Capital Markets Foundation Course

Capital Markets Foundation Course
Summary Duration
This course provides a good understanding of Capital
Markets and how they work. It also gives an overview of 10 hours
various financial instruments/ products used, capital
market mechanics, interactions & operations.
Entry Criteria Target Audience

None All Capco employees working in the
Capital Markets domain.
Learning Objectives Topics Covered

 Articulate the characteristics  Introduction to Capital Markets
of Capital Markets and how
they work  Dynamics of Capital Markets
 Describe the various types  Market Sectors

of Markets and Instruments  Financial Instruments/ Products
 Detail the Trading Life Cycle (Cash & Derivative Segments)
 Explain Capital Market  The Life of a Trade

Mechanics, Interactions &  Loan Activity Securitization
Operations
 Asset Management
1 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Capital Markets
Foundation Course
March 2012
Learning Objectives
 Articulate the characteristics of Capital Markets and how

they work
 Describe the various types of Markets and Instruments
 Detail the Trading Life Cycle
 Explain Capital Market Mechanics, Interactions & Operations

Topics Covered
 Introduction to Capital Markets

 Dynamics of Capital Markets
 Market Sectors
 Financial Instruments/ Products (Cash & Derivative
Segments)
 The Life of a Trade
 Loan Activity Securitization
 Asset Management

INTRODUCTION TO CAPITAL
MARKETS
Capital is the “life blood” of a business
To Sustain To Grow
Businesses
need Capital
To Expand To Diversify

Capital means different things to different people
Economists define capital

To many people, it is the
as assets other than labor
value of their assets like
and land, which are used to
property, bank deposits,
facilitate production. ‘Capital
cars, jewelry, etc - net of
Goods’ include plant and
their liabilities.
machinery.
In financial markets, capital refers to

financial instruments, in particular fixed
income securities and equities.

Financial instruments can be of various types
Stocks Bonds Foreign Exchange
Fixed Deposits Futures Options

Trading of financial instruments takes place in
Capital Markets
Capital Markets
Capital Markets are financial

In these markets, medium and
markets in which financing
long term finance is raised,
instruments like stocks and
facilitating the flow of funds.
bonds are bought and sold.

Capital Markets allow buyers of financial instruments
to meet sellers of financial instruments
Buyers Sellers
(Buy financial (Sell financial
instruments and instruments and
supply cash) receive cash)

There are two categories of buyers and sellers
Man on the street

Retail (Indirect investors/
issuers)
Buyers and
Sellers
Financial companies
which invest their client
money in a portfolio of
Institutional securities on a pooled
basis, or issue financial
instruments

These buyers and sellers are of different types
Supra-nationals
Governments
Local Governments
Government agencies/ Public
Sector Organizations
Firms
Banks
Finance Companies
Savings Institutions
Individuals

Capital markets facilitate transactions between
buyers and sellers
generated cash financial assets
Need financing Surplus funds

require cash to
Firms investment invest Investors
dividends/interest
Capital Markets
Reinvestment

DYNAMICS OF CAPITAL
MARKETS
Capital Markets use various market mechanisms
Order driven Quote driven

OTC market
market market
• Buy and sell • Prices are • No standards, all

instructions are determined negotiable
fed into a central principally by • 24-hour trading
computer system professional activity
• Automatic dealers’ bid/offer
matching quotations
• Order
management

There are two types of Capital Markets
Primary Markets Secondary Markets
• Where new financial • Where existing financial

instruments are created. instruments are traded
• Original issue of stocks, • Provide liquidity
bonds and other financial • Operate through
assets takes place • Official exchanges
Eg. Stock Exchange
• OTC (Over the counter)
market Eg. NASDAQ)

Capital Markets offer two key benefits
Price discovery
process
Efficiency

The price discovery process is used to
determine the market price of an instrument
Price discovery process

The interactions of buyers and sellers in the financial market
determines the price of an asset/ required return on an asset.
The market price

Should reflect all available Should adjust quickly to new
information information

Efficiency (operational and informational) is the key to
the effective functioning of the Capital Markets
Trading Large number of Low cost of

convenience participants trading
Rapid execution
of trades

MARKET SECTORS
Capital Markets are divided into five market
sectors
Foreign
Equity Debt Money Commodity
Exchange
Markets Markets Markets Markets
Markets

These market sectors are categorized based on the
financial instruments/ products traded in them
• Markets in which shares are issued and

Equity Markets traded
• Markets where participants can issue new

Debt Markets debt, or buy and sell debt instruments like
Bonds
Foreign Exchange • Markets where currencies are bought, sold or

exchanged
Markets
• Markets in which financial instruments with
Money Markets high liquidity and very short maturities are
traded
• Markets that deal with the buying and selling

Commodity Markets of raw materials (commodities) via standard
contracts

There are two forms of financial instruments
used for trading
Derivative instruments
Cash instruments A derivative instrument is a
A cash instrument is a financial contract between two parties
instrument that is traded for that specifies conditions under
cash. which payments are to be made
between the parties.

Some examples of cash and derivative
instruments used in these market sectors…
Foreign
Exchange
Markets
Cash Cash Cash Cash Cash

instruments instruments instruments instruments instruments
(Shares) (Bonds) (FX Spot) (Fixed (Metals,
deposits, Energy,
Certificate of Grains)
deposit)
Derivative Derivative Derivative Derivative Derivative

instruments instruments instruments instruments instruments
(Equity (Bond (FX (FRA, MM (Commodity
derivatives derivatives, derivatives) Future) derivatives)
and Interest rate
warrants) derivatives)

The Capital Market structure summarized
Equity Debt Foreign Money Commodity

Markets Markets Exchange Markets Markets
Markets
Cash Shares Bonds FX spot Deposits Metals

Certificate of Energy
deposit (CD)
Commercial
Paper (CP)
Repo
Equity Bond / fixed FX derivatives FRA Commodity

Derivatives
derivatives income MM future derivatives
Warrants derivatives
Interest rate
derivatives
Credit default
swaps (CDS)
Securitization
(e.g. MBS /
ABS)

FINANCIAL INSTRUMENTS/
PRODUCTS (CASH SEGMENT)
We will now look at financial instruments/
products traded across market sectors
Foreign
Exchange
Markets

Foreign
Exchange
Markets

Equity represents ownership
Equity
Equity, i.e. stocks & shares, are financial

instruments representing ownership interest in
a corporation or a similar entity.

An investor/ trader can acquire Equity through
the primary or secondary markets
Through secondary
Through primary markets
markets
 In primary markets, new  In secondary markets,

stocks/ shares are sold to existing stocks/ shares are
investors/ general public sold and bought by
through a “public issue”, via investors or traders, usually
a mechanism known as through a stock exchange
“underwriting”. or OTC markets.

