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INTRODUCTION OF FINANCIAL MARKET


A financial market is a broad term describing any marketplace
where buyers and sellers participate in the trade of assets such as
equities, bonds, currencies and derivatives. Financial markets are
typically defined by having transparent pricing, basic regulations
on trading, costs and fees, and market forces determining the
prices of securities that trade.
Financial markets can be found in nearly every nation in the
world. Some are very small, with only a few participants, while
others - like the New York Stock Exchange (NYSE) and the forex
markets - trade trillions of dollars daily.
Investors have access to a large number of financial markets and
exchanges representing a vast array of financial products. Some
of these markets have always been open to private investors;
others remained the exclusive domain of major international
banks and financial professionals until the very end of the
twentieth century
A financial market is an organized trading platform for exchanging
financial instruments under a regulated framework. The
participants of the financial markets are borrowers (issuers of
financial instruments or securities), lenders (investors or buyers of
financial instruments) and financial intermediaries that facilitate
investment in financial instruments or securities. The financial
markets comprise two markets (A) Money markets, which are
regulated by the Reserve Bank of India (RBI) and (B) Capital
markets, which are regulated by the Securities Exchange Board of
India (SEBI)

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Capital Markets
A capital market is one in which individuals and institutions trade
financial securities. Organizations and institutions in the public
and private sectors also often sell securities on the capital
markets in order to raise funds. Thus, this type of market is
composed of both the primary and secondary markets.
Any government or corporation requires capital (funds) to finance
its operations and to engage in its own long-term investments. To
do this, a company raises money through the sale of securities stocks and bonds in the company's name. These are bought and
sold in the capital markets.

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Stock Markets
Stock markets allow investors to buy and sell shares in publicly
traded companies. They are one of the most vital areas of a
market economy as they provide companies with access to capital
and investors with a slice of ownership in the company and the
potential of gains based on the company's future performance.
This market can be split into two main sections: the primary
market and the secondary market. The primary market is where
new issues are first offered, with any subsequent trading going on
in the secondary market.

Equity Shares: Features, Advantages and


Disadvantages of Equity Shares
Equity shares were earlier known as ordinary shares. The holders
of these shares are the real owners of the company. They have a
voting right in the meetings of holders of the company. They have
a control over the working of the company. Equity shareholders
are paid dividend after paying it to the preference shareholders.
The rate of dividend on these shares depends upon the profits of
the company. They may be paid a higher rate of dividend or they
may not get anything. These shareholders take more risk as
compared to preference shareholders.
Equity capital is paid after meeting all other claims including that
of preference shareholders. They take risk both regarding
dividend and return of capital. Equity share capital cannot be
redeemed during the life time of the company.

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Equity shares
An equity share, commonly referred to as ordinary share also
represents the form of fractional or part ownership in which a
shareholder, as a fractional owner, undertakes the maximum
entrepreneurial risk associated with a business venture. The
holders of such shares are members of the company and have
voting rights

Features of Equity Shares:


Equity shares have the following features:
(i) Equity share capital remains permanently with the company. It
is returned only when the company is wound up.
(ii) Equity shareholders have voting rights and elect the
management of the company.
(iii) The rate of dividend on equity capital depends upon the
availability of surplus funds. There is no fixed rate of dividend on
equity capital.

Advantages of Equity Shares:


1. Equity shares do not create any obligation to pay a fixed rate of
dividend.
2. Equity shares can be issued without creating any charge over
the assets of the company.
3. It is a permanent source of capital and the company has to
repay it except under liquidation.

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4. Equity shareholders are the real owners of the company who


have the voting rights.
5. In case of profits, equity shareholders are the real gainers by
way of increased dividends and appreciation in the value of
shares.
Disadvantages of Equity Shares:
1. If only equity shares are issued, the company cannot take the
advantage of trading on equity.
2. As equity capital cannot be redeemed, there is a danger of over
capitalisation.
3. Equity shareholders can put obstacles for management by
manipulation and organising themselves.
4. During prosperous periods higher dividends have to be paid
leading to increase in the value of shares in the market and it
leads to speculation.
5. Investors who desire to invest in safe securities with a fixed
income have no attraction for such shares.

Deferred Shares:
These shares were earlier issued to Promoters or Founders for
services rendered to the company. These shares were known as
Founders Shares because they were normally issued to founders.
These shares rank last so far as payment of dividend and return of
capital is concerned. Preference shares and equity shares have
priority as to payment of dividend.
These shares were generally of a small denomination and the
management of the company remained in their hands by virtue of
their voting rights. These shareholders tried to manage the
company with efficiency and economy because they got dividend
only at last. Now, of course, they cannot be issued and they are

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only of historical importance. According to Companies Act 1956,


no public limited company or which is a subsidiary of a public
company can issue deferred shares.

1.Ordinary shares
These carry no special rights or restrictions. They rank after
preference shares as regards dividends and return of capital but
carry voting rights (usually one vote per share) not normally given
to holders of preference shares (unless their preferential dividend
is in arrears).
Some companies create more than one class of ordinary shares
e.g. A Ordinary Shares, B Ordinary shares etc. This gives
flexibility for different dividends to be paid to different
there may be 1 Ordinary shares and 0.01 Ordinary shares. If
each share had the right to one vote (and assuming the shares
were issued at their nominal value), then the 0.01 Ordinary
shareholders would get 100 votes per 1 paid while the 1
Ordinary shareholders would get 1 vote for paying the same
amount.shareholders or, for example, for pre-emption rights to
apply to some shares but not others.
In some cases, different classes of ordinary share may be of
different nominal values for example,

2.Deferred ordinary shares


A company can issue shares which will not pay a dividend until all
other classes of shares have received a minimum dividend.
Thereafter they will usually be fully participating. On a winding up
they will only receive something once every other entitlement has
been met.

