Chapter-2

FINANCIAL MARKETS IN FINANCIAL SYSTEM

This chapter contains the following topics

 The organization and structure of markets.

 The money markets.
 The capital markets
 The derivative markets.
 The debt markets.
 The foreign exchange market.

Financial Market

Introduction

Money always flows from surplus sector to deficit sector. That means persons having excess of
money lend it to those who need money to fulfill their requirement. Similarly, in business sectors
the surplus money flows from the investors or lenders to the businessmen for the purpose of
production or sale of goods and services. So, we find two different groups, one who invest
money or lend money and the others, who borrow or use the money.

There are two groups who meet and transact with each other. The financial markets act as a link
between these two different groups. It facilitates this function by acting as an intermediary
between the borrowers and lenders of money. So, financial market may be defined as a
transmission mechanism between investors (or lenders) and the borrowers (or users) through
which transfer of funds is facilitated. It consists of individual investors, financial institutions and
other intermediaries who are linked by a formal trading rules and communication network for
trading the various financial assets and credit instruments.

Thus, financial markets can be referred to as those centers and arrangements which
facilitate buying and selling of financial assets, claims and services.

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Functions of Financial Market

1. Interaction between the investors and the borrowers: It provides facilities for interaction
between the investors and the borrowers.
2. Provides pricing information: It provides pricing information resulting from the interaction
between buyers and sellers in the market when they trade the financial assets.
3. Provides security: It provides security to dealings in financial assets.
4. Ensures liquidity: It ensures liquidity by providing a mechanism for an investor to sell the
financial assets.
5. Ensures low cost of transactions: It ensures low cost of transactions and information.

THE ORGANIZATION AND STRUCTURE OF FINANCIAL MARKET OR

CLASSIFICATION OF FINANCIAL MARKETS
The classifications of financial markets/Structure of financial market are as follows.

Classificati
on of
Financial
Markets

Organized Unorganiz
Market ed Market
Money
Lenders
Money Capital
Market Market Indigenou
s Bankers
etc.
Governme
Call Commerci Short Industrial Long
Treasury nt
Money al Bill Term Loan Securities Term Loan
Bill Market Securities
Market Market Market Market sMarket
Market
Market for
Terrm
Primary Secondary Market for Financial
Loan
Market Market Mortgages Guarantee
Market
s
1. Unorganized Markets
Financial market which is not regulated by the government or central bank of the country is
known as unorganized market.
In these markets there are a number of money lenders, indigenous bankers, and traders etc., who
lend money to the public. Indigenous bankers also collect deposits from the public. There are

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also private finance companies, chit fluids etc., whose activities are not controlled by the central
bank of country. Now days the central banks of developing countries have taken steps to bring
private finance companies and chit funds under its strict control.

2. Organized Markets

Financial market which is regulated by the government or central bank of the country is known
as organized market.
In the organized markets, there are standardized rules and regulations governing their financial
dealings. There is also a high degree of institutionalization and instrumentalisation. These
markets are subject to strict supervision and control by the Central bank of the country or other
regulatory bodies.
These organized markets can be further classified into two. They are:

(A) MONEY MARKET

(B) CAPITAL MARKET

(A) MONEY MARKET

The money market is a market for short-term funds. When a business firm requires money for
short term (i.e. for less than one year), it procure money from the money market. On the other
hand, those who have surplus money and want to invest for short term, they invest in the money
market.
Money market deals in financial assets whose period of maturity is up to one year. It should be
noted that money market does not deal in cash or money as such but simply provides a market
for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury
bills, etc. These financial instruments are close substitute of money. These instruments help the
business units, other organizations and the Government to borrow the funds to meet their short-
term requirement.

Money market does not imply to any specific market place. Rather it refers to the whole
networks of financial institutions dealing in short-term funds, which provides an outlet to lenders

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and a source of supply for such funds to borrowers. Most of the money market transactions are
taken place on telephone, fax or Internet.

Functions of a Money Market

1. Provides Funds

It provides short-term funds to the public and private institutions needing such financing for their

working capital requirements. It is done by discounting trade bills through commercial banks,

discount houses, brokers and acceptance houses. Thus the money market helps the development

of commerce, industry and trade within and outside the country.

2. Use of Surplus Funds

It provides an opportunity to banks and other institutions to use their surplus funds profitably for

a short period. These institutions include not only commercial banks and other financial

institutions but also large non-financial business corporations, states and local governments.

3. No Need to Borrow from Banks

The existence of a developed money market removes the necessity of borrowing by the

commercial banks from the central bank. If the former find their reserves short of cash

requirements they can call in some of their loans from the money market. The commercial banks

prefer to recall their loans rather than borrow from the central banks at a higher rate of interests.

4. Helps Government

The money market helps the government in borrowing short-term funds at low interest rates on

the basis of treasury bills. On the other hand, if the government were to issue paper money or

borrow from the central bank. It would lead to inflationary pressures in the economy.

