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Exchange

1. Exchange

An exchange is a marketplace where financial instruments are traded. Securities,commodities, derivatives, foreign currency are examples of financial instruments.

Examples of exchanges- National Stock Exchange(NSE, New !ork "ercantileExchange(N!"E#, New !ork Stock Exchange(N!SE

2. Functions of an exchange

$he %enefit of having an exchange is that it allows people to trade through a commonplatform in a fair and orderly manner. &n an exchange, due to the availa%ility ofinformation, trading occurs %etween the most deserving %uyer and seller which eventually

leads to a price discovery for an instrument$he exchange is responsi%le for the efficient circulation of price information for anyinstrument %eing traded on that particular exchange. $his allows the free flow ofinformation a%out all the different financial instruments availa%le in the exchange. $hishelps the traders to calculate the fundamental value of an instrument and ensure that thereis no price mismatch.Additionally, all financial instruments must fulfil certain rules and regulations %efore theyare listed on an exchange. "oreover, all exchanges work under the strict supervision ofthe government, therefore ensuring that an exchange is a fair place for trading to occur.

'or example, one of the common regulations in a stock exchange generally reuires acompany to post uarterly results and an annual report accessi%le to the general pu%lic.$his guideline ensures transparency and gives an opportunity to the general pu%lic toscrutini)e the reports sent %y the company and calculate the companies* value and itscorresponding share price.

3. Types of exchanges

$he type of an exchange is dependent on the financial instrument traded through it. AStock Exchange provides an opportunity for traders to %uy euity shares, derivatives or

%onds of a company listed on the exchange. +ommodities exchange is where variouscommodities like wheat, cocoa and sugar are traded. A 'oreign Exchange "arket is anexchange where all kinds of currencies are traded. 'or example, S/0! is a currency

pair, where the value of the /apanese !en against one S ollar can %e traded for.

4. Difference between stock market and stock exchange

Stock market is the pool of euity shares of pu%licly listed companies, i.e. companieswhose shares are availa%le for trading. Stock exchange facilitates the traders to %uy andsell in the stock market. $herefore, without a stock exchange, companies would have no

formal system on which to list shares, and without a stock market, exchanges would haveno reason to exist.


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. !oints to ponder

What if two parties want to trade outside the exchange?

Why would two parties deliberately want to do such a transaction without using the facilities

provided by the exchange?

"redit #ating

1. Definition

+redit rating is an assessment of the credit worthiness of a %orrower (financial instrumentor financial entity. &t is a rating given to a particular entity %ased on the credentials and the

extent to which the financial statements of the entity are sound, in terms of %orrowing andlending that has %een done in the past. A credit rating can %e assigned to any entity thatseeks to %orrow money 1 an individual, corporation, state, or sovereign government.+redit assessment and evaluation for companies and governments is generally done %y acredit rating agency such as Standard 2 0oor*s or "oody*s. 'or individuals, credit ratingsare derived from the credit history maintained %y credit-reporting agencies. +redit ratingagencies typically assign letter grades to indicate ratings. Standard 2 0oor*s, for instance,has a credit rating scale ranging from AAA (excellent and AA3 all the way to + and .A de%t instrument with a rating %elow 444- is considered to %e speculative grade or a 5unk

%ond.

2. $mp%ication

+redit rating of a %orrower has a ma5or impact on the interest rates charged %y the lenders.6hile a %orrower will strive to have the highest possi%le credit rating, the rating agenciesmust take a %alanced and o%5ective view of the %orrower*s financial situation and capacityto servicerepay the de%t. $he credit rating has an inverse relationship with the possi%ility ofde%t default. &n the opinion of the rating agency, a high credit rating indicates that the

%orrower has a low pro%a%ility of defaulting on the de%t7 conversely, a low credit ratingsuggests a high pro%a%ility of default.

+hanges in credit rating can have a significant impact on financial markets. A primeexample of this effect is the adverse market reaction to the credit rating downgrade of the.S. federal government %y Standard 2 0oor*s on August 8, 9:;;.


