Introduction To Capital Markets1

Capital Markets Training
Morgan Stanley
January, 2006
Copyright ©2005 Kanbay Incorporated. All rights reserved. COMPANY CONFIDENTIAL

Introduction
Lets introduce
Copyright ©2005 Kanbay Incorporated. All rights reserved. COMPANY CONFIDENTIAL PAGE 2
Agenda
Overview of Capital Markets

Financial Instruments
Participants
Life Cycle of a Trade
Trade process
Introduction to the capital markets
What is capital ?
To many people it is the value of their assets - property, bank deposits, cars,
jewelry etc - net of their liabilities
In the financial markets capital refers to financing instruments, in particular fixed
income securities and equity. That are traded for cash
Who supplies capital ?
(purchases financial products)
Firms
Individuals
Funds:
ÆInvestment/mutual
ÆInsurance
ÆPension
ÆHedge etc
Banks, governments and probably everyone else
Who demands capital?
(sells financial products)
Firms
Individuals
Funds:
ÆInvestment/mutual
ÆInsurance
ÆPension
ÆHedge etc
Banks, governments and probably everyone else
Exactly the same set of participants
So what are capital markets ?
Capital markets are markets in which financial securities like stocks

and bonds are bought and sold. Markets in which medium and long
term finance is raised, facilitating the flow of funds
Capital Markets
generated cash financial assets
Need financing Surplus funds

require cash to
Firms investment invest Investors
dividends/interest
Capital markets
Reinvestment
Importance of Capital Markets
Capital markets serve several important functions in the economy
Match capital providers with capital seekers
Match those willing to take risk with those seeking to mitigate risk
Help with allocation of resources across regions (globally) and industries
Help with integration of world economies and bypass local inefficiencies
Facilitate integration of different markets (e.g. farmers with food

products industry)
The characteristics of capital markets
– price discovery
Price discovery process - The interactions of buyers and sellers in the financial
market to determine the price of an asset/ required return on an asset.
The market price should:
Æreflect all available information
Æadjust quickly to new information
Characteristics – operational efficiency
In order for capital markets to be “informationally” efficient,

they must be “operationally” efficient as well
trading convenience
large number of participants
low cost of trading
rapid execution of trades
Characteristics - efficiency (cont.)
If capital markets are efficient:

The price of an asset is the same everywhere in the market
Most financial transactions are zero-sum; i.e. one party gains only at the expense of
another
The “law of one price” holds; i.e. equivalent securities must sell at the same price
Arbitrage opportunities can not exist - arbitrage allows you to earn risk-less profits
without any capital commitments
Characteristics - market types
Primary market ( Eg: Buying a new house from the dealer)

Æwhere new securities are created by surplus units lending to deficit units
Æoriginal issue of stocks, bonds and other financial assets
Secondary market (Eg: Buying a second hand house from user)
Æwhere existing securities are traded
Æprovide liquidity
Æofficial exchanges: stock exchanges, derivatives exchanges
ÆOTC market
Characteristics – types- market mechanisms
Order driven market

Æbuy and sell instructions are fed into a central computer system
Æautomatic matching
Quote driven market
Æprices are determined principally by professional dealers bid/offer quotations
Æorder management
OTC markets
Æno standards, all negotiable
Æ24 hours trading activity
Financial Instruments
Covers Instruments in brief
Does not cover Credit Derivatives and exotic derivatives
Equity
What is equity ?
Equity i.e. stocks & shares, are financial instruments representing ownership
interest in a corporation or similar entity
The characteristics of equities
You share in the profit the company makes

ÆDividends - payments declared quarterly, six months, yearly
Voting rights at AGM’s
ÆPro-rata on your share holding
Types of shares
Ordinary
Preferential
Rights
Depository receipts
Ordinary Shares or Common Stock
Purpose:
Æ To raise long term financing by selling ownership stake in the corporation.
• Shareholders have certain rights

Æ To Elect/remove Company Board of Directors
Æ Voting on resolutions at company meeting (AGM, Special Meetings)
• Key Characteristics:
• Right to elect directors to the board and vote on corporate resolutions
• Right to residual claim in liquidation (after all other claims have been paid)
• Entitled to pro-rata share in profits of the company
Preferred Shares
• Purpose:
• Ownership at reduced risk, in exchange for reduced upside
• Lifecycle:
• Like common stock but normally no voting rights
• Can be perpetual, redeemable by holder, callable by issuer or converted into

common stock
Characteristics
Æ Right to fixed dividends
Æ Priority over Common Stockholders
Æ Voting rights in exceptional situations, e.g. dividend skipped for 3 years in a row
Characteristics of preferred dividends
Æ Can be cumulative, i.e., skipped dividends are not forgotten
Æ Can be participating, i.e., in good times, can receive additional dividends
Rights
Purpose
Æ To raise additional equity capital without diluting ownership of existing stockholders
Lifecycle
Æ Offered by corporation to existing stockholders in proportion to their existing holdings
Æ Usually trades as intrinsic part of the common stock from announcement of Corporate
Action and until completion of distribution. Stock price reflects the value of right.
(concepts: announcement, record and pay dates, ex-date, cum-rights)
Æ Set to expires after a date in near future
Æ Often followed by secondary public offering to make up for quantity yet unsubscribed
Characteristics
Æ Represents a right to buy shares of common stock at set price within set expiry date
Æ Short life (months or weeks)
Æ May be listed on exchanges for secondary market trading
The rights holder can
Æ Sell the right if traded separately, renounce the right in favor of someone else, or sell
the stock cum-rights
Æ Exercise the rights and purchase additional shares at the set price
Æ Let it lapse
ADR
AMERICAN DEPOSITORY RECEIPTS (ADR)

