Financial Markets - Final

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Financial System, Financial

Instruments & Financial
Markets: A Guide
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Financial System
The following chart gives you an overview of the financial system:
(OLD)
(New)
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In finance, the financial system is the system that allows the transfer of money
between savers and borrowers. It comprises a set of complex and closely
interconnected financial institutions, markets, instruments, services, practices, and
transactions.
Financial systems are crucial to the allocation of resources in a modern economy.
They channel household savings to the corporate sector and allocate investment
funds among firms; they allow inter temporal smoothing of consumption by
households and expenditures by firms; and they enable households and firms to
share risks. These functions are common to the financial systems of most developed
economies.
Financial Instruments
Financial Assets can be of the following types:
Shares
Equity shares
Preference Shares
Debt/ Fixed Income Securities
Capital Market Instruments
Money Market Instruments

Mutual Funds
Derivatives
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Equity
Equity shares or shares of common stock represent ownership in a business
enterprise. When an investor subscribes to the issue of shares by a company he
becomes a part owner of the business. Ownership of shares entitles an investor to
dividends paid by the firm.
The rate of dividends is not fixed neither is it contractually guaranteed. That is,
dividends can and do fluctuate from year to year. Secondly a company is under no
obligation to declare dividends in a particular year. However, good companies try to
keep dividends at steady levels to avoid sending wrong signals to the outside world.
A firm will however not pay out its entire profits for the year as dividends. A fraction
of the profits for the year will be reinvested in the company. This is known as
`Retained Earnings.
If a firm is forced to declare bankruptcy, then the shareholders are entitled to the
residual value if any of the business, after the claims of the other creditors are fully
settled.
Equity shares never mature, in the sense that they have no expiry date. This is
because when a firm is created, it comes into existence with the assumption that it
will last forever. No one starts a company with the expectation that he will wind it up
after a few years.
Shareholders are given voting rights. That is, they can vote on various issues at the
Annual General Meetings of companies, including the election of the board of
directors.
Not all shares carry voting rights, however. There are non-voting shares. These
shareholders are not entitled to vote. This category is created to restrict corporate
control to only certain groups of shareholders.
Preferred Shares
They are a hybrid of debt and equity. They are promised a fixed rate of return like
debt holders and unlike equity holders.
But if the firm is unable to pay as promised then preferred shareholders cannot seek
legal recourse unlike debt holders. However, till their overdue dividends are paid, the
firm usually cannot pay dividends to equity holders. Such shares are therefore called
cumulative preferred shares.
Dividends on preferred shares can be paid only after a company has made interest
payments on its outstanding debt. In the event of liquidation, preferred shareholders
get priority over equity shareholders.
Pre-Tax versus Post-Tax Payments
Equity and preferred dividends are paid out of post-tax profits. However interest paid
by the company on debt can be deducted from the profits while computing its tax
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liability. This reduces the tax burden for the firm or in other words gives it a `tax
shield.
Debt Securities
Debt instruments are financial claims issued by borrowers to the lenders of funds.
The ownership of a debt security does not constitute part ownership of a business
venture. It is merely an IOU.
Issuers of debt promise to pay interest at periodic intervals, and to repay the
principal at maturity. Long term debt securities (with a time to maturity of one year
or more) issued by the government or by corporations, are called Bonds or
Debentures.
A debenture in global financial jargon is a bond for which no assets of the firm have
been specified as collateral. Thus debentures constitute unsecured debt. Firms also
issue debt securities for which specific assets are designated as collateral are called
Bonds.
In India, the terms are often used interchangeably. Thus both the terms; bonds as
well as debentures, could refer to secured as well as unsecured debt.
The Treasury Department issues long term bonds (with a time to maturity of 10-30
years) called Treasury Bonds or T-bonds. The Treasury also issues medium term debt
(with maturities ranging from 1 to 10 years) called T-notes. These are otherwise
similar to T-bonds.
Companies and governments also issue short term debt instruments (with a time to
maturity at the time of issue of one year or less). T-bills are short term debt
instruments issued by the Treasury Department and have a maturity of either 13, 26,
or 52 weeks. Corporations issue Commercial Paper to meet their Working Capital
requirements.
Terminology often differs across countries. T-notes in Australia, for instance,
correspond to T-bills in the U.S.
Interest payments on debt securities are contractually guaranteed. That is, they are
not a function of the profits made by a firm. In other words a firm is obligated to
pay interest on its outstanding debt irrespective of whether or not it has made
profits. Consequently all interest payments have to be made, before any
payments can be made to equity.
Similarly in the event of bankruptcy, the claims of the bondholders have to be settled
first. Consequently if a company defaults on a scheduled interest payment, or
principal repayment, the bond holders can stake a claim on its assets. After
liquidating the assets of the firm the claims of the bondholders will be settled. Only if
something were to remain, would the equity shareholders be entitled to stake a
claim.
Debt instruments can be `Negotiable or `Non-negotiable
Negotiable instruments can be freely traded because they can be endorsed by

one party to another. A Treasury Bond is an obvious example.
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Non negotiable securities cannot be transferred. Examples include bank loans

and bank time deposits.
Govt Bonds & Notes:

A Government/Treasury bond is a bond issued by a national government
denominated in the country's own currency. Bonds issued by national
governments in foreign currencies are normally referred to as sovereign
bonds.
They generally have a maturity of 10 30 years.
Treasury Notes have a maturity of 1 10 years.
Municipal Bonds:
A municipal bond is a bond issued by a city or other local government, or
their agencies. Potential issuers of municipal bonds include cities, counties,
redevelopment agencies, special-purpose districts and any other
governmental entity (or group of governments) below the state level.
State Government Bonds:
A State Government bond is a bond issued by a state government, or their
agencies.
Corporate Bonds:
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It is a bond that a corporation issues to raise money in order to expand its

business. The term is usually applied to longer-term debt instruments,
generally with a maturity date falling at least a year after their issue date.
If the bonds are unsecured (not collateralized) then it is generally called a
Debenture.
Treasury Bills:
A short-term debt obligation backed by the U.S. government with a maturity
of less than one year. T-bills are sold in denominations of $1,000 up to a
maximum purchase of $5 million and commonly have maturities of one month
(four weeks), three months (13 weeks) or six months (26 weeks).
These bills are issued through a competitive bidding process at a discount.
Repurchase Agreement (Repo):
Repo is a form of short-term borrowing for dealers in government securities.
The dealer sells the government securities to investors, usually on an
overnight basis, and buys them back the following day.
Reverse Repurchase Agreement (Reverse Repo):
Purchase of securities with the agreement to sell them at a higher price at a
future date.
Bankers' acceptances
A bankers' acceptance is also called as bill of exchange. It was invented to suit the
needs of a party requiring temporary finance to facilitate the trading of specific
goods. The party needing finance would approach investors for this temporary
finance. The investors or lenders would then lend a certain amount to the borrower
in exchange for a document called bill of exchange, stating that the debt would be
paid back on a certain date in the short-term future. For this arrangement to be
attractive to the lender, the amount paid back by the borrower (called the nominal
amount) would have to be more than the amount advanced by the lender. The
difference between the amount advanced and the amount paid back (the nominal
amount) is known as the discount on the nominal amount. A bank would normally
bring the two parties together.
The redemption of the loan would have to be guaranteed by a bank, called the
acceptance by the bank making the arrangement. Hence it is called "bankers'
acceptance".
The bearer of the document may, at the redemption date approach the bank that will
pay the nominal amount to the holder. The bank will then claim the nominal amount
from the borrower.
A bank acceptance can, in formal terms, can be described as an unconditional order
in writing
Addressed and signed by a drawer (the lender)
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To a bank which signs the document and becomes the acceptor
Promising to pay a certain amount of money at a fixed date in the future
To the bearer or holder (the borrower) of the document (the acceptance).

