Financial Markets
Financial Markets
Core Course
MA ECONOMICS
IV SEMESTER
ECO4 C13
FINANCIAL MARKETS
190314
FINANCIAL MARKETS
IV SEMESTER
Core Course
MA ECONOMICS
(2019 Admission onwards)
(CBCSS)
UNIVERSITY OF CALICUT
SCHOOL OF DISTANCE EDUCATION
Calicut University (P.O), Malappuram, Kerala, India 673635
Prepared by
Dr. Shiji O.
(Assistant Professor, SDE, University of Calicut)
Scrutinised by
Dr. YC. Ibrahim
(Associate Professor & Vice Principal, Government
College Kodenchery, Kozhikode)
190314: MA Economics - IV SEMESTER
Contents
Detailed Syllabus
Module I
FINANCIAL MARKETS
Financial System
2. Mobilisation of savings
Another important activity of the financial system is to mobilise
savings and channelise them into productive activities. The financial
system should offer appropriate incentives to attract savings and
make them available for more productive ventures. Thus, the
financial system facilitates the transformation of savings into
investment and consumption. The financial intermediaries have to
play a dominant role in this activity.
3. Size transformation function
Generally, the savings of millions of small investors are in the nature
of a small unit of capital which cannot find any fruitful avenue for
investment unless it is transformed into a perceptible size of credit
unit. Banks and other financial intermediaries perform this size
transformation function by collecting deposits from a vast majority
of small customers and giving them as loan of a sizeable quantity.
Thus, this size transformation function is considered to be one of
the very important functions of the financial system.
4. Maturity transformation function
Another function of the financial system is the maturity
transformation function. The financial intermediaries accept deposits
from public in different maturities according to their liquidity
preference and lend them to the borrowers in different maturities
according to their need and promote the economic activities of a
country.
5. Risk transformation function
Most of the small investors are risk-averse with their small holding
of savings. So, they hesitate to invest directly in stock market. On
the other hand, the financial intermediaries collect the savings from
individual savers and distribute them over different investment units
with their high knowledge and expertise. Thus, the risks of individual
investors get distributed. This risk transformation function promotes
industrial development. Moreover, various risk mitigating tools are
available in the financial system like hedging, insurance, use of
derivatives, etc.
Structure of Financial System
• Financial Institutions
• Financial Markets
• Financial Instruments/Assets/Securities
• Financial Services.
Financial System is a combination of financial institutions,
financial markets, financial instruments and financial services to facilitate
the transfer of funds. Financial system provides a payment mechanism
for the exchange of goods and services. So, the four major components
that comprise the Financial System are:
The structure of the financial system is shown in the figure 1.1:
Figure 1.1: Financial System
Private Bank
Commercial
Banks
Public Bank
Co-operative
Banking Banks
Institutions Regional Rural
Financial Institutions Banks
Non-banking
Institutions Foreign Bank
Financial System
Secondary
Unorganized Market
Financial Markets Capital Market
Organized Primary Market
Financial Money Market
Assets/Instruments
Fund-Bases Leasing, Hire Purchase, Consumer Credit, Bill
Service Discounting, Factoring, Insurance etc..
Financial Services
Fee-Bases Issue Management, Merchant Banking, Credit
Service Rating, Debt Restructuring Stocks Broking etc..
I. Financial Institutions/Intermediaries
(i). Regulatory
Regulatory institutions are those which regulate the Financial
Institutions. For example, RBI is the regulatory institution of money
market and SEBI is the regulatory institution of capital market in
India.
(ii). Intermediaries
Intermediaries are those institutions which intermediate between
savers and investors. They are classified into Banking Financial
Intermediary (BFI) and Non-Banking Financial Intermediary
(NBFI).
Banking Financial Intermediaries are the creators of credit. They
accept deposit and give loans and advances.
E.g. Commercial Banks (Public and Private), Co-op. Banks, RRBs.
On the other hand, Non-Banking Financial Intermediaries are
mere suppliers of credit. They have no credit creation capacity-
E.g., LIC, GIC, UTI
(iii). Non-Intermediaries
Non-Intermediaries do the loan business but their resources are
not directly obtained from savers. They came into exist because
of governmental effort to provide for specific purposes, sections
and regions-E.g., IDBI, IFC, NABARD
(iv). Others
Other intermediaries are unorganised financial institutions. They
include Money Lenders, Indigenous bankers, Traders, Pawn
Brokers, Land Lords etc.
Primary securities
These are securities directly issued by the ultimate investors to
the ultimate savers, e.g., shares and debentures issued directly to the
public.
Secondary securities
These are securities issued by some intermediaries called
financial intermediaries to the ultimate savers, e.g., Unit Trust of India
and Mutual Funds issue securities in the form of units to the public and
the money pooled is invested in companies.
Again, these securities may be classified on the basis of duration
as follows:
(i) Short-term securities.
b) Price Determination:
The financial commodities traded in a financial market get their prices
from the rules of demand and supply. The investors or the household
are the suppliers of the funds, and the industries are the ones demanding
them. The interaction between the two and other market factors will
help determine the prices.
c) Information aggregation and Coordination:
FM acts as collectors and aggregators of information about
financial asset values and the flow of funds from lenders to
borrowers.
d) Risk Sharing:
FM allow a transfer of risk from those who undertake investment
to those who provide fund for investment.
e) Liquidity:
The instruments sold in the financial market tend to have high liquidity.
This means at any given time the investors can sell their financial
commodities and convert them to cash in a very short period. This
is an important factor for investors who do not want to invest long
term.
f) Efficiency:
Channelling of funds from savers to spenders so important to the
economy because the people who save are frequently not the
same people who have profitable investment opportunities
available to them, the entrepreneurs. Without financial markets, it
is hard to transfer funds from a person who has no investment
opportunities to one who has them. Financial markets are thus
FIs provide/lend long term funds for industry and agriculture. FIs
raise their resources through long-term bonds from financial system
and borrowings from international financial institutions like
International Finance Corporation (IFC), Asian Development Bank
4) Depositories
5) Clearing Corporations
6) Share brokers
8) Underwriters
9) Custodians
4. Housing Finance:
As a part of improving dwelling houses, financial intermediaries
are providing housing loans. They are also providing refinancing facility
to agencies such as HUDCO (Housing and Urban Development
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5. Priority Sector:
As per RBI guidelines, commercial banks have to provide
certain percentage of their lending to priority sector which consists of
agriculture and its allied activities, such as poultry, dairy, etc, cottage
industries, small scale industries, small industry and business.
Financial Innovation
Financial innovation is the process of creating new products,
services, or processes related to the finance sector. Recent financial
innovations include hedge funds, private equity, weather derivatives,
retail-structured products, exchange-traded funds, multi-family offices,
and Islamic bonds (Sukuk). The shadow banking system has spawned
an array of financial innovations including mortgage-backed securities
products and collateralized debt obligations (CDOs). There are
three categories of innovation: institutional, product, and process.
Institutional innovations relate to the creation of new types of
financial firms such as specialist credit card firms like Capital One,
electronic trading platforms such as Charles Schwab Corporation, and
direct banks. Product innovation relates to new products such as
derivatives, securitization, and foreign currency mortgages. Process
innovations relate to new ways of doing financial business, including
online banking and telephone banking.
They occur with the advancement in financial instruments and
payment systems with time. Financial innovation is a general term and
can be broken down into specific categories based on updates to
various spheres of the financial system.
They are made in the lending and borrowing of funds. The term
can be seen in the light of various spheres of the financial system such
as equity capital, remittances, mobile banking, and many more.
Financial innovation has come via advances over time in financial
instruments and payment systems used in the lending and borrowing of
funds. These changes – which include updates in technology, risk
transfer, and credit and equity generation – have increased available
credit for borrowers and given banks new and less costly ways to raise
equity capital.
Module II
MONEY MARKET
Call Money
Call Money Market is sometimes referred as “loans or money
at call and short notice’’. The rate at which funds are borrowed and
lend in this market is called the call money rate. The borrowers and
lenders contact each other through telephone in the call market. After
negotiation the lender issues cheques in favour of the borrower. After
receiving the cheques, the borrower issues a receipt. On payment of
loan and interest the receipt is returned to the lender.
Bill of Exchange/Commercial Bills
A commercial bill or a bill of exchange is a short-term,
negotiable, and self-liquidating money market instrument which
evidences the liability to make a payment on a fixed date when goods
are bought on credit. It is an asset with high degree of liquidity and a
low degree of risk. The two main types of bills are demand bill and
usance bill. A demand bill is payable ‘at sight’ or ‘on presentation’ to
the drawee. Usance or time bill is payable at a specified later date.
Bills can also be classified as clean bills, documentary bills, inland bills,
foreign bills, accommodation bills and supply bills. Commercial bills
are used to finance the movement and storage of agricultural and
industrial goods in domestic and foreign trade. The Normal maturity
period of bills varies considerably as follows: a) usuance hundi-30 to
120 days b) export bills- 90 days c) import bills-60 days d) internal
trade bills-90 to 180 days.
A bill of exchange is transferable, so the drawee may find
itself paying an entirely different party than it initially agreed to pay.
The payee can transfer the bill to another party by endorsing the
back of the document. A payee may sell a bill of exchange to another
party for a discounted price in order to obtain funds prior to the
Yield
Negotiable certificates of deposit provide a return in the form
of interest along with the difference between the price at which the
NCD is redeemed (or sold in the secondary market) and the purchase
price. Given that an institution issues an NCD at par value, the annualized
yield that it will pay is the annualized interest rate on the NCD. If investors
purchase this NCD and hold it until maturity, their annualized yield is
the interest rate. However, the annualized yield can differ from the
annualized interest rate for investors who either purchase or sell the
NCD in the secondary market instead of holding it from inception until
maturity.
Banker’s Acceptance
A banker’s acceptance indicates that a bank accepts
responsibility for a future payment. Banker’s acceptances are commonly
used for international trade transactions. An exporter that is sending
goods to an importer whose credit rating is not known will often prefer
that a bank act as a guarantor. The bank therefore facilitates the
transaction by stamping ACCEPTED on a draft, which obligates
payment at a specified point in time. In turn, the importer will pay the
bank what is owed to the exporter along with a fee to the bank for
guaranteeing the payment. Exporters can hold a banker’s acceptance
until the date at which payment is to be made, but they frequently sell
the acceptance before then at a discount to obtain cash immediately.
The investor who purchases the acceptance then receives the
payment guaranteed by the bank in the future. The investor’s return on
a banker’s acceptance, like that on commercial paper, is derived from
the difference between the discounted price paid for the acceptance
and the amount to be received in the future. Maturities on banker’s
acceptances typically range from 30 to 270 days. Because there is a
possibility that a bank will default on payment, investors are exposed
47 School of Distance Education, University of Calicut
190314: MA Economics - IV SEMESTER
to a slight degree of credit risk. Thus, they deserve a return above the
T-bill yield in compensation. Because acceptances are often discounted
and sold by the exporting firm prior to maturity, an active secondary
market exists. Dealers match up companies that wish to sell acceptances
with other companies that wish to purchase them. A dealer’s bid price
is less than its ask price, and this creates the spread (or the dealer’s
reward for doing business). The spread is normally between one-eighth
and seven-eighths of 1 per cent.
Steps Involved in Banker’s Acceptances
The sequence of steps involved in a banker’s acceptance is
illustrated in figure 2.1.
Figure 2.1
1 Purchase Order
Importer 5 Shipment of Goods Exporter
L/C Notification
2 4 6
3 L/C
American Bank
7 Shipping Documents & Time Draft Japanese Bank
(Import’s Bank
Draft Accepted (B/A Created) (Export’s Bank
Repurchase Agreements
With a repurchase agreement (or repo), one party sells securities
to another with an agreement to repurchase the securities at a specified
date and price. In essence, the repo transaction represents a loan backed
by the securities. If the borrower defaults on the loan, the lender has
claim to the securities. Most repo transactions use government securities,
although some involve other securities such as commercial paper or
NCDs. A reverse repo refers to the purchase of securities by one party
from another with an agreement to sell them. Thus, a repo and a reverse
repo refer to the same transaction but from different perspectives. These
two terms are sometimes used interchangeably, so a transaction
described as a repo may actually be a reverse repo.
Financial institutions such as banks, savings and loan
associations, and money market funds often participate in repurchase
agreements. Many nonfinancial institutions are also active participants.
The size of the repo market is about Rs.4.5 trillion, and transaction
amounts are usually for Rs.10 million or more. The most common
maturities are from 1 to 15 days and for one, three, and six months. A
secondary market for repos does not exist. Some firms in need of
funds will set the maturity on a repo to be the minimum time period for
which they need temporary financing. If they still need funds when the
repo is about to mature, they will borrow additional funds through new
repos and use these funds to fulfil their obligation on maturing repos.
Placement
Repo transactions are negotiated through a telecommunications
network. Dealers and repo brokers act as financial intermediaries to
create repos for firms with deficient or excess funds, receiving a
commission for their services.
quickly move cash in and out of a money market fund without fees or
penalties.
Money market mutual funds were first developed in the 1970s
before bank money market accounts came on the scene, as an alternative
to low-yielding savings accounts. As its name suggests, a money market
fund is a type of mutual fund, which invests its shareholders’ money in
short-term, high-quality debt. This makes a money market fund much less
risky than mutual funds that buy stocks or even longer-term bonds.
Money market funds can be categorized into three groups:
prime, government and tax-free.
• Prime money market funds are typically invested in short-term
corporate and bank debt securities.
• Government money market funds invest at least 99.5 per cent of their
funds in government- backed securities, making them extremely safe
investments.
• Tax-free money market funds are invested primarily in municipal bonds
or debt issued by other entities whose interest payments are exempt
from federal income taxes.
Money market funds can be a highly useful tool for holding the
cash component of your investment portfolio. The key advantage of money
market funds is the fact that they are highly liquid investments. Money market
funds offer higher liquidity than certificates of deposit (CDs) and Treasury
bills while also offering ultra-low risk. Unlike CDs, which you generally
need to hold to maturity to cash out without penalty, money market funds
don’t have maturities and can be liquidated on demand. You can sell Treasury
bills on the secondary market with ease, but it’s also possible to take a loss
on the sale.
can bring down the prices. This will be possible only when all the
economic activities in the country are carried through the banking
sector.
The Central bank can help the commercial banks in undertaking
various activities so that the entire economic activities are financed
by the commercial banks. The commercial banks must have a better
cordial relationship with Central bank so that they can always
depend on Central bank for assistance. This position can be attained
by the Central bank only when it is strong enough to assist the
commercial bank.
2. Organised Banking System:
An organised and integrated banking system is the second feature
of a developed money market. In fact, it is the pivot around which
the whole money market revolves. It is the commercial banks which
supply short-term loans, and discount bills of exchange. They form
an important link between the borrowers, brokers, discount houses
and acceptance houses and the central bank in the money market.
3. Specialised Sub-Markets:
A developed money market consists of a number of specialised
sub-markets dealing in various types of credit instruments. There
is the call loan market, the bill market, the Treasury bill market, the
collateral loan market and the acceptance market, and the foreign
exchange market. The larger the number of sub-markets, the more
developed is the money market. But the mere number of sub-
markets is not enough. What is required is that the various sub-
markets should have a number of dealers in each market and the
sub-markets should be properly integrated with each other.
Defects:
4) They provide loans against crops. In this way they compel the
consumers to supply the crops to them.
B. Organised Banking Sector
It consists of Reserve Bank of India, the State Bank of India
and its seven subsidiaries, 19 nationalized banks, the other joint stock
banks including commercial banks, co-operative banks, regional Rural
Banks, special institutions like LIC, UTI, IDBI, SFCs, NABARD, Exim
bank etc. DFHI, non-banking companies and quasi-Government bodies
and large companies which supply funds in the money market through
banks. Reserve Bank of India (RBI) is the central bank and monitory
authority of our country. So, RBI is the leader of Indian money market.
Participants in Money Market:
1. Lenders: These are the entities with surplus lendable funds like
Banks (commercial, co- operative and Private) Mutual Funds
Corporate Entities with bulk lendable resources of minimum of
Rs.3 crores per transaction and Financial Institutions.
2. Borrowers: these are entities with deficit funds and include the
ones as above.
Players or Organisations in Money Market:
Money market is dominated by a small number of large players.
The Reserve bank of India is the most important constituent of Indian
b. Institutional Players
They consist of Mutual funds, foreign Institutional players,
insurance Firms, etc. Their participation depends on the regulations.
For instance, the level of participation of the FIIs in the Indian money
market is restricted to investment in Government Securities.
c. Discount Houses and Primary Dealers
Discount houses discount and rediscount commercial bill and
treasury bills. Primary dealers were introduced by RBI for developing
an active secondary market for Government securities.
