~~~ UNDERSTANDING OF THE DERIVATIVES ~~~

~~ The Instruments Of Capital Market

Capital market instruments are responsible for generating funds for individuals, companies,
corporations and sometimes national governments. These are used by the investors to make a profit
out of their respective market.There are 3 main category of financial instruments used for capital
market trade :

The Equity
the value of an ownership interest in property, including shareholders' equity in a business. Equity or
shareholders equity is the same as capital in a business. The equity market such as shares,
securities, stocks etc.

The Debts
An amount of money borrowed by one party from another.Many corporations/individuals use debt as
a method for making large purchases that they could not afford under normal circumstances. A debt
arrangement gives the borrowing party permission to borrow money under the condition that it is to be
paid back at a later date, usually with interest. The debts market such as banking facilities like
mortgage, hire purchase, over draft, insurance etc.

The Derivatives
A derivative is a security whose price is dependent upon or derived from one or more
underlying assets.In finance, a derivative is a special type of contract which derives its value from the
performance of an underlying entity. This underlying entity can be an asset, index, or interest rate,
and is often called the "underlying". Derivatives can be used for a number of purposes - including
insuring against price movements (hedging), increasing exposure to price movements for speculation
or getting access to otherwise hard to trade assets or markets.
Some of the common derivatives include futures, forwards, swaps, options, and variations of these
such as caps, floors, collars, and credit default swaps. Most derivatives are traded over-the-
counter (off-exchange) or on an exchange. Derivatives are further distinguished from cash
instruments in that they are contracts between two or more parties. These contracts are promises to
convey ownership of an asset rather than the asset itself. Like other contracts, derivatives represent
an agreement between two parties or more.
Investors use derivatives to capture profits resulting from price variations in the
underlying investment.Because of this, derivatives are often referred to as leveraged
investments. Derivatives are generally used to hedge risk, but can also be used for speculative
purposes. Despite the risks, derivatives are also attractive to investors because they trade for a
fraction of the price of the underlying asset, enabling investors to control more of an asset for less
money.



~~ The Importance Of Derivatives In Financial Industry/ Modern Banking
Today's sophisticated international markets have helped foster the rapid growth in derivative
instruments. In the hands of knowledgeable investors, derivatives can derive profit from:

Changes in interest rates and equity markets around the world

Currency exchange rate shifts

Changes in global supply and demand for commodities such as agricultural products, precious and
industrial metals, and energy products such as oil and natural gas
Adding some of the wide variety of derivative instruments available to a traditional portfolio of
investments can provide global diversification in financial instruments and currencies, help hedge
against inflation and deflation, and generate returns that are not correlated with more traditional
investments. The two most widely recognized benefits attributed to derivative instruments are price
discovery and risk management.

-
Price Discovery
Futures market prices depend on a continuous flow of information from around the world and require
a high degree of transparency. A broad range of factors (climatic conditions, political situations, debt
default, refugee displacement, land reclamation and environmental health, for example) impact supply
and demand of assets (commodities in particular) - and thus the current and future prices of the
underlying asset on which the derivative contract is based. This kind of information and the way
people absorb it constantly changes the price of a commodity. This process is known as price
discovery.

-
Risk Management
This could be the most important purpose of the derivatives market. Risk management is the process
of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal
the former. This process can fall into the categories of hedging and speculation.

Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position
while speculation referred to taking a position in the way the markets will move. Today, hedging and
speculationstrategies, along with derivatives, are useful tools or techniques that enable companies to
more effectively manage risk in the new era of finance industry.


-
Improve Market Efficiency
For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund or
replicate the fund by buying S&P 500 futures andinvesting in risk-free bonds. Either of these methods
will give them exposure to the index without the expense of purchasing all the underlying assets in the
S&P 500.

If the cost of implementing these two strategies is the same, investors will be neutral as to which they
choose. If there is a discrepancy between the prices, investors will sell the richer asset and buy the
cheaper one until prices reach equilibrium. In this context, derivatives create market efficiency.


