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Key Financial Markets Traded

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K ey Financia l Markets TradedThe first chapter is a very gentle introduction to the different types of financial instrumentstraded in the United States of America. It mainly is a collection of functions and definitions offinancial instruments in general. We also briefly set the scene for some of the later chapters byclassifying the types of markets these products trade along with the classification of the

products themselves. Depending on your background, you can choose to read the chapterthoroughly or skim through. We have written this chapter to be informative rather thaninstructive.

Introduction

Before, we discuss about the types of financial instruments, let us first discuss why do financialmarkets exist? What are the benefits of having financial markets to the society?

Financial Markets like any other markets are there to facilitate the exchange of goods, the goodhere being value. The value of each financial product may be different for different people.Due to this disagreement in value some of the people are buyers and some are sellers of thisvalue. Financial Markets facilitate these transactions by connecting the buyers and the sellers.This value can be in the form of value of equity in the company, value of a particular commodity,or value of one currency with respect to the other currency. The other very subtle reason forexistence of financial markets is to connect the issuers and borrowers of securities to those whowish to purchase those securities. For example, a company may want to issue shares to raisecapital or a country may want to issue debt to build its roads and infrastructure, in such asituation it can go to financial markets to raise funds by issuing debt or equity. We haveintroduced two major categories of financial instruments Debt and Equity. We will define theseand many more, later in this chapter. To sum up the discussion of existence of financial marketsit is worth mentioning that financial markets exist for three major reasons. Firstly, to connect theinvestors and lenders to issuers and borrowers respectively, Secondly, to help nations buildinfrastructure and other developmental activities and finally to better position companies andbusinesses to take bigger challenges and projects and hence drive innovation and industrialdevelopment. There are various other uses and functions of financial markets and productswhich will be clear as we discuss each of the products in this chapter.

As we discussed above, Equity and Debt are the two major instruments of value, we will fromnow formally classify them asset classes. Together with Commodities and FOREX, theyconstitute the four major asset classes in financial markets. Although market structures differ byasset class which is the discussion of this book, all of them share some common characteristicsof market structure on a broader scale. This can be classified as Primary or Secondary Markets,OTC or Exchange traded and Cash or Derivatives market. We will leave the discussion for theformer two structures later, but it is worth mentioning the Cash or Derivatives market at this


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point to continue the discussion.

Cash or Derivatives Market

Cash Markets provide actual ownership of the asset to participants in the financial markets. ACash market is traded for immediate (within the allowed settlement period which can bedifferent for different product) delivery or possession of asset. A Derivatives Market on the otherhand gives the holder either an obligation or choice to buy or sell an asset at some future pointin time. Derivatives market has financial contracts that derive their value from the underlying inthe Cash market.

Equities (Stocks) Markets:

Although Equities Markets may consist of variety of instrument type: Common stock andPreferred stock are two most prevalent types. There are other types of stocks traded in theUnited States of America, namely ADR or ETF which vary significantly from the common stockin terms of underlying risk and product formation dynamics.

Belgium boasted a stock exchange as far back as 1531, in Antwerp. Brokers and moneylenderswould meet there to deal in business, government and even individual debt issues. It is odd tothink of a stock exchange that dealt exclusively in promissory notes and bonds, but in the 1500sthere were no real stocks. There were many flavors of business-financier partnerships thatproduced income like stocks do, but there was no official share that changed hands.

Trading stocks can be compared to gambling in a casino, where you are betting against thehouse, so if all the customers have an incredible string of luck, they could all win.

Stock represents the residual asset of the company that would be due to stockholders afterdischarge of all senior claims such as secured and unsecured debt. Stockholders equity cannotbe withdrawn from the company in a way that is intended to be detrimental to the companys
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creditors.

A holder of stock (a shareholder) has a claim to a part of the corporation's assets andearnings. In other words, a shareholder is an owner of a company. Ownership is determined bythe number of shares a person owns relative to the number of outstanding shares. For example,if a company has 1,000 shares of stock outstanding and one person owns 100 shares, thatperson would own and have claim to 10% of the company's assets.Stocks are the foundation of nearly every portfolio. Historically, they have outperformed mostother investments over the long run.

When you own a share of a stock, you are a part owner in the company with a claim onevery asset and every penny in earnings. Individual stock buyers rarely think like owners, andit's not as if they actually have a say in how things are done.