When
called
When
called
a
a
a
a
draft promises immediate payment to the holder of the draft, it is

sight draft. Buyer does not need to sign the draft.
draft promises a deferred payment to the holder of the draft, it is
time draft. Buyer needs to sign the draft.
Negotiable Certificates of Deposit (NCDs):

A negotiable certificate of deposit is a certificate issued by a bank for a deposit made
at the bank. This deposit attracts a fixed rate of interest, which is normally payable
to the holder of the instrument together with the nominal amount invested, at
redemption date.
NCDs are a bearer document, which means that the name of the owner (holder or
depositor) does not appear on the document. The bearer or holder of the document
will receive the maturity value at maturity date.
Certificate of Deposit (CD):
It is a savings certificate entitling the bearer to receive interest.
A CD bears a maturity date, a specified fixed interest rate and can be issued in
any denomination. CDs are generally issued by commercial banks.
Commercial Paper and other Discount Instruments
Commercial paper refers to short-term unsecured promissory notes normally issued
by corporate companies with a high credit rating. These instruments are also issued
on a discount basis such as BAs. Because they are unsecured, the risk involved will
be higher than that of BAs, and therefore the issuing institution must be financially
strong and sound. Because of the risk attached to these instruments they would
normally be issued and traded at a higher discount than the prevailing BA rate.
Finance can be obtained by making use of various alternative kinds of discount
instruments. Other discount instruments that have been used are secured
promissory notes and asset backed commercial paper. The Central Bank also issue
discount bills from time to time. It is thus clear that finance, using money market
instruments, can be arranged between parties over the counter, as needs be.
Standardised instruments as discussed above are more liquid and tradable.
ASSET
CLASS
INSTRUMENT TYPE
Securities
Debt (Long
Term)
Bonds
>1 year
Other cash
Loans
Exchange traded
OTC derivatives
derivatives
Bond
Options
futures
Interest
rate
swaps
Interest rate caps
futures
and
floors
on bond
Interest
rate
options
Exotic
instruments
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Bills, e.g. TDebt (Short
Deposits
Bills
Term)
Certificates
Commercial
<=1 year
deposit
paper
Equity
Stock
Foreign
Exchange
N/A
N/A
of
Short term interest Forward

rate futures
agreements
rate
Stock
options
Stock
options
Exotic
Equity futures
instruments
Spot
foreign
Currency futures
exchange
Foreign exchange
options
Outright forwards
Foreign exchange
swaps
Currency swaps
Mutual funds
A mutual fund is a professionally managed type of collective investment
scheme that pools money from many investors and invests typically in
investment securities (stocks, bonds, short-term money market instruments,
other mutual funds, other securities, and/or commodities such as precious
metals).
The mutual fund will have a fund manager that trades (buys and sells) the
fund's investments in accordance with the fund's investment objective.
Derivatives
These are essentially contracts which are based on, or the demand for which is
derived from, the demand for an underlying asset. The underlying assets could be
stocks, bonds, physical assets, stock market indices, or foreign currencies.
There are four broad classes of derivative securities
Forward contracts
Futures contracts
Options contracts
Swaps
Required Attributes for an Investor

When an investor invests or trades in a security, he is essentially concerned with the
following issues:
What is the rate of return on the security? (The rate of return from a security
is known as the Yield from the asset)
How risky is the rate of return?
How liquid is the asset?
What is the time pattern of returns?
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Returns or Yields
In the case of equity shares, returns accrue in the form of:
Dividends
And/or capital gains/losses
Dividends are paid out in the form of cash periodically. Capital gains/losses arise
when an asset is sold.
If the subsequent selling price of an asset is greater than the original cost of
acquisition, the profit is termed a capital gain. However, if the subsequent selling
price is less, it will give rise to a capital loss.
In the case of bonds, the investor gets returns by way of periodic interest payments
known as coupon payments. In addition there can be capital gains/losses when the
bond is sold.
Risk
The risk associated with investments in financial assets is that they may firstly not
pay dividends or interest as anticipated. Secondly the level of capital appreciation
may be less than expected, or worse there may be a capital loss. Finally a firm may
go into bankruptcy, in which case a part or all of the investment would be lost.
Liquidity
Liquidity may be defined as follows:
It is the ability of market participants to transact quickly at prices that are close to
the true or fair value of the asset. It refers to the ability of buyers and sellers to
discover each other quickly and without having to induce a transaction by offering a
large premium or discount.
In liquid markets there will always be plenty of potential buyers and sellers available.
So traders will not be required to spend precious time and money in locating
counterparties. If a market is liquid, large trades will not have a significant price
impact. In the absence of liquidity, large purchase orders will send prices shooting
up, while large sale orders will end up depressing prices substantially. Liquid markets
in other words have a lot of depth. Securities which trade in illiquid markets are said
to be thinly traded.
Time Pattern of Cash Flows

Cash flows from bonds, at least from those carrying fixed rates of interest, are fairly
predictable. However, the dividends received from shares can be substantially
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volatile, depending on the financial performance of the company, and its dividend
policy.
Rational Investors
A rational investor would prefer assets which give a high rate of return and are highly
liquid. Everything else remaining the same, he would prefer an asset whose return is
less risky.
However, all investors are not identical. A particular investor may be willing to take
on a greater degree of risk as compared to another risk-averse investor. He would of
course demand adequate compensation by way of higher expected returns.
The requirements in terms of time patterns of cash flows also differ across investors.
Young people are more likely to prefer equities, for they may not require regular
cash flows immediately, and may be content with the possibilities of substantial
capital gains. Retired persons usually prefer to invest in bonds. For them, the key
issue is the availability of predictable periodic cash flows from the asset.
Financial Markets
Capital Market:
A capital market is a market for securities (debt or equity), where business
enterprises (companies) and governments can raise long-term funds.
The capital market includes the stock market (equity securities) and the bond
market (debt).
It can be subdivided into Primary Market and Secondary Market.
Primary versus Secondary Markets
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A primary market is one where the company offers new financial instruments to the
investing public. Thus companies issue shares and bonds in the primary market. The
very first issue of shares by a company is called an Initial Public Offering or IPO.
Once an asset has been bought by an investor from the company, subsequent
transactions in the instrument take place in the secondary market. Primary markets
therefore enable borrowers to raise funds. Secondary markets merely represent the
transfer of ownership of an asset from one investor to another.
Illustration
TCS is issuing shares for the first time to the public at Rs 850 per share. Assume that
Ravi applies for 1000 shares and is allotted 200 shares at a price of Rs 850.This is a
primary market transaction.
Assume that six months later, Ravi sells these shares on the National Stock Exchange
for Rs 1250 per share. This represents a secondary market transaction.
Are Primary Markets Alone Sufficient?

In order to facilitate savings and investment in the economy we need both primary
as well as secondary markets. What would be the consequences if we had only
primary markets?
If we were to subscribe to a bond in such conditions, we would have no option

but to hold it to maturity.
In the case of equity shares the problem would be even more serious.
We and our heirs would have to hold on to the shares forever.
This will not be a satisfactory arrangement! In real life we like assets which can be
easily liquidated or converted into cash. Since liquidity needs can never be perfectly
anticipated, we need developed and active secondary markets, where assets can be
bought and sold. Secondly nobody typically invests in a single asset. That is,
everyone likes to hold a portfolio of assets.
This is because putting all your eggs in one basket is a very risky proposition.
Consequently investors like to spread out or diversify their risk by investing in a
basket of securities. Quite obviously, all the companies will not experience difficulties
at the same time.
However, our risk propensity will not remain constant during our lifetimes. Young
people are more risk taking, while old people are more risk averse. Consequently
investors need the freedom to periodically adjust their portfolios over a period of
time. Once again, secondary markets are critical.
Money Market:
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The money market is a component of the financial markets for assets
involved in short-term borrowing and lending with original maturities of one
year or shorter time frames.
Instruments traded in the money market include Treasury bills, commercial
paper, bankers' acceptances, certificates of deposit, federal funds, and shortlived mortgage- and asset-backed securities.
Money versus Capital Markets
1. Money market instruments have a time to maturity at the time of issue, of
one year or less. Money market instruments by definition have to be debt
instruments.
2. Capital markets are markets for medium to long term instruments. Capital
market securities include both long and medium term debt as well as equities.
3. The functions of the two markets are fundamentally different Money markets
are used to adjust temporary liquidity imbalances. In practice, for any
company, inflows and outflows at any point in time will rarely match. Thus
money markets help firms to borrow short term and also to deploy surplus
funds on a short term basis.
4. Money markets tend to be wholesale markets. That is, these instruments
have high denomination. Consequently small investors usually do not
participate in such markets. Small investors can however participate indirectly
by investing in Money Market Mutual Funds (MMMFs).These funds primarily
invest in money market securities.
5. These securities carry relatively low default risk. The logic is simple. The odds
of a firm getting into financial difficulties in the short run are definitely less
than such an event occurring over a longer term horizon
6. Money markets tend to be very liquid. That is, the trading volumes are very
high.
Capital markets serve a different economic purpose. They channel funds from those
who wish to save to those who seek to make long term productive investments. Thus
capital markets are where companies source funds for their long term investment
needs.
Foreign Exchange
FOREX markets are characterized by the buying and selling of currencies. A currency
is nothing but a financial commodity. Consequently each currency will have a price in
terms of another currency. The price of one countrys currency in terms of that of
another is known as the exchange rate.
Currencies are traded amongst a network of buyers and sellers linked by phone/fax.
Traders do not come face to face on an organized exchange. Major participants are
commercial banks and multinational corporations (MNCs). Physical currency is rarely
exchanged. All transfers are done electronically from one bank account to another.
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Commodity Market:
A physical or virtual marketplace for buying, selling and trading raw or
primary products is called Commodity Market.
For investors' purposes there are currently about 50 major commodity
markets worldwide that facilitate investment trade in nearly 100 primary
commodities.
Commodities are split into two types: hard and soft commodities. Hard
commodities are typically natural resources that must be mined or extracted
(gold, rubber, oil, etc.), whereas soft commodities are agricultural products or
livestock (corn, wheat, coffee, sugar, soybeans, pork, etc.)
Financial Intermediaries /Market Participants

The structure of the financial intermediaries is depicted below:
Why do we need intermediaries?