• Purpose
• To facilitate investing in foreign corporations by eliminating burdens of
currency conversions, time zones and foreign market regulations
• Lifecycle
• A custodian creates a pool of shares of original stock from the home market
• The custodian issues receipts representing proportional shares of this pool.
These receipts represent indirect ownership.
• The receipts are listed on US exchanges for secondary market trading
• Custodian manages currency issues, home market regulations, dividends and
other corporate actions
Value of stocks
Company profile
Sector profile
Tax regime
Political climate
Social climate
Cyclical climate
Energy prices
Commodity prices
Interest rates
Basically ANYTHING
Valuing equities - information
Annual reports and balance sheets

Research publishers such as S & P, D & B
Registrar of Companies
Stock Exchanges / Market information / SEBI
Stockbrokers’ circulars
THE PRESS
Popular Stock Exchanges / Indices
NYSE (New York Stock Exchange)

Æ Dow Jones Industrials (since 1894)
Æ Standard and Poors 500
Æ NASDAQ Composite - Technology stocks
Tokyo Stock Exchange: Nikkei 225
Hong Kong Stock Exchange: Hang Seng
Frankfurt Stock Exchange: DAX
London Stock Exchange: FTSE100
Paris Stock Exchange: CAC40
National Stock Exchange / BSE: Nifty / Sensex
Fixed Income
What is a bond ?
A bond is a loan made by investors to companies, banks,

corporations and governments. They are debt obligations
with long-term maturities
Bonds
What is a Debt Instrument ?

It’s essentially an I Owe You (IOU).
Lender lends the money to the Borrower in exchange for
Æ Interest payments during the term of IOU
Æ Principal repayment at maturity of the IOU
Lender may impose certain terms and conditions on the Borrower.
Why borrow ?
Need funds for limited period
Earnings expectations > interest costs
Tax advantage – typically interest expenses can be expensed
Financial covenants may require company to maintain certain financial ratios
Bond - forms
Bearer bonds
ÆNo registered owner on the certificate hence holder is the owner
Registered bonds
ÆOwnership is recorded in either physical form on the certificate or on a book
entry account
Bond - coupon payments
Bearer bonds
ÆOn each coupon date the bondholder (or their custodian bank) clips the relevant
coupon from the bond certificate and claims the interest due from the issuer’s
paying agent
Registered bonds
ÆPaying agent will automatically pay the registered holder
Characteristics
ÆStraights - the amount of each coupon is the same and is fixed at issue
ÆZero-coupon bonds - issued at a discount with a fixed final maturity value.
Hence coupon received at maturity
ÆFloating rate bond - coupon adjusted at predetermined periods, linked to a
benchmark rate
Examples
• Corporate Bonds
• US Treasury Bills, Notes and Bonds
• Municipal Bonds
• Collateralized Mortgage Obligations (CMO)
• Asset Backed Securities (ABS)
• Commercial Paper
Corporate Bonds
• Purpose
• To raise capital for limited duration
• Lifecycle
• Issued through public offer or private placement
• Secondary market trading facilitated by brokers. A small fraction is also listed
on exchanges for secondary market trading.
• Periodic interest payment by issuer. Some bonds are sold at a discount (zero-
coupon bonds)
• Call & Put Option - May permit early redemption by holder, early call by issuer
• At maturity, issuer repays holder as per issuance terms
Corporate Bonds
Characteristics
Æ Face value, typically $1000. Issuance price may be different from face value
Æ Long term instruments in excess of 1 year to maturity usually nearer 10 year
life span
Æ Maturity date and value. The maturity value may be different from face or
issuance price. May be bullet or staggered repayment.
Æ Provisions to pre- or post-pone maturity
Æ Interest payment terms. Rate can be fixed or floating rate tied to a
benchmark, e.g. LIBOR, or Zero coupon
Æ Seniority
Æ Most bonds are rated by a rating agencies such as S&P, Moody’s, etc.
Æ Some bonds allow coupons to be stripped and traded separately
An example - GM JJ15 7.5% of 2022
Æ Face value is $1000 (this can be assumed)
Æ Coupon is 7.5%, paid twice a year on 15th of Jan/June. Twice a year is typical.
Æ It matures in 2022
The ratings
Long term debt S&P Moody’s

Best quality grade AAA Aaa
AA+ Aa1
High quality grade AA Aa2
AA- Aa3
A+ A1
Upper medium grade A A2
A- A3
BBB+ Baa1
Medium grade
BBB Baa2
BBB- Baa3
Short term debt S&P Moody’s

A1+ P1
A1
A2 P2
A3 P3
What are the money markets ?
Markets for short term debt instruments with original maturity of

one year or less
Technically speaking, “capital markets” are for longer dated

securities
Money markets
Interest (or benefits) paid at maturity (date when the security is returned to the
issuer and the debt is repaid)
High grade securities with little or no risk of default (sovereign states, banks and
major corporations)
Money market instruments can be sold on either a:
ÆDiscount basis - the money market instrument is sold at a discounted price and
bought back at its real face value by the issuer
ÆCoupon basis - the instrument is sold at its face value and bought back at its
face value plus a coupon element
Money markets instruments -
discount basis
Treasury Bills (T-Bills)

