Republic of the Philippines

North Eastern Mindanao State University

LIANGA CAMPUS

Lianga Surigao del Sur, 8307

CAPITAL MARKET
NARRATIVE REPORT

PREPARED BY:

BSBA FM3A

SUBMITTED TO:

LUCEJIN L. GUERREA, MBA

May 2023
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TABLE OF CONTENTS
Capital Market ----------------------------------------------------------------------------------- 4

Elements of capital market ---------------------------------------------------------

Overview of capital market --------------------------------------------------------

Market participants and innovation -----------------------------------------------

Justification for government regulation of market -----------------------------

Primary and Secondary Market --------------------------------------------------------------- 11

Primary market ------------------------------------------------------------------------

Function of primary market -----------------------------------------------

Factors to be considered by investor -------------------------------------

Secondary market --------------------------------------------------------------------

Features of secondary market ----------------------------------------------

Function of secondary market ---------------------------------------------

Risk and Return: Capital Market Theory -------------------------------------------------- 14

Portfolio Returns and Portfolio Risk ---------------------------------------------

Calculating a Portfolio’s Expected Rate of Return --------------------------

Financial Future Market ------------------------------------------------------------------------- 24

Role of clearing house ----------------------------------------------------------------------------------

Understanding the clearinghouse -------------------------------------------------------------------

Option market --------------------------------------------------------------------------------------------

Option value ----------------------------------------------------------------------------------------------

Swaps ---------------------------------------------------------------------------------------------------------- 38

Types of swaps -------------------------------------------------------------------------------------------

Stock market options market ------------------------------------------------------------------------

Interest Rate ----------------------------------------------------------------------------------------------------------- 45

Real interest rate in economy -----------------------------------------------------------------------

Understanding money market ----------------------------------------------------------------------

Advantage of commercial papers -------------------------------------------------------------------

Types of credit rating ----------------------------------------------------------------------------------

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GROUP 1

Lucejin L. Gurrea

Instructor, MBA

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CAPITAL MARKET

Financial market that bring buyers and sellers together to trade stock, bonds,
currencies, and other financial assets. Capital market also includes the stock market
and the bond market. Where they help people with ideas become entrepreneurs and
help small businesses grow into big companies. Capital market are composed of the
suppliers and users of the funds, a crucial part of functioning modern economy because
they move money from the people who have it to those who need it for production.

There are 3 types of Capital Market

 Stock market
The aggregation of buyers and sellers of stock, which represent ownership
claims on businesses, these may include securities listed on a public stock
exchange, as well as stock that is only traded privately such as shares of private
companies which are sold to investors through equity crowd funding platforms.
 Bond Market
Financial market where participants can issue how debt, known as a
primary market, or buy and sell debt securities, known as the secondary market.
 Related Markets
An organized market on which futured and/or options contracts on a relevant
share or index are traded as specified in the final terms, or any successor
market or any other market that may be subsequently designated by the issuer
to replace the related market specified in the final terms.

ELEMENTS OF CAPITAL MARKET

 Individual Invest
 Commercial Banks
 Financial Institutions
 Insurance Compares
 Business Corporation
 Retirement Funds
 Entrepreneurs
 Governments
 Long term investment
 Stock exchange

OVERVIEW OF CAPITAL MARKET

TRADE STOCK

Buying and selling shares to companies to try to make money on price changes.

BONDS

Issued by Governments and Corporations when they want to raise money.

CURRENCIES

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Standardization of money in any forms, in use or circulation as a medium of

exchange.

FINANCIAL CAPITAL

Money entrepreneurs and Businesses use to buy resources and supplies. These
are then used to make products or provide services to buyers.

FINANCIAL MARKET PARTICIPANTS

There are two basic financial market distinction, Investor Vs. Speculator and
Institutional Vs. Retail. Action in financial markets by Central Banks in usually regarded
as intervention rather then participation. The major participants in the money market are
Commercial Banks, Government, Corporations, Government sponsored enterprises,
Money Market Mutual Funds, Futures market exchanges. Brokers and dealers and the
federal reserve, commercial bank play three important roles in the money market.

What is Investor Vs. Speculator?

Investors take a systematic approach to growing their wealth, buying assets,

with reasonable levels of risk in exchange for long term growth. While the speculator, on
the other hand, buy assets that may experience rapid growth, but also lose their entire
value if they go out of favor.

What is Institutional vs. Retail?

* Institutional investors are big companies with terms of professional investment
managers who invest other people’s money.
* Retail investors are individuals who typically manage their own investment (for
retirement or college savings).
BROKER DEALERS
A person or firm in the business of buying and selling securities for its own account
or on behalf of its customers. The term broker dealers is used in vs. securities
regulations parlance to describe stock brokerage, because most of them act as both
agents and principals.
INVESTMENT BANKS
> Provides services to large corporations
> More competitive and higher paying
> Salary as a career, but often work long hours
COMMERCIAL BANKING
> Works with many different clients in the general public
> Offers a better work life balance but not as high of a salary as investment banking
ASSET MANAGERS
> Asset management is the practice of increasing wealth over time by acquiring and
trading investment that can grow in value.

MANAGEMENT OF ASSET AND LIABILITIES

- Asset/ liabilities management (ALM) refers to using assets and cash flows to lower
the firms-risk, a flows-due to not paying a liability and time.

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- Asset and liability management is a process use by a Companies to help address

any risk resulting from a mismatch of liabilities of assets.

ALM RISK
 Interest rate risk
 Liquidity risk
 capital market risk
 currency risk

JUSTIFICATION FOR GOVERNMENT REGULATION

OF MARKETS
Why should the government regulate the market?
-Regulations are indispensable to the proper function of economies and societies.
They create the “rules of the game’ for citizens, business governments and civil society.
Justification for Government
- The justification of the state refers to the source of legitimate authority for the state
or government. Typically, such exist, and to some degree scopes the role of
government. What a legitimate state should of government not be able to do.

What is a Regulated Market?

