BFS Investment Banking and Brokerage
At a broad level, financial Instruments can be classified into three types
- Variable Income Instruments (shares and warrants)
- Fixed Income Instruments (bonds, Treasury bills etc.)
- Derivatives (Options, Futures, Forward Contracts and Swaps)
Warrant: A warrant gives the holder of the warrant the option to buy a preferred or a common stock at a specified price within a specified time. When the warrants are exercised the company issues new shares.
Convertibles: Convertibles are securities that are exchangeable for a set number of another form at a pre-stated price. They are usually in the form of preferred shares or bonds and are usually converted in to common share. Convertibles are appropriate for investors who want safer income than what is available from common stock, together with greater appreciation potential than what regular bonds offer.
In India Stock Dividend is referred as Bonus Shares.
Fixed income instruments are those instruments that offer a fixed amount of money for a specified period of time. It is different from equity because in equity the returns are dependent upon the performance of a company. Bonds are the loans taken by governments or corporate. Typically a bond pays a fixed rate at a pre-specified amount of time. This is called coupon rate and the amount of currency that is paid is called as a coupon.
- Par Value: It is the principal amount that is returned at the end of the maturity. It is also known as the principal or face value.
- Coupon Rate: It is the annual rate of interest that a bond’s issuer promises to pay the bondholder at the time of issue. The interest rate is calculated upon the par value of the bond.
- Maturity period or Time to maturity: Maturity is the date on which the principal or nominal value of a bond becomes due and payable in full to the holder. Time to maturity is the time between now and when the bond matures.
Bonds can be divided into following categories:
- Central Government Bonds (Treasuries): These are bonds issued by the central government of a country. These bonds are very liquid i.e. a lot of trading happens in these bonds, and they are very safe.
- Municipal Bonds: The state governments or local government bodies issue these bonds.
- Corporate Bonds: these are the bonds that companies issue. The risk of these bonds depends on the company issuing them. There are various types of corporate bonds i.e. secured bonds (bonds secured by fixed assets or financial assets), unsecured bonds, etc.
The primary characteristics of a bond are: par value, Rate of Return or Coupon rate, Maturity period and Price what determines the price of a bond? Actually a bond is nothing but a series of cash flows. When you buy a bond you have negative cash flow, and when you get the coupons, they are nothing but positive cash flows. Thus we need to discount the cash flows with the opportunity cost of capital, i.e. the rate of a similar risk? Same maturity bond. Some of the rates used in practice are: Spot rate is the interest rate on an investment starting today and ending after some specified day. A forward rate is an interest rate contracted today on an investment that will be initiated after some time in future. In other words it is spot rate in future. Forward rates and spot rates are interlinked.
Bonds having longer maturities will be more sensitive to changes in interest rates i.e. for the same interest rate change, the price of a bond with longer maturity changes more than the price of a bond with lesser maturity.
What is yield? Roughly speaking, yield is the return on the bond. There are three types of yields. Nominal yield is the same as the coupon rate. It is the rate of income that you receive based on the par value of the bond. It is the same throughout the life of the bond.
Current yield is a measure of the return on the bond based on the current price. Yield to maturity is the overall return on the bond if it is held to maturity. It is the interest rate at which the current price of the bond is equal to the net present value of all future payments ie interest and principal payments. This is the most valuable measure of yield because it reflects the total income on the bond.
Yield curve is a graphical representation of the relationship between maturity and yield to maturity, at a particular point of time. The yield of a bond depends on the time to maturity. For similar bonds, the yield increases as maturity increases. The graph shows the relation between the yield and maturity of a bond. The yield curve depends on the type of bond i.e. different types of bonds e.g. corporate bonds and government bonds have different yield curves. Also the shape of the yield curve changes from time to time.
The cost of an option is the money you spend to acquire the option. The strike price is the price at which you can buy/sell the underlying security. The Actual price is the price at which the underlying security is traded on the exchange on that date.
Stock markets: Stock markets are a place where organized trading of stocks is done through exchanges. Stock markets are most commonly known among all financial markets because of the large participation of ‘retail investors’ i.e. common people who invest from their own savings.
The modern stock markets are basically the stock exchanges, such as the London stock exchange (UK), New York stock exchange (USA), Euronext (Europe) National Stock Exchange (India) etc.
