1

L-5
Bond Market
Features of Bonds
Bonds represent long-term debt securities that are issued by government agencies or corporate bodies..
The issuer of a bond is obligated to pay interest (or coupon) payments periodically (such as annually or
semiannually) and the par value (principal) at maturity.
Bonds are often classified according to the type of issuer. Treasury bonds are issued by the Treasury,
federal agency bonds are issued by federal agencies, municipal bonds are issued by state and local
governments, and corporate bonds are issued by corporations.
Most bonds have maturities of between 10 and 30 years. But, these can be sold in the secondary market by
the holders. If they hold the bond for a very short time period (such as less than one year), they may
estimate their holding period return as the sum of the coupon payments plus the difference between the
selling price and the purchase price of the bond, as a percentage of the purchase price.
Bonds are classified by the ownership structure as either bearer bonds or registered bonds. Bearer bonds
require the owner to clip coupons attached to the bonds and send them to the issuer to receive coupon
payments. Registered bonds require the issuer to maintain records of who owns the bond and automatically
send coupon payment to the owners.
Bond Yields. The issuers cost of financing with bonds is commonly measured by the yield to maturity,
which reflects the annualized yield that is paid by the issuer over the life of the bond. The yield to maturity
is the annualized discount rate that equates the future coupon and principal payments to the initial proceeds
received from the bond offering.
Risk of holding bond -Since the selling price to be received by investors is uncertain if they do not held
the bond to maturity, their holding period yield is uncertain at the time they purchase the bond.
Consequently, an investment in bonds is subject to the risk that the holding period return will be less than
expected.
Bond Valuation Process
It is similar to capital budgeting process whereby present value of expected cash flows are calculate by
choosing appropriate discount factor

()

()

()

()

C=Coupon payment for each period
Par=Par value
=
N=Number of period to maturity
Types of Bond
1. Treasury Bond & their Auction
Characteristics
The Treasury (Government) obtains long-term funding through Treasury bond offerings, which are
conducted through periodic auctions.
Treasury bond auctions are normally held in the middle of each quarter. The Treasury announces its plans
for an auction, including the date, the amount of funding that it needs, and the maturity of the bonds to be
issued.
At the time of the auction, financial institutions submit bids for their own accounts or for their clients.
Bids can be submitted on
i. a competitive basis: Competitive bids specify a price that the bidder is willing to pay and the amount
of securities to be purchased. The Treasury ranks the competitive bids in descending order according to
the price bid per $100 of par value. All competitive bids are accepted until the point at which the
desired amount of funding is achieved. Competitive bids are commonly used because many bidders
want to purchase more Treasury bonds than the maximum that can be purchased on a noncompetitive
basis.