5. Helps in Monetary Policy

A well-developed money market helps in the successful implementation of the monetary policies

of the central bank. It is through the money market that the central banks are in a position to

control the banking .system and thereby influence commerce and industry.

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6. Helps in Financial Mobility

By facilitating the transfer for funds from one sector to another, the money market helps in

financial mobility. Mobility in the flow of funds is essential for the development of commerce

and industry in an economy.

7. Promotes Liquidity and Safety

One of the important functions of the money market is that it promotes liquidity and safety of

financial assets. It thus encourages savings and investments.

8. Equilibrium between Demand and Supply of Funds

The money market brings equilibrium between the demand and supply of loan able funds. This it

does by allocating saving into investment channels. In this way, it also helps in rational

allocation of resources.

9. Economy in Use of Cash

As the money market deals in near-money assets and not money proper, it helps in economizing
the use of cash. It thus provides a convenient and safe way of transferring funds from one place
to another, thereby immensely helping commerce and industry.

Types of Money Market

The money market may be subdivided into four. They are:

1. Call Money Market

2. Commercial Bills Market
3. Treasury Bills Market
4. Short Term Loan Market

1. Call Money Market: The call money market is a market for extremely short period loans
say one day to fourteen days. So, it is highly liquid. The loans are repayable on demand at the
option of either the lender or the borrower. The special feature of this market is that the interest

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rate varies from day to day and even from hour to hour and centre to centre. It is very sensitive to
changes in demand and supply of call loans.

2. Commercial Bills Market: It is a market for bills of exchange arising out of genuine trade
transactions. In the case of credit sale, the seller may draw a bill of exchange on the buyer. The
buyer accepts such a bill promising to pay at a later date specified in the bill. The seller need not
wait until the due date of the bill. Instead, he can get immediate payment by discounting the bill.

3. Treasury Bills Market: It is a market for treasury bills which have 'short-term' maturity. A
treasury bill is a promissory note or a finance bill issued by the Government. It is highly liquid
because its repayment is guaranteed by the Government. It is an important instrument for short
term borrowing of the Government. There are two types of treasury bills namely:
(i) Ordinary or regular and
(ii) Adhoc treasury bills popularly known as 'adhocs’.

Ordinary treasury bills are issued to the public, banks and other financial institutions. Adhoc
treasury bills are issued in favour of the Central Bank of the country only. They are not sold
through tender or auction.

4. Short-Term Loan Market: It is a market where short-term loans are given to corporate
customers for meeting their working capital requirements. Commercial banks play a significant
role in this market. Commercial banks provide short term loans in the form of cash credit and
overdraft. Overdraft facility is mainly given to business people whereas cash credit is given to
industrialists. Overdraft is purely a temporary accommodation and it is given against the current
account. But cash credit is for a period of one year and it is sanctioned in a separate account.

MONEY MARKET INSTRUMENTS

Following are some of the important money market instruments or securities.
1. Call Money
Call money is mainly used by the banks to meet their temporary requirement of cash. They
borrow and lend money from each other normally on a daily basis. It is repayable on demand and

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its maturity period varies in between one day to a fortnight. The rate of interest paid on call
money loan is known as call rate.
2. Treasury Bill
A treasury bill is a promissory note issued by the Central bank of the country to meet the short-
term requirement of funds. Treasury bills are a highly liquid instrument that means, at any time
the holder of treasury bills can transfer of or get it discounted from Central bank. These bills are
normally issued at a price less than their face value; and redeemed at face value. So the
difference between the issue price and the face value of the Treasury bill represents the interest
on the investment. These bills are secured instruments and are issued for a period of not
exceeding 364 days. Banks, Financial institutions and corporations normally play major role in
the Treasury bill market.
3. Commercial Paper
Commercial paper (CP) is a popular instrument for financing working capital requirements of
companies. The CP is an unsecured instrument issued in the form of promissory note. It can be
issued for period ranging from 15 days to one year. Commercial papers are transferable by
endorsement and delivery. The highly reputed companies (Blue Chip companies) are the major
player of commercial paper market.
4. Certificate of Deposit
Certificates Of Deposit (CDs) are short-term instruments issued by Commercial Banks and
Special Financial Institutions (SFIs), which are freely transferable from one party to another. The
maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, co-
operatives and companies.
5. Trade Bill/Bill of Exchange
Normally the traders buy goods from the wholesalers or manufactures on credit. The sellers get
payment after the end of the credit period.But if any seller does not want to wait or in immediate
need of money he/she can draw a bill of exchange in favour of the buyer. When buyer accepts
the bill it becomes a negotiable instrument and is termed as bill of exchange or trade bill. This
trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the
payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial
Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer
of the bill to get funds for short period to meet the working capital needs.

