International Financial market

In economics, a financial market is a mechanism that allows people to buy and

sell (trade) financial securities (such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of value at low transaction costs
and at prices that reflect the efficient-market hypothesis.

Both general markets (where many commodities are traded) and specialized markets
(where only one commodity is traded) exist. Markets work by placing many interested
buyers and sellers in one "place", thus making it easier for them to find each other. An
economy which relies primarily on interactions between buyers and sellers to allocate
resources is known as a market economy in contrast either to a command economy or to a
non-market economy such as a gift economy.

In finance, financial markets facilitate:

• The raising of capital (in the capital markets)

• The transfer of risk (in the derivatives markets)
• International trade (in the currency markets)

– and are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back the capital.
These receipts are securities which may be freely bought or sold. In return for lending
money to the borrower, the lender will expect some compensation in the form of interest
or dividends.

In mathematical finance, the concept of a financial market is defined in terms of a

continuous-time Brownian motion stochastic process.
DEFINITION

In economics, typically, the term market means the aggregate of possible buyers
and sellers of a certain good or service and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations
that facilitate the trade in financial securities, e.g., a stock exchange or commodity
exchange. This may be a physical location (like the NYSE) or an electronic system (like
NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions
(merger, spinoff) are outside an exchange, while any two companies or people, for
whatever reason, may agree to sell stock from the one to the other without using an
exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade
on a stock exchange, and people are building electronic systems for these as well, similar
to stock exchanges.

Financial markets can be domestic or they can be international.

The financial markets can be divided into different subtypes:

• Capital markets which consist of:

o Stock markets, which provide financing through the issuance of shares or
common stock, and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.
• Commodity markets, which facilitate the trading of commodities.
• Money markets, which provide short term debt financing and investment.
• Derivatives markets, which provide instruments for the management of financial
risk.
• Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
• Insurance markets, which facilitate the redistribution of various risks.
 • Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly formed
(issued) securities are bought or sold in primary markets. Secondary markets allow
investors to sell securities that they hold or buy existing securities.The transaction in
primary market exist between investors and public while secondary market its between
investors

FINANCIAL INSTRUMENT

A financial instrument is either cash; evidence of an ownership interest in an entity; or a

contractual right to receive, or deliver, cash or another financial instrument.

A real or virtual document representing a legal agreement involving some sort of

monetary value. In today's financial marketplace, financial instruments can be classified
generally as equity based, representing ownership of the asset, or debt based, representing
a loan made by an investor to the owner of the asset. Foreign exchange instruments
comprise a third, unique type of instrument. Different subcategories of each instrument
type exist, such as preferred share equity and common share equity.

CATEGORIZATION

Financial instruments can be categorized by form depending on whether they are cash
instruments or derivative instruments:

• Cash instruments are financial instruments whose value is determined directly

by markets. They can be divided into securities, which are readily transferable,
and other cash instruments such as loans and deposits, where both borrower and
lender have to agree on a transfer.
• Derivative instruments are financial instruments which derive their value from
the value and characteristics of one or more underlying assets. They can be
divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.
Alternatively, financial instruments can be categorized by "asset class" depending on
whether they are equity based (reflecting ownership of the issuing entity) or debt based
(reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further
categorised into short term (less than one year) or long term.

Foreign Exchange instruments and transactions are neither debt nor equity based and
belong in their own category.

FUTURES

In finance, a futures contract is a standardized contract between two parties to buy or

sell a specified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a
specified future date at a price agreed today (the futures price). The contracts are traded
on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds,
rights or warrants. They are still securities, however, though they are a type of derivative
contract. The party agreeing to buy the underlying asset in the future assumes a long
position, and the party agreeing to sell the asset in the future assumes a short position.

The price is determined by the instantaneous equilibrium between the forces of supply
and demand among competing buy and sell orders on the exchange at the time of the
purchase or sale of the contract.