Importance of Money Market
The money market is an integral part of a country’s economy. The
money market is an indispensable necessity for the economic
development of a country. A developed money market helps the
development of country in a number of ways.
1. Development of Capital Market: capital market deals with medium-
and long-term lending and borrowing of funds. The short-term
interest rates and the conditions prevailed in the money market
influences the interest on long term lending and resource mobilization
in the market.
2. Financing Trade: Money market plays crucial role in financing both
internal as well as international trade. The acceptance houses and
discount market help in financing foreign trade.
3. Financing Industry: money market contributes to the growth in two
ways:
• Money market helps the industries in securing short-term loans
to meet their working capital requirements through the system of
financial bills, commercial papers etc.
should be Rs.1 lakh and in multiples of Rs. 1 lakh thereafter. The maturity
period of certificate of deposit at present should not be less than 7 days
and not more than one year from the date of issue in case of CD issued
by a bank. The financial institutions can issue CDs for a period not less
than one year and not exceeding three years from the date of issue.
6. Commercial Papers
CPs are short term promissory notes issued by reputed
companies with good credit standing and having sufficient tangible
assets. CPs are unsecured and are negotiable by endorsement and
delivery. CPs are normally issued by banks, public utilities, insurance
and non-banking financial institutions. CPs in India were launched by
the RBI’s notification in January 1990. With a view to enable highly
reputed companies to diversify their sources of short-term borrowings
and also to provide an additional instrument to investors. The issuing
company is required to meet the stamp duty, credit rating agency fees,
stand by facility charges etc. the maturity period of CPs was 30 days.
7. Repurchase agreement [REPO]
It is very important instrument of the money market. It enables
smooth adjustment of short- term liquidity among varied categories of
market participants. As it is a market-based instrument it serves the
purpose of an indirect instrument of monetary control in a liberalized
financial market. The monetary policy of 1999-2000 recognised that
the Repo rates are being increasingly accepted by the market as signals
for movement in the market rate of interests especially the call money
rates.
It is a money market instrument which enables collateralized
short-term borrowing and lending through sale/ purchase operations in
debt instruments. Repo rates is the annualized rate for the funds
Module III
CAPITAL MARKET
The term capital market refers to the institutional arrangements
for facilitating the borrowing and lending of long-term funds. It is
concerned with those private savings, individuals as well as corporate,
that are turned into investments through new capital issues and also
new public loans floated by government and semi-government bodies.
A capital market may be defined as an organised mechanism for effective
and efficient transfer of money capital or financial resources from
investing parties, i.e, individuals or institutional savers to the entrepreneurs
engaged in industry or commerce in the business either be in the private
or public sectors of an economy. Firms that issue capital market
securities and the investors who buy them have very different motivations
than those who operate in the money markets. Firms and individuals
use the money markets primarily to warehouse funds for short periods
of time until a more important need or a more productive use for the
funds arises. By contrast, firms and individuals use the capital markets
for long-term investments.
The following are the important features of a developed capital market
• Market for long term funds.
• Important component of financial system.
• Facilitates borrowing and lending of funds.
• Helps in raising capital.
• Involves both individual and institutional investors.
private capital into public capital. The financial assets sold can be
redeemed by the original holder of security.
Function of New Issue Market
The main function of a new issue market can be divided into
three service functions:
Origination: It refers to the work of investigation, analysis and
processing of new project proposals. This function is done by merchant
bankers who may be commercial banks, all India financial institutions
or private firms. The success of the issue depends to a large extent on
the efficiency of the market.
Underwriting: It is an agreement whereby the underwriter promises to
subscribe to a specified number of shares or debentures or a specified
amount of stock in the event of public not subscribing to the issue.
Underwriting is a guarantee for marketability of shares. There are two
types of underwriters in India- Institutional (LIC, UTI, IDBI, ICICI)
and Non- institutional are brokers.
Distribution: It is the function of sale of securities to ultimate investors.
This is performed by specialized agencies like brokers and agents who
maintain a regular and direct contact with the ultimate investors.
Role of New Issue/ Primary Market:
Capital Formation: It provides attractive issue to the potential investors
and with this company can raise capital at lower costs.
Liquidity: As the securities issued in primary market can be immediately
sold in secondary market. The rate of liquidity of securities is higher.
2. Underwriters:
Underwriting is an act of undertaking the guarantee by an
underwriter of buying the shares or debentures placed before the public
in the event of non-subscription. According to SEBI Rules 1993,
underwriting means an agreement with or without conditions to subscribe
to the securities of a body corporate when the existing shareholders of
such body corporate or the public do not subscribe to the securities
offered to them. “underwriter” means a person who engages in the
business of underwriting of an issue of securities of a body corporate.
3. Bankers to an Issue:
Bankers to an issue is an important intermediary who accepts
applications and application monies, collects all monies, refund
application monies after allotment and participates in the payment of
dividends by companies. No person can act as a banker to an issue
without obtaining a certificate of registration from SEBI. Registration is
granted by SEBI after it is satisfied that the applicant possesses the
necessary infrastructure, communication and data processing facilities
and requisite manpower to discharge its duties effectively.
4. Registrars to an Issue & Share Transfer Agent:
The Registrar to an issue is an intermediary who performs the functions
of:
1. Collecting applications from investors.
2. Keeping a record of applications.
3. Keeping a record of money received from investors or paid to
sellers of shares.
4. Assisting the companies in the determination of basis of
allotment of shares.
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2. Private placement
Private placements mean that when a company offers its securities
to a small group of people. The securities may be bonds, stocks, or
other securities. The investors can be either individual or institution
or both.
Comparatively, private placements are more manageable to issue
than an IPO. The regulatory norms are significantly less. Also, it
reduces cost and time. The private placement is suitable for
companies that are at early stages (like startups). The company
may raise capital through an investment bank or a hedge fund or
ultra-high net worth individuals (HNIs)
3. Preferential Issue
The preferential issue is one of the quickest methods for a company
to raise capital for their business. Here, both listed and unlisted
companies can issue shares. Usually, these companies issue shares
to a particular group of investors.
It is important to note that the preferential issue is neither a public
issue nor a rights issue. In the preferential allotment, the preference
shareholders receive dividends before the ordinary shareholders
receive it.
4. Qualified Institutional Placement.
Qualified institutional placement is another type of private placement.
Here, the listed company issues equity shares or debentures (partly
or wholly convertible) or any other security not including warrants.
These securities are convertible in nature. Qualified institutional buyer
(QIB) purchases these securities.
5. Rights Issue
This is another type of issue in the primary market. Here, the
company issues share to its existing shareholders by offering them
to purchase more. The issue of securities is at a predetermined price.
In a rights issue, the investors have a choice of buying shares at a
discount price within a specific period. It enhances the control of
the existing shareholders of the company. It helps the company to
raise funds without any additional costs.
6. Bonus Issue
When a company issues fully paid additional shares to its existing
shareholders for free. The company issue shares from its free
reserves or securities premium account. These shares are a gift for
its current shareholders. However, the issuance of bonus shares
does not require fresh capital.
Companies come to the primary market to raise money for several
reasons. Some of them are for business expansion, business
development, and improving infrastructure, repaying its debts and
many more. This helps the company to increase its liquidity. Also, it
provides a scope for more issuance of shares in raising further capital
for business.
The company can raise capital through
• Equity: when the company raises money by issuing shares to the
public. It is termed as stock capital, also known as share capital
of the company.
• Debt: the companies raise capital by taking loans where interest is
payable on it.
Objectives of NSE
The following are the objectives of NSE:
I. Providing a national wide trading facility for equities, debt
instruments etc.
II. Ensure equal access to investors all over the country through
an appropriate communication network.
III. Provide fair, efficient and transparent securities market to
investors using electronic trading systems.
IV. Enable shorter settlement cycles and book entry settlement
system.
V. Attain current international standards of securities market.
Working
The settlement cycle is completed within eight days from the
last day of the trading cycle. The trading period is a week (Wednesday
to Tuesday) and settlement of trade takes place in the ensuing week.
3. Over the Counter Exchange of India (OTCEI)
It was established in October 1990, with an objective to provide
an alternative market for securities of smaller companies. This exchange
has been jointly promoted by UTI, ICICI, IDIB, SBI Capital Markets
Ltd. IFCI, GIC and Can bank Financial services Ltd.
The following are the main features of OTCEI.
1. It is ringless and electronic national exchange.
2. It caters the need of the small business which have so far not met
the requirements for listing on the stock exchange.
3. This exchange has a nationwide reach.
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9 Selection of a broker.
9 Placing an order.
9 Making the contract.
9 Contact note.
9 Settlement.
The settlement for ready delivery and forward contracts is
done with a different procedure.
Settlement of ready delivery contracts: The settlement in
different stock exchange is done between 3 to 7 days of the
transaction. If the settlement is done by giving actual delivery
of securities on receiving the price it is called liquidation in full.
Settlement of forward delivery contracts: The forward delivery
contracts are done for speculative purposes. Only the active
and broad market securities are traded in forward contracts.
Settlement of forward contracts can be done in any of the
three ways,
a) Liquidation in full.
b) Liquidation by payment of difference.
c) Carry over to the next settlement.
The buyer will have to pay certain amount to the seller for this
concession and the amount paid is known as “Badla” or
Contago charge”
ii. Electronic Trading: The individual investor can get instant
confirmation of his trade in the electronic trading system. It
also facilitates online investing by bringing investor closer to
the market. The advantage of electronic trading is that it brings
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only after a specific period of time, he may sell the securities in the cash
market on margin trading and hedge his risk. Similarly, the shares under
say ESOP to be available to the employees after a while may be hedged
with the help of the margin trading. Further, margin trading and trading
of derivatives generally complement rolling settlement, where the time
for round about transactions is limited to a day. This is why the markets
having the rolling settlements generally provide for the facility of margin
trading. This is important for the efficiency of the market and smooth
settlement in the rolling settlement environment. Physical settlement in
the derivatives especially American Options also requires the availability
of the funds and the securities for the smooth settlement of the trades.
Funds and securities lending and borrowing become critically important
in the environment when the derivatives are settled through the physical
delivery.
Mechanism of margin trading It is necessary to understand the
mechanism to fully appreciate the risks in margin trading. In a typical
transaction, a client interested to do margin trading is required to sign
an agreement with the lender of funds (usually the broker) to formalise
the arrangement for margin trading. The agreement provides for the
margin rate and the extent of margin. The margin rate is the prime
lending rate / bank rate plus a mark-up depending on exposure in the
margin account. The interest is normally compounded on daily basis.
The agreement provides for two types of margins, namely the initial
margin and the maintenance margin. The initial margin is the portion of
purchase value which the client deposits with lender of funds before the
actual purchase. After the agreement, the client opens a margin account
and deposits initial margin amount, based on which the lender executes
purchase order on behalf of the client. The securities so purchased are
kept as collateral with the lender. In addition to initial margin, the client
is required to maintain a certain minimum equity in the margin account.
The equity is nothing but the net value of portfolio, that is, the
value of portfolio less the margin debt. This equity should be a certain
percentage of the market value of securities. This percentage is called
maintenance margin. If the equity is less than the maintenance margin,
the client is called upon to bring in the shortfall. For example, assume
that the initial and maintenance margins are 50 per cent and 25 per cent
respectively. A client has bought securities for Rs. 100. The price
depreciates by 40 per cent. The value of portfolio reduces to Rs. 60.
The equity becomes Rs. 10 (Rs. 60 – Rs. 50 (debt)), which is less than
Rs. 15 (25 per cent of the value of securities). The client is required to
bring in Rs. 5. When the equity in the margin account falls below the
maintenance margin, the lender makes a margin call. If margin call is
not met, the lender can sell the collateral, partially or fully, to increase
the equity.
However, when price falls to an extent that the equity becomes
zero, the lender, instead of making margin call, usually sells off the
securities to recover the debt. If he waits and prices fall further, he
would not be able to recover the debt from collateral. In the above
example, the lender would make margin call, when the portfolio
depreciates by 33.33 per cent. If margin call is not met or if the equity
reduces to Rs. 0, the lender sells off the collateral. If the minimum and
maintenance margins were 50 per cent, margin call will be made with
smallest depreciation in the value of portfolio. The lender is not generally
required make a margin call or notify the client that the equity has reduced
below minimum. It is for the client to find out for himself and make
payment accordingly. The client is required to repay the debt and interest
as per agreement and till the full repayment is made, the collateral remains
with the lender. In case he wants to sell the securities earlier, the proceeds
go to the lender first to the extent of debt.
2. Short Sale
A short sale is the sale of an asset or stock the seller does not
own. It is generally a transaction in which an investor sells borrowed
securities in anticipation of a price decline; the seller is then required to
return an equal number of shares at some point in the future. In contrast,
a seller owns the security or stock in a long position.
Understanding Short Sales
A short sale is a transaction in which the seller does not actually
own the stock that is being sold but borrows it from the broker-dealer
through which they are placing the sell order. The seller then has the
obligation to buy back the stock at some point in the future. Short
sales are margin transactions, and their equity reserve requirements
are more stringent than for purchases.
Brokers borrow the shares for short sale transactions from
custody banks and fund management companies that lend them as a
revenue stream. Institutions that lend shares for short selling include
JPMorgan Chase & Co. and Merrill Lynch Wealth Management.
The main advantage of a short sale is that it allows traders to
profit from a drop in price. Short sellers aim to sell shares while the
price is high, and then buy them later after the price has dropped. Short
sales are typically executed by investors who think the price of the
stock being sold will decrease in the short term (such as a few months).
traders who sorted their stock suffered a 2 per cent drop in their returns
per month in the next year.
Legendary investor Warren Buffett welcomes short sellers. “The
more shorts, the better, because they have to buy the stock later on,”
he is reported to have said. According to him, short sellers are necessary
correctives who “sniff out” wrongdoing or problematic companies in
the market.
Alternative Short Sale Meaning
In real estate, a short sale is the sale of real estate in which the
net proceeds are less than the mortgage owed or the total amount of
lien debts that secure the property. In a short sale, the sale is executed
when the mortgagee or lienholder accepts an amount less than what is
owed and when the sale is an arm’s length transaction. Although not the
most favourable transaction for buyers and lenders, it is preferred over
foreclosure.
Example of a Short Sale
Suppose an investor borrows 1,000 shares at Rs.25 each, or
Rs.25,000. Let’s say the shares fall to Rs.20 and the investor closes
the position. To close the position, the investor needs to purchase 1,000
shares at Rs.20 each, or Rs.20,000. The investor captures the difference
between the amount he receives from the short sale and the amount he
paid to close the position, or Rs.5,000.
3. Securities lending and Borrowing
Selling short on margin is the other dimension of the business.
It has been argued by the market that margin trading on both the buy
and the sell sides should be in place to provide the equilibrium and
efficient price discovery. At present, securities borrowing and lending
facility is available in the market but market participants think there are
alternative ways to approach the securities lending in efficient and
effective manner. Issues covered under part 3 are present state of
securities lending and borrowing and alternative business models for
the same.
Present state of Securities Lending and Borrowing
SEBI approved the Securities Lending Scheme, which came
into existence on February 6, 1997 and is called as SLS, 1997.
According to the SLS, securities can be lent and borrowed through an
approved intermediary, which is duly registered with SEBI. As of now,
there are eight entities, which are registered with SEBI as approved
intermediaries, under the SLS (list enclosed at annexure A). Borrowers
and Lenders do transact through these intermediaries as per the
procedure laid down in the said scheme.
It is important to describe the existing business model of these
approved intermediaries. These intermediaries deal with the lenders
and borrowers on one-to-one basis. It essentially means lenders lend
the securities to the approved intermediaries and they in turn lend them
to the counterparties i.e., borrowers. Full credit risk on the securities
lent is born by the approved intermediaries. Therefore, in a broader
sense, in these transactions intermediaries provide full novation in lending
and borrowing transactions. It may also be noted that the existing market
for the securities lending and borrowing is an over-the-counter market
(OTC market).
As these approved intermediaries have limited geographical
reach, facility of borrowing and lending of securities is not available to
the widely scattered retail segment of the securities market. Limited
participation in the securities borrowing and lending market and lack of
For instance, depositories may offer the securities lending and borrowing
mechanism through using the exchanges’ infrastructure. It may be left
to the market forces, assuming that the market is prudent enough to
analyse the economic dynamics of the business.
Now, all the borrowers, who would have short position in the
market, would put in their requirements through brokers on the online
computer system with number of securities required and their borrowing
horizon. Supply side would offer the shares indicating the associated
costs. Lending and borrowing transactions would be matched through
the automated system in a transparent environment on price and time
priority basis.