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MONEY MARKET PARTICIPANTS
The major players in the money market are as follows:
1. The State Treasury
2. The Central Bank of the Country
3. Commercial Banks
4. Money Market Mutual Funds
5. Brokers and Dealers
6. Corporations
7. Other Financial Institutions
8. Individuals

(B) CAPITAL MARKET

Capital Market that trade debt and equity instruments with maturities of more than one year.
OR
The capital market is a market for financial assets which have a long or indefinite maturity.

Generally, it deals with long term securities which have a maturity period of above one year. It is
a market from which one can raise money for long term and one can invest for long term.

Capital market may be further divided into three namely:

i. Industrial securities market
ii. Government securities market and
iii. Long term loans market

I. Industrial Securities Market

As the very name implies, it is a market for industrial securities namely: (i) Equity shares or
ordinary shares, (ii) Preference shares, and (iii) Debentures or bonds. It is a market where
industrial concerns raise their capital by issuing appropriate instruments. It can be further
subdivided into two. They are:
(i) Primary Market or New Issue Market
(ii) Secondary Market or Stock Exchange

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(i) Primary Market: It is also called first hand market. Primary markets are markets in which
users of funds (e.g., corporations) raise funds through new issues of financial instruments, such
as stocks and bonds. The fund users have new projects or expanded production needs, but do not
have sufficient internally generated funds (such as retained earnings) to support these needs.
Thus, the fund users issue securities in the external primary markets to raise additional funds.
New issues of financial instruments are sold to the initial suppliers of funds (e.g., households) in
exchange for funds (money) that the issuer or user of fund needs. Thus, primary market
facilitates capital formation.

There are three ways by which a company may raise capital in a primary market. They are:
(a) Public issue
(b) Rights issue
(c) Private placement

The most common method of raising capital by new companies is through sale of securities to
the public. It is called public issue. When an existing company wants to raise additional capital,
securities are first offered to the existing shareholders on a pre-emptive basis. It is called rights
issue. Private placement is a way of selling securities privately to a small group of investors.

(ii) Secondary Market: It is also called second hand market. Once financial instruments such as
stocks are issued in primary markets, they are then traded—that is, rebought and resold in
secondary markets.

Securities which have already passed through the new issue market are traded in this market.
Generally, such securities are quoted in the stock exchange and it provides a continuous and
regular market for buying and selling of securities. This market consists of all stock exchanges
recognized by the Government. The stock exchanges are regulated under the Securities Contracts
(Regulation) Act in different countries.

II. Government Securities Market

It is also called Gilt-Edged securities market. It is a market where Government securities are
traded. Government’s Long term securities are traded in this market while short term securities

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are traded in the money market. Securities issued by the Central Government, State
Governments, Semi-Government authorities like City Corporations, State Electricity Boards, and
public sector enterprises are dealt in this market.

Government securities are issued in denominations of $.100. Interest is payable half-yearly and
they carry tax exemptions also. The role of brokers in marketing these securities is practically
very limited and the major participant in this market is "commercial banks" because they hold a
very substantial portion of these securities to satisfy their S.L.R. requirements.

The secondary market for these securities is very narrow since most of the institutional investors
tend to retain these securities until maturity.

The Government securities are in many forms. These are generally:

(i) Stock certificates or inscribed stock
(ii) Promissory Notes
(iii) Bearer Bonds which can be discounted.
Government securities are sold through the Public Debt Office of the Central bank of the country
while Treasury Bills (short term securities) are sold through auctions.

III. Long Term Loans Market

Development banks and commercial banks play a significant role in this market by supplying
long term loans to corporate customers. Long term loans market may further be classified into:
(i) Term loans market
(ii) Mortgages market
(iii) Financial Guarantees market

(i) Term Loans Market: Most of the countries, industrial financing institutions have
been created by the Government both at the national and regional levels to supply
long term and medium term loans to corporate customers directly as well as
indirectly. These development banks dominate the industrial finance in most of
countries.

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 (ii) Mortgages Market: The mortgages market refers to those centers which supply
mortgage loan mainly to individual customers. A mortgage loan is a loan against the
security of immovable property like real estate. The transfer of interest in a specific
immovable property to secure a loan is called mortgage. This mortgage may be
equitable mortgage or legal one. Again it may be a first charge or second charge.
Equitable mortgage is created by a mere deposit of title deeds to properties as security
whereas in the case of legal mortgage the title in the property is legally transferred to
the lender by the borrower. Legal mortgage is less risky.

Similarly, in the first charge, the mortgager transfers his interest in the specific property to the
mortgagee as security. When the property in question is already mortgaged once to another
creditor, it becomes a second charge when it is subsequently mortgaged to somebody else. The
mortgagee can also further transfer his interest in the mortgaged property to another. In such a
case, it is called a sub-mortgage.