Common Stock

Common shareholders are owners of the corporation. Holders of common stock exercisecontrol by electing a board of directors and voting on corporate policy. Common stockholdersare on the bottom of the priority ladder for ownership structure. In the event of liquidation,common shareholders have rights to a company's assets only after bondholders, preferredshareholders and other debt holders have been paid in full. In the U.K., these are called"ordinary shares"

If the company goes bankrupt, the common stockholders will not receive their moneyuntil the creditors and preferred shareholders have received their respective share of theleftover assets. This makes common stock riskier than debt or preferred shares. The upside tocommon shares is that they usually outperform bonds and preferred shares in the long run asthey are entitled to the profits of the company.

Preferred Stock

A class of ownership in a corporation that has a higher claim on the assets and earningsthan common stock i.e. preferential treatment is called Preferred stock. Preferred stockgenerally has a dividend that must be paid out before dividends to common stockholders andthe shares usually do not have voting rights.

The precise details as to the structure of preferred stock are specific to each corporation.However, the best way to think of preferred stock is as a financial instrument that hascharacteristics of both debt (fixed dividends) and equity (potential appreciation) also known as"preferred shares".

There are certainly pros and cons when looking at preferred shares. Preferredshareholders have priority over common stockholders on earnings and assets in the event ofliquidation and they have a fixed dividend (paid before common stockholders), but investorsmust weigh these positives against the negatives, including giving up their voting rights and less


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potential for appreciation.

(Strumpf, Dan. "U.S. Public Companies Rise Again." The Wall Street Journal. 5 Feb. 2014.)

The number of companies traded on major U.S. stock exchanges rose by 92 last year,taking the count of U.S.-listed companies to 5,008 at year-end, according to data provided bythe World Federation of Exchanges, a trade association.


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Top 10 Stock Exchanges(By market capitalization) in the world:

Rank Exchange Country MarketCap($Billion)

TradeVolume(Billion)

1 New York Stock Exchange United States 18,779 11,2992 NASDAQ United States 6,683 8,7393 Japan Exchange Group Japan 4,485 4,0114 Euronext Netherlands France

Belgium Portugal3,504 1443

5 London Stock Exchange United KingdomItaly

3,396 1,890

6 Hong Kong StockExchange

China 3,146 1,093

7 Shanghai Stock Exchange China 2,869 2,9208 TMX Group Canada 2,204 1,008

9 Shenzhen Stock China 1,913 3,67710 Deutsche Bourse Germany 1,716 1,095Data from "world federation of exchanges" September 2014

An important point to discuss here or may be for any instrument in the financial markets will be:How these instruments come to the markets? How are they available for trading? Where arethey traded? Who trades these instruments? Many more such details about each instrumentare inevitable. These questions are answered in details in the future chapters, but we will touchupon some of the details here for completion.

Here we describe the second important classification of the financial market structure i.e.Primary Markets and Secondary Markets.

Primary Markets

The Primary markets are the place where creation of securities takes place. These Marketscreate a mechanism where companies and governments can access funds from investors andtheir intermediaries. Basically these markets provide the initial point of inception for thesecurities. There are various methods by which each instrument may be introduced in theprimary markets and the method of raising funds. Some of these methods may be Underwriting,

Auctions etc.

Secondary Markets

The Secondary markets are the place that does not raise money for corporations orgovernments but they facilitate the function of transferring the ownership of securities from oneowner to the other. The function is promoted by the activity which we call Trading. Thesecurities are traded at trading venues for example, Exchanges like NYSE or CME. Thesecondary market structure is further subdivided into different types of buyers and sellers,


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brokers, dealers, broker / dealer which will be covered in depth in further chapters.

This brings us to our third and important classification due to difference in type of trading venuesExchange Traded and Over the Counter (OTC)

Exchange Traded and OTC Markets

The securities in the secondary market where the trading venue is an organized exchange arecalled Exchange traded instruments. The important terminology here is organized. In fact, thestudy of trading which takes place at organized exchanges is described as MarketMicrostructure by Larry Harris in his book titled Trading and Exchanges: Market Microstructurefor practitioners . The securities that trade without any intermediary exchange to facilitate thetransaction are called OTC traded instruments.

We shall now discuss other types of Equities and discuss about various instruments in Cash aswell as Derivatives Segment.

American Depositary Receipt (ADR)

Introduced to the financial markets in 1927, an American depositary receipt (ADR) is astock that trades in the United States but represents a specified number of shares in a foreigncorporation. ADRs are bought and sold on American markets just like regular stocks, and areissued/sponsored in the U.S. by a bank or brokerage.

