CF Final Project 7

8/2/2019 CF Final Project 7

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March 20, 2012 CORPORATE FINANACE SUPERIOR UNIVERSITY

2012

CORPORATE FINANCE

Submitted to:

Prof. Jameel

Submitted by:

Khurram Sattar (MCE11304)

SUPERIOR UNIVERSITY


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Foreign Exchange:

The markets, in which participants are able to buy, sell exchange and

speculate on currencies. Foreign exchange markets are made up of banks,

commercial companies, central banks, investment management firms, hedge funds,

and retail forex brokers and investors. The forex market is considered to be the

largest financial market in the world.

The foreign exchange market (forex, FX, or currency market) is a global, worldwide-

decentralized financial market for trading currencies. Financial centers around the

world function as anchors of trading between a wide range of different types of

buyers and sellers around the clock, with the exception of weekends. The foreign

exchange market determines the relative values of different currencies.

The foreign exchange market assists international trade and investment by

enabling currency conversion. For example, it permits a business in the United

States to import goods from the European Union member states especially Euro

zone members and pay Euros, even though its income is in United States dollars. It

also supports direct speculation in the value of currencies, and the carry trade,

speculation on the change in interest rates in two currencies.

In a typical foreign exchange transaction, a party purchases a quantity of one

currency by paying a quantity of another currency. The modern foreign exchangemarket began forming during the 1970s after three decades of government

restrictions on foreign exchange transactions (the Bretton Woods system of

monetary management established the rules for commercial and financial relations

among the world's major industrial states after World War II), when countries

gradually switched to floating exchange rates from the previous exchange rate

regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

its huge trading volume representing the largest asset class in the worldleading to high liquidity;

its geographical dispersion;
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its continuous operation: 24 hours a day except weekends, i.e. trading from20:15 GMT on Sunday until 22:00 GMT Friday;

the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed

income; and

The use of leverage to enhance profit and loss margins and with respect toaccount size.

As such, it has been referred to as the market closest to the ideal of perfect

competition, notwithstanding currency intervention by central banks. According to

the Bank for International Settlements as of April 2010, average daily turnover in

global foreign exchange markets is estimated at $3.98 trillion, a growth of

approximately 20% over the $3.21 trillion daily volume as of April 2007. Some

firms specializing on foreign exchange market had put the average daily turnover

in excess of US$4 trillion

Market size and Liquidity:

The foreign exchange market is the most liquid financial market in the

world. Traders include large banks, banks, institutional, currency speculators,

corporations, governments, other financial institutions, and retail investors. The

average daily turnover in the global foreign exchange and related markets is

continuously growing. According to the 2010 Triennial Central Bank Survey,

coordinated by the Bank for International Settlements, average daily turnover

was US$3.98 trillion in April 2010 (vs. $1.7 trillion in 1998). Of this $3.98 trillion,

$1.5 trillion was spot transactions and $2.5 trillion was traded in outright

forwards, swaps and other derivatives.

Trading in the United Kingdom accounted for 36.7% of the total, making it by far

the most important centre for foreign exchange trading. Trading in the United

States accounted for 17.9%, and Japan accounted for 6.2%.

Turnover of exchange-traded foreign exchange futures and options have grown

rapidly in recent years, reaching $166 billion in April 2010 (double the turnover
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recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC

foreign exchange turnover. Foreign exchange futures contracts were introduced in

1972 at the Chicago Mercantile Exchange and are actively traded relative to most

other futures contracts.

Most developed countries permit the trading of derivative products (like futures

and options on futures) on their exchanges. All these developed countries already

have fully convertible capital accounts. Some governments of emerging

economies do not allow foreign exchange derivative products on their exchanges

because they have capital controls. The use of derivatives is growing in many

emerging economies. Countries such as Korea, South Africa, and India have

established currency futures exchanges, despite having some capital controls.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and

has more than doubled since 2004. The increase in turnover is due to a number of

factors: the growing importance of foreign exchange as an asset class, the

increased trading activity of high-frequency traders, and the emergence of retail

investors as an important market segment. The growth of electronic and the
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diverse selection of execution venues has lowered transaction costs, increased

market liquidity, and attracted greater participation from many customer types. In

particular, electronic trading via online portals has made it easier for retail traders

to trade in the foreign exchange market. By 2010, retail trading is estimated to

account for up to 10% of spot turnover, or $150 billion per day (see retail foreign

exchange platform).