Æ issued and guaranteed by the Government
Æ Sold on a discount basis: difference between the face
value and the purchase price represents interest earned
by the investors
Commercial paper
Æ a promissory note sold by very large, creditworthy corporations
Æ issued for a specific amount and maturing on specific date
Æ backed by a “standby letter of credit” from a bank
Banker’s acceptances
Æ Bank promises to pay the face amount when the acceptance is presented to it - made
to importers and exporters
Money markets instruments - coupon
basis
Fixed deposits/loans
Certificates of deposits (CD’s)
Repurchase agreements (Repos)
Bond - pricing
Issuer rating
Coupon rate (compared to MM rate)
Time to maturity
Yield to maturity
Bond - prices
Interest Rates and Time Value of Money
Time-value of money – key concepts
Æ FV (future value) and PV (present value)
Æ NPV (net present value)
Æ IRR (internal rate of return)
Most financial calculators (and MS-Excel) have built-in functions for FV/PV
FV & PV
FV = PV * (1+r/100)^t
PV = FV/(1+r/100)^t
FV = Future Value
PV = Present Value
r = Interest rate
t = Time to Maturity
Case Study – Bond Pricing
Bond A, FV=$1000, Bond B, FV=$1000,

redemption at par redemption at par
Nominal annual coupon 10% 10%
Yield-to-maturity 8% 9%
Time-to-maturity 5 years 5 years
Market price ? ?
Case Study…
Bond A, FV=$1000, Bond B, FV=$1000, DISCOUNTING FACTOR (IN %)

redemption at par redemption at par
Nominal annual 10% 10%
coupon YEARS 7% 8% 9% 10%
Yield-to-maturity 8% 9% 1 0.935 0.926 0.917 0.909
(YTM)
2 0.873 0.857 0.842 0.826
Time-to-maturity 5 years 5 years
3 0.816 0.794 0.772 0.751
Market price = 100*0.926 = 100*0.917

4 0.763 0.735 0.708 0.683
+ 100*0.857 + 100*0.842
5 0.713 0.681 0.650 0.621
+ 100*0.794 + 100*0.772
+ 100*0.735 + 100*0.708 6 0.666 0.630 0.596 0.564
+ 1100*0.681 + 1100*0.650 7 0.623 0.583 0.547 0.513
= $1079.85 = $1038.90 8 0.582 0.540 0.502 0.467
NB: price and YTM 9 0.544 0.500 0.460 0.424
move in opposite
10 0.508 0.463 0.422 0.386
directions
Mutual Funds
Mutual Funds
Purpose
• To create a vehicle for small investors to diversify their portfolio by pooling their
investments
Advantages
Diversified portfolio used to reduce risk
Greater financial leverage not available to individual small investor
Lower transaction costs resulting from size
Only investment option in certain markets (e.g., certain retirement plans)
Regulated by SEC
Some key facts:
• Funds are a big business. Over 50% of US stocks are owned by mutual funds
• a/k/a the “buy side”. Morgan Stanley for example is a “sell side” firm.
Trading in Funds Is Limited
Most funds restrict trading to once a day (at market close)
Most funds impose restrictions on frequent turnover
Funds may also impose penalties for frequent trading – load increases
Mutual Funds - characteristics
Investment objective (e.g., growth, tax planning, income, balanced)
Benchmark for performance comparison (e.g., SP500, Russel 2000)
Investment universe (e.g., stocks/bonds; large/medium/small caps; sectoral)
Investment policy (asset allocation strategy) : passive, active, immunization
Investment restrictions (e.g., socially responsible, sin fund, restricted list)
Open or Close ended funds
Sales charge (front-end/back-end load, no-load)
Daily NAV computation
Æ Varies by country
Æ Most funds price shares after market close.
Æ Sometimes funds price shares several times during the trading day
Examples of Investment Methods available to investors

Direct investments
Sponsored plans, e.g. 401-k
Periodic investments
Mutual Fund – entities
Fund Analysts &

Sponsor Rating Agencies
Asset Management
Trustee company Company
Auditors
Fund Manager Fund Administrator Marketing and Distribution
Fund Accountant RTA and

Custodian Consulting and Legal Firms
Client Servicing
Mutual Fund – Life Cycle
Fund
Creation
Subscriptions Mktg. /
Redemptions Distribution
Investment
Investor
corpus
Service
Income Fund
Distrib.. Mgmt.
Hedge Funds - Introduction
Entities that collect monies from wealthy and financially knowledgeable

investors and invest in securities including derivatives
May borrow monies and invest in securities (leveraging)
May borrow securities and sell them (shorting or short sales)
High minimum investment by investors
Offering documents are privately circulated
Restrictions on redemptions
Focus on high returns
Being unregulated, considerable operating freedom
Try and provide absolute return rather than relative return
Risk Management
What is risk ?
Risk is the uncertainty associated with an expected outcome or event
Risks
controllable (diversifiable, unsystematic)
uncontrollable (non-diversifiable, systematic)
Classification of Risks
Broad classification of financial risk
Credit Risk
Market Risk
Operational Risk
Credit Risk
Basically risk due to exposure to third parties
Counter-party risk / Issuer Risk
Default risk
Exposure risk
Market Risks
Emanates from movement in market forces
Price Risk
Interest Rate Risk
Currency Risk
Liquidity Risk
Operational Risks
Emanating from inadequacy or failure of internal processes
Components of IR risk
Basis Risk
Yield Curve Risk
Embedded Option Risk
Reinvestment Risk
Price Risk
Risk Mitigants
Credit Risk Mitigants
Credit Enhancements
Guarantees
Loan covenants
Credit Derivatives
Market Risks
Interest Rate Derivatives
Currency Derivatives
Life Cycle of a Trade
The life of a trade - a health warning
Generic example
Not representative of any specific market
In practice some steps may not figure in every trading scenario
Takes a functional view of the process
It shows a high level overview of all participants
The life of a trade
foreign buying foreign selling
fund manager fund manager
1 7 7 1
2 OTC 2
int’l buying local broker/ local broker/ int’l selling
participants 3&4 participants
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
custodian 14 14 custodian
clearing &
9 15 11 settlement 11 15 9
10 13 10
local 13 registry/ local

