Financial Market
Financial market deals in financial securities or instruments and financial services. It may be variously classified as primary and secondary, money markets and capital markets, organised and unorganised markets official and parallel markets, and foreign and domestic markets. Financial market provides money and capital supply to the industrial concern as well as promote the savings and investments habits of the public. In simple censes financial market is a market which deals with various financial instruments (share, debenture, bonds, treasury bills, commercial bills etc.) and financial services (merchant banking, underwriting etc).
Money Market
Money market is one of the part of Indian financial market which provides short-term financial requirements of the industrial and business concern. Money market again subdivided into the following categories on the basis of the instruments used in the money market.
A well-organised money market is the basis for an effective monetary policy. A money market may be defined as the market for lending and borrowing of short-term funds. It is the place where the short-term surplus investable funds at the disposal of banks and other financial institutions are bid by borrowers comprising companies, individuals and the government. The RBI in India occupies a pivotal position in the money market as it controls the flow of currency and credit into the market.
Some important money market instruments are:
Call Money
Call money is short-term finance repayable on demand, with a maturity period of one to fifteen days, used for inter-bank transactions. The money that is lent for one day in this market is known as “call money” and, if it exceeds one day, is referred to as “notice money.”
Call money is a method by which banks lend to each other to be able to maintain the cash reserve ratio. The interest rate paid on call money is known as the call rate. It is a highly volatile rate that varies from day to day and sometimes even from hour to hour. There is an inverse relationship between call rates and other short-term money market instruments such as certificates of deposit and commercial paper. A rise in call money rates makes other sources of finance, such as commercial paper and certificates of deposit, cheaper in comparison for banks to raise funds from these sources.
The term, in the international market, usually refers to the short term financing by banking institutions to brokers for maintaining the margin account. It is different from the term ‘loan’ as the schedule for the payment of interest and principal is not fixed. Since, the loan can be called at any time, it is riskier than other forms of loans. It helps in meeting liquidity needs at short notice.
Treasury Bills
Short-term (usually less than one year, typically three months) maturity promissory note issued by a national (federal) government as a primary instrument for regulating money supply and raising funds via open market operations. Issued through the country’s central bank, T-bills commonly pay no explicit interest but are sold at a discount, their yield being the difference between the purchase price and the par-value (also called redemption value). This yield is closely watched by financial markets and affects the yield on municipal and corporate bonds and bank interest rates. Although their yield is lower than on other securities with similar maturities, T-bills are very popular with institutional investors because, being backed by the government’s full faith and credit, they come closest to a risk free investment. Issued first time in 1877 in the UK and in 1929 in the US.
In India, the Reserve Bank of India has been issuing 91-day, 182-day and 364-day treasury bills. the auction format of 91-day treasury bill has changed from uniform price to multiple price to encourage more responsible bidding from the market players.
Commercial Papers
Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of no more than 270 days. Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet short-term debt obligations (for example, payroll), and is backed only by an issuing bank or corporation’s promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized credit rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution pays. Interest rates fluctuate with market conditions, but are typically lower than banks’ rates.
Certificate of Deposits
Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialized form or as a Issuance Promissory Note against funds deposited at a bank or other eligible financial institution for a specified time period. CD refers to instruments of relatively short duration or savings accounts that pay a fixed rate of interest until a given maturity date. Also, funds placed in a Certificate of Deposit usually cannot be withdrawn prior to maturity or they can perhaps only be withdrawn with advanced notice and/or by having a penalty assessed. The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, from the date of issue. CDs will often be used by individuals, businesses and financial institutions around the world as a means of storing their liquid funds for a fixed period of time for future use. In the retail market, a Certificate of Deposit is a relatively safe investment when provided by insured financial institutions such as banks, savings and loan corporations and credit unions that are usually regulated within the country in which they operate.
Repurchase Agreement
A form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for the party on the other end of the transaction, (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest. The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate.
Central banks often use repos to boost money supply, buying Treasury bills or other government paper from commercial banks so the banks can boost their reserves, and selling the paper back at a later date. When the central bank wants to tighten money supply, it sells the paper first, and buys it back later – this is called a reverse repo, an agreement to lend securities rather than funds.