-
Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in them has to be
low or investors will not find it economically sound to purchase such "insurance" for their positions.


Derivatives are used for the following:

Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in
the opposite direction to their underlying position and cancels part or all of it out

Create option ability where the value of the derivative is linked to a specific condition or event

Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g. weather
derivatives)

Provide leverage (or gearing), such that a small movement in the underlying value can cause a large
difference in the value of the derivative

Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g.
moves in a given direction, stays in or out of a specified range, reaches a certain level)

Switch asset allocations between different asset classes without disturbing the underlying assets, as
part of transition management

Avoid paying taxes. For example, an equity swapallows an investor to receive steady payments, while
avoiding paying capital gains tax and keeping the stock.




~~ The Role Of Associates In Derivatives Market


-
The Exchange
Exchange is a marketplace in which securities, commodities, derivatives, and other financial
instruments are traded. It may be a physical location where traders meet to conduct business or an
electronic trading platform.

In practice, futures exchanges are usually commodities exchanges. All derivatives, including financial
derivatives, are usually traded at commodities exchanges. However, a future exchange is a central
financial exchange where people can trade standardized futures contract. These types of contracts
fall into the category of derivatives.


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The Fund Manager
An individual, or a firm responsible for implementing a fund's investing strategy and managing its
portfolio trading activities. The whole point of investing in a fund is to leave the investment
management function to the professionals. Fund managers are paid a fee for their work, which is a
percentage of the fund's average assets under management.
Therefore, the quality of the fund manager is one of the key factors to consider when analyzing the
investment quality of any particular fund.


-
The Clearing House
A clearing house is a financial institution that provides clearing and settlement services for financial
and commodities derivatives and securities transactions. These transactions may be executed on
a futures exchange or securities exchange, as well as off-exchange in the over-the-counter (OTC)
market. A clearing house stands between two clearing firms (also known as member firms or clearing
participants) and its purpose is to reduce the risk of one (or more) clearing firm failing to honor its
trade settlement obligations.



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The Brokerage Firm
A brokerage firm, or simply brokerage, is a financial institution that facilitates the buying and selling
of financial securities between a buyer and a seller. Brokerage firms serve a clientele of investors who
trade public stocks and other securities, usually through the firm's agentstockbrokers. A traditional, or
"full service," brokerage firm usually undertakes more than simply carrying out a stock or bond trade.
The staff of this type of brokerage firm is entrusted with the responsibility of researching the markets
to provide appropriate recommendations and in so doing they direct the actions of pension fund
managers and portfolio managers alike. These firms also offer margin loans for certain approved
clients to purchase investments on credit, subject to agreed terms and conditions. Traditional
brokerage firms have also become a source of up-to-date stock prices and quotes.



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The Traders
A trader is person or entity, in finance, who buys and sells financial instruments such
as stocks,bonds, commodities and derivatives, in the capacity of agent, hedger, arbitrageur,
or speculator.



-
The Online Trading System : Electronic Trading Platform (ETP)
In finance, an electronic trading platform is a computer system that can be used to place orders for
financial products over a network with a financial intermediary. This includes products such
as stocks, bonds, currencies, commodities and derivatives with a financial intermediary, such
asbrokers, market makers, Investment banks or stock exchanges. Such platforms allow electronic
trading to be carried out by users from any location and are in contrast to traditional floor trading
using open outcry and telephone based trading.
Electronic trading platforms typically stream live market prices on which users can trade and may
provide additional trading tools, such as charting packages, news feeds and account management
functions. Some platforms have been specifically designed to allow individuals to gain access to
financial markets that could traditionally only be accessed by specialist trading firms such as
allowing margin trading on forex and derivatives such as contract for difference. They may also be
designed to automatically trade specific strategies based on technical analysis or to do high-
frequency trading.


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The Investment Banker
An investment bank is a financial institution that assists individuals, corporations, and governments in
raising capital by underwriting or acting as the client's agent in the issuance ofsecurities (or both). An
investment bank may also assist companies involved in mergers and acquisitions and provide
ancillary services such as market making, trading of derivatives andequity securities, and FICC
services (fixed income instruments, currencies, and commodities).