12
custodian depository custodian
12
Central Bank
payment system
The national securities governing body

The life of a trade
Morgan Stanley Deutsche Bank

Asset manager Asset Manager
1 7 7 1
2 OTC 2
HSBC CSFB CL Ask Raymond
Securities 3&4 Securities
8 16 Brokerage 6
James
6 16 8
3 4 3
14 London Stock 14
Exchange
10 10 Deutsche Bank
Citibank Custody 5 5 5
14 14 Custody
LCH
9 15 11 11 15 9
10 13 10
Citibank (UK) 13 HSBC (UK)

CREST 12
Custody Custody
12
Bank of England

Trade date
Step 1
Investor/fund manager (the client) places an order to buy or sell securities in a particular
market with a broker/ dealer
NB. The instruction sent by the client will be in a mutually agreed upon format, most likely by
client workstation or by fax
Step 2
Where necessary the broker/ dealer will often utilize the services of a local broker
present in the market where the security is to be traded
NB. Local regulations, convenience
Trade date (cont.)
Step 3
Stock exchange trades - brokers enter their orders into the trading system of the stock exchange
where they are matched.
OTC trade - communication would occur between brokers through an organized system, direct via
phone, e-mail or some other form of communication where they can find a match
Step 4
Following matching, a trade confirmation is sent to the appropriate brokers
Step 5
Stock exchange trades - End of each stock exchange trading session, the stock exchange sends a
summary list of all trades to the CSD which will enable the CSD to begin lining up trades for
settlement
OTC trade - both buying and selling local brokers send through their trade details to the clearing
house for settlement
Trade date (cont.)
Step 6
Confirmations are the passed on to International Brokers where necessary
Step 7
Brokers inform their clients (fund managers etc) of their obligations; i.e. funding, shares
required and relevant accounts
Step 8 & 9
End of trading cycle - Client sends a settlement instruction to their global custodian
authorizing the transaction (forwarded to local custodian where necessary). Sent by
agreed communication method; i.e. workstation, SWIFT, fax, etc. and containing all
information about the pending trade:
name of the security, ISIN code, net settlement amount, counterpart, trade date,
settlement date, etc.
Physical intervention is dependent on STP capabilities
Trade date + 1 to settlement day – 1
(may cover a period of two days in a
T+3 environment)
Step 10
On the morning of T+1, the clearing house will send out a pending settlement list to all
participants (including custodians) detailing all trades. Report sent each day
Step 11
On receipt of the list, the local custodian will match the trade instructions and assuming they
match, will send through an affirming order to the CSD assuring them that they will do their part
to settle the trade either on the cash or securities side
Step 12 - if sale (buy involves FX and cash unblocking)
The local custodian must release the securities (may involve an ICSD like Euroclear or Cedel)
which have been sold by contacting the registry and unblocking the shares. In a physical market,
the local custodian would arrange for the securities to be transferred to a holding account at the
central depository for the benefit of the buyer
Settlement day
Step 13
The CSD is responsible for arranging all trades entered into its system for settlement. Check necessary
shares are in registry/ depository, cash in the a/c and block them. Then arrange their transfer. Safe
settlement will see a simultaneous exchange
Step 14
Upon settlement in the CSD system, notifications confirming settlement are sent to all local market
participants including local custodians
Step 15
Upon receipt of the settlement confirmation, the local custodian immediately forwards the confirmation
on to the global custodian
Step 16
The global custodian in turn forwards the settlement confirmation on to the fund manager
Participants
Market participants - intermediaries
Financial institutions/ intermediaries help the flow of money from the users to the
suppliers of capital
They are the banks, exchanges, brokers etc who:
ÆBring buyers and sellers together
ÆFacilitate the trading and settlement process
ÆParticipate in the issuance process
ÆAct as market makers in secondary markets
Technically all financial institutions are intermediaries
Funds/Investors
The life of a trade
1 7 7 1
2 OTC 2
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
clearing &
9 15 11 settlement 11 15 9
10 13 10

12
12
Central Bank
payment system

Investment funds - description
Investment funds are pools of assets made up from numerous individual investors
where the assets are collectively invested in a variety of instruments around the
globe
They interact with broker/dealers to initiate trades, and with custodians to manage
the settlement of the executed trades
Types of investments include equities, government bonds, corporate bonds and
money market instruments. Mainly quoted on recognized securities markets
Types of investment funds
Pension funds
Insurance funds
Hedge funds
Unit trusts
Collections of high net worth individuals (investors) / private trusts
Investment funds - Examples
UBS
Fidelity Investments
Deutsche Bank
Credit Suisse Group
AXA Group
Barclays Global Investors
Merrill Lynch
Fund managers interaction in the life
of a trade
broker
de
r a
T
fund
manager
Se
ttle
m en
t
global
custodian
Fund managers - Operational
responsibility
An investment manager decides to make a purchase and informs a broker (diagram

lines 1&2)
The broker will act on this instruction.
The trade will be executed when possible
The investment manager will receive a trade confirmation back from the broker
stating all the trade details for settlement (diagram line 7)
The fund manager will arrange to send settlement instructions to the global
custodian (diagram line 8)
These instructions contain all the necessary information to settle the securities and
cash side of the transactions
Fund manager - Operational
responsibility (cont.)
The fund managers responsibilities are basically finished, barring failed trades, and
waits now to receive confirmation from the global custodian
Upon settlement, the global custodian sends through a settlement confirmation
stating the number of shares/amount of cash transferred and the date effected.
Ideally this is sent at the end on the day which the trade actually settled (diagram
line 16)
The fund manager may have additional settlement confirmations/reporting duties
to underlying owners
Fund manager - Operational
Ultimately responsible to all holders of shares/units of the fund - Account

maintenance
The quality of custodians and brokers chosen
The ability to liquidate a client’s holding on request
Constant ability to give up to date, marked to market pricing; i.e. valid fund
valuation
Why do fund managers use a
custodian?
Market information from around the globe on market settlement practices