A regulated market is a market over which government bodies or less,
commonly industry or labor groups exert a level of oversight and control.
Why is it important to regulate markets?
The objectives of markets regulation are to control fraud, control agency
problems, promote fairness, set mutually beneficial standards prevent undercapitalized
financial firms from making excessively risky investments, and to ensure that ling-term
liabilities are funded.

4 types of Justification
• Appeal to Authority
• Argument from Analogy
• Generalization
• Personal Experience
7 basic rules of the Government
• Providing Public Goods
• Managing Externalities
• Government Spending
• Distribution of Income
• Federal Budget
• Taxation
• Social Security

How a Regulated Market Works?

Regulation curtails the freedom of market participants or grants them special
privileges. Regulations include rules regarding how good and services can be marketed
what rights consumers have to demand refunds or replacement, safety standards for

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products, workplace, food and drugs, mitigation of environmental and social impacts,
and the level of control a given participants is allowed to assume over a market.
Arguments for against Regulated Markets
Supporters of given regulation or regulatory regimes in general tend to cite
benefits to the wider society.
Example: Include legitimating base in race or religions and granting credit card users
the right to dispute charges.

What are the 3 Types of Regulations?

• Command and Control
• Performance-based
• Management Based
What are the forms of market regulation?
A variety of forms if regulations exist in a regulated market. These include
Control, Oversight, Anti-discrimination, Environmental protection, Taxation and Labor
Laws.

MARKET PARTICIPANTS AND FINANCIAL INNOVATION

Issuers and Investors
Classification of Entities:
1. Central governments
2. Agencies of central governments
3. Municipalities
4. Supranational organization
5. Non- financial businesses
6. Financial enterprise
7. Households
Services that are provided by financial institutions
1. Transform financial assets acquired into assets that are more attractive to
the public. (Financial intermediaries)
2. Exchange financial assets on the behalf of others(brokers)
3. Exchange financial assets for their own (dealers)
4. Assist in the creation of financial assets for their customers and then sell
these financial assets to others. (underwriting)
5. Provide innovative advices.
6. Provide portfolio management.

TYPES OF FINANCIAL INTERMEDIARIES;

*Depository Institutions
-Commercial banks
-saving and loan association
-saving banks
-credit unions
*Non-depository institution
-insurance companies

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-pension funds
-finance companies

Role of Financial Intermediaries

*Transforming of financial assets that are less desirable into other financial assets
which are more widely preferred by public.
-providing maturity intermediation
-risk reduction via diversification
-reducing the cost of contraction and information processing
-providing a payments mechanism
Overview of assets and liability management of financial institutions;
*Spread: Difference between the returns in assets and costs of funds of the depository
institutions.
*Positive spread

Financial Innovation
Categories of financial innovation;
-market broadening instruments
-risk management instruments
-arbitraging instruments
Motivation for financial Innovation
1. Increased volatility of interest rate, inflation, equity prices, exchange rates.
2. Advances in computer and telecommunication technologies
3. Greater sophistication and educational training among professional market
participants
4. Financial intermediary competition
5. Incentives to get around existing regulation and tax laws
6. Changing global patterns of financial wealth.

Asset Securitization
-it involves the collection or pooling of loans and sale of securities backed by those
loans. It means more than one institution may be involved in lending capital.
Consider the loans for the purchased of automobiles.
1. A commercial bank originates automobile loans.
2. The commercial bank securities backed by these loans.
3. The commercial bank obtains credit insurance for the pool of loans from a private
insurance company.
4. The commercial banks sells the right to service the loans to another company
that specializes in the serving of loans.
5. The commercial bank uses the service of a securities firm to distribute the
securities to individual institutional investors.

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Group 2

LUCEJIN L. GURREA

Instructor, MBA

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Primary Market and Secondary Market

Primary Market

 Also known as "New Issue Market"

 Success of the capital market depends on primary market.
 Is the market for new issuers?
 Can be directly bought from the shareholders
 Small and medium scale business, enter the primary market to raise money from
the public
 Accelerates the process of capital formation in a country's economy

FUNCTION OF PRIMARY MARKET

ORIGINATIONS
 It starts before an issue It refers to the work of investigation, analysis and
processing of new project proposals.
 is actually floated in the market.
 This function is done by merchant bankers who may be commercial banks, all
India financial institutions or private firms.
 At present, financial institutions and private firms also perform this service.
UNDERWRITING
 It is an agreement whereby the underwriter promises to subscribe to a specified
number of shares or debentures or a specified amount of stock in the event of
public not subscribing to the issue.
 If a part of share issues remains unsold, the underwriter will buy the shares or
else he is not liable.
 Thus, underwriting is a guarantee for marketability of shares. There are two types
of underwriters in India - Institutional (LIC, UTI, IDBI, ICICI) and Non- institutional
are brokers.
DISTRIBUTION
 It is the function of sale of securities to ultimate investors.
 This service is performed by brokers and agents who maintain a regular and
direct contact with the ultimate investors.

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Method of FLOAT New Issue

Initial Public Offer (IPO)
 IPO. The first sale of stock by a company to the public. The most common
reason for a company to initiate an IPO is in order to raise more capital.

Right Issue
 According to the section 81 of the companies Act 1956, if a public
company wants to increase its subscribed capital by allotment of further
share after two years from the date of its formation or one year from the
date of its allotment, whichever is earlier, should offer share first to its
existing shareholders in proportion to the share held by them at the time of
offer.

Offer for Sale

Condition

 A notice should be issued to specify the number of shares issued.

 The time given to accept should not be less than 15 days.
 Right of the shareholders to renounce the offer in favour of others
 Promoter places his shares with an investment banker (bought out dealer
or sponsor) who offer it to the public at a later date.
 Promoter Investment Banker Public.
 Hold on period is 70 days to more than a year.
 Bought out dealer decides the price after analyzing the viability, the
gestation period, promoters' background and future projections.
 Bought out dealer sheds the shares at a premium to the public

Private Placement
 Small numbers of financial intermediaries (like Unit Trust of India, mutual
funds, insurance companies, merchant banking subsidiaries of
commercial banks) purchase the shares and sell them to investors at a
later date at a suitable price.

