Structured Finance and Financial Markets

K.C.
COLLEGE
STRUCTURED FINANCE
DEFINITION
Structured finance is a term that evolved in 1980s to refer to a wide variety

of debt and related securities whose promise to repay is backed by the
value of some form of financial asset or credit support from a third party
transaction. Very often, both types of backing are used to achive a desired
credit rating.
Structured finance is a broad term used to describe a sector of finance that

was created to help transfer risk using complex legal and corporate entities.
This risk transfer as applied to securitization of various financial assets
(e.g. mortgages, credit card receivables, auto loans, etc.) has helped to
open up new sources of financing to consumers. However, it arguably
contributed to the degradation in underwriting standards for these financial
assets, which helped give rise to both the inflationary credit bubble of the
mid-2000s and the credit crash and financial crisis of 2007-2009.
Structured finance encompasses all advanced private and public financial
arrangements that serve to efficiently refinance and hedge any profitable
economic activity beyond the scope of conventional forms of on-balance
sheet securities (debt, bonds, equity) in the effort to lower cost of capital
and to mitigate agency costs of market impediments on liquidity. Most
structured investments combine traditional asset classes with contingent
claims, such as risk transfer derivatives and/or derivative claims on
commodities, currencies or receivables from other reference assets, or
replicate traditional asset classes through synthetication. Structured finance
is invoked by financial and non-financial institutions in both banking and
capital markets if established forms of external finance are either
unavailable (or depleted) for a particular financing need, or traditional
sources of funds are too expensive for issuers to mobilize sufficient fund for
what would otherwise be an unattractive investment based on the issuer‘s
desired cost of capital. Structured finance offers the issuers‘ enormous
flexibility in terms of maturity structure, security design and asset types,
which allows issuers to provide enhanced return at a customized degree of
STRUCTURED FINANCE AND FINANCIAL MARKETS Page 1
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diversification commensurate to an individual investor‘s appetite for risk.

Hence, structured finance contributes to a more complete capital market by
offering any mean-variance trade-off along the efficient frontier of optimal
diversification at lower transaction cost. However, the increasing
complexities of the structured finance market, and the ever growing range
of products being made available to investors, invariably create challenges
in terms of efficient assembly, management and dissemination of
information. Structured finance has become a major segment in the
financial industry since the mid-1980s. Collateralized bond obligations
(CBOs), collateralized debt obligations (CDOs), syndicated loans and
synthetic financial instruments are examples of structured financial
instruments.
The Main Advantages of Using Structured Finance Include

 Lowering Funding Cost
 Changes In Debt And Equity Composition Of Balance sheet
 Taking Companies Public Or Private
 Financing Assets
 Tax Management
 Hedge Fund Speculation
 Sheltering Corporations From Operating Liabilities

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SECURITIZATION
Securitisation is the process of pooling and repackaging of homogenous

illiquid financial assets into marketable securities that can be sold to
investors. Inshort, securitisation is the process of conversion of illiquid
loans into tradable securities. The process leads to the creation of financial
instruments that represent ownership interest in, or are secured by a
segregated income producing asset or pool of assets. The pool of assets
collateralises securities. These assets are generally secured by personal or
real property (e.g. automobiles, real estate, or equipment loans), but in
some cases are unsecured (e.g. credit card debt, consumer loans).
Traditionally, a lender advances a loan to a borrower and gets repayment

of principal, along with interest, over a period of time. In securitisation, the
lender sells his right to receive the future payments from the borrowers to a
third party and receives consideration for the same much earlier than the
maturity of the original loans. These future cash flows from borrowers are
sold to investors in the form of marketable securities.

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SECURITISATION TRANSACTION
The successful execution of a securitisation depends on the investor's

uncontested right to securitised cash flows. Hence, securitised loans need
to be legally separated from the originator of the loans. In order to achieve
this separation, a securitisation is structured as a three-step framework:
 A pool of loans is sold to an intermediary by the originator of the

loans. This intermediary (called a Special Purpose Vehicle, or SPV) is
usually incorporated as a trust. The SPV is an entity formed for the
specific purpose of transferring the securitised loans out of the
originator's balance sheet, and does not carry out any other business.
 The SPV issues securities, backed by the loans, and by the payment
streams associated with these loans. Investors purchase these
securities. The proceeds from the sale of the securities are paid to
the originator as purchase consideration for the loan receivables.

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 The cash flows generated by the loans over a period of time are used
to repay investors. There could also be some credit support built into
the transaction to protect investors against possible losses in the
pool. However, the investors will typically have no recourse to the
originator.
The keyelements of securitization are
 Legal true sale of assets to an SPV

 Issuance of securities by the SPV to the investors collateralized by
the underlying assets
 Reliance by the investors on the performance of the assets for
repayment - rather than the credit of their Originator (the seller) or the
issuer (the SPV)
 Consequent to the above, ―Bankruptcy Remoteness‖ (no right over
the sold out loan in case of Bankruptcy) from the Originator.
 Apart from the above, the following additional characteristics are
generally noticed: Administration of the assets, including continuation
of relationships with obligors support for timely interest and principal
repayments in the form of suitable credit enhancements ancillary
facilities to cover interest rate / forex risks, guarantee, etc.
 Formal rating from one or more rating agencies

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PARTIES INVOLVED IN A SECURITISATION TRANSACTION
The entities involved in a securitisation deal, and their role, are briefly
explained below. It is possible for a single party in any transaction to
perform multiple roles.
Originator
The originator is the original lender and the seller of the receivables. It is
the entity on whose books the assets to be securitised exist. It is the prime
mover of the deal i.e. it sets up the necessary structures to execute the
deal. It sells the assets on its books and receives the funds generated from
such sale. In a true sale, the Originator transfers both the legal and the
beneficial interest in the assets to the SPV.
Seller
The seller pools the assets in order to securitise them. Usually, the
originator and the seller are the same, but, in some cases, originators sell
their loans to other companies that securities them.
Obligors/borrowers
The borrower is the counter party to whom the originator makes the loan.
The amount outstanding from the Obligor is the asset that is transferred to
the SPV. The payments made by borrowers are the source of cash flows
used for making investor payments.
Investors
The investors may be in the form of individuals or institutional investors like
FIs, mutual funds, provident funds, pension funds, insurance companies,
etc. They buy a participating interest in the total pool of receivables and
receive their payment in the form of interest and principal as per agreed
pattern.

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Issuer
The issuer in a securitisation deal is the special purpose vehicle (SPV),
which is typically set up as a trust. The trust issues securities, which
investors subscribe to.
Servicer
The servicer collects the periodic installments due from individual
borrowers in the pool, makes payouts to investors, and follows up on
delinquent accounts. The servicer also furnishes periodic information to the
rating agency and the trustee on pool performance. There is a service fee
payable to the servicer.
Trustee
Trustees are normally reputed Banks, Financial Institutions or independent
trust companies set up for the purpose of settling trusts. Trustees oversee
the performance of the transaction till maturity, and are vested with the
necessary powers to protect investors' interests.
Arrangers
These are Investment banks responsible for structuring the securities to be
issued, and liasoning with other parties such as investors, credit enhancers
and rating agencies to successfully execute the securitization transaction.
Rating agencies
Independent rating agencies analyse the risks associated with a
securitisation transaction and assign a credit rating to the instrument
issued. Since the investors take on the risk of the asset pool rather than the
Originator, an external credit rating plays an important role. The rating
process would assess the strength of the cash flow and the mechanism
designed to ensure full and timely payment by the process of selection of
loans of appropriate credit quality, the extent of credit and liquidity support
provided and the strength of the legal framework.