Unlike commercial banks and retail banks, investment banks do not take deposits. There are two
main lines of business in investment banking.

The "sell side" involves trading securities for cash or for other securities (e.g. facilitating transactions,
market-making), or the promotion of securities (e.g. underwriting, research, etc.).

The "buy side" involves the provision of advice to institutions concerned with buying investment
services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge
fundsare the most common types of buy side entities.
An investment bank can also be split into private and public functions with an information barrierwhich
separates the two to prevent information from crossing. The private areas of the bank deal with
private insider information that may not be publicly disclosed, while the public areas such as stock
analysis deal with public information.


-
The Private Banker
Private banker is a bank providinginvestment and other financial services to private individuals who
enjoy high levels of income or invest sizable assets. The term "private" refers to customer service
rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank
advisers. It does not refer to a private bank, which is a non-incorporated banking institution.
Private banking forms an important, more exclusive, subset of wealth management. At least until
recently, it largely consisted of banking services, discretionary asset management, brokerage, limited
tax advisory services and some basic concierge-type services, offered by a single designated
relationship manager. Taking a largely passive approach to financial decision making, most clients
trust their private banking relationship manager to get on with it.


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The Regulator
The regulator is a person, an organization, or a body who empowered to oversee the operational
frameworks, compliance, and related parties in the activities. A Regulator has the ultimate
responsibility of protecting the investors apart from discharging its regulatory functions, and also,
obliged by statute to encourage and promote the development of derivatives market in financial
industry.

Other regulatory functions include of licensing and supervising all licenses persons; Encouraging self-
regulations; Ensuring proper conduct of market institutions and licensed persons.



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The Principal
The Principal - is a company acting as a financial intermediary to coordinate with other associates and
related parties to complete the services for investors in the market transaction. Registered Principle
obtained the approval or licenses issued under the Regulator such as Securities Commissions, the
Central Bank, the Ministry Of Finance, or other monetary governing body of its registered country.

Some Principal may carry various orientated platforms via different international brokerage firms,
exchange or other financial institutions, to feed the needs of investors in derivatives market like Over
The Counter (OTC) & Contract For Different (CFD).



-
The Market Maker
A market maker or liquidity provider is a company, or an individual, that quotes both a buy and a sell
price in afinancial instrument or commodity held in inventory, hoping to make a profit on the bid-offer
spread, or turn. The U.S. Securities and Exchange Commission defines a market maker as a firm
that stands ready to buy and sell stockon a regular and continuous basis at a publicly quoted price.
How a market maker makes money is usually, the difference between the price at which a market
maker is willing to buy a stock and the price that the firm is willing to sell, it is known as the market
maker spread, or buy-sell spread. Due to the fact that each market maker can either buy or sell
a stock at any given time, the spread represents how much profit the market maker earns on each
trade. Market makers also provide liquidity to their own firm's clients, for which they earn a
commission.





~~ A Little About Over-The-Counter (OTC)
OTC market is a decentralized market, without a central physical location, where
market participants trade with one another through various communication modes such as the
telephone, email and proprietary electronic trading platform. An over-the-counter (OTC) market and
an exchange market are the two basic ways of organizing financialmarkets. In an OTC market,
dealers act as market makers by quoting prices at which they will buy and sell a derivatives
or security or currency etc.

OTC markets are primarily used to trade bonds, currencies, derivatives and structured products. They
can also be used to trade equities. OTC markets are typically bifurcated into thecustomer market
where dealers trade with their clients such as corporations and institutions and the interdealer
market, where dealers trade with each other. The price a dealer quotes to a client may very well differ
from the price it quotes to another dealer, and the bid-ask spread may also be wider in the case of the
former than in the latter.Over-the-counter (OTC) or off-exchange trading is done directly between two
parties, without any supervision of an exchange.