Facilitate cross border settlements
Assist in monitoring/tracking of assets held as well as entitlements to those assets
A local presence acting on behalf of the investors in all markets
Maximize asset safety and minimize risk
Access to additional banking services
Fund manager - Custodian criteria
High credit rating

Segregation of client assets from bank’s own assets
High SWIFT usage/automation - STP capabilities
Customized reporting capabilities
No lien taken on customer assets
Secure, efficient IT systems
Value for money
No lien
A fund manager requires that custodians do not use assets within their custody to
secure loans or allow any third party legal claim to the assets
lien is the right to take and hold or sell the property of a debtor as security or
payment for a debt or duty
Broker - Dealer
The life of a trade
1 7 7 1
2 OTC 2
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
clearing &
9 15 11 settlement 11 15 9
10 13 10

12
12
Central Bank
payment system

What does a broker/dealer do?
Broker/dealers - Description
Broker/dealers ‘arrange’ (broke) deals by either:

Æmatching buy and sell orders placed by clients (acting as an agent)
Æor by satisfying a client order, if there are no equal and opposite orders from
another client, by taking a position onto its own trading book (establishing a
proprietary position). The broker/dealer will usually endeavor to offset any such
proprietary position against other client orders at the earliest opportunity
Broker/dealer - Examples
Merrill Lynch & Co

Morgan Stanley Dean Witter
Lehman Brothers
Credit Suisse First Boston
Goldman Sachs
Salomon Smith Barney
Donaldson, Lufkin & Jenrette Inc
Deutsche Bank
Broker’s interaction in the life of a trade
Fund
manager/ Broker Counterpart
investor broker
Exchange
Broker/dealer - Operational
responsibility
Trade capture - the capturing of all information sent to the broker by clients,
exchanges, or any party in communication with the broker
Information is authenticated and validated for accuracy and completeness
The broker’s system forwards all captured information to the order room to
determine where the instruction should be sent
Order management - Orders enter the broker’s processing system via previously
agreed methods of communication
Types include:
Æat market orders or ‘best’
Ælimit orders
Ætime orders
Brokers must give priority to client transactions over proprietary ones
Matching - Through trading operations of either an exchange or an OTC

environment, two orders, one buy and one sell, will be matched
ÆThese matched trades are confirmed to the appropriate brokers
Brokers are responsible for distributing trade confirmations to their customers by
the end of the business day in most markets
Settlement - Ensure securities are either on their client’s account for a sale
transaction or cash is on account to fund a purchase
ÆIf a custodian is used, the broker must communicate with the local custodian
For a proprietary trade, the broker will arrange for the transfer of either cash or
securities into the central clearing system
Post-settlement - Confirmation of the securities and/or cash transfers are sent to

all participants daily, reflecting the new positions
Æinternal reconciliation
Æexternal reconciliation
Account maintenance - For clients who hold their shares in a segregated account
with the broker, the broker has certain responsibilities in administering the
accounts with services such as:
Ædividend collection
Æcorporate action notifications
Æproxy voting services
Æaccount statements
What is a Prime Broker
A prime broker is a broker offering professional services specifically aimed at hedge

funds and other large institutional customers.
Services Offered
Prime Broker
Custody Swaps
Clearing NAV fund services
Reporting Research
Securities Lending IPOs
Money Lending Seed Capital
Execution Consulting services
Leverage/pricing FX services (hedging)
Capital Introduction Yield enhancement
Start-up services Fund administration
Relationship/co-ordination Structuring: wrap products
Credit intermediation Hedge Fund swaps
Risk Management Partial principal guarantees
Contracts for differences Trade structuring/finance coverage
Straight through processing Global access
Futures/options clearing
Exchanges
The life of a trade
1 7 7 1
2 OTC 2
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
clearing &
9 15 11 settlement 11 15 9
10 13 10

12
12
Central Bank
payment system

Exchanges - Description
The primary role of an exchange is to provide a centralized market place where

buyers and sellers can meet to negotiate asset prices and to execute trades.
Exchanges aim to maximize price transparency and liquidity at the lowest cost by
providing a centralized trading platform into which all buy and sell orders are
submitted
Exchanges - Characteristics
There are two main types of central markets:

Ætraditional “open outcry” (floor-based) markets, which operate in a specific building with a
physical trading floor e.g. NYSE, LIFFE, AMEX,
Æelectronic screen-based stock exchanges e.g. Nasdaq, Eurex.
Markets may be price/quote-driven or order-driven
Æin a price-driven market, market makers will quote both bid and offer prices, but the
transaction remains an individually negotiated contract
Æin an order-driven market, trading revolves around an order book where market participants
post buy and sell orders (quantities and prices) at which they are prepared to trade
Exchanges - Examples
NASDAQ
American Stock Exchange (AMEX)
Tradepoint
London Stock Exchange
Clearing and Settlement Agents
The life of a trade
1 7 7 1
2 OTC 2
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
clearing &
9 15 11 settlement 11 15 9
10 13 10