Capital Market
Capital markets help channelise surplus funds from savers to institutions which then invest them into productive use. Generally, this market trades mostly in long-term securities. It is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions. Securities Exchange Board of India (SEBI) is the Regulator of Capital Market in India.
Capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and other securities, whereas secondary market deals with the exchange of existing or previously-issued securities.
Equity Market
Equity market that gives companies a way to raise needed capital and gives investors an opportunity for gain by allowing those companies’ stock shares to be traded. In this market shares are issued and traded, either through exchanges or over-the-counter markets. It is also known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance. This market can be split into two main sectors: the primary and secondary market. The primary market is where new issues are first offered. Any subsequent trading takes place in the secondary market.
Equities (Shares)
It is an instrument that signifies an ownership position, or equity, in a corporation, and represents a claim on its proportionate share in the corporation’s assets and profits. A person holding such an ownership in the company does not enjoy the highest claim on the company’s earnings. Instead, an equity holder’s claim is subordinated to creditor’s claims, and the equity holder will only enjoy distributions from earnings after these higher priority claims are satisfied.
It may comprise ordinary shares and preference shares. Companies issues their shares electroniclly through stock exchanges on which investor can trade with the help of members of strock exchange.
Ordinary Shares: An ordinary share represents equity ownership in a company. It entitles the owner to a vote in matters put before shareholders in proportion to their percentage ownership in the company. Shareholders are entitled to receive dividends if any are available after dividends on preferred shares are paid. If the company does badly, it is also the ordinary shareholders that will suffer. The true value of an ordinary share is based on the price obtained through market forces, the value of the underlying business and investor sentiment toward the company.
Preference Shares: Preference shares are a hybrid security with elements of both debt and equity. It have legal priority over ordinary shareholders in respect of earnings and in the event of bankruptcy, in respect of assets. Fixed dividend is paid each year. Shareholders have no voting rights, except in certain circumstances such as when their dividends have not been paid.
Types of Preference Shares
Cumulative: dividend is accumulated if the company does not earn sufficient profit to pay the dividend i.e., if the dividend is not paid in one year it will be carried forward to successive years;
Non-cumulative: if the company is unable to pay the dividend on preference shares because of insufficient profits, the dividend is not accumulated. Preference shares are cumulative unless expressly stated otherwise;
Participating: participating preference shares, in addition to their fixed dividend, share in the profits of a company at a certain rate;
Convertible: apart from earning a fixed dividend, convertible preference shares can be converted into ordinary shares on specified terms;
Redeemable: redeemable preference shares can be redeemed at the option of the company either at a fixed rate on a specified date or over a certain period of time.
Primary Market
The Primary Market is, hence, the market that provides a channel for the issuance of new securities by issuers (Government companies or corporates) to raise capital. The securities (financial instruments) may be issued at face value, or at a discount / premium in various forms such as equity, debt etc. They may be issued in the domestic and / or international market.
Features of primary markets include:
- The securities are issued by the company directly to the investors.
- The company receives the money and issues new securities to the investors.
- The primary markets are used by companies for the purpose of setting up new ventures/ business or for expanding or modernizing the existing business
- Primary market performs the crucial function of facilitating capital formation in the economy
A primary market is not inclusive of sources, from where companies can generate external finance over a long term, such as loans provided by financial organizations. Through these markets, companies can also go public, which means changing private capital to public capital. The primary market accelerates the process of capital formation in a country’s economy.
Many companies have entered the primary market to earn profit by converting their capital, which is basically a private capital, into a public one, releasing securities to the public. This phenomena is known as “public issue” or “going public”.
Investors can obtain news of upcoming shares only in the primary market. The issuing firm collects money, which is then used to finance its operations or expand business, by selling its shares. Before selling a security on the primary market, the firm must fulfill all the requirements regarding the exchange.