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ASSET CLASSES UNDER SECURITIZATION
ASSET BACKED SECURITY (ABS)

An asset-backed security is a security whose value and income payments
are derived from and collateralized (or "backed") by a specified pool of
underlying assets. The pool of assets is typically a group of small and
illiquid assets that are unable to be sold individually. Pooling the assets into
financial instruments allows them to be sold to general investors a process
called securitization, and allows the risk of investing in the underlying
assets to be diversified because each security will represent a fraction of
the total value of the diverse pool of underlying assets. The pools of
underlying assets can include common payments from credit cards, auto
loans, and mortgage loans, to esoteric cash flows from aircraft leases,
royalty payments and movie revenues.

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MORTGAGE BACKED SECURITY (MBS)

A mortgage-backed security (MBS) is an asset-backed security or debt
obligation that represents a claim on the cash flows from mortgage
loans through a process known as securitization.Most bonds backed by
mortgages are classified as an MBS. This can be confusing, because a
security derived from an MBS is also called an MBS. To distinguish the
basic MBS bond from other mortgage-backed instruments the
qualifier pass-through is used, in the same way that "vanilla" designates
an option with no special features.
COLLATERALIZED DEBT OBLIGATIONS (CDO)

Collateralized debt obligations are securitized interests in pools of generally
non-mortgage assets. Assets called collateral usually comprise loans or
debt instruments. A CDO may be called acollateralized loan
obligation (CLO) or collateralized bond obligation (CBO) if it holds only
loans or bonds, respectively. Investors bear the credit risk of the collateral.
Multiple tranches of securities are issued by the CDO, offering investors
various maturity and credit risk characteristics. Tranches are categorized
as senior, mezzanine, and subordinated/equity, according to their degree of
credit risk. If there are defaults or the CDO's collateral otherwise
underperforms, scheduled payments to senior tranches take precedence
over those of mezzanine tranches, and scheduled payments to mezzanine
tranches take precedence over those to subordinated/equity tranches.
RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS)

Residential mortgage-backed securities (RMBS) are a type
of bond commonly issued in American security markets. They are a type
of mortgage-backed security which is backed by mortgages on residential
rather than commercial real estate.
COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS)

Commercial mortgage-backed securities (CMBS) are a type of mortgage-
backed security backed by mortgages on commercial rather than
residential real estate. CMBS issues are usually structured as

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multiple tranches, similar to CMOs, rather than typical residential

"passthroughs." The typical structure for the securitization of commercial
real estate loans is a Real Estate Mortgage Investment Conduit (REMIC), a
creation of the tax law that allows the trust to be a pass-through entity
which is not subject to tax at the trust level.
COLLATERALIZED LOAN OBLIGATION (CLO)
Collateralized loan obligations are the same as collateralized mortgage
obligations (CMOs) except for the assets securing the obligation. CLOs
allow banks to reduce regulatory capital requirements by selling large
portions of their commercial loan portfolios to international markets,
reducing the risks associated with lending.
COLLATERALIZED BORROWING OBLIGATIONS (CBO)

Collateralized borrowing obligations (CBOs) are a type of structured asset-
backed security (ABS) whose value and payments are derived from a
portfolio of fixed-income underlying assets. CBOs securities are split into
different risk classes, or tranches, whereby "senior" tranches are
considered the safest securities. Interest and principal payments are made
in order of seniority, so that junior tranches offer higher coupon payments
(and interest rates) or lower prices to compensate for additional default risk.

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ECONOMIC BENEFITS OF SECURITIZATION
FOR ORIGINATOR
Efficient financing
Through securitisation, companies holding financial assets like loans have
ready access to low-cost sources of funds, and can reduce their
dependence on financial intermediaries for their capital requirements. This
translates into lower interest costs, the benefits of which are also passed
on to end consumers. In securitisation, it is possible to achieve a much
higher target rating for instruments than the originator's credit rating, by
providing credit enhancements for the transaction. Thus the borrower can
obtain funding at lower interest rates applicable to highly rated instruments,
and gain a pricing advantage.
Off-balance sheet funding

For accounting purposes, securitisation is treated as a sale of assets, and
not as financing. Therefore the originator does not record the transaction as
a liability on its balance sheet. Such off-balance sheet transactions raise
funds without increasing the originator's leverage or debt-to-equity ratio.
Lower capital requirements

Securitisation enables banks and financial institutions to meet regulatory
capital adequacy norms by transferring assets, and their associated risks,
off the balance sheet. The capital supporting the assets is released and the
proceeds from securitisation can be used for further growth and
investment.
Liquidity management
Tenor mismatch due to long term assets funded by short-term liabilities can
be rectified by securitisation, as long-term assets are converted into cash.
Thus, securitisation is a tool for Asset Liability management.

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Improvement in financial ratios

Since securitisation helps in undertaking larger transaction volumes with
the same capital, profitability and return on investment ratios increase post
securitisation.
Profit on sale
Securitisation helps in up-fronting profits, which would otherwise accrue
over the tenor of the loans. Profits arise from the spread between the
interest rate received on underlying loans and the coupon rate paid on the
securitised instruments backed by those loans. This interest spread is
booked as profit, leading to increased earnings in the year of securitisation.
FOR INVESTORS
Return on investment/Yield
Securitized assets offer a combination of attractive Return on
investments/yields (compared with other instruments of similar quality),
increasing secondary market liquidity, and generally more protection by
way of collateral overages and/or guarantees by entities with high and
stable credit ratings. Yields of ABS/MBS/CDOs are higher than those of
other debt instruments with comparable ratings. Spreads of securitised
instruments are typically in the range of 50 - 100 basis points over
comparable AAA corporate paper.
Flexibility
An important advantage of securitisation is the flexibility to tailor the

instrument to meet the investor's risk and tenor appetite.
 Durations can range from few months to many years.
 Repayments are usually made on a monthly basis but can also be
structured on a quarterly or semiannual basis.

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 Interest rates can be fixed or floating depending on investor

preferences.
Safety Features
Securitisation offers investors a diversification of risk, since the exposure is
to a pool of assets. Most issuances are also highly rated by independent
credit rating agencies, and have credit support built into the transactions.
Investors get the benefit of a payment structure closely monitored by an
independent trustee, which may not always be the case in traditional debt
instruments.
Performance track record

Securitised instruments have demonstrated consistently good performance,
with no downgrades or defaults on any securitised instrument in India till
date.
EFFECTS ON THE NATIONAL ECONOMY
In those countries where a high proportion of residential montages and

other claims have been securitized, the gains to the national economy can
be measured in the billions of dollars.
The effect of securitization on the economies of different countries is still

difficult to assess because the technique is in its infancy in many parts of
the world. Asset securitization, if introduced in a transparent and orderly
fashion, offers Asian countries additional gains from:
 Capital market development, as more high-quality securities are

added to the fixed-income market.

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 A source of funds for rapidly growing, capital-constrained, banks,

finance companies and industrial companies whose expansion
depends on the extension of credit to their customers.
 An expanded source of financing for residential home ownership.
 The potential for financing of infrastructure projects, such as toll
roads, that produce reliable revenue streams capable of being
contractually assigned to a separate legal entity.
 There is a strong argument favoring the growth of asset securitization
in those nations with developing capital markets as well as in the
more mature ones.

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DIFFERENCE BETWEEN SECURITISATION AND TRADITIONAL DEBT

INSTRUMENTS
Securitised instruments have some distinct features, which distinguish

them from traditional debt:
Isolation of pool of assets

In a securitisation, the securitised assets are separated from the original
lender through a sale to a separate legal entity called a Special Purpose
Vehicle (SPV), which acts as an intermediary.
Claim against a pool of assets

Traditional debt instruments represent claims against the company that
issues the debt. Investors rely entirely on the borrower company's credit
quality for repayment of their debt. In securitisation transactions, investor
payouts are made from collections on securitised assets, and the
instruments are thus claims on the assets securitised. Investors do not
typically have recourse to the originator.
Credit enhancement
Credit enhancement is an additional source of funds that can be used if
collections on the assets are insufficient to pay investors their dues in full.
Credit enhancement thus supports the credit quality of the securitised
instrument, and enables it to achieve a higher credit rating than the pool of
assets on its own; in many cases the rating would also be higher than that
of the originator. This is not possible in conventional debt.
Payment Mechanisms
Securitised instruments typically incorporate structural features to ensure
that scheduled payments reach investors in a timely manner.