12
12
Central Bank
payment system

Clearing & settlement in the bigger
picture
Custodians External payment

system
Stock Clearance &

exchange
settlement
entity
Depository/
Brokers/
Registry
Participants
What do we mean by settlement ?
Settlement is the final, irrevocable transfer of cash from

the purchaser to the seller in exchange for the delivery
of securities to the purchaser
Delivery versus payment
Delivery versus payment (DVP) is the simultaneous and irrevocable transfer of

ownership of an asset in exchange for the equivalent assured countervalue in same
day funds
Settlement conventions - Physical vs book entry
Physical delivery
ÆShare certificates and duly signed transfer documents lodged with clearing
house
Book entry
ÆDematerialized
computerized record only no physical certificate
transfer is by Dr sellers account and Cr. buyers
ÆImmobilized
as above but physical certificates exist in centralized location
Settlement conventions - Rolling vs
fixed
Rolling settlement
ÆT+ defined market standard - each day the date rolls on
ÆMajority of markets
Fixed settlement
ÆFixed day each week
ÆTrading for week settles on one day
ÆHigh fail cost
ÆSouth Africa
Clearing & settlement - Operational responsibility
The C&S entity receives initial instructions from a stock exchange or directly from
participants immediately after a trade has been matched on the trading
system/agreed ‘over the counter’ between participants (diagram line 5)
Internally, the C&S entity begins positioning of the pending transactions by
matching all buyers and sellers
Depending on market system, trades will either be netted or settled trade by trade
Between trade day and settlement day, there is the opportunity for amendments to
be made and for custodians to affirm trades
On settlement day, all pending trades have been matched and the settlement
activity begins, i.e. shares are transferred between buyers and sellers at the same
time as cash (or should be!) based on C&S interaction with the payment system and
the depository (diagram lines 13)
Upon the settlement, confirmations are sent to all participants detailing the new
positions
If there were unsettled transactions, a list of failed trades is also sent giving
participants a reason for the fail
Failed trades
Trades may fail for a variety of reasons increasing the importance of DVP
Ælate or incorrect settlement instructions from a counterpart to the custodian or
clearing agent
Æseller has insufficient quantity of securities to deliver
Æpurchaser has insufficient funds to pay
Æcertificated securities are not yet available from the registrar from a recent
purchase to cover a sale
Buy-in
Custodian
The life of a trade
1 7 7 1
2 OTC 2
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
clearing &
9 15 11 settlement 11 15 9
10 13 10

12
12
Central Bank
payment system

What does a custodian do?
Custodian - Description
Custodians manage the safekeeping of assets on behalf of their clients

Custodians handle all administrative issues that arise with regard to assets in their
safekeeping
Æcorporate actions announcements
Ædividend payments
Æsecurities lending etc.
A global custodian offers both core custody services and value added services; the
latter enables the custodian to differentiate itself from other players in the market
Local custodian
The vast majority of global custodians select local agents in foreign countries, the
local supplier will in turn handle direct interfaces with the domestic clearing
settlements and depository systems
Local suppliers are able to handle business more effectively as they have
connections within the market place, no language barriers, and are knowledgeable
of local market regulations
Custodian - Examples
Citibank
State Street Bank & Trust Co.
Paribas
Brown Brothers Harriman & Co
HSBC Group (formerly Midland Bank)
Chase Manhattan
Bank of New York
Custody within the life of a trade
clearing & settlement

entity
global local central depository/

investor
custodian custodian registry
payment system
Custodian - Operational
responsibility
The custodian is ultimately responsible for the safety and securities administration
of all client assets placed in their care
While both custodians and depositories are responsible for safekeeping, a bank,
acting as a custodian, has the obligation to protect clients which differs slightly
from a CSD whose responsibility is to the market and its’ participants
Custody service provisions
Core services
Æsettlement of trades & registration (securities & cash)
Æsafekeeping
Æcash management & foreign exchange
Æcorporate actions notification & processing
Æproxy voting
Æincome collections
Ætax reclaims
Æreporting
Custody service provisions (cont.)
Value added services

Æinvestment accounting (multi-currency, full accrual reporting)
Æpricing/valuation (calculation of net asset values)
Æperformance measurement (calc. rates of return)
Æsecurities lending (collateralized loan of securities)
Æcollateral management (managing client’s open positions)
Æfutures clearing (exchange traded futures & options)
Æmarket intelligence (timely news affecting investments)
responsibility
Initial receipt of settlement instructions from a client (diagram line 8) via SWIFT,
Telex, fax, or workstation
Æthe method of communication will be set in a ‘Service Level Agreement’ at the
beginning of a relationship between a client and the custodian
The settlement instructions will include all the relevant information
Once received, the global custodian processes the trade instructions in-house
The instruction includes all information mentioned (previous slide) which provides
the authorization to release/deliver shares on a sale transaction or authorizes a
foreign exchange transaction and payment to be made in the market for the
purchase of securities
The local custodian receives the information from the clearing and settlement
entity (who received it from the stock exchange) informing of all pending trades for
which settlement needs to be affirmed (diagram line 10)
The local custodian matches the information from the clearing house with the
authorization for settlement from the global custodian. If the information matches,
the local custodian ‘affirms’ the trade with the clearing house
If the information does not match, the local custodian identifies which part of the
information is outstanding and will contact the appropriate party to resolve the
dispute
Depending on whether the trade to be settled is a purchase or sale (diagram line(s)