Participants in the Primary Markets
Merchant Banks:
Merchant Banking is a combination of Banking and consultancy services. It provides consultancy to its clients for financial, marketing, managerial and legal matters. Consultancy means to provide advice, guidance and service for a fee. It helps a businessman to start a business. It helps to raise (collect) finance. It helps to expand and modernize the business. It helps in restructuring of a business. It helps to revive sick business units. It also helps companies to register, buy and sell shares at the stock exchange. It deals mostly in international finance, long-term loans for companies and underwriting. Merchant banks do not provide regular banking services to the general public. merchant banking provides a wide range of services for starting until running a business. It acts as Financial Engineer for a business. Major operations performed by the merchant banks are:
- Management of Debt and Equity Offerings
- Placement and Distribution,
- Rights Issues of Shares,
- Corporate Advisory Services,
- Project Advisory,
- Loan Syndication,
- Venture Capital & Mezzanine Financing,
- Mergers & Acquisitions,
- Takeover Defense.
Primary Market Underwriters:
Investment banks are the main underwriters in the primary markets and thus are the major facilitators of these types of markets. They normally decide the base price of the securities on sale and then administer the entire process of its sale to the investors. The underwriters also play the important role of safeguarding the issue related risks for the companies that are offering the shares for sale.
Underwriters generally receive underwriting fees from their issuing clients, but they also usually earn profits when selling the underwritten shares to investors. However, underwriters have the responsibility of distributing a securities issue to the public. If they can’t sell all of the securities at the specified offering price, they may be forced to sell the securities for less than they paid for them, or retain the securities themselves.
The Bankers to an issue:
The Bankers to an issue are scheduled banks which engaged in activities such as acceptance of applications along with application money from investors in respect if issues of capital and refund of application money. Banker to an issue has to obtain a certificate of registration granted by the regulator of the country. Every banker to an issue enters into an agreement with the issuing company.
Activities related to bankers to an issue are:
- acceptance of application
- acceptance of allotment
- refund of application
- payment of dividend or interest warrants.
Brokers to an Issue
Companies making public issues appoint brokers to procure subscription. The managers to the issue distribute prospectuses and application forms to the brokers. A broker that sells shares that are being made available for the first time in a share issue. Broker are responsible for procuring the subscription to the issue from the prospective investors. They provide a vital connecting link between the prospective investors and the issuer, thus, assisting in speedy subscription of issue by the public. Broker has to obtain membership cerificate from the stock exchange to act as a broker to the issuer company.
Registrar to an Issue & Share Transfer Agents
Registrar to an Issue is the person appointed by a body corporate or any person or group of persons to carry on the activities like:
- collecting applications from investors in respect of an issue;
- keeping a proper record of applications and monies received from investors or paid to the seller of the securities. and
- assisting body corporate or person or group of persons in-
- determining the basis of allotment of securities in consultation with the stock exchange;
- finalising of the list of persons entitled to allotment of securities;
- processing and despatching allotment letters, refund orders or certificates and other related documents in respect of the issue.
Share Transfer Agent is any person, who on behalf of any body corporate maintains the record of holders of securities issued by such body corporate and deals with all matters connected with the transfer and redemption of its securities. A department or division (by whatever name called) of a body corporate performing the activities referred in sub-clause (i) if, at any time the total number of the holders of securities issued exceed one lakh.
Different types of issues:
Primary markets are basically the platform where an investor gets the first opportunity to purchase a new security. The group or company that issues the security gets the money by selling a certain amount of securities. Normally, the entire process of buying a primary market security involves several rules and regulations that have to be properly adhered to before a security can change hands.
Methods of Issuing Securities in the Primary Market:
There are three methods through which securities can be issued in the primary market:
- Public Issue
- Initial Public Offer (IPO)
- Follow-on Public Offer (FPO)
- Rights Issue
- Private Placement
Initial Public Offer (IPO)
The most common primary mechanism for raising capital is an Initial Public Offer (IPO), under which shares are offered to the public as a precursor to trading in the secondary market of an exchange. In this method shares are issued to the underwriter after the issue of prospectus which provides details of financial and business information as regards the issuer. Shares are then released to the underwriter and the underwriter releases the share to the public as per their application. The price at which the shares are to be issued is decided with the help of the book building mechanism; in the case of over subscription, the shares are allotted on a pro rata basis.
