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Term Paper of F-302 (Financial

Markets & Institutions)

Topic: ‗Securities Traded in Financial Markets‘

Submitted to:

M. Farid Ahmed

Professor

Department of Finance

University of Dhaka.

Submitted by:

Manzuma Sharmin

ID: 18-090 (Section B)

Department of Finance

University of Dhaka.

Date of Submission: 07/07/2014

Introduction

This term-paper is on the securities, which are commonly traded in financial markets. There are two

types of financial markets: Money Market & Capital Market. In money market, all the short-term

securities, such as: Treasury bills, commercial papers, negotiable certificates of deposits etc. are

traded and in the capital market, all the long-term securities such as: Bonds, mortgages, stocks etc. are

traded. These all financial market securities have been discussed in this term paper.

Securities Traded in Financial Market:

A financial market refers to a broad term describing any marketplace where buyers and sellers participate in the

trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by

having transparent pricing, basic regulations on trading, costs and fees and market forces determining the prices

of securities that trade. Some financial markets only allow participants that meet certain criteria, which can be

based on factors like the amount of money held, the investor's geographical location, knowledge of the markets

or the profession of the participant.

Securities traded in financial market can be classified as:

1) Money Market Securities

2) Capital Market Securities

3) Derivative Securities.

Money Market Securities:

Money market securities are debt securities that have a maturity of one year or less. They generally have a high

degree of liquidity. Money market securities tend to have a low expected return but also a degree of risk.

Common types of money market securities include:

1) Treasury Bills (issued by the U.S. Treasury),

2) Commercial Paper (issued by corporations) and

3) Negotiable Certificates of Deposit (issued by depository institutions).

Now, each of the money market securities is discussed below:

Treasury bill:

A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-

bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly

have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). T-bills

are issued through a competitive bidding process at a discount from par, which means that rather than

paying fixed interest payments like conventional bonds, the appreciation of the bond provides the

return to the holder. Another definition of treasury bill can be explained as that, treasury bill is a

short-term (usually less than one year, typically three months) maturity promissory note issued by a

national (federal) government as a primary instrument for regulating money supply and raising funds

via open market operations. Issued through the country's central bank, T-bills commonly pay no

explicit interest but are sold at a discount, their yield being the difference between the purchase price

and the par-value (also called redemption value). This yield is closely watched by financial markets

and affects the yield on municipal and corporate bonds and bank interest rates. Although their yield is

lower than on other securities with similar maturities, T-bills are very popular with institutional

investors because, being backed by the government's full faith and credit, they come closest to a risk

free investment. Treasury bills were issued for the first time in 1877 in the UK and in 1929 in the US.

Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest

prior to maturity; instead they are sold at a discount of the par value to create a positive yield to

maturity. Many regard Treasury bills as the least risky investment available to U.S. investors. Regular

weekly T-Bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91

days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52

weeks, about 1 year). Treasury bills are sold by single-price auctions held weekly. Offering amounts

for 13-week and 26-week bills are announced each Thursday for auction, usually at 11:30 a.m., on the

following Monday and settlement, or issuance, on Thursday. Offering amounts for 4-week bills are

announced on Monday for auction the next day, Tuesday, usually at 11:30 a.m., and issuance on

Thursday. Offering amounts for 52-week bills are announced every fourth Thursday for auction the

next Tuesday, usually at 11:30 am, and issuance on Thursday. Purchase orders at Treasury Direct

must be entered before 11:00 on the Monday of the auction. The minimum purchase, effective April

7, 2008, is $100. (This amount formerly had been $1,000.) Mature T-bills are also redeemed on each

Thursday. Banks and financial institutions, especially primary dealers, are the largest purchasers of T-

bills.

Like other securities, individual issues of T-bills are identified with a unique CUSIP number. The 13-

week bill issued three months after a 26-week bill is considered a re-opening of the 26-week bill and

is given the same CUSIP number. The 4-week bill issued two months after that and maturing on the

same day is also considered a re-opening of the 26-week bill and shares the same CUSIP number. For

example, the 26-week bill issued on March 22, 2007, and maturing on September 20, 2007, has the

same CUSIP number (912795A27) as the 13-week bill issued on June 21, 2007, and maturing on

September 20, 2007, and as the 4-week bill issued on August 23, 2007 that matures on September 20,

2007.

During periods when Treasury cash balances are particularly low, the Treasury may sell cash

management bills (or CMBs). These are sold at a discount and by auction just like weekly Treasury

bills. They differ in that they are irregular in amount, term (often less than 21 days), and day of the

week for auction, issuance, and maturity. When CMBs mature on the same day as a regular weekly

bill, usually Thursday, they are said to be on-cycle. The CMB is considered another reopening of the

bill and has the same CUSIP. When CMBs mature on any other day, they are off-cycle and have a

different CUSIP number.

A specimen of Treasury bill is given below:

This is an example of Treasury bill, which is traded on short-term basis.

How It Works:

T-Bills are issued at a discount to the maturity value. Rather than paying a coupon rate of interest, the

appreciation between issuance price and maturity price provides the investment return.

Example:

For example, a 26-week T-bill is priced at $9,800 on issuance to pay $10,000 in six months. No

interest payments are made. The investment return comes from the difference between the discounted

value originally paid and the amount received back at maturity, or $200 ($10,000 - $9,800). In this

case, the T-bill pays a 2.04% interest rate ($200 / $9,800 = 2.04%) for the six-month period.

Why It Matters:

T-bills are considered the safest possible investment and provide what is referred to as a "risk-free rate

of return," based on the credit worthiness of the United States of America. This risk-free rate of return

is used as somewhat of a benchmark for rates on municipal bonds, corporate bonds and bank interest.

In addition, because T-bills are very short-term investments (as opposed to Treasury notes and

Treasury bonds) there is very little interest rate risk. When interest rates rise, the price of fixed-

income securities falls as the relative value of their future income stream is discounted. However,

short-term securities are much less affected than long-term securities because higher rates will have a

very limited effect on future income streams.Treasury interest is also exempt from state and local

taxes because of the law of reciprocal immunity, which stipulates that states cannot tax federal

securities and vice versa.

Treasury bill’s Practice in Bangladesh:

Treasury Bills are issued by the government as an important tool of raising public finance were of

three types, although all of them were 90-day bills. Among these three types, bulk was represented by

ad-hoc treasury bills issued to meet the cash balance need of the government. A second type was the

3-months treasury bills on tap introduced in August 1972 and their purpose was to mop up the excess

liquidity of banks. The third type was the 3-months treasury bills introduced for subscription

exclusively by the non-bank financial institutions, non-financial enterprises and the public.

Initially, a limit of Tk. 250 million was set for the issue of such treasury bills. Later this limit was

withdrawn and Bangladesh bank was empowered to issue any amount of treasury bills for the non-

bank public. Despite the withdrawal of the limit, the holdings of non-banking sectors remained small

and commercial banks comprised the main market for the treasury bills. These bills continued to be

reissued in every ninety days. In December 1994, however, treasury bills on tap and the treasury bills

for non-banks were abolished. The holdings of treasury bills by the deposit money banks generally

did not exceed the amount needed to meet the liquidity requirement. A substantial part of the treasury

bills issued, therefore, needed to be held by Bangladesh Bank. Of the total Treasury bill holdings, the

amount of holdings by the deposit money banks was 57% at the end of 1973 and amidst fluctuation,

they came down to 27% at the end of June 1982. Later, the share started to rise and stood at 68% at

the end of 1992. Thereafter, it fell sharply and came down to a lowest minimum of 4% at the end of

June 1995.

That the Bangladesh Bank bills were allowed as approved securities for the statutory liquidity

requirement of the banks and these bills were of yields higher than the treasury bill rate, might have

induced the banks to reduce their holdings of treasury bills. This trend continued up to February 1997.