2

ii. Non-competitive basis: Noncompetitive bids specify only the amount of securities (not the rate at
which) to be purchased (subject to a maximum limit).The lowest accepted bid price is applied to all
accepted noncompetitive bids.
Trading Treasury Bonds
Bond dealers serve as intermediaries in the secondary market by marching up buyers and sellers of reasury
bonds, and they also take positions in these bonds.
2. Federal Agency Bonds
Federal agency bonds are issued by federal agencies. The Government National Mortgage Association (Ginnie
Mae) in the USA issues bonds and uses the proceeds to purchase mortgages that are insured by the Federal
Housing Administration(FHA) and by the Veterans Administration (VA). The bonds are backed both by the
mortgages that are purchased with the proceeds and by the federal government.
The federal Home Loan Mortgage Association(called Freddie Mac) issues bonds and uses the proceeds to
purchase conventional mortgages. These bonds are not backed by the federal government, but have a very low
degree of credit risk.
3. Municipal Bond
Like the federal government, state and local governments frequently spend more than the revenues they receive.
To finance the difference, they issue municipal bonds, most which can be classified as either general obligation
bonds or revenue bonds. Payments on general obligation bonds are supported by the municipal governments
ability to tax whereas payments on revenue bonds must be generated by revenues of the project (toll way, toll
bridge, state college dormitory, etc.) for which the bonds were issued. If insufficient revenues are generated,
revenue bonds can defaults.
Revenue bonds and general obligation bonds typically promise semiannual interest payments. Common
purchasers of these bonds include financial and nonfinancial institutions as well as individuals. The minimum
denomination of municipal bonds is typically $5000. A secondary market exists for them, although it is less
active than the one for Treasury bonds. One of the most attractive features of municipal bonds is that the
interest income the bonds provide is normally exempt from federal taxes and in some cases is exempt from state
and local taxes.
4. Corporate Bonds
When corporations need to borrow for long-term periods, they issue corporate bonds, which usually promise the
owner interest on a semiannual basis. The minimum denomination is Fixed to be subscribed in multiple. Larger
bond offerings are normally achieved through public offerings, which must first be registered with the SEC.
The degree of secondary market activity varies; some big corporations having a large amount of bonds
outstanding, which increases secondary market activity and the bonds liquidity. The bonds issued by smaller
corporations tend to be less liquid because their trading volume is relatively low.
Common purchasers of corporate bonds include many financial and some non financial institutions as well as
individuals.
Private Placements of Corporate Bonds
Some corporate bonds are privately placed rather than sold in a public offering. A private placement does not
have to be registered with the SEC. Small firms that borrow relatively small amounts of funds (such as $30
million) may consider private placements rather than public offerings, since they may be able to find an
institutional investor that will purchase the entire offering. Although the issuer does not need to register with
SEC, it still needs to disclose financial data to convince any prospective purchasers that the bonds will be repaid
in a timely manner. The issuer may hire a securities firm to place the bonds because such firms are normally
better able to indentify institutional investors that may be interest in purchasing privately place debt.
The institutional investors that commonly purchase a private placement are insurance companies and pension
funds. Since privately placed bonds do not have an active secondary market, they are more desirable to
institutional investors that are willing to invest for long periods of time.
Characteristics of Corporate Bonds
Corporate bonds can be described according to a variety of characteristics; The bond indenture is a legal
document specifying the rights and obligations of both the issuing firm and the bondholders. It is very
comprehensive (normally several hundred pages) and is designed to address all matters related to the bond issue
(collateral, payment dates, default provisions, call provisions etc.)
Sinking-Fund Provision. Bond indentures frequently include a sinking-fund provision, or a requirement
that the firm retire a certain amount of the bond issue each year. This provision is considered to be an
advantage to the remaining bondholders because it reduces the payments necessary at maturity.

