Equity and derivatives market

Q1: Write a note on the Equity Market.

Ans: EQUITY MARKET.

*INTRODUCTION:

~ Equity Market is the market that deals with issue / trade of shares.

~ The shares can be traded exchanges or over the counter markets.

~ Equity market is also known as stock market.

~ Equity market comprises of:

^ Primary market (raising of fresh capital in the form of equities).

^ Secondary market (deal with equities already issued).

*MEANING:

~ A company raises capital through equities in the form of ordinary shares and preference shares.

ORDINARY SHARES:

^ Equity shares are also known as ‘ordinary shares’ and equity capital is also known as ‘owned capital’

^ Equity shareholders share the reward and risk associated with ownership of corporate enterprises.

^ The following are the futures of ‘Ordinary Shares’:

i)PERMANENT CAPITAL:

~ The equity share capital is the permanent capital of the company and so there is no obligation on the part of the company to repay the capital. Equity shares are irredeemable.

ii) RESIDUAL CLAIM TO INCOME:

~ The equity shareholders receive the residual income of the company after all outside claims are met.

~ ‘EQUITY SHAREHOLDERS’ INCOME = PROFIT AFTER TAX – PREFERENCE DIVIDEND’

~ The amount actually received by shareholders also depends on the decision of the Board of Directors.

~ A part of the net profit may be received by shareholders later in the form of capital appreciation / bonus shares.

iii) FLUCTUATING DIVIDEND:

~ There is no guarantee of minimum dividend.

~ The rate of dividend depends on the earning of the company.

iv) RESIDUAL SHARE ON ASSETS:

~ In the event of liquidation of the company, the equity shareholders are the last to claim the asset of the company.

~ Their claim will be considered after the claims of the creditors and preference holders are duly met.

v) RIGHT TO CONTROL:

~ Equity shareholders are the part owners of the company and so they have the right to participate in the management of the company.

~ However, in practice, the control is indirect and very weak as all the major decisions / policies are approved by the Board of Directors.

vi) PRE-EMPTIVE RIGHTS:

~ Equity shareholders of a company enjoy certain pre-emptive rights. i.e. legally they have the right to be first offered the opportunity to purchase additional issues of equity capital in proportion to their existing holdings.

~ The shareholders can: Exercise

: Sell in the market

: Renounce / forfeit their pre – emptive rights (partially / fully).

~ The shares available due to non-exercise of rights would be allotted on a pro-rate basis to other shareholders exercising the rights.

~ The balance of shares can be offered to the public for sale.

vii) LIMITED LIABILITY:

~ Shareholders share the ownership risk of the company but their liability is limited to the extent of their investment in the share capital of the company.

viii) VOTING RIGHTS:

~ The equity shareholders enjoy normal voting rights.

~ They have the right to vote on all the resolutions passed at the shareholders meeting.

# PREFERNCE SHARES:

~ A preference share is a long-term capital market instrument that combines the futures of equity shares and debentures.

~ It is an ownership security but carries a fixed rate of return.

~ The preference shareholders are entitled to income of the company after all the claims of the creditors have been met but before the ordinary shareholders receive any income.

~ Preference shares are of the following types:

i)^ CUMULATIVE PREFERENCE SHARES:- In case of lapse in payment of dividend it is subsequently paid.

^ NON-CUMULATIVE PREFERENCE SHARES:- Any lapse in dividend is not paid.

ii) ^ CONVERTIBLE PREFERENCE SHARES:- Can be converted into equity shares.

^ NON-CONVERTIBLE PREFERENCE SHARES:- Cannot be converted into equity shares.

iii) ^ REDEEMABLE PREFERENCE SHARES:- Mature in a fixed period of time.

^ NON-REDEEMABLE PREFERENCE SHARES:- Have no fixed time limit.

iv) ^ PARTICIPATING PREFERENCE SHARES:- Can earn a fixed dividend plus more if the company makes good profit.

^ NON-PARTICIPATING PREFERENCE SHARES:- Cannot earn any income higher than the fixed dividend.

~ The market for preference shares in narrow and less active.

~ These shares are mostly held by institutional investors.

