Basics of Financial Management

Table of Contents

1. Introduction to Financial System


The financial system mobilises savings by distributing it to the industrial investment thereby stimulating capital formation to accelerate the process of economic growth.

There are three basic components of Financial System which are:

  • Financial Institutions,

  • Financial Markets &,

  • Financial Instruments.

The Nature of the Financial System:

  1. Financial system is central nervous system of a market economy containing number of separate, though interdependent, components, all of which are essential to its effective working such as financial institutions, markets, instruments, and services which facilitates the transfer and allocation of funds, efficiently and effectively.

  2. Financial system plays a vital role in the economic development of a country. It encourages both savings and investment and also creates links between savers and investors.

  3. Financial system ensures the efficient functioning of the payment mechanism in an economy. All transactions between the buyers and sellers of goods and services are affected smoothly because of financial system.

  4. Financial system helps in risk transformation by diversification.

  5. Financial system promotes high-quality growth by providing a means of hedging against the uncertainties of investment.

  6. Financial system provides risk sharing among buyers and sellers.

  7. Financial system provides liquidity, meaning ease of converting assets to cash.

  8. Financial system is collection and communication of information between trading parties.

  9. Financial system promotes competition and also ensures market integrity.

1.1. The Nature of Financial System

  1. Financial system is central nervous system of a market economy containing number of separate, though interdependent, components, all of which are essential to its effective working such as financial institutions, markets, instruments, and services which facilitates the transfer and allocation of funds, efficiently and effectively.

  2. Financial system plays a vital role in the economic development of a country. It encourages both savings and investment and also creates links between savers and investors.

  3. Financial system ensures the efficient functioning of the payment mechanism in an economy. All transactions between the buyers and sellers of goods and services are affected smoothly because of financial system.

  4. Financial system helps in risk transformation by diversification.

  5. Financial system promotes high-quality growth by providing a means of hedging against the uncertainties of investment.

  6. Financial system provides risk sharing among buyers and sellers.

  7. Financial system provides liquidity, meaning ease of converting assets to cash.

  8. Financial system is collection and communication of information between trading parties.

  9. Financial system promotes competition and also ensures market integrity.

1.2. Functions of Financial System

The following are the functions of the finance system:

1. Pooling of Funds:

The pooling of funds in a financial system is done so that businesses could undertake large-scale projects, expand and flourish. Modern economies cannot find capital for even the minimum investment required to start or maintain a business. It is often beyond the regular means of an individual or even several individuals together. Hence, financial systems enable the businesses raise capital through variety of mechanisms such as security markets financial intermediaries and Banks.

2. Facilitates Payment and Settlements:

A financial system provides ways of clearing and settling payments. Banks and other depository financial institutions fulfil this function through wire transfers, checking accounts, debit cards credit cards etc.

3. Provides Liquidity:

Financial system enables the ability to convert assets into cash. The Banks enable savings through savings account, fixed deposits, recurring deposits etc. and converting these assets to cash when required. Similarly, the financial market provides the investors the opportunity to invest as well as liquidate their investments which are in the form of instruments such as shares, debentures, bonds, etc.

4. Lending to meeting requirements:

The financial markets, the banks and non-banking financial institutions are into the businesses of lending which facilitates the needs of individuals and businesses. Financial system arranges smooth, efficient, and socially equitable allocation of credit. This facilitates optimum use of finances for productive purposes.

5. Protects from Risk:

The Insurance cover protects both businesses and individual from various risks. The derivatives in the financial markets too do the job of hedging risk. Risk Management is an essential component of a growing economy which financial systems take care.

6. Induce Savings:

Financial systems enable individuals and businesses to save in the form of assets. The financial system promotes savings by providing a wide array of financial assets as stores of value, aided by the services of financial markets and intermediaries. For wealth holders too financial system offers ample choice of portfolios with attractive combinations of income, safety and yield.

7. Finances Government Needs:

The financial system enables governments to raise money (say through bonds in financial market), lends money for government projects and infrastructures and thus developing the nation as a whole.

8. Facilitates Investments:

Banks and other depository institutions and the non-banking financial services mobilise capital and capital needs for investments.

9. Regulation of currency:

As a part of the financial system, central banks generally control the supply of a currency and interest rates, while currency traders control exchange rates.

10. Price Determination:

Financial system has important role of pricing the financial instruments such as securities, banks are directly involved in controlling and determining the interest rates and exchange rates of currencies which directly affect the pricing of all services and goods.

11. Information and coordination:

Financial systems act as collectors’ aggregators of information about financial asset values and the flow of funds in the economy.

1.3. Components of Financial System-Financial Institutions

Financial institutions are the firms that provide financial services. The financial institutions are generally regulated by the respective Central banks of those countries. In US "The U.S. Federal Financial Institution Regulatory Agencies Group (Group)" regulates the financial institutions and consists of the 'Federal Deposit Insurance Corporation (FDIC)', the 'National Credit Union Administration (NCUA)', the 'Office of the Comptroller of the Currency (OCC)', the 'Office of Thrift Supervision (OTS)', and the Board of Governors of the 'Federal Reserve System (FRB)'. The regulation of Financial Institutions in the UK is undertaken by three main regulators, the 'Bank of England (BoE)', the 'Prudential Regulation Authority (PRA)' (a division of the BoE) and 'Financial Conduct Authority (FCA)'. In Singapore the financial institution’s regulator is ‘Monetary Authority of Singapore’ and in Hong Kong it is ‘Hong Kong Monetary Authority’.

Classification of Financial Institutions: The type of financial institutions can be divided into two types as follows:

A) Depository Institutions:

A depository institution is a financial institution that is legally allowed to accept monetary deposits from consumers. The depository institutions include:

1) Commercial Banks:

Commercial banks are those financial institutions, which help in pooling the savings of surplus units and arrange their productive uses. They basically accept the deposits from individuals and institutions, which are repayable on demand. These deposits from individuals and institutions are invested to satisfy the short-term financing requirement of business and industry.

2) Central Banks:

The central bank is also called the banker's bank in any country. The Federal Reserve in USA and the Bank of England in UK function as the central bank. This bank makes various monetary policies, decides the rates of interest, controlling the other banks in the country, manages the foreign exchange rate and the gold reserves and also issues paper currency in a country.

3) Thrifts:

This only applies is US. Thrifts in US differ from commercial banks wherein they can borrow money from the Federal Home Loan Bank System, which allows them to pay members higher interest. The types of thrifts are

a. Saving and Loan Associations:

Saving and loan associations are the financial institutions involved in collecting funds of many small savers and lending these funds to home buyers and other types of borrowers.

b. Saving Banks:

Saving banks are more or less similar to saving and loan associations. They primarily accept savings of individuals and they are lent to the home users and consumers on a long-term basis.

4) Credit Unions:

Credit unions are cooperative associations where large numbers of people are voluntarily associated for savings and borrowing purposes. These individuals are the members of credit unions as they make share investment along with deposits. The saving generated from these members is used to lend the members of the union only.

1.3.1. Components of Financial System-Financial Institutions

B) Non-depository Institutions:

Non-depository Institutions are Organizations that serves as an intermediary between savers and borrowers, but does not accept time deposits. Such institutions fund their lending activities either by selling securities (bonds, notes, stock/shares) or insurance policies to the public.

a) Insurance Companies:

Insurance companies specialize in writing contracts to protect their policyholders from the risk of financial losses associated with particular events, such as death, automobile accidents, fires etc. Insurance companies make money on the policies they sell, which protect against financial loss and/or build income for later use.

b) Pension/Provident Funds/Trust Companies:

Pension funds are financial institutions which accept saving to provide pension and other kinds of retirement benefits to the employees of government units/other corporations. Pension funds are basically funded by corporation and government units for their employees, which make a periodic deposit to the pension fund and the fund provides benefits to associated employees on the retirement. The pension funds basically invest in stocks, bonds and other type of long-term securities including real estate.

c) Finance Companies:

Finance companies are the financial institutions that engage in satisfying individual credit needs, and perform merchant banking functions. In other words, finance companies are non-bank financial institutions that tend to meet various kinds of consumer credit needs. They involve in leasing, project financing, housing and other kind of real estate financing.

d) Mutual Funds:

Mutual funds accepts funds from members and then use these funds to buy common stocks, preferred stocks, bonds and other short-term debt instruments issued by government and corporations and share the profits with investors with a management fee involved.

e) Brokerage Houses:

A brokerage firm, or simply brokerage, is a financial institution that facilitates the buying and selling of financial securities between a buyer and a seller. Brokers are people who execute orders to buy and sell stocks and other securities. They are paid commissions.

f) Currency Exchanges:

Currency exchanges are private companies that cash cheque, sell money orders, or perform other exchange services. They charge a fee, usually a percentage of the amount exchanged.

1.4. Financial Market

A financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. A trade mean either buy or sell of a security between two parties. A financial market is a market in which people and entities can trade financial securities, commodities and other fungible assets at prices that are determined by pure supply and demand principles. Markets work by placing the two counterparts, buyers and sellers, at one place so they can find each other easily, thus facilitating the deal between them.

Financial markets influence shape the economic landscape. A strong rally on Stock Exchange instils confidence in businesses to expand operations and take risks. In these cases, companies hire more workers, improve the employment rate and in turn, give consumers more disposable income. Market crashes signal the opposite Companies grow concerned over how to fund their operations, layoffs rise and consumers don’t spend as much disposable income. Financial markets help to efficiently direct the flow of savings and investment in the economy in ways that facilitate the accumulation of capital and the production of goods and services. The combination of well-developed financial markets and institutions, as well as a diverse array of financial products and instruments, suits the needs of borrowers and lenders and therefore the overall economy. Large financial markets with lots of trading activity provide more liquidity for market participants than thinner markets with few available securities and participants and thus limited trading opportunities.

Financial market not only helps in raising capital and managing the monetary risks of an economy. The global financial transactions of a nation can be easily cleared because of the existence of financial markets. These markets have also encouraged and developed international trade over the years. It has greatly contributed in bringing the economies close together and reducing the trade barriers across the globe. Financial markets serve six basic functions.

1. Borrowing and Lending:

Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.

2. Price Determination:

Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.

3. Information Aggregation and Coordination:

Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.

4. Risk Sharing:

Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.

5. Liquidity:

Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.

6. Efficiency:

Financial markets reduce transaction costs and information costs.

1.4.1. Types of Financial Markets

I. Capital Market: Capital market is a venue where suppliers of capital such as retail investors, institutional investors and foreign institutional investors who have capital to invest lend to the entities that are in need of capital such as businesses, governments, municipalities etc. Capital markets are divided into 'Primary Market' where new securities are issued and sold and the 'Secondary Market', where already-issued securities are traded. Stock Exchange is a regulated financial market where securities such as shares, bonds and notes are bought and sold at prices governed by the forces of demand and supply and Over-the-counter (OTC) or off-exchange trading of securities is done directly between two parties, without the supervision of an exchange. Based on the type of securities sold, capital markets are divided into the stock market and the bond market whose description is as given below:

a. Stock Market: The stock market act both as primary market and as secondary market. The primary market is reserved for first time issued equities (/shares) for public meaning, initial public offerings (IPOs) will be issued on this market. Equities are then made available on the secondary market for trading.

b. Bond Market: The market where investors go to trade debt securities (also called fixed income securities) such as bonds, bills and notes, prominently bonds, which may be issued by corporations or government is called bond market. It is also known as the debt market. The bond market does not have a centralized location to trade, meaning bonds mainly sell over the counter (OTC). The large institutional investors like pension funds, foundations, endowments, investment banks, hedge funds, and asset management firms mainly participate in bond markets.

II. Commodity Market: A commodity market facilitates commodity trading; where buyers and sellers can trade in commodities like grain, precious metals, electricity, oil, beef, orange juice natural gas, foreign currencies, emissions credits etc. Buyers and sellers can trade a commodity either in the spot market (sometimes called the cash market), whereby the buyer and seller immediately complete their transaction based on current prices, or in the futures market where a contract is written between buyer and seller giving the buyer an obligation to purchase the commodity and the seller an obligation to sell the commodity at a set price at a future point in time.

III. Money Market: Money market facilitates trading of financial instruments with high liquidity and short-term maturities. Examples of money market instruments are treasury bills commercial papers and certificate of deposits. Over-the-counter trading is done in the money market and it is a wholesale process. Money market consists of various financial institutions and dealers, who seek to borrow or loan securities. The money market is an unregulated and informal market and not structured like the capital markets. Also, money market gives lesser return to investors who invest in it but provides a variety of products.

IV. Derivatives Market: Derivatives market is the financial market for derivatives where financial instruments like futures, options and swaps which are derived from other forms of assets are traded. The market is divided into two one, exchange-traded derivatives or derivatives traded in a regulated market and that of over-the-counter derivatives which are usually one-one contracts between two parties.

V. Foreign Exchange Markets: The foreign exchange market facilitates the trading of currencies. The forex market is always over-the-counter (OTC) market whose participants are banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers and investors.

VI. Cryptocurrency Market: Cryptocurrency market allows people to trade cryptocurrencies. Cryptocurrency is a type of digital currency that uses cryptography for security and anti-counterfeiting measures.

c) Financial assets of Financial Markets:

  1. Debt Securities (e.g. Bonds and Debentures)

  2. Equity Securities (e.g. Common Stocks/Shares) &

  3. Derivatives (e.g., Forwards, Futures, Options and Swaps).

1.5. Financial Instruments

In financial markets, the financial instruments that are used which are legal agreements that require one party to pay cash or something of value or to promise to pay under stipulated conditions to a second party/counterparty in exchange for the payment of interest, for the acquisition of rights, for premiums or for indemnification (to give compensation in case of loss) against risk. In exchange for the payment of the money, the counterparty hopes to profit by receiving interest, capital gains, premiums, or indemnification for a loss event. There are many types of financial instruments. Some of the most common examples of financial instruments include the following:

1. Cheques:

A cheque is a document that orders a bank to pay a specific amount of money from a person's account to the person in whose name the cheque has been issued.

2. Bank Draft:

A bank draft is a payment on behalf of a payer that is guaranteed by the issuing bank. A draft ensures the payee a secure form of payment.

3. Stocks/Shares:

It is the capital of a company which is divided into shares. Each share forms a unit of ownership of a company and is offered for sale so as to raise capital for the company.

4. Bonds:

A bond is a debt investment in which an investor loans money to any entity/firm/company which borrows the funds for a defined period of time at a variable or fixed interest rate.

5. Bill of Exchange:

It is a written, unconditional order by one party (the drawer) to another party (the drawee) to pay a certain sum, either immediately (On sight of the bill) or on a fixed date (a term bill), for payment of goods and/or services received.

6. Futures:

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price.

7. Options:

An option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on a specified date.

8. Insurance:

Insurance contracts promise to pay for a loss event in exchange for a premium.

9. Swaps:

Swaps are an exchange of interest rate payments.

10. Funds:

Includes mutual funds, exchange-traded funds, real estate investment trusts, hedge funds, and many other funds. The fund buys other securities earning interest and capital gains which increases the share price of the fund. Investors of the fund may also receive interest payments.

1.6. Functions of Financial Markets

  1. Transfer of Resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers

  2. Enhancing Income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income.

  3. Productive Usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.

  4. Capital Formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country.

  5. Price Determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and to the supply through the mechanism called price discovery process.

  6. Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets.

  7. Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.

1.7. Financial Markets Slang

  1. Poison Pill: A poison pill is a tactic utilized by companies to prevent or discourage hostile takeovers. A company targeted for a takeover uses a poison pill strategy to make shares of the company’s stock look unattractive or less desirable to the acquiring firm. Bips, meaning "bps" or basis points: A basis point is a financial unit of measurement used to describe the magnitude of percent change in a variable. One basis point is the equivalent of one hundredth of a percent. For example, if a stock price were to rise 100bit/s (bps), it means it would increase 1%.

  2. Quant: A quantitative analyst with advanced training in mathematics and statistical methods.

  3. Rocket Scientist: He/She is a financial consultant of mathematical and computer programming skill. They invent derivatives of high complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training.

  4. IPO: An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuer’s securities. The sale of securities can be either through book building or through normal public issue.

  5. White Knight: A white knight is a company that acquires another company that is trying to avoid acquisition by a third party. For example, let's assume that Company XYZ wants to acquire Company ABC. Company ABC feels that Company XYZ is a hostile bidder and will ruin the company. As a result, Company ABC's directors go on the offensive and tell the shareholders that a sale to Company XYZ would not be a good thing. If, Company 123, which has worked with Company ABC for years and has a good relationship with its board, sees an opportunity to "save" Company ABC from the tense situation and make a lucrative acquisition at the same time. Company ABC welcomes Company 123's bid and merges with it to avoid acquisition by Company XYZ. Company 123 is a white knight.

  6. Round-Tripping: Smurfing, a deliberate structuring of payments or transactions to conceal it from regulators or other parties, a type of money laundering that is often illegal.

  7. Spread: The difference between the highest bid and the lowest offer.

  8. Market Capitalisation: The market value of a quoted company, which is calculated by multiplying its current share price (market price) by the number of shares in issue, is called as market capitalization. E.g., Company A has 120 million shares in issue. If the current market price is. 100 then the market capitalisation of company A is $ 12000 million.

2. Introduction to Capital Markets

I. Definition:

Capital market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions. Capital markets help channelize surplus funds from savers to institutions which then invest them into productive use. Generally, this market trades mostly in long-term securities.

II. Components of Capital Market:

Capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and other securities, whereas secondary market deals with the exchange of existing or previously-issued securities. Another important division in the capital market is made on the basis of the nature of security traded, i.e. stock market and bond market. Details as below:

2.1. Components of Capital Markets-Stock Markets

It is a place where shares of pubic listed companies are traded. The primary market is where companies float shares to the general public in an initial public offering (IPO) to raise capital.

Once new securities have been sold in the primary market, they are traded in the secondary market where one investor buys shares from another investor at the prevailing market price or at whatever prices both the buyer and seller agree upon. The secondary market or the stock exchanges are regulated by the regulatory authority. In US, the secondary and primary markets are governed by the SEC (Securities and Exchange Commission).

A stock exchange facilitates stock brokers to trade company stocks and other securities. A stock may be bought or sold only if it is listed on an exchange. Thus, it is the meeting place of the stock buyers and sellers. World's premier stock exchanges are the “The NYSE”, “The NASDAQ”, “The Tokyo Stock Exchange”, “The Shanghai Stock Exchange” and “The Euronext Stock Exchange”.

2.1.1. Components of Capital Markets-Bond Markets

A financial marketplace where debt instruments, primarily bonds, are bought and sold is called a bond market. The dealings in a bond market are limited to a small group of participants. Contrary to stock or commodities trading, the bond market (also known as the debt market) lacks a central exchange.

The bond market involves transactions among three key players:

1. Issuers: They comprise of organizations and other entities that sell bonds to raise funds to finance their operations. These include banks, both local and multinational, as well as the government as an issuing entity.

2. Underwriters: This segment consists mainly of investment banks and institutions that are leaders in the investing business. They help the issuer to raise funds by selling bonds. Also, they perform the key role of middlemen and undertake crucial activities, such as preparing legal documents, prospectus and other collaterals to simplify transactions.

3. Purchasers: This is the group that buys the debt instruments. In addition to the government and corporations, this section consists of individual investors who invest in the bond market through unit-investment trusts, close-ended funds and bond funds.

Based on the types of bonds in which they deal the bond market is segregated into five types.

1. Corporate: includes trading in debt securities issued by corporations and industries to raise funds.

2. Government and Agency: involves trading in bonds issued by government departments as well as enterprises sponsored by the government or agencies backed by it.

3. Municipal: covers transactions in municipal securities issued by states, districts and counties.

4. Mortgage-Backed Securities: includes dealings in asset-backed securities that are protected by mortgages.

Although dealings in the fixed-income market might be lucrative, an investor must be aware that these are prone to variations in interest rates. When the market-based interest rate rises, there is a decline in the value of existing bonds. This is on account of the issuance of new bonds at a higher interest rate. In order to limit your exposure to losses arising from escalations in the interest rate, it is advisable to hold a bond till maturity.