When an investor seeks to trade, the issue is essentially one of identifying a counter
party. A potential buyer has to find a seller and vice versa. Not only should a counter
party be available, there should be compatibility in terms of price expectations and
quantities sought to be traded.
Price Compatibility
Every trader seeks to trade at a `good price. What is a good price?
Buyers are on the lookout for sellers who are willing to offer securities at a price
which is less than or equal to what they are willing to pay.
Sellers seek buyers willing to offer prices greater than or equal to what they expect.
Quantity Compatibility
The quantity being offered should match the quantity being demanded. Often a large
sell order may require more than one buyer to take the opposite position before
getting fully executed. The same is true for large buy orders.
Intermediaries are important because they:
Reduce transaction costs

Help in achieving Economies of scale
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Helps in overcoming Asymmetry in information

Helps to Overcome Moral hazards
Central Bank:
It is an autonomous or semi-autonomous organization entrusted by a
government to; administer certain key monetary functions, such as to
issue, manage, and preserve value of the country's currency
regulate the amount of money supply
supervise the operations of commercial banks
Serve as a banker's bank and the local lender of last resort.
Commercial Bank
Commercial banks comprise of public sector banks, foreign banks, and private sector
banks and represent the most important financial intermediary in any financial
system. These institutions have a wide geographical spread and deep penetration
and strong deposit mobilizing ability. Bank credit is provided to all sectors of the
economy and the rural sector is accorded priority. They play very important role in
the money market and play a vital role in the call money market.
Investment / Developmental Financial Institutions
The developmental financial institutions provide the long-term financial needs of
corporations. These institutions have been responsive to the growing and varied long
term capital needs of economy. Their wide range of activities may be divided into five
broad categories, (i) direct financing, (ii) indirect financing, (iii) assistance financing,
(iv) promotional work, and (v) miscellaneous activities. Examples of investment
financial intermediaries are: UBS, Credit Suisse, Citi Bank etc.
In banking, a merchant bank is a traditional term for an Investment Bank. It can
also be used to describe the private equity activities of banking.
Investment Bankers
They are people who specialize in helping companies bring issues to the primary
market. They help issuers comply with legal and procedural requirements.
These include preparing a prospectus or offer document. Such a document gives full
details about the issue and the potential risk factors for investors to take into
account. They also provide advice on compliance with the listing requirements of the
stock exchange where the shares are proposed to be listed for trading. Finally, they
usually underwrite the issue.
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Market Intermediaries
We will look at three types of market intermediaries:
Brokers
Dealers
Brokers
Brokers are intermediaries who buy and sell securities on behalf of their clients. Their
job is to arrange trades by helping their clients to locate suitable counter parties.
They receive a processing fee or commission for performing this task. A broker does
not finance the transaction. He merely enables others to execute their trades.
However he has to have a license to carry on the above mentioned function.
There are various types of brokerage firms:

Full Service
Full service brokerage firms offer clients professional research reports and advice on what/when
to buy or sell other than their regular function of trading in securities on behalf of their clients.
They charge higher commissions and sometimes even the account maintenance fees to cover the
cost of their services.
e.g.: Merrill Lynch (now part of Bank of America), Morgan Stanley Smith Barney, and Wells
Fargo Securities. (*Note: Many of these companies offer both full service and discount options
based on your needs and personality.)
Discount Broker
A broker who executes buy and sell orders at commission rates lower than a full service broker,
but typically provides less services such as research and advice. They were originally order takers
and charged commissions as much as 80% lower than their full service counterparts. Today
however some of them do provide research inputs but these are taken from outside agencies like
Bloomberg.
e.g.: E-Trade, TD Ameritrade, and Scot trade
Prime Broker
A broker who acts as settlement agent, provides custody for assets, provides financing for
leverage, and prepares daily account statements for its clients, who are money managers,
hedge funds, market makers, arbitrageurs, specialists and other professional investors.
The Prime Broker also operates many other activities such as:
Clearing and settlement of trades in global markets

Support trade strategies through stock borrowing
Hedge Fund consulting services
Facilitate communication between sales, trading and research.
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EG: UBS, Goldman Sachs, Morgan Stanley
Broker Dealer
Any individual or firm in the business of buying and selling securities for itself and
others. Broker/dealers must register with the SEC. When acting as a broker, a
broker/dealer executes orders on behalf of his/her client. When acting as a dealer, a
broker/dealer executes trades for his/her firm's own account. Securities bought for the
firm's own account may be sold to clients or other firms, or become a part of the firm's
holdings.
Dealers
Dealers maintain an inventory of assets and stand ready to buy and sell at any point
in time. Thus dealers unlike brokers have funds that are tied up in the asset. A
dealer effectively takes over the trading problem of the client.
If a client is seeking to sell, the dealer will buy the asset from him in the hope of
selling it later at a higher price. If a client is seeking to buy, the dealer will sell the
asset in the hope of being able to replenish his inventory at a lower price. Dealers
have to be expert traders. Some dealers may act in the capacity of a dealer as well
as that of a broker. They are called Dual Traders.
Primary Dealers
Who is a primary dealer?
A pre-approved bank, broker/dealer or other financial institution that is able
to make business deals with the Central Bank, such as underwriting new
government debt. These dealers must meet certain liquidity and quality
requirements
These primary dealers purchase the majority of Treasuries at auction and
then redistribute them to their clients, creating the initial market in the
process.
A PD is a bank or securities broker-dealer that directly deals in U.S. government

securities with the Federal Reserve Bank of New York. As of August 2004 there were
22 primary dealers, down from a number of 46 in 1988. The most important reason
is consolidation. That is many firms have merged or refocused their core lines of
business.
A firm wishing to become a primary dealer must notify the Central Bank of the
country in writing. The Central Bank will then consult the applicants principal
regulator to verify that the applicant complies with relevant capital standards.
Applicants must either be commercial banks or broker-dealers registered with the
SEC. They may be foreign owned.
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The Central Bank requires primary dealers to participate meaningfully in both open
market operations as well as Treasury Auctions. The current list of primary dealers is
as follows:
List of Primary Dealers
1.
2.
3.
4.
5.
6.
7.
8.
Citigroup Global Markets

Deutsche Bank Securities
Goldman Sachs
HSBC Securities
Nomura Securities
Barclays Capital
J.P. Morgan Securities
UBS Securities
Underwriting
What is underwriting?
An underwriter undertakes to buy that part of the issue which remains unsubscribed
if the issue is under subscribed. Underwriting helps in two ways:
Firstly it reduces the risk for the issuer.

Secondly it sends a positive signal to potential investors.
This is because, in the case of an underwritten issue, a potential investor knows

that the banker is willing to take whatever portion of the issue is left unsubscribed.
An investment banker may not however like to take on the entire risk. Sometimes
a group of investment bankers may underwrite an issue. This is called Syndicated
Underwriting.
Underwriters:
As an underwriter, a person (or firm) bears the risk of selling the securities to
the public and guarantees the proceeds from a sale, essentially taking
ownership of the securities.
If the underwriter can't sell the securities at the asking price, the underwriter
may have to sell them for less than they paid or retain the securities
themselves.
The Role of Intermediaries in Indirect Markets

