Financial Markets

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Bond and Currency Markets

A bond is an instrument that typically carries a specific rate of interest (called Coupon) that the issuer agrees to pay the bond holder; as well as a promise to repay the principal on maturity. The bond market is largely an institutional market, with limited retail (individual) participation. Central Government bonds constitute the major bulk of the bonds issued and traded in these markets. We also have state government bonds and bonds issued by companies, which are called corporate bonds. The participants in the bond market are: a) b) c) d) e) Government and Corporations: They are the issuers of bonds, to raise money. Commercial Banks: They are the main subscribers to the bond issues. They purchase bonds for their own books (trading) or on behalf of clients. Investment Managers and Mutual Funds: They manage the wealth of corporations and individuals and are also subscribers to these bond issues, on their clients behalf. Depository & Clearing Corporation: They perform a role similar to that in stock markets, of facilitating the trades. Regulators: RBI regulates the bond market in India.

Bond Pricing
The price of a bond at any point of time, is the present value of all its future cash flows. Bond prices change due to various factors affecting demand and supply (interest rates, time to maturity, etc.). There are two steps to calculate pricing of a bond: Step 1: determine the cash flows on the bond. Step 2: find the present value of each of future cash flows. Bond Price = c / (1 + r /m )^m*t where c= coupon or cash flows, r= Yield in the market, m= number of times compounding happens in a year, t= time period in years As the yield in the market changes, the price changes inversely. Bonds are valued by Marking to Market. If a bond is purchased at say 101, end of day if the yield has changed, find the new price using the new yield. The difference between the purchase price and new market price gives the notional profit/loss at that point.

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Financial Markets
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Money Market
The money market is one where money market instruments are traded. Money market instruments are very shortterm instruments, unlike bonds and debentures. Money market instruments are part of the of fixed income or debt category instruments, like bonds.

Foreign Exchange Markets

Foreign exchange markets are markets where foreign currencies are bought and sold. Exporters need to sell the foreign currency they receive for their exports. Importers need to buy foreign currency to pay for their imports. Currency trading is conducted in the Over-The-Counter (OTC) market, that is, directly between the dealers. Banks/institutions play the role of authorized dealers in these markets. US Dollar (USD), British Pound Sterling (GBP), Euro (EUR) and Japanese Yen (JPY) and Swiss Franc (CHF) are the most traded currencies worldwide, since the maximum business transactions are carried out in these currencies. A unique feature of the currency market is that it is a 24 hour market.

Foreign Exchange Rates

Foreign exchange rates express the value of one currency in terms of another. An exchange rate involves two currencies: a) b) Base or fixed currency rate: which is the currency being priced. Quoted or variable currency rate: the currency used to express the price.

When the market says I buy, they have bought the base currency in the currency pair. When they say I sell, they are selling the base currency in the currency pair. Exchange rates are always quoted on a two-way basis: a) b) Bid rate: The rate at which the bank is willing to buy the base currency Offer rate: The rate at which the bank is willing to sell the base currency. The bid rate will be lower than the offer rate.

Cross Rates
A cross rate is a foreign exchange rate between two currencies, via a third currency. Exchange rates are typically quoted in the market against the US dollar (USD). Cross rates can be computed by taking their respective exchange rates against the USD. For example, if there are two quotes available: one of INR-USD and other is USD-JPY, then a cross rate of INR-JPY can be computed.

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Financial Markets
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Types of Exchange Rates

Exchange rates are classified as a) b) c) d) Spot transactions: those that settle, two working days from the date of the transaction. Forward transaction: any transaction beyond the spot date. Cash transactions: settle on the same day, and Tom transactions: settle the next working day.

Cash and Tom transactions are also called short dated transactions.

Trading Position
This denotes the size of holding in each currency pair and is expressed in terms of the base currency. Trading Position = Total Purchases - Total Sales. (regardless of maturity)

Valuation of currencies
How are currencies valued? Let us say a bank buys USD 1 mio at INR 47.60 and sells it at INR 47.70. What is the profit or loss? It is calculated as follows BUY USD 1 mio = SELL USD 1 mio = _________ PROFIT - INR 47,600,000 +INR 47,700,000 INR 100,000

The position is expressed in terms of the base currency and the profit is expressed in terms of the quoted currency in a currency pair.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!