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Lessons

CHAPTER 1
IMPORTANCE OF MONEY AND CAPITAL MARKETS IN THE PHILIPPINE
ECONOMY

The money and capital markets are the mechanism in our society for converting
public savings into investments such as buildings, machinery and equipment, airports and
highways, and inventories of goods and raw materials so the economy can grow, new
jobs can be created and living standards can rise. It is the system of money and capital
markets handling most of the payments made each day for purchases of food, clothing,
shelter and ten thousands of other goods and services.

KEY TERMS
Capital Market – designed to finance long-term investments by businesses, government,
and households.
Money Market – designed for making short-term loans.
The money market refers to the market where borrowers and lenders exchange short-
term funds to solve their liquidity needs. Money market instruments are generally financial
claims that have low default risk, maturities under one year and high marketability.

Treasury Bills – short-term government fund that are a safeguard and a popular
investment medium for financial institutions and corporations of all sizes.
Consumer Loans – availed by households to make purchases ranging from automobiles
to home appliances.
Credit Union – attracts small savings deposits from individuals and families and grants
loans to credit union members.
Pension Fund – protects customers against the risk of out-living their sources of income
in the retirement years.
Investments – refers to the acquisition of capital goods, such as a buildings and
equipment and the purchase of inventories of raw materials and goods to sell.

The importance of money and the capital markets are as follows:

 Facilitating savings and investments

 Making payments
 Supplying credits
 Accumulating wealth
 Supplying liquidity
 Protecting against risk
 Supporting public policy

Negotiable Certificate of Deposits (CDs) – issued by best-known banks and other

depository institutions to raise funds in order to carry out their lending activities.
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Banker’s Acceptance and Commercial Papers – instruments that are raise from large
corporation’s borrowing money.

Capital Market
The Capital Market is a market for financial investments that are direct or
indirect claims to capital. It is wider than the Securities Market and embraces all forms of
lending and borrowing, whether or not evidenced by the creation of a negotiable financial
instrument. The Capital Market comprises the complex of institutions and mechanisms
through which intermediate term funds and long term funds are pooled and made
available to business, government and individuals. The Capital Market also
encompasses the process by which securities already outstanding are transferred.
Residential and Commercial Loans - availed to support building of homes and business
structures (e.g. Factories, Shopping centers).
Consumer Loans - availed to make purchases ranging from automobiles to home
appliances.
FUNCTIONS OF THE CAPITAL MARKET
The major objectives of capital market are:
– To mobilize resources for investments.
– To facilitate buying and selling of securities.
– To facilitate the process of efficient price discovery
– To facilitate settlement of transactions in accordance with the predetermined time
schedules.

FINANCIAL INSTITUTIONS
Classifications of Financial Institutions
 Depository Institutions
o Commercial Banks
o Savings and Loans Associations
o Savings Banks
o Credit Unions
 Contractual Institutions
o Insurance Companies
o Pension Funds
 Investment Institutions
o Investment Companies
o Money Market Funds
o Real Estate Investment Trusts
Major Financial Institutions
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 Commercial Bank - dominates the financial system.

 Savings and Loans Association - deposit type financial intermediary active
in the mortgage market
 Savings Bank – for small savings from individuals and families
 Credit Union – attracts small savings from individual and families and
grants loans to credit union members
Non-deposit Institutions
 Life Insurance Company – protects policy holders against the risk of
premature death and disability
 Insurer – offers policies to reduce risk of loss associated with crime,
weather damages, and personal negligence
 Pension Fund – protects customers against the risk of outliving their
sources of income in the retirement years
Other Financial Institutions
 Financial Company – lends money to business and consumers to meet
short-term working capital and long-term investments needs
 Investment Company (Mutual Funds) – pools funds contributed by
thousands of savers by selling shares and then investing in securities sold
in the open market
 Money Market Fund – a specialized type of investment which accepts
savings accounts from businesses and individuals and places those funds
in high quality money market securities.
Nature of Investments
Investment – refers to the acquisition of capital goods, such as buildings and equipment
and the purchase of inventories of raw materials and goods to sell.
For Business Firms Investment
 capital goods (e.g. buildings and equipment)
 inventories (raw materials and goods offer for sale)
Government Investment
 building monuments, highways etc
 maintaining public facilities
Types of Markets
Factor Market - allocates factors of production (land, labor, capital, managerial
skills) and distributes income (wages, rental payments) to the owners of production
resources.
Product Market – consumes units from factor markets to purchase goods and
services.
Financial Market – channels savings to individuals and institutions needing more
funds from spending than are provided by their current income.
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Underwriting - The purchase of a new issue from the issuing corporation at a fixed
price and the reselling of such issue to the public.
The Investment Banker - Persons who effect underwriting are called investment
bankers.
The Investment Banker as Principal or Agent
Principal - An investment banker acts as principal if he makes a financial
commitment to the issuer. In other words, the investment banker undertakes to
purchase all the securities to be issued by the corporation.
Agent - An investment banker acts as an agent if he merely participates in the
marketing of the new securities but does not purchase such securities outright from the
issuer.
Investment House - Is any enterprise which primarily engages, whether
regularly or on an isolated basis, in the underwriting of securities of another person or
enterprise, including securities of the government or its instrumentalities. I t shall be
organized in the form of stock corporation in accordance with the provisions of the
Corporation Code of the Philippines
Prohibitions
No investment House shall undertake underwriting commitments in an amount
exceeding twenty times than its net worth.
Any or all of the following sanctions may be imposed by the Commission on any
Investment House which fails to comply with the capital requirement or having complied
shall to maintain thereafter such capital requirement, to:
 Cease and desist order
 Prohibition from underwriting
 Prohibition against declaration of cash dividends
 Prohibition from extending new loans or making new investments
 Suspension of the privilege to establish and/ or open approved branches,
agencies or offices; and/ or
 Other sanctions prescribed under existing pertinent laws, rules and regulations.

Securities – shares, participation or interest in a corporation or commercial

enterprise evidenced by a certificate, contract whether written or electronic in
character.

FUNCTIONS OF SECURITIES MARKET

The Securities Market allows people to do more with their savings than they would
otherwise could. It also provides financing that enables people to do more with their
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ideas and talents than would otherwise be possible. The people’s savings are
matched with the best ideas and talents in the economy. Stated formally, the
Securities Market provides a linkage between the savings and the investment across
the entities, time and space. It mobilizes savings and channelizes them through
securities into preferred enterprises. The Securities Market also provides a market
place for purchase and sale of securities and thereby ensures transferability of
securities, which is the basis for the joint stock enterprise system. The existence of
the Securities Market makes it possible to satisfy simultaneously the needs of the
enterprises for capital and the need of investors for liquidity

Private Placement – the sale of securities to less than 20 persons or enterprises.

Public distribution – the sale of securities to at least 20 persons or enterprises.

Type of security Offerings:
Primary – proceeds from the sale of securities go to the issuing corporation. This
type of offering raises fresh capital for the corporation.
The primary market provides the channel for sale of new securities, while the
secondary market deals in securities previously issued. The issuer of securities sells
the securities in the primary market to raise funds for investment and/or to discharge
some obligation. In other words, the market wherein resources are mobilized by
companies through issue of new securities is called the primary market. These
resources are required for new projects as well as for existing projects with a view to
expansion, modernization, diversification and upgradation. The Primary Market (New
Issues) is of great significance to the economy of a country. It is through the primary
market that funds flow for productive purposes from investors to entrepreneurs. The
latter use the funds for creating new products and rendering services to customers in
India and abroad. The strength of the economy of a country is gauged by the activities
of the Stock Exchanges. The primary market creates and offers the merchandise for
the secondary market.
Secondary- proceeds from the sale of securities go to the previous owners.
Therefore no additional funds are infused on the corporation.
The secondary market enables those who hold securities to adjust their holdings in
response to changes in their assessment of risk and return. They also sell securities
for cash to meet their liquidity needs. The price signals, which subsume all information
about the issuer and his business including associated risk generated in the
secondary market, help the primary market in allocation of funds. Secondary market
essentially comprises of stock exchanges which provide platform for purchase and
sale of securities by investors. The trading platform of stock exchanges are accessible
only through brokers and trading of securities is confined only to stock exchanges.
The stock market or secondary market ensures free marketability, negotiability and
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price discharge. For these reasons the stock market is referred to as the nerve center
of the capital market, reflecting the economic trend as well as the hopes, aspirations
and apprehensions of the investors. This secondary market has further two
components, First, the spot market where securities are traded for immediate delivery
and payment, The other is futures market where the securities are traded for future
delivery and payment. Another variant is the options market where securities are
traded for conditional future delivery. Generally, two types of options are traded in the
options market. A put option permits the owner to sell a security to the writer of the
option at a pre-determined price before a certain date, while a call option permits the
buyer to purchase a security from the writer of the option at a particular price before a
certain date.
Initial Public Offering- the first time that the corporation is issuing its securities to
the public. The IPO can be primary offering or secondary or combination of both.
Distribution Process
1. Book Building Process (30%)
2. Local Small Investors (10%)
3. General Public (60%)
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ACTIVITY 1

QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on

your own understanding.

1. Explain the concept of capital and money market?

2. What is the difference between primary and secondary market?
3. Discuss the difference and importance of different types of market?
4. Discuss the role and importance of securities function?
5. What do you understand and realize from the whole topic?
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CHAPTER 2
FINANCIAL ASSETS

We begin with a few basic definitions. An asset is any possession that has Value
in an exchange. Assets can be classified as tangible or intangible. The value of tangible
asset depends on particular physical properties—examples include buildings, land, or
machinery. Tangible assets may be classified further into reproducible assets such as
machinery, or non-reproducible assets such as land, a mine, or a work of art.
Intangible assets, represent legal claims to some future benefit. Their value bears
no relation to the form, physical or otherwise, in which the claims are recorded. Financial
assets, financial instruments, or securities are intangible assets. For these instruments,
the typical future benefit comes in the form of a claim to future cash.

The Value of a Financial Asset

The Role of Financial Assets

Financial assets serve two principal economic functions.
A. Assets transfer funds from those parties who have surplus funds to invest to
those who need funds to invest in tangible assets.
B. As their second function, they transfer funds in such a way as to redistribute
the unavoidable risk associated with the cash flow generated by tangible assets
among those seeking and those providing the funds. However, the claims held
by the final wealth holders generally differ from the liabilities issued by the final
demanders of funds because of the activity of entities operating in financial
markets, called financial intermediaries, who seek to transform the final
liabilities different financial assets preferred by the public. Financial
intermediaries are discussed in the next chapter.