1. Banks, mutual funds etc. have access to large pools of money. They also
accept deposits ranging from a few dollars to a few million dollars. They can
therefore easily subscribe to large denomination assets.
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2. Secondly, they can also accept short term deposits and lend long term. This is
because deposits keep getting rolled over, either due to renewals, or due to
new clients.
3. Financial institutions also facilitate risk diversification. Diversification means
dont put all your eggs in one basket. It is costly for an individual investor to
diversify across assets because of transactions costs. In practice, each time a
security is bought or sold, the trader incurs transactions costs. Banks however
indirectly diversify because every deposit is invested across a spectrum of
projects.
4. Banks can also afford to employ professionals who can assess risk related
issues.
5. Finally financial institutions are able to take advantage of `economies of
scale. That is, the fixed costs of their operations tend to get spread over a
vast pool of transactions and assets. This leads to cost efficiency as compared
to an individual borrower/lender.
Insurance Company:
The act of insuring, or assuring, against loss or damage by a contingent
event; a contract whereby, for a stipulated consideration, called premium, one
party undertakes to indemnify or guarantee another against loss by certain
specified risks.
Any organization which provides this service is known as an Insurance
company.
Exchange:
Financial assets are usually traded on exchanges. What is an exchange?
It is a trading system where traders can interact to buy and sell securities. In order
for a trader to trade he has to be a member of the exchange. Non members have to
consequently route their orders through a member. For instance if you want to trade
on the National Stock Exchange, you have to approach a registered broker or a subbroker. He will then feed your order into the system.
Historically trading on exchanges has taken place on trading rings or floors. This is
called the Open-Outcry method of trading. The BSE used to have this system until it
introduced online trading. Many older exchanges, for instance the NYSE, have a
combination of floor based and electronic trading. These days most exchanges are
essentially electronic communications networks. Consequently most traders no
longer interact face to face.
Traditionally exchanges have been owned by the member brokers and dealers. Of
late many exchanges are characterized by corporate ownership. Such exchanges are
said to be Demutualized. For instance the NSE is owned by a number of institutions
such as IDBI, LIC etc.
Examples of Demutualized Exchanges
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1.
2.
3.
4.
5.
6.
The
The
The
The
The
The
NASDAQ
Stockholm Stock Exchange
Toronto Stock Exchange
Deutsche Borse
National Stock Exchange
Chicago Mercantile Exchange
Stock Exchanges
Its a place where securities are bought and sold by the investors with or without the help
of brokers or dealers. Investors can be individuals, institutional investors, funds etc. In
the U.S. about 8,250 stocks are listed on the major exchanges. However, only a
small fraction is actively traded. On the NYSE the 250 most active stocks accounted
for 62% of the reported trading volume and an even larger percentage of the dollar
volume in 2000.
When a corporation desires that its shares be admitted for trading, it has to first
apply to have its shares listed.
All exchanges are governed by certain rules and regulations. Some of them are:
Securities Exchange Commission (SEC) USA.
Financial Conduct Authority (FCA) in London.
Securities and Exchange Board of India (SEBI) in India.
EG: New York Stock Exchange (NYSE) USA
American Stock Exchange (AMEX) USA
National Association of Securities Dealers Automated Quotation system (NASDAQ)
USA
National Stock Exchange (NSE) India
Bombay Stock Exchange (BSE) India
Deutsche Borse Europe
FTSE 100 Europe
International Stock Exchanges
Over the past two decades exchanges have mushroomed across the globe. This has
happened due to the increasing acceptance of the free market economic mechanism
which has manifested itself by the LPG process: Liberalization, Privatization, and
Globalization. Not all emerging market exchanges have been success stories.
Successful exchange development requires the following:
Strong property rights

Strong contract laws and securities regulation laws
Successful privatization programs
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Regulatory authorities with teeth
Major Global Exchanges

1. Deutsche Borse
2. Euronext
3. London
4. Madrid
5. Italy
6. Stockholm
7. Switzerland
8. Australian
9. Hong Kong
10. Korea
11. Osaka
12. Taiwan
13. Tokyo
Traders in the market can be divided into two categories. There are those who trade
on their own account and those that arrange trades for others. Proprietary traders
trade on their own account. Agency traders act on behalf of or as agents of others
who wish to trade. They are also known as brokers, commission traders, or
commission merchants (in futures markets).
Regulatory infrastructure
A regulatory mechanism is needed to regulate the working of the financial system.
Its main function is to control compliance according to the regulations of the Central
Bank, commercial banks, financial institutions, insurance companies, non banking
financial institutions, exchange houses and official credit institutions. It is also
responsible for their supervision. It also inspects and supervises issuers registered in
the Public Stock Registry. It also supervises compliance with the dispositions
applicable to the Pension Savings System and Public Pension System, and especially
administrative institutions for Pension Funds, the Public Employee Pension Institute
and the Social Security's Disability, Old Age and Death Program. The specific aims of
financial regulators are usually:
1. To minimize financial loss of depositors in banks or policy holders of insurance
companies
2. To enforce applicable laws
3. To prosecute cases of market misconduct, such as insider trading
4. To license providers of financial services
5. To protect clients, and investigate complaints
Some of the important agencies, responsible for regulating the money and capital
markets by country are:
1.
2.
3.
4.
Federal bank, USA

U.S. Securities and Exchange Commission (SEC), USA
Investment Dealers Association of Canada (IDA), Canada
Financial Conduct Authority (FCA), UK
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5. Authorit des Marchs Financiers (AMF), France
6. Financial Supervisory Authority, Sweden
7. The Australian Prudential Regulation Authority (APRA), Australia
International Organization of Securities Commissions
The International Organization of Securities Commissions (IOSCO) is an
international organization that brings together the regulators of the worlds securities
and futures markets. It, along with its sister organizations, the Basel Committee on
Banking Supervision and the International Association of Insurance Supervisors,
together make up the Joint Forum of international financial regulators. Currently,
IOSCO members regulate more than 90 percent of the world's securities markets.
IOSCO currently has 177 members.
Investor
Investor is an Individual or a company that regularly purchases and sells securities from stock
exchanges for financial gains. They focus on increasing the market value of their investments or
regular income through the receipt of dividends on shares, or coupons on bonds.
Buying and selling will happen between two parties:
Buyer - who purchase securities from the market
Seller who sells securities in the market.
Counterparty refers to the party to whom we sell or the party from whom we buy
securities
Types of investors:
1. Retail investors: Also called as individual or small investors buy/sell securities for
their personal account and not for any company or organization usually in small
quantities.
2. Institutional investors: Institutional investors are a non-bank person or an
organization that trades securities in large quantities. Example: life Insurance
companies, pension funds etc.
3. High Net-worth individual: A high net-worth individual is a person with large
personal financial holdings. Their financial assets are worth more than $1 million
excluding their primary residence.
4. Private equity investors: Private equity investors invest in securities that are not
traded in stock exchanges. The securities are directly sold to companies as private
offering.
Agent
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An agent is an individual or firm that places securities transactions for clients. Agent acts as an
intermediary capacity for buying and selling securities on behalf of its client. An agent, besides
providing trading services to their clients, may also operate as custodian of theirs client securities
for which the client may be charged a fee.
STO
Securities Trading Organization (STO) is collective term used to describe a trader or
market maker who sells or buys securities for agents, individuals and institutional
investors.
Traders: Traders are professionals or individuals (employed by the STO) who buy and
sell securities in a market place in order to generate profit for the STO.
May decide to trade only some securities and not all of them.
Mat trade or may not trade according to the price at which a prospective
counterparty wishes to trade.
Market maker: Individuals who trade securities over-the-counter are called market
makers. They are responsible for shareholders, clients and brokers with whom they enter
into a contract.
Publicizes the price with which trade of specific securities will be done.
The market maker chooses the securities to be traded.
Custodian
An agent, bank, trust company, or other organization which holds and safeguards an
individual's or firms, securities, mutual funds, or investment company's assets for them.
Functions:
-
Holding of securities and cash in safe custody on behalf of the client.

Movement of securities and/or cash on behalf of the client.
Collection of income arising from the portfolios of the clients.
Notification and dealing with corporate actions.
Global Custodians typically operate as a network of sub custodians that hold securities
and cash, settlement of trades and collection of corporate actions. They provide custody
services for cross-border securities transactions. This is more important for institutional
investors.
Local Custodian is one who runs a specific financial center/geographic location.
EG: JP Morgan Chase, Citibank
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Clearing House
Clearing house is an external organization that helps in clearing of a trade by acting as a

single point of contact for financial institutions. They act a central counterparty between
buyer and seller. They guarantee a safe and secure transaction which reduces the risk of
defaulting from both the parties. They may also provide settlement services. Clearing and
Settlement process calculates the mutual obligation of the participants (buyer and seller)
and makes payments, deliveries or both, in connection with transactions.
EG: NSCC- National Securities Clearing Corporation (US)
LCHClearnet in London.
Depository
In simple words depository can be defined as a bank or company which holds funds or
securities deposited by others, and where exchanges of these securities take place. A
depository holds securities of investors in electronic form. The investors are members of
this depository and they transfer the securities electronically.
EG: DTCC Depository Trust Clearing Corporation
Euroclear and Clearstream in Europe
NSDL and CDSL in India.
INTERACTION BETWEEN MARKET PARTICIPANTS

The initial stages of trading are depicted in the following graphic:
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An investor places an order to an agent to buy securities.

The agent forwards the order to an STO.
STO executes the order by purchasing the stock from a stock
exchange.
STO then forwards the record of the sale to the agent.
The agent records a purchase from the STO and confirms the sale to
the investor. In fact this step is known as confirmation. It is a step
which is mandatory as per ISDA guidelines.
If the investor is an individual investor, instructions are issued to the
clearing house to clear and settle the trade matched between the
investors and the agent.
If the investor is an institutional investor, information is given to its
custodian regarding the purchase of the securities.
The custodian then issues instructions to the clearing house to clear
and settle the trade matched between its client (that is, the
institutional investor) and agent.
Agent issues instructions to clearing house to clear and settle the trade
matched between themselves and the investor.
STO issues instructions to clearing house to clear and settle the trade
matched between themselves and the agent
Clearing house then authorizes the settlement of trade through the
security depository. The custodian, agent and STO must be members of
this security depository.
On the day of exchange the depository transfers the ownership of
securities for cash from the STOs account to agents account.
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At the same time the depository transfers the ownership of securities

for cash from agents account to the custodians account.
$$$$
Derivatives
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 linked - called the
underlying asset.
There are two groups of Derivative contracts:
Over-the-counter derivatives (OTC)

Contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary
Exchange-traded derivative contracts (ETD )
Instruments that are traded via specialized derivatives exchanges or other
exchanges.
These are essentially contracts which are based on, or the demand for which is
derived from, the demand for an underlying asset. The underlying assets could be
stocks, bonds, physical assets, stock market indices, foreign currencies or exotic non
tradeable (weather, temperature).
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There are four broad classes of derivative securities
Forward contracts
Futures contracts
Options contracts
Swaps
Forward Contracts
These are agreements for the future delivery of an asset at the end of a pre-specified
time period, based on a price that is fixed at the outset. Unlike a conventional
transaction, no money changes hands when a forward contract is negotiated. The
goods will be delivered and the money will be paid in return only at the end of a prespecified period.
Example:
Assume that today is 1 November, 2003.
Consider a contract between a farmer Ajay, and a merchant Vijay, according to which
Vijay agrees to buy 100 kg of rice from Ajay on 15 December 2003 at Rs 14 per kg.
This is an illustration of a forward contract.

