2. Foreign exchange derivative ................................................................................................................. 8
Interest rate derivative ......................................................................................................................... 8
Credit derivative.................................................................................................................................... 8
Commodity Derivative .......................................................................................................................... 8
Over-the-counter ...................................................................................................................................... 8
Financial markets
The financial markets can be divided into different subtypes:
Capital markets which consist of:
o Stock markets, which provide financing through the issuance of shares or
common stock, and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and enable
the subsequent trading thereof.
Commodity markets, which facilitate the trading of commodities.
Money markets, which provide short term debt financing and investment.
Derivatives markets, which provide instruments for the management of financial risk.
Futures markets, which provide standardized forward contracts for trading products at
some future date; see also forward market.
Insurance markets, which facilitate the redistribution of various risks.
Foreign exchange markets, which facilitate the trading of foreign exchange.
Security
A security is generally a fungible, negotiable financial instrument representing financial value.
Securities are broadly categorized into:
debt securities (such as banknotes, bonds and debentures),
equity securities, e.g., common stocks; and,
derivative contracts, such as forwards, futures, options and swaps.
Fungibility
It is the property of a good or a commodity whose individual units are capable of mutual substitution,
such as crude oil, shares in a company, bonds, precious metals or currencies. For example, if someone
lends another person a $10 bill, it does not matter if they are given back the same $10 bill or a different
one, since currency is fungible; if someone lends another person their car, however, they would not
expect to be given back a different car, even of the same make and model, as cars are not fungible.
3. Debt Security
Banknote
Banknote (often known as a bill, paper money or simply a note) is a kind of negotiable instrument; a
promissory note (i.e. enforceable by law) made by a bank payable to the bearer on demand, used as
money, and in many jurisdictions is legal tender. In addition to coins, banknotes make up the cash or
bearer forms of all modern fiat money (money that derives its value from government regulation or
law). With the exception of non-circulating high-value or precious metal commemorative issues, coins
are used for lower valued monetary units, while banknotes are used for higher values.
Bonds
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the
principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with
interest at fixed intervals (semi-annual, annual, sometimes monthly).
Types of bonds:
1. Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
2. Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of
interest, such as LIBOR(The Libor is the average interest rate that leading banks in London
charge when lending to other banks. It is an acronym for London Interbank Offered Rate ) or
Euribor (The Euro Interbank Offered Rate (Euribor) is a daily reference rate based on the
averaged interest rates at which Euro zone banks offer to lend unsecured funds to other banks
in the euro wholesale money market )
3. Zero coupon bonds
4. Inflation linked bonds
5. Asset-backed securities are bonds whose interest and principal payments are backed by
underlying cash flows from other assets. Examples of asset-backed securities are mortgage-
backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt
obligations (CDOs).
6. Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date
7. Bearer bond is an official certificate issued without a named holder. In other words, the person
who has the paper certificate can claim the value of the bond
8. Treasury bond, also called government bond, is issued by the Federal government and is not
exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A
treasury bond is backed by the “full faith and credit” of the federal government. For that reason,
this type of bond is often referred to as risk-free.
9. Foreign currencies : Some companies, banks, governments, and other sovereign entities may
decide to issue bonds in foreign currencies as it may appear to be more stable and predictable
than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers
the ability to access investment capital available in foreign markets. The proceeds from the
4. issuance of these bonds can be used by companies to break into foreign markets, or can be
converted into the issuing company's local currency to be used on existing operations
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and
collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically a
group of small and illiquid assets that are unable to be sold individually. Pooling the assets into financial
instruments allows them to be sold to general investors; a process called securitization, and allows the
risk of investing in the underlying assets to be diversified because each security will represent a fraction
of the total value of the diverse pool of underlying assets. The pools of underlying assets can include
common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from
aircraft leases, royalty payments and movie revenues.
MBS
A mortgage-backed security (MBS) is an asset-backed security that represents a claim on the cash flows
from mortgage loans through a process known as securitization.
The process of securitization is complicated, and is highly dependent on the jurisdiction within
which the process is conducted. The basics are:
1. Mortgage loans (mortgage notes) are purchased from banks and other lenders and
assigned to a trust
2. The trust assembles these loans into collections, or "pools"
3. The trust securitizes the pools by issuing mortgage-backed securities
CMO
CMO is a debt security issued by an abstraction - a special purpose entity - and is not a debt owed by the
institution creating and operating the entity. The entity is the legal owner of a set of mortgages, called a
pool. Investors in a CMO buy bonds issued by the entity, and they receive payments from the income
generated by the mortgages according to a defined set of rules
CDO
Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with
multiple "tranches"(In structured finance, a tranche (often misspelled as traunch or traunche) is one of
a number of related securities offered as part of the same transaction) that are issued by special
purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a
varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived
from a portfolio of fixed-income underlying assets
Debenture
A debenture is a document that either creates a debt or acknowledges it, and it is a debt without
collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by
large companies to borrow money.
5. Equity Securities
Common stock
Common stock is a form of corporate equity ownership, a type of security. The terms "voting
share" or "ordinary share" are also used in other parts of the world; common stock being
primarily used in the United States.