In March 1997, the auctioning of Bangladesh Bank bills was suspended and only the 90-day treasury

bills were sold through auction. Up to 25 October 1995, the treasury bills of ninety days maturity were

sold at pre-determined rate usually fixed time to time by the government. Thereafter, these were sold

through auction at market determined rate of interest. Subsequently, on 7 February 1996, the

government introduced 30-days and 180-days treasury bills and on 16 March 1997, 1-year treasury

bills for auction. Up to August 1998, four categories of treasury bills viz, 30-day, 90-day, 180-day and

1-year bills were sold regularly through weekly auction basis. From 6 September 1998, these were

replaced by newly introduced 28-days, 91-days, 182-days, 364-days, 2-years and 5-years treasury

bills. With the introduction of repo and reverse repo systems as tools of monetary policy in 2003, a

new scope was created for the treasury bills in the money market. Banks and financial institutions had

no short-term liquidity management tools. So these organisations were allowed to use treasury bills as

securities for enjoying repo facility from Bangladesh Bank. Despite the application of reverse repo

auction to supplement the Treasury bill auction for controlling the liquidity of banks, Treasury bill is

being used as an outstanding tool of monetary policy. Bangladesh Bank takes initiative to sell

Treasury bill for reducing excessive liquidity increased due to the growth of export sector and the

increase of remittance flow. As a tool of government loan, Treasury bill was also allowed to accept as

a security in the interbank repo market. The auction of 5-years term Treasury bill was stopped from

2004. Bangladesh Bank appointed nine primary dealers in 2004 to extend support and strengthen for

developing the secondary market of the government treasury bills and other machineries of

government loan. Later three more dealers were appointed and those agents actively participate in

auction to enhance the number of subscribers both at individual and institutional level. In the auction

process, the French system of auctioneering for the treasury bills is followed and the treasury bills are

issued accordingly. Treasury bills ranging from the minimum yield to the amount of given yield fixed

for the auction is issued by them. The distribution of treasury bills is also held proportionate by at the

cut off price. One of the landmark developments that took place in the Treasury bill market on 20

October 2003 is the market started transaction through electronic system. Since then, the on-line

transfer process of treasury bills among the banks and financial institutions is being done. This new

marketing strategic management is expected to be helpful for strengthening and widening the

country‘s money market.

A market based auction system of treasury bills was introduced from the FY of 2007-08. Under the

system, an auction calendar mentioning the date and the amount of price is prepared and made public

every year. However, the transaction of the treasury bill of 2 years term has been stopped following

the international rules relating to the terms of treasury bills. Moreover the auction of treasury bill

having 28 days validity also suspended from 01 July 2008 to avoid overlapping with the 30 day

Bangladesh Bank Bill. Following these steps only three categories of treasury bills namely 91-day,

182-day and 364-day bills are now (2012) available in the market for transaction.

The yield structure of treasury bills takes various shapes depending on the liquidity situation of the

money market. During the FY of 2009-10, the yield of treasury bills of different terms by the end of

June increased to 8.6% from 3.02% due to huge liquidity with the banks in the market. By June 2008,

the rate was 7.28% to 8.48%.

Commercial Paper:

Commercial paper, in the global financial market, is an unsecured promissory note with a fixed

maturity of no more than 270 days. It isan unsecured, short-term debt instrument issued by a

corporation, typically for the financing of accounts receivable, inventories and meeting short-term

liabilities. The debt is usually issued at a discount, reflecting prevailing market interest

rates.Commercial paper is a money-market security issued (sold) by large corporations to obtain funds

to meet short-term debt obligations (for example, payroll), and is backed only by an issuing bank or

corporation's promised to pay the face amount on the maturity date specified on the note. Since it 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. Commercial paper is usually

sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically,

the longer the maturity on a note, the higher the interest rate the issuing institution pays. Interest rates

fluctuate with market conditions, but are typically lower than banks' rates.

Commercial paper – though a short-term obligation – is issued as part of a continuous rolling

program, which is either a number of years long (as in Europe), or open-ended (as in the U.S.). The

use of commercial paper has been adopted by every state in the United States except Louisiana. At the

end of 2009, more than 1,700 companies in the United States issued commercial paper. As of October

31, 2008, the U.S. Federal Reserve reported seasonally adjusted figures for the end of 2007: there was

$1.7807 trillion (short-scale, or 1,780,700,000,000) in total outstanding commercial paper; $801.3

billion was "asset backed" and $979.4 billion was not; $162.7 billion of the latter was issued by non-

financial corporations, and $816.7 billion was issued by financial corporations. Commercial credit, in

the form of promissory notes issued by corporations, has existed since at least the 19th century. For

instance, Marcus Goldman, founder of Goldman Sachs got his start trading commercial paper in New

York in 1869.

Commercial paper – though a short-term obligation – is issued as part of a continuous significantly

longer rolling program, which is either a number of years long (as in Europe), or open-ended (as in

the U.S.).[1][5] Because the continuous commercial paper program is much longer than the individual

commercial paper in the program (which cannot be longer than 270 days), as commercial paper

matures and is paid down the proceeds from the pay-down are used to buy new commercial paper in

the same program – the process is referred to as "rolling" the commercial paper. Because the program

is a continuous rolling one that runs for many years, it can be viewed as a source for long-term funds

for issuers, even though composed of shorter-term obligations. By having the constituent parts of the

Program be no longer than 270 days, the issuer avoids the cost, delays, and complications of being

required to file a registrations statement.

There are two methods of issuing credit. The issuer can market the securities directly to a buy and

hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who

then sells the paper in the market. The dealer market for commercial paper involves large securities

firms and subsidiaries of bank holding companies. Most of these firms also are dealers in US Treasury

securities. Direct issuers of commercial paper usually are financial companies that have frequent and

sizable borrowing needs and find it more economical to sell paper without the use of an intermediary.

In the United States, direct issuers save a dealer fee of approximately 5 basis points, or 0.05%

annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates

for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower

outside the United States.

Negotiable Certificates of Deposit:

Negotiable Certificates of Deposit is a certificate of deposit with a minimum face value of $100,000.

These are guaranteed by the bank and can usually be sold in a highly liquid secondary market, but

they cannot be cashed-in before maturity.Large-denomination Certificate of Deposit ($100,000 or

more) issued by a commercial bank. Negotiable CDs are issued as interest-bearing time deposits,

paying the holder a fixed amount of interest at maturity. These negotiable instruments are typically

held by wealthy individuals, insurance companies, and financial institutions. There is an active

secondary market for negotiable CDs of the 25 largest U.S. Banks. Maturities vary from 14 days to 12

months, with the average maturity being about 3 months. CDs sold in the secondary market generally

trade in round lots of $1 million or more, and frequently $5 million. Negotiable CDs also have been

issued in discount form, paying the holder the face value at maturity. It is a short-term (2 to 52 weeks)

large denomination ($100,000 minimum) CD that is issued at a discount on its par value, or at a fixed

interest rate payable at maturity. Negotiable CDs issued by large banks are freely traded in secondary

markets.

Repurchase Agreement:

A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of

securities together with an agreement for the seller to buy back the securities at a later date. The

repurchase price should be greater than the original sale price, the difference effectively representing

interest, sometimes called the repo rate. The party that originally buys the securities effectively acts as

a lender. The original seller is effectively acting as a borrower, using their security as collateral for a

secured cash loan at a fixed rate of interest. A repo is almost equivalent to a spot sale combined with a

forward contract. The spot sale results in transfer of money to the borrower in exchange for legal

transfer of the security to the lender, while the forward contract ensures repayment of the loan to the

lender and return of the collateral of the borrower. The difference between the forward price and the

spot price is effectively the interest on the loan, while the settlement date of the forward contract is the

maturity date of the loan.