Advantage

 Cost Effective statutory and non-statutory expenses are avoided.

 Time Effective Structure Effectiveness - flexible to suit the financial
intermediaries.
 Access Effective-issue of all sizes can be accommodated

Place Allotment

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 Preferential allotment offers shares to selected investors at a special price

not available to the general public.

Factors to be Considered by Investors

 Promoters Credibility
 Project Details
 Product
 Financial Data
 Risk Factors
 Auditors Report
Secondary Market
The secondary market is that market in which the buying and selling of the
previously issued securities is done. The transactions of the secondary market are
generally done through the medium of stock exchange. The chief purpose of the
secondary market is to create liquidity in securities. If an individual has bought some
security and he now wants to sell it, he can do so through the medium of stock
exchange to sell or purchase through the medium of stock exchange requires the
services of the broker presently, there are 24 stock exchanges in India.

FEATURES OF PRIMARY MARKET

■It Creates Liquidity
■It Comes After Primary Market
■It Has A Particular Place
■It Encourage New Investments
■Aids in financing the industry
■Insures safe fair Dealing ( MEDIA BROADCASTING)
Function of Secondary Market

■ Provides regular information about the value of security.

■ Helps to observe prices of bonds and their interest rates.

■ Offers to investors liquidity for their assets.

■ Secondary markets bring together many interested parties.

■ It keeps the cost of transactions low.

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Risk and Return: The Capital Theory

Portfolio Returns and Portfolio Risk

 With appropriate diversification, can lower risk of the portfolio without lowering
the portfolio’s expected rate of return.
 Some risk can be eliminated by diversification, and those risks that can be
eliminated are not necessarily rewarded in the financial marketplace.

Calculating Expected Return of a Portfolio

 To calculate a portfolio’s expected rate of return, weight each individual

investment’s expected rate of return using the fraction of the portfolio that is
invested in each investment.
 Example 8.1: Invest 25% of your money in Citibank stock (C) with expected
return = -32% and 75% in Apple (AAPL) with expected return=120%. Compute
the expected rate of return on portfolio.
 Expected rate of return

= .25(-32%) + .75 (120%) = 82%

Calculating Expected Return of Portfolio

 E(rportfolio) = the expected rate of return on a portfolio of n assets.

 Wi = the portfolio weight for asset i.
 Sum of Wi = 1
 E(ri ) = the expected rate of return earned by asset i.
 W1 ×E(r1) = the contribution of asset 1 to the portfolio expected return. Weight
times the rate!

Calculating a Portfolio’s Expected Rate of Return

Penny Simpson has her first full-time job and is considering how to invest her savings.
Her dad suggested she invest no more than 25% of her savings in the stock of her
employer, Emerson Electric (EMR), so she is considering investing the remaining 75%
in a combination of a risk-free investment in U.S. Treasury bills, currently paying 4%,
and Starbucks (SBUX) common stock. Penny’s father has invested in the stock market
for many years and suggested that Penny might expect to earn 9% on the Emerson
shares and 12% from the Starbucks shares. Penny decides to put 25% in Emerson,

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25% in Starbucks, and the remaining 50% in Treasury bills. Given Penny’s portfolio
allocation, what rate of return should she expect to receive on her investment?

Class Problem – modify previous

Evaluate the expected return for Penny’s portfolio where she places 1/4th of her money
in Treasury bills, half in Starbucks stock, and the remainder in Emerson Electric stock.

Portfolio E (return) X weight = Product

Treasury Bill 4.0% .25 1%
EMR Stock 8.0% .25 2%
SBUX Stock 12.0% .50 6%
Expected Return 9%
on Portfolio

Evaluating Portfolio Risk and Diversification

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 Unlike expected return, standard deviation is not generally equal to the a

weighted average of the standard deviations of the returns of investments held in
the portfolio.
– This is because of diversification effects.
 Effect of reducing risks by including large number of investments in portfolio is
called diversification.
 As a consequence of diversification, the standard deviation of the returns of a
portfolio is typically less than the average of the standard deviation of the returns
of each of the individual investments.

Portfolio Diversification

 The diversification gains achieved by adding more investments will depend on

the degree of correlation among the investments.
 The degree of correlation is measured by using the correlation coefficient.
 Correlation coefficient can range from -1.0 (perfect negative correlation),
meaning two variables move in perfectly opposite directions to +1.0 (perfect
positive correlation), which means the two assets move exactly together.
 Correlation coefficient of 0 means no relationship exists between returns earned
by the two assets.
 As long as the investment returns are not perfectly positively correlated, there will
be diversification benefits.

– However, the diversification benefits will be greater when the correlations are
low or positive.

– The returns on most investment assets tend to be positively correlated.

Diversification Lessons

1. A portfolio can be less risky than the average risk of its individual investments in
the portfolio.
2. Key to reducing risk through diversification is combine investments whose
returns do not move together.

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Calculating the Standard Deviation of a Portfolio Returns – The Formula

Calculating the Standard Deviation of a Portfolio Returns (Example)

Portfolio Weight Expected Return Standard Deviation

Apple .50 .14 .20
Cola-Cola .50 .14 .20

 Determine the expected return and standard deviation of above portfolio

consisting of two stocks that have a correlation coefficient of .75.
 Expected Return = .5 (.14) + .5 (.14)

= .14 or 14%

 Standard deviation of portfolio

= √ { (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}

= √ .035

= .187 or 18.7%

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 Had we taken a simple weighted average of the standard deviations of the Apple
and Coca-Cola stock returns, it would produce a portfolio standard deviation
of .20.
 Since the correlation coefficient is less than 1 (.75), it reduces the risk of portfolio
to 0.187.

Figure 1.