Foreign exchange is an over-the-counter market where brokers/dealers negotiate

directly with one another, so there is no central exchange or clearing house. The

biggest geographic trading center is the United Kingdom, primarily London, which

according to The City UK estimates has increased its share of global turnover in

traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to

London's dominance in the market, a particular currency's quoted price is usually

the London market price. For instance, when the International Monetary

Fund calculates the value of its Special Drawing Rights every day, they use the

London market prices at noon that day.

Foreign Exchange Dealing/Trading

There is no unified or centrally cleared market for the majority of trades,

and there is very little cross-border regulation. Due to the over-the-counter (OTC)nature of currency markets, there are rather a number of interconnected

marketplaces, where different currencies instruments are traded. This implies that

there is not a single exchange rate but rather a number of different rates (prices),

depending on what bank or market maker is trading, and where it is. In practice the

rates are often very close, otherwise they could be exploited by arbitrageurs

instantaneously. Due to London's dominance in the market, a particular currency's

quoted price is usually the London market price. Major trading exchanges

include EBS and Reuters, while major banks also offer trading systems. A jointventure of the Chicago and Reuters, called Fxmarketspace opened in 2007 and

aspired but failed to the role of a central market clearing mechanism.

The main trading center is London but New York, Tokyo, Hong Kong and

Singapore are all important centers as well. Banks throughout the world
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participate. Currency trading happens continuously throughout the day; as

the Asian trading session ends, the European session begins, followed by

the North American session and then back to the Asian session, excluding

weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well

as by expectations of changes in monetary flows caused by changes in gross

domestic product (GDP) growth, inflation (parity theory), interest rates (interest

rate parity, Domestic Fisher effect, International Fisher effect), budget and trade

deficits or surpluses, large cross-border M&A deals and other macroeconomic

conditions. Major news is released publicly, often on scheduled dates; so many

people have access to the same news at the same time. However, the large banks

have an important advantage; they can see their customers' order flow.

Theories Of Exchange Rate:

The following theories explain the fluctuations in exchange rates in a floating

exchange rate regime (In a fixed exchange rate regime, rates are decided by its

government):

1.International parity conditions: Relative Purchasing Power Parity, interestrate parity, Domestic Fisher effect, International Fisher effect. Though to

some extent the above theories provide logical explanation for the

fluctuations in exchange rates, yet these theories falter as they are based on

challengeable assumptions [e.g., free flow of goods, services and capital]

which seldom hold true in the real world.

2. Balance of payments model This model, however, focuses largely ontradable goods and services, ignoring the increasing role of global capital

flows. It failed to provide any explanation for continuous appreciation of

dollar during 1980s and most part of 1990s in face of soaring US current

account deficit.

3. Asset market model: views currencies as an important asset class forconstructing investment portfolios. Assets prices are influenced mostly by

people's willingness to hold the existing quantities of assets, which in turn
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depends on their expectations on the future worth of these assets. The asset

market model of exchange rate determination states that the exchange rate

between two currencies represents the price that just balances the relative

supplies of, and demand for, assets denominated in those currencies.

None of the models developed so far succeed to explain exchange rates and

volatility in the longer time frames. For shorter time frames (less than a few

days) algorithms can be devised to predict prices. It is understood from the above

models that many macroeconomic factors affect the exchange rates and in the end

currency prices are a result of dual forces of demand and supply. The world's

currency markets can be viewed as a huge melting pot: in a large and ever-

changing mix of current events, supply and demand factors are constantly shifting,

and the price of one currency in relation to another shifts accordingly. No other

market encompasses (and distills) as much of what is going on in the world at any

given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced

by any single element, but rather by several. These elements generally fall into

three categories: economic factors, political conditions and market psychology.

