Derivatives
Derivatives are financial instrument whose value depends upon the value of some
underlying assets. Such assets could be tangible such as wheat, cotton, real estate
or financial instrument like equity etc. The underlying might be even another derivative
contract, such as future and options.
Types of financial derivatives
1. Forwards
2. Futures
3. Options
4. Swaps
Forwards contract
A forward contract is an agreement between two parties to buy or sell an asset at
a future date at a price agreed today. So in case of forward contract, the date,
the rate and the quantity all are decided at the contract date, but the contract
is implemented in future on the agreed date. There may not be a standard form of
forward contract. The parties may contract as per their own requirement and suitability.
So, the forward contracts are generally tailor made.
Futures contract
A futures contract is a contract to buy or sell a stated quantity of a commodity
or a financial claim at a specified price at a future specified date. Futures are
traded on the exchanges and the terms of the futures contracts are standardized
by the exchange with reference to quantity, date, units of price quotation, minimum
change in price etc.
Futures can be in respect of commodities such as agriculture products, oil, gas,
gold, silver etc. or of financial claims such as shares, debentures, treasury bonds,
share index, foreign exchange etc.
Benefits of using Future Contracts:
- a) Futures provide a hedging facility to counter the expected movements in prices.
- b) It helps indicating the future price movement in the market.
- c) It provides an arbitrage opportunity to the investor.
- d) Futures enable a party to transfer the risk to another person who is willing
to accept the risk.
- e) Futures provide incentive to make profit with minimal amount of capital.
Options:
Options are contracts which provide the holder the right to sell or buy a specified
quantity of an underlying asset at a fixed price on or before the expiration of
the option date. Options provide a right n and not the obligation to buy or sell.
The holder of the option can exercise the option at his discretion or may allow
the option to lapse. The person who acquires the right is known as option holder
and the person who grants this right is known as option seller or option writer.
Types of options:
Call Options:
A call option provides to the holder right but not the obligation to buy specified
assets at a specified price on or before a specified date.
Put options:
A put option provides to the holder right but not the obligation to sell specified
assets at a specified price on or before a specified date.
Benefits of using Options:
- a) In buying option risk is limited to the amount paid in terms of option premium.
- b) An investor can profit on changes in an equity market price without ever having
to actually put up the money to buy the equity.
- c) Options pay higher percentage return to investors at the time of pay off.
- d) There are several strategies available in options to hedge the risk and maximizing
the profit.
Risk in the future & option trading:
- a) Futures expose investor to unlimited liability.
- b) In future trading profit and losses are settled on a daily basis at the end of
each trading day.
- c) Trading related risks of futures trading has to do with investor’s ability to
make the correct futures trading decisions and actions like price analysis, future
tend etc.
Swaps: A swap is a contract in which two parties agreed to exchange their
respective future cash flow. There are private arrangements between parties to exchange
cash flows according to some pre-arranged formula. The parties to the swap contract
are known as counter-parties. In swaps, one party agrees to exchange his set of
pre-determined cash flows with the pre-determined set of cash flows of the other
party.
Bond
Bonds are the debt instrument issued by the government or corporate to raise money
from the market under the borrowing agreement. Under the agreement, the issuer has
to pay periodic interest payments to the bond holder on the specific date. This
rate of interest rate is called the coupon rate.
Features of Bond:
Credit Instrument: A bond is a type of loan. A bond holder is a creditor
of the company and is entitled to receive payment of interest and the principle.
Collateral: Bond issue may or may not be secured and, therefore, bond may
be called secured or unsecured bond.
Voting Right: as the bond holder is the creditor of the company, they do
not have the voting right in normal situation.
Priority in Liquidation: In case of liquidation of the company, the claim
of debt holders is settled in priority over all shareholders, and generally other
unsecured creditors also.
Types of bond:
Secured and unsecured Bonds- Whenever a long term source of funds is issues
it is issued as a secured debenture and having fixed or floating charges on the
assets of the company. The security helps reducing the risk of debt investors. Mortgage
backed bonds are the example of secured bonds which are backed by the homes and
other real estate properties. On the other side, the unsecured bonds are those bonds
which are secured by the general liability of the company but do not carry any particular
assets or specific charge as security.
Zero Coupon Bond- Zero coupon bonds are those bonds which do not pay any
payment in terms of interest during the whole life of bond and these bonds are sold
at a deep discount from its face value or we can say that investor bought these
bonds at a price below than the face value. The main idea behind the issuance of
zero-coupon bond is to provide an option to investor to purchase bond at a lower
price than its face value and decrease rate upfront in return for paying this, a
rate of interest is offered to the bond holder that will ultimately yield a return
which is equal to the face value of that bond or possibly little more than that.
Junk Bond- Junk bonds are generally speculative in nature and come under
high risk and high yield bonds class. The coupon rate of interest is high on these
bonds as comparison to other type of bonds. However, the interest risk and principle
risk of these bonds are also higher. In principle, these bonds have a very low or
no credit rating. Only speculators may likely to trade in junk bonds and investors
generally do not favor these bonds.
