Capital Markets

Primary Markets
*The primary market is the market for the initial issue and placement of securities.
*An organization that need funds contacts their investment banker who typically assembles a syndicate of securities dealers
that will sell the new stock issue
*This process of selling the new stock issues to prospective investors in the primary market is called underwriting
*The securities that they sell are called initial public offerings (IPOs)
Secondary Markets
*The secondary market (also called "aftermarket") is the market for trading of securities that have already been issued in its
initial public offering. Stock exchanges are examples of secondary markets.
*In the secondary market, securities are sold by and transferred from one investor to another.
Over The Counter (OTC) market
*it is a network of independent traders (stockbrokers), who between themselves perform purchase and sales transactions via
a telephone or computer network without intermediaries like stock exchanges.
*its name over-the-counter (OTC) market – a market across a counter is historically derived from the fact that most of these
trades were made over banks’ counters
*it allows the registration of securities also of small and new companies that do not meet the demanding criteria of
exchanges.

Stocks
*A stock, also referred to as a share, is commonly a share of ownership in a corporation.
*The purchase of one share entitles the owner of that share to literally a share in the ownership of the company, including
the right to a fraction of the assets of the company, a fraction of the decision-making power, and potentially a fraction of the
profits, which the company may issue as dividends.
Some terminology related to Common Stock
*Record Date
*Cum Dividend/Ex- Dividend
Sources of income from an Equity stock
*Dividends
*Capital gain/loss on sale of the Stock

Bonds
*Face value
*Coupon
*Coupon Frequency
*Maturity date
*Accrued Interest
*Yield to maturity (YTM)
*Yield Curve
US Treasury Yield Curve as of 15 June 2005
Sources of income from a bond
*Periodic coupon
*Capital gain/loss on sale of the bond
Bond Prices
*Bond prices in the US are quoted in terms of 32nds, i.e. the smallest movement in the price of the bond would be 1/32.
*For example if the price of a bond is quoted as 100-12/32 what does it mean?
*It means that the price of the bond is $100.375 = 100+ 0.375(=12/32)
*Similarly 100-32/32 would mean the price is $101.
Foreign Exchange
*A forex or foreign exchange transaction involves
*Buying of one country’s currency by paying for it in another country’s currency
*Selling one country’s currency for payment to be received in another country’s currency

Factors affecting exchange rates

*Economic Factors
*Balance of Payments
*Economic Growth
*Relative Inflation
*Interest Rates
*Money Supply
*Fiscal Policy - Budget Deficits / Surpluses
*Resource Discoveries
*Capital Movements / Asset Markets
*Reserves
Factors affecting exchange rates (contd.)
*Political Factors
*Random Shocks (Gulf War / September 11 attacks)
*Sentiment
*Speculation
*Technical Factors
*Exchange Rate Policy
*Central Bank Intervention
Quotes
*Quotes expressed in terms of pairs
*of currencies first currency is ‘base currency’ and
*second currency is ‘counter-currency’ or ‘quote-currency’
*Quotes in terms of the bid price of base currency and ask price of base currency
*Base currency always the U.S. $ except for the Euro, British Pound and the Australian $
Cross Currency Rates
*The quote will refer to two currencies both of which are not the currency of the country in which quote is given

Derivatives
Basics
*Derivatives are financial contracts whose value is linked to the price of an underlying commodity, asset, rate,index or the
occurrence or magnitude of an event.
* They do not have a value of their own
*Derivatives are used for both speculation and risk management
Basic Derivatives
*Forward Contracts
*Futures
*Options
*Swaps
Derivatives based on underlying
*Stock derivatives
*Index derivatives
*Currency derivatives
*Interest rate derivatives
*Credit derivatives
Terminology common to Forwards & Futures
*Two parties to the contract: the one which buys the contract is said to have gone “long”, while the one which sells the
contract is said to gone “short” the contract.
*Underlying asset
*Maturity period
*Settlement Price
All about futures
*Contracts
*Both parties to perform
*Unlimited profit or loss for both parties
*Profit of one party = Loss of other party
Currency Forwards and Futures
*A company needs foreign currency after 3 months
*What can it do ?
*Forward Contract for purchasing Foreign Currency after months at a priced fixed now
*Buy futures on foreign currency for a date which is close to the time when the currency is required
Index Futures
*Underlying is an index
*Future Contract Size ($ times)
*Profit / loss depends on movement of index
*Profit / loss = Number of points moved X lot size
Interest Rate Futures
*Underlying is the reference interest rate
*Profit / Loss depends on the movement of the reference interest rate and the standard contract size
Regulators of Futures market in the US
*Commodity Futures Trading Commission (CFTC: www.cftc.gov)
*National Futures Association(NFA: www.nfa.futures.org)
*Securities and Exchange Commission(SEC: www.sec.gov)
Options v/s Forwards
*Options give the buyer a right but no obligation.
*Good instrument to hedge adverse price moves & avoiding opportunity loss.
*Upfront premium
*Can choose the strike price
*Forwards are fixed price contracts wherein the buyer/seller is obligated to the price
*Opportunity loss
*No upfront premium
*Cannot choose the price
Some more terminology
For a Call Option,
*In-the-money
*Spot price > strike price
*Out-the-money
*Spot price < strike price
*At-the-money
*Spot price = strike price
Stock Options
*Options on underlying stock
*Standard number of shares per option contract
*Limited number of strike prices
Index Options
Other Options
*Currency Options
*Interest Rate Options
Option Greeks
*Delta: The rate of change of the price of a derivative with the price of the underlying.
*Gamma: The rare of change of delta with respect to the underlying asset price.
*Rho: The rate of change of the price of a derivative with the interest rate.
*Theta: The rate of change of the price of a derivative with the passage of time.
*Vega: The rate of change of the price of a derivative with the volatility
Regulators of Options market in the US
*Commodity Futures Trading Commission (CFTC: www.cftc.gov)
*Securities and Exchange Commission(SEC: www.sec.gov)
Swaps
*A swap contract is an agreement between 2 parties known as counterparties to exchange a sequence of cash flows over an
agreed future period. The two basic kinds of swaps are interest rate swaps and currency swaps.
*OTC traded.

