Fin Market Terminologies-1

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FINANCIAL MARKETS

UNDERSTANDING DOCUMENT

FOR

BROKERAGE INDUSTRY AND SECURITIES MARKETS

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Brokerage Industry - Commonly used terminologies:

Broker:

Broker is an agent who arranges trades for his clients, in return for a commission.Brokers are used for trading by individual clients because:

Brokers can solve clearing and settlement problems at a lower cost than theclients themselves can

Brokers can often access exchanges and clients who may otherwise beinaccessible to the party placing the order

Brokers are considerably more experienced when it comes to trading than anaverage investor

Brokers can find easily the parties willing to trade than individual clients

Brokers are better negotiators than individual clients

Brokers can represent clients in the market at a time when the client may be

unable to represent himself Brokers also help their clients to determine as to which dealer is offering the best

quotes at a particular point in time

Brokers also handle order exposure better. This means that a trader with a largeorder would not like to expose it all at once to the market, since it will have alarge market impact. This is particularly important for traders who have areputation for being well informed and generally place large trades.

Dealer:

Dealers maintain an inventory of assets and stand ready to buy and sell at anypoint in time.

Thus dealers unlike brokers have funds that are tied up in the asset. A dealer effectively takes over the trading problem of the client. If a client is seeking to sell, the dealer will buy the asset from him in the hope of

selling it later at a higher price. If a client is seeking to buy, the dealer will sell the asset in the hope of being able

to replenish his inventory at a lower price. Dealers have to be expert traders. In the U.S. dealers specialize in particular

segments of the market like T-bills, Commercial Paper etc.

Bid and Ask:

The price at which a dealer is willing to acquire an asset will obviously be less

than the price at which he is willing to sell the same asset. The price at which a dealer is willing to buy is called the bid The price at which he is willing to sell is called the ask The difference between the two prices is their profit margin and is called the bid-

ask spread

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Settlement Agents:

Settling entails the payment of cash by the purchaser and the delivery of securitiesby the seller.

The job of a settlement agent is to receive the cash from one party and thesecurities from the other, ensure that the amounts are in order, and pass the

cash/securities to the counterparty. The largest settlement agent in the US is the NSCC, which is not surprising sinceclearing and settlement are related functions.

In practice settlement is made very efficient by ensuring settlement on a net basis.What this means is that the buys and sells for each client will be netted into a netsecurity position

All money credits and debits will be netted into a net money position and onlythese net positions will be settled.

For net settlement to work most efficiently, all traders must use the samesettlement agent.

The netting process significantly reduces the number of required transactions.

Settlement Terminology:

Normal-way settlement in the US occurs 3 business days after the day of trade. This is called T+3 settlements. I.e. Exchange of cash for securities takes place 3

business days from the day of the trade. There are also special settlements like cash settlements. Cash settlement means that the trade is cleared and settled on the day of trade

itself.

Depositories and Custodians:

These entities hold cash and securities on behalf of their clients. They facilitate the settlement process by quickly transferring cash and securities

to settlement agents upon receiving instructions from the traders. The largest depository in the world is the Depository Trust Company (DTC),

which holds nearly 20 trillion dollars in assets.

Margin:

To enable the broker gauge the ability of his client to buy or sell securities, the clientswill have to deposit a collateral or performance guarantee with their brokers prior to theexecution of their trades. This is known as Margin.(There also exist credit agencies, which provide on demand, information about the credithistories of individuals.)

When a client places a buy order but fails to pay for the stock, the broker willliquidate the margin and use the proceeds to settle the trade. The losses if any willbe debited to the clients account.

Similarly if a client sells a security and fails to deliver, the broker will borrow itfrom someone else to settle the trade. He will then liquidate the clients assets tosettle his debts.

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Clearing House:

The clearinghouse is an entity that undertakes the clearing and settlement activities for allthe trades placed on the exchange. Now every broker will not have a credit relationshipwith the clearinghouse. Only certain brokers called clearing members will have such afacility. So what this means is that all the trades must be routed through a clearing

member.

Clearing Agents:

When a trade occurs, either on the exchange floor, or over the telephone, bothparties will make a record of the terms of the trade and the identity of thecounterparty.

Before the trade is settled, the two records must be compared to ensure that thefacts and figures tally. This is called clearing.

Clearing agents are entities, which match and verify records, in order to confirmthat both the parties have agreed on the same terms and conditions.

If the records match, the trade is said to clear and can then be settled.

If there is a discrepancy, it will be reported to the traders who will then try andresolve the problem. Trades with discrepancies are called DKs (Dont Knows). In the futures markets they are called out trades. The largest clearing agency in the US is the National Securities Clearing

Corporation (NSCC). Clearing is a very important exercise in the context of conventional manual

exchanges. In electronic systems, the orders are matched by the computer, which contains all

the required information about the orders. Consequently clearing becomes atrivial exercise.

Introducing Brokers:

Thus if an investor places an order with a broker who is not a clearing member, he in turnmust route the order through a clearing member. Brokers who route orders in this fashionare called Introducing Brokers.

Subscribers:

These days, there are cases where the broker will allow a client direct access to anelectronic order routing system. When these systems in turn connect to an automatedorder execution system, the client is effectively given an opportunity to trade directly.Clients who are given such access are called subscribers. However even in these casesthe responsibility to settle the trade ultimately lies with the broker who is providing suchaccess.

Monitoring the Market:

Traders who use limit orders and stop orders would be required to watch the marketclosely in order to modify or cancel their orders if required. However many traderscannot do this in practice, and consequently entrust this task to their brokers.

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Structure of a Brokerage Firm:

The activities of a brokerage firm can be broken into three broad categories:

Front-Office Operations

All activities that involve client contact take place in the front office.

o These tasks include the soliciting and taking of orders; execution of trades;and provision of investment advice.

o Brokers solicit order flow by advertising and by calling prospective

clients.o They also provide potential clients with extensive investment information

and research inputs, to induce them to trade.o Sales Brokers are front office staff whose primary function is to interact

with clients. They work in the Sales & Trading department of the firm.o Floor Brokers are employees who arrange trades on the exchange and on

the trading floor of the firm, if the firm itself were to operate a tradingplatform. This division of a brokerage firm is called Floor Operations.

o Large brokerage firms have a Corporate Finance department whose staff isengaged in distributing large stock and bond offerings made bycompanies.

o These personnel work closely with Sales Brokers

Back-Office Operations

The back-office clears and settles all trades; maintains accounts, produces researchreports; and creates and operates information systems.

o Brokerage firms use computerized accounting systems to keep track of

their accounts, and to clear and settle trades.o Most small firms and some large firms buy such systems off the shelf.

o Some of the larger brokerage houses however use proprietary systems.

o In some cases it is because these firms have special needs, which ready-

made systems cannot satisfy.o In other cases it is simply because an in house system had been developed,

before the advent of sophisticated off the shelf systems.

Proprietary Operations

Proprietary operations include cash and risk management; and speculative deals onaccount of the firm itself.

Street Name Securities:

Traders often choose to allow brokers or depositories to hold securities on their behalf.Such securities are said to be held in Street Name.

o In these cases, where a broker holds the security on behalf of the client, the

broker is the legal owner.o The client only has a corresponding relationship in his account.

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o When a security is held in Street Name, the broker has certain responsibilities

thrust on him. Firstly he must collect interest or dividends payments from theissuing firms, and credit them to the proper client accounts.

o He must keep track off and handle corporate re-organizations such as name

changes, splits/reverse splits, bonus issues, mergers, acquisitions, and

liquidations.o He must also ensure that the issuers of securities can at all times communicate

with the beneficial owners of the securities, namely the clients.o Such activities are overseen by the Corporate Reorganizations Department

of the brokerage firm.

Communication protocols used in Trading Industry:

The software industry has developed certain communications protocols that enablesystems developed by different vendors to interact with each other. The protocols allowtraders to route orders and transmit related information in standard formats that can be

interpreted by any FIX or OFE based system.