The mortgage market may have primary market as well secondary market. The primary market
consists of original extension of credit and secondary market has sales and re-sales of existing
mortgages at prevailing prices.
(iii) Financial Guarantees Market: A Guarantee market is a center where finance is
provided against the guarantee of a reputed person in the financial circle. Guarantee is
a contract to discharge the liability of a third party in case of his default. Guarantee
acts as a security from the creditor's point of view. In case the borrower fails to repay
the loan, the liability falls on the shoulders of the guarantor. Hence the guarantor must
be known to both the borrower and the lender and he must have the means to
discharge his liability.

Though there are many types of guarantees, the common forms are: (i) Performance Guarantee,
and (ii) Financial Guarantee. Performance guarantees cover the payment of earnest money,
retention money, advance payments, non-completion of contracts etc. On the other hand
financial guarantees cover only financial contracts.

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Importance of Capital Market

The importance of capital market can be briefly summarized as follows:

1. Mobilizes the Savings: The capital market serves as an important source for the productive
use of the economy's savings. It mobilizes the savings of the people for further investment and
thus avoids their wastage in unproductive uses.

2. Capital Formation: It provides incentives to saving and facilitates capital formation by

offering suitable rates of interest as the price of capital.

3. Provide Opportunities to Investors: It provides an avenue for investors, particularly the

household sector to invest in financial assets which are more productive than physical assets.

4. Increase Income: It facilitates increase in production and productivity in the economy and
thus enhances the economic welfare of the society. Thus, it facilitates "the movement of stream
of command over capital to the point of highest yield" towards those who can apply them
productively and profitably to enhance the national income in the aggregate.

5. Economic Growth: The operations of different institutions in the capital market induce
economic growth. They give quantitative and qualitative directions to the flow of funds and
bring about rational allocation of scarce resources.

6. Stability in the Economy: A healthy capital market consisting of expert intermediaries

promotes stability in values of securities representing capital funds.

7. Help in technological up gradation: it serves as an important source for technological up

gradation in the industrial sector by utilizing the funds invested by the public.
Thus, a capital market serves as an important link between those who save and those who aspire
to invest these savings.

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THE DERIVATIVE MARKETS

Meaning of Derivative Market

The Derivatives Market is meant as the market where exchange of derivatives takes place.
Derivatives are one type of securities whose price is derived from the underlying assets. And
value of these derivatives is determined by the fluctuations in the underlying assets. These
underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and
market indices.

Defining Derivatives
The word derivatives have taken from the word Derive which means to produce something from
something.For example, sugar is derived from cane. Sugar is derivatives of cane. Price of sugar
is dependent upon the price of cane

The term 'derivative' indicates that it has no independent value, i.e., its value is entirely derived
from the value of the underlying asset. The underlying asset can be securities, commodities,
bullion, currency, livestock or anything else.

Derivative is a contract which derives its price quotation from some other contracts

Features/Characteristics of Derivatives
1. Contract
It is a contract. Derivative is defined as the future contract between two parties. It means there
must be a contract-binding on the underlying parties and the same to be fulfilled in future. The
future period may be short or long depending upon the nature of contract, for example, short
term interest rate futures and long term interest rate futures contract.

2. Derives Value from Underlying Asset

Normally, the derivative instruments have the value which is derived from the values of other
underlying assets, such as agricultural commodities, metals, financial assets, intangible assets,
etc. Value of derivatives depends upon the value of underlying instrument and which changes as

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per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are
closely related.

3. Specified Obligation
In general, the counter parties have specified obligation under the derivative contract.
Obviously, the nature of the obligation would be different as per the type of the instrument of a
derivative. For example, the obligation of the counter parties, under the different derivatives,
such as forward contract, future contract, option contract and swap contract would be different.
4. Direct or Exchange Traded

The derivatives contracts can be undertaken directly between the two parties or through the
particular exchange like financial futures contracts. The exchange-traded derivatives are quite
liquid and have low transaction costs in comparison to tailor-made contracts. Example of ex-
change traded derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior that
are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange,
Bombay Stock Exchange and so on.

5. Related to Notional Amount

In general, the financial derivatives are carried off-balance sheet. The size of the derivative
contract depends upon its notional amount. The notional amount is the amount used to calculate
the payoff. For instance, in the option contract, the potential loss and potential payoff, both may
be different from the value of underlying shares, because the payoff of derivative products
differs from the payoff that their notional amount might suggest.

6. Delivery of Underlying Asset not involved

Usually, in derivatives trading, the taking or making of delivery of underlying assets is not
involved; rather underlying transactions are mostly settled by taking offsetting positions in the
derivatives themselves. There is, therefore, no effective limit on the quantity of claims, which
can be traded in respect of underlying assets.