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Standard Deviation of a Portfolio Returns and Diversification logic

 Figure 8-1 illustrates the impact of correlation coefficient on the risk of the
portfolio. We observe that lower the correlation, greater is the benefit of
diversification.

Correlation between investment return Diversification Benefits

+1 No benefit
0.0 Substantial benefit
-1 Maximum benefit. Indeed, the risk of
portfolio can be reduced to zero.

Systematic Risk and Market Portfolio

 An ugly task to calculate the correlations when we have thousands of possible

investments.
 Capital Asset Pricing Model or the CAPM provides a relatively simple measure of
risk.
 CAPM assumes that investors chose to hold the optimally diversified portfolio
that includes all risky investments.

– This optimally diversified portfolio that includes all of the economy’s assets is
referred to as the market portfolio.

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 According to the CAPM, the relevant risk of an investment relates to how the
investment contributes to the risk of this market portfolio.
 Classify the risks of individual investments into two categories:
– Systematic risk, and Unsystematic risk
 The systematic risk component measures the contribution of the investment to
the risk of the market. For example:
 War, hike in corporate tax rate.
 The unsystematic risk is the element of risk that does not contribute to the risk of
the market. This component is diversified away when the investment is combined
with other investments. For example: Product recall, labor strike, change of
management.
 An investment’s systematic risk is far more important than its unsystematic risk.
– If the risk comes mainly from unsystematic risk, the investment will tend to
have low correlation with returns of most other stocks in the portfolio, and
will make a minor contribution to the portfolio’s overall risk.
 Figure 8-2 illustrates that as the number of securities in a portfolio increases, the
contribution of the unsystematic or diversifiable risk to the standard deviation of
the portfolio declines.
 Figure 8-2 illustrates that systematic or non-diversifiable risk is not reduced even
as we increase the number of stocks in the portfolio.

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 Systematic sources of risk (such as inflation, war, interest rates) are common to
most investments resulting in a perfect positive correlation and no diversification
benefit.
 Figure 8-2 illustrates that large portfolios will not be affected by unsystematic risk
but will be influenced by systematic risk factors.

Systematic Risk and Beta

 Systematic (market) risk is measured by beta coefficient, which estimates the extent to
which a particular investment’s returns vary with the returns on the market portfolio.
– In practice, it is estimated as the slope of a straight line (see figure 8-3)
– Beta could be estimated using excel or financial calculator, or readily obtained
from various sources on the internet (such as Yahoo Finance and Money
Central.com)

Systematic Risk and Beta – Market Model

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Calculating Portfolio Beta

 The portfolio beta measures the systematic risk of the portfolio and is calculated
by taking a simple weighted average of the betas for the individual investments
contained in the portfolio.

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 Example 8.2 Consider a portfolio comprised of four investments with betas equal
to 1.5, .75, 1.8 and .60. If you invest equal amount in each investment, what is
the beta for the portfolio?

 Portfolio Beta

= .25(1.5) + .25(.75) + .25(1.8) + .25 (.6)

= 1.16

The Security Market Line and the CAPM

 CAPM also describes how the betas relate to the expected rates of return that
investors require on their investments.
 The key insight of CAPM is that investors will require a higher rate of return on
investments with higher betas.

Figure 8-4 provides the expected returns and betas for a variety of portfolios
comprised of market portfolio and risk-free asset. However, the figure applies to all
investments, not just portfolios consisting of the market and the risk-free rate.

Figure 8.4 – The Security Market Line (Beta and Portfolio Return)

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The Security Market Line

 The straight line relationship between the betas and expected returns in Figure 8-
4 is called the security market line (SML), and its slope is often referred to as the
reward to risk ratio.
– SML is one graphical representation of the CAPM.
 SML can be expressed as the following equation, which is also referred to as the
CAPM pricing equation:

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The CAPM intuition

 CAPM Equation implies the higher the systematic risk of an investment, all else
equal, the higher will be the expected rate of return an investor would require to
invest in the asset.
– This is consistent with Principle 2: There is a Risk-Return Tradeoff.
 Example 8.2 What is the expected rate of return on AAPL stock with a beta of
1.49; the risk-free rate is 2% and the market risk premium is estimated to be 8%?

E(rAAPL ) = .02 + 1.49 (.08) = .1392 or 13.92%

Checkpoint 8.3 – Class Example

Estimating the Expected Rate of Return Using the CAPM

Jerry Allen graduated from Texas Tech University with a finance degree in the spring of
2010 and took a job with a Houston-based investment banking firm as a financial
analyst.

One of his first assignments is to investigate the investor-expected rates of return for
three technology firms: Apple (APPL), Dell (DELL), and Hewlett Packard (HPQ).

Jerry’s supervisor suggests that he make his estimates using the CAPM where the risk-
free rate is 4.5%, the expected return on the market is 10.5%,and the risk premium for
the market as a whole (the difference between the expected return on the market and
the risk-free rate) is 6%. Use the two estimates of beta provided for these firms in Table
8.1to calculate two estimates of the investor-expected rates of return for the sample
firms.

Checkpoint 8.3

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Group 3

LUCEJIN L. GURREA

Instructor, MBA

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FINANCIAL FUTURE MARKET

- A future contract is an agreement that requires a party to the agreement both to

buy and sell something at a designated future date at a predetermined price.
- Future contracts are categorized as either commodity futures or financial futures.
-
Who do you use futures contracts markets?

• Hedgers
• Speculators
• Brokers

Function of future contract

A future contract is a legally binding agreement to buy and sell a "standardized"

asset on a specific date or during a specific month.
 1. Quality and Quantity of a commodity
 2. Unit pricing of the asset and maximum price fluctuation
 3. Date and geographic location for physical "delivery" of the underlying
asset
The purpose of Future Markets

• Price discovery
Future market provides a central market place where buyers and sellers
from all over the world can interact commodity.

• Transfer price risk

Future give buyers and sellers of commodity the opportunity to establish
prices for future delivery. This price risk transfer process is called HEDGING.