3.Non-voting ordinary shares

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Voting rights on ordinary shares may be restricted in some way


e.g. they only carry voting rights if certain conditions are met.
Alternatively, they may carry no voting rights at all. They may
also preclude the shareholder even attending a General Meeting.
In all other respects they will have the same rights as ordinary
shares.

4.Redeemable shares
The terms of redeemable shares give the company the option to
buy them back in the future; occasionally, the shareholder may
(also) have the option to sell them back to the company, although
thats much less common.
The option may arise at or after a specific date, between two
dates or be effective at any time the shares are in issue. The
redemption price is usually the same as the issue price, but can
be set differently. A company can only redeem shares out of
profits or the proceeds of a new share issue, which may restrict its
ability to redeem shares even if the directors would like to
exercise the option.
If a company chooses to have redeemable shares, it must also
have non-redeemable shares in issue. At no point can all of its
share capital be made up of redeemable shares.

5.Preference shares
These shares are called preference or preferred since they have a
right to receive a fixed amount of dividend every year. This is
received ahead of ordinary shareholders. The amount of the
dividend is usually expressed as a percentage of the nominal
value. So, a 1, 5% preference share will pay an annual dividend
of 5p. The full entitlement will be paid every year unless the
distributable reserves are insufficient to pay all or even some of
it. On a winding up, the holders of preference shares are usually
entitled to any arrears of dividends and their capital ahead of

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ordinary shareholders. Preference shares are usually nonvoting (or only have a vote only when their dividend is in arrears).

6.Cumulative preference shares


If the dividend is missed or not paid in full then the shortfall will
be made good when the company next has sufficient distributable
reserves. It follows that ordinary shareholders will not receive any
dividends until all the arrears on cumulative preference shares
have been paid.
By default, preference shares are cumulative but many
companies also issue non-cumulative preference shares.

7.Redeemable preference shares


Redeemable preference shares combine the features of
preference shares and redeemable shares. The shareholder
therefore benefits from the preferential right to dividends (which
may be cumulative or non-cumulative) while the company retains
the ability to redeem the shares on pre-agreed terms in the
future.

Most companies start by just having one type of shares in the


form of an ordinary share class. These will typically carry equal
rights to voting, capital and dividends. The issue of new
shares after company incorporation will generally be allotments of
these ordinary shares, unless circumstances suggest a need for
flexibility or varied rights.
Just as a company may issue shares in multiple share classes,
theres also nothing to stop a shareholder holding more than one
class of share in the same company and thereby benefiting from
the differing rights (e.g. voting or dividend entitlement) that each
class offers.

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Bond Markets
A bond is a debt investment in which an investor loans money to
an entity (corporate or governmental), which borrows the funds
for a defined period of time at a fixed interest rate. Bonds are
used by companies, municipalities, states and U.S. and foreign
governments to finance a variety of projects and activities. Bonds
can be bought and sold by investors on credit markets around the
world. This market is alternatively referred to as the debt, credit
or fixed-income market. It is much larger in nominal terms that
the world's stock markets. The main categories of bonds are
corporate bonds, municipal bonds, and U.S. Treasury bonds, notes
and bills, which are collectively referred to as simply "Treasuries."
(For more, see the Bond Basics Tutorial.)

Primary Markets vs. Secondary Markets


A primary market issues new securities on an exchange.
Companies, governments and other groups obtain financing
through debt or equity based securities. Primary markets, also
known as "new issue markets," are facilitated by underwriting
groups, which consist of investment banks that will set a
beginning price range for a given security and then oversee its
sale directly to investors.
The primary markets are where investors have their first chance
to participate in a new security issuance. The issuing company or
group receives cash proceeds from the sale, which is then used to
fund operations or expand the business. (For more on the primary
market, see our IPO Basics Tutorial.)

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The secondary market is where investors purchase securities or


assets from other investors, rather than from issuing companies
themselves. The Securities and Exchange Commission (SEC)
registers securities prior to their primary issuance, then they start
trading in the secondary market on the New York Stock Exchange,
Nasdaq or other venue where the securities have been accepted
for listing and trading. (To learn more about the primary and
secondary market, read Markets Demystified.)
The secondary market is where the bulk of exchange trading
occurs each day. Primary markets can see increased volatility
over secondary markets because it is difficult to accurately gauge
investor demand for a new security until several days of trading
have occurred. In the primary market, prices are often set
beforehand, whereas in the secondary market only basic forces
like supply and demand determine the price of the security.
Secondary markets exist for other securities as well, such as when
funds, investment banks or entities such as Fannie Mae purchase
mortgages from issuing lenders. In any secondary market trade,
the cash proceeds go to an investor rather than to the underlying
company/entity directly. (To learn more about primary and
secondary markets, read A Look at Primary and Secondary
Markets.)
What Is Primary and Secondary Market?
The financial market is a world where new securities are issued to
the public regularly. It is a world full of varied financial products
and services, tailored to the need of every individual from all
income brackets. These financial products are bought and sold on
the capital market, which is divided into primary market and
secondary market.