7. May be used as Deferred Delivery

Derivatives are also known as deferred delivery or deferred payment instrument. It means that it
is easier to take short or long position in derivatives in comparison to other assets or securities.
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Further, it is possible to combine them to match specific, i.e., they are more easily amenable to
financial engineering.
8. Secondary Market Instruments
Derivatives are mostly secondary market instruments and have little usefulness in mobilizing
fresh capital by the corporate world; however, warrants and convertibles are exception in this
respect.
9. Exposure to Risk
Although in the market, the standardized, general and exchange-traded derivatives are being
increasingly evolved, however, still there are so many privately negotiated customized, over-the-
counter (OTC) traded derivatives are in existence. They expose the trading parties to operational
risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory
status of such derivatives.
10. Off balance Sheet Item
Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be
used to clear up the balance sheet. For example, a fund manager who is restricted from taking
particular currency can buy a structured note whose coupon is tied to the performance of a
particular currency pair.

Types of Derivatives/Products of Derivatives Market

There are two types of derivatives. These are commodity derivatives and financial derivatives.
Firstly derivatives originated as a tool for managing risk in commodities markets. In commodity
derivatives, the underlying asset is a commodity. It can be agricultural commodity like wheat,
soybeans, rapeseed, cotton etc. or precious metals like gold, silver etc. The term financial
derivative denotes a variety of financial instruments including stocks, bonds, treasury bills,
interest rate, foreign currencies and other hybrid securities. Financial derivatives include futures,
forwards, options, swaps, etc.

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The most commonly used derivatives contracts are forwards, futures and options. Here we take a
brief look at various derivatives contracts that have come to be used.
1. Forward Contract
A forward contract is a customized contract between two entities, where settlement takes place
on a specific date in the future at today's pre-agreed price. Forwards contract are not traded on an
exchange, rather traded in the over-the-counter market, usually between two financial institutions
or between a financial institution and one of its client or it may be between parties.

Example of Forward Contract

On 25 February, a buyer wants to buy 100 kg of wheat from a seller. But buyer wants the
delivery of wheat after three months. Now the buyer is asking the price of wheat per kg
(Quotation).Now the seller starts calculation of wheat price per kg.
Today’s spot price per kg 10 Birr
Storage cost (Godown expenditure) 01 Birr
Interest on funds needed to finance the goods 01Birr
-------------
Total (spot price +cost of carry) 12 Birr
Seller asks 12 birr per kg of wheat which he will delivers after three months. (i.e., 25th February)
Quantity is 100 kg. Both the parties agreed on this and it became a forward contract.
Settlement date of the contract is 25th February. There will be two type of settlement.
1. Delivery versus Payment (buyer has taken the delivery of 100 kg wheat on 25th February)
2. Cash Settlement, No delivery but Adjustment of Profit/Loss (there will be two scenarios)

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Scenario-1
Suppose on the day of settlement cash market or spot market moves higher than “Agreed Price”
i.e. forward price. Here buyer will take the profit only. Suppose spot price of wheat per kg is 14
birr and the agreed price is 12 birr. Buyer will get profit of 200 birr (2×100) from the seller.

Scenario-2
Suppose on the day of settlement cash market or spot market moves lower than “Agreed Price”
i.e. forward price. Here seller will take the profit only. Suppose spot price of wheat per kg is 10
birr and the agreed price is 12 birr. Seller will get profit of 200 birr (2×100) from buyer.

2. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the future contract are standardized exchange-traded contracts.
Example of Future
Suppose a farmer produces rice and he expects to have an excellent yield on rice; but he is
worried about the future price fall of that commodity. How can he protect himself from falling
price of rice in future? He may enter into a contract on today with some party who wants to buy
rice at a specified future date on a price determined today itself. In the whole process the farmer
will deliver rice to the party and receive the agreed price and the other party will take delivery of
rice and pay to the farmer. In this illustration, there is no exchange of money and the contract is
binding on both the parties. Hence future contracts are forward contracts traded only on
organized exchanges and are in standardized contract-size. The farmer has protected himself
against the risk by selling rice futures and this action is called short hedge while on the other
hand, the other party also protects against-risk by buying rice futures is called long hedge.

Forwards versus Future Contracts

Futures and forwards both allow people to buy or sell an asset at a specific time at a given price,
but forward contracts are not standardized or not traded on an exchange. They are private
agreements with terms that may vary from contract to contract.

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Futures contracts  traded in a stock exchange and follow the rules and regulations of the stock
exchange. So, it is more organized and secured

3. Options

Options are of two types - Calls and Puts.

(a) Calls

It gives the buyer the right to buy but not the obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future date.

Example of Call

Suppose one share of Apple Ltd. is at $40 and you think its price is going to go up to $50 in the
next few weeks one way to profit from this expectation is to buy 100 shares of Apple Ltd at $40
and sell it in a few weeks when it goes to $50. This would cost $4,000 today and when you sold
the 100 shares of the Apple Ltd. in a few weeks you would receive $5,000 for a $1,000 profit.

Let's start by trading one call option contract for 100 shares of Apple Ltd with a strike price of
$40 which expires in two months.