3

Protective Covenants. Bond indentures normally place restrictions on the issuing firm that are
designed to protect the bondholders from being exposed to increasing risk during the investment period.
These so-called protective covenants frequently limit the amount of dividends and corporate officers
salaries the firm can pay and also restrict the amount of additional debt the firm can issue. Other
financial policies may be restricted as well.
Call Provisions. Most bonds include a provision allowing the firm to call the bonds. A call provision
normally requires the firm to pay a price above par value when it calls its bonds. The difference between
the bonds call price and par value is the call premium. Call provisions have two principal uses. First, if
market interest rates decline after a bond issue has been sold, the firm might end up paying a higher rate
of interest than the prevailing rate for a long period of time. Under these circumstances, the firm may
consider selling a new issue of bonds with a lower interest rate and using the proceeds to retire the
previous issue by calling the old bonds.Second, a call provision may be used to retire bonds as required
by a sinking-fund provision.
Bond Collateral Provisin . Bonds can be classified according to whether they are secured by collateral
and by the nature of that collateral.
*Secured Bonds-Usually, the collateral is a mortgage on real property (land and buildings). A first
mortgage bond has first claim on the specified assets.
*Bonds unsecured by specific property are called debentures (backed only by the generally credit
of the issuing firm). These bonds are normally issued by large, financially sound firms whose
ability to service the debt is not in question.
*Subordinated bonds/debentures have claims against the firms assets that are junior to the claims
of both mortgage bonds and regular debentures. Owners of subordinated debentures receive nothing
until, the claims of mortgage bondholders, regular debenture owners, and secured short term
creditors have been satisfied. The main purchasers of subordinated debt are pension funds and
insurance companies.
Zero-Coupon Bonds. These zero-coupon bonds are issued at a deep discount from par value. To the
issuing firm, these bonds have the advantage of requiring low or no cash outflow during their life.
Additionally, the firm is permitted to deduct the amortized discount as interest expense.
Variable-Rate Bonds. The highly volatile interest rates experienced during the 1970s inspired the
development of variable-rate bonds, which affect the investor and borrower as follows: (1) they allow
investors to benefit from rising market interest rates over time, and (2) they allow issuers of bonds to
benefit from declining rates over time.
Convertibility. Another type of bond, known as a convertible bond, allows investors to exchange the
bond for a stated number to shares of the firms common stock. This conversion feature offers investors
the potential for high returns if the price of the firms common stock rises. Investors are therefore willing
to accept a lower rate of interest on these bonds, which allows the firm to obtain financing at a lower
cost.
Trends of the issuance of Debt Security (Bond) instruments in Bangladesh
1. The first effort to mobilise savings for use of development expenditure was the issue of Wage Earners
Development Bonds in 1981 to be sold to Bangladeshi wage earners abroad.
2. A two-year special treasury bond was issued in January 1984 to be sold to individuals, public and
private sector organisations including banks.
3. In December 1985, another instrument, the National Bond, was issued to be sold to non-bank investors.
4. 15-Years Treasury Bonds were issued during the implementation period of the financial sector reform
programme with effect from 1990, to raise the capital base of nationalised commercial banks,
specialised banks and development financial institutions.
5. The government also issued some bonds for augmenting loanable funds for speacialised banks (BKB)
and financial institutions.
6. Moreover, some bonds were also issued to mobilise funds for a number of public sector organisations
like the T&T Board, Bangladesh Biman etc.
7. In October, 2004 Islamic Investment Bonds( Islamic Bonds) in accordance with Islamic Shariah was
introduced for investments by the Bangladeshi Institutions and individuals and non- resident
Bangladeshis, who are willing to share profit or loss. These Bonds are of 6-Month, 1-Year and 2-Year
maturities and are quite attractive to the investors due to short maturity profile and flexible attractive
return.

4

8. Bangladesh Government Treasury Bonds (BGTB).
To mobilize long term fund from domestic sources for financing government expenditure programme
Bangladesh Government Treasury Bonds(BGTB), bearing half yearly interest coupons, with tenors of 5-
year, 10-year, 15-year 20-year have been introduced. These bonds are issued at par through yield based
multiple price auction mechanism held in Bangladesh Bank with effect from 2007. The basic features of
these bonds are:
Individual and institutions resident in Bangladesh are eligible to purchase these .
Non-resident individual and institutions also are eligible to purchase these with foreign currency
but, are not allowed to sale within one year of purchase.
In accordance with government fund raising programme, bonds are issued by the Bangladesh Bank
through auction system at cut-off prices. Auctions are held as per auction calendar prepared and
announced prior to each financial year on the basis of government debt management strategy.
The Primary Dealers act as the underwriters and market makers with commitments to bid in
auctions. The unsold portion of the bond in any particular auction are devolved to the primary
dealers.
The bonds ( Primary Issues) are issued by Bangladesh Bank, at coupon rates which are determined
at the auction dates and are payable at six monthly intervals from the date of issue.
Banks and financial institutions maintaining current account with Bangladesh Bank including the
PDs , may submit bids on own account and on behalf of others for face value amount in multiples
of Taka 1.00 lac.
Separate bids are to be submitted for bonds of different maturities. Bangladesh Bank also
participate in bond market (both primary and secondary) for maintaining desired yield curve on
residual amount not accepting by the market participants. Allowing market first, Bangladesh Bank
assumes position for market development as well as macroeconomic stability of the country..

