JaiShankar's Notes Financal Market-1&2

FINANCIAL MARKETS
Day 1 & 2
WE SPECIALISE IN EXCELLENCE
Financial Markets – A Program for DSL Software
TABLE OF CONTENTS
Financial Markets – Generic Framework..............................................3
Primary Market & Secondary Market...........................................................3
Types of Offering..................................................................................3
Trading – Order Placement.......................................................................4
Conventions ........................................................................................5
Clearing & Settlement............................................................................6
Activities............................................................................................6
Financial Market Systems.........................................................................6
Stock Markets..............................................................................8
Key Market Indices................................................................................8
Clearing & Settlement............................................................................9
Custodial services................................................................................10
Stock Pricing......................................................................................11
Valuation of Stock................................................................................11
The Bond Market.........................................................................13
Participants :......................................................................................13
Interest rate concepts...........................................................................13
Bond Pricing.......................................................................................15
Valuation – Investments.........................................................................17
Instruments........................................................................................17
Asset Backed Securities ( ABS )................................................................19
The Foreign Exchange Market.........................................................22
Types of Exchange rates........................................................................23
Trading Position..................................................................................23
Currency Forward Markets......................................................................25
Participants.......................................................................................27
Activities...........................................................................................27
Financial Derivatives – Building Blocks..............................................28
Interest Rates Arithmetic.......................................................................29
References................................................................................31
© Catalyst Consulting 2 Page

THIS HANDOUT IS STRICTLY FOR THE INTERNAL USE OF DSL SOFTWARE EMPLOYEES ONLY
Financial Markets – Generic Framework
Primary Market & Secondary Market

• Primary market is the market where a financial instrument is first offered to the
public. The interaction is between the issuer and the investor.
• Secondary market is the market where the instrument is subsequently traded (bought
and sold) and the interaction is between one investor (seller) and another investor
(buyer).
Types of Offering
• IPOs - the process by which a private company transforms itself into a public company.
The company offers, for the first time, shares of its equity (ownership) to the investing
public.
• Primary Offering - issue of additional shares by an existing company to the public
• Private Placement – Issue offered to a single or group of private investors and not to
the public at large.
Secondary Markets
The secondary markets are classified into two types
Listed Market –
- Exchanges where an Auction method is used at a physical location.
(e.g.) The New York Stock Exchange (NYSE) .
- Exchanges where trade execution is automated using Order Matching
Systems. All the exchanges are registered with the SEC / SEBI. E.g.
stock markets.
Over-the-Counter Market (OTC, Unlisted) –
» A negotiated market without a physical location where transactions are done
via telecommunications. E.g. Currency markets.
Financial Markets – Auction Method

NYSE (partially) and London are the only major exchanges which still use a trading floor. When
a customer calls their broker to place a trade, to buy say IBM stock, the following sequence of
activities happen:

» The Order room then wires the order to the Commission House Broker (CHB),
an employee of the broker/dealer who trades on the floor of the exchange for that
broker/dealer.
» There are 1500 trading booths and 17 trading posts in NYSE
» The CHB makes his way over to the respective Trading Post.
» At the post, the CHB encounters other folks who want to trade IBM stock.
» The deal is executed.
» Transaction Report is sent to the originating brokerage firms (buying and
selling). This is followed by the Clearing and Settlement cycle at which time
transfer of ownership (shares for dollars or vice versa) is completed.
» Brokerage Firm: credits or debits the customer's account for the number of
shares bought or sold.
» Investor: Receives a trade confirmation from his/her firm. If shares were
purchased, the investor submits payment. If shares were sold, the investor's
account is credited with the proceeds.
Global Markets – Automated Method

In the automated method the process is the same, except for the fact that the broker will
place the order in an order system and the system will do the process of matching the trade
i.e if there is a buy order for 100 shares of IBM , the system will look for a sale order for IBM,
depending on the nature of order placed.
The various types of orders that can be placed are given below.
Trading – Order Placement

ORDER TYPES(Based on price)
• Market order – Market orders are executed at once, “at the market”. A market order
guarantees execution, but does not guarantee a price. The final price is determined by
supply and demand.
• Limit order - A Limit order is executed at a set price or better and will not be
executed if that price is not met.
• Stop order - If the market price hits or passes through the stop price (Trigger), a
market order is Elected. A potential problem with a stop order is that it triggers a
market order, which does not guarantee a purchase or sale price. A stop order must be
triggered (activated or elected) before execution as a market order.
ORDER TYPES(Based on time)

• Day order - The order is valid till end of day and if it is unfilled at days end, it gets
cancelled.
• Open order or Good Till Cancelled(GTC) - The order can remain open for up to six
months. It is the responsibility of the registered representative to cancel at the

customer’s direction. In addition, at the end of April and the end of October, all GTC
orders must be reconfirmed or eliminated.
ORDER TYPES(Based on Volume)

• Fill or Kill(FOK) - The order must be immediately filled in one trade or cancelled
completely.
• All or None(AON) - The entire order must be filled or cancelled completely, but unlike
FOK, AON can remain good till cancelled.
Secondary Markets – OTC Market
Unlike listed securities that trade on an exchange, unlisted securities trade Over the Counter
(OTC). Most securities actually trade OTC, since U.S. government, Municipal and most
corporate securities trade OTC. OTC price information is either published periodically in paper
form, disseminated over telephone lines, or displayed real-time electronically through
NASDAQ, ATS, ECN.
Conventions
Bid/Offer
Bid:the rate at which the quoting party is willing to buy the security
Offer: the rate at which the the quoting party is willing to sell the security
The Golden Rule - “ Buy low at bid, sell high at offer.”