*ADVANTAGES OF EQUITY SHARES:-

To The Company

To The shareholders

i) It represents permanent capital and there is no obligation for repayment.

i) Enjoy control over the company’s management.

ii) No fixed obligation for payment of dividend

ii) Liability limited to the extent of unpaid amount of shares.

iii) Enhances credit worthiness of the company.

iii) Income through high dividend.

iv) No charge on the asset of the company.

iv) Eligibility for bonus shares and rights shares

v) Equity share capital with a higher promoters contribution reduces chances of take-overs

v) Increase in wealth due to bonus shares and high dividend

Q2: Write a note on derivatives market.

Ans: DERIVATIVES MARKET.

*INTRODUCTION:

~ Derivatives are securities/ instruments that are available for investment and trading.

~ In India, various measures are measures are being taken to develop the derivatives market.

*MEANING:

~ The derivatives market is the market that involves exchange of derivatives.

~ A derivative is a type of security / contract whose value is derived from the value of another asset such as a share, a stock market index, a commodity, a currency or an interest rate. These assets are known as ‘underlying assets’.

~ The value of the derivatives is determined by changes in underlying assets.

~ Thus, derivatives are secondary market instruments that offer a range of mechanisms to redistribute the risk arising in the financial world.

*BENEFITS:

~ Price Discovery and Risk Management are the two most important benefits of the derivatives market. These, along with other benefits are explained below:-

i)PRICE DISCOVERY:

~ Price of a product is determined by the market forces of demand and supply.

~ These forces in turn depend on various regional economic social and political factors and a continuous flow of information from around the world.

~ An impending change in these factors can have its impact on the demand / supply of a particular product and thus on the current and future prices of the underlying product on which the derivatives contract is based.

~ Thus, derivates help in determining the current or future prices of an underlying asset.

~ This helps in discovering the true price of the asset.

~ The price in the derivates market reflect the perceptions of the market participants about the future and this lead the prices of the underlying asset to the perceived future level.

ii) RISK MANAGEMENT:

~ Derivatives help to manage the risk and thus increase the willingness to hold the underlying asset.

~ Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and changing the actual level to the desired level.

~ This involves hedging and speculation.

~ Hedging implies reducing the risk in holding a market position whereas speculation implies taking a position in the way the market will move.

~ Thus, hedging and speculation, along with derivatives enable companies to manage risk more effectively.

iii) INCREASE LIQUIDITY:

~ Derivatives increase the liquidity in the market for the underlying assets’

~ It provides a liquid market where traders readily trade commodities or financial instruments for a price that is close to its true value.

~ The trading volume increases in the underlying market due to participation by a large number of players.

iv) LOWER TRANSACTION COSTS:

~ Derivatives bring down transaction costs as transaction costs associated with trading a financial derivative are much lower than trading the underlying asset.

v) SMOOTHEN FLUCTUATIONS:

~ Derivatives help to smoothen price fluctuations by narrowing the price spread and integrating price structures.

~ Speculation, competitive trading and different risk taking preferences help smoothen price fluctuations.

vi) GROWTH OF STOCK MARKET:

~ Derivatives play an instrumental role in the growth of stock markets.

~ Derivatives lead to wider participation in the securities market.

vii) PROVIDE INFORMATION ABOUT DIRECTION OF INDICES:

~ Derivatives provide information about magnitude and the direction in which various market indices are expected to move.

*DERIVATIVES PRODUCTS:

~ Derivatives products are of two types:

Commodity Derivatives:

~ In commodity derivatives, the underlying asset is a commodity like rice, wheat, cotton, crude oil, gold, silver, etc.

~ Commodity futures and options have been existing in our country for several centuries.

~ Commodity derivatives help in hedging against fluctuations in commodity price.

^ Financial Derivatives:

~ In financial derivates, the underlying asset includes stock, bonds, treasuries, foreign exchange, stock index, etc.

~ The financial derivatives market has witnessed substantial growth with respect to variety of instruments and turnover.

*TYPE OF DERIVATIVES:

~ The following are the different type of derivatives:

i)FORWARDS:

~ It is an agreement between two parties to exchange a particular good / instrument at a set price on a future date specified today.

~ It is the oldest of all the derivatives.