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This post will be a detailed explanation of primary market and


secondary market, and will draw the distinction of primary market
vs. secondary market.

What Is Primary Market?


The primary market is also known as new issues market. Here,
the transaction is conducted between the issuer and the buyer. In
short, the primary market creates new securities and offers them
to the public.
For instance, Initial Public Offering (IPO) is an offering of the
primary market where a private company decides to sell stocks to
the public for the first time. An important point to remember here
is that in the primary market, securities are directly purchased
from the issuer.
Capital or equity can be raised in primary market by any of the
following four ways:

1. Public Issue
As the name suggests, public issue means selling securities to
public at large, such as IPO. It is the most vital method to sell
financial securities.

2. Rights Issue

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Whenever a company needs to raise supplementary equity


capital, the shares have to be offered to present shareholders on
a pro-rata basis, which is known as the Rights Issue.

3. Private Placement
This is about selling securities to restricted number of classy
investors like frequent investors, venture capital funds, mutual
funds and banks comes under Private Placement.

4. Preferential Allotment
When a listed company issues equity shares to a selected number
of investors at a price that may or may not be pertaining to the
market price is known as Preferential Allotment.
The primary market is also known as the New Issue
Market (NIM) as it is the market for issuing long-term equity
capital. Since the companies issue securities directly to the
investors, it is responsible to issue the security certificates too.
The creation of new securities facilitates growth within the
economy.

What Is Secondary Market?


In secondary market, the securities issued in the primary market
are bought and sold. Here, you can buy a share directly from a
seller and the stock exchange or broker acts as an intermediary
between two parties.
The secondary market is actually formed by another layer of
investors who deal with primary market investor to buy and sell
financial securities such as bonds, futures andstocks. These
dealings happen in the proverbial stock exchange.
National Stock Exchange (NSE) and New York Stock Exchange
(NYSE) are some popular stock exchanges. Majorly, the trade

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happens between investors without any involvement with the


company that issued the securities in the primary market.
The secondary market is further divided into two kinds of market.

1. Auction Market
The auction market is a place where buyers and sellers convene
at a place and announce the rate at which they are willing to sell
or buy securities. They offer either the bid or ask prices,
publicly. Since all buyers and sellers are convening at the same
place, there is no need for investors to seek out profitable options.
Everything is announced publicly and interested investors can
make their choice easily.

2. Dealer Market
In a dealer market, none of the parties convene at a common
location. Instead, buying and selling of securities happen through
electronic networks which are usually fax machines, telephones or
custom order-matching machines.
Interested sellers deliver their offer through these mediums,
which are then relayed over to the buyers through the medium of
dealers. The dealers possess an inventory of securities and earn
their profit through the selling. A lot of dealers operate within this
market and therefore, a competition exists between them to
deliver the best offer to their investors. This makes them deliver
the best price to the investors. An example of a dealer market is
the NASDAQ.
The secondary markets are important for price discovery. The
market operations are carried out on stock exchanges.
A variation to the dealer market is the OTC market. OTC stands
for Over the Counter market. The concept came into existence
during the early 1920s period through Wall Street trading, which
implied the prevalence of an unorganized system of dealers who

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conducted trades via networks. Stock shops existed to buy and


sell shares over-the-counter. In other words, these were unlisted
stocks which were sold privately.
Over time, the notion of OTC underwent a change. These days the
over-the-counter denotes those stocks which are not traded over
NYSE, NASDAQ or American Stock Exchange (AMEX). The overthe-counter implies those stocks which are traded on thepink
sheets or on over-the-counter bulletin boards (OTCBB). Pink
sheets are a name given to the daily list of stocks published with
ask and bid prices by the National Quotation Bureau. The OTCBB
service is offered by the National Association of Securities Dealers
(NASD) which accurately displays the last sale prices, real time
quotations and other volume information of over-the-counter
securities.
Endnote
I hope the article clarified and made you understand the concepts
of primary and secondary markets. Now you know the importance
of both primary and secondary markets.
It will also interest you to know that there is something
called third markets andfourth markets but they are not heard
of publicly. In the third and fourth markets, transactions of high
volume happen between the dealers and the brokers, and large
institutions using over-the-counter networks.
The third market caters to transactions between dealer/brokers
and large institutions whereas the fourth market is only about
transactions between large institutions. The activities of these
markets have little or no influence on the workings of the usual
stock trading by an average investor. Moreover, the transactions
in these markets are always of high volume.

Capital market instruments:

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1.

Debt Instruments

A debt instrument is used by either companies or governments to


generate funds for capital-intensive projects. It can obtained
either through the primary or secondary market. The relationship
in this form of instrument ownership is that of a borrower
creditor and thus, does not necessarily imply ownership in the
business of the borrower. The contract is for a specific duration
and interest is paid at specified periods as stated in the trust
deed* (contract agreement). The principal sum invested, is
therefore repaid at the expiration of the contract period with
interest either paid quarterly, semi-annually or annually. The
interest stated in the trust deed may be either fixed or flexible.
The tenure of this category ranges from 3 to 25 years. Investment
in this instrument is, most times, risk-free and therefore yields
lower returns when compared to other instruments traded in the
capital market. Investors in this category get top priority in the
event of liquidation of a company.
When the instrument is issued by:
The Federal Government, it is called a Sovereign Bond;
A state government it is called a State Bond;
A local government, it is called a Municipal Bond; and
A corporate body (Company), it is called a Debenture, Industrial
Loan orCorporate Bond

2.