First bid rate, then offer rate.
e.g. : MSFT = USD 10.25/10.30.
Sometimes to save time, market uses abbreviations (only last two digits are quoted). e.g.,
25/30 in the above example or they may say
“Offered at 30 , Bid at 25”
Quantities are also mentioned, if not, the counterparty is liable for any amount
Trading Position
When you buy / sell a security, you are said to hold a Position. Position denotes your size of
holding in that security.
When you buy – you are said to be “going long or overbought”
When you sell – you are said to be “going short or oversold”
If you have no position – you are said to be “square”

Clearing & Settlement

• Clearing is the process of determination of obligations. It can be either ‘gross’
(transaction by transaction) or ‘net’ .
• Settlement is the actual fulfillment of obligations (e.g., transfer of funds one way and
securities the other)
• Role of a Clearing House
It reduces counter party risk. It regulates and controls market and guarantees
settlement – Margins.
Settlement Conventions vary across Markets and across countries.

• e.g. Settlement convention in Indian Stock markets is T+2.
• e.g. Settlement convention in U.S Treasuries is T+1.
• e.g. Settlement convention in Currency markets can be T,T+1,T+2 or even >T+2
depending on the nature of the trade.
• e.g. Settlement convention in U.S T-Bill Futures
» The third business day following the Federal T-bill auction of the third week of
the delivery month
Activities
The activities in a financial market can be classified into
Front Office activity – This is where the pre-trade analysis , the actual execution of the trade
on the trading system and the deal capture for accounting and settlement takes place.
Middle Office – This is where the risk management and the regulatory reporting of the trade
takes place.
Back Office – This is where the actual processing and settlement of the trade takes place.
Financial Market Systems

The demands of the capital market transactions, the need for tracking and managing risks, the
pressure to reduce total transaction costs and the obligation to meet compliance requirements
make it imperative that the functions be automated using advanced computer systems. Some
of the major types of systems in capital market firms are briefly described below.
Information dissemination systems

These are information providers that enable you to take trading and investment decisions.
There are a lot of international agencies in this space, namely Reuters, Telerate, Bloomberg
etc.
Analytics and Simulation systems

These are sophisticated systems that enable you do some pre trade analysis. This could be in
the form of impact on your profit or loss on doing the deal, effect of change in market events
etc.
Trading Systems
The volume of transactions in capital markets demands advanced systems to ensure speed and
reliability. Due to proliferation of Internet technology, trading systems are also now accessible
online allowing even more participants from any part of the world to transact, helping to
increase efficiency and liquidity. The trading systems can be divided into front-end order entry
and back-end order processing systems.
Order entry systems also offer functions such as order tracking, calculation of profit and loss
based on real-time price movements and various tools to calculate and display risk to the value
of investments due to price movement and other factors.
Back-office systems validate orders, route them to the exchange(s), receive messages and
notifications from the exchanges, interface with external agencies such as clearing firm,
generate management, investor and compliance reports, keep track of member account
balances etc.
Deal capture and Processing systems
These are systems that include all processes, post the execution of the deal. This includes
recording the deal, accounting for it, and valuing the deal each day to determine how much
money you have made or lost on it.
Control and Risk Monitoring systems
These are systems that monitor the trades once they are entered. These include checking
whether the trade is permitted, within the limits prescribed by the organisation etc. Good
systems throw up alerts in case any limits are exceeded. Automation can be to the extent of
sending out emails to the respective managers on any limit excesses.
• Portfolio management and Custodial systems

• Accounting systems and Reporting tools
• RTGS systems
• Nostro reconciliation systems

Stock Markets
Stock markets are the most commonly known among all financial markets because of the large
participation of “retail investors”, i.e. common people who invest from their own savings.
Instruments traded are

• Equity / Common stock
» Represents ownership
» unique CUSIP number
» exchange listed or OTC
» broker or ATS /ECN
» Dividends / Capital gains
» Voting rights
» Perpetual
» Entail Credit and Market risk
• Preferred stock
» Represents ownership
» unique CUSIP number
» Guaranteed Dividends in case of profit
» No Voting rights
» Perpetual/Redeemable
» Entail mainly Credit Risk
» priority over common stock in case of liquidation
Key Market Indices
Market Index
US Diversified market Dow Jones Industrial Average(Dow)
US Technology NASDAQ 100
UK (London) Financial Times Stock Exchange Index (FTSE)
Germany (Frankfurt) DAX
France (Paris) CAC
Switzerland (Zurich) SMI
Japan (Tokyo) Nikkei
Hong Kong Hang Seng
Singapore Strait Times Index(STI)
India(Mumbai) Sensex/Nifty

Market Participants
Member firms or Broker-Dealers

One needs membership of a stock exchange to access the exchange trading system. These
members are called by various names such as brokers, dealers, market makers, specialists etc.
based on the type of membership or services offered. Investors who are not members of the
exchanges have to open trading accounts with a member firm. Member firms accept and route
orders on the account, send notifications and take care of settlement of the trade in exchange
for a fee.
Clearing firms
The depository, on receipt of delivery instructions, releases the shares to a firm offering
Clearing and Settlement services, that also receives the money from the buyer and after
verifying the trade details, delivers shares to the demat account of the buyer and money to the
seller (via corresponding broker or member firm). Clearing firm is an organization that works
with the exchanges to handle confirmation, delivery and settlement of transactions.
Depository
Brokers do not hold the shares or money that need to be exchanged when the order is
executed. Most of the securities (shares) are held in electronic (also called “dematerialized”)
form (i.e. as a record similar to bank balance) in the “demat” (short for dematerialized)
accounts at firms providing “depository” services. When a trade is executed, the seller must
“release” the shares held in the demat account by giving “delivery instructions” to the
depository.
Clearing & Settlement
• Trade Matching
The exchange/clearing house at the end of the day will match all purchases and sale
trade slips and report any reconciliation errors.
• Confirmation has to be sent to the brokerage firms (both purchase and sales) who will
then inform their respective clients.
• Netting
Settlement takes place through the process of Netting.
Netting Example
Time Buy/Sell Quantity Stock Price