~ It is an over-the-counter agreement.

~ It is a private bilateral agreement that is exposed to a default risk by counter party.

~ Each forwards contract is unique in terms of contract size, expiration date and asset type.

~ The contract price is not publicly disclosed.

~ Forward contracts have to be settled by delivery of the asset on expiry date.

ii) FUTURES:

~ Futures are legally binding, standardised contracts between buyers and sellers, who fix the terms of the exchange that will take place between them at a fixed future date.

~ Futures are traded in an organised exchange.

~ Futures can be commodity futures or financial futures.

~ Futures obligate the buyers to receive and sellers to deliver the given assets in the specified quantity at a fixed time in the future at a contracted price.

iii) OPTIONS:

~ An option is a common form of a derivative.

~ In fact it is a contract that gives one party (The option holder) the right, but not the obligation to perform the said transaction with another party (The option writer) as per specified terms.

~ Most exchange trade options have stocks as their underlying assets but OTC-traded options have various underlying assets. (Bonds, currencies, commodities, swaps, etc.)

~ The two main type of options are call options and put options.

^ CALL OPTIONS: – Provide the option holder the right (but not the obligation) to BUY an underlying asset at a specified price on or before a specified time.

PUT OPTIONS:- Provide the option holder the right (but not the obligation) to SELL an underlying asset at a specified price on or before a specified time.

~ To obtain the right of option, the buyer must pay an option premium, which is the price paid for the right. The premium is paid at the commencement of the contract.

iv) SWAPS:

~ A SWAP is an agreement between two parties to exchange sequences of cash flows for a set period of time.

~ This result in exchange of financial obligations as per the terms of the agreement.

~ These customised transactions include both, spot and forward transactions and are determined by random or uncertain variables like interest rate, foreign exchange rate, equity price or commodity price.

v) WARRANTS:

~ Warrants is a derivative security that gives the holder to purchase or subscribe to the stated number of equity shares of the issuing company at aspecific price within a certain period of time.

~ Warrants help the issuing company to raise capital without bearing service costs.

~ Warrants are detachable and can be traded.

~ Warrants are generally included in a new debt issue to attract investors.

vi) CREDIT DERIVATIVES:

~Credit derivatives are privately held negotiable bilateral contracts that are used to manage credit risk.

~ Credit risks can be managed by insuring against adverse changes in the quality of borrowers.

~ If the borrowers default, the loss can be recovered by gains from credit derivatives.

*PARTICIPANTS:

~ Hedgers, Speculators and Arbitrageurs participate in the derivatives market.

# HEDGERS:

~ They enter the market to lock-in the price at which they will be able to buy / sell transactions in the future.

~ They have a position in the underlying asset.

~ Since they are exposed to risk associated with unfavourable movements in the price of the asset, they try to reduce the risk by dealing in derivatives.

#SPECULATORS:

~ Speculators are risk takers who take advantage at a future price movements of the asset.

~ They enter the derivatives market to get extra leverage and buy and sell in anticipation of future price movements.

~ They do not intend to actually own the underlying asset.

#ARBITRAGEURS:

~ They keep a watch on the spot and futures market.

~ Whenever they see a mismatch in the price of these two markets, they enter to buy a transaction in one market and sell in the other market to get a profit in a risk free transaction.

~ They take advantage of the discrepancy between the prices in the two different markets.

Q3: Explain the meaning of futures and forwards and bring out the difference between them.

Ans:

*INTRODUCTION:

~ A derivative is a type of security or contract whose value is derived from the value of another asset such as a share, a stock market index, a currency or an interest rate.

~ These are two important types of derivatives: Forwards, Futures.

*FORWARD CONTRACTS:

•MEANING:

~ Forwards is a customised contract.

~ It is an agreement between two parties to exchange a particular good / instrument at a set price on a future date specified today.

~ It is the oldest of all the derivatives.

~ It is an over-the-counter agreement.

~ It is a private bilateral agreement that is exposed to a default risk by counter party.

~ Each forwards contract is unique in terms of contract size, expiration date and asset type.

~ The contract price is not publicly disclosed.

~ Forward contracts have to be settled by delivery of the asset on expiry date.