Divisibility and Denomination

Divisibility relates to the minimum size at which a financial asset can be liquidated and
exchanged for money. The smaller the size, the more the financial asset is divisible.
Financial asset such as a deposit at a bank is typically infinitely divisible (down to
the penny), but other financial assets set varying degrees of divisibility depending on their
denomination, Which is the dollar value of the amount that each unit of the asset will pay
at maturity. Thus many bonds come in $1,000 denominations, while some debt
instruments come in $1 million denominations. In general, divisibility is desirable for
investors.
Reversibility
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Reversibility refers to the cost of investing in a financial asset and then getting out of it
and back into cash again. Consequently, reversibility is also referred to as roundtrip
cost—
A financial asset such as a deposit at a bank is obviously highly reversible because
usually the investor incurs no charge for adding to or withdrawing from it. Other
transaction costs may be unavoidable, but these costs are small. For financial assets
traded in organized markets or with "market makers" (discussed in Chapter 7), the most
relevant component of round-trip cost is the so-called bid-ask spread, to which might be
added commissions and the time and cost, if any, of delivering the asset. The bid-ask
spread consists of the difference between the price at which a market maker is willing
To sell a financial asset (i.e., the price it is asking) and the price at which a market
maker is willing to buy the financial asset (i.e., the price it is bidding). For example, if a
market maker is willing to sell some financial asset for $70.50 (the ask price) and buy it
for $70.00 (the bid price), the bid-ask spread is $0.50. The bid-ask spread is also referred
to as the bid-offer spread.
The spread charged by a market maker varies sharply from one financial asset to
another, reflecting primarily the amount of risk the market maker assumes by "making" a
market. This market-making risk can be related to two main forces. One is the variability of
the price as measured, say; by some measure of dispersion of the relative price over time.
The greater the variability, the greater the probability ot the market

Term to Maturity
The term to maturity is the length of the interval until the late when the instrument
is scheduled to make its the owner is entitled to demand liquidation. Often, term to
maturity is simply referred to as maturity, which is the practice that we will follow in this
book.
Instruments for which the creditor can ask for repayment at any time, such as
checking accounts and many savings accounts, are called demand instruments.
Maturity is an important characteristic of financial assets such as debt instruments,
an in the United States can range from one day to 100 years. For example, U.S. Treasury
bills mature in one day. At the other extreme, in 1993, The Walt Disney Company issued
a debt instrument that matures in 100 years, dubbed by Wall Street as "Mickey Mouse"
bonds. Many other instruments, including equities, set no maturity and are thus a form of
perpetual instrument.3
It should be understood that even a financial asset with a stated maturity may termi
nate before its stated maturity. An early termination may occur for several reasons,
including bankruptcy or reorganization, or because of provisions entitling the debtor to
repay in advance, or the investor may have the privilege of asking for early repayment, 4

Liquidity
Liquidity serves an important and widely used function, although no uniformly accepted
definition of liquidity is presently available. A useful way to think of liquidity and illiquidity,
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proposed by Professor James Tobin, is in terms of how much sellers stand to lose if they
wish to sell immediately against engaging in a costly and time consuming search.
Convertibility
An important property of some financial assets is their convertibility into other
financial assets. In some cases, the conversion takes place within one class of financial
assets, as when a bond is converted into another bond. In other situations, the conversion
spans classes. For example, with a corporate convertible bond the bondholder can
change it into equity shares. Some preferred stock may be convertible into common
stock. The timing, costs, and conditions for conversion are clearly spelled out in the legal
descriptions of the convertible security at the time of issuance.
Currency
Most financial assets are denominated in one currency, such as U.S. dollars or
yen or euros and investors must choose them with that feature in mind. Some issuers,
responding to investors' wishes to reduce foreign exchange risk, have issued dual
currency securities. For example, some pay interest in one currency but principal or
redemption value in a second. Further, some bonds carry a currency option that allows
the investor to specify that payments of either interest or principal be made in either one
of two currencies.
Cash Flow and Return Predictability
As explained earlier, the return that an, investor will realize by holding a financial
asset depends on the cash flow expected to be received, which includes dividend
payments on stock and interest payments on debt instruments, as well as the repayment
of principal for a debt instrument and the expected sale price of a stock. Therefore, the
predictability of the expected return depends on the predictability of the cash flow. Return
predictability, a basic property of financial assets, provides the major determinant of their
value. Assuming investors are risk averse, as we will see in later.

The Role of Financial Markets

The two primary economic functions of financial assets were already discussed.
Financial markets provide three additional economic functions.
1. The interactions of buyers and sellers in a financial market determine the price
of the traded asset; or, equivalently, the required return on a financial asset is
determined. The inducement for firms to acquire funds depends on the required
return that investor’s demand, and this feature of financial markets signals how
the funds in the economy should be allocated among financial assets. It is
called the price discovery process.
2. Financial markets provide a mechanism for an investor to sell financial asset.
This feature offers liquidity in financial markets, an attractive characteristic
when circumstances either force or motivate an investor to sell. In the absence
of liquidity, the owner must hold a debt instrument until it matures and an equity
instrument until the company either voluntarily or involuntarily liquidates.
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Although all financial markets provide some form of liquidity, the degree of
liquidity is one of the factors that differentiates various markets.
3. The third economic function of a financial market reduces the search and
information of transaction. Search costs represent explicit costs, such as the
money spent to to sell or purchase a financial asset, and implicit costs, such as
the spent in locating a counterparty. The presence of some form of organized
financial market reduces search costs. Information costs are incurred in
assessing the investment merits of a financial asset, that is, the amount and
the likelihood of the cash flow expected to be generated. In an efficient market,
prices reflect the aggregate information collected by all market participants.

Classification of Financial Markets

Of the many ways to classify financial markets, one way is by the type of financial
claim. The claims traded in a financial market may be either for a fixed dollar amount or
a residual amount. As explained earlier, the former financial assets are referred to as
debt instruments ånd the financial market in which such Instruments are traded is
referred to as the debt latter financial assets are called equity instruments and the
financial market where such instruments are traded is referred to as the equity market.
Alternatively, this market is referred to as the stock market. Preferred stock represents
an equity claim that entitles the investor to receive a fixed dollar amount. Consequently,
preferred stock shares characteristics of instruments classified as part of the debt market
and the equity market. Generally, debt instruments and preferred Stock are classified as
part of the fixed income market. The sector of the stock market that does not include
preferred stock is called the common stock market. Figure 1-2 summarizes these
classifications.
Globalization of Financial Markets
Globalization means the integration of financial markets throughout the world into
an international financial market. Because of the globalization of financial markets,
entities-in any country seeking to raise funds need not be limited to their domestic
financial market. Nor are investors in a country limited to the financial assets issued in
their domestic market.
The factors contributing to the integration of financial markets include (l)
deregulation or liberalization of markets and the activities of market participants in key
financial centers of the technological advances for monitoring world markets, executing
orders, and analyzing financial opportunities; and (3) increased institutionalization of
financial markets. These factors are not mutually exclusive.
Global competition forces governments to deregulate or liberalize various aspects of their
financial markets so that their financial enterprises can compete effectively around the
world. Technological advances increase the integration and efficiency o/ the global
financial market. Advances in telecommunication systems link market participants
throughout the world enabling orders to be executed within seconds.
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Classification of Global Financial Markets

Although no uniform system provides a classification of global financial markets, Figure

1-4 offers a schematic presentation of an appropriate classification system. From the
perspective of a given country, financial markets can be classified as either internal or
external. The internal market, also called the national market, can be decomposed into
two parts: the domestic market and the foreign market. The domestic market is where
issuers domiciled in the country issue securities and where those securities are
subsequently traded.
In the foreign market) of a country, securities of issuers not domiciled in the country are
sold and traded. The regulatory authorities where the security is issued impose the rules
governing the issuance of foreign securities.

The external market, also called the international market, includes securities with the
following distinguishing features: at issuance they are offered simultaneously to investors
in a number of countries; and they are issued outside the jurisdiction of any single country.
The external market is commonly referred to as the offshore market, or more popularly,
the Euromarket (even though this market is not limited to Europe, it began there
DERIVATIVE MARKETS
Some contracts give the contract holder either the obligation or the choice to buy
or sell a financial asset. Such contracts derive their value from the price of the underlying
financial asset. Consequently, these contracts are called derivative instruments. The
array of derivative instruments includes options contracts, futures contracts, forward
contracts, •swap agreements, and cap and floor agreements. Each of these derivative
instruments and the role they play in financial markets will be discussed throughout this
book.
The existence of derivative instruments is the key reason why investors can more
effectively implement investment decisions-to achieve their financial goals and issuers
can more effectively raise funds on more satisfactory terms. Several of the financial
innovations and strategies discussed throughout this book rely on the market for
derivative instruments.
As with any financial asset, derivative instruments can be used for speculative purposes
as well as for accomplishing a specific financial or investment objective. Unfortunately,
several financial fiascoes involved the use of derivative instruments. As a result, some
regulators and lawmakers fear derivative instruments, viewing them as the "product of
the devil."
SUMMARY
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In this chapter we explained the characteristics of financial assets and the markets
where they are traded. A financial asset (financial instrument or security) entitles the
owner to future cash flows to be paid by the issuer. The claim can be either an equity or
debt claim.
The value of any financial asset equals the present value of the & expected cash
flow. The cash flow is the cash payments (dividends, interest, repayment of borrowed
funds for a debt instrument, and the expected sale price of an equity instrument). For
most financial assets, the cash flow is not known with certainty. The first step to value a
financial asset is to estimate the cash flow. Historically in the United States, the minimum
interest rate coincided with the rate on U.S. Treasury securities. The reduction in U.S.
Treasury debt issuance, however, prompted a search for a new benchmark that best
represents the minimum interest rate. To that rate a premium must be added to reflect
the risks associated with realizing the cash flow.
Financial assets possess certain properties that determine or influence their
attractiveness to different classes of investors. The ten properties of financial—include
money, divisibility and denomination, reversibility, term to maturity, Liquidity,
convertibility, currency, cash flow and return predictability, complexity, and tax status.
Two principal economic function
(1) Transferring funds from those w o a e surplus funds to invest to those who e
funds to invest in tangible assets, and
(2) Transferring funds in such a way that redistributes the unavoidable risk
associated with the cash flow generated by tangible assets among those seeking and
those providing the funds.
Financial marks provide the following the additional functions beyond that of
financial assets themselves:
(1) They provide a mechanism for determining the price (or, equivalently, the
required return) of financial assets;
(2) They make assets more liquid; and
(3) They reduce the costs of exchanging assets. The costs associated with market
transactions are search costs and information costs.
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ACTIVITY 2
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. What is the difference between a financial asset and a tangible asset?
2. What is the basic principle in determining the value of a financial asset?
3. Why is it difficult to determine the cash flow of a financial asset?
4. What factors affect the interest rate used to discount the cash flow expected from
a financial asset?
5. Explain why liquidity may depend not only on the type of financial asset but also
on the quantity one wishes to sell or buy.
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CHAPTER 3
Primary and Secondary Markets

Pre-emptive Rights Offering

A corporation can issue new common stock directly to existing shareholders via pre-
emptive rights offering. A pre-emptive right grants existing shareholders the right to buy
some proportion of the new shares issued at a price below market value. "Ihe price at
which new shares can be purchased is called the subscription price. A rights offering
insures that current shareholders may maintain their proportionate equity interest in the
corporation. In the United States, the practice of issuing common stock via a pre-emptive
rights offering is uncommon. In other countries it is much more common; in some
countries, it is the only means by which a new offering of common stock may be sold.

World Capital Markets Integration and Fund-Raising Implications

An entity may seek funds outside its local capital market with the expectation of doing so
at a lower cost than if its funds are raised in its local capital market. Whether lower costs
are possible depends on the degree of integration of capital markets. At the two extremes,
the world capital markets can be classified as either completely segmented or completely
integrated.

At the other extreme, a completely integrated market contains no restriction to prevent

investors from investing in securities issued in any capital market throughout the world.
In such an ideal world capital market, the required return on securities of comparable risk
will be the same in all capital markets after adjusting for taxes and foreign exchange rates.
This situation implies that the cost of funds will be the same regardless of where in the
capital markets throughout the world a fund-seeking entity elects to raise funds.

Real-world capital markets are neither completely segmented nor completely integrated,
but fall somewhere in between. A mildly segmented market or mildly integrated market
implies that world capital markets offer opportunities to raise funds at a lower cost outside
the local capital market.

Motivation for Raising Funds Outside of the Domestic Market

A corporation may seek to raise funds outside of its domestic market for four reasons.
First, in some countries, large corporations seeking to raise a substantial amount of funds
may have no other choice but to obtain financing in either the foreign market sector of
another country-or-the Euromarkets because the fund-raising corporation's domestic
market is not fully developed enough to be able to satisfy its demand for funds on globally
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competitive terms. Governments of developing countries use these markets in seeking

funds for government-owned corporations in the process of privatizing.
The second reason is the opportunities for obtaining a reduced cost of funding (taking
into consideration issuing costs) compared to that available in the domestic market. As
explained in Chapter 17, in the case of debt the cost will reflect two factors: (1) the risk
free rate, which is accepted as the interest rate on a U.S. Treasury security with the same
maturity or some other low-risk security (called the base rate); and (2) a spread to reflect
the greater risks that investors perceive as being associated with the issue or issuer.
A corporate borrower who seeks reduced funding costs is seeking to reduce the spread.
The integration of capital markets throughout the world diminishes such opportunities.
Nevertheless, as discussed in the next chapter, imperfections in capital markets
throughout the world prevent complete integration and thereby may permit a reduced cost
of funds. These imperfections, or market frictions, occur because of differences in security
regulations in various countries, tax structures, restrictions imposed on regulated
institutional investors, and the credit risk perception of the issuer. In the case of common
stock, a corporation seeks to gain a higher value for its stock and to reduce the market
impact cost of floating a large offering.
"The third reason to seek funds in foreign markets is a desire by corporate treasurers to
diversify their source of funding in order to reduce reliance on domestic investors the case
of equities, diversifying funding sources may encourage foreign investors have different
perspectives of the future performance of the corporation.