10.00 Buy 100 IBM $10.00
10.30 Sell 50 IBM $10.50
11.00 Buy 100 MSFT $20.00
11.30 Sell 20 IBM $11.00

12.00 Sell 10 MSFT $20.50

3.30 Sell 30 IBM $9.50
Net position for IBM: +100 – 50-20-30 = 0.

Net position for MSFT: +100 – 10 = 90.
How much does the broker owe the exchange?
Net Cash Position
Buy/Sell Quantity Price Amount

Buy 100 $10.00 ($1,000.00)
Sell 50 $10.50 $525.00
Buy 100 $20.00 ($2,000.00)
Sell 20 $11.00 $220.00
Sell 10 $20.50 $205.00
Sell 30 $9.00 $270.00
Total ($1,780.00)
Custodial services
Custody is the safekeeping and administration of securities and cash on behalf of others.
• Administrative activities
» Trade Processing
» Income Collection
» Corporate Actions
» Cash Management
• Trade processing
» Monitoring the sale and purchase of securities via brokers
» Receiving and delivering securities/funds ( settlement)
» Processing foreign exchange to make/receive payment
» Reporting to customers of movements in accounts
» Safekeeping of shares
• Income collection
» Collection of dividends and interest
• Corporate actions
» Responding to offers / rights
» Processing nominee functions
• Reporting
» Pricing of positions
» Periodic account statements

» Establish master files that produce accurate and updated management and
customer reports
Stock Pricing
The share price is, as noted before, determined by the market forces, i.e. the demand and
supply of shares at each price. The demand and supply vary primarily as the perceived value of
the stock for different investors varies. An investor will consider buying the stock if the market
price is less than his perceived value of the stock, and will consider selling if it is higher. A
large number of factors have a bearing on the perceived value.
Some of them are:

• Performance of the company
• Performance of the industry to which it belongs
• State of the country’s economy where it operates as well as the global economy
• Market sentiment or mood relating to the stock and the market as a whole
Apart from these, many other factors, including performance of other financial markets, affect
the demand and supply.
Some specific measures used in the equity markets to value a stock are
• EPS and P/E Ratio
» Most popular tools for determining valuation.
» For example, if the aluminium industry has a P/E ratio of 10 times, and if
Company Z has an EPS of Rs. 12, then the value of Company Z stock should be
EPS X P/E Ratio, namely Rs. 120 per share.
» Historical P/E
• When the market price is compared with past earnings
» Projected P/E
• When the market price is compared with projected earnings
» A high P/E ratio means
• The market views the stock favourably, or
• The share is over-valued
Valuation of Stock
Exchange guidelines:
• Closing price or the Average of last half hour traded prices
• Profit/Loss = ( CPT-CPT-1 ) * Holding quantity,where CPT is the closing price today and
CPT-1 is the closing price of the previous day.

• Realized and Unrealized P/L – This gives the break up of the amount of profits that
have been actually booked ( in the kitty) and the amount which is purely a case of
valuation based on closing price, and is still to be realized.
Example :
Let us say you buy 100 shares of Reliance at Rs.500.

You sell 40 shares at Rs.550.
Closing price of Reliance is Rs.450.
What is your total profit or loss?
Realised profit:
(550-500)*40 = Rs.2000
Unrealised loss:
(450-500)*60=-Rs.3000
Total profit or loss is –Rs.1000.

The Bond Market
A bond is an instrument that typically carries a specific rate of interest that the issuer agrees
to pay the bond holder, as well as a promise to repay the principal over time / maturity.
The market is primarily OTC.
Participants :
• Government
• Commercial banks
• Corporations
Interest rate concepts

Yield curve: Relationship between interest rate and term to maturity, at a specified time.
Positive yield curve :Interest rate for shorter maturities are lower than the rates for
longer maturities.
Negative yield curve : Interest rate for shorter maturities are higher than the rates for
longer maturities.
Flat yield curve :Same interest rate level across maturities.
Coupon and Yield

Coupon is the interest rate contracted by the issuer in the primary market. This remains the
same irrespective of market conditions.
Yield is the prevalent market interest rate of the same bond for its balance term to maturity.
This will keep changing based on market conditions.
Day Count Conventions

The next concept about interest rates is the day count convention. Simply put, day count
conventions tell us how to count the number of days between two interest dates and convert
the number of days into a year fraction. A year fraction has two parts
1. The numerator that is the number of days between two dates

2. The denominator that is the number of days in a year
The day count conventions that are commonly used are:
Act/360
The number of days between two dates is the Actual number of days. The denominator that
contains the number of days in a year is 360. This is the day count convention used for US
Dollar deposits, and most G7 currency deposits.

