Money and Capital Markets

Money and Capital Markets

DISCUSSION TOPICS Financial Markets Money Markets Capital Markets Money Market Instruments Capital Market Instruments Fixed Income Equity Financial Risk Management Description Instruments (Options, Futures, Forwards, Swaps, Exotics and other structures) Hedging

Money Market: is a market where money or its equivalent can be traded. Capital Market: is a market where capital can be raised and also those instruments could be traded

FINANCIAL MARKETS MONEY MARKET Short-term, Liquid, Low risk debt securities or called cash equivalents Longer-term, riskier and diverse DEBT MARKET CAPITAL MARKET LONG-TERM LONG-TERM BOND/DEBT OR BOND FIXED MARKET INCOME MARKET EQUITY MARKET DERIVATIVES MARKET FOR FUTURES OPTIONS DERIVATIVES MARKET FOR OPTIONS/OTHERS

DEBT MARKETS SHORT TERM CAPITAL LONG MARKET TERM MONEY MARKET INSTRUMENTS CDs, CPs, Call/Notice Money, T-Bills, Euro Dollars, Repos/Reverse Repos, LIBOR G-SEC LONG-TERM (CENTRAL BOND & STATE) MARKET INTERNATIONAL EQUITY MARKET BONDS/LOANS DERIVATIVES MARKET FOR DEBENTURES OPTIONS CORPORATE BONDS, MBS, ABS

Basic Security Types & Major Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options

MONEY MARKET INSTRUMENTS

Money Market is a market where money or its equivalent can be traded. is a wholesale market of short term debt instrument and is synonym of liquidity.. is part of financial market where instruments with high liquidity and very short term maturities ie one or less than one year are traded. Due to highly liquid nature of securities and their short term maturities, money market is treated as a safe place is a place where short term obligations are met by different market participants. Potential gains/losses: A known future payment/except when the borrower defaults (i.e., does not pay). Price quotations: Usually, the instruments are sold on a discount basis, and only the interest rates are quoted. Therefore, investors must be able to do calculate prices from the quoted rates.

Money Market Instruments Vs Fixed Income Instruments Money market instruments are short-term debt obligations of large corporations and governments. These securities promise to make one future payment. When they are issued, their lives are less than one year. Fixed-income securities are longer-term debt obligations of corporations or governments. These securities promise to make fixed payments according to a pre-set schedule. When they are issued, their lives exceed one year.

Money Market Players Reserve Bank of India SBI DFHI Ltd (Amalgamation of Discount & Finance House in India and SBI in 2004) Acceptance Houses Commercial Banks, Co-operative Banks and Primary Dealers are allowed to borrow and lend. Specified All-India Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders Individuals, firms, companies, corporate bodies, trusts and institutions can purchase the treasury bills, CPs and CDs.

Primary Dealers The system of Primary Dealers (PDs) in the Government Securities Market was introduced by Reserve Bank of India in 1995 to strengthen the market infrastructure of Government Securities DFHI was set up by RBI in March 1988 to activate the Money Market. It got the status of Primary Dealer in February 1996. Over a period of time, RBI divested its stake and DFHI became a subsidiary of State Bank of India (SBI). SBI had also set up a subsidiary in 1996 for doing PD business namely SBI Gilts Limited. Both these companies were merged in 2004 to become the largest Primary Dealer in the country Primary Dealers can also be referred to as Merchant Bankers to Government of India as only they are allowed to underwrite primary issues of government securities other than RBI PDs are allowed the following activities as core activities: 1. Dealing and underwriting in Government securities. 2. Dealing in Interest Rate Derivatives. 3. Providing broking services in Government securities. 4. Dealing and underwriting in Corporate / PSU / FI bonds/ debentures. 5. Lending in Call/ Notice/ Term/ Repo/ CBLO market. 6. Investment in Commercial Papers. 7. Investment in Certificates of Deposit. 8. Investment in debt mutual funds where entire corpus is invested in debt securities.