So,repurchase Agreement is a form of short-term borrowing for dealers in government securities. The

dealer sells the government securities to investors, usually on an overnight basis, and buys them back

the following day. For the party selling the security (and agreeing to repurchase it in the future) it is a

repo; for the party on the other end of the transaction, (buying the security and agreeing to sell in the

future) it is a reverse repo.A repo is economically similar to a secured loan, with the buyer (effectively

the lender or investor) receiving securities for collateral to protect himself against default by the

seller. The party who initially sells the securities is effectively the borrower. Almost any security may

be employed in a repo, though highly liquid securities are preferred as they are more easily disposed

of in the event of a default and, more importantly, they can be easily obtained in the open market

where the buyer has created a short position in the repo security by a reverse repo and market sale; by

the same token, non-liquid securities are discouraged. Treasury or Government bills, corporate and

Treasury/Government bonds, and stocks may all be used as "collateral" in a repo transaction. Unlike a

secured loan, however, legal title to the securities passes from the seller to the buyer. Coupons

(interest payable to the owner of the securities) falling due while the repo buyer owns the securities

are, in fact, usually passed directly onto the repo seller. This might seem counterintuitive, as the legal

ownership of the collateral rests with the buyer during the repo agreement. The agreement might

instead provide that the buyer receives the coupon, with the cash payable on repurchase being

adjusted to compensate, though this is more typical of sell/buybacks.

Although the transaction is similar to a loan, and its economic effect is similar to a loan, the

terminology differs from that applying to loans: the seller legally repurchases the securities from the

buyer at the end of the loan term. However, a key aspect of repos is that they are legally recognised as

a single transaction (important in the event of counterparty insolvency) and not as a disposal and a

repurchase for tax purposes.

Types of Repo:

There are two types of repo maturities: term, and open repo. Overnight refers to a one-day maturity

transaction. Term refers to a repo with a specified end date. Open simply has no end date. Although

repos are typically short-term, it is not unusual to see repos with a maturity as long as two years. Repo

transactions occur in three forms: specified delivery, tri-party, and held in custody (wherein the

"selling" party holds the security during the term of the repo). The third form (hold-in-custody) is

quite rare, particularly in developing markets, primarily due to the risk that the seller will become

insolvent prior to maturation of the repo and the buyer will be unable to recover the securities that

were posted as collateral to secure the transaction. The first form—specified delivery—requires the

delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party

essentially is a basket form of transaction, and allows for a wider range of instruments in the basket or

pool. In a tri-party repo transaction a third party clearing agent or bank is interposed between the

"seller" and the ―buyer‖. The third party maintains control of the securities that are the subject of the

agreement and processes the payments from the "seller" to the "buyer."

Reverse Repo:

A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's.

Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same

transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind

of transaction, just being described from opposite viewpoints. The term "reverse repo and sale" is

commonly used to describe the creation of a short position in a debt instrument where the buyer in the

repo transaction immediately sells the security provided by the seller on the open market. On the

settlement date of the repo, the buyer acquires the relevant security on the open market and delivers it

to the seller. In such a short transaction the buyer is wagering that the relevant security will decline in

value between the date of the repo and the settlement date.

Uses:

For the buyer, a repo is an opportunity to invest cash for a customized period of time (other

investments typically limit tenures). It is short-term and safer as a secured investment since the

investor receives collateral. Market liquidity for repos is good, and rates are competitive for investors.

Money Funds are large buyers of Repurchase Agreements.

For traders in trading firms, repos are used to finance long positions, obtain access to cheaper funding

costs of other speculative investments, and cover short positions in securities. In addition to using

repo as a funding vehicle, repo traders "make markets". These traders have been traditionally known

as "matched-book repo traders". The concept of a matched-book trade follows closely to that of a

broker who takes both sides of an active trade, essentially having no market risk, only credit risk.

Elementary matched-book traders engage in both the repo and a reverse repo within a short period of

time, capturing the profits from the bid/ask spread between the reverse repo and repo rates. Currently,

matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral

swaps, and liquidity management.

Risks:

While classic repos are generally credit-risk mitigated instruments, there are residual credit risks.

Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities

sold, at the maturity date. In other words, the repo seller defaults on his obligation. Consequently, the

buyer may keep the security, and liquidate the security to recover the cash lent. The security,

however, may have lost value since the outset of the transaction as the security is subject to market

movements. To mitigate this risk, repos often are over-collateralized as well as being subject to daily

mark-to-market margining (i.e., if the collateral falls in value, a margin call can be triggered asking

the borrower to post extra securities). Conversely, if the value of the security rises there is a credit risk

for the borrower in that the creditor may not sell them back. If this is considered to be a risk, then the

borrower may negotiate a repo which is under-collateralized. Credit risk associated with repo is

subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved,

etc. Certain forms of repo transactions came into focus within the financial press due to the

technicalities of settlements following the collapse of Refco in 2005. Occasionally, a party involved in

a repo transaction may not have a specific bond at the end of the repo contract. This may cause a

string of failures from one party to the next, for as long as different parties have transacted for the

same underlying instrument. The focus of the media attention centres on attempts to mitigate these

failures.

In 2008, attention was drawn to a form known as repo 105 following the Lehman collapse, as it was

alleged that repo 105s had been used as an accounting trick to hide Lehman's worsening financial

health. Another controversial form of repurchase order is the "internal repo" which first came to

prominence in 2005. In 2011 it was suggested that repos used to finance risky trades in sovereign

European bonds may have been the mechanism by which MF Global put at risk some several hundred

million dollars of client funds, before its bankruptcy in October 2011. Much of the collateral for the

repos is understood to been obtained by the rehypothecation of other collateral belonging to the

clients.

Market Size:

The US Federal Reserve and the European Repo Council (a body of the International Capital Market

Association) try to estimate the size of their respective repo markets. At the end of 2004, the US repo

market reached US$5 trillion.

Especially in the US and to a lesser degree in Europe, the repo market contracted in 2008 as a result of

the financial crisis. But, by mid-2010, the market had largely recovered and, at least in Europe, had

grown to exceed its pre-crisis peak.

Other countries including Chile, India, Japan, Mexico, Hungary, Russia, China, and Taiwan, have

their own repo markets, though activity varies by country, and no global survey or report has been

compiled.

Placement:

Repo transactions are negotiated through a telecommunication network. Dealers and rep brokers act

as financial intermediaries to create repos for firms with deficient and excess funds, receiving a

commission for their services.

When the borrowing firm can find a counterparty to the repo-transaction, it avoids the transaction fee

involved in having a government securities dealer find the counterparty. Some companies that

commonly engage in repo-transactions have an in-house department for finding counterparties and

executing the transactions. These same companies that borrow through repos may, from time to time,

serve as the lender. That is, they purchase the government securities and agree to sell them back in the

near future. Because the cash flow of any large company changes on daily basis, it is not unusual for a

firm to act as an investor one day (when it has excess funds) and a borrower the next (when it has a

cash shortage).

Estimating the Yield:

The yield (or repo rate) is determined by using the formula given below:

Repo rate= [(SP-PP)/PP]*(360/n)

Banker’s Acceptance:

A banker's acceptance, or BA, is a promised future payment, or time draft, which is accepted and

guaranteed by a bank and drawn on a deposit at the bank. The banker's acceptance specifies the

amount of money, the date, and the person to which the payment is due. After acceptance, the draft

becomes an unconditional liability of the bank. But the holder of the draft can sell (exchange) it for

cash at a discount to a buyer who is willing to wait until the maturity date for the funds in the deposit.

A banker's acceptance starts as a time draft drawn on a bank deposit by a bank's customer to pay

money at a future date, typically within six months, analogous to a post-dated check. Next, the bank

accepts (guarantees) payment to the holder of the draft, analogous to a post-dated check drawn on a

deposit with over-draft protection.