Equities (also called Common Stock)

This instrument is issued by companies only and can also be


obtained either in the primary market or the secondary
market. Investment in this form of business translates to
ownership of the business as the contract stands in perpetuity
unless sold to another investor in the secondary market. The
investor therefore possesses certain rights and privileges (such as

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to vote and hold position) in the company. Whereas the investor in


debts may be entitled to interest which must be paid, the equity
holder receives dividends which may or may not be declared.
The risk factor in this instrument is high and thus yields a higher
return (when successful). Holders of this instrument however rank
bottom on the scale of preference in the event of liquidation of a
company as they are considered owners of the company.

3. Preference Shares
This instrument is issued by corporate bodies and the investors
rank second (after bond holders) on the scale of preference when
a company goes under. The instrument possesses the
characteristics of equity in the sense that when the authorised
share capital and paid up capital are being calculated, they are
added to equity capital to arrive at the total. Preference shares
can also be treated as a debt instrument as they do not confer
voting rights on its holders and have a dividend payment that is
structured like interest (coupon) paid for bonds issues.
Preference shares may be:
Irredeemable, convertible: in this case, upon maturity of the
instrument, the principal sum being returned to the investor is
converted to equities even though dividends (interest) had earlier
been paid.
Irredeemable, non-convertible: here, the holder can only sell his
holding in the secondary market as the contract will always be
rolled over upon maturity. The instrument will also not be
converted to equities.
Redeemable: here the principal sum is repaid at the end of a
specified period. In this case it is treated strictly as a debt
instrument.

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Note: interest may be cumulative, flexible or fixed depending on


the agreement in the Trust Deed.

4.

Derivatives

These are instruments that derive from other securities, which are
referred to as underlying assets (as the derivative is derived from
them). The price, riskiness and function of the derivative depend
on the underlying assets since whatever affects the underlying
asset must affect the derivative. The derivative might be an
asset, index or even situation. Derivatives are mostly common in
developed economies.
Some examples of derivatives are:
forward
Futures
Options
Swaps
Derivative securities:
some basic concepts The Oxford dictionary defines a derivative as
something derived or obtained from another, coming from a
source; not original. In the field of financial economics, a
derivative security is generally referred to a financial contract
whose value is derived from the value of an underlying asset or
simply underlying. There are a wide range of financial assets that
have been used as underlying, including equities or equity index,
fixed-income instruments, foreign currencies, commodities, credit
events and even other derivative securities. Depending on the
types of underlying, the values of the derivative contracts can be
derived from the corresponding equity prices, interest rates,
exchange rates, commodity prices and the probabilities of certain
credit events.

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1 former Senior Economist, BIS Representative Office for Asia and


the Pacific, Hong Kong 4 IFC Bulletin No 35 What is the main
function of derivatives? They allow users to meet the demand for
costeffective protection against risks associated with movements
in the prices of the underlying. In other words, users of derivatives
can hedge against fluctuations in exchange and interest rates,
equity and commodity prices, as well as credit worthiness.
Specifically, derivative transactions involve transferring those
risks from entities less willing or able to manage them to those
more willing or able to do so.
Derivatives transactions are now common among a wide range of
entities, including commercial banks, investment banks, central
banks, fund mangers, insurance companies and other nonfinancial corporations. Participants in derivatives markets are
often classified as either hedgers or speculators. Hedgers
enter a derivative contract to protect against adverse changes in
the values of their assets or liabilities. Specifically, hedgers enter
a derivative transaction such that a fall in the value of their assets
will be compensated by an increase in the value of the derivative
contract. By contrast, speculators attempts to profit from
anticipating changes in market prices or rates or credit events by
entering a derivative contract. According to this definition,
activities of speculators are inherently more risky and should
warrant close monitoring by financial regulators. However, it is
difficult to differentiate the two in practice. As pointed out by
Jarrow and Turnbull (20), Hedging risk reduction speculation
risk augmentation are flip sides of the same coin. Hedging and
speculating are not the only motivations for trading derivatives.
Some firms use derivatives to obtain better financing terms. For
example, banks often offer more favourable financing terms to
those firms that have reduced their market risks through hedging
activities than to those without. Fund managers sometimes use
derivatives to achieve specific asset allocation of their portfolios.
For example, passive fund managers of specific index-tracking

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funds may need to use derivatives to replicate exposures to some


not so liquid financial assets.
Derivatives have a long history and early trading can be traced
back to Venice in the 12th century.2 Credit derivative deals at that
period took the form of loans to fund a ship expedition with some
insurance on the ship not returning. Later in the 16th century,
derivatives contracts on commodities emerged. During that time,
the slow speed in communication and high transportation costs
presented key problems for traders. Merchants thus used
derivatives contracts to allow farmers to lock in the price of a
standardised grade of their produces at a later delivery date. A
number of fundamental changes in global financial markets have
contributed to the strong growth in derivative markets since the
1970s. First, the collapse of the Bretton Woods system of fixed
exchange rates in 1971 increased the demand for hedging
against exchange rate risk. The Chicago Mercantile Exchange
allowed trading in currency futures in the following year. Second,
the changing of its monetary policy target instrument by the US
Federal Reserve (FED) promoted various derivatives markets.
The adoption of a target for money growth by the FED in 1979 has
led to increased interest-rate volatility of Treasury bonds. That in
turn raised the demand for derivatives to hedge against adverse
movements in interest rates. Later in 1994 when the US Federal
Open Market Committee moved to explicitly state its target level
for the federal funds rate, that policy has spurred the growth of
derivatives on the federal funds rates. Third, the many emerging
market financial crises in the 1990s, which were often
accompanied by a sharp rise in corporate bankruptcy, greatly
increased the demand of global investors for hedging against
credit risk. 2 See Swan (2000). IFC Bulletin No 35 5 Fourth,
innovation in financial theory was another contributing factor.
The advancements in options pricing research, most notably the
Nobel-prize winning Black-Scholes options pricing model, provided