Act/365
This convention is similar to the previous one, except that the denominator used is 365 instead
of 360. This is the day count convention used for INR deposits and most emerging market
currency deposits.
30/360
The denominator year count used is 360. The denominator is the number of 30 day months
between two dates.
Act/Act
This convention is used in the US Treasury bond market. The numerator is the actual number
of days between two interest dates. For the denominator, we take the actual number of days
in the current coupon period and multiply it by the number of coupons paid in a year. So, if the
number of days in the current coupon period is 184 and coupons are paid twice a year, the
denominator will be 2x184 = 368.
There are many more day count conventions, however these cover the most commonly used
ones. The 30/360 convention is commonly referred to as the bond convention as it is used for
calculating interest rates in the bond market. The Act/365 convention is known as the money
market convention for the same reason.
Day Count Convention- Examples

Jul 17th – Sep 1st
• Act/Act– 46 days
• 30/360– 44 days
March 1st and Sep 1st

• Actual – 184 days
• 30/360 – 180 days
Floating Interest Rates

Floating interest rates were born because banks could no longer afford to lend or borrow at
fixed rates for long tenors due to interest rate volatility.
Various benchmark rates are available:
• LIBOR (London Inter-bank Offered Rate)
• SIBOR / MIBOR
• Treasury Bill yield
In order to qualify as a benchmark rate, a rate index must satisfy certain criteria
• Fairness
• Accessibility for borrowing and lending transactions
• Liquidity
• Transparency

The most popular international benchmark rate is LIBOR.

LIBOR is determined by a poll of leading international banks. The banks are asked what, in
their view, are the offered rates at which deposits are quoted to prime banks in the London
inter-bank market at 11 am London time. The two highest and two lowest rates are discarded
and an average of the remaining quotes is the fixed as the LIBOR for each tenor.
LIBOR is published every day by Reuters and Telerate.
Bond Pricing
Bond prices change due to various factors affecting demand and supply (Interest rates, time to
maturity, etc.). Price of a bond is the present value of all its future cashflows.
The price of a 5 year, 10% coupon bond, FV 100,interest paid annually, can be calculated given
the current yield to maturity(YTM) of the bond.
If the YTM is 5% , you can present value each of the cashflows ( 10 in year 1 – 4,and 110 in year
5) using the YTM as the discounting factor to get the price. It works out to 121.65.
Work it out!
Similarly , if the price of the bond is known to you , one can compute the YTM. This YTM is the
same as the IRR of the bond.
The above illustration assumes that settlement between the buyer and seller is happening on a
coupon date. But typically an investor will purchase a bond between coupon dates.
To determine the price when Settlement date falls between two coupon dates, we need to
answer the following questions
» How many days are there until the next coupon payment
» How should we determine PV of cash flows for fractional periods
» How much must the buyer compensate the seller
Example:
Suppose that a corporate bond with a coupon rate of 10% maturing March 1, 2006 is purchased
with a settlement date of July 17, 2000. What would be the price of this bond be if it is priced
to yield 6.5%?
Illustration:
The next coupon payment will be made on September 1, 2000. Because the bond is a corporate
bond, based on a 30/360 day count convention, there are 44 days between the settlement date
and the next coupon date.

PV of cash
Period Cash flow PV factor flow
0.12222 $5.00 0.992212404 4.961062
0.62222 $5.00 0.960981 4.804903
1.12222 $5.00 0.930732 4.653659
1.62222 $5.00 0.901435 4.507176
2.12222 $5.00 0.873061 4.365303
2.62222 $5.00 0.845579 4.227897
3.12222 $5.00 0.818963 4.094815
3.62222 $5.00 0.793185 3.965923
4.12222 $5.00 0.768217 3.841087
4.62222 $5.00 0.744036 3.720181
5.12222 $5.00 0.720616 3.603081
5.62222 $105.00 0.697933 73.283008
Total $120.028094
The price of this corporate bond would be $120.02809 per $100 par value. The price calculated
in this way is called the full price or dirty price because it reflects the portion of the coupon
interest that the buyer will receive but that the seller has earned.
The buyer must compensate the seller for the portion of the next coupon interest payment the
seller has earned but will not receive from the issuer because the issuer will send the next
coupon payment to the buyer. This amount is called accrued interest and depends on the
number of days from the last coupon payment to the settlement date. The accrued interest is
computed as follows:
AI = c x Number of days from last coupon payment to settlement date

Number of days in coupon period
Where
AI = Accrued interest ($)
c= Semiannual coupon payment ($)
Illustration: Let’s continue with the above example. Because the number of days between
settlement(July 17, 2000) and the next coupon payment(September 1, 2000) is 44 days and the
number of days in the coupon period is 180, the number of days from the last coupon payment
date(March 1, 2000) to the settlement date is 136(180-44). The accrued interest per $100 of
par value is
AI = $5 * (136/180) = $3.77778
The full or dirty price includes the accrued interest that the seller is entitled to receive. For
example, in the calculation above, the next coupon of $5 is included as part of the cash flow.
The clean price or flat price is the full price of the bond minus the accrued interest.
The price that the buyer pays the seller is the full price. It is important to note that in
calculation of the full price, the next coupon payment is a discounted value, but in calculation
of accrued interest it is an undiscounted value. Because of this market practice, if a bond is

selling at par and the settlement date is not a coupon date, the yield will be slightly less than
the coupon rate. Only when the settlement date and the coupon date coincide is the yield
equal to the coupon rate for a bond selling at par.
In the U.S. market, the convention is to quote a bond’s clean or flat price. The buyer,
however, pays the seller the full price. In some non-U.S. markets, the full price is quoted.
Valuation – Investments
On a daily basis, the Base Yield curve is taken for government securities. The spreads over Base
yield curve for other bonds is based on the risk premium associated with these bonds. The risk
premium is based on the rating or credit risk associated with these bonds.
The yield is converted into a price as in the above method and the profit calculated is as
follows:
(Valuation price – Cost price) * holding quantity.
Instruments
» Treasury bonds, Treasury notes, Treasury bills
» Municipal bonds, Corporate bonds, etc.
The bonds can also be classified based on their characteristics
» Secured and Unsecured
» Callable bonds
» Convertible bonds
Debt – Treasury securities
• Also called U.S.Treasuries