Intermediary, managing the online platform for the securities
lending and borrowing purpose, would be responsible for the clearance
and settlement of all said transactions. It is also thought that this session
of the lending and borrowing could take place simultaneous to the normal
trading sessions.
However, it may be noted here that this session of Securities
Lending and Borrowing would have no linkage whatsoever with the
actual trading session at the exchanges. In other words, the exchange
trading and settlement system would be independent of the Securities
Lending and Borrowing Mechanism, which is being proposed.
Now, there are certain issues in the proposed system, which
are elaborated on here:
a) Which securities would be eligible to participate in the proposed
lending and borrowing mechanism: Though, theoretically speaking, all
the securities listed and traded on the exchanges should be eligible to
participate in the proposed mechanism, globally, wherever the securities
lending and borrowing facility is available, securities eligible for the same
are clearly defined.
Decision on eligible securities is based on the following:
1. Liquidity in the scrips.
2. Avoid the participation of scrips with low liquidity in the borrowing
and lending mechanism, which in turn would reduce the chances
of manipulation through the use of system.
Further, in India, as market is moving towards the T + 2 rolling settlement
environment, only the electronic form of shares may be lent in the
market. This would also keep the cost of transactions low. It is
assumed that this move would also encourage the investors to
convert their physical holding into electronic form to create values
from their idle holdings.
b) Who can lend the securities: Strictly speaking, anyone who has
the securities would be eligible to participate in the lending process.
But this model limits the lenders to only the DPs, Custodians and
other approved intermediaries under the Securities Lending
Scheme, 1997 of SEBI. This feature of the limited number of
professional parties on the supply side of securities is a very
important feature of this model. This is expected to professionalize
the operating environment at the securities lending and borrowing
front. This also leads to the other dimension of the business called
securities banking.
c) Who can borrow the securities: Again, anyone operating in the
market should be eligible to borrow the securities. However, any
borrower has to go through his broker to borrow securities. Broker
would borrow the securities for its client/ clients as an intermediary
Other small investors may not be able to enjoy the values created
through the system.
Indeed, the model 1, suggested above is the refined version of
this model wherein even the small investors would be eligible to
participate in the lending process through their depository participants.
Accordingly, some market participants feel that the model 1 scores
over the instant model in terms of values to the investors at large.
Model 4 – Lending through the special purpose bank.
Creation of the special bank say “limited purpose bank” for
the securities lending and borrowing is another idea given by the market
participants. This assumes that a dedicated entity can undertake the
activity of supporting the securities market trades. It is felt that the
dedicate bank may do things in an organized manner with available
resources. People interested in lending the securities to the market may
deposit their securities with this limited purpose bank and borrowers
may borrow from this bank.
As described in case of the funds borrowing and lending, this bank
may lend the securities to clients in number of alternative following ways:
Bank may lend the securities to clients direct.
Bank may lend the securities to clients through the brokers of
the exchanges.
Bank may lend the securities clients through the clearing
corporation/exchange through an on-line trading platform
In the first two cases, bank would manage its risk itself. But, in
the last scenario, exchange/clearing corporation would
manage the risk for the bank.
caused the Sensex index to plummet 1,744 points during the day’s
session, which was greater than an eight per cent drop at the time.
This market disturbance was in response to investor and
government worries that the curbing of the P-Notes would be a direct
hit on the Indian economy. That is because foreign institutional investors
help fuel the growth of the Indian economy, industries, and capital
markets, and increasing regulation would make it more difficult for foreign
money to enter the market. The government ultimately decided not to
regulate participatory notes.
Example:
P-Notes can be used to purchase any Indian security an investor
wants through a series of steps.
An investor deposits funds with the U.S. or European operations
of a registered foreign institutional investor (FII), such as HSBC or
Deutsche Bank. The investors then inform the bank of the Indian security
or securities they wish to purchase. Funds transfer from the investor to
the foreign institutional investment account, and the foreign institutional
investment issues the participatory notes to the client and buys the
underlying stock or stocks in the correct quantities from the Indian
marketplace.
The investor is eligible to receive dividends, capital gains and
any other pay-outs due to stockholders holding the shares of the Indian
company. The foreign institutional investor
reports all of its issuances each quarter to the Indian regulators, but as
per law, it does not disclose the identity of the actual investor.
Insider Trading
Insider trading is the trading of a public company’s stock or
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Investor Protection
Investor protection means that up to a certain limit, you receive
your money back if the broker goes into bankruptcy or commits fraud.
It is an important factor to consider when you open an account with an
online broker. When you open a trading account at a brokerage, you
usually get investor protection.
The investor protection amount defines the limit of protection
and it varies country by country. In Europe the amount of investor
protection it is usually • 20,000, while in the US is significantly higher,
Rs. 500,000. Some other countries like Australia does not provide any
investor protection. The investor protection amount is usually guaranteed
by a state fund.
The Role of SEBI in Investor Protection
SEBI has given out various methods and measures to ensure
the investor protection from time to time. It has published various
directives, driven many investor awareness programmes, set up investor
protection Fund (IPF) to compensate the investors.
Investor protection legislation is implemented under the Section
11(2) of the SEBI Act. The measures are as follows:
Stock Exchange and other securities market business regulation.
Registering and regulating the intermediaries of the business-
like brokers, transfer agents, bankers, trustees, registrars, portfolio
managers, investment consultants, merchant bankers, etc.
Recording and monitoring the work of custodians, depositors,
participants, foreign investors, credit rating agencies, etc.
CRAs, investor can take better decision in terms of selecting the securities
for investment purposes.
Credit rating helps in the following:
• To solve the problem of information asymmetry.
• Enhances the ability of corporate to access capital market.
• Helps pricing of securities
• Gives wake up call for institutions that have taken on too much
debt
• Provides a simple indicator of the credit quality
• Yardstick against which different instruments can be compared.
Ratings agencies don’t confine only to ratings to securities or
financial instruments but also to company and country as sovereign
credit ratings. These country ratings analyse the political economic
conditions of the country in general. It assesses the various government
policies and overall stability in the country. Various FDIs and FIIS take
decision based on these ratings.
Credit rating is not only important to public but also to the
issuer and economy as a whole.
1. Importance of credit rating to Investors
Ratings provide an independent and professionally evaluated
opinion of credit quality of financial instruments companies or
countries to investors. Investors can use this opinion in making
investments. They get information at low cost or no cost. However,
it must be noted that these ratings are not the recommendations to
buy or sell any instrument. It is not a guarantee but an opinion.
1964 by an Act to provide credit and other financial facilities for the
development of the fledgling Indian industry. It is a development
financial institution and now a subsidiary of Life Insurance Corporation.
Many national institutes find their roots in IDBI like SIDBI, India Exim
Bank, National Stock Exchange of India and National Securities
Depository Limited.
Initially, it operated as a subsidiary of the Reserve Bank of
India and later RBI transferred it to the Government of India. On 29
June 2018, Life Insurance Corporation of India (LIC) has got a
technical go-ahead from the Insurance Regulatory and Development
Authority of India (IRDAI) to increase stake in IDBI Bank up to 51
per cent. LIC completed the acquisition of 51 per cent controlling stake
on 21 January 2019 making it the majority shareholder of the IDBI
Bank. Reserve Bank of India has clarified vide a Press Release dated
14 March 2019, that IDBI Bank stands re-categorized as a Private
Sector Bank for regulatory purposes with effect from 21 January 2019.
The Industrial Development Bank of India (IDBI) was
established in 1964 under an Act of Parliament as a wholly-owned
subsidiary of the Reserve Bank of India. In 1976, the ownership of
IDBI was transferred to the Government of India and it was made the
principal financial institution for coordinating the activities of institutions
engaged in financing, promoting and developing industry in India. IDBI
provided financial assistance, both in rupee and foreign currencies, for
green-field projects and also for expansion, modernization, and
diversification purposes. In the wake of financial sector reforms unveiled
by the government since 1992, IDBI also provided indirect financial
assistance by way of refinancing of loans extended by State- level
financial institutions and banks and by way of rediscounting of bills of
exchange arising out of the sale of indigenous machinery on deferred
payment terms.
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Bank Ltd. under Section 391-394 of the Companies Act, 1956 vide
Government of India, Ministry of Corporate Affairs order dated April
08, 2011. The appointed day under the scheme of amalgamation has
been approved as January 01, 2011. In terms of Section 394(3) of the
Companies Act 1956, the Government of India’s above order has been
filed with the Registrar of Companies on April26, 2011.
Re-categorization of IDBI Bank Ltd. a as Private Sector Bank
LIC of India completed acquisition of 51 per cent controlling
stake in IDBI Bank on January 21, 2019 making it the majority
shareholder of the bank. Subsequent to enhancement of equity stake
by LIC of India on January 21, 2019, Reserve Bank of India has clarified
vide a Press Release dated March 14, 2019, that IDBI Bank stands
re-categorized as a Private Sector Bank, with retrospective effect from
January 21, 2019.
3. Industrial Finance Corporation of India
Industrial Finance Corporation of India (IFCI) is actually
the first financial institute the government established after independence.
The main aim of the incorporation of IFCI was to provide long-term finance
to the manufacturing and industrial sector of the country. Let us study more
about IFCI.
Initially established in 1948, the Industrial Finance Corporation of India
was converted into a public company on 1 July 1993 and is now known
as Industrial Finance Corporation of India Ltd.
The main aim of setting up this development bank was to provide
assistance to the industrial sector to meet their medium and long-term
financial needs.
The IDBI, scheduled banks, insurance sector, co-op banks are
some of the major stakeholders of the IFCI. The authorized capital of the
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190314: MA Economics - IV SEMESTER
IFCI is 250 crores and the Central Government can increase this as and
when they wish to do
Functions of the IFCI
? First, the main function of the IFCI is to provide medium and long-
term loans and advances to industrial and manufacturing concerns.
It looks into a few factors before granting any loans. They study
the importance of the industry in our national economy, the overall
cost of the project, and finally the quality of the product and the
management of the company. If the above factors have satisfactory
results the IFCI will grant the loan.
? The Industrial Finance Corporation of India can also
subscribe to the debentures that these companies’ issue in the
market.
? The IFCI also provides guarantees to the loans taken by such
industrial companies.
? When a company is issuing shares or debentures the Industrial
Finance Corporation of India can choose to underwrite such
securities.
? It also guarantees deferred payments in case of loans taken from
foreign banks in foreign currency.
? There is a special department the Merchant Banking & Allied
Services Department. They look after matters such as capital
restructuring, mergers, amalgamations, loan syndication, etc.
? It the process of promoting industrialization the Industrial Finance
Corporation of India has also promoted three subsidiaries of its
own, namely the IFCI Financial Services Ltd, IFCI Insurance
Services Ltd and I-Fin. It looks after the functioning and regulation
of these three companies.
4. ICICI Bank Limited
ICICI is an Indian multinational banking and financial services
company with its registered office in Vadodara, Gujarat and corporate
office in Jharkhand. It offers a wide range of banking products and
financial services for corporate and retail customers through a variety
of delivery channels and specialised subsidiaries in the areas of
investment banking, life, non-life insurance, venture capital and asset
management. The bank has a network of 5,275 branches and 15,589
ATMs across India and has a presence in 17 countries.
ICICI was formed in 1955 at the initiative of the World Bank,
the Government of India and representatives of Indian industry. The
principal objective was to create a development financial institution for
providing medium-term and long-term project financing to Indian
businesses. Until the late 1980s, ICICI primarily focused its activities
on project finance, providing long-term funds to a variety of industrial
projects. With the liberalization of the financial sector in India in the
1990s, ICICI transformed its business from a development financial
institution offering only project finance to a diversified financial services
provider that, along with its subsidiaries and other group companies,
offered a wide variety of products and services.
As India’s economy became more market-oriented and
integrated with the world economy, ICICI capitalized on the new
opportunities to provide a wider range of financial products and services
to a broader spectrum of clients. ICICI Bank was incorporated in 1994
as a part of the ICICI group. In 1999, ICICI became the first Indian
company and the first bank or financial institution from non-Japan Asia
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190314: MA Economics - IV SEMESTER
month- to-month basis. The secondary market price of the units usually
fluctuates within the boundaries of the sale and redemption prices set
by the UTI. NAVs of most of its unit schemes are published on a regular
basis (monthly or weekly). UTI believes that in the case of US-64,
however, it is difficult to make an accurate and timely estimation of the
NAV due to the nature of its investments, which include term loans and
non- transferable debentures.
Further, UTI has evolved into an institution with a wide range
of functions from mobilizing savings through assured return savings
schemes to acting as an investment and term-lending institution. Multiple
autonomous business units have been established under the umbrella
of the UTI, such as the UTI Bank, the UTI Securities Ltd., the UTI
Investor Services Ltd., and the UTI Investment Advisory.
The October 1998 Crisis and the Restructuring of UTI
The decline in stock prices during May-June 1998 resulted in
significant valuation losses for US-64 on its investment portfolio. Despite
these losses, however, UTI decided to maintain a dividend rate of 20
per cent for the 1997/98 financial year. At the same time, the decision
was taken by the fund’s management to revise the accounting practices
followed by US-64 so as to account for the unrealized capital losses.
These developments resulted in the balance in the US- 64’s reserve
account turning negative in June 1998, and when this became public
with the release of UTI’s 1997/98 Annual Report in the fall of 1998,
investor confidence in the US-64 scheme deteriorated sharply.
If UTI had been following the standard valuation and pricing
procedures prescribed by SEBI, the sharp decline in the market value
of its assets between May and June 1998 would have resulted in a
proportionate revision of the NAV and a lower sale price. Instead,
after it was revealed that US-64’s reserves were negative, UTI raised
the sale price of its units in line with its usual annual pricing policy.
Redemption pressures continued to build, and the unit capital of US-
64 declined from Rs 156 billion in June 1998 to Rs 148 billion in
December 1998. Following the October 1998 difficulties, UTI
constituted a committee (the Deepak Parekh Committee) to undertake
a comprehensive review of the functioning of US-64 and recommend
measures for sustaining investor confidence and strengthening the
operations of the scheme.
The Committee’s report was released in March 1999 and its
view was that the problems at US- 64 were due to the excessively high
yield offered by the scheme, combined with its large equity exposure.
Consequently, it recommended that the equity exposure be gradually
reduced, the pricing of the scheme become NAV driven, and its dividend
distribution policy become more responsive to changes in market
conditions.
As part of the restructuring of UTI, the government has recently
undertaken a debt-for-equity swap with US-64 along the lines of the
Committee’s recommendations. A number of poorly performing Public
Sector Undertakings (PSU) shares, valued at Rs 3.3 billion, have been
placed in a new scheme, the Special Unit Scheme 1999 (SUS-99),
and in return the government issued five-year maturity bonds to US-
64. UTI has also implemented a number of other reforms in line with
the recommendations of the Committee. Separate Asset Management
Companies (AMCs)—equity and debt schemes, each with seven
members (five outside experts and two senior UTI officials) have been
established for US-64. The dividend on US-64 was also lowered to
13.5 per cent (implying a yield of 10 per cent on the July 1999 sale
price). Given the tax exemption, however, the after-tax yield was largely
unchanged from the previous year, while the sale and redemption prices
were reduced in July to bring them closer to the NAV. UTI also
announced that starting in July 2000, the NAV of US-64 would be
declared on a fortnightly basis, and UTI was required to submit regular
compliance reports to the Ministry of Finance on progress toward
meeting the Parekh Committee’s recommendations.
Outstanding Policy Issues
The mutual fund industry has played an important role in the
mobilization of domestic savings and the development of capital markets
in India. Substantial progress has also been made in strengthening the
regulation and improving the transparency and uniformity of the standards
in the mutual fund industry through the SEBI (Mutual Funds) Regulations
of 1996, and the subsequent amendments in 1998. However, a number
of areas remain where further improvement to the regulatory regime
would he beneficial, and, in the case of UTI, the challenges remain
considerable. Bringing UTI under SEBI’s purview, as well as the
introduction and implementation of international accounting principles
(IAP) across the whole of the mutual fund industry, will increase the
soundness and stability of the sector. Some of the other outstanding
issues are discussed below.
Mutual Fund Regulation
? Valuation standards. Existing regulations appropriately require that
the sale and redemption prices of funds should be based on their
NAVs, which should be computed according to the uniform rules
specified in the regulations. There is scope, however, for
improvements in at least two areas. First, while the regulations have
Reform of UTI
The reforms proposed by the Parekh Committee provide a
useful blueprint for restructuring UTI. In particular, it is critical for US-
64 to move quickly to a NAV-based pricing system to bring it in line
with industry standards and to improve investor protection.
The reduction of US-64 equity exposure will help align the scheme’s
investments with its objective of providing unit holders with a regular
income flow. Further, the establishment of an independent board of
trustees and an AMC with an independent board would bring it more
in line with the mutual fund regulations, leading to significantly improved
accountability.
