Chapter 1 notes 2012 08 02


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Chapter 1 notes 2012 08 02

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 1Overview of Securities and FuturesAugust 2012
  2. 2. Chapter summary and outlineThis chapter provides a brief overview of the products covered in themodule and the derivatives markets in Singapore.Chapter outline:• Introduction• DerivativesfinlogIQ 2
  3. 3. Introduction• Financial assets may be broadly classified into three categories: – Money market securities – Capital market securities – Derivative securities• Money Market Securities: – Low risks, highly liquid, short-term debt instruments issued by governments, financial institutions and corporations, – Minimum denominations are relatively large and the size of the transactions can be substantial, – Maturities range from one day to one year and are often less than 90 days. – Include Treasury bills, commercial papers, bankers acceptances, negotiable certificates of deposits and repurchase agreements.finlogIQ 3
  4. 4. Introduction – 2• Capital Market Securities: – Include debt securities with maturities of more than 1 year and equity securities.• Debt securities: – Borrowings by the issuers, – Holder of a debt security is lending a certain amount of money (called the principal) to the issuer, – In return, issuer makes periodic interest payments and returns principal at the maturity.• Equity securities: – Ownership interest in an entity such as company, trust or partnership, – Two forms of equities – common stock and preferred stock, – Apart from entitlement, holder is entitled to a pro rata portion of control of the issuer and has a residual claim on both the income and assets of company.finlogIQ 4
  5. 5. Derivatives• Derivative Securities: – Financial security whose value is linked to the value of one or more underlying assets. – Payoff depends on the performance of the underlying assets such as interest rates, foreign exchange rates, stock index values, commodity prices, stock prices or other variables such as the occurrence or non-occurrence of a specified event, – Basic types of derivatives: futures, forwards, swaps and options. – Wide range of more complex or “exotic” derivatives, created by combining different types of derivatives or creating additional features to a traditional derivatives product. – Examples of exotic derivatives: Barrier options, knock-out products, swaptions and structured notes. – Can either be traded on centralized and regulated exchanges such as Singapore Exchange Limited (“SGX”), or between counterparties in the unregulated over- the-counter (“OTC”) markets.finlogIQ 5
  6. 6. Exchange Traded Derivatives• Are standardized products, that are traded on centralized and regulated exchanges (e.g. trading floors or computerized trading)• Characteristic of the product is specified according to standard conventions such as: – Contract size, – Underlying asset, – Delivery or expiration dates, – Delivery arrangements, – Others.• Most exchange-traded derivatives include futures or options.• After expiry, contract is settled either by: – Physical delivery (typically for commodity underlying assets) or – Cash settlement (typically for financial underlying assets).finlogIQ 6
  7. 7. Exchange Traded Derivatives - 2• Once a trade is executed between buyer and seller– trade is recorded with exchange’s clearinghouse• Contracts are ultimately between the holders of securities at expiry, and the exchange who acts as guarantor that the trade will be settled, as originally intended, using pooled initial margin from both sides of the trade.finlogIQ 7
  8. 8. OTC Derivatives• OTC derivatives are traded between two parties without going thorough an exchange• Usually include forwards or swaps• Largely unregulated with respect to disclosure of information between the parties• Contracts are privately negotiated between the buyer and seller, and transactions are confirmed and settled bilaterally between the counterparties involved.finlogIQ
  9. 9. Uses of Derivatives• Used as a means of implementing investment views,• Allowing investors to access broader investment opportunities,• Typical use of derivatives: – Hedging or insuring against risk – Speculating, or adopting a view on the future direction of the market – Arbitraging, or taking advantage of price differentials between two or more markets to make a profit – Changing the nature of an asset or liability to meet specific needs that cannot be met from the standardised financial instruments available in the markets – Creating synthetic positions without incurring the costs of buying or selling the underlying assetsfinlogIQ 9
  10. 10. Types of Derivatives - 1Forwards• Most popular and straightforward type of derivatives• An agreement to buy or sell an asset at a fixed date in the future, for a fixed price• Enables the investor to eliminate price uncertainty• Delivery of the underlying asset occurs in the future, unlike spot contracts where delivery is immediate• Are usually OTC contracts• Customised to the specific needs of the two parties• Disadvantages: – Credit risk that the counterparty may default on its obligations – Limited liquidityfinlogIQ 10