Let’s assume that this call option was priced at $2.00 per share, which would cost $200 per
contract since each option contract covers 100 shares (Lot Size). So when you see the price of an
option is $2.00, you need to think $200 per contract. Trading or buying one call option on Apple
Ltd now gives you the right but not the obligation, to buy 100 shares of Apple Ltd at $40 per
share anytime between now and the 3rd Friday in the expiration month.

When shares of Apple Ltd goes to $50, our call option to buy Apple Ltd market price of $50, so
that right has to be worth $10! This option is said to be "in-the-money" $10 or it has an "intrinsic
value" of $10.

So when trading the Apple Ltd $40 call, we paid $200 for the contract and sold it at $1,000 for
$800 profit on a $200 investment-that's a 400% return.

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(b)Puts

It gives the buyer the right to sell, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date. A put option is a security that you
buy when you think the price of a stock or index is going to go down. More specifically, a put
option is the right to SELL 100 shares of a stock or an index at a certain price by a certain date.
That "certain price" is known as the strike price, and that "certain date" is known as the expiry or
expiration date.

Example of Puts

For example, if a trader purchases a put option contract for Company Apple Ltd for $2 (i.e. $02
per share for a 100 share contract) with a strike price of $40 per share, the trader can sell the
shares at $40 before the end of the option period. If Company Apple's share price drops to $30
per share, the trader can buy the shares on the open market and sell the put option at $40 per
share (the strike price on the put option contract).Taking into account the put option contract,
trader will earn a profit of $800.

4. Warrants: Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.

5. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is
usually a moving average or a basket of assets. Equity index options are a form of basket
options.
6. Swaps: A swap is a private agreement between two parties to exchange a series of
future cash flows.
In simple words, swap means exchange of anything

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HOW IT WORKS (EXAMPLE)

Swaps are financial agreements to exchange cash flows. Swaps can be based on interest

rates, stock indices, foreign currency exchange rates and even commodities prices.

Company XYZ issues $10 million in 15-year corporate bonds with a variable interest rate

of LIBOR + 150 basis points. LIBOR is currently 3%, so Company XYZ
pays bondholders 4.5%. 

After selling the bonds, an analyst at Company XYZ decides there's reason to believe LIBOR
will increase in the near term. Company XYZ doesn't want to be exposed to an increase in
LIBOR, so it enters into a swap agreement with Investor ABC.

Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for 15 years.
Investor ABC agrees to pay Company XYZ LIBOR + 1.5% on $10,000,000 per year for 15
years.  Note that the floating rate payments that XYZ receives from ABC will always match the
payments they need to make to their bondholders.

Investor ABC thinks that interest rates are going to go down. He is willing to accept fixed rates
from Company XYZ

To do this, Company XYZ structures a swap of the future interest payments with an investor
willing to buy the stream of interest payments at this variable rate and pay a fixed amount for
each period.  At the time of the swap, the amount to be paid over the life of the debt is the same. 

Types of Swaps

The two commonly used swaps are:

(i) Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
(ii) 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.

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Participants of Derivatives Market
The following three broad categories of participants trade in the derivatives market.

i. Hedgers
ii. Speculators
iii. Arbitrageurs

1. Hedgers

Generally there is a tendency to transfer the risk from one party to another in investment
decisions. Put differently, a hedge is a position taken in futures or other markets for the purpose
of reducing exposure to one or more types of risk. A person who undertakes such position is
called as 'hedger'. In other words, a hedger uses futures markets to reduce risk caused by the
movements in prices of securities, commodities, exchange rates, interest rates, indices, etc. As
such, a hedger will take a position in futures market that is opposite a risk to which he or she is
exposed. By taking an opposite position to a perceived risk is called 'hedging strategy in futures
markets'.

2. Speculators

A speculator is a person who is willing to take a risk by taking futures position with the
expectation to earn profits. Speculator aims to profit from price fluctuations. The speculator
forecasts the future economic conditions and decides which position (long or short) to be taken
that will yield a profit if the forecast is realized. For example, suppose a speculator forecasts that
price of silver will be $ 300 per 100 grams after one month. If the current silver price is $ 250 per
100 grams, he can take a long position in silver and expects to make a profit of $ 50 per 100
grams. This expected profit is associated with risk because the silver price after one month may
decrease to $225 per 100 grams, and may lose $ 25 per 100 grams.

3. Arbitrageurs

Arbitrageurs are another important group of participants in futures markets. They take advantage
of price differential of two markets. An arbitrageur is a trader who attempts to make profits by

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locking in a riskless trading by simultaneously entering into transactions in two or more markets.
In other words, an arbitrageur tries to earn riskless profits from discrepancies between futures
and spot prices and among different futures prices. For example, suppose that at the expiration of
the gold futures contract, the futures price is $500 per 10 grams, but the spot price is $ 450 per 10
grams. In this situation, an arbitrageur could purchase the gold for $ 450 and go short a futures
contract that expires immediately, and in this way making a profit of $50 per 10 grams by
delivering the gold for $500 in the absence of transaction costs.