Financial Information eXchange (FIX) protocol - Primarily serves institutional tradersOpen Financial Exchange (OFE) protocol - Essentially for Internet based retail traders.

Margin Trading:

Brokers often extend credit to clients, to other brokers, and to dealers. A client may have insufficient funds to buy securities and may consequently seek

to borrow a part of the required amount. This is called Margin Trading.

Short Selling: Brokers may seek to sell a security that he does not own, in which case he will

need to borrow a security. This is called Short Selling. The broker must carefully evaluate all credit relationships to avoid potential

losses. The Credit Manager of the firm undertakes this task.

Margin Department/Compliance Department:

A brokerage firm will have a Compliance Department or what is known as aMargin Department.

This department is entrusted with the task of ensuring that the firm and its clients

comply with all applicable regulations. Stock lending and borrowing comes into the picture where short sales areinvolved.

A broker may lend a share or arrange for a share to be lent to a client or anotherbroker for undertaking a short sale.

Or else he may borrow a share from a client or another broker to enable his clientto short sell.

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Employees who handle such activities are a part of the Margin Department or theStock Loan Department.

Risk Management:

The Risk Manager is required to monitor all activities of the firm to ensure that risks do

not become unmanageable. The specific roles are:o To ensure that management is aware of all financial and legal risks

o To ensure that adequate controls are in place to prevent rogue traders

from creating unauthorized positionso To ensure that the concerned employees understand the financial

ramifications of all proprietary trades.o To ensure that proper credit appraisal of potential clients is

undertaken.

Account Opening:

The minimum information necessary to open an account with an NYSE member firmincludes:

o Full Name

o Address Residential and Business (if any)

o Telephone Number

o Social Security or TIN (taxpayer identification number)

o Employment Details

o Marital Status

o An acknowledgement that the client is of legal age

Investment Objectives:

Every client must provide a statement of purpose listing the goal of the account/.The Possible goals include:

o Preservation of capital

o Earning of income

o Earning of tax-free income

o Capital gains

o Speculation

o Hedging

o The broker and the client should reach an agreement on how the goals

ought to be indicated, to avoid potential legal disputes

Options Trading:

Accounts set up for trading listed options require additional information regarding:o Income

o Liquid Net Worth

o Total Net Worth

o Investment experience with regards to stocks, bonds, and options

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Prospective customers must also acknowledge receipt of the Options ClearingCorporation Disclosure Document. This describes the risks inherent in optionstrading in detail.

Option traders must sign and return an `options agreement within 15 days of theaccount being opened.

Types of Accounts:

Almost all customers related securities transactions take place in either a cashaccount or in a margin account.

In addition brokers/dealers transact significant business with each other throughhouse accounts.

Investment advisors, mutual funds, and other institutions use omnibus accounts. It allows institutions to make large single transactions, which can then be

allocated to various sub-accounts. Futures contracts are executed through special accounts that are set up for this

purpose.

Futures accounts are regulated by the rules of the National Futures Association(NFA) and the Commodity Futures Trading Commission (CFTC). These accounts require more detailed financial disclosure since trading in

derivatives is inherently riskier.

Cash Accounts:

A trader can buy or sell any security on a cash and carry basis. I.e. if the purchaseis paid for in full, or if adequate funds exist in the account, then cash accounttransaction can be put through.

The securities traded may be stocks, bonds, mutual funds, warrants, or options. Customers will receive a written confirmation from their broker that payments are

due within 3 business days, in the case of T+3 settlements. If the client fails to pay, the broker will liquidate the position, and impose a 90-

day block or freeze on the account.

Margin Accounts:

Margin accounts are used to gain leverage through the use of borrowed funds, andfor executing short sales.

Margin customers have to sign a margin agreement also called a customersagreement or a hypothecation agreement.

The margin agreement pledges the customers securities as collateral for themargin loans extended by the broker.

The agreement may also contain a stock-loan consent form, which allows thebroker to lend the margined securities of his clients to other clients for short sales,and arbitrage transactions.

Margin customers have to be provided with a copy of the Federal Truth-in-lending agreement, which describes how the broker will compute interest.

Truth-in-lending Act:

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The U.S. Congress passed this Act more correctly known as the Consumer CreditProtection Act in 1968.

It is firstly about truthful disclosure of the terms of a loan. But beyond that, itdefines and prohibits extortionate credit practices.

The Act puts restrictions on the possible seizure of the wages of a borrower to

settle his debts. It also leads to the creation of a National Commission on Consumer Finance tooversee enforcement of the law.

The Act requires lenders to provide significant information about credit contracts,in easily understood terms, so that a potential borrower can make an intelligentdecision.

It also provides certain rights to a consumer. Viz. Lenders, who fail to conform tothe Act, can be sued.

The Act requires lenders to disclose the Annual Percentage Rate of interest(APR) that is being charged on the loan.

Lenders must disclose the total dollar cost associated with granting a loan

known as the Finance Charge which is the sum of all the charges that arerequired to be paid by the consumer in order to secure the loan. These additional charges may include credit investigation fees, insurance premia

etc. Since every lender has to quote his APR based on the same method of

computation, it makes it easier for the consumer to shop around.

Street Name Stocks:

Securities in a margin account are held in street name. This is done so as to facilitate the transfer and pledging of such securities. This is because the broker has a lien on such securities as long as there is a debit

balance in the account. Consequently, if a client fails to respond to a payment request, the broker can

liquidate or transfer the shares without obtaining his signature. Thus when securities are held in street name, the customers name will not be on

the share certificate and nor will it be known to the issuer. In such cases, therefore the brokerage firm is the registered owner or owner of

record. The customer is considered to be the beneficial owner. This is because all dividend and interest payments, and other reports issued by the

issuer will be received and forwarded to the client by the broker. Holding of securities in street name offers certain advantages to clients.

o Firstly it simplifies the transfer process.

o Secondly it reduces the risk of the securities being lost or stolen, for

the broker performs the safekeeping functions.o When the client wants to sell all it requires a mere phone call.

o Neither signatures, nor signature verifications, are required.

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Joint Accounts:

Two or more individuals may share joint interests in the same share account. The most common joint accounts are known as joint tenants with rights of

survivorship shown as JTWROS orJTROS on trade confirmations or accountstatements. This is nothing but an `either or survivor provision. Married couples commonly

use such accounts. The major advantage of course is that in the event of death of one party, the asset

goes directly to the surviving tenant. Another type of arrangement is called `tenancy in common. In this case, each partys ownership is clearly delineated and is independent of the

property of others. They can achieve economies of scale leading to lower commissions. Secondly all the parties need to deal with only one trade confirmation per trade, a

single periodic account statement, and more importantly need to go through onlyone broker. In case of a death of a joint member, remaining members can either claim their

respective portions or go their separate ways, or else they can set up a newtenancy jointly.

Transfer on Death Registration:

TOD is actually a form of registration and is not an account type. It however offers certain features, which make many investors, prefer it to a joint

account. In this kind of an arrangement the owner of the securities can designate a

beneficiary to receive the securities upon his death.

Advisory Accounts:

Some customers lack the knowledge, time, or inclination to manage theirinvestments. They therefore seek the services of a professional money manager,investment advisor, or counselor.

Such facilities can be availed of from a number of sources. These include:

o Bank Trust Departments

o Large National Advisory Firms

o

Smaller Specialized Advisory Firmso Investment Counseling Subsidiaries of Major Securities Firms

Having chosen an advisor, the client will sign a limited power of attorney ortrading authorization in his favor.

The advisor can then trade without consulting the client. The customer is liable for all transactions costs and advisor fees. Large advisors give a lot of business to brokers and consequently can command

lower commissions.

