Financial Markets

Financial Markets are the market place where Financial Instruments of varying maturities are traded. They can be both exchange-traded and Over the Counter(OTC) traded. An important trait of Financial Markets is that the Risk is entirely borne by the investor, be it the money market, foreign exchange market, or any other. Over the years, the Financial Markets have grown in size as well as complexity. With the advent of technology, more people than ever before are now able to get access to these markets.

The functions of Financial markets are more than apparent. The most important and primary function is to facilitate price discovery in a free and transparent manner. Along with the determination of prices at which the financial instruments are traded in Financial Markets, other functions are but not limited to Funds mobilization, Liquidity, Risk Sharing, Easy Access, Capital Formation, Reduction in transaction costs, and provision of the Information.

The Financial Markets can be broadly classified into 2 major types: Short term Markets and Long term Markets.

Today, Let’s discuss Long Term Markets, or also known as Capital Markets. Capital Markets can be broadly classified into two major types: Fixed Income and Equity Markets.

FIXED INCOME MARKET / BOND MARKET

It is the biggest of all financial markets in the world. Just to give you some numbers: At the end of 2016, $101 Trillion (2.1 million bonds) worth of traded bonds was in existence, while the whole world GDP was $79 Trillion and the total market cap of the World Stock market was $65 Trillion. US govt alone had 1086 actively traded bonds and bills, which were worth $14 Trillion.

Whopping Numbers!!! Right? So let’s get into it and understand the basic terminologies of this market.

Fixed income in simple words is an investment that returns payment to you on a regular schedule.

To define precisely-

• Fixed income is a class of assets and securities that pay out a set level of cash flows to investors, typically in the form of fixed interest or dividends.
• At maturity for many fixed income securities, investors are repaid the principal amount they had invested in addition to the interest they have received.
• Government and corporate bonds are the most common types of fixed-income products.
• In the event of a company’s bankruptcy, fixed-income investors are often paid before common stockholders.

Bonds

Bonds are units of corporate debt and are securitized as tradable assets. They are referred to as fixed-income instruments since they traditionally pay fixed interest rates to debtholders and at maturity principal amount is paid back in full or risk default. Variable and floating interest rates are also quite common.

In the simplest terms, the Bonds are “I owe You” notes. Just that. These notes promise to make a regular fixed amount payment which we call Coupons and a large payment at the end known as Principal.

Bond prices are inversely related to interest rates i.e. prices go down when interest rises and vice versa.

Characteristics of a Bond:

Most bonds share some common basic characteristics including:

• Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium of $1,090, and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
• The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
• Yield is the annualized return that is earned on a bond, based on the price paid and the interest payments received
• Yield To Maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond’s yield to maturity rises or falls depending on its market value and how many payments remain to be made.
• Current Price: Depending on the level of interest rate in the environment, the investor may purchase a bond at par, below par, or above par. For example, if interest rates increase, the value of a bond will decrease since the coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will trade at a discount, that is, below par. However, the bondholder will be paid the full face value of the bond at maturity even though he purchased it for less than the par value.
• Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made at any interval, but the standard is semiannual payments.
• The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
• The issue price is the price at which the bond issuer originally sells the bonds.

Note:- Fixed Income does not mean Fixed APR(Annual Percentage Return) or Yield.

Bond Valuation

Bond valuation is a way to determine the theoretical fair value (or par value) of a particular bond. It involves calculating the present value of a bond’s expected future coupon payments, or cash flow, and the bond’s value upon maturity, or face value. As a bond’s par value and interest payments are set, bond valuation helps investors figure out what rate of return would make a bond investment worth the cost.

Two features of a bond — credit quality and time to maturity — are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.

Yield Curve

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve), and flat.

A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.

An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of an upcoming recession.

A Flat or humped yield curve is one where the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition.

Bond Risks

Although bonds may not necessarily provide the biggest returns, they are considered a fairly reliable investment tool. That’s because they are known to provide regular income. But they are also considered to be a stable and sound way to invest your money because — especially those offered by the government — are guaranteed. That doesn’t mean they don’t come with their own risks.

As an investor, you should be aware of some of the pitfalls that come with investing in the bond market. Here’s a look at some of the most common risks.

• Reinvestment risk means a bond or future cash flows will need to be reinvested in security with a lower yield. Callable bonds have provisions that allow the bond issuer to purchase the bond back and retire the issue when interest rates fall.
• Credit / Default risk occurs when the issuer can’t pay the interest or principal in a timely manner or at all.
• Interest rate / Market risk occurs due to the fact that rising interest rates are a key risk for bond investors. Generally, rising interest rates will result in falling bond prices, reflecting the ability of investors to obtain an attractive rate of interest on their money elsewhere.
• Inflation risk occurs when the rate of price increases in the economy deteriorates the returns associated with the bond.
• Liquidity risk is the risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value.

EQUITY / STOCK MARKET:

What is a stock?

According to Investopedia,

“stock or share is a financial instrument that represents ownership in a company or corporation and represents a proportionate claim on its assets and earnings.”

In simple terms, it represents the ownership of a fraction of the corporation. There are two main types of stocks :

1. Common Stock :

Common stock is a security that represents ownership in a corporation. In a liquidation, common stockholders receive whatever assets remain after creditors, bondholders, and preferred stockholders are paid.

2. Preferred stock

Preferred stock is also called preference shares and it is generally considered a hybrid instrument that includes properties of both an equity and a debt instrument.

The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock does.

Why does the stock market exist?

It helps individuals earn a profit on their income when they invest in the stock market and allows firms to spread their risks and receive large rewards. It also enables the government to increase spending through the tax revenue they earn from corporations that trade on the stock exchange.

Generally, stocks help in making money by 2 methods :

1. Through trading stocks

The price of a stock is liquid and hence can be easily converted to cash. The way to make money as a trader is to buy the stock when its price is low, and to sell it when the price rises.

2. With Stock Dividends

When someone is a stockholder in a company, that company’s profits are also the stockholder’s profits as they are the partial owner of that company. Every quarter the company splits up the segment of its profits and gives those profits to stockholders according to how much stock someone has. The more profit the company makes, the more money the stockholder gets paid at the end of the quarter.

Participants of the stock market:

On a broader basis, participants of the Stock market can be categorized into companies, investors and traders, stockbrokers, stock exchanges, financial intermediaries, and regulators.

Role of the various participants:

1.Companies: Companies generally participate in the stock markets by filing an Initial Public Offering and hence getting listed on the stock exchanges to raise money.

2.Investors and Traders:

Investors put capital to use for long-term gain, whereas the traders seek to generate short-term profits by buying and selling securities again and again over time.

3.Stock Brokers: Stockbrokers buy and sell the stocks and other securities for both retail and institutional clients through a stock exchange or over the counter in return for a fee or commission.

4.Stock Exchanges: A stock exchange facilitates stock brokers to trade company stocks and other securities.

5. Financial Intermediaries: Financial Intermediaries play their role quietly