• Issued by the Treasury deptt.
• Dutch Auction Mechanism
• Safe investment – backed by the Govt.
• Default risk minimized but interest rate risk remains
• High min. investment
• Individuals can invest through a mutual fund
• Used to regulate money supply
Types of Treasuries
• Treasury bills - < 1 year
• Quoted on an yield basis
• Treasury notes – 1 - 10 yrs
• Treasury bonds - > 10 yrs
• Quoted in 1/32nd of a point
 e.g. a bid of 121:16 means that the bond is actually bid at 121 16/32

If T-bills of $1000 face value and 180 days maturity are auctioned and fetch a price of
$993.7888, what is the yield?
1.25%
If a bank quoted you a discount of 4.67%, for a $1000 T-bill maturing 23 days from now, what
would be the price that you have to pay?
$ 9971.16
Municipal bonds or Municipals

» issued by state govt.
» tax exempt yield
Corporate Bonds
» issued by companies
Callable bonds
» Issuer retains the right to retire the debt, fully or partially, before the
scheduled maturity date
» Permits the borrower , if market rates fall, to replace the bond issue with a
lower interest cost issue.
» Carry higher yield for the investor
» Put-call provision
» Yield to call ( based on call date)
• Interest rate that will make the PV of the cashflows till the call date
equal to the price of the bond
» Yield to worst
• Compute yield to every coupon date following the first call date and
taking the lowest
Convertibles
» Exchanged for specified amounts of common stock
» Conversion ratio and price defined in the initial contract terms
Medium Term Notes(MTNs)

» Actually range in maturity from 9m to 30 years
» Non-callable, unsecured, flexible in terms of, features, continuous offering in
small amounts etc.
» Issuer posts offering rates over a range of maturities
Eurobonds
» bonds issued and traded outside the jurisdiction of any single country
» need not conform to domestic regulations

Bonds with Sinking Fund provisions

» Requires the issuer to retire a certain part of the outstanding debt each year
» The firm may purchase the bonds in the open market if below par
» Or may make payments to a trustee who will then call a certain number of
bonds chosen by lottery
» The investor would then receive the prearranged price
» U.S treasuries are free of this provision
» Ensures orderly retirement of debt
» Ensures a certain degree of price stability as the issuer is there on the buy side
when prices fall
» Yield tends to be less than for normal bonds
Asset Backed Securities ( ABS )
• Packaging of multiple consumer loans into a portfolio that is turned into a single issue of a
security
• Mortgage backed security(MBS) – securitisation of retail mortgages
 individual mortgage loans are placed into a pool, and securities are issued so that
each security represents a fractional interest in the pool.
• Loans act as collateral for the security
• helps in releasing balance sheet, and the bank can take on more risk.
• principal keeps changing as people make mortgage payments and pay off their loans
• Investment in MBS is in terms of amount and not quantity.
• MBS carry Prepayment risk
• Homeowner has the option to prepay the mortgage in whole or part at any time
• No penalty may be imposed for prepayment
• Partial prepayment helps reduce mortgage life
• An investor is never certain of his cashflows or maturity of the investment
 30 year mortgage loan could turn out to be a 1 year loan
• Key in analyzing a mortgage pool is the projection of prepayments
• MBS can be issued by U.S Govt. agencies
• GNMA – Govt. National Mortgage association
 owned by the govt.
 buy mortgages from banks, packages them into securities.
 credit risk is low
MBS - Classifications
• Pass through securities or Participation Certificates(PC)

» represent direct ownership in a pool of mortgage loans

• e.g. Ten mortgage loans given by a bank of $100,000 each, totalling $ 1 mio.
» 10 loans used as collateral against which a security is issued, with the cashflow
on that security reflecting the cashflow from the loans.
» Suppose 40 units of the security are issued, each unit worth $25,000 each.
» Each unit will be entitled to 2.5% of the cashflow from the loan.
» The security created is called a pass-through.
» Monthly cashflow from the loan is distributed on a pro-rata basis.
• Collateralised Mortgage Obligations (CMOs)

» CMOs are divided into tranches(Class A,B& C),such that investors in earlier
tranches are repaid their principal in full, before the owners of the later
tranches are paid any principal.
» The final tranche is called a Z-bond
• holders receive no cash till all earlier tranches are paid in full, but
interest accumulates and is paid on maturity along with the final
principal repayments
» minimises prepayment risk
• Distributed amongst the three tranches.
» Class A absorbs prepayments first, then Class B and then Class C
» Class A becomes effectively a shorter term security and Class C the longest
maturity.
MBS- Market Dynamics

• maturity of upto 40 years
• repayments typically monthly
• pricing based on assumptions regarding potential repayments based on historical
patterns.
» Standard Prepayment model of the Bond Market association
• quoted in 1/32nd of a point
• As mortgage rates go down , risk of prepayments go up.
Money market instruments

• Commercial paper
» Short term , unsecured , issued in the open market
» 90 days most popular ( < 2 m in U.S )
» Discount instrument
• Certificates of Deposit
» Issued by banks for financing their business activities
» Interest bearing basis
» Typically short term

• Repurchase agreements (Repos)

» Lending transaction where the borrower uses a security as collateral for the
borrowing
» Specifies the sale and subsequent repurchase at a future date
» The difference is the interest cost of the borrowing
» Lower than overnight Fed funds rate as it is secured
» Amount loaned is less than market value of securities to provide cushion to the
lender in case prices decline (margin 1-3%)
• Collateral is Marked to market daily and repo amount adjusted
» instrument of monetary policy

