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Exchange

1. Exchange
An exchange is a marketplace where financial instruments are traded. Securities,
commodities, derivatives, foreign currency are examples of financial instruments.
Examples of exchanges- National Stock Exchange(NSE), New York Mercantile
Exchange(NYMEX), New York Stock Exchange(NYSE)
2. Functions of an exchange
The benefit of having an exchange is that it allows people to trade through a common
platform in a fair and orderly manner. In an exchange, due to the availability of
information, trading occurs between the most deserving buyer and seller which eventually
leads to a price discovery for an instrument
The exchange is responsible for the efficient circulation of price information for any
instrument being traded on that particular exchange. This allows the free flow of
information about all the different financial instruments available in the exchange. This
helps the traders to calculate the fundamental value of an instrument and ensure that there
is no price mismatch.
Additionally, all financial instruments must fulfil certain rules and regulations before they
are listed on an exchange. Moreover, all exchanges work under the strict supervision of
the government, therefore ensuring that an exchange is a fair place for trading to occur.
For example, one of the common regulations in a stock exchange generally requires a
company to post quarterly results and an annual report accessible to the general public.
This guideline ensures transparency and gives an opportunity to the general public to
scrutinize the reports sent by the company and calculate the companies value and its
corresponding share price.
3. Types of exchanges
The type of an exchange is dependent on the financial instrument traded through it. A
Stock Exchange provides an opportunity for traders to buy equity shares, derivatives or
bonds of a company listed on the exchange. Commodities exchange is where various
commodities like wheat, cocoa and sugar are traded. A Foreign Exchange Market is an
exchange where all kinds of currencies are traded. For example, USD/JPY is a currency
pair, where the value of the Japanese Yen against one US Dollar can be traded for.
4. Difference between stock market and stock exchange
Stock market is the pool of equity shares of publicly listed companies, i.e. companies
whose shares are available for trading. Stock exchange facilitates the traders to buy and
sell in the stock market. Therefore, without a stock exchange, companies would have no
formal system on which to list shares, and without a stock market, exchanges would have
no reason to exist.

5. Points to ponder
What if two parties want to trade outside the exchange?
Why would two parties deliberately want to do such a transaction without using the facilities
provided by the exchange?

Credit Rating
1. Definition
Credit rating is an assessment of the credit worthiness of a borrower (financial instrument
or financial entity). It is a rating given to a particular entity based on the credentials and the
extent to which the financial statements of the entity are sound, in terms of borrowing and
lending that has been done in the past. A credit rating can be assigned to any entity that
seeks to borrow money an individual, corporation, state, or sovereign government.
Credit assessment and evaluation for companies and governments is generally done by a
credit rating agency such as Standard & Poors or Moodys. For individuals, credit ratings
are derived from the credit history maintained by credit-reporting agencies. Credit rating
agencies typically assign letter grades to indicate ratings. Standard & Poors, for instance,
has a credit rating scale ranging from AAA (excellent) and AA+ all the way to C and D.
A debt instrument with a rating below BBB- is considered to be speculative grade or a junk
bond.
2. Implication
Credit rating of a borrower has a major impact on the interest rates charged by the lenders.
While a borrower will strive to have the highest possible credit rating, the rating agencies
must take a balanced and objective view of the borrowers financial situation and capacity
to service/repay the debt. The credit rating has an inverse relationship with the possibility of
debt default. In the opinion of the rating agency, a high credit rating indicates that the
borrower has a low probability of defaulting on the debt; conversely, a low credit rating
suggests a high probability of default.
Changes in credit rating can have a significant impact on financial markets. A prime
example of this effect is the adverse market reaction to the credit rating downgrade of the
U.S. federal government by Standard & Poors on August 5, 2011. Global equity markets
plunged for weeks following the downgrade.
India credit rating according to Standard & Poors is BBB-. In 2013, owing to the doubts
raised about India meeting the current account deficit target, there was a threat of
downgrading Indias credit rating further. The efforts this year to curtail this deficit has
improved the outlook and rating agencies do not warrant any changes in the rating in the
near future.