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Operational & administrative requirements

As the SPV is only a shell entity; the administration of the pool of
securitised loans involves multiple parties performing various functions.
These functions include collection, accounting, loan servicing, legal
compliance etc that need to be performed throughout the life of the
transaction.

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RISKS INVESTORS FACE IN SECURITISATION DEALS
Investors in securitised instruments can take advantage of the benefits that

these instruments offer; however, they also need to be aware of the
inherent risks in these transactions. These risks can be classified into:
Asset pool risks

These arise due to the unpredictable behaviour of underlying borrowers.
However, the payment behaviour of underlying borrowers can be estimated
with a reasonable degree of accuracy based on historical data
Counter party risks

These arise as a securitisation transaction involves multiple parties
throughout the tenure of the instrument. The investor's returns can be
impacted by nonperformance or bankruptcy of any of these counter parties.
Investment risks
Like all other investments, securitised instruments are subject to market
related risks. Investors are protected against these risks by means of
structural features and credit enhancements, which enable the instruments
to achieve high credit ratings.
Credit risk
Investors have a direct exposure to the repayment ability of the underlying
borrowers whose loans have been securitised. If borrowers default on
payments of instalments, or make delayed payments, collections will be
inadequate to service scheduled investor payouts. Thus, timely investor
payments will depend on the credit quality of the pool borrowers.
Risk of prepayments
Investors face the risk that underlying borrowers may prepay all or part of
the principal outstanding on their loans. When prepayments occur, they are

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passed on to the investor (unless the instrument structure provides for a

separate class of PTCs to absorb prepayments). This can affect the
investor in two ways:
 Reinvestment risk: If there are heavy prepayments in the pool, the

average tenure of the instrument reduces, resulting in reinvestment
risk for the investor.
 Prepayment loss: If the investor has paid an additional consideration
to receive 1 excess interest spreads generated by the pool, the
investor's principal outstanding is greater than the pool principal
outstanding. Hence, when a contract is prepaid, this excess interest
spread payable to the investor from that contract is lost.
Property/asset price risk

Assets backing securitised instruments may be prepossessed and sold
post securitisation. The proceeds and loss on sale depends upon market
values of the assets, which fluctuate.
Legal risk
In any securitisation transaction, it is essential that the transfer of
receivables is a ―true sale‖, i.e. the originator should not retain any control
over the receivables or any claim to the receivables that could override the
claim of the PTC holders. Further, the transfer of receivables should not in
any way vitiate the terms of the underlying loan documents. It should also
be ensured that investors have unrestricted access to the cash collateral.
CRISIL conducts its own due diligence to ascertain that the transaction
structure conforms to a true sale. However, in the absence of any judicial
precedent in India on the subject of true sale, CRISIL also bases its
analysis on an independent legal opinion from an external legal counsel,
certifying that:

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 The assignment of receivables is valid in terms of the underlying loan

documents;
 The transfer of receivables to the trust constitutes a true sale,
 That the structure ensures that receivables are bankruptcy remote
from the originator in light of the originator continuing as the servicer;
 The cash collateral is bankruptcy remote from the originator;
 The transaction complies with all applicable laws;
 All transaction documents are valid and enforceable have been
executed in accordance with the relevant stamp duty and registration
laws.
Servicer Risk
The investor faces the risk of bankruptcy and non-performance of the
servicer, since the servicer is critical in ensuring robust collections from
underlying borrowers. The transaction documents give the trustee the
authority to appoint an alternate servicer in case of nonperformance or
downgrade of the existing servicer.
Commingling risk
This risk arises on account of time lag between pool collections and
investor payouts (typically a month), during which the servicer continues to
hold the pool collections. In this interim period, collections from the
securitised loans may mingle with the normal funds of the servicer. In case
of bankruptcy of the servicer, there could be problems in recovery of these
funds and additional costs, which the investor will bear.
Swap Counterparty Risk

In transactions where a swap is required to convert interest rate from fixed
to floating or vice-versa, the rating of the instrument is dependent on the
timely discharge of obligations by the swap counterparty which agrees to
swap the cash flows.

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Interest Rate Risk

If PTCs have a floating rate yield linked to a benchmark market rate, while
the underlying pool of loans contains fixed rate contracts, there is a basis
risk. The risk arises due to the possibility of a fluctuation in interest rates in
the economy. This risk is generally borne by floating rate PTC investors.
Interest rate risk could be mitigated by an interest rate swap or adequately
covered by the credit enhancement.

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GLOBAL STRUCTURED FINANCE

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The United States is the largest, deepest and widest securitization market
in the world Australia has a market size of A $10bn. and is dominated by
residential mortgages and commercial property leases. In Japan,
securitization is largely undeveloped with transactions confined to about
US$4.8bn In Asia, assets worth only US$2bn. has been securitized, half of
which were in Hong Kong. India, Indonesia, and Thailand are the future
markets on horizon with a few deals of low volume having been concluded
in each country. In Latin America, securitization transactions were up from
about US$3.67bn. In 1995 to 10.3bn in 1996. In South Africa, very few
transactions have taken place although the Government has enacted a
special law in 1992.

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INDIAN STRUCTURED FINANCE
Securitization is a relatively new concept in India but is gaining ground

quite rapidly. One of the earliest structured financing deals in India was the
India Infrastructure Developer issue on BOLT structure to institutional
investors. Global Telesystems also used the SPV structure to raise capital
on its telecom future receivables.ICICI and DOT did one of the first deals
for securitizing receivables.
TELCO did a hire-purchase deal, where the future receivables from truck
sales, along with the ownership of assets, were assigned to investors
directly without an SPV. CRISIL rated the first securitization program in

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India in 1991 when Citibank securitized a pool from its auto loan portfolio
and placed the paper with GIC Mutual Fund. While some of the
securitization transactions which took place earlier involved sale of hire
purchase or loan receivables of NBFCs arising out of auto-finance activity,
many manufacturing and service companies are now increasingly looking
towards securitizing their deferred receivables and future flows also.
In FY2005, the market for SF transactions grew by 121%-y-o-y in value
terms. The number of transactions increased only by 41%, pointing to a
significant rise in average deal size. Within the SF domain, the ABS market
showed maximum growth. This was largely due to strong increase in retail
lending by banks and NBFCs. The SF scenario is largely based on ABS,
accounting for 72% of the SF market in 2005, covering a variety of asset
classes like cars, commercial vehicles, construction equipment, two-
wheelers and personal loans.
The three stages of securitization in India
 The early years
 The growth phase
 The new era

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NOTABLE SHIFTS IN INDIAN MARKET
In ABS
 ABS is the dominant type of instrument in the Indian SF market. The
growth of ABS issuances in recent years has been due to a
continued increase in disbursements by key retail asset financiers,
investors‘ familiarity with the underlying asset class, relatively
shorter average tenure of issuances and stability in the performance
of a growing number of past pools.
 FY2005 saw relatively newer asset classes such as loans for
financing used cars, three wheelers and two-wheelers which were
securitized in a significant way.
 The average ABS deal size almost doubled y-o-y to Rs. 2.9billion in
FY2005, mainly due to large pools securitized by leading vehicle
financiers like ICICI Bank and HDFC Bank.

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 There is a growing preference for floating-rate yields, given the

volatile interest rate conditions.
 Time-tranching is increasingly becoming the norm: during FY2005,
64% of ABS issuances involved multiple tranches with different
tenures.
In MBS
 The largest ever MBS transaction in India, a RS. 12billion mortgage-
backed pool of ICICI Bank happened in FY2005.
 MBS has the potential for maximum growth, given the significant
expansion in the underlying housing finance business underway.
However, the long tenure of MBS papers and the lack of secondary
market liquidity still deter investors.
In CDO
 Investment decisions influenced by the rating of the underlying
corporate exposures in a CDO pool (and not purely the rating of the
instrument) have impeded the growth of CDO in India. Corporate loan
securitization has been far lower than that in retail securitization.