The Foreign Exchange Market
The main feature of this market is that, it is continuous - i.e., open 24 hours a day.
The daily volumes traded is over USD 1.4 Trillion. The major currencies traded are USD, JPY,
EUR, GBP & CHF.
Spot Rates
Foreign Exchange rates express the value of one currency in terms of another currency.
For e.g.,
• 1 USD = 1.2900 CHF.
• 1.6750 USD = 1 GBP.
• 100 yen = 40.00 INR.
• USD 0.6495 = 1 AUD.
Last decimal place in the rate = ‘pip.’
Foreign Exchange Rates - Bid/Offer

Bid: the rate at which the quoting bank is willing to buy the commodity currency, or sell the
terms currency.
Offer: the rate at which the the quoting bank is willing to sell the commodity currency, or buy
the terms currency.
Cross Rates
A cross rate is a foreign exchange rate between two currencies, via a third currency.
For e.g., EUR /INR rate via USD :
Rate scenario :
1 EUR = USD 1.2100
1 USD = USD 43.50
What is the EUR /INR rate ?
ALGEBRAICALLY, it is :
1.2100*43.50
USD 1 = INR 52.6350

PROBLEM 1:
A British importer would like to buy JPY in terms of GBP . At what rate can he buy
from the bank if the following market rates prevail?
GBP 1 = USD 1.8350 - 55

USD 1 = JPY 105.20 - 25
a) Importer sells GBP to bank. (rate : USD 1.8350)
b) Importer sells USD to bank. (rate : JPY 105.20)
Algebraically, GBP 1 = USD 1.8350, USD 1 = JPY 105.20
Therefore, GBP 1 = JPY 193.04
Types of Exchange rates

• SPOT : DELIVERY 2 business days from date of transaction.
• FORWARD : DELIVERY 3 or more business days from date of transaction.
• CASH and TOM deals : DELIVERY the same day or the next business day respectively.
Trading Position
TOTAL PURCHASES - TOTAL SALES
(Regardless of Maturity)
Example :
» BANK 1 buys USD 5 mio against INR AT 45.20
» The bank now has a position of USD 5 mio.
» The bank is overbought USD 5 mio and oversold INR 226 mio (5 mio * 45.20)
» In market jargon, the bank is said to be Long USD 5 mio and Short INR 226 mio.
• BANK 1 sells USD 5 mio against INR at 45.30.

• The bank now has a zero position.
• In market jargon, the bank is said to have a square position.
• The bank has made a profit of INR 500,000 : ( 45.30 - 45.20)* 5 mio.
• BANK 1 sells USD 5 MIO against INR at 45.35.

• The bank now has an Oversold position of USD 5mio or an Overbought INR position of
INR 226.75 mio.
• In market jargon, the bank is said to be Short USD 5 mio and Long INR 226.75 mio
• BANK 1 buys USD 3 mio against INR AT 45.40.

• The bank is now short USD 2 mio only.
• The bank has incurred a loss of INR 1.5 lacs and has an ‘Open position’ of USD 2 mio.

• BANK 1 buys 2 mio against INR at 45.35.

• The bank has now squared its position.
• The loss incurred by the bank is still INR 1.5 lacs as the 2 mio has been purchased at
cost.
Overall bank Position
• Simply, all overbought, NET open positions in various currencies are listed in one line
and their LOCAL currency equivalents are determined at a market closing rate.
Similarly, all oversold, NET open positions in various currencies are listed in another
line and their LOCAL currency equivalents are determined at the same market closing
rate.
• The greater of the local currency equivalents is taken as the Bank’s position and is
reported in the Local currency.
Trading position
EXERCISE:
• Market Closing rates :
» EUR/USD = 1.2200 USD/INR = 45.35
» USD / CHF = 1.2700
• Open Positions:
» EUR 5 MIO Long against USD
» USD 5 MIO Long against INR.
» USD 5 MIO Short against CHF
OVERBOUGHT POSITIONS OVERSOLD POSITIONS

INR equivalent INR equivalent
• EUR 5 MIO 276.63 mio
• USD - 6.1 MIO 276.63 MIO
• CHF 6.35 MIO 226.75 MIO
• POSITION 503.38 MIO 276.63 MIO
• Hence the bank's position is the bigger Local currency equivalent, i.e. INR 503.38 MIO
SHORT
Deal Settlement - Example

• Transaction : On Jan 7th Zed Bank Manila buys USD 1 mio at DM / USD 1.78 value spot
( i.e. , Jan 9th ) from Chem Bank, Singapore.
» Manila : Jan 7th, Zed Bank Manila sends DM payment instructions to Zed Bank
Frankfurt, for value Jan 9th.

» Singapore : Jan 7th, Chem Bank Singapore sends USD payment instructions to
Chem Bank New York, for value Jan 9th.
» Frankfurt : Zed Bank Frankfurt debits Zed Bank Manila DM account, and pays
DM 1.78 mio to West Deutsche Frankfurt for account of Chem Bank Singapore,
for value Jan 9th.
» New York : Chem Bank New York debits Chem Bank Singapore USD account,
and pays USD 1 MM to Zed Bank New York, for account of Zed Bank Manila for
value Jan 9th.
Currency Forward Markets

Forward Contract :
A contractual commitment to buy or sell a specified amount of foreign exchange for a
specified price (forward exchange rate) at a specified future date (maturity of contract).
Premium/ Discount :
Forward exchange rates can be higher or lower than the applicable spot rate. If the forward
exchange rate is lower than the spot rate, the currency is said to be at a forward DISCOUNT.
If the forward exchange rate is higher than the spot rate, the currency is said to be at a
forward PREMIUM.
Market Rates :
3 Month GBP : 4.0 %

3 Month USD : 1.0 %
Spot GBP / USD : 1.7900
Spot rate * Interest rate differential × No. of months forward @

100 12 Months@
@ or actual number of days
1.7900 * 3 X 3 = 0.0134
100 12
SPOT RATE USD 1.7900