2.1.2. Components of Capital Markets-Primary Markets

The primary market is an important part of capital market, which deals with issuance of new securities. It enables corporates, public sector institutions as well as the government to raise resources (through issuance of debt or equity-based securities), to meet their capital requirements. In addition, the primary market also provides an exit opportunity to private equity and venture capitalists by allowing them to off-load their stake to the public. Initial Public Offer (IPO) is the most common way for firms to raise capital in the primary market. In an IPO, a company or a group floats new security for subscription by the public. In return, the issuing conglomerate receives cash proceeds from the sale, which are then used to fund operations or expand the business. It is only after an IPO that a security becomes available for trading in the secondary market of the stock exchange platform. The price at which the securities are issued is decided through the book building mechanism; in the case of oversubscription, the shares are allotted on a pro-rata basis. When securities are offered exclusively to the existing shareholders of a company, as opposed to the general public, it is known as the Rights Issue. Another mechanism whereby a listed company can issue equity shares (as well as fully and partially convertible debentures, which can later be converted into equity shares), to a Qualified Institutional Buyer (QIB) is termed as Qualified Institutional Placement. In addition to domestic market, companies can also raise capital in the international market through the issuance of American Depository Receipts (ADRs), Global Depository Receipts (GDRs) and also by way of External Commercial Borrowings (ECBs). The securities can be issued and capital rose either through public issues or through private placement (which involves issuance of securities to a relatively small number of select investors).

New issue in the primary market can be placed as a) Public Issue b) Offer for Sale c) Private Placement and d) Right Issue.

a) Public Issue:

The most popular method for floating the issues in new issue market is through "prospectus" which is viewed as a legal document. A common method followed by corporate enterprises to raise capital through the issue of securities is by means of a prospectus inviting subscription from the public. Under this method, the issuing companies themselves offer directly to the general public a fixed number of shares at a stated price known as the face value of the securities. Public issues can be further classified into Initial Public Offerings (IPOs) and Further Public Offerings (FPOs). Initial Public Offering (IPO) is the first sale of stock by a private company to the public and Further Public Offering (FPO) is an issuing of shares to investors by a public company which is already listed on stock exchange. An FPO is essentially a stock issue of supplementary shares made by a company that is already publicly listed and has gone through the IPO process.

b) Offer for Sale:

Under this method, instead of issuing company itself offering its shares directly to the public, it offers through the sponsoring intermediary of issue houses/merchant banks/investment banks or firms of stockbrokers are hired to offer the share to the public. It is a method of floatation of share through an “intermediary” and “indirectly” through an issue house for converting the private company into public company.

c) Private Placement:

As the name suggests it involves selling of securities privately to a group of investors. The sale of securities to a relatively small number of selected investors as a way to raising capital is called private placement. Investors involved in private placements are usually large banks, mutual funds, insurance companies and pension funds.

d) Right Issue:

This is the method of raising funds from existing shareholders by offering additional securities to them on a pre-emptive basis. In the case of companies whose shares are already listed and widely-held, then shares can be offered to the existing shareholders. Generally, the issue price of right issue is lower than the market price of the company's stock. Shares are offered to existing shareholders in proportion to their current shareholding, respecting their pre-emption rights.

2.1.3. Components of Capital Markets-Secondary Markets

Secondary Market is a market, in which an investor purchases a security from another investor rather than the issuer, subsequent to the original issuance in the primary market. It is also called aftermarket. Secondary market is a mechanism, which provides liquidity; transferability and continuous price formation of securities to enable investors to buy and sell them with ease. The securities are traded, cleared and settled within the regulatory framework prescribed by the Stock exchanges.

2.2. Performers in Capital Markets-Bonds

I. Bonds


A bond is a debt investment in which an investor loans money to an entity which borrows the funds for a defined period of time at a variable or fixed interest rate.

A bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The government, states, cities, corporations, and many other types of institutions sell bonds. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities.

Indenture: A legal and binding contract between a bond issuer and the bondholders. The indenture specifies all the important features of a bond, such as its maturity date, timing of interest payments, method of interest calculation, callable/convertible features if applicable and so on. The indenture also contains all the terms and conditions applicable to the bond issue. Other critical information included in the indenture is the financial covenants that govern the issuer and the formulas for calculating whether the issuer is within the covenants. Should a conflict arise between the issuer and bondholders, the indenture is the reference document used for conflict resolution. As a result, the indenture contains all the minutiae of the bond issue. In the fixed-income market, an indenture is hardly ever referred to when times are normal. But the indenture becomes the go-to document when certain events take place, such as if the issuer is in danger of violating a bond covenant. The indenture will then be scrutinized closely to make sure there is no ambiguity in calculating the financial ratios that determine whether the issuer is abiding by the covenants. The indenture is another name for the bond contract terms, which are also referred to as a deed of trust.

2.2.1. Performers in Capital Markets-Bond Market

The bond market is where participants buy and sell debt securities, usually in the form of bonds. Other names include the debt market, credit market or fixed income market.

Bond markets in most countries remain decentralized and lack common exchanges like equity, future and commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the number of different securities outstanding is far larger. Although there are some electronic exchanges emerging, the vast majority of bond trades continue to be conducted directly between market participants without a facilitating market utility i.e., they are conducted over the counter (OTC). Market liquidity is provided by dealers and other market participants.

Within the fixed income markets, dealers do not charge brokerage fees. Instead, they earn revenues based on the difference between the price at which the dealers buy a bond from one investor (the bid price) and the price at which they sell the same bond to another investor (the ask or offer price). The so-called bid/offer spread represents the total transaction costs associated with transferring a bond from one investor to another.

2.2.2. Performers in Capital Markets-Understanding Bonds

1. Bond Market Participants:

Bond market Participants: Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both. So typical market participants include:

  • Institutional investors

  • Governments

  • Traders

  • Individuals

2. Coupon: Coupon is the interest rate, which the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. Hence bonds are often called fixed income instruments. The coupon can also be fixed relative to a varying money market index, such as LIBOR. More complicated coupons can also be defined which are called exotic. The interest rate is affected by many factors, including current market interest rates, the length of the term and the credit worthiness of the issuer. The name coupon originates from when physical bonds were issued with coupons attached to them. On coupon dates, the bond holder would give the coupon to a bank in exchange for the interest payment. Coupon date is the date on which the issuer pays the coupon to the bond holders. In the UK and Europe, many bonds are annual and pay only one coupon a year. In contrast, most bonds are six monthly in the US.

3. Principal (Nominal or Face amount): Principal is the total amount on which the issuer of the bond pays interest. This is the amount which must be repaid at the end of the life of the bond i.e. at the maturity date.

4. Maturity: The issuer has to repay the nominal amount on the maturity date. As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds.

5. Yield: The yield is the rate of return received from investing in the bond. The yield of a bond is inversely proportional to its price: as bond prices increase, bond yields fall.

6. Bond Market Volatility: Bond holders who collect coupons and hold the bonds until maturity are not subjected to market volatility, as the principal and interest payments occur to a pre-determined and well-defined schedule. However, bond holders who buy and sell their bonds before maturity are subjected to a number of risks; the most significant of which is changes in national interest rates. When these interest rates increase, the value in the existing bond falls, as any newly issued bond will pay a lower yield. So we can see there is an inverse correlation between bond prices and interest rates. As interest rates fluctuate, as a natural part of a country’s monetary policy, the bond market also experiences volatility in a reaction to this activity.

2.2.3. Performers in Capital Markets-Types of Bonds

1. Fixed Rate Bonds: Fixed rate bond is a bond that pays the same amount of interest for its entire term. The benefit of owning a fixed-rate bond is that investors know with certainty how much interest they will earn and for how long. As long as the bond issuer does not default, the bondholder can predict exactly what his return on investment will be. An investor who wants to earn a guaranteed interest rate for a specified term could purchase a fixed-rate Treasury bond, corporate bond or municipal bond. A key risk of owning fixed-rate bonds is interest rate risk, or the chance that bond interest rates will rise, making an investor’s existing bonds less valuable.

For example, if Mr. X purchases a bond that pays a fixed rate of 5%, but interest rates increase and new bonds are being issued at 7%, Mr. X is no longer earning as much interest as he could be. If he wants to sell his 5% bond to invest in the new 7% bonds, he will do so at a loss, because a bond’s market price decreases when interest rates increase. The longer the fixed-rate bond’s term, the greater the risk that interest rates might rise and make the bond less valuable. If interest rates decrease to 3%, however, Mr. X’s 5% bond would become more valuable if he were to sell it, since a bond’s market price increases when interest rates decrease. Mr. X could reduce his interest rate risk by choosing a shorter bond term. He would probably earn a lower interest rate, though, because a shorter-term fixed-rate bond will typically pay less than a longer-term fixed-rate bond. If Mr. X wants to hold his bond until maturity and is not considering selling it on the open market, he will not be concerned about possible fluctuations in interest rates.

2. Convertible Bonds/ Exchangeable Bonds: As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bond's sub-par return (below what a non-convertible corporate bond would get). As always, there is a trade-off between risk and return. A conversion ratio of 45:1 means one bond (with a Re.1,000 par value) can be exchanged for 45 shares of stock. Or it could be specified at a 50% premium, meaning that if the investor chooses to convert the shares, he or she will have to pay the price of the common stock at the time of issuance plus 50%.

3. Callable Bond (/Redeemable Bond): A bond that can be redeemed by the issuer prior to its maturity. Usually, a premium is paid to the bond owner when the bond is called. The main cause of a call is a decline in interest rates. If interest rates have declined since a company first issued the bonds, it will likely want to refinance this debt at a lower rate of interest. In this case, company will call its current bonds and reissue them at a lower rate of interest.

4. Floating Rate Notes (FRNs): A debt instrument with a variable interest rate; also known as a “floater” or “FRN," a floating rate notes interest rate is tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, EUROBOR, the fed funds or the prime rate. Floaters are mainly issued by financial institutions and governments, and they typically have a two- to five-year term to maturity. Floating rate notes (FRNs) make up a significant component of the investment-grade bond market, and they tend to become more popular when interest rates are expected to increase. Compared to fixed-rate debt instruments, floaters protect investors against a rise in interest rates. Because interest rates have an inverse relationship with bond prices, a fixed-rate notes market price will drop if interest rates increase. FRNs, however, carry lower yields than fixed notes of the same maturity. They also have unpredictable coupon payments, though if the note has a cap and/or a floor, the investor will know the maximum and/or minimum interest rate the note might pay. An FRN's interest rate can change as often or as frequently as the issuer chooses, from once a day to once a year. The “reset period” tells the investor how often the rate adjusts. The issuer may pay interest monthly, quarterly, semi-annually or annually. FRNs may be issued with or without a call option. Commercial banks, state and local governments, corporations and money market funds purchase these notes, which offer a variety of terms to maturity and may be callable or non-callable.

5. Zero-Coupon Bonds/Discount Bonds: Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero-coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest. The maturity dates on zero coupon bonds are usually long-term many don’t mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the deep discount, an investor can put up a small amount of money that can grow over many years. Investors can purchase different kinds of zero-coupon bonds in the secondary markets that have been issued from a variety of sources, including the corporations, and state and local government entities. Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. In addition, although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year. Some investors avoid paying tax on the imputed interest by buying municipal zero coupon bonds or purchasing the few corporate zero-coupon bonds that have tax-exempt status.

6. Inflation linked (/indexed) Bonds: Inflation-linked bonds are designed to help protect investors from the negative impact of inflation by contractually linking the bonds’ principal and interest payments to a nationally recognized inflation measure such as the Consumer Price Index in the U.S. and the Retail Prices Index in the U.K. ILBs are indexed to inflation so that the principal and interest payments rise and fall with the rate of inflation. The UK government was the first to issue inflation linked gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the US.

7. Subordinated Bonds: Subordinated bond is a class of bond that, in the event of liquidation, is prioritized lower than other classes of bonds. For example, a subordinate bond may be an unsecured bond, which has no collateral. Should the issuer be liquidated, all secured bonds and similar debts must be repaid before the subordinated bond is repaid. A subordinate bond carries higher risk, but also pays higher returns than other classes.

8. Senior Bonds: In finance, senior bonds, frequently issued in the form of senior notes or referred to as senior loans, is debt that takes priority over other unsecured or otherwise more "junior" debt owed by the issuer. Senior debt has greater seniority in the issuer's capital structure than subordinated bonds. If a company goes bankrupt, senior bonds are most likely to be repaid first.

9. Perpetual Bonds or Perpetuities: A bond in which the issuer does not repay the principal, rather, a perpetual bond pays the bondholder a fixed coupon as long as he/she holds it. Prices for perpetual bonds vary widely according to long-term interest rates. When interest rates rise, perpetual bonds fall and vice versa.

10. Municipal Bonds: Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems.

11. Bermudan Callable Bonds: These have several call dates, which typically are the same as the coupon dates.

12. European Callable Bonds: These have only one call date and may be thought of as a special case of a Bermudan callable.

13. American callable bonds: These are bonds which can be called at any time until the maturity date.

14. Death Put or Survivor’s Option: This is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation.

15. Junk Bonds: A high-yielding high-risk security, typically issued by a company seeking to raise capital quickly in order to finance a takeover.

16. Tax Free Bonds: These bonds are mostly issued by government enterprises and pay a fixed coupon rate (interest rate). As the proceeds from the bonds are invested in infrastructure projects, they have a long-term maturity of typically 10, 15 or 20 years. The income by way of interest on tax-free bonds is fully exempted from income tax. The interest earned from these bonds does not form part of your total income. There is no deduction of tax at source (TDS) from the interest, which accrues to the bondholder. But remember that no tax deduction will be available for the invested amount. The coupon (interest) rates of tax-free bonds are linked to the prevailing rates of government securities. So these bonds become attractive when the interest rates in the financial system are high. The interest on these bonds is paid annually and credited directly in the bank account of the investor. Since tax-free bonds are mostly issued by government-backed companies, the credit risk or risk of non-repayment is very low.

17. Lottery Bond: Lottery bonds are a type of government bond in which some randomly selected bonds within the issue are redeemed at a higher value than the face value of the bond. Lottery bonds have been issued by public authorities in Belgium, France, Ireland, Pakistan, Sweden, New Zealand, the UK and other nations.

18. War Bond: Debt securities issued by a government for the purpose of financing military operations during times of war. It is an emotional appeal to patriotic citizens to lend the government their money because these bonds offer a rate of return below the market rate.

19. Serial Bond: A bond issue in which a portion of the outstanding bonds matures at regular intervals until eventually all of the bonds have matured. As they mature gradually over a period of years, these bonds are used to finance a project providing regular, level or predictable income streams.

20. Climate Bond: Climate bonds, also known as green bonds, are a relatively new asset class. Climate bonds are issued in order to raise finance for climate change solutions - climate change mitigation or adaptation related projects or programs.

21. Bearer Bond: A bearer bond is a bond or debt security issued by a business entity, such as a corporation or a government. It differs from the more common types of investment securities in that it is unregistered hence, no records are kept of the owner, or the transactions involving ownership.

2.3. Debentures

Definition: The capital is not only raised through shares, it is sometimes raised through loans, taken in the form of debentures. A debenture is a written acknowledgment of a debt taken by a company. It contains a contract for the repayment of principal sum by some specific date and payment of interest at a specified rate irrespective of the fact, whether the company has a profit or loss. Debenture holders are, therefore, creditors of the company. Of course, they do not have any right on the profits declared by the company. Like shares, debentures can also be sold in or purchased from the market and all the terms used for shares also apply in this case; with the same meanings.

2.3.1. Types of Debentures

1. On the basis of security point of view:

(i) Secured or Mortgage Debentures: These are the debentures that are secured by a charge on the assets of the company. These are also called mortgage debentures. The holders of secured debentures have the right to recover their principal amount with the unpaid amount of interest on such debentures out of the assets mortgaged by the company. Secured debentures can be of two types:

(a) First Mortgage Debentures: The holders of such debentures have a first claim on the assets charged.

(b) Second Mortgage Debentures: The holders of such debentures have a second claim on the assets charged.

(ii) Unsecured Debentures: Debentures which do not carry any security with regard to the principal amount or unpaid interest are called unsecured debentures. These are called simple debentures.

2. On the basis of redemption:

(i) Redeemable Debentures: These are the debentures which are issued for a fixed period. The principal amount of such debentures is paid off to the debenture holders on the expiry of such period. These can be redeemed by annual drawings or by purchasing from the open market.

(ii) Non-redeemable Debentures: These are the debentures which are not redeemed in the life time of the company. Such debentures are paid back only when the company goes into liquidation.

3. On the basis of records:

(i) Registered Debentures: These are the debentures that are registered with the company. The amount of such debentures is payable only to those debenture holders whose name appears in the register of the company.

(ii) Bearer Debentures: These are the debentures which are not recorded in a register of the company. Such debentures are transferrable merely by delivery. Holder of these debentures is entitled to get the interest.

4. On the basis of convertibility:

(i) Convertible Debentures: These are the debentures that can be converted into shares of the company on the expiry of predefined period. The term and conditions of conversion are generally announced at the time of issue of debentures.

(ii) Non-convertible Debentures: The debenture holders of such debentures cannot convert their debentures into shares of the company.

5. On the basis of priority:

(i) First Debentures: These debentures are redeemed before other debentures.

(ii) Second Debentures: These debentures are redeemed after the redemption of first debentures.

2.3.2. Difference between Bonds and Debentures

Debentures and bonds are types of debt instruments that can be issued by a company. In some markets (India, for instance) the two terms are interchangeable, but in the United States they refer to two separate kinds of debt-based securities. The functional differences centre on the use of collateral, and they are generally purchased under different circumstances.

Bonds are the most frequently referenced type of debt instrument. Investor loans money to an institution, such as a government or business; the bond acts as a written promise to repay the loan on a specific maturity date. Normally, bonds also include periodic interest payments over the bond's duration, which means that the repayment of principle and interest occur separately. Bond purchases are generally considered safe, and highly rated corporate or government bonds come with little perceived default risk. Debentures have a more specific purpose than bonds. Both can be used to raise capital, but debentures are typically issued to raise short-term capital for upcoming expenses or to pay for expansions. Sometimes called revenue bonds because they may be expected to be paid for out of the proceeds of a new business project.


To start an industry on a large scale requires huge amount of capital, professional skills, and other resources. Sometime it may not be possible for a single individual to do the needful. In such cases, a group of likeminded people get together and set up a company registered under company’s act. The people who start the company are called promoters of the company, who frame the constitution of the company, which lays down the objectives of the company. To raise the capital from the general public, the company issues a prospectus giving details of the projects undertaken, background of the company, its strength and risks involved. The capital of the company is divided into convenient units of equal value, called shares. Normally, they are of the denomination of $ 10 or $100.

2.4.1. Terminologies Related to Shares

Share: The total capital of the company is divided into convenient units of equal value and each unit is called a share. A share represents a part ownership in a business.

Shareholder: An individual who purchases/possesses the share/shares of the company is called a shareholder of the company. Each shareholder is issued a share certificate by the company, indicating the number of shares purchased and value of each share.

Par value: The original value of the share, which is written on the share certificate, is called its par value. This is also called nominal value or face value of the share.

Dividend: When the company starts production and starts earning profit, after retaining some profit for running expenses interest on loans, if raised, the remaining part of the profit is divided among shareholders, and is called dividend. Dividend is usually expressed as certain percentage of its par value or certain among per share.

Stock Exchange: It is the place where shares are sold and purchased. The price of a share as quoted in the market is called the market value of the share. The market value of shares keep on changing according to demand in the market.

At Par: When the market value of a share equals its face value, the share is said to be at par.

Premium/Discount: If the market value of a share is more than its face value, it is said to be above par (or at premium). On the contrary, if the market price of a share is less than its face value, it is said to be below par (or at discount).

Stock: Stock is “Par value of a share × Number of shares”.

Forfeiture of Shares: If a shareholder fails to pay the due amount of allotment or any call on shares issued by the company, the Board of directors may decide to cancel his/her membership of the company. With the cancellation, the defaulting shareholder also loses the amount paid by him/her on such shares. Thus, when a shareholder is deprived of his/her membership due to non- payment of calls, it is known as forfeiture of shares.

Reissue of Shares: Shares are forfeited because only a part of the due amount of such shares is received and the balance remains unpaid. On forfeiture the membership of the original allottee is cancelled. He/she cannot be asked to make payment of the remaining amount. Such shares become the property of the company. Therefore, company may sell these shares. Such sale of shares is called ‘reissue of shares. Thus, reissue of shares means issue of forfeited shares.