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Discretionary Accounts:

This is an alternative approach to fund management. The customer in such cases will sign a trading authorization in favor of a

registered representative of a brokerage firm. Some firms have separate registration account agreements for this purpose. However there is a potential conflict of interest between the client and the

registered representative. This is because the brokers representative gets no management fee. On the contrary his compensation is based on the volume of trading activity in the

account. Since the representative does not need permission to trade, it is always possible

for a client to level allegations of excessive trading subsequently. Such charges may or may not be justified. Another criticism is that brokers use such accounts as dumping grounds for

unsuccessful IPOs. Thus there is a lot of potential for regulatory and legal problems. Many brokers either prohibit such accounts or else restrict them to carefully

screened customers. They also ensure that their senior personnel handle such accounts.

DRIPs:

Some corporations offer their shareholders the option of reinvesting their dividends inadditional shares of stock. In these cases, shareholders can directly purchase additionalstocks from the issuing firm without using the services of a broker. This is known as aDividend Reinvestment Plan (DRIP).

To be eligible for a dividend reinvestment plan, most firms require that theshareholder purchase his original shares from a brokerage house.

Once the investor has acquired some shares of the firm, he can subsequentlyenroll in a DRIP.

Brokerage houses provide advice to investors regarding the choices available withregard to DRIPs.

There are two types of DRIPs:

Offering pre-existing or old shares:o In the first types of a DRIP there is a trustee who will purchase

shares in the secondary market. The objective of acquiring the

shares is to enable their re-issuance to DRIP members.o The shareholders will get the additional shares at the market price.

o However, in order to encourage shareholders to participate, the

companies will often offer to cover the commissions and fees.

Offering new shares:o In the second type of a DRIP, the shareholders receive newly

issued shares directly from the firm.

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o The company has the power to decide whether or not the shares

should be issued at a discount to the prevailing market price.o Some companies offer discounts of up to 5%.

Discounts are offered because the firm saves the costs of going through aninvestment banker.

The primary goal of the issuing firm in such cases is to induce repeatedinvestments by existing shareholders.

DRIPs are popular because by offering a DRIP, a company can raise capitalinexpensively.

DRIPs also provide stability for the companys stock price by offering perpetualdemand for shares as new dividends continue to be declared.

The issuer also has the flexibility of increasing or decreasing the availability andbenefits of the DRIP, depending on the amount of capital required to be raised.

DRIPs also enable firms to conserve cash, which would otherwise have to be paidout as dividends.

Finally these plan help build shareholder loyalty.

Investors too stand to benefit. An investor will usually save brokerage fees or will be offered other discountsthat a corporation will provide at the time of issuing shares.

DRIPs give them the option of purchasing shares in a company that they trust, andthat too by investing small amounts regularly.

Shareholders will have to open a separate account with each sponsor of a DRIP, ifthey seek to participate.

Transactions can be accomplished by mail or by automatic checking accountdebits.

Some companies charge a small brokerage fee and a service charge pertransaction.

Others charge a one-time enrollment fee and/or transactions fees. Many companies require a minimum starting investment of $ 1,000. Periodic investments may also have to be of a prescribed minimum or more.

Revenues:

Commissions (Primary source of revenue) Payment for orders Interest on cash balances Margin interest on loans Underwriting fees M&A consulting fees

Security lending fees

Commissions:

In most countries commissions are negotiable. There are however countries where government or exchange regulations specify

fixed commission rates that a broker must charge.

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Until 2003, the minimum commission in Hong Kong was 0.25% of the tradevalue.

Deep discount brokers charge the least. However they provide only the bare minimum by way of service. Full service brokers charge the maximum, but offer value-added services and

advice. Discount and deep discount brokers specify standard commission schedules. They may even offer additional discounts to their best clients. The commission schedule provided by a full service broker is usually just list

prices, analogous to the rack rate quoted by a hotel. Very few clients will pay the list price. The regular clients can negotiate substantially lower rates. Full service brokers are increasingly charging a flat fee for the accounts that they

advise. This fee covers:

o All trading commissions

o

Investment research feeso Portfolio management fees

o Account maintenance fees

In the absence of a flat fee, the client would have to pay separately for eachservice.

Clients are happy because this system takes away the incentive for the broker tochurn the account.

Churning refers to inducing trades primarily to benefit from commissions. The typical flat fee is 1 to 3 percent of the total value of the account, and is

negotiable. Fixed fee accounts are also known as wrap accounts because all commissions and

expenses are wrapped in a single fee. Institutional brokers in the U.S. typically charge a fixed price per share traded. The average price is 5-6 cents per share, but it can range from 1-12 cents per

share. In most countries, however, institutional brokers base their commissions on the

size of the transaction. In almost all countries the rates are negotiable. The rate may vary depending on:

o The size of the trade

o The difficulty of arranging it

o The soft dollars that it generates

Institutional clients sometimes get volume discounts based on the total volumetraded during a month, quarter, or year.

Most NYSE/NASD member firms establish a rate schedule and revise itperiodically.

The smaller brokerage firms generally wait for changes from industry leaders likeMerrill Lynch or Salomon Smith Barney before adjusting their own rates.

The rates inevitably favor larger transactions over smaller ones.

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The brokerage house will share the commission with the registered representativewho is handling the client.

The principle is the same. For a large transaction, the representative may receive 25-50% of the gross

commissions earned by the firm.

But for smaller trades the payout will be less and may even be nil. Thus representatives lack an incentive to handle small investors who areperceived as unprofitable.

Institutional investors on the other hand witness fierce competition for theirbusiness.

There are cases where large institutions are charged no commission. The loss in such cases can be justified by the perceived gains from liquidity and

order flow. Brokerage houses welcome greater liquidity because most of them are dual

traders. However, it is not as if institutions have been the sole beneficiaries of

deregulation. Retail customers too have benefited. Prior to deregulation, the fixed commission structure was subsidizing retail

customers at the expense of institutional clients. Thus when rates were deregulated, retail clients witnessed a sharp increase in

rates. This lead to the evolution ofDiscount Broking.

Discount Brokers:

These firms started out as small no-frills players. But some of them like Charles Schwab and Fidelity Investment have grown large

enough to be comparable with the big full service brokerage houses. Such brokers offer the same services or attractions to all their clients. In most cases they do not offer their own research. Many simply offer Standard and Poors reports on major companies. Fidelity is an exception. In 1997 it established an agreement with Salomon to

offer its institutional research. In return Fidelity agreed to provide Salomon withaccess to its customers for marketing new equity issues.

In a discount brokerage house, the registered representative is merely an ordertaker. He is forbidden by firm policy to make any kind of investmentrecommendation.

The representatives pay is not linked to the solicitation of new business or toactive trading and it is much lower than that of a representative working with afull service firm.

Deep Discount Brokers:

These firms charge even less as compared to discount brokers. But they usually require a minimum number of trades annually and/or a large

account balance.

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Soft Commissions:

In an unregulated market a broker obtains greater order flow by lowering hiscommissions and trying to offer better services.In a price regulated market the only choices are:

Offer better service Or offer other things of value

Before deregulation brokers gave institutional clients many free services. The services took many forms.o They provided investment research

o They gave away accounting systems; communications systems;

computing systems; and provided staff training.o Clients were given marketing incentives such as:

o Tickets to major sporting events

o All expense paid trips to investment conferences in exotic

locationso In return clients paid high commissions.

To promote fairness in the systems, that is, to ensure that the services provided

were commensurate with the value of business, they created a system ofsoftdollar accounting.

Under this scheme, a client earned one soft or notional dollar for a certain amountof hard dollars spent by way of commissions.

These soft dollars could then be used to procure services from the broker. They could even be used to procure services from third parties via brokers. The soft dollar system allowed brokers to compete for business despite the fixed

commissions. A more aggressive broker would simply gift away soft dollars more easily. Clients benefited from the competition and by way of lower net trading costs. The soft dollar system basically undermined the concept of fixed brokerage

commissions and hastened deregulation. But the abolition of the fixed commission regime has not lead to the end of the

soft dollar system. In fact, the use of soft dollars has increased after deregulation. According to the SEC the total value of research paid for with soft dollars

exceeded US dollars 1 billion in 1998. In fact to obtain such soft dollars, many institutional traders, and willing pay

much higher commissions than they would otherwise have had to pay for tradeexecution.