Questions regarding the scope and implementation of the
Committee’s recommendations remain. A critical issue is the systemic
importance and role of UTI in Indian financial markets. UTI operates
as a financial conglomerate, which is involved in virtually every segment
of the financial system. Also, the size of UTI’s flagship fund, US–64,
affects the flexibility of its operations as active portfolio management
becomes difficult and costly when the size of transactions has significant
impact on prices of individual stocks being traded. Moreover, the size
and complexity of UTI has made its regulations more challenging.
The size of UTI relative to overall stock market capitalization
and the number of actively traded stocks can make it difficult for the
Trust to meet prudential norms specified in mutual fund regulations.
Under the regulations, a mutual fund may not own more than 10 per
cent of a company’s voting capital. At the same time, UTI’s own
prudential guidelines stipulate that no scheme can invest more than 5
per cent of its resources in the equity of any single company.
on the death of any one of those who have taken the joint life
policy. The sum assured will be paid to the survivor(s). For example,
a joint life policy may be taken on the lives of husband and wife,
sum assured will be payable to the survivor on the death of the
spouse.
6. With Profit and Without Profit Policy
Under with profit policy the assured is paid, in addition to the sum
assured, a share in the profits of the insurer in the form of bonus.
Without profit policy is a policy under which the assured does not
get any share in the profits earned by the insurer and gets only the
sum assured on the maturity of the policy. With profit and without
profit policies are also known as participating and non–participating
policies respectively.
7. Double Accident Benefit Policy
This policy provides that if the insured person dies of any accident,
his beneficiaries will get double the amount of the sum assured.
8. Annuity Policy
Under this policy, the sum assured is payable not in one lump sum
payment but in monthly, quarterly and half-yearly or yearly
instalments after the assured attains a certain age. This policy is
useful to those who want to have a regular income after the expiry
of a certain period e.g., after retirement.
9. Policies for Women
Women, now a days are free to take life assurance policies.
However, some specially designed policies suit their needs in a
unique manner; important policies for women are
2) Innovative/recent instruments
Some of the new financial instruments introduced in recent years
may be briefly explained as below:
1. Floating rate bonds:
The interest rate on these bonds is not fixed. It is a concept which
has been introduced primarily to take care of the falling market or
to provide a cushion in times of falling interest rates in the economy.
It helps the issuer to hedge the loss arising due to interest rate
fluctuations. In India, SBI was the first to introduce FRB for retail
investors.
2. Zero interest bonds:
These carry no periodic interest payment. These are sold at a huge
discount. These can be converted into equity shares or non-
convertible debentures
3. Deep discount bonds:
These bonds are sold at a large discount while issuing them. These
are zero coupon bonds whose maturity is very high (say, 15 years).
There is no interest payment. IDBI was the first financial institution
to offer DDBs in 1992.
4. Auction related debentures:
These are a hybrid of CPs and debentures. These are secured,
redeemable, non-convertible instrument. The interest on them is
determined by the market. These are placed privately with bids.
ANZ Grind lays designed this new instrument for Ashok Leyland
Finance.
one or more stages between the third and fifth year from the date
of allotment.
9. Non-convertible debentures with detachable equity warrants:
In this instrument, the holder is given an option to buy a specified
number of shares from the company at a predetermined price within
a definite time frame.
10. Zero interest fully convertible debentures:
On these instruments, no interest will be paid to the holders till the
lock in period. After a notified period, these debentures will be
automatically and compulsorily converted into shares.
11. Fully convertible debentures with interest:
This instrument carries no interest for a specified period. After this
period, option is given to apply for equities at premium for which
no additional amount is payable. However, interest is payable at a
predetermined rate from the date of first conversion to second /
final conversion and equity will be issued in lieu of interest.
12. Non-voting shares:
The Companies Bill,1997 proposed to allow companies to issue
non-voting shares. These are quasi -equity instruments with
differential rights. These shares do not carry voting right. Their
divided rate is also not predetermined like preference shares.
13. Inverse float bonds:
These bonds are the latest entrants in the Indian capital market.
These are bonds carrying a floating rate of interest that is inversely
related to short term interest rates.
over time. While holding the customers’ money, the institutions lend it
to others in the form of mortgage or business loans, generating more
interest on the money than the interest paid to customers.
Transferring the ownership of shares from one investor’s
account to another account when a trade is executed is one of the
primary functions of a depository. This helps reduce the paperwork for
executing a trade and speeds up the transfer process. Another function
of a depository is the elimination of risk of holding the securities in
physical form such as theft, loss, fraud, damage, or delay in deliveries.
An investor who wants to purchase precious metals can
purchase them in physical bullion or paper form. Gold or silver bars or
coins can be purchased from a dealer and kept with a third- party
depository. Investing in gold through futures contracts is not equivalent
to the investor owning gold. Instead, gold is owed to the investor.
A trader or hedger looking to take actual delivery on a futures
contract must first establish a long (buy) futures position and wait until
a short (seller) tenders a notice to delivery. With gold futures contracts,
the seller is committing to deliver the gold to the buyer at the contract
expiry date. The seller must have the metal in this case, gold in an
approved depository. This is represented by holding COMEX approved
electronic depository warrants which are required to make or take
delivery.
Types of Depositories
The three main types of depository institutions are credit unions,
savings institutions, and commercial banks. The main source of funding
for these institutions is through deposits from customers. Customer
deposits and accounts are insured by the Federal Deposit Insurance
Corporation (FDIC) up to certain limits.
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Table3.2
BANK DEPOSITORY
Holds funds in an account Hold securities in an account
Transfers funds between accounts Transfers securities between
on the instruction of the account accounts on the instruction of
holder the account holder.
Facilitates transfers without having Facilitates transfers of
to handle money ownership without having to
handle securities.
Facilitates safekeeping of Money Facilitates safekeeping of
shares.
1. Personal services
Some of the personal services they offer include:
• Demat Account
• Insurance
• Mutual Funds
• NPS (Retirement)
• GOI Bonds (Government of India)
• IPOs
• Stock Holding
2. GoldRush
A platform that allows users to buy gold online and is one of the
only two ways to do so in India.
3. Corporate services
• Demat services for business
• CSGL services (government bonds)
• Trading accounts
• NPS accounts
• Bullion (gold and silver) 4.Custodial services
Custodial services include any safekeeping, administration,
transaction and further activities done on behalf of a company by
its custodian, and include:
• Fund accounting
• FDI (Foreign Direct Investment)
• Company Valuation
• Vaults
• Customized Reporting
• Electronic and Physical Safekeeping Services
• Clearing and Settlement Services
Securities Trading Corporation of India
STCI Finance Ltd (formerly Securities Trading Corporation of
India Limited), is a Systemically Important Non-Deposit taking NBFC
registered with Reserve Bank of India (RBI). Presently STCI Finance
Ltd is classified as a loan NBFC.
In May 1994, STCI Finance Limited was promoted by RBI
with the main objective of fostering an active secondary market in
Government of India Securities and Public Sector bonds. RBI owned
a majority stake of 50.18 per cent in the paid-up share capital of the
company. In 1996, the Company was accredited as the first Primary
Dealer in the India. As one of the leading Primary Dealers in the country,
the Company was a market maker in government securities, corporate
bonds and money market instruments. Its other lines of activities included
trading in interest rate swaps and trading in equity - cash & derivatives
segment. The Company enjoyed a successful track record of achieving
profits during consecutive years spanning nearly a decade. RBI divested
its entire shareholding in STCI in two stages- first in 1997 to bring it
down from 50.18 per cent to 14.41per cent and the balance in 2002 to
the existing shareholders. Bank of India became the largest shareholder
in the company with 29.96 per cent stake.
In order to diversify into new activities, the Company hived off
its Primary Dealership business to its separate 100 per cent subsidiary,
STCI Primary Dealer Limited (STCI-PD) in June 2007. Since year
2007, the Company has been undertaking lending and investment
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activities with its main focus on lending/ financing activities. With growth
in the size of the Look Book, the lending activity became the core
business of the Company and STCI Finance Limited was classified as
a Loan NBFC. With a view to reflecting the lending/ financing business
of the Company, the name of the Company was changed from Securities
Trading Corporation of India to ‘STCI Finance Limited’ with effect
from October 24, 2011.
STCI Finance Limited is a diversified mid-market B2B NBFC
offering its product and services across multiple locations in the areas
of Capital Markets, Real Estate, Corporate Finance and Structured
Finance.
Subsidiaries:
STCI Primary Dealer Limited (STCI PD)
This company is a wholly owned subsidiary of STCI Finance
Limited established consequent to the hiving off of the Company’s
primary dealership business in line with the Reserve Bank of India
guidelines on diversification of business activities by primary dealers.
The Company undertakes trading in government securities, corporate
bonds, money market instruments, interest rate swaps and trading in
equity.
STCI Commodities Limited
This company is a wholly owned subsidiary of STCI Finance
Limited. The Company has discontinued its commodity broking
operations with effect from September 20, 2011 and has also
surrendered its membership with Multi Commodity Exchange (MCX)
and National Commodity and Derivative Exchange (NCDEX).
Functions of SEBI
SEBI has the responsibility to safeguard the interests of the investors in
securities and to enhance the development of, and regulation of the
securities market by such measures as it thinks fit. The measures referred
to therein may provide for: -
1. Protective Functions:
• It stops and bans unfair trade practices in the securities
market, e.g., price rigging, market misleading statements in
prospectus manipulations etc.
• It controls insider trading and imposes penalties for such
practices.
• It undertakes steps for investors protection
• It promotes fair practices and code of conduct in securities
market.
2. Regulatory Functions:
• It involves regulation of the business in security markets and
other stock exchanges;
• It involves registration and regulation of the working of a variety
of agents such as stock brokers share transfer agent, bankers
and sub brokers to a given issue, trustees belonging to trust
deeds, registrars for a particular issue, underwriters, merchant
bankers, portfolio managers, investment advisers and many
other intermediaries who may be associated with securities
markets in any manner;
• Registration and regulation of participants working,
depositories, custodians of securities, FNIS, credit rating
Module IV
DERIVATIVES MARKET
Derivative securities are financial instruments that are based on
other assets. In this one sense, they are similar securitized assets.
However, derivative securities, unlike securitized assets, are not
obligations backed by the original issuer of the underlying security.
Instead, derivative securities are contracts between two parties other
than the original issuer of the underlying security derivative securities
have evolved to help protect investors from certain risks:
A manufacturer of cereal products is dependent on the grain
market for inputs for its finished products. If the crops during a
particular year are damaged by drought or other unfavourable
conditions, the price of grain (and the manufacturer’s cost of
doing business) will increase.
The owner of a large block of stock may fear that the stock’s
price will decline. such a decline occurs, the investor will sustain
large losses.
A commercial bank may need to offer relatively long term, fixed-
rate loans in order to be competitive with other financial
institutions. If interest rates increase significantly, the bank
will incur a significant opportunity cost in the form of lost interest
income.
All of these are financial risks that derivative securities can help reduce.
The food manufacturer can lock in the price of grain by buying a futures
contract. The owner of the common stock can guard against losses by
buying an option to sell the stock at a predetermined price. The
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of a call option will exercise if the market price is sufficiently above the
strike price. Exercising the call option enables the investor to purchase
the asset below its current market value and resell at the higher market
price.
Conversely, the owner of a put option will exercise if the market
price is sufficiently below the strike price, because the asset can be
bought at the lower market price and immediately sold for the higher
strike price. Thus, the owner of a large block of common stock can
purchase a put option on the stock with a strike price at or near the
current market price; should the market price decline in the future, the
owner can exercise the option to sell at the higher strike price. When it
is profitable to exercise an option, the option is in the money. When it is
out of the money, exercising is unprofitable. An option buyer obtains
the right to buy or sell by paying a fee, or premium, to an option writer,
or seller. This premium depends on the current market price, the strike
price, and volatility of the price of the asset. Volatility is an important
factor because the market value of a relatively volatile asset is more
likely to reach a given strike price than a less volatile asset, all other
things being equal. An option can be written so that the buyer can
exercise either any time up to the expiration date or only on the expiration
date. The first is an American option, the second a European option.
The four different roles market participants may play in the
options market are to: Buy a call and obtain the right to buy the asset.
Write (sell) a call and make a commitment to sell the asset, if the option
is exercised. Write (sell) a put and make a commitment to buy the
asset, if the option is exercised Buy a put and obtain the right to sell the
asset. The buyer of an option will lose no more than the premium paid
at the time of purchase. But the writer can lose much more.
Types of Options
1.Call Options
A call option gives the purchaser (or buyer) the right to buy an
underlying security (e.g., a stock) at a prespecified price called the
exercise or strike price (X). In return, the buyer of the call option must
pay the writer (or seller) an up-front fee known as a call premium (C).
This premium is an immediate negative cash flow for the buyer of the
call option. However, he or she potentially stands to make a profit
should the underlying stock’s price be greater than the exercise price
(by an amount exceeding the premium). If the price of the underlying
stock is greater than X (the option is referred to as “in the money”), the
buyer can exercise the option, buying the stock at X and selling it
immediately in the stock market at the current market price, greater
than X. If the price of the underlying stock is less than X (the option is
referred to as “out of the money”), the buyer of the call would not
exercise the option (i.e., buy the stock at X when its market value is
less than X). If this is the case when the option matures, the option
expires unexercised. The same is true when the underlying stock price
is exactly equal to X when the option expires (the option is referred to
as “at the money”). The call buyer incurs a cost C (the call premium)
for the option, and no other cash flows result.
2. A Put Option
A put option gives the option buyer the right to sell an underlying
security (e.g., a stock) at a prespecified price to the writer of the put
option. In return, the buyer of the put option must pay the writer (or
seller) the put premium (P). If the underlying stock’s price is less than
the exercise price (X) (the put option is “in the money”), the buyer will
buy the underlying stock in the stock market at less than X and
price of Rs.7.00 are trading in the money (Rs.7.00 is greater than the
current stock price, Rs.6.27).
5. Credit Options
Options also have a potential use in hedging the credit risk of a
financial institution. Compared to their use in hedging interest rate risk,
options used to hedge credit risk are a relatively new phenomenon.
Two alternative credit option derivatives exist to hedge credit risk on a
balance sheet: credit spread call options and digital default options. A
credit spread call option is a call option whose payoff increases as the
(default) risk premium or yield spread on a specified benchmark bond
of the borrower increases above some exercise spread. A financial
institution concerned that the risk on a loan to that borrower will increase
can purchase a credit spread call option to hedge its increased credit
risk. A digital default option is an option that pays a stated amount in
the event of a loan default (the extreme case of increased credit risk).
In the event of a loan default, the option writer pays the financial
institution the par value of the defaulted loans. If the loans are paid off
in accordance with the loan agreement, however, the default option
expires unexercised. As a result, the institution will suffer a maximum
loss on the option equal to the premium (cost) of buying the default
option from the writer (seller).
Different Uses of Options:
There are a number of reasons for being either a writer or a
buyer of options. The writer assures an uncertain amount of risk for a
certain amount of money, whereas the buyer assures an uncertain
potential gain for a fixed cost. Such a situation can lead to a number of
reasons for using options.
It also attempts to prevent price fixing among floor brokers that could
cause wider bid–ask spreads that would impose higher costs on
customers.
5. How Option Trades Are Executed
When options exchanges were created, floor brokers of
exchanges were available to execute orders for brokerage firms. They
went to a specific location on the trading floor where the option was
traded to execute the order. Today, computer technology allows
investors to have trades executed electronically. Most small,
standardized transactions are executed electronically, whereas complex
transactions are executed by competitive open outcry among exchange
members. Many electronic communication networks (ECNs) are
programmed to consider all possible trades and execute the order at
the best possible price. Market-makers can also execute stock option
transactions for customers. They earn the difference between the bid
price and the ask price for this trade, although the spread has declined
significantly in recent years. Market-makers also generate profits or
losses when they invest their own funds in options.
6. Types of Orders
As with stocks, an investor can use either a market order or a
limit order for an option transaction. A market order will result in the
immediate purchase or sale of an option at its prevailing market price.
With a limit order, the transaction will occur only if the market price is
no higher or lower than a specified price limit. For example, an investor
may request the purchase of a specific option only if it can be purchased
at or below some specified price. Conversely, an investor may request
to sell an option only if it can be sold for some specified limit or more.
7. Online Trading
Option contracts can also be purchased or sold online. Many
online brokerage firms, including E*Trade and TD Ameritrade, facilitate
options orders. Online option contract orders are commonly routed to
computerized networks on options exchanges, where they are executed.
For these orders, computers handle the order from the time it is placed
until it is executed.