The stocks of most foreign companies that trade in the U.S. markets are traded as American Depositary Receipts (ADRs). Each ADR represents one or more shares of foreignstock or a fraction of a share. If you own an ADR, you have the right to obtain the foreign stock itrepresents, but U.S. investors usually find it more convenient to own the ADR. The price of an

ADR corresponds to the price of the foreign stock in its home market, adjusted to the ratio of the ADRs to foreign company shares. (SEC.gov)
http://www.investopedia.com/terms/a/adr.asphttp://www.investopedia.com/terms/a/adr.asp


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Manish. "American Depositary Receipts (ADRs) - Finance Train." Finance Train 05 Nov.2014.

A negotiable certificate issued by a U.S. bank representing a specified number of shares(or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated inU.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help

to reduce administration and duty costs that would otherwise be levied on each transaction.This is an excellent way to buy shares in a foreign company while realizing any

dividends and capital gains in U.S. dollars. However, ADRs do not eliminate the currency andeconomic risks for the underlying shares in another country. For example, dividend payments ineuros would be converted to U.S. dollars, net of conversion expenses and foreign taxes and inaccordance with the deposit agreement. ADRs are listed on either the NYSE, AMEX orNASDAQ as well as OTC.

Exchange Traded Fund(ETF)

A security that tracks an index or a basket of assets like an index fund, but trades like a


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stock on an exchange is called an ETF. ETFs experience price changes throughout the day asthey are bought and sold.

In less than 20 years, exchange-traded funds (ETFs) have become one of the mostpopular investment vehicles for both institutional and individual investors. Often promoted ascheaper, and better, than mutual funds, ETFs offer low-cost diversification, trading and arbitrageoptions for investors.Now with over $1 trillion assets under management, new ETF launches number from severaldozen to hundreds, in any particular year. ETFs are so popular that many brokerages offer freetrading in a limited number of ETFs to their customers.

Because it trades like a stock, an ETF does not have its net asset value (NAV)calculated every day like a mutual fund does.Think of an ETF as a mutual fund that trades like astock. Just like an index fund, an ETF represents a basket of stocks that reflect an index suchas the S&P 500. An ETF, however, isn't a mutual fund; it trades just like any other company ona stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end

of each trading day, an ETF's price changes throughout the day, fluctuating with supply anddemand. It is important to remember that while ETFs attempt to replicate the return on indexes,there is no guarantee that they will do so exactly. It is not uncommon to see a 1% or moredifference between the actual index's year-end return and that of an ETF.

By owning an ETF, you get the diversification of an index fund as well as the ability tosell short, buy on margin and purchase as little as one share. Another advantage is that theexpense ratios for most ETFs are lower than those of the average mutual fund. When buyingand selling ETFs, you have to pay the same commission to your broker that you'd pay on anyregular order. One of the most widely known ETFs is called the Spider (SPDR), which tracks theS&P 500 index and trades under the symbol SPY.

Mutual Funds Stocks

ETF
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Derivatives

Derivatives markets have become more and more important in the finance world. It hasbecome necessary for finance people to know how these markets work, and how they can beused, and what determines there price. Derivatives are instruments that derive its value from an

underlying. This underlying instrument can be Equities, Commodities, Bonds or even anotherDerivative.

Futures

Futures markets have formed in the middle ages. Originally they were used tomeet the needs of farmers and merchants.

A future contract is an agreement to buy or sell an asset at a certain time in the future fora certain price. There are many exchanges throughout the world trading futures contracts. TheChicago Board of Trade, the Chicago Mercantile Exchange, and the New York MercantileExchange have merged to form the CME Group. Other large exchanges include NYSEEuronext, Eurex, BM&FBOVESPA, and the Tokyo Financial Exchange.

Future exchanges allow people buy or sell assets in the future to trade with eachother. For Example:

"In September a trader in Chicago might contact a broker with instructions to buy500 barrel of crude oil for December delivery. The broker would immediately communicate theclients instructions to the Chicago Board of Trade. At about the same, another tra der in Los

Angels might instruct a broker to sell 500 Barrel of crude oil for December delivery. These

instructions would also be passed on the Chicago Board of Trade. A price would be determinedand the deal would be done."