3. Credit Score - Credit Rating for an individual

When you use credit, you are borrowing money that you promise to pay back within a
specified period of time. A credit score is a statistical method to determine the likelihood of
an individual paying back the money he or she has borrowed.
When you apply for a credit card, mortgage or even a phone hookup, your credit rating is
checked. Credit reporting makes it possible for stores to accept checks, for banks to issue
credit or debit cards and for corporations to manage their operations. Depending on your
credit score, lenders will determine what risk you pose to them.
According to financial theory, increased credit risk means that a risk premium must be
added to the price at which money is borrowed. Basically, if you have a poor credit score,
lenders will lend you money at a higher rate than the one paid by someone with a better
credit score.
4. Points to Ponder
1) How do you think your credit score would be calculated?

Bid-Ask Spread
1. Bid
The price at which an investor, trader or a market maker is willing to buy a security is
called the bid price. Along with the price, a bid also specifies the quantity that they are
willing to buy.
An example of a bid in the market would be $15.15 x 1,000, which means that an investor
is willing to purchase 1,000 shares at the price of $15.15. If a seller in the market is willing
to sell that amount for that price, then the transaction is completed.
2. Ask
The price at which a seller is willing to sell a security is known as the ask price. Along with
the price, the ask will generally also stipulate the amount of the security willing to be sold
at that price.
Similar to the way a bid is quoted, an ask in the stock market would be $15.18 x 1,000
which means that someone is offering to sell 1,000 shares for $15.18.
The ask will always be higher than the bid it is easy to understand why. One would be
wiling to sell a security at a higher price than they would be willing to buy. The terms "bid"
and "ask" are used in nearly every financial market in the world covering stocks, bonds,
currency and derivatives.

3. Bid-Ask Spread

The bid-ask spread is the amount by which the ask price exceeds the bid. This is essentially
the difference in price between the highest price that a buyer is willing to pay for an asset
and the lowest price for which a seller is willing to sell it.
If the bid price is $15.15 and the ask price is $15.18 then the "bid-ask spread" is $0.03.
There may be several bid prices and several ask prices for a security at any point in time.
However, only the best bid (that is, the highest price offered for a security) and the best ask
(that is, the lowest price asked for a security) are used to calculate the bid-ask spread.
Significance of the bid-ask spread
The bid-ask spread signifies the liquidity of an asset. The smaller the size of the spread is,
the more liquid the asset would be. This would be because for these assets, the buyers and
sellers generally agree about what the right price for a security should be.
Market makers quote both the bid and ask prices on the market and thus contribute to
transparency and efficiency of the marketplace.
4. Points to Ponder
1) Do you think the bid-ask spread for currencies would be high? What about small-cap
stocks?
2) What happens to this difference between the bid and the ask price?

Rally and Sell-off


1. Rally
A rally is a significant short-term recovery in the price of a stock or commodity, or of a
market in general, after a period of decline or sluggishness. You wouldve heard the phrase,
the markets rallied today this refers to the increase in prices of stocks, bonds,
commodities etc. in the market following a period of flat or declining prices.
A rally can also be used to refer to a period of sustained increases in the prices of stocks,
bonds or indexes in the market.
It is caused by a large amount of money entering the market, bidding up the prices. The
length or magnitude of a rally depends on the depth of buyers along with the amount of
selling pressure they face. If there is a large pool of buyers but few investors willing to sell,
owing to the excessive demand and high bids, the prices are likely to increase considerably
and there could be a large rally. If, however, the same large pool of buyers is matched by a
similar amount of sellers, the rally is likely to be short and the price movement minimal.
For instance,