Economic factors

These include: (a) economic policy, disseminated by government agencies

and central banks, (b) economic conditions, generally revealed through economic

reports, and other economic indicators.

Economic policy: comprises government fiscal policy (budget/spendingpractices) and monetary policy (the means by which a government's central

bank influences the supply and "cost" of money, which is reflected by the level

of interest rates).

Government budget deficits or surpluses: The market usually reactsnegatively to widening government budget deficits, and positively to narrowing

budget deficits. The impact is reflected in the value of a country's currency.

Balance of trade levels and trends: The trade flow between countriesillustrates the demand for goods and services, which in turn indicates demand

for a country's currency to conduct trade. Surpluses and deficits in trade of
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goods and services reflect the competitiveness of a nation's economy. For

example, trade deficits may have a negative impact on a nation's currency.

Inflation levels and trends: Typically a currency will lose value if there is ahigh level of inflation in the country or if inflation levels are perceived to be

rising. This is because inflation erodes purchasing power, thus demand, for

that particular currency. However, a currency may sometimes strengthen when

inflation rises because of expectations that the central bank will raise short-

term interest rates to combat rising inflation.

Economic growth and health: Reports such as GDP, employment levels, retailsales, capacity utilization and others, detail the levels of a country's economic

growth and health. Generally, the more healthy and robust a country's

economy, the better its currency will perform, and the more demand for it there

will be.

Productivity of an economy: Increasing productivity in an economy shouldpositively influence the value of its currency. Its effects are more prominent if

the increase is in the traded sector.

Political Conditions:

Internal, regional, and international political conditions and events can have

a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about

the new ruling party. Political upheaval and instability can have a negative impact

on a nation's economy. For example, destabilization of coalition governments in

Pakistan and Thailand can negatively affect the value of their currencies. Similarly,

in a country experiencing financial difficulties, the rise of a political faction that is

perceived to be fiscally responsible can have the opposite effect. Also, events in

one country in a region may spur positive/negative interest in a neighboring

country and, in the process, affect its currency.

Market psychology:

Market psychology and trader perceptions influence the foreign exchange market

in a variety of ways:
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Flights to quality: Unsettling international events can lead to a "flight toquality", a type of capital flight whereby investors move their assets to a

perceived "safe haven". There will be a greater demand, thus a higher price, for

currencies perceived as stronger over their relatively weaker counterparts.

The U.S. dollar, Swiss franc and gold have been traditional safe havens during

times of political or economic uncertainty. Long-term trends: Currency markets

often move in visible long-term trends. Although currencies do not have an

annual growing season like physical commodities, business cycles do make

themselves felt. Cycle analysis looks at longer-term price trends that may rise

from economic or political trends.

"Buy the rumor, sell the fact": This market truism can apply to many currencysituations. It is the tendency for the price of a currency to reflect the impact of

a particular action before it occurs and, when the anticipated event comes to

pass, react in exactly the opposite direction. This may also be referred to as a

market being "oversold" or "overbought To buy the rumor or sell the fact can

also be an example of the cognitive bias known as anchoring, when investors

focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economicpolicy, some reports and numbers take on a talisman-like effect: the number it

becomes important to market psychology and may have an immediate impact

on short-term market moves. "What to watch" can change over time. In recent

years, for example, money supply, employment, trade balance figures and

inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated pricemovements in a currency pair such as EUR/USD can form apparent patterns that