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FINANCIAL MARKETS
In economics, a financial market is a mechanism that allows people to buy
and sell (trade) financial securities (such as stocks and bonds),
commodities (such as precious metals or agricultural goods), and other
fungible items of value at low transaction costs and at prices that reflect the
efficient-market hypothesis.
Both general markets (where many commodities are traded) and
specialized markets (where only one commodity is traded) exist. Markets
work by placing many interested buyers and sellers in one "place", thus
making it easier for them to find each other. An economy which relies
primarily on interactions between buyers and sellers to allocate resources
is known as a market economy in contrast either to a command economy
or to a non-market economy such as a gift economy.
Definition
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 National
Stock Exchange (NSE).
Most financial markets have periods of heavy trading and demand for
securities in these periods, prices may rise above historical norms. The
converse is also true downturns may cause prices to fall past levels of
intrinsic value, based on low levels of demand or other macroeconomic
forces like tax rates, national production or employment levels .Information
transparency is important to increase the confidence of participants and
therefore foster an efficient financial marketplace.

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TYPES OF FINANCIAL MARKETS

The financial markets can be divided into different subtypes
 Capital markets which consist of
o Stock markets, which provide financing through the issuance of
shares or common stock, and enable the subsequent trading
thereof.
 Bond markets, which provide financing through the issuance of
bonds, and enable the subsequent trading thereof.
 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and
investment.
 Derivatives markets, which provide instruments for the management
of financial risk.
 Futures markets, which provide standardized forward contracts for
trading products at some future date see also forward market.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign
exchange.

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CAPITAL MARKETS
A market in which individuals and institutions trade financial securities.
Organizations/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. When
referring to a capital market, it is important to note that the term can refer to
a rather broad range of products and services that are associated with
finances and investments. To that end, a capital market will include such
components as the stock market, commodities exchanges, the bond
market, and just about any physical or virtual facility or medium where debt
and equity securities can be bought or sold. s a market for securities with a
very broad reach, the capital market is an ideal environment for the
creation of strategies that can result in raising long-term funds for bond
issues or even mortgages. At the same time, the capital market provides
the medium for short-term fund strategies as well. Essentially, any type of
financial transaction that is meant to result in the buying and selling of
securities and commodities for profit can rightly be considered part of the
capital market.
Institutions are also part of the framework of the capital market. Stock
exchanges are one of the more visible examples of established operations
that give form and function to the capital market. Along with the stock
exchanges, support organizations such as brokerage firms also form part of
the capital market. Over the counter markets are also included in the
working definition for a capital market. By providing the mechanisms that
make trading possible, these outward expressions of the capital market
make it possible to keep the process ethical and more easily governed
according to local laws and customs. Because of the broad structure of the
capital market, investors of all types have the opportunity to participate in
financial strategies that can strengthen the general economy as well create
financial security. Persons who wish to focus on investment opportunities
that are very stable and more or less ensure a modest return can find
plenty of different offerings to choose from. At the same time, investors who
tend to be more adventurous can also find a wide array of investment types
that will allow them to take some additional risk and possibly realize larger
returns on their investments. While the overall structure of the capital
market may be broad, there are a number of checks and balances that help
to keep the market on an even keel, ensuring that the capital market
functions in a manner that is both ethical and legal.

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Capital Markets is divided in to

 Primary Markets
 Secondary Markets
Primary market
A market that issues new securities on an exchange. Companies,
governments and other groups obtain financing through debt or equity
based securities. Primary 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.
Also known as "New issue market" (NIM).
The primary markets are where investors can get first crack at 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. Exchanges have varying levels of requirements which must be
met before a security can be sold.
Once the initial sale is complete, further trading is said to conduct on the
secondary market, which 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.
Secondary Market
A market where investors purchase securities or assets from other
investors, rather than from issuing companies themselves. The national
exchanges - such as the National Stock Exchange and the Bombay Stock
Exchange are secondary markets. In any secondary market trade, the
cash proceeds go to an investor rather than to the underlying
company/entity directly. A newly issued IPO will be considered a primary
market trade when the shares are first purchased by investors directly from
the underwriting investment bank after that any shares traded will be on the
secondary market, between investors themselves. 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.

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BOND MARKET
The bond market also known as the debt, credit, or fixed income market is
a financial market where participants buy and sell debt securities, usually in
the form of bonds. As of 2009, the size of the worldwide bond market total
debt outstanding is an estimated $82.2 trillion, of which the size of the
outstanding U.S. bond market debt was $31.2 trillion according to BIS
Nearly all of the $822 billion average daily trading volume in the U.S. bond
market takes place between broker-dealers and large institutions in a
decentralized, over-the-counter (OTC) market. However, a small number of
bonds, primarily corporate, are listed on exchanges.
References to the "bond market" usually refer to the government bond
market, because of its size, liquidity, lack of credit risk and, therefore,
sensitivity to interest rates. Because of the inverse relationship between
bond valuation and interest rates, the bond market is often used to indicate
changes in interest rates or the shape of the yield curve.
Market structure
Bond markets in most countries remain decentralized and lack common
exchanges like stock, future and commodity markets. This has occurred, in
part, because no two bond issues are exactly alike, and the variety of bond
securities outstanding greatly exceeds that of stocks.
However, the New York Stock Exchange (NYSE) is the largest centralized
bond market, representing mostly corporate bonds. The NYSE migrated
from the Automated Bond System (ABS) to the NYSE Bonds trading
system in April 2007 and expects the number of traded issues to increase
from 1000 to 6000.
Besides other causes, the decentralized market structure of the corporate
and municipal bond markets, as distinguished from the stock market
structure, results in higher transaction costs and less liquidity. A study
performed by Profs Harris and Piwowar in 2004, Secondary Trading Costs
in the Municipal Bond Market, reached the following conclusions
"Municipal bond trades are also substantially more expensive than similar
sized equity trades. We attribute these results to the lack of price
transparency in the bond markets. Additional cross-sectional analyses
show that bond trading costs decrease with credit quality and increase with
instrument complexity, time to maturity, and time since issuance."Our
results show that municipal bond trades are significantly more expensive
than equivalent sized equity trades. Effective spreads in municipal bonds
average about two percent of price for retail size trades of 20,000 dollars
and about one percent for institutional trade size trades of 200,000 dollars."

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Types of bond markets

The Securities Industry and Financial Markets Association (SIFMA) classify
the broader bond market into five specific bond markets.
 Corporate
 Government & agency
 Municipal
 Mortgage backed, asset backed, and collateralized debt obligation
 Funding
BOND MARKET PARTICIPANTS

Bond market participants are similar to participants in most financial
markets and are essentially either buyers (debt issuer) of funds or sellers
(institution) of funds and often both.
Participants include
 Institutional investors
 Governments
 Traders
 Individuals
Because of the specificity of individual bond issues, and the lack of liquidity
in many smaller issues, the majority of outstanding bonds are held by
institutions like pension funds, banks and mutual funds. In the United
States, approximately 10% of the market is currently held by private
individuals.
Bond indices
A number of bond indices exist for the purposes of managing portfolios and
measuring performance, similar to the S&P 500 or Russell Indexes for
stocks. The most common American benchmarks are the Barclays
Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices
are parts of families of broader indices that can be used to measure global
bond portfolios, or may be further subdivided by maturity and/or sector for
managing specialized portfolios.

