Foreign exchange derivative ................................................................................................................. 8 Interest rate derivative ......................................................................................................................... 8 Credit derivative.................................................................................................................................... 8 Commodity Derivative .......................................................................................................................... 8 Over-the-counter ...................................................................................................................................... 8Financial marketsThe financial markets can be divided into different subtypes: Capital markets which consist of: o Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. o Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange.SecurityA security is generally a fungible, negotiable financial instrument representing financial value.Securities are broadly categorized into: debt securities (such as banknotes, bonds and debentures), equity securities, e.g., common stocks; and, derivative contracts, such as forwards, futures, options and swaps.FungibilityIt is the property of a good or a commodity whose individual units are capable of mutual substitution,such as crude oil, shares in a company, bonds, precious metals or currencies. For example, if someonelends another person a $10 bill, it does not matter if they are given back the same $10 bill or a differentone, since currency is fungible; if someone lends another person their car, however, they would notexpect to be given back a different car, even of the same make and model, as cars are not fungible.
Debt SecurityBanknoteBanknote (often known as a bill, paper money or simply a note) is a kind of negotiable instrument; apromissory note (i.e. enforceable by law) made by a bank payable to the bearer on demand, used asmoney, and in many jurisdictions is legal tender. In addition to coins, banknotes make up the cash orbearer forms of all modern fiat money (money that derives its value from government regulation orlaw). With the exception of non-circulating high-value or precious metal commemorative issues, coinsare used for lower valued monetary units, while banknotes are used for higher values.BondsIn finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay theprincipal at a later date, termed maturity. A bond is a formal contract to repay borrowed money withinterest at fixed intervals (semi-annual, annual, sometimes monthly).Types of bonds: 1. Fixed rate bonds have a coupon that remains constant throughout the life of the bond. 2. Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest, such as LIBOR(The Libor is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate ) or Euribor (The Euro Interbank Offered Rate (Euribor) is a daily reference rate based on the averaged interest rates at which Euro zone banks offer to lend unsecured funds to other banks in the euro wholesale money market ) 3. Zero coupon bonds 4. Inflation linked bonds 5. Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage- backed securities (MBSs), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs). 6. Perpetual bonds are also often called perpetuities or Perps. They have no maturity date 7. Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond 8. Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the “full faith and credit” of the federal government. For that reason, this type of bond is often referred to as risk-free. 9. Foreign currencies : Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the
issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing companys local currency to be used on existing operationsAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from andcollateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically agroup of small and illiquid assets that are unable to be sold individually. Pooling the assets into financialinstruments allows them to be sold to general investors; a process called securitization, and allows therisk of investing in the underlying assets to be diversified because each security will represent a fractionof the total value of the diverse pool of underlying assets. The pools of underlying assets can includecommon payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows fromaircraft leases, royalty payments and movie revenues.MBSA mortgage-backed security (MBS) is an asset-backed security that represents a claim on the cash flowsfrom mortgage loans through a process known as securitization.The process of securitization is complicated, and is highly dependent on the jurisdiction withinwhich the process is conducted. The basics are: 1. Mortgage loans (mortgage notes) are purchased from banks and other lenders and assigned to a trust 2. The trust assembles these loans into collections, or "pools" 3. The trust securitizes the pools by issuing mortgage-backed securities CMOCMO is a debt security issued by an abstraction - a special purpose entity - and is not a debt owed by theinstitution creating and operating the entity. The entity is the legal owner of a set of mortgages, called apool. Investors in a CMO buy bonds issued by the entity, and they receive payments from the incomegenerated by the mortgages according to a defined set of rulesCDOCollateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) withmultiple "tranches"(In structured finance, a tranche (often misspelled as traunch or traunche) is one ofa number of related securities offered as part of the same transaction) that are issued by specialpurpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers avarying degree of risk and return so as to meet investor demand. CDOs value and payments are derivedfrom a portfolio of fixed-income underlying assetsDebentureA debenture is a document that either creates a debt or acknowledges it, and it is a debt withoutcollateral. In corporate finance, the term is used for a medium- to long-term debt instrument used bylarge companies to borrow money.
Equity SecuritiesCommon stock Common stock is a form of corporate equity ownership, a type of security. The terms "votingshare" or "ordinary share" are also used in other parts of the world; common stock beingprimarily used in the United States.It is called "common" to distinguish it from preferred stock. If both types of stock exist, commonstock holders cannot be paid dividends until all preferred stock dividends (including payments inarrears) are paid in full.In the event of bankruptcy, common stock investors receive any remaining funds afterbondholders, creditors (including employees), and preferred stock holders are paid. As such,such investors often receive nothing after a bankruptcy.Preferred stockPreferred stock, also called preferred shares, preference shares, or simply preferreds, is aspecial equity security that has properties of both an equity and a debt instrument and isgenerally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to commonstock, but are subordinate to bonds in terms of claim or rights to their share of the assets of thecompany.Preferred stock usually carries no voting rights, but may carry a dividend and may havepriority over common stock in the payment of dividends and upon liquidation. Terms of thepreferred stock are stated in a "Certificate of Designation".Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating forpreferreds is generally lower since preferred dividends do not carry the same guarantees asinterest payments from bonds and they are junior to all creditorsDerivative A derivative instrument is a contract between two parties that specifies conditions (especially thedates, resulting values of the underlying variables, and notional amounts) under which payments, orpayoffs, are to be made between the parties. Derivatives are broadly categorized by the relationshipbetween the underlying asset and the derivative (such as forward, option, swap); the type of underlyingasset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodityderivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile.