In 1998 soft dollar brokers offered 1 dollar of soft dollar services on an average,for every 1.7 dollars received by way of hard dollar commissions.

The reason for popularity of Soft dollars is that mutual funds find this system tobe attractive.

When an investment fund pays hard dollars for expenses other than tradingcommissions, the cost appears as an expense in the books of accounts.

Trading commissions, however, even though they are paid for with hard dollarsdo not show up as direct expenses in the books of account.

Instead they have a financial impact on the net price at which the fund buys orsells shares.

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Commissions will raise purchase prices, and lower sales proceeds. Many investors prefer to invest in funds with a low expense ratio. Thus many funds prefer to pay for services with soft dollars in order to create an

illusion that costs are being managed more effectively.

Directed Brokerage & Commission Recapture: Many institutional investment sponsors direct their investment advisors to use theservices of specific brokers.

The sponsors thus create direct brokerage relationships to support specificbrokers.

For instance, political considerations force many state and municipal pensionfunds to use in-state brokers.

Pension plans at times negotiate commission recapture agreements with brokers towhom they direct orders.

These agreements require the broker to return to the sponsor some of thecommissions that are paid.

These recaptured commissions may reflect volume discounts or may simply berebates. State and municipal plan sponsors use this money to pay for investment

consulting services for which they would otherwise have no budget. According to the Employment Retirement Income Security Act (ERISA), trustees

of private pension plans in the U.S have to treat commissions as assets of thefund.

Thus if they were to recapture any commissions they would have to return them tothe fund.

Thus private pension plans generally do not negotiate such recapture agreements.

Interest Income:

Some times brokers lend a part of the money that is required by an investor to buysecurities. This is called Margin Trading.

In such cases the broker will charge interest on the margin loan. The rate of interest is based on the brokercall money rate. This is the rate at which a broker can borrow from another broker. Brokers also earn interest on the cash that is deposited with them by their clients. But this is largely offset by the interest that they are required to pay to their clients

on such balances. But in the net the broker will still make money. Some brokers will not pay interest on the clients cash balance. And there are others who will pay only if the balance were to exceed a certain

minimum figure.

Short Interest Rebate:

When a trader wants to short sell a security his broker must have the securityready for delivery to the buyer.

Thus before a broker accepts an order to short sell, he will first determine if thesecurity is available.

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In practice the broker will usually have securities that he is holding in street name. If so, he can deliver these securities. If not he must borrow the securities from someone else. When the broker delivers a security that he holds in street name, he will not pass

on the proceeds to the short seller.

He will keep the cash as collateral in order to ensure that the short seller is able torepurchase the security. Thus the broker can invest the proceeds from the short sale, and will earn interest

income on the same. If the broker is forced to borrow the security to facilitate the short sale, he must

deposit the sale proceeds plus about 2% more with the lender to collateralize theloan.

The lender of the stock can invest this money and earn interest on it. Since the market for lending securities is competitive, lenders will pay the

borrowing brokers interest on the cash collateral in order to solicit business. This interest is called Short Interest Rebate.

The short interest rate is based on a benchmark such as LIBOR minus a smallborrowing fee. The borrowing fee would depend on the availability of the security. Securities, which are difficult to borrow, are said to be on special. The borrowing fees for them are higher. The interest that a broker earns directly or indirectly on the proceeds from a short

sale can be a very significant source of revenue. Large clients and professional traders demand that their brokers rebate some of

the interest earned on the proceeds of the short sale. This kind of an interest payment is also called a short interest rebate. Retail brokers however, generally refuse to pay short interest rebates to their

clients as a matter of firm policy.

Security Lending Fees:

A broker who holds securities in street name will often lend them for short sales. In return he will get securities lending fee. The fee would depend on the demand for short positions and the availability of

the shares.

Money Markets

Features of the Market:

It is a market for instruments with an original time to maturity of one year or less. It is a wholesale market.

Instruments are: Highly Liquid Short Term Debt Securities Not for small investors.

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However they can participate indirectly through MMMFs. The money market facilitates large-scale transfer of funds. For most banks except the Bank of America, fund requirements usually

exceed deposits. For smaller state and local banks, deposits usually exceed fund

requirements. It helps parties to adjust liquidity imbalances. Corporations and institutions with temporary surpluses can transfer them

to corporations and institutions with short-term needs.

The Federal Reserve:

The Federal Reserve is the central bank of the United States. It consists of 12 member banks located in the following cities.

o Boston

o New York

o Philadelphia

o Clevelando Richmond

o Atlanta

o Chicago

o St. Louis

o Minneapolis

o Kansas City

o Dallas

o San Francisco

Open Market Operations:

The money market is where the Federal Reserve carries out open-marketoperations.

The term refers to the buying and selling of Treasury securities by theFED in the secondary market.

This is done to regulate the money supply and influence interest rates. In order to increase the money supply, the FED will buy Treasury

securities. To decrease the money supply, it will sell Treasury securities. The decision to undertake such operations is taken by the Federal Open

Market Committee (FOMC).

The Federal Reserve of New York implements it.

Features of Trading:

Because of the large volumes involved, skill and expertise in trading are of theutmost importance.

Most traders specialize in narrow segments of the market. The market is bound by a strict code of honor.

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Billions of dollars worth of business is conducted over the phone, and noone reneges.

The market is relatively unregulated and therefore highly innovative. They are short-term debt instruments issued by the U.S. Treasury. They are devoid of credit risk.

They are highly liquid. Bills with original terms to maturity of 13 weeks, 26 weeks, and 52 weeksare regularly issued.

T-Bills:

13 week and 26 week bills are issued every week. One-year bills are issued once a month. The most recently issued securities are called On-The-Run securities. These are highly liquid. Instruments issued earlier are called Off-The-Run securities. They tend to be less liquid.

These are zero coupon securities. That is, they are issued at a discount from the face value. The yield that is quoted for bills is a discount yield.

Such yields are used to calculate the difference between the facevalue and the price to be paid.

Calculation of the Discount:

For all calculations involving money market instruments the year is assumed tohave 360 days.

Let us use the following symbols: V = Face Value Tm = Days to Maturity d = Quoted Yield

Dollar Discount: D = d x V x Tm/360

Rate of Return:

The rate of return if the bill is purchased at this price will be greater than thequoted yield.

Bankers Acceptances (BAs):

In international trade when goods are exported the exporter will draw up a Draftor a bill of exchange.

A Draft is an instrument that instructs the importer to pay the amountmentioned upon presentation.

A Draft may be a Sight Draft or a Time Draft.

Sight Drafts:

In such cases the importer has to pay for the goods on sight of the draft. His bank will not release the shipping document until he pays.

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Such transactions are known as Documents against Payment transactions.

Time Drafts: These are also known as Usance Drafts. The bank will release the shipping documents in such cases as soon as the

importer accepts the draft by signing on it. The importer need not pay immediately. In other words the exporter is offering him credit for a period. When the importer accepts a draft it becomes a Trade Acceptance.

Letters of Credit (LCs):

Most international transactions are backed by LCs. An LC is a written guarantee given by the importers bank to honor any

drafts or claims for payment presented by the exporter. LC based transactions are more secure. Shipments under an LC can be on the basis of a sight draft or a

time draft.

LC Based Transactions:

In the case of a sight draft the importers bank will pay on presentation. In the case of a time draft it will accept it by signing on it. A draft that is accepted by a bank is called a Bankers Acceptance.

It is obviously more marketable than a trade acceptance.

The Market for BAs:

In the U.S. there is an active secondary market for BAs. They are short term zero coupon assets which are redeemed at the face

value on maturity BAs with a face value of 5MM USD are considered to constitute a round

lot. Once a BA is issued the exporter can get it discounted by the accepting

bank.o That is he can sell it for its discounted value.

Or he can sell it to someone else in the secondary market. The credit risk involved in holding a BA is minimal.

This is because it represents an obligation on the part of the acceptingbank.

