2. Financial Instruments And Participants.ppt

FINANCIAL INSTRUMENTS AND PARTICIPANTS ©2017 BSE Institute Limited

Recap of Session 1 • • • • • •

Describe Financial System Of the economy. List Components of the Securities markets. Describe Stock Exchanges. List Various Stock Exchanges. List Classification of Securities Markets. Describe Equity, Debt and Money Markets.

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Session Objectives In this session, you will be able to: •Describe Mutual Funds •Describe Derivatives •Describe Commodity Markets •Describe Forex Markets

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Classroom activity/discussion • Take a financial newspaper like economic times and list 10 different mutual fund schemes listed there. • Find out their NAVs and tabulate the results. • List the derivatives traded on BSE from the paper. • From this find out how many derivatives are traded. • Classify them into index futures and index options and stock futures and stock options and find out how many such options and futures are traded.

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Mutual Funds •

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Investment vehicles which pool money of many investors who share a common financial goal and invest them in various asset classes including stocks, bonds, money market instruments and other securities, as per the goals. Mutual funds are an important financial intermediary contributing to the development of capital markets and bringing stability to the financial system

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Advantages of Mutual Funds • Professional management through dedicated fund mangers • Diversification • Cost efficiency • Transparency • Administrative convenience • Liquidity • Well regulated • Low cost of management IFM2/ Financial Instruments and Participants

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Who can Invest in MFs? • • • • • • • •

Individuals including residents, NRI, PIOs Legal Guardians Partnerships and HUFs Companies Banks FIs FIIs Other specified legal entities

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Introduction to Derivatives •

A derivative is a financial product whose value is dependant on the value of one or many underlying products / assets. It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.

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The product whose value determines the value of the derivative is known as the Underlying Asset, or just the Underlying.

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As per the Securities Contracts (Regulation) Act, 1956 (SCRA), a derivative is:  A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.  A contract which derives its value from the prices, or index of prices, of underlying securities.

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Economic Functions of Derivatives • Prices of the derivative products such as futures and forwards are good determinants of perceived future level of prices of the underlying assets. • Derivative products and their trade helps transfer risks, which may otherwise be assumed by an unwilling person. • Speculative trades shift to a more controlled environment of derivatives market. • The existence and functioning of the derivatives market acts as a catalyst for new entrepreneurial activity.

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History of Derivatives • First emerged as hedging devices against fluctuations in commodity prices. • The first derivatives were traded on the Chicago Board of Trade (CBOT) in 1875.

• Financial derivatives emerged after 1970s due to growing instability in the financial markets. • In India, the Securities Exchange Board of India (SEBI) introduced trading of equity-based derivative instruments on stock exchanges in June 2000.

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Derivatives and Risk • Major types of Risk include:  Market Risk  Credit Risk  Counterparty Risk

• Derivatives help in managing these risks in varying measures. • Market risk is the risk related to changes in the financial market or the instrument itself  This risk can be managed (reduced) by trading other financial derivatives hedging

• Credit risk and counterparty risk relate to credit worthiness of the counterparty to the transaction and the willingness of the counterparty to the transaction to honor the contract involved.  This can be managed by the trade of various credit derivative instruments to transfer the credit risk.

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Participants in Derivatives Market •

There are 3 broad categories of participants in the Derivatives Market:  Hedgers –  Hedging is the act of balancing one’s risk. A hedger may have a risk exposure to a particular asset, which can be balanced out by entering into an equal and opposite derivatives transaction related to the same asset.

 Speculators –  Speculators are entities who wish to bet on future movements in the price of an asset and hope to gain profits from favourable movement of the assets.  Use of derivatives instead of actually buying the asset may help reduce losses in case of adverse movements, in certain cases.

 Arbitrageurs –  Arbitrageurs take advantage of the difference between the prices of a particular asset in the spot market and the derivatives market respectively, in order to make a gain using this differential pricing.

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Types of Derivative Markets •

Derivatives are created and traded on the following 2 markets:

 Over-the-counter:  Terms of the derivatives contracts are customized and bilaterally confirmed between the parties to the transaction  Order-matching is either done by electronic means or on the telephone between the buyer and the seller of the derivatives contract  Management of counter-party risk is decentralized. Each party to the transaction assumes the counterparty risk associated with the contract.  OTC contracts are not regulated by a regulatory authority, but are affected by national legal systems, banking supervision etc.  There are no formal centralized limits on individual positions, leverage, or margining  There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants

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Types of Derivative Markets • Exchange – traded:  These are standardized derivatives contracts are traded on formal stock exchanges or dedicated futures exchanges across the globe.  All terms of the contract, such as price, settlement date, quantity of underlying etc are standardized. It can not be customized for an individual transaction.  Order-matching is done by electronic means  Counterparty risk is assumed by the exchange on which the contract is traded.  The exchange sets centralized limits on individual positions, leverage, and takes initial margins from each participant to ensure a more regulated environment for trading.