Bond Market in Bangladesh.
1. Marketability of bonds issued in the country was very limited up to 2005 as there was no secondary
market for trading of these instruments. These bonds were held by the banks, majority of which were
government owned. These were held by the banks due to the government allocation system, as well as
to maintain statutory liquidity requirements (SLR). So, essentially it was a captive market. Non-bank
financial institutions also purchase these for maintaining liquidity ratio.
2. There were provisions for holding of these bonds by the individuals, but response from them was
minimum due mainly to maturity profile and non flexibility in the rate return offered on those
instruments.
3. The most important event in the history of Bond market in Bangladesh is that from January 10, 2005
Bonds are being traded in the secondary market. A total of 18 Bonds are listed in Dhaka Stock
Exchange for trading in the market.
4. Bangladesh Bank has appointed primary dealers to facilitate development of bond market in the country
and till today 15 Primary Dealers comprising of banks and non-bank financial institutions are engaged
in freely sale /purchase of bonds issued through auction mechanism. Primary dealers also get necessary
support from Bangladesh Bank in case fund shortages.
5. Since government is the single borrower in the bond market, the rates offered in other government
savings instrument basically determine the yield structure of bond market. Given the nature and
duration of maturities, yields had been relatively low for the bonds issued in the market as compared to
the government savings instruments. This is clearly against the traditional rule of high- risk-high-return
and vice versa which significantly impeded the growth of bond market in the country.
6. The overall situation of bond market in Bangladesh is not satisfactory due to absence of corporate
bonds. The presence of a vibrant corporate bond market has strong and positive effect in reducing
dominance of bank lending in private enterprises and ensure competitive structure of rate of interest in
the economy reflecting opportunity cost of money which is still lacking.

) 1 (
) 1 (
) 1 (
) 1 (
1 1
r
C
r
C
r
C
r
C
DUR
t t



5

L-6
Equity Securities and their Trading-P-66
Equity market facilitates the flow of funds from individuals or institutional investors to the corporate sectors.
Thus they enable the corporation to finance their investments in new or expansion of the existing business
activities.
Stocks- These are issued by the corporations to be subscribed by the general public. The subscriber become the
owner of the company and as such they obtain the voting power in the management affairs of the corporations.
The stocks are of three types
1. Common Stocks or ordinary Stock. These are issued in two processes
Initial Public Offerings (IPOs) at par or premium values depending asset valuation of the
company issuing share.
Secondary Offerings for expansion or modernization of the firm
Placement Shares-These are not offered to the public rather through underwriters are sold to
a group institutional investors or wealthy person .These cannot be traded in the secondary
market as usual in the case of IPOs. These are less liquid.
2. Preferred Stock no voting power but with certainty in earnings the holders of preferred stocks earn
fixed dividend which may be accumulated due to shortfall of companys cash position. However, the dividend
on common stacks cannot be paid until and unless the dividend of preferred stock is paid including arrears.

Process of IPO issue or offerings and the obligations
1. Development of prospectus which contains detailed information about the firm and includes the
financial statements and the discussion of risks involved. It is intended to provide potential investors
with the information they need to decide whether to invest in the firm.
2. Submission of the prospectus to the Securities and Exchange Commission(SEC) for approval. Within a
certain period the SEC approve the prospectus
3. Appointment of underwriter who provide guarantee to purchase the unsold portion of the offerings.
Underwriters may be a single or multiple institutions. They also provide bridge financing to the firm
issuing IPOs
4. Appointment of Issue Managers- who sells the share and collect money on behalf of the firm
5. Placement of IPOs.IP
6. Os are sometimes issued to the institutional investors on placement basis. However, these shares are
locked for a certain period generally, for one year in which period they cannot be sold in the secondary
market.
7. IPOs are to be listed with the organized stock exchange for secondary trading
8. Holding of AGM ia mandatory for the firms issuing IPOs, otherwise, enlistment for secondary trading
with the organized stock exchange will be cancelled.
9. If SEC allows, the IPOs can be traded in the Over The Counter (OTC) market where trading floor is not
required, rather tradings are conducted through telecommunications.
Investment/Merchant Bankers and underwriters:
Investment or merchant bankers are the adviser who advises the firms regarding the terms and conditions on
which the securities are to be offered. Underwriting is the arrangement whereby the investment bankers
purchase the securities from the issuer to sell those to the public. These are done in two ways such as
Firm commitment:-Under this practice the issuer firm sells all the securities to a underwriter or a
Syndicate at a lower price than the public offering which serves as spread for risk taking by the
underwriters. The underwriters take the full risk of selling the securities and the unsold portion if any,
are to be retained by them.
Best effort agreement; - Under this arrangement, the investment banker agrees to sell the securities in
the market putting their all out effort and they do not purchase the securities. They act simply as an
intermediatory between the firm and the public. For this they receive a commission and the unsold
portion of the securities are returned to the issuer.