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a new framework for portfolio managers to manage risks. More


importantly, the rapid improvements in computer technology in
the 1990s allowed these asset managers to design and develop
increasingly sophisticated derivatives as part of their risk
management tools.

3. Major types of derivatives


There are four main types of derivatives contracts: forwards;
futures, options and swaps. This section discusses the basics of
these four types of derivatives with the help of some specific
examples of these instruments.

3.1 Forwards and futures contracts


Forward and futures contracts are usually discussed together as
they share a similar feature: a forward or futures contract is an
agreement to buy or sell a specified quantity of an asset at a
specified price with delivery at a specified date in the future. But
there are important differences in the ways these contracts are
transacted. First, participants trading futures can realise gains and
losses on a daily basis while forwards transaction requires cash
settlement at delivery. Second, futures contracts are standardised
while forwards are customised to meet the special needs of the
two parties involved (counterparties). Third, unlike futures
contracts which are settled through established clearing house,
forwards are settled between the counterparties. Fourth, because
of being exchange-traded, futures are regulated whereas
forwards, which are mostly over-the-counter (OTC) contracts, and
loosely regulated (at least in the run up to the global financial
crisis). This importance of exchange-traded versus OTC
instruments will be discussed further in later section.

3.2 Options contracts

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Options contracts can be either standardised or customised.


There are two types of option: call and put options. Call option
contracts give the purchaser the right to buy a specified quantity
of a commodity or financial asset at a particular price (the
exercise price) on or before a certain future date (the expiration
date). Similarly, put option contracts give the buyer the right to
sell a specified quantity of an asset at a particular price on a
before a certain future date. These definitions are based on the
so-called American-style option. And for a European style option,
the contract can only be exercised on the expiration date. In
options transaction, the purchaser pays the seller the writer of
the options an amount for the right to buy or sell. This amount is
known as the option premium. Note that an important difference
between options contracts and futures and forwards contracts is
that options do not require the purchaser to buy or sell the
underlying asset under all circumstances. In the event that
options are not exercised at expiration, the purchaser simply loses
the premium paid. If the options are exercised, however, the
option writer will be liable for covering the costs of any changes in
the value of the underlying that benefit the purchasers.

3.3 Swaps
Swaps are agreements between two counterparties to exchange a
series of cash payments for a stated period of time. The periodic
payments can be charged on fixed or floating interest rates,
depending on contract terms. The calculation of these payments
is based on an agreed-upon amount, called the notional principal
amount or simply the national.

Money Market

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The money market is a segment of the financial market in which


financial instruments with high liquidity and very short maturities
are traded. The money market is used by participants as a means
for borrowing and lending in the short term, from several days to
just under a year. Money market securities consist of
negotiable certificates of deposit (CDs), banker's acceptances,
U.S. Treasury bills, commercial paper, municipal notes,
eurodollars, federal funds and repurchase agreements
(repos). Money market investments are also called cash
investments because of their short maturities.
The money market is used by a wide array of participants, from a
company raising money by selling commercial paper into the
market to an investor purchasing CDs as a safe place to park
money in the short term. The money market is typically seen as a
safe place to put money due the highly liquid nature of the
securities and short maturities. Because they are extremely
conservative, money market securities offer significantly lower
returns than most other securities. However, there are risks in the
money market that any investor needs to be aware of, including
the risk of default on securities such as commercial paper. (To
learn more, read our Money Market Tutorial.)

Money markets is the collective name given to the various


firms and institutions that deal in the various grades
in near money[3]. The definition implies that the money market
caters to short-term demand and supply of funds. The major
participants of the money market are as follows:
Lenders: Lenders include the regulator RBI, commercial banks and
brokers. These participants facilitate the expansion or contraction
of money in the market

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Borrowers: Borrowers include commercial banks, stock brokers,


other financial institutions, businesses houses and governments
provide financial instruments to other investors depending upon
the money borrowed from lenders
Accordingly, the characteristics of money market include the
following:
Short-term The instruments in the money market have
maturities mostly less than a year and cater to short-term
demand and supply of funds.
Highly liquid The money market is considered highly liquid
wherein securities (financial instruments) are purchased and sold
in large denominations to reduce transaction costs[4] (because
they are a close substitute to cash)[5]. The market distributes and
redistributes cash balances in accordance to the liquidity needs of
the participants
Safe The instruments are considered safe with RBI playing a
pivotal role in monitoring regulating and managing monetary
requirements of all participants.
Lower returns The transactions are on a same-day-basis and the
returns on these investments accordingly, are low.
Institutional investors Retail or individuals investors cannot
directly participate in money markets. The money market mainly
caters to institutional investors who require instant cash for
running their operations in the financial system. However, retail or
individual investors indirectly participate in money markets by
lending money to institutions (large corporations and
government) through bonds to gain high returns.
Monetary policy The money markets are governed and
influenced by changes in the monetary policy. For example,
changes in interest rates announced by RBI play a critical role in
determining liquidity requirements in the overall financial system