Equity has two distinct characteristics
A share in the profit the

company makes Voting rights at AGMs
(Dividends)
Dividends -
payments declared Pro-rata on your
quarterly, six- share holding
monthly, yearly

The value of a stock is influenced by various
factors
Factors affecting value of a Where this information is

stock available
• Company profile • Annual reports and balance

• Sector profile sheets
• Tax regime • Research publishers such as
• Political climate S & P, D & B
• Social climate • Registrar of Companies
• Cyclical climate • Stock Exchanges / Market
information / SEBI
• Energy prices
• Stockbrokers’ circulars
• Commodity prices
• The Press
• Interest rates

Some of the popular Stock Exchanges / Indices
are…
NYSE (New York Stock
Exchange)
• Dow Jones Industrials (since Tokyo Stock Exchange: Hong Kong Stock
1894) Nikkei 225 Exchange: Hang Seng
• Standard and Poors 500
• NASDAQ Composite -
Technology stocks
Frankfurt Stock London Stock Paris Stock Exchange:

Exchange: DAX Exchange: FTSE100 CAC40
National Stock
Exchange / BSE: Nifty /
Sensex

Equity can be affected by Corporate Actions/
Events
Corporate Action/ Event
A corporate action is an event initiated by a public company that affects

the securities (both in price and in number) issued by the company.
Why do companies use corporate actions?
To influence the share price

Here are some examples of Corporate Actions
Dividend payment Scrip issues

(Stock and Cash) (Bonus)
Corporate Actions
(Events)
Stock splits Rights issues

Dividends are payments made by a company to
its shareholders
Dividends
(Cash)
When a company earns a profit or surplus, that money

can be put to two uses: it can either be re-invested in
the business or it can be distributed to shareholders.
The amount that is distributed to shareholders is called

Dividend. Shareholders receive dividends in proportion
to their shareholding.

Trading in shares continues between the time a
dividend is announced and the dividend is paid
Ex Dividend (EX)
• A stock trades “cum
dividend” when the price
of the share includes the • A stock trades “ex
right to receive a dividend” when the price
dividend which has of the share does not
been announced include the right to
receive the dividend (i.e.
the seller will receive the
dividend).
Cum Dividend (CD)
A stock trades cum-dividend up until the ex-dividend date. On or after this point,
the stock trades without its dividend rights.

The dividend payment process…
TIME
Shares start Shares start Record date Dividend is

trading Cum trading Ex •Deadline for paid
dividend dividend registration by •Dividend paid to
cum dividend cum dividend
•Company •From this date, shareholders to
announces new purchasers shareholders
receive dividends. registered by
dividend of shares are not
•Done by registrar record date
•Press release entitled to
•Vendor declared dividend
(Telekurs/ •Price will
Bloomberg) decrease to
•From this date represent loss of
purchasers of built in value
shares are
entitled to
declared
dividends

A company may allot additional shares free of
charge to existing shareholders
Scrip Issues (Bonus)
• A Scrip Issue is the process of creating new shares

which are given free of charge to existing
shareholders.
• Through a Scrip Issue, while the number of shares in
existence has expanded, the value of the company
has not increased. This means that the relative value
of each pre-existing share has been reduced.

Companies may use corporate events like “Stock
Splits” to increase the liquidity
• A Stock Split is used to achieve a

share price reduction by increasing
the number of shares.
• The price is adjusted such that the
Stock Split market capitalization (total value of
tradable shares) of the company
before and after the stock split
remains the same, and dilution does
not occur.

Companies usually turn to “Rights Issues” to
raise money when they really need it
Rights Issue
• A rights issue is an invitation to existing shareholders to

purchase additional new shares in the company at a
discount to the market price on a stated future date.
• Companies may usually turn to rights issues to raise
money:
• When they need to pay debt and are unable to borrow
more money
• To fund acquisitions and growth strategies

There are different forms of Equity trading
Forms of Equity
Trading
Shares
Participation
Certificates
Equity
Funds

Shares are units of ownership interest in a
company
Definition
• Non-debt capital employed by companies to finance their operations. Equities represent
ownership shares in a corporation. Each share of common stock (ordinary shares) entitles its
owner to one vote on any matters of corporate governance that are put to a vote at the
corporation's annual meeting and to a share in the financial benefits of ownership. Investors earn
returns in the form of dividends which can vary over time. Preferred stocks (preference shares)
have fixed dividends. Holders of preferred stock are paid before owners of common stock.
Product Construction
• No construction.
Redemption and Annual Payouts (if any)

• Most companies pay dividends according to their earnings and strategy. Dividends are paid to the
investor on a quarterly, semi-annual or yearly basis. Secondly, the shareholder profits from the
increasing prices at the stock market exchange (or suffers from a decrease). No redemption is
expected because there is no maturity date.
Trading and Pricing

• An equity is traded in units.
Features and Advantages

• Direct ownership and right to vote in a corporation with a limited liability in case of a bankruptcy.

Shares are of four types
Common
• Common stock holders are, in effect, part-owners of their company in proportion to
the number of shares held
• They have the last (residual) claim on the assets of the company in the event of
liquidation
• They are entitled to pro-rata share in the profits of the company in the form of
dividends
• Dividend payments are proposed by the board of directors and agreed by vote at the
shareholder’s meeting
• They appoint and remove directors - one vote for each share - Annual general
meetings etc.
• There is a class of ordinary shares known as non-voting shares. The yields are higher
to compensate their loss of voting power
Preferential
• Similar to a bond, guaranteed dividends but no voting rights
Warrants
• An option a firm issues that permits the owner to buy from the issuer a certain number
of ordinary shares at a specified price during a specified period
Depository receipts
• A depository receipt is a certificate evidencing the existence of a share deposited with
a financial institution

A Participation Certificate represents interest in
a separate class of share capital
Definition (ET)
• Non-debt capital employed by companies to finance their operations. A Participation
Certificate behaves like an equity. A certificate representing interest in a separate class
of share capital, i.e. participation capital and normally carrying similar economic rights to
ordinary shares, but no voting rights. Investors earn returns in the form of dividends
which can vary over time.

• Most companies pay dividends according to their earnings and strategy. Dividends are
paid to the investor on a quarterly, semi-annual or yearly basis. Secondly, the
shareholder profits from the increasing prices at the stock market exchange (or suffers
from a decrease). No redemption is expected because there is no maturity date.
Trading and Pricing

• A Participation Certificate is traded in units.

• Direct ownership in a corporation with a limited liability in case of a bankruptcy.

An Equity Fund is a mutual fund that invests
principally in stocks
Definition (ET / OTC)

• A Fund is a managed portfolio of securities, whereby investors are credited with units according
to the amount of their investment, the price of each unit depending on the net asset value of the
basket. The diversification of the fund reduces the overall risk. Banks and fund companies issue
in a broad variety industry, country, region or index tracking funds.
• Different equities are bound together to a fund.

• Earnings are distributed to unit holders in the form of income and capital-gains dividends. There
is no maturity date.
Trading and Pricing

• The funds are traded in units on a daily basis. Some are quoted on the stock market and others
can only be bought through the issuer company. Most of the time, the price of one Fund unit is
the net asset value of the fund divided by the number of units. But there also existed funds which
are traded at a premium.

• Through the diversification in the fund, the systematic risk is reduced.

Foreign
Exchange
Markets

A Bond is a loan made by investors to issuers of
the Bond
Bond
• A bond is a loan made by investors to companies,
banks, corporations and governments. They are debt
obligations with medium to long-term maturities.
• The organization which needs money issues a bond,
and whoever buys the bond is essentially lending
money to the organization.
• The seller or issuer of the bond (i.e. the organization
borrowing money) agrees to repay the loan amount
after a specified time and with interest.