It is called "common" to distinguish it from preferred stock. If both types of stock exist, common
stock holders cannot be paid dividends until all preferred stock dividends (including payments in
arrears) are paid in full.
In the event of bankruptcy, common stock investors receive any remaining funds after
bondholders, creditors (including employees), and preferred stock holders are paid. As such,
such investors often receive nothing after a bankruptcy.
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a
special equity security that has properties of both an equity and a debt instrument and is
generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common
stock, but are subordinate to bonds in terms of claim or rights to their share of the assets of the
company.[1]
Preferred stock usually carries no voting rights,[2] but may carry a dividend and may have
priority over common stock in the payment of dividends and upon liquidation. Terms of the
preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for
preferreds is generally lower since preferred dividends do not carry the same guarantees as
interest payments from bonds and they are junior to all creditors
Derivative
A derivative instrument is a contract between two parties that specifies conditions (especially the
dates, resulting values of the underlying variables, and notional amounts) under which payments, or
payoffs, are to be made between the parties. Derivatives are broadly categorized by the relationship
between the underlying asset and the derivative (such as forward, option, swap); the type of underlying
asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity
derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-
counter); and their pay-off profile.
6. Based on the relationship between underlying asset and derivative
Forward
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.[1] 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.
Option
In finance, an option is a derivative financial instrument that specifies a contract between two parties
for a future transaction on an asset at a reference price (the strike).[1] The buyer of the option gains the
right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding
obligation to fulfill the transaction. The price of an option derives from the difference between the
reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures
contract) plus a premium based on the time remaining until the expiration of the option. Other types of
options exist, and options can in principle be created for any type of valuable asset.
Swap
In finance, a swap is a derivative in which counterparties (parties to a contract) exchange cash flows of
one party's financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. The five generic types of swaps, in order
of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity
swaps and equity swaps.
Interest rate swaps
The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate
loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for
this exchange is to take benefit from comparative advantage. Some companies may have comparative
advantage in fixed rate markets while other companies have a comparative advantage in floating rate
markets. When companies want to borrow they look for cheap borrowing i.e. from the market where
they have comparative advantage. However this may lead to a company borrowing fixed when it wants
floating or borrowing floating when it wants fixed.
Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one
currency for principal and fixed rate interest payments on an equal loan in another currency. Just
like interest rate swaps, the currency swaps are also motivated by comparative advantage.
Currency swaps entail swapping both principal and interest between the parties, with the
cashflows in one direction being in a different currency than those in the opposite direction. It is
also a very crucial uniform pattern in individuals and customers.
7. Commodity Swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for
a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.
Credit default swap (CDS)
A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to the
seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default
(fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing
restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been
compared with insurance because the buyer pays a premium and, in return, receives a sum of money if
one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is
allowed to profit from the contract and may also cover an asset to which the buyer has no direct
exposure.
Equity Swaps
An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to
be exchanged between two counterparties at set dates in the future.
Based on the underlying asset
Equity Derivative
An equity derivative is a class of derivatives whose value is at least partly derived from one or more
underlying equity securities. Options and futures are by far the most common equity derivatives,
however there are many other types of equity derivatives that are actively traded.
Futures
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.(thus differentiating them from forwards).
Warrants
In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a
specified price, which is much lower than the stock price at time of issue. Warrants are frequently
attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or
dividends. They can be used to enhance the yield of the bond, and make them more attractive to
potential buyers.
Convertible bonds
Convertible bonds are bonds that can be converted into shares of stock in the issuing company, usually
at some pre-announced ratio. It is a hybrid security with debt- and equity-like features. It can be used by
investors to obtain the upside of equity-like returns while protecting the downside with regular bond-
like coupons.
8. Foreign exchange derivative
A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange
rate(s) of two (or more) currencies. These instruments are commonly used for currency specurlation and
arbitrage or for hedging foreign exchange risk.
Interest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a
notional amount of money at a given interest rate. These structures are popular for investors with
customized cash flow needs or specific views on the interest rate movements (such as volatility
movements or simple directional movements) and are therefore usually traded OTC.
Credit derivative
In finance, a credit derivative refers to any one of "various instruments and techniques designed to
separate and then transfer the credit risk" of the underlying loan.[1] It is a securitized derivative whereby
the credit risk is transferred to an entity other than the lender.
Commodity Derivative
Commodity markets are markets where raw or primary products are exchanged. These raw
commodities are traded on regulated commodities exchanges, in which they are bought and sold in
standardized contracts.
Over-the-counter
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds,
commodities or derivatives directly between two parties. It is contrasted with exchange trading, which
occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchanges or
stock exchanges. Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other intermediary.
Products such as swaps, forward rate agreements, exotic options - and other exotic derivatives - are
almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is
largely unregulated with respect to disclosure of information between the parties, since the OTC market
is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC
amounts are difficult because trades can occur in private, without activity being visible on any exchange.
According to the Bank for International Settlements, the total outstanding notional amount is US$708
trillion (as of June 2011).[14] Of this total notional amount, 67% are interest rate contracts, 8% are credit
default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity
contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no
central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since
each counter-party relies on the other to perform.