured in the smallest units – pips or points
– Smallest amount price can move in any quote
– Most currencies trade in a range of 100-150 pips/day
– Seem insignificant but result in large movements due
to leverage
Trading the Forex Market
 World of Investments
• Instruments (securities), markets and financial
institutions
• Money, Debt, Derivatives, Equity and Forex
markets
• Modern trading practices – pros & cons
• Explosive growth in trade has led to fierce
competition amongst markets
• Ever changing strategies to respond to change
• Investing for self or clients
 What is an Investment?

“ An investment is the current commitment

of money or other resources in the
expectation of reaping future benefits.”
 Issues in managing investments
• Financial and Real assets
• Types of markets
• Types of securities
• Valuation of securities
• Risk management principles
• Portfolio construction
 Real v/s Financial assets
• Real Assets
– Assets used to produce goods and services
– Function of the productive capacity
– Determine the material wealth of society
– Generate net income to the economy
 Real v/s Financial assets
• Financial Assets
– Claims on real assets or the income generated
by them
– Do not directly contribute to productive
capacity
– Means to hold claims to assets
– Define the allocation of income or wealth
– Allow us to make the most of the economy’s
real assets
 Financial Assets
• Three Broad types
• Debt
– Fixed-income or debt securities
– Fixed stream of income or
– Determined according to specified formula
– Vast variety of maturities and payment options
 Financial Assets
• Equity
– Common stock or equity
– Represents ownership share
– Prorated ownership in the real assets
– Holders receive returns via dividends
– Performance of equity investments tied to
success of firm and real assets
– Riskier than debt securities
 Financial Assets
• Derivatives
– E.g. Futures and Options contracts
– Payoffs determined by prices of other assets
– Primary use is hedging
– Also heavily used for speculation
– Important role in portfolio construction
 Financial Markets & The Economy
• Information and financial markets
• Consumption timing
• Allocation of Risk
• Ownership & Management
• Corporate Governance & Ethics
 Investment Process
• Portfolio – collection of investment assets
• Can be expanded, shrunk or rebalanced
• Made up of broad asset classes (asset allocation)
• Security selection populates asset classes
• Achieved through security analysis & valuation
• Top-down or Bottom-up approach
 Additional Concerns
• Risk-Return Trade-off
– Investment for anticipated future returns
– Actual performance can not be accurately predicted
– Higher risk assets offer higher expected returns

• Efficient Markets
– Prices usually reflect all information (assumption)
– Passive Management
– Active Management
 Market Participation
• Key participants
– Businesses
– Households
– Governments
• Financial Intermediaries
– Investment Companies; Banks; Insurers etc
• Investment Banks (I-Bank)
• Venture Capital (VC)
• Private Equity (PE)
 Asset Classes
• Broad market segments
• Financial assets main vehicles of investing
• Money Markets
• Capital Markets
– Longer term debt markets
– Equity markets
– Derivative markets
 Trading the Securities Market
• Stock Issuance
– Primary Markets (IPOs)
– Secondary Markets
• Privately Held Firms
• Publicly Traded Companies
Issuing Securities
 Trading the Securities Market
• Market Types
– Direct Search Markets
– Brokered Markets
– Dealer Markets
– Auction Markets
 Trading the Securities Market
• Types of Orders
– Market Orders
– Price-contingent orders
• Limit buy orders
• Limit sell orders
– Stop Orders
• Stop loss orders
• Stop buy orders
– Short Sales
 Trading the Securities Market
• Trading Mechanisms
– Dealer Markets
– ECNs
– Market Makers
– Algorithmic Trading
– High-frequency Trading
– Dark Pools
 Mutual Funds
• Trust that pools savings of investors sharing a
common investment goal
• Opportunity to invest in diversified,
professionally managed set of securities
• Defined investment objective and strategy
• Available across most asset classes
• Relatively low cost of management
• Operates through the mechanism of units
Overview
 MF Classification
• Functional Classification
– Open Ended Funds
– Close Ended Funds
• Portfolio Classification
– Equity Funds
– Debt Funds
– Special Funds
• Ownership Classification
– Public Sector Mutual Funds
– Private Sector Mutual Funds
– Foreign Mutual Funds
 MF Classification
• Equity Mutual Funds
– Growth Funds
– Aggressive Funds
– Income Funds
– Balanced Funds
• Debt Mutual Funds
– Bond Funds
– Gilt Funds
 MF Classification
• Special Mutual Funds
– Index Funds
– International Funds
– Offshore Funds
– Sector Funds
– Money Market Funds
– Fund of Funds
– Capital Protection Oriented Funds
– Gold Funds
 Types of Schemes
• Balanced Funds
• Equity Diversified Funds
– Flexicap / Multicap Fund
– Contra Fund
– Index Fund
– Dividend Yield Fund
• Equity Linked Savings Scheme (ELSS)
• Sector Fund
 Types of Schemes
• Thematic Fund
• Arbitrage Fund
• Hedge Fund
• Cash Fund
• Exchange Traded Fund
– Index
– Bond
– Commodity
– Currency
 MF Structure
• Sponsor
• Asset Management Company
• Trustee
• Unit Holder
• Mutual Fund
 Structure…
• Market Intermediaries
– Custodian
– Transfer Agent
– Depository
 MF - Advantages
• Professional Management
• Diversification
• Convenient Administration
• Higher Returns
• Low Cost of Management
 MF - Advantages
• Liquidity
• Transparency
• Highly Regulated
• Economies of Scale
• Flexibility
• Others
 MF - Disadvantages
• No Guarantee of Return
• Diversification
• Selection of Proper Fund
• Cost Factor
• Unethical Practices
• Taxes
• Transfer Difficulties
 Performance Evaluation
• MF investor is part owner of all assets and
liabilities of the fund
• Returns to investors are variable
• Determined by interplay of two factors
– Net Asset Value
– Costs of Management
• Past performance is no indicator of future
returns
 Net Asset Value
• Amount unit holder receives if fund winds up
• Basis for assessing the returns on investment
• Net value of all assets less liabilities
• Changes daily
• Computed as value per unit of holding
 Computing NAV