Bonds have certain key features
Principal/ Par/ Face value

• The amount of money which the investor will get back once the Bond
matures; it is also the amount on which the issuer pays interest
Issue price
• The price at which investors buy the bonds when they are first issued –
this will typically be approximately equal to the principal amount
Coupon
• The regular cash that the issuer will pay to the Bond holders
Maturity
• The date on which the Bond will be redeemed and the investor can
expect to get his money back

Bonds may be classified based on four
parameters
By Issuer By Seniority Class
• Government bonds (Govvies) • Senior
• Municipal bonds • Senior secured
• Corporate bonds • Junior
• Telecom • Junior subordinated
• Automotive
• Transport
• ...
Classification
of Bonds
By Rating By Coupon type

• Moody’s • Fixed rate bond
• Standard & Poors • Floating rate note
• Bloomberg composite • Reverse floater
• AAA/ AA/ A/ ...... • Fixed to floating
• Floating to fixed
• Zero coupon bond
The quality of the issue determines the Bond’s
credit grading.
• Government
• Bond (10 years +)
Generally, bonds • Note (1-10 years)
issued by the • Bill (<1 year)
federal government • Agencies
have the lowest risk • Corporation
of default, while • International (more complicated because
corporate bonds are of differing currencies)
more risky. • Eurobond
• Foreign
• Global

Priority for payments is decided by the seniority
class of the Bond, should the issuer default
Priority for payment
Priority 1
Senior or
Unsubordinated
Bonds
Priority 2
Junior or
Subordinated
Bonds

Bond issuers may choose from a variety of types
of coupons or interest payments
Types of Coupons
Inverse
Fixed Floater Zero Coupon
Floater
Pre-determined Coupon changes

Coupon changes No interest paid,
rate through inverse to market
with market rates traded at discount
maturity rates

Some Bonds offer certain “redemption features”
to issuers and investors
Redemption Features of Bonds
Callable Convertible Puttable
Issuer can redeem Bond can be Holder can redeem

the bond before converted into the bond before
maturity common stock maturity

Bonds have three income sources
Coupon Interest on Capital gain or

payments interest loss
• From coupons • The income • From disposal of
(Remark: Zero- from the the bonds
bonds - offered reinvestment of
at a discount) coupons

Bonds are usually redeemed at maturity
• The redemption date on which the issuer will redeem the

issue and repay the debt
Maturity
• The bondholder (or their custodian bank) claims the final

coupon and the redemption value of the bond certificate
Settlement from the issuer’s paying agent
process
• Bullet issue (The principal is repaid in one amount at

maturity )
• Amortized issues (Repayment can be made early - serial
Repayment bonds)

Bonds find many uses
• For capital improvements such as roads

and airports
For large scale funding • For the country’s growth and development
• For acquiring new companies
• For consistent cash flow

To provide a
guaranteed income
stream
• For large scale players

To facilitate large scale
investment

The pricing of Bonds takes into account various
factors
Market
interest
rate Time to
Currency
maturity
Industry Yield to
sector maturity
Bond Demand
Issuer
and
rating Pricing Supply

Bonds can be purchased at either a premium, a
discount, or at par
Premium
• If the bond's price is higher than its par value, it would sell at a
premium because its interest rate is higher than current prevailing
rates.
Discount
• If the bond's price is lower than its par value, the bond would sell at a
discount because its interest rate is lower than current prevailing
interest rates.
Par
• If the bond’s price is equal to its par value, the bond is said to be
selling at par. A newly issued bond usually sells at par value.
• When calculating the price of a bond, the calculations include the
maximum price one would pay for the bond given the bond's coupon
rate in comparison to the average rate most investors are currently
receiving in the bond market

Understanding the “Time Value of Money"
• Money available at the present

time is worth more than the same
amount in the future due to its
potential earning capacity – i.e.
you can invest the money today
Time Value of and earn interest.
Money

Bond pricing takes into account the “Time value
of money”
Bondholders are entitled to the following cash flows in the future:
The coupon payments that will The par value of the Bond
be made
Hence, using the “time value of money” concept for pricing a Bond, you
need to know how much these future cash flows will be worth today, i.e.,
what their Present Value is.

The price of a Bond is the Present Value of all
future cash flows (coupon payments & par value)
Bond price
Sum of the Present

Values of all
expected coupon
payments
Present Value of
the par value at
maturity

Calculating the Bond price
The present value of the bond is the current value of the future cash
flows discounted at an appropriate interest rate/ rates.
For bond pricing, this interest rate is the required yield. (Required yield or
required rate of return is the interest rate that a security needs to offer, in
order to encourage investors to purchase it. Usually, the required yield on a
bond is equal to or greater than the current prevailing interest rates.)
Present Value (PV) = Future Value (FV) / (1 + r)n

[where PV = Value at time 0, FV = value at time n,
n = number of periods, r = rate of interest]

The Bond price is affected by market interest
rates
The higher the market interest rate, the lower the present value of the
future cash flows, i.e., the Bond price.

An example to illustrate Bond pricing
 Each full moneybag on the top right in the diagram

alongside represents the fixed coupon payments
(future value) received in periods 1, 2, and 3. Notice
how the present value (PV) decreases for those
coupon payments that are further into the future:
the present value of the second coupon payment is
worth less than the first coupon, and the third
coupon is worth the least amount today. The further
into the future a payment is to be received, the less
it is worth today — this is the fundamental concept
for which the present value-of-ordinary-annuity
formula accounts. It calculates the sum of the
present values of all future cash flows
The formula for calculating a bond’s price using the

present value-of-ordinary-annuity formula:
C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value

Bond pricing - an exception: Zero Coupon Bonds
Zero Coupon Bonds
• Zero Coupon bonds are bonds sold at a

discount to their face value. They do not
have interest payments. At maturity, the
bond redeems at face value. Pricing the
bond is therefore different, as there are no
coupons to affect the price or present
value.

Zero Coupon bonds are priced differently
Zero Coupon bond pricing
• Zero coupon bonds are priced in the following way:
where n = number of periods

i = interest rate, or required yield
M = value at maturity, or par value
• To determine the number of periods, one can assume, unless otherwise

indicated, the required yield of most zero-coupon bonds is based on a
“semi-annual coupon payment”. The reason for this is because the
interest on a zero-coupon bond is equal to the difference between the
purchase price and maturity value of the bond. Therefore, the number of
periods for zero-coupon bonds will be doubled. A zero coupon bond
maturing in five years will have ten periods (5 x 2).
• To determine the yield, one must divide by the number of annual
periods. If annual interest is 6% and there are two periods, the yield will
be half or 3%.
• Zero-coupon bonds are always priced at a discount: if zero-coupon
bonds were sold at par, investors would have no way of making money
from them and therefore no incentive to buy them.

Finally, as a recap, let’s do a quick comparison of
stocks and bonds
Stocks Bonds
• Partial ownership • No ownership

• Voting rights • No voting rights
• Uncertain • Fixed coupon
dividends rate
• Unlimited • Fixed maturity
duration • Liquidation:
• Liquidation: lower higher ranking
ranking

Foreign
Exchange
Markets

Foreign Exchange is the trading of currencies
Foreign Exchange (Forex)
• Foreign Exchange is the exchange of one

country's currency for that of another.

Why Forex trading is needed
For import/ export needs of

companies or individuals
For direct investment in

another country
To purchase foreign financial

instruments
For profit from short-term,

fluctuations in exchange rates
To hedge against currency

fluctuations

Trading of currencies takes place in the Foreign
Exchange market
Foreign Exchange Market
• The foreign exchange market

(Forex, FX, or currency market) is a
market where foreign exchange of
different countries are bought and
sold.