traders may attempt to use. Many traders study price charts in order to identify

such patterns.
http://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Capital_flighthttp://en.wikipedia.org/wiki/Safe-haven_currencyhttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Swiss_franchttp://en.wikipedia.org/wiki/Gold_as_investmenthttp://en.wikipedia.org/wiki/Market_trendshttp://en.wikipedia.org/wiki/Business_cyclehttp://en.wikipedia.org/wiki/Cognitive_biashttp://en.wikipedia.org/wiki/Anchoringhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Technical_analysishttp://en.wikipedia.org/wiki/Technical_analysishttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Anchoringhttp://en.wikipedia.org/wiki/Cognitive_biashttp://en.wikipedia.org/wiki/Business_cyclehttp://en.wikipedia.org/wiki/Market_trendshttp://en.wikipedia.org/wiki/Gold_as_investmenthttp://en.wikipedia.org/wiki/Swiss_franchttp://en.wikipedia.org/wiki/United_States_dollarhttp://en.wikipedia.org/wiki/Safe-haven_currencyhttp://en.wikipedia.org/wiki/Capital_flighthttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_quality


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Foreign Exchange Exposure:

Exposure in its most generic term is defined as the condition of being

unprotected and investigating further is defined as the disclosure of something

secret. When digging into FX one sees that it is clearly a piece or sections of

sensitized material, applicable in both foreign exchange as well as photography. In

the area of medicine acute as well as chronic exposures come to mind short and

long-term respectively both causing health effects that are immediate or can occur

days or even years later.

All definitions whether in photography, medicine or foreign exchange lead to the

root of solving a problem: managing exposure. In any case mismanagement will

lead to bad pictures, significant impact on shareholder value and illnesses. Whilesome may say I want to manage risk, the fundamental question remains what is the

root of the risk. It is the exposure that causes the risk.

So for the purpose of FX best practices I begin with the fundamental definition of

foreign exchange exposure being the state of laying open or bare, to danger; and

the accessibility to anything that may affect, especially detrimentally a companys

well being. The laying bare to the danger are those currency exchange rate changes

that influence the companys value.

Types of Exposures:

A. Transaction ExposuresB. Translation ExposuresC. Economic Exposures

Translation exposure, often called accounting exposure, measures theimpact of an exchange rate change on the firm`s financial statements. An

example would be the impact of a Euro devaluation on a U.S. firm`s reported

income statement and balance sheet.


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Transaction exposure, measures potential gains or losses on the futuresettlement of outstanding obligations (receivables and payables) that are

denominated in a foreign currency. An example would be a U.S. dollar loss

after the Euro devalues, on payments received for an export invoiced in

Euros before that devaluation.

Operating exposure, often called economic exposure, is the potential forthe change in the present value of future cash flows due to an unexpected

change in the exchange rate.

Foreign Exchange Risk Management:

Foreign exchange (FX) is a risk factor that is often overlooked by small and

medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the

global marketplace. Although most U.S. SME exporters prefer to sell in U.S. dollars,

creditworthy foreign buyers today are increasingly demanding to pay in their local

currencies. From the view point of a U.S. exporter who chooses to sell in foreign

currencies, FX risk is the exposure to potential financial losses due to devaluation

of the foreign currency against the U.S. dollar. Obviously, this exposure can be

avoided by insisting on selling only in U.S. dollars. However, such an approach

may result in losing export opportunities to competitors who are willing to

accommodate their foreign buyers by selling in their local currencies. This

approach could also result in the non-payment by a foreign buyer who may find it

impossible to meet U.S. dollar-denominated payment obligations due to the

devaluation of the local currency against the U.S. dollar. While coverage for non-

payment could be covered by export credit insurance, such what-if protection is

meaningless if export opportunities are lost in the first place because of the

payment in U.S. dollars only policy. Selling in foreign currencies, if FX risk is

successfully managed or hedged, can be a viable option for U.S. exporters who

wish to enter and remain competitive in the global marketplace.

Key Points:


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Most foreign buyers generally prefer to trade in their local currencies to avoid FX

risk exposure.

U.S. SME exporters who choose to trade in foreign currencies can minimize FX

exposure by using one of the widely-used FX risk management techniques availablein the United States.

The volatile nature of the FX market poses a great risk of sudden and drastic FX

rate movements, which may cause significantly damaging financial losses from

otherwise profitable export sales.