Before the 2014 elections, the Indian stock market rallied as investors were betting big on
NDAs victory. The optimism stemmed from the hope of a stable alliance forming a
business-friendly government that will speed up reforms and accelerate economic growth.
From the beginning of the year, the Sensex has seen an increase in levels of over 20%.
2. Sell-off
A sell-off refers to the rapid selling of securities, such as stocks, bonds and commodities.
This increase in supply leads to a sharp decline in price.
A sell-off may occur for many reasons. For example, if a company issues a disappointing
earnings report, it can spark a sell-off of that company's stock. External forces can also
cause a sell-off. For example, a spike in grain prices may trigger a sell-off in food stocks
because of the increases in raw materials costs.
Sell-offs are important market events. Investors should try to sell a security well before a
dramatic sell-off so as not to be the last one holding the stock. At the same time, investors
can take advantage of sell-offs, especially broad market sell-offs, to buy fundamentally
goods stocks at very affordable prices.
In the beginning of this month, Sensex and other Indices slid. The sell-off was triggered
because of the weak global cues and continuing geo-political tensions and the news of
Argentina's debt default among other factors.
3. Points to Ponder
1) What could be the macro-economic indicators of a rally or a sell-off?
2) Do you think the speculation activities increase more than general during a rally or a
sell-off?

Arbitrage
1. Definition
Arbitrage is the simultaneous purchase and sale of an asset in order to make a risk-less
profit from a difference in price. It is a trade that profits by exploiting price differences of
identical or similar financial instruments, on different markets or in different forms.
Looking at this in the context of stocks, a stock can be traded on multiple exchanges and on
each exchange the quoting price may be a bit different. One can buy this stock at a lower
price on one of the exchanges, and sell it at a higher price on the other thus making a
profit owing to the disparity in prices. A point to note is that the buying and selling of this
stock must occur simultaneously to avoid exposure to market risk (the risk that prices may
change on one exchange before both transactions are complete).
Arbitrage exists as a result of market inefficiencies. It is possible when one of three
conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future price
discounted at the risk-free interest rate.
2. Example
Suppose WalMart is selling the DVD of Movie XYZ for $10. However, you know that on
eBay the last 20 DVDs of Movie XYZ sold for around $25. You could then buy the DVD
from WalMart, sell them on eBay for a profit of $15 per DVD. This difference in price is
deferred to as having an arbitrage opportunity and the $15 gain you make represents the
arbitrage profit.
3. Applications

Arbitrage is a necessary force in the financial marketplace. Arbitrageurs are experienced


investors that exploit price inefficiencies they play an important role in the operation of
capital markets. The presence of these investors in the market leads to prices being more
accurate than they otherwise would be.
Given the advancement in technology it has become extremely difficult to profit from
mispricing in the market. Many traders have computerized trading systems set to monitor
fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted
upon quickly and the opportunity is often eliminated in a matter of seconds.
4. Point to Ponder
What is the potential downside of a firm that does only arbitrage?

Long Position/Short Position


1. Position
We often come across phrases like Mr. A is long company XYZ, Mr. Z is short company
ABC let us try to understand what this means.
A position is a general reference to an investment holding the amount of security either
owned or borrowed.
An investor can essentially take two types of positions long or short.
2. Long Position
In the context of stocks, having a long position means you have bought a security and thus
you own it. You have the right to collect the dividends or interest the security pays, the right
to sell and the right to keep any profits if you do sell.

Similarly, in the context of options, a long position refers to the buying of an options
contract. You have the right (but not an obligation) to exercise the option before expiration
or sell it.
A long position on a stock or an option is taken with the expectation that the asset will rise
in value in the future.
For example, John decides to take a long position on Google - he buys 10 shares of Google
at yesterdays closing price of $577.86. His initial investment = 10 * $577.86 = $5778.60.
Suppose, a year later, the price of the Google stock is $600, Johns investment would be
worth $6000 (a gain of $221.40, which he can realize by selling these stocks).
3. Short Position