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3. "redit &core ' "redit #ating for an indi(idua%

6hen you use credit, you are %orrowing money that you promise to pay %ack within a

specified period of time. A credit score is a statistical method to determine the likelihood ofan individual paying %ack the money he or she has %orrowed.6hen you apply for a credit card, mortgage or even a phone hookup, your credit rating ischecked. +redit reporting makes it possi%le for stores to accept checks, for %anks to issuecredit or de%it cards and for corporations to manage their operations. epending on yourcredit score, lenders will determine what risk you pose to them.According to financial theory, increased credit risk means that a risk premium must %eadded to the price at which money is %orrowed. 4asically, if you have a poor credit score,lenders will lend you money at a higher rate than the one paid %y someone with a %ettercredit score.

4. !oints to !onder

1) How do you think your credit score would be calculated?

)id'*sk &pread

1. )id

$he price at which an investor, trader or a market makeris willing to %uy a security iscalled the %id price. Along with the price, a %id also specifies the uantity that they arewilling to %uy.An example of a %id in the market would %e >;8.;8 x ;,:::, which means that an investoris willing to purchase ;,::: shares at the price of >;8.;8. &f a seller in the market is willingto sell that amount for that price, then the transaction is completed.

2. *sk

$he price at which a seller is willing to sell a security is known as the ask price. Along withthe price, the ask will generally also stipulate the amount of the security willing to %e soldat that price.Similar to the way a %id is uoted, an ask in the stock market would %e >;8.;? x ;,:::which means that someone is offering to sell ;,::: shares for >;8.;?.$he ask will always %e higher than the %id 1 it is easy to understand why. @ne would %ewiling to sell a security at a higher price than they would %e willing to %uy. $he terms %idand ask are used in nearly every financial market in the world covering stocks, %onds,currency and derivatives.
http://www.investopedia.com/terms/m/marketmaker.asphttp://www.investopedia.com/terms/m/marketmaker.asp


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3. )id'*sk &pread

$he %id-ask spread is the amount %y which the ask price exceeds the %id. $his is essentially

the difference in price %etween the highest price that a %uyer is willing to pay for an assetand the lowest price for which a seller is willing to sell it.&f the %id price is >;8.;8 and the ask price is >;8.;? then the %id-ask spread is >:.:=.$here may %e several %id prices and several ask prices for a security at any point in time.Bowever, only the %est %id (that is, the highest price offered for a security and the %est ask(that is, the lowest price asked for a security are used to calculate the %id-ask spread.&ignificance of the bid'ask spread1$he %id-ask spread signifies the liuidity of an asset. $he smaller the si)e of the spread is,

the more liuid the asset would %e. $his would %e %ecause for these assets, the %uyers andsellers generally agree a%out what the right price for a security should %e."arket makers uote %oth the %id and ask prices on the market and thus contri%ute totransparency and efficiency of the marketplace.

4. !oints to !onder

1) Do you think the bid-ask spread for currencies would be high? What about small-cap

stocks?

2) What happens to this difference between the bid and the ask price?

#a%%y and &e%%'off

1. #a%%y

A rally is a significant short-term recovery in the price of a stock or commodity, or of amarket in general, after a period of decline or sluggishness. !ou would*ve heard the phrase,

Cthe markets rallied todayD 1 this refers to the increase in prices of stocks, %onds,commodities etc. in the market following a period of flat or declining prices.A rally can also %e used to refer to a period of sustained increases in the prices of stocks,

%onds or indexes in the market.&t is caused %y a large amount of money entering the market, %idding up the prices. $helength or magnitude of a rally depends on the depth of %uyers along with the amount ofselling pressure they face. &f there is a large pool of %uyers %ut few investors willing to sell,owing to the excessive demand and high %ids, the prices are likely to increase considera%lyand there could %e a large rally. &f, however, the same large pool of %uyers is matched %y asimilar amount of sellers, the rally is likely to %e short and the price movement minimal.