Some key characteristics of the foreign
exchange market
The foreign exchange market is a global network of

traders
Trading is conducted through the use of electronic

trading platforms or by telephone through trading desks
There is no central trading location or exchange
Trading goes on 24 hours a day, 5 days a week

The Foreign Exchange market determines the
exchange rate
• An exchange rate is
defined as the amount of
one currency that can be
exchanged per unit of
Exchange rate another currency.

Exchange rates are priced in two ways
It is the price paid for the

“immediate” delivery of an
Spot price asset . It includes time in
between for processing/
administration, e.g. T+3
It is the price paid for

Forward price delivery at some future
date, other than spot.

How exchange rates are quoted
 Each currency is given a 3-letter code (ISO code)

 USD, JPY, ITL, GBP
currency
country
 Currencies are often quoted as a bid-offer price - Pips and
figures Bid Offer
 EUR/USD:
1.0654 / 56
pips
(small) figure
BIG figure
- 76 - The capital markets foundation for HP - June 14 Capco confidential - © Capco -

2005 - Capco confidential
There are two ways in which exchange rates can
be quoted
Direct
Indirect (reciprocal)
(multiplicative)
quotation
quotation
• Value of the foreign • Value of the national
currency expressed in currency expressed in
terms of the home terms of the foreign
currency (“American currency (“foreign
terms”) terms”)
• DEM/USD: 0.5529/31 • USD/DEM: 1.8084/87
(it takes 0.5529 USD (it takes 1.8084 DEM
to buy 1DEM) to buy $1)

Nostro and Vostro accounts are used to facilitate
settlement of foreign exchange and trade transactions
• A cash account held by a domestic bank with another

bank in a foreign country
Nostro • Eg. CSFB London’s account with Paribas Paris
account
(Latin for “our”)
• The account of a foreign bank held by a domestic bank

in its home country
(Vostro • Eg. Paribas Paris sees CSFB’s account as a Vostro
account
Latin for “your”)

An illustration of a Forex settlement
Sanwa Bank payment yen105,500M Fuji Bank

Tokyo Tokyo
payment instruction notice to receive
FX contract
Paribas Rabo
Paris Rabo sells $10M and buys Yen 105,500M Utrecht
notice to receive payment instruction
Bank of NY payment $10M

Citibank NY
New York

Foreign
Exchange
Markets

Money markets instruments are short-term debt
instruments
Money market instruments
Money market instruments are forms of debt that mature

in less than one year and are very liquid

Some key characteristics of money market
instruments
Interest (or benefits) paid

at maturity (date when the
security is returned to the
issuer and the debt is
repaid)
High grade securities with

little or no risk of default
(sovereign states, banks
and major corporations)

Money market instruments can be sold in two
ways
Discount basis Coupon basis
The money market The instrument is sold

instrument is sold at a at its face value and
discounted price and bought back at its face
bought back at its real value plus a coupon
face value by the issuer element

Examples of money market instruments sold on
a discount basis
Treasury Bills Banker’s

Commercial Paper
(T-Bills) Acceptance
A promissory note sold

Issued and by very large,
guaranteed by the creditworthy
government corporations
Bank promises to pay
Issued for a specific the face amount when
Sold on a discount amount and maturing the acceptance is
basis: difference on specific date presented to it - made
between the face to importers and
value and the exporters
purchase price Backed by a “standby
represents interest letter of credit” from a
earned by the bank
investors

Examples of money market instruments sold on
a coupon basis
Repurchase
Fixed Deposits/ Certificates of
Agreements
Loans (Interbank) Deposits (CDs)
(Repos)
Written by commercial Contracts for the sale

Interest-bearing banks and future repurchase
deposits for a fixed of a security -
term, non-negotiable effectively a
Issuing bank promises collateralized loan
to pay the face value
plus a fixed interest
rate
Price and period
LIBOR, etc Negotiable in a agreed at point of sale
secondary market
(‘Bearer’)

Treasury Bill
Definition: (ET)
• The US Treasury Bills are the most marketable of all money market instruments. They are short term
debt securities that usually are highly marketable, liquid, and have a low risk. The government raises
money by selling bills to the public. Sales are conducted via weekly and monthly auctions (13w or 26w
maturity / 52w maturity).

• Investors buy T-Bills for a price less than their par (face) value, and when they mature the government
pays back their par value. Your interest is the difference between the purchase price of the security and
what the government pays you at maturity (or what you get if you sell the T-Bill before it matures). The
income earned on T-Bills is exempt from all state and local US taxes (in the US).
Trading and Pricing

• Bills are issued at a discount. The discount rate, price and investment yield are determined in each
auction.

• T-Bills are a highly liquid; that is; they are very easily to convert in converted to cash and sold to at low
transactions cost and with not much price risk.

Commercial Papers (CPs)
Definition: (OTC)
• Large, well-known companies often issue their own short-term unsecured debt notes rather than
borrow directly from banks. These notes are called commercial papers. Very often, Commercial Paper
is backed by a bank line of credit, which gives the borrower access to cash that can be used (if
needed) to pay off the paper at maturity. Commercial Papers maturities range up to 270 days but most
often it is issued with maturities than one or two months, Usually it is issued in multiples of $ 100'000.

• The issuing bank pays interest and principal to the depositor only at the end of the first term of the
Commercial Paper.
Trading and Pricing

• The interest rate or the yield to maturity of the Commercial Paper is stated to each denomination and
maturity date.

• Commercial papers is considered to be a fairly safe asset because a firm' condition presumably can be
monitored and predicted over a term as short as one month.

Bankers Acceptance
Definition: (OTC)
• A Banker's Acceptance starts as an order to a bank by a bank's customer to pay a sum of
money at a future date, typically within six months. At this stage, it is similar to a post-dated
check. When the bank endorses the order for payment as "accepted", it assumes for ultimate
payment to the holder of the acceptance. At this point, the acceptance may be traded in
secondary markets like any other claim an the bank.

• Bankers' Acceptances are sold at a discount from the face value. The redemption is at par
%100
Trading and Pricing

• Bankers' Acceptance are issued and traded at a discount rate in percentage of the face value.

• Bankers' acceptances are considered very safe assets because trades can substitute the
bank's credit standing for their own.

Certificate of Deposit (CDs)
Definition: (OTC)
• A Certificate of deposit (CD), is a time deposit issued by a bank. Time deposit may not be withdrawn
on demand. CD's typically are interest-bearing, though-like the medium-term notes issued by
corporations. CD's issued in denomination higher then USD 100000 are usually negotiable, however
that is, they can be sold to another investor if the owner needs to cash in the certificates before its
maturity date. Short term CD's are highly marketable, although the market thins out for maturity of six-
month or more.

• Bank pays interest and principal to the depositor only at the end of the first term of the CD.
Trading and Pricing

• The interest rate or the yield to maturity of the CD is stated to each denomination and maturity date.

• United States CD's are treated as bank deposits by the Federal Deposit Insurance Corporations, so
they are insured for up to $ 10000 in event of a bank insolvency. In addition, they offer higher CD-rates
than the traditional saving account does.

Re-purchase Agreements (REPO)
Definition: (ET)
• A financing arrangement used primarily in the government securities markets whereby a dealer or
other holder of government securities sells the securities to a lender and agrees to repurchase them at
an agreed future date at an agreed price which will provide the lender with an extremely low risk return.
The government bonds are collaterals for the landed money. Most repo transactions are overnight, but
term repos (over 30 days) are common.