Money market instruments Money market instruments Treasury Bills Call Money Markey Commercial Papers Certificate of deposit Repos

Call Money Market Refers to the market for short term funds The call money market is an integral part of the Indian Money Market, where the day-to-day surplus funds (mostly of banks) are traded. The loans are of shortterm duration varying from 1 to 14 days. The money that is lent for one day in this market is known as "Call Money", and if it exceeds one day (but less than 15 days) it is referred to as "Notice Money". Banks borrow in this market for the following purpose To fill the gaps or temporary mismatches in funds To meet the CRR & SLR mandatory requirements as stipulated by the Central bank To meet sudden demand for funds arising out of large outflows.

Certificate of Deposit Short term deposit instruments Issued by banks and financial institutions to raise large sum of money Issued at a discount to the face value Denominations of Rs. 1lakh or multiples Maturities between a minimum of 7 days and a maximum up to one year CRR & SLR are to be maintained by banks Rates are usually higher than the term deposit rates, due to the low transactions costs CDs are to be stamped Issued by all scheduled commercial banks except RRBs and selected all India financial institutions, permitted by RBI to raise large sum of money

Commercial Paper Short term, unsecured, negotiable promissory notes with fixed maturity Issued by rated corporates, Primary Dealers (PDs), satellite dealers (SDs), Indian Financial Institutions (FIs) Issued at a discount on face value. In denominations of Rs. 5lakh or multiples. Maturities between a minimum of 7 days and a maximum up to one year CP is issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs).

Eligibility for issue of CP The tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and the borrowal account of the company is classified as a Standard Asset by the financing bank/s. All eligible participants should obtain the credit rating for issuance of Commercial Paper The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies

Treasury Bills Treasury bills, commonly referred to as T-Bills are issued by Government of India against their short term borrowing requirements with maturities ranging between 14 to 364 days. All these are issued at a discount-to-face value and redeemed at par. Who can invest in T-Bill Banks, Primary Dealers, State Governments, Provident Funds, Financial Institutions, Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs & OCBs can invest in T-Bills. At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills issued by State Governments. Amount Treasury bills are available for a minimum amount of Rs.25,000 and in multiples of Rs. 25,000. Types of Bills: on tap bills, ad hoc bills, auctioned T- bills

Collateralized Borrowing and Lending Obligation An obligation by the borrower to return the money borrowed, at a specified future date; An authority to the lender to receive money lent, at a specified future date with an option/privilege to transfer the authority to another person for value received; An underlying charge on securities held in custody (with CCIL) for the amount borrowed/lent. It is a money market instrument as approved by RBI, is a product developed by CCIL. CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from one day to ninety Days (can be made available up to one year as per RBI guidelines). In order to enable the market participants to borrow and lend funds, CCIL provides the Dealing System through: - Indian Financial Network (INFINET), a closed user group to the Members of the Negotiated Dealing System (NDS) who maintain Current account with RBI. - Internet gateway for other entities who do not maintain Current account with RBI.

CBLO Participants Banks, financial institutions, primary dealers, mutual funds and co-operative banks, who are members of NDS, are allowed to participate in CBLO transactions. Non-NDS members like corporates, co-operative banks, NBFCs, Pension/Provident Funds, Trusts etc. are allowed to participate by obtaining Associate Membership to CBLO Segment.

Repos Collateralized borrowing and lending Sold temporarily promise to buy back at a fixed future Date & fixed price In reverse repos securities are purchased in a temporary purchase with a promise to sell it back When one is doing a repo, it is reverse repo for the other party. The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, Central/State Govt securities).

CAPITAL MARKET - FIXED INCOME MARKET (LONG TERM DEBT)

Market Segments and Products in Indian Debt market

Indian Debt Market - Pillars of the Indian Economy The Indian debt market is today one of the largest in Asia and includes securities issued by the Government (Central & State Governments), public sector undertakings, other government bodies, financial institutions, banks and corporates. The Government Securities (G-Secs) market is the oldest and the largest component of the Indian debt market in terms of market capitalization, outstanding securities and trading volumes. The G-Secs market plays a vital role in the Indian economy as it provides the benchmark for determining the level of interest rates in the country through the yields on the government securities which are referred to as the risk-free rate of return in any economy.