8. Institutional Use of Options
Although options positions are sometimes taken by financial
institutions for speculative purposes, they are more commonly used for
hedging. Savings institutions and bond mutual funds use options to hedge
interest rate risk. Stock mutual funds, insurance companies, and pension
funds use stock index options and options on stock index futures to
hedge their stock portfolios. Some of the large commercial banks often
serve as an intermediary between two parties that take derivative
positions in an over-the-counter market.
Trading Mechanics
Options were originally traded in the over-the-counter (OTC)
market, where the terms of the contract were negotiated. The advantage
of the OTC market over the exchanges is that the option contracts can
be tailored: strike prices, expiration dates, and the number of shares
can be specified to meet the needs of the option buyer. However,
transaction costs are greater and liquidity is less.
Option trading really took off when the first listed option
exchange the Chicago Board Options Exchange (CBOE) was organized
in 1973 to trade standardized contracts, greatly increasing the market
and liquidity of options. The CBOE was the original exchange for options,
Table 4.1
TYPE PF FINANCIAL
INSTITUTION PARTICIPATION IN OPTIONS MARKETS
Savings Institutions Sometimes take positions in options on futures contracts to hedge interest risk.
Mutual funds Stock mutual funds take positions in stock index options to hedge against a
possible decline in prices of stocks in their porfolios.
Stock mutual funds spmetimes take speculative positions in stock index
options in an attempt to increase their returns.
Bond mutual funds sometimes take positions in options on futures to hedge
interest rate risk.
Securities firms Serve as brokers by executing stock option transactions for individuals and business.
Pension funds Take positions in stock index options to hedge against a possible decline in
prices of stocks in their porfolio.
Take posiotions in options on futures contracts to hedge their bond porfolios
against interest rate movements.
Insurance Take positions in stock index options to hedge against a possible decline in
Companies prices of stocks in their porfolio.
Take posiotions in options on futures contracts to hedge their bond porfolios
against interest rate movements.
to pay a higher premium for a call option on such a stock. The influence
of the market price of a stock (relative to the exercise price) on the call
option premium can also be understood by comparing stock options
with different exercise prices on the same instrument at a given time.
Influence of the Stock’s Volatility
The greater the volatility of the underlying stock, the higher the
call option premium, other things being equal. If a stock is volatile,
there is a higher probability that its price will increase well above the
exercise price. Thus, a purchaser would be willing to pay a higher
premium for a call option on that stock. For instance, call options on
small stocks normally have higher premiums than call options on large
stocks because small stocks are typically more volatile.
Influence of the Call Option’s Time to Maturity
The longer the call option’s time to maturity, the higher the call
option premium, other things being equal. A longer time period until
expiration allows the owner of the option more time to exercise the
option. Thus, there is a higher probability that the stock’s price will
move well above the exercise price before the option expires.
Determinants of Put Option Premiums
The premium paid on a put option depends on the same factors
that affect the premium paid on a call option. However, the direction of
influence varies for one of the factors, as explained next. Influence of
the Market Price The higher the existing market price of the underlying
stock relative to the exercise price, the lower the put option premium,
all other things being equal. A stock’s value has a higher probability of
decreasing well below the exercise price if it is already close to or
below the exercise price. Thus, a purchaser would be willing to pay a
higher premium for a put option on that stock. This influence on the put
option premium differs from the influence on the call option premium
because, from the perspective of put option purchasers, a lower market
price is preferable. The influence of the market price of a stock (relative
to the exercise price) on the put option premium can also be understood
by comparing options with different exercise prices on the same
instrument at a given moment in time.
Influence of the Stock’s Volatility
The greater the volatility of the underlying stock, the higher the
put option premium, all other things being equal. This relationship also
held for call option premiums. If a stock is volatile, there is a higher
probability of its price deviating far from the exercise price. Thus, a
purchaser would be willing to pay a higher premium for a put option on
that stock because its market price is more likely to decline well below
the option’s exercise price.
Influence of the Put Option’s Time to Maturity
The longer the time to maturity, the higher the put option
premium, all other things being equal. This relationship also held for call
option premiums. A longer time period until expiration allows the owner
of the option more time to exercise the option. Thus, there is a higher
probability that the stock’s price will move well below the exercise
price before the option expires.
Profits and Losses with Options
Options traders can profit by being an option buyer or an option
writer. Options allow for potential profit during both volatile times, and
when the market is quiet or less volatile. This is possible because the
prices of assets like stocks, currencies, and commodities are always
moving, and no matter what the market conditions are there is an options
strategy that can take advantage of it.
Basics of Option Profitability
A call option buyer stands to make a profit if the underlying
asset, let’s say a stock, rises above the strike price before expiry. A
put option buyer makes a profit if the price falls below the strike
price before the expiration. The exact amount of profit depends on the
difference between the stock price and the option strike price at
expiration or when the option position is closed.
A call option writer stands to make a profit if the underlying
stock stays below the strike price. After writing a put option, the
trader profits if the price stays above the strike price. An option writer’s
profitability is limited to the premium they receive for writing the option
(which is the option buyer’s cost). Option writers are also called option
sellers.
Option Buying vs. Writing
An option buyer can make a substantial return on investment if
the option trade works out. This is because a stock price can move
significantly beyond the strike price.
An option writer makes a comparatively smaller return if the
option trade is profitable. This is because the writer’s return is limited
to the premium, no matter how much the stock moves. So, write
options because the odds are typically overwhelmingly on the side of
the option writer. A study in the late 1990s, by the Chicago Mercantile
Exchange (CME), found that a little over 75 per cent of all options held
to expiration expired worthless.
Buying a Call
This is the most basic option strategy. It is a relatively low-risk
strategy since the maximum loss is restricted to the premium paid to
buy the call, while the maximum reward is potentially limitless. Although,
as stated earlier, the odds of the trade being very profitable are typically
fairly low. “Low risk” assumes that the total cost of the option represents
a very small percentage of the trader’s capital. Risking all capital on a
single call option would make it a very risky trade because all the money
could be lost if the option expires worthless.
Buying a Put
This is another strategy with relatively low risk but the potentially
high reward if the trade works out. Buying puts is a viable alternative to
the riskier strategy of short selling the underlying asset. Puts can also be
bought to hedge downside risk in a portfolio. But because equity indices
typically trend higher over time, which means that stocks on average
tend to advance more often than they decline, the risk/reward profile of
the put buyer is slightly less favourable than that of a call buyer.
Writing a Put
Put writing is a favoured strategy of advanced options traders
since, in the worst-case scenario, the stock is assigned to the put writer
(they have to buy the stock), while the best-case scenario is that the
writer retains the full amount of the option premium. The biggest risk of
put writing is that the writer may end up paying too much for a stock if
it subsequently tanks. The risk/reward profile of put writing is more
unfavourable than that of put or call buying since the maximum reward
equals the premium received, but the maximum loss is much higher.
That said, the probability of being able to make a profit is higher.
Writing a Call
Call writing comes in two forms, covered and naked. Covered
call writing is another favourite strategy of intermediate to advanced
option traders, and is generally used to generate extra income from a
portfolio. It involves writing calls on stocks held within the portfolio.
Uncovered or naked call writing is the exclusive province of risk-tolerant,
sophisticated options traders, as it has a risk profile similar to that of a
short sale in stock. The maximum reward in call writing is equal to the
premium received. The biggest risk with a covered call strategy is that
the underlying stock will be “called away.” With naked call writing, the
maximum loss is theoretically unlimited, just as it is with a short sale.
Options Spreads
Often times, traders or investors will combine options using a
spread strategy, buying one or more options to sell one or more different
options. Spreading will offset the premium paid because the sold option
premium will net against the options premium purchased. Moreover,
the risk and return profiles of a spread will cap out the potential profit
or loss. Spreads can be created to take advantage of nearly any
anticipated price action, and can range from the simple to the complex.
As with individual options, any spread strategy can be either bought or
sold.
Reasons to Trade Options
Investors and traders undertake option trading either to hedge
open positions (for example, buying puts to hedge a long position, or
buying calls to hedge a short position) or to speculate on likely price
movements of an underlying asset.
The biggest benefit of using options is that of leverage. For
example, say an investor has Rs.900 to use on a particular trade and
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stock was not going to move above the strike price, they could sell the
option for its remaining time value in order to reduce the loss. For
example, the trader paid Rs.3 for the options, but as time passes, if the
stock price remains below the strike price, those options may drop to
Rs.1. The trader could sell the three contracts for Rs.1, receiving
Rs.300 of the original Rs.900 back and avoiding a total loss.
The investor could also choose to exercise the call options rather
than selling them to book profits/losses, but exercising the calls would
require the investor to come up with a substantial sum of money to buy
the number of shares their contracts represent. In the case above, that
would require buying 300 shares at Rs.95.
Selecting the Right Option
Here are some broad guidelines that should help you decide
which types of options to trade.
Bullish or Bearish
Making the determination regarding you are rampantly,
moderately, or just a tad bullish/bearish will help you decide which
option strategy to use, what strike price to use and what expiration to
go for. Let’s say you are rampantly bullish on hypothetical stock ZYX,
a technology stock that is trading at Rs.46.
Volatility
If the implied volatility for ZYX is not very high (say 20 per
cent), then it may be a good idea to buy calls on the stock, since such
calls could be relatively cheap.
Strike Price and Expiration
As you are rampantly bullish on ZYX, you should be
comfortable with buying out of the money calls. Assume you do not
want to spend more than Rs.0.50 per call option, and have a choice
of going for two-month calls with a strike price of Rs.49 available for
Rs.0.50, or three-month calls with a strike price of Rs.50 available for
Rs.0.47. You decide to go with the latter since you believe the slightly
higher strike price is more than offset by the extra month to expiration.
Option Trading Tips
As an option buyer, your objective should be to purchase
options with the longest possible expiration, in order to give your trade
time to work out. Conversely, when you are writing options, go for the
shortest possible expiration in order to limit your liability.
Trying to balance the point above, when buying options,
purchasing the cheapest possible ones may improve your chances of a
profitable trade. Implied volatility of such cheap options is likely to be
quite low, and while this suggests that the odds of a successful trade are
minimal, it is possible that implied volatility and hence the option are
under-priced. So, if the trade does work out, the potential profit can
be huge. Buying options with a lower level of implied volatility may be
preferable to buying those with a very high level of implied volatility,
because of the risk of a higher loss (higher premium paid) if the trade
does not work out.
There is a trade-off between strike prices and options
expirations, as the earlier example demonstrated. An analysis of support
and resistance levels, as well as key upcoming events (such as an earnings
release), is useful in determining which strike price and expiration to
use.
Understand the sector to which the stock belongs. For example,
biotech stocks often trade with binary outcomes when clinical trial results
of a major drug are announced. Deeply out of the money calls or puts
call option on an ETF will receive delivery of the ETF in their account.
Investors who exercise a put option on an ETF will have the ETF
transferred from their account to the counterparty on the put option.
A stock index option provides the right to trade a specified
stock index at a specified price by a specified expiration date. Call
options on stock indexes allow the right to purchase the index, and put
options on stock indexes allow the right to sell the index. If and when
the index option is exercised, the cash payment is equal to a specified
dollar amount multiplied by the difference between the index level and
the exercise price.
Options on stock indexes are similar to options on ETFs.
However, the values of stock indexes change only at the end of each
trading day, whereas ETF values can change throughout the day.
Therefore, an investor who wants to capitalize on the expected
movement of an index within a particular day will trade options on
ETFs. An investor who wants to capitalize on the expected movement
of an index over a longer period of time (such as a week or several
months) can trade options on either ETFs or indexes.
Options on indexes have become popular for speculating on
general movements in the stock market. Speculators who anticipate a
sharp increase in stock market prices overall may consider purchasing
call options on one of the market indexes. Likewise, speculators who
anticipate a stock market decline may consider purchasing put options
on these indexes.
Options on sector indexes also exist, allowing investors the
option to buy or sell an index that reflects a particular sector. These
contracts are distinguished from stock index options because they
represent a component of a stock index. Investors who are optimistic
managers may still believe the options were worthwhile for temporary
protection against downside risk.
Dynamic Asset Allocation with Stock Index Options
Dynamic asset allocation involves switching between risky and
low-risk investment positions over time in response to changing
expectations. Some portfolio managers use stock index options as a
tool for dynamic asset allocation. For example, when portfolio managers
anticipate favourable market conditions, they purchase call options on
a stock index, which intensify the effects of the market conditions.
Essentially, the managers are using stock index options to increase their
exposure to stock market conditions. Conversely, when they anticipate
unfavourable market movements, they can purchase put options on a
stock index in order to reduce the effects that market conditions will
have on their stock portfolios. Because stock options are available
with various exercise prices, portfolio managers can select an exercise
price that provides the degree of protection desired.
Using Index Options to Measure the Market’s Risk
Just as a stock’s implied volatility can be derived from
information about options on that stock, a stock index’s implied volatility
can be derived from information about options on that stock index.
The same factors that affect the option premium on a stock affect the
option premium on an index. Thus, the premium on an index option is
positively related to the expected volatility of the underlying stock index.
If investors want to estimate the expected volatility of the stock index,
they can use software packages to insert values for the prevailing option
premium and all the other factors (except volatility) that affect an option
premium.
period of time. Because interest rate futures contracts can hedge interest
rate risk, options on interest rate futures might be considered by any
financial institution that is exposed to that risk, including savings
institutions, commercial banks, life insurance companies, and pension
funds.
FUTURES
Futures are widely used in various markets to hedge against
price volatility, and by speculators who want to take advantage of price
movements. A futures contract gives a buyer or seller the right to buy or
sell a particular asset at a specific future price.
Types of Futures
There are many types of futures, in both the financial and
commodity segments. Some of the types of financial futures include
stock, index, currency and interest futures. There are also futures for
various commodities, like agricultural products, gold, oil, cotton, oilseed,
and so on.
Different types of futures are:
1. Currency Futures:
We shall look at both hedging and speculation in currency
futures. Corporations, banks and others use currency futures for hedging
purposes.
The underlying principle is as follows:
Assume that a corporation has an asset, e.g., a receivable in a
currency A that it would like to hedge, it should take a futures position
such that futures generate a positive cash whenever the asset declines
in value. In this case, since the firm in long, in the underlying asset, it
should go short in futures, i.e., it should sell futures contracts in A.
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190314: MA Economics - IV SEMESTER
Obviously, the firm cannot gain from an appreciation of A since the gain
on the receivable will be eaten away by the loss on the futures. The
hedger is willing to sacrifice this potential profit to reduce or eliminate
the uncertainty. Conversely, a firm with a liability in currency A, e.g., a
payable, should go long in futures.
In hedging too, the corporation has the option of a direct hedge
and a cross hedge. A British firm with a dollar payable can hedge by
selling sterling futures (same effect as buy dollar futures) on the IMM
or LIFFE. This is an example of a direct hedge. If the dollar appreciates,
it will lose on the payable but gain on the futures, as the dollar price of
futures will decline.
An example of a cross hedge is as follows:
A Belgian firm with a dollar payable cannot hedge by selling
Belgian franc futures because they are not traded. However, since the
Belgian franc is closely tied to the Deutschemark in the European
Monetary System (EMS). It can sell DM futures.
An important point to note is that, in a cross hedge, a firm must
choose a futures contract on an underlying currency that is highly
positively correlated with the currency exposure being hedged.
Also, even when a direct hedge is available, it is extremely
difficult to achieve a perfect hedge. This is due to two reasons. One is
that futures contracts are for standardized amounts as this is designed
by the exchange. Evidently, this will only rarely match the exposure
involved. The second reason involves the concept of basis risk.
The difference between the spot price at initiation of the contract
and the futures price agreed upon is called the basis. Over the term of
the contract, the spot price changes, as does the futures price. But the
change is not always perfectly correlated in other words, the basis is
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190314: MA Economics - IV SEMESTER
not constant. This gives rise to the basis risk. Basis risk is dealt with
through the hedge ratio and a strategy called delta hedging.
A speculator trades in futures to profit from price movements.
They hold views about the future price movements – if these differ from
those of the general market, they will trade to profit from this discrepancy.
The flip side is that they are willing to take the risk of a loss if the prices
move against their views of opinions.
Speculation using futures can be in the either open position
trading or spread trading. In the former, the speculator is betting on
movements in the price of a particular futures contract. In the latter, he
is betting on the price differential between two futures contracts.
An example of open position trading is as follows: Rs. /DM Prices:
Spot – 0.5785
March Futures – 0.5895
June Futures – 0.5915
September Futures – 0.6015
These prices evidently indicate that the market expects the DM
to appreciate over the next 6-7 months. If there is a speculator who
holds the opposite view i.e., he believes that the DM is actually going
to depreciate. There is another speculator who believes that the DM
will appreciate but not to the extent that the market estimates in other
words, the appreciation of the DM will fall short of market expectations.