Architectural Structure of Secondary Markets

There are different architectural structures that can be used in establishing a secondary
market for a financial asset. The two general architectural structures are order-driven
and quote-driven markets. Real-world financial markets use a blend of these structures
for different types of financial assets. To understand the difference between an order
driven and quote-driven market, we must make clear who are the potential parties.

The natural buyers and natural sellers want to take a position for their own portfolio.
They can be retail investors or institutional investors.
A broker is a third party in a trade that acts on behalf of a buyer or seller who wishes to
execute an order. In economic and legal terms, a broker is said to be an "agent" of the
one of the parties to the trade. What is critical to understand is that the brokerage activity
does not require the broker to buy and hold in inventory or sell from inventory the
financial asset that is the subject of the trade. Rather, the broker receives, transmits, and
executes a customer's orders and in exchange for this service the broker receives an
explicit commission.
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A dealer is an entity that acts as an intermediary in a trade by buying and selling i for its
own account. Basically, a dealer will buy a financial asset to place in its inventory or will
sell a financial asset from its own inventory. A dealer is said to "take a position in an
asset."

Role of Brokers and Dealers in Real Markets

Brokers
One way in which a real market might not meet all the exacting standards of a theoretically
perfect market is that many investors may not be present at all times in the marketplace.
Further, a typical investor may not be skilled in the art of the deal or completely informed
about every facet of trading in the asset. Clearly, most investors in even smoothly
functioning markets need professional assistance. Investors need someone to receive
and keep track of their orders for buying or selling, to find other parties wishing to sell or
buy, to negotiate for good prices, to serve as a focal point for trading, and to execute the
orders. The broker performs all of these functions. Obviously, these functions are more
important for the complicated trades, such as the small or large trades, than for simple
transactions or those of typical size.

Dealers as Market Makers

A real market might also differ from the perfect market because of the possibly frequent
event of a temporary imbalance in the number of buy and sell orders that investors may
place for any security at any one time. Such unmatched or unbalanced flow causes two
problems. First, the security's price may change abruptly even if there has been no shift
in either supply or demand for the security. Second, buyers may have to pay higher than
market-clearing prices (or sellers accept lower ones) if they want to make their trade
immediately.
The potential for imbalances explains the need for the dealer, who stands ready and
willing to buy a financial asset for its own account (add to an inventory of the security) or
sell from its own account (reduce the inventory of the security). At a given time, dealers
are willing to buy a security at a price (the bid price) that is less than what they are willing
to sell the same security for (the ask price).
The price stabilization role relates to our earlier example of what may happen to the price
of a particular transaction in the absence of any intervention in the case of a temporary
imbalance of orders. By taking the opposite side of a trade when no other orders are
available, the dealer prevents the price from materially diverging from the price at which
a recent trade was consummated.
Investors are concerned with immediacy, and they also want to trade at reasonable
prices, given prevailing conditions in the market. Although dealers cannot know with
certainty the true price of a security, they do occupy a privileged position in some market
 P a g e | 18

structures with respect to the flow of market orders. They also enjoy a privileged position
regarding "limit" orders, the special orders that can be executed only if 'the market price
of the security changes in a specified way.
Three types of risks are associated with maintaining a long or short position in a given
security. First, the uncertainty about the future price of the security presents a substantial
risk. A dealer who takes a long position in the security is concerned that the price will
decline in the future; a dealer who is in a short position is concerned that the price will
rise.
The second type of risk concerns the expected time it will take the dealer to unwind a
position and its uncertainty, which, in turn, depends primarily on the rate at which buy and
sell orders for the security reach the market (i.e., the thickness of the market). Finally,
although a dealer may be able to access better information about order flows than the
general public, in some trades the dealer takes the risk of trading with someone in
possession of better information.1 This situation results in the better informed trader
obtaining a better price at the expense of the dealer. Consequently, in establishing the
bid-ask spread for a trade, a dealer will assess whether the trader may hold better
information.

Market Efficiency

The term efficient, used in several contexts, describes the operating characteristics of a
capital market. A distinction, however, can be made between an operationally (or
internally) efficient market and a pricing (or externally) efficient capital market.

Operational Efficiency

In an operationally efficient market, investors can obtain transaction services as cheaply

as possible, given the costs associated with furnishing those services. For example, in
national equity markets throughout• the world the degree of operational efficiency varies.
At one time, brokerage commissions in the United States were fixed, and the brokerage
industry charged high fees. That changed in May 1975, as the U. S. exchanges were
forced to adopt a system of competitive and negotiated commissions. Non-U.S. markets
continue to move toward more competitive brokerage fees. France, for example, adopted
a system of negotiated commissions for large trades in 1985. In its "Big Bang" of 1986,
the London Stock Exchange abolished fixed commissions.
Commissions are only part of the cost of transacting, as already noted. The other part is
the dealer spread. Bid-ask spreads for bonds vary by type of bond.

Pricing Efficiency

1
Walter Bagehot, "The Only Game in Town," Financial Analysts Journal (March/April 1971). pp. 12—14,22.
 P a g e | 19

Pricing efficiency refers to a market where prices at all times fully reflect all available
information that is relevant to the valuation of securities. That is, relevant information
about the security is quickly integrated into the price of securities.

Transaction Costs
In an investment era where one-half of one percentage point can make a difference when
a money manager is compared against a performance benchmark, an important aspect
of the investment process is the cost of implementing an investment strategy. Transaction
costs are more than merely brokerage commissions—they consist of commissions, fees,
execution costs, and opportunity costs.
Commissions are the fees paid to brokers to trade securities. In May 1975 commissions
became fully negotiable and have declined dramatically since then. Included in the
category of fees are custodial fees and transfer fees. Custodial fees are the fees charged
by an institution that holds securities in safekeeping for an investor.
Execution costs represent the difference between the execution price of a security and
the price that would have existed in the absence of the trade. Execution costs can be
further decomposed into market (or price) impact and market timing costs. Market impact
cost is the result of the bid-ask spread and a price concession extracted by dealers to
mitigate their risk that an investor's demand for liquidity is information-motivated. Market
timing cost arises when an adverse price movement of the security during the time of the
transaction can be attributed in part to other activity in the security and is not the result of
a particular transaction. Execution costs, then; are related to both the demand for liquidity
and the trading activity on the trade date.
 P a g e | 20

ACTIVITY 3
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. What is the difference between primary and capital markets
2. What is the role of primary and secondary markets in capital market?
3. How will you define market efficiency?
4. How will you achieve operational efficiency?
5. How do you think pricing efficiency can be achieved?
 P a g e | 21

CHAPTER IV
RISK AND RETURN THEORIES: 1
Portfolio theory and capital market theory with the selection of portfolio that
maximize expected returns consistent with individually acceptable levels of risk. Capital
market theory-deals with the effects of investor decisions on security prices. More
specifically it shows the relationship that should exist between security returns and risk,
if investors constructed portfolios as indicated by portfolio theory.

Together, portfolio and capital market theories provide a framework to specify and
measure investment risk and to develop relationships between risk and expected return
(and hence between risk and the required return on an investment). These theories have
revolutionalized the world of finance, by allowing portfolio managers to quantify the
investment risk and expected return of a portfolio and allowing corporate treasurers to
quantify the cost of capital and risk of a proposed capital investment.

MEASURING INVESTMENT RETURN

Before proceeding with the theories, we explain how the actual investment return of a
portfolio should be measured. The return portfolio during a given interval is equal to the
change in value of the portfolio is any distributions received from the portfolio, expressed
as a fraction of the initial-portfolio value. It is important that any capital or income
distributions made to the investor be included, or the measure of return will be deficient.

VI ¯ Vo + D

where VI = the portfolio market value at the end of the interval

Vo = the portfolio market value at the beginning of the interval
D = the cash distributions to the investor during the interval
The calculation assumes that any interest or dividend income received on the
portfolio of securities and not distributed to the investor is reinvested in the portfolio (and
thus reflected in VI).
Further, the calculation assumes that any distributions occur at the end of the
interval, or are held in the form of cash until the end of the interval. If the distributions
were reinvested prior to the end of the interval, the calculation would have to be modified
to consider the gains or losses on the amount reinvested. The formula also assumes
no capital inflows during the interval. Otherwise, the calculation would have to be
modified to reflect the increased investment base.
Capital inflows at the end of the interval (or held in cash until the end), however, can
be treated as just the reverse of distributions in the return calculation.
Arithmetic Average Rate of Return
 P a g e | 22

The arithmetic average rate of return is an unweighted average of the returns achieved
during a series of such measurement intervals. The general formula is:

RA = the arithmetic average return

RPk= the portfolio return in interval k as measured by equation (8.1),

N = the number of intervals in the performance evaluation period

For example, if the portfolio returns were —10%, 20%, and 5% in July, August, and
September, respectively, the arithmetic average monthly return is 5%.
The arithmetic average can be thought of as the mean value of the withdrawals expressed
as a fraction of the initial portfolio value of each interval while maintaining the initial
portfolio value intact. In the preceding example, the investor must add 19% of the initial
portfolio value at the end of the first interval and can withdraw 20% and 5% of the initial
portfolio value per period.

Portfolio theory
In constructing a portfolio of assets, investors seek to maximize the expected return from
their investment given some level of risk they are willing to accept. Portfolios that satisfy
this requirement are called efficient portfolios. Portfolio theory tells us how to achieve
efficient portfolios. Because Markowitz is the developer of portfolio theory, efficient
portfolios are sometimes referred to as "Markowitz efficient portfolios."
To construct an efficient portfolio of risky assets, it is necessary to make some assumption
about how investors behave in making investment decisions. A reasonable assumption
is that investors are risk averse. A risk-averse investor, when faced with two investments
with the same expected return with two different risks, will prefer the one with the lower
risk. Given a choice of efficient portfolios from which an investor can select, an optimal
portfolio is the one most preferred.
RISKY ASSETS VERSUS RISK-FREE ASSETS

It is important to distinguish between risky assets and risk-free assets. A risky asset is
one for which the return that will be realized in the future is uncertain. For example,
suppose an investor purchases the stock of General Motors today and plans to hold the
stock for 1 year. At the time she purchased the stock, she does not know what return will
be realized. The return will depend on the price of General Motors stock 1 year from now
and the dividends that the company pays during the year. Thus, General Motors stock,
and indeed the stock of all companies, are risky assets.
 P a g e | 23

MEASURING PORTFOLIO RISK

The definition of investment risk leads us into less-explored territory. Not everyone agrees
on how to define risk, let alone measure it. Nevertheless, some attributes of risk are
reasonably well accepted.

An investor holding a portfolio of Treasury securities until date faces no uncertainty about
monetary outcome. The value of the portfolio at maturity of the securities will be identical
with the predicted value; the investor bears no price risk. In the case of a portfolio
composed of common stocks, however, it will be impossible to predict the value of the
portfolio at any future date. The best an investor can do is to make a best-guess or most-
likely estimate, qualified by statements about the range and likelihood of other values. In
this case, the investor does bear price risk.

Defining risk in terms of price risk, one measure of risk is the extent to which future
portfolio values are likely to diverge from the expected or predicted value. More
specifically, risk for most investors is related to the chance that future portfolio values will
be less than expected. That is, if the investor's portfolio has a current value of $100,000,
and an expected value of $110,000 at the end of the next year, what matters is the
probability of values less than $110,000.

Expected Portfolio Return

A particularly useful way to quantify the uncertainty about the portfolio return is to specify
the probability associated with each of the possible future returns. Assume, for example,
that an investor identifies five possible outcomes for the portfolio return during the next
year. Associated with each return is a subjectively determined probability, or relative
chance of occurrence.

The expected return is simply the weighted average of possible outcomes, where the
weights are the relative chances of occurrence.