'or instance,


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4efore the 9:; elections, the &ndian stock market rallied as investors were %etting %ig onNA*s victory. $he optimism stemmed from the hope of a sta%le alliance forming a%usiness-friendly government that will speed up reforms and accelerate economic growth.'rom the %eginning of the year, the Sensex has seen an increase in levels of over 9:F.

2. &e%%'off

A sell-off refers to the rapid selling of securities, such as stocks, %onds and commodities.$his increase in supply leads to a sharp decline in price.A sell-off may occur for many reasons. 'or example, if a company issues a disappointingearnings report, it can spark a sell-off of that companyGs stock. External forces can alsocause a sell-off. 'or example, a spike in grain prices may trigger a sell-off in food stocks

%ecause of the increases in raw materials costs.Sell-offs are important market events. &nvestors should try to sell a security well %efore a

dramatic sell-off so as not to %e the last one holding the stock. At the same time, investorscan take advantage of sell-offs, especially %road market sell-offs, to %uy fundamentallygoods stocks at very afforda%le prices.&n the %eginning of this month, Sensex and other &ndices slid. $he sell-off was triggered

%ecause of the weak glo%al cues and continuing geo-political tensions and the news ofArgentinaGs de%t default among other factors.

3. !oints to !onder

; What could be the macro-economic indicators of a rally or a sell-off?

2) Do you think the speculation activities increase more than general during a rally or a

sell-off?

*rbitrage

1. Definition

Ar%itrage is the simultaneous purchase and sale of an asset in order to make a risk-lessprofit from a difference in price. &t is a trade that profits %y exploiting price differences ofidentical or similar financial instruments, on different markets or in different forms.Hooking at this in the context of stocks, a stock can %e traded on multiple exchanges and oneach exchange the uoting price may %e a %it different. @ne can %uy this stock at a lower

price on one of the exchanges, and sell it at a higher price on the other 1 thus making aprofit owing to the disparity in prices. A point to note is that the %uying and selling of thisstock must occur simultaneously to avoid exposure to market risk (the risk that prices maychange on one exchange %efore %oth transactions are complete.

Ar%itrage exists as a result of market inefficiencies. &t is possi%le when one of threeconditions is metI


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;. $he same asset does not trade at the same price on all markets (the law of one price.9. $wo assets with identical cash flows do not trade at the same price.=. An asset with a known price in the future does not today trade at its future pricediscounted at the risk-free interest rate.

2. Examp%e

Suppose 6al"art is selling the J ofovie !"#for >;:. Bowever, you know that one4ay the last 9: Js ofovie !"#sold for around >98. !ou could then %uy the Jfrom 6al"art, sell them on e4ay for a profit of >;8 per J. $his difference in price isdeferred to as having an ar%itrage opportunity and the >;8 gain you make represents thear%itrage profit.

3. *pp%ications

Ar%itrage is a necessary force in the financial marketplace. Ar%itrageurs are experiencedinvestors that exploit price inefficiencies 1 they play an important role in the operation ofcapital markets. $he presence of these investors in the market leads to prices %eing moreaccurate than they otherwise would %e.


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Similarly, in the context of options, a long position refers to the %uying of an optionscontract. !ou have the right (%ut not an o%ligation to exercise the option %efore expirationor sell it.A long position on a stock or an option is taken with the expectation that the asset will risein value in the future.

'or example, /ohn decides to take a long position on 8LL.?M >8LL?.M:.Suppose, a year later, the price of the M::, /ohn*s investment would %eworth >M::: (a gain of >99;.:, which he can reali)e %y selling these stocks.

3. &hort !osition

A short position refers to two scenarios 1

; Selling a security you own.9 4orrowing a security (from a %roker or a financial institution for a period and selling ittoday. At the end of the period, it needs to %e returned to the owner with some additional

interest.

&n the context of options, a short position means that you have sold the option, giving theholder the right to exercise it and o%ligated yourself to fulfilling the terms of the contract ifthe %uyer of the option exercises it.A short position on a stock or an option is taken when the asset value is expected to fall.'or example, /ohn thinks that the price of the 8LL.?M, thus making >8LL?.M:.Suppose, a week later, the price of the 8M:, he can %uy ;:: shares fromthe market (at >8M::, return them to his %roker along with the interest (:.8F O >8LL?.M: 9?.?P. Be thus spends a total of 8M9?.?P, still making some money on his originalinvestment.