2.4.2. Types Shares

1) Equity Shares: An equity share, commonly referred to as ordinary share also represents the form of fractional or part ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture. The holders of such shares are members of the company and have voting rights. Types of equity shares are as given below:

a) Blue Chip Shares: A blue-chip stock is the stock of a large, well-established and financially sound company that has operated for many years. A blue-chip stock typically has a market capitalization in the billions, is generally the market leader.

b) Income Shares: The term can refer to shares bought in anticipation of an above average income being produced. It is also referred to as high yield shares. This normally means that the investor has chosen shares in companies that have a history of paying consistently high dividends.

c) Growth Shares: Growth Shares in a company whose earnings are expected to grow at an above-average rate relative to the market. They are also known as a "Glamor Shares".

d) Cyclical Shares: A share of a company in an industry sector that is particularly sensitive to swings in economic conditions.

e) Defensive Shares: The term defensive shares is synonymous to non-cyclical shares, or companies whose business performance and sales are not highly correlated with the larger economic cycle. These companies are seen as good investments when the economy sours.

f) Speculative Shares: A speculative shares may offer the possibility of substantial returns to compensate for its higher risk profile. Speculative shares are favoured by speculators and investors because of their high-reward, high-risk characteristics.

2) Preference Shares: Company shares with dividends that are paid to shareholders before common share dividends are paid out. In the event of a company bankruptcy, preferred share shareholders have a right to be paid company assets first. Preference shares typically pay a fixed dividend, whereas common shares do not. And unlike common shareholders, preference share shareholders usually do not have voting rights. The types of preference shares are as given below:

a) Cumulative Preference Shares: A preference share is said to be cumulative when the arrears of dividend are cumulative and such arrears are paid before paying any dividend to equity shareholder. Suppose a company has not paid dividends for two years so far. The directors before they can pay the dividend to equity shareholders for the current year must pay the pref. dividends for the arrear years + current year before making any payment of dividend to equity shareholders for the current year.

b) Non-cumulative Preference Shares: In the case of non-cumulative preference shares, the dividend is only payable out of the net profits of each year. If there are no profits in any year, the arrears of dividend cannot be claimed in the subsequent years. If the dividend on the preference shares is not paid by the company during a particular year, it lapses. Preference shares are presumed to be cumulative unless expressly described as non-cumulative.

c) Redeemable Preference Shares: Those preference shares, which can be redeemed or repaid after the expiry of a fixed period or after giving the prescribed notice as desired by the company, are known as redeemable preference shares. Terms of redemption are announced at the time of issue of such shares.

d) Non-redeemable Preference Shares: Those preference shares, which cannot be redeemed during the life time of the company, are known as non-redeemable preference shares. The amount of such shares is paid at the time of liquidation of the company.

e) Participating Preference Shares: Those preference shares, which have right to participate in any surplus profit of the company after paying the equity shareholders, in addition to the fixed rate of their dividend, are called participating preference shares.

f) Non-participating Preference Shares: Preference shares, which have no right to participate on the surplus profit or in any surplus on liquidation of the company, are called non-participating preference shares.

g) Convertible Preference Shares: Those preference shares, which can be converted into equity shares at the option of the holders after a fixed period according to the terms and conditions of their issue, are known as convertible preference shares.

h) Non-convertible Preference Shares: Preference shares, which are not convertible into equity shares, are called non-convertible preference shares.

2.4.3. Share Capital

A company should have capital in order to finance its activities. The Memorandum of Association must state the amount of capital with which the company is desired to be registered and the number of shares into which it is to be divided. When total capital of a company is divided into shares, then it is called share capital. It constitutes the basis of the capital structure of a company. In other words, the capital collected by a company for its business operation is known as share capital. Share capital is the total amount of capital collected from its shareholders for achieving the common goal of the company as stated in Memorandum of Association.

2.4.4. Types of Share Capital

Share capital of a company can be divided into the following different categories:

1. Authorized, registered, maximum or normal capital: The maximum amount of capital, which a company is authorized to raise from the public by the issue of shares, is known as authorized capital. It is a capital with which a company is registered; therefore, it is also known as registered capital.

2. Issued Capital: Generally, a company does not issue its authorized capital to the public for subscription, but issues a part of it. So, issued capital is a part of authorized capital, which is offered to the public for subscription, including shares offered to the vendor for consideration other than cash. The part of authorized capital not offered for subscription to the public is known as 'un-issued capital'. Such capital can be offered to the public at a later date.

3. Subscribed Capital: It cannot be said that the entire issued capital will be taken up or subscribed by the public. It may be subscribed in full or in part. The part of issued capital, which is subscribed by the public, is known as subscribed capital.

4. Called Up Capital: It is that part of subscribed capital, which is called by the company to pay on shares allotted. It is not necessary for the company to call for the entire amount on shares subscribed for by shareholders. The amount, which is not called on subscribed shares, is called uncalled capital.

5. Paid-up Capital: It is that part of called up capital, which actually paid by the shareholders. Therefore it is known as real capital of the company. Whenever a particular amount is called and a shareholder fails to pay the amount fully or partially, it is known unpaid-calls or calls in arrears.

Paid-up Capital = Called up capital - Calls in arrears

6. Reserve Capital: It is that part of uncalled capital which has been reserved by the company by passing a special resolution to be called only in the event of its liquidation. This capital cannot be called up during the existence of the company. It would be available only in the event of liquidation as an additional security to the creditors of the company.

2.4.4. Types of Share Capital

Share capital of a company can be divided into the following different categories:

1. Authorized, registered, maximum or normal capital: The maximum amount of capital, which a company is authorized to raise from the public by the issue of shares, is known as authorized capital. It is a capital with which a company is registered; therefore, it is also known as registered capital.

2. Issued Capital: Generally, a company does not issue its authorized capital to the public for subscription, but issues a part of it. So, issued capital is a part of authorized capital, which is offered to the public for subscription, including shares offered to the vendor for consideration other than cash. The part of authorized capital not offered for subscription to the public is known as 'un-issued capital'. Such capital can be offered to the public at a later date.

3. Subscribed Capital: It cannot be said that the entire issued capital will be taken up or subscribed by the public. It may be subscribed in full or in part. The part of issued capital, which is subscribed by the public, is known as subscribed capital.

4. Called Up Capital: It is that part of subscribed capital, which is called by the company to pay on shares allotted. It is not necessary for the company to call for the entire amount on shares subscribed for by shareholders. The amount, which is not called on subscribed shares, is called uncalled capital.

5. Paid-up Capital: It is that part of called up capital, which actually paid by the shareholders. Therefore it is known as real capital of the company. Whenever a particular amount is called and a shareholder fails to pay the amount fully or partially, it is known unpaid-calls or calls in arrears.

Paid-up Capital = Called up capital - Calls in arrears

6. Reserve Capital: It is that part of uncalled capital which has been reserved by the company by passing a special resolution to be called only in the event of its liquidation. This capital cannot be called up during the existence of the company. It would be available only in the event of liquidation as an additional security to the creditors of the company.

2.5. Key Players in the Primary Markets

A. Corporations:

In the capital market, corporations require investments and funds to manage and grow the business. The composition of the corporations varies with respect to size, industry and geographical locations. Examples of publically traded corporations include Amazon, Apple, Microsoft and etc.

B. Institutions:

Institutions in capital market includes banks, insurance companies, pensions, hedge funds, REITs, investment advisors, endowments and mutual funds.

C. Investment bankers: the role of the investment banks is to guide their clients in making the right decisions and finalising right deals so that they face minimum loss. Investment banks also advise their clients to buy back their shares from the market at the right time and offer advisory services to big companies and corporate bodies. The investment bank works as an intermediary between corporations and institutions. The job of the investment banks is to connect the institutions with the corporate and assisting clients with mergers and acquisitions (M&A s) and advising them on unique investment opportunities such as derivatives. Examples of top investment banks are: Goldman Sachs, JP Morgan, Credit Suisse, HSBC, Morgan Stanley

D. Public accounting firms: Public accounting refers to business that provides accounting services to other firms. Public accountants provide accounting expertise, auditing and tax services to their clients. This can include the handling of many accounting functions on an outsourced basis. Depending on their divisions, public accounting firms can engage in multiple roles in the primary market. The roles include financial reporting, auditing financial statements, taxation, consulting on accounting systems, M&A advisory and raising capital. Therefore, public accounting firms are usually hired by corporations for their accounting and advisory services. Examples of best public accounting firms include: Deloitte, PwC, Ernst & Young, and KPMG.

2.6. Key Players in The Secondary Markets

In the primary market, the companies initially issue the debt or equity instruments mainly to raise funds for business and funding new projects. Whereas, the secondary market enables the investors to sell and trade in the existing securities with other investors. The trading is facilitated by brokers, who enable both parties to reach a mutual agreement. The secondary market allows the trading of the issued bonds and shares between investors and enables them to enter or exit securities easily, making the market liquid.

1. Buyers and Sellers:

The buyers and sellers transact on an exchange in the secondary market. In the secondary market, fund managers or any investors who wish to purchase securities or debts will have to locate a seller. Transactions are facilitated through a central marketplace, including a stock exchange or Over the Counter (OTC).

2. Investment Banks:

The investment banks are specialized in the field of debt and equity research and they work closely with traders and security sales personnel to determine the approximate prices of securities in the current market situation. They expedite the sales and trading of issued debts and equities between buyers and sellers in the secondary market. The investment banks provide services like equity search and potential risk analysis to help their clients take well-informed decisions. Moreover, investment banks sell and trade securities on behalf of the clients to maximize their profits.

3. Introduction to Money Markets

The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable Certificates of Deposit (CDs), Bankers Acceptances, Treasury Bills, Commercial Paper, Municipal Notes, Eurodollars, Federal Funds and Repurchase Agreements (repos). Money Market investments are also called cash investments because of their short maturities.

The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities. However, there are risks in the money market that any investor needs to be aware of, including the risk of default on securities.

3.1. Money Market Types-Certificate of Deposits

The Certificate of Deposit is a promissory note that the bank, thrifts or Credit Union issues that offers an interest rate in exchange for the customer depositing money for a predetermined period of time. In the USA, CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for banks and by the National Credit Union Administration (NCUA) for credit unions. CD has a specific, fixed term often one, three, or six months, or range from one to five years with a fixed interest rate. Fixed rates are common, but some institutions also offer CDs with forms of variable rates as well.

Features of Certificate of Deposit:

  1. Certificate of deposit is preferred over other investments as principal amount is safe with Certificates of Deposit. Hence, they are less risky than stocks, bonds and other volatile instruments.

  2. The Certificate of Deposit offers a higher rate of interest and better returns as compared to traditional savings accounts

  3. Certificate of Deposits typically require a minimum deposit, and may offer higher rates for larger deposits.

  4. Withdrawals of Certificate of Deposits before maturity are usually subject to a sizable penalty.

  5. Credit Unions offers better rates for Certificate of deposits than most of the banks

  6. The interest is not paid on a Certificate of Deposit until it matures.

  7. One can sell bank Certificate of Deposits at the issuing bank. Usually, banks charge one to three months of interest as a penalty, depending on the length until maturity of the CD.

  8. The CD “matures” at the end of its term, and owner of the CD has to decide what to do next. The bank will notify owner of CD as it near maturity date. If owner of the CD do nothing, money will most likely be reinvested into another CD with the same term as the one that just matured.

Types of Certificate of Deposits:

1. Liquid or "No Penalty" CDs:

Liquid CDs allow customers to pull funds out at any time without paying an early withdrawal penalty. This flexibility allows customers to move their funds to a higher paying CD if the opportunity arises (but it comes at a price). Liquid CDs pay lower interest rates than CDs that comes with lock in period.

2. Bump-Up CDs

Bump-up CDs provide a benefit similar to liquid CDs meaning customer get to keep existing CD account and switch to a new, higher rate, assuming the issuing bank is offering higher rates. However, customer is required to inform bank in advance that customer want to exercise bump-up option. The bank assumes that customer is sticking with the existing rate if customer do nothing.

3. Step-Up CDs:

These come with regularly scheduled interest rate increases so you're not locked into the rate that was in place at the time you bought your CD. Increases might come every six months, every nine months, or in the case of long-term CDs, once a year.

4. Brokered CDs

Brokered CDs are another alternative. Brokered CDs are sold in brokerage accounts. Customer can buy brokered CDs from numerous banks and keep them all in one place instead of opening an account at a bank and using their selection of CDs. This gives customer ability to pick and choose, but brokered CDs come with additional risks such as bank customer considering may not be FDIC insured or getting out of a brokered CD early can be challenging.

5. Jumbo CDs:

As the name suggests, jumbo CDs have very high minimum balance requirements. It's a safe place to park a large amount of money because it is FDIC insured, and customer earns a significantly higher interest rate.

3.2. Money Market Types-Bankers Acceptance

A banker’s acceptance (BA, aka bill of exchange) is a commercial bank draft requiring the bank to pay the holder of the instrument a specified amount on a specified date, which is typically 90 days from the date of issue, but can range from 1 to 180 days. The banker’s acceptance is issued at a discount, and paid in full when it becomes due; the difference between the value at maturity and the value when issued is the interest. If the banker’s acceptance is presented for payment before the due date, then the amount paid is less by the amount of the interest that would have been earned if held to maturity.

A banker’s acceptance is used for international trade as means of ensuring payment. For instance, if an importer wants to import a product from a foreign country, he will often get a letter of credit from his bank and send it to the exporter. The letter of credit is a document issued by a bank that guarantees the payment of the importer's draft for a specified amount and time. Thus, the exporter can rely on the bank's credit rather than the importer's. The exporter presents the shipping documents and the letter of credit to his domestic bank, which pays for the letter of credit at a discount, because the exporter's bank won't receive the money from the importer's bank until later. The exporter's domestic bank then sends a time draft to the importer's bank, which then stamps it "accepted" and, thus, converting the time draft into a bankers acceptance. This negotiable instrument is backed by the importer's promise to pay, the imported goods, and the bank's guarantee of payment.

In most cases, banker’s acceptances are used in the import or export of goods. However, in some cases, it may involve trading within the same country. In some instances, a bankers acceptance, which in this case is termed a third-country acceptance, is created to ship between countries where neither the importer nor the exporter is located. Acceptance financing is the financing of commercial transactions, most of which are usually import/export businesses, by using banker’s acceptances. Banker’s acceptances have low credit risk because they are backed by the importer, the importer's bank, and the imported goods. Hence, BAs offer slightly higher yields than Treasuries of the same terms. Major investors of these money market instruments naturally include money market mutual funds, and municipalities. However, as other forms of financing have become available, the secondary market for BAs has declined considerably.

What a bank charges for a BA depends not only on its own fees and commissions for creating the BA, but is also commensurate with general market yields of other money market instruments. For BAs that are ineligible as collateral for Federal Reserve loans, the Fed imposes reserve requirements on the amount of ineligible BAs—hence, ineligible BAs are discounted more, with the result that the borrower receives less money for the initial loan, but the investor receives a higher yield. Major investors of these money market instruments naturally include money market mutual funds, and municipalities. However, as other forms of financing have become available, the secondary market for BAs has declined considerably. What a bank charges for a BA depends not only on its own fees and commissions for creating the BA, but is also commensurate with general market yields of other money market instruments. For BAs that are ineligible as collateral for Federal Reserve loans, the Fed imposes reserve requirements on the amount of ineligible Bas hence, ineligible BAs are discounted more, with the result that the borrower receives less money for the initial loan, but the investor receives a higher yield.

The Central Banker’s does, however, impose limits on the number of eligible BA that can be issued by a bank.

3.3. Money Market Types-Treasury Bills

Investors looking for a safe, short-term place to invest their money choose Treasury Bills, or T-Bills. These are highly liquid (short-term) government securities issued by governments, typically for terms of four weeks, three months, six months or one year. Essentially, T-Bills are a means for the government to raise money from the public. T-Bills can be purchased at a single auction. As they are fully backed by the credit of government and thus are considered essentially risk-free. Like other low-risk investments, such as savings accounts and certificates of deposit, T-Bills often earn relatively low interest; unlike with those other options, however, interest earned by a T-Bill is not subject to state or local taxes, although it is subject to federal income tax. When an investor buy a T-Bill, investor initially pay less than its par (face) value. Then, when it matures, investor receives the full par value. Investor can sell a T-Bill before its maturity date without penalty, although investors will be charged a commission.

Investors can buy T-Bills through either a non-competitive or a competitive bidding process at regularly held auctions. They can either buy them directly from the government or through a bank, stock broker or dealer. With a non-competitive bid, investor agrees to accept whatever discount rate is determined at the auction. This guarantees investor will receive the T-Bill amounts required. Non-competitive bids may be made using a bank, broker or dealer for those transactions.


  • Treasury Bills are not deducted at Source (TDS).

  • Treasury Bills are Zero default risk as these are the liabilities of Government of a country.

  • Treasury Bills is a Liquid Money Market Instrument.

  • Treasury Bills are available in secondary market thereby enabling holder to meet immediate fund requirement.

  • When liquidity is tight in the economy; returns on Treasury Bills sometimes become even higher than returns on bank deposits of similar maturity.

3.4. Money Market Types-Commercial Papers

Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of not more than 270 days. Commercial paper is an unsecured money-market security issued by large corporation and banks to obtain funds to meet short-term debt obligations and is backed only either by an issuing bank or company itself to pay the face amount on the maturity date specified on the note. Commercial paper is usually sold at a discount from face value and generally carries lower interest repayment rates than bonds due to the shorter maturities of commercial paper. CP is not backed by collateral; only firms with excellent credit ratings from a recognized credit rating agency will be able to sell their commercial paper at a reasonable price. The longer the maturity on a note, the higher the interest rate the issuing institution pays. There are four types of commercial paper which are drafts, checks, notes, and certificates of deposit. Retail investors can buy commercial paper from a broker as commercial paper is typically on higher amounts for example, in US it is traded in increments of $100,000 or more hence, it takes a substantial investment. Retail investors can also put money in funds or money market accounts that invest in commercial paper. Commercial paper constitutes personal property hence, is transferable by sale or gift; it can be even loaned. Commercial paper entails credit risk, and programs are rated by the major rating agencies. Commercial papers are actively traded in the secondary market in the OTC market.

Advantages of Commercial Papers:

  • Commercial Papers are a cost effective way of raising working capital.

  • Commercial Papers provide the exit option

  • Commercial Papers are cheaper than a bank loan.

  • Good rating Commercial Papers reduces the cost of capital for the company.

3.5. Money Market Types-Municipal Bonds (Munis)

A municipal note/bond (also called munis) is debt-instrument issued by municipality or local and state governments to finance expenditures such as for construction of highways, bridges or schools. Municipal notes are good to investors as they have maturity of one year or less. The municipal note offer fixed income, and are often exempt from income tax at the federal and/or state levels. There are two main types of municipal bonds; the general obligation bonds and revenue bonds. General Obligation bonds are backed by the issuer's taxing power. Revenue bonds, on the other hand, are repaid from a specified revenue stream. The revenue stream can be generated by either a project (a bridge, for example) or a tax (some bondholders have a claim on state sales tax receipts). This interest on munis is usually paid every six months until the date of maturity and issuers of munis have a record of meeting interest and principal payments in a timely manner. Municipal notes can be bought through bond dealers, banks, brokerage firms, and in a few cases directly from the municipality. Most municipal bonds are exempt from federal taxes.

3.6. Money Market Types-Euro Dollars

The term Eurodollar refers to U.S. dollar-denominated time deposits denominated in U.S. dollars at banks outside the United States, and thus is not under the jurisdiction of the Federal Reserve. The Eurodollar is also sold at the overseas branches of American banks. Mostly, they are held in branches located in the Bahamas and the Cayman Islands. The fact that the Eurodollar market is relatively regulation free means such deposits pay higher interest. The offshore location makes them subject to political and economic risk; however, most branches where the deposits are housed are in very stable locations.

Deposits of overnight to till a week Eurodollar are priced based on the fed funds rate. Prices for longer maturities are based on the corresponding London Interbank Offered Rate (LIBOR). Eurodollar deposits are quite large and are made by professional counterparties. Overnight Eurodollars between banks are done via the Fedwire and CHIPS systems and Eurodollar transactions with maturities greater than six months are usually done as certificates of deposit (CDs).

3.7. Money Market Types-Federal Funds

Federal Funds is a United States concept, where overnight borrowings between banks happen to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements. These loans are usually made overnight and the interest rate at which these deals are done is called the federal funds rate which are not collateralized.

