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Contract for difference (CFD)

A contract for difference (CFD) is similar to a future. The difference is that a CFD cannot be settled by delivery. It an agreement to pay an amount based on the change in some number. This also means that a CFD can exist where the underlying asset is not deliverable. For example, a CFD may pay 1 for every point an index gains (and charge 1 for every point the index loses). This means that it is possible to have CFDs on indices, natural phenomena (such as the weather) and anything else that is measurable. It is common practice to call many CFDs futures: e.g., an index future. Where the underlying is not deliverable the "future" is in fact a CFD. CFDs sold to private investors also sometimes called spread bets. Options with a non-deliverable underlying asset are also closely related to CFDs. These contracts can resemble insurance contracts (in that they can transfer the risk of an event occurring) and cat bonds. A good example would be the purchase of CFDs or options on weather by a company that has a business that depends on weather conditions. A spread bet is legally different from a contract for difference, and is taxed very differently, but it is very similar in its effect. Exchange traded contracts for difference A contract for difference may be traded on a stock exchange (this is another key difference from a spread bet). This tends to make spreads narrower and liquidity higher, but, of course, broker's commissions will reflect the cost of accessing the market, so it is not necessarily the cheapest option.

Derivatives
A derivative is a security, the value of which depends on the value of another asset. The asset in which its value depends is called the underlying asset. Derivatives are used for both hedging risk and as high risk investments. There is a wide range of different types of derivatives available. The commonest are futures, options and warrants. Swaps are also important. Contracts for difference are also common. They are widely used to provide derivatives of an underlying number that can not itself be directly traded

(index values, weather etc.) and to provide access to derivatives for retail investors. Derivatives are used for hedging by buying a derivative with a value that moves against that of another investment that an investor holds. For example, shares in a given company can be hedged by buying put options in the same company. As speculative investments, derivatives allow investors to:
Make a greater gain (or loss!) from the same price movement than

would result from buying the underlying. Make a gain from a fall in the price of the underlying. Arbitrage certain inconsistencies between the prices of other investments

The common types of derivatives (e.g. futures and options) are sometimes described as vanilla, while more complex types are described as exotic.

Futures
Futures contracts are like forwards, but they are standardised and often publicly traded on exchanges. Futures are used both to hedge and as (fairly speculative) investments in themselves. Futures are most often used in commodity and currency markets where both producers and buyers gain security from fixing their buying or selling prices, but have little to gain by paying the extra for an option as their possession of, or foreseeable future need for, the underlying commodity or currency is hedged by the future. As with options, almost all futures traded on exchanges are settled by payment of their value on the day they expire rather than by delivery of the underlying asset.

DVP (delivery vs payment)


Delivery vs payment (DVP) is a way of controlling the risk to which securities market participants are exposed. Delivery of securities (i.e. the change in their ownership) is done simultaneously with payment. This means that neither the buyer or the seller is exposed to the risk that the other will default. It directly protects security market participants (such as brokers) rather than investors. This indirectly reduces the cost and risks of trading for everyone.

DVP is far from being a perfect system. Unless settlement is real time (done immediately on the trade being agreed) it means that, if there is a trade failure, trades will have to be unwound. If buyers are allowed to sell before settlement (as is usual), multiple trades may have to be unwound for a single failure. Being forced to unwind a trade can mean investors make a loss. Major markets either use DVP with real time settlement, or a central counterparty to eliminate the risk of having to unwind trades.

Counterparty risk
A counterparty is a party with which a transaction is done. If A sells something to B, then B is a counter-party from A's point of view and viceversa. The risk that the counterparty will fail to fulfil their obligations - usually either by failing to pay or by failing to deliver securities - is called counterparty risk. There are a number of ways of controlling counterparty risk. Some are trading mechanisms such as DVP or the use of a central counterparty. Financial institutions should track and manage counterpart risk in much the same way as any other credit risk, and this should be integrated into institutions' overall risk management system. The counterparty risks from securities trading are either simple credit risks (where the risk is that the other party will not pay) or a combination of credit risk with the risk of a position in a derivative (where the risk is that the other part will not deliver securities). Counterparty risk tends to be at least as much of a concern to regulators as to the institutions exposed to it. This is because a large financial institution will be a counterparty to many others, and therefore the knock-on effects of its failure pose a systemic risk.