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COMMODITY MARKET
Commodity markets are markets where raw or primary products are
exchanged. These raw commodities are traded on regulated commodities
exchanges, in which they are bought and sold in standardized contracts.
Commodity Market in India

India has a long history of future trading in commodities. In India, trading
inCommodity future has been existence from the 19th Century with
organized tradingin Cotton, through the establishment at Bombay Cotton
Association Ltd. in 1875.Over a period of time other commodities were
permitted to be traded in futureexchanges. Spot trading in India occurs
mostly in regional mandis and unorganized market, which are fragmented
and isolated. There were booming activities in these market at one time as
many as 100 unorganised exchanges were conducting forward trade in
various commodities.The securities market was a poor competitor of this
market as there were not manypapers to be traded at that time. However,
many feared that derivatives fuelled unnecessary speculation and were
detrimental to the healthy functioning of the market for the underlying
commodities. As a result, after independence, commodity option trading
and cash settlement of commodity future were banned in 1952. A further
blow come in 1960‘s when following several years of several droughts has
forced many farmers to default on forward contact and even caused some
suicides, forward trading was banned in many commodities considered
primary or essential. Consequently, the commodities derivatives market
dismantled and remained dormant for about four decades until the new
millennium when the Govt. in a complete change in policy, started actively
encouraging the commodity derivatives market. The year 2003 marked the
real turning point in the policy frame work for commodity market when the
government issued notifications for withdrawing all prohibitions and
opening up forward trading in all commodities. This period also witnessed
other reforms, such as, amendments to the Essential Commodities Act,
Securitas (contract) Rules, which have reduced bottlenecks in the
development and growth of commodity markets of the country is total GDP,
commodities related and dependent industries constitute about roughly 50-
60% which itself cannot be ignored.
Modern Commodity Exchange-

To make up the loss of growth and development during the four decades
ofrestrictive Govt. policies, FMC and the government encouraged setting
upcommodity exchanges using the most modern system and practices in
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the world.Some of the main regulatory measures imposed in the FMC

include daily market tomarket system of margins, creation of trade
guarantee fund, back office computerization for the existing single
commodity exchanges , online trading for thenew exchanges,
demutualization for the new exchanges and one thirdrepresentation of
independent Directions the Board of existing Exchanges etc.
National Level Commodity Exchanges in India are
 NMCE National Multi Commodity Exchange of India.
 NCDEX National Commodity Derivatives Exchange Ltd.
 MCX Multi Commodity Exchange of India Ltd.
 ICEX Indian Commodity Exchange Ltd.
Regulator of Commodity exchanges

FMCL forward Market commission headquarted in Mumbai, is
regulationauthority which is overseen by the minister of consumer affairs,
food and publicdistribution Govt. of India, It is station body set up in 1953
under the forwardcontract (Regulation) Act 1952.
Key Factors for success of commodities market

The following are source of the key factors for the success of the
commodities market
 How are can make the business grow?
 How many products are covered?
 How many people participate in the Platform?
Key Factors for success of commodity exchanges

Strategy, method of execution, background of promoters, credibility of
theinstitution, transparency of platforms, scale able technology, robustness
ofsettlement structure wider participation of Hedgers speculators and
arbitragers,acceptable clearing mechanism, financial soundness and
capability, covering awide range of commodity, reach of the organization
and adding value on theground.In addition to his, if the Indian Commodity
exchanges needs to be competitive inthe Global Market, then it should be
backed with proper ―capital accountconvertibility‖.

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MONEY MARKET
Money market means market where money or its equivalent can be traded.
Money is synonym of liquidity. Money market consists of financial
institutions and dealers in money or credit who wish to generate liquidity. It
is better known as a place where large institutions and government
manage their short term cash needs. For generation of liquidity, short term
borrowing and lending is done by these financial institutions and dealers.
Money Market is part of financial market where instruments with high
liquidity and very short term maturities are traded. Due to highly liquid
nature of securities and their short term maturities, money market is treated
as a safe place. Hence, money market is a market where short term
obligations such as treasury bills, commercial papers and banker‘s
acceptances are bought and sold.
Benefits and functions of Money Market

Money markets exist to facilitate efficient transfer of short-term funds
between holders and borrowers of cash assets. For the lender/investor, it
provides a good return on their funds. For the borrower, it enables rapid
and relatively inexpensive acquisition of cash to cover short-term liabilities.
One of the primary functions of money market is to provide focal point for
RBI‘s intervention for influencing liquidity and general levels of interest
rates in the economy. RBI being the main constituent in the money market
aims at ensuring that liquidity and short term interest rates are consistent
with the monetary policy objectives.
Money Market Instruments

Investment in money market is done through money marketInstruments.
Money market instrument meets short term requirements of the borrowers
and provides liquidity to the lenders. Common Money Market Instruments
are as follows
Treasury Bills
Treasury Bills, one of the safest money market instruments, are short term
borrowing instruments of the Central Government of the Country issued
through the Central Bank (RBI in India). They are zero risk instruments,
and hence the returns are not so attractive. It is available both in primary
market as well as secondary market. It is a promise to pay a said sum after
a specified period. T-bills are short-term securities that mature in one year
or less from their issue date. They are issued with three-month, six-month
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and one-year maturity periods. The Central Government issues T- Bills at a

price less than their face value (par value). They are issued with a promise
to pay full face value on maturity. So, when the T-Bills mature, the
government pays the holder its face value.
Commercial Papers
Commercial paper is a low-cost alternative to bank loans. It is a short term
unsecured promissory note issued by corporates and financial institutions
at a discounted value on face value. They are usually issued with fixed
maturity between one to 270 days and for financing of accounts
receivables, inventories and meeting short term liabilities.They yield higher
returns as compared to T-Bills as they are less secure in comparison to
these bills however chances of default are almost negligible but are not
zero risk instruments.
Certificate of Deposit
It is a short term borrowing more like a bank term deposit account. It is a
promissory note issued by a bank in form of a certificate entitling the bearer
to receive interest. The certificate bears the maturity date, the fixed rate of
interest and the value. It can be issued in any denomination. They are
stamped and transferred by endorsement. Its term generally ranges from
three months to five years and restricts the holders to withdraw funds on
demand. However, on payment of certain penalty the money can be
withdrawn on demand also. The returns on certificate of deposits are higher
than T-Bills because it assumes higher level of risk.
Bankers Acceptance
It is a short term credit investment created by a non financial firm and
guaranteed by a bank to make payment. It is simply a bill of exchange
drawn by a person and accepted by a bank. It is a buyer‘s promise to pay
to the seller a certain specified amount at certain date. The same is
guaranteed by the banker of the buyer in exchange for a claim on the
goods as collateral. The person drawing the bill must have a good credit
rating otherwise the Banker‘s Acceptance will not be tradable. The most
common term for these instruments is 90 days. However, they can very
from 30 days to180 days.
An individual player cannot invest in majority of the Money Market

Instruments, hence for retail market, money market instruments are
repackaged into Money Market Funds.
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It is like a mutual fund, except the fact mutual funds cater to capital market
and money market funds cater to money market. Money Market funds can
be categorized as taxable funds or non taxable funds.