Variability of Expected Return

If risk is defined as the- chance of achieving returns less than expected, it would seem
logical to measure risk by the dispersion of the possible returns below the expected
value. Risk measures based on below-the-mean variability are difficult to work with,
however, and moreover are unnecessary as long as the distribution of future return is
reasonably symmetric about the expected value.
 P a g e | 24

For a symmetrical distribution, the dispersion of returns on one side of the expected
return is the same as the dispersion on the other side of the expected return.
If future distributions are symmetrical distributions, it makes little difference whether we
measure variability of returns on one or both sides of the expected return.

Diversification
Diversification results from combining securities whose returns are less than perfectly
correlated in order to reduce portfolio risk. As already noted, the portfolio return is simply
a weighted average of the individual security returns, no matter the number of securities
in the portfolio. Therefore, diversification will not systematically affect the portfolio return,
but it will reduce the variability (standard deviation) of return. In general, the less the
correlation among security returns, the greater is the impact of diversification on reducing
variability. This result is true no matter how risky the securities of the portfolio are when
considered in isolation.
Often, one hears investors talking about diversifying their portfolio. By diversifying, an
investor means constructing a portfolio in such as way as to reduce portfolio risk without
sacrificing return. This goal is certainly one that investors should seek. However, the
question is how one carries out this goal in practice.
When the distribution of historical returns over a long period of time for a portfolio of
diversified common stock is compared to the distribution for individual stocks, a curious
relationship is observed. Even though the standard deviation of returns for the stock alone
can be significantly greater than that of the portfolio, the stock average return is less than
the portfolio return! Is the capital market so imperfect that it rewards substantially higher
risk with lower stock return?
Not so. "Ihe answer lies in the fact that not all of a security's risk is relevant. Much of the
total risk (standard deviation of return) of an individual security is diversifiable. That is, if
that investment were combined with other securities, a portion of the variation in its
returns could be smoothed or canceled by complementary variation in other securities.
The same portfolio diversification effect accounts for the low standard deviation of return
for a diversified stock portfolio of 20 or more stocks. In fact, it would be found that the
portfolio standard deviation is lower than that of the typical security in the portfolio. Much
of the total risk of the component securities is eliminated by diversification.
As long as much of the total risk can be eliminated simply by holding a stock in a portfolio
it presents no economic requirements for the return earned to be in line with the total risk.
Instead, we should expect realized returns to be related to that portion of security risk that
cannot be eliminated by portfolio combination—so-called systematic risk.

CHOOSING A PORTFOLIO OF RISKY ASSET

 P a g e | 25

Diversification in the manner suggested previously leads to the construction of portfolios

with the highest expected return at a given level of risk, called Markowitz efficient
portfolios. In order to construct Markowitz efficient portfolios, the theory requires some
assumptions about asset selection behavior by investors. First, it assumes that only two
parameters affect an investor's decision: the expected return and the risk. Second, it
assumes that an investor is risk averse. Third, it assumes that an investor seeks to
achieve the highest expected return at a given level of risk.
 P a g e | 26

ACTIVITY 4
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. Discuss the essence and imporatance of portfolio and capital market theory?
2. Why do we have to measure the investment return?
3. What are the common difficulties in measuring investment return?
4. Explain efficient portfolio.
5. Explain the concept of diversification.
 P a g e | 27

CHAPTER 5
INTRODUCTION TO FINANCIAL CULTURE MARKETS

Systematic and Unsystematic Risk

Systematic risk is the portion of an asset's return variability that can be attributed to a
common factor. It is also called undiversifiable risk or market risk. Systematic risk is the
minimum level of risk that can be obtained for a portfolio by means of diversification
across a large number of randomly chosen assets. As such, systematic risk results from
general market and economic conditions that cannot be diversified away.
The portion of an asset's return variability that can be diversified away is referred to as
unsystematic risk. It is also sometimes called diversifiable risk, residual risk, or company-
specific risk. This is the risk that is unique to a company such as a strike, the outcome of
unfavorable litigation, or a natural catastrophe.

Quantifying Systematic Risk

Quantification of systematic risk can be accomplished by dividing security return into two
parts: one perfectly correlated with and proportionate to the market return, and a second
independent from (uncorrelated with) the market. The first component of return is usually
referred to as systematic, the second as unsystematic or diversifiable return. Thus we
have
Security return = Systematic return + Unsystematic return

MECHANICS OF FUTURES TRADING

A futures contract is a firm legal agreement between a buyer (seller) and an established
exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery
of something at a specified price at the end of a designated period of time. The price at
which the parties agree to transact in the future is called the futures price. The designated
date at which the parties must transact is called the settlement or delivery date.

LIQUIDATING A POSITION
The contract with the closest settlement date is called the nearby futures contract. The
next futures contract is the one that settles just after the nearby contract. The contract
farthest away in time from the settlement is called the most distant futures contract.

A party to a futures contract has two choices on liquidation of the position. First, the
position can be liquidated prior to the settlement date. For this purpose, the party must
take an offsetting position in the same contract. For the buyer of a futures contract, it
 P a g e | 28

means selling the same number of identical futures contracts; for the seller of a futures
contract, it means buying the same number of identical futures contracts.
The Role of the Clearinghouse
The clearinghouse exists to meet this problem. When an investor takes a position in the
futures market, the clearinghouse takes the opposite position and agrees to satisfy the
terms set forth in the contract. Because of the clearinghouse, the investor need not worry
about the financial strength and integrity of the party taking the opposite side of the
contract.
After initial execution of an order, the relationship between the two parties ends. The
clearinghouse interposes itself as the buyer for every sale and the seller for every
purchase. Thus investors are free to liquidate their positions without involving the other
party in the original contract, and without worry that the other party may default. While
counterparty risk still exists for both parties, that risk is minimal since the risk is with the
exchange, not with the original counterparty. and no exchange has failed. For this reason,
we define a futures contract as an agreement between a party and a clearinghouse
associated with an exchange.

FUTURES VERSUS FORWARD CONTRACTS

A forward contract, just like a futures contract, is an agreement for the future delivery of
something at a specified price at the end of a designated period of time. Futures contracts
are standardized agreements as to the delivery date (or month) and quality of the
deliverable, and are traded on organized exchanges. A forward contract differs in that it
is usually non-standardized (that is, the terms of each contract are negotiated individually
between buyer and seller), no clearinghouse coordinates forward contract trading, and
secondary markets are often nonexistent or extremely thin. Unlike a futures contract,
which is an exchange-traded product, a forward contract is an over-the-counter
instrument.

RISK AND RETURN CHARACTERISTICS OF FUTURES CONTRACTS

When an investor takes a position in the market by buying a futures contract the investor
is said to be in a long position or long futures. If, instead the investor's opening position
is the sale of a futures contract, the investor is said to be in a short position or short
futures.

THE ROLE OF FUTURES IN FINANCIAL MARKETS

 P a g e | 29

Without financial futures, investors would have only one trading location to alter portfolio
positions when they get new information that is expected to influence the value of
assets—the cash market. If economic news that is expected to impact the value of an
asset adversely is received, investors can reduce their price risk exposure to that asset.
The opposite is true if the new information is expected to impact the value of that asset
favorably: an investor would increase price-risk exposure to that asset. Of course,
transaction costs are associated with altering exposure to an asset—explicit costs
(commissions), and hidden or execution costs (bid-ask spreads and market impact costs).

Futures provide another market that investors can use to alter their risk exposure to an
asset when new information is acquired. But which market—cash or futures— should the
investor employ to alter position quickly on the receipt of new information? The answer is
simple: the one that is the more efficient to use in order to achieve the objective. Tie
factors to consider are liquidity, transaction costs, taxes, and leverage advantages of the
futures contract.
The market that investors feel is the one that is more efficient to use to achieve their
investment objective should be the one where prices will be established that reflect the
new economic information. That is, it will be the market where price discovery takes place.
Price information is then transmitted to the other market. In many of the markets that we
discuss in this book, it is in the futures market that it is easier and less costly to alter a
portfolio position. We give evidence for this proposition when we discuss the specific
contracts in later chapters. Therefore, it is the futures market that will be the market of
choice and will serve as the price discovery market.
Effect of Futures on Volatility of Underlying Asset
Some investors and the popular press consider that the introduction of a futures market
for an asset will increase the price volatility of the asset in the cash market. This criticism
of futures contracts is referred to as the "destabilization hypothesis."
Two variants of the destabilization hypothesis are the liquidity variant and the populist
variant. According to the liquidity variant, large transactions that are too difficult to
accommodate in the cash market will be executed first in the futures markets because of
better liquidity. The increased volatility that may occur in the futures contracts market is
only temporary because volatility will return to its normal level once the liquidity problem
is resolved. The implication is that no long-term impact on the volatility of the underlying
cash market asset will be felt.

The populist variant, in contrast, asserts that as a result of speculative trading in derivative
contracts, the cash market instrument does not reflect fundamental economic value. The
implication here is that the asset price would better reflect economic value in the absence
of a futures market.
 P a g e | 30

SUMMARY
This chapter explains the basic features of financial futures markets. The traditional
purpose of futures markets is to provide an important opportunity to hedge against the
risk of adverse future price movements. Futures contracts are creations of exchanges,
which require initial margin from parties. Each day positions are marked to market.
Additional (variation) margin is required if the equity in the position falls .below the
maintenance margin. The clearinghouse guarantees that the parties to the futures
contract will satisfy their obligations. That is, with a futures contract counterparty risk is
minimal.
A forward contract differs in several important ways from a futures contract. In contrast to
a futures contract, the parties to a forward contract are exposed to counterparty risk (i.e.,
the risk that the other party to the contract will fail to perform). While there is no
requirement that the parties to a forward contract mark positions to market, this is typically
done to mitigate counterparty risk. Finally, unwinding a position in a forward contract may
be difficult.
A buyer (seller) of a futures contract realizes a profit if the futures price increases
(decreases). The buyer (seller) of a futures contract realizes a loss if the futures price
decreases (increases). Because only initial margin is required when an investor takes a
futures position, futures markets provide investors with substantial leverage for the money
invested.
 P a g e | 31

ACTIVITY 5

QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on

your own understanding.

1. How do you explain the concept of systematic and unsystematic risk?

2. What do you think is the role of future in financial market? How it affects to it?
3. Explain what is clearinghouse and its functions to financial market?
4. What is the use of future contract?
5. Explain the concept of risk and return.
 P a g e | 32

CHAPTER 6
INTRODUCTION TO OPTION MARKET

OPTION CONTRACT DEFINED

An option is a contract in which the writer of the option grants the buyer of the option the
right, but not the obligation, to purchase from or sell to the writer something at a specified
price within a specified period of time (or at a specified date). The writer, also referred to
as the seller, grants this right to the buyer in exchange for a certain sum of money, which
is called the option price or option premium. The price at which the asset may be bought
or sold is called the exercise or strike price. The date after which an option is void is called
the expiration date.

Margin Requirements
The buyer of an option is not subject to margin requirements after the option price is
paid in full. Because the option price is the maximum amount the investor can lose, no
matter how adverse the price movement of the underlying asset, margin is not
necessary. Because the writer of an option agreed to accept all of the risk (and none of
the reward) of the position in the underlying asset, the writer is generally required to put
up the option price received as margin. In addition, as price changes occur that
adversely affect the writer's position, the writer is required to deposit additional margin
(with some exceptions) as the position is marked to market.

DIFFERENCES BETWEEN OPTIONS AND FUTURES CONTRACTS

Notice that, unlike in a futures contract, one party to an option contract is not obligated to
transact—specifically, the option buyer has the right but not the obligation to transact.
The option writer does have the obligation to perform. In the case of a futures contract,
both buyer and seller are obligated to perform. Of course, a futures buyer does not pay
the seller to accept the obligation, while an option buyer pays the seller an option price.
Consequently, the risk/reward characteristics of the two contracts are also different. In
the case of a futures contract, the buyer of the contract realizes a dollar-fordollar gain
when the price of the futures contract increases and suffers a dollar-fordollar loss when
the price of the futures contract drops. The opposite occurs for the seller of a futures
contract. Options do not provide this symmetric risk/reward relationship. The most ghat
the buyer of an option can lose is -the option price. The buyer of an option retains all the
potential benefits, but the gain is always reduced by the amount of the option price. The
maximum profit that the writer may realize is the option price; this potential is offset
against substantial downside risk. This difference is extremely important because, as we
 P a g e | 33

shall see in subsequent chapters, investors can use futures to protect against symmetric
risk and options to protect against asymmetric risk.