Notice the following features:
The contract is negotiated individually between Ajay and Vijay. Such contracts
are called OTC (Over-the-Counter) or customized contracts.
No money changes hand on 1 November.
The actual transaction will take place only on 15 December.
However, the terms, including the transaction price are set on 1 November.
Both the parties have an obligation to perform.
o Ajay is obligated to deliver the rice on 15 December.
o Vijay is obligated to accept the rice and pay the money on 15
December.
Futures Contracts
They are similar to forward contracts in the sense that they too are agreements for
the future delivery of an asset at terms decided upon in advance. But forward
contracts are customized or Over-The-Counter Contracts (OTC) which are negotiated
individually between the buyer and the seller, whereas Futures contracts are traded
on organized exchanges like stocks and bonds. These exchanges are called futures
exchanges.
Notice the following features of Future contracts:

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1.
2.
3.
Contracts are standardized.

In equity market, futures can be stock future or index future.
Initial margin money needs to be paid initially
Example:
A Cigarette company requires Tobacco 6 months down the line. The company can go to
exchange and buy a Future contract on tobacco with 6 months maturity.
1. Initial margin needs to be paid to the cigarette company
2. Agrees with exchange for Mark to Market (daily settlement)
3. The daily cash flows between buyer and seller are equal to the change in
the future price.
The Cigarette Company (buyer) will hold long position on tobacco.
Future Margins:
It can be cash or marketable securities deposited with the broker. It takes care of the
adverse price movement in market.
Options Contracts
In Options contract the owner/buyer has the right but not the obligation to exercise a
feature of contract (buy or sell asset) on or before expiry date. For this right buyer pays
premium to the seller. The seller of an option has the duty to buy or sell at the strike price,
if the buyer exercises his right. These are both exchange and OTC traded.
They can be of two types Calls and Puts.
A call option gives the buyer the right to buy an underlying asset on or before
a pre-specified date, at a price decided upon in advance.
A put option gives the buyer the right to sell an underlying asset on or before
a pre-specified date, at a price decided upon in advance.
Notice the difference between an option and a forward/futures contract.
Call options give the holder the right to buy the underlying asset.
Futures/forward contracts impose an obligation to buy the underlying asset,
on the buyer of the contract.
The difference between rights and obligations is that rights need be exercised only if
such action is beneficial. If the holder of a call option decides to exercise his right to
buy, the seller of the option has an obligation to deliver/sell the underlying asset. He
does not have the right to refuse.
The same is true for put options. That is, if a put holder were to exercise his right,
the seller of the put has an obligation to buy the asset. In life rights are never given
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free. So the buyer of both call and put options has to pay a price to acquire the
option from the sellers. This is called the option price or premium.
If the right is subsequently exercised the call/put holder will pay/receive a price per
unit of the underlying asset. This is called the Strike or Exercise Price.
Futures/forward contracts however impose equivalent obligations on both parties.
Consequently neither party has to pay the other to enter into the agreement.
Payments are required only when the underlying asset is delivered.
Example of a Put Option:
Ajay buys a put option from Vijay that gives him the right to sell 100 kg of rice to
Vijay at Rs 14 per kg on 15 December. Vijay will not give this right for free.
Let us assume that Ajay pays Rs 0.25 per kg or Rs 25 in all to acquire this right. This
amount has to be paid at the outset and is called the Option Price or Premium.
Assume that the price of rice on 15 December is Rs 12 per kg. Ajay will most
certainly exercise his option and ask Vijay to pay Rs 1400. This price of Rs 14 per kg
is called the Strike Price or Exercise Price. Vijay cannot refuse since he has an
obligation to perform.
What if the price on 15 December is Rs 16 per kg? Ajay will simply forget the option
and sell the rice in the market for Rs 16 per kg. He is in a position to do so since an
option is a right and not an obligation.
Assume that Vijay acquires the right to buy 100 kg of rice from Ajay on 15 December
at an exercise price of Rs 14 per kg. Let us assume that the premium is Rs .40 per
kg. Consequently Vijay will pay Rs 40 to Ajay at the outset.
Assume that the price of the asset on December 15 is Rs 16 per kg. Vijay will happily
exercise his option and take delivery at the exercise price of Rs 14. Ajay cannot
refuse since he has an obligation.
What if the price of rice on 15 December is Rs 12? Vijay will simply forget the option
and buy from the market at Rs 12.
Swaps
These are contractual arrangements between two parties to exchange specified cash
flows at pre-specified points in time. These are traded Over-The-Counter (OTC).
There are two categories:
Interest-Rate Swaps
Currency Swaps.
Interest Rate Swaps
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A principal amount called the Notional Principal will be specified in such cases. The
principal amount never changes hands and consequently the name Notional Principal.
Each party will calculate interest on this notional amount based on a pre-decided
method.
For instance one party (Buyer) may be obliged to pay interest at a fixed rate of 10%
with an aim to transform the variable rate of its liabilities into fixed rate liabilities to
better match the fixed returns earned on its assets. The other (Seller) may be
required to pay at the going interest rate on Treasury Bonds with an aim to
transform the fixed nature of its liabilities to variable rate liabilities to better match
the variable return on its assets. Both the cash flows will be denominated in the
same currency. Consequently they can be netted and one party will pay the
difference to the other. This is an example of a fixed rate-variable rate swap.
In practice one can also have a variable rate variable rate swap.
Cross Currency Swaps
An agreement between two parties to exchange interest payments and principal on
loans denominated in two different currencies. In a cross currency swap, a loan's
interest payments and principal in one currency would be exchanged for an equally
valued loan and interest payments in a different currency. Consequently it is
exchanged both at inception and at the end of the contract.
The reason companies use cross-currency swaps is to take advantage of comparative

advantages. For example, if a U.S. company is looking to acquire some yen, and a
Japanese company is looking to acquire U.S. dollars, these two companies could perform
a swap. The Japanese company likely has better access to Japanese debt markets and
could get more favorable terms on a yen loan than if the U.S. company went in directly to
the Japanese debt market itself, and vice versa in the U.S. for the Japanese company.
One party will pay a fixed/variable rate in one currency while the other will pay a
fixed/variable rate in the other. At the end the principal amounts will be swapped
back. Since two different currencies are involved, we can have:
Fixed rate Variable rate swaps: In a fixed-for-Variable cross currency

swap, the interest rate on one leg is floating, and the interest rate on the
other leg is fixed. Such swaps are usually used for a minor currency against
USD.
Variable rate Variable rate swaps: In a variable-for-variable cross

currency swap, the interest rates on both legs are floating rates. Such swaps
are also called cross currency basis swap. Variable-for-Variable swaps are
commonly used for major currency pairs, such as EUR/USD and USD/JPY.
Fixed rate Fixed rate swaps: In a fixed-for-fixed cross currency swap,

the interest rate on one leg is fixed.
Use of Derivative products
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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).
Difference between Exchange traded derivatives and Over the counter.