6

Where securities are traded
Trading of securities started at the time of its issue which must follow some procedure. After completion of
primary issue process secondary trading starts.
Secondary Trading of Equity Shares: Equity shares have no maturity and therefore, the investors cannot get
back money until and unless the company is wind up. However, transfer of shares through mutual agreement or
through secondary trading is widely practiced Seconary market consist of three forms such as
1. National and Local securities exchange Houses-An Exchange provides trading facilities to its members.
Only members have seat there for trading purposes and the get a commission from the investors for
facilitating trade. Asset value of a seat of a member is determined by the commission earned by them.
DSE and CSE are the two Stock exchanges in Bangladesh. In Bangladesh, all the equity shares are to be
listed compulsorily in the stock Exchanges but few bonds are traded
2. Over the counter Market-It is not a formal market and as such there is no membership requirement.
Computer linkage trading is the integral part of this types of trading In this system thousands of brokers
are enlisted with the Stock Exchanges and they establish network through internet facility. They quote
prices for buying an selling. A dealer who receive buy or sell order from the investor scrutinize prices
quoted by others and execute trade.Sometimes, in many countries particularly in the developed
countries become market maker by maintain inventory for securities.
3. Direct Trading between two parties- It is a opportunity create by electronic communication network
(ECN). The ECN is an alternative to either formal stock exchange or dealer market rather, it allowes
members to post buy or sell orers and to have those orders matched upor crossed with orders of other
traders in the system.
Types of Order:
Market Order-These are simply buy and sell order at market prices.The retail broker will relay this to
the commission broker in the floor.
Limit order-Here specific prices are mentioned at which buy or sell will be executed.
Stop loss buy and sell order- Stocks are not to be traded until and unless the stock prices hits to a point.
Block sell- This is generally done to help sell of securities received through placement. Institutional
investors are the major participant to this mechanism
Trading cost- It is distribute among the retail to the members of Stock Exchanges
Buying on Margin-
When purchasing securities, investors have easy access to a source of debt financing fund called call loan. The
act of taking advantage of brokers call loan is called buying on margin.Purchasing on margin means that the
investors borrow a part of the purchase price of stock from the broker. The borrower inturn borrow money from
the market at call money rate and charges the borrower with a service charge in addition to the borrowing rate
from the banks.
Regulation of the security market
Circuit breaker to eliminate excess volatility
Lock in prevent rapid gain from the IPOs particularly to the foreign investors
Disclosure of financial statements
Some important concept of the Equity Market
1. Price /Earning Ratio-which represents the prevailing stock price per share divided by the firms
earnings per share
2. Bullish market. This is the situation when the prices of shares goes up continuously
3. Bearish Market. This is the situation when the prices of the shares continue to go down. It wise to sell
the shares in suc a market.