Buying Call Options

The purchase of a call option creates a financial position referred to as a long call
position. To illustrate this position, assume that a call option on Asset XYZ expires in 1
month and states a strike price of $100. The option price is $3. Suppose that the current
price of Asset XYZ is $100. What is the profit or loss for the investor who purchases this
call option and holds it to the expiration date?
The profit and loss from the strategy will depend on the price of Asset XYZ at the
expiration date. A number of outcomes are possible.

1. If the price of Asset XYZ at the expiration date is less than $100, then the investor
will not exercise the option. It would be foolish to pay the option writer $100 when Asset
XYZ can be purchased in the market at a lower price. In this case, the option buyer loses
the entire option price of $3. Notice, however, that it is the maximum loss that the option
buyer will realize regardless of how low Asset XYZ's price declines.
2. If Asset XYZ's price is equal to $100 at the expiration date, the option buyer would
again find no economic value in exercising the option. As in the case where the price is
less than $100, the buyer of the call option loses the entire option price, $3.
3. If the price of Asset XYZ at the expiration date is equal to $103, no loss or gain is
realized from buying the call option. "The long position in Asset XYZ, however, produces
a gain of $3.
4. If Asset XYZ's price at the expiration date is greater than $103, both the call option
buyer and the long position in Asset XYZ post a profit, but the profit for the buyer of the
call option is $3 less than that for the long position. If Asset XYZ's price is $113, for
example, the profit from the call position is $10, while the profit from the long position in
Asset XYZ is $13.

Basic Components of the Option Price

The option price reflects the option's intrinsic value and any additional amount over its
intrinsic value. The premium over intrinsic value is often referred to as the time value or
time premium. The former term is more common; however, we use the term time
premium to avoid confusion between the time value of money and the time value of the
option.
 P a g e | 34

Intrinsic Value
The intrinsic value of an option is the economic value of the option if it
is exercised immediately. If no positive economic value will result from
exercising immediately then the intrinsic value is zero.
The intrinsic value of a call option is the difference between the
current price of the underlying asset and the strike price if positive; it
is otherwise zero. For example, if the strike price for a call option is
$100 and the current asset price is $105, the intrinsic value is $5. That
is, an option buyer exercising the option and simultaneously selling
the underlying asset would realize $105 from the sale of the asset,
which would be covered by acquiring the asset from the option writer
for $100, thereby netting a $5 gain.
When an option holds intrinsic value, it is said to be "in the
money." When the strike price of a call option exceeds the current
asset price, the call option is said to be "out of the money"; it has no
intrinsic value. An option for which the strike price is equal to the
current asset price is said to be "at the money." The intrinsic value of
both at-the-money and out-of-the-money options is zero because it is
not profitable to exercise the option. Our call option with a strike price
of $100 would be (1) in the money when the current asset price is
greater than $100, (2) out of the money when the current asset price
is less than $100, or (3) at the money when the current asset price is
equal to $100.
For a put option, the intrinsic value equals the amount by which
the current asset price is below the strike price. For example, if the
strike price of a put option is $100 and the current asset price is $92,
the intrinsic value is $8. That is, the buyer of the put option who
exercises the put option and simultaneously sells the underlying asset
nets $8 by exercising. The asset is sold to the writer for $100 and
purchased in the market for $92. For our put option with a strike price
of $100, the option would be (1) in the money when the asset price is
less than $100, (2) out of the money when the current asset price
exceeds the strike price, or (3) at the money when the strike price is
equal to the asset's price.
Time Premium
The time premium of an option is the amount by which the option
price exceeds its intrinsic value. The option buyer hopes that, at some
time prior to expiration, changes in the market price of the underlying
asset will increase the value of the rights conveyed by the option. For
this prospect, the option buyer is willing to pay a premium above the
intrinsic Value. For example, if the price of a call option with a strike
 P a g e | 35

price of $100 is $9 when the current asset price is $105, the time
premium of this option is $4 ($9 minus its intrinsic value of $5). A
current asset price of $90 instead of $105 means that the time
premium of this option would be the entire $9 because the option has
no intrinsic value. Clearly, other things being equal, the time premium
of an option increases with the amount of time remaining to expiration.
Time to Expiration of the Option
An option is a "wasting asset." That is, after the expiration date the option has no value.
All other factors being equal, the longer the time to expiration of the option, the greater
the option price, because as the time to expiration decreases, less time remains for the
underlying asset's price to rise (for a call buyer) or fall (for a put buyer) —that is, to
compensate the option buyer for any time premium paid—and therefore the probability of
a favorable price movement decreases.
 P a g e | 36

ACTIVITY 6
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. WHAT DO YOU THINK IS THE DIFFERENCES BETWEEN OPTIONS AND
FUTURES CONTRACTS
2. What is the difference of time premium and instrinsic value?
3. What is the use of option contract?
4. An option is a "wasting asset after the expiration date”. Explain.
5. When to use option contract and future contract?
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CHAPTER 7
CAPITAL MARKET

Introduction

The primary role of the capital market is to raise long-term funds for governments,
banks, and corporations while providing a platform for the trading of securities. This
fundraising is regulated by the performance of the stock and bond markets within the
capital market. The member organizations of the capital market may issue stocks and
bonds in order to raise funds. Investors can then invest in the capital market by
purchasing those stocks and bonds. The capital market, therefore, functions as a link
between savers and investors. It plays an important role in mobilizing the savings and
diverting them in productive investment. In this way, capital market plays a vital role in
transferring the financial resources from surplus and wasteful areas to deficit and
productive areas, thus increasing the productivity and prosperity of the country and
promotes the process of economic growth in the country. The capital market includes the
stock market (equity securities) and the bond market (debt).

Capital markets may be classified as primary markets and secondary markets. In

primary markets, new stock or bond issues are sold to investors via a mechanism known
as underwriting. In the secondary markets, existing securities are sold and bought among
investors or traders, usually on a securities exchange, over-the-counter, or elsewhere.
The capital market facilitates lending to the businessmen and the government and thus
encourages investment. It provides facilities through banks and nonbank financial
institutions. Various financial assets, e.g., shares, securities, bonds, etc., induce savers
to lend to the government or invest in industry. With the development of financial
institutions, capital becomes more mobile, interest rate falls and investment increases.
The capital market not only reflects the general condition of the economy, but also
smoothens and accelerates the process of economic growth. Various institutions of the
capital market like nonbank financial intermediaries allocate the resources rationally in
accordance with the development needs of the country. The proper allocation of
resources results in the expansion of trade and industry in both public and private sectors,
thus promoting balanced economic growth in the country.

Capital market is that segment of the financial market that deals with the effective
channeling of medium to long-term funds from the surplus to the deficit unit. The process
of transfer of funds is done through instruments, which are documents (or certificates),
showing evidence of investments. The trading instruments in the capital market consist
of
 P a g e | 38

A. Debt Instruments which is used by either companies or governments to

generate funds for capital-intensive projects. When the instrument is issued by
the federal government, it is called a Sovereign Bond
B. Equities issued by companies only and can also be obtained either in the
primary market or the secondary market.
C. Preference Shares issued by corporate bodies and the investors rank second
(after bond holders) on the scale of preference. The instrument possesses the
characteristics of equity in the sense that when the authorized share capital
and paid up capital are being calculated, they are added to equity capital to
arrive at the total
D. derivatives are those instruments that derive from other securities, which are
referred to as underlying assets (as the derivative is derived from them). The
price, riskiness and function of the derivative depend on the underlying assets
since whatever affects the underlying asset must affect the derivative. The
derivative might be an asset, index or even situation. Derivatives are mostly
common in developed economies. Some examples of derivatives are
Mortgage-Backed Securities (MBS), Asset-Backed Securities (ABS), Futures,
Options, Swaps, Rights, Exchange Traded Funds or commodities, every
capital market in the world is monitored by financial regulators and their
respective governance organization. The purpose of such regulation is to
protect investors from fraud and deception.

Financial regulatory bodies are also charged with minimizing financial losses,
issuing licenses to financial service providers, and enforcing applicable laws. In
Pakistan the Securities Exchange Commission of Pakistan (SECP) serve as a
regulatory body for smooth functioning of Capital Market.

Capital Market Reforms and Developmental Activities undertaken during 2012-13

In line with its objectives to develop a robust, efficient and competitive capital
market, the Securities and Exchange Commission during the period under review
introduced various structural, legal and fiscal reforms aimed at strengthening risk
management, increasing transparency, improving governance of the capital
market infrastructure institutions, enhancing investor protection and launching new
product/market development initiatives. The highlights of these reform measures
are as follows: `

A. Demutualization of Stock Exchanges: The stock exchanges in Pakistan were

successfully corporatized and demutualized on August 27, 2012 consequent
to promulgation of the Stock Exchanges (Corporatization, Demutualization and
 P a g e | 39

Integration) Act, 2012. The Act was approved in a joint session of the
Parliament and subsequently promulgated after presidential consent on May
7, 2012. Demutualization is a ground-breaking reform for the Pakistan capital
market as it would address the conflicts prevalent in the earlier mutualized set-
up of the stock exchanges by segregation of commercial and regulatory
functions and separation of ownership and trading rights. This development
has brought the Pakistan stock exchanges on par with their global
counterparts. While bringing enhanced governance and transparency at the
stock exchanges, demutualization will also project a positive image of the
Pakistan stock market on the international platform and will facilitate the
exchanges in attracting global strategic investors of good stature and increase
the depth of primary and secondary market. `
B. Default Management in the Post Demutualized Environment Post
demutualization, each member/initial shareholder of the stock exchanges has
been allotted shares and a Trading Right Entitlement Certificate (TREC) in lieu
of the membership card. In the event of default of any TREC holder, the
proceeds of such card are no longer available for utilization to satisfy the
members and investor’s claims. In order to cater this, a concept of Base
Minimum Capital (BMC) was introduced which is required to be deposited and
maintained at all times by each TREC holder with the respective stock
exchanges. The BMC will be available for utilization as collateral in the event
of default by the relevant TREC holder in the demutualized regime. `
C. Revamping of Capital Gains Tax (CGT): With the aim to facilitate the
government in its objective of documentation of the economy and to bring the
income of securities market investors within the tax ambit, CGT regime was
revamped to address the practical issues and encourage activity in the security
market. Accordingly, the Finance (Amendment) Ordinance, 2012 was
promulgated on April 24, 2012 and the Income Tax Rules were promulgated
subsequently to give effect to the revised CGT regime. Under the revised CGT
regime, the National Clearing Company of Pakistan Limited is acting as an
intermediary to deduct and deposit CGT from investors’ transactions while
providing an automated and efficient mechanism for the calculation, deduction
and deposit of tax. `
D. Code of Corporate Governance 2012: With the objective of fostering good
governance principles and practices in the corporate sector, a new Code of
Corporate Governance, 2012 was introduced for the listed companies as a part
of the stock exchanges’ regulations. The Code incorporates international best
practices and standards and introduces more stringent requirements to ensure
transparency and good governance in companies with public stake.
E. Introduction of Index-based Option Contracts: To add depth to the market and
to allow investors to leverage positions for large diversified portfolios, Index-
based Option Contracts were launched at the Karachi Stock Exchange in line
with international best practices. Options are globally popular derivative
 P a g e | 40

products which provide various benefits such as help to create orderly, efficient,
and liquid markets, and giving flexibility, leverage and risk minimization to the
investors.

Debt Capital Markets

A well-developed corporate bond market is essential for the growth of economy as it
provides an additional avenue to corporate sector for raising funds to meet their financial
requirements.