Bonds A bond is a tradable instrument that represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity. Advantages of Bonds over Stocks Bonds, while a more conservative investment than stocks, can offer certain investors some very attractive features: Safety Reliable income Potential for capital gains Diversification (especially for an otherwise all-equity portfolio) Tax advantages

Factors affecting yields RB I Bank Rate RB I Bank Rate

CAPITAL MARKET - EQUITY

Capital Market - Equity Common Stock Preferred Stock Warrants IDR GDR ADR ETFs Mutual Fund Units ULIPs (Equity Linked)

FINANCIAL RISK MANAGEMENT

BACKGROUND AND MOTIVATION

WHY SHOULD WE STUDY FINANCIAL RISK MANAGEMENT? To better understand the nature and volatility of financial markets To understand the development of new financial products -- e.g., derivatives and hybrid securities To understand how these products can be used to change a firm s risk profile and protect its financial condition

UNPREDICTABILITY Interest rates Inflation, cash flows (investing / lending), asset and liability values Commodity prices Costs, substitute products Price shocks Oil touching $140 in 2008 FX rates International cash flows, relative competitiveness `

FINANCIAL RISKS -- EXAMPLES Interest rates Savings & Loans (Subprime crisis) Inversion of yield curve eg: current situation in India (short term interest rates higher than long-term rates) Commodity prices eg: Prices shot up after QE1 in US & Europe Foreign exchange Strengthening of US$ relative to pound in 1981

FINANCIAL RISK MANAGEMENT: A BROAD FRAMEWORK FRM can take several (familiar and unfamiliar) forms Asset hedges Liability hedges Asset-liability management Contingent financing Post-loss financing and recapitalization

Risks Associated with Bonds Interest Rate Risk Call and Repayment Risk Yield Curve Risk Re-investment Risk Credit Risk (Default, Credit Spread, Downgrade) Liquidity Risk Exchange-rate risk Volatility Risk Inflation/purchasing power risk Event Risk Sovereign risk

WHY DO CORPORATIONS USE FINANCIAL DERIVATIVES? Transaction hedges FX; debt Currency and interest rate risk Strategic (economic) hedges Protect cash flows or company value from movements in financial prices Reduce funding costs FX; synthetic debt Trading derivatives for profit

WHY DON T CORPORATIONS USE MORE DERIVATIVES? Credit risk No suitable instrument Lack of knowledge Accounting / legal issues Transaction costs Resistance by Board / upper management

VOCABULARY Financial derivative: a financial instrument whose value is a function of another ( underlying ) financial instrument Financial engineering: the creation and use of financial derivatives to aid in the management of risk Risk profile: describes the effect of changes in a financial price on the value of a firm

FORWARDS AND FUTURES

FORWARD CONTRACTS Obligation / agreement to buy/sell in the future Contract price is the exercise price ; no payment until maturity Physical delivery or cash-settled Buyer (holder) is long ; seller (writer) is short OTC -- can be tailored Two-sided risk

FUTURES CONTRACTS Obligation; agree to a future transaction Traded on organized exchanges Standardized Daily settlement (marking to market) Reduces default risk: essentially, a series of one- day contracts Margins (performance bonds) Initial margin Maintenance margin Margin call Exchange clearinghouse

EXCHANGES VS. OTC Exchanges Advantages Clearinghouse Liquidity Standardization Disadvantages Lack of flexibility Regulation Trading costs Public OTC Markets Disadvantages Credit risk Low liquidity Non-standardization Advantages Flexible Less regulation Lower regulatory costs Private

TYPES OF CONTRACTS Agricultural commodities Wheat, corn, soybeans Farmer (supplier) can lock in sales price before harvest (short futures) Consumer (user) can lock in purchase price (long futures) Other commodities Metals, petroleum Financial assets FX, stock market indices, interest rates

EXAMPLE X agrees to buy from Y one barrel of oil, five months from now, for Rs20/- X is in the long position Y is in the short position If the price of oil is Rs25/- five months from now, who pays to whom, and how much? If the price of oil is Rs12/- five months from now, who pays to whom, and how much?