• The money and the government bonds are restored and the moneylender will receive additionally the
repo-rate (special interest rate) from the borrower at the end.
Trading and Pricing

• Repo trades are the main instrument for the Central Bank to control the money supply. But this
business is also common between different banks. Repo's are traded in nominal amounts with daily
varying interest rates attached to it.

• Repos are popular because they can virtually eliminate credit problems, but a number of significant
losses over the years suggests that lenders in this market have not always checked their
collateralization closely enough.

Reverse Re-purchase Agreements (RevREPO)
Definition: (ET)
• A financing arrangement used primarily in the government securities markets whereby a dealer or
other interested company who is willing to lend money buys the securities from a borrower and agrees
to resell them at an agreed future date at an agreed price which will provide the lender with an
extremely low risk return. The government bonds are collaterals for the lent money. Most repo
transactions are overnight, but term repos (over 30 days) are common.

• The money and the government bonds are restored and the moneylender will receive additionally the
repo-rate (special interest rate) from the borrower at the end.
Trading and Pricing

• Repo trades are the main instrument for the Central Bank to control the money supply. But this
business is also common between different banks. Repo's are traded in nominal amounts with daily
varying interest rates attached to it.

• Repos are popular because they can virtually eliminate credit problems, but a number of significant
losses over the years suggests that lenders in this market have not always checked their
collateralization closely enough.

Foreign
Exchange
Markets

A Commodity is a class of goods for which there
is demand
It is supplied without qualitative differentiation

across a market
It is interchangeable with other commodities of

the same type, no matter who produces it

Commodities are traded through commodity
markets
Buyers and sellers work

Investors buy and together to either get the
product they need or
sell commodities make a profit from the
fluctuating prices

These Commodity markets may be OTC or
exchange-based
Commodity
OTC
Exchanges
Commodity
Markets

There are four categories of commodities traded
Commodities
Livestock and
Energy Metals Agricultural
Meat
Eg. Corn,
Eg. crude oil,
Eg. Gold, silver, Eg. Lean hogs, soybeans, wheat,
heating oil, natural
platinum, copper, pork bellies, cattle, rice, coffee,
gas, gasoline,
etc etc cotton, sugar, etc
power, etc

Commodity contracts may be physically or
financially settled
Settlement of
commodity contracts
Physical delivery Financial settlement

These commodities can be broadly classified
into two types
Agricultural products
Soft or livestock (corn,
wheat, coffee, sugar,
commodities soybeans, pork, etc.)
Commodities
Typically natural
Hard resources that must be
commodities mined or extracted
(gold, rubber, oil, etc.)

There are several commodity exchanges around
the world
CME Group
[merger of Chicago Intercontinental Kansas City Board of
Mercantile Exchange exchange (ICE) Trade (KCBT)
(CME) and Chicago
Board of Trade (CBOT)]
London Metal Commodity Exchange New York Mercantile

Exchange (LME) (COMEX) Exchange (NYMEX)
Multi Commodity
Exchange of India Ltd.
(MCX)

FINANCIAL INSTRUMENTS/
PRODUCTS
(DERIVATIVES SEGMENT)
A derivative is a contract between two parties
Derivative
Its performance is based (or

A contract between two parties
derived) on the behaviour of the
that specifies conditions under
price of its underlying asset.
which payment is to be made
The underlying itself does not
between the two parties.
need to be bought or sold.
The value of a derivative is determined by the
fluctuations in the price of the underlying asset
• The underlying of a derivative is an

asset, basket of assets, index, or
even another derivative, such that
the cash flows of the derivative
depend on the value of this
Underlying underlying.
Examples of derivatives and their underlying
assets
Derivatives Underlying
Currency future, Currency forward Foreign Exchange
Single stock future, Equity swap Equity
Interest rate swap, Bond option Interest rate
Total return swap, credit default Credit Risk

swap
Derivatives are primarily used for two purposes
Derivatives
Hedging
(for protection)
Speculation
(for profit)
There are two ways of trading derivatives
Exchanges OTC
• Traded on a organized market • Traded over the counter

• Standardized contracts between counterparties or
• Cleared through a clearing through brokers
house • Customized contracts; terms
• Eg. Options, Futures are agreed upon by the
counterparties
• Eg. Options, FRAs, SWAPS
There are five primary derivative markets
Primary Derivative Markets
Interest Foreign
Equity Commodity Other
rates exchange
There are different types of users of derivatives
Supra-nationals
Governments
Government agencies
Banks
Financial institutions
Companies
HNWIs
Private clients
Hedge funds
We are now going to look at some common
types of derivatives
Forwards/
Options Swaps
Futures
Forwards/
Options Swaps
Futures
A Forward contract is a non-standardized contract to
buy or sell an asset at a specified future time
Forward contract
Forward contracts are private agreements

between parties for delivery of an asset in the
future, based on a price determined on the
initial trade date.
A Forward contract has certain key features
Delivery of the asset (security / commodity)

happens at some future date
The delivery price is determined at the time of the

contract
The delivery price is defined such that it has no

initial monetary value
The grade and quantity of goods to be delivered is

defined
The time and place of delivery are also defined
An example to illustrate how a Forward contract
works
Say that I am the owner of a company that makes

ketchup.
Based on a forecast in September, I know that I will

need 20,000 tons of tomatoes during March.
It would really help my budget if I could lock-in in

September the price of the tomatoes I will need in
March.
I enter into a forward contract.
Forward contracts are traded on OTC markets
Forward contracts are private agreements

between two parties and are not rigid in their
stated terms and conditions.
As Forward contracts are non-standardized,

they are traded on OTC markets and not
exchanges.
A Futures contract, unlike a Forwards contract, is a
standardized contract to buy or sell a product on a
specific date in the future
Futures contract
• It is a standardized agreement to buy or sell a specific

quantity and quality of a product (a commodity or a
financial instruments), on a specific date in the future,
at a price agreed when the contract is traded. Both
parties must fulfill the contract on the specified date.
Futures contracts are traded on Futures
Exchanges
Futures contracts are standardized contracts and are

traded on Futures exchanges.
The futures exchange acts as an intermediary and

minimizes the risk of default by either party.
While Forward and Futures contracts have the
same function, they differ in certain key aspects
Forward contracts Futures contracts

Non-standardized contracts Standardized contracts
Traded on OTC markets Traded through Futures exchanges
Likely risk of default No risk of default (as clearing houses

guarantee the transactions)
Settlement of the contract occurs at They are “marked to market” daily

the end of the contract (one until end of the contract (settlement
settlement date) occurs over a range of dates)
Delivery usually takes place Delivery often never happens

(usually closed out prior to maturity)
How Futures contracts came about – a brief
history…
US farmers producing grain wanted an

agreed price for delivery of their crop to be
harvested later in the year.
Buyers also wanted an agreed price

against quality assurance.
Thus CME (one of the world’s leading

derivatives marketplace) emerged as
structured arena for trading.
There are three key reasons why Futures are
traded
• You have a forward price for genuine purchase of the