Question for Discussion
Broad Question
Short Question

7

L-7
Mutual Fund and their Operation Page-108
Mutual Fund is an investment company that sales shares and use the proceeds to manage a portfolio of
securities and in this way it provides ownership to the investors to Mutual Fund Company. It provides an
avenue to the small investors who are unable to diversify their risks in financial investment.
2. Background: It was found that small investors have little idea about the investment climate in the complex
market situation and very often they loss their capital. Moreover, since they have very small fund they cannot
diversify their portfolio. Therefore, with the broad objectives of
Protecting the small investors Funds from capital loss
Maintaining a stable income for them
Help the process of industrialization, the idea of mutual fund was developed.

3. Basic characteristics:

1. Board of directors having adequate knowledge on capital market activities are assigned to manage a
combination of portfolio to ensure an income stream to the investors.
2. Hired portfolio Managers are engaged to conduct the day-to-day affairs of the fund so that its business
is carried out with professionalism like other portfolio manager, they analyze economic and industry
trends and forecast & assess the potential impact of various conditions on companies. They
continuously involve in adjusting the potfolio in response to the changing economic conditions
3. Chose securities to be pulled for a particular portfolio and determine the amount of funds to be raised
4. Offer liquidity services/ money transfer and other related services
5. Offer information services on account

4. Regulation and Taxation:

1. The must abide by the law of the country
2. Must be listed with the SEC
3. Must disclose the prospectus containing the composition of the funds, the risk and returns
4. Name of the portfolio manager and his duration of employment
5. Performance record of the company
6. Tax exemption status

5. Estimation of Net Asset Value (NAV)

It indicates value per share. It is estimated every day by first determining the market value of the securities
comprising the mutual fund plus any interest or dividend accrued on these. Then the expenses are subtracted
and the amount is divided by the numbers of shares.When a mutual fund pays its shareholders dividend, its
NAV declines by per share to the amount paid in the form of dividend.

6. Distribution to shareholders: The returns of the Mutual Funds can be distributed in three ways. These are:
1. Dividend payment
2. Distribute capital gains
3. Share price appreciation- Shareholders can encash it.

7.I nvestment Policies and Classification of Funds. Each mutual fund has a specific investment policy. The
policies are set on the basis of objectives of the fund management and accordingly securities are also selected.
Mutual Funds can be classified on the basis of underlying securities of the Funds such as:
Stock/Equity mutual Fund. Some of these funds are as follows
I. Growth funds-This consists of the securities of the companies that has not yet fully matured and
expected to grow ahead.The main objective is to grow the value of investments.
II. Capital Appreciation funds-These are highly risk-return based securities. The investors are risk
loving persons with high expectation.
III. Growth and income funds-This comprises of securities of the companies that give high dividends
and some fixed income bonds.
IV. International and global funds-This comprises of foreign securities
V. Internet funds-This fund comprised of the securities of the technology based companies.

8

VI. Specialty funds-This covers the securities of the company that specialize in particular activities
having potentials ahead
VII. Index Funds-Indexes are constructed on the basis of similar performance of certain securities and
the values of these securities are expected to move in the same direction of the Index
VIII. Multi-fund Funds-This is created by the portfolio managers by investing inportfolio of different
mutual funds
Bond Mutual Fund-This comprises of various types of bonds such as high yielding bonds, tax free
bonds, convertible bonds etc. which are relatively less liquid but provide a certain source of income
with some volatility.
Money market Mutual Fund-This consists of money market Securities which are highly liquid in nature
and provide a certain and regular income stream to its holders