Essential steps involved in the IPO method are as follows:
Order: Broker receives order from the client and places orders on behalf of the client with the issuer.
Share Allocation: The issuer finalizes share allocation and informs the broker of the same.
Client: Broker advises the successful clients of the share allocation. Clients then submit the application forms for shares and make payment to the issuer through the broker.
Primary Issue Account: Issuer opens a separate escrow account (primary issue account) for the primary market issue. Clearing house of the exchange debits this account of the broker and credits the issuer’s account.
Certificates: Certificates are then delivered to investors. Otherwise depository account may be credited.
Follow-on Public Issue (FPO)
FPOs are popular methods for companies to raise additional equity capital in the capital markets through a stock issue. Public companies can also take advantage of an FPO issuing an offer for sale to investors, which is made through an offer document. FPOs should not be confused with IPOs, as IPOs are the initial public offering of equity to the public while FPOs are supplemantary issues made after a company has been established on an exchange.
Right Issue
This method is used by those companies who have already issued their shares. When an existing company issues new shares, first of all it invites its existing shareholders. This issue is called the right issue. In this case, the shareholder has the right either to accept the offer for himself or assign a part or all of his right in favour of another person.
Private Placement
Private Placement of shares means the company sells its shares to a small group of investors at a higher price. In this method, securities are placed to a select group of persons not exceeding 49, and it is neither a rights issue nor a public issue. It can sell to banks, insurance companies, financial institutions, etc. It is an economical and quick method of selling securities. The company does not sell its shares to the public.
What is Prospectus?
An offer document through which public are solicited to subscribe to the share capital of a corporate entity is called ‘prospectus’. Its purpose is to invite the public for the subscription/purchase of securities of a company. As per the guidelines of regulator of stock market it is nessesary to disclose all information like the reason for raising the money, the way money is proposed to be spent, the return expected on the money to public while coming with new issue, these information are disclose by the company through Prospectus, which also includes information regarding the size of the issue, the current status of the company, its equity capital, its current and past performance, the promoters, the project, cost of the project, means of financing, product and capacity etc. It also contains lot of mandatory information regarding underwriting and statutory compliances. This helps investors to evaluate short term and long term prospects of the company.
Deemed prospectus: a prospectus that is deemed to have been made by the issuer, though it is actually offered to the public by a third party or the so-called issue house (Indian terminology). The issuer saves the underwriting expenses in selling its securities.
Statement in Lieu of Prospectus: A public document prepared in the second schedule of company’s ordinance by every such public company which doesn’t issue a prospectus on its formation with the registrar before allotment or shares of debentures, and signed by every person who is named therein. A statement in lieu of prospectus gives practically the same information as a prospectus and is signed by all the directors or proposed directors. In case, the company has not filed a statement in lieu of prospectus with the registrar, it is then not allowed to allot any of its shares or debentures. An offer document (filed with the RoC at least three days before making allotment of shares or debentures) may be considered to be a ‘statement in lieu of prospectus’ under any of the following circumstances:
- Where a company could raise the necessary capital without any public subscription, or
- Where a company could not make any allotment on account of the minimum subscription not being obtained.
A statement in lieu of the prospectus contains the information as described below:-
1- Name of the company
2- Statement of capital
3- Description of the business
4- Names, addresses, and occupation of directors
5- Estimated initial expenses
6- Names of vendors and details of property
7- Material contracts
8- Director’s interest
9- Minimum subscription
Red-herring prospectus: a prospectus that contains most of the information that will be presented in the final prospectus but often does not mention a price and/or the number of securities. A red-herring prospectus is alternatively known as a preliminary prospectus. It is issued where a company offers its securities through the “book-building issue”. In case of book-build issues, there is a process of price discovery and the price cannot be determined, until the bidding process is complete. Once the bidding process is complete, the details of the final price are included in the offer document. The offer document filed thereafter with RoC is called a prospectus. It shall be filed with the RoC at least three days before the opening of the offer. A copy of the same must be filed with the regulator (SEBI) also. It carries the same obligations and liabilities as are applicable to an ordinary prospectus.