A short position refers to two scenarios


1) Selling a security you own.
2) Borrowing a security (from a broker or a financial institution) for a period and selling it
today. At the end of the period, it needs to be returned to the owner with some additional
interest.
In the context of options, a short position means that you have sold the option, giving the
holder the right to exercise it and obligated yourself to fulfilling the terms of the contract if
the buyer of the option exercises it.
A short position on a stock or an option is taken when the asset value is expected to fall.
For example, John thinks that the price of the Google stock will fall - he can decide to take
a short position on it. To do so, he can borrow shares (lets say, 100) from his broker
promising to return it a week later, with some added interest, say 0.5% weekly. He can sell
these shares in the open market at $577.86, thus making $5778.60.
Suppose, a week later, the price of the Google stock is $560, he can buy 100 shares from
the market (at $5600), return them to his broker along with the interest (0.5% * $5778.60 =
28.89). He thus spends a total of 5628.89, still making some money on his original
investment.
4. Points to Ponder
1) What are the factors to be taken into consideration while deciding whether a long or a
short position should be taken on a stock/underlying?
2) Are short positions riskier than long positions? Why or why not?

Trading Objectives :
1. Hedging:
An investment strategy to limit or offset probability of loss due to adverse price
movement. A perfect hedge reduces risk to zero. Hedging techniques generally involve
the use of complicated financial instruments known as derivatives, the two most common

of which are futures and options.


Futures: A future contract is a standardized contract to buy or sell an underlying on a
specified date for a pre-determined price.
Options: A financial derivative that offers the buyer of the option contract the right, but
not the obligation, to buy (call) or sell (put) a an financial asset in future.
Hedging using Futures:
Suppose a company needs to pay $20 million in three months for oil imports with the
current INR/USD exchange rate at 59. It bears the risk of the rupee falling in value
(depreciating). For example if the exchange rate is 62 INR/USD after 3 months the
company has to pay INR 60 mm extra. To protect itself (to hedge) the company will buy a
3-month futures contract. This will enable the company to fix the amount to be paid after
3-months. Assuming the futures rate to be 60 INR/USD the company has to pay INR
1200 mm irrespective of the actual exchange rate after 3 months.
Hedging using options:
Suppose an investor owns 10 shares of XYZ company. The share price is INR 100.
Investor is worried that the price may decrease. To hedge this risk, the investor can buy
put option contract (right to sell an asset in future at a specific price called strike price). If
the quoted option contract premium is INR 1 per share, then an option contract of 10
shares would cost INR 10. Also, let the strike price be INR 95. If the share price falls
below INR 95, say INR 90, then option can be exercised and a net value of INR 940 can
be realized.
2. Speculation:
While hedging is aimed at avoiding risk, speculation involves taking advantage of
fluctuations in price. Speculators are either betting on price moving up or moving down.
They act as market makers and increase liquidity in the market. It is often confused with
gambling or investment. A speculation involves taking calculated risks and is not a game
of pure chance.
3. Points to Ponder:
Suppose an Indian exporter is to receive $1 mm in 6 months and he wants to
protect himself against appreciation of the rupee. How would he/she hedge?
If a share trader expects Reliance to announce the launch of a new power project. How
will he/she speculate?

Money Market Instruments


1. Money Market

Money Market is the part of financial market where instruments with high liquidity and
very short-term maturities are traded. It's the place where large financial institutions,
dealers and government participate and meet out their short-term cash needs.Trading in
the money markets is done over the counter. The most common money market
instruments are Commercial Papers, Repurchase Agreements and Banker's Acceptance.
2. Types of instruments