SWAP RATE USD 0.0134
Therefore, 3 month forward rate USD 1.7766

Forward rate can also be computed using the following formula,
S ( 1 + Rt)
F= _________
( 1 + R c)
Swaps
A swap is a simultaneous purchase/sale and sale/purchase of two currencies across different
tenors. An outright forward transaction can be divided into a spot + swap transaction as the
interbank market does not quote an outright forward price. The spot legs would cancel out and
you would be left with an outright forward which is what you wanted.
Meaning of Swap Quotations :

Premium
Spot USD / CHF 1.2820 - 30

3 - month Swap Rate 30 - 40
3- Month outright forward 1.2850 - 70
Discount
Spot USD / Yen 111.30 - 111.40

3 - month Swap Rate 150 - 130
3- Month outright forward 109.80 - 110.10
Swap rates/ Forward rates are, therefore, a function of the interest rate differential
between the two currencies involved.
Example
Market rates:
Spot USD/INR = 45.25 / 30
6 months Swap points = 15 / 20
The Bank can buy dollars Spot from the market at 45.30 ( r.h.s).
The bank has to pay swap points when it undertakes a Sell/Buy swap ( USD is at a premium <
lower interest rate>to the INR) in the market. So it has to pay ( i.e 20 points , and not 15 as it
will be the calling party in this case and has to face the market spread, just like the company).
In case of USD/INR , USD is the fixed currency and when the fixed currency is at a premium,
the forward rate is higher than the spot rate ( explained earlier ). Hence we need to add the
swap points.

So the Outright 6 months Forward rate for the customer will be :

45.30 + 20 = INR 45.50
A Company may have a receivable or payable in a currency other than the USD. In that case
one will have to compute the cross rate e.g CHF / INR or GBP/INR. The only point to remember
is, the cross rate is computed at the last step i.e after the respective outright forward rates
are computed against the USD.
Participants
» Authorised Dealers -Banks and FIs
» Corporates
» Brokers
» Central Bank( to stabilize the market in times of volatility)
Activities
As mentioned earlier, all activities in each financial market can be classified into a Front
Office, Middle office and Back office.
Front Office
» Pre-Deal Analysis
» Deal Execution
Middle office
• Limits Monitoring
» Bank / Counterparty Limits
» Gap Limits
» Position Limits – Overnight and Daylight
» Dealer-wise
» Currency wise
• Regulatory Reporting
Back Office
• Deal slip matching
• Deal Confirmation
• Rate Reasonability
• Authorisation
• Payment Messages
• Nostro reconciliation
• Position and Gap reports
• Valuation

Financial Derivatives – Building Blocks
Derivatives are financial instruments that derive their value from the value of some other,
more basic, underlying financial instrument or variable.
Derivatives are used as an effective hedging tool for Corporate Risk management.
Why hedge?
• To Combat Volatility and Risk
• To Allow for Long Term Planning
• To Avail of Opportunities
• To Relieve “Distress Costs”
• To Maximise Shareholder Wealth
Examples of Derivatives
A Equity Warrant - The value of an equity warrant depends on the value of the underlying
equity share
A Contract to purchase a flat one year from today - The value of the contract depends on the
prevailing price of similar flats today
A Car Insurance Policy - The value of the policy depends on value of the car being insured
All Derivatives can be thought of as being a combination of three basic building blocks
• Credit Extension
• Price Fixing Contracts
• Price Insurance Contracts
Credit Extension Products
Credit extension products are forms of extending credit or loans. Various debt securities are
credit extension products such as loans and bonds. Interest paid on debt instruments is known
as Coupon. There are four basic types of credit extension products:
• Zero Coupon
• Level Coupon
• Floating Rate Coupon
• Amortizing
Price Fixing Products

Price Fixing Products fix the price at which exchange of value takes place on a future date.
There are three basic types of price fixing products
• Forward Contracts
• Futures Contracts

• Swaps
Price Fixing Products are two-sided obligations. Both the parties to the product have to
perform. The buyer and seller of the Price Fixing Product are obligated to deliver assets or cash
flows at the predetermined rate.
Price Insurance Products
Price insurance products are one-sided obligations.

A Price Insurance Product gives the owner the right, but not the obligation to exchange value
at a predetermined rate at a future date
Price Insurance Products thus provide price insurance to the owner of the product against
adverse movements in the price of the underlying variable or asset
Example of Price Insurance Products - Options

A Price Insurance Product that protects the purchase price is a Call Option
A Price Insurance Product that protects the selling price is a Put Option
Hybrid Financial Products
Hybrid financial products can be constructed by combining basic financial products. We will
take one simple example
“Convertible Bond”.
A convertible bond is a bond that pays a fixed coupon. In addition, it offers the holder the
option of converting the principal amount into equity shares of the Issuer Company on maturity
Interest Rates Arithmetic
The arithmetic of interest rates is rooted in the time value of money. Very simply, a sum of
money given today is worth more than the same sum of money promised at a future date. This
is because the sum of money can be invested to produce a positive return on the initial
investment over time.
If an amount is invested for T years at a compound interest rate of r then the maturity
value will be
A(1 +r )
T
This is, of course, the maturity value if the interest rate is compounded annually. Compounding
frequency is the frequency with which interest is paid out. If interest is paid out n times in a
year, then each interest amount is r / n. The principal and this interest amount is re-invested
nT times. The maturity value is then