Exchange Traded Derivatives (ETD)
1. Standardized products with smaller
notional Values
2. Reach to various segments of
economy
3. Safety of margins and settlement
guarantee funds
4. Better price discovery mechanism
5. Generally higher transparency than
OTC markets
6. Lower transaction costs
7. Ignoring margins and special
situations like early exercise, the
cash flows in exchange traded
contracts generally arise at the
maturity of contract.
Over The Counter (OTC)

1. Customized products
2. Credit risk differentiation high
rated counterparties get better
pricing
3. Innovation Newer and more
exotic nature of products are easy to
adopt.
4. Longer maturities are easy to
transact
5. OTC contracts can have multiple
cash flows which can be structured
to suit any situation.
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$$$$
Corporate Actions
A corporate action is an event which changes the structure of a companys capital or
when a company wants to distribute its profits.
Corporate actions are events which bring material change to a company and affect
its stakeholders.
A corporate action is an event initiated by a public company that affects the securities
(equity or debt) issued by the company.
The primary reasons for companies to declare corporate actions are:
Return profits to shareholders : When a company wants to distribute profits to
its shareholders they declare Cash dividends, Bonus issue
Influence the share price: Corporate actions such as stock splits or reverse stock
splits increase or decrease the number of outstanding shares to decrease or
increase the stock price respectively.
Corporate Restructuring: Corporations re-structure in order to increase their

profitability. Mergers, Spinoffs are an example of a corporate action where a
company breaks itself up in order to focus on its core competencies.
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Types of events
There are two types of events:
Mandatory
-
Voluntary
-
A corporate event which is compulsory to all share holders
A corporate event on which all shareholders have to make

a decision
Mandatory with Choice Corporate Action

-
This corporate action is a mandatory corporate action

where shareholders are given a chance to choose among
several options.
Mandatory Events
Cash Dividend cash payment by a company to its shareholders
Name change - e.g. Horizon Education & Technology Ltd to Global Voice
Exchange/merger 2 or more companies elect to combine their assets or

liabilities e.g. Poh Lian to Unifiber
Redemption existing security must be surrendered for cash
Bonus issue extra shares distribute by a company to its shareholders
Spin off - separation of a subsidiary /division from its parent company. New
shares & entity.
Stock split/change of par value - division of outstanding shares into larger/smaller

shares. Proportionate equity remains the same.
An n:1 split means that n new shares will be issued to an existing shareholder for
every old share that he is holding. For instance an 11:10 split means that a holder of
10 existing shares will receive 11 shares. This is exactly analogous to a 10% stock
dividend. Thus theoretically, stock splits and stock dividends are mathematically
equivalent.
Differences
Stock dividends entail the capitalization of reserves. Stock splits do not. What
happens in the case of a split is that the par value of an existing share is reduced.
The number of shares will increase proportionately. The product of the par value and
the number of shares outstanding or the Issued Capital will remain unchanged.
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Why Split Shares?
Companies generally go in for a split when the share price becomes too high.
If so the scrip is considered to be out of reach for small and medium
investors. What is high is subjective. But the belief is that most managers
have a feel of the popular price range for the stock. That is, they know the
range in which the stock should trade in order to attract enough investor
attention.
Investors normally prefer to trade in round lots. A round lot is usually defined
as 100 shares. Anything less than a 100 is considered to be an odd lot. At
very high prices, small and medium investors may be unable to afford odd
lots.
Voluntary Events
Rights issue - a right gives the shareholder an opportunity to purchase additional

shares in the company for a specific price & time. Generally short term. Offered
below current market price.
Pre-emptive Rights
The laws governing companies usually require that existing shareholders be given
pre-emptive rights to new shares that are being issued for a monetary consideration,
as and when they are issued. This is to enable them to maintain their proportionate
ownership in the company.
Often, rights issues are made at a price that is lower than the prevailing market price
of the share. When this happens, the rights acquire a value of their own. In such
cases an existing shareholder can either exercise his rights or else sell them to
someone else.
Exchange offer - an offer to exchange a specific security for another security at a

specified rate. The offer is made by the company itself or another company.
Tender offer - an offer to purchase shares at a specific price. The offer can be
made by the company its or by another company.
Buy back offer an offer to repurchase share at a specific price. The offer is made
by the company to its shareholders.
Takeover one company obtains control of another company.
Optional stock dividends gives the shareholder an option to elect Cash/Stock

when a company pays to its shareholders.
Mandatory with Choice Corporate Action
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Cash/Stock dividend option with one of the options as default.
Shareholders may or may not submit their elections.
In case a shareholder does not submit the election, the default option will be
applied.
Dividend Entitlement Dates

Dividend-related Dates
In the context of a dividend payment, there are four dates that are important:
1.
2.
3.
4.
The
The
The
The
Declaration Date
Record Date
Ex-dividend Date
Distribution Date
Declaration Date
It is the date on which the decision to pay a dividend is declared by the directors and
the amount of the dividend is announced.
The Record Date
The dividend announcement will mention the Record Date. Only those shareholders,
whose names appear on the register of shareholders as of the record date, will be
eligible to receive the forthcoming dividend.
The Ex-Dividend Date
This is specified by the exchange on which the stocks are traded. An investor who
purchases the stock on or after the ex-dividend date will not be eligible for the
dividend.
Obviously the ex-dividend date will be such that share transactions prior to that date
will be reflected in the register of shareholders as on the record date, whereas
transactions on or after that date will be reflected on the register only after the
record date. This date will therefore be set a few days before the share transfer book
is scheduled to be closed. This is to enable the registrar to complete all the
administrative formalities.
This date is a function of the settlement cycle followed by the exchange. For instance
the NYSE follows a T+3 cycle. That is, if a trade occurs on day T, then delivery of
shares to the buyer and payment of funds to the seller will take place on day T+3.
Thus a transfer of shares two days before the record date or later will not be
reflected in the books on the record date. Thus on the NYSE the ex-dividend date is
specified as two business days prior to the record date announced by the firm.
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Cum-Dividend and Ex-Dividend
Prior to the ex-dividend date, the shares will be trade cum-dividend. This implies that
the buyer of the share is eligible for the forthcoming dividend. On the ex-dividend
date the shares will begin to trade ex-dividend. Thus buyers of the share on or after
this date will not be eligible for the approaching dividend.
Ex-Dividend Prices
On the ex-dividend date the share price ought to, in theory, decline by the amount of
the dividend. For instance if the cum-dividend price is $50 per share and the
quantum of the dividend is $2 per share, then theoretically the share should trade at
$48 ex-dividend. In practice however, the price decline may not be exactly equal to
the amount of the dividend.
The Distribution Date
This is the date on which the dividends are actually paid or distributed.
Stock Dividends
These are called Bonus Shares in India. It is a dividend that is paid in the form of
shares of stock rather than in the form of cash. This entails the issue of additional
shares without monetary consideration.
What happens is that funds are transferred from the Reserves & Surplus account to
the Share Capital account. This is called the Capitalization of Reserves
From a theoretical standpoint, stock dividends do not create any value for their
shareholders. We will illustrate this using a numerical example.
Ex-Bonus Price Declines

In practice, the ex-bonus price may not fall to its theoretically predicted value. This is
because the market may interpret the bonus issue as a signal of enhanced future
profitability.
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$$$$
Trade Life Cycle

TRADE
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What is a trade?
A Trade is a transaction done between two parties buying/selling a particular securities product.
Example
Investco, a pension fund in Hong Kong, call a CSFB Sales Trader, and ask CSFB to buy 100,000
HSBC shares, at a limit price of $112.00. CSFB execute the order on the Hong Kong Stock
Exchange on Investcos behalf, at an average price of $111.50. The trades are cleared through the
exchange clearing house the same day, and settlement takes place within three days.
CSFB receive a commission for providing the brokerage service, and Invesco increase their
position in HSBC.
Attributes of A Trade.
Attribute
Product / Security
Side / Direction
Quantity / Nominal
Price
Proceeds/ consideration
Booking account
Booking Entity
Commissions
Market Charges
Trade Date
Value date / Settlement date/ Contract date
Trade time
Counterparty
Notes
Stock Code Internally, these are represented
using either Reuters Instrument Codes (RIC) or
International Security Identification
Numbers(ISIN)
Buy, Sell
The number of shares bought or sold
Price of the trade
Dollar value of the trade
Defines the book to which the trade will be
credited
Legal entity which contains many accounts,
typically represents a branch office
The fee charged for providing the trading
service
Charges associated with trading on a particular
Exchange.
Date on which the trade is executed
Date on which the trade is settled
Time at which trade is executed
The other party which bought or sold the
securities.
TRADE LIFE CYCLE

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The Trade Life Cycle involves a series of steps that include both internal and external
management of trades. Every trade has its own life cycle. It tracks the activities
associated with an equity trade, from order initiation through execution to settlement. The
entire Life Cycle of a trade can be broken down into pre-trade and post-trade events.
During its lifecycle a trade generally passes through the three departments in the
brokerage firm:
Front Office
Middle Office
Back Office
The various steps in the Trade Life Cycle are:
Client On-Boarding
Client Onboarding is a one-time set of processes executed when the relationship with the
client is established involving 3 steps as mentioned below.
1. Due Diligence: Cornerstone for Due diligence is Know your customer (KYC),
activities that financial institutions and other regulated companies must perform to
ascertain relevant information from their clients for the purpose of doing business
with them. KYC program has the following four key elements
a. Customer Identifications Program (CIP)
b. Customer acceptance policy
c. Risk management
d. Monitoring, reporting and record-keeping.
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2. Documentation: Depending on the counterparty type and market type, different
legal agreements are required among different parties. There is considerable
progress and standardization and automation of documentation.
3. Account Setup: The provisions in legal agreement are translated into operative
provisions and summarized into account setup. It is for the operation staff to refer
the legal document in an easy-to-read format without reading the legal language
of the agreements.
Below are Front Office activities which happens on T+0.