Both these speculators sell a September futures contract (standard size
– DM 125,000) at Rs.0.6015.
On September 10, the following rates prevail:
Spot Rs. /DM – 0.5940, September Futures – 0.5950
Market Mechanics
With a futures contract, the underlying merchandise is known.
For example, an investor can buy a futures contract on gold, lumber,
pork bellies, swiss francs, and many other items. The underlying item
or commodity is described specifically in the contract specifications
which are determined by the futures exchange on which it trades. The
price of a futures transaction is agreed upon initially between the buyer
and seller, and remains fixed over the holding period, or length of the
contract. Each participant in a futures contract is required to open a
futures account for depositing margin. Margin is money deposited by
both the buyer and the seller to assure the integrity of the contract.
Finally, the full price of the commodity must be paid only upon contract
expiration at which point the trader takes delivery, if the trader bought
futures, or make delivery, if he sold futures, of the underlying commodity.
Transactions in futures can only be done on futures exchanges. These
exchanges are located primarily in Chicago and New York.
Mechanics of Futures Markets include:
• Specification of a futures contract
• Convergence of futures price to spot price
• Operation of margins
• Quotes and prices
• Delivery
• Types of orders
• Regulation
• Accounting and taxes
Market Participants
While there are thousands of traders who are trading in and
out of various precious metals, industrial metals and agricultural
commodities, these traders and participants can be broadly classified
into four broad categories. This classification is very important as each
of these categories of participants has a unique imprint on the market
and contributes to the robustness of the market in their own way.
1. Commodity Market Speculators
Speculators are there in the market for a very short period of
time. They may look to exit their long / short position within the same
day or may look to exit in a few day time. They operate on thin margins,
leveraged trades and rapid churning of funds. Speculators are also
popularly referred to as intraday traders in the equity derivatives market.
Speculators are largely agnostic to direction of the market and are willing
to trade both ways i.e., on the long side and on the short side. Speculators
typically try to ensure that they are on the side of the momentum of the
market overall and the specific commodity they are trading. Since
speculators rely heavily on minor trading opportunities in the commodity
markets, they extensively base their speculative trades on technical charts,
supports, resistances, break-outs, patterns etc. Speculators have a very
important role to play in the commodity markets in the sense that they
provide liquidity in the markets and also ensure that the bid-ask spreads
are kept at the bare minimum.
2. Directional Margin Traders
These traders have a slightly longer-term view on specific
commodities compared to speculators who typically operate at the short
end of the market. Margin traders use futures as a proxy for buying
the commodity in the sport market as the benefit of margin trading is
after considering all these costs, then the arbitrageur will buy in the spot
and sell in the futures. By ironing out any pricing anomalies, the arbitrageur
will not only make an assured profit but will also ensure that the market
becomes more efficient in the process. Arbitrage requires much more
resources compared to speculating or margin trading.
4. Commodity Price Hedgers
Hedgers are those participants who have an underlying
exposure to a particularly commodity. Let us assume that you have a
large order of silver that you need to deliver to a jeweller after 3
months. The only problem is that the deal will be done at the prevailing
price on that date. That exposes you to the price risk over the next 3
months. You are quite satisfied with the price of silver today but you are
apprehensive that 3 months down the line the price of silver may be
lower. You can hedge by selling 3-month silver futures short. By doing
so you are locking in your position at a price that is prima facie attractive
to you. You are therefore indifferent to the price movement of silver
over the next 3 months. Of course, you will incur a notional loss if the
price of silver goes up but that is the job of a speculator. As a hedger,
your job is to protect your downside risk and that is something you
have managed effectively. Hedgers are traders with genuine exposure
to the underlying market and hence lend stability and credibility to the
commodity markets.
These four participants actually form the four pillars of the
commodity markets. It is the joint actions of these four participants that
determines the direction and robustness of the commodity markets.
The Clearing Processes
Futures exchanges provide access to clearing houses that stands
in the middle of every trade. Suppose trader A purchases Rs.145,000
The margin system ensures that on any given day, if all parties in a trade
closed their positions after variation margin payments after settlement,
nobody would need to make any further payments as the losing side of
the position would have already sent the whole amount, they owe to
the profiting side of the position. The clearinghouse does not keep any
variation margin. When traders cannot pay the variation margin they
owe or are otherwise in default the clearing house closes their positions
and tries to cover their remaining obligations to other traders using
their posted initial margin and any reserves available to the
clearing house. Several popular methods are used to compute initial
margins. They include the CME- owned SPAN (a grid simulation
method used by the CME and about 70 other exchanges),
STANS (a Monte Carlo simulation based methodology used by the
Options Clearing Corporation (OCC)), TIMS (earlier used by the
OCC, and still being used by a few other exchanges).
Traders do not interact directly with the exchange, they interact
with clearing house members, usually futures brokers, that pass contracts
and margin payments on to the exchange. Clearing house members are
directly responsible for initial margin and variation margin requirements
at the exchange even if their client’s default on their obligations, so they
may require more initial margin (but not variation margin) from their
clients than is required by the exchange to protect themselves. Since
clearing house members usually have many clients, they can net out
margin payments from their client’s offsetting positions. For example, if
a clearing house member have half of their clients holding a total of
1000 long position in a contract, and half of their clients holding a total
of 500 short position in a contract, the clearing house member is only
responsible for the initial and variation margin of a net 500 contracts
the time of settlement, the investor can sell the stock in the stock market
for a gain of Rs.3 per share or Rs.300 for the contract (ignoring
commissions). This gain would likely reflect a substantial return on the
investment, since the investor had to invest only a small margin (perhaps
20 per cent of the contract price) to take a position in futures. If Zyco
stock is valued at Rs.46 at the time of settlement, the investor would
incur a loss of Rs.4 share, which would reflect a substantial percentage
loss on the investment. Thus, single stock futures offer potential high
returns but also high risk.
Investors who expect a particular stock’s price to decline over
time can sell futures contracts on that stock. This activity is similar to
selling a stock short, except that single stock futures can be sold without
borrowing the underlying stock from a broker (as short-sellers must
do). To obtain a contract to sell March futures of Zyco stock, an
investor must deliver Zyco stock to the clearinghouse on the third Friday
in March and will receive the payment specified in the futures contract.
Investors can close out their position at any time by taking the
opposite position. Suppose that, shortly after the investor purchased
futures on Zyco stock with a March delivery at Rs.50 per share, the
stock price declines. Rather than incur the risk that the price could
continue to decline, the investor could sell a Zyco futures contract with
a March delivery. If this contract specifies a price of Rs.48 per share,
the investor’s gain will be the difference between the selling price and
the buying price, which is Rs.2 per share or Rs.200 for the contract.
Risk of Trading Futures Contracts
Users of futures contracts must recognize the various types of
risk exhibited by such contracts and other derivative instruments.
a. Market Risk
Market risk refers to fluctuations in the value of the instrument as a
result of market conditions. Firms that use futures contracts to
speculate should be concerned about market risk. If their
expectations about future market conditions are wrong, they may
suffer losses on their futures contracts. Firms that use futures
contracts to hedge are less concerned about market risk because
if market conditions cause a loss on their derivative instruments,
they should have a partial offsetting gain on the positions that they
were hedging.
b. Basis Risk
A second type of risk is basis risk, or the risk that the position
being hedged by the futures contracts is not affected in the same
manner as the instrument underlying the futures contract. This type
of risk applies only to those firms or individuals who are using
futures contracts to hedge. The change in the value of the futures
contract position may not move in perfect tandem with the change
in value of the portfolio that is being hedged, so the hedge might
not perfectly hedge the risk of the portfolio.
c. Liquidity Risk
A third type of risk is liquidity risk, which refers to potential price
distortions due to a lack of liquidity. For example, a firm may
purchase a particular bond futures contract to speculate on
expectations of rising bond prices. However, when it attempts to
close out its position by selling an identical futures contract, it may
find that there are no willing buyers for this type of futures contract
at that time. In this case, the firm will have to sell the futures contract
at a lower price.
Where,
F = Future Price
S = Spot value of index
e = Exponential constant with value r = Cost of carry or interest cost
y = Carry return e.g., dividend income t = Time to maturity in years
Stock index futures are the most popular equity derivatives
where the contract value is based on the stock index value. For instance,
if BSE-200 is currently trading at 350 points then the contract value
will be Rs.35,000 which is derived by multiplying index value of 350
by 100 which is fixed.
The investor has to deposit a margin of say 10 per cent of the
contract value which is Rs.3,500. As the margin is mark to market, the
margin requirements shall be calculated daily linked to the value of the
stock index. Thus, if the BSE-200 moves in the following manner over
the next 6 days the margin requirement will be calculated accordingly.
Particulars Day0 Day1 Day2 Day3 Day4 Day5 Day6
BSE - 200 350 370 340 355 340 335 360
Value of the contract ( `) 35,000 37,000 34,000 35,500 34,000 33,500 36,000
Margin 3,500 3,400 3,400 3,550 3,400 3,350 3,600
the stock index futures enjoy great popularity, they are likely to be
more liquid than all other types of equity derivatives.
NSE’s Volatility Index: India VIX:
The Chicago Board Options Exchange was the first to develop
volatility index in 1993. The CBOE Volatility Index is a key measure of
market expectations of near-term implied volatility conveyed by S&P
500 Stock Index Options prices. Implied volatility increases when the
market is bearish and decreases when the market is bullish. This is due
to the common belief that bearish markets are more risky than bullish
markets.
NSE introduced volatility index called ‘India VIX’ into Indian
stock market. A volatility index reflects the market’s expectation of
volatility in the near term. Volatility index is a measure of the amount by
which an underlying index is expected to fluctuate in the near term,
based on the order book of the underlying index options.
It is a volatility index based on the Nifty 50 index option prices.
From the best bid/ask prices of Nifty 50 options contracts (which are
traded on the F&O segment of the NSE), a volatility figure percentage
is calculated, which indicates the expected market volatility over the
next 30 calendar days. Higher the implied volatility, higher the India
VIX value and vice versa. Options prices themselves change with changes
in spot prices and volatility.
There are some differences between a price index, such as the
Nifty 50 and India VIX. Nifty 50 is calculated based on the price
movement of the underlying 50 stocks, which comprises the index.\
India VIX is calculated based on the bid-offer prices of the
near-and mid-month Nifty 50 Index Options. While Nifty 50 signifies
how the markets have moved directionally, India VIX indicates expected
near-term volatility and how the volatility is changing from time to time.
Speculation in Stock Index Futures Trading:
An investor can speculate by trading in Stock Index Futures
based on his expectations of market rise or market fall. Suppose an
investor expects market to rise then he can buy Stock Index Futures.
For instance, if the BSE-200 rises from 350 to 400 over a contract
period of 3 months then the investor makes a profit of Rs.5,000 [(400
– 350) x 100] on a contract value of Rs.35,000.
Supposing if the investor buys 10 BSE-200 at 350 points cash,
then he makes a profit of Rs.50,000 [(400 – 350) × 100 × 10]. On the
other hand, if the investor expects market to fall then he can sell Stock
Index Futures. Thus, without the backing of a commercial position an
investor can make profits by speculation. However, if the investor makes
a wrong judgment regarding the movement of the market, then he loses
in the case of speculation.
Hedging with Stock Index Futures:
Hedging technique is very useful in the case of high-net-worth
entities such as mutual funds having a portfolio of securities. For instance,
if the investor wants to reduce the loss on his holding of securities due
to uncertain price movements in the market, then he can sell futures
contracts.
In such a case if the market comes down then the losses incurred
on individual securities shall be compensated by profits made in the
futures contract. On the contrary if the market rises, then the loss
incurred in the futures contract shall be compensated by profit made on
the individual securities.
6. The Stock Index Futures can considerably take care for investing
the funds raised by floating a new scheme with suitable securities
at reasonable price without losing time.
7. Stock Index Futures allow the unit holders to liquidate a part of
portfolio in case of open- end fund.
8. Stock Index Futures offer an attractive strategy for maintaining
the desired stock market exposure of the portfolio at all points of
time.
9. Stock Index Futures are strategically used for insuring against
market risks.
10. Stock Index Futures offer an effective ‘beta’ control to the portfolio
manager for having advantages of:
(a) The optimal stock mix;
(b) Considerably lower transaction costs; and
(c) Achieving the portfolio target ‘beta’ through buying targeted
futures.
11. Stock Index Futures offer the most productive as well as effective
asset allocation strategy to the portfolio manager in order to
maximize the investors’ wealth by minimizing the market risks.
12. The market volatility can be effectively managed by Stock Index
Futures by making transactions with greater speed with lower
implementation cost.
13. The market disruptions caused by the external investment
managers can effectively be reduced with the strategic use of Stock
Index Futures.
14. The most important advantage of Stock Index Futures is that less
money needs to be involved to alter the asset- mix due to the
leveraged impact of contracts.
Criteria for Stock Market Derivatives Trading:
In the derivatives market there shall be a two-level system of
members viz., clearing members and non-clearing members. The
clearing member takes the responsibility for settlement of trades on
behalf of the non-clearing member. Thus, the clearing member acts as a
guarantor for the non-clearing member.
The clearing member shall have a minimum net worth of Rs.300
lakhs as per the SEBI’s definition and shall made a deposit of Rs.50
lakhs with the exchange/clearing corporation in the form of liquid assets
such as cash. Fixed deposits pledged in the name of the exchange, or
other securities. Bank guarantees in lieu of such deposit may also be
accepted.
The broker members/dealers in the derivatives market should
have passed a certification program considered adequate by SEBI.
Moreover, they should be registered with SEBI as brokers/dealers of
derivative exchange apart from their registration as brokers/dealers of
any stock exchange. The stock exchange should have minimum of 50
members to start derivatives trading.
Stock Index Derivatives Market in India:
The most notable development concerning the secondary
segment of the Indian capital market is the introduction of derivatives
trading in June 2000. SEBI approved derivatives trading based on
futures contracts at both BSE and NSE in accordance with the rules/
by laws and regulations of the stock exchanges.
A beginning with equity derivatives has been made with the introduction
of stock index futures by BSE and NSE. Stock Index Futures contract
allows for the buying and selling of the particular stock index for a
specified price at a specified future date. Stock Index Futures, inter
alia, help in overcoming the problem of asymmetries in information.
Information asymmetry is mainly a problem in individual stocks
as it is unlikely that a trader has market-wide private information. As
such, the asymmetric information component is not likely to be present
in a basket of stocks.
This provides another rationale for trading in stock index futures.
Trading in index derivatives involves low transaction cost in comparison
with trading in underlying individual stocks comprising the index.
While the BSE introduced Stock Index Futures for S&P CNX
Nifty comprising 50 scrips. Stock Index Futures in India are available
with one month, two month and three-month maturities. While derivatives
trading based on the Sensitive Index (Sensex) commenced at the BSE
on June 9, 2000, derivatives trading based on S&P CNX Nifty
commenced at the NSE on June 12, 2000.
SIF is the first attempt in the development of derivatives trading.
This was followed by approval for trading in options based on these
two indices and options on individual securities. The trading in index
options commenced in June 2001 and trading in options on individual
securities is scheduled to commence in July 2001.
Table 4.2
Index based and Individual Securities based Futures and Options: Comparison
Quantity freeze 20,000 units or 20,000 units or Lower of 1% of market Same as Individual
greater greater wide position limit futires
stipulated for open
positions or 5 crores
that they do not have any value of their own but their value is derived
from an underlying asset. For example, options and futures on Reliance
Industries will be linked to the stock price of Reliance Industries and
will derive their value from the same. Options and Futures trading
constitutes an important part of the Indian equity markets. Let us
understand the differences between Options and Futures and how equity
futures and the options market form an integral part of the overall equity
market.
A Future is a right and an obligation to buy or sell an underlying
stock (or other assets) at a predetermined price and deliverable at a
predetermined time. Options are a right without an obligation to buy or
sell equity or index. A Call Option is a right to buy while a Put Option is
a right to sell.
Benefit from Options and Futures
Let us look at futures first. Assume that you want to buy 1500
shares of Tata Motors at a price of Rs.400. That will entail an investment
of Rs.6 lakhs. Alternatively, you can also buy 1 lot (consisting of 1500
shares) of Tata Motors. The advantage is that when you buy futures,
you only pay the margin which (let us say) is around 20 per cent of the
full value. That means your profits will be five-fold that of when you are
invested in equities. But the losses could also be five-fold and that is the
risk of leveraged trades.