Changes in a Future contract's Value

-A futures contract's value is simply the number of units (bushels, hundredweight.) in

each contract times the current price.

Each contract specifies the volume of grain or livestock it covers.

• Trade grain and oilseed futures contracts cover 5,000 bushels.

• Live cattle futures contract covers 40,000 pounds (400
hundredweight).
• Lean hog futures contract covers 40,000 pounds (400
hundredweight).
• Feeder cattle futures contract covers 50,000 pounds (500
hundredweight).
The effect of a change in contract value depends on whether you previously sold or
purchased a future contract.

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• A decrease in contract value (a price decline) is a loss to

anyone who previously purchased a futures contract, but a gain for
a trader who previously sold a future contract.
• An increase in contract value (a price increase) is a gain to anyone
who previously purchased a futures contract (i.e., is long), but it is a
loss for a trader who previously sold a future (i.e., is short)

Role of clearing house

-A clearing house is an intermediary between buyers and sellers of financial instruments.

-It is an agency or separate corporation of a futures exchange responsible for

setting trading accounts, clearing trades, collecting and maintaining margin monies,
regulating delivery, and reporting trading data.

ex. Imagine that a trader purchases a futures contract, depositing the required
initial margin that proves they are afford the trade. The clearing house holds these funds
aside in the trader account, meaning they can’t be used for additional trading purposes.

Understanding the Clearinghouse

The responsibilities of clearinghouse include "clearing" or finalizing trades, setting

trading accounts, collecting margin payments, regulating delivery of the assets to their new
owners, and reporting trading data.

How does a clearing house facilitate the trading of financial future contract?

• The clearinghouse records all transactions and guarantees timely payments on

future contract. This precludes the need for a purchase of a future contract to
check the creditworthiness of the contract seller.
• Clearing house must be financially robust in order to sustain a clearing
member default in the markets in which they operate.
• The process of establishing a futures contract in the name of the clearing
house as counterparty, to each clearing member, is called NOVATION.

Counter Party Risk

o Counterparty Risk- the risk that the counterparty to a financial contract will default
prior to the expiration of the contract and will not make all the payments required
by the contract.
• Only the contracts privately negotiated between counterparties- over-the-counter
(OTC) derivatives and security financing transactions (SFT)- are subject to
counterparty risk.
• Exchanged-traded derivatives are not affected by CCR because of the exchange
guaranties.

CCR specific nature:

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o the uncertainty of exposure

o the bilateral nature of credit risk

Understanding Counterparty Risk

• Counterparty risk is also known as default risk.

• Lenders and investors are exposed to default risk in virtually all forms of credit
extensions.
• Counterparty risk is a risk that both parties should consider when evaluating a
contract.
• Financial investments product such as stocks, options, bonds and derivatives
carry counterparty risk.

Example of Counterparty risk

o A bank borrows a security from a counterparty and posts cash to counterparty as

collateral.
o The bank is exposed to the risk that is counterparty defaults and does not
return the cash that the bank posted as collateral.

OPTIONS MARKET
MEANING

 A contract (agreement)
 Giving a right to buy/sell
 A specific asset
 Within a specific time period

♥ An Options contract confers the right but not the obligation to buy or sell a
specified underlying instrument or asset at a specified price
-the Strike or Exercise price, until or at specified future date - the Expiry date.

♥ The option buyer has the right and option seller has the obligation
i.e., option buyer may or may not exercise the option given, but, if option buyer
decides to exercise the option, option seller has no choice but to honor the
obligation.

Key Terms:

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♣ Buyer of an option: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his option on the
seller/writer.

♣ Writer/seller of an option: The writer / seller of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asset if the
buyer exercises on him.

♣ Call option: A call option gives the holder the right but not the obligation to buy
an asset by a certain date for a certain price.

♣ Put option: A put option gives the holder the right but not the obligation to sell an
asset by a certain date for a certain price

♣ Option price/premium: Option price is the price which the option buyer pays to
the option seller. It is also referred to as the option premium.

♣ Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.

♣ Strike price: The price specified in the options contract is known as the strike
price or the exercise price.

CE PE

Spot Price < Strike

In the money Spot Price > Strike Price
Price

Spot Price = Strike

At the money Spot Price = Strike Price
Price

Spot Price > Strike

Out of money Spot Price < Strike Price
Price

Option Pay Offs

▼ Payoff for buyer of call option

▼ Payoff for seller of call option

▼ Payoff for buyer of put option

▼ Payoff for seller of put option

Payoff for buyer of call option

♠ The profit/loss that the buyer makes on the option depends on the spot price of
the underlying.

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♠ If upon expiration, the spot price exceeds the strike price, he makes a profit.
Higher the spot price, more is the profit he makes.

♠ If the spot price of the underlying is less than the strike price, he lets his option
expire un-exercised.

♠ His loss in this case is the premium he paid for buying the option

An Example

The payoff for the buyer of a three-month call option with a strike of 2250 bought at a
premium of 86.60 is as follows:

On expiry
Pay Off from
Nifty Net Pay Off
CE
closes at

2400 150 63.4

2350 100 13.4

2300 50 -36.6

2250 0 -86.6

2200 -86.60 -86.6

2150 -86.60 -86.6

2100 -86.60 -86.6

Payoff profile for writer of call options

• For selling the option, the writer of the option charges a premium.
• The profit/loss that the buyer makes on the option depends on the spot price of
the underlying.
• Whatever is the buyer's profit being the seller's loss. If upon expiration, the spot
price exceeds the strike price, the buyer will exercise the option on the writer.
Hence as the spot price increases the writer of the option starts making losses.
Higher the spot price, more is the loss he makes.
• If upon expiration the spot price of the. underlying is less than the strike price, the
buyer lets his option expire un-exercised and the writer gets to keep the premium

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An example

The payoff for the writer of a three month calls with a strike of 2250 sold at premium of
86.60.