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Classification of Derivatives • There are two kinds of classifications of derivatives:  Nature of Underlying  Nature of the derivative product itself.

• On the basis of the Nature of Underlying asset:  Commodity Derivative – Underlying is a commodity such as gold, silver, wheat  Financial Derivative – Underlying is a stock, index, bond  Currency Derivative – Underlying is a currency such as INR, USD, GBP.  Interest Rate Derivative – Underlying is an interest rate which may be floating / fixed.

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Classification of Derivatives •

On the basis of the Nature of the derivative product:

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Classification of Derivatives • Forward commitment derivatives:  Forwards  An agreement between two parties to sell and buy an underlying asset respectively at a future date at a price fixed at the start

 Futures  A special form of forward contracts in which the contract terms are standardized in terms of the price of contract, size of transaction and the maturity date of the contract.  They are exchange-traded products which trade on major stock exchanges or dedicated derivative exchanges in the world

 Swaps  A private agreements between two parties to exchange cash flows in the future according to a prearranged formula.  They can be regarded as a portfolio of forward contracts IFM2/ Financial Instruments and Participants

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Classification of Derivatives • Contingent Claim:  Options  A contract that provides the buyer of the option a right to either sell or buy the underlying asset, depending on the type of option he has purchased, at a later date at a fixed price.

 Warrants

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There are similar to options, however, they are dated longer than options.

 Options on Futures  A contract that provides the buyer of the option is a right to either buy or sell a futures contract as the case may be.

 Exotic options  These are more complex options, designed to specifically meet certain requirements of the buyer or the seller.

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Classification of Derivatives  Asset-backed securities  A security whose value and income payments are derived from and backed by a specified pool of underlying assets.  This pool of assets would normally consist of assets that otherwise cannot be sold individually

 Swaptions:  An option to buy or sell a swap at the maturity date of the option.  In other words, a swaption is an option on a forward swap.

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Commodity Markets •

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Commodity markets, as the name suggests, are places for trading in raw materials or primary products. The market place could be physical or on the exchanges, which is virtual. The market comprises of both Hard and Soft Commodities –  

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Hard commodities are natural resources that must be mined or extracted like metals, coal, rubber, etc. Soft commodities are agricultural produces like wheat, rice, etc. or livestock products like meat, etc.

The most common form of trading in commodities takes the form of commodities futures. Investors can also invest in companies whose prime business is commodities, or invest in mutual funds that trade in commodities. Derivatives such as futures contracts, Swaps, Exchange-traded Commodities, forward contracts have become the primary trading instruments in commodity markets.

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Commodity Exchange •

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A commodities exchange is an exchange where various commodities and derivatives are traded. Futures are traded on regulated commodities exchanges Cash commodities or "actuals" refer to the physical goods—e.g., wheat, corn, soybeans, crude oil, gold, silver—that someone is buying/selling/trading as distinguished from derivatives Exchange-traded funds (ETFs) began to feature commodities in 2003. Gold ETFs are based on "electronic gold" that does not entail the ownership of physical bullion, with its added costs of insurance and storage in repositories.

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Currency Market • The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies • Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. • The foreign exchange market determines the relative values of different currencies and assists international trade and investment by enabling currency conversion. • It also supports speculation in the value of currencies, which is influenced by various macroeconomic factors. • Functions of the Currency Market  Facilitates the conversion of one country’s currency into another  Sets and quotes exchange rates  Offers contracts to manage foreign exchange exposure IFM2/ Financial Instruments and Participants

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Indian Foreign Exchange Market

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Recap • • • •

Describe Mutual Funds Describe Derivatives Describe Commodity Markets Describe Forex Markets

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Quiz • • • •

Question 1: Name any two derivatives. Question 2: Define Mutual funds Question 3: Which is the most commonly traded commodity instrument? Question 4: Name the two types of derivative markets.

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Daily Activity

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THANK YOU ©2017 BSE Institute Limited