3.8. Money Market Types-Repos and Reverse Repo's

Repurchase Agreements (or ‘repos’) Repo is defined as an agreement in which one party sells securities or other assets to a counterparty in order to get cash, and simultaneously commits to repurchase the same or similar assets from the counterparty, at an agreed future date or on demand, at a repurchase price equal to the original sale price plus a return on the use of the sale proceeds during the term of the repo. Repos are one of the most widely used securities financing transactions. They have become a key source of capital market liquidity. Repos are integral components of the banking industry’s treasury, liquidity and assets/liabilities management disciplines. Also, repos are an essential transaction used by central banks for the management of open market operations. In a repo transaction, the cash giver will expect some form of collateral, securities for example, to be placed in its account by the cash taker as a form of protection in the event the cash taker is not able to return the borrowed cash before or at the end of the repo agreement. The characteristics of the collateral to be exchanged are defined and agreed up front. A given transaction is a repo when viewed from the point of view of the supplier of the securities (the party acquiring funds) and a reverse repo when described from the point of view of the supplier of funds.

3.8. Money Market Types-Money Market Mutual Funds (/MMMF)

MMMF are used to manage the short-run cash needs. It is an open-ended scheme in the debt fund category which deals only in cash or cash equivalents. These securities have an average maturity of one-year; that is why these are termed as money market instruments. The fund manager invests in high quality liquid instruments like Treasury Bills (T-Bills), Repurchase Agreements (Repos), Commercial Papers and Certificate of Deposits. This fund aims to earn interest for the unit holders.

3.9. Money Market Types-Foreign Exchange Swap

FX Swap consists of two legs i.e., a foreign exchange spot transaction and a foreign exchange forward transaction. By concluding this transaction, investor agrees with the bank to exchange a set amount of one currency for another for a specified period of time. Under this transaction, the parties purchase or sell an agreed amount of one currency against another and agree to sell or purchase the same amount of one currency against another at the agreed strike price on a future date.

3.10. Short Lived ABS/MBS

An Asset Backed Security (ABS) is a type of investment vehicle that is backed up by an underlying pool of assets such as loans, leases, credit card balances etc. The ABS is in the form of a bond where a coupon is paid to the investor at fixed interval of time. If the underlying asset is Mortgage loan it is called Mortgage Backed Securities (/MB). The Short lived Asset Backed Securities and Mortgage Backed Securities are categorized under Money Market and the issuers here even raise cash.

4. Cash or Spot Market

The spot market is where financial instruments, such as commodities, currencies and securities, are traded for immediate delivery. Investing in the cash or "spot" market is highly sophisticated, with opportunities for both big losses and big gains. Cash Markets work with the concept “Pay now and Get now” meaning goods are sold for cash and are delivered immediately. Similarly, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills. An example of a spot market commodity that is often sold is crude oil. It is sold at the existing prices, and physically supplied later.

4.1. Spot in Forex Market

The spot market is where financial instruments, such as commodities, currencies and securities, are traded for immediate delivery. Investing in the cash or "spot" market is highly sophisticated, with opportunities for both big losses and big gains. Cash Markets work with the concept “Pay now and Get now” meaning goods are sold for cash and are delivered immediately. Similarly, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills. An example of a spot market commodity that is often sold is crude oil. It is sold at the existing prices, and physically supplied later.

4.2. Spot in OTC

OTC markets are characterised by market participants trading directly with each other. The two counterparties to a trade bilaterally agree a price and have obligations to settle the transaction (e.g. exchange of cash for gold) with each other and only the two contracting parties know the specifics of the price. Hence, OTC markets typically lack high levels of transparency and expose market participants to credit counterparty risks. However, the price transparency of exchange trading does influence OTC trading, since spot market prices serve as benchmarks for OTC pricing. Although OTC trading has the advantage of potentially lower fees and transaction costs, the barriers for market-entry are higher than on the exchange. On the stock exchange, securities must only be deposited once, while in OTC trading, securities must be deposited for each individual trading partner. This makes the entry into OTC trading more difficult for smaller trading companies, while big trading companies stand to save money on the OTC market. OTC trading is significantly more expensive, which inhibits participation by smaller market players. OTC trading also lacks fixed standards. Compared to exchange trading, this increases the flexibility of OTC trading, but also increases the risk. Default and loss risks stemming from poor decisions or business misunderstandings increase the likelihood of entering a bad contract, which can carry serious consequences. In order to lower the risks associated with free OTC trading and to simplify trading transactions, some exchanges offer standardized OTC contracts. These standardized contracts are usually templates that are adapted by the contracting parties. Due to the lack of regulation and transparency, manipulation of the OTC market is an inherent risk of OTC trading. Traders can manipulate the exchange price through targeted purchases and yield high OTC trade profits. This is illegal, and such manipulation is difficult to detect. The problem arise when market participants start to doubt the financial health of their counterparts, such as happened during the financial crisis of 2007/8, market liquidity can quickly disappear and lead to disorderly function of the market. OTC markets also face several regulatory challenges that have increased the typical costs of transacting under this model.

4.4. Spot in Exchanges

The spot transactions are better in exchanges as on an exchange, the products are standardised. The exchange brings buyers and sellers together and the trades are conducted through the exchange hence, the parties stay anonymous so that they don’t know who they have been trading with. Exchanges are typically regulated platforms that centralise and intermediate transactions between market participants. Exchanges are also good for spot transactions as due date, place of delivery, the time in which the deliveries will take place, load type and the conditions for clearing and settlement are standardised.

4.5. Features of the Spot

Spot, is a contract of buying or selling a commodity, security or currency for immediate settlement (payment and delivery) on the spot date, which is normally two business days after the trade date.

Spot markets are also referred to as “physical markets” or “cash markets” because trades are swapped for the asset effectively immediately.

Cash Markets are regulated in both exchanges as well as OTC markets.

Futures trades in contracts that are about to expire are also sometimes called spot trades since the expiring contract means that the buyer and seller will be exchanging cash for the underlying asset immediately.

Spot markets are influenced solely by supply and demand in the market (exchange or OTC)

Role of exchange is to: 'Based on all the orders provided by participants, it provides the current price and volume available to traders with access to the exchange.'

The spot price is the current price in the marketplace at which a given asset, such as a security, commodity, or currency can be bought or sold for immediate delivery.

The Cash-Spot market is largely a high-volume interbank market as it is based upon banks borrowing in one currency and lending in the other, usually to meet overnight reserve requirements.

Spot transaction attracts speculators, since spot market prices are known to the public almost as soon as deals are transacted.

Important aspect of spot market that affects spot market prices is whether the ‘commodity is perishable or non-perishable’.

A spot deal is a binding agreement to deliver funds in one currency, for transfer to another country at the quoted and agreed upon exchange rate (spot exchange rate) by a set date (the spot date).

5. Derivatives Markets

A derivative is a contract between two parties which derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps. It is a financial instrument which derives its value/price from the underlying assets. Originally, underlying corpus is first created which can consist of one security or a combination of different securities. The value of the underlying asset is bound to change as the value of the underlying assets keep changing continuously. Generally, stocks, bonds, currency, commodities and interest rates form the underlying asset.

The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can be used quite effectively as part of a risk management program. Not only are these instruments complex but so too are the strategies deployed by this market's participants.

The market can be divided into two, that for exchange-traded derivatives (Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange) and that for over-the-counter derivatives (Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options and other exotic derivatives are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchange).

One of the key features of financial market is that it is extremely volatile. Prices of foreign currencies, petroleum and other commodities, equity shares and instruments fluctuate all the time, and pose a significant risk to those whose businesses are linked to such fluctuating prices. To reduce this risk, modern finance provides a method called hedging. Derivatives are widely used for hedging. Of course, some people use it to speculate as well although in some countries like Singapore say, such speculation is prohibited. Derivatives are products whose value is derived from one or more basic variables called underlying assets or base, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps. The other types of derivatives are Warrants, Leaps and Baskets. The primary objectives of any investor are to bring an element of certainty to returns and minimise risks. Derivatives are contracts that originated from the need to limit risk.

Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customised as per the needs of the user by negotiating with the other party involved. Such derivatives are called over-the-counter (OTC) derivatives.

A Derivative Includes:

(a) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(b) A contract which derives its value from the prices, or index of prices, of underlying securities.

Advantages of Derivatives:

  • They help in transferring risks from risk adverse people to risk oriented people.

  • They help in the discovery of future as well as current prices.

  • They catalyze entrepreneurial activity.

  • They increase the volume traded in markets because of participation of risk adverse people in greater numbers.

  • They increase savings and investment in the long run.

5.1 Derivative Instruments-Forward Contracts

This is a form of contract wherein two parties agree on buying or selling an asset at an agreed price. The actual exchange then happens on a future date, thus the term forwards. The contract happens among the parties themselves without an outside party interfering. The contract in a forward type of financial derivative is non-standardized. It is subject to the choices of the parties engaged in a forward contract. The main features of forward contracts are:

They are bilateral contracts and hence exposed to counter party risk.

  • Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

  • The contract price is generally not available in public domain.

  • The contract has to be settled by delivery of the asset on expiration date.

  • In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

Forward contracts are very popular because they are unregulated by the government, they provide privacy to both the buyer and seller, and they can be customized to meet both the buyer's and sellers specific needs. Unfortunately, due to the opaque features of forward contracts, the size of the forward market is basically unknown. This, in turn, makes forward markets the least understood of the various types of derivative markets.

Suppose that Ganesh wants to buy a house a year from now. At the same time, suppose that Ramesh currently owns $100000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104000 Ramesh and Ganesh have entered into a forward contract. Ganesh, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Ramesh will have the short forward contract. At the end of one year, suppose that the current market valuation of Ramesh's house is $110000. Then, because Ramesh is obliged to sell to Ganesh for only $104000, Ganesh will make a profit of $6000. To see why this is so, one need only to recognize that Ganesh can buy from Ramesh for $104000 and immediately sell to the market for $110000. Ganesh has made the difference in profit. In contrast, Ramesh has made a potential loss of $6000, and an actual profit of $4000.

Why the initial amount was settled at 104000?

Continuing on the example above, suppose now that the initial price of Ramesh's house is $100000 and that Ganesh enters into a forward contract to buy the house one year from today. But since Ramesh knows that he can immediately sell for $100000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104000, risk free. So Ramesh would want at least $104000 one year from now for the contract to be worthwhile for him – the opportunity cost will be covered.

5.1.1. Derivative Instruments-Forward Contracts Types

1. Time Option Forward Contract:

A time option on forward contract gives one of the counterparties to a trade the right to choose which date, within a range of specified dates, that party can settle the trade. Many market makers quote forward FX rates with time options for their corporate and institutional clients. They rarely offer this service to market counterparties.

2. Open Forward Contract:

An Open forward contract allows the purchaser to complete a foreign exchange transaction on a future date based on today's exchange rate. It is called an "open" forward contract as, unlike a closed forward contract, it gives the purchaser some flexibility with regard to closing the contract. The purchaser of the contract can make as many payments, known as drawdowns, inside a specific period of time indicated on the contract, up to its final date as long as the entire contract is paid up in full by its expiry.

For example, a US-based company knows it will have to pay a number of bills to a supplier based in the euro zone over the next year. It decides to purchase a year-long open USD-EUR forward contract, which allows it to make drawdowns to pay their supplier in euros as and when necessary up to the expiry of the contract.

3. Closed Forward Contract:

A closed forward, in contrast to an open forward, is a contract in which a currency transaction is to be completed at an agreed exchange rate on a specified future date, known as the value date. There is no flexibility regarding the date of transaction completion and drawdowns are not permitted, in comparison with an open forward. Closed forwards are used essentially as a simple, straight-forward FX product for hedging foreign exchange market volatility risk.

4. Drawdown Forward Contract:

With a forward draw down contract you can take a portion of funds at intervals throughout the contract. Each withdrawal is termed a 'forward drawdown'. With a forward drawdown you can take as small or large a portion of the funds as you require, however each withdrawal may be subject to a fee. As with the forward contract, there may be a deposit required upon set up.

5. Fixed Term Forward Contract:

These contracts specify a 'fixed' future date at which it is anticipated delivery of the foreign currency will be effected. If delivery is made on the fixed date (expiry of the contract) the contract rate applies. However, delivery may be made at any time during the term of the contract but if prior to the stated due date (i.e. a pre-delivery) the contract rate may be adjusted in accordance with forward margins then applicable.

6. Minimum Price Forward Contract:

A forward contract with a provision that guarantees a minimum price at delivery of the underlying commodity. A minimum price contract enables a seller to specify a minimum price for any commodity, such as grain, while still being able to take advantage of price increases in the event the market rallies. The minimum price contract specifies the quantity, minimum price and delivery period for the particular commodity, as well as the time period during which the seller has the opportunity to take advantage of rising market prices.

Minimum price contracts can be advantageous to sellers because the risk of price decline is removed, a minimum price is guaranteed and the seller is still able to profit from price rallies during the specified time period.

5.2. Derivative Instruments-Future Contracts

Future contracts evolved out of forward contracts and possess many of the same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges, called future markets. The first futures contracts were negotiated for agricultural commodities, and later for natural resources such as oil. Financial futures were introduced in 1972, and in recent decades, currency futures, interest rate futures and stock market index futures have played an increasingly large role in the overall futures markets.

The underlying asset in a futures contract could be commodities, stocks, currencies, interest rates and bond. The original use of futures contracts was to mitigate the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions. This could be advantageous when (for example) a party expects to receive payment in foreign currency in the future, and wishes to guard against an unfavourable movement of the currency in the interval before payment is received. However, futures contracts also offer opportunities for speculation in that a trader who predicts that the price of an asset will move in a particular direction can contract to buy or sell it in the future at a price which (if the prediction is correct) will yield a profit.

5.2.1. Derivative Instruments-Futures Participants

There are two basic categories of futures participants: Hedgers and Speculators.

1. Hedgers:

Hedgers are very often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take, for instance, a major food processor who cans corn. In case if corn prices go up, he must pay the farmer or corn dealer more. For protection against higher corn prices, the processor can "hedge" his risk exposure by buying enough corn futures contracts to cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if corn prices rise enough to offset cash corn losses.

2. Speculators:

Speculators are the second major group of futures players. These participants include independent floor traders and investors. Independent floor traders, also called "locals", trade for their own accounts. Floor brokers handle trades for their personal clients or brokerage firms. If the trader's judgment is good, he can make more money in the futures market faster because futures prices tend, on average, to change more quickly than real estate or stock prices, for example. On the other hand, bad trading judgment in futures markets can cause greater losses than might be the case with other investments.

5.2.2. Derivative Instruments-Types of Futures

1) Stock Futures: Stock Futures are financial contracts where the underlying asset is an individual stock. Stock Future contract is an agreement to buy or sell a specified quantity of underlying equity share for a future date at a price agreed upon between the buyer and seller. The contracts have standardized specifications like market lot, expiry day, unit of price quotation, ticket size and method of settlement. In case of stock futures, both the buyer and seller are obliged to buy/sell the underlying share. Presently, stock futures are settled in cash. The final settlement price is the closing price of the underlying stock.

The theoretical price of a future contract is sum of the current spot price and cost of carry. However, the actual price of futures contract very much depends upon the demand and supply of the underlying stock. Generally, the futures prices are higher than the spot prices of the underlying stocks.

Futures Price = Spot Price + Cost of Carry

Cost of carry is the interest cost of a similar position in cash market and carried to maturity of the futures contract less any dividend expected till the expiry of the contract.


Spot Price of Co.X= 1600, Interest Rate = 7% p.a. Futures Price of 1 month contract=1600 + 1600*0.07*30/365 = 1600 + 11.51 = 1611.51

2) Stock Index Futures: An Index future is a futures contract on a stock or financial index. Index futures are the primary way of trading stock indices. All of the major stock indices have corresponding futures contracts that are traded on a futures exchange. For example, the E-mini–Dow is the main futures contract on the Dow Jones. Index futures are essentially the same, and trade in the same way, as all other futures contracts.

Taking a long position: Taking a long position means that you are buying the index at a fixed price now, for expiry on a set date in the future. You would do this if you expected the price of the index to rise between now and the expiry date, so you could profit by selling for a higher price than you paid.

Taking a short position: Taking a short position means that you are selling the index at a fixed price now, for expiry on a set date in the future. You would do this if you thought the price of the index would fall between now and the expiry date, so you could then profit by buying at a lower price.

Like other futures markets, index futures trade on leverage: you put down a margin of the total value of your contract, and this gives you magnified exposure to the market.

Example: the E-mini S&P 500

The E-mini-S&P 500 is one fifth of the size of the standard S&P 500 contract, and closely tracks the performance of the larger index. If you think the S&P 500 is going to increase in value over the next three months, you might choose to buy index futures on the E-mini.

The contracts are priced at $50 x the E-mini (futures) price. So, if the E-mini futures price is at 1000.00, your $50 contract has a full exposure worth $50,000 ($50 x 1000.00). Like all futures products, you only need to put down a fraction of the full value of the contract in order to open a position; in the case of index futures, this amount is known as a ‘performance bond’. If the market moves against you, you might need to add additional funds to maintain the necessary margin.

For every point the E-mini moves in your favour, you gain $50. For every point the E-mini moves against you, you lose $50.

Ticks: Ticks are the minimum price movement of a futures contract. For the S&P 500 E-mini, the tick is 0.25 index points, which equates to $12.50 of a $50 contract; so if the E-mini price moves from 1000.00 to 1000.25, a buy position would gain $12.50 and a sell position would lose $12.50.

1. Advantages of stock index futures:

a. Short-term trading: As a form of derivative, futures can fit into your overall trading strategy. In volatility trading, for instance, the aim is to take small but regular profits from a volatile market.

b. Hedging against losses: Let’s assume you have a portfolio of shares. You can limit your exposure to unwanted risk by opening an opposite position as an index future. So if you had a number of long shares positions, you could take a short position on the relevant index future. This would help you to offset any losses if your shares moved against you.

c. Investing: Being leveraged products, stock index futures give you exposure to a stock market or sector as a whole for a much smaller amount of up-front capital, and without having to purchase the individual constituent shares directly. Stock index futures are leveraged products, giving you potential gains (or losses) greater than your up-front capital.

2. Limitations of Stock Index Futures:

a. Standardisation: Futures contracts are standardised by the exchange, which mean you must deal in a certain size. This size might not exactly match your needs, especially if you are hedging an existing portfolio.

b. Margin rates: As you are dealing with such a high-value and volatile asset, you're likely to need to put down a fairly substantial figure as your margin payment. You’ll need to maintain this margin throughout the time your position is open.

5.3. Derivative Instruments-Commodity Futures

This is an agreement to exchange a specific quantity of a commodity at a fixed date in the future, at a price agreed today. The price will be a ‘forward price’, taking into account foreseeable fluctuations such as the cost of carry. Futures contracts are traded through a futures exchange. Each contract is an agreement between two parties to exchange a given quantity of a commodity, at a specific date in the future, at a price defined today. Effectively, it follows the ‘buy now, pay and collect later’ principle.

On the supply side, by trading commodities through forward contracts, suppliers are able to lock in the price of their commodity before they can deliver it to the consumer. This also fixes the future price for consumers, which helps to maintain price stability in the markets. The commodity markets help to ensure some stability in price, especially through futures contracts. These allow suppliers to lock in the price they’ll receive for their produce at a future date; so the price is also fixed for the buyer. The commodity prices quoted in the market, therefore, are often the futures price for each commodity; the fixed price at which a commodity will be traded at a specified point in time.

Key factors affecting these prices:

1. Supply and Demand:

Let’s take oil as an example. If the supply of oil becomes more plentiful but demand remains level, the price of each barrel will decrease. If more people are using oil but producers don’t have the capacity to match this demand, the price of each barrel will increase.

2. Economic and Political Factors:

Although commodities are normally traded on futures prices, economic events that happen now will affect the levels of these prices. For example, political unrest in the Middle East often causes the futures price of oil to fluctuate due to uncertainties on the supply side.

3. Weather:

Agricultural commodities such as wheat or coffee will be heavily influenced by the weather, as it controls the harvest. A poor harvest will result in low supply, causing rising prices.

4. The Currency:

Commodities are normally priced in say $ and generally move inversely to that currency. A rising $ is anti-inflationary, so it applies downward pressure on commodity prices. Similarly, a falling currency will usually apply upward pressure on commodity prices.

5.3. Derivative Instruments-Currency Futures

This is an agreement to exchange a specific quantity of a commodity at a fixed date in the future, at a price agreed today. The price will be a ‘forward price’, taking into account foreseeable fluctuations such as the cost of carry. Futures contracts are traded through a futures exchange. Each contract is an agreement between two parties to exchange a given quantity of a commodity, at a specific date in the future, at a price defined today. Effectively, it follows the ‘buy now, pay and collect later’ principle.