The party that holds the banker's acceptance may keep the acceptance until it matures, and thereby

allow the bank to make the promised payment, or it may sell the acceptance at a discount today to any

party willing to wait for the face value payment of the deposit on the maturity date. The rates at which

they trade, calculated from the discount prices relative to their face values, are called banker's

acceptance rates[1] or simply discount rates. The banker's acceptance rate with a financial institution's

commission added in is called the all-in rate.

Banker's acceptances make a transaction between two parties who do not know each other safer,

because they allow the parties to substitute the bank's credit worthiness for that who owes the

payment. They are used widely in international trade for payments that are due for a future shipment

of goods and services. For example, an importer may draft a banker's acceptance when it does not

have a close relationship with and cannot obtain credit from an exporter. Once the importer and bank

have completed an acceptance agreement, whereby the bank accepts liabilities of the importer and the

importer deposits funds at the bank (enough for the future payment plus fees), the importer can issue a

time draft to the exporter for a future payment with the bank's guarantee.Banker's acceptances are

typically sold in multiples of US $100,000. Banker's acceptances smaller than this amount are referred

to as odd lots.

Banker‘s acceptance is also referred to as A short-term debt instrument issued by a firm that is

guaranteed by a commercial bank. Banker's acceptances are issued by firms as part of a commercial

transaction. These instruments are similar to T-Bills and are frequently used in money market funds.

Banker's acceptances are traded at a discount from face value on the secondary market, which can be

an advantage because the banker's acceptance does not need to be held until maturity. Banker's

acceptances are regularly used financial instruments in international trade.

Some Specimens of Banker’s Acceptance:

A Specimen of Banker‘s Acceptance is given below:

Another specimen is as follows:

Another specimen is also given below:

Banker's acceptances vary in amount, according to the size of the commercial transaction. The date of

maturity typically ranges between 30 and 180 days from the date of issue. However, banks or

investors often trade the instruments on the secondary market before the acceptances reach maturity.

Banker's acceptances are considered to be relatively safe investments, since the bank and the borrower

are liable for the amount that is due when the instrument matures.

Capital Market Securities:

Stocks and bonds are generally termed as the capital market securities. These are traded in separate

markets. These capital market securities are used by a number of companies, corporations and

governments to raise funds for various purposes. These funds are raised for long terms. There are the

regulatory authorities in every country to supervise the capital market securities and their respective

markets. The bond market is a part of the capital market and provides the opportunity to deal in the

debt securities. Bond is the medium of dealing in the debt securities. As one of the capital market

securities, bond enjoys a vast international market which is estimated around $45 trillion. A huge

portion of this bond market transaction generally takes place in the over-the-counter market. On the

other hand, the corporate bonds are listed on the exchanges. There are different types of bonds

available in the market like the corporate bond, the municipal bond, the government bond and many

more. Among all these capital market securities, the government bond is the most secured one. The

government bond market is very big and its liquidity is also beyond comparison. Another important

capital market security is known as stocks. These are preferred by the investors because an investor

can get huge returns from this capital market instrument. The stock market is used for trading of

company stocks, other securities and derivatives. $45 trillion is the estimated size of the global stock

market. This market is used by the companies to raise funds for different purposes. At times, the

governments also turn towards the stock market to generate funds. The market participants include

every kind of investor. There are both the individual investors and the institutional investors who are

taking part in the market. In the past, there were only the individual investors in the market but the

market trend has completely changed and today‘s market is mainly dominated by the institutions

which in turn, is increasing the volume of the market. The investor should take proper care while

selecting the capital market securities because the risk factors related to these securities are different.

At the same time, the returns may also vary. So a proper research should be done before investment.

Now, all the capital market securities are particularly described below:

Bond:

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt

security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is

obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the

maturity date. Interest is usually payable at fixed intervals (semi-annual, annual, sometimes monthly).

Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the

secondary market. This means that once the transfer agents at the bank medallion stamp the bond, it is

highly liquid on the second market.

Thus a bond is a form of loan or IOU ("I Owe You"): the holder of the bond is the lender (creditor),

the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the

borrower with external funds to finance long-term investments, or, in the case of government bonds,

to finance current expenditure. Certificates of deposit (CDs) or short term commercial paper are

considered to be money market instruments and not bonds: the main difference is in the length of the

term of the instrument.

Bonds and stocks are both securities, but the major difference between the two is that (capital)

stockholders have an equity stake in the company (i.e. they are investors), whereas bondholders have

a creditor stake in the company (i.e. they are lenders). Being a creditor, bondholders have absolute

priority and will be repaid before stockholders (who are owners) in the event of bankruptcy. Another

difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed,

whereas stocks are typically outstanding indefinitely. An exception is an irredeemable bond, such as

Consols, which is perpetuity, i.e. a bond with no maturity.

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in

the primary markets. The most common process for issuing bonds is through underwriting. When a

bond issue is underwritten, one or more securities firms or banks, forming a syndicate, buy the entire

issue of bonds from the issuer and re-sell them to investors. The security firm takes the risk of being

unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange

the bond issue, have direct contact with investors and act as advisers to the bond issuer in terms of

timing and price of the bond issue. The bookrunner is listed first among all underwriters participating

in the issuance in the tombstone ads commonly used to announce bonds to the public. The

bookrunners' willingness to underwrite must be discussed prior to any decision on the terms of the

bond issue as there may be limited demand for the bonds. In contrast, government bonds are usually

issued in an auction. In some cases both members of the public and banks may bid for bonds. In other

cases only market makers may bid for bonds. The overall rate of return on the bond depends on both

the terms of the bond and the price paid. The terms of the bond, such as the coupon, are fixed in

advance and the price is determined by the market. In the case of an underwritten bond, the

underwriters will charge a fee for underwriting. An alternative process for bond issuance, which is

commonly used for smaller issues and avoids this cost, is the private placement bond. Bonds sold

directly to buyers and may not be tradable in the bond market. Historically an alternative practice of

issuance was for the borrowing government authority to issue bonds over a period of time, usually at a

fixed price, with volumes sold on a particular day dependent on market conditions. This was called a

tap issue or bond tap.

Features:

The main features of bond are discussed below:

Principal:

Nominal, principal, par or face amount is the amount on which the issuer pays interest, and which,

most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption

amount which is different from the face amount and can be linked to performance of particular assets

such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor

receiving less or more than his original investment at maturity.

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. Most bonds have a term of up to

30 years. Some bonds have been issued with terms of 50 years or more, and historically there have

been some issues with no maturity date (irredeemable). In the market for United States Treasury

securities, there are three categories of bond maturities:

1) Short term (bills): maturities between one to five year; (instruments with maturities less than one

year are called Money Market Instruments)

2) Medium term (notes): maturities between six to twelve years;

3) Long term (bonds): maturities greater than twelve years.

Coupon:

The coupon is the interest rate that the issuer pays to the holder. Usually this rate is fixed throughout

the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even

more exotic. The name "coupon" arose because in the past, paper bond certificates were issued which

had coupons attached to them, one for each interest payment. On the due dates the bondholder would

hand in the coupon to a bank in exchange for the interest payment. Interest can be paid at different

frequencies: generally semi-annual, i.e. every 6 months, or annual.

Yield:

The yield is the rate of return received from investing in the bond. It usually refers either to the

current yield, or running yield, which is simply the annual interest payment divided by the current

market price of the bond (often the clean price), or to the yield to maturity or redemption yield, which

is a more useful measure of the return of the bond, taking into account the current market price, and

the amount and timing of all remaining coupon payments and of the repayment due on maturity. It is

equivalent to the internal rate of return of a bond.