Commercial Papers- Commercial Paper is the short term unsecured promissory note
issued by corporate and financial institutions at a discounted value on face value. They
come with fixed maturity period ranging from 1 day to 270 days. These are issued for the
purpose of financing of accounts receivables, inventories and meeting short term
liabilities. The return on commercial papers is higher as compared to Treasury Bills so is
the risk as they are less secure in comparison to these bills.
Repurchase Agreements- Repurchase Agreements
which
are
also
called
as Repo or Reverse Repo are short term loans that buyers and sellers agree upon for
selling and repurchasing. Repo or Reverse Repo transactions can be done only between
the parties approved by RBI and allowed only between RBI-approved securities such as
state and central government securities, PSU bonds and corporate bonds. They are usually
used for overnight borrowing. Repurchase agreements are sold by sellers with a promise
of purchasing them back at a given price and on a given date in future. On the flip side,
the buyer will also purchase the securities and other instruments with a promise of selling
them back to the seller.
Bankers Acceptance- Banker's Acceptance is like a short term investment plan created by
non-financial firm, backed by a guarantee from the bank. It's like a bill of exchange
stating a buyer's promise to pay to the seller a certain specified amount at a certain date.
And, the bank guarantees that the buyer will pay the seller at a future date. Firm with
strong credit rating can draw such bill. These securities come with the maturities between
30 and 180 days and the most common term for these instruments is 90 days. Companies
use these negotiable time drafts to finance imports, exports and other trade.

3. Characteristics of Instruments

Liquidity - Since they are fixed-income securities with short-term maturities of a year or
less, money market instruments are extremely liquid.
Safety - They also provide a relatively high degree of safety because their issuers have the
highest credit ratings.
Discount Pricing- A third characteristic they have in common is that they are issued at a
discount to their face value.

4. Points to ponder
How many types of options are there?
What are the differences between two options?

Fixed Income Instruments


1. Fixed Income Instruments
Fixed Income Instruments are investments that provide a minimum assured return.
Examples of some popular fixed income instrutments are bonds, certificate of deposits,
and treasury bills.
2. Popular Fixed Income Instruments
Bonds- A bond is an obligation or a loan made by an investor to an issuer (e.g. a
government or a company). In turn, the issuer promises to repay the principal (or face
value) of the bond on a fixed maturity date and to make regularly scheduled interest
payments (usually every six months). The major issuers of bonds are governments and
corporations and some examples of bonds are government, corporate and zero coupon
bonds.
Treasury Bills- Treasury bills (T-bills) are the safest type of short-term debt instrument
issued by a federal government. Ideal for investors seeking a 1- to 12- month investment
period, T-bills are highly liquid and very secure. T-bills are issued through a competitive
bidding process at a discount from par, which means that rather than paying fixed interest
payments like conventional bonds, the appreciation of the bond provides the return to the
holder.
Certificate of deposits- Sold by banks, certificates of deposit (better known as CDs) are
low-risk - and relatively low-return investments suitable for cash you dont need for
months or years. If you leave the money alone during the investment period (known as the
term or duration), the bank will pay you an interest rate slightly higher than what you
would have earned in a money market or savings account. A CD bears a maturity date, a
specified fixed interest rate and can be issued in any denomination. The term of a CD
generally ranges from one month to five years.
3. Investors

Investors in fixed-income securities are typically looking for a constant and secure return
on their investment. For example, a retired person might like to receive a regular
dependable payment to live on, but not consume the principal. This person can buy a bond
with their money, and use the coupon payment (the interest) as that regular dependable
payment. When the bond matures or is refinanced, the person will have their money
returned to them.
4. Points to ponder
Can a firm raise capital for the short term without risking any collateral?
Are there ways for a company with surplus cash to redistribute its cash to another company who
needs it?