Futures can be used either to hedge or to speculate on the price movement of theunderlying asset. For example, a producer of corn could use futures to lock in a certain priceand reduce risk(hedge). On the other hand, anybody could speculate on the price movement of


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corn by going long or short using futures

CBOT(The Chicago Board of Trade), established in 1848, is the oldest futures andoptions exchange in the world. CBOT now offer futures contracts on many different underlyingassets, including corn, soybeans, soybean meal, soybean oil, oats, wheat, Treasury bonds, andTreasury notes. More than 50 different options and futures contracts are traded by over 3600CBOT members through open outcry and electronic trading. 36 years later CME(The ChicagoMercantile Exchange) was established, it provding a market for butter and eggs. On July 122007, CBOT merged with the CME to form the CME Group.(CME,NYMEX, COMEX)

Options

There are two types of options Call option and Put option.

A call option gives the holder of the option the right to buy an asset by a certain date for

a certain price.

A put option gives the holder the right to sell an asset by a certain date for a certainprice.

The date specified in the contract is know as the expiration date or the maturity date.The price specified in the contract is know as the exercise price or the strike price.

Option gives the holder the right to do something, that means the holder does not haveexercise the right. This methods distinguish between the future contracts from options."theholder of a long futures contract is committed to buying an asset at a certain price at a certaintime in the future. By contrast, the holder of a call option has a choice as to whether to buy theasset at a certain price at a certain time in the future. It costs nothing( except for marginrequirements) to enter into a futures contract. By contrast, an investor must pay an up-frontprice, know as the option premium", for an options contract." written by John C. Hull. Also oneimportant difference between stocks and options is that stocks give you a small piece ofownership in the company, while options are just contracts that give you the right to buy or sellthe stock at a specific price by a specific date. It is important to remember that there are alwaystwo sides for every option transaction: a buyer and a seller. So, for every call or put optionpurchased, there is always someone else selling it.

Jim Graham written in "Getting Acquainted With Options Trading" said Trading options is

more like betting on horses at the racetrack. There they use parimutuel betting, whereby eachperson bets against all the other people there. The track simply takes a small cut for providingthe facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer'sgain is the option seller's loss and vice versa: any payoff diagram for an option purchase mustbe the mirror image of the seller's payoff diagram.

Premium is the price of an option. The buyer of an option cannot lose more than theinitial premium paid for the contract, no matter what happens to the underlying security. So the
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risk to the buyer is never more than the amount paid for the option. The profit potential, on theother hand, is theoretically unlimited.

In return for the premium received from the buyer, the seller of an option assumes therisk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of thestock. Unless that option is covered by another option or a position in the underlying stock, theseller's loss can be open-ended, meaning the seller can lose much more than the originalpremium received.

Other Option types

There have many different kinds of option types

According to the underlying assets

Equity option

Bond option

Future option

Index option

Commodity option

Currency option

According to the trading markets

Exchange-traded options includes

Stock options


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Bond option and other interest rate options

Stock market index option or simply, index options

Options on futures contracts

Callable bull/ bear contract

Over the counter options includes

Interest rate options

Currency cross rate options

Options on swaps or swaptions

Another important class of options, particularly in the United States are employee stockoptions, which are awarded by a company to their employees as a form of incentivecompensation. other types of options exist in many financial contracts, for example real estateoptions are often used to assemble large parcels of land, and prepayment options are usuallyincluded in mortgage loans. However, many of the valuation and risk management principlesapply across all financial options.

Option styles

European option An option that may only be exercisedon expiration.

American option An option that may be exercised onany trading day on or before expiry.

Bermudan option An option that may be exercised onlyon specified dates on or before expiration.

Asian option An option whose payoff is determinedby the average underlying price over somepreset time period.
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Barrier option Any option with the generalcharacteristic that the underlying security'sprice must pass a certain level or "barrier"before it can be exercised.

Binary option An all-or-nothing option that pays thefull amount if the underlying security meetsthe defined condition on expiration otherwiseit expires worthless.

Exotic option Any of a broad category of optionsthat may include complex financial structures

Vanilla option Any option that is not exotic.

The two basic well know options are American and European option. An American or American-style option can be exercised at any time between the date of purchase and theexpiration date. Most exchange-traded options are American style and all stock options are

American style. A European, or European-style, option can only be exercised on the expirationdate. Many index options are European style.

When the strike price of a call option is above the current price of the stock, the call isout of the money; when the strike price is below the stock's price it is in the money. Put optionsare the exact opposite, being out of the money when the strike price is below the stock priceand in the money when the strike price is above the stock price.

Note that options are not available at just any price. Stock options are generally tradedwith strike prices in intervals of $2.50 up to $30 and in intervals of $5 above that. Also, onlystrike prices within a reasonable range around the current stock price are generally traded. Farin- or out-of-the-money options might not be available.

