IIM, CALCUTTA

1. IIM, CALCUTTA Operation of Money Market, Capital Market, Foreign Exchange Market and Derivative Market A Broad Overview July 2009

2. Financial Market Financial Market is that market where any kind of financial deal or transaction can be put through. All fund raising need not necessarily be through the market route. For instance, borrowing can be by way of some bilateral negotiations rather than by access to the market. Credit Rating necessary and Transparent Pricing achieved for Financial Markets.

3. Segments of Financial Market Financial Market Money Market Capital Market Financial Derivative Market Foreign Exchange Market Used for Converting Existing Fund From one Currency to another Used for Raising Short Term Finance Used for Managing/Hedging Market Risk Used for Raising Long Term Finance

4. Money Market Money Market (Short Term Finance) Treasury Bill Call Money Market Certificate of Deposit CBLO Repo and Reverse Repo Commercial Paper Fixed Income Securities

5. Capital Market Capital Market (Long Term Finance) Debt Shares Preference Equity Fixed Income Security Variable Income Security

6. Security Definition of Security Security Contract Regulation Act (SCRA) Stock Exchange and Listing Fixed Income Security - Long Term (Bond, Preference Shares) & Short Term (Treasury Bill, Commercial Paper, Certificate of Deposit) Variable Income Security – Long (Infinite) Term only ( Equity Shares)

7. Commercial Paper Short Term – Tenure 7 to 365 days Maximum Depth – 90 days Issuer – Corporates Security – Yes Traded in – Money Market Nature – Usance Promissory Note issued at a discount to the face value Amount – Multiples of Rs 5 lacs

8. Risk Management

9. Risk Management • Definition of Risk, Exposure and Market Volatility • Quantification of Risk • Interest Rate Risk and Capital Market Risk • Systematic and Unsystematic Risk • Need for Risk Management • Portfolio Theory • Risk Management and Financial Derivatives • Stock and Index Futures and Option • Interest Rate Swap • FRA

10. RiskFactors • Diversification will reduce risk by eliminating unsystematic risk. • With an integrated market for securities, the investor is able to reduce risk more quickly and further by diversifying across international stocks as opposed to only domestic ones

11. Degrees of Exposure on Existing Assets and Liabilities • Hekman has derived a framework for categorizing assets and liabilities as to their degree of exposure • Coefficient of 1.0 means the market value of the balance sheet item is entirely exposed • Coefficient of 0.0 means the market value is unexposed • Coefficients between 0 and 1 means the item is partially exposed

12. DerivativeSecurities • Derive their value from primary securities • Primary financial instrument evidences a direct claim against some other party • Traded in the spot market with prices set by the forces of supply and demand • Put and Call Options on stocks • Cascade of new derivatives • Insulate a corporation from different types of risk

13. HedgingRisk • Use futures contracts, forward contracts, options, or swaps for hedging. • Taking a derivative position opposite to your exposure. • Value of the derivatives used to hedge do not move in concert with that of the underlying assets • Slight to moderate deviations create basis risk

14. Hedging Fundamentals • Hedge ratio is the ratio of one position relative to the other where risk is neutralized • Must adjust the hedge ratio over time (known as dynamic hedging) if risk is to be minimized • The lower the transaction cost, the more that adjustments can occur and the more that risk is minimized • Requires continual vigilance if risk is to be controlled

15. Arguments for Corporate Hedging • In spite of imperfections, hedging may be a thing of value. • Stabilize accounting earnings and reduce the probability of falling below some regulatory requirement. • Insulate operating managers from the vagaries of interest-rate changes and currency movements.

16. Futures Market • Futures contract is a standardized agreement that calls for delivery of an asset at some specific future date (in some cases only cash delivery is allowed.) • With financial futures the asset is a security • Only a small percentage of contracts come to actual delivery • Buyers and sellers take offsetting positions • Open interest is the number of futures contracts outstanding that have not been closed

17. Several Interest-Rate Futures Markets • Eurodollars • Treasury notes • Indian Scenario

18. Features of Futures Markets • Margin requirements • Amount of money that must be pledged to cover fluctuations in the market price of the contract, and is subject to daily reset • Initial and maintenance margin requirements • Marked-to-market means daily valuation of a contract with the loser owing money to the winner • Longer-term instruments • Settlement price multiplied by a conversion factor • Established for each coupon rate and time to maturity

19. Hedging and Speculation • Hedging represents taking a futures contract position opposite to a position taken in the spot market to reduce risk exposure • Speculator takes position in futures markets in the pursuit of profits and assumes price risk • Long hedges involves buying a futures contract • Futures market provides a “two-sided” hedge • Short hedges involves writing a contract • Cross hedge