Credit Quality:

The "quality" of the issue refers to the probability that the bondholders will receive the amounts

promised at the due dates. This will depend on a wide range of factors. High-yield bonds are bonds

that are rated below investment grade by the credit rating agencies. As these bonds are more risky

than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk

bonds.

Market Price:

The market price of a tradable bond will be influenced amongst other things by the amounts, currency

and timing of the interest payments and capital repayment due, the quality of the bond, and the

available redemption yield of other comparable bonds which can be traded in the markets. The price

can be quoted as clean or dirty. ("Dirty" includes the present value of all future cash flows including

accrued interest. Bonds are most often used in Europe. "Clean" does not include accrued interest.

Most often used in the U.S. The issue price at which investors buy the bonds when they are first

issued will typically be approximately equal to the nominal amount. The net proceeds that the issuer

receives are thus the issue price, less issuance fees. The market price of the bond will vary over its

life: it may trade at a premium (above par, usually because market interest rates have fallen since

issue), or at a discount (price below par, if market rates have risen or there is a high probability of

default on the bond).

Indentures and Covenants: An indenture is a formal debt agreement that establishes the terms of a

bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of

bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is

prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the

enforcement of these agreements, which are construed by courts as contracts between issuers and

bondholders. The terms may be changed only with great difficulty while the bonds are outstanding,

with amendments to the governing document generally requiring approval by a majority (or super-

majority) vote of the bondholders.

Optionality:Occasionally a bond may contain an embedded option; that is, it grants option-like

features to the holder or the issuer:

Callability:Some bonds give the issuer the right to repay the bond before the maturity date on the call

dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the

issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so-called call

premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting

the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but

only at a high cost.

Putability:Some bonds give the holder the right to force the issuer to repay the bond before the

maturity date on the put dates; see put option. These are referred to as retractable or putable bonds.

Call Dates and Put Dates: The dates on which callable and putable bonds can be redeemed early.

There are four main categories.

::A Bermudan callable has several call dates, usually coinciding with coupon dates.

::A European callable has only one call date. This is a special case of a Bermudan callable.

::An American callable can be called at any time until the maturity date.

::A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the

estate of a deceased bondholder to put (sell) the bond (back to the issuer) at face value in the event of

the bondholder's death or legal incapacitation. Also known as a "survivor's option".

Sinking fund provision: Sinking fund provision of the corporate bond indenture requires a certain

portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity

date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to

trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in

open market, then return them to trustees.

Types of Bond:

Different types of bonds are discusses below:

Treasury bond:

Treasury bond is a marketable, fixed-interest U.S. government debt security with a maturity of more

than 10 years. Treasury bonds make interest payments semi-annually and the income that holders

receive is only taxed at the federal level.

Treasury bonds are issued with a minimum denomination of $1,000. The bonds are initially sold

through auction in which the maximum purchase amount is $5 million if the bid is non-competitive or

35% of the offering if the bid is competitive. A competitive bid states the rate that the bidder is

willing to accept; it will be accepted depending on how it compares to the set rate of the bond. A non-

competitive bid ensures that the bidder will get the bond but he or she will have to accept the set rate.

After the auction, the bonds can be sold in the secondary market.

Specimen of Treasury bond:

A specimen of Treasury bond is given below:

Treasury bond is a negotiable, coupon-bearing debt obligation issued by the U.S. government and

backed by its full faith and credit, having a maturity of more than 7 years. Interest is paid semi-

annually. Treasury bonds are exempt from state and local taxes. These securities have the longest

maturity of any bond issued by the U.S. Treasury, from 10 to 30 years. The 30-year bond is also

called the "long bond." Denominations range from $1000 to $1 million. Treasury bonds pay interest

every 6 months at a fixed coupon rate. These bonds are not callable, but some older Treasury bonds

available on the secondary market are callable within five years of the maturity date. also called U.S.

Treasury bond or T-bond.

Treasury STRIPS:

Treasury STRIPS isan acronym for 'separate trading of registered interest and principal securities'.

Treasury STRIPS are fixed-income securities sold at a significant discount to face value and offer no

interest payments because they mature at par. These securities are Backed by the U.S. government,

STRIPS, which were first introduced in 1985, offer minimal risk and some tax benefits in certain

states, replacing TIGRs and CATS as the dominant zero-coupon U.S. security. Although you receive

no tangible income, you typically still have to pay federal income tax on the bond's accretion for the

year.

Savings Bond:

Savings bonds are debt securities issued by the U.S. Department of the Treasury to help pay for the

U.S. government‘s borrowing needs. U.S. savings bonds are considered one of the safest investments

because they are backed by the full faith and credit of the U.S. government.

Savings Bonds come in eight values: $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. After

purchase, the holder must wait at least six months before cashing it in, when they will receive the

capital plus some interest. The maturity periods can vary. For example, if you buy a bond with a value

of $50 for $25, you'll have to wait at least 17 years to get back your investment from the government.

Though you are able to wait as long as you want to get your money back, the longer you wait the

greater interest you earn. Savings Bonds are protected because they are secured by the U.S.

government. The principal and earned interest are registered with the Treasury Department, so if a

bond is lost, stolen, or destroyed they can be replaced at no cost. Savings bonds can also have value as

a collectible since the government stopped issuing them in paper form.

Specimen of Savings Bond:

A Specimen of Savings Bond is given below:

Purchasing Savings Bond:

Bonds require the purchaser to have a Treasury Direct account, which requires a social security

number, a driver's license, a checking or savings account, and an email address. The purchaser can

select the owner of the security, and the amount of the Savings Bond ($50, $100, $500, etc.) After

submitting an order, a message confirms the money will be taken out of the account within one day. A

record of the Savings Bond purchase is placed in the purchasers‘ account, as paper bonds are not

issued.

Overview of Savings Bond:

•Minimum Purchase: $25

•Maximum Purchase: $30,000 per person per year

•Interest: 90% of 6-month average of 5-year Treasury security yields, added monthly and paid when

the bond is cashed

•Minimum Term Of Ownership: 12 months

•Early Redemption Penalty: Forfeit three most recent months' if cashed before 5 years.

Municipal Bond:

A municipal bond is a bond issued by a local government, or their agencies. Potential issuers of

municipal bonds include states, cities, counties, redevelopment agencies, special-purpose districts,

school districts, public utility districts, publicly owned airports and seaports, and any other

governmental entity (or group of governments) at or below the state level. Municipal bonds may be

general obligations of the issuer or secured by specified revenues. In the United States, interest

income received by holders of municipal bonds is often exempt from the federal income tax, and may

be exempt from state income tax, although municipal bonds issued for certain purposes may not be

tax exempt. Unlike new issue stocks that are brought to market with price restrictions until the deal is

sold, municipal bonds are free to trade at any time once they are purchased by the investor.

Professional traders regularly trade and retrade the same bonds several times a week.

Corporate Bond:

A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise

money effectively in order to expand its business. The term is usually applied to longer-term debt

instruments, generally with a maturity date falling at least a year after their issue date. (The term

"commercial paper" is sometimes used for instruments with a shorter maturity.) Sometimes, the term

"corporate bonds" is used to include all bonds except those issued by governments in their own

currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of

local authorities and supranational organizations do not fit in either category. Corporate bonds are

often listed on major exchanges (bonds there are called "listed" bonds) and ECNs, and the coupon (i.e.

interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value.

However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in

most developed markets takes place in decentralized, dealer-based, over-the-counter markets. Some

corporate bonds have an embedded call option that allows the issuer to redeem the debt before its

maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into

equity. Corporate Credit spreads may alternatively be earned in exchange for default risk through the

mechanism of Credit Default Swaps which give an unfunded synthetic exposure to similar risks on the

same 'Reference Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS and the

credit spreads on corporate bonds can be significantly different.