OPTIONS

OPTIONS Option to buy or sell the underlying asset Right, not obligation Call option: right to buy the U/L asset Put option: right to sell the U/L asset Buyer = holder = long position (option to exercise) Seller = writer = short position

PARAMETERS OF OPTIONS Exercise price = strike price = price at which the holder of the option can exercise the option (and thus buy or sell the underlying asset) Expiration date Premium = amount paid for the option American option: can exercise any time up to and including expiration date European option: can exercise only on expiration date

EXAMPLES OF OPTIONS -- THEY RE EVERYWHERE Traded options On stocks, indices, FX, interest rates, futures, swaps, options,... Convertible bonds Call provisions on bonds On projects To expand, abandon, postpone Insurance

EXAMPLE Patel sells Raju a January European call option on one share of Reliance stock Suppose Reliance stock is trading at 32.5 Exercise price = 35 Premium = 3 In January, suppose: S T =30 S T =40 Total payoff [profit/loss] Patel (seller) 0 [3] -5 [-2] Raju: (buyer) 0 [-3] 5 [2]

OPTION VALUES (cont.) Prior to expiration: Call Put In-the-money S t > X S t < X At-the-money S t = X S t = X Out-of-the-money S t < X S t > X Intrinsic value - profit that could be made if the option was immediately exercised Call: stock price - exercise price Put: exercise price - stock price Time value - the difference between the option price and the intrinsic value

OPTION VALUES: PAYOFF CHART Call -- long position Call -- short position Payoff X S T Put -- long position Put -- short position

PUT-CALL PARITY Arbitrage implies a certain relationship between put, call, and underlying asset prices Two portfolios have, at payoff, identical values: One European call option + cash of PV(X) One European put option + one share of stock C + PV(X) = P + S

BLACK-SCHOLES FORMULA V C = S N(d 1 ) - X e -rt N(d 2 ) d 1 = [ln(s/x)+(r+0.5σ 2 )t] /σt 0.5 d 2 = d 1 -σt 0.5

PURPOSES OF DERIVATIVES Speculative Highly risky Highly leveraged Very volatile Hedging Combine with other securities Hedge (minimize) risk from other securities

HEDGING Hedge : Take a position that offsets a risk Risk: Uncertainty regarding the value of the underlying asset By hedging, one changes the risk inherent in owning the underlying asset The return distribution of the underlying asset is not changed

USING OPTIONS TO HEDGE Combine the underlying asset with an option or options Can reduce or eliminate downside risk while retaining upside potential Can protect against falls in held asset values, or against increases in input prices

OPTION STRATEGIES Protective put Own stock (long position) Own put (long position) Covered call Own stock (long position) Sell call (short position) Straddle Spread

PROTECTIVE PUT Investor owns asset Investor also buys (holds) a put on the asset Guarantees investment portfolio proceeds at least equal to the exercise price of the put + =

PROTECTIVE PUT EXAMPLE Suppose you own a share of stock, and you purchase a put option with an exercise price of 22.5 on that stock, for a premium of $ 0.75 S T : 30 25 20 15 Premium: -0.75-0.75-0.75-0.75 Put Payoff: 0 0 2.50 7.50 === === === === Overall: 29.25 24.25 21.75 21.75

COVERED CALL Investor purchases stock Investor also sells (writes) a call option on the stock Option position is covered by owning the underlying stock itself (vs. naked option ) Provides additional (premium) income + =

COVERED CALL EXAMPLE Suppose you own a share of stock, and you write a call option with an exercise price of 35 on that stock, for a premium of $ 2.00 S T : 30 35 40 45 Premium: 2 2 2 2 Call Payoff: 0 0-5 -10 === === === === Overall: 32 37 37 37