Public Issue Pricing
An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. This Initial Public Offering can be made through the fixed price method, book building method or a combination of both.
Fixed Price Issue: In the fixed price issue the price at which the securities are offered and would be allotted is made known in advance to the investors. Demand for the securities offered is known only after the closure of the issue. This method serves as an excellent mode of disclosure of all the information pertaining to the issue. Besides disclosure of information, this method also facilitates satisfactory compliance with the legal requirements of transparency. The method promotes confidence of investors through transparency and non-discriminatory basis of allotment. It prevents artificial jacking up of prices as the issue is made public. In this 100% advance payment is required to be made by the investors at the time of application. 50% of the shares offered are reserved for applications below Rs. 1 lakh and the balance for higher amount applications. It is a time consuming process as it needs the due compliance with various formalities before being placed. Issuing through fixed price it inccured high costs such as underwriting expenses, brokerage, administrative costs, publicity costs, legal costs etc.
Book Building Isuue: Book Building is essentially a process used by companies raising capital through Public Offerings-both Initial Public Offers (IPOs) or Follow-on Public Offers ( FPOs) to aid price and demand discovery. It is a mechanism where, during the period for which the book for the offer is open, the bids are collected from investors at various prices, which are within the price band specified by the issuer. The process is directed towards both the institutional as well as the retail investors. The issue price is determined after the bid closure based on the demand generated in the process. In this issue 10% advance payment is required to be made by the QIBs along with the application, while other categories of investors have to pay 100% advance along with the application. 50% of shares offered are reserved for QIBS, 35% for small investors and the balance for all other investors.
The Process:
- The Issuer who is planning an offer nominates lead merchant banker(s) as ‘book runners’.
- The Issuer specifies the number of securities to be issued and the price band for the bids.
- The Issuer also appoints syndicate members with whom orders are to be placed by the investors.
- The syndicate members input the orders into an ‘electronic book’. This process is called ‘bidding’ and is similar to open auction.
- The book normally remains open for a period of 5 days.
- Bids have to be entered within the specified price band.
- Bids can be revised by the bidders before the book closes.
- On the close of the book building period, the book runners evaluate the bids on the basis of the demand at various price levels.
- The book runners and the Issuer decide the final price at which the securities shall be issued.
- Generally, the number of shares are fixed, the issue size gets frozen based on the final price per share.
- Allocation of securities is made to the successful bidders. The rest get refund orders
Based on the total demand the cut off price is then decided by the issuer and merchant banker. The cut off price is the price at which the cumulative demand for shares, equals or exceeds the offer size.
Secondary Market
Securities issued by a company for the first time are offered to the public in the primary market. Once the IPO is done and the stock is listed, they are traded in the secondary market. This is the market wherein the trading of securities is done. It is also called aftermarket where buyer or seller can trade on securities between them on stock exchange rather than from issuing companies. Secondary market consists of both equity as well as debt markets. For the general investor, the secondary market provides an efficient platform for trading of his securities.
The capital of a company is made up of a combination of borrowing and the money invested by its owners. The long-term borrowings, or debt, of a company are usually referred to as bonds, and the money invested by its owners as shares, stocks or equity.
Debt Market (Bond Market)
It is a market meant for trading (i.e. buying or selling) fixed income instruments. Fixed income instruments could be securities issued by Central and State Governments, Municipal Corporations, Govt. Bodies or by private entities like financial institutions, banks, corporates, etc. Its primary goal is to provide long-term funding for public and private expenditures. The bond market has largely been dominated by the United States, which accounts for about 44% of the market. Debt Markets in India and all around the world are dominated by Government securities, which account for between 50 – 75% of the trading volumes and the market capitalization in all markets. Government securities (G-Secs) account for 70 – 75% of the outstanding value of issued securities and 90-95% of the trading volumes in the Indian Debt Markets.