Municipal bond
Municipal bonds are those bonds which are issued by the civic authority of a city.
The basic idea behind these bonds is to raise fund for the development of infrastructure
in the city or ongoing government expenditures. Tax benefit may or may not be available
on these bonds because interest received from such types of bonds are full exempted
from all types of tax if the person lives in that city or state in which these bonds
issued but the capital gain on these bonds are taxable. These bonds may be issued
to retail investors or institutional investors. The coupon rate is relatively low
as these bonds have a guarantee provided by the government and due to the tax saving
by purchasing of these kinds of bonds.
YTM
Yield to Maturity (YTM) can be define as the annual rate of return that will be
earned if the bond is purchased today at the current market price and is held by
the investor till maturity.
So, YTM is the average rate of return that will be earned on a bond if it is bought
now and held till maturity. It shows an effective annual return from a security
expressed as a percentage of the current market price of the security. It is a measure
of total income earned by an investor over the total life of security. YTM is also
known as market rate of return on market rate of interest.
Knowledge before investing in bond:
- a) Issuer – This is the company name which is the issuer of the bond
- b) Coupon- it shows the fixed interest rate that the issuer of bond pays to the
investor or the buyer of bond.
- c) Maturity Date- This is the date on which bond will mature and issuer will repay
the principal amount to investor.
- d) Bid Price- This is the price at which bond is traded in the market or we can
say that someone is willing to pay for the bond. Whatever the par value is, the
bid price is quoted in relation to 100 i.e. percentage terms.
- e) Yield- Yield shows the annual return if the investor holds the bond till maturity.
- f) Face value of a bond is the amount which is repaid by the issue to the investor
at the time of maturity. Bond face value generally represents the redemption value
of the bond. The interest on bonds is also calculated on face value.
PRIMARY MARKET
Primary market is basically a Market for new issues, known as the new issues market.
Primary market refers to the long-term flow of funds from the surplus sector to
the government and corporate sector through primary issues. When the company goes
public first time the issue is known as 'Initial Public Offer' the process of IPO
(Initial Public Offer) is held by the merchant banks.
SECONDARY MARKET
Secondary market is basically the Market where outstanding or existing securities
are traded. It is the market for previously issued financial instruments. After
IPO is issued in the primary market from the owners of the issuing company, when
the stock is traded among the different investors is known as secondary market.
Share
The smallest part of the total share capital of a company. It has a distinctive
number and a par value.
Common stock
It is the legal representation of an equity position in a company. Common stock
holder can exercise their control by electing a board of directors and voting on
corporate policy. Common stockholders are on the bottom of the priority ladder for
ownership structure. At the time of winding up or liquidation of company, common
stock holders are last for any financial settlement.
Benefits of Common stock
Voting right
Voting right attached to the shareholder entitles him to vote for the selection
of the board of directors. The top management of the company is related by the board
of directors. Generally 1 share hold by the investor entitles him for 1 vote. Number
of votes held by an investor gives him the considerable power. Large number of shares
held by one investor gives him the power to influence the voting decision.
Limited liability
Limited liability of a shareholder is when in the process of liquidation, shareholders
are liable to pay /contribution only part of their wealth which they own in the
company and nothing from their personal asset.
Claim on Income
Every shareholder gets the right to claim the income of the company when the company’s
growth prospects are good and the company is earning profits by doing well in the
industry, every investor wants to have a share of the profit . Company can either
distribute these profits as dividends or can also reinvest the profit again into
the business for the future growth prospectus. If the company doesn’t wants to distribute
the cash then it may also issue a stock dividend which will entitle the existing
investor with an additional number of shares in proportion to the shares already
held by him.
Pre-Emptive Rights
Pre-emptive right is a privilege given to the existing share holder of the company
to get the additional shares of the company. In other words, existing shareholder
has the first priority on the new shares of the company before the company go to
the public. This right will not dilute the shareholder proportionate interest in
the company.
Stock-Split
Stock-split is where a company issues the new shares to the existing shareholders
in proportion to the shares held by them. But when new stocks are issued the market
price of the shares decreases so that the combines volume of old shares plus the
new shares of the investors remains same as before.
Preferred stocks
Preferred stocks are those stocks which provide a fixed dividend to the preferred
shareholder. Dividend must be paid to preferred share holder before the payment
to be made to holders of common shares. Main advantages of preferred stocks are
as follows:
- a) Preferred stockholders receive dividend first in comparison to common stockholder
in the event of winding up, bankruptcy of a company.
- b) Holder of preferred stockholders have greater claim right on the assets of the
company than the common stock holders.
- c) Some preferred stocks can be convertible into common stocks after a certain period
of time. The main benefit of this convertibility is that the preferred shareholder
gets the voting right after covert it into common stock.
- d) Dividend in preferred stocks is cumulative in nature.
- e) These stocks can be callable at any time according to the needs of the company
which issue the preferred stocks.