Measures for the development of debt markets: Following measures have been taken for
the development of corporate debt market: `

a. For encouragement of Islamic debt Market, the draft Issue of Sukuk Regulations,
2012 were notified for seeking public comments. These regulations are being
finalized in light of comments received from the stake holders.
b. In order to encourage listing of debt securities on the exchanges, separate set of
regulations for debt securities are being framed.
c. Regulatory framework for the credit rating agencies (CRAs) are being revamped
so that CRAs play an effective role in the development of debt market. In this
regard a committee, comprising of the representatives of SECP, CRAs and SBP
constituted by the Commission has submitted its report and given the
recommendations in respect of strengthening the existing Regulatory Framework
for CRAs viz. the Credit Rating Companies Rules, 1995 and the Code of Conduct
for CRAs dated February 17, 2005; to review the proposals of CRAs regarding
enhancement of the rating universe; Diversification of capital structure of CRAs
and their listing on the stock exchanges; and Regulatory framework for
establishment of a Bond Pricing Agency (BPA).
d. In order to rationalize the cost of issue of corporate bonds, steps are being taken
to reduce the rate of stamp duty applicable on issue and transfer of Term Finance
Certificates (TFCs) and Commercial Papers.
e. For the development of the debt capital market, the settlement of trading in debt
securities listed at OTC (Over-The-Counter) segment of the stock exchanges has
been made mandatory through the National Clearing and Settlement System
(NCSS) of National Clearing Company of Pakistan Limited (NCCPL) against the
earlier practice of settlement of these trades on counter party basis outside the
NCSS. This initiative will facilitate auto settlement of these trades.
 P a g e | 41

Commodities Market developments:

For developing the commodities market, the possibility of setting up new commodity
futures and spot exchanges will be explored. The said measure will also facilitate healthy
competition and business generation while contributing towards greater market outreach
to the investors resulting in growth in the size of the commodities market.

SME Exchange
In order to provide alternate source of financing for the Small and Medium Enterprises
(SME) of the country, coordination with stakeholders is important to implement a
framework for establishment of an SME Exchange for allowing fund raising through IPOs
and secondary trading of the securities of SME sector.

Strengthening of the Debt Market:

To accelerate growth in the debt market, efforts will be made for listing of Government
Debt instruments at the stock exchanges and integration of National Savings Scheme
instruments into the mainstream capital market in coordination with the federal
government and the SBP. Also, to promote transparency and price discovery of debt
securities and to minimize pricing issues of debt securities, establishment of an
independent Bond Pricing Agency (BPA) conforming to international standards is in the
pipeline.
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ACTIVITY 7
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. How strengthening of the Debt Market be possible?
2. What is the connection of Small and Medium Enterprises to capital market?
3. How important capital market is for the economy of the country.
4. Explain and differentiate the stock market and bond market.
5. What is the role and importance of debt capital market?
 P a g e | 43

CHAPTER 8
COMMON STOCK MARKET

In the United States, secondary market trading in common stocks occurs in two different
ways. The first is on organized exchanges, which are specific geographical locations
called trading floors, where buyers and sellers physically meet. The trading mechanism
on exchanges is the auction system, which results from the presence of many competing
buyers and sellers assembled in one place. The second type is via over-the-counter
(OTC) trading, which results from geo-graphically dispersed traders or market makers
linked to one another via telecommunication systems, which requires no trading floor.
This trading mechanism is a negotiated system whereby individual buyers negotiate with
individual sellers. Exchange markets are called central auction specialist systems, and
OTC markets are called multiple market maker systems.

STOCK EXCHANGES
Stock exchanges are formal organizations, approved and regulated by the Securities and
Exchange Commission (SEC).These exchanges are physical locations and are made up
of "members" that use the exchange facilities and systems to exchange or trade listed
stocks. Stocks traded on an exchange are said to be listed stocks. To be listed, a
company must apply and satisfy requirements established by, the exchange for minimum
capitalization, shareholder equity, average closing share price, and other criteria.
Even after being listed, exchanges may delist a company's stock if it no longer meets the
exchange requirements.

The right to trade securities or make markets on an exchange floor is granted to a firm
or individual who becomes a member of the exchange by buying a seat on the exchange.
The number of seats is fixed by the exchange, and the cost of a seat is deter-mined by
supply and demand.

Two kinds of stocks are listed on a regional stock exchange:

(1) stocks of companies that either could not qualify for listing on one of the major
national exchanges or could qualify for listing but chose not to list; and
(2) stocks, known as dually listed stocks, that are also listed on one of the major national
exchanges. A company may be motivated to dual list if a local brokerage firm that
purchases a membership on a regional exchange can trade the company's listed stocks
without having to purchase a considerably more expensive membership on the national
stock exchange where the stock is also listed.

Commissions
Before 1975, regulations allowed stock exchanges to set minimum commissions on
transactions. The fixed commission structure did not allow the commission rate to decline
as the number of shares in the order increased. For example, brokers incur lower total
costs in executing an order of 10,000 shares of one stock for one investor than in
 P a g e | 44

executing 100 orders for the same stock from 100 investors. Consequently, fixed
commissions did not reflect economies of scale in executing transactions.
The introduction of negotiated commissions provided' the opportunity for the
development of discount brokers. These brokers charge commissions at rates much less
than those charged by other brokers, but offer little or no advice or any other service apart
from the execution of the transaction. Discount brokers have been particularly effective
in inducing retail investors to participate in the market for individual stocks.

THE THIRD MARKET

A stock may be both listed on an exchange and also traded in the OTC market, called
the third market. The third market grew as institutional investors used it in the early 1960s
to avoid these fixed minimum commissions. the third market is a network of
broker/dealers that aggregates quotation information and provides inter-participant order
routing tools, but leaves order execution to market participants.

Offshore Trading
Broker/dealers may trade exchange-listed and offshore via foreign exchanges.
THE ROLE AND REGULATION OF DEALERS IN EXCHANGE
AND OTC MARKETS
In exchanges, the one market maker or dealer per stock is the specialist.
With only one specialist for a given stock, no other market makers on the exchange are
available to provide competition. Does it mean that the specialist enjoys a monopolistic
position? Not necessarily. Specialists face competition from several sources. Brokers in
the crowd may have public market or limit orders that compete with specialists. In the
case of multiple listed stocks, competition comes from specialists on other exchanges
where the stock is listed. Since the repeal of Rule 390 during late 1999, competition can
come from dealers in the OTC market.
In the OTC market, the number of dealers depends on the volume of trading in a stock.
For example, there could be more than 60 dealers for an actively traded stock. If a stock
is not actively traded, itmay have only one or two dealers. As trading activity increases in
a stock, no barriers prevent more entities from becoming dealers in that stock, other than
satisfaction of capital requirements. Competition from more dealers—or the threat of new
dealers—forces bid-ask spreads to more competitive levels. Moreover, the capital
providing capacity of more than one dealer may benefit the markets more than a single
specialist performing the role of a market maker.
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TRADING OF STOCKS OUTSIDE THE COUNTRY WHERE THEY ARE DOMICILED

The stock of a corporation can be listed for trading on stock exchanges in other countries
as well as an exchange in its own country. Stocks of some large corporations are listed
on stock exchanges in several countries. In fact, the multiple listing of stocks is an
increasingly common phenomenon.
A firm may want to list its shares on the exchanges of other countries for several reasons.
Firms seek to diversify their sources of capital across national boundaries and to tap
various funds available globally for investment in new issues. In addition, firms may
believe that an internationally varied ownership diminishes the prospect of takeover by
other domestic concerns. Finally, firms may expect foreign listings to boost their name
awareness and, as a result, the sales of their products. 10 Research tends to support these
views of multiple listing. Firms whose shares are listed on exchanges in different countries
tend to be quite large and to have a relatively substantial amount of foreign sales revenue.
An important question is whether a share traded in different markets is subject to different
prices in those markets. The answer is "no" because investors can buy or sell the shares
in any of the markets, and they would arbitrage any meaningful differences in prices.
 P a g e | 46

ACTIVITY 8
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. What is the role of Philippines Stock Exchange in capital market?
2. What is your understanding about the common stock market?
3. What is the function of security and exchange commission (SEC)?
4. How will you manage/handle stock market?
5. What do you think is the common problem in managing stock market?
 P a g e | 47

CHAPTER 9

STOCK EXCHANGE TRADING MECHANISM

The stock exchange is a key institution facilitating the issue and sale of various types of
securities. It is a pivot around which every activity of the capital market revolves. In the
absence of the stock exchange, the people with savings would hardly invest in corporate
securities for which there would be no liquidity (buying and selling facility). Corporate
investments from the general public would have been thus lower. Stock exchanges thus
represent the market place for buying and selling of securities and ensuring liquidity to
them in the interest of the investors. The stock exchanges are virtually the nerve center
of the capital market and reflect the health of the country’s economy as a whole. Securities
are traded in three different ways in stock exchanges ring, namely–settlement basis, spot
basis and cash basis. Shares of companies which are not in the spot list are known as
‘cash’ shares or ‘B’ Category shares. They are traded on cash basis or delivery basis and
cannot be traded on settlement basis. The actual delivery of securities and payment has
to be made on or before the settlement date fixed in the case of cash basis trading. As
far as spot trading is concerned the actual delivery of securities must be made to the
buying broker within 48 hours of the contract. It is expected that the seller would be paid
by the buyer immediately on delivery of securities. All securities whether the specified list
or cash list can be traded on spot basis or cash basis.

MARKET MAKING
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Market making is a process where the market makers offers a two way quote (both buy
and sell) to increase the supply and demand of the scrip. This increase the liquidity in the
stock. Market-making is aimed at infusing liquidity in securities that are not frequently
traded on stock exchanges. A market-maker is responsible for enhancing the demand
supply situation in securities such as stocks and futures & options (F&O). To understand
this concept better, it would be helpful to have an idea about the existing screen based
electronic trading system. In this system, orders placed by buyers and sellers are
matched by a computer.

Settlement System
Settlement is the process of netting of transactions and actual delivery/receipt of
securities and transfer deeds against receipts/payment of agreed amount. It is necessary
to make a settlement to know the net effect of a series of transactions during a given
period. Settlement date is the date specified for delivery of securities between securities
firms. For administrative convenience, a stock exchange divides the year into a number
of settlement periods so as to enable members to settle their trades. All transactions
executed during the settlement period are settled at the end of the settlement period.
Settlement risk or principal risk is the risk that the seller of a security or funds delivers its
obligation but does not receive payment or that the buyer of a security or funds makes
payment but does not receive delivery. In this event, the full principal value of the
securities or funds transferred is at risk.
DIRECT MARKET ACCESS (DMA)
Direct Market Access (DMA) is a facility which allows brokers to offer clients direct access
to the exchange trading system through the broker’s infrastructure without manual
intervention by the broker. Some of the advantages offered by DMA are direct control of
clients over orders, faster execution of client orders, reduced risk of errors associated
with manual order entry, greater transparency, increased liquidity, lower impact costs for
large orders, better audit trails and better use of hedging and arbitrage opportunities
through the use of decision support tools / algorithms for trading.

DEMUTUALIZATION OF STOCK EXCHANGES

The process of demutualization is to convert the traditional “not for-profit” stock
exchanges into a “for profit” company and this process is to transform the legal structure
from a mutual form to a business corporation form. SEBI had set up a committee under
the Chairmanship of Justice Kania for the same which came up with report on
demutualization of Stock Exchanges through uniform scheme prescribed.
The important features of the demutualization exercise are as follows:
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(1) The board of a stock exchange should consist of 75% public interest/ shareholder
directors and only 25% broker directors, and
(2) 51% shareholding of the stock exchange should be divested to public/ investors other
than trading member brokers and only 49% of shareholding can remain with the trading
member brokers. This will transform our broker-owned stock exchanges into
professionally-run corporate stock exchanges.

Debt Market
Debt markets are markets for the issuance, trading and settlement of various types and
features of fixed income securities. Fixed income securities can be issued by any legal
entity like central and state governments, public bodies, statutory corporations, banks and
institutions and corporate bodies.