Face value
face value of a security is the amount that is shown on certificates (if issued) or on legal documents. The face value of a share is also called its par value and it has little importance. For ordinary shares it represents little more than an arbitrary value chosen the company.

The face value of a bond is more important because it is the amount payable on maturity: the face value of bonds has an effect on their value that the face value of shares does not.

Clearing house
A clearing house provides clearing services for trades that take place through an exchange. The exchange matches buyers with sellers, the clearing house then has to deal with the transfer of ownership. The clearing house used by the London Stock Exchange is LCH Clearnet. In the US the Depositary Trust & Clearing Corporation (DTCC) has a monopoly on clearing services. It is common for a clearing house to guarantee trades by acting as a central counterparty (as happens for most securities trading in the UK). It is also common for a clearing house to provide depositary services, recording ownership of dematerialised securities as DTCC does.

Settlement
Settlement is the last step in the post-trade process. Settlement may be:
net: obligations between participants are set-off against each other,

or, gross: each transaction is settled individually,

and may be:


real-time: transactions are settled as and when trades are agreed

with no delay, or, occur at regular intervals, usually on a rolling schedule at the end of a day.

Preference shares
Preference shares (prefs) are legally shares, but they are very different from ordinary shares. The economic effect of prefs is more like that of bonds. Like convertibles, they are regarded as hybrids of debt and equity:
Dividends on preference shares have to be paid before dividends on

ordinary shares. Dividends on ordinary shares may not be paid unless the fixed dividends on preference shares is paid first. Dividends are fixed like bond coupons, although there are usually provisions to not pay, or delay payments.

Preference shareholders have a higher priority if a company is

liquidated than ordinary shareholders, although a lower priority than debt holders. In the case of cumulative prefs, if the dividend is not paid in full, the unpaid amount is added to the next dividend due. Preference dividends are fixed, so they do not participate in increases (or decreases) in profits as ordinary shareholders do.

The effect of these is to make the income stream from preference shares more similar to that from debt than that from ordinary shares. Most importantly, fixed dividends are similar to interest payments. However, they are legally shares and are subject to the same tax treatment.

Equity
Equity is the stake its owners have in a company. The word can be used to refer to balance sheet quantities, or as an adjective to describe securities that give their holders a share of ownership of the issuer. On a balance sheet, the equity is the amount that belongs to the shareholders; a company's assets less its liabilities. Equity one of the two main sources of funding for companies, the other being debt. Companies raise equity capital by issuing equity securities. This is most commonly in the form of ordinary shares. Ordinary shares usually have equal voting rights to all other ordinary shares (one share, one vote), and are entitled to equal dividends. The other common type of shares are preference shares, which have some characteristics that make them more akin to bonds, although they are legally (and therefore for tax purposes) shares. Some companies may have special classes of shares that have more rights than ordinary shares. This has become uncommon. Golden shares and founders' shares still sometimes exist for particular purposes. Some companies also have classes of share that have fewer rights than ordinary shares, most commonly non-voting shares, but there are also various types of deferred shares. These are typically entitled to the same share of profits as ordinary shares, but do not give the shareholder who holds one any voting rights. Again, these are becoming less common. Investors are generally (quite rightly) very wary of companies that voting rights structured to distribute control differently from economic interests in the company. This usually means that a particular group of shareholders can run the company (or very strongly influence its running) to suit themselves.