12):
Æfor purchases - the local custodian will, based on instructions, have booked a
foreign exchange and will transfer the local currency from the global
custodian’s cash account with the correspondent bank (likely to be the local
custodian itself) to the central payment system used by the clearing house
Æfor sales - the local custodian will need to ensure the securities which are to be
transferred to a new owner are delivered to the clearing house if not held
centrally (physical markets) / OR are authorized to be released from the
register (dematerialized markets with a centralized registry)
Once the settlements are complete within the central clearing house, a settlement
confirmation will be sent to all participants including the local custodian as will any
failed transactions for the day (diagram line 14)
The local custodian will send settlement confirmation immediately to the global
custodian. This may be manually entered into SWIFT, Telex, etc. or the confirms
may be generated automatically if the local custodian has ‘straight through’
processing capability (diagram line 15)
The global custodian will forward the settlement confirmation immediately to the
fund manager/client (diagram line 16)
‘Straight Through Processing’ may be possible where appropriate
system/communication links have been put in place. For the initial settlement
instructions, steps 8,9 &11 could go from the system of the client/fund manager
straight through to the clearing & settlement house. Additionally, the confirmation
steps 14-16 can also flow automatically from the settlement system back to client
What is the custodian NOT
responsible for?
Investment decisions in terms of investment type or country

Communication with beneficial owners below direct customer level i.e. beneficial
owners of funds
Achieving best prices on securities traded
Compliance of fund mangers with local regulations
Market inherent settlement risks
Central securities depositories & registries
The life of a trade
1 7 7 1
2 OTC 2
8 16 broker 6
broker
6 16 8
3 4 3
14 stock 14
exchange
global 10 10 global
5 5 5
clearing &
9 15 11 settlement 11 15 9
10 13 10

12
12
Central Bank
payment system

Central Securities Depository -
Description
Central Securities Depositories (CSDs) are established in domestic markets by

governments or privately owned consortium(s) to hold securities in a central
depository
They provide a mechanism for the transfer and delivery of securities
CSDs usually hold and process securities in book entry (or electronic) form. Varies
The CSD will inform the registrar if there is a change in legal. In recent years,
securities firms have been trying to reduce the flows of physical securities, the
depository has been central to this advancement
Registrar - Description
A professional securities market participant performing maintenance of the Registry

of registered securities holders
The registrar will have authorization by way of a contract with the issuer to
maintain the register on the issuers behalf
The register may be an aggregation of data, in paper form and/or on electronic
media, identifying registered persons and confirming their rights to securities
registered in their name and recorded in the personal accounts of registered
persons, which makes it possible to obtain and forward information to the
registered persons
CSDs - Examples
France : Sicovam
Germany : Clear stream
(previously Deutsche Börse Clearing)
Hong Kong : Hong Kong Clearing
Japan : Japan Securities Depository Centre (JASDEC)
Switzerland : SEGA/INTERSETTLE
United Kingdom CREST
& Ireland :
USA : The Depository Trust Company (DTC)
ICSDs - Examples
Clearstream
Euroclear
Central depository / registry interactions with market participants
brokers custodians
clearing & settlement central

entity depository
national securities
commission
CSDs - Operational responsibility
Interaction with custodians and brokers who may need to deliver shares or
authorize shares for release on settlement day
Custodians/brokers send instructions directly to a depository with instructions prior
to actual settlement
The depository receives instructions from the clearing and settlement entity
checking for available shares and orders the blocking of shares for pending
settlement
CSDs - Operational responsibility
The depository confirms securities present for settlement and blocks them awaiting
final instructions
The clearing and settlement entity then orders the final movement of securities
from sellers to buyers accounts (having checked for available cash)
Final settlement/movement statements sent to the clearing house or perhaps to the
participants depending on the market practice
Activities of the CSD/ registry
Provides central clearing and settlement (CCS) body

with status of accounts/available securities
Transfers ownership based on instructions from CCS
Provides issuers with updated list of shareholders upon their request
Performs daily reconciliation of shareholders & issuers
Reporting responsibility to securities commission regarding ownership limits/
restrictions
When participation is mandatory and legislation supports the activity, it is the one
place where ownership is determined
Trade Process
Trading Process
Institutional Investor
Sales &
Retail Investor Service
Delivery
Private Client
Risk management - Market, Credit & Operational Risks
Front Office Middle Office Back Office

¡ Trade Execution ¡ Trade Support ¡ Settlement
¡ Trade Delivery ¡ Risk Management ¡ Clearing

Custodian
¡ Pre Trade Decision ¡ Reconciliation ¡ Accounting
¡ Reference Data ¡ Portfolio Management
Market Other Market

Exchange
Data Institution Clearing
Roles in Trading Process
Sales
Focuses on sales of financial products, fee based buy / sell orders for execution and
client relationship
Front Office
Focuses on research, trade execution at the best possible price, identifying potential
profitable trades
Middle Office
Facilitate, Control and monitor trade execution and settlement

Back Office
Payment / Receipt, Settlement and Accounting

Custodian
Completion of deliveries of securities and safe keeping of securities
Straight Through processing
Automating the information flow from one stage to another stage without manual intervention
Includes the information flow within internal system / systems
Involves interfacing with external systems
Stock exchanges
Custodian
Counter-party
Payment Systems
Results in ability to handle volumes of transactions without increasing the processing cost
Reduces possible human errors in data processing
Trading system
Products Equities
Equities Money
Money Market
Market Credit
Credit Derivatives.
Derivatives.
Fixed
Fixed Income
Income FX
FX Interest
Interest Rate
Rate Derivatives.
Derivatives.
Front
Trade
Trade Capture
Capture Real
Real time
time blotter
blotter Analytics
Analytics
Office
Pricing
Pricing
Middle office
Limits
Limits Analysis
Analysis (MTM,Hedge…)
(MTM,Hedge…)
Reconciliation
Reconciliation Documentation
Documentation Inventory
Inventory
Back Office
Accounting
Accounting Revaluation
Revaluation
Settlements
Settlements Payments
Payments
Technology
Real
Real Time
Time Event
Event Driven
Driven Database
Database
Web
Web Enabled
Enabled Scalability
Scalability Extensibility
Extensibility
Thank You

Introduction To Capital Markets1

Hochgeladen von

Dokumentinformationen

Originalbeschreibung:

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Introduction To Capital Markets1

Hochgeladen von

Copyright:

Verfügbare Formate

Capital Markets Training

Copyright ©2005 Kanbay Incorporated. All rights reserved. COMPANY CONFIDENTIAL

 Overview of Capital Markets

 Exactly the same set of participants

Capital markets are markets in which financial securities like stocks

generated cash financial assets

Need financing Surplus funds

Capital markets serve several important functions in the economy

 Match capital providers with capital seekers

 Help with allocation of resources across regions (globally) and industries

 Help with integration of world economies and bypass local inefficiencies

 Facilitate integration of different markets (e.g. farmers with food

In order for capital markets to be “informationally” efficient,

If capital markets are efficient:

 Primary market ( Eg: Buying a new house from the dealer)

 Order driven market

 You share in the profit the company makes

• Shareholders have certain rights

• Right to elect directors to the board and vote on corporate resolutions

• Entitled to pro-rata share in profits of the company

• Ownership at reduced risk, in exchange for reduced upside

• Like common stock but normally no voting rights

• Can be perpetual, redeemable by holder, callable by issuer or converted into

Æ Right to fixed dividends

Æ Priority over Common Stockholders

 Characteristics of preferred dividends

Æ Can be cumulative, i.e., skipped dividends are not forgotten

Æ Can be participating, i.e., in good times, can receive additional dividends

AMERICAN DEPOSITORY RECEIPTS (ADR)

 Annual reports and balance sheets

 NYSE (New York Stock Exchange)

A bond is a loan made by investors to companies, banks,

What is a Debt Instrument ?

Financial covenants may require company to maintain certain financial ratios

Long term debt S&P Moody’s

Short term debt S&P Moody’s

Markets for short term debt instruments with original maturity of

Technically speaking, “capital markets” are for longer dated

 Treasury Bills (T-Bills)

 Time-value of money – key concepts

Æ FV (future value) and PV (present value)

Æ NPV (net present value)

Æ IRR (internal rate of return)

Bond A, FV=$1000, Bond B, FV=$1000,

Time-to-maturity 5 years 5 years

Bond A, FV=$1000, Bond B, FV=$1000, DISCOUNTING FACTOR (IN %)

Yield-to-maturity 8% 9% 1 0.935 0.926 0.917 0.909

Market price = 100*0.926 = 100*0.917

+ 1100*0.681 + 1100*0.650 7 0.623 0.583 0.547 0.513

= $1079.85 = $1038.90 8 0.582 0.540 0.502 0.467

NB: price and YTM 9 0.544 0.500 0.460 0.424

Examples of Investment Methods available to investors

Fund Analysts &

Fund Manager Fund Administrator Marketing and Distribution

Fund Accountant RTA and

 Entities that collect monies from wealthy and financially knowledgeable

 May borrow monies and invest in securities (leveraging)

 May borrow securities and sell them (shorting or short sales)

 High minimum investment by investors

 Offering documents are privately circulated

 Focus on high returns

 Being unregulated, considerable operating freedom

Overview of Capital Markets

Exactly the same set of participants

Match capital providers with capital seekers

Help with allocation of resources across regions (globally) and industries

Help with integration of world economies and bypass local inefficiencies

Facilitate integration of different markets (e.g. farmers with food

Primary market ( Eg: Buying a new house from the dealer)

Order driven market

You share in the profit the company makes

Characteristics of preferred dividends

Annual reports and balance sheets

NYSE (New York Stock Exchange)

Treasury Bills (T-Bills)

Time-value of money – key concepts

Market price = 1000.926 = 1000.917

+ 11000.681 + 11000.650 7 0.623 0.583 0.547 0.513

Entities that collect monies from wealthy and financially knowledgeable

May borrow monies and invest in securities (leveraging)

May borrow securities and sell them (shorting or short sales)

High minimum investment by investors

Offering documents are privately circulated

Focus on high returns

Being unregulated, considerable operating freedom

Try and provide absolute return rather than relative return

Risk is the uncertainty associated with an expected outcome or event

controllable (diversifiable, unsystematic)

uncontrollable (non-diversifiable, systematic)

Broad classification of financial risk

Basically risk due to exposure to third parties

Counter-party risk / Issuer Risk

Emanates from movement in market forces

Interest Rate Risk

Emanating from inadequacy or failure of internal processes

Yield Curve Risk

Embedded Option Risk

Credit Risk Mitigants

Interest Rate Derivatives

An investment manager decides to make a purchase and informs a broker (diagram

Ultimately responsible to all holders of shares/units of the fund - Account

Market information from around the globe on market settlement practices

High credit rating

Broker/dealers ‘arrange’ (broke) deals by either:

Merrill Lynch & Co

Matching - Through trading operations of either an exchange or an OTC

Post-settlement - Confirmation of the securities and/or cash transfers are sent to

A prime broker is a broker offering professional services specifically aimed at hedge

The primary role of an exchange is to provide a centralized market place where

There are two main types of central markets:

Delivery versus payment (DVP) is the simultaneous and irrevocable transfer of

Custodians manage the safekeeping of assets on behalf of their clients

Value added services

Depending on whether the trade to be settled is a purchase or sale (diagram line(s)

Investment decisions in terms of investment type or country

Central Securities Depositories (CSDs) are established in domestic markets by

A professional securities market participant performing maintenance of the Registry

Provides central clearing and settlement (CCS) body

Facilitate, Control and monitor trade execution and settlement

Payment / Receipt, Settlement and Accounting

Completion of deliveries of securities and safe keeping of securities

Includes the information flow within internal system / systems

Involves interfacing with external systems

Reduces possible human errors in data processing