STRADDLE (Long) Straddle: buy both a call and a put on a stock Each option has the same exercise price and expiration date Believe stock will be relatively volatile Worst-case: no movement in stock price

SPREAD Combination of options Two or more calls, or Two or more puts Vertical spread: simultaneous sale and purchase of options with different exercise prices Horizontal spread: sale and purchase of options with different expiration dates

INTEREST RATE OPTIONS Cap: a call option on an interest rate Floor: a put option on an interest rate Collar: simultaneously buying a cap and selling a floor These options can be used to hedge ratesensitive debt and assets

INTEREST RATE OPTIONS: TERMINOLOGY Underlying index: interest rate being hedged or speculated upon; e.g., LIBOR, prime rate Strike rate: determines cash flows (similar to exercise price) Settlement frequency: how often the strike rate and underlying index are compared Notional amount: principal to which the interest rate is applied Up-front premium: paid by purchaser to seller for the option

INTEREST RATE CAPS At each settlement date, check whether index rate is greater than strike rate If not, cap purchaser does not receive cash flows If so, purchaser receives from seller: [ (index rate - strike rate) x (days in settlement period / 360) x notional amount ]

INTEREST RATE CAPS: EXAMPLE $20,000,000 two-year quarterly interest rate cap on 3-month LIBOR with a strike rate of 8% Cost: 150 basis points Up-front premium = 0.015 x $20M = $300,000 If 3-month LIBOR = 9%, seller pays (.09-.08) x 90/360 x $20M = $50,000 (for that quarter)

INTEREST RATE FLOORS At each settlement date, check whether index rate is greater than strike rate If so, floor purchaser does not receive cash flows If not, purchaser receives from seller: [ (strike rate - index rate) x (days in settlement period / 360) x notional amount ]

INTEREST RATE COLLARS Purchase a cap to hedge floating-rate liabilities Sell a floor at a lower strike rate Sale of floor helps finance purchase of cap Net result: Interest expense will be limited on both ends -- will float between the cap and floor strike rates Can achieve zero-premium collar

SWAPS

SWAPS Agreement between two parties Counterparties Exchange sets of future cash flows Two major types Interest rate swaps Currency swaps Relatively new FRM tool

SWAPS VS. FUTURES Futures Standardized Exchange-traded Short horizons Swaps Custom tailored between counterparties Little regulation; potential for privacy Term flexibility

INTEREST RATE SWAPS One party pays a fixed interest rate and receives a floating rate The other party pays a floating rate and receives a fixed rate Floating rates involve greater exposure to interest rate risk Notional principal is amount on which the interest payments are determined

INTEREST RATE SWAPS (cont.) Principal is not actually exchanged -- only interest payments Generally, only net interest payments are transacted Avoids unnecessary transactions Helps credit risk At each settlement date, a net payment is made, based on the difference between the two interest rates (applied to the notional principal)

CURRENCY SWAPS One party holds one currency, and desires a different currency Three sets of cash flows: Exchange principal at inception of swap Periodic interest payments Exchange principal at termination of swap Interest rates fixed ==> only change in value is from FX change Generally, only make net payments

LIMITATIONS OF SWAPS Counterparties must find each other Meet specific needs Cost, time; facilitators Lack of liquidity ; difficult to unwrap / trade / change without consent of other party Credit risk of counterparty

DEVELOPMENT OF SWAP MARKET Originally: Unique contracts Had to search for counterparty Investment banks were dominant intermediaries More recently: More standardized and liquid Intermediaries accept contract, then lay off risk More highly capitalized firms -- e.g., commercial banks

Other Exotic Structured Products Exotic structures like the following also have gained importance in the recent times Swaptions (Options on Swaps) Credit Default Swaps (CDS) Options on ETFs (50% of equity volumes in US) Range Accruals/Structured notes/elds

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