In addition it is also a contingent obligation on the part of the exporter.o That is if the bank fails to pay, the holder has recourse to the

exporter who is the drawer of the draft

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Commercial Paper (CP):

Commercial Paper is a short-term unsecured promissory note. Unsecured means that the loan is not backed by a pledge of assets. Thus it is backed only by the liquidity and earning power of the borrower. CP markets are wholesale because the denominations are large.

For a large credit worthy issuer CP issues offer low cost alternatives to abank loan. Unlike T-Bills CPs carry a risk of default.

o Consequently investors demand higher yields.

Sale of Paper:

Most paper is sold through dealers who buy it from the issuer and resell it mainlyto banks.

They get a fee for this. Dealers also provide advice on what rate to offer on newly issued paper. Dealers also undertake to buy unsold paper.

Large and regular issuers of paper often employ their own sales force.

Rating of Commercial Paper:

Paper is rated by one or more of the following main rating agencies in the U.S.o Moodys

o Standard and Poor

o Duff and Phelps

o Fitch

Credit Rating:

Agencies are paid by the issuers of paper.

A good rating makes it easier and cheaper to borrow However rating agencies always look at the issue from the perspective of a

potential investor. This is because their credibility is based on their track record from the

standpoint of accuracy.

Evaluation Criteria:

Rating agencies use the following criteria. Strong management. Good position for the company in a well established industry. Good earnings record.

Adequate liquidity. Ability to borrow to meet both anticipated and unanticipated needs.

Repurchase Agreements (Repos):

In a Repo transaction a borrower of securities sells them to the lender at a pricewith a promise to buy it back subsequently at a higher price.

Sometimes the securities are bought back at the same price, in which caseinterest is explicitly calculated and paid.

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It is collateralized loan because it is backed by the underlying securities. From the perspective of the borrower, such a deal is a Repo. From the perspective of the lender, it is a Reverse Repo. Investors do reverse repos because they want a better return on cash that is

temporarily idle.

Types of Repos:

Most repos are done on an overnight basis. Typically a dealer will locate a corporation or MMMF, which has funds to

invest overnight. Some dealers may also undertake long-term speculative positions, which

consequently need to be financed for longer periods.o Such repos are called Term Repos and carry a higher rate of

interest.

Collateral for Repos:

Most repos are collateralized by government securities. Sometimes other money market instruments like commercial paper andBAs may be used.

Credit Risk:

In practice both he borrower and the lender are subject to credit risk. If interest rates rise sharply, the value of the collateral will decline and the

lender will be vulnerable.o In this case, if the borrower were to go bankrupt, the lender

will be left with assets, which may be worth less than the loanamount.

If interest rates decline the value of the collateral will rise.o Now if the lender goes bankrupt, the borrower will be left with

an amount that is less than the market value of the securities. There is no strategy, which will reduce the risk for both the parties.

o Increasing protection for one means enhanced risk for the

other. The lender can ask for margin.

What this means is that he can lend less than the market value of theassets.

But this will increase the risk for the borrower. The borrower can ask for reverse margin.

That is, he can ask the lender to lend more than the market value of thesecurities. But this will increase the risk for the lender.

In practice it is the lenders who receive margins. This is because they are parting with cash, which is the more liquid of the

two assets. Thus the market value of the collateral will exceed the loan amount.

The excess is called a Haircut.

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Haircuts:

The size of the haircut would depend on: The maturity of the collateral. Its liquidity.

Its price volatility. The term to maturity of the Repo Creditworthiness of the borrower.

Market Risk and Marking to Market:

Market risk is the risk that the value of the collateral may decline. To reduce market risk, the collateral must be periodically marked to

market. That is the market value of the security should be checked to see if

it is adequately in excess of the loan amount.o If not more collateral should be asked for.

o

Or else a partial return of cash must be demanded.

Negotiable Certificates of Deposit:

A CD is an instrument issued by a bank in return for a time deposit. The term negotiable indicates that there is an active secondary market

where these deposit receipts can be bought and sold. A CD can have any maturity in excess of 30 days. Most CDs have maturities ranging from one to three months.

CDs:

CDs are interest-bearing instruments and not discount instruments.o

So to get a certificate with a face value of $100,000 one has toactually deposit $100,000. CDs pay interest on an Actual/360 basis.

Yields on CDs:

These are a function of demand and supply.o CDs are not risk less because the issuing bank could fail.

o For the issuing bank, the effective cost of the CD is greater

than the quoted rate of interest because of reserve requirementsand insurance premia.

Derivatives: These are assets whose demand is based on, or derived from, the demand for an

underlying asset. The underlying assets could be stocks, bonds, physical assets, stock market

indices, or foreign currencies. Derivative securities, more appropriately termed as derivative contracts, are

assets, which confer the investors who take positions in them with certain rightsor obligations.

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They owe their existence to the presence of a market for an underlying asset orportfolio of assets, which may be considered as primary securities.

Consequently such contracts are derived from these underlying assets, andhence the name.

Thus if there were to be no market for the underlying assets, there would

be no derivatives.

Broad Categories of Derivatives:

Forward Contracts Futures Contracts Options Contracts Swaps

For Options, the derivative categories are:o Futures Options Options contracts which are written on futures

contractso

Compound options Options contracts which are written onoptions contractso Swaptions Options on Swaps

Forward Contract:

A forward contract is an agreement between two parties that calls for the deliveryof an asset on a specified future date at a price that is negotiated at the time ofentering into the contract.

Unlike a conventional transaction, no money changes hands when a forwardcontract is negotiated.

When the contract expires, the goods will be delivered and the money will be paid

in return. A forward contract is an Over-the-Counter orOTC contract. This means that the terms of the agreement are negotiated individually between

the buyer and the seller. Every forward contract has a buyer and a seller.

The buyer has an obligation to pay cash and take delivery on the futuredate.

The seller has an obligation to take the cash and make delivery on thefuture date.

Futures Contract: A futures contract too is a contract that calls for the delivery of an asset on aspecified future date at a price that is fixed at the outset.

It too imposes an obligation on the buyer to take delivery and on the sellerto make delivery.

Thus it is essentially similar to a forward contract. Futures contracts are however traded on organized futures exchanges, just the way

common stocks are traded on stock exchanges.

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The features of such contracts, like the date and place of delivery, and thequantity to be delivered per contract, are fixed by the exchange.

Options:

An options contract gives the buyer the right to transact on or before a future dateat a price that is fixed at the outset. It imposes an obligation on the seller of the contract to transact as per the

agreed upon terms, if the buyer of the contract were to exercise his right. Consequently there are two types of options Calls and Puts.

A Call Option gives the holder the right to buy/acquire the asset. A Put Option gives the holder the right to sell the asset. If a call holder were to exercise his right, the seller of the call would have to make

delivery of the asset. If a put holder were to exercise his right, the seller of the put has an obligation to

buy the asset.

The buyers of both call and put options have to pay a price to acquire the optionfrom the sellers. This called the Option Price orPremium. If the right is subsequently exercised the call/put holder will pay/receive a price

per unit of the underlying asset. This is called the Strike orExercise Price.

Longs and Shorts:

The buyer of a forward, futures, or options contract is known as the Long. A trader who owns an asset is said to have a Long position. People with long positions will gain if prices rise subsequently and will

lose if they subsequently fall. Thus those desirous of taking long positions attempt to buy low and sell

high. The seller of a forward, futures, or options contract, is known as the Short.

A trader is said to have a short position when he has sold an asset thatwas not owned by him.

In such cases he has to eventually buy the asset and return it to theinvestor who lent it to him to facilitate the sale.

The hope is that prices would have declined by then. When a person with a short position re-acquires the asset, he is said to be

`covering his position. The objective of a short seller is to sell high and buy low.

In the case of options, a Short is also known as the Option Writer.

Comparison of Futures/Forwards versus Options:

Instrument Nature of Longs

Commitment

Nature of Shorts

Commitment

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Forward/FuturesContract

Obligation to buy Obligation to sell

Call Options Right to buy Obligation to sell

Put Options Right to sell Obligation to buy

Swaps:

A swap is a contractual agreement between two parties to exchange specified cashflows at pre-defined points in time.