Nifty closes at Pay Off from CE Net Pay Off

2100 86.60 86.60

2150 86.60 86.60

2200 86.60 86.60

2250 86.60 86.60

2300 -50 36.6

2350 -100 13.4

2400 -150 -63.4

2500 -250 -163.4

Nifty closes at Pay Off from CE Net Pay Off

2100 150 88.3

2150 100 38.3

2200 50 -11.7

2250 0 -61.70

2300 -61.70 -61.70

2350 -61.70 -61.70

2400 -61.70 -61.70

An example

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The payoff for the buyer of a three-month put option (often referred to as long
put) with a strike of 2250 bought at a premium of 61.70.

Payoff profile for writer of put options:

 For selling the option, the writer of the option charges a premium.
 The profit/loss that the buyer makes on the option depends on the spot price of
the underlying.
 Whatever is the buyer's profit being the seller's loss
 If upon expiration, the spot price happens to be below the strike price, the buyer
will exercise the option on the writer.
 If upon expiration the spot price of the underlying is more than the strike price,
the buyer lets his option un-exercised and the writer gets to keep the premium.
OPTION VALUE

The model most commonly used by a practitioners and traders to price and value
options is the Black-Scholes pricing model. The Black-Scholes model examines five
factors that affect the price of an option:
o The spot price of the underlying asset
o . The exercise price on the option
o . The option's exercise date
o Price volatility of the underlying asset
o The risk-free rate of interest

Time value

-Time Value of an option: Time value is difference between option premium and
intrinsic value. It comprises of

 Risk free rate

 Volatility
 Time to Expiry
-The time value of an option is always positive and declines exponentially with
time, reaching zero at the expiration date. At expiration, where the option value is simply
its intrinsic value, time value is zero.

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Group 4

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LUCEJIN L. GURREA

Instructor, MBA

Swaps

- Is a contract or agreement between two parties where they can exchange liabilities
or cash flows from two different financial instruments.

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Caps and Floor Markets

- A "cap" is a type of derivative that gives the holder the right, but not the obligation,
to buy a underlying asset at a predetermined price (the "cap price") on or before a
specified date (the "expiration date").
- A "floor" is the opposite of a cap. It is a type of derivative that gives the holder the
right, but not the obligation, to sell a underlying asset at a predetermined price (the
"floor price") on or before a specified date (the "expiration date").

To acquire Knowledge on:

National Amount

- Notional amount means the contracted amount of a derivatives contract for swaps
and options on which interest payments or other payments are based. For futures
contracts, the notional amount is represented by the contract size.

Types of Swaps

Interest Rate Swaps

- The most popular types of swaps are plain vanilla interest rate swaps. They allow
two parties to exchange fixed and floating cash flows on an interest-bearing
investment or loan. 
Commodity Swaps

- are common among individuals or companies that use raw materials to produce
goods or finished products. Profit from a finished product may suffer if commodity
prices vary, as output prices may not change in sync with commodity prices.
Zero Coupon Swap

- offers flexibility to one of the parties in the swap transaction. In a fixed-to-floating

zero coupon swap, the fixed rate cash flows are not paid periodically, but just once
at the end of the maturity of the swap contract.

Total Return Swap

- gives an investor the benefits of owning securities, without actual ownership. A TRS

is a contract between a total return payer and total return receiver. The payer
usually pays the total return of agreed security to the receiver and receives a
fixed/floating rate payment in exchange.
Swap Contracts 

- can be easily customized to meet the needs of all parties. They offer win-win
agreements for participants, including intermediaries like banks that facilitate the
transactions.

Relationship between cap, floor and market

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- Caps are agreements between two parties, whereby one party for an up-front fee
agrees to compensate the other if a designated interest rate (called the reference
rate) exceeds a predetermined level. For a floor the payment is made if the
reference rate is below a predetermined level. The party that benefits if the
reference rate exceeds (in the case of a cap) or falls below (in the case of a floor) a
predetermined level is called the buyer, and the party that must potentially make
payments is called the seller. The predetermined interest rate level is called the
strike rate.

Stock Market Options Market

- A stock option (also known as an equity option), gives an investor the right, but not
the obligation, to buy or sell a stock at an agreed-upon price and date. There are
two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet
that a stock will rise. 

The Basic features of Stock Options

Maturity Period

- As per the Companies Act 1956, a company as an entity is not eligible to purchase
its own shares. The equity shares can provide capital to the company, which cannot
be regained for as long as the company is functional. Individuals who have invested
in the company’s shares can only redeem their capital at the time of the company’s
liquidation; after all other claims have been fulfilled.

Shareholders Voting Rights

- When an individual purchases the equity shares of a company, he/she becomes a real
stakeholder of the organisation. The power to participate in the company’s meetings is
bestowed upon such participants, and they have the right to voice their opinions on a
company’s executive decisions. However, this right is exercised indirectly through a
company’s Board of Directors, elected by the shareholders.

Income from Equity Shares

- When an individual invests in a company’s shares, he/she acquires the right to

claim on a company’s income. These investors can claim on the company’s residual
income which is left after a preference shareholders’ dividend has been paid. If a
company has insufficient profits, equity shareholders might not earn any gains from
their shares. On the other hand, they also stand a chance of earning higher
dividends through capital appreciation.

Claim on Company’s Asset

- Every individual who has invested in a company’s equity shares gains an ownership claim
on the company’s assets. For instance, if a company is liquidated, the equity assets are first
used to fulfil the claims of preference shareholders and creditors while whatever is left
belongs to the equity shareholders.

Limited Liability

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- Even though shareholders are a company’s real owners, they enjoy the advantage of
limited liability. It means that their liabilities are limited only to the value of shares they have
invested in. If an investor has paid the price of the share in its entirety, he/she will not be
affected by the losses that the company suffers, even at the time of its liquidation.

Different Stock Options Strategies

Covered Call

- With calls, one strategy is simply to buy a naked call option. You can also structure
a basic covered call or buy-write. This is a very popular strategy because it
generates income and reduces some risk of being long on the stock alone.