Functions of Derivatives Market

Derivatives are supposed to provide the following services:

1. Risk Aversion Tools

One of the most important services provided by the derivatives is to control, avoid, shift and
manage efficiently different types of risks through various strategies like hedging, arbitraging,
spreading, etc. Derivatives assist the holders to shift or modify suitably the risk characteristics of
their portfolios. These are specifically useful in highly volatile financial market conditions like
erratic trading, highly flexible interest rates, volatile exchange rates and monetary chaos.

2. Prediction of Future Prices

Derivatives serve as barometers of the future trends in prices which result in the discovery of
new prices both on the spot and futures markets. Further, they help in disseminating different
information regarding the futures markets trading of various commodities and securities to the
society which enable to discover or form suitable or correct or true equilibrium prices in the
markets. As a result, they assist in appropriate and superior allocation of resources in the society.

3. Enhance Liquidity
As we see that in derivatives trading no immediate full amount of the transaction is required
since most of them are based on margin trading. As a result, large number of traders, speculators
arbitrageurs operates in such markets. So, derivatives trading enhance liquidity and reduce trans-
action costs in the markets for underlying assets.
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4. Assist Investors
The derivatives assist the investors, traders and managers of large pools of funds to devise such
strategies so that they may make proper asset allocation increase their yields and achieve other
investment goals.

5. Integration of Price Structure

It has been observed from the derivatives trading in the market that the derivatives have
smoothen out price fluctuations, squeeze the price spread, integrate price structure at different
points of time and remove gluts and shortages in the markets.

6. Catalyze Growth of Financial Markets

The derivatives trading encourage the competitive trading in the markets, different risk taking
preference of the market operators like speculators, hedgers, traders, arbitrageurs, etc. resulting
in increase in trading volume in the country. They also attract young investors, professionals and
other experts who will act as catalysts to the growth of financial markets.

7. Brings Perfection in Market

Lastly, it is observed that derivatives trading develop the market towards 'complete markets'.
Complete market concept refers to that situation where no particular investors can be better off
than others, or patterns of returns of all additional securities are spanned by the already existing
securities in it, or there is no further scope of additional security.

THE DEBT MARKETS

Introduction
Debt markets are markets in which debentures/bonds/bills are issued and traded. They are used
to assist in the transfer of funds from individuals, corporations, and government units with excess
funds to corporations and government units in need of long-term debt funding.

Meaning of Debt Market

The Debt Market is the market where fixed income securities (Debentures/Bonds, Bills,
Commercial papers) of various types and features are issued and traded. Debt Markets are

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therefore, markets for fixed income securities issued by Central and State Governments,
Municipal Corporations, Government bodies and commercial entities like Financial Institutions,
Banks, public Sector Units. Public Ltd. companies and also structured finance instruments.

Fixed-income securities are investments where the cash flows are according to a
predetermined amount of interest, paid on a fixed schedule.

Instruments/Securities traded in Debt Market

The instruments traded can be classified into the following segments based on the
characteristics of the identity of the issuer of these securities:

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Risk in the Debt Market
The following are the risks associated with debt securities:
1. Default Risk: This can be defined as the risk that an issuer of a bond may be unable to make
timely payment of interest or principal on a debt security or to otherwise comply with the
provisions of a bond indenture and is also referred to as credit risk.
2. Interest Rate Risk: It can be defined as the risk emerging from an adverse change in the
interest rate prevalent in the market so as to affect the yield on the existing instruments. A
good case would be an upswing in the prevailing interest rate scenario leading to a situation
where the investors' money is locked at lower rates whereas if he had waited and invested in
the changed interest rate scenario, he would have earned more.
3. Reinvestment Rate Risk: It can be defined as the probability of a fall in the interest rate
resulting in a lack of options to invest the interest received at regular intervals at higher rates
at comparable rates in the market. The following are the risks associated with trading in debt
securities.
4. Counter Party Risk: It is the normal risk associated with any transaction and refers to the
failure or inability of the opposite party to the contract to deliver either the promised security
or the sale-value at the time of settlement.
5. Price Risk: It refers to the possibility of not being able to receive the expected price on any
order due to an adverse movement in the prices.

Importance of Efficient Debt Market to the Financial System and the Economy

1. Diversification of Portfolio: Debt market provides opportunities for investors to diversify

their investment portfolio.

2. Liquidity: It provides higher liquidity and control over credit.

3. Better Corporate Governance: Debt market helpful for better corporate governance

4. Transparency: It helps to improve transparency because of stringent disclosure norms and

auditing requirements.

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5. Less Risky: Debt market is less risky as compared to the equity markets, encouraging low-risk
investments. This leads to inflow of funds in the economy.

6. Lower Cost: Government can raise funds for implementation of development plans. The
government can raise funds at lower costs by issuing government securities.

7. Implementation of a Monetary Policy: Debt market helps to implement the monetary policy.

8. Reduced Role of Banks and Political Intervention: It reduced the role of banks and political
intervention in use of funds, as banks have to follow norms laid down by the central bank.