Low and Zero Coupon Bonds:

A zero-coupon bond (also known as low-coupon bond or discount bond or deep discount bond) is a

bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It

does not make periodic interest payments, or have so-called "coupons", hence the term zero-coupon

bond. When the bond reaches maturity, its investor receives its par (or face) value. In contrast, an

investor who has a regular bond receives income from coupon payments, which are usually made

semi-annually. The investor also receives the principal or face value of the investment when the bond

matures.

Strip bonds:

Zero coupon bonds have a durationwhich is equal to the bond's time to maturity, which makes them

sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from

the principal of coupon bonds, which is known as the residue, so that different investors may receive

the principal and each of the coupon payments. This creates a supply of new zero coupon bonds.

The coupons and residue are sold separately to investors. Each of these investments then pays a single

lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are

known as strip bonds. "STRIPS" stands for Separate Trading of Registered Interest and Principal

Securities.

Dealers normally purchase a block of high-quality and non-callable bonds—often government

issues—to create strip bonds. A strip bond has no reinvestment risk because the payment to the

investor occurs only at maturity.

The impact of interest rate fluctuations on strip bonds, known as the bond duration, is higher than for

a coupon bond. A zero coupon bond always has a duration equal to its maturity; a coupon bond

always has a lower duration. Strip bonds are normally available from investment dealers maturing at

terms up to 30 years. For some Canadian bonds the maturity may be over 90 years.

In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet

their needs in a single security. These packages may consist of a combination of interest (coupon)

and/or principal strips.

In New Zealand, bonds are stripped first into two pieces—the coupons and the principal. The coupons

may be traded as a unit or further subdivided into the individual payment dates.

In most countries, strip bonds are primarily administered by a central bank or central securities

depository. An alternative form is to use a custodian bank or trust company to hold the underlying

security and a transfer agent/registrar to track ownership in the strip bonds and to administer the

program. Physically created strip bonds (where the coupons are physically clipped and then traded

separately) were created in the early days of stripping in Canada and the U.S., but have virtually

disappeared due to the high costs and risks associated with them.

Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond

holder is calculated to have a set amount of purchasing power rather than a set amount of money, but

the majority of zero coupon bonds pay a set amount of money known as the face value of the bond.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates

typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond

markets. Short-term zero coupon bonds generally have maturities of less than one year and are called

bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.

Variable-Rate Bonds:

Unlike a plain-vanilla bond, which pays a fixed rate of interest, a variable rate bond or a floating rate

bond has a variable rate that resets periodically. Typically, the rates are based on either federal funds

rate or LIBOR plus an added ―spread.‖ For instance, a rate could be quoted as ―LIBOR + 0.50%;‖ if

LIBOR stood at 1.00%, the rate would be 1.50%. While the yield changes throughout the life of the

security as prevailing interest rates fluctuate, the spread (the ―+0.50‖ in the example above) typically

stays the same. The frequency at which the yield of floating rate note resets can be daily, weekly,

monthly, or every three, six, or 12 months. Corporations, municipalities, and some foreign

governments typically offer floating rate notes – which are sometimes called ―FRNs‖. The U.S.

Treasury now issues floating rate notes as well.

Convertible Bond:

In finance, a convertible bond or convertible note (or a convertible debenture if it has a maturity of

greater than 10 years) is a type of bond that the holder can convert into a specified number of shares

of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and

equity-like features. It originated in the mid-19th century, and was used by early speculators such as

Jacob Little and Daniel Drew to counter market cornering. Convertible bonds are most often issued by

companies with a low credit rating and high growth potential.

To compensate for having additional value through the option to convert the bond to stock, a

convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The

investor receives the potential upside of conversion into equity while protecting downside with cash

flow from the coupon payments and the return of principal upon maturity. These properties lead

naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced

by a short position in the underlying equity.

From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a

reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if

the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of

reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution

expected when bondholders convert their bonds into new shares.

Junk Bond:

Junk bond is a colloquial term for a high-yield or non-investment grade bond. Junk bonds are fixed-

income instruments that carry a rating of 'BB' or lower by Standard & Poor's, or 'Ba' or below by

Moody's. Junk bonds are so called because of their higher default risk in relation to investment-grade

bonds.

Junk bonds are risky investments, but have speculative appeal because they offer much higher yields

than safer bonds. Companies that issue junk bonds typically have less-than-stellar credit ratings, and

investors demand these higher yields as compensation for the risk of investing in them. A junk bond

issued from a company that manages to turn its performance around for the better and has its credit

rating upgraded will generally have a substantial price appreciation.

Mortgages:

A mortgage, also referred to as a mortgage loan, is used by purchasers of real property to raise money

to buy the property to be purchased or by existing property owners to raise funds for any purpose.

Mortgages are long term debt obligations created to finance the purchase of real estate. The loan is

"secured" on the borrower's property. This means that a legal mechanism is put in place which allows

the lender to take possession and sell the secured property ("foreclosure" or "repossession") to pay off

the loan in the event that the borrower defaults on the loan or otherwise fails to abide by its terms. The

word mortgage is derived from a "law French" term used by English lawyers in the middle ages

meaning "death pledge", and refers to the pledge ending (dying) when either the obligation is fulfilled

or the property is taken through foreclosure.

Mortgage borrowers can be individuals mortgaging their home or they can be businesses mortgaging

commercial property (for example, their own business premises, residential property let to tenants or

an investment portfolio). The lender will typically be a financial institution, such as a bank, credit

union or building society, depending on the country concerned, and the loan arrangements can be

made either directly or indirectly through intermediaries. Features of mortgage loans such as the size

of the loan, maturity of the loan, interest rate, method of paying off the loan, and other characteristics

can vary considerably. The lender's rights over the secured property take priority over the borrower's

other creditors which means that if the borrower becomes bankrupt or insolvent the other creditors

will only be repaid the debts owed to them from a sale of the secured property if the mortgage lender

is repaid in full first. In many jurisdictions, though not all (Bali, Indonesia being one exception), it is

normal for home purchases to be funded by a mortgage loan. Few individuals have enough savings or

liquid funds to enable them to purchase property outright. In countries where the demand for home

ownership is highest, strong domestic markets for mortgages have developed.

Stock:

The stock (also capital stock) of a corporation constitutes the equity stake of its owners. It represents

the residual assets of the company that would be due to stockholders after discharge of all senior

claims such as secured and unsecured debt. Stockholders' equity cannot be withdrawn from the

company in a way that is intended to be detrimental to the company's creditors.

Shares:

The stock of a corporation is partitioned into shares, the total of which are stated at the time of

business formation. Additional shares may subsequently be authorized by the existing shareholders

and issued by the company. In some jurisdictions, each share of stock has a certain declared par value,

which is a nominal accounting value used to represent the equity on the balance sheet of the

corporation. In other jurisdictions, however, shares of stock may be issued without associated par

value. Shares represent a fraction of ownership in a business. A business may declare different types

(classes) of shares, each having distinctive ownership rules, privileges, or share values. Ownership of

shares may be documented by issuance of a stock certificate. A stock certificate is a legal document

that specifies the amount of shares owned by the shareholder, and other specifics of the shares, such

as the par value, if any, or the class of the shares.

In the United Kingdom, Republic of Ireland, South Africa, and Australia, stock can also refer to

completely different financial instruments such as government bonds or, less commonly, to all kinds

of marketable securities.

Types of Stock:

Stock typically takes the form of shares of either common stock or preferred stock. As a unit of

ownership, common stock typically carries voting rights that can be exercised in corporate decisions.

Preferred stock differs from common stock in that it typically does not carry voting rights but is

legally entitled to receive a certain level of dividend payments before any dividends can be issued to

other shareholders. Convertible preferred stock is preferred stock that includes an option for the

holder to convert the preferred shares into a fixed number of common shares, usually any time after a

predetermined date. Shares of such stock are called "convertible preferred shares" (or "convertible

preference shares" in the UK).