All stock options expire on a certain date, called the expiration date. For normal listedoptions, this can be up to nine months from the date the options are first listed for trading.Longer-term option contracts, called LEAPS, are also available on many stocks, and these canhave expiration dates up to three years from the listing date.

Options officially expire on the Saturday following the third Friday of the expirationmonth. But, in practice, that means the option expires on the third Friday, since your broker isunlikely to be available on Saturday and all the exchanges are closed. The broker-to-brokersettlements are actually done on Saturday.

Unlike shares of stock, which have a three-day settlement period, options settle the nextday. In order to settle on the expiration date (Saturday), you have to exercise or trade the option
http://www.investopedia.com/articles/optioninvestor/08/european-options.asphttp://www.investopedia.com/articles/optioninvestor/08/european-options.asphttp://www.investopedia.com/terms/i/indexoption.asphttp://www.investopedia.com/terms/o/outofthemoney.asphttp://www.investopedia.com/terms/i/inthemoney.asphttp://www.investopedia.com/terms/l/leaps.asphttp://www.investopedia.com/articles/optioninvestor/03/090303.asphttp://www.investopedia.com/articles/optioninvestor/03/090303.asphttp://www.investopedia.com/articles/optioninvestor/03/090303.asphttp://www.investopedia.com/articles/optioninvestor/03/090303.asphttp://www.investopedia.com/terms/l/leaps.asphttp://www.investopedia.com/terms/i/inthemoney.asphttp://www.investopedia.com/terms/o/outofthemoney.asphttp://www.investopedia.com/terms/i/indexoption.asphttp://www.investopedia.com/articles/optioninvestor/08/european-options.asphttp://www.investopedia.com/articles/optioninvestor/08/european-options.asp


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by the end of the day on Friday.

The largest exchange in the world for trading stock options is the Chicago Board Options

Exchange(CBOE)

Swaps

A swap is an agreement between two companies to exchange cash flows in the future.The agreement defines the dates when the cash flows are to be paid and they way in whichthey are to be calculated. Usually the calculation of the cash flows involves the future value ofan interest rate, an exchange rate, or other market variable.

A forward contract can be viewed as a simple example of a swap. Suppose it is Aug 1,

2014, an a company enters into a forward contract to buy $200 ounces of gold for $800 perounce in one year. The company can sell the gold in one year as soon as it is received. Theforward contract is therefore equal to a swap where the company agrees that on Aug 1, 2015, itwill pay $160.000 and receive $200*P. Where p is the market price of one ounce of gold on thatdate.

If firms in separate countries have comparative advantages on interest rates, then aswap could benefit both firms. For example, one firm may have a lower fixed interest rate, whileanother has access to a lower floating interest rate. These firms could swap to take advantageof the lower rates.

(WEINBERG, ARI I. "'Swaps' Add a New Risk." The Wall Street Journal. Dow Jones &Company,05 Nov. 2014.)( Hull, John C. Fundamentals of Futures and Options Markets. Boston: Prentice Hall, 2011)


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Plain Vanilla

The most common type of swap is a"plain vanilla" interest rate swap. In this acompany agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional

1. To replicate a $1Million investment in thesecurity, the fund entersinto a swap agreementfor that "notional"amount with a bank

2. The fund deposits aportion of that $1 million,20% as collateral at athird party andsegregates theremainder as cash in itsportfolio.

3. If the security rises invalue, the bank sendsmoney to collateralmanager and ultimatelyto the fund.

4. If the security falls invalue the bank is paidaand the fund postsmore collateral to get

back to 20%.

5. Fund investors getreturns, for good or bad,as if the fund hadowned the security

directly.

Collateral manager


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principal for a number of years. In return, it receives interest at a floating rate on the samenotional principal for the same period of time.

LIBOR

The floating rate in most interest rate swap agreements is the London InterbankOffered Rate(LIBOR), it is the rate of interest at which a bank is prepared to deposit money withother banks that have a AA credit rating . One month, three month, six month and twelvesmonth LIBOR are commonly quoted in all major currencies.

A LIBOR quote by a particular bank is the rate of interest at which the bank isprepared to make a large wholesale deposit with other banks. Large banks and other financialinstitutions quote LIBOR for maturities up to 12 months in all major currencies.

A deposit with a bank can be regarded as a loan to that bank. A bank must therefore

satisfy certain creditworthiness criteria in order to be able to accept a LIBOR quote from anotherbank and receive deposits from that bank at LIBOR. Typically it must have to have a AA creditrating.


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