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DERIVATIVES MARKETS
A derivative security is a financial contract whose value is derived from the
value of something else, such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of prices. Derivatives may
be traded for a variety of reasons. A derivative enables a trader to hedge
some preexisting risk by taking positions in derivatives markets that offset
potential losses in the underlying or spot market. In India, most derivatives
users describe themselves as hedgers and Indian laws generally require
that derivatives be used for hedging purposes only. Another motive for
derivatives trading is speculation (i.e. taking positions to profit from
anticipated price movements). In practice, it may be difficult to distinguish
whether a particular trade was for hedging or speculation, and active
markets require the participation of both hedgers and speculators.
Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India. The
committee submitted its report on March 17, 1998 prescribing necessary
pre–conditions for introduction of derivatives trading in India. The
committee recommended that derivatives should be declared as ‗securities‘
so that regulatory framework applicable to trading of ‗securities‘ could also
govern trading of securities. SEBI also set up a group in June 1998 under
the Chairmanship of Prof.J.R.Varma, to recommend measures for risk
containment in derivatives market in India. The report, which was submitted
in October 1998, worked out the operational details of margining system,
methodology for charging initial margins, broker net worth, deposit
requirement and real–time monitoring requirements. The Securities
Contract Regulation Act (SCRA) was amended in December 1999 to
include derivatives within the ambit of ‗securities‘ and the regulatory
framework was developed for governing derivatives trading. The act also
made it clear that derivatives shall be legal and valid only if such contracts
are traded on a recognized stock exchange, thus precluding OTC
derivatives. Derivatives trading commenced in India in June 2000 after
SEBI granted the final approval to this effect in May 2001. SEBI permitted
the derivative segments of two stock exchanges, NSE and BSE, and their
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clearing house/corporation to commence trading and settlement in

approved derivatives contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty and BSE–30(Sensex)
index.The trading in BSE Sensex options commenced on June 4, 2001 and
the trading in options on individual securities commenced in July 2001.
Futures contracts on individual stocks were launched in November 2001.
The derivatives trading on NSE commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on
June 4, 2001 and trading in options on individual securities commenced on
July 2, 2001. Single stock futures were launched on November 9, 2001.
The index futures and options contract on NSE are based on S&P CNX.
Types of Derivatives
 Forwards
A forward contract is a customized contract between two entities,
where settlement takes place on a specific date in the future at
today‘s pre-agreed price.
 Futures
A futures contract is an agreement between two parties to buy or sell
an asset at a certain time in the future at a certain price. Futures
contracts are special types of forward contracts in the sense that the
former are standardized exchange-traded contracts
 Options
Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the
underlyingasset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given
date.
 Warrants
Options generally have lives of upto one year, the majority of options
traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally
traded over-the-counter.
 Leaps

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The acronym LEAPS means Long-Term Equity Anticipation

Securities. These are options having a maturity of upto three years.
 Baskets
Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average or a basket of assets.
Equity index options are a form of basket options.
 Swaps
Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts. The two commonly used
swaps are
o Interest rate swaps
These entail swapping only the interest related cash flows
between the parties in the same currency.
o Currency swaps
These entail swapping both principal and interest between
theparties, with the cashflows in one direction being in a
different currency than those in the opposite direction.
o Swaptions
Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options.Rather than have calls
and puts, the swaptions market has receiver swaptions and
payer swaptions. A receiver swaption is an option to receive
fixed and pay floating. A payer swaption is an option to pay
fixed and receive floating.

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FORWARDS
A forward contract or simply a forward is a contract between two parties to
buy or sell an asset at a certain future date for a certain price that is pre-
decided on the date of the contract. The future date is referred to as expiry
date and the pre-decided price is referred to as Forward Price. It may be
noted that Forwards are private contracts and their terms are determined
by the parties involved. A forward is thus an agreement between two
parties in which one party, the buyer, enters into an agreement with the
other party, the seller that he would buy from the seller an underlying asset
on the expiry date at the forward price. Therefore, it is a commitment by
both the parties to engage in a transaction at a later date with the price set
in advance. This is different from a spot market contract, which involves
immediate payment and immediate transfer of asset. The party that agrees
to buy the asset on a future date is referred to as a long investor and is said
to have a long position. Similarly the party that agrees to sell the asset in a
future date is referred to as a short investor and is said to have a short
position. The price agreed upon is called the delivery price or the Forward
Price. Forward contracts are traded only in Over the Counter (OTC) market
and not in stock exchanges. OTC market is a private market where
individuals/institutions can trade through negotiations on a one to one
basis.
Settlement of forward contracts

When a forward contract expires, there are two alternate arrangements
possible to settle the obligation of the parties physical settlement and cash
settlement. Both types of settlements happen on the expiry date and a re
given below.
Physical Settlement
A forward contract can be settled by the physical delivery of the underlying
asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer)
and the payment of the agreed forward price by the buyer to the seller on
the agreed settlement date.
Cash Settlement
Cash settlement does not involve actual delivery or receipt of the security.
Each party either pays (receives) cash equal to the net loss (profit) arising
out of their respective position in the contract.

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Default risk in forward contracts

A drawback of forward contracts is that they are subject to default risk.
Regardless of whether the contract is for physical or cash settlement, there
exists a potential for one party to default, i.e. not honor the contract. It could
be either the buyer or the seller. This results in the other party suffering a
loss. This risk of making losses due to any of the two parties defaulting is
known as counter party risk. The main reason behind such risk is the
absence of any mediator between the parties, who could have undertaken
the task of ensuring that both the parties fulfill their obligations arising out of
the contract. Default risk is also referred to as counter party risk or credit
risk.

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FUTURES
Like a forward contract, a futures contract is an agreement between two
parties in which the buyer agrees to buy an underlying asset from the
seller, at a future date at a price that is agreed upon today. However, unlike
a forward contract, a futures contract is not a private transaction but gets
traded on a recognized stock exchange. In addition, a futures contract is
standardized by the exchange. All the terms, other than the price, are set
by the stock exchange rather than by individual parties as in the case of a
forward contract. Also, both buyer and seller of the futures contracts are
protected against the counter party risk by an entity called the Clearing
Corporation. The Clearing Corporation provides this guarantee to ensure
that the buyer or the seller of a futures contract does not suffer as a result
of the counter party defaulting on its obligation. In case one of the parties
defaults, the Clearing Corporation steps in to fulfill the obligation of this
party, so that the other party does not suffer due to non-fulfillment of the
contract. To be able to guarantee the fulfillment of the obligations under the
contract, the Clearing Corporation holds an amount as a security from both
the parties. This amount is called the Margin money and can be in the form
of cash or other financial assets. Also, since the futures contracts are
traded on the stock exchanges, the parties have the flexibility of closing out
the contract prior to the maturity by squaring off the transactions in the
market.

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The basic flow of a transaction between three parties, namely Buyer, Seller
and Clearing Corporation is depicted in the diagram below
Difference between forwards and futures
Forwards Futures
Privately negotiated contracts. Traded on an exchange.
Not standardized contracts. Standardized contracts.
Settlement dates can be set by Fixed settlement dates as

the parties. declared by the Exchange.
High counter party risk Almost no counter party risk.

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OPTIONS
An option is a derivative contract between a buyer and a seller, where one
party (say First Party) gives to the other (say Second Party) the right, but
not the obligation, to buy from (or sell to) the First Party the underlying
asset on or before a specific day at an agreed-upon price. In return for
granting the option, the party granting the option collects a payment from
the other party. This payment collected is called the ―premium‖ or price of
the option. The right to buy or sell is held by the ―option buyer‖ (also called
the option holder) the party granting the right is t he ―option seller‖ or
―option writer‖. Unlike forwards and futures contracts, options require a
cash payment (called the premium) upfront from the option buyer to the
option seller. This payment is called option premium or option price.
Options can be traded either on the stock exchange or in over the counter
(OTC) markets. Options traded on the exchanges are backed by the
Clearing Corporation thereby minimizing the risk arising due to default by
the counter parties involved. Options traded in the OTC market however
are not backed by the Clearing Corporation.
There are two types of options

 Call options
 Put options
Call option
A call option is an option granting the right to the buyer of the option to buy
the underlying asset on a specific day at an agreed upon price, but not the
obligation to do so. It is the seller who grants this right to the buyer of the
option. It may be noted that the person who has the right to buy the
underlying asset is known as the ―buyer of the call option‖. The price at
which the buyer has the right to buy the asset is agreed upon at the time of
entering the contract. This price is known as the strike price of the contract
(call option strike price in this case). Since the buyer of the call option has
the right (but no obligation) to buy the underlying asset, he will exercise his
right to buy the underlying asset if and only if the price of the underlying
asset in the market is more than the strike price on or before the expiry
date of the contract. The buyer of the call option does not have an
obligation to buy if he does not want to.