4. !oints to !onder

1) What are the factors to be taken into consideration while deciding whether a long or ashort position should be taken on a stock$underlying?

2)%re short positions riskier than long positions? Why or why not?

Trading -becti(es /

1. 0edging/

An investment strategy to limit or offset pro%a%ility of loss due to adverse price

movement. A perfect hedge reduces risk to )ero. Bedging techniues generally involvethe use of complicated financial instruments known as derivatives, the two most common
http://www.investopedia.com/terms/o/option.asphttp://www.investopedia.com/terms/o/option.asp


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of which are futures and options.'uturesI A future contract is a standardi)ed contract to %uy or sell an underlying on aspecified date for a pre-determined price.

@ptionsI A financial derivative that offers the %uyer of the option contract the right, %utnot the o%ligation, to %uy (call or sell (put a an financial asset in future.0edging using FuturesISuppose a company needs to pay >9: million in three months for oil imports with thecurrent &NQS exchange rate at 8P. &t %ears the risk of the rupee falling in value(depreciating. 'or example if the exchange rate is M9 &NQS after = months thecompany has to pay &NQ M: mm extra. $o protect itself (to hedge the company will %uy a=-month futures contract. $his will ena%le the company to fix the amount to %e paid after=-months. Assuming the futures rate to %e M: &NQS the company has to pay &NQ

;9:: mm irrespective of the actual exchange rate after = months.0edging using options/

Suppose an investor owns ;: shares of #!K company. $he share price is &NQ ;::.&nvestor is worried that the price may decrease. $o hedge this risk, the investor can %uy

put option contract (right to sell an asset in future at a specific price called strike price. &fthe uoted option contract premium is &NQ ; per share, then an option contract of ;:shares would cost &NQ ;:. Also, let the strike price %e &NQ P8. &f the share price falls

%elow &NQ P8, say &NQ P:, then option can %e exercised and a net value of &NQ P: can%e reali)ed.

2. &pecu%ation/

6hile hedging is aimed at avoiding risk, speculation involves taking advantage offluctuations in price. Speculators are either %etting on price moving up or moving down.$hey act as market makers and increase liuidity in the market. &t is often confused withgam%ling or investment. A speculation involves taking calculated risks and is not a gameof pure chance.

3. !oints to !onder/

&uppose an 'ndian e(porter is to receive 1 mm in * months and he wants to

protect himself against appreciation of the rupee+ How would he$she hedge?

'f a share trader e(pects ,eliance to announce the launch of a new power proect+ How

will he$she speculate?

oney arket $nstruments

1. oney arket


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"oney "arket is the part of financial market where instruments with high liuidity andvery short-term maturities are traded. &tGs the place where large financial institutions,dealers and government participate and meet out their short-term cash needs.$rading inthe money markets is done over the counter. $he most common money market

instruments are +ommercial 0apers, Qepurchase Agreements and 4ankerGs Acceptance.

2. Types of instruments

+ommercial 0apers- +ommercial 0aper is the short term unsecured promissory noteissued %y corporate and financial institutions at a discounted value on face value. $heycome with fixed maturity period ranging from ; day to 9L: days. $hese are issued for the

purpose of financing of accounts receiva%les, inventories and meeting short termlia%ilities. $he return on commercial papers is higher as compared to $reasury 4ills so is

the risk as they are less secure in comparison to these %ills.Qepurchase Agreements- Qepurchase Agreements which are also calledas Qepo or Qeverse Qepo are short term loans that %uyers and sellers agree upon forselling and repurchasing. Qepo or Qeverse Qepo transactions can %e done only %etweenthe parties approved %y Q4& and allowed only %etween Q4&-approved securities such asstate and central government securities, 0S %onds and corporate %onds. $hey are usuallyused for overnight %orrowing. Qepurchase agreements are sold %y sellers with a promiseof purchasing them %ack at a given price and on a given date in future. @n the flip side,the %uyer will also purchase the securities and other instruments with a promise of sellingthem %ack to the seller.