  11. 11. Types of Derivatives - 2Swaps• Obligation between two parties to exchange one entitlement for another to maximise revenue or to minimize financing costs• Entails exchanging their forms of borrowings (fixed interest rate for floating interest rate) – Or, can be buying a currency on the spot market and simultaneously selling it forward• Swaps may entail exchanging income flows e.g. exchanging the fixed rate coupon stream of a bond for a variable rate payment stream, or vice versa• Types of swaps: interest rate swaps, currency swaps, credit default swaps, commodity swaps and equity swaps. – Normally traded on OTC marketfinlogIQ 11
  12. 12. Types of Derivatives - 3Futures• An agreement to buy or sell an asset, such as a commodity or a financial instrument, at a fixed future date and price• Traded on an exchange• Contracts are standardised• Participants need to place a margin payment with a member of the exchangefinlogIQ 12
  13. 13. Types of Derivatives - 4Options• By definition refers to a choice or a right• Buyer has the right to exercise the option if the situation is in the buyer’s advantage• Seller has the obligation to fulfil the contractual terms should the buyer exercise the option• Call option: gives holder the right to buy the underlying from the writer at the strike price on or before a specified date• Put option: gives holder the right to receive the strike price upon delivery of the underlying to the writer on or before a specified datefinlogIQ 13
  14. 14. Types of Derivatives - 5Options (cont)• Strike price (a.k.a exercise price): - price paid to acquire the underlying or price received to sell the underlying, – Also known as exercise price, – Normally there is a series of expiration dates either a monthly or quarterly or combination, depending on type of instrument and market where it is traded• Option are traded on an underlying asset which determines the value of the option – Options are derivative securities• There are two fundamental types of options: – An American option permits the owner to exercise at any time before or at expiration, – A European option can be exercised only at expiration.finlogIQ 14
  15. 15. Types of Derivatives - 6Warrants• Is a derivative that gives investor an option to buy or sell a stated number of shares of an underlying instrument at a specified price (exercise or strike price) within a specified time period• Generally issued by listed companies as a “sweetener” attached to an offering of bonds or rights issues for shares• Allows the issuer to obtain a lower interest rate on its bond issue, hence lower its financing cost.• The warrants are detachable from the host instrument and may be listed and traded separately.• Traded on SGX-Securities Trading Ltd• Warrant holders do not receive nor pay any dividend income or cash distributions even if the underlying instrument pays a dividend or cash distribution• A company warrant is a long-dated call option as its maturity is typically 3 to 5 years (compared to options and structured warrants have expiration dates of less than 1 year).finlogIQ 15
  16. 16. Types of Derivatives - 7Structured Products• A complex financial product that allows risk/return customisation through a combination of two or more underlying instruments• Achieved through a conventional fixed income instrument and replacing the payments from that instrument (e.g. interest coupons and final principal) with cash flows derived from the other financial instruments• Allow investors better access to certain types of financial products• Normally consist of two components – Principal component: - a fixed income instrument such as a bond. This component is used to create a feature which allows for preservation of capital in the structured product so as to ensure that part or whole of the investment amount will be preserved – Return component: comprises other underlying financial instruments such as securities, securities indices, debt instruments, derivative instruments relating to securities, credit, foreign currency and commodities or any combinations of these instrumentsfinlogIQ 16
  17. 17. Types of Derivatives - 8Structured Products (cont)• Often structured products are customized, hence there are no fixed combinations of the underlying financial instruments in a structured product• Can be more complex like in a basket of bonds and various derivatives• Its is possible for structured products to consist of only derivatives products• Three major types: – Structured notes – Structured funds – Structured investment-linked productsfinlogIQ 17
  18. 18. Other Financial Derivatives - 1Knock-Out Products• Financial instruments that combine an underlying asset with an option• Payoff profile of “all or nothing” outcome and• Value of the option can become worthless should price of the underlying instrument or some other predetermined reference reach a certain price levelContracts for Differences (“CFDs”)• OTC derivatives product• Based on an agreement between two parties to settle the difference of opening price and closing price of the transaction• The buyer or the seller who has positive or negative views of market, takes a position on asset price movement without ownership of the underlying assetExtended Settlement (“ES”) Contracts• A contract between two parties, to buy or sell a specific quantity of a specific underlying security at a specific price for settlement at a specific future date• Also known as single stock futures contractfinlogIQ 18