On the supply side, by trading commodities through forward contracts, suppliers are able to lock in the price of their commodity before they can deliver it to the consumer. This also fixes the future price for consumers, which helps to maintain price stability in the markets. The commodity markets help to ensure some stability in price, especially through futures contracts. These allow suppliers to lock in the price they’ll receive for their produce at a future date; so the price is also fixed for the buyer. The commodity prices quoted in the market, therefore, are often the futures price for each commodity; the fixed price at which a commodity will be traded at a specified point in time.

Key factors affecting these prices:

1. Supply and Demand:

Let’s take oil as an example. If the supply of oil becomes more plentiful but demand remains level, the price of each barrel will decrease. If more people are using oil but producers don’t have the capacity to match this demand, the price of each barrel will increase.

2. Economic and Political Factors:

Although commodities are normally traded on futures prices, economic events that happen now will affect the levels of these prices. For example, political unrest in the Middle East often causes the futures price of oil to fluctuate due to uncertainties on the supply side.

3. Weather:

Agricultural commodities such as wheat or coffee will be heavily influenced by the weather, as it controls the harvest. A poor harvest will result in low supply, causing rising prices.

4. The Currency:

Commodities are normally priced in say $ and generally move inversely to that currency. A rising $ is anti-inflationary, so it applies downward pressure on commodity prices. Similarly, a falling currency will usually apply upward pressure on commodity prices.

5.4. Derivative Instruments-Options Contracts

An options contract is an agreement between a buyer and seller that gives the purchaser of the option the right to buy or sell a particular asset at a later date at an agreed upon price. Options contracts are often used in securities, commodities, and real estate transactions.

There are several types of options contracts in financial transactions. An exchange traded option, for example, is a standardized contract that is settled through a clearing house and is guaranteed. These exchange traded options cover stock options, commodity options, bond and interest rate options, index options, and futures options. Another type of option contract is an over –the-counter option which is a trade between two private parties. This may include interest rate options, currency exchange rate options.

Options are traded in units called contracts. Each contract entitles the option buyer/owner to 100 shares of the underlying stock upon expiration. Thus, if you purchase seven call option contracts, you are acquiring the right to purchase 700 shares. For every buyer of an option contract, there is a seller (also referred to as the writer of the option). In exchange for the cash received upon creating the option, the option writer gives up the right to buy or sell the underlying stock to someone else for the duration of the option. For instance, if the owner of a call option exercises his or her right to buy the stock at a particular price, the option writer must deliver the stock at that price.

Strike Price: It is the price at which a derivative can be exercised, and refers to the price of the derivative’s underlying asset. In a call option, the strike price is the price at which the option holder can purchase the underlying security. For a put option, the strike price is the price at which the option holder can sell the underlying security.

5.4. Derivative Instruments-Options According To Option Rights -Call Option

A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation. For stock options, each contract covers 100 shares.

Example: Suppose the stock of XYZ Company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares. Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying strategy will get you a profit of $800.

Let us take a look at how we obtain this figure.

Say you were proven right and the price of XYZ stock rallies to $50 on option expiration date. With underlying stock price at $50, if you were to exercise your call option, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Since you had paid $200 to purchase the call option, your net profit for the entire trade is therefore $800. However, if you were wrong in your assessments and the stock price had instead dived to $30, your call option will expire worthless and your total loss will be the $200 that you paid to purchase the option. For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages. However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commission’s broker.

5.4.1. Derivative Instruments-Options According To Option Rights -Call Option-Types

1) Out-of-the-money calls:

A call option is considered to be "out-of-the-money" if the strike price for the option is above the current price of the underlying security. For example, if a stock is trading at $22.50 a share, then the $25 strike price call option is currently "out-of-the-money." The lure of out-of-the-money options is that they are less expensive than at-the-money or in-the-money options. This is simply a function of the fact that there is a lower probability that the stock will exceed the strike price for the out-of-the-money option. Likewise, for the same reason, out-of-the-money options for a nearer month will cost less than options for a further-out month. On the positive side, out-of-the-money options also tend to offer great leverage opportunities. In other words, if the underlying stock does move in the anticipated direction, and as the out-of-the-money option gets closer to becoming - and ultimately becomes - an in-the-money option, its price will increase much more on a percentage basis than an in-the-money option would. As a result of this combination of lower cost and greater leverage it is quite common for traders to prefer to purchase out-of-the-money options rather than at- or in-the-moneys.

2) In-the-money calls:

A call option is said to be an in the money call when the current market price of the stock is above the strike price of the call option. It is an "in the money call" because the holder of the call has the right to buy the stock below its current market price. When you have the right to buy anything below the current market price, then that right has value. That value is equal to at least the amount that your purchase price (strike price) is below the market price. In the world of call options, your call is "in the money" when the strike price is less than the current market price of the stock. The amount that your call's strike price is below the current stock price is called its "intrinsic value" because you know it is worth at least that amount.

Suppose ABC stock trades at $300 per share. An ABC call option with a strike price of $200 is in the money since the option holder could buy ABC at $200 and turn around and sell it for $300. The intrinsic value of this call option is $100.

5.5. Derivative Instruments-Options According To Option Rights -Put Option

A put option is a financial contract between the buyer and seller of a securities option allowing the buyer to force the seller (or the writer of the option contract) to buy the security.

In options trading, a buyer may purchase a short position (i.e. the expectation that the price will go down) on a security. This position gives the buyer the right to sell the underlying security at an agreed-upon price (i.e. the strike price) by a certain date. If the market price falls below the strike price, as expected, the buyer can decide to exercise his or her right to sell at that price and the writer of the option contract has the obligation to buy the security at the strike price. With the exercise of the put, the trader makes the difference between the cost of the security in the market (i.e. a lower price than the option strike price) and the sale of the option to the put writer (i.e. at the strike price).

For example, if a trader purchases a put option contract for Company XYZ for $1 (i.e. $01/share for a 100 share contract) with a strike price of $10 per share, the trader can sell the shares at $10 before the end of the option period. If Company XYZ's share price drops to $8 per share, the trader can buy the shares on the open market and sell the put option at $10 per share (the strike price on the put option contract). Taking into account the put option contract price of $.01/share, the trader will earn a profit of $1.99 per share.

5.5.1. Derivative Instruments-Options According To Option Rights -Put Option Types

1) Out-of-the-money Put:

A Put option is considered to be "out-of-the-money" if the strike price for the option is below the current price of the underlying security. For example, if a stock is trading at $22.50 a share, then the $20 strike price put option is currently "out-of-the-money."

2) In-the-money Put:

A put option is said to be an in the money put when the current market price of the stock is below the strike price of the put. It is "in the money" because the holder of this put has the right to sell the stock above its current market price. When you have the right to sell anything above its current market price, then that right has value. That value is equal to at least the amount that your sales price is above the market price. In the world of put options, your put is "in the money" when the strike price of your put is above the current market price of the stock. The amount that your put's strike price is above the current stock price is called its "intrinsic value" because you know it is worth at least that amount.

5.6. Derivative Instruments-Options According To Underlying Assets

1) Equity Option: Equity options are the most common type of equity derivative. They provide the right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a certain period of time (prior to the expiration date).

2) Bond Option:

A bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. These instruments are typically traded OTC (Over The Counter). A European bond option is an option to buy or sell a bond at a certain date in future for a predetermined price. An American bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price. Generally, one buys a call option on the bond if one believes that interest rates will fall, causing an increase in bond prices. Likewise, one buys the put option if one believes that the opposite will be the case. One result of trading in a bond option, is that the price of the underlying bond is "locked in" for the term of the contract, thereby reducing the credit risk associated with fluctuations in the bond price.

5.7. Options Embedded in a Bond

1. Callable Bond:

Allows the issuer to buy back the bond at a predetermined price at a certain time in future. The holder of such a bond has, in effect, sold a call option to the issuer. Callable bonds cannot be called for the first few years of their life. This period is known as the lock out period.

2. Puttable Bond:

Allows the holder to demand early redemption at a predetermined price at a certain time in future. The holder of such a bond has, in effect, purchased a put option on the bond.

3. Convertible Bond:

Allows the holder to demand conversion of bonds into the stock of the issuer at a predetermined price at a certain time period in future.

4. Extendible Bond:

Allows the holder to extend the bond maturity date by a number of years.

5. Exchangeable Bond:

Allows the holder to demand conversion of bonds into the stock of a different company, usually a public subsidiary of the issuer, at a predetermined price at certain time period in future.

5.8. Swaps

A swap is a derivative instrument that permits counterparties to exchange (or "swap") a series of cash flows based on a specified time horizon. Typically, one series of cash flows would be considered the fixed leg of the agreement while the other would be less predictable, such as cash flows based on an interest rate benchmark or a foreign exchange rate, usually referred to as the floating leg. The swap agreement as it is known, which would be agreed upon by both parties, will specify the terms of the swap, including the underlying values for the legs along with the payment frequency and dates. A party would enter a swap typically for one of two reasons, as a hedge for another position or to speculate on the future value of the floating leg's underlying index/currency/etc. Swaps are derivative contracts and trade over-the-counter.

5.8.1. Types of Swaps-Interest Rate Swap

Interest rate Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead. Each group has their own priorities and requirements, so these exchanges can work to the advantage of both parties. As a definition, an interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed payments where these cash flows are known. A floating rate payer makes a series of payments that depend on the future level of interest rates (e.g., a quoted index like LIBOR for example) and at the beginning of the swap, most or all of these cash flows are not known.

An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a basis swap). In brief, an interest rate swap is priced by first calculating the present value of each leg of the swap (using the appropriate interest rate curve) and then aggregating the two results.

Let us take an example to better understand interest rate swap: One company may have a bond that pays the London Interbank Offered Rate (LIBOR), while the other party holds a bond that provides a fixed payment of 5%. If the LIBOR is expected to stay around 3%, then the contract would likely explain that the party paying the varying interest rate will pay LIBOR plus 2%. That way both parties can expect to receive similar payments. The primary investment is never traded, but the parties will agree on a base value (perhaps $1 million) to use to calculate the cash flows that they’ll exchange.

5.8.1. Types of Swaps-Currency Swap

A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either act on their own or as an agent for a nonfinancial corporation.

Cross currency swaps are frequently used by financial institutions and multinational corporations for funding foreign currency investments, and can range in duration from one year to up to 30 years. Currency swaps are often used to exchange fixed-interest rate payments on debt for floating-rate payments; that is, debt in which payments can vary with the upward or downward movement of interest rates. However, they can also be used for fixed rate-for-fixed rate and floating rate-for-floating rate transactions. Each side in the exchange is known as counterparty.

In a typical currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received. Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another.

An example of a cross currency swaps for a EUR/USD transaction between a European and an American company follows: In a cross-currency basis swap, the European company would borrow US$1 billion and lend ‎€500 million to the American company assuming a spot exchange rate of US$2 per EUR for an operation indexed to the London Interbank Rate (Libor), when the contract is initiated.

Throughout the length of the contract, the European company would periodically receive an interest payment in euros from its counterparty at Libor plus a basis swap price, and it would pay the American company in dollars at the Libor rate. When the contract comes to maturity, the European company would pay US$1 billion in principle back to the American company and would receive its initial ‎€500 million in exchange.

5.8.2. Types of Swaps-FX Swap

FX swap agreement is a contract in which one party borrows one currency from, and simultaneously lends another to, the second party. Each party uses the repayment obligation to its counterparty as collateral and the amount of repayment is fixed at the FX forward rate as of the start of the contract. Thus, FX swaps can be viewed as FX risk-free collateralised borrowing/lending.

Let us see a euro/US dollar swap as an example. At the start of the contract, A borrows X*S USD from B and lends X EUR to B, where S is the FX spot rate. When the contract expires, A returns X*F USD to B and B returns X EUR to A, where F is the FX forward rate as of the start.

FX swaps have been employed to raise foreign currencies, both for financial institutions and their customers, including exporters and importers, as well as institutional investors who wish to hedge their positions. They are also frequently used for speculative trading, typically by combining two offsetting positions with different original maturities.

FX swaps are most liquid at terms shorter than one year, but transactions with longer maturities have been increasing in recent years.

Unlike in a cross-currency swap, in an FX swap there are no exchanges of interest during the contract term and a differing amount of funds is exchanged at the end of the contract. Given the nature of each, FX swaps are commonly used to offset exchange rate risk, while cross currency swaps can be used to offset both exchange rate and interest rate risk.

5.8.3. Types of Swaps-Commodity Swap

Traders use commodity swap to hedge against price fluctuations in commodity prices, commonly energy and agriculture commodities. No commodities are exchanged during the ‘swap trade’, cash is exchanged instead. In commodity swaps, exchanged cash flows are dependent on the price (floating/market/spot) of an underlying commodity. It’s more or less similar to a fixed-floating interest rate swap, the difference is the floating leg is based on the price of the underlying commodity instead LIBOR or EURIBOR.

The advantage of being linked with a commodity swap is that the user can secure a maximum price to the commodity and agree to pay a financial institution a fixed amount. In return, he/she gets payments based on the market price of the commodity. Fixed-floating and commodity-for-interest are the two types of commodity swaps commonly seen.

As an example, assume that Company X needs to purchase 250,000 barrels of oil each year for the next two years. The forward prices for delivery on oil in one year and two years are $50 per barrel and $51 per barrel. Also, the one-year and two-year zero-coupon bond yields are 2% and 2.5%. Two scenarios can happen: paying the entire cost up-front or paying each year upon delivery.

To calculate the upfront cost per barrel, take the forward prices, and divide by their respective zero-coupon rates, adjusted for time. In this example, the cost per barrel would be:

Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels of oil per year for two years.

However, there is counterparts’ risk, and the oil may not be delivered. In this case, the consumer may opt to pay two payments, one each year, as the barrels are being delivered.

5.8.3. Types of Swaps-Credit Default Swap

A credit default swap (CDS) is a contract between two parties in which one party purchases protection from another party against losses from the default of a borrower for a defined period of time. The features of a CDS are as given below:

  1. A CDS is written on the debt of a third party, called the reference entity, whose relevant debt is called the reference obligation, typically a senior unsecured bond.

  2. A CDS written on a particular reference obligation normally provides coverage for all obligations of the reference entity that have equal or higher seniority.

  3. The two parties to the CDS are the credit protection buyer, who is said to be short the reference entity’s credit, and the credit protection seller, who is said to be long the reference entity’s credit. The seller (buyer) is said to be long (short) because the seller is bullish (bearish) on the financial condition of the reference entity.

  4. The CDS pays off upon occurrence of a credit event, which includes bankruptcy, failure to pay, and, in some countries, restructuring.

  5. Settlement of a CDS can occur through a cash payment from the credit protection seller to the credit protection buyer as determined by the cheapest-to-deliver obligation of the reference entity, or by physical delivery of the reference obligation from the protection buyer to the protection seller in exchange for the CDS notional.

  6. A cash settlement payoff is determined by an auction of the reference entity’s debt, which gives the market’s assessment of the likely recovery rate.

  7. The credit protection buyer must accept the outcome of the auction even though the ultimate recovery rate could differ.

  8. CDS can be constructed on a single entity or as indexes containing multiple entities.

  9. The fixed payments made from CDS buyer to CDS seller are customarily set at a fixed annual rate of 1% for investment-grade debt or 5% for high-yield debt.

  10. Valuation of a CDS is determined by estimating the present value of the protection leg, which is the payment from the protection seller to the protection buyer in event of default, and the present value of the payment leg, which is the series of payments made from the protection buyer to the protection seller.

  11. Any difference in the two series results in an upfront payment from the party having the greater present value to the counterparty.

  12. An important determinant of the value of the expected payments is the hazard rate, the probability of default given that default has not already occurred.

  13. CDS prices are often quoted in terms of credit spreads, the implied number of basis points that the credit protection seller receives from the credit protection buyer to justify providing the protection.

  14. Credit spreads are often expressed in terms of a credit curve, which expresses the relationship between the credit spread on bonds of different maturities for the same borrower.

  15. CDS change in value over their lives as the credit quality of the reference entity changes, which leads to gains and losses for the counterparties, even though default may not have occurred or may never occur.

  16. Either party can monetize an accumulated gain or loss by entering into an offsetting position that matches the terms of the original CDS.

  17. CDS are used to increase or decrease credit exposures or to capitalize on different assessments of the cost of credit among different instruments tied to the reference entity, such as debt, equity, and derivatives of debt and equity.

6. Forex Markets

The forex market is where currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds Re.1.9 trillion per day and includes all of the currencies in the world. The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market. There is no central marketplace for currency exchange; trade is conducted over the counter. The forex market is open 24 hours a day, five days a week and currencies are traded worldwide among the major financial centres of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney. Until recently, forex trading in the currency market had largely been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts.

6.1. Forex Markets-Characteristics

1. Ease of trading in Forex:

Just like stocks, any investor can trade currency based on perception of currency value or where it's headed. But the big difference with forex is that investor can trade up or down just as easily. If investor think a currency will increase in value, can buy it; if investor think it will decrease, can sell it. With a market this large, finding a buyer when an investor is selling and a seller when an investor is buying is much easier than in in other markets. Example, say, China is devaluing its currency to draw more foreign business into its country. If investor thinks that trend will continue, could make a forex trade by selling the Chinese currency against another currency, say US dollar. The more the Chinese currency devalues against the US dollar, the higher will be the profits. If the Chinese currency increases in value while and investor is in sell position open, then losses occur.

2. Understanding PIP’s:

All forex trades involve two currencies because investors bet on the value of a currency against another. As an example, let’s take a pair of EUR/USD, the most-traded currency pair in the world. EUR, the first currency in the pair, is the base, and USD, the second, is the counter. When you see a price quoted on forex platform, that price is how much one euro is worth in US dollars, investor will see two prices because one is the buy price and one is the sell. The difference between the two is the spread. When you click buy or sell, you are buying or selling the first currency in the pair. Let's say investor think the euro will increase in value against the US dollar and investor's pair is EUR/USD. Since the euro is first, and investor think it will go up, will buy EUR/USD. If investor thinks the euro will drop in value against the US dollar, investor sells EUR/USD. Making it simpler, if the EUR/USD buy price is 0.80684 and the sell price is 0.80680 then the spread is 0.4 pips (percentage in points). If the trade moves in investors favour makes a profit or vice versa. Pip stands for “Percentage In Point”. For most currency pairs, it corresponds to the movement of one unit of the fourth decimal digit in a rate, but there are exceptions like the Japanese Yen pairs, where a pip corresponds to the movement of one unit of the second decimal digit in a rate. A quick example:

If the EUR/USD moves from 1.1020 to 1.1021, this .0001 rise in value is one Pip.

3. Liquidity vs. Leverage in Forex Market:

With trillions of dollars trades happening each day in the forex market, the liquidity is so deep that liquidity providers like the big banks, allow investor to trade with leverage. To trade with leverage, you simply set aside the required margin for your trade size. If you're trading 200:1 leverage, for example, you can trade $2,000 in the market while only setting aside $10 in margin in your trading account. This gives investor much more exposure, while keeping investor's capital investment down. But leverage doesn't just increase investors profit potential. It can also increase losses, which can exceed deposited funds. When someone is new to forex, that investor should always start trading small with lower leverage ratios, until feel comfortable in the market.

4. Power of Leverage in Forex market:

Let’s say investor want to trade EUR/USD, for example. If the price of one euro is $1.1200, with a €100 investment, investor could have bought $112, without leverage.

By using leverage the same investor can open a deal worth up to 400 times the initial investment. For example, with a €100 investment, investor can buy €40,000 worth of dollars, using 400:1 leverage.

€100 X 400 = €40,000

5. Types of currency trades:

There are many types of currencies that an investor can invest (in fact, there are over 80 pairs to choose from). Let’s take a close look at some of investor options.

1. Majors: The most traded currency pairs are called ‘majors’ and they compose about 85% of the entire foreign exchange market. Note that they all include the USD. These major pairs are: EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF, NZD/USD and USD/CAD

2. Cross pairs: (Also known as ‘Crosses’) Currency pairs that do not include the US Dollar are commonly known as ‘cross currency pairs’. A few examples will be GBP/JPY, JPY/CAD

3. Exotics: Exotic currency pairs are made up of one major currency and a currency of an emerging economy. Examples would be USD/ZAR, USD/HKD

6. Timings of Forex Market:

The forex market operates 24 hours a day and is commonly separated into four sessions: The Sydney session, the Tokyo session, the London session, and the New York session.