Types of swaps
*Interest rate swaps
*Currency swaps
*Index swaps
*Credit swaps
*Credit default swaps
Basic Features
*Currency swaps
*exchange of currencies
*pre-determined rate
*actual exchange of currencies
*Index swaps
*exchange of income streams of two indices
* income streams could be positive or negative
*depends on movements of index
*Interest Rate Swaps
*Exchange of interest streams

Trading in Derivatives
Futures - Features
*Exchange rules applicable
*Standard contract sizes
*Standard delivery dates and months
*Specified trading periods
*Specified Minimum price movement
*Future Price depends on market - not fixed by exchange
*Price change limits; trading stopped if limits reached
*‘Position limits’ - limit on the number of contracts a speculator holds
Futures - Profit / Loss and Margins
*Margin requirement - Initial margin, Maintenance margin
*Marking to market daily
*Profit / Loss determined daily
*Daily changes in margin account
*On settlement day, no delivery; cash settled
*On settlement day, spot price = future price
Options - Features
*Exchange rules applicable for exchange traded options
*Standard contract sizes
*Specified expiration dates and months
*Specified strike prices
*Specified trading periods
*Position limits and Exercise limits specified
*Traded in OTC markets also - negotiated terms
Options - Premium, Margins
*Buyer pays ‘premium’ to Seller
*Seller of the option to maintain margins
Credit Derivatives
Major Equity Derivative Exchanges
Popular Stock Index Futures
*NYSE Composite
*S & P 500
*Value Line
*Dow Jones Industrial Average
*Russel 1000
*S & P Midcap 400
*NASDAQ 100
*NIKKEI 225 AVERAGE

Investment Banking
Functions
*Primary Market Operations
*Advisory service to Corporates for raising long term resources
*Raising long term resources for Corporations and Governments
*Advisory service to individuals (High Net Worth)
*Secondary Market Operations
*Advisory service to individuals (High Net Worth)
*Providing market making service
*Providing broking service

Mutual Funds
Introduction
*Entities that collect monies from investors and invest in securities
*Returns to the investor
*dividends from MF
*capital gain on investments in MF
Operations
Shares & NAV
*Investors receives ‘shares’ in the MF for their investments in MF
*Investors called as ‘shareholders’
*Market / Book Value of Share varies daily
*Market / Book Value of Share known as Net Asset Value (NAV)
*NAV per share comprises of total of assets less total of liabilities divided by outstanding number of shares
Purchase & Redemption
*Purchase of shares directly from fund or through brokers
*Purchase price = NAV / share
*Redemption of shares directly from fund
*Redemption proceeds = NAV / share

Open and Close Ended MFs

*Open Ended Funds
*Issue new shares continuously
*Any time redemption of shares
*No need to sell shares to others as redemption possible
*Close Ended Funds
*Shares Issued initially
*Redemption of shares only on specified events / time / conditions
*Shareholders may sell shares to others
Some more funds
*Pooled funds
*Segregated funds
*Labor Venture Funds
*Royalty Trusts"
Types of Funds
*Equity Funds
*Income Funds
*Balanced Funds
*Money Market Funds
*Index Funds
*Sector Funds
*Socially Responsible Funds or
*Ethical Funds
Loads
*Load Funds
*Sales Charge
*Front-end load
*Back-end load (Deferred Sales Load)
*Contingent Deferred Sales Charge
*No Load Funds
*No Sales Charge
Charges / Fees
*Management Fees
*12b-1 Fees
*Redemption Fees (exit fees)
Regulations
Hedge Funds
Introduction
*Entities that collect monies from wealthy and financially knowledgeable investors and invest in securities including
derivatives
*May borrow monies and invest in securities (leveraging)
*May borrow securities and sell them (shorting or short sales)
Features
*Investors restricted to certain categories called ‘accredited investors’
*Maximum number of investors
* 100 (35 non-accredited investors allowed)
* 500 if ‘qualified’ purchasers
*High minimum investment by investors
*Offering documents are privately circulated
*Restrictions on redemptions
*Focus on high returns
*Being unregulated, considerable operating freedom
Accredited Investors & Qualified Purchasers
*Accredited Investors
*Individuals with networth of $1mn.or annual income of $200,000 for 2 years or income of $300,000 with
spouse
*Entities such as banks, insurance companies, trusts with specified value of assets etc.
*Qualified Purchasers
*Individual with $5mn. investments
*Entity with $25mn. investments