4anker*s Acceptance- 4ankerGs Acceptance is like a short term investment plan created %ynon-financial firm, %acked %y a guarantee from the %ank. &tGs like a %ill of exchangestating a %uyerGs promise to pay to the seller a certain specified amount at a certain date.And, the %ank guarantees that the %uyer will pay the seller at a future date. 'irm withstrong credit rating can draw such %ill. $hese securities come with the maturities %etween=: and ;?: days and the most common term for these instruments is P: days. +ompaniesuse these negotia%le time drafts to finance imports, exports and other trade.

3. "haracteristics of $nstruments

Hiuidity - Since they are fixed-income securities with short-term maturities of a year orless, money market instruments are extremely liuid.

Safety - $hey also provide a relatively high degree of safety %ecause their issuers have thehighest credit ratings.

iscount 0ricing- A third characteristic they have in common is that they are issued at a

discount to their face value.


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4. !oints to ponder

How many types of options are there?

What are the differences between two options?

Fixed $ncome $nstruments

1. Fixed $ncome $nstruments

'ixed &ncome &nstruments are investments that provide a minimum assured return.Examples of some popular fixed income instrutments are %onds, certificate of deposits,and treasury %ills.

2. !opu%ar Fixed $ncome $nstruments

4onds- A %ond is an o%ligation or a loan made %y an investor to an issuer (e.g. agovernment or a company. &n turn, the issuer promises to repay the principal (or facevalue of the %ond on a fixed maturity date and to make regularly scheduled interest

payments (usually every six months. $he ma5or issuers of %onds are governments andcorporations and some examples of %onds are government, corporate and )ero coupon

%onds.

$reasury 4ills- $reasury %ills ($-%ills are the safest type of short-term de%t instrumentissued %y a federal government. &deal for investors seeking a ;- to ;9- month investment

period, $-%ills are highly liuid and very secure. $-%ills are issued through a competitive%idding process at a discount from par, which means that rather than paying fixed interestpayments like conventional %onds, the appreciation of the %ond provides the return to theholder.+ertificate of deposits- Sold %y %anks, certificates of deposit (%etter known as +s arelow-risk 1- and relatively low-return R investments suita%le for cash you don*t need formonths or years. &f you leave the money alone during the investment period (known as the

CtermD or CdurationD, the %ank will pay you an interest rate slightly higher than what youwould have earned in a money market or savings account. A + %ears a maturity date, aspecified fixed interest rate and can %e issued in any denomination. $he term of a +generally ranges from one month to five years.

3. $n(estors


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&nvestors in fixed-income securities are typically looking for a constant and secure returnon their investment. 'or example, a retired person might like to receive a regulardependa%le payment to live on, %ut not consume the principal. $his person can %uy a %ondwith their money, and use the coupon payment (the interest as that regular dependa%le

payment. 6hen the %ond matures or is refinanced, the person will have their moneyreturned to them.

4. !oints to ponder

Can a firm raise capital for the short term without risking any collateral?

Are there ways for a company with surplus cash to redistribute its cash to another company whoneeds it?

&tocks1. &tocks

A stock is a form of security that signifies ownership in a corporation and represents a claimon the corporation*s assets and earnings. $here are three types of stock- common stock,

preferred stock and converti%le preferred stock. Stocks are issued to raise capital for thecompany.

2. Types of stocks

+ommon stock- &t is a form of corporate euity ownership. @rdinary shares are also known aseuity shares. An ordinary share gives the right to its owner to share in the profits of the

company (dividends and to vote at general meetings of the company0referred stock- A class of ownership in a corporation that has a higher claim on the assetsand earnings than common stock. 0referred stock generally has a dividend that must %e paidout %efore dividends to common stockholders and the shares usually do not have votingrights.$he %est way to think of preferred stock is as a financial instrument that hascharacteristics of %oth de%t (fixed dividends and euity (potential appreciation. Also knownas preferred shares.+onverti%le shares- $hese shares are corporate fixed-income securities that the investor canchoose to turn into a certain num%er of shares of the companyGs common stock after a

predetermined time span or on a specific date. $he fixed-income component offers a steadyincome stream and some protection of the investorsG capital. Bowever, the option to convertthese securities into stock gives the investor the opportunity to gain from a rise in the share

price. $hat said, converti%le preferred shareholders, unlike common shareholders, rarelyhave voting rights.