A company's articles define the rights of different classes of shareholders and endless variations on the above are possible. Changes to the rights of different classes of shareholders usually require the agreement of the majority of shareholders of each class of shares affected, even if these are non-voting shares.

Bonds
A bond is a financial security that pays interest. Most bonds have a fixed life, and the principal is returned on maturity. A debenture is similar to a bond from the point of view of investors, but is legally different. The interest rate is most often a fixed rate, but it may be a floating rate. In either case, it is expressed as a percentage of the nominal value (face value) of the bond. Some bonds are issued at a discount to their face value so the payment at maturity is greater than the purchase cost. Zero coupon bonds pay no interest, and are therefore issued at a deep discount. Bond prices change if interest rates or the market's perception of the credit risk changes. The interst rate sensitivity of a bond may be measured by its duration or (more accurately) its modified duration. Bonds are issued by companies, governments (see government bonds) and other organisations. The credit worthiness of an organisation is reflected in the risk premium on the bond. The rates on bonds issued by governments in their own currency (on which default is virtually impossible) are used to measure the risk free rate of return. The real value of bonds may also be eroded by inflation - whereas shares give partial ownership of a real business, which provides a hedge against inflation. An exception to this are the index linked bonds issued by some governments that have interest payments and a return of principal that are adjusted for inflation. A company may have several classes of bonds, and some may take priority over others for repayment (in the case of liquidation). Those with a lower priority (junior or subordinated bonds) are higher risk and therefore should have a higher yield. A company may also issue bonds with extra or different characteristics - the most common example are convertible bonds. Preference shares are legally shares but are economically (from an investors point of view) little different from very junior bonds.

Credit risk

Credit risk is the risk that the issuer of a debt security such as a bond will default on the payments due. Credit risk is one of the main determinants of the price of a bond. The price of a debt security can be explained as the present value of the payments (of interest and repayment of principal) that will be made. This leaves the question of what determines the discount rate. This can be decomposed into two elements:
the risk free rate the risk premium or yield spread.

The risk free rate depends only on the currency and the timing of payments. The risk premium depends on the level of credit risk and the correlation of the the credit risk with the risk of holding other investments (in accordance with the CAPM). Credit risk is also an issue for lenders such as banks. In this context the key is the risk of losses to the bank so correlation with the bank's other lending is what matters, not correlation with debt available in the market.

Zero coupon bond


A zero coupon bond is one which does not pay interest. It is instead issued at a discount to its face value (which is what the holder will receive at maturity). Instead of interest payments, the holder receives a capital gain at maturity. The duration of a zero coupon bond is clearly longer than that of an otherwise similar bond that pays interest and it will be more sensitive to changes in interest rates. This is best understood by looking at how the present values of a zero coupon and an interest paying bond will be affected by changes in interest rates. The UK, and many other countries, treat some of the capital gain on a zero coupon bond as income for tax purposes.

Convertible bonds
A convertible bond (convertible) is a bond that can be exchanged for shares on or before maturity. A convertible bond is equivalent to a straight bond plus a warrant: in other words, it contains an embedded option. Convertibles give bond holders a hedge against the risks arising from agency issues. A that has issued bonds may choose to follow a riskier

strategy. If the strategy works, the equity holders will keep the profit. If the riskier strategy fails, then bond holders face higher default risk. As the shareholders control the company, they may well choose such a riskier strategy. In this case holders of convertibles can choose to convert. Debt covenants are also used to control this risk but warrants and convertibles are simpler and tackle the problem at its root (by removing the incentive) rather than trying to impose controls. Another way of looking at convertibles is as shares with a long term put option. The holders of convertibles get all the benefits of shares (except for the dividends and voting rights before conversion), but they get interest payments until conversion (more than making up for dividends). In addition, if the shares under-perform, they can choose to keep the bonds. The equivalence is not exact (as it is to a bond plus warrant) but it does reflect a possible reason for buying convertibles.