There are two main types of stocks: common stock and preferred stock.

Common Stock:

Common stock is, well, common. When people talk about stocks they are usually referring to this

type. In fact, the majority of stock is issued is in this form. We basically went over features of

common stock in the last section. Common shares represent ownership in a company and a claim

(dividends) on a portion of profits. Investors get one vote per share to elect the board members, who

oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost

every other investment. This higher return comes at a cost since common stocks entail the most risk.

If a company goes bankrupt and liquidates, the common shareholders will not receive money until the

creditors, bondholders and preferred shareholders are paid.In order to have a say in how the company

is run, you must own common stock. When individual investors or groups of investors (for example,

institutional investors) attempt to influence company policy or attempt a hostile takeover, they must

be shareholders in that company. Common stock does not have any guaranteed dividends; instead,

investors hope that the company will pay larger dividends from the profits. Since common shares do

not guarantee returns, these shares are more responsive to the performance of the company. Similarly,

the growth potential is greater because there is no cap on the dividends that can be paid out if the

company does very well. However, with common shares there is also the added risk of losing the

entire investment because common stockholders are generally paid only what's left after everyone else

takes their share when a company goes out of business.

Preferred Stock:

Preferred stock represents some degree of ownership in a company but usually doesn't come with the

same voting rights. (This may vary depending on the company.) With preferred shares, investors are

usually guaranteed a fixed dividend forever. This is different than common stock, which has variable

dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred

shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock

may also be callable, meaning that the company has the option to purchase the shares from

shareholders at anytime for any reason (usually for a premium).

New equity issue may have specific legal clauses attached that differentiate them from previous issues

of the issuer. Some shares of common stock may be issued without the typical voting rights, for

instance, or some shares may have special rights unique to them and issued only to certain parties.

Often, new issues that have not been registered with a securities governing body may be restricted

from resale for certain periods of time.

Preferred stock may be hybrid by having the qualities of bonds of fixed returns and common stock

voting rights. They also have preference in the payment of dividends over common stock and also

have been given preference at the time of liquidation over common stock. They have other features of

accumulation in dividend. In addition, preferred stock usually comes with a letter designation at the

end of the security; for example, Berkshire-Hathaway Class "B" shares sell under stock ticker BRK.B,

whereas Class "A" shares of ORION DHC, Inc. will sell under ticker OODHA until the company

drops the "A" creating ticker OODH for its "Common" shares only designation. This extra letter does

not mean that any exclusive rights exist for the shareholders but it does let investors know that the

shares are considered for such, however, these rights or privileges may change based on the decisions

made by the underlying company.Some people consider preferred stock to be more like debt than

equity. A good way to think of these kinds of shares is to see them as being in between bonds and

common shares.

Preferred stock is more secure than common stock because it has priority should the company go

bankrupt. However, it has less potential for growth and no voting rights, so it will generally provide

lower returns than common stock. Preferred stocks are also more likely to receive dividends which

provide a guaranteed return on the investment. However, if you have no aspirations of owning the

company and are looking for a stable investment, preferred stock may be a good option.

Different Classes of Stock:

Common and preferred are the two main forms of stock; however, it's also possible for companies to

customize different classes of stock in any way they want. The most common reason for this is the

company wanting the voting power to remain with a certain group; therefore, different classes of

shares are given different voting rights. For example, one class of shares would be held by a select

group who are given ten votes per share while a second class would be issued to the majority of

investors who are given one vote per share.

When there is more than one class of stock, the classes are traditionally designated as Class A and

Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The different forms are

represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or

"BRK.A, BRK.B".

Stock Derivatives:

A stock derivative is any financial instrument which has a value that is dependent on the price of the

underlying stock. Futures and options are the main types of derivatives on stocks. The underlying

security may be a stock index or an individual firm's stock, e.g. single-stock futures. Stock futures are

contracts where the buyer is long, i.e., takes on the obligation to buy on the contract maturity date, and

the seller is short, i.e., takes on the obligation to sell. Stock index futures are generally not delivered in

the usual manner, but by cash settlement.

A stock option is a class of option. Specifically, a call option is the right (not obligation) to buy stock

in the future at a fixed price and a put option is the right (not obligation) to sell stock in the future at a

fixed price. Thus, the value of a stock option changes in reaction to the underlying stock of which it is

a derivative. The most popular method of valuing stock options is the Black Scholes model. Apart

from call options granted to employees, most stock options are transferable.

Derivative Securities:

In finance, a derivative security is a special type of contract which derives its value from the

performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and

is often called the "underlying". Derivative securities can be used for a number of purposes -

including insuring against price movements (hedging), increasing exposure to price movements for

speculation or getting access to otherwise hard to trade assets or markets.

Some of the more common derivative securities include futures, forwards, swaps, options, and

variations of these such as caps, floors, collars, and credit default swaps. Most derivatives are traded

over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while

most insurance contracts have developed into a separate industry. Derivative securities are one of the

three main categories of financial instruments, the other two being equities (i.e. stocks or shares) and

debt (i.e. bonds and mortgages).

Derivative securities usually takes the form of an agreement to buy or sell an asset or item

(commodity, property, security) at a fixed price on or before a certain date. Derivative securities are

traded on exchanges like other financial instruments, and their value varies with the value of the

underlying assets (which are traded separately from the derivatives). Futures contracts, forward

contracts, options and swaps are some common types of derivatives used in hedging or to gain

leverage. Also called contingent claim since the payoff from a derivative is dependent upon whether

or not some event occurs.

Derivatives are a contract between two parties that specify conditions (especially the dates, resulting

values and definitions of the underlying variables, the parties' contractual obligations, and the notional

amount) under which payments are to be made between the parties.[3][4] The most common

underlying assets include commodities, stocks, bonds, interest rates and currencies, but they can also

be other derivatives, which adds another layer of complexity to proper valuation. The components of a

firm's capital structure, e.g. bonds and stock, can also be considered derivatives, more precisely

options, with the underlying being the firm's assets, but this is unusual outside of technical contexts.

There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivative

securities such as swaps that do not go through an exchange or other intermediary, and exchange-

traded derivatives (ETD) that are traded through specialized derivatives exchanges or other

exchanges.

Derivative securities are more common in the modern era, but their origins trace back several

centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice

Exchange since the eighteenth century. Derivative securities are broadly categorized by the

relationship between the underlying asset and the derivative (such as forward, option, swap); the type

of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives,

commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-

traded or over-the-counter); and their pay-off profile.

Derivative securities may broadly be categorized as "lock" or "option" products. Lock products (such

as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the

contract. Option products (such as interest rate caps) provide the buyer the right, but not the obligation

to enter the contract under the terms specified.

Derivative securities can be used either for risk management (i.e. to "hedge" by providing offsetting

compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a

financial "bet"). This distinction is important because the former is a prudent aspect of operations and

financial management for many firms across many industries; the latter offers managers and investors

a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.

Along with many other financial products and services, derivative securities reform is an element of

the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many

rule-making details of regulatory oversight to the Commodity Futures Trading Commission and those

details are not finalized nor fully implemented as of late 2012.

A derivative security, also known as a derivative stock, is a financial instrument whose price is

dependent on one or a number of underlying financial assets. In itself, the derivative security is no

more than an agreement between two contracted parties to buy or sell an asset at a fixed price on or

before a date of expiration. The value of the security is dictated by the value of the underlying asset,

which is usually a stock, a commodity, a bond, currency, interest rates or markets indexes. Derivative

securities usually are valued by using a version of the Black-Scholes Option Pricing Model.