7. Type of Market:

Foreign exchange market is described as an OTC (Over the counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and selling currencies, connected to each other by telecommunications like telex, telephone and SWIFT.

8. Efficiency:

Efficiency Developments in communication have largely contributed to the efficiency of the forex market. The participants are aware of current happenings by access to such services like Dow Jones Telerate and or Reuters. Any significant development in any market is almost instantaneously received by the other market situated at a far off place.

9. Physical Markets:

In few stock exchanges such as Paris and Brussels, the banks meet in the presence of representatives of the central bank and on the basis of bargains, fix rates for a number of major currencies. This practice is called fixing.

10. Cover Deals:

Purchase and sale of foreign currency in the market undertaken to acquire or dispose of foreign exchange required or acquired as a consequence of the dealings with its customers is known as the 'cover deal'. Mainly, Banks do cover deals for its customers.

6.2. Forex Markets-Functions

The foreign exchange market performs the following important functions:

1. Transfer Function:

The basic and the most visible function of foreign exchange market is the transfer of funds (foreign currency) from one country to another for the settlement of payments. The transfer function is performed through the credit instruments like, foreign bills of exchange, bank draft and telephonic transfers.

2. Credit Function:

Another function of foreign exchange market is to provide credit and promote foreign trade. Bills of exchange is usually used for international payments example, a UK company wants to purchase the machinery from the USA, can pay for the purchase by issuing a bill of exchange in the foreign exchange market (essentially with a three-month maturity).

3. Hedging Function:

Due to volatility in the currencies, the foreign exchange market performs the hedging function too. Hedging is the act of equating one’s assets and liabilities in foreign currency to avoid the risk resulting from future changes in the value of foreign currency (example hedging through forward contracts).

6.3. Forex Markets-Transactions

1. Spot:

The term spot exchange refers to foreign exchange transaction which requires the immediate delivery or exchange of currencies on the spot. A foreign exchange spot transaction is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate.

2. Forwards:

Forward market is a market in which foreign exchange is bought and sold for future delivery is known as Forward Market. It deals with transactions (sale and purchase of foreign exchange) which are contracted today but implemented sometimes in future. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called Forward Rate. Thus, forward rate is the rate at which a future contract for foreign currency is made. This rate is settled now but actual transaction of foreign exchange takes place in future. The forward rate is quoted at a premium or discount over the spot rate. Forward Market for foreign exchange covers transactions which occur at a future date.

3. Futures:

FX future or a foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price that is fixed on the purchase date. While a futures contract is similar to a forward contract, there are several differences between them. While a forward contract is tailor made for the client, a future contract has standardized features such as the contract size and maturity dates. Futures can be traded only on an organized exchange and they are traded competitively. Margins are not required in respect of a forward contract but margins are required of all participants in the futures market.

4. Options:

FX options are fundamentally driven by the factors same that drive the underlying currency pairs, such as interest rates, inflation expectations, geopolitics and macroeconomic data (such as unemployment, GDP). A call option gives an investor the right to buy, and put option gives investor the right to sell. There are two styles of options; European and American. The European-style option can only be exercised on the expiry date. The American-style option can be exercised at the strike price, any time before the expiry date.

5. Swap:

A foreign exchange swap is simultaneous purchase and sale of same or identical amounts of one currency for another with two different value dates (normally spot to forward) or it is an agreement between two parties to exchange a given amount of one currency for an equal amount of another currency based on the current spot rate. The two parties will then give back the original amounts swapped at a later date, at a specific forward rate.

6. Arbitrage:

Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets.

7. Regulations Financial Markets-MIFID

The Markets in Financial Instruments Directive, commonly known as MiFID, is a law that was created by the European Union for the purpose of regulating all investment services in member states of the European Economic Area. It was created in 2004 to replace the Investment Services Directive, and it was implemented in 2007. The Markets in Financial Instruments Directive (MiFID) is the framework of European Union (EU) legislation for:

  • Investment intermediaries that provide services to clients around shares, bonds, units in collective investment schemes and derivatives (collectively known as ‘financial instruments’)

  • The organised trading of financial instruments.

MiFID is meant to aid the regulation of the financial industry. One of the main requirements of MiFID is client categorization. Due to this MiFID, firms are required to place their clients into categories in order to determine the level of protection that is needed with their types of accounts and investments. A firm in European Economic Area must implement appropriate written internal policies and procedures to classify its clients.

MiFID also requires that firms abide by both pre-trade and post-trade transparency. Pre-trade transparency means that those who operate order-matching systems must make information regarding the five best pricing levels (on both buy and sell side) available to all.

Similarly, those who run quote-driven markets must make the best bids and offers publicly available. Post-trade transparency is a similar concept, but differs slightly. By requiring post-trade transparency, MiFID requires that firms release information regarding the price, time, and volume of all trades pertaining to listed shares, even if they are not executed in an open market scenario. There are certain circumstances where deferred publication may be granted, but that varies from case to case and must be dealt with on an individual level.

MiFID introduces two main categories of clients, retail clients and professional clients and a separate and distinct category for a limited range of businesses called eligible counterparties. Different levels of regulatory protection are attached to each category, and hence to the clients within each category as given below:

  • Retail Clients are afforded the most regulatory protection

  • Professional Clients are considered to be more experienced, knowledgeable and sophisticated as well as able to assess their own risk and make their own investment decisions so they are afforded less regulatory protection

  • Eligible Counterparties are investment firms, credit institutions, insurance companies, UCITS and their management companies, other regulated financial institutions and in certain cases, other undertakings. They are considered to be the most sophisticated investors or capital market participants so they are afforded with least regulatory protection among the other categories.

II. Detailed Description of Client Categorization:

1. Professional Clients:

A Professional Client is a client who possesses the experience, knowledge and expertise to make its own investment decisions and properly assess the risks that it incurs. In order to be considered a Professional Client, the Client must comply with the following criteria:

Α. The following shall be regarded as professionals in relation to all investment services and activities and financial instruments:

1. Entities which are required to be authorised or regulated to operate in the financial markets. The list below should be understood as including all authorised entities carrying out the characteristic activities of the entities mentioned – entities authorised by a member state under a European Community Directive, entities authorised or regulated by a member state without reference to such Directive, and entities authorised or regulated by a non-member State:

(a) Credit institutions;

(b) Investment Firms;

(c) Other authorised or regulated financial institutions;

(d) Insurance undertakings;

(e) Collective investment schemes and management companies of such schemes;

(f) Pension funds and management companies of such funds;

(g) Commodity and commodity derivatives dealers;

(h) Locals;

(i) Other institutional investors.

2. Large undertakings meeting two of the following size requirements, on a proportional basis: - balance sheet total at least: 20’000’000 Euro; - net turnover at least: 40’000’000 Euro; - own funds at least: 2’000’000 Euro.

3. National and regional governments, public bodies that manage public debt, central banks, international and supranational institutions such as the World Bank, the International Monetary Fund, the European Central Bank, the European Investment Bank and other similar international organisations.

4. Other institutional investors whose main activity is to invest in financial instruments, including entities dedicated to the securitisation of assets or other financial transactions. The entities mentioned above are considered to be professionals.

B. A client who does not fall under any of the categories in Section ‘A’ above may also be treated as a professional client upon request. The Company will forward a questionnaire in order to establish whether the client possesses sufficient experience, knowledge and expertise to enable him/her to make his/her own investment decisions and properly assess the risks that such investment incurs. In the course of this assessment two of the following criteria, as a minimum, should be satisfied:

  • The Client has carried out transactions, of significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters;

  • The size of the Client's financial instrument portfolio, defined as including cash deposits and financial instruments exceeds 500’000 Euro;

  • The Client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.

2. Retail Clients:

Any Clients not falling within this list are, by default, Retail Clients.

3. Eligible Counterparties:

Eligible counterparties are any of the following entities to which a credit institution or an investment firm provides the services of reception and transmission of orders on behalf of clients and/or execution of such orders and/or dealing on own account:

a) Investment Firms or other investment firms;

b) Credit institutions;

c) Insurance companies;

d) UCITS and UCITS management companies;

e) Pension funds and their management companies;

f) Other financial institutions authorized by a Member State or regulated under Community legislation or the national law of a Member State;

g) Undertakings exempted from the application of the Law in accordance with the MIFID in terms of Article (l) (k) and (l) thereof; and (l) of subsection (2) of section 3;

h) National governments and their corresponding offices, including public bodies that deal with public debt;

i) Central banks and supranational institutions.

Request for Different Classification:

  • The Retail Client has the right to request the different classification of Professional Client but he/she will be afforded a lower level of protection. The Company is not obliged to deal with him/her on this basis.

  • The Professional Client has the right to request the different classification of Retail Client in order to obtain a higher level of protection. The Company is not obliged to deal with the Client on this basis.

  • The Eligible Counterparty has the right to request a different classification of either as a Professional Client or Retail Client in order to obtain a higher level of protection. The Company is not obliged to deal with the Client on this basis.

III. Changes in MiFID:

MiFID applied in the UK from November 2007, and was revised by MiFID II, which took effect in January 2018, to improve the functioning of financial markets in light of the financial crisis and to strengthen investor protection. MiFID II is made up of MiFID (2014/65/EU) and the Markets in Financial Instruments Regulation (MiFIR - 600/2014/EU). MiFID II extended the MiFID requirements in a number of areas including:

  • New market structure requirements.

  • New and extended requirements in relation to transparency.

  • New rules on research and inducements.

  • New product governance requirements for manufacturers and distributers of MiFID ‘products’.

  • Introduction of a harmonised commodity position limits regime.

The EU hoped that the directive would help to increase competition amongst investment services while also boosting consumer protection and providing harmonious regulations for all participating states.

IV. Expectations from regulators (of MiFID):

There are several expectations if Mifid from investment firms. Let’s look at the most important ones as given below:

1) Appropriate Disclosures:

a) Clear Communication with clients: A firm must ensure that its communications with all clients are fair, clear and not misleading.

b) Costs and associated charges: A firm must provide clients with information on costs and associated charges.

c) Details and risks of packaged investments: A firm that offers an investment service as part of a package must provide adequate description of the different components of the agreement or package and the risks involved.

d) Provide a prospectus: A firm should provide minimum a prospectus with information about the offer

e) Information about currency fluctuations: A firm must provide enhanced warnings that returns may increase or decrease as a result of currency fluctuations.

2. Order Execution:

  • The firm must take all sufficient steps to obtain the best possible results for its clients when executing orders

  • Summary execution policy must provide with the customer the information on the most recent execution quality data.

  • A firm should take into consideration all factors that will allow it to deliver the best possible execution of the order.

  • All the factors such as size and nature of the order, market impact and any other implications of cost considerations needs to be factored while execution of trade for speedy execution and settlement.

  • The firm must inform its customer the difficulties that may come while execution of orders.

3. Custody:

  • MiFID II expects firms that use retail clients’ assets only to do so for the purposes of entering into securities financing transactions. Firms may use the assets of professional clients on terms agreed between such clients and the firm in accordance with the FCA’s CASS rules.

  • Where a firm enters into arrangements for securities financing transactions in respect of safe custody assets held by it on behalf of any retail client the regulation requires that the firm ensures that relevant collateral is provided by the borrower in favour of the retail client.

7.1. Regulations Financial Markets-Market Abuse Regulation

The Market Abuse Regulation (MAR) came into effect on 3 July 2016. It aims to increase market integrity and investor protection, enhancing the attractiveness of securities markets to raise capital. MAR strengthens the previous UK “Market Abuse Framework” by extending its scope to new markets, new platforms and new behaviours.

Application of MAR

The Market Abuse Regulation (MAR) applies to:

a) Financial instruments admitted to trading on a regulated market or for which a request for admission to trading on a regulated market has been made

b) Financial instruments traded on a multilateral trading facility (MTF), admitted to trading on an MTF, or for which a request for admission to trading on an MTF has been made

c) Financial instruments traded on an organised trading facility (OTF)

d) Financial instruments not covered by point (a), (b) or (c), the price or value of which depends on or has an effect on the price or value of a financial instrument referred to in those points, including, but not limited to, credit default swaps and contracts for difference

Features of MAR:

  • It contains prohibitions of insider dealing, unlawful disclosure of inside information and market manipulation, and provisions to prevent and detect these.

  • This Regulation also applies to behaviour or transactions, including bids, relating to the auctioning on an auction platform.

  • MAR requires issuers of instruments to maintain an insider list comprised of employees and advisers who are in possession of inside information. Insider lists will include personal details of insider’s date of birth, national identification number, addresses, telephone numbers etc. and also the date and time and the reason that the individual has been included on the insider list.

  • For the purposes of transparency, operators of a regulated market, an MTF (Multilateral Trading Facility) or an OTF (Organised Trading facility) or an OTC (Over the Counter) should notify, without delay, their competent authority of details of the financial instruments which they have admitted to trading, for which there has been a request for admission to trading or that have been traded on their trading venue.

  • MAR is critical to ensuring minimising the risk of asymmetric information in the market.

  • MAR applies even to financial instruments which are not traded on a trading venue but can be used for market abuse. Examples of where such instruments can be used for market abuse include inside information relating to a share or bond, which can be used to buy a derivative of that share or bond, or an index the value of which depends on that share or bond.

  • MAR requires that the issuers of financial instrument entities' competent authorities should have investigative and enforcement powers to combat market abuse.

  • MAR includes an explicit trading ban imposed on PDMRs during Closed Periods.

    1. PDMR: Person discharging managerial responsibilities: A member of the administrative, management or supervisory body of an entity (Example, a director) or a senior executive who is not a member of the bodies referred to above but who has regular access to inside information relating directly or indirectly to that entity and has power to take managerial decisions affecting the future developments and business prospects of that entity.

    2. Closed Period: 30 calendar days before the publication of half-year and full-year financial reports.

  • MAR introduces new provisions covering the disclosure of inside information in the course of market soundings

    1. Market soundings are interactions between a seller of financial instruments and one or more potential investors, prior to the announcement of a transaction, in order to gauge the interest of potential investors in a possible transaction and its pricing, size and structuring.

  • MAR requires the issuers of financial instruments to have recordings of telephone conversations and data traffic records (say from investment firms, credit institutions and financial institutions) executing and documenting trades, which constitute crucial, and sometimes the only, evidence to detect and prove the existence of insider dealing and market manipulation.

  • MAR requires issuers of financial instruments to report suspicious transactions to the competent authority. This has been extended to suspicious orders, modification to and/or cancellation of transactions or orders and OTC derivative transactions and orders.

  • Since market abuse can take place across borders and markets, MAR require competent authorities should cooperate and exchange information with other competent and regulatory authorities. Also, it is necessary for competent authorities to have the necessary tools for effective cross-market order book surveillance.

  • MAR encourage whistle-blowers who may bring new information to the attention of competent authorities which assists them in detecting and imposing sanctions in cases of insider dealing and market manipulation.

7.1. Regulations Financial Markets-Dodd-Frank

The Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly referred to as Dodd-Frank) is a United States federal law that was enacted on July 21, 2010. The Dodd-Frank Act is a law that regulates the financial markets and protects consumers. Its eight components help prevent a repeat of the 2008 financial crisis. The Dodd-Frank Act is named after the two Congressmen who created it. Senator Chris Dodd introduced it on March 15, 2010. On May 20, it passed the Senate. U.S. Representative Barney Frank revised it in the House, which approved it on June 30. On July 21, 2010, President Obama signed the Act into law. Many banks complained that the regulations were too harsh on small banks. On May 22, 2018, Congress passed a rollback of Dodd-Frank rules for these banks. The Economic Growth, Regulatory Relief, and Consumer Protection Act eased regulations on "small banks." These are banks with assets from $100 billion to $250 billion.

Titles of Dodd Frank:

Title I:-Financial Stability:

Title I establish new supervisory structure for the risk-based oversight of the U.S. financial system that will focus on:

  1. Identifying and addressing systemic risks to the stability of the U.S. financial system

  2. Bringing nonbank financial companies (nonbanks) that are determined to be significant to U.S. financial stability under comprehensive financial regulation and

  3. Imposing new and heightened prudential standards for the operation of financial institutions and financial markets in the U.S.

Subtitle A-Financial Stability Oversight Council (Council):

The Financial Stability Oversight Council is tasked to identify threats to the financial stability of the United States, promote market discipline, and respond to emerging risks in order to stabilize the United States financial system. The purposes of the Council are:

  • To identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace;

  • To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the Government will shield them from losses in the event of failure; and

  • To respond to emerging threats to the stability of the United States financial system.

The Council shall, in accordance with this title:

  • Collect information from member agencies, other Federal and State financial regulatory agencies, the Federal Insurance Office and, if necessary to assess risks to the United States financial system, direct the Office of Financial Research to collect information from bank holding companies and nonbank financial companies;

  • Provide direction to, and request data and analyses from, the Office of Financial Research to support the work of the Council

  • Monitor the financial services marketplace in order to identify potential threats to the financial stability of the United States

  • To monitor domestic and international financial regulatory proposals and developments, including insurance and accounting issues, and to advise Congress and make recommendations in such areas that will enhance the integrity, efficiency, competitiveness, and stability of the U.S. financial markets

  • Facilitate information sharing and coordination among the member agencies and other Federal and State agencies regarding domestic financial services policy development, rulemaking, examinations, reporting requirements, and enforcement actions

  • Identify gaps in regulation that could pose risks to the financial stability of the United States identify systemically important financial market utilities and payment, clearing, and settlement activities

Subtitle B-Office of Financial Research:

The Office of Financial Research is designed to support the Financial Stability Oversight Council through data collection and research. Office of Financial Research is established within the Department of the Treasury. The Office shall be headed by a Director, who shall be appointed by the President, by and with the advice and consent of the Senate. The Director shall serve for a term of 6 years. The director has subpoena power and may require from any financial institution (bank or nonbank) any data needed to carry out the functions of the office

The purpose of the Office is to support:

  • Collecting data on behalf of the Council (Financial Stability Oversight Council), and providing such data to the Council and member agencies

  • Standardizing the types and formats of data reported and collected

  • Performing applied research and essential long-term research

  • Developing tools for risk measurement and monitoring

  • Performing other related services

  • Making the results of the activities of the Office available to financial regulatory agencies

  • Assisting such member agencies in determining the types and formats of data authorized by this Act to be collected by such member agencies.

Title II-Orderly Liquidation Authority:

Title II responds to concerns that Federal authorities were hampered in dealing effectively with large non-bank institutions during the 2008 financial crisis because they lacked the type of authority that the Federal banking agencies, including the FDIC, are able to bring to play when a large depository institution is in a seriously troubled condition.

Overview of the Title II:

The Act establishes a multi-step, high-level process for determining whether to place a company in receivership (a situation in which a company is controlled by the receiver because it is bankrupt) that may include a prior judicial approval component that is not present in the depository institution receivership process. As a general matter, the Fed and the FDIC, either on their own initiative or at the request of the Treasury Secretary, are responsible for considering whether to make a recommendation as to whether the Treasury Secretary should appoint the FDIC as receiver for a financial company. In the case of an insurance company that is a covered financial company or a subsidiary or affiliate of such a company, the liquidation will be conducted under state law either by the appropriate regulatory agency or the FDIC on a backup basis. A receivership recommendation must be approved by a vote of at least 2/3’s of the members of the board of directors of both the Fed and the FDIC. In the case of a broker or dealer, the FDIC’s role is assigned to the SEC. In the case of an insurance company, the FDIC’s role is assigned to the Director of the Federal Insurance Office.

Title III-Transfer of Powers to the Comptroller, the FDIC, and the Fed:

The Office of Thrift Supervision ("OTS") will be eliminated under Title III. The OTS's supervisory responsibilities (not including those transferred to the Bureau) will be allocated among the three Federal bank regulatory agencies. The Fed will assume responsibility for regulating savings and loan holding companies ("SLHCs"). The OCC will assume responsibility for Federal savings associations and the FDIC will have responsibility for State savings associations.

Title IV – Regulation of Advisers to Hedge Funds and Others:

Title IV eliminates private-fund advisers’ ability to opt out of SEC registration. Advisers to hedge funds and private equity funds must register with the SEC and are subject to recordkeeping rules and other requirements applicable to registered advisers. Title IV requires the SEC to “conduct periodic inspections of the records of private funds.” Venture capital funds and private-fund advisers with less than $150 million under management need not register, but are subject to reporting requirements and arguably examinations. Certain foreign advisers are also excluded, as are certain small business investment company advisers and certain advisers registered with the Commodity Futures Trading Commission (CFTC). Family offices, which manage wealthy families’ money, are also exempt from registration.