DEBT MARKET INSTRUMENTS CORPORATE DEBENTURE

It is a debt security issued by a company, which offers to pay interest in lieu of the money
borrowed for a certain period. In essence it represents a loan taken by the issuer who
pays an agreed rate of interest during the lifetime of the instrument and repays the
principal normally, unless otherwise agreed, on maturity. These are long-term debt
instruments issued by private sector companies, in denominations as low as ` 1000 and
have maturities ranging between one and ten years. Debentures enable investors to reap
the dual benefits of adequate security and good returns. Unlike other fixed income
instruments such as Fixed Deposits, Bank Deposits, Debentures can be transferred from
one party to another. Debentures can be divided into different categories on the basis of
convertibility of the instrument and Security. The debentures issued on the basis of
Security includes – – Non-Convertible Debentures (NCDs) – Partly Convertible
Debentures (PCDs) – Fully convertible Debentures (FCDs) – Optionally Convertible
Debentures (OCDs) – Secured Debentures – Unsecured Debentures.

DEBT MARKET INTERMEDIARIES/PARTICIPANTS

Primary Dealers
Primary dealers (PDs) are important intermediaries in the government securities markets.
They act as underwriters in the primary market, and as market makers in the secondary
market. PDs underwrite a portion of the issue of government security that is floated for a
predetermined amount. The underwriting commitment of each PD is broadly decided on
the basis of its size in terms of its net owned funds, its holding strength, the committed
amount of bids and the volume of turnover in securities.
 P a g e | 50

Brokers
Brokers play an important role in secondary debt market by bringing together
counterparties and negotiating terms of the trade. It is through them that the trades are
entered on the stock exchanges. The brokers are regulated by the stock exchange.

INVESTORS IN DEBT MARKET

Investors are the entities who invest in fixed income instruments. The investors in such
instruments are generally Banks, Financial Institutions, Mutual Funds, Insurance
Companies, Provident Funds etc. The individual investors invest to a great extent in Fixed
Income products.
Banks
Collectively all the banks put together are the largest investors in the debt market. Banks
lend to corporate sector directly by way of loans and advances and also invest in
debentures issued by the private corporate sector.
Insurance Companies
The second largest category of investors in the debt market are the insurance companies.
Provident Funds
Provident funds are estimated to be the third largest investors in the debt market.
Investment guidelines for provident funds are being progressively liberalized and
investment in private sector debentures is one step in this direction. Most of the provident
funds are very safety oriented and tend to give much more weightage to investment in
government securities although they have been considerable investors in PSU bonds as
well as state government backed issues.
Mutual Funds
Mutual funds represent an extremely important category of investors. World over, they
have almost surpassed banks as the largest direct collector of primary savings from retail
investors. Mutual funds include the Unit Trust of India, the mutual funds set up by
nationalized banks and insurance companies as well as the private sector mutual funds
set up by corporates and overseas mutual fund companies.
Trusts
Trusts include religious and charitable trusts as well as statutory trusts formed by the
government and quasi government bodies. There are very few instruments in which trusts
are allowed to invest. Most of the trusts invest in CDs of banks and bonds of financial
institutions and units of Unit Trust of India.
Corporate Treasuries
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Corporate Treasuries have become prominent investors only in the last few years.
Treasuries could be either those of the public sector units or private sector companies or
any other government bodies or agencies. The treasuries of PSUs as well as the
governmental bodies are allowed to invest in papers issued by DFIs and banks as well
as GOISECs of various maturities. However the orientation of the investments is mostly
in short-term instruments or sometimes in extremely liquid long term instruments which
can be sold immediately in the markets. In complete contrast to public sector treasuries,
those in the private sector invest in CDs of banks and CPs of other private sector
companies, GOISECs as well as debentures of other private sector companies.
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ACTIVITY 9
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. Explain the concept of DEBT market.
2. Discuss the importance and functions of market making.
3. How do you define and understand the concept of demutualization?
4. Differentiate and explain the two types of securities.
5. Explain corporate treasures and its functions.
 P a g e | 53

CHAPTER 10
Money Market
INTRODUCTION
Money market is a very important segment of a financial system. Monetary assets of
short-term nature up to one year and financial assets that are close substitutes for money
are dealt in the money market. Money market instruments have the characteristics of
liquidity (quick conversion into money), minimum transaction cost and no loss in value.
Excess funds are deployed in the money market, which in turn is availed of to meet
temporary shortages of cash and other obligations. Money market provides access to
providers and users of short-term funds to fulfill their investments and borrowings
requirements respectively at an efficient market clearing price. It performs the crucial role
of providing an equilibrating mechanism to even out short-term liquidity, surpluses and
deficits and in the process, facilitates the conduct of monetary policy. The money market
is one of the primary mechanism through which the Central Bank influences liquidity and
the general level of interest rates in an economy. The Bank’s interventions to influence
liquidity serve as a signaling-device for other segments of the financial system.
The money market functions as a wholesale debt market for low-risk, highly liquid, short
term instruments. Funds are available in this market for periods ranging from a single day
up to a year. Mostly government, banks and financial institutions dominate this market. It
is a formal financial market that deals with short-term fund management.

FEATURES OF MONEY MARKET

The money market is a wholesale market where the volumes of transactions is very large
and is settled on a daily basis. Trading in the money market is conducted over the
telephone, followed by written confirmation through e-mails, texts from the borrowers and
lenders.

MONEY MARKET vs. CAPITAL MARKET

The money market possesses different operational features as compared to capital
market. Money market is distinguished from capital market on the basis of the maturity
period, credit instruments and the institutions:
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FACTORING
Factoring is a financial transaction where an entity sells its receivables to a third party
called a ‘factor’, at discounted prices. Factoring is a financial option for the management
of receivables. In simple definition it is the conversion of credit sales into cash. In
factoring, a financial institution (factor) buys the accounts receivable of a company (Client)
and pays up to 80%(rarely up to 90%) of the amount immediately on formation of
agreement. Factoring company pays the remaining amount (Balance 20%-finance cost-
operating cost) to the client when the customer pays the debt.
PARTIES IN FACTORING
The factoring transaction involves three parties: – The Seller, who has produced the
goods/services and raised the invoice. – The Buyer, the consumer of goods/services
and the party to pay. – The Factor, the financial institution that advances the portion of
funds to the seller.

Mutual Funds
Mutual fund is a mechanism for pooling the resources by issuing units to the investors
and investing funds in securities in accordance with objectives as disclosed in offer
document. Investments in securities are spread across a wide cross-section of industries
and sectors and thus the risk is reduced. Diversification reduces the risk because all
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stocks may not move in the same direction in the same proportion at the same time.
Mutual fund issues units to the investors in accordance with quantum of money invested
by them. Investors of mutual funds are known as unitholders. The profits or losses are
shared by the investors in proportion to their investments. The mutual funds normally
come out with a number of schemes with different investment objectives which are
launched from time to time. A mutual fund is required to be registered with SEBI before it
can collect funds from the public.

ADVANTAGES OF MUTUAL FUNDS

The advantages of investing in a mutual fund are:
1. Professional Management: Investors avail the services of experienced and skilled
professionals who are backed by a dedicated investment research team which analyses
the performance and prospects of companies and selects suitable investments to achieve
the objectives of the scheme.
2. Diversification: Mutual funds invest in a number of companies across a broad cross-
section of industries and sectors. This diversification reduces the risk because seldom do
all stocks decline at the same time and in the same proportion. Investors achieve this
diversification through a Mutual Fund with far less money than one can do on his own.
3. Convenient Administration: Investing in a mutual fund reduces paper work and helps
investors to avoid many problems such as bad deliveries, delayed payments and
unnecessary follow up with brokers and companies. Mutual funds save investors time
and make investing easy and convenient.
4. Return Potential: Over a medium to long term, Mutual funds have the potential to
provide a higher return as they invest in a diversified basket of selected securities.
5. Low Costs: Mutual funds are a relatively less expensive way to invest compared to
directly investing in the capital markets because the benefits of scale in brokerage,
custodial and other fees translate into lower costs for investors.
6. Liquidity: In open ended schemes, investors can get their money back promptly at net
asset value related prices from the mutual fund itself. With close ended schemes,
investors can sell their units on a stock exchange at the prevailing market price or avail
of the facility of direct repurchase at net asset value (NAV) related prices which some
close ended and interval schemes offer periodically or offer it for redemption to the fund
on the date of maturity.
7. Transparency: Investors get regular information on the value of their investment in
addition to disclosure on the specific investments made by scheme, the proportion
invested in each class of assets and the fund manager’s investment strategy and outlook.
 P a g e | 56

RISKS INVOLVED IN MUTUAL FUNDS

Mutual funds may face the following risks, leading to non-satisfactory performance:
1. Excessive diversification of portfolio, losing focus on the securities of the key segments.
2. Too much concentration on blue-chip securities which are high priced and which do
not offer more than average return.
3. Necessity to effect high turnover through liquidation of portfolio resulting in large
payments of brokerage and commission.
4. Poor planning of investment with minimum returns.
5. Un-researched forecast on income, profits and Government policies.
6. Fund managers being unaccountable for poor results.
7. Failure to identify clearly the risk of the scheme as distinct from risk of the market.
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ACTIVITY 10
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. Explain the concept of mutual funds and its importance.
2. How will you manage and avoid the risk in mutual funds?
3. Why do you think risks happens in mutual funds?
4. How do you think mutual funds helps in capital market or the economy?
5. Which is difficult to manage or handle, capital market or money market?
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CHAPTER 11
THE MARKET FOR STOCK INDEX PRODUCTS AND OTHER EQUITY
DERIVATIVES

Portfolio Strategies with Stock Index Options

How stock options can be used to take advantage of the anticipated price
movement of individual stocks? Alternatively, they can be used to protect current or
anticipated positions in individual stocks. For example, an investor can protect against a
decline in the price of a stock held in her portfolio by buying a put option on that stock. By
doing so, the investor is guaranteed a minimum price equal to the strike price minus the
option price. Also, if an investor anticipates buying a stock in the future but fears that the
stock price will rise making it more expensive to buy the stock, she can buy a call option
on the stock. By pursuing this strategy, the investor guarantees that the maximum price
that will be paid in the future is the strike price plus the option price.
Consider an institutional investor that holds a portfolio consisting of a large number
of stock issues. To protect against an adverse price movement, the institutional investor
must buy a put option on every stock issue in the portfolio, which would be quite costly.
By taking an appropriate position in a suitable stock index option, an institutional investor
with a diversified portfolio can protect against adverse price movements.

FLEX Option
A FLEX option is an option contract with some customized terms. It is traded on an
options exchange and cleared and guaranteed by the associated clearinghouse for the
exchange. The need for customization of certain terms arises because of the wide range
of portfolio strategy needs of institutional investors that cannot be satisfied by standard
exchange-traded options.
A FLEX option can be created for individual stocks and stock indexes. The value of FLEX
options comes from the ability to customize the terms of the contract along four
dimensions: underlying, strike price, expiration date, and settlement style.
Index Warrants
Warrants on stock indexes are called index warrants. As with a stock index option, the
buyer of an index warrant s can purchase the underlying stock index. Index warrants are
issued by either corporate or sovereign entities as part of a security offering, and they
are guaranteed by an option clearing corporation.

STOCK INDEX FUTURES MARKET

A futures contract is a firm legal agreement between a buyer and an established
exchange or its clearinghouse in which the buyer agrees to take delivery of something at
a specified price at a designated time (called the settlement date). On the other side of
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the contract is a seller who agrees to deliver the "something." A stock index futures
contract is a futures contract where the underlying "something" is a stock index.

Depositories
A Depository is an organization like a Central Bank where the securities of a
shareholder are held in the electronic form at the request of the shareholder through the
medium of a Depository Participant. To utilize the services offered by a Depository, the
investor has to open an account with the Depository through a Depository Participant.