The primary objective of FX risk management is to minimize potential currency

losses, not to make a profit from FX rate movements, which are unpredictable and

frequent.

FX Risk Management Options:

A variety of options are available for reducing short-term FX exposure. The

following sections list FX risk management techniques considered suitable for new-

to-export U.S. SME companies. The FX instruments mentioned below are available

in all major currencies and are offered by numerous commercial lenders. However,

not all of these techniques may be available in the buyers country or they may be

too expensive to be useful.

Non-Hedging FX Risk Management Techniques:

The exporter can avoid FX exposure by using the simplest non-hedging

technique: price the sale in a foreign currency. The exporter can then demand cash

in advance, and the current spot market rate will determine the U.S. dollar value of

the foreign proceeds. A spot transaction is when the exporter and the importer

agree to pay using todays exchange rate and settle within two business days.

Another non-hedging technique is to net out foreign currency receipts with foreign

currency expenditures. For example, the U.S. exporter who exports in pesos to a

buyer in Mexico may want to purchase supplies in pesos from a different Mexican

trading partner. If the companys export and import transactions with Mexico are

comparable in value, pesos are rarely converted into dollars, and FX risk is


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minimized. The risk is further reduced if those peso-denominated export and

import transactions are conducted on a regular basis.

FX Forward Hedges:

The most direct method of hedging FX risk is a forward contract, which

enables the exporter to sell a set amount of foreign currency at a pre-agreed

exchange rate with a delivery date from three days to one year into the future. For

example, suppose U.S. goods are sold to a Japanese company for 125 million yen

on 30-day terms and that the forward rate for 30-day yen is 125 yen to the dollar.

The U.S. exporter can eliminate FX exposure by contracting to deliver 125 million

yen to his bank in 30 days in exchange for payment of $1 million dollars. Such a

forward contract will ensure that the U.S. exporter can convert the 125 million yen

into $1 million, regardless of what may happen to the dollar-yen exchange rates

over the next 30 days. However, if the Japanese buyer fails to pay on time, the U.S.

exporter will be obligated to deliver 125 million yen in 30 days. Accordingly, when

using forward contracts to hedge FX risk, U.S. exporters are advised to pick

forward delivery dates conservatively. If the foreign currency is collected sooner,

the exporter can hold on to it until the delivery date or can swap the old FX

contract for a new one with a new delivery date at a minimal cost. Note that there

are no fees or charges for forward contracts since the lender hopes to make a

spread by buying at one price and selling to someone else at a higher price.

FX Options Hedges:

If there is serious doubt about whether a foreign currency sale will actually

be completed and collected by any particular date, an FX option may be worth

considering. Under an FX option, the exporter or the option holder acquires the

right, but not the obligation, to deliver an agreed amount of foreign currency to the

lender in exchange for dollars at a specified rate on or before the expiration date of

the option. As opposed to a forward contract, an FX option has an explicit fee,

which is similar to a premium paid for an insurance policy. If the value of the

foreign currency goes down, the exporter is protected from loss. On the other

hand, if the value of the foreign currency goes up significantly, the exporter can


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sell the option back to the lender or simply let it expire by selling the foreign

currency on the spot market for more dollars than originally expected, but the fee

would be forfeited. While FX options hedges provide a high degree of flexibility,

they can be significantly more costly than FX forward hedges.

Types of Options:

In the special language of options, contracts fall into two categories - Calls

and Puts. A Call represents the right of the holder to buy stock. A Put represents

the right of the holder to sell stock.

Exercising the Option:

Options investors dont actually have to buy or sell the underlying sharesthat are associated with their options. They can and often do simply opt to resell

their options - or "trade out of their options positions". If they do choose to

purchase or sell the underlying shares represented by their options, this is

called exercising the option.