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Interrelated sub-markets The money market consists of the


following interrelated markets

TYPES OF MONEY MARKET INTRUMENTS:


1.Treasury Bills
Treasury bills (T-bills) are short-term notes issued by the U.S.
government. They come in three different lengths to maturity: 90,
180, and 360 days. The two shorter types are auctioned on a
weekly basis, while the annual types are auctioned monthly. T-bills
can be purchased directly through the auctions or indirectly
through the secondary market. Purchasers of T-bills at auction can
enter a competitive bid (although this method entails a risk that
the bills may not be made available at the bid price) or a
noncompetitive bid. T-bills for noncompetitive bids are supplied at
the average price of all successful competitive bids.

2. Promissory Note:
The promissory note is the earliest types of bill. It is a written
promise on the part of a businessman today to another a certain
sum of money at an agreed future data. Usually, a promissory
note falls due for payment after 90 days with three days of grace.
A promissory note is drawn by the debtor and has to be accepted
by the bank in which the debtor has his account, to be valid. The
creditor can get it discounted from his bank till the date of
recovery. Promissory notes are rarely used in business these days,
except in the USA.

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3. Bill of Exchange or Commercial Bills:


Another instrument of the money, market is the bill of exchange
which is similar to the promissory note, except in that it is drawn
by the creditor and is accepted by the bank of the debater. The
creditor can discount the bill of exchange either with a broker or a
bank. There is also the foreign bill of exchange which becomes
due for payment from the date of acceptance. The rest of the
procedure is the same as for the internal bill of exchange.
Promissory notes and bills of exchange are known as trade bills.

4.Federal Agency Notes


Some agencies of the federal government issue both short-term
and long-term obligations, including the loan agencies Fannie Mae
and Sallie Mae. These obligations are not generally backed by the
government, so they offer a slightly higher yield than T-bills, but
the risk of default is still very small. Agency securities are actively
traded, but are not quite as marketable as T-bills. Corporations
are major purchasers of this type of money market instrument.

5.Short-Term Tax Exempts


These instruments are short-term notes issued by state and
municipal governments. Although they carry somewhat more risk
than T-bills and tend to be less negotiable, they feature the added
benefit that the interest is not subject to federal income tax. For
this reason, corporations find that the lower yield is worthwhile on
this type of short-term investment.

6.Certificates of Deposit
Certificates of deposit (CDs) are certificates issued by a federally
chartered bank against deposited funds that earn a specified
return for a definite period of time. They are one of several types

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of interest-bearing "time deposits" offered by banks. An individual


or company lends the bank a certain amount of money for a fixed
period of time, and in exchange the bank agrees to repay the
money with specified interest at the end of the time period. The
certificate constitutes the bank's agreement to repay the loan.
The maturity rates on CDs range from 30 days to six months or
longer, and the amount of the face value can vary greatly as well.
There is usually a penalty for early withdrawal of funds, but some
types of CDs can be sold to another investor if the original
purchaser needs access to the money before the maturity date.
Large denomination (jumbo) CDs of $100,000 or more are
generally negotiable and pay higher interest rates than smaller
denominations. However, such certificates are only insured by the
FDIC up to $100,000. There are also eurodollarCDs; they are
negotiable certificates issued against U.S. dollar obligations in a
foreign branch of a domestic bank. Brokerage firms have a
nationwide pool of bank CDs and receive a fee for selling them.
Since brokers deal in large sums, brokered CDs generally pay
higher interest rates and offer greater liquidity than CDs
purchased directly from a bank.

7.Commercial Paper
Commercial paper refers to unsecured short-term promissory
notes issued by financial and nonfinancial corporations.
Commercial paper has maturities of up to 270 days (the
maximum allowed without SEC registration requirement). Dollar
volume for commercial paper exceeds the amount of any money
market instrument other than T-bills. It is typically issued by large,
credit-worthy corporations with unused lines of bank credit and
therefore carries low default risk.
Standard and Poor's and Moody's provide ratings of commercial
paper. The highest ratings are A1 and P1, respectively. A2 and P2
paper is considered high quality, but usually indicates that the

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issuing corporation is smaller or more debt burdened than A1 and


P1 companies. Issuers earning the lowest ratings find few willing
investors.
Unlike some other types of money-market instruments, in which
banks act as intermediaries between buyers and sellers,
commercial paper is issued directly by well-established
companies, as well as by financial institutions. Banks may act as
agents in the transaction, but they assume no principal position
and are in no way obligated with respect to repayment of the
commercial paper. Companies may also sell commercial paper
through dealers who charge a fee and arrange for the transfer of
the funds from the lender to the borrower.

8. Call and Notice Money:


There is the call money market in which funds are borrowed and
lent for one day. In the notice market, they are borrowed and lent
upto 14 days without any collateral security. But deposit receipt is
issued to the lender by the borrower who repays the borrowed
amount with interest on call. In India, commercial banks and
cooperative banks borrow and lend funds in this market but
mutual funds and all-India financial institutions participate only as
lenders of funds.