BENEFITS OF DEPOSITORY SYSTEM

In the depository system, the ownership and transfer of securities takes place by means
of electronic book entries. At the outset, this system rids the capital market of the dangers
related to handling of paper. The system provides numerous direct and indirect benefits,
like:
Elimination of bad deliveries - In the depository environment, once holdings of an investor
are dematerialized, the question of bad delivery does not arise i.e. they cannot be held
"under objection". In the physical environment, buyer of shares was required to take the
risk of transfer and face uncertainty of the quality of assets purchased. In a depository
environment good money certainly begets good quality of assets.
Elimination of all risks associated with physical certificates - Dealing in physical securities
have associated security risks of theft of stocks, mutilation of certificates, loss of
certificates during movements through and from the registrars, thus exposing the investor
to the cost of obtaining duplicate certificates and advertisements, etc. This problem does
not arise in the depository environment.
Immediate transfer and registration of securities - In the depository environment, once the
securities are credited to the investors account on pay out, he becomes the legal owner
of the securities. There is no further need to send it to the company's registrar for
registration. Having purchased securities in the physical environment, the investor has to
send it to the company's registrar so that the change of ownership can be registered.
Faster disbursement of non cash corporate benefits like rights, bonus, etc. – Depository
system provides for direct credit of non cash corporate entitlements to an investors
account, thereby ensuring faster disbursement and avoiding risk of loss of certificates in
transit.
Reduction in brokerage by many brokers for trading in dematerialized securities - Brokers
provide this benefit to investors as dealing in dematerialized securities reduces their back
office cost of handling paper and also eliminates the risk of being the introducing broker.
Reduction in handling of huge volumes of paper and periodic status reports to investors
on their holdings and transactions, leading to better controls.
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Elimination of problems related to change of address of investor, transmission, etc. - In

case of change of address or transmission of shares, investors are saved from
undergoing the entire change procedure with each company or registrar. Investors have
to only inform their DP with all relevant documents and the required changes are effected
in the database of all the companies, where the investor is a registered holder of
securities.
Elimination of problems related to selling securities on behalf of a minor - A natural
guardian is not required to take court approval for selling securities on behalf of a minor.

DEPOSITORY SYSTEM - AN OVERVIEW

The Depository System functions very much like the banking system. A bank holds funds
in accounts whereas a Depository holds securities in accounts for its clients. A Bank
transfers funds between accounts whereas a Depository transfers securities between
accounts. In both systems, the transfer of funds or securities happens without the actual
handling of funds or securities. Both the Banks and the Depository are accountable for
the safe keeping of funds and securities respectively. In the depository system, share
certificates belonging to the investors are to be dematerialized and their names are
required to be entered in the records of depository as beneficial owners. Consequent to
these changes, the investors’ names in the companies’ register are replaced by the name
of depository as the registered owner of the securities. The depository, however, does
not have any voting rights or other economic rights in respect of the shares as a registered
owner. The beneficial owner continues to enjoy all the rights and benefits and is subject
to all the liabilities in respect of the securities held by a depository. Shares in the
depository mode are fungible and cease to have distinctive numbers. The transfer of
ownership changes in the depository is done automatically on the basis of delivery vs.
payment.

STOCKS AND STOCK VALUATION

Characteristics of common stock
a. Ownership in a corporation: control of the firm Claim on income: residual claim on
income
b. Claim on assets: residual claim on assets
c. Commonly used terms: voting rights, proxy, proxy fight, takeover, preemptive
rights, classified stock, and limited liability
The market price vs. intrinsic value
Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should be worth)
Market price is the actual price of a stock, which is determined by the demand and supply
of the stock in the market
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Determinants of Intrinsic Values and Market Prices

Intrinsic value is supposed to be estimated using the “true” or accurate risk and return
data. However, since sometimes the “true” or accurate data is not directly observable, the
intrinsic value cannot be measured precisely.
Market value is based on perceived risk and return data. Since the perceived risk and
return may not be equal to the “true” risk and return, the market value can be mispriced
as well.
Stock in equilibrium: when a stock’s market price is equal to its intrinsic value the stock is
in equilibrium
Stock market in equilibrium: when all the stocks in the market are in equilibrium (i.e. for
each stock in the market, the market price is equal to its intrinsic value) then the market
is in equilibrium.

Preferred stock
- A hybrid security because it has both common stock and bond features.
- Claim on assets and income: has priority over common stocks but after bonds
- Cumulative feature: all past unpaid dividends should be paid before any dividend
can be paid to common stock shareholders

The efficient market hypothesis (EMH)

Efficient market: prices of securities in the market should fully and quickly reflect all
available information, which means that market prices should be close to intrinsic values
(market in equilibrium)
Levels of market efficiency
Weak-form efficiency - stock prices already reflect all information contained in the
history of past price movements (only past trading information, including past prices,
volumes, and returns)
Semi-strong-form efficiency - stock prices already reflect all publicly available
information in the market (only past publicly available information)
Strong-form efficiency - stock prices already reflect all available information in the
market, including inside information (all publicly and privately available information)
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ACTIVITY 11
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.
1. When do we say that we have an efficient market?
2. How can we create or improve the market efficiency?
3. Explain and discuss stock valuation?
4. What is the role of depository system? Cite its importance.
5. Discuss what is market value and stock market in equilibrium.
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CHAPTER 12
CAPITAL BUDGETING & CAPITAL STRUCTURE

Capital budgeting
Capital budgeting: the process of analyzing and deciding what projects (assets) should
be included in capital budget.
Capital budget: a plan that outlines projected expenditures during a future period
Capital Budgeting

Capital budgeting is simply the process of deciding which capital projects to pursue and
which to reject. At any given time, a business may have countless projects it could
pursue. Even a project as straightforward as opening a new store could go in multiple
directions: where to put it, how big it should be, what product mix it should offer and so
on. A business can't -- and shouldn't -- pursue every possible project. For one thing, you
only have so many resources. Also, some projects are mutually exclusive, and projects
might not even be profitable when all costs are considered. Capital budgeting separates
the promising projects from the bad ones.

Budgeting vs. Rationing

Capital budgeting is not the same thing as capital rationing, although the two often go
hand in hand. Capital budgeting simply identifies which projects are worth pursuing,
regardless of their upfront cost. When a company has a finite amount of capital to invest
-- a familiar situation to the small business owner -- capital rationing helps the business
choose the projects it can afford that will produce the greatest return. One common
method for doing this is the "profitability index."

Net Present Value Method

Under the net present value (NPV) method, you examine all the cash flows, both positive
(revenue) and negative (costs), of pursuing a project, now and in the future. You then
adjust, or "discount," the value of future cash flows to reflect what they're worth in the
present day.

NPV makes this adjustment using a "discount rate" that takes into account inflation, the
risk of the project and the cost of capital – either interest paid on borrowed money or
interest not earned on money spent to pursue the project. Finally, it adds up the present
values of all the positive and negative cash flows to arrive at the net present value, or
NPV. If the NPV is positive, the project is worth pursuing; if it's negative, the project
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should be rejected. When deciding between projects, choose the one with the higher
NPV.

Payback Period Method

Under the payback period method, estimate how much it will cost your business to
launch the project and how much money it will generate once it's up and running. Then
calculate how long it will take the project to "break even," or generate enough money to
cover the startup costs. Companies using the payback period method typically choose
a time horizon – for example, 2, 5 or 10 years. If a project can "pay back" the startup
costs within that time horizon, it's worth doing; if it can't, the project will be rejected.
When deciding between projects, choose the one with the shorter payback period.

Payback Period
The payback period calculates the length of time required to recoup the original
investment. For example, if a capital budgeting project requires an initial cash
outlay of $1 million, the PB reveals how many years are required for the cash
inflows to equate to the one million dollar outflow. A short PB period is preferred
as it indicates that the project would "pay for itself" within a smaller time frame.

Pros and Cons of Each Method

The payback period method has some key weaknesses that the NPV method does
not. One is that the payback method doesn't take into account inflation and the cost of
capital. It essentially equates $1 today with $1 at some point in the future, when in fact
the purchasing power of money declines over time. Another is that the payback
method ignores all cash flows beyond the time horizon – and those cash flows may be
substantial. Big moneymakers, after all, sometimes take a while to get going.

On the other hand, the big drawback of the NPV method lies in its assumptions. If you
don't get your estimate of the discount rate correct, your calculation will be off – and
you won't know it until the project turns into a big money-loser.

Combining the Two Methods

Many businesses use a combination of methods when making capital budgeting

decisions. You could use the payback period method to narrow down options, then
apply the NPV method to identify the best of the remaining projects. Or you could use
the NPV method to separate the "winners" from the "losers" among possible projects,
then look at payback periods to see which projects return their costs more quickly.

Capital Structure
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Capital structure
The mix of debt, preferred stock, and common equity that is used by a firm to finance its
assets.
The optimal capital structure: the capital structure that maximizes the company’s
value or stock price (or minimizes the company’s overall cost of capital, WACC) Capital
structure changes over time.

Business risk vs. financial risk

Business risk: the riskiness inherent in the firm’s operations if it uses no debt It is
measured by the variability of expected ROE (ROA)
Business risk depends on:
Competition
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Operating leverage
Foreign risk Regulations

Operating leverage: the extent to which the fixed costs are used, the higher the fixed
costs, the higher the operating leverage, the higher the business risk Financial risk: the
additional risk placed on stockholders as a result of the firm’s decision to use debt

Capital structure theories

Assumptions: perfect capital markets with no taxes, homogeneous information, EBIT is
not affected by using debt, and investors can borrow at the same rate as corporations
Irrelevance theory (MM 58): capital structure doesn’t matter; the capital structure does
not affect firm value or stock price (or the overall cost of capital) The effect of taxes (MM
63): if corporate taxes are considered, stock price and overall cost of capital will be
affected by the capital structure. The higher the debt, the lower the overall cost of capital,
the higher the stock price.
The trade-off model: corporate taxes are considered and firms may fail
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Costs of financial distress vs. benefits from tax shields

The greater the use of debt, the larger the fixed interest charges, the greater the
probability that a firm will go bankruptcy. At the same time, the greater the use of debt,
the larger the tax shields.

Signaling theory: asymmetric information means that investors and management have
different information. Any change in capital structure reveals inside information. For
example, a firm issues new stock to raise money is viewed as a negative signal, which
causes stock price to drop.

Pecking order theory: due to flotation costs and asymmetric information, firms should
consider using retained earnings and short-term debt to raise money first. If those funds
are not available, firms can consider long-term debt and preferred stock financing. Issuing
new common stocks to raise money should be the last choice.

TIME VALUE OF MONEY – THE CONCEPT AND ITS UTILITY

The concept of time value of money is simple to understand and interpret. The value of
money affected with the passage of time is called as time value of money. In the period
of deflation the value of money increases while it is reverse in case of inflationary period.

It is the medium of exchange. Money serves the purpose of exchange as it is the measure
of value. The value is the purchasing power of money which makes it powerful
commodity. Moreover, if any comparison is to be made in the values of money, few rules
need to be followed. Firstly the unit should be same, like all values should be in same
currency. Secondly, the values should be at same point of time. That means, Rs 100
today cannot be treated as equal to Rs 100 at a future date. The value of money at
different points of time is different like today it is having a specific value and after one year
it will have different value then after two years, it will have different value. Usually, with
passage of time, the value of money decreases. The reasons for the same are described
in the following paragraph. It would be worthy to note here that the difference between
the value of money today and the value of same money on a future date is called time
value of money
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Internal Rate of Return

The internal rate of return (or expected return on a project) is the discount rate that
would result in a net present value of zero. Since the NPV of a project is inversely
correlated with the discount rate—if the discount rate increases then future cash
flows become more uncertain and thus become worth less in value—the
benchmark for IRR calculations is the actual rate used by the firm to discount after-
tax cash flows.

An IRR which is higher than the weighted average cost of capital suggests that
the capital project is a profitable endeavor and vice versa.

The IRR rule is as follows:

IRR > Cost of Capital = Accept Project

IRR < Cost of Capital = Reject Project

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ACTIVITY 12
QUESTIONS. Explain each question with a minimum of 5 sentences each. Do it on
your own understanding.

1. Why do we use payback period? How it helps businesses and owners?

2. Explai the concept and importance of capital budgeting.
3. What do you think will be the common problem or struggle in capital budgeting? How
wll you manage and avoid those dffculties?
4. Discuss the role and functions of RR in business and how it affects the capital
market?
5. What s the relationship of capital market to captal structure?
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REFERENCES
 CAPITAL MARKETS AND SECURITIES LAWS
(CapitalMarketandSecuritesLaw.pdf (icsi.edu)

 Capital Market Institutions and instrument 4th edition by Frank J. Fabozzi and
Franco Modigllani