Married Put

- In a married put strategy, an investor purchases an asset—such as shares of stock

—and simultaneously purchases put options for an equivalent number of shares.

Bull Call Spread

- In a bull call spread strategy, an investor simultaneously buys calls at a

specific strike price while also selling the same number of calls at a higher strike
price. Both call options will have the same expiration date and underlying asset.

Bear Put Spread

- The bear put spread strategy is another form of vertical spread. In this strategy, the
investor simultaneously purchases put options at a specific strike price and also
sells the same number of puts at a lower strike price.

Protective Collar

- A protective collar strategy is performed by purchasing an out-of-the-money (OTM)

put option and simultaneously writing an OTM call option (of the same expiration)
when you already own the underlying asset.

Long Straddle

- A long straddle options strategy occurs when an investor simultaneously purchases

a call and put option on the same underlying asset with the same strike price and
expiration date.

Long Strangle

- In a long strangle options strategy, the investor purchases a call and a put option

with a different strike price: an out-of-the-money call option and an out-of-the-money
put option simultaneously on the same underlying asset with the same expiration
date.

Long Call Butterfly Spread

- The previous strategies have required a combination of two different positions or

contracts. In a long butterfly spread using call options, an investor will combine both
a bull spread strategy and a bear spread strategy.

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Iron Condor

- In the iron condor strategy, the investor simultaneously holds a bull put spread and
a bear call spread. The iron condor is constructed by selling one out-of-the-money
(OTM) put and buying one OTM put of a lower strike–a bull put spread–and selling
one OTM call and buying one OTM call of a higher strike–a bear call spread.

Iron Butterfly

- In the iron butterfly strategy, an investor will sell an at-the-money put and buy an
out-of-the-money put. At the same time, they will also sell an at-the-money call and
buy an out-of-the-money call.

Black-Scholes Option Pricing Models

- The model is used to find the current value of a call option whose ultimate value
depends on the price of the stock at the expiration date. Because the stock price
keeps changing, the value of this call option will change too

Pricing Efficiency of the Stock Options Market

- Pricing efficiency is the assumption that a price is reflective of everyone in the

market being in possession of all available information. It is also using smart
process decisions to minimize the inefficiencies that are cutting into profits.

References

Swaps

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https://scripbox.com/pf/swaps-in-derivatives/

Caps and Floor Markets

https://www.causal.app/whats-the-difference/caps-vs-floors

National Amount

https://www.law.cornell.edu/definitions/index.php?
width=840&height=800&iframe=true&def_id=b42512a80d6fcf4b22fb33db97036f15&term_occ
ur=999&term_src=Title:12:Chapter:VII:Subchapter:A:Part:703:Subpart:B:703.101

Types of Swaps

https://www.investopedia.com/articles/investing/052915/different-types-swaps.asp

Relationship between Cap, Floor and Option

https://www.oreilly.com/library/view/introduction-to-securitization/9780470419571/
h2_fabo_9780470419571_oeb_c06_r1.html#:~:text=Caps%20are%20agreements%20between
%20two,is%20below%20a%20predetermined%20level.

Stock Options Market

https://www.investopedia.com/terms/s/stockoption.asp

The Basic Features of Stock Options Market

https://groww.in/p/equities

Different stock options strategies

https://www.investopedia.com/trading/options-strategies/

Black-scholes option pricing models

https://www.futurelearn.com/info/courses/risk-management/0/steps/39298

Pricing Efficiency of the Stock Options Market

https://www.vendavo.com/glossary/pricing-efficiency/#:~:text=What%20Is%20Pricing
%20Efficiency%3F,that%20are%20cutting%20into%20profits.

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Group 5

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LUCEJIN L. GURREA

Instructor, MBA

To Gain Knowledge on Interest Rates

1. Federal Reserve: The Federal Reserve is the central bank of the United States

and sets monetary policy, which includes interest rates. The Federal Reserve

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website is a good source of information on interest rates, including the federal

funds rate, which is the rate at which banks lend to each other overnight.

2. Financial news websites: Financial news websites such as Bloomberg, CNBC,

and Reuters provide up-to-date news and analysis on interest rates, including

changes in interest rates by central banks around the world.

3. Economic textbooks: Economic textbooks can provide a comprehensive

overview of interest rates, including the theories behind interest rate movements

and their impact on the economy.

4. Investment blogs: Investment blogs such as Seeking Alpha and The Motley

Fool provide insights into interest rates and their impact on investment

opportunities.

5. Online courses: Online courses such as those offered by Coursera and edX

provide structured learning on various topics related to interest rates, including

monetary policy and the yield curve.

Rate of Time Preference (MRTP) is a concept in economics that measures the rate

at which an individual is willing to trade consumption in the present for consumption in

the future. It represents the rate at which an individual discounts the value of future

consumption in relation to present consumption.

The MRTP is an important concept in economics because it helps to explain the

intertemporal decisions that individuals make regarding saving, borrowing, and

investment.

REAL INTEREST RATE IN ECONOMY

REAL INTEREST RATE – Is the nominal interest rate adjusted for inflation.

NOMINAL INTEREST RATE – Is the percentage increase in money you pay the lender

for the use of the money you borrowed.

INFLATION – Is the rate of increase in prices over a given period of time.

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Real Interest Rate = nominal interest rate – inflation rate

For instance, if the nominal rate of interest is 5% and the inflation rate is 2%, the real

interest rate would be 3%.

The real interest rate is important for both borrowers and lenders.

For borrowers the real interest rate determines the actual cost of borrowing money.

For lenders the real interest rate determines the actual return on their investment.

MARKET EQUILIBRIUM INTEREST RATE

The equilibrium interest rate is the rate at which the quantity of money demanded

is equal to the quantity of money supplied. The Federal Reserve can alter the

equilibrium interest rate by adjusting the supply of money.

The demand for money and supply of money can be graphed to determine the

equilibrium interest rate. The equilibrium interest rate is the rate of interest at which the

quantity of money demanded is equal to the quantity interest rate can be affected by

monetary policy adjustments or changes in income levels.