- f) Equal participation is to be done by the common shareholders if the earnings
made through additional issuance of ordinary shares. But, in case of preferred stock,
there is no such participation is to be done by preferred shareholders. Their claims
per share are restricted up to a limited amount.
Income stock
Income stocks are those stocks which give consistent income to the investors by
way of regular dividends. These are safe stocks and generally investors in expectation
of regular income go for these stocks. As all the earning is distributed as dividend
and is not reinvested back into the business these stocks shows less capital appreciation.
Growth Stock
Growth stocks are the stock are the stocks whose value of shares increase over the
time. Growth stocks are categorized as those stocks which are issued by the company
which has established in the recent past. As the name itself suggests the growth
stocks promises growth in income of the investor. When an investor invests in a
growth stock he expects that the company will experience the high growth and thus
resulting in high earnings, which in turn will be shared by the investors.
Blue Chip Stock
The stocks issued by large companies are generally categorized as Blue chip stocks.
These stocks perform consistently in the market and also track the overall growth
in the market. Since these stocks are consistent in nature they are best suited
for the low risk appetite investors they give slow and steady returns.
Cyclical Stock
The stocks which are sensitive to the business cycle are categorized as cyclical
stocks. ups and downs in the economy moves the prices of these securities. Some
of the examples of cyclical stocks are cars, airlines, furniture etc.
Defensive Stock
The stocks which are less sensitive to the movements in the market are the defensive
stocks. The portfolios consisting of these stocks are relatively stabilized during
market downturn. These companies’ products are always in demand regardless the market
conditions.
Industry and Sector stock
Industry specific stocks are those which are of a particular or related industry.
Sector stocks are stock of a specific sector in an economy. Eg- banking, pharmaceutical
etc.
Stock Market Index
A stock market index is a measure which evaluates the performance of bunch of a
certain sector’s stocks which are clubbed together. Generally the base of its measure
is stock price or sometime weighted average price of selected stocks. It is used
by investors as a comparison tool which compares the returns of the specific investments
and also describes the market conditions. One stock index calculations is different
from other stock index but they are generally in percentage change terms which are
far better and significant than numerical values. Some of the measure stock market
indexes are SENSEX, S&P Global 100, S&P 500 Index, NYSE, NASDAQ etc.
Market Capitalization
Market capitalization is basically the total value of the company’s share in the
market. Market capitalization is calculated on the current market price of the share.
It is the number of shares outstanding in the market multiplied by the current market
price. Market capitalization classifies the companies as large cap, mid cap and
small cap.
Large cap companies are those companies which have the market capitalization
of $ 5 billion or above. These companies are well established companies and are
into existence since many years. The stocks of these companies are relatively stable.
Mid Cap companies are those companies which have the market capitalization
between $ 1 billion to $3 billion. These companies are smaller than large cap companies
but larger than small cap companies. These stocks are have advantages of both large
cap and small cap companies.
Small cap companies are those companies which have market capitalization
of less than $1 billion along with annual revenues below $250 million.
Margin call
A Margin call is a situation which occurs when the amount in the margin account
has dropped below the minimum margin requirement (a set percentage of investment).
It may also be happened when the broker do some changes in their minimum margin
requirement. As a result broker will give a call to investor to maintain the sufficient
margin requirement either by raise money through other sources and deposit it in
to the account or by selling of underlying stocks.
Selling Short
Selling short is just the reverse of Selling long. As in Selling Long investor buy
the stock and hold the stock to make money assuming that market will go upward in
future. In the same manner, Selling short is a technique in which investor make
money or profit by selling stock which are not hold by the investor and borrowed
from the agent account with the intention that the market would go down in future
and that time repurchase those stocks at lower price. To initiate selling short
investor must have opened the margin account with the broker which allows the investor
to borrow stocks for short selling. The difference of the price at which investor
sells the stock and repurchase that stock at lower price after the falling down
the price is the profit of investors.
Close price
Close price is the last price at which a particular stock is traded during the whole
trading day on the stock exchange. It is the most refined and most updated price
of a stock during that particular day which can be compared with the last day closing
price to find out the volatility of a particular stock or security.
Earnings Per Share (Eps)
If we calculate the return as a percentage of the total funds then, profitability
is measured through Return on Equity. The profitability of a firm also be measure
in terms of equity shares. This is known as EPS. In other words EPS is amount which
is earned on each equity shares of the company. It is derived by dividing the Profit
after Tax (PAT) by the total number of outstanding equity shares. So, EPS = (PAT
– preference Dividend) / Number of Equity shares
Price Earnings Ratio (P/E Ratio)
P/E ratio is the ratio which establishes the relationship between the EPS and the
Market price of a share. In simple words this ratio shows that to earn one rupee
how much money an investor need to invest in that particular share. It is calculated
as follows: P/E Ratio = Market price per share/ Earning per share (EPS)
BETA
Beta is a relatively measure of sensitivity of the return of the asset to change
in the market portfolio’s return. In simple word if on a particular day market is
increase or decrease by 1 percent than by how much percent the share price of a
particular share are expected to move this is called beta. It is a measure of systematic
risk.
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