In many cases, the underlying asset to a futures contract may not be traditional
"commodities" at all – that is, for financial futures, the underlying asset or item can be
currencies, securities or financial instruments and intangible assets or referenced items
such as stock indexes and interest rates.

The future date is called the delivery date or final settlement date. The official price of
the futures contract at the end of a day's trading session on the exchange is called the
settlement price for that day of business on the exchange.[1]

A closely related contract is a forward contract; they differ in certain respects. Futures
contracts are very similar to forward contracts, except they are exchange-traded and
defined on standardized assets.[2] Unlike forwards, futures typically have interim partial
settlements or "true-ups" in margin requirements. For typical forwards, the net gain or
loss accrued over the life of the contract is realized on the delivery date.

A futures contract gives the holder the obligation to make or take delivery under the
terms of the contract, whereas an option grants the buyer the right, but not the obligation,
to establish a position previously held by the seller of the option. In other words, the
owner of an options contract may exercise the contract, but both parties of a "futures
contract" must fulfill the contract on the settlement date. The seller delivers the
underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is
transferred from the futures trader who sustained a loss to the one who made a profit. To
exit the commitment prior to the settlement date, the holder of a futures position has to
offset his/her position by either selling a long position or buying back (covering) a short
position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, (but not future or future contract) are exchange-
traded derivatives. The exchange's clearing house acts as counterparty on all contracts,
sets margin requirements, and crucially also provides a mechanism for settlement.[3]

Risks and Advantages of Futures

The terms ‘options’ and ‘futures’ appear together often enough to confuse even
knowledgeable traders into thinking they are the same thing. But, while they have
important similarities, options and futures are distinct trading instruments.

An option is a contract conferring the right to its buyer to purchase an underlying asset at
a fixed price (the ’strike price’). The right – not the obligation. A futures contract, by
contrast, obligates the buyer (the ‘long position’) to purchase and the seller (the ’short
position’) to deliver some asset by a set date.
That underlying asset, in either case, can be a commodity (such as wheat, oil, gold),
shares of stock, or some more nebulous instrument such as an index. Since an index is
just a number no physical delivery is possible, such trades are settled in cash.

Futures have value as a mechanism for trading risk, publishing prices, and (like options)
taking speculative advantage of leverage.

A farmer may not know in April precisely how much wheat he can deliver. Insect
damage, droughts and other kinds of crop failure are even today very much real supply
problems. Similarly, he can’t predict in April exactly how much demand will exist in
October. (In part, that depends on the supply.)

Selling a futures contract allows him to offload that risk to someone willing to bear it. He
obtains a set price commitment today in exchange for a promise to deliver a good by a
certain date in the future. On the other side of the contract, the buyer offers a promise
today to accept delivery of the good in the future.

Neither knows with certainty what the market price will be on the expiration date of the
contract, only what the market price is on the day it’s entered.

For the contract buyer, a future offers several values in exchange for accepting the
obligation to take delivery of (and pay for) a set amount of goods at a pre-set price.

One major value is, as in the case of options, the use of leverage. While options require
paying of a premium (usually around 5%-10% of the current market price), futures have
no in-built cost (apart from a small commission).

The buyer is required, though, to put up a ‘good-faith’ deposit, also in the neighborhood
of 5% of the total. But that margin deposit allows the trader to control 10-20 times the
amount of good he would otherwise have to pay for. That ‘multiplied control’ is leverage.

[Note: Though it's called a 'margin', it's NOT the same as buying stocks 'on margin'. In
the latter case, that is a form of borrowing - with the broker lending the trader the amount
needed to purchase all the shares the trader then owns.]
As a practical matter, a very small percentage of futures contracts actually result in the
buyer accepting delivery of, say, 1000 barrels of oil. While the behind-the-scenes
mechanics are somewhat complicated, at expiration the goods are ultimately transferred
to brokers who sell them to those who actually make use of them.

To the traders the exchange is simple, though. Any change in prices is reflected in the
accounts of the trading partners at the end of each day’s trade. At some point the contract
is either sold (the most frequent result) or expires.

Option
In finance, an option is a derivative financial instrument that establishes a contract
between two parties concerning the buying or selling of an asset at a reference price. The
buyer of the option gains the right, but not the obligation, to engage in some specific
transaction on the asset, while the seller incurs the obligation to fulfill the transaction if
so requested by the buyer. The price of an option derives from the difference between the
reference price and the value of the underlying asset (commonly a stock, a bond, a
currency or a futures contract) plus a premium based on the time remaining until the
expiration of the option. Other types of options exist, and options can in principle be
created for any type of valuable asset.

An option which conveys the right to buy something is called a call; an option which
conveys the right to sell is called a put. The reference price at which the underlying may
be traded is called the strike price or exercise price. The process of activating an option
and thereby trading the underlying at the agreed-upon price is referred to as exercising it.
Most options have an expiration date. If the option is not exercised by the expiration date,
it becomes void and worthless.

In return for granting the option, called writing the option, the originator of the option
collects a payment, the premium, from the buyer. The writer of an option must make
good on delivering (or receiving) the underlying asset or its cash equivalent, if the option
is exercised.
An option can usually be sold by its original buyer to another party. Many options are
created in standardized form and traded on an anonymous options exchange among the
general public, while other over-the-counter options are customized to the desires of the
buyer on an ad hoc basis, usually by an investment bank.

The Advantages of Options

1. Cost Efficiency
Options have great leveraging power. As such, an investor can obtain an option
position that will mimic a stock position almost identically, but at a huge cost
savings. For example, in order to purchase 200 shares of an $80 stock, an investor
must pay out $16,000. However, if the investor were to purchase two $20 calls
(with each contract representing 100 shares), the total outlay would be only
$4,000 (2 contracts x 100 shares/contract x $20 market price). The investor would
then have an additional $12,000 to use at his or her discretion. Obviously, it is not
quite as simple as that. The investor has to pick the right call to purchase (a topic
for another discussion) in order to mimic the stock position properly. However,
this strategy, known as stock replacement, is not only viable but also practical and
cost efficient. (For more on this strategy, see Using Options Instead Of Equity.)

2. Less Risk - Depending on How You Use Them

There are situations in which buying options is riskier than owning equities, but
there are also times when options can be used to reduce risk. It really depends on
how you use them. Options can be less risky for investors because they require
less financial commitment than equities, and they can also be less risky due to
their relative imperviousness to the potentially catastrophic effects of gap
openings.

3. Higher Potential Returns

You don't need a calculator to figure out that if you spend much less money and
 make almost the same profit, you'll have a higher percentage return. When they
pay off, that's what options typically offer to investors.

4. More Strategic Alternatives

The final major advantage of options is that they offer more investment
alternatives. Options are a very flexible tool. There are many ways to use options
to recreate other positions. We call these positions synthetics.

Synthetic positions present investors with multiple ways to attain the same
investment goals, and this can be very, very useful. While synthetic positions are
considered an advanced option topic, there are many other examples of how
options offer strategic alternatives. For example, many investors use brokers that
charge a margin when an investor wants to short a stock. The cost of this margin
requirement can be quite prohibitive. Other investors use brokers that simply do
not allow for the shorting of stocks, period. The inability to play the downside
when needed virtually handcuffs investors and forces them into a black-and-white
world while the market trades in color. But no broker has any rule against
investors purchasing puts to play the downside, and this is a definite benefit of
options trading.

The use of options also allows the investor to trade the market's "third
dimension", if you will: no direction. Options allow the investor to trade not only
stock movements, but also the passage of time and movements in volatility. Most
stocks don't have large moves most of the time. Only a few stocks actually move
significantly, and then they do it rarely. Your ability to take advantage of
stagnation could turn out to be the factor that decides whether your financial goals
are reached or whether they remain simply a pipe dream. Only options offer the
strategic alternatives necessary to profit in every type of market.

Swap
In finance, a swap is a derivative in which counterparties exchange certain benefits of
one party's financial instrument for those of the other party's financial instrument. The
benefits in question depend on the type of financial instruments involved. For example, in
the case of a swap involving two bonds, the benefits in question can be the periodic
interest (or coupon) payments associated with the bonds. Specifically, the two
counterparties agree to exchange one stream of cash flows against another stream. These
streams are called the legs of the swap. The swap agreement defines the dates when the
cash flows are to be paid and the way they are calculated. [1] Usually at the time when the
contract is initiated at least one of these series of cash flows is determined by a random or
uncertain variable such as an interest rate, foreign exchange rate, equity price or
commodity price.[1]

The cash flows are calculated over a notional principal amount, which is usually not
exchanged between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices.

The first swaps were negotiated in the early 1980s.[1] David Swensen, a Yale Ph.D. at
Salomon Brothers, engineered the first swap transaction according to "When Genius
Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein.
Today, swaps are among the most heavily traded financial contracts in the world: the
total amount of interest rates and currency swaps outstanding is more thаn $426.7 trillion
in 2009, according to International Swaps and Derivatives Association (ISDA).

ADVANTAGES

1. Borrowing at Lower Cost:

Swap facilitates borrowings at lower cost. It works on the principle of the theory of
comparative cost as propounded by Ricardo. One borrower exchanges the comparative
advantage possessed by him with the comparative advantage possessed by the other
borrower. The net result is that both the parties are able to get funds at cheaper rates.

2. Access to New Financial Markets:

Swap is used to have access to new financial markets for funds by exploring the
comparative advantage possessed by the other party in that market. Thus, the comparative
advantage possessed by parties is fully exploited through swap. Hence, funds can be
obtained from the best possible source at cheaper rates.

3. Hedging of Risk:

Swap cal also be used to hedge risk. For instance, a company has issued fixed rate bonds.
It strongly feels that the interest rate will decline in future due to some changes in the
economic scene. So, to get the benefit in future from the fall in interest rate, it has to
exchange the fixed rate obligation with floating rate obligation. That is to say, the
company has to enter into swap agreement with a counterparty, whereby, it has to receive
fixed rate interest and pay floating rate interest. The net result is that the company will
have to pay only floating rate of interest. The fixed rate it has to pay is compensated by
the fixed rate it receives from the counterparty. Thus, risks due to fluctuations in interest
rate can be overcome through swap agreements. Similar, agreements can be entered into
for currencies also.

4. Tool to correct Asset-Liability Mismatch:

Swap can be profitably used to manage asset-liability mismatch. For example, a bank has
acquired a fixed rate bearing asset on the one hand and a floating rate of interest bearing
liability on the other hand. In case the interest rate goes up, the bank would be much
affected because with the increase in interest rate, the bank has to pay more interest. This
is so because, the interest payment is based on the floating rate. But, the interest receipt
will not go up, since, the receipt is based on the fixed rate. Now, the asset- liability
mismatch emerges. This can be conveniently managed by swap. If the bank feels that the
interest rate would go up, it has to simply swap the fixed rate with the floating rate of
interest. It means that the bank should find a counterparty who is willing to receive a
fixed rate interest in exchange for a floating rate. Now, the receipt of fixed rate of interest
by the bank is exactly matched with the payment of fixed rate interest to swap
counterparty. Similarly, the receipt of floating rate of interest from the swap counterparty
is exactly matched with the payment of floating interest rate on liabilities. Thus, swap is
used as a tool to correct any asset- liability mismatch in interest rates in future.

5. ADDITIONAL INCOME:

By arranging swaps, financial intermediaries can earn additional income in the form of
brokerage.

Related posts:

1. Financial derivative types: Swaps

2. Advantages and limitations of universal banking
3. Advantages and disadvantages of the Depository System

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