Pre Trade analytics and Order management
Pre trade is the first step in the Trade Life cycle that serves the function of order
management, order routing and related activities. This step takes place in the Front Office
where the order gets initiated.
There are entities that specialize and operate in the Pre Trade arena to facilitate these
activities known as broker dealer.
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Trade Execution
When you call your broker to buy or sell a stock or hit "enter" when placing an order
through your online brokerage account that's only the beginning of the transaction. Your
broker's firm must then send your order to a market to be filled. This process of filling
your order is known as "trade execution."
Trade execution can happen on a face to face basis, on the trading floor of a stock
exchange via telephone or computerized exchanges. It is the process in which the trade
booked by the broker is placed in the exchange and a successful match is found for it.
Trade capture and allocation
Trade capture is the process of recording of related trade information in the organizations
transactional service processing systems. This function is done on Trade Date (T+0).
While doing it utmost care needs to be taken to ensure that the data entered matches the
used during execution. Traditionally, trade captures occurs twice: first by the front office
in its own systems and later by back office or middle office in its own systems.
Data entered as part of trade capture is used by the operations team mainly for
confirmation creation, other instruction generation and Cash & Depot account
reconciliation. Its also used by other teams for preparation of financial statements P&L
reporting etc.
Trade Allocation is a process of allocating parent trade into multiple child trades is called
allocation. The following is the process of the trade allocation:
1. Investment manager gives allocation instructions to executing broker.
2. Executing broker splits and allocates it and informs investment manager with
copy to custodian
3. Investment managers affirm allocation to executive broker with copy to
custodian.
----------------------------------------------------------------------------------------------------------Below are Middle Office activities which happens on T+0 and T+1.
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Trade Enrichment
Trade Enrichment is performed automatically after each trade execution. In this step, all
necessary details for the clearing or the settlement of cash securities are added. Trade
enrichment involves the selection, calculation and attachment of relevant information to a
trade, necessary to complete a number of essential actions. It is achieved through
incorporating relevant information from the store of information; commonly known as
static data defaulting. The information or data that is added is of two types:
Trade Data This is trade specific data. It keeps changing from trade to trade. In fact the
data entered as part of trade execution is generally trade data.
EG: Buy/sell, counterparty, quantity, price etc.
Static Data Data that does not keep changing from trade to trade i.e. it remains
constant.
EG: client account details, client contact details, global calendars and
holidays
Components that require enrichment are:
Calculation of cash values

Counterparty trade confirmation requirements
Selection of custodian details
Methods of transmission of settlement instruction
Trade Validation
This is probably the most important step in the entire Trade Life Cycle. This is a step
which ensures data accuracy i.e. accuracy of data that has been captured into the system
for the trading purpose. This is the last step before settlement where we can identify an
error if any at all. This step is undertaken by many STOs to reduce the possibility of
sending erroneous information to the outside world by checking the data contained in a
fully enriched trade. Successful settlement of a trade is directly and almost entirely
dependent on the result of Trade Validation. Trade Validation can be automatic or manual.
Some of the basic Trade Validations are as follows:
Trading Book It may be restricted to specific transaction types,

instrument groups or traders.
Trade Date The date should be at least the current date or a future
date for a new trade. Also it should be a business day.
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Trade Time The time should be at least the current time or a future
time.
Value date The Value Date should be a business day in the location of
settlement. It cannot be earlier than Trade Date. In fact it will always
be a function of the settlement cycle of the settlement location in
consideration.
Quantity The quantity may not be less than a particular amount or

there may be restriction on trading in odd lots.
Security The security cannot be a matured bond or an expired

warrant. It shouldnt be scrip which has been delisted.
Price The price must be expressed according to the security group.
Counterparty The counterparty must be distinguishable from any

other counterparty.
SSI The appropriate standard settlement instructions have to be

applied.
Trade Agreement
This step is also referred to as Confirmations. The action that is typically regarded as the
most urgent is the act of gaining agreement of the trade details with the counterparty.
Once a trade deal is finalized the information needs to be sent to the clients regarding the
details of the trade that has just been booked and executed. Confirmation is mandatory as
per ISDA (The International Swaps and Derivatives Association) guidelines. It includes
all the details of the trade like
-
trade date,
quantity,
price,
settlement date and location,
Commission charged etc.
These details are sent to both the counterparties. Why this step assumes extreme
importance is that this step allows the counterparties (investors) to identify any errors in
trade booking or execution. If both counterparties agree on all the economic details of the
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confirmation then it is said to be an affirmed trade and can be taken forward for
settlement. If there is any discrepancy then that needs to be corrected and that may
require editing an existing order or placing a completely new order depending on the
existing rules in the market in which the trade is taking place.
On successful completion of this step all required reports needs to be sent to the
regulatory bodies.
Transaction Reporting
It is an obligation to submit regulatory reports when conducting trading activity to the
respective regulatory body. There are two types:
1. Trade reporting
2. Transaction reporting.
The reports enable the regulatory body to monitor the market to protect investors,
monitor conduct and produce market statistics. Penalty for failure to meet requirements is
subjective and dependent on the nature of the breach, responsiveness to failure, control
framework and historic track record
The regulator has the power to impose trading restrictions, imprison responsible persons,
demand unlimited fines, publicize failure and impose further regulatory scrutiny
-
TRAX is one example of transaction reporting that is relevant to all functions

Some functions will also produce Client reports. E.g. Custody
Internal reporting requirements e.g. SAR
----------------------------------------------------------------------------------------------------------Clearing and Settlement

Clearing
Once a trade is done, Exchange sends the trade information to its clearing corporation for
clearing the trades at the end of the day. Clearing Corporation acts as legal counter party
to all the trades and guarantees settlement for all members. Clearing corporation sends a
message for confirmation to all clearing firm/brokerage house/ custodian involved in
trading for that day. Once the custodian/clearing member agrees to settle a trade they
confirm the same to Clearing Corporation through a confirmatory message.
Clearing Corporation then sends obligations to clearing banks & custodian for settling the
trade. If positive confirmatory message is received for settlement from clearing bank &
custodian its known as clearing is done & settlement will take place successfully.
Funding
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Funding is a commonly used term to describe the financing of investments through the
borrowing of cash on a secured and/or unsecured basis, and the act of minimizing the cost
of borrowing cash, and maximizing the benefit of lending cash. In short, the efficient
management of our cash positions is important to ensure we have cash positions to satisfy
settlement obligations
STO will move cash in/out of our accounts to avoid a shortfall or surplus amount of cash
There are differing deadlines for currencies, but the majority of funding will be done
either the day before Settlement (T+2 / S-1) or on Settlement date (S)
Settlement
Once clearing is done, Clearing Corporation asks Depository to debit securities from
sell-side clients (depository participants) account. Depository does the same.
Clearing corporation sends the similar instructions to Clearing Bank to transfer cash
from buyer, to its account & Clearing Bank does the same. This completes the
settlement process & investors receive the securities & cash. If any of the buyer or
the seller fails to deliver the securities or cash the trade doesnt settle and its known
as a fail trade. In that case the process of fails management is put into operation to
try and determine the cause of the fail trade.
Settlement is the transfer of cash and or securities to complete a trade

on an agreed date which is called as settlement date or value date.
The number of days between Trade Date and Settlement Date is called
as settlement cycle and vary according to the market and
Instrument, many markets trade on a T+3 basis but there is a move to
reduce this.
This is a back office activity.
Settlement Types
We have 2 types of settlement instructions, they are DVP and FOP.
Delivery Versus Payment (DVP)

In this type of settlement securities and cash is exchanged simultaneously
and only one instruction to be issued for settlement.
Free of Payment (FOP)

Securities and cash are settled separately requiring two instructions to be
issued for settlement, to different agents. We need to send one instruction
for stock settlement and send another instruction only when we need to
make payment (i.e. on our buy trades, client delivered securities to us
and when we have to make payment to them).
Normally occurs where currency of the cash consideration is different to
that of the Securitys originating country.
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For example: When we are trading in Russian stock, payment of cash is in
USD currency instead of RUB currency.
Free of Payment is more risky when compared to DVP as on our sell trades we deliver
stock first and later receive cash from the counterparty. There is risk of counterparty
defaulting the payment in the case of FOP.
Client Custodian / Agent Bank
A custodian is a company that effects settlements and holds securities in safe
custody on behalf of another company
Settlement Instruction Data
Each Settlement Instruction includes the Standard Settlement Instructions (SSIs) or
Standard Payment Instructions (SPIs).
UBS hold SSIs and SPIs for us and for our clients
Each SSI will include account details where the securities will be transferred / received
from/to - known as a depot and account details where the cash will be
transferred/received from/to - known as a Nostro
It is very important that our static information about SSIs, SPIs are up to date and
accurate to ensure timely settlement.
Settlement Instructions are sent for each trade to the local agents and should be sent by
authenticated message.
Majority of UBS settlement instructions are transmitted using the global
SWIFT system. The Society for Worldwide Interbank Financial
Telecommunications
Some of the message types which we use to send settlement instructions
are MT540, MT542, MT541, and MT543.
SWIFT messages need to comply with ISO 15022 standards
Messages are also sent and received (mostly by SWIFT) to confirm
settlement has taken place and it is called as settlement confirmation.
After the settlement confirmation hits our systems, cash and asset
positions get updated and postings are done.
Various Types of SSI
Cash Settlement Instructions - Details of the payment or receipt of funds between
organizations.
Securities Settlement Instructions- Instructions for security settlements. Consists of
settlement agent, Custodian a/c, name and BIC
Clearing Instructions - Instructions sent to a clearing house for undertaking the
settlement of indebtedness between members and is used to rationalize securities trading
and bank transfers.
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Netting
Settling mutual obligations at the net value of a contract as opposed to its gross currency
value is called Netting.
It reduces the transfer of funds between subsidiaries to a net amount.
Bilateral Netting is operated by 2 counterparties netting off their respective positions
regarding payables and receivables
Central Counterparty Netting (CCP)
A central clearing organization can also act as counterparty to all its members
Advantages
Credit risk for each counterparty becomes minimal
Therefore firms do not have to maintain credit lines
Collateral is reduced
Custody
This is the last step in the trade life cycle. This is the step after settlement where the
securities will be handed over to the investor account. It will be held with the custodian
until the investor decides to sell off the securities. The functions of a custodian have
already been defined in an earlier section.
The financial assets covered by custodians are:
-
Equities,
Debts such as govt. bonds, corporate bonds
Derivatives
Mutual Funds
Warrants.
Entities that use custodian services are:

