Financial markets .......................................................................................................................................... 2 Security ......................................................................................................................................................... 2 Fungibility ...................................................................................................................................................... 2 Debt Security................................................................................................................................................. 3 Banknote ................................................................................................................................................... 3 Bonds ........................................................................................................................................................ 3 Asset-backed security ........................................................................................................................... 4 MBS ....................................................................................................................................................... 4 CMO ...................................................................................................................................................... 4 CDO ....................................................................................................................................................... 4 Debenture ................................................................................................................................................. 4 Equity Securities............................................................................................................................................ 5 Common stock .......................................................................................................................................... 5 Preferred stock.......................................................................................................................................... 5 Derivative ...................................................................................................................................................... 5 Based on the relationship between underlying asset and derivative ...................................................... 6 Forward ................................................................................................................................................. 6 Option ................................................................................................................................................... 6 Swap ...................................................................................................................................................... 6 Interest rate swaps ........................................................................................................................... 6 Currency swaps ................................................................................................................................. 6 Commodity Swap .............................................................................................................................. 7 Credit default swap (CDS) ................................................................................................................. 7 Equity Swaps ..................................................................................................................................... 7 Based on the underlying asset .................................................................................................................. 7 Equity Derivative ................................................................................................................................... 7 Futures .............................................................................................................................................. 7 Warrants ........................................................................................................................................... 7 Convertible bonds ............................................................................................................................. 7
Foreign exchange derivative ................................................................................................................. 8 Interest rate derivative ......................................................................................................................... 8 Credit derivative.................................................................................................................................... 8 Commodity Derivative .......................................................................................................................... 8 Over-the-counter ...................................................................................................................................... 8
Financial markets
Capital markets which consist of: o Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. o Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange.
Security
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:
debt securities (such as banknotes, bonds and debentures), equity securities, e.g., common stocks; and, derivative contracts, such as forwards, futures, options and swaps.
Fungibility It is the property of a good or a commodity whose individual units are capable of mutual substitution, such as crude oil, shares in a company, bonds, precious metals or currencies. For example, if someone lends another person a $10 bill, it does not matter if they are given back the same $10 bill or a different one, since currency is fungible; if someone lends another person their car, however, they would not expect to be given back a different car, even of the same make and model, as cars are not fungible.
Debt Security
Banknote
Banknote (often known as a bill, paper money or simply a note) is a kind of negotiable instrument; a promissory note (i.e. enforceable by law) made by a bank payable to the bearer on demand, used as money, and in many jurisdictions is legal tender. In addition to coins, banknotes make up the cash or bearer forms of all modern fiat money (money that derives its value from government regulation or law). With the exception of non-circulating high-value or precious metal commemorative issues, coins are used for lower valued monetary units, while banknotes are used for higher values.
Bonds
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (semi-annual, annual, sometimes monthly). Types of bonds:
1. Fixed rate bonds have a coupon that remains constant throughout the life of the bond. 2. Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest, such as LIBOR(The Libor is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate ) or Euribor (The Euro Interbank Offered Rate (Euribor) is a daily reference rate based on the
averaged interest rates at which Euro zone banks offer to lend unsecured funds to other banks in the euro wholesale money market ) Zero coupon bonds Inflation linked bonds Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgagebacked securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs). Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond Treasury bond, also called government bond, is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the full faith and credit of the federal government. For that reason, this type of bond is often referred to as risk-free. Foreign currencies : Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the
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issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations Asset-backed security An asset-backed security is a security whose value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors; a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues. MBS A mortgage-backed security (MBS) is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.
The process of securitization is complicated, and is highly dependent on the jurisdiction within which the process is conducted. The basics are: 1. Mortgage loans (mortgage notes) are purchased from banks and other lenders and assigned to a trust 2. The trust assembles these loans into collections, or "pools" 3. The trust securitizes the pools by issuing mortgage-backed securities
CMO CMO is a debt security issued by an abstraction - a special purpose entity - and is not a debt owed by the institution creating and operating the entity. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and they receive payments from the income generated by the mortgages according to a defined set of rules CDO Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple "tranches"(In structured finance, a tranche (often misspelled as traunch or traunche) is one of a number of related securities offered as part of the same transaction) that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets
Debenture
A debenture is a document that either creates a debt or acknowledges it, and it is a debt without collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money.
Equity Securities
Common stock
Common stock is a form of corporate equity ownership, a type of security. The terms "voting share" or "ordinary share" are also used in other parts of the world; common stock being primarily used in the United States. It is called "common" to distinguish it from preferred stock. If both types of stock exist, common stock holders cannot be paid dividends until all preferred stock dividends (including payments in arrears) are paid in full. In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid. As such, such investors often receive nothing after a bankruptcy.
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but are subordinate to bonds in terms of claim or rights to their share of the assets of the company.[1] Preferred stock usually carries no voting rights,[2] but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a "Certificate of Designation". Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for preferreds is generally lower since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors
Derivative A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-thecounter); and their pay-off profile.
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.
Commodity Swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.
Credit default swap (CDS) A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure. Equity Swaps An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future.
Foreign exchange derivative A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate(s) of two (or more) currencies. These instruments are commonly used for currency specurlation and arbitrage or for hedging foreign exchange risk. Interest rate derivative An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. These structures are popular for investors with customized cash flow needs or specific views on the interest rate movements (such as volatility movements or simple directional movements) and are therefore usually traded OTC. Credit derivative In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" of the underlying loan.[1] It is a securitized derivative whereby the credit risk is transferred to an entity other than the lender. Commodity Derivative Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.
Over-the-counter
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchanges or stock exchanges.