Title V – Insurance:

Title V creates the Federal Insurance Office ("Office"), a new Federal office charged with studying the insurance industry and reporting to Congress on recommendations concerning Federal regulation of insurance.

Title VI: Improvements to Regulation of Bank and Savings Association Holding Companies and Depository Institutions:

Title VI contains the Volcker Rule, which severely limits the ability of certain bank and bank-related entities to engage in proprietary trading or invest in hedge funds and private equity funds. Title VI also strengthens the ability of banking agencies to regulate and supervise Banking Holding Companies and Savings and Loan Holding Companies, and their non-depository institution subsidiaries, and requires consistent standards to be applied to the examination of bank permissible activities. The Title also places new restrictions on acquisitions that would result in a financial company controlling more than 10% of liabilities as defined in the Act, and requires Fed approval for a financial holding company to acquire a company with consolidated assets of more than $10 billion. The Act also conditions acquisitions and expanded activities authority on achieving high standards of capital and management at the holding company level.

Title VII-Wall Street Transparency and Accountability:

Title VII concerns regulation of over the counter swaps markets. This section includes the credit default swaps and credit derivative that was the subject of several bank failures. Title VII grants the CFTC regulatory authority over swaps, except for security-based swaps, which are regulated by the SEC. In order to clarify which types of agreements and contracts fall subject to the jurisdiction of the SEC or the CFTC, Title VII directs the SEC and the CFTC to jointly specify the scope of certain terms within the Dodd-Frank Act, such as “swap,” “security-based swap,” “swap dealer”.

Title VIII-Payment, Clearing, and Settlement Supervision:

Title VIII establishes a framework for a systemic approach to ensuring the stability of the payment, clearing and settlement systems. In Title VIII Congress has given broad discretion to Federal regulators to determine what measures are necessary to ensure the sound functioning of these systems. Title VIII has two principal points. The first point addresses parties that operate or manage multilateral systems for the purpose transferring, clearing, or settling payment, securities, or other financial transactions among or financial institutions or between financial institutions and the system operator. These system operators are referred to as financial market utilities ("Utilities"). The second point of Title VIII involves financial institutions that participate in the payments, clearing or settlement system ("Participants"). Title VIII ensures that these parties will be subject to enhanced regulation and supervision.

Title IX-Investor Protections and Improvements to the Regulation of Securities:

Title IX contains a broad set of initiatives intended to improve (i) investor protection in a variety of areas; (ii) securities disclosures, including disclosures regarding executive compensation and asset-backed securities; and (iii) securities enforcement, including improvements to the timeliness of the enforcement process. Title IX has below mentioned subtitles:

(I) Subtitle A-Increasing Investor Protection:

The Act attempts to improve the effectiveness of the SEC's efforts at investor protection. It establishes an Investor Advisory Committee charged with providing the SEC with investor perspectives and recommendations. It also establishes an Office of Investor Advocate that will be charged with assisting investors and recommending regulatory changes to protect investors.

(II) Subtitle B-Increasing Regulatory Enforcement and Remedies:

Subtitle B gives the SEC further powers of enforcement, including a "whistleblower bounty program". The SEC program rewards individuals providing information resulting in an SEC enforcement action. The law also provides job protections for SEC whistleblowers and promises confidentiality for them.

(III) Subtitle C-Improvements to the Regulation of Credit Rating Agencies:

The Act expands the regulation of credit rating agencies, including nationally recognized statistical ratings organizations ("NRSROs") by the SEC. It also requires NRSROs to maintain more robust internal supervision of the ratings process, imposes increased accountability on credit rating agencies.

(IV) Subtitle D-Improvements to the Asset-backed Securitization Process:

In the context of asset-backed securitization, the Act pursues the general goal of investor protection by emphasizing the importance of collateral quality and focuses on two main objectives:

  • Implementing structural changes in the issuance of certain asset-backed securities ("ABS") to require risk retention by securitizers and originators at a default level of up to 5% to promote the credit quality of the assets being securitized and

  • Requiring additional disclosure relating to the securitized assets to enable investors to independently assess credit quality.

(V) Subtitle E-Accountability and Executive Compensation:

The Act includes a number of provisions intended to enhance shareholder understanding of executive compensation (refers to the financial payment and other non-monetary rewards given to the top executives of an organization) and to increase shareholder involvement in the compensation process. These measures include:

  • "Say on pay" (a firm's shareholders have the right to vote on the remuneration of executives) provisions whereby companies are required to hold non-binding votes on executive compensation and golden parachutes (a large payment or other financial compensation guaranteed to a company executive if they should be dismissed as a result of a merger or takeover.)

  • Requiring that members of compensation committees be independent directors;

  • Disclosure comparing company performance with executive compensation paid and the ratio of the chief executive officer's compensation to that of the median of all other employees of the company

  • A prohibition on the payment by certain financial companies, including banks and BHCs, of incentive compensation that provides excessive compensation or that could lead to material financial loss

  • "Clawback" provisions that provide compensation awarded to executives who have engaged in wrongdoing are required to pay back their compensation to the company

  • Disclosure regarding whether the roles of CEO and Chairman have been separated;

  • Restrict proxy voting by brokers on behalf of security holders; and

  • Authorize the SEC to permit shareholders to nominate nominees for board positions.

(VI) Subtitle F-Improvements to the Management of the Securities and Exchange Commission:

The Act contains a series of measures intended to evaluate the operations of the SEC and to improve its operations. These measures will, among other things, address internal controls, personnel management and oversight of FINRA.

(VII) Subtitle G-Strengthening Corporate Governance:

Subtitle G provides the SEC to issue rules and regulations including a requirement permitting a shareholder to use a company's proxy solicitation materials for nominating individuals to membership on the board of directors. The company is also required to inform investors regarding why the same person is to serve as the board of directors' chairman and its chief executive officer, or the reason that different individuals must serve as the board's chairman or CEO.

(VIII) Subtitle H – Municipal Securities:

This Act, Creates a new registration requirement for "municipal advisor"; Changes the composition of the Municipal Securities Rulemaking Board ("MSRB"); Requires the Comptroller General to conduct studies of municipal disclosure and municipal markets; Creates a funding mechanism for the Government Accounting Standards Board ("GASB"); and Elevates the office within the SEC that is responsible for oversight of the municipal securities markets.

(IX) Subtitle I-Public Company Accounting Oversight Board (PCAOB), Portfolio Margining, and Other Matters:

  1. PCOAB: The Act amends the authority of the PCAOB to permit them to establish an inspection program for auditors of broker-dealers and to permit the PCAOB to refer investigations concerning audit reports for broker-dealers to FINRA or other self-regulatory organizations.

  2. Portfolio Margining: The Act amends the SIPA to clarify that options on commodities are treated the same as claims for securities with respect to customer claims, and that customers include those who have a claim against a debtor broker-dealer that include options and futures acquired as part of portfolio margining, but exclude those whose claim is part of the capital of the debtor broker-dealer.

Other matters include senior investor protections, insurance commission, misleading designation etc.

Title X-Bureau of Consumer Financial Protection:

Title X establishes the Bureau of Consumer Financial Protection ("Bureau"). The new Bureau regulates consumer financial products and services in compliance with federal law. The Bureau is headed by a director appointed by the President, with advice and consent from the Senate, for five-year term.

Title XI – Federal Reserve System Provisions:

This Title gives the Fed Board the power to establish policies and procedures for emergency lending. It states that emergency lending should be done only to provide liquidity when there is enough security for the loan to protect taxpayers and not to aid a failing financial company. Title XI allows the Comptroller to audit the Board, any Federal reserve bank or any Federal Reserve credit facility. The Comptroller General of US can conduct audit of FED and credit facility offered by the Fed. This Title also allows the Federal Deposit Insurance Corporation (“FDIC”) to create a program to guarantee any obligations of solvent insured depository institutions or solvent depository institution holding companies.

Title XII—Improving Access to Mainstream Financial Institutions:

Title XII was enacted to provide millions of low-to-moderate income individuals living in the United States the opportunity to access and utilize appropriate mainstream financial products and services. Title XII attempts to minimize the exposure of low-to-moderate income individuals to predatory lenders by diminishing their need to use non-traditional financial products and services, such as pay-day loans and cash advances.

Title XIII-Pay It Back Act:

Title XIII, commonly known as the “Pay It Back Act” (the “Act”), amends the Emergency Economic Stabilization Act of 2008 (the “EESA”) by decreasing the Secretary of the Treasury’s (the “Secretary”) authority to purchase distressed assets under the Troubled Asset Relief Program (“TARP”) from $700 billion to $475 billion.

Title XIV-Mortgage Reform and Anti-Predatory Lending Act:

The provisions of Title XIV bring in significant changes to the mortgage industry. These will include new specific duties on the part of mortgage originators to act in the best interests of consumers and to take steps to seek to ensure that consumers will have the capability to repay loans that they obtain.

7.1. Regulations Financial Markets-Volker Rule

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act added a new section 13 to the Bank Holding Company Act of 1956 ("BHC Act"), commonly referred to as the Volcker rule, that generally prohibits insured depository institutions and any company affiliated with an insured depository institution from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund (also called covered funds). These prohibitions are subject to a number of statutory exemptions, restrictions, and definitions. Trading account means any account that is used by a banking entity to purchase or sell one or more financial instruments principally for the purpose of:

(A) Short-term resale

(B) Benefitting from actual or expected short-term price movements

(C) Realizing short-term arbitrage profits

(D) Hedging one or more positions resulting from the purchases or sales of financial instruments

On December 10, 2013, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission issued jointly developed final regulations to implement section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the Volcker Rule. The final regulations were published in the Federal Register on January 31, 2014, and become effective on April 1, 2014. National banks (other than certain limited-purpose trust banks), federal savings associations, and federal branches and agencies of foreign banks (collectively, banks) are required to fully conform their activities and investments to the requirements of the final regulations by the end of the conformance period, which the FRB has extended to July 21, 2015.

Highlights of final Volker rule:

  1. Prohibit banks from engaging in short-term proprietary trading of certain securities, derivatives commodity futures, and options on these instruments for their own accounts.

  2. Impose limits on banks' investments in, and other relationships with, hedge funds and private equity funds.

  3. Provide exemptions for certain activities, including market making-related activities, underwriting, risk-mitigating hedging, trading in government obligations, insurance company activities, and organizing and offering hedge funds and private equity funds.

  4. Clarify that certain activities are not prohibited, including acting as agent, broker, or custodian.

  5. Scale compliance requirements based on the size of the bank and the scope of the activities.

  6. Larger banks are required to establish detailed compliance programs and their chief executive officers must attest to the OCC that the bank's programs are reasonably designed to achieve compliance with the final regulations. Smaller banks engaged in modest activities are subject to a simplified compliance program.

  7. Banks with trading assets and liabilities of at least $50 billion will be required to report metrics designed to monitor their permitted trading activities.

  8. Community banks with $10 billion or less in total consolidated assets and total trading assets and liabilities of 5 percent or less of total consolidated assets are excluded from the Volcker Rule.

  9. The final rule excludes foreign public funds from the definition of covered fund. To qualify for this exclusion, these funds must, among other conditions, be authorized to offer and sell ownership interests to retail investors in the foreign public fund's home jurisdiction and must sell ownership interests predominantly in public offerings outside of the United States.

8. Mutual Funds

A mutual fund is made up of a pool of money collected from several investors to invest in securities (such as stocks, bonds) and other assets. Mutual funds are investment strategies that allow an investor to pool money together with other investors to purchase a collection of stocks, bonds, or other securities that might be difficult for that investor to recreate on own.

This collection of securities is referred to as a “Portfolio”. The price of the mutual fund is determined by its net asset value (NAV) which is the total value of the securities in the portfolio, divided by the number of the fund's outstanding shares {NAV = (Value of Assets-Value of Liabilities)/number of shares outstanding}. Outstanding shares are those held by all shareholders, institutional investors, and company officers (or insiders). This price fluctuates based on the value of the securities held by the portfolio at the end of each business day.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual fund shares can typically be purchased or redeemed as needed at the fund's current NAV (which unlike a stock price doesn't fluctuate during market hours, but is settled at the end of each trading day). The average mutual fund holds hundreds of different securities, which mean mutual fund shareholders, gain important diversification at a low price.

8. Mutual Funds

A mutual fund is made up of a pool of money collected from several investors to invest in securities (such as stocks, bonds) and other assets. Mutual funds are investment strategies that allow an investor to pool money together with other investors to purchase a collection of stocks, bonds, or other securities that might be difficult for that investor to recreate on own.

This collection of securities is referred to as a “Portfolio”. The price of the mutual fund is determined by its net asset value (NAV) which is the total value of the securities in the portfolio, divided by the number of the fund's outstanding shares {NAV = (Value of Assets-Value of Liabilities)/number of shares outstanding}. Outstanding shares are those held by all shareholders, institutional investors, and company officers (or insiders). This price fluctuates based on the value of the securities held by the portfolio at the end of each business day.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual fund shares can typically be purchased or redeemed as needed at the fund's current NAV (which unlike a stock price doesn't fluctuate during market hours, but is settled at the end of each trading day). The average mutual fund holds hundreds of different securities, which mean mutual fund shareholders, gain important diversification at a low price.

8.1. Mutual Funds-Advantages

  1. Mutual funds are regulated hence safe to invest in.

  2. Mutual funds invest across a number of different securities bringing in diversification of investor's investment and reducing the risk of losses.

  3. Investors who lack the financial know-how to manage their own portfolio have easy access to Mutual funds which is managed by professionals who ensure best returns for investor's money.

  4. Mutual funds reinvest investor's dividends and interest in additional fund shares. In effect, this allows investors to take advantage of the opportunity to grow their portfolio without paying transaction fee.

  5. Mutual funds are available in range of investment options and objectives hence, depending on trait of investor such as ‘aggressive’ investor/the ‘risk avert’ investor/the ‘middle-of-the-road investor’ all have options to invest.

  6. Mutual funds trade in big volumes, giving their investors the advantage of lower trading costs.

  7. Anyone can start an investment in a mutual fund through a Systematic Investment Plan (SIP) with as little as $50 per month.

  8. Investments in open-ended mutual funds can be redeemed in part or as a whole any time to receive the current value of the units hence, they are liquid in nature.

  9. There are various tax benefits available on investments in mutual funds.

8.2. Mutual Funds-Disadvantages

  1. Investor has no control over funds and is dependent on the decisions of the investment manager of the mutual fund.

  2. In a mutual fund, investor is taxed when the fund distributes gains it made from selling individual holdings even if the investor haven’t has sold shares.

  3. Some mutual funds may assess a sales charge on all purchases, also known as a “load”

  4. Although there are many benefits of diversification, there are pitfalls of being over-diversified.

  5. Investments in Mutual funds reduce risk to the investor, but, investor is also susceptible to more losses in an improper combination or components of a portfolio.

8.3. Mutual Funds Regulation-United States

1. Securities Exchange Act of 1934:

Mutual fund regulations were put forth during the administration of President Franklin D. Roosevelt after the Wall Street Crash of 1929 left the Great Depression in its wake. It was the Securities Exchange Act of 1934 that created the SEC and gave it regulatory authority over the mutual fund industry, along with the stock market and brokerage houses.

2. The Securities act of 1933:

  • The legislation addressed the need for better disclosure by requiring mutual fund companies to register with the Securities and Exchange Commission (SEC). Registration ensures that companies provide the SEC and potential investors with all relevant information by means of a prospectus and registration statement. The act also known as the "Truth in Securities" law, the 1933 Act, and the Federal Securities Act requires that investors receive financial information from securities being offered for public sale. This means that prior to going public; companies have to submit information that is readily available to investors. Today, the required prospectus has to be made available on the SEC website. A prospectus must include the following information:

  • A description of the company’s properties and business.

  • A description of the security being offered.

  • Information about executive management.

  • Financial statements that have been certified by independent accountants.

3. Investment Company Act of 1940:

Act of 1940 provisions include regulations for transactions of certain affiliated persons and underwriters; accounting methodologies; recordkeeping requirements; auditing requirements; how securities may be distributed, redeemed, and repurchased; changes to investment policies; and actions in the event of fraud or breach of fiduciary duty. Other pertinent requirements of the Investment Company Act of 1940 include:

  • 75% of board of directors of an investment company must be independent directors.

  • Limitations on investment strategies

  • Certain percentage of assets should be maintained in cash for investors who might wish to sell.

  • Disclosure of investment company structure, financial condition, investment policies, and objectives to investors.

8.3. Mutual Funds Regulation-United Kingdom

1. Financial Services and Markets Act 2000:

FSMA in terms of mutual funds require the mutual funds to:

  1. Maintain confidence in the financial system.

  2. Promote awareness of the benefits and risks associated with different kinds of investment or any financial dealing.

  3. Inform investors the differing degrees of risk involved in different kinds of investments.

  4. Consider the differing degrees of experience and expertise that different customers may have in relation to investments and provide product accordingly as per their risk appetites.

  5. Provide appropriate advice to its customers and pass on accurate information (including hidden charges; if any).

8.4. Mutual Funds Regulation- Australia

1. FOFA:

The Australian Securities and Investments Commission (ASIC) is the regulator of corporate markets and financial services. ASIC is the main regulator for retail mutual funds. Starting in July 2013, the Australian Treasury implemented reforms known as Future of Financial Advice (FOFA). The legislation amends the Corporations Act and introduces:

A prospective ban on conflicted remuneration structures including commissions and volume based payments, in relation to the distribution of and advice about a range of retail investment products.

A duty for financial advisers to act in the best interests of their clients, subject to a “reasonable steps” qualification, and place the best interests of their clients ahead of their own when providing personal advice to retail clients.

There is a safe harbor that advice providers can rely on to show they have met their “best interests” duty.

An opt-in obligation that requires advice providers to renew their clients’ agreement to ongoing fees every two years. ASIC will have the ability to exempt an adviser from the opt-in obligation if it is satisfied that the adviser is signed up to a professional code that makes the need for the opt-in provisions unnecessary.

8.4. Mutual Funds- Types

1. Actively Managed Funds:

Actively managed mutual funds have a portfolio manager buying and selling investments on behalf of the investor to try to outperform the market. Expense fees are higher for actively managed funds.

2. Index Funds:

Index funds invest in equities or fixed income securities chosen to mimic a specific index (such as the S&P 500). Some index funds will track a larger or smaller number of companies in the index. If an investor was looking to match the market rate of growth, these are typically the funds they would be looking at.

3. Money Market Funds:

Money Market Funds are investment vehicles structured as mutual funds that invest in treasury bills and commercial paper. These funds attempt to maintain a stable net asset value (say of $1 per share in US) while returning interest in the form of dividends to investors. Since these funds invest in such low risk investments while paying out all gains in dividends (removing the compounding of capital gains), they are considered low-risk, low-return investments.

4. Bond Funds:

Bond funds /fixed income, or income funds invest in a combination of treasury bills, debentures, mortgages and bonds. The goal of these funds is to provide a regular income payment through the interest the fund earns with a possibility of capital gains. Each of these bond mutual funds has a particular emphasis or objective: corporate bonds, government bonds, municipal bonds, agency bonds, and so on. Most of these funds have specific maturity objectives, which relate to the average maturity of the bonds in the fund’s portfolio. Bond mutual funds can either be taxable or tax-free, depending on the types of bonds the fund owns. Bond funds do carry interest rate risk, especially longer-term bonds.

5. Equity Funds:

Equity Funds invest in stocks. For the most part, they can be broken down into small-cap, mid-cap, or large-cap, and foreign equity.

6. Balanced Funds:

These funds invest in a variety of equities and bond securities. The goal is to balance the safety of bond securities with the return of equities. Most of these funds follow a formula to split money between the two different types of investments, depending on whether their objective is more aggressive or more conservative. Aggressive funds will hold more equities and conservative funds more bonds. As the balanced fund name suggests, they are a mix and thus have more risk than bond funds but lower risk than pure equity funds.

7. Specialty Funds:

Specialty funds focus on specialized objectives that include sector funds, socially responsible investing, real estate, commodities, quantitative strategies, currencies, and other unique types like funds of funds. Specialty funds favor concentration over diversification, and focus on a certain strategy or segment of the economy.