OTC trading, as well as exchange trading, occurs with commodities, financial
instruments(including stocks), and derivatives of such. Products traded on the exchange must be well
standardized. This means that exchanged deliverables match a narrow range of quantity, quality, and
identity which is defined by the exchange and identical to all transactions of that product. This is
necessary for there to be transparency in trading. The OTC market does not have this limitation. They
may agree on an unusual quantity, for example. In OTC market contracts are bilateral (i.e. contract
between only two parties), each party could have credit risk concerns with respect to the other party.
OTC derivative market is significant in some asset classes: interest rate, foreign exchange, equities,
and commodities.OTC derivatives can lead to significant risks. Especially counterparty risk has
gained particular emphasis due to the credit crisis in 2007.

~ Exchange -Traded vs Over-The-Counter Derivatives
Like their underlying cash instruments, some derivatives are traded on established. These are
referred to as exchange-traded derivatives and, generally, they have highly standardized terms and
features. The advantage of exchange-traded derivatives is that regulated exchanges provide clearing
and regulatory safeguards to investors.

Many other derivative instruments, including forwards, swaps and exotic derivatives, are traded
outside of the formal, established exchanges. These are over-the-counter or OTC-traded derivatives.
They can be created by any two counterparties with highly flexible terms and a nearly infinite number
of underlying assets or asset combinations. In the OTC derivatives market, largefinancial
institutions serve as derivatives dealers, customizing derivatives for the specific needs of clients.





~~ A Little About Contract For Difference (CFD)
An arrangement made in a futures contract whereby differences in settlement are made through cash
payments, rather than the delivery of physical goods or securities is called CFD.

This is generally an easier method of settlement because losses and gains are paid in cash. CFDs
provide investors with all the benefits and risks of owning a security without actually owning it.
Means simply the difference between where a trade is entered and exited is the contract for
difference (CFD). A CFD is a tradable instrument that mirrors the movements of the asset underlying
it. It allows for profits or losses to be realized when the underlying asset moves in relation to the
position taken, but the actual underlying asset is never owned. Essentially, it is a contract between the
client and the broker. Trading CFDs has several major advantages, and these have increased the
popularity of the instruments over the last several years.


Most CFD brokers offer products in all the world's major markets. This means traders can easily trade
any market while that market is open from their broker's platform. No Shorting Rules or
Borrowing StockCertain markets have rules that prohibit shorting at certain times, require the trader to
borrow the instrument before shorting or have different margin requirements for shorting as opposed
to being long. The CFD market generally does not have short selling rules. An instrument can be
shorted at any time, and since there is no ownership of the actual underlying asset, there is no
borrowing or shorting cost. Professional Execution With No Fees CFD brokers offer many of the same
order types as traditional brokers. Very few, if any, fees are charged for trading a CFD. Many brokers
do not charge commissions or fees of any kind to enter or exit a trade. Rather, the broker makes
money by making the trader pay the spread. To buy, a trader must pay the ask price, and to sell/short,
the trader must take the bid price. Depending on the volatility of the underlying asset, this spread may
be small or large, although it is almost always a fixed spread. No Day Trading Requirements Certain
markets require minimum amounts of capital to day trade, or place limits on the amount of day trades
that can be made within certain accounts. The CFD market is not bound by these restrictions, and
traders can day trade if they wish.
Also note that the CFD industry is not highly regulated. The credibility of the broker is based on
reputation, life span and financial position. There are many fantastic CFD brokers, but it is important,
as with any trading decision, to investigate whom to trade with and which broker best fulfills your
trading needs.
CFD trading in its most basic form is no different from any other market transaction in that it involves
an agreement between two parties (a buyer and a seller) to transfer a contract at a specific price and
time. One common misconception about CFD trading is that money can only be made when markets
are in an uptrend, but nothing could be further from the truth. Here we will outline some of the basic
elements that allow CFD investors to achieve gains in both rising and falling markets.