FEATURES:

– BILATERAL CONTRACTS:

Forwards are bilateral contracts and all contract details are negotiated mutually by the parties in the contract. Hence there is a risk of counter party default.

OVER THE COUNTER TRADING:

~ Since forwards are private bilateral contracts, they are traded over the counter (OTC) and not in exchanges.

~ Hence there is no secondary market for forward contracts.

– CUSTOM DESIGNED:

~ Each forward contract is custom-designed. Thus, each contract is unique in term of contract size, expiry date, asset type, asset quality etc. Also, the contract price is not available in public domain.

– NO DOWN PAYMENT:

~ There is no need for down payment at the time of the initiation of the contract.

~ There is need for promise to buy a specified asset at an agreed price at a future date by one party and the promise to supply the asset at the agreed price at the agreed future date.

– SETTLEMENT AT MATURITY:

~ The contract is settled by delivery of the asset and payment of money on maturity as stated in the contract.

– NEED FOR INTERMEDIARY:

~ Parties need intermediaries for entering into a forward contract.

~ The intermediaries may be a bank, a financial institution or any other party.

– REVERSAL OF CONTRACT:

~ There is possibility to reverse the contract if needed. However, the party who wishes to reverse the contract has to approach the same counterparty. Thus, the counter party being in a monopoly situation, can charge a high price.

*FUTURES CONTRACTS:

•MEANING:

~ Futures are legally binding, standardised contracts between buyers and sellers, who fix the terms of the exchange that will take place between them at a fixed future date.

~ Futures are traded in an organised exchange.

~ Futures can be commodity futures or financial futures.

~ Futures obligate the buyers to receive and sellers to deliver the given assets in the specified quantity at a fixed time in the future at a contracted price.

•FEATURES:

– HIGHLY STANDARDISE:

~ Futures are highly standardise and are legally enforceable. There is no flexibility as the terms of futures contracts cannot be changed during the life of the contract.

– DOWN PAYMENTS:

~ Futures exchanges protect themselves by requiring the contracting parties to maintain ‘Margin Money’ (a certain % of a contract price).

~ On execution of the contract, they are required to make a security cash deposit with the clearing house.

– DELIVERY OF ASSET:

~ The motive of futures contract is not actual delivery, but they are entered mostly for hedging or for speculation.

~ In fact, the parties can only exchange the difference between the future (agreed) price and the spot price prevailing on the date of maturity.

– SECONDARY MARKET:

~ There is secondary market for futures as futures can be traded on organised exchanges.

~ The futures exchanges organise auction markets in which futures are traded. They also have their own clearing houses. These houses guarantee the performance of each party to the contract.

– SETTLEMENT:

~ The settlement of a futures contract takes place daily, irrespective of the maturity date. The difference between the futures price and the spot price on a day constitutes the profit / loss.

~ The settlement of outstanding contracts takes place on maturity dates by actual delivery.

~ However, there is simply no deliverable asset in case of bond / equity index futures. The settlement has to be in cash.

– TYPE:

~ Depending on the underlying assets, futures can be:

^ Commodity futures (wheat, sugar, metals, etc.)

^ Financial futures (stock market instruments, bonds, T-bills, etc)

– INTERMEDIARY:

~ Futures contracts are carried out only through organised exchanges.

*DIFFRENCES BETWEEN FORWARDS AND FUTURES:

~ Futures is a kind of FORWARDS contract and the structures, pay-off profile and uses of ‘forwards’ and ‘futures’ are the same.

~ However, there are certain striking differences between them that need to be specified.

~ The differences between forwards and futures are explained below:

FORWARDS

FUTURES

i) TERMS OF CONTRACT

Standardised instruments

Customised instruments

Only price is negotiated

All elements of the contract are negotiated

ii) TRADING PLACE

Over-the counter markets and off exchanges

Organised and recognised exchanges

iii) TRANSPARENCY

They are bilateral, non-transparent contracts

They are highly transparent contracts

iv) LIQUIDITY

Forwards are comparatively less liquid

Futures are comparatively more liquid

v) SETTLEMENT

Contracts are settled on date of maturity or date agreed upon by the parties.