FOREIGN EXCHANGE MARKET

Foreign exchange markets are the markets in which traders of foreign currencies transact most
efficiently and at the lowest cost. As a result, foreign exchange markets facilitate foreign trade,
the raising of capital in foreign markets, the transfer of risk between participants, and speculation
on currency values.

According to Dr. Paul Einzing "Foreign exchange is the system or process of converting one
national currency into another, and of transferring money from one country to another".
It consists of a number of dealers, banks and brokers engaged in the business of buying and
selling foreign exchange. It also includes the central bank of each country and the treasury
authorities who enter into this market as controlling authorities.

Foreign Exchange Rate

A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can be
exchanged for another currency (e.g., the Ethiopian Birr) in the foreign exchange markets.

Foreign Exchange Risk

Risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign
investment changes due to a change in foreign exchange rates.

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Foreign Exchange transactions expose corporations and investors to foreign exchange risk as the
cash flows are converted into and out of U.S. dollars. The actual amount of U.S. dollars received
on a foreign transaction depends on the (foreign) exchange rate between the U.S. dollar and the
foreign currency when the non-dollar cash flow is received (and exchanged for U.S. dollars) at
some future date. If the foreign currency declines (or depreciates) in value relative to the U.S.
dollar over the period between the time a foreign investment is made and the time it is liquidated,
the dollar value of the cash flows received will fall. If the foreign currency rises (or appreciates)
in value relative to the U.S. dollar, the dollar value of the cash flows received on the foreign
investment increases.

Currency Depreciation
When a country's currency falls in value relative to other currencies, meaning that the country's
goods become cheaper for foreign buyers and foreign goods become more expensive for foreign
sellers.
Currency Appreciation
When a country's currency rises in value relative to other currencies, meaning that the country's
goods are more expensive for foreign buyers and foreign goods are cheaper for foreign sellers.

Distinguish Between a Spot Foreign Exchange Transaction and a Forward Foreign

Exchange Transaction (Types of Foreign Exchange Market)

1. SPOT FOREIGN EXCHANGE TRANSACTION/MARKET

There are two types of foreign exchange rates and foreign exchange transactions: spot and
forward. Spot foreign exchange transactions involve the immediate exchange of currencies at
the current (or spot) exchange rate. Spot transactions can be conducted through the foreign
exchange division of commercial banks or a non-bank foreign currency dealer.

Example of Spot Market

A U.S. investor wanting to buy Ethiopian Birr through a local bank on August 19, 2017,
essentially has the dollars transferred from his or her bank account to the dollar account of a Birr

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seller at a rate of $I equal to 22.90 Birr. Simultaneously, Birrs are transferred from the seller's
account designated by the U.S. investor.

2. FORWARD FOREIGN EXCHANGE TRANSACTION/MARKET

A forward foreign exchange transaction is the exchange of currencies at a specified exchange

rate (or forward exchange rate) at some specified date in the future. An example is an agreement
today (at time 0) to exchange dollars for pounds at a given (forward) exchange rate three months
into the future. Forward contracts are typically written for one-, three-, or six-month periods, but
in practice they can be written over any given length of time.

Return and Risk of Foreign Exchange Transactions

Measuring Risk and Return on Foreign Exchange Transactions.

The risk involved with a spot foreign exchange transaction is that the value of the foreign
currency may change relative to the U.S. dollar over a holding period. Further, foreign exchange
risk is introduced by adding foreign currency assets and liabilities to a firm's balance sheet. Like
domestic assets and liabilities, returns result from the contractual income from or costs paid on a
security. With foreign assets and liabilities, however, returns are also affected by changes in
foreign exchange rates.

Example
Foreign Exchange Risk
Suppose that on August 19, 2016, a U.S. firm plans to purchase 3 million Ethiopian Birr for
investment in Ethiopia from an Ethiopian financial institution. The spot exchange rate for August
19, 2016 of U.S. dollars for Birr is 22.90. Consequently, the U.S. firm must convert:

USD required
3,000,000/22.90=131,004 dollars
One month after the conversion of dollars to Ethiopian Birr, the U.S firm changed the decision to
invest in Ethiopia and the U.S. firm no longer needs the Birr, it purchased at 22.90 per dollar.
The spot exchange rate of the Birr to the dollar has fallen or depreciated over the month so that

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the value of a Birr is worth one dollar equal to 23.30. The U.S. dollar value of 3 million Birr is
now only:

USD gets back

3,000,000/23.30=128,755 dollars
The depreciation of the relative to the dollar over the month has caused the U.S. firm to suffer a
$2,249 ($131,004 - $128,755) loss due to exchange rate fluctuations.

To avoid such a loss in the spot markets, the firm could have entered into a forward transaction,
which is the exchange of currencies at a specified future date and a specified exchange rate (or
forward exchange rate).

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