Based on the relationship between underlying asset and derivativeForwardIn finance, a forward contract or simply a forward is a non-standardized contract between two partiesto buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spotcontract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlyingasset in the future assumes a long position, and the party agreeing to sell the asset in the futureassumes a short position. The price agreed upon is called the delivery price, which is equal to theforward price at the time the contract is entered into.OptionIn finance, an option is a derivative financial instrument that specifies a contract between two partiesfor a future transaction on an asset at a reference price (the strike). The buyer of the option gains theright, but not the obligation, to engage in that transaction, while the seller incurs the correspondingobligation to fulfill the transaction. The price of an option derives from the difference between thereference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futurescontract) plus a premium based on the time remaining until the expiration of the option. Other types ofoptions exist, and options can in principle be created for any type of valuable asset.SwapIn finance, a swap is a derivative in which counterparties (parties to a contract) exchange cash flows ofone partys financial instrument for those of the other partys financial instrument. The benefits inquestion depend on the type of financial instruments involved. The five generic types of swaps, in orderof their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodityswaps and equity swaps.Interest rate swapsThe most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rateloan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason forthis exchange is to take benefit from comparative advantage. Some companies may have comparativeadvantage in fixed rate markets while other companies have a comparative advantage in floating ratemarkets. When companies want to borrow they look for cheap borrowing i.e. from the market wherethey have comparative advantage. However this may lead to a company borrowing fixed when it wantsfloating or borrowing floating when it wants fixed.Currency swapsA currency swap involves exchanging principal and fixed rate interest payments on a loan in onecurrency for principal and fixed rate interest payments on an equal loan in another currency. Justlike interest rate swaps, the currency swaps are also motivated by comparative advantage.Currency swaps entail swapping both principal and interest between the parties, with thecashflows in one direction being in a different currency than those in the opposite direction. It isalso a very crucial uniform pattern in individuals and customers.
Commodity SwapA commodity swap is an agreement whereby a floating (or market or spot) price is exchanged fora fixed price over a specified period. The vast majority of commodity swaps involve crude oil.Credit default swap (CDS)A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to theseller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default(fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoingrestructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have beencompared with insurance because the buyer pays a premium and, in return, receives a sum of money ifone of the events specified in the contract occur. Unlike an actual insurance contract the buyer isallowed to profit from the contract and may also cover an asset to which the buyer has no directexposure.Equity SwapsAn equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed tobe exchanged between two counterparties at set dates in the future.Based on the underlying assetEquity DerivativeAn equity derivative is a class of derivatives whose value is at least partly derived from one or moreunderlying equity securities. Options and futures are by far the most common equity derivatives,however there are many other types of equity derivatives that are actively traded.FuturesIn finance, a futures contract is a standardized contract between two parties to exchange a specifiedasset of standardized quantity and quality for a price agreed today (the futures price or the strike price)with delivery occurring at a specified future date, the delivery date. The contracts are traded on afutures exchange.(thus differentiating them from forwards).WarrantsIn finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at aspecified price, which is much lower than the stock price at time of issue. Warrants are frequentlyattached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates ordividends. They can be used to enhance the yield of the bond, and make them more attractive topotential buyers.Convertible bondsConvertible bonds are bonds that can be converted into shares of stock in the issuing company, usuallyat some pre-announced ratio. It is a hybrid security with debt- and equity-like features. It can be used byinvestors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons.
Foreign exchange derivativeA foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchangerate(s) of two (or more) currencies. These instruments are commonly used for currency specurlation andarbitrage or for hedging foreign exchange risk.Interest rate derivativeAn interest rate derivative is a derivative where the underlying asset is the right to pay or receive anotional amount of money at a given interest rate. These structures are popular for investors withcustomized cash flow needs or specific views on the interest rate movements (such as volatilitymovements or simple directional movements) and are therefore usually traded OTC.Credit derivativeIn finance, a credit derivative refers to any one of "various instruments and techniques designed toseparate and then transfer the credit risk" of the underlying loan. It is a securitized derivative wherebythe credit risk is transferred to an entity other than the lender.Commodity DerivativeCommodity markets are markets where raw or primary products are exchanged. These rawcommodities are traded on regulated commodities exchanges, in which they are bought and sold instandardized contracts.Over-the-counterOver-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds,commodities or derivatives directly between two parties. It is contrasted with exchange trading, whichoccurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchanges orstock exchanges. Over-the-counter (OTC) derivatives are contracts that are traded (and privatelynegotiated) 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 - arealmost always traded in this way. The OTC derivative market is the largest market for derivatives, and islargely unregulated with respect to disclosure of information between the parties, since the OTC marketis made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTCamounts are difficult because trades can occur in private, without activity being visible on any exchange.According to the Bank for International Settlements, the total outstanding notional amount is US$708trillion (as of June 2011). Of this total notional amount, 67% are interest rate contracts, 8% are creditdefault swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equitycontracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is nocentral counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, sinceeach counter-party relies on the other to perform.