In trading , the purchase of a CFD is typically referred to as a long position and this generally
requires an expectation that the value of an asset will increase over the life of the investment contract
(the CFD). In order for this purchase to be made, however, there must be a party willing to take the
opposing view and sell that asset to the buyer. The selling of an asset is often referred to as a short
position. One essential concept that new traders must understand is that CFD trading is flexible
enough to allow for a wide variety of strategies and that traders are able to establish either long or
short positions at any time, based on their individual market expectations.



~ What Is CFD Trading?
A CFD, or Contract for Difference, is an agreement between two parties to exchange the difference
between the opening price and closing price of a contract.
CFDs are derivatives products that allow you to trade on live market price movements without actually
owning the underlying instrument on which your contract is based.
You can use CFDs to speculate on the future movement of market prices regardless of whether the
underlying markets are rising or falling. You can go short (sell), allowing you to profit from falling
prices, or hedge your portfolio to offset any potential loss in value of your physical investments.
Moreover, with over 10,000 markets to trade, you can gain exposure to markets you may not have
had access to before. CFDs offer prices on shares, indices, currencies, commodities and more.
CFDs are leveraged products, enabling you to trade by paying just a small fraction of the total value
of thecontract. This means you can potentially magnify your return on investment. However, that
higher leverage can result in losses that could exceed your initial deposit.










~ Features Of CFD Trading:

-
Ability to Go Long or Short
CFD trading enables you to go long (buy) if you believe market prices will rise, or go short (sell)
if you believe market prices will fall. So if you believe that a company or market will experience
a loss of value in the short term, you can use CFDs to sell it today, and your profits will rise in
line with any fall in that price. However, if the market moves against you, your losses will also
increase. CFDs are therefore a flexible alternative to trading the movements of market prices as
they enable you to benefit from any move, regardless of whether the markets are rising or
falling.

-
24-Hour Dealing
Dealing with CFDs, completely recognize the importance of being able to access the account
and trade whenever client want, wherever he/sheis, particularly when market prices are moving
quickly. Therefore unrestricted access to the account 24 hours day, 7 days a week usually is
one of the CFDs terms. Meaning sometimes CFDs can be trade even if the underlying markets
are closed.

-
High Leverage
CFDs are traded on leverage, meaning you pay only a small fraction of the total trade value to
open your position rather than paying for it in full, this is known as margin.Youcan use leverage
to magnify your return on investment as your full trade exposure is much more than the initial
deposit required for your trade. However, your lossesaremagnified in exactly the same way if
the market moves against you and can lead to losses exceeding your initial outlay.

-
No Stamp Duty
As CFDs are a derivative product, you don't actually own the underlying instrument. This
therefore means that you do not have to pay a stamp duty, enabling you to save 0.5% on the
value of each trade. However tax laws can change and are subject to individual circumstances.

-
Hedge Portfolio
If believe existing portfolio may lose some of its value, can use CFDs to offset this loss by short
selling. For example, let's say you hold 5,000 worth of Vodafone shares in your portfolio. You
can short sell the equivalent of 5,000 worth of Vodafone shares through a CFD trade. Should
Vodafone share prices fall by 5% in the underlying market, the loss in value of your share
portfolio would be offset by a gain in your short sell CFD trade. Many investors today use CFDs
to hedge their portfolio, especially in volatile markets.





-
Offset Losses
CFDs can be extremely tax efficient as, depending on your circumstances, you can use any
losses you incur to offset against your Capital Gains Tax (CGT) liabilities.

-
Wide Range of Markets
CFDs provides on thousands of individual markets including shares, indices, currencies,
commodities, interest rates and sectors. You can use CFDs to gain instant exposure on all
major global markets.


The bottom line, advantages to CFD trading include lower margin requirements, easy access to global
markets, no shorting or day trading rules and little or no fees. However, high leverage magnifies
losses when they occur, and having to continually pay a spread to enter and exit positions can be
costly when large price movements do not occur. CFDs provide an excellent alternative for certain
types of trades or traders, such as short- and long-term investors, but each individual must weigh the
costs and benefits and proceed according to what works best within their trading plan.