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Put option
A put option is a contract granting the right to the buyer of the option to sell
the underlying asset on or before a specific day at an agreed upon price,
but not the obligation to do so. It is the seller who grants this right to the
buyer of the option. The person who has the right to sell the underlying
asset is known as the ―buyer of the put option‖. The price at which the
buyerhas the right to sell the asset is agreed upon at the time of entering
the contract. This price is known as the strike price of the contract (put
option strike price in this case). Since the buyer of the put option has the
right (but not the obligation) to sell the underlying asset, he will exercise his
right to sell the underlying asset if and only if the price of the underlying
asset in the market is less than the strike price on or before the expiry date
of the contract. The buyer of the put option does not have the obligation to
sell if he does not want to.

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Differences between futures and options
Futures Options
Both the buyer and the seller are The buyer of the option has the
under an obligation to fulfill the right and not an obligation
Contract. whereas the seller is under
obligation to fulfill the contract if
and when the buyer Exercises
his right.
The buyer and the seller are The seller is subjected to
Subject to unlimited risk of loss. unlimited risk of losing whereas
the buyer has limited potential to
lose(This is the option premium).
The buyer and the seller have The buyer has potential to make
potential to make unlimited gain unlimited gain while the seller
or has a potential to make unlimited
Loss. Gain. On the other hand the
buyer has a limited loss potential
and the seller has an unlimited
loss potential.

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COMMODITY DERIVATIVES MARKET

Why is Commodity Derivatives Required?
India is among the top-5 producers of most of the commodities, in addition
to being a major consumer of bullion and energy products. Agriculture
contributes about 22% to the GDP of the Indian economy. It employees
around 57% of the labor force on a total of 163 million hectares of land.
Agriculture sector is an important factor in achieving a GDP growth of 8-
10%. All this indicates that India can be promoted as a major center for
trading of commodity derivatives. It is unfortunate that the policies of FMC
during the most of 1950s to 1980s suppressed the very markets it was
supposed to encourage and nurture to grow with times. However, it is not in
India alone that derivatives were suspected of creating too much
speculation that would be to the detriment of the healthy growth of the
markets and the farmers. Such suspicions might normally arise due to a
misunderstanding of the characteristics and role of derivative product. It is
common knowledge that prices of commodities, metals, shares and
currencies fluctuate over time. The possibility of adverse price changes in
future creates risk for businesses. Derivatives are used to reduce or
eliminate price risk arising from unforeseen price changes. A derivative is a
financial contract whose price depends on, or is derived from, the price of
another asset.
Two important derivatives are futures and options.
 Commodity Futures Contracts
A futures contract is an agreement for buying or selling a commodity
for a predetermined delivery price at a specific future time. Futures
are standardized contracts that are traded on organized futures
exchanges that ensureperformance of the contracts and thus remove
the default risk. The commodity futureshave existed since the
Chicago Board of Trade (CBOT, www.cbot.com) was establishedin
1848 to bring farmers and merchants together. The major function of
futures markets is to transfer price risk from hedgers to speculators.
For example, suppose a farmer isexpecting his crop of wheat to be
ready in two months time, but is worried that the priceof wheat may
decline in this period. In order to minimize his risk, he can enter into
afutures contract to sell his crop in two months‘ time at a price
determined now. This wayhe is able to hedge his risk arising from a
possible adverse change in the price of hiscommodity.
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 Commodity Options contracts Like futures, options are also

financial instruments used for hedging and speculation. The
commodity option holder has the right, but not the obligation, to buy
(or sell) a specific quantity of a commodity at a specified price on or
before a specified date. Option contracts involve two parties – the
seller of the option writes the option in favour of the buyer (holder)
who pays a certain premium to the seller as a price for the option.
There are two types of commodity options a ‗call‘ option gives the
holder a right to buy a commodity at an agreed price, while a ‗put‘
option gives the holder a right to sell a commodity at an agreed price
on or before a specified date (called expiry date).The option holder
will exercise the option only if it is beneficial to him otherwise he will
let the option lapse.
For example, suppose a farmer buys a put option to sell 100 Quintals
of wheat at a price of $25 per quintal and pays a ‗premium‘ of $0.5
per quintal (or a total of $50). If the price of wheat declines to say $20
before expiry, the farmer will exercise his option and sell his wheat at
the agreed price of $25 per quintal. However, if the market price of
wheat increases to say $30 per quintal, it would be advantageous for
the farmer to sell it directly in the open market at the spot price, rather
than exercise his option to sell at $25 per quintal.

K.C. COLLEGE
INSURANCE MARKET
INSURANCE
A system to protect persons, groups, or businesses against the risks of
financial loss by transferring the risks to a large group who agree to share
the financial losses in exchange for premium payments.The Indian
insurance market in spite of having a history covering almost two centuries
took a turn after the establishment of the Life insurance corporation in India
in 1956. From being an open competitive market to being nationalized and
then back to a liberalized market again, the insurance sector has witnessed
all aspects of contest. The Indian insurance market conventionally focused
around life insurance until recently, a various range of other insurance
policies covering sectors like medical, automobile, health and other classes
falling under general insurance came up, generally provided by the private
companies. The life insurance of India added 4.1% to the GDP of the
economy in 2009, an immense growth since 1999, when the gates were
opened for the private company in the market.
The Insurance Regulatory Development Act, 1999 (IRDA Act) allowed the
entry of private companies in the insurance sector, which was so far the
sole prerogative of the public sector insurance companies. The act was
passed to protect the concerns of holders of insurance policy and also to
govern and check the growth of the insurance sector.
This new act allowed the private insurance companies to function in
India under the following circumstances
 The company should be established and registered under the 1956
company Act
 The company should only the serve the purpose of life or general
insurance or reinsurance business.
 The minimum paid up equity capital for serving the purpose of
reinsurance business has been decreed at Rs 200 crores.
 The minimum paid up equity capital for serving the purpose of
reinsurance business has been decreed at Rs 100 crores.
 The average holdings of equity shares by a foreign company or its
subsidiaries or nominees should not go above 26% paid up equity
capital of the Indian Insurance company.

K.C. COLLEGE
Future of Indian Insurance Market

As per the report of 'Booming Insurance Market in India' (2008-2011),
concentration of insurance markets in many developed countries of the
world has made the Indian insurance market more magnetic in terms of
international insurance players. Furthermore, the report says
 Total life insurance premium in India is projected to grow Rs
1,230,000 Crore by 2010-11.
 Total non-life insurance premium is expected to increase at a CAGR
of 25% for the period spanning from 2008-09 to 2010-11.
 Home insurance segment is set to achieve a 100% growth as
financial institutions have made home insurance obligatory for
housing loan approvals.
 Health insurance is poised to become the second largest business for
non-life insurers after motor insurance in next three years.
 A booming life insurance market has propelled the Indian life
insurance agents into the ‗top 10 country list‘ in terms of membership
to the Million Dollar Round Table (MDRT) — an exclusive club for the
highest performing life insurance agents.
 With the entry of several low-cost airlines, along with fleet expansion
by existing ones and increasing corporate aircraft ownership, the
Indian aviation insurance market is all set to boom in a big way in
coming years.
INSURANCE COMPANIES IN INDIA

Registration has been granted to 12 private life insurance companies and 9
general insurance companies so far by the IRDA. Considering the existing
public sector companies in the Indian insurance market there are 13
companies functioning in both life and general insurance business
respectively.
Some of the major insurance companies in public sector are

 Life Insurance Corporation (LIC) of India
 National Insurance Company Limited
 Oriental Insurance Limited