Call Options:

A Call option is a contract that gives the buyer the right to buy 100 shares of

an underlying equity at a predetermined price (the strike price) for a preset period

of time. The seller of a Call option is obligated to sell the underlying security if the

Call buyer exercises his or her option to buy on or before the option expiration

date. For example, an American-style WXYZ Corporation May 21, 2011 60 Call

entitles the buyer to purchase 100 shares of WXYZ Corporation common stock at

$60 per share at any time prior to the option's expiration date of May 21, 2011.

Put Options:

A Put option is a contract that gives the buyer the right to sell 100 shares of

an underlying stock at a predetermined price for a preset time period. The seller of

a Put option is obligated to buy the underlying security if the Put buyer exercises

his or her option to sell on or before the option expiration date. Likewise, an

American-style WXYZ Corporation May 21, 2011 60 Put entitles the buyer to sell
http://www.nasdaq.com/investing/glossary/e/exercising-the-optionhttp://www.nasdaq.com/investing/glossary/e/exercising-the-option


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100 shares of WXYZ Corp. common stock at $60 per share at any time prior to the

option's expiration date in May.

Forward Contract:

In finance, a forward contract or simply a forward is a non-standardized

contract between two parties to buy or sell an asset at a specified future time at a

price agreed today.]This is in contrast to a spot contract, which is an agreement to

buy or sell an asset today. The party agreeing to buy the underlying asset in the

future assumes a long position, and the party agreeing to sell the asset in the

future assumes a short position. The price agreed upon is called the delivery price,

which is equal to the forward price at the time the contract is entered into

A cash market transaction in which delivery of the commodity is deferred until

after the contract has been made. Although the delivery is made in the future, the

price is determined on the initial trade date.

The price of the underlying instrument, in whatever form, is paid before control of

the instrument changes. This is one of the many forms of buy/sell orders where

the time and date of trade is not the same as the value date where

the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price,

which is the price at which the asset changes hands on the spot date. The

difference between the spot and the forward price is the forward premium or

forward discount, generally considered in the form of a profit, or loss, by the

purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically

currency or exchange rate risk), as a means of speculation, or to allow a party to

take advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects.

Forward contracts are very similar to futures contracts, except they are not
http://en.wikipedia.org/wiki/Forward_contract#cite_note-hull-0http://en.wikipedia.org/wiki/Forward_contract#cite_note-hull-0http://en.wikipedia.org/wiki/Forward_contract#cite_note-hull-0http://en.wikipedia.org/wiki/Spot_contracthttp://en.wikipedia.org/wiki/Long_positionhttp://en.wikipedia.org/wiki/Short_positionhttp://en.wikipedia.org/w/index.php?title=Delivery_price&action=edit&redlink=1http://en.wikipedia.org/wiki/Forward_pricehttp://en.wikipedia.org/wiki/Value_datehttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Forward_pricehttp://en.wikipedia.org/wiki/Spot_pricehttp://en.wikipedia.org/wiki/Spot_datehttp://en.wikipedia.org/wiki/Forward_premiumhttp://en.wikipedia.org/wiki/Profit_(accounting)http://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Futures_contract#Futures_versus_forwardshttp://en.wikipedia.org/wiki/Futures_contract#Futures_versus_forwardshttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Speculationhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Profit_(accounting)http://en.wikipedia.org/wiki/Forward_premiumhttp://en.wikipedia.org/wiki/Spot_datehttp://en.wikipedia.org/wiki/Spot_pricehttp://en.wikipedia.org/wiki/Forward_pricehttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Value_datehttp://en.wikipedia.org/wiki/Forward_pricehttp://en.wikipedia.org/w/index.php?title=Delivery_price&action=edit&redlink=1http://en.wikipedia.org/wiki/Short_positionhttp://en.wikipedia.org/wiki/Long_positionhttp://en.wikipedia.org/wiki/Spot_contracthttp://en.wikipedia.org/wiki/Forward_contract#cite_note-hull-0


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exchange-traded, or defined on standardized assets. Forwards also typically have

no interim partial settlements or "true-ups" in margin requirements like futures

such that the parties do not exchange additional property securing the party at

gain and the entire unrealized gain or loss builds up while the contract is open.