There are two broad categories of swaps:o Interest Rate Swaps and

o Currency Swaps.

Interest Rate Swaps:

In the case of these contracts, the cash flows being exchanged represent interestpayments on a specified principal, which are computed using two differentparameters.

For instance one interest payment may be computed using a fixed rate ofinterest, while the other may be based on a variable rate such as LIBOR.These are called fixed floating Swaps.

There are also floating floating Swaps where both the interest payments arecomputed using two different variable rates For instance one may be based onthe LIBOR and the other on the Prime Rate of a country.

Obviously a fixed-fixed swap will not make sense. Since both the interest payments are denominated in the same currency, the actual

principal is not exchanged. This principal is known as a notional principal.Also, once the interest due from one party to the other is calculated, only thedifference or the net amount is exchanged.

LIBOR:

The most common benchmark is the London Interbank Offer Rate or LIBOR. LIBOR is the rate at which a Eurobank is willing to lend to another Eurobank. Commercial loans made on a floating basis are priced at LIBOR plus a spread. The spread would depend on the credit worthiness of the borrower.

Currency Swaps:

These are also known as cross-currency swaps. In this case the two parties first exchange principal amounts denominated

in two different currencies. Each party will then compute interest on the amount received by it as per a

pre-defined yardstick, and exchange it periodically.

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At the termination of the swap the principal amounts will be swappedback.

In this case, since the payments being exchanged are denominated in twodifferent currencies, we can have fixed-floating, floating-floating, as wellas fixed-fixed swaps.

Deregulation of the Brokerage Industry:

On 1 May 1975, fixed brokerage commissions were abolished in the U.S. Subsequently, brokers and clients were given the freedom to negotiate

commissions while dealing with each other. In October 1986, fixed commissions were eliminated in London, and in

1999 Japan deregulated its brokerage industry. Also, from February 1986, the LSE began admitting foreign brokerage

firms as full members. The objective of the entire exercise was to make London an attractive

international financial market, which could effectively compete with

markets in the U.S.

Why Use Derivatives:

Derivatives have many vital economic roles in the free market system. Firstly, not every one has the same propensity to take risks.

Hedgers consciously seek to avoid risk, while speculatorsconsciously take on risk.

Thus risk re-allocation is made feasible by active derivatives markets. In a free market economy, prices are everything.

It is essential that prices accurately convey all pertinentinformation, if decision making in such economies is optimal.

How does the system ensure that prices fully reflect all relevant information? It does so by allowing people to trade. An investor, whose perception of the value of an asset differs from

that of others, will seek to initiate a trade in the market for theasset.

If the perception is that the asset is undervalued, there will bepressure to buy.

On the other hand if there is a perception that the asset isovervalued, there will be pressure to sell.

The imbalance on one or the other side of the market will ensurethat the price eventually attains a level where demand is equal tothe supply.

When new information is obtained by investors, trades will obviously be induced,for such information will invariably have implications for asset prices.

In practice it is easier and cheaper for investors to enter derivativesmarkets as opposed to cash or spot markets.

This is because; the investor can trade in a derivatives market bydepositing a relatively small performance guarantee or collateral known asthe margin.

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On the contrary taking a long position in the spot market would entailpaying the full price of the asset.

Similarly it is easier to take a short position in derivatives than to short sellin the spot markets.

In fact, many assets cannot be sold short in the spot market.

Consequently new information filters into derivatives markets very fast. Thus derivatives facilitate Price Discovery. Because of the high volumes of transactions in such markets, transactions costs

tend to be lower than in spot markets. This in turn fuels even more trading activity. Also derivative markets tend to be very liquid. That is, investors who enter these markets, usually find that traders who

are willing to take the opposite side are readily available. This enables traders to trade without having to induce a transaction by

making major price concessions. Derivatives improve the overall efficiency of the free market system.

Due to the ease of trading, and the lower associated costs, informationquickly filters into these markets. At the same time spot and derivatives prices are inextricably linked. Consequently, if there is a perceived misalignment of prices, arbitrageurs

will move in for the kill. Their activities will eventually lead to the efficiency of spot markets as

well. Finally derivatives facilitate speculation.

And speculation is vital for the free market system.

Offsetting:

What happens when a trader who has entered into a futures contract, desires to getout of his position without having to deliver or to accept delivery?

He can simply offset by taking a counter-position in the same contract, onthe floor of the futures exchange. (If a trader has taken a long positioninitially, taking a counter-position would entail going short subsequentlyand vice versa.)

Margins:

Let us first see as to why a margin is required. Since a futures contract imposes an obligation on both the parties, it is but

logical that given a chance, one of the two parties would like to default onthe expiration date, since it will not be in his interest to go through withthe contract.

The question is how can the clearinghouse guard itself against thiseventuality?

Remember it has provided a performance guarantee to both the parties,and unless it takes adequate precautions, it could be saddled with a loss.

The protection technique is fairly simple. Estimate the potential loss for either party and collect it in advance.

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Since both the parties have an obligation, both can lose in principle. Consequently it is necessary to collect collateral from both the parties. Once the potential loss is collected from a party, there is no incentive to

default. And even if the party that ends up on the losing side of the transaction

were to fail to perform its obligations, the clearinghouse is in a position totake care of the interests of the other party. This is the crux of margining.

Marking to Market:

Closely related to the system of margining is the concept of marking to market. What is marking to market?

Now, the reason for collecting margins is to protect both the partiesagainst default by the other party.

The potential for default arises because a position once opened, can andinvariably will lead to a loss for one of the two parties if that party were to

comply with the terms of the futures contract. Now this loss will not simply arise all of a sudden at the time of expirationof the contract.

As the prices in the market fluctuate from trade to trade, one of the twoparties to an existing futures position will experience a loss while the otherwill experience a gain.

The total loss or gain from the time of getting into a position, till the timethe contract expires or is offset by taking a counter-position, whicheverwere to happen first, will be the sum of the these small losses/profitscorresponding to each observed futures price in the interim.

Marking to Market refers to the process of calculating the loss for oneparty, which implies a corresponding gain for the other, at specified pointsin time, with reference to the futures price that was prevailing at the timethe contract was previously marked to market.

When a futures contract is entered into, it will be marked to market for the firsttime at the end of that day.

Subsequently, it will be marked to market everyday until either the position isoffset or else the contract expires.

Remember that both the parties have deposited a performance guarantee orcollateral in their margin accounts.

The amount of margin that is deposited when the contract is first enteredinto is called the Initial Margin.

Margin Accounts:

If a profit is made subsequently, the margin account will be credited, whileif a loss is made, it will be debited.

An increase in the balance in the margin account can be withdrawn by theinvestor.

However the broker has to ensure that the balance in the account does notdip below a threshold level due to repeated losses.

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Otherwise the entire purpose of depositing margins will be defeated. This threshold is known as the Maintenance Margin. If the balance dips below this level, the trader will get a Margin Call

asking for additional funds to be deposited, to take the balance back to theInitial Margin level.

Maintenance Margins:

On many exchanges, a loss suffered by a party does not automatically manifestitself as a call for funds.

The broker will fix a minimum threshold level for the balance in themargin account of the trader.

This is called the Maintenance Margin. As long as the account balance remains above this level, the trader does

not have to deposit any additional funds, not withstanding any losses thathe may have suffered.

However if the account balance were to dip below this level, the broker

will issue a Margin Call.

VaR:

The whole purpose of margining is to remove the incentive to default bycollecting an amount equal to the potential loss in advance.

The pertinent question is therefore, How do we calculate the potential loss over agiven time horizon?

This is where the concept ofValue at RiskorVaRcomes in. The Value at Risk of a position is a statistical measure of the possible

loss of value of a portfolio of assets over a specified time horizon.

For instance, the 99% VaR of a portfolio over a one day horizon signifiesthat the portfolio is expected to suffer a loss exceeding the calculated VaRonly with a probability of 1% over a one day horizon.