An Option is a right without an obligation. So, you can buy a
Tata Motors 400 Call Option at a price of Rs. 10. Since the lot size
is 1,500 shares, your maximum loss will be Rs. 15,000 only. On the
downside, even if Tata Motors goes up to Rs .300, your loss will only
be Rs. 15,000. On the upside, above Rs. 410 your profits will be
unlimited.
if you expect the stock price to go down then you sell Futures on the
stock or the index. Options will have 4 possibilities. Let us understand
each one of them with an Options and Futures trading example. Let us
assume that Infosys is currently quoting at Rs. 1,000. Let us understand
how different traders will use different kinds of options based on their
outlook.
1. Investor A expects Infosys to go up to Rs. 1,150 over the next 2
months. The best strategy for him will be buying a Call Option on
Infosys of 1,050 strike. He will get to participate in the upside by
paying a much lower premium.
2. Investor B expects Infosys to go down to Rs. 900 over the next 1
month. The best approach for him will be to buy Put Options on
Infosys of 980 strikes. He can easily participate in the downside
movement and make profits after his premium cost is covered.
3. Investor C is not sure of the downside in Infosys. However, he is
certain that with the pressure on the stock from global markets,
Infosys will not cross 1,080. He can sell Infosys 1,100 Call Option
and take home the entire premium.
4. Investor D is not sure of the upside potential of Infosys. However,
he is certain that considering its recent management changes, the
stock should not dip below Rs. 920. A good strategy for him will
be to sell the 900 Put Option and take the entire premium.
Options and Futures are conceptually different but intrinsically they
are the same as they try to profit from stock or an index without
investing the full sum.
SWAPS
A swap is an agreement between two parties (called
counterparties) to exchange specified periodic cash flows in the future
based on some underlying instrument or price (e.g., a fixed or floating
rate on a bond or note). Like forward, futures, and option contracts,
swaps allow firms to better manage their interest rate, foreign exchange,
and credit risks. However, swaps also can result in large losses. At the
heart of the financial crisis in 2008–2009 were derivative securities,
mainly credit swaps, held by financial institutions. Specifically, in the
late 2000s, FIs such as Lehman Brothers and AIG had written and
also (in the case of AIG) insured billions of dollars of credit default
swap (CDS) contracts. When the mortgages underlying these contracts
fell drastically in value, credit swap writers found themselves unable to
make good on their promised payments to the swap holders. The
result was a significant increase in risk and a decrease in profits for the
FIs that had purchased these swap contracts. To prevent a massive
collapse of the financial system, the federal government had to step in
and bail out several of these FIs.
Swaps were introduced in the early 1980s, and the market for
swaps has grown enormously in recent years. The five generic types of
swaps are interest rate swaps, currency swaps, credit risk swaps,
commodity swaps, and equity swaps. The asset or instrument underlying
the swap may change, but the basic principle of a swap agreement is
the same in that it involves the transacting parties restructuring their
asset or liability cash flows in a preferred direction. In this section, we
consider the role of the two major generic types of swaps—interest
rate and currency.
Diagram 4.1
Fixed Floating
Interest Interest
Payments Payments
Fixed - Rate
Long Terms Floating - Rate
Deposits Long
European
European European
Financial
Depositors Borrowers
Institution
Interest on Floating Interest
Deposits Payments on Loans
Some types of interest rate swaps are more effective than others
at offsetting any unfavourable effects of interest rate movements on the
U.S. institution. However, those swaps also offset any favourable effects
to a greater degree. Other types of interest rate swaps do not provide
as effective a hedge but do allow the institution more flexibility to benefit
from favourable interest rate movements.
Scenario of Declining
Scenario of Rising Floating Inflow Payments Interest Rates
Interest Rates
Fixed Outflow Payments Fixed Outflow Payments
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
represents the floating interest rate received minus the fixed interest
rate paid. The net dollar amount to be transferred as a result of the
swap is determined by multiplying the swap differential by the notional
principal.
a. Forward Swaps
A forward swap involves an exchange of interest payments
that does not begin until a specified future time. It is useful for financial
institutions or other firms that expect to be exposed to interest rate risk
at some time in the future.
Eg: Detroit Bank is currently insulated against interest rate risk. Three
years from now, it plans to increase its proportion of fixed-rate loans
(in response to consumer demand for these loans) and reduce its
proportion of floating-rate loans. In order to prevent the adverse effects
of rising interest rates after these changes go into effect, Detroit Bank
may want to engage in interest rate swaps. It can immediately arrange
for a forward swap that will begin three years from now. The forward
swap allows Detroit Bank to lock in the terms of the arrangement today
even though the swap period is delayed (diagram 4.3). Although Detroit
Bank could have waited before arranging for a swap, it may prefer a
forward swap to lock in the terms of the swap arrangement at the
prevailing interest rates. If it expects interest rates to be higher three
years from now than they are today, and waits until then to negotiate a
swap arrangement, the fixed interest rate specified in the arrangement
will likely be higher. A forward interest rate swap may allow Detroit
Bank to negotiate a fixed rate today that is less than the expected fixed
rate on a swap negotiated in the future. Because Detroit Bank will be
exchanging fixed payments for floating-rate payments, it wants to
minimize the fixed rate used for the swap agreement.
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
End of Year End of Year
Eg: Reconsider the U.S. institution that wanted to swap fixed interest
payments for floating interest payments to reduce any adverse effects
of rising interest rates. If interest rates decline, the interest rate swap
arrangement offsets the potential favourable effects on this institution. A
callable swap allows the institution to terminate the swap in the event
that interest rates decline (diagram 4.4).
Diagram 4.4: Illustration of a Callable Swap
Interest Rates
Level of Interest Payments
Interest Rates
Floating Inflow Payments* Fixed Outflow
Fixed Outflow Payments Payments*
0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
a. Extendable Swaps
An extendable swap contains a feature that allows the fixed-
for-floating party to extend the swap period.
Eg: Cleveland Bank negotiates a fixed-for-floating swap for eight years.
Assume that interest rates increase over this time period as expected.
If Cleveland Bank believes interest rates will continue to rise, it may
prefer to extend the swap period (diagram 4.6). Although it could create
a new swap, the terms would reflect the current economic conditions.
A new swap would typically involve an exchange of fixed payments at
the prevailing higher interest rate for floating payments. Cleveland Bank
would prefer to extend the previous swap agreement that calls for fixed
School of Distance Education, University of Calicut 262
190314: MA Economics - IV SEMESTER
payments at the lower interest rate that existed at the time the swap
was created. It has additional flexibility because of the extendable
feature.
Diagram 4.6: Illustration of an Extendable Swap
Fixed Outflow
Fixed Outflow Payments*
Payments
Floating Inflow
At this time the institution At this time the institution Payments
would likely extend the would likely extend the
swap period swap period
0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
several years ago. At the time it purchased the bonds, it expected interest
rates to decline. Now it has become concerned that interest rates will
rise over time, which will not only increase its cost of funds but also
reduce the market value of the bonds. This financial institution can
request a swap period that matches the maturity of its bond holdings. If
interest rates rise over the period of concern, the institution will benefit
from the swap arrangement, thereby offsetting any adverse effects on
the institution’s cost of funds. The other party in this type of transaction
might be a firm that expects interest rates to decline (diagram 4.7).
Such a firm would be willing to provide floating-rate payments based
on this expectation because the payments will decline over time even
though the single payment to be received at the end of the swap period
is fixed.
Diagram 4.7: Illustration of a Zero-Coupon-for-Floating Swap
Payments
Floating Inflow
Payments
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
a. Rate-Capped Swaps
A rate-capped swap involves the exchange of fixed-rate
payments for floating-rate payments that are capped. Reconsider the
example in which the Bank of Orlando arranges to swap fixed payments
for floating payments. The counterparty may want to limit its possible
payments by setting a cap or ceiling on the interest rate it must pay. The
floating-rate payer pays an up-front fee to the fixed-rate payer for this
feature.
In this case, the size of the potential floating payments to be
received by the Bank of Orlando would now be limited by the cap,
which may reduce the effectiveness of the swap in hedging its interest
rate risk. If interest rates rise above the cap, the floating payments
received will not move in tandem with the interest the Bank of Orlando
will pay depositors for funds (diagram 4.8). Yet the Bank of Orlando
might believe that interest rates will not exceed a specified level and
would therefore be willing to allow a cap. Moreover, the Bank of
Orlando would receive an upfront fee from the counterparty for allowing
this cap.
An equity swap involves the exchange of interest payments for
payments linked to the degree of change in a stock index. For example,
using an equity swap arrangement, a company could swap a fixed interest
rate of 7 per cent in exchange for the rate of appreciation on the S&P
500 index each year over a four-year period. If the stock index
appreciates by 9 per cent over the year, the differential is 2 per cent (9
per cent received minus 7 per cent paid), which will be
Diagram 4.8: Illustration of a Rate-Capped Swap Equity Swaps
Floating Inflow
Payer of Fixed Outflow Payments Payer of Fixed Outflow Payments
Receives Premium at This Time Payments Receives Premium
for Agreeing to Cap at This Time for Agreeing to Cap
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
U.S.
Risk- Free
Interest Rate
London Interbant
Offer Rate
(LIBOR)
Fixed-Rate Floating-Rate
Swap Payment Swap Payment
Per Period Per Period
Net Payment
Due to
Interest Rate
Swap
Module V
GLOBAL FINANCIAL MARKETS
Instruments
The flow of external funds into a country depends on various
factors like the policy guidelines of the country on commercial
borrowings by individual entities, the exchange control regulations of
the country, the interest rate ceilings in the financial sector and the structure
of taxation. The integration of financial markets across countries has
opened up the international markets and large varieties of financial
instruments have merged to suit the changing needs of the international
investor. The global financial markets include the market for foreign
exchange, the Eurocurrency and related money markets, the international
capital markets, notably the Eurobond and global equity markets, the
commodity market and last but not least, the markets for forward
contracts, options, swaps and other derivatives.
As in any domestic capital structuring we can segregate
international financing into two broad categories.
These are:
i. Equity financing and
ii.Debt financing.
The various instruments used to raise funds abroad include; Equity,
straight debt or hybrid instruments. The figure 5.1shows the classification
of international capital markets based on instruments used and market(s)
accessed.
Figure 5.1
International Capital Markets
• Level III – Level III ADRs are the most prestigious. With these,
an issuer floats a public offering of ADRs on a U.S. exchange.
They can be used to establish a substantial trading presence in the
U.S. financial markets and raise capital for the foreign issuer. Issuers
are subject to full reporting with the SEC.
American Depositary Receipt Pricing and Costs
An ADR may represent the underlying shares on a one-for-one
basis, a fraction of a share, or multiple shares of the underlying
company. The depositary bank will set the ratio of U.S. ADRs per
home-country share at a value that they feel will appeal to investors.
If an ADR’s value is too high, it could deter some investors.
Conversely, if it is too low, investors may think the underlying
securities resemble riskier penny stocks. Because of arbitrage, an
ADR’s price closely tracks that of the company’s stock on its
home exchange.
Holders of ADRs realize any dividends and capital gains in U.S.
dollars. However, dividend payments are net of currency conversion
expenses and foreign taxes. Usually, the bank automatically
withholds the necessary amount to cover expenses and foreign
taxes. Since this is the practice, American investors would need to
seek a credit from the IRS or a refund from the foreign government’s
taxing authority to avoid double taxation on any capital gains
realized.
Pros
• Easy to track and trade
• Denominated in dollars
• Available through U.S. brokers
War and its subsequent oil crisis, the companies were asked to get
their own foreign currencies which led to the advent of the GDRs.
The Instrument
As mentioned earlier, GDRs are essentially those instruments
which possess a certain number of underlying shares in the custodial
domestic bank of the company. That is, a GDR is a negotiable instrument
which represents publicly traded local-currency-equity share. By law,
a GDR is any instrument in the form of a depository receipt or certificate
created by the Overseas Depository Bank outside India and issued to
non-resident investors against the issue of ordinary shares or foreign
currency convertible bonds of the issuing company. Usually, a typical
GDR is denominated in US dollars whereas the underlying shares would
be denominated in the local currency of the Issuer.
GDRs may be at the request of the investor – converted into
equity shares by cancellation of GDRs through the intermediation of
the depository and the sale of underlying shares in the domestic market
through the local custodian. GDRs, per se, are considered as common
equity of the issuing company and are entitled to dividends and voting
rights since the date of its issuance. The company effectively transacts
with only one entity – the Overseas Depository – for all the transactions.
The voting rights of the shares are exercise d by the Depository as per
the understanding between the issuing company and the GDR holders.
Issuance of GDR
The following are the sequence of activities that take place during the
issuance of GDRs:
a. Shareholder Approval Needed:
The issuance of an equity instrument like the GDR needs the
The government, after considering all the above information will give a
final approval for the issue if satisfied.
The Documentation
Documentation for Euro equities is a complex and elaborate
process in the procedure of GDR launch. A typical Euro-issue consists
of the following main documents:
a. Prospectus
b. Depository agreement
c. Custodian agreement
d. Subscription agreement
e. Paying and conversion agency agreement
f. Trust deed
g. Underwriting agreement and
h. Listing agreement.
e. Custodian Agreement:
It is an agreement between the depository and the custodian. In this
agreement the depository and the custodian determine the process
of conversion of underlying shares into depository receipts and vice
versa. For the process of conversion of the GDRs into shares,
(popularly termed as RE-materialization) shares have to be released
by the Custodian.
f. Trust Deed and Paying and Conversion Agreement:
While the trust deed is a standard document which provides for
duties and responsibilities of trustees, the paying and conversion
agreement enables the paying and conversion agency which performs
a typical banking function by undertaking to service the bonds until
the conversion, and arranging for conversion of bonds into GDRs
or shares, as necessary.
g. Listing Agreement:
As far as the listing is concerned, most of the companies which issue
a GDR prefer Luxembourg Stock Exchange as the listing
requirements in this exchange are by far, the simplest. The New
York Stock Exchange (NYSE) and the Tokyo Stock Exchange (TSE)
have the most stringent listing requirements. London Stock Exchange
and the Singapore Stock Exchange fit in the middle with relatively
fewer listing requirements than the NYSE and TSE. The listing agents
have the onus of fulfilling listing requirements of a chosen stock
exchange. The requirements of London Stock Exchange are
provided in the 48-hour documents. The 48- hour documents are
the final documents that have to be lodged at the exchange not later
than mid-day, at least two business days prior to the consideration
of the application for admission to listing.
Marketing
It is not only the Indian issues which thrive on suave marketing,
but also the GDR and other International bond offerings. A judicious
mix of financials and marketing would help in raising the investors interest
in the issue. Most of the marketing activities are handled by the lead
manager in consonance with the advertising agencies. A back-up
material consisting of preliminary offering circular, recent annual report,
interim financial statements, copies of newspaper articles about the
business of the company and a review of the structure and performance
of the Indian stock market, among other things is prepared.
Road shows form a pre-dominant facet of the launch of any
GDR. They are a series of face-to- face presentations with fund managers
and analysts and is a vital part of marketing process. Road shows,
which involve much more than must inform about the company are
getting increasing attention from the investors and the fund managers.
Road shows for Euro equities acquire considerably greater degree of
risk than under any other financial instrument. Road Shows are backed
by the information of the financials and operations and a view regarding
the future profitability and growth prospects. This gives an opportunity
to the investors (generally, fund managers) to interact with the senior
management of the issuing company and understand the activities of
the issuer company which may eventually lead to the investment in the
company. These are normally conducted at the financial centres of the
globe like London, New York, Boston, Los Angeles, Paris, Edinburgh,
Geneva, Hong Kong, etc.
The back-up material prepared will support presentations made
by the company’s senior personnel inviting the fund managers to invest
in the company. The price that is preferred for a particular number of
shares is noted by the boo-runner at each of such presentations and the
eventual price that is most likely to find favour with the fund manager is
finalized. This will go a long way in making the issue to be accepted.
Pricing and Closing
This forms the most vital part of the whole process of a GDR
issue. The pricing is key to the overall performance of a GDR after the
same has been listed. The price is determined after the underwriter’s
response has been considered and an inference of the response may
be drawn.
The final price is determined after the Book Runner closes the
books after the completion of the Road Shows. The book-runner
keeps the books open for 1-2 weeks, for the potential investors to
start placing their orders/bids with details of price and quantity. After
analysing all the bids at the end of book-building period, lead managers,
in consultation with the issuer, will fix a particular price for the issue
which will be communicated back to the bidders/investors and a fresh
demand figure is arrived at. If there is excess demand, the company
can go in for ‘green shoe option’ where it can issue additional GDRs in
excess of target amount.
A tombstone advertisement will be issued in the financial press
to publicize syndicated loans and other funding deals. Following this,
the GDRs will get listed in the notified stock exchange signalling the
consummation of the process of the issue of stock exchange. The time
period that is generally needed for typical GDR issue is given in the
table 5.1. It is arranged sequentially so as to convey information on the
step by-step process that is followed.
companies came out with a Euro-issue was their eagerness to flaunt the
GDR issue as a symbol of being well known in the international markets.