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Figure 1

Figure 2

Figure 3

MONEY SUPPLY is the sum total of all the currency and other liquid assets in a

country's economy on the date measured. The money supply includes all cash in

circulation and all bank deposits that the account holder can easily convert to cash.

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MONEY DEMAND is the desired holding the financial assets in the form of money: that

is cash or bank deposits rather than investments.

PARETO OPTIMALITY

Pareto efficiency or pareto optimality pertains to the highest efficiency level

resulting from an optimal allocation where any change to tis allocation would make

something or someone worse off.

Pareto originally used the word optimal for the concept, but as it describes a

situation where a limited number of people will be made better off under finite

resources, and it does not take equality or social well-being into account, it is in effect a

definition of and better captured by efficiency.

What is Risk Premium?

 A risk premium refers to the additional return an investor expects to receive for

taking on higher-risk investments compared to investments considered to be less

risky.

 In other words, it is the extra compensation an investor demands for bearing

risky beyond the risk-free rate.

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 The risk premium is typically calculated as the difference between the expected

return of a risky asset, such as stocks or bons, and the risk-free rate, which is the

return an investor can earn from a risk-free investment, such as a government

bond.

 The amount of risk premium demanded by investors depends on various factors,

including the level of risk associated with a particular investment, the economic

and market conditions, and the investor’s risk appetite.

Factors affecting yields between two bonds and swap bonds:

1. Credit risk – the creditworthiness of the issuer is a key factor in determining the

yield of a bond. If a bond issuer has a higher credit rating, the bond will typically

have a lower yield and vice versa.

2. Term to Maturity – the term to maturity of a bond is also a significant factor in

determining its yields. Bonds with longer maturities typically offer higher yields

that those with shorter maturities.

3. Inflation Expectations – inflation erodes the purchasing power of a bond’s

future payments.

4. Supply and Demand – the supply and demand for a particular bond can affect

its yields.

5. Interest Rate Environment –the prevailing interest rate environment also affects

bond yields. When interest rates rise, bond prices tend to yield o existing bonds.

6. Liquidity – bonds that are less liquid tend to have a higher yields than more

liquid bonds. This is because investors demand a higher return for the increased

risk if not being able to sell the bond quickly if they need to.

7. Currency Risk – when comparing the yields of bonds denominated in different

currencies, currency risk can affect the yield differential.

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Swap Bonds have additional factors that can affect their yields, such as the

underlying interest rates of the two currencies being swap, counter party risk, and the

terms of the swap agreement.

UNDERSTANDING MONEY MARKET

MONEY MARKET

- Money market refers to the market where money and highly liquid marketable

securities are bought and sold having a maturity period of one or less than one

year.

“Money Market Instrument” like treasury bills, commercial paper etc.

FEATURE OF MONEY MARKET

 It is a purely for short-terms funds or financial assets called near money.

 It deals with financial assets having a maturity period less than one year only.

 Transaction Have to be conducted without the help of brokers

OBJECTIVE OF MONEY MARKET

 To provide a parking place to employ short term surplus funds.

 To provide room for overcoming short term deficits.

 To enable the central bank to influence and regulate liquidity in the economy

through its intervention in this market.

IMPORTANT OF MONEY MARKET

 Development of trade and industry

 Development of capital market

 Smooth functioning of commercial banks

 Effectiveness central bank control

 Formulation of suitable monetary policy

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 Source of finance to government

TREASURY BILLS (T-bill)

 T-bills are most marketable money market

 They are issued with three-months, six-months and one-year maturities.

 T-bills are so popular among money market instruments because of affordability

to the individual investors.

COMMERCIAL PAPER

- A short term unsecured negotiable instrument consisting of promissory note with

a fixed maturity generally issued by companies as a means of raising short term

debt. Issued at a discounted face value. The issuer promises a fixed amount at a

future date but pledges no assets.

TYPES OF CPs

 Direct Paper

 Dealer Paper

ADVANTAGES OF COMMERCIAL PAPER

SIMPLICITY

- The advantage of commercial paper lies in its simplicity.

- It involves hardly any documentation between the issuer and investor.

FLEXIBILITY

- The issuer can issue commercial paper with the maturities tailored to match the

cash flow of the company.

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DIVERSIFICATION

- A well rated company can diversity its source of finance from banks to short-term

money markets at somewhat cheaper cost.

EASY TO RISE LONG-TERM CAPITAL

- The companies which are able to raise funds through commercial paper become

better known in financial world and are there by placed in a more favourable

position for raising such long-term capital as they may, from time to time,

require.

HIGH RETURNS

- The commercial paper provides investors with higher returns that they could get

from banking system.

MOVEMENT OF FUND

- Commercial paper facilities securitization of loans resulting in creation of a

secondary market for the paper and efficient movement of funds providing cash

surplus to cash deficit entities.

CREDIT RATING

- Refers to a quantified assessment of the creditworthiness of the borrower in

general terms or with respect to a financial obligation.

TYPES OF CREDIT RATING

INVESTMENT GRADE

- Refers to the fact that the investment made is solid, and the borrower will most

likely meet the payment terms.

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SPECULATIVE GRADE

- These ratings show that the investment are at a higher risk, and they often have

a higher interest rates.

FEDERAL FUNDS MARKET RETENTION

Federal funds referred to as fed funds. These are the excess reserves that ate

from the commercial banks and other financial institutions that are deposited to Federal

Reserve Bank.

Reserves in a bank’s Federal Reserve Bank account are known as fed funds. A

bank can led its excess reserves to another financial institution with an account at a

Federal Reserve Bank if it holds more fed funds than it needs to meet its Regulation D

reserve requirement.

REPURCHASE AGREEMENT

Repos, short for repurchase agreement is a short-term arrangement for dealers

to sell securities and then again at the same price as he sold it, and pays for the interest

for the use of funds on the termination date. It is a contract that last from overnight to 30

days.

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