9. Inter-bank Term Market:


This market is exclusively for commercial and cooperative banks
in India, which borrow and lend funds for a period of over 14 days
and upto 90 days without any collateral security at marketdetermined rates.

10.Bankers' Acceptances:

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A banker's acceptance is an instruments produced by a


nonfinancial corporation but in the name of a bank. It is document
indicating that such-and-such bank shall pay the face amount of
the instrument at some future time. The bank accepts this
instrument, in effect acting as a guarantor. To be sure the bank
does so because it considers the writer to be credit-worthy.
Bankers' acceptances are generally used to finance foreign trade,
although they also arise when companies purchase goods on
credit or need to finance inventory. The maturity of acceptances
ranges from one to six months.

11.Repurchase Agreements:
Repurchase agreementsalso known as repos or buybacksare
Treasury securities that are purchased from a dealer with the
agreement that they will be sold back at a future date for a higher
price. These agreements are the most liquid of all money market
investments, ranging from 24 hours to several months. In fact,
they are very similar to bank deposit accounts, and many
corporations arrange for their banks to transfer excess cash to
such funds automatically.

Cash or Spot Market


Investing in the cash or "spot" market is highly sophisticated,
with opportunities for both big losses and big gains. In the cash
market, goods are sold for cash and are delivered immediately. By
the same token, contracts bought and sold on the spot market are
immediately effective. Prices are settled in cash "on the spot" at
current market prices. This is notably different from other
markets, in which trades are determined at forward prices.
The cash market is complex and delicate, and generally not

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suitable for inexperienced traders. The cash markets tend to be


dominated by so-called institutional market players such as hedge
funds, limited partnerships and corporate investors. The very
nature of the products traded requires access to far-reaching,
detailed information and a high level of macroeconomic analysis
and trading skills.

Derivatives Markets
The derivative is named so for a reason: its value is derived from
its underlying asset or assets. A derivative is a contract, but in
this case the contract price is determined by the market price of
the core asset. If that sounds complicated, it's because it is. The
derivatives market adds yet another layer of complexity and is
therefore not ideal for inexperienced traders looking to speculate.
However, it can be used quite effectively as part of a risk
management program. (To get to know derivatives, read The
Barnyard Basics Of Derivatives.)
Examples of common derivatives
are forwards, futures, options, swaps and contracts-for-difference
(CFDs). Not only are these instruments complex but so too are the
strategies deployed by this market's participants. There are also
many derivatives, structured products and collateralized
obligations available, mainly in theover-the-counter (nonexchange) market, that professional investors, institutions and
hedge fund managers use to varying degrees but that play an
insignificant role in private investing.

Forex and the Interbank Market

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The interbank market is the financial system and trading of


currencies among banks and financial institutions, excluding retail
investors and smaller trading parties. While some interbank
trading is performed by banks on behalf of large customers, most
interbank trading takes place from the banks' own accounts.
The forex market is where currencies are traded. The forex market
is the largest, most liquid market in the world with an average
traded value that exceeds $1.9 trillion per day and includes all of
the currencies in the world. The forex is the largest market in the
world in terms of the total cash value traded, and any person, firm
or country may participate in this market.
There is no central marketplace for currency exchange; trade is
conducted over the counter. The forex market is open 24 hours a
day, five days a week and currencies are traded worldwide among
the major financial centers of London, New York, Tokyo, Zrich,
Frankfurt, Hong Kong, Singapore, Paris and Sydney.
Until recently, forex trading in the currency market had largely
been the domain of large financial institutions,
corporations, central banks, hedge funds and extremely wealthy
individuals. The emergence of the internet has changed all of this,
and now it is possible for average investors to buy and
sell currencies easily with the click of a mouse through online
brokerage accounts. (For further reading, see The Foreign
Exchange Interbank Market.)

'Financial Instrument'

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Financial instruments are assets that can be traded. They can also
be seen as packages of capital that may be traded. Most types of
financial instruments provide an efficient flow and transfer of
capital all throughout the world's investors. These assets can be
cash, a contractual right to deliver or receive cash or another type
of financial instrument, or evidence of one's ownership of an
entity.

BREAKING DOWN 'Financial Instrument'


Financial instruments can be real or virtual documents
representing a legal agreement involving any kind of monetary
value. Equity-based financial instruments represent ownership of
an asset. Debt-based financial instruments represent a loan made
by an investor to the owner of the asset. Foreign
exchange instruments comprise a third, unique type of financial
instrument. Different subcategories of each instrument type exist,
such as preferred share equity and common share equity.
International Accounting Standards defines financial instruments
as "any contract that gives rise to a financial asset of one entity
and a financial liability or equity instrument of another entity."