Warrants
Warrants are securitised options and can be regarded as options from the point of view of valuation. They may be issued by the issuer of the underlying, or by a third party. They differ from traded options in a number of ways:
Warrants are securities, whereas options are (transferable in the case

of traded options) contracts. This is a legal difference and not important to investors. Warrants are issued by a range of companies and banks, whereas traded options are issued by the exchange on which they trade. Warrants issued by a third party (i.e. not the issuer of the underlying and usually a bank) are usually covered warrants. These are the most accessible way for most private investors to buy options. The terms of a warrant are decided by the issuer. One effect of this is that some issuers (especially companies issuing call warrants on their own shares) choose very long dates expiries, that may run into many years. Warrants are more accessible to investors to buy: private investors can buy them in the same way was shares. They are less accessible to write (i.e. short).

Enterprise value
Enterprise value (EV), attempts to measure the value of a company's business rather than the company. It answers the question "what would it cost to buy this business free of its debt and other liabilities?" EV is calculated by adding together:
1. the market capitalisation of the company

2. the value of its debt financing (bonds and bank loans, not items such as trade creditors) 3. the value of other liabilities such as a deficit in the company pension fund

and subtracting the value of liquid assets such as cash and investments. The calculation is made more complex where there are minority stakes in associates and subsidiaries: see EV/EBITDA. These adjustments also apply to other valuation measures using EV such as EV/EBIT and EV/EBITA.

PE ratio
The price/earnings ratio (PE) is the most commonly used valuation measure. It compares the price of a share to the EPS. It directly relates the price of a share to the proportion of the company's profits that belong to the owner of that share. One of the reasons for the popularity of the PE ratio is its simplicity. It is: share price EPS Headline or adjusted EPS is usually preferable to basic EPS. A diluted EPS is usually preferable to an undiluted one. A higher PE means that the same share of a company's profits will cost a prospective shareholder more. There are usually reasons for a higher PE. It may reflect faster expected earnings growth, or lower risk earnings.

EPS
Earnings per share (EPS) is the profit attributable to shareholders (after interest, tax, minority interests and everything else) divided by the number of shares in issue. It is the amount of a company's profits that belong to a single ordinary share. Companies are required to publish the statutory (also called basic) EPS but there are a number of adjusted EPS numbers that are more useful to investors. The most common alternative EPS numbers used are adjusted or headline EPS and diluted EPS.

Uses of EPS

The most common use of EPS is to calculate the PE ratio, which puts EPS into context by comparing it to the share price. There are a number of variants of the PE ratio, using past earnings, forecast earnings, or the average over many years. Trends in EPS are also an important measure of growth EPS growth is combined with PE in the PEG ratio. It is also used to screen for growth companies. EPS growth is a key measure of management performance as shows how much money the company is making for shareholders, not only because of changes in profits, but also after all the effects of new share issues (this is particularly important when growth is acquisitive).

Custodian
A custodian bank holds securities on behalf of an institutional investors. The main reason for custodian banks to hold assets, rather than the institution that owns or manages the assets are cost cost savings. The cost economies come from that fact that custodian banks usually act as custodians for many institutional investors. As a result of this, they are able to invest more in systems that provide lower costs and to exploit economies of scale in general. The cost savings are particularly large where investors invest in markets in which they themselves do not have local operations. In these markets, custodians have the systems and expertise to deal with issues such as local withholding taxes. Because large investors invest globally, many large banks offer global custody services that, as the name suggests, allow fund mangers to use a single custodian across all (or nearly all) the markets they invest in. They usually use sub-custodians in for at least some markets. In addition to the traditional safekeeping and administrative services, many custodians now offer higher margin value added services such as performance and risk measurement and reporting to regulators.