Some of the companies coming out with GDRs could not explain the
core business they are in and also whether they have judiciously utilized
the investment made by the GDR holders.
Foreign Currency Convertible Bonds (FCCB)
Foreign currency convertible bond (FCCB) is a Euro-bond
which can be converted into shares at the option of the investor. FCCBs
have a fixed coupon rate with a legal payment obligation. It has greater
flexibility with the conversion option - at the choice of the investor – to
equity. The price of the conversion of FCCB closely resembles the
trading price of the shares at the stock exchange. Also, the company
may incorporate a ‘call option’ at the choice of the issuer to obtain
FCCBs before maturity. This may be due to the adverse market
conditions, changes in the shareholding pattern, changes of tax laws
etc
Understanding Foreign Currency Convertible Bonds (FCCB)
A bond is a debt instrument that provides income to investors
in the form of regularly scheduled interest payments called coupons. At
the maturity date of the bond, the investors are repaid the full face value
of the bond. Some corporate entities issue a type of bond known as
convertible bonds.
A bondholder with a convertible bond has the option of
converting the bond into a specified number of shares of the issuing
company. Convertible bonds have a conversion rate at which the bonds
will be converted to equity. However, if the stock price stays below the
conversion price, the bond will not be converted. Thus, convertible
bonds allow bondholders to participate in the appreciation of the issuer’s
a favourable move in the exchange rates can reduce the issuer’s cost of
debt, which is the interest payment made on bonds.
Since the principal has to be repaid at maturity, an adverse
movement in exchange rates in which the local currency weakens can
cause cash outflows on repayment to be higher than any savings in
interest rates, resulting in losses for the issuer. In addition, issuing bonds
in a foreign currency exposes the issuer to any political, economic, and
legal risks prevalent in the country. Furthermore, if the issuer’s stock
price declines below the conversion price, FCCB investors will not
convert their bonds to equity, which means the issuer will have to make
the principal repayments at maturity.
An FCCB investor can purchase these bonds at a stock
exchange, and has the option to convert the bond into equity or a
depositary receipt after a certain period of time. Investors can participate
in any price appreciation of the issuer’s stock by converting the bond
to equity. Bondholders take advantage of this appreciation by means
of warrants attached to the bonds, which are activated when the price
of the stock reaches a certain point.
External Commercial Borrowings
ECBs are commercial loans raised by eligible resident entities
from recognised non-resident entities and should conform to parameters
such as minimum maturity, permitted and non- permitted end-uses,
maximum all-in-cost ceiling, etc.
The framework for raising loans through ECB, comprises of the following
three tracks:
Track I: Medium term foreign currency denominated ECB with minimum
average maturity of 3/5 years.
Track II: Long term foreign currency denominated ECB with minimum
average maturity of 10 years.
The Master Direction has also clearly mentioned the negative list for
which ECBs cannot be used as under:
1. Real estate activities.
2. Investment in capital market.
3. Equity investment.
4. Working capital purposes, except in case of ECB mentioned at
v(b) and v(c) above.
5. General corporate purposes, except in case of ECB mentioned at
v(b) and v(c) above.
6. Repayment of Rupee loans, except in case of ECB mentioned at
v(d) and v(e) above.
7. On-lending to entities for the above activities, except in case of
ECB raised by NBFCs as given under the Master Direction.
With favourable overseas conditions such as low interest rates
and liquidity, the ECB is expected to be the preferred choice of India
Inc., to bring investment/ loan for new projects, permitted use by RBI.
The overseas market is expected to be favourable market for the
foreseeable future, and therefore it is expected to lead to higher
borrowings by India Inc. With RBI’s check on the ECB, making industry
specific distinctions for automatic route and approval route, clearly
establishing the end-use restriction and minimum average maturity period
etc., it is expected that the ECBs are going to be the priority for bringing
investment in India.
With RBI allowing the use of ECB proceeds for repayment of
loans, the Indian GDP is expected to keep its stability intact and at the
same time allows the Indian Corporates to seek required funds (which
may not be allowed through local banks/ NBFC) from the overseas
market with lesser interest rates.
International Bonds
International Bonds International bonds are a debt instrument.
They are issued by international agencies, governments and companies
for borrowing foreign currency for a specified period of time. The issuer
pays interest to the creditor and makes repayment of capital. There are
different types of such bonds. The procedure of issue is very specific.
All these need some explanation here.
Types of International Bonds Foreign Bonds and Euro Bonds
International bonds are classified as foreign bonds and Euro
bonds. There is a difference between the two, primarily on four counts.
First, in the case of foreign bond, the issuer selects a foreign financial
market where the bonds are issued in the currency of that very country.
If an Indian company issues bond in New York and the bond is
denominated in a currency other than the currency of the country where
the bonds are issued. If the Indian company’s bond is denominated in
US dollar, the bonds will be used in any country other than the USA.
Then only it will be called Euro bond.
Secondly, foreign bonds are underwritten normally by the
underwriters of the country where they are issued. But the Euro bonds
are underwritten by the underwriters of multi nationality.
Thirdly, the maturity of a foreign bond is determined keeping in
mind the investors of a particular country where it is issued. On the
other hand, the Euro bonds are tailored to the needs of the multinational
investors. In the beginning, the Euro bond market was dominated by
individuals who had generally a choice for shorter maturity, but now the
institutional investors dominate the scenes who do not seek Euro bond
maturity necessarily to march their liabilities. The result is that the maturity
of Eurobonds is diverse. In England, Euro bonds with maturity between
8 and 12 years are known as intermediate Euro bonds.
Fourthly, foreign bonds are normally subjected to governmental
regulations in the country where they are issued. For example, in the
case of Yankee bonds (the bonds issued in the USA), the regulatory
thrust lies on disclosures. In some of the European countries, the thrust
lies on the resource allocation and on monetary control. Samurai bonds
(bonds issued in Japan) involved minimum credit rating requirements
prior to 1996. But the Euro bonds are free from the rules and regulations
of the country where they are issued. The reason is that the currency of
denomination is not the currency of that country and so it does not have
a direct impact on the balance of payments.
Eurobonds
The term ‘Euro’ originated in the fifties when the USA under
the Marshall Plan was assisting the European nations in the rebuilding
process a after the devastation caused by the Second World War. The
dollars that were in use outside the US came to be called as
“Eurodollars”. In This context the term ‘Euro’ signifies a currency outside
its home country. The term ‘Eurobonds’ thus refer to bonds issued and
sold outside the home country of the currency. For example, a dollar
denominated bond issued in the UK is a Euro (dollar) bond, similarly, a
Yen denominated bond issued in the US is a Euro (Yen) bond.
The Instruments
All Eurobonds, through their features can appeal to any class
of issuer or investor. The characteristics which make them unique and
flexible are,
for them. To cater to the varying shifts in the investor preferences and
borrowers’ financial requirements, variations have been introduced in
the basic FRN concept.
FRNs have thus been restructured into the following types:
1. Flip-Flop FRNs:
The investors have the option to convert the paper into flat interest
paying instrument at the end of a particular period. The investor
could change his mind and convert the note into perpetual note
once again at maturity. World Bank had come out with a FRNs
issue with perpetual life and having a spread of 50 basis points
over the US treasury rate. Every 6 months the investors had the
option of converting the FRN into 3-month note with a flat 3-
month yield. The investor could also revert his decision and change
it to a perpetual note.
2. Mismatch FRNs:
These notes have semi-annual interest payments though the actual
rate is fixed monthly. This enables investors to benefit from
arbitrage arising on account of differentials in interest rates for
different maturities. They are also known as rolling rate FRNs.
3. Mini-Max FRNs:
These notes include both minimum and maximum coupons. The
investors will earn a minimum rate as well as a maximum rate on
these notes. Depending on the differential between these rates the
spreads are earned on these notes. These notes are also known
as collared FRNs.
4. Capped FRNs:
An interest rate cap is given over which the borrower is not required
to service the notes, even if Libor goes above that level. Typically,
the investors have margins higher than that is normally applicable.
5. VRN-Structured FRNs:
These represent long-dated paper with variable interest spreads,
with margins over Libor. The margins rise for longer maturities.
6. Perpetual FRNs:
These notes which are irredeemable are also known as perpetual
floaters or undated issues
Procedure
Coming out with a bond issue is the most complex and elaborate
of the procedures of all the funding programs. Bonds need to be carefully
designed and executed, especially as these are placed with international
clientele.
The success of the bond issue depends not so much on costs
as on the position and capabilities of the bidders for launching the issue.
The cheapest bid therefore, may not be the best bid because the track
record and current market standing of the bidders would have to be
carefully weighed while choosing the lead manager.
Therefore, the mandate of the bond issue has to be awarded
after proper deliberation on the modalities involved. The bids should
include all necessary information relating to the placement strategy,
market support operations, listing details, paying agency arrangements,
delivery and handling of notes and trustee arrangements.
Listing
Bond issue are listed at one or more stock exchanges depending
upon the type of bond issue, the currency of denomination and the
desire of the issuer to seek a quotation at various centres. Generally,
the Eurobonds denominated in dollars are listed at London/ Luxembourg
Stock Exchanges, the bonds denominated ill French Franc at
Luxembourg Stock Exchange and those bonds denominated in DM at
German Stock Exchanges. Bonds issued in domestic markets like Japan,
Switzerland or Germany have to be listed as per the requirements.
Bond issue procedures are finally concluded with the tombstone
advertisement and bible compilation.
Clearing Arrangements
With a view to facilitating both new issue and secondary market
operations, clearing house arrangements have been made and systems
laid down for handling transactions. Eurobonds are usually handed over
to either the Euro clear system (Brussels) or Cedel (Luxembourg). The
two systems have been linked by what is known as an electric bridge.
Euroclear and Cedel follow two distinct practices, fungible and non-
fungible accounts, for concluding transactions between parties. While
the fungible accounts system is most popular in Euromarkets, the non-
fungible system is useful for control purposes. In a fungible account
system, details regarding the identity of the owners and location of
individual securities are not provided. Euroclear system handles trades
on fungible basis, whereas Cedel permits both procedures. The two
clearing systems have been providing various other facilities, apart from
settlement of secondary market trading transactions. For instance, finance
is provided by them for facilitating market-making operations.
When the loan amounts are small and the parties are familiar
with each other; lending banks form a club and advance a loan hence
the name of club loan. Syndicated Euro credit, however, has a full-
fledged public arrangement for organizing a loan transaction. 159 It is
treated as an integral part of the financial market mechanism with a
wide network of banks participating in the transaction over the globe.
Typically, a syndicated loan is available for a maturity of seven years
with shorter period transactions having a maturity of 3 to 5 years.
Eurodollars
The term Eurodollar refers to U.S. dollar-denominated deposits
at foreign banks or at the overseas branches of American banks.
Because they are held outside the United States, Eurodollars are not
subject to regulation by the Federal Reserve Board, including reserve
requirements. Dollar-denominated deposits not subject to U.S. banking
regulations were originally held almost exclusively in Europe (hence,
the name Eurodollar). Now, they are also widely held in branches located
in the Bahamas and the Cayman Islands.
The fact that the Eurodollar market is relatively free of regulation
means such deposits can pay higher interest. Their offshore location
makes them subject to political and economic risk in the country of
their domicile; however, most branches where the deposits are housed
are in very stable locations.
The Eurodollar market is one of the world’s primary international
capital markets. They require a steady supply of depositors putting
their money into foreign banks. These Eurodollar banks may have
problems with their liquidity if the supply of deposits drops.
Deposits from overnight out to a week are priced based on the
fed funds rate. Prices for longer maturities are based on the
situated in U.S. dealing rooms, and the money is on loan to fund domestic
and international operations.
Eurocurrency Market
Euro-currency market, also known as Euro-dollar market, is
an international capital market which specializes in borrowing and
lending of currencies outside the country of issue. Thus, deposits in
dollars with a bank in London are Euro dollars. Similarly, French francs
held by banks in London are Euro-francs; pound-sterling held by banks
in Germany are Euro-sterling, and so on. They are all Euro-currencies.
Predominantly, the dealings in the market are in dollars and hence the
name Euro-dollar market is still in vogue.
The main centres of Euro-currency are London and a few other
places in Europe. The growth of the market has extended beyond
these limits and now it includes a few centres of Asia too, such as
Singapore. The centres in Asia are known as Asian-dollar n the terms
Euro-dollars and Euro-currency are used universally to denote all such
markets, including the Asian dollar market.
Special Features of the Market
The following are the special features of the Euro-currency market:
1. Transactions in each currency take place outside the country of
its issue. For example, dollars earned by a Japanese firm from
exports may be deposited with a bank in London. The London
bank is free to use the funds for lending to any other bank. The
bank may use it for lending to French Bank. Thus, the utility of the
currency is entirely outside the control of the central bank of the
country issuing the currency. For this reason, Euro-currencies are
also referred to as offshore Currencies
2. Even though the currency is utilised outside the country of its origin,
it has to be held only in the country of its issue. To continue our
example, the Japanese firm deposits its dollar earnings with a bank
in London. The London Bank will keep the funds in a New York
Bank in its own name. When the London Bank lends the amount
to the French Bank, it will give suitable instructions to the New
York Bank. On receipt of the instructions, the New York Batik
will debit the account of the London Bank and credit it to the
account of the French Bank. Thus, ultimately the settlement of all
dollar transactions takes place in New York. Similarly, settlement
of all Euro-sterling transactions is made in London, all Euro-French
franc transactions in Paris and so on.
3. Though Euro-currencies are outside the direct control of the
monetary authorities of their respective countries of issue, they
are subject to some form of indirect control. This is because the
settlement of all transactions has to take place only in the country
of issue. If the country of issue imposes any restrictions, the
conversion of balances in the currency held outside the country
into another currency would also be affected. As already stated,
conversion into another currency would involve clearing in the
country of issue at some point of the transaction. This automatically
subjects them to the restriction.
4. Euro-currency market is not a foreign exchange market. It is a
market for deposits with and between banks (inter-bank deposits)
and for loans by banks to the non-bank public. It is a market in
which foreign currencies are lent and borrowed as distinct from
the foreign exchange market, where they are bought and sold. It
consists of a pool of predominantly short- term deposits which
provide the big single source of funds that commercial banks
will be based on the Libor then prevailing. This vi1l be repeated every
six months.
LIBOR is the ‘London Inter-Bank Offered Rate’ and represents
the rate’ which banks in London will lend a currency to other banks for
a specific maturity. Since London is a major Eurocurrency market. Libor
is used as the basis for most Eurocurrency transactions) Libor varies
for different maturities. Thus, we have 1 month Libor, 3 months Libor,
6 months Libor etc. Rates quoted by different banks may vary slightly,
the bigger banks offering lower rates. In respect of a particular contract
based on Libor, say a Eurobond issue, the rate is fixed by nominating
reference banks. The reference banks may be from among those
syndicating the issue. Or, to maintain neutrality, they may be banks
outside the syndicate.
The rates quoted by these banks at a stipulated time, often 11
AM London time, two business days before start of the due date, is
taken as the basis. The average of such rates is rounded off to the
nearest 1/8 per cent.
LIBID is the ‘London Interbank Bid’ rate. It is the rate at which
banks accept euro deposits.
Bid rates are lower than offered rates usually by 1/8 to 1/4 per cent.
LIMEAN is the average of Libor and Libid. Prime Rate is the
rate of interest charged by first class banks in USA on advances to
their first-class borrowers. For example, it may relate to an advance
made to a multinational corporation with a very high credit rating. This
rate is usually a couple of per centage points higher than the discount
and Federal funds rate. While it follows the same trends, it is determined
rate calculated from money market rates, especially from the 90 days
Certificate of Deposit rate.
Adverse Effects:
However, these flows of Euro-currencies have three adverse effects:
First, when the monetary authority of a country is trying to curb
inflation through a restrictive monetary policy, an inflow of short-term
capital defeats such a policy. Again when there is an outflow of capital
and the country is following an easy monetary policy to combat
unemployment, such a policy again becomes ineffective. This is because
the Euro-currency market does not operate under the regulations of
any authority.
Second, Euro-currencies provide an enormous fund of liquid
resources which are used for speculative capital movements. These
expose the economies of the concerned countries to severe strains of
sudden and large withdrawals of credits. Such financial upheavals and
disturbances also affect the international monetary system as a whole,
especially when the countries involved are not protected by exchange
controls or trade barriers.
Third, according to Milton Friedman, “The Euro-currency
market has almost surely raised the world’s nominal money supply
(expressed in dollar equivalents) and has thus made the world
price level (expressed in dollar equivalents) higher than otherwise it
would be.”