Investment Strategies
*Multiple Investment Strategies
*Strategies aimed at maximising returns
*Focus on ‘Absolute Returns’
Types of Investment Strategies
*Market Neutral Group
*Distressed Securities
*Market Neutral Arbitrage
*Special Situations
*Long/Short Equity Group
*Aggressive Growth
*Market Neutral Securities Hedging
*Opportunistic
*Value
Types of Investment Strategies (contd.)
*Directional Trading Group
*Macro
*Market Timing
*Futures
*Specialty Strategies Group
*Emerging Markets
*Income
*Multi-Strategy
*Short Selling
*Other
*Fund of Funds

Charges / Fees
*Management Fees on Funds Managed (approx. 1%)
*Performance Fees on appreciation to funds managed (around 20%)
Regulations
*HF, as such, not regulated
*However, regulations applicable indirectly
*Securities Act of 1933
*Investment Company Act of 1940
 *National Futures Association
*Investment Advisers Act of 1940
Fund of HFs
*A fund that invests in several HFs
*No restrictions on minimum investment from investors
*No restrictions on investors
*Optional registration with SEC
*High fees as management fees paid for FoHF also

Risk Management
What is risk ?
*Risk is the uncertainty associated with an expected outcome or event
*Risks
*controllable (diversifiable, unsystematic)
* uncontrollable (non-diversifiable, systematic)
Classification of Risks
*Broad classification of financial risk
*Credit Risk
*Market Risk
*Operational Risk
Credit Risk
*Basically risk due to exposure to third parties
*Counter-party risk / Issuer Risk
*Default risk
*Exposure risk

Market Risks
*Emanates from movement in market forces
*Price Risk
*Interest Rate Risk
*Currency Risk
*Liquidity Risk

Operational Risks
*Emanating from inadequacy or failure of internal processes
Components of IR risk
*Basis Risk
*Yield Curve Risk
*Embedded Option Risk
*Reinvestment Risk
*Price Risk
Risk Mitigants
*Credit Risk Mitigants
*Credit Enhancements
*Guarantees
*Loan covenants
*Credit Derivatives
*Market Risks
*Interest Rate Derivatives
*Currency Derivatives

Statistics
*Standard Deviation, Variance
*Normal Distribution
*Sigma, 2 Sigma, 3 Sigma
*Confidence Levels
A normal Curve with Confidence intervals
Value at Risk (VaR)
*If Lehman has a portfolio of $100-m then what does a 1-day VaR of $1-m at 95% confidence level tell you?
*It means that on an average in 1 out of 20 days would the loss figure exceed $1-m on this given portfolio.
Computing VaR
*Three methods to compute VaR
*Based on historical data
*Using variance and co-variance
*Monte Carlo Simulation method
Stress Testing
*This involves estimating risk in response to a specific extreme event like natural disasters, wars or political
coups.
*VaR gives us a picture of the loss in normal market conditions, while stress testing is used in abnormal market
conditions.
Back Testing
*Testing the validity of VaR with historical data
Risks in Banks
*Credit Risk, Market Risk, Operational Risk
*BASEL II Accord
*Capital Adequacy
*Risk weighted assets
Duration
*It is a measure of the interest rate sensitivity of a bond.
*Average tenor or the Weighted average maturity of the bond
*The relationship between price and yield is expressed as duration in years
*Duration / (1+yield) will gives the modified duration.
*% change in price as a result of % change result in YTM = (-)mod. Duration * % change in YTM
*Mod. Duration is a measure of interest rate sensitivity of a bond - higher the duration, higher is the interest rate
risk of the bond, all else equal.
*Mod. Duration * .01 (100 bps) * current trading price will give change in price in dollar terms for a 1% change in
yield (DV01)
*PV01 = DV01 / 100 I.e. expressed in terms of 1 basis point
Graphical representation of Duration
Convexity
*Duration accurately measures the interest rate sensitivity of a bind for small changes in the yield generally less
than 1%. But Duration being a first derivative of the price-yield function of the bond loses its ability to
accurately measure the price change in bonds for larger yield changes.
*In such situations the second derivative of the price-yield function- Convexity- is used.