Secured underlying asset
• Your view is that the market will rise making the purchase of
Speculative the future cheap, allowing you to sell the same future at a
later date (prior to delivery date) at a higher price
• You hold shares that you think are going to rise in value
Hedging • To secure speculation, you buy a future on the underlying shares
• If the market goes against you, the future will allow you to sell at the
(limiting your loss) agreed price
• You close out (sell the future) as the price meets your expectations
Key elements of a Futures contract
Buyer
• The party agreeing to buy the underlying (said to take a “long” position)
Seller
• The party agreeing to sell the underlying (said to take a “short” position)
Specified asset
• The asset being bought or sold (commodity or a financial instrument)
Standardized quantity and quality

• The specified quality and quantity of the asset being traded
Futures price (strike price)

• The mutually agreed price of the asset
Delivery date
• The specified future date when the delivery will occur
The price of a Futures contract is based on the
speculated view of the price of the underlying
Price of a Futures contract
• The price of a futures contract represents the speculated

view of the value or price of the underlying asset on the
contract date specified.
• Eg. If the current price of a future for 25 June 2006
HSBC shares is 720p , the market therefore feels that
the market price of these shares will be 720p on 25th
June 2006
The Futures price reflects the expectation of the
parties
Buyer
• Hopes or expects that the
asset price will increase in the
future
Seller
• Hopes or expects that the
asset price will decrease in
the future
Futures contracts have certain key
characteristics
• Structured market with clearly defined products and regulations;
Traded on exchanges i.e. standard delivery dates - floor brokers
Clearing houses • Clearing house represents the trade counterpart to mitigate risk
• The cash required by the Clearing House to guarantee performance of the

Initial margin trade (against default), this is returned when the contract is closed or
expired (can also be in the form of securities)
• Cash required by the Clearing House to cover mark to market

Variation margin (MTM) losses, the clearing house will pay if the MTM is positive
Defined value • All contracts have a defined value (nominal)
• The underlying asset could be financial instruments and/or

Underlying commodities
Seldom reach delivery • Financial futures do not usually reach delivery
Futures contracts have two settlement options
Settlement options
Cash
• On the expiry of the contract all open positions are MTM against the
final price and closed, any price differences are settled in cash (like
variation margin), normally financial contracts
Physical
• On the expiry date the trade becomes ‘real’ and delivery of the
underlying takes place, under the supervision of the Clearing House.
Contracts generally physically settled Gilt's/Oil/Wheat, contracts where
there is a tangible underlying
A typical Futures trade flow
Selling Buying
client Margin
Margin client
calls
calls
Clearing Clearing
member member
Margin
Margin calls
calls Trader Trader
Pit
Clearing house
Forwards/
Options Swaps
Futures
An Option contract gives the right, not the
obligation, to buy or sell
Option contract
• It is an agreement which gives the right, but not the obligation,

to buy or sell a specified product at a specified price within a
specified time period for a premium agreed when the option
contract is traded.
• The buyer of the option gains the right, but not the obligation,
to engage in that transaction, while the seller incurs the
corresponding obligation to fulfill the transaction.
• An option contract is an insurance against a certain event
happening
Understanding key aspects of Option contracts
• The person who pays the premium and who has the right but no
Buyer obligation to exercise an option
• The person who receives the premium and who is obliged to

Seller (Writer) fulfill the terms of the option, if called upon to do so
Call • The buyer will buy the underlying
Put • The buyer will sell the underlying
American style • Option can be exercised at any time during the option period
European style • Option can only be exercised on the option maturity date
Strike or Exercise Price • The price at which the underlying instrument will be bought/ sold
Exercise • The buyer takes up his right to buy/ sell the underlying
• The option passes the maturity date without being exercised; at

Expiry this time the option will cease to exist
Options may be traded OTC or on exchanges
OTC
Exchange- traded
(Over the counter)
• The option is traded • The Option is traded on

directly between a recognized exchange
counterparties. The (LIFFE), has a
terms of an OTC option standardized contract,
are unrestricted and may and is settled through a
be individually tailored to clearing house (LCH).
meet any business need. • Eg. Stock options,
• Eg. interest rate Bond options, stock
options, currency cross market index options,
rate options, etc. etc
There are two types of Options
Call Option Put Option

• An option which • An option which
conveys the right to conveys the right to
buy something at a sell something at a
specific price (strike specific price (strike
price) is called a Call price) is called a Put
Option Option
Types of
Options
How Call and Put Options work
CALL PUT
buyer seller buyer seller
RIGHT OBLIGATION RIGHT OBLIGATION

(to buy) (to sell) (to sell) (to buy)
The strike price of an Option may vary from the
market price of the underlying
At The Money In The Money Out Of The Money
An option whose An option whose

strike price is more strike price is less
An option whose advantageous than advantageous than
strike is the same as the market value of the market value of
the market value of the underlying - Call the underlying - Call
the underlying strike below market, strike above the
Put strike above market, Put strike
market below the market
How Options are valued
• Black-Scholes (used for European options)

Option premiums are • Cox-Ross Rubenstein (used for American
calculated using options)
• And many others…
mathematical models
Underlying price
Volatility
Exchange rate
Premium
Interest rate
Risks associated with Options
For the buyer For the seller (Writer)
In theory unlimited,
The amount of premium
depending on the price of
paid to do the option
the underlying
Risk that a counterpart

There is a small risk of not
does not fulfill the ‘physical’
receiving the premium
trade when called upon
Some exchanges where Options are traded
German LIFFE –
Euronext
Eurex
• Belfox – Belgium
[Merger of DTB (German) Simex - Singapore
• AEX – Netherlands
and SOFFEX (Swiss)] • Monep – French Options
• Matif – French Futures
National Stock
CBOT- Chicago, USA - CME - Chicago, USA -
Exchange of India Ltd
Financials Commodities
(NSE)
Forwards/
Options Swaps
Futures
A Swap is an agreement to periodically exchange
cash flows
• A generic swap is an
agreement between two
Swap parties to periodically
exchange cash flows
(payments) for a stated period
Swap agreements have some key features
• This is the value of the underlying, on which swap payments are

Notional value determined. It is generally not exchanged.
Reference Price • An agreed upon pricing source to establish the floating price.
Fixed Price • The agreed upon price for calculating the fixed payment.
• This is the variable price and becomes the reference price on

Floating Price settlement date for calculating floating payment.
Settlement date • The date on which payments will be made.
Settlement period • The time between settlement dates.
Termination date • The expiration date of the contract.
Swap Tenor • The time between starting of the contract till its expiration.
• The parties settle the differential amount and exchange only the
Netting net amount.
There are three common types of Swaps
Types of Swaps
Forex Swaps Interest rate Swaps Asset Swaps
THE LIFE OF A TRADE
Intermediaries and players
The Trade Life Cycle is made up of a series of
steps
The steps in the trade life cycle cover stages from order
placement through to settlement
However, as each trade has its own life cycle, not every step will
figure in every trading scenario
There are several participants that play key roles in the trade life
cycle – like investors, brokers, exchanges, clearing agencies,
clearing banks, etc
Understanding the trade life cycle, the steps, and
participants involved…
Let’s look at the life of a trade illustrated through an example. In

this example, the trade goes through 16 distinct steps.
• This is only a generic example

• This is not representative of any
specific country or system
• Not every step will figure in every
Health warning! trading scenario
• This takes a functional view of the
process
• It shows a high level overview of all
participants in a single domestic
market
Trade Life Cycle - Step 0
Trade date
 The Investment Fund hires

the Asset Manager to
manage its assets as per the
defined investment policy.
Trade date
 The Asset Manager places an

order with an International
Broker or a Local Broker to buy
or sell securities in a particular
market.
 For reasons of convenience, or due
to local regulations, the international
broker/ dealer will often utilize the
services of a local broker present in
the market where the security is to
be traded
 Asset Managers tend to have a few
favorite brokers which they funnel
their orders through. This saves the
manager from having to choose local
brokers in many different markets
 The instruction sent by the client will
be in a mutually agreed upon format,
most likely by client workstation or
by fax.
Trade date
 For a Stock exchange trade