Shares
Shares are a unit of ownership in an organisation or corporation. It
is a part of the companys capital. Those individuals who are
getting shares from any company, are called Shareholders. When
a company wants to borrow and increase their capital, they issue
their shares in the stock market (exchange) for their investors.
However, companies also require to refund the amount from their
Net Profit. Therefore, shares play a significant role in the lives of
companies and investors / shareholders. Companies can issue two
types of shares, which they offer to investors/shareholders. The
two types of shares are:

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(a) Equity shares


(b) Preference shares

Bonds
Bonds are issued by the banks, organisations and financial
institutions. They issue bonds for getting an amount of money
from public (as a loan) and commit them a refund with an actual
interest and within a maturity period. They issue their bonds for
financing their capital expenses and their various projects or
activities.
This is one of the most frequently used methods for increasing
their capital and profits. When companies offer their bonds to
public, they define a specified interest rate and maturity period in
an applicant form.
Bonds have various types(i.e risk free bonds, high interest bonds,
etc.) and different companies issued various types of bond to
public

Debentures
Debenture is an instrument which is used by the Corporations and
Government for getting a loan from public and it is given under
the companys Stamp Act. Corporations and Government can
secure their debenture on company assets which it issues as long
term loans. In Debentures, companies are required to announce a
fixed return at the time of issuing.
Therefore, holders know that, how much amount they will get in
future by issuer. Debentures have various advantages for holders
and issuers. It implies that holders know that how much amount
they will get in future, therefore they do not worry about their
payment and, in general, debentures are freely transferable by
their holder to others. Therefore, holders have a right to transfer
their shares to anyone before their redemption.

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Fixed Deposit
Fixed Deposit is that kind of bank account, where the amount of
deposit is fixed for a specified period of time. All Commercial
banks are given these opportunities to their customers for
opening a fixed account in their bank. In a Fixed account, the
amount of deposit is fixed, which means we cannot withdraw an
unlimited amount from this account, therefore it is also called a
Fixed Deposit.
If an account holder wants to withdraw a small amount of money
from their account, then he will require closing of the Fixed
deposit account. The main purpose of account holders to open
this account, is to earn interest money from their actual money,
which is given by the banks during a specified period of time.

Foreign exchange market (Forex market)


Forex is one of the most biggest investment markets in the world
and it is a huge platform for investors for their investment. There
are various forms of currencies included for trading on
international level. The investors invest their money on the value
of currencies fluctuation because of variation in the economic
position of countries and entire world economy.
In the Forex market, we are dealing with different currencies of
countries. We are not dealing with only one currency at one time,
we have to deal with a couple of currencies at one time, for
example USD/INR. In the example, the left side currency is called
a Base currency and the right side currency is called a
Quote/Counter currency.
A price of one currency expressed in terms of the currency of
another country is called as the exchange rate. For example, the
ratio of both currencies is 53.9, which implies that one unit of US
Dollar can buy or equals 53.9 Rupees of India. In that case, the US
Dollar is a base currency and the Indian Rupee is quote currency.

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Gold ETF
Gold ETF is one of the most popular funds as it does not get
influenced due to stock fluctuations or inflation. Gold ETF fund is a
fiscal instrument which works as a mutual fund and whose prices
are depending upon the market price of gold. When the market
price of gold increases, gold ETF prices also increase.
The services of Gold ETF fund transfers is available in few stock
exchanges, such as Mumbai, Paris, Zurich and New York. Gold ETF
fund provides a variety of advantages to their holders, such as
Low cost, Tax advantage, Gold purity, there is no need to worry
about safety, Issue of selling gold bars and also beneficial in short
term investments.

Commodity markets (overview)


INTRODUCTION
Commodity markets cover physical assets such as precious
metals, base metals, energy (oil, electricity), food (wheat, cotton,
pork bellies), and weather. Most of the trading is done using
futures (total trading volume around 200 billion dollars for the
year 2002). However, over the last few years, an OTC market has
also been growing (total size estimated to several tens of billion
dollars for the year 2002), as an increasing number of market
participants are trading in exotic options.

DESCRIPTION OF THE VARIOUS MARKETS


Commodity markets cover the following assets:

Energy:

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mainly oil and gas like crude oil, jet fuel, gasoline, fuel oil, heating
oil, natural gas and propane. electricity as well as renewable
forms of energies like solar and wind energy

weather:
weather is obviously not a tradable asset but we include them
here because, over the last years, many derivative products
whose underlying is weather (temperature, wind, precipitation)
have been forth and traded.

Agricultural:
Livestock: live hogs, cattle and pork bellies. Grain: corn, wheat,
soybeans, soyoil, sunflower seed and oil. Forest products group:
lumber and plywood. Textiles: cotton. Foodstuffs: cocoa, coffee,
orange juice, rice, cheddar, and sugar.
Metals Base metals:
aluminium, copper, zinc, nickel, and lead, tin, iron. Precious
metals: gold, silver, platinum, rare metals (palladium, titanium).

SPOT MARKETS
Spot markets are organized exchanges where commodity
products can daily be traded (by large amounts, even). Typical
examples are the CME (Chicago Mercantile Exchange), the MCE
(Mid America Commodity Exchange).

FUTURES MARKETS
At their very early stage, commodity markets futures trading
exchanges, served the purpose of hedging against price
fluctuations in agricultural commodities. Sellers (farmers) and

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buyers would commit themselves to future exchanges of grain for


a certain amount of cash. Nowadays, the rationale for trading
futures is threefold:
Hedging against price fluctuations. Both producers, refiners (in
the case of oil) and consumers would look to it. For example, a
producer, that is a participant who wants to sell the physical
commodity, will hedge by selling futures. On the other hand, a
consumer will try to be long futures, once she decided to buy the
commodity in question.
Speculation: trading futures, as compared to spot assets,
presents many advantages, as futures: are more leveraged than
the spot instruments because of the low margin requirement, are
cheaper in term of transaction costs and finally do not require
storage during the lifetime of the contract.
Arbitrage between spot and futures markets: for commodities,
the cash and carry arbitrage is more difficult to realize because of
storage and delivery costs.

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