However, being traded OTC; forward contracts specification can be customized and

may include mark-to-market and daily margining. Hence, a forward contract

arrangement might call for the loss party to pledge collateral or additional

collateral to better secure the party at gain.

Future Contract:

In finance, a futures contract is a standardized contract between two parties

to exchange a specified asset of standardized quantity and quality for a price

agreed today (the futures price or the strike price) with delivery occurring at a

specified future date, the delivery date. The contracts are traded on a futures

exchange. The party agreeing to buy the underlying asset in the future, the "buyer"

of the contract, is said to be "long", and the party agreeing to sell the asset in the

future, the "seller" of the contract, is said to be "short". The terminology reflects

the expectations of the parties -- the buyer hopes or expects that the asset price is

going to increase, while the seller hopes or expects that it will decrease. Note thatthe contract itself costs nothing to enter; the buy/sell terminology is a linguistic

convenience reflecting the position each party is taking (long or short).

In many cases, the underlying asset to a futures contract may not be

traditional commodities at all that is, for financial futures the underlying asset or

item can be currencies, securities or financial instruments and intangible assets or

referenced items such as stock indexes and interest rates.

While the futures contract specifies a trade taking place in the future, the purposeof the futures exchange institution is to act as intermediary and minimize the risk

of default by either party. Thus the exchange requires both parties to put up an

initial amount of cash, the margin. Additionally, since the futures price will

generally change daily, the difference in the prior agreed-upon price and the daily

futures price is settled daily also. The exchange will draw money out of one party's
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margin account and put it into the other's so that each party has the appropriate

daily loss or profit. If the margin account goes below a certain value, then a margin

call is made and the account owner must replenish the margin account. This

process is known as marking to market. Thus on the delivery date, the amount

exchanged is not the specified price on the contract but the spot value (since any

gain or loss has already been previously settled by marking to market).

New Issue Market:

The New Issue market is that part of the capital markets that deals with the

issuance of new securities. Companies, governments or public sector institutions

can obtain funding through the sale of a new stock or bond issue. This is typically

done through a syndicate of securities dealers. The process of selling new issues to

investors is called underwriting. In the case of a new stock issue, this sale is

an initial public offering (IPO). Dealers earn a commission that is built into the

price of the security offering, though it can be found in the prospectus. Primary

markets create long term instruments through which corporate entities borrow

from capital market.

Features of primary markets are:

This is the market for new long term equity capital. The primary market is themarket where the securities are sold for the first time. Therefore it is also

called the new issue market (NIM).

In a primary issue, the securities are issued by the company directly toinvestors.

The company receives the money and issues new security certificates to theinvestors.

Primary issues are used by companies for the purpose of setting up newbusiness or for expanding or modernizing the existing business.

The primary market performs the crucial function of facilitating capitalformation in the economy.

The new issue market does not include certain other sources of new long termexternal finance, such as loans from financial institutions. Borrowers in the new
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issue market may be raising capital for converting private capital into public

capital; this is known as "going public."

The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

Initial public offering; Rights issue (for existing companies); Preferential issue

Stock Exchange:

A stock exchange provides services for stock brokers and traders to

trade stocks , bonds, and other securities. Stock exchanges also provide facilities

for issue and redemption of securities and other financial instruments, and capital

events including the payment of income and dividends. Securities traded on a

stock exchange include shares issued by companies, unit trusts, derivatives,

pooled investment products and bonds.

To be able to trade a security on a certain stock exchange, it must be listed there.

Usually, there is a central location at least for record keeping, but trade is

increasingly less linked to such a physical place, as modern markets are electronic

networks, which gives them advantages of increased speed and reduced cost of

transactions. Trade on an exchange is by members only.

The initial offering of stocks and bonds to investors is by definition done in

the primary market and subsequent trading is done in the secondary market. A

stock exchange is often the most important component of a stock market. Supply

and demand in stock markets is driven by various factors that, as in all free

markets, affect the price of stocks (see stock valuation).