A derivative security is particularly appealing to those investors looking to offset or hedge their risk

when investing, but a number of other financial players also take an interest in stock derivatives from

a range of motives. Among these other players stand most prominently the speculators and arbitrators

who are less interested in off-setting or hedging risk and are instead motivated by the prospective

profit that stock derivative speculation can bring. Some other players who typically participate in the

stock derivatives market are brokers, banks, financial institutions, and commodity trading advisers.

The term derivative is commonly used to describe a type of security whose market value is directly

related to, or derived from, another traded security. Option, futures, and forward contracts are

examples of derivatives as well as stock warrants, swap agreements and other more exotic variations.

A simple example of a derivative would be a call option on a company's stock. The most important

determinant of the price of the option is the current price of the company's shares on the open market

(the underlying asset).

The development of derivative securities has facilitated the market for risk associated with a certain

asset, apart from its actual ownership. Consider the following example: A farmer wishes to hold his

corn crop until spring because prices tend to be higher in spring than in the fall. However, he doesn't

like the uncertainty that comes with waiting six months to know the value of the corn crop. Futures

contracts would allow the farmer to keep the corn until spring yet lock in the current price. The

contract would, in effect, sell off the price uncertainty to someone in the market that is willing to hold

it. In this case the farmer has hedged his risk of a price drop. The person who accepts the risk is

engaged in the practice of speculation. It was the need for this type of transaction that spawned the

first derivative securities markets; medieval Japan, for example, was known to have organized trading

in rice futures.

OPTIONS:

Call options are securities that allow a person to buy a stock at a specified price, known as the

exercise (or strike) price, on or before a certain date, known as the expiration date. For example, IBM

call options at 50 would refer to a security that allows the buyer to acquire a share of IBM stock for

$50 any time on, or before, the expiration date. As long as the price of IBM is greater than $50,

exercising the option would generate positive cash flow when the stock is purchased by the

optionholder and then sold to another investor. If IBM stock sells for less than $50 there is no

obligation to exercise (and lose money), hence the name option. The amount of money paid to acquire

the option is known as the option premium.

Put options are similar to call options except that they give the buyer the right to sell stock at a

specific price instead of buying it. Following the previous example, if IBM stock is below $50 then

the buyer of the option could exercise the option and generate a positive cash flow. Here, the stock is

purchased for less than $50 then immediately sold at the exercise value. Once again, the buyer of the

option is under no obligation to exercise.

On the opposite side of every option purchase is someone who agrees to sell either the put or call.

This investor accepts the premium payment up front, and also accepts the risk that the buyer will later

exercise the option, forcing them to pay the buyer whatever the amount of positive cash flow the

exercise generates. The premium is determined in the open market as the value that equates buy

orders with sell orders.

Futures and Forward Contracts:

Futures contracts are agreements to buy or sell assets at some time in the future. The first futures

markets were for agricultural commodities such as corn and wheat, but now items such as Treasury

bond futures, foreign exchange futures, and stock index futures trade far higher volumes than do

agricultural futures.

The unit of trade on the futures exchange is one contract, which varies in size with the amount of the

commodity traded. For example, a September corn futures contract could be an agreement to buy

5,000 bushels of corn in September at the stated price. A Treasury bond futures contract may require

delivery of $100,000 face value of treasury bonds at the stated date. The futures price is the price that

matches buyers of these contracts with sellers.

In theory, no money needs to change hands when the agreement is made since it is a future sale or

purchase; however, a cash deposit, called a margin, must be established up front. During the period

prior to the expiration of the contract, gains and losses from the movement of the futures price are

charged directly to the investor's margin account. This process, which occurs on a daily basis, is

called "marking-to-market". For example, if the futures price of corn goes down $.10 a bushel, then

anyone holding a previously purchased contract would be asked to pay the extra $.10 per bushel on

the aggregate quantity. The party who sold the contract would be paid the amount over market price

that they are due immediately.

Forward contracts work similarly to futures except they are not traded on formal exchanges, and they

are not marked-to-market. Gains and losses accrue until the contract's expiration date or until the

holder of the contract reverses his position. Forward contracts are used mainly by large corporations

and financial institutions to hedge foreign exchange risk.

Other Derivative Securities:

Warrants are essentially call options given by a company for their own stock, usually as "sweetener"

along with a bond issue. When this occurs, the buyer of a bond with an attached warrant will receive

the bond and a call option with an expiration date of several years or more. Convertible bonds are

very similar except that the bond is converted into stock if the holder chooses to exercise the

option.Interest rate swaps are agreements to trade fixed interest rate payments for floating interest rate

payments in return for a premium. Currency swaps are agreements to exchange debt in two different

currencies. Although these, and other derivatives, are complicated, they can generally be analysed as

extensions of either the basic options or basic futures contracts. In fact, the diversity of the derivatives

markets is so great there are even options on futures contracts.

Hedging:

Almost all participants in derivative securities markets may be classified as hedgers, speculators, or

arbitrageurs. However, the same participant may fill different roles at different times. A market

participant is said to be hedging if he uses the derivative market to manage his exposure to risk.

Common examples of hedging include:

A food processor with commitments to buy grain at market price in the future will buy futures

contracts now so that future increases in grain price will be offset by gains in the futures market.

A large international pension fund buys or sells foreign currency forward so that any losses in value of

their foreign stock holdings due to currency movements will be offset by gains in the value of the

forward contract.

A corporation that plans to take over another company may buy stock index futures to protect against

a general market price increase during the time that shares are being acquired. If the company is going

to hold a large position for a long time they may also use call and put options to protect against stock

price movements. For example, buying puts will compensate for lost value if the stock price falls.

Selling calls will allow the company to pay for the puts, and if the stock price goes up, the losses on

the calls are compensated for by the fact that the stock itself is worth more.

In general, hedging with futures and forward contracts requires taking a position opposite to the

position one holds in the primary market. Generally, options hedging involves buying puts or selling

calls to protect against declines in the value of stock one owns. Other, more complicated variants also

exist.

Speculation:

Speculators are derivative securities market participants who do not hold the underlying assets. A

speculator does not buy futures contracts because he expects to purchase a commodity later. A

speculator buys futures contracts merely because he believes that the price of the commodity will

increase beyond the current price. If this happens the speculator makes money, without ever needing

to buy the actual asset. The drawback is that should the futures price of the commodity fall; the

speculator will lose money, again without ever actually having owned the asset. Needless to say,

speculation is extremely risky and scrupulous brokers will only handle these transactions for

sophisticated clients who thoroughly understand the risks involved.

Speculation in options is similar; traders who believe a security is increasing in price would buy calls,

and those who believe it is falling would buy puts. There are a number of complicated strategies,

given fancy names such as the "butterfly spread," the "straddle," etc., but they all serve the same

purpose. Namely, to design a payoff structure such that the speculator makes money when the asset

price moves in the proper direction. Should the asset fail to move in the desired direction, the option

premiums paid are lost without the receipt of any physical goods?It has long been debated among

economists whether speculators are good for the market. Although some people still argue that

speculation can be destabilizing, most agree that speculators are necessary participants in the market

who help provide liquidity that hedgers need to trade.

Derivative securities markets play an important role by allowing investors who do not want the risks

associated with holding an asset to transfer it to those who do. However, because they are markets for

risk as opposed to physical assets, derivatives markets can be very dangerous places for

unsophisticated investors. People who reduce their risk by entering a derivative market are called

hedgers, and those who increase their risk are called speculators. The derivative securities markets

play a vital role in the modern financial systems and without them many common business

transactions would be rendered much riskier or practically impossible.

So, these are the securities which are commonly traded in financial market.

Reference & Bibliography:

The references which have been useful in making this term-paper are given below:

1) Financial Markets and Institutions.

By Jeff Madura.

2) www.google.com

3) Wikipedia

4) Investopedia