3. "omparison between the types of stocks


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$he ma5or difference %etween preference shares and euity shares occurs due to ranking

given to them for raising capital. +ommon stock is lower in the ranking than preferenceshares, therefore gets paid only after preference shares have %een paid out. Bowever,common stock holders do get the opportunity to vote and participate in a company*smanagement whereas preference share holders do not.4. !oints to !onder

Are there instruments where one can receive a fixed payment schedule?

How does one mitigate the risk one takes on when trading in stocks?

-T"' -(er the "ounter

1. -T"

@ver $he +ounter trading is conducted %etween two parties without the facilitation of theexchange. $his allows traders to directly interact with each other and fix the prices ofsecurities not listed on the exchange. @ne of the significant challenges with an @$+transaction is the counterparty risk involved. ey instruments traded through an @$+market are swaps, forward rate agreements, credit derivatives, %onds and etc.

2. -T" arket and its imp%ications

)asis of Difference !reference &hare Euity &hare

Qight of dividend 0aid dividend %efore euityshares

0aid dividend out of the%alance of profit availa%leafter the dividend paid to

preference shares

Qate of dividend 'ixed rate ecided year on yeardepending on performance

+onverti%ility "ay %e converted Not converti%le

Joting rights No voting rights Qight to vote

0articipation inmanagement

o not have right toparticipate in management

Qight to participate inmanagement of company

Qefund of +apital &f company shuts down,receives pay%ack %eforeeuity shares

&f company shuts down,receives pay%ack after

preference share pay%ack


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An @$+ market is a decentrali)ed market where people trade with each other through thevarious forms of communication availa%le. $he difference %etween an @$+ and anexchange market is the lack of transparency in an @$+ transaction. $his occurs as the

price is not disclosed %y the traders. $he trade in the @$+ market is also su%5ect to fewerguidelines.

@$+ markets are split into two segments- the customer market and the interdealer market.$he customer market is for customers who trade through dealers %ecause of the highsearch and transaction cost involved. 6hereas the interdealer market is run %y largeinstitutions that use their expertise to organi)e transactions for their clients.@$+ markets have gained significant importance in recent years. $raders from investment

%anks create tailor-made derivatives for their clients such as hedge funds, commercial%anks, governments and etc. $he total face value of @$+ derivatives stood at >L;: trillionas of ecem%er 9:;=.

$here is a significant risk that is undertaken in an @$+ transaction that %oth the partieswill fulfil their o%ligations. Bowever, there is always the pro%a%ility that an issuer of aderivative fails to follow through the pay schedule and will default on the trade. $heserisks are called as counterparty risks and they were under the spotlight during the financialcrises. uring the crises people were una%le to pay on their o%ligations which led to astrong decrease in transaction activity and a lack of %uyers. $his exacer%ated the liuiditycrises around the world.

4. #e%ation between Exchange market and -T" market

As exchange traded contracts have a one si)e fits all instrument, it is hard for traders toreduce their risk in the exchange market. $herefore, traders use the @$+ market to createthe Tperfect hedge* to help mitigate the risk and tailor a product, %est suited for their risk

exposure.

. -T" in $ndia


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&n &ndia, the @$+ derivative products were introduced %y Q4& in a phased manner.Bowever, in line with the reforms set forth after the financial crises, all over-the-countertransactions %y %anks in currency swaps and interest rate derivatives have to %e reportedto the +learing +orporation of &ndia Htd (++&H. Additionally, for any derivativetransaction, there has to %e at least one party that is recognised %y the Q4&. $his has

helped reduce counterparty risks in &ndia.

. !oints to !onder

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

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

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