Fixed Income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. The debt securities are issued by the eligible entities against the moneys borrowed by them from the investors in these instruments. Therefore, most debt securities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. The investors benefit by investing in fixed income securities as they preserve and increase their invested capital or also ensure the receipt of dependable interest income. The investors can even neutralize the default risk on their investments by investing in Govt. securities, which are normally referred to as risk-free investments due to the sovereign guarantee on these instruments
Derivatives Market
The derivatives market is the financial market for derivatives security, generally referred to a financial contract whose value is derived from the value of an underlying asset or simply underlying. There are a wide range of financial assets that have been used as underlying, including equities or equity index, fixed-income instruments, foreign currencies, commodities, credit events and even other derivative securities. Depending on the types of underlying, the values of the derivative contracts can be derived from the corresponding equity prices, interest rates, exchange rates, commodity prices and the probabilities of certain credit events.
The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. According to BIS, outstanding amount for future contracts traded on orgainsed exchanges globally is USD 30,149.9 billion till September 2014 & for options USD 47,719.9 billion. In OTC market outstanding amount is USD 766,274 billion at the end of June 2014.
Participants of Derivatives Market
The derivatives market is similar to any other financial market and has following three broad categories of participants:
Hedgers: These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios.
Speculators: These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset.
Arbitrageurs: They take positions in financial markets to earn risk less profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a risk less profit.
Types of Derivative Contracts
Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps. Over the past couple of decades several exotic contracts have also emerged but these are largely the variants of these basic contracts.
Forward Contracts: These are promises to deliver an asset at a pre- determined date in future at a predetermined price. Forwards are highly popular on currencies and interest rates. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties. Since these contracts do not fall under the purview of rules and regulations of an exchange, they generally suffer from counter party risk i.e. the risk that one of the parties to the contract may not fulfill his or her obligation.
Futures Contracts: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. These are basically exchange traded, standardized contracts. The exchange stands guarantee to all transactions and counterparty risk is largely eliminated. The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. It should be noted that this is similar to any asset market where anybody who buys is long and the one who sells in short. Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other tradable assets. They are highly popular on stock indices, interest rates and foreign exchange.
Options Contracts: Options give the buyer a right but not an obligation to buy or sell an asset in future. Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. One can buy and sell each of the contracts. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position. In case of options only the seller (also called option writer) is under an obligation and not the buyer (also called option purchaser). The buyer has a right to buy (call options) or sell (put options) the asset from / to the seller of the option but he may or may not exercise this right. In case the buyer of the option does exercise his right, the seller of the option must fulfill whatever is his obligation (for a call option the seller has to deliver the asset to the buyer of the option and for a put option the seller has to receive the asset from the buyer of the option). An option can be exercised at the expiry of the contract period (which is known as European option contract) or anytime up to the expiry of the contract period (termed as American option contract).
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
- Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
- Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Forex Market (Currency Market)
The foreign exchange market is a global decentralized market for the trading of currencies. In terms of volume of trading, it is by far the largest market in the world. The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock. The foreign exchange market determines the relative values of different currencies. RBI regulates the forex market in India.
The foreign exchange market works through financial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as “dealers,” who are actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market”, although a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions. The foreign exchange market assists international trade and investments by enabling currency conversion.
The currency market is considered to be the largest financial market in the world, processing 5.3 trillions of US dollars worth of transactions each day. The foreign exchange markets isn’t dominated by a single market exchange, but involves a global network of computers and brokers from around the world. As the most traded currency, the US dollar makes up 85% of Forex trading volume. At nearly 40% of trading volume, the euro is ahead of the third place Japanese yen that takes almost 20%.
Commodities Market
A physical or virtual marketplace for buying, selling and trading raw or primary products. For investors’ purposes there are currently about 50 major commodity markets worldwide that facilitate investment trade in nearly 100 primary commodities. Commodities are split into two types: hard and soft commodities. Hard commodities are typically natural resources that must be mined or extracted (gold, rubber, oil, etc.), whereas soft commodities are agricultural products or livestock (corn, wheat, coffee, sugar, soybeans, pork, etc.) Forward Market Commission (FMC) is the regulator of Commodity market in India.
The highest volume of trading occurs in oil, gold and agricultural products. Since no one really wants to transport all those heavy materials, what is actually traded are futures contracts. These are agreements to buy or sell at an agreed upon price on a specific date.