8. Other category of classification:
Mutual Funds are also classified on the basis of cost structure involve in its transactions. An investor should
actively consider management fees and other expenses besides the stated investment policy as well as its
performances.
1. Load Fund- It is of two types
o Front End Load-It is a commission or sales charge to be paid at the time of purchase to the
brokers which actually reduce the amount of money invested. The rate of this commission
varies depending on the cost of management and other expenses relating to the fund.
o Back-End-Loan- It is redemption or exit fee while selling the shares.
2. No-load Mutual Funds-No fees are charged but the cost relating to the management are adjusted in the
asset value of the fund.
3. Open-Ended Mutual Fund- The company is willing to repurchase the shares anytime from the
investors they sell. This is the most attractive part of mutual fund because it ensures liquidity to the
investors.
4. Closed-End Mutual Fund-There is no provision to repurchase these shares by the company; rather the
investors will have to sell these to a stock exchange to liquidate the invested money.The number of
closed ended fund remains constant and is equal to the shares originally issued.
How Funds are Sold
Mutual Fund in Bangladesh
Though the mutual funds have been in existence in advanced countries for many decades, its development in
Bangladesh is comparatively of recent origin. ICB is the pioneering organization that first issued Mutual Fund
in 1980 amounting to TK 5 million only. Recorded responses by the investors induced ICB to float more
Mutual Funds. Till today a total of 8 Mutual Funds with share value of Taka 10/ have been floated by ICB. All
the ICB mutual funds are performing well among which 1
st
ICB is super performer.

Other Mutual Funds:
Being induced by the performance of ICB Mutual fund, a good number of portfolio managers emerged in the
country to float and operate mutual fund. At present, there are 33 mutual funds other than those of ICB, listed
in stock exchange for secondary trading. Among them 9 are performing very well but the rest as appears in
stock exchange information are not performing up to the mark. Market value of the most of the mutual funds is
less than the face value.


9

L-8
Derivative Securities
Outline:
The concept
Uses
Mechanism
In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a
value, based on the expected future price movements of the asset to which it is linkedcalled the underlying
asset
[1]
such as a share or a currency. There are many kinds of derivatives, with the most common being
swaps, futures, and options. Derivatives are a form of alternative investment.
A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of
derivatives have been traded on markets before their expiration date as if they were assets. Among the
oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth
century.
[2]

Derivatives are usually broadly categorized by:
the relationship between the underlying asset and the derivative (e.g., forward, option, swap);
the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate
derivatives, commodity derivatives or credit derivatives);
the market in which they trade (e.g., exchange-traded or over-the-counter);
their pay-off profile.

Uses
Derivatives are used by investors to:
provide leverage (or gearing), such that a small movement in the underlying value can cause a large
difference in the value of the derivative;
speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves
in a given direction, stays in or out of a specified range, reaches a certain level);
hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the
opposite direction to their underlying position and cancels part or all of it out;
obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather
derivatives);
create option ability where the value of the derivative is linked to a specific condition or event (e.g., the
underlying reaching a specific price level).

Mechanism:
Forward Contract:
What is Forward Contract?
A forward contract in foreign exchange is a transaction by which foreign currency is bought or sold for delivery
in a future date at predetermined rate of exchange. The contract between parties is made at current date but the
actual transaction will occur at a future date. The rate of exchange has also to be decided for future
transactions. The authorized dealers calculate the rates based on the current market and possible rates given in
current market for forward delivery. Taking a small cushion and forward margin into account against the
adverse fluctuations, the bank generally quote the firm rates that will be applied at the time of the actual
transaction. The essentials of forward contract are:
1. Value date or duration after which transaction will be settled
2. Contracted amount
3. Rate of exchange to be applied on the transaction date.
4. The place where the transaction is to be made effective.
Overbought or long position
If in forward transaction a dealer or bank's total purchase side of the exchange position is more than the total
sales, the result is called overbought or long position
Oversold or short position
If in forward transaction a dealer or bank's total sales se side of the exchange position is more than the total
purchase, the result is called oversold or short position

10

Types of Transaction in forward market
Outright deal: It involves forward sale/purchase of a currency at a forward exchange rate to be effective
at a value date. It follows that the outright rate is the spot rate plus/minus the forward margin. This is
common in Bangladesh and other developing markets.
Swap deal is common in developed market. It involves sales/purchase of a currency in spot market with
a reserve deal in forward market. The difference is called the Swap Margin or Swap Rate.
Quotations in forward market
On the basis of the relationship between spot rate and the forward rate there arise three types of quotations.
These are:
At Per-This means both spot and forward rate are same
At Premium-This implies forward rate is expensive or costly. It implies that less foreign currency will be
available for the same unit of home currency. For direct quotation premium will be added to the spot rate
and for indirect quotation premium will be deducted from the spot rate.
-Example Spot US $ 1=TK.69.70-69.80
3 months 15-25 /p
6 months 20-30/p
At Discount-Forward rate will be less than spot rate. It implies that more foreign currency will be
available for the same unit of home currency. For direct quotation discount will be deducted from the
spot rate and for indirect quotation it will be added to the spot rate. The rate of discount is determined
on the basis of interest rate differentials of the currencies to be traded