This does not mean that the maximum loss that a portfolio can suffer from oneday to the next is equal to the VaR.

The maximum possible loss of value is always equal to the initial value ofthe portfolio, since, in principle, the value of the assets constituting theportfolio can go to a minimum of zero.

A given measure of VaR is meaningless unless the corresponding probabilitylevel and time horizon are specified.

Margins Calls & Variation Margin:

The trader is expected to deposit enough funds to take the account balanceback to the level of the Initial Margin, whenever he receives a MarginCall.

The additional funds that are deposited are known as Variation Margin.

Gross versus Net Margining:

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Clearinghouses collect margins through the brokers of the traders who haveplaced the orders.

The margin collected by a clearinghouse is known as the ClearingMargin.

The individual clients in turn will deposit margins with their respective brokers.

While a broker may demand a greater margin than the amount stipulatedby the clearinghouse, he certainly will not ask for less. However every broker is not authorized to collect margins.

FCMs:

In the U.S. only a Futures Commission Merchant (FCM) is authorized to openan account on behalf of a client who wishes to trade.

Opening and maintenance of an account entails the collection of margin money;the maintenance of balances in margin accounts; and the recording and reportingof all trading activities.

Every broker need not be an FCM. A broker who merely facilitates a transaction by routing an order to anFCM is known as an Introducing Broker.

Secondly every FCM is not a member of a clearinghouse. In other words, not every FCM is authorized to clear and settle trades with

the clearinghouse. Members who are authorized to perform this function are called Clearing

Members. Thus if you place an order with a non-clearing FCM, he must route the

order through a clearing member. Every trader has to deposit margin with his FCM. However, an FCM may or may not have to deposit margins for every trade that is

routed through him, with the clearinghouse. Whether he has to do so or not, would depend on whether the exchange

uses Gross or Net Margining.

Net Margining System:

Consequently under this system, the clearinghouse will collect marginonly for net difference between short and long positions the broker ishaving. The broker is responsible for guaranteeing performance from thestandpoint of the remaining positions, which are actually short or longapart from the net value.

Net margining is also known as Broker Level margining. In the case of net margining, traders have to carefully evaluate the

integrity and creditworthiness of their brokers, for they cannot always relyon the clearinghouse to bail them out.

Gross/Client Level Margining System:

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Under this system, the clearinghouse will ask the broker to deposit marginequivalent to all the 300 contracts that have been routed through him.

Now if the shorts default, and the brokers go insolvent, the clearinghousewill have adequate resources to take care of all the 180 long positions.

India has adopted a gross margining system.

Gross margining provides greater safety but carries a higher economic price tag.

Trading Volume:

Trading Volume refers to the number of contracts that are traded during a givenperiod, usually a day.

Every trade will consequently lead to an increase in the value recorded forthe trading volume for that day.

Open Interest:

Open Interest refers to the number of open positions at any point in time. Obviously the number of open long positions will be equal to the number

of open short positions. Consequently, we need to total up only one side of the market whilecalculating the open interest.

Trading Volume vs. Open Interest:

Every trade need not lead to an increase in the open interest. If both parties to a trade are increasing their respective positions, then

open interest will rise. However, if in the process of trading, one of the parties is offsetting, and

then open interest will remain unchanged. However, if the trade results in both parties offsetting their existing

positions, then open interest will actually fall. A high trading volume indicates that the market was very liquid on that day. A high open interest on the other hand is a signal that liquidity on future days is

likely to be high. Because, the higher the open interest, the greater is the potential for

offsetting.

The relationship between the spot price and the forward price at any point in time is

a function of the carrying cost.

Arbitrage:

The inefficiencies in a system are overcome in practice by a process known asarbitrage.

We will define arbitrage as the potential to make costless risk-less profits bysimultaneously transacting in multiple markets.

These opportunities cannot persist for long. As investors rush to buy shares in New York, the price on the NYSE will rise. As everyone starts selling shares in London the price on the LSE will fall.

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As people start selling pounds and buying dollars, the dollar will appreciaterelative to the pound.

Consequently equilibrium will be restored.

Cash and Carry Arbitrage: What would be the consequence ifF > S + rS

If so, an arbitrageur would borrow and buy the asset and go short in aforward contract to deliver at a future date.

At the time of delivery he would receive F, return S + rS, which representthe loan plus interest, and pocket the difference.

Such a strategy is called Cash and Carry Arbitrage. To rule it out, we require that

F S rS F S (1+r) The rate of return obtained from a cash and carry arbitrage strategy is called the

Implied Repo Rate. Thus cash and carry arbitrage is profitable only if the Implied Repo Rateexceeds the borrowing rate.

We have seen that if F > S + rS then it can be exploited by an arbitrageur by goingshort in a forward contract.

However, what if F < S + rS? This too represents an arbitrage opportunity. However to exploit it, one would have to take a long position in a forward

contract. Under such circumstances, the arbitrageur would have to short sell the

asset and invest the proceeds as the risk-less rate.

He would have to simultaneously go long in a forward contract toreacquire the asset at a predetermined price. Such a strategy is called Reverse Cash and Carry Arbitrage.

Synthetic T-Bill:

A combination of a long position in the asset and a short position in theforward contract is equivalent to a long position in a Zero Couponinstrument.

Such a Zero Coupon instrument is called a Synthetic T-Bill. Symbolically

Spot Forward = Synthetic T-BillThe negative sign indicates a short position in the forward contract. Thus if we have a natural position in two out of the three assets, we can

artificially create a position in the third.

Short Sales:

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When an investor expects the market to go through a bull phase, orexpects stocks to rise in value He will acquire stocks in anticipation ofbeing able to sell them subsequently at a higher price

The maxim is Buy Low and Sell High But what if an investor anticipates a bear phase?

He would like to Sell High and Buy Low Short selling requires an investor to sell a stock that he does not own How can one sell something that one does not possess?

The answer is simple, borrow the asset from someone and sell it In this case, borrow the shares from a broker and sell

When an investor requests that a share be borrowed on his behalf and sold,the proceeds will be credited to his account.

At some point in time he will have to actually buy the share in order toreturn it

This is called Covering the Short Position Obviously the anticipation is that the share price will be lower when the

short position is covered. If so, the investor will reap a profit If not, he will make a loss

Margin Trading:

The term Margin Trading refers to the purchase of shares by borrowing a fractionof the required amount

Short Selling too is a form of Margin Trading the difference is thatinstead of cash, shares are being borrowed

Consequently, short selling in the U.S is governed by Regulation T (RegT), the same regulation that governs margin trading

Thus when a share is sold short, the seller must deposit at least 50% of thesale proceeds as collateral, in addition to the proceeds from the short sale

A short position is inherently more risky than a long position acquired on themargin

When one buys an asset on the margin, the maximum possible loss isequal to the purchase price of the share

When a stock is bought on the margin the broker will tolerate losses tillthe maintenance margin level is reached

If the investor fails to respond the position will be liquidated and the fundsdue to the broker will be recovered

The balance will be refunded to the investor Short sales entail finite profits and infinite losses

That is profits are capped at 100%, while losses are unbounded Short Sale undoubtedly contributes positively to the functioning of the free

market system It provides liquidity and helps drive down the prices of overvalued stocks

to realistic levels

The Uptick Rule:

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The SEC, NYSE, and NASD have rules that prevent short selling unless the saleis at a price that is higher than the last different price

That is, the trade must be on an Uptick or on a zero Uptick The objective is to prevent short sales in a declining market, because

sustained short selling under such conditions, can cause markets to crash

Implied Reverse Repo Rate:

The cost of borrowing funds using a reverse cash and carry strategy iscalled the Implied Reverse Repo Rate.

Reverse cash and carry arbitrage is profitable only if the Implied ReverseRepo Rate is less than the lending rate.

The No-Arbitrage Condition:

In order to rule out cash and carry arbitrage, we require that

F S (1+r) In order to rule out reverse cash and carry arbitrage we require that

F S (1+r)Hence to rule out both forms of arbitrage it must be the case that F = S (1+r)

Futures or Options?