K.C. COLLEGE
Some of the major insurance companies in Private sector are

 Tata AIG Life
 HDFC Standard
 Bajaj Allianz
 ICICI Prudential
 SBI Life

K.C. COLLEGE
FOREIGN EXCHANGE MARKET
Foreign Exchange Markets in India
Foreign exchange market in India started in earnest less than three

decades ago when in 1978 the government allowed banks to trade foreign
exchange with one another. Today over 70% of the trading in foreign
exchange continues to take place in the inter-bank market. The market
consists of over 90 Authorized Dealers (mostly banks) who transact
currency among themselves and come out ―square‖ or without exposure at
the end of the trading day. Trading is regulated by the Foreign Exchange
Dealers Association of India (FEDAI), a self regulatory association of
dealers. Since 2001, clearing and settlement functions in the foreign
exchange market are largely carried out by the Clearing Corporation of
India Limited (CCIL) that handles transactions of approximately 3.5 billion
US dollars a day, about 80% of the total transactions. The liberalization
process has significantly boosted the foreign exchange market in the
country by allowing both banks and corporations greater flexibility in
holding and trading foreign currencies. The Sodhani Committee set up in
1994 recommended greater freedom to participating banks, allowing them
to fix their own trading limits, interest rates on FCNR deposits and the use
of derivative products.
The growth of the foreign exchange market in the last few years has been
nothing less than momentous. In the last 5 years, from 2000-01 to 2005-06,
trading volume in the foreign exchange market (including swaps, forwards
and forward cancellations) has more than tripled, growing at a compounded
annual rate exceeding 25%

K.C. COLLEGE
The Chart above shows the growth of foreign exchange trading in India
between 1999 and 2006. The inter-bank forex trading volume has
continued to account for the dominant share (over 77%) of total trading
over this period, though there is an unmistakable downward trend in that
proportion. (Part of this dominance, though, result s from double-counting
since purchase and sales is added separately, and a single inter-bank
transaction leads to a purchase as well as a sales entry.) This is in keeping
with global patterns. In March 2006, about half (48%) of the transactions
were spot trades, while swap transactions (essentially repurchase
agreements with a one-way transaction – spot or forward – combined with
a longer- horizon forward transaction in the reverse direction) accounted for
34% and forwards and forward cancellations made up 11% and 7%
respectively. About two-thirds of all transactions had the rupee on one side.
In 2004, according to the triennial central bank survey of foreign exchange
and derivative markets conducted by the Bank for International Settlements
(BIS (2005a) the Indian Rupee featured in the 20th position among all
currencies in terms of being on one side of all foreign transactions around
the globe and its share had tripled since 1998. As a host of foreign
exchange trading activity, India ranked 23rd among all countries covered
by the BIS survey in 2004 accounting for 0.3% of the world turnover.
Trading is relatively moderately concentrated in India with 11 banks
accounting for over 75% of the trades covered by the BIS 2004 survey.

K.C. COLLEGE
Foreign exchange reserves

India‘s foreign exchange reserves are maintained at the level USD 280
billion in April 2010-11. It is interesting to note that, from USD 250 billion in
April 2009 the reserves swelled gradually adding almost USD 28 billion in a
year‘s time.
Currency Futures
India's financial market has been increasingly integrating with rest of the
world through increased trade and finance activity, as noted above, giving
rise to a need to permit further hedging instruments, other that OTC
products, to manage exchange risk like currency futures. With electronic
trading and efficient risk management systems, exchange traded currency
futures were expected to benefit the universe of participants including
corporates and individual investors. The RBI Committee on Fuller Capital
Account Convertibility recommended that currency futures may be
introduced subject to risks being contained through proper trading
mechanism, structure of contracts and regulatory environment.
Accordingly, Reserve Bank of India in the Annual Policy Statement for the
Year 2007-08 proposed to set up a Working Group on Currency Futures to
study the international experience and suggest a suitable framework to
operationalise the proposal, in line with the current legal and regulatory
framework. RBI and Securities and Exchange Board of India (SEBI) jointly
constituted a Standing Technical Committee to inter-alia evolve norms and
oversee implementation of Exchange Traded Currency Derivatives.
Standardized currency futures have the following features
 Only USD-INR contracts are allowed to be traded.
 The size of each contract shall be USD 1000.

K.C. COLLEGE
 The contracts shall be quoted and settled in Indian Rupees.

 The maturity of the contracts shall not exceed 12 months.
 The settlement price shall be the Reserve Bank's Reference Rate on
the last tradingday.
Road Ahead for currency futures markets in India

Market statistics of the first seven months of the launch of exchange traded
currency futures reveal growing interest in the markets. However, these
markets have not been able to evince the kind of activity that OTC markets
are witnessing. Many corporates using currency derivatives for hedging
their foreign currency exposure find requirement of margin and settlement
of daily mark to market differences cumbersome especially since there is
no such requirement for OTC trades. It would perhaps take some time for
them to realize the concomitant benefits of these risk containment
measures. There is a perceive resistance to change or switch over from
OTC to Exchange traded framework with the grip and comfortability level in
the OTC markets. Further, presently the markets are restricted in a number
of ways. In conclusion, considering the nascent stage of development of
these markets in the country, the cautious approach of the regulators is
understandable. One hopes to see further developments in exchange
traded currency markets over time. There is no doubting that this is a
market which will eventually establish its niche and would be an area of
activity to watch and gain from for all market participants in the near future.

K.C. COLLEGE
BIBLIOGRAPHY
WEBLIOGRAPHY / RESEARCH REPORTS
http//business.mapsofindia.com/india-insurance/market.html
http//www.researchandmarkets.com/reports/616565
http//www.indiainbusiness.nic.in/indian-economy.pdf
http//www.nse-india.com/content/press/NS_apr2009.pdf
http//www.iief.com/Research/CHAP10.PDF
http//www.vinodkothari.com
BOOKS
INTRODUCTION TO STRUCTURED FINANCE - FRANK J.
STRUCTURED FINANCE - STEFANO CASELLI

Structured Finance and Financial Markets

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K.C.

Structured finance is a term that evolved in 1980s to refer to a wide variety

Structured finance is a broad term used to describe a sector of finance that

diversification commensurate to an individual investor‘s appetite for risk.

The Main Advantages of Using Structured Finance Include

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 2

Securitisation is the process of pooling and repackaging of homogenous

Traditionally, a lender advances a loan to a borrower and gets repayment

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 3

The successful execution of a securitisation depends on the investor's

 A pool of loans is sold to an intermediary by the originator of the

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 4

The keyelements of securitization are

 Legal true sale of assets to an SPV

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 5

PARTIES INVOLVED IN A SECURITISATION TRANSACTION

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 6

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 7

ASSET CLASSES UNDER SECURITIZATION

ASSET BACKED SECURITY (ABS)

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 8

MORTGAGE BACKED SECURITY (MBS)

COLLATERALIZED DEBT OBLIGATIONS (CDO)

RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS)

COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS)

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 9

multiple tranches, similar to CMOs, rather than typical residential

COLLATERALIZED BORROWING OBLIGATIONS (CBO)

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 10

ECONOMIC BENEFITS OF SECURITIZATION

Off-balance sheet funding

Lower capital requirements

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 11

Improvement in financial ratios

An important advantage of securitisation is the flexibility to tailor the

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 12

 Interest rates can be fixed or floating depending on investor

Performance track record

EFFECTS ON THE NATIONAL ECONOMY

In those countries where a high proportion of residential montages and

The effect of securitization on the economies of different countries is still

 Capital market development, as more high-quality securities are

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 13

 A source of funds for rapidly growing, capital-constrained, banks,

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 14

DIFFERENCE BETWEEN SECURITISATION AND TRADITIONAL DEBT

Securitised instruments have some distinct features, which distinguish

Isolation of pool of assets

Claim against a pool of assets

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 15

Operational & administrative requirements

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 16

RISKS INVESTORS FACE IN SECURITISATION DEALS

Investors in securitised instruments can take advantage of the benefits that

Asset pool risks

Counter party risks

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 17

passed on to the investor (unless the instrument structure provides for a

 Reinvestment risk: If there are heavy prepayments in the pool, the

Property/asset price risk

STRUCTURED FINANCE AND FINANCIAL MARKETS Page 18

 The assignment of receivables is valid in terms of the underlying loan

Swap Counterparty Risk