8.5. Mutual Funds- Types (As per Charges)

1. Front end load:

A front-end load mutual fund charges commission or sales charge applied at the time of purchase of the mutual fund. The front-end load is deducted during purchase of funds increasing the investment cost. But, these are charges are essential as front-end loads are paid to financial intermediaries as compensation for finding and selling the investment which best matches the needs, goals, and risk tolerance of the investors. So, these are one-time charges, not part of the investment's ongoing operating expenses. Class A Shares usually charge front end load.

2. Back end load: A back-end load is a fee that investors pay while selling mutual fund shares usually is a percentage of the value of the share being sold. A back-end load can be a flat fee or gradually decreasing fee as per the holding period of the fund. Class B shares and Class C shares are back end loaded.

3. Level end load: Level end load is a periodic fee (usually annual) deducted from an investor's mutual fund assets to pay for distribution and marketing costs. Level end load mutual funds are often referred to as "C Shares". The level end load is not a one-time fee but is levied as long as the investor holds the fund. Level end loads and other fees are disclosed in a mutual fund's prospectus, and it is important to understand that a level end load is only one of several types of fees that may be charged.

4. No Load Fund: A No Load Fund is a mutual fund that does not charge a sales commission to investors. Shares of no load funds are purchased directly from the fund companies rather than through brokers.

8.6. Mutual Funds- Net Asset Value

The price per share at which shares are redeemed is known as the net asset value (NAV). NAV is the current market value of all the fund’s assets (All Cash+Securities in the Fund), minus liabilities (e.g., fund expenses), divided by the total number of outstanding shares. This calculation ensures that the value of each share in the fund is identical. An investor may determine the value of his or her pro rata share of the mutual fund by multiplying the number of shares owned by the fund’s NAV. A fund’s NAV is calculated at least once each trading day. The price at which a fund’s shares may be purchased is its NAV per share plus any applicable frontend sales charge (the offering price of a fund without a sales charge would be the same as its NAV per share).

8.7. Mutual Funds- Organization and Creation of Mutual Fund

A mutual fund is organized/ incorporated either as a corporation or a trust. If mutual funds are created as companies, officers and directors are the controlling parties whereas if they are formed as trust, trustees control the mutual funds. Mutual fund is created by the fund’s sponsor. The fund sponsor has a variety of responsibilities. For example, it must assemble the group of third parties needed to launch the fund, including the persons or entities charged with managing and operating the fund. The sponsor provides officers and affiliated directors to oversee the fund, and recruits unaffiliated persons to serve as independent directors. In US, some of the major steps in the process of starting a mutual fund include organizing the fund under state law as either a business trust or corporation, registering the fund with the SEC as an investment company pursuant to the Investment Company Act of 1940, and registering the fund shares for sale to the public pursuant to the Securities Act of 1933. Unless otherwise exempt from doing so, the fund must also make filings and pay fees to each state (except Florida) in which the fund’s shares will be offered to the public. The Investment Company Act also requires that each new fund have at least $100,000 of seed capital before distributing its shares to the public; this capital is usually contributed by the adviser or other sponsor in the form of an initial investment.

8.8. Mutual Funds- Players of Mutual Fund

1. Shareholders:

Investors are given comprehensive information about the fund to help them make informed decisions. A mutual fund’s statutory prospectus describes the fund’s investment goals and objectives, fees and expenses, investment strategies and risks, and informs investors how to buy and sell shares. In US the SEC requires a fund to provide a prospectus either before an investor makes his or her initial investment or together with the confirmation statement of an initial investment.

2. Board of Directors:

A fund’s board of directors is elected by the fund’s shareholders to govern the fund, and its role is primarily one of oversight. The board of directors typically is not involved in the day-to-day management of the fund company. Instead, day-to-day management of the fund is handled by the fund’s investment adviser or administrator pursuant to a contract with the fund. Mutual funds in US are required by law to have independent directors on their boards in order to better enable the board to provide an independent check on the fund’s operations. Independent directors cannot have any significant relationship with the fund’s adviser or underwriter.

3. Investment Advisers:

The investment adviser has overall responsibility for directing the fund’s investments and handling its business affairs. The investment adviser has its own employees, including investment professionals who work on behalf of the fund’s shareholders and determine which securities to buy and sell in the fund’s portfolio, consistent with the fund’s investment objectives and policies.

4. Administrators:

A fund’s administrator handles “back office” functions for a fund. For example, administrators often provide office space, clerical and fund accounting services, data processing, bookkeeping and internal auditing, and preparing and filing tax, shareholder, and other reports. Fund administrators also help maintain compliance procedures and internal controls, subject to oversight by the fund’s board and Chief Compliance Officer.

5. Principal Underwriters:

Investors buy and redeem fund shares either directly or indirectly through the principal underwriter, also known as the fund’s distributor. In US, Principal underwriters are registered under the Securities Exchange Act of 1934 as broker-dealers, and, as such, are subject to strict rules governing how they offer and sell securities to investors. The principal underwriter contracts with the fund to purchase and then resell fund shares to the public. A majority of both the fund’s independent directors and the entire fund board must approve the contract with the principal underwriter.

6. Custodians:

To protect fund assets, all mutual funds need to maintain strict custody of fund assets, separate from the assets of the adviser. Hence, all funds use a bank custodian for protection of securities. A fund’s custody agreement with a bank is typically far more elaborate than that used for other bank clients. The custodian’s services generally include safekeeping and accounting for the fund’s assets, settling securities transactions, receiving dividends and interest, providing foreign exchange capabilities, paying fund expenses, reporting failed trades, reporting cash transactions, monitoring corporate actions, and tracking loaned securities. Foreign securities are required to be held in the custody of a foreign bank or securities depository.

7. Transfer Agents:

Mutual funds and their shareholders also rely on the services of transfer agents to maintain records of shareholder accounts calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances, and maintain customer service departments, including call centers, to respond to shareholder inquiries.

9. Hedge Funds

1. Introduction:

Hedge funds are regarded as alternative investments, where pooling of investment happens through a limited group of investors called accredited investors or qualified purchasers or institutional investors as given below. Hedge funds seek to profit in ‘all kinds of markets’, by using leverage, short-selling and other speculative investments.

2. Hedge Funds Structure:

The limited partnership model is the most common structure for the pool of investment funds that make up a U.S. hedge fund although; the structure can be set up as a Limited Liability Company (/LLC) too. In the limited partnership model, the general partner is responsible for selecting the service providers that perform the operations of the fund. Limited partners can make investments into the partnership and are liable only for that amount. General partners typical use a limited liability company structure. The general partner's responsibility is to select service providers to market and manage the fund as well as perform any functions necessary in the normal course of business.

3. Fund Manager of a Hedge Fund:

Hedge funds are often marketed by the fund managers who networks with HNI friends or business acquaintances or through third-party placement agents. A hedge fund typically pays its fund manager an annual management fee (for example, 2% of the assets of the fund), and a performance fee (for example, 20% of the increase in the fund's net asset value during the year). Some of the noted hedge fund managers are as given below:

  • George Soros, fund manager of Quantum Group of Funds

  • Ray Dalio, fund manager of Bridgewater Associates

  • Steven A. Cohen of Point72 Asset Management

  • John Paulson of Paulson & Co

  • David Tepper of Appaloosa Management

  • Paul Tudor Jones II of Tudor Investment Corporation

  • Daniel Och of Och-Ziff Capital Management Group

9.1. Hedge Funds-Service Providers

A. Executing Broker:

Executing brokers are often associated with hedge funds that need trade execution services for large transactions. The executing broker locates the securities for a purchase transaction or locates a buyer for a sale transaction.

B. Prime Broker:

While a hedge fund traditionally operates through accounts at a number of brokerage firms, it commonly instructs these executing brokers to clear all trades through its designated prime broker. Prime Broker is an entity which provides a consolidation services such as clearing and settling trades, taking custody of the securities, loaning of securities for short sales, providing margin financing, and providing back office technology and reporting. Prime brokerage services are provided majorly by investment banks (such as Merrill Lynch/Deutsche/Goldman Sachs).

C. Administrator:

A hedge fund administrator is a service provider to the hedge fund whose main job is to provide fund accounting and back office services as detailed below:

  1. Monthly or quarterly accounting of investor contributions and withdrawals and computing the profits and losses for the accounting period.

  2. Transfer agent services (handling the subscription documents and making sure checks are cashed or wires are appropriately handled)

  3. A relatively new service which some administrators provide is a “second signer” service which is designed to give investors greater confidence that a hedge fund manager will not run off with their money. Under a “second signer” agreement, the hedge fund manager will need to get a sign off from the administrator before the manager can make a transfer or a withdrawal from the fund’s account.

  4. Calculating the management fee and performance fee

  5. Working with the auditor and keeping financial records clean

  6. Offshore hedge funds administrator act as the registered agent/registrar

  7. Offshore hedge funds administrator also does Anti Money Laundering review

  8. The costs of the administrator are usually paid by the fund and not by the fund management company.

D. Distributor:

A distributor is usually the underwriter or broker hired by the fund who participates in the distribution of securities. The distributor is also responsible for marketing the fund to potential investors. Hedge funds also use placement agents and broker-dealers for distribution. The investment manager will be responsible for distribution of securities and marketing for Hedge funds that do not have distributors.

E. Auditor:

Hedge funds use an independent accounting firm to audit the assets of the fund, get verified the fund's NAV & ‘Assets Under Management’ (AUM) and to prepare fund's financial statements. Hedge funds choose to have their funds audited in an attempt to attract investors by showing the quality and transparency of their fund. The purpose of auditing is to verify data, to ensure consistency.

9.2. Hedge Funds-Strategies

Hedge fund strategies cover a broad range of collection of investments, such as in debt and equity, commodities, currencies, derivatives, real estate etc. Below is description of some of the most common hedge fund strategies:

1. Long or Short Equity:

In this Hedge Fund Strategy, Investment manager maintains long and short positions in equity and equity derivative securities. Wide varieties of techniques are employed by the fund manager to arrive at an investment decision using quantitative and qualitative techniques then, the fund manager decide on to buy in equity that they feel is undervalued and sell those which are overvalued. It can range broadly in terms of exposure, leverage, holding period and valuations. Basically, the fund goes long and short in two competing companies in the same industry but, most managers do not hedge their entire long market value with short positions. For example, if Oracle looks cheap relative to IBM, a pair’s trader might buy $100,000 worth of Oracle and short an equal value of IBM shares. The net market exposure is zero, but if Oracle does outperform IBM, the investor will make money no matter what happens to the overall market. Suppose IBM rises 20% and Oracle rises 27%; the trader sells Oracle for $127,000, covers the IBM short for $120,000 and pockets $7,000. If IBM falls 30% and Oracle falls 23%, he sells Oracle for $77,000, covers the IBM short for $70,000, and still pockets $7,000. If the trader is wrong and IBM outperforms Oracle, however, he will lose money.

2. Credit Funds:

Credit funds make debt investments based on lending inefficiencies. Credit funds include distressed debt strategies, direct lending and others.

a. Distressed Debt Strategies:

Distressed debt investing entails buying the bonds of firms that have already filed for bankruptcy or are likely to do so. Companies that have taken on too much debt are often prime targets. The aim is to become a creditor of the company by purchasing its bonds at a low price. This gives the buyer considerable power during either a reorganization or liquidation of the company, allowing the buyer to have a significant say in what happens to the company. Hedge funds focus on purchasing liquid debt securities that they can sell at a profit in the short run.

b. Direct Lending:

Hedge funds providing loans to companies with some tangible assets as collateral without intermediaries such as an investment bank, a broker or a private equity firm.

3. Arbitrage:

Arbitrage strategies seek to exploit observable price differences between closely-related investments by simultaneously purchasing and selling investments. When properly used, arbitrage strategies produce consistent returns with low risk. Below are some strategies of arbitrage used by Hedge Funds:

a. Fixed Income Arbitrage: Fixed income arbitrage seeks to exploit pricing differences in fixed income securities, most commonly by taking various opposing positions in inefficiently priced bonds or their derivatives, with the expectation that prices will revert to their true value over time. Common fixed income arbitrage strategies include swap-spread arbitrage, yield curve arbitrage and capital structure arbitrage.

b. Convertible Arbitrage: Convertible arbitrage seeks to profit from price inefficiencies of a company’s convertible securities relative to its company’s stock. At its most basic level, convertible arbitrage involves taking long positions in a company’s convertible securities while simultaneously taking a short position in a company’s common stock.

c. Relative Value Arbitrage: Relative value arbitrage, or “pairs trading” involves taking advantage of perceived price discrepancies between highly correlated investments, including stocks, options, commodities, and currencies. A pure relative value arbitrage strategy involves high risk and requires extensive expertise.

d. Merger Arbitrage: Merger Arbitrage involves taking opposing positions in two merging companies to take advantage of the price inefficiencies that occur before and after a merger. Upon the announcement of a merger, the stock price of the target company typically rises and the stock price of the acquiring company typically falls.

4. Event-Driven Strategies:

Event-Driven strategies are closely related to arbitrage strategies, seeking to exploit pricing inflation and deflation that occurs in response to specific corporate events, including mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, liquidations, bankruptcy and other events creating inefficient stock pricing.

5. Quantitative (Black Box) Strategies:

Quantitative hedge fund strategies rely on quantitative analysis to make investment decisions. Such hedge fund strategies typically utilize technology-based algorithmic modeling to achieve desired investment objectives. Quantitative strategies are often referred to as “black box” funds, since investors usually have limited access to investment strategy specifics. Funds that rely on quantitative technologies take extensive precautions.

6. Global Macro:

Global macro refers to the general investment strategy making investment decisions based on broad political and economic outlooks of various countries. Global macro strategy involves both directional analysis, which seeks to predict the rise or decline of a country’s economy, as well as relative analysis, evaluating economic trends relative to each other. Global macro funds are not confined to any specific investment vehicle or asset class, and can include investment in equity, debt, commodities, futures, currencies, real estate and other assets in various countries.

7. Multi Strategy:

Multi-strategy funds are not confided to a single investment strategy or objective, but use a variety of investment strategies to achieve positive returns regardless of overall market performance.

8. Fund of Funds:

Fund of Funds usually invests in other hedge funds or mutual funds. The fund of funds (FOF) strategy aims to achieve broad diversification and minimal risk. Funds of funds tend to have higher expense ratios than regular mutual funds.

9. Emerging Markets:

An emerging market hedge fund is a hedge fund that specialize its investments in the securities of emerging market countries.

10. Directional Hedge Fund Strategies:

In the directional approach, managers bet on the directional moves of the market (long or short) as they expect a trend to continue or reverse for a period of time. A manager analyzes market movements, trends, or inconsistencies, which can then be applied to investments in vehicles such as long or short equity hedge funds and emerging markets funds.

9.3. Hedge Funds-Strategies

1. Open-ended hedge funds:

Shares are continuously issued to investors and allow periodic withdrawals of the net asset value for each share.

2. Closed-end hedge funds:

They issue only a limited number of shares through an initial offering and do not issue new shares even if investor demand increases.

3. Shares of listed hedge funds:

They are traded on stock exchanges and non-accredited investors may purchase the shares.

10. Private Equity Funds

Private equity fund is an alternative investment where the pooling of funds are done through wealthy individuals, investment banks, endowments, pension funds, insurance companies and various financial institutions to make investment in businesses. The managers of private equity funds receive an annual management fee (usually 2% of the invested capital) and a portion of the fund’s net profits (typically 20%).

10.1. Strategies of Private Equity Funds

1. Venture Capital:

Venture Capital is funding given to startups or other early stage emerging firms that show potential for long-term growth. Private Equity firms which run as Venture Capital firm’s funds these young companies in exchange for equity (ownership stake). These young firms are not only funded but mentored for networking and business models. The businesses in which venture capitalists invests in are technology firms, bio-technology firms, FMCG firms, Innovative business model firms and Innovative Apps.

2. Growth Capital: Growth Capital refers to equity investments of PE funds in mature/already established companies that are looking for capital to expand or restructure operations/balance sheets or enter new markets or finance a major acquisition without a change of control of the business. Private equity firms achieve this by partnering with the growth firms by purchasing equity. PE funds also invest in public equities by purchasing publicly traded common shares or some of the preferred stocks or convertible security. It is an allocation of shares of a public company in private and not through a public offering in a stock exchange.

3. Mergers and Acquisitions:

A Private Equity (PE) firm buys companies with the intention of reselling them later for a sizable profit. This can be done through both mergers and acquisitions. The PE fund acquires businesses by buying equity and then operates those companies for 3 to 5 years in a manner that significantly increases the valuation of the business. They are successful in doing this as PE Funds does the following:

  • As soon as an acquisition or merger is completed, private equity focuses on establishing strong financial controls, internal reporting, eliminates unprofitable units, streamlines operations, and works with management to identify operational inefficiencies.

  • Private equity understands that much of the return on investment is based on their ability to acquire businesses in the best way possible from the start and to minimize their risk. They invest heavily in identifying acquisition targets that fit their criteria, perform substantial industry and competitor research before making an offer, and rarely overpay for a business. Part of their targeting includes identifying underperforming businesses that can be improved through better management and proper investment in critical areas.

  • Private equity invests based upon a shorter time horizon compared to strategic acquirers or existing business owners. The private equity investor expects to exit an acquired company in 3 to 5 years, and rarely more than 7 years. This mentality forces discipline to make sure that each business decision and investment of capital will provide tremendous business results within just a few years.

  • Private equity typically uses cash and debt to acquire businesses. This use of leverage sets up a much higher internal rate of return (IRR) since this is based only on their invested cash.

4. Leveraged Buyouts:

A leveraged buyout (LBO) is the acquisition of a company with a combination of equity and debt, such that the company's cash flow is the collateral used to secure and repay the borrowed money. The buyer puts up only a small amount of money and borrows the rest usually from a PE firm. The private equity firm agrees to buy a company with 60 to 90 percent debt. The fund covers the remaining 10 to 40 percent, with the managers of the purchased company contributing an additional small fraction of the equity. Private equity firms restructure the companies they buy and hope to sell them or “exit” at a much higher price, either by selling the business to another company or private equity firm, or through an initial public offering. The median holding period is roughly six years, but has varied over time.

5. Mezzanine Financing:

Mezzanine capital refers to subordinated debt or preferred equity securities that often represent the most junior portion of a company's capital structure. This type of capital is usually not secured by assets, and is lent strictly based on a company's ability to repay the debt from free cash flow. This form of financing is often used by private equity investors to reduce the amount of equity capital required to finance a leveraged buyout or major expansion. Mezzanine loans can often be converted to equity if the agreed amount of the loan is not paid back within the stipulated time period or terms. There is a reasonable protection for the fund in it investments unless the company itself files bankruptcy. Even in such a case, mezzanine fund holders get precedence over equity shareholders during the liquidation process. Mezzanine funds are targeting an overall return of investment between 13% - 25%.

6. Distressed and Special Situations:

Distress condition to a company is unable to meet its financial obligations. This is generally due to high fixed costs, illiquid assets, or revenues sensitive to economic downturns. Such, companies’ equities are purchased by the PE Funds. The strategy, also known as ‘distressed-to-control’ or, ‘loan-to-own’, involves the purchase of troubled company debt with the aim of converting that debt into a controlling equity stake in the restructured business. The position might be sold soon after the debt-for-equity exchange (which itself could take one year or more), or held for longer perhaps through an operational restructuring, to allow the equity to appreciate. Either way, the distressed private equity investor needs the analytical and bankruptcy specific skills of the distressed trader, the medium-term business planning and board-oversight skills of an LBO investor, and the ability to drive a restructuring process while a company is going through crisis. Thus the strategy requires not only deep specialist skills, but also the ability for the fund manager to invest significant time, energy and resource into the restructuring process inevitably at the expense of working on other opportunities.

7. Fund of Funds:

A "fund of funds" (FOF) also known as a multi-manager investment is a pooled investment fund that invests in other types of funds. A fund of funds aggregates capital from multiple investors and makes commitments to a number of private equity limited partnerships, sometimes investing a small portion of the fund in direct co-investments in attractive private companies along with underlying fund general partners to enhance returns, adjust allocations, and effectively reduce fees. A fund of funds is advantageous for both investors with small private equity allocations and for investors with large private equity investment allocations. Although funds of funds add an additional level of fees, the fees can be far less than the costs of managing a private equity portfolio in-house. In addition, using a competent professional manager brings the necessary expertise, to effectively gain access to select and manage private equity fund relationships.