-
Institutional Investors
Mutual Funds
Hedge Funds
Pension Funds
Broker Dealer
Insurance Companies
Individual investors
This concludes the discussion on the Trade Life Cycle.
Post Settlement
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Settlement Accounting
Settlement accounting is different from financial accounting. On settlement
date, accounting/ledger entries are posted assuming all settlements are
successful. The entries are posted in a document called Ledgers. Later these
ledger entries are reconciled with actual Nostro and Depot entries posted by
the custodian.
Account & P&L reconciliation
All trade / transaction related postings must be recorded in the financial
records (General Ledger) of the organization
1. Need to ensure that postings reflect what has actually happened e.g.
date and quantity/consideration settled and importance of
Nostro/Depot reconciliations to maintain data integrity for financial
reporting
2. Prepare & produce P&L, Balance Sheet and Cash Flow statements to
meet financial reporting obligations
3. They actively reconcile the P&L versus the general ledger (what
happens in Risk Management Vs the real world).
Settlement fails: A trade is said to be a fail when it is not settled on the
value date or contractual settlement date. Common causes for trade failure
are:
1. Insufficient securities or cash
2. Mismatching or Non matching of settlement instructions.
All settlement fails are logged in exception register and followed up for
corrective actions such as compensation claims, back valuations, etc.
Buy-in Auctions: A buy-in is the practice whereby a lender of securities
enters the open market to buy securities to replace those that have not been
returned by a borrower. Strict market prices govern buy-ins.
Brokerage: Brokerage is paid to the intermediaries at defined intervals for
the trades successfully settled in that interval.
Interest Claims: A request by a seller to the buyer for reimbursement of lost
cash interest, where the seller was able to deliver securities (on or after value
date) but the buyer was unable to pay/settle.
The following is a pictorial representation of the functions of a full service brokerage

firm, the various departments in it, and the respective functions of those departments.
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Life cycle and Persistent Events

Certain process are monitored and managed throughout on a continued and
presidents basis. Such processes are exceptions and escalations, corporate
actions and data management. The first arises only during the life cycle of
the trade while others are persistent even after the trade is settled.
Exceptions and escalations: Exception is a deviation from the established
procedure anytime during the trade life cycle. Such events are logged,
analyzed and rectified. They are also reported to the next level, which is
called escalation. When the exception is failed to be rectified within the
stipulated time, it needs to be escalated immediately to the supervisor.
(Detailed notes on escalation procedure are covered in the escalation training
e-learning module.
Corporate Actions: Corporate actions are actions that affect investors cash
balance or securities holding or both. In parallel to settlement of trade, an
STO should have complete control of processing and management of
corporate actions which means:
Being aware of each corporate action that may affect a position or
outstanding trades.
Understanding the nature of each corporate action
Operating within the necessary deadlines
Knowing the cost or benefit of each corporate action
Ensuring receipt of entitled assets at the appropriate time
Ensuring cost is charged at the appropriate time.
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Failure to adequately control corporate actions may result in entitled assets

due to STO. A detailed note on corporations is discussed in corporate actions
e-learning module.
Data management
What is a data?
Data generally speaking refers to Collection of Organized Information and can be
anything numbers, words or images.
Generally speaking data can be of two types
The Data that does not change over a period of time or static data
The data that changes very frequently or Market Data
Types of Data
We have two types of data:
1. Static Data (Also known as Reference data) is the fundamental
data underlying and defining the customers, securities and
transactions that flow through the world's financial systems.
2. Market Data (also known as Streaming data) generally refers to
the quotes and trade related data that changes on a real time basis.
Usage of Data:
Reference data is used in the processing of transactions, in compliance
measurement, analytics, risk management, and client reporting. Without this
common data trading, clearing and settling securities transactions would not
be possible.
Market data is useful in Analysis, Trading and Dealing, Risk Management,
Back Office and Settlement processes.
Static Data
Static/Reference Data is the fundamental data underlying and defining
the customers, securities and transactions that is used for trade and
acts as a reference entity for all transactions.
Static data is critical to Straight-Through Processing (STP) [STP enables
the entire trade process for capital markets and payment transactions
to be conducted electronically without the need for re-keying or
manual intervention].
Although stable, static data is prone to periodic updates.
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Reference data constitutes:
Instrument Data
Client Related information
Counterparty related information
Standing Settlement Instructions (SSI)
Holiday Master
Corporate Action Data
Fee, Tax and Commission Rates
Examples of static data
Market Data
Market Data generally refers to quotes and trade related data that
changes on a real time basis.
It is associated with equity, fixed income, financial derivatives,
currency, and other investment instruments.
The term traditionally refers to numerical price data, reported from
trading venues such as stock exchanges.
Market data constitutes:
Real time data: (Quotes, Indices, News, Economic Indicators)

Historic data: (Intra-day Prices, End-of-day prices, News Archive,
Economic data Archived)
Interpretative data: (Earnings, Economic Commentary, Internal
and External Research, Flow of funds)
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Examples of Market data:
-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-*-
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Version 1.

Financial System, Financial

This Guide belongs to:

Wipro BPO Talent Transformation Internal and Restricted

Wipro BPO Talent Transformation Internal and Restricted

Capital Market Instruments

Money Market Instruments

Wipro BPO Talent Transformation Internal and Restricted

Wipro BPO Talent Transformation Internal and Restricted

Negotiable instruments can be freely traded because they can be endorsed by

Wipro BPO Talent Transformation Internal and Restricted

Non negotiable securities cannot be transferred. Examples include bank loans

Govt Bonds & Notes:

It is a bond that a corporation issues to raise money in order to expand its

Addressed and signed by a drawer (the lender)

Wipro BPO Talent Transformation Internal and Restricted

To a bank which signs the document and becomes the acceptor

Promising to pay a certain amount of money at a fixed date in the future

To the bearer or holder (the borrower) of the document (the acceptance).

draft promises immediate payment to the holder of the draft, it is

Negotiable Certificates of Deposit (NCDs):

Wipro BPO Talent Transformation Internal and Restricted

Short term interest Forward

Required Attributes for an Investor

Wipro BPO Talent Transformation Internal and Restricted

Time Pattern of Cash Flows

Wipro BPO Talent Transformation Internal and Restricted

Primary versus Secondary Markets

Wipro BPO Talent Transformation Internal and Restricted

Are Primary Markets Alone Sufficient?

If we were to subscribe to a bond in such conditions, we would have no option

Wipro BPO Talent Transformation Internal and Restricted

Wipro BPO Talent Transformation Internal and Restricted

Financial Intermediaries /Market Participants

Why do we need intermediaries?

Reduce transaction costs

Wipro BPO Talent Transformation Internal and Restricted

Helps in overcoming Asymmetry in information

issue, manage, and preserve value of the country's currency

regulate the amount of money supply

supervise the operations of commercial banks

Serve as a banker's bank and the local lender of last resort.

Wipro BPO Talent Transformation Internal and Restricted

There are various types of brokerage firms:

Clearing and settlement of trades in global markets

Wipro BPO Talent Transformation Internal and Restricted

A PD is a bank or securities broker-dealer that directly deals in U.S. government

Wipro BPO Talent Transformation Internal and Restricted

Citigroup Global Markets

Firstly it reduces the risk for the issuer.

This is because, in the case of an underwritten issue, a potential investor knows

The Role of Intermediaries in Indirect Markets

Wipro BPO Talent Transformation Internal and Restricted

Examples of Demutualized Exchanges

Wipro BPO Talent Transformation Internal and Restricted

Strong property rights

Wipro BPO Talent Transformation Internal and Restricted

Regulatory authorities with teeth

Major Global Exchanges

Federal bank, USA

Wipro BPO Talent Transformation Internal and Restricted

Wipro BPO Talent Transformation Internal and Restricted