20. Basis Risk • Is the random fluctuation in net position that remains after hedging Futures price (adjusted • Basis = Spot market - by appropriate price conversion factor) • Spot price less the futures price should equal the cost of carry • Positive carry • Negative carry

21. Option Contract • One-sided Hedges • Put and Call • European/American • In the Money, At the Money, Out of the Money • Use of Hedge Options

22. Caps, Floors, and Collars • Cap is a put option on a fixed-income security’s value • Floor is a call option • Collar is a combination of a cap and a floor, with variation only in the mid-range • Developed as customized derivative products

23. Interest-Rate Swaps • Exchanges a floating-rate obligation for a fixed-rate one, or vice versa • With an interest-rate swap, interest-payment obligations are exchanged between two parties denominated in the same currency • Floating-/fixed-rate exchange • A fixed-rate interest payment is exchanged for a floating rate • Basis swap • Two floating-rate obligations are exchanged • Swaps can be customized

24. Credit Risk • Default risk with respect to differential in interest payments • Intermediaries increasingly interposed themselves between the parties in such a way as to assume the default risk • Replacement risk is that of having to replace a counterparty in case of default • Swap positions can be sold giving them a degree of liquidity not found in many loans • Standardized contract specifies how swaps are to be liquidated in event of default • Margin is not sufficient to compensate for the credit risk if default occurs

25. CreditDerivatives • Unbundle default risk from the other features of a loan • Can be transferred to others for a price • Protection buyer transfers risk • Protection seller assumes the credit risk and receives a premium for providing the insurance • Credit-swap spread is the periodic premium paid

26. Total Return Swap Protection Buyer Protection Seller Debt instrument’s total return Reference rate +/- spread

27. Credit Swap Premium Protection Buyer Protection Seller No credit event: $0 Credit event: Face value -market value

28. Options

29. A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put is an option to sell a certain asset by a certain date for a certain price (the strike price) Options

30. Profit ($) 30 20 10 Terminal stock price ($) 30 40 50 60 0 70 80 90 -5 Long Call on Microsoft Profit from buying a European call option on Microsoft: option price = $5, strike price = $60

31. Profit ($) 70 80 90 5 0 30 40 50 60 Terminal stock price ($) -10 -20 -30 Short Call on Microsoft Profit from writing a European call option on Microsoft: option price = $5, strike price = $60

32. Profit ($) 30 20 10 Terminal stock price ($) 0 60 70 80 90 100 110 120 -7 Long Put on IBM Profit from buying a European put option on IBM: option price = $7, strike price = $90

33. Profit ($) Terminal stock price ($) 7 60 70 80 0 90 100 110 120 -10 -20 -30 Short Put on IBM Profit from writing a European put option on IBM: option price = $7, strike price = $90

34. Payoff Payoff K K ST ST Payoff Payoff K K ST ST Payoffs from OptionsWhat is the Option Position in Each Case? K = Strike price, ST = Price of asset at maturity

35. Types of Traders • Hedgers • Speculators • Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

36. Types of Options • A call is an option to buy • A put is an option to sell • A European option can be exercised only at the end of its life • An American option can be exercised at any time

37. Assets UnderlyingExchange-Traded Options • Stocks • Stock Indices • Foreign Currency • Commodity • Futures

38. Specification ofExchange-Traded Options • Expiration date • Strike price • European or American • Call or Put (option class)

39. Terminology Moneyness : • At-the-money option • In-the-money option • Out-of-the-money option

40. Terminology(continued) • Option Premium • Option series • Intrinsic value • Time value

41. Executive Stock Options • Option issued by a company to executives • When the option is exercised the company issues more stock • Usually at-the-money when issued

42. Executive Stock Options continued • They become vested after a period ot time • They cannot be sold • They often last for as long as 10 or 15 years

43. Types of Options • A call is an option to buy • A put is an option to sell • A European option can be exercised only at the end of its life • An American option can be exercised at any time

44. Assets UnderlyingExchange-Traded Options • Stocks • Foreign Currency • Stock Indices • Futures

45. Specification ofExchange-Traded Options • Expiration date • Strike price • European or American • Call or Put (option class)

46. Terminology Moneyness : • At-the-money option • In-the-money option • Out-of-the-money option

47. Terminology(continued) • Option class • Option series • Intrinsic value • Time value

48. Market Makers • Most exchanges use market makers to facilitate options trading • A market maker quotes both bid and ask prices when requested • The market maker does not know whether the individual requesting the quotes wants to buy or sell

49. Trading Strategies Involving Options

50. Three Alternative Strategies • Take a position in the option and the underlying • Take a position in 2 or more options of the same type (A spread) • Combination: Take a position in a mixture of calls & puts (A combination)