1.1.6Trade Enrichment
The process of trade enrichment involves the selection, calculation and attachment to a trade of relevant information necessary for efficiently servicing the clients. The trade components, whichrequire enrichment, are:

Calculation of cash value: The cash value calculation is done keeping the trade components in consideration. Counter party Trade confirmation requirement: The trade details needs to be enriched to determine if the counter party needs the trade confirmation and if at all it needs the trade confirmation, theformat in which the confirmation would be send across to them. Selection of custodian details: The client might have multiple accounts with multiple or single custodian. The investor would send the custodian details at which the settlement would take place. Thetrade details are enriched with the account number of the custodian, which will handle the cash/ securities settlement. Method of Transaction reporting: The transaction reporting dependsupon the security group as well as the country in which thetransaction has occurred. For e.g. the UK equities may require onemethod of reporting whereas the international bonds would requireanother method.

1.1.7Trade Validation
Trade validation is a process of checking the data contained in the fully enriched trade, in order to reduce the possibility of erroneous information being sent to the client (in case of institutionalclient) also the wrong trade related information can lead to delay in the settlement or even in settlement failure. The basic trade related information that are validated are following: Trade Date Trade Time Value Date Operation Quantity Security Price Trade Cash Value Methods of Trade Validation: The validation of trade can be effected manually or automatically according to the availability of the system. Manual Trade Validation

Automatic Trade Validation 1.1.8Trade Clearing Clearing process signifies the execution of individual obligations with respect to a buyer andseller. Once the terms of a securities transaction have been confirmed, the respective obligationsof the buyer and seller are established and agreed. This process is known as clearance and determines exactly what the counter parties to the trade expect to receive. Clearance is a servicenormally provided by a Clearing Corporation (CC).Clearance can be carried out on a gross or net basis. When clearance is carried out on a grossbasis, the respective obligations of the buyer and seller are calculated individually on a trade-by-trade basis. When clearance is carried out on a net basis, the mutual obligations of the buyer andseller are offset yielding a single obligation between the two counter parties. Accordingly,clearance on a net basis reduces substantially the number of securities/payment transfers that require to be made between the buyer and seller and limits the credit-risk exposure of both counter parties. NETTING PROCESS The Settlement process for the securities is expensive as moving securities and money involves costs. Since a given trader may engage in dozens or even hundreds of trades each day, thesecosts soon add up. One way to reduce these costs is through netting.For example, suppose you sold the shares to Smith because you expected the price of GE to fallSay an hour later the price does fall to 75 and you buy the shares back at that price. Bycoincidence, you buy them from Smith. You and Smith could save a lot of transaction costs if younetted the two transactions your earlier sale and your later repurchase. Net, Smith owes you10,000 x ($80 - $75) = $50,000. if Smith just pays you this amount, no securities and a lot lessmoney need change hands.You could extend this idea beyond just netting pairs of specific transactions to a general bilateralnetting arrangement with Smith. You could keep a running tab of your trading in GE shares over a period of time, and just settle your net position at the end of the period. You could save evenmore if you engaged in multi-issue netting netting your trade in all securities. Continuous Net Settlement The Continuous Net Settlement (CNS)System is an automated book-entry accounting systemthat centralizes the settlement of compared security transactions and maintains an orderly flow of security and money balances. Throughout the CNS processing cycles, the system generatesreports that provide participants with a complete record of security and money movements andrelated information. CNS provides clearance for equities, corporate bonds, Unit Investment Trustsand municipal bonds that are eligible at The

Depository Trust Company (DTC). DTC is an institution that provides depository services in US. Clearing Process The process of clearing is explained in the following example:A deal is struck between with Smith and you on Monday. That night your back-office people andSmiths each send electronic notification of the trade to the computer of the National SecuritiesClearing Corporation (NSCC)