Net Assets of the scheme

NAV = -----------------------------------------
Number of Units Outstanding
 Valuation Rules
Nature of Asset Valuation Rule
Liquid Assets e.g. cash held As per books

All listed and traded Closing market price

securities (other than those
held as not for sale)
Debentures and Bonds Closing traded price or yield

Illiquid shares or Last available price or book value

debentures whichever is lower. Estimated Market
Price approach to be adopted if
suitable benchmark is available
Fixed income securities Current Yield
 Netting Asset Values
Additions Deduction for Liabilities
Dividends and Interest Expenses accrued
accrued
Other receivables Liabilities towards unpaid assets
considered good
Other assets (owned Other short term or long term
assets) liabilities
 Net Assets

Net Assets of the Scheme =

Market value of investments + Receivables +
Other accrued income + Other assets
– Accrued expenses – Other payables – Other
Liabilities
 Rs. Lacs
Listed shares at cost (ex-dividend) 20.00

Cash in hand 1.23

Bonds and debentures at cost 4.30

Bonds not listed and quoted 1.00

Other fixed interest securities at cost 4.50

Dividend accrued 0.80

Amount payable on shares 6.32

Expenditure accrued 0.75

Number of units (Rs. 10 FV each) 2,40,000

Current realizable value of fixed income securities of FV 100 106.50
 Costs of MF
• Initial Expenses
• Ongoing recurring expenses (Management
Expense Ratio)
– Cost of investment analysts
– Administrative costs
– Promotion and maintenance costs
• Expense Ratio = Expense / Average value of
portfolio
• Expense Ratio = Expense per unit / Average net
asset value
 Selection Factors
• Past performance
• Timing
• Size of fund
• Age of fund
• Largest holding
• Fund manager
• Expense ratio
• PE ratio
• Portfolio turnover
 Contrasting Funds
Parameter Open Ended Close Ended Exchange
Fund Fund Traded
Fund size Flexible Fixed Flexible
NAV Daily Daily Real Time
Liquidity provider Fund itself Stock market Stock market / Fund
itself
Sale price At NAV plus load if Significant premium Very close to actual
any /discount to NAV new scheme
Availability Fund itself Through exchange Through exchange /
where listed with fund itself
Portfolio disclosure Monthly Monthly Daily / Real-time
Uses Equitising cash Equitising cash,
hedge. Arbitrage
Intra-day trading Not possible Expensive Possible at low cost