Futures contracts lock in the price at which the hedger can buy or sell theasset. When a futures contract is entered into, the futures price is set insuch a way that the value of the contract to both the parties is zero. Thusneither party need pay to get into a futures position.

Options however give protection on one side, while permitting the hedgerto benefit from favorable price movements on the other side.

In the case of an option, whether it is a call or a put, the buyer has to pay aprice to the writer at the outset, in order to acquire the right. This price is called the Option Price or the Option Premium. This amount cannot be recovered if the buyer were to decide not to

exercise the option subsequently.

Exercise Price:

The exercise price is what the option holder has to pay per unit of theasset, if he decides to exercise the option.

Speculating With Futures:

The advantage of speculating with futures is that the entire value of theasset need not be paid in order to acquire a long position. All that the speculator has to do is to deposit the required margin. Secondly, because of the high volumes of transactions involved,

transactions costs are much lower in futures markets.

Bulls and Bears:

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A person who anticipates that the market will move up is a Bull. He can speculate by either going long in futures, or by buying call options.

An investor who anticipates that the market will fall is called a Bear. A Bear can speculate by going short in futures or by buying put options.

Options: Options are by design different from forward and futures contracts. The buyer of the options contract is called the Holder or the Long, and he

has aright. The seller of the contract is called the Writer or the Short and he has an

obligation. Options contract, which can be exercised only at the time of expiration, are called

European options. Contracts, which can be exercised at any time, up to, and including the time of

expiration are called American options. Most exchange-traded options are American.

Option Price or Premium:

This is the cost of acquisition of the option. It is payable by the buyer to the writer at the outset. Thus unlike in the case of a forward or a futures contract, the long has to

pay the short to get into an options contract.

Strike Price/Exercise Price:

This is the price payable per unit of the underlying asset, if a call option isexercised by the holder.

It is the price receivable per unit of the underlying asset, if a put option isexercised by the holder.

Thus when the buyer of an options contract pays the option premium, he merelyacquires the right to transact.

If he subsequently decides to go through with the transaction, he must payto acquire the underlying asset in the case of call options.

Or else he must be paid when he delivers the underlying asset in the caseof put options.

Expiration date:

This is the point in time after which the contract becomes null and void. It is the only point in time at which a European option can be exercised. It is the last point in time at which an American option can be exercised

Profit Bounds:

For a call holder the maximum profit is unlimited, since theoretically, there isno upper bound on the price of the asset.

Thus if the call is exercised: = (ST X) C, which has no upper bound.

ST is the stock price, X is the exercise price and C is the premium.

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If the call is not exercised: = -C

For a call writer the maximum profit is the option premium. This is because the best thing that can happen from his standpoint is that

the holder does not exercise, and he consequently gets to retain the entirepremium. Thus if the call is not exercised:

= C. If the call were to be exercised the writer has to deliver a share, whose

price is theoretically unbounded, at the exercise price. That is: = C (ST X) Thus the maximum possible loss for a call writer is infinite.

For a put writer the maximum possible profit is the premium. This is because the best thing that can happen to him is that the option is

not exercised. His loss if the put is exercised is: = P (X ST) which has a lower bound of(P X) = -(X-P)

Thus both calls and puts are Zero Sum Games. One mans profit is always another mans loss.

Exchange Trade and OTC Options:

Exchange traded options were introduced for the first time by the Chicago BoardOptions Exchange (CBOE) in 1973.

Until then options were only traded Over the Counter. OTC options are customized, in the sense that the exercise price, the

expiration date, and the contract size are negotiated between the buyer andthe seller.

Exchange traded options are howeverstandardized like futures contracts. That is the allowable exercise prices and expiration dates are specified by

the exchange. Individual buyers and sellers can incorporate any of the allowable exercise

prices and expiration dates into their agreements, but cannot design theirown contracts.

The contract size too is specified by the exchange.Advantages of Exchange Trade Options:

The advantage of standardization is that volumes tend to be high andtransactions costs tend to be low.

Secondly because of high volumes, these markets tend to be liquid. Also standardized option contracts can be offset by taking counter-

positions, without necessarily involving the original counter-party.

Counter Positions:

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Taking a counter-position means that if you have originally bought a call/put, younow sell an identical call/put.

By identical we mean that the offsetting contract should be on the sameasset, and have the same exercise price and time to expiration.

Similarly if you have sold a call/put, you would now have to buy an

identical call/put in order to offset.

OTC Markets:

The OTC market is dominated by institutional investors. Contracts are entered into privately by large corporations, financial institutions,

and sometimes even governments. When buying an OTC option you have to be either familiar with the

creditworthiness of the writer or else seek a guarantee. Nevertheless OTC markets always carry an element of credit risk. They do offer certain advantages however.

Firstly terms and conditions like expiration dates and exercise prices canbe tailored to the specific needs of the two parties. Often the contract may be on an asset on which an exchange traded

contract is not available. Since the market is private, neither the public nor other investors need to

know about the transaction taking place. However, seeking privacy need not mean that an illegal activity is

taking place. The OTC market is unregulated.

Consequently government approval is not required to design newtypes of contracts.

FLEX Options:

Their disadvantages not withstanding, customized contracts have an appealparticularly for institutional investors.

For many institutions, exchange designed contracts are often inadequateand they desire their freedom to create their own contracts.

Traditionally, an institution in need of a tailor-made contract has had to seek outanother like minded institution like a commercial bank that is seeking to write anoption with similar features.

Of late, in response to competition the exchanges have been making aneffort to grab a slice of the growing OTC market.

Both FLEX and E-FLEX options are cleared by the clearinghouse.

Money ness:

Let us denote the current stock price by St and the exercise price by X. If St > X, the call option is said to be in the money.

Example: St = 110; X = 100 If St < X the call option is said to be out of the money.

Example: St = 90; X = 100

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If St = X the call option is said to be at the money. Example: St =100; X = 100

For put options, if St > X, the option is said to be out of the money. Example: St = 110; X = 100

If St < X, the put option is said to be in the money.

If St = X, the put option is said to be at the money. If St is very close to X, both call and put options are said to be near themoney.

Obviously, an option, whether a call or a put will exercised only if it is in themoney.

Long Term Equity Anticipation Securities or LEAPS:

In addition both the CBOE and the Amex offer long term options with up to twoyears to maturity called Long Term Equity Anticipation Securities orLEAPS.

Option Class: All contracts on a given stock, which are of the same, type that is calls or puts, aresaid to constitute an Option Class.

For instance all the calls that are available on IBM at a point in time,irrespective of their strike price or the expiration date, would be said toconstitute an Option Class.

Options Series:

All the contracts in a given class, that is, the Call Class or the Put Class, andwhich have the same exercise price and the same expiration date, are said toconstitute an Options Series.

Thus all call options contracts on XYZ stock with X = 75 and expiring inJune 2003 would constitute an Options series.

Cash Settlement:

Cash settlement is used for Index options globally. So if an index option is exercised the holder will receive the difference between

the current index value and the exercise price, in the case of call options. In the case of puts, the holder will receive the difference between the exercise

price and the current index level, from the writer.

Equity:

Equity shares or shares of common stock represent ownership in a businessenterprise.

When an investor subscribes to the issue of shares by a company he becomes apart owner of the business.

Ownership of shares entitles an investor to dividends paid by the firm. The rate of dividends is not fixed neither is it contractually guaranteed.

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However good companies try to keep dividends at steady levels to avoid sendingwrong signals to the outside world.

A firm will however not pay out its entire profits for the year as dividends. A fraction of the profits for the year will be reinvested in the company. This is known as Retained Earnings.

If a firm is forced to declare bankruptcy, then the shareholders are entitled to theresidual value of the business, after the claims of the other creditors are fullysettled.

Equity shares never mature, in the sense that they have no expiry date. This is because when a firm is created, it comes into existence with the

assumption that it will last forever. Shareholders are given voting rights. They can vote on various issues at the Annual General Meetings of companies,

including the election of the board of directors.