The NSCC computer checks the two confirms against each other. If they match, the trade iscompared. NSCC confirms to each of you on Tuesday morning, with instructions for settlementthe same Thursday. If the trade does not compare, you are both notified and you can sort thingsout and resubmit the trade before the settlement date.On Wednesday, the day before the settlement, NSCC interposes itself between the two parties tothe transaction. That is, instead of the original deal between you and Smith, there are now twodeals one between you and NSCC and the other between NSCC and Smith. You now have adeal to sell 10,000 shares of GE to NSCC at 80, and Smith has a del to buy them from NSCC atthe same price. You receive a notice to deliver the shares to NSCC; Smith receives a notice tomake payment. By interposing itself in this way, NSCC is guaranteeing settlement to both of you.Whether or not Smith pays up, you will get your money on time. Whether or not you deliver theshares, Smith will get 10,000 shares of GE on Thursday.The automated comparison is an important function of the clearing corporation because itenables the participant to ensure that the trade details agree with those of counter party prior tosettlement. 1.1.9Trade Affirmation/Confirmation The trade affirmation/confirmation process occurs when a depository forwards the selling brokersconfirmation of the transaction to the buyers custodian. The custodian reviews the tradeinstructions from the depository and matches the information to instructions for the trade receivedfrom its customer. If the instructions match, the custodian affirms the trade. If the instructions donot match, then the custodian will DK (dont know, or reject) the trade or will instruct the sellingbroker how to handle the mismatch. The affirmation/confirmation process is generally completedby T+1 in a normal T+3 settlement cycle. On day T+2, depositories send settlement instructionsto the custodian bank after affirmation and prior to settlement date. The instructions contain thedetails of the trade that has been affirmed and agreed to by the parties in the trade. Custodianswill match the settlement instructions to their records and prepare instructions to send funds or expect funds from the depository on T+3 of the settlement

cycle.The following media is used for the transmission of trade confirmation/affirmation Fax: Telex S.W.I.F.T e-mail Paper 1.1.10Trade Settlement Failure Trade settlement is the act of buyer and seller exchanging securities and cash on or after thevalue date in accordance to the contractual agreement. Settlement is successful when the seller is able to deliver the securities and buyer is able to pay the cash it owns to the seller. In somecases the settlement fails primarily because the seller was awaiting the delivery of securities fromits purchase and therefore could not deliver the securities to the buyer It is mandatory now days to settle trade on the value date and whenever there is a settlementfailure the authority imposes penalties to the party concerned. Causes of Settlement Failure NonMatching settlement instruction Insufficient Securities

Insufficient Cash 1.1.11Trade Settlement Trade settlement is the act of buyer and seller exchanging securities and cash on or after thevalue date in accordance to the contractual agreement.Settlement is successful when the seller is able to deliver the securities and buyer is able to pay the cash it owns to the seller. There aredifferent settlement methods depending upon the payment mechanism, security types etc.In most of the markets the settlement is done on a rolling basis. In a Rolling Settlement, all tradesoutstanding at end of the day have to be settled, which means that the buyer has to makepayments for securities purchased and seller has to deliver the securities sold. For instance, USAand UK follow a T+3 system which means that a transaction entered into on Day 1 has to besettled on the Day 1 + 3 working days, when funds pay in or securities pay out takes place. SETTLEMENT TYPES The settlement process has evolved over the period. Traditionally the settlement used to takeplace with the physical delivery of the shares, but with advent of Certificate Immobilization theBook Entry settlement system has evolved. Physical Settlement Book Entry Settlement SETTLEMENT PERIOD The settlement period is the time between the execution of the trade and the settlement of trade.It is time allowed before the securities sold must be delivered to the buyer. The settlementperiods depend upon the type of the securities traded. Appendix C has the list of the settlementperiod for different types of security. SETTLEMENT PROCESS Trade settlement occurs when securities and money are exchanged to complete the trade.Settlement occurs on T+3 in a T+3 settlement cycle. Settlement of a securities transactioninvolves the delivery of the securities and the payment of funds between the buyer and seller.The payment of funds is effected in the settlement system via a banking/payments system. Adepository typically carries out the delivery of securities. A trade is not declared settled until both(funds and securities) transfers are final