Contracts are settled daily through exchange clearing house, profits / losses are settled daily

vi) DEFAULT RISK

Forwards are highly subject to counter party default risk

Due to presence of clearing houses, futures are effectively safe guarded against default risk

vii) TRANSACTION COST

Transaction costs of forwards are based on bid-ask spread

Futures involve brokerage fees for buy / sell orders

viii) MARGIN

Margin are not required in forwards contracts

Margins are required from both parties in futures contracts

ix) REGULATIONS

Forwards contracts are traded in unregulated market

Futures contracts are regulated by financial regulators

Q4: Write a note on options.

Ans: OPTIONS:

*MEANING:

~ Options are contracts that give the holder or the buyer of the ‘option’ to buy or sell the specified quantity of the underlying asset at a specified quantity of the underlying asset at a specified price (known as the strike price / exercise price) on or before the specified time period.

~ The word ‘option’ indicates that the holder of the option has the right but not the obligation to buy or sell the underlying asset. These underlying assets may be commodities such as wheat, cotton, rice, gold, etc. Orfinancial instrumentssuch as equity shares, stock index, currency, bonds, etc.

~ By entering into stock options contract, the investor can retain the opportunity to buy shares at lower price (if the price declines) and also protects against the risk of having to buy at a higher price, if the price rises in the near future.

*TYPES OF OPTIONS:

i)’CALL’ AND ‘OPTIONS’:

~ A ‘CALL’ option is a right to buy an underlying asset at a specified price on / before a specified date by paying a premium.

~ Similarly, a ‘PUT’ option is a right to sell the underlying asset at a specified price on / before a specified date.

~ In the option transaction, the potential loss of the seller is unlimited while the potential loss of the buyerislimitedto the amount of option premium.

~ Similarly the potential gain of the buyer is unlimitedwhile the potential gain of the selleris limitedtothe amount of option premium charged by him.

ii) ‘EUROPEAN’ OPTION AND ‘AMERICAN’ OPTION:

~ In the ‘European’ option, options can be exercised only on the maturity (expiry) date of option.

~ In the ‘American’ option, options can be exercised at any time before or on maturity (expiry) date of option.

iii) ‘OVER THE COUNTER’ AND ‘EXCHANGE’ TRADED OPTIONS:

~ Option can be ‘over the counter’ traded wherein options are private agreements between two parties and are made according to the requirements of the party buying the options. They are highly customised contracts.

~ Options can be ‘exchange’ traded where options can be bought / sold in an organised market. They are highly standardised contracts.

iv) STOCK INDEX OPTIONS:

~ Through stock index options, investors trade on stock market movements.

~ These options are exercised by cash payment and the amount of cash settled is the difference between the closing price of the index and the strike price of the option.

~ Investors expecting a market rise buy calls and those expecting a market decline buy puts.

v) CURRENCY OPTIONS:

~ Currency options help to protect against exchange rate fluctuations.

~ They offer to buy or sell foreign currency at a specified price at a specified future date.

vi) STOCK OPTIONS:

~ These options require actual delivery of the stocks when option is exercised.

*BENEFITS TO OPTION HOLDERS:

~ Call options enable investors to control a claim on the underlying asset for a smaller investment than what is required to buy the asset itself.

~ Put option enable investor to duplicate a short sale at a modest cost.

~ In case of options, the maximum loss to the investor is the price of the option.

~ Options make it possible to make enormous profits from favourable price movements.

~ Options expand investment opportunities available to investors.

~ They reduce total portfolio transaction costs.

~ Options enable investors to gain such returns that cannot be possible through conventional investments.

*DIFFRENCE BETWEEN FUTURES AND OPTIONS:

FUTURES

OPTIONS

i) RISK EXPOSURE AND PROFIT POTENTIAL

Unlimited for both parties

Seller has unlimited risk exposure and limited profit potential

Buyer has limited risk exposure and unlimited profit potential

ii) MATURITY OF CONTRACT

Comparatively longer

Comparatively shorter

iii) PREMIUM

No premium is paid or received

Buyer pays premium to seller

iv) OBLIGATIONS

Futures impose obligations on the both the parties

Obligations are imposed only on the sellers

Source by hiral

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