n×T
 r
A1 + 
 n
If the compounding frequency is made more frequent, for the same interest rate r results in a
higher maturity value. In other words, the same nominal interest rate results in a higher
effective interest rate. Let’s look at some examples.
Continuously Compounding…
In general, the more frequent the compounding the higher the effective interest rate and
lower the nominal interest rate. In the limiting case if we make n a very large number close to
infinity then the interest rate is said to be continuously compounded. The maturity value is
  r
nT
 nT
Lt A1 +   = A Lt 

r
1 +  = Ae rT
∞  n  n
  
n→ n→∞

where e is the mathematical constant 2.71828.
Example
What is the continuously compounded interest rate that is equal to an interest rate of 10% per
annum, compounded semi-annually?
Semi-annual compounding implies that n=2. Replacing terms in Equation 5, we have
 0.10 
r = 2 × log e 1 +  = 2 × log e (1.05 ) = 2 × 0.04879 = 0.09758 = 9.758 %
 2 
Determining discount factors from compound interest rates - Bootstrapping
In the U.S, the money market yield curve (upto 1 year tenor) is based on simple interest rates.
The par yields are the zero coupon yields as there are no intermediate cashflows. However, for
tenors beyond one year interest rates are usually quoted as compound interest rates. In
compound interest rates, interest on the principal is paid at periodic intervals (monthly,
quarterly, or semi-annually) prior to maturity. For example if we are given that the 18 month
USD rate is 7.20% per annum, Act/360 basis, semi-annual payments, it means that interest on
the principal will be paid twice a year for 1.5 years at the end of which we will receive the
principal back. As this stream of cashflows is similar to that of a bond purchased at par, the
yield curve is also known as the par yield curve.
If we invest a sum of USD 100 at this rate for 18 months, the cashflows will look like this
Rate Date Cashflow

7.20% 26-Jul-00 -100.0000

26-Jan-03 3.6800
26-Jul-03 3.6200
26-Jan-04 103.6800
If the rate is correct, then the present value of the future cashflows must be equal to the sum
invested today. We can determine the PV of the cashflows on 26-Jan-03 and 26-Jul-03 using
the par yields or the zero coupon yields. If we subtract the PV of these two cashflows from
100.00 the residual amount (93.0750) must be the PV of the final cashflow on 26-Jan-04.
18m Rate Date Cashflow DF PV

7.20% 26-Jul-02 -100.0000
26-Jan-03 3.6800 0.96546 3.5529
26-Jul-03 3.6200 0.93153 3.3721
26-Jan-04 103.6800 ? 93.0750
The discount factor for 26-Jan-04 is then simply the present value (93.0750) divided by its
future value (103.6800).
18m Rate Date Cashflow DF PV

7.20% 26-Jul-02 -100.0000
26-Jan-03 3.6800 0.96546 3.5529
26-Jul-03 3.6200 0.93153 3.3721
26-Jan-04 103.6800 0.89771 93.0750
Once we know the discount factor for up to 18 months based on the money market yield curve
up to 1 year and the rate for 18 months, we can determine the discount factor for 2 years using
the previously calculated discount factors up to 18 months. This method of progressively
calculating discount factors is known as bootstrapping so called because it is similar to the
process of trying to pull yourself up by your own bootstraps.
References
For further reference, you may consult any of the following books :
1. “The Handbook of Fixed Income Securities” by Frank J Fabozzi
2. “International Financial Management” by P.G.Apte
If you have any specific queries, contact us at jai@corporateacademy.com.
***************


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FINANCIAL MARKETS

© Catalyst Consulting 2 Page

Financial Markets – Generic Framework

Primary Market & Secondary Market

Financial Markets – Auction Method

© Catalyst Consulting 3 Page

Global Markets – Automated Method

Trading – Order Placement

ORDER TYPES(Based on time)

© Catalyst Consulting 4 Page

ORDER TYPES(Based on Volume)

Secondary Markets – OTC Market

The Golden Rule - “ Buy low at bid, sell high at offer.”

© Catalyst Consulting 5 Page

Clearing & Settlement

Settlement Conventions vary across Markets and across countries.

Financial Market Systems

Information dissemination systems

© Catalyst Consulting 6 Page

• Portfolio management and Custodial systems

© Catalyst Consulting 7 Page

Instruments traded are

Key Market Indices

© Catalyst Consulting 8 Page

Member firms or Broker-Dealers

Clearing & Settlement

Time Buy/Sell Quantity Stock Price

© Catalyst Consulting 9 Page

12.00 Sell 10 MSFT $20.50

Net position for IBM: +100 – 50-20-30 = 0.

Net Cash Position

Buy/Sell Quantity Price Amount

© Catalyst Consulting 10 Page

Some of them are:

© Catalyst Consulting 11 Page

Let us say you buy 100 shares of Reliance at Rs.500.

© Catalyst Consulting 12 Page

The Bond Market

Interest rate concepts

Coupon and Yield

Day Count Conventions

1. The numerator that is the number of days between two dates

The day count conventions that are commonly used are:

© Catalyst Consulting 13 Page

Day Count Convention- Examples

March 1st and Sep 1st

Floating Interest Rates

© Catalyst Consulting 14 Page

The most popular international benchmark rate is LIBOR.

© Catalyst Consulting 15 Page

AI = c x Number of days from last coupon payment to settlement date

© Catalyst Consulting 16 Page

Debt – Treasury securities

• Also called U.S.Treasuries

© Catalyst Consulting 17 Page

Municipal bonds or Municipals

Medium Term Notes(MTNs)

© Catalyst Consulting 18 Page

Bonds with Sinking Fund provisions

Asset Backed Securities ( ABS )

• Pass through securities or Participation Certificates(PC)

© Catalyst Consulting 19 Page

• Collateralised Mortgage Obligations (CMOs)

JaiShankar's Notes Financal Market-1&2

JaiShankar's Notes Financal Market-1&2