There is usually no compulsion to issue stock via the stock exchange itself, nor

must stock be subsequently traded on the exchange. Such trading is said to be off
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exchange or over-the-counter. This is the usual way that derivatives and bonds are

traded. Increasingly, stock exchanges are part of a global market for securities.

The functions of stock exchange are as following

1. Main activities:

To promote the savings and for them to be canalized towards ofcarrying through investment projects that otherwise wouldnt be

possible you need that the issuing institution of the securities to be

admitted for quoting. The negotiations will be done on the primary

market.

To provide liquidity to the investors. The investor can recuperate themoney invested when needed. For it, he has to go to the stock

exchange market to sell the securities previously acquired. This

function of the stock market is done on the secondary market.

2. Functions as an organization are:

To guarantee the legal and economic security of the agreed contracts. To provide official information about the quantities that are

negotiated and of the quoted prices.

To fix the prices of the securities according to the fundamental law ofthe offer and the demand.

Specifying a bit more and centering on the two main agents that intervene in the

market, investors and companies, we could do the following classification:

3. Functions in favor of the investor:
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It permits him the access to the profitable activities of the bigcompanies.

It offers liquidity to the security investments, through a place inwhich to sell or buy securities.

It permits for the investor to have a political power in the companiesin which he invests its savings due that the acquisition of ordinary

shares gives him the right (among other things) to vote in the general

shareholders meetings of the company in question.

It offers the possibility of diversifying your portfolio by enlargingthe field of strategy of investments due to alternative options, as

could be the derived market, the money market, etc.

4. Function in favor of the companies:

It supplies them with the obtaining of long-term funds that permitsthe company to make profitable activities or to do determine projects

that otherwise wouldnt be possible to develop for lack of financing.

Also, this funding signifies a less cost than if obtained at other

channels.

The securities quoted at the stock exchange market usually have morefiscal purpose advantages for the companies.

It offers to the companys free publicity, which in other way wouldsuppose considerable expenses. The institution is objecting of

attention of the media (television, radio, etc.) in case any important

change in its owners (the share holders).

5. Constant following of the quotations.

Therefore we can see how the stock exchange market supposes a great advantage

to the companies, but there are also some inconveniences to have in mind:

First of all, they need of a series of conditions to be apt to enter to thequotations, not all the companies that apply can do it.

The issuing of shares may suppose a loss of power for the founders of thecompany. Anyway, this is very relative because it will depend on the grade


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of atomization on the participations of the new shareholders and of the

percentage of shares that the founders keep over the total capital of the

company.

If for example a 49% of the share capital is in hands of the founders, thesecould lose the control of in case the other 51% would be in hands of one

main shareholder. However, this rarely happens, due that the share capital

that usually goes to the stock market tends to be distributed between a great

number of shareholders that acquire modest participations in respect to that

of the capital of the company the founders may still keep control with share

capital is distributed between a great number of participants.

Now then, the property of these shares implies the possession of certainrights over the company in which you participate.

These are: political rights, among which appears the possibility of participating in

the general share holders meetings and in the administration of the company by

means of the execution of your rights to vote; and the economic right, which

embraces the possibility of receiving dividends, preferential rights of subscription,

the transmission of shares (selling) and the right to the liquidity value.

This last implies that at the moment in which the company is liquidated, what

remains is proportionally divided between the shareholders.

5. The possession of all these rights is what reduces the power of the founders.

The shares may pass to be property of unknown people to the founders. Atthe moment in which they are object of quotations at the stock exchange

market any supplier of capital may have them. If its a company that

previously knew all its shareholders, considering this as an asset of value to

the company. The stock market quotation may generate an important change

that will not always be positive.

The companies that are quoted at the stock market offer a bettertransparency, in a way that the general public may have access to any

information related to their evolution and activities.


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This makes them have a greater control and to supervise every movementdone.

Documents

CF Final Project 7