-Example Spot US $ 1=TK.69.70-69.80
3 months 15-25 /d
6 months 20-30/d
Principles or methodology used in forward transactions
Two types of contract are used in forward transactions. They are
Fixed Forward-to be delivered at a fixed date within banking hour. now a days this is almost
non existence
Option Forward-Range of time is fixed for delivery.
Why it is done? What are the risks covered in forward deal?
Risk coverage is the major consideration in forward exchange rate transaction. Uncertainty is the main
characteristics in foreign exchange business and the traders want to minimize this risk. It is said to be an
umbrella which gives protection to the dealers against the adverse movement of exchange rates

How a bank can cover its risk through forward transactions
Bank can cover it s risk basically in two ways .These are
Amount of forward purchase from customers and other banks can be adjusted to forward sale to the
customer and other banks
Against the currencies sold in forward market, spot purchase can be undertaken to build up nostro
account abroad for the same currency. This will help to meet the forward liability in due time.
Who are the participants in forward transactions?
Banks -for customers and hedging of their own risks
Exporters to protect their export receipt on account of exchange rate fluctuations
Importers for payments in future
Speculators -to earn profit by investing in different currencies

11

Non-deliverable Forward (NDF) Contract.
NDF does not result in result in an actual exchange of the currencies at the future date. That is there is no
delivery, instead one party to the agreement makes a payment to the other party based on the exchange rate at
the future date.
A. Currency Option Market (contract)
Currency provides the right to purchase or sale currencies at specified prices. It can be of two types:
i. Call Options:- It grants the right to buy a specific currency at a designated price within a specific
period of time. The designated price is called strike price or exercise price. Call options are desirable
when one wishes to lock in a maximum price to be pai for a currency in future. If the spot prices of
the currency rise above the strike price, the owner of the call options can exercise their option by
purchasing the currency at the strike price, which will be cheaper than the spot rate.
ii. Put Options: - The owner of the put option receives the right to sell the currency at the strike price
within specified period of time but he is not obligated to exercise the option.
B. Currency Future Market (Contract):
It is similar to that of forward contract in trading but differs in many other respects. It is done with some
standardized specific value and date. These are commonly used by the MNC for speculation purposes to make
profit.
Difference between Forward Contract & Future contract are given below
Sl.No. Subjects Forward Contracts Future Contract
1 Size of Contract Tailored to individual nees Standardized
2 Delivery Date Tailored to individual nees Standardized
3 Participants Banks, Brokers and Multinational
Corporations. Public Speculation not
encouraged
Banks, Brokers and Multinational
Corporations. Qualified Public
Speculation encouraged
4 Security Deposits None as such, but compensating
bank balances or lines of credit
required
Small Security deposit required
5 Clearing Operations Handling contingent on individual
banks and brokers. No separate
clearinghouse functions
Handling by clearing House.
Daily settlements to the market
price
6 Market Place Telecommunication Method Central Exchange floor with
worldwide communications
7 Regulations Self Regulating Commodity future trading
Commission. National Futures
Association
8 Liquidation Most settled by actual delivery.
Some by offset at cost
Most by offset. Very few by
delivery
9 Transaction Cost Set by spread between banks buy
and sell prices
Negotiated brokerage fees
C. SWAP DEAL Contract
Simultaneous sale/purchase of same currency is called SWAP. generally bank do this to cover exchange rate
risk. A bank may purchase an amount of US $ on forward contract basis, the bank can sell this amount in the
forward market also to hedge against the future risk.