 Brokers enter their orders into
the trading system of the stock
exchange where they are
matched.
 For an OTC trade
 Communication would occur
between brokers through an
organized system, direct via
phone, e-mail or some other
form of communication where
they can find a match.
Trade date
 Following matching, a trade

confirmation is sent to the
appropriate brokers.
Trade date
 The Local Broker informs its

client (Asset Manager) of
their obligations and
provides all information
related to the settlement of
the trades (i.e. funding
required, number of shares
to be received/delivered,
broker’s local custodian,
etc).
Trade date
 For Stock exchange trades

 At the end of the stock exchange
trading session, the Stock
Exchange sends to the Clearing
House a list of the trades that
need to be cleared and settled.
 The Clearing House sends out a
pending settlement list to all
‘Clearing Agents’ which details
all the cash and securities
obligations for future settlements
(obligation per execution and/or
net obligations).
 For OTC trades
 Both buying and selling local
brokers send through their trade
details to the clearing house for
settlement .
Trade date
 The Local Broker sends instructions

to his Clearing Agent who is
responsible for settling the stock
exchange transaction
 This instruction may be sent in any
method of communication agreed upon
by the Clearing Agent and the Local
Broker in the service level agreement
(ie. Workstation, SWIFT, fax, etc).
 It will contain all information about the
trade including the name of the
security, ISIN code, settlement amount,
counterparty, trade date, settlement
date, etc.
 The instruction will also indicate that
the transaction requires a settlement
(realignment) with the Local Custodian
of the Asset Manager’s Global
Custodian.
Trade date
 The Asset Manager sends through a

settlement instruction to its Global
Custodian authorizing it to settle the
trade with the Local Broker’s
Clearing Agent, by either making
payments and receiving securities
(for a purchase) or releasing
securities and receiving cash (for a
sale).
 This instruction may be sent in any
method of communication agreed upon
by the Global Custodian and the Asset
Manager in the service level
agreement (ie. Workstation, SWIFT,
fax, etc).
 It will contain all information about the
trade including the name of the
security, ISIN code, settlement amount,
counterparty, trade date, settlement
date, etc.
 Physical intervention is dependent on
STP capabilities.
Trade date
 The Global Custodian forwards

settlement instructions on to the
Local Custodian authorizing
them to settle the trade with the
Local Broker’s Clearing Agent,
by either making payments and
receiving securities (for a
purchase) or releasing securities
and receiving cash (for a sale).
 These instructions may pass straight
through the Global Custodian with
the output being a SWIFT formatted
message addressed to the Local
Custodian.
 It will contain all information about
the trade including the name of the
security, ISIN code, settlement
amount, counterparty, trade date,
settlement date, etc.
Trade date
 Once the Local Broker’s

Clearing Agent has received
the pending settlement
obligations from the
Clearing House (5) and the
settlement
instructions/authorization
from the Local Broker (6),
the Local Broker’s Clearing
Agent ‘affirms’ the order to
the Clearing House assuring
them that they will do their
part to settle the trade either
on the cash or securities
side.
TD + 1 to SD – 1 (may cover a period of two days in a T+3
environment)
 The Global Custodian’s

Local Custodian and the
Local Broker’s Clearing
Agent enter a settlement
instruction in the CSD to
‘realign’ the necessary
securities/cash so that the
Local Broker’s Clearing
Agent can fulfill his
obligations towards the
Clearing House.
environment)
 The Clearing House sends

payment against settlement
instructions to the (I)CSD,
which represent the cash
and securities obligations
that the clearing agents
must settle on the next day
(on settlement date)
environment)
 The (I)CSD is responsible for

arranging all trades entered
into its system for settlement.
 The key aspect in safe
settlement is to ensure that
neither cash nor securities are
released without the other being
present for simultaneous
exchange.
 The CSD ensures that shares
are available on behalf of the
seller and sends to the Central
Bank an instruction to move
cash from the buyer’s account to
the seller’s account .
environment)
 Once the Central Bank

confirms the cash
settlement, the (I)CSD will
arrange for the transfer of
the securities.
Settlement day
 Upon settlement in the

(I)CSD system, notifications
confirming settlement are
sent to all local market
participants (the Local
Broker’s Clearing Agent and
the Global Custodian’s
Local Custodian)
 The Central Bank also confirms
the cash movements.
Settlement day
 Upon receipt of the

settlement confirmation
from the CSD, the Global
Custodian’s Local
Custodian immediately
forwards the confirmation
on to the Global Custodian
who in turn forwards the
settlement confirmation on
to the Asset Manager
 The Local Broker’s Clearing
Agent also sends a settlement
confirmation to the Local
Broker.
Settlement day
 The Asset Manager reports

to the Investment Funds the
new holdings it owns.
The Trade Life Cycle – a quick recap
Investment Investment
Fund A Fund B
16 0 0 16
(Foreign buying asset (Foreign selling asset
Foreign buying 1 1 Foreign selling
manager) manager)
4 4
Asset Manager Local buying broker Local selling broker Asset Manager
15 7 (SE trading member) (SE trading member) 7 15
3 3
(Foreign buying asset
2 2 (Foreign selling asset
manager) Stock Exchange manager)
Receiving 15 6 6 15 Delivering
Global custodian 5 Global custodian
(Local buying broker) 5 5
Clearing House (Local selling broker)
Receiving 9 9 Delivering
15 8 8 15
Clearing Agent 11 Clearing Agent
10 10
(Receiving global 14 14 (Delivering global
custodian) 14 (I)CSD 14 custodian)
Receiving Delivering
10 12 13 10
Local custodian 14 14 14 Local custodian
14
Central Bank Payment system
Steps in the Trade Life Cycle - summarized
The Trade Life Cycle steps can be categorized
into five key stages
Order Placement
Risk Management and Order

Routing
Order Matching and Conversion

into Trade
Affirmation and Confirmation
Clearing and Settlement
These stages can be mapped to the Front Office,
Middle Office and Back Office activities of a Brokerage
firm
Front Office Middle Office Back Office

• Order • Risk • Affirmation and
Placement Management Confirmation
• Order Routing • Clearing and
• Order Settlement
Matching and
Conversion
into Trade
Trade workflow in the Front, Middle and Back
Offices
Trades are initiated through Orders, which are
instructions from customers to brokers to buy or sell
IOC
(Immediate Limit Order
or Cancel)
GTD
Market
(Good till Order
date)
GTC
Types of Stop Loss
(Good till Order
cancelled)
Orders
Order are matched based on certain pre-defined
criteria
Primary Secondary
Precedence Precedence
Time
Disclosed vs.
Price Undisclosed Orders
Size
Market Intermediaries facilitate the channeling of
funds during the Trade Life Cycle
Intermediaries
Intermediaries are typically financial institutions

that facilitate the channeling of funds between
lenders and borrowers
Intermediaries offer three key benefits
Increase
Efficiency
Increase
Reduce Risk
Liquidity
Market
Intermediaries
There are various types of Market Intermediaries
Investor/Trader
Depositories Member of the