Stocks
1. Stocks
A stock is a form of security that signifies ownership in a corporation and represents a claim
on the corporations assets and earnings. There are three types of stock- common stock,
preferred stock and convertible preferred stock. Stocks are issued to raise capital for the
company.
2. Types of stocks
Common stock- It is a form of corporate equity ownership. Ordinary shares are also known as
equity shares. An ordinary share gives the right to its owner to share in the profits of the
company (dividends) and to vote at general meetings of the company
Preferred stock- A class of ownership in a corporation that has a higher claim on the assets
and earnings than common stock. Preferred stock generally has a dividend that must be paid
out before dividends to common stockholders and the shares usually do not have voting
rights.The best way to think of preferred stock is as a financial instrument that has
characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known
as "preferred shares".
Convertible shares- These shares are corporate fixed-income securities that the investor can
choose to turn into a certain number of shares of the company's common stock after a
predetermined time span or on a specific date. The fixed-income component offers a steady
income stream and some protection of the investors' capital. However, the option to convert
these securities into stock gives the investor the opportunity to gain from a rise in the share
price. That said, convertible preferred shareholders, unlike common shareholders, rarely
have voting rights.
3. Comparison between the types of stocks

Basis of Difference
Right of dividend

Preference Share
Paid dividend before equity
shares

Equity Share
Paid dividend out of the
balance of profit available
after the dividend paid to
preference shares
Rate of dividend
Fixed rate
Decided year on year
depending on performance
Convertibility
May be converted
Not convertible
Voting rights
No voting rights
Right to vote
Participation in
Do not have right to
Right to participate in
management
participate in management
management of company
Refund of Capital
If company shuts down,
If company shuts down,
receives payback before
receives payback after
equity shares
preference share payback
The major difference between preference shares and equity shares occurs due to ranking
given to them for raising capital. Common stock is lower in the ranking than preference
shares, therefore gets paid only after preference shares have been paid out. However,
common stock holders do get the opportunity to vote and participate in a companys
management whereas preference share holders do not.
4. Points to Ponder
Are there instruments where one can receive a fixed payment schedule?
How does one mitigate the risk one takes on when trading in stocks?

OTC- Over the Counter


1. OTC
Over The Counter trading is conducted between two parties without the facilitation of the
exchange. This allows traders to directly interact with each other and fix the prices of
securities not listed on the exchange. One of the significant challenges with an OTC
transaction is the counterparty risk involved. Key instruments traded through an OTC
market are swaps, forward rate agreements, credit derivatives, bonds and etc.
2. OTC Market and its implications

An OTC market is a decentralized market where people trade with each other through the
various forms of communication available. The difference between an OTC and an
exchange market is the lack of transparency in an OTC transaction. This occurs as the
price is not disclosed by the traders. The trade in the OTC market is also subject to fewer
guidelines.
OTC markets are split into two segments- the customer market and the interdealer market.
The customer market is for customers who trade through dealers because of the high
search and transaction cost involved. Whereas the interdealer market is run by large
institutions that use their expertise to organize transactions for their clients.
OTC markets have gained significant importance in recent years. Traders from investment
banks create tailor-made derivatives for their clients such as hedge funds, commercial
banks, governments and etc. The total face value of OTC derivatives stood at $710 trillion
as of December 2013.
There is a significant risk that is undertaken in an OTC transaction that both the parties
will fulfil their obligations. However, there is always the probability that an issuer of a
derivative fails to follow through the pay schedule and will default on the trade. These
risks are called as counterparty risks and they were under the spotlight during the financial
crises. During the crises people were unable to pay on their obligations which led to a
strong decrease in transaction activity and a lack of buyers. This exacerbated the liquidity
crises around the world.
4. Relation between Exchange market and OTC market

As exchange traded contracts have a one size fits all instrument, it is hard for traders to
reduce their risk in the exchange market. Therefore, traders use the OTC market to create
the perfect hedge to help mitigate the risk and tailor a product, best suited for their risk
exposure.

5. OTC in India

In India, the OTC derivative products were introduced by RBI in a phased manner.
However, in line with the reforms set forth after the financial crises, all over-the-counter
transactions by banks in currency swaps and interest rate derivatives have to be reported
to the Clearing Corporation of India Ltd (CCIL). Additionally, for any derivative
transaction, there has to be at least one party that is recognised by the RBI. This has
helped reduce counterparty risks in India.

6. Points to Ponder

Can a company issue shares without giving up their voting rights?


Is there any way of getting more assured returns through shares?