Bond Markets:Bond markets, as the name implies, are the financial markets where bonds and other debt instruments are issued and traded. Government bonds constitute the major bulk of the bonds issued and traded in these markets. The different bonds traded in the bonds market are treasury bonds, treasury bills and treasury notes and municipal bonds.
Bond markets are also called fixed income markets because the promised return on a bond i.e. interest rate is generally fixed. While some of the bonds are traded on the exchange, most of the bond trading is conducted over-the-counter i.e. by direct negotiations between dealers.
Derivatives Markets: Derivatives markets are one in which trading can be done in derivative instruments, such as futures and options. A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular pre-determined price. An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.
In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.
Some of the exchanges that offer trading in derivative instruments are Chicago Board Options Exchange and London International Financial Futures and Options Exchange.
Money Market: A money market is a market for short-term debt instruments such as negotiable certificates of deposit, treasury bills, commercial paper, repos, bankers’ acceptances, etc. Instruments that are traded in money markets are typically of a short maturity (from as less as 1-7 days to less than a year).
Money market securities are relatively safe instruments but usually offer a lower rate of interest. The value of individual transactions in this market is usually very high and hence most of the trades are of institutional nature. Many institutions including banks use the money markets for the treasury and cash management activities wherein they could borrow or lend money for short-term time horizon.
A forex market is an over the counter market where buyers and sellers conduct foreign exchange transactions.
A forex market is not what may be termed as a securities market but it is an important financial market nevertheless, accounting for extremely large financial transactions in terms of volume and value.
The basic concepts related to broker-dealers, custodian and depositary.
To access the exchange trading system, one needs a membership of a stock exchange and they are all called as brokers, dealers, market-makers, specialists and so on. Investors open trading accounts with these member firms, who will then accept and route orders. The member firms (broker-dealer) take care of settlement of the trade in exchange for a fee.
Broker-dealers are so called, as they act as an agent (broker), executing orders on behalf of commissions as well as principals (dealer), trading on their own account.
Custodian is a financial institution, which holds stocks, bonds and other securities on behalf of an investor for guaranteed safekeeping
Two kinds of service of custodian, related and additional.
Related: collection of income on custodial securities, the settlement of transactions, the investment of cash overnight and the provision of accounting reports.
Additional: performance evaluation and analysis, on-line reporting, global custody and securities lending.
The basics of depository and clearing firms are:
Brokers do not hold the shares or money that need to be exchanged when the order gets executed. Most of the securities are held in electronic (also called dematerialized) accounts at firms providing depository services (custodians). When a trade is executed, the seller must release the shares held in the demat account by giving delivery instructions (sometimes also called settlement instruction) to the depository. The depository is thus a custodian of custodians.
Clearing firm is an organization that works with the exchanges to handle confirmation, delivery and settlement of transactions. It is also called a clearinghouse or clearing corporation
Clearing firms act as a central counter party in all exchange initiated trades guarantying the settlement of transaction between market participants and ensures that sellers are paid and buyers receive their securities in a manner that reduces risk, cost and post-trade uncertainties. In USA, The National Securities Clearing Corporation is the clearinghouse for all trades done on the New York Stock Exchange and NASDAQ.
The clearing firms work in conjunction with the depository.
The participation of clearing and central banks in the financial markets is:
Funds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with the clearing firm designated clearing bank.
Central Bank (in case of Bonds issued by Government)
Since the government is the biggest issuer of bonds, the central bank of the country, such as Federal Reserve in the US and Reserve Bank of India, in India is the biggest player in the bond market.
Buy and Sell Side: Market participants can be divided into the buy side and the sell side.
The investing institutions such as mutual funds, pension funds, investment management firms and insurance firms that tend to buy large portions of securities comprise the buy side. These firms invest the money of their clients in various securities thereby providing portfolio management services. The buy side firms do not actually do the trading on the exchanges or in the OTC markets as their competency lies in managing the portfolio. The main aim of the buy side firms is to design the least risk, best return portfolios for their clients.
The sell side includes retail brokers, institutional brokers, traders and research departments. The sell side firms directly interact with the exchange by placing orders in securities. It’s the responsibility of the sell side to ensure the best execution price for an order from the buy side. They also help firms raise money from the market by creating new securities.
Thus a buy side firm like a mutual fund would design a portfolio of securities in which investment needs to be made and contact the sell side brokerage firm that would in turn place orders on the exchange on behalf of buy side. If an institutional portfolio manager changes jobs and becomes a registered representative, he or she has moved from the buy side to the sell side.