• Beneficiary account exchange
• Clearing member • Floor Broker
account • Specialist
Banks
• Clearing a/c Clearing
(Clearing bank) Corporations
• Investor & Trader
bank a/c
Market Intermediaries
Example: Investment Banks
• Investment Banks are intermediaries

that assist investors (Businesses,
Governments, Individuals) in raising
capital by underwriting and/or acting
as the client's agent in the issuance
Investment Banks of securities.
• Investment banks differ from
commercial banks in that they don't
accept deposits and grant retail
loans.
Investment Banks offer various services
• Acts as an underwriter/ agent for clients by

Raising Capital issuing securities in the primary markets
• Act as intermediaries in Trading and order

Brokerage Services execution for clients
• Provide research and analysis for clients on

Research Activities securities and offer recommendations
• Advice clients on asset & risk management,

Advisory Services corporate restructuring, M&A, IPO, etc
170 - Introduction to Capital Markets Capco confidential - © Capco - February 2012

There are two main lines of business in
Investment Banking
“Sell” side “Buy” side
• Trading securities for cash • Dealing with pension funds,

or for other securities (i.e., mutual funds, hedge funds,
facilitating transactions, and the investing public
market-making), or the (who consume the products
promotion of securities (i.e., and services of the sell-side
underwriting, research, in order to maximize their
etc.) return on investment)
LOAN ACTIVITY
SECURITIZATION
A loan is a type of debt
• A loan is an arrangement in
which a lender gives money or
property to a borrower, and the
Loan borrower agrees to return the
property or repay the money,
usually along with interest, at
some future point(s) in time.
Loans can be broadly classified into eight
categories
Manufactured
Housing Auto Loans
Loans
Student
Bonds
Loans
Corporate Small
Loans Business
Mortgage Loans
(Residential and Credit Card
Commercial
property) Loans Receivables
A Bond is a type of loan
Lends
money
Lendor/ Creditor Borrower

(The holder of (The issuer of
the bond) the bond)
Pays Interest
(Coupon)
Bonds can be placed in primary markets, just
like Equity
• The mechanism of putting Bonds into primary markets is

similar to that of Equity
• Investment bankers are involved in advising the issuer and

distributing the securities to investors
• The underwriters typically work with a group of investment

bankers, who try to presell the issue to institutional clients, to
avoid interest rate risk during the period they hold the issue
Various mechanisms are used to place Bonds in
primary markets
Mechanisms
Negotiated
offering
Auction
process
Private
placements
Putting Bonds into Primary Markets
Mechanism: Negotiated offering
Negotiated Offering
Firm Commitment Best Effort Basis

• Underwriter purchases the entire issue • Agreement of the underwriter with the
and resell it. It assumes all the risk issuer to sell the offering to investors as
(inventory, price) and earns from the much as possible. The underwriter is not
spread between the purchase price and responsible for the issues which are left
the public offering price. out. It reduces the price risk for the
underwriter.
Mechanism: Auction process
Auction Process
The Issuer determines the size and terms and conditions of the
issue, while investment bankers bid for the yield/ interest rate that
they require to sell it. Banker with the lowest bid on yield (or
highest bid on price) is allocated the deal that the bid for.
Mechanism: Private placements
Private Placements (Rule 144A)
In the US, all securities offered to the public should be registered

with the SEC. Through private placements, the issue can be sold
to small number of institutional investors even if the issue is not
registered with SEC. Such issue demands high yield since the
issue is illiquid.
Securitization is the process of pooling financial
assets and turning them into tradable securities
Debt Securitization
Process of pooling of similar type of debt issues (e.g.

Mortgage, auto loans, etc.) and deriving another
class of debt securities out of the pool.
This process creates liquidity by enabling smaller

investors to purchase a piece of a larger asset pool.
Securitization
Examples
Residential Mortgage backed Security

• Mortgage Pass-through Security (MPS)
• Collateralized Mortgage Obligation (CMO)
• Stripped Mortgage Backed Securities
Commercial Mortgage backed Security

• Derived from income producing properties
Asset backed Security

• Derived from assets as such credit card receivables, student loans,
auto loans etc.
Creation of a CMO (Collateralized Mortgage
Obligation)
ASSET MANAGEMENT
Asset Management is management of a client’s
investments
Asset Management services are provided by financial services

companies, usually Investment Banks. The company invests on
behalf of its clients and gives them access to a wide range of
traditional and alternative product offerings.
The distribution channels for asset management products and

services vary according to the size, complexity, financial capacity,
and geographic characteristics of each institution.
Asset Management includes four key activities
Traditional fiduciary
Retail brokerage
services
Asset Management
Activities
Investment company Custody and security-

services holder services
Asset Management activities
Fiduciary Services
Fiduciary Services
• Traditional fiduciary services include personal trust and

estate administration, retirement plan services,
investment management services and corporate trust
administration.
• National banks also provide other fee- or transaction-
based fiduciary-related services, such as financial
planning; cash management; tax advisory and
preparation; and advice on, and execution of, financial
risk management products, such as derivatives.
Custody and Security Holder Services
Custody and Security Holder Services
• Include custody, safekeeping, payment,

settlement, record keeping, transfer agent,
securities lending, and other reporting functions
for security instruments, such as equities, debt,
and related hybrids.
• Banks may serve in a trustee or agent capacity
with or without investment discretion authority.
Retail Securities Brokerage
Retail Securities Brokerage
• Include the sale of equities, fixed-income products,

mutual funds, annuities, cash management sweep
accounts, and other types of investment
instruments.
• Service capacities range from full-service brokerage
that provides clients investment advice to discount
brokerages that provides trade execution on an
unsolicited basis.
Investment Company Services
Investment Company Services
• Include fund administration, investment advisory,

custody, and transfer agency activities.
• Financial subsidiaries of national banks are
permitted to underwrite and distribute shares of
registered investment companies.

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Learning Objectives Topics Covered

 Describe the various types  Market Sectors

 Explain Capital Market  The Life of a Trade

1 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

 Articulate the characteristics of Capital Markets and how

3 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

 Introduction to Capital Markets

4 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

6 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Economists define capital

In financial markets, capital refers to

7 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Stocks Bonds Foreign Exchange

Fixed Deposits Futures Options

8 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Capital Markets are financial

9 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

10 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Man on the street

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12 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

generated cash financial assets

Need financing Surplus funds

13 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Order driven Quote driven

• Buy and sell • Prices are • No standards, all

15 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Primary Markets Secondary Markets

• Where new financial • Where existing financial

16 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

17 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Price discovery process

The market price

18 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Trading Large number of Low cost of

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21 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

• Markets in which shares are issued and

• Markets where participants can issue new

Foreign Exchange • Markets where currencies are bought, sold or

• Markets that deal with the buying and selling

22 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

23 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Cash Cash Cash Cash Cash

Derivative Derivative Derivative Derivative Derivative

24 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Equity Debt Foreign Money Commodity

Cash Shares Bonds FX spot Deposits Metals

Equity Bond / fixed FX derivatives FRA Commodity

25 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

27 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

28 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Equity, i.e. stocks & shares, are financial

29 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

 In primary markets, new  In secondary markets,

30 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

A share in the profit the

31 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012

Factors affecting value of a Where this information is

• Company profile • Annual reports and balance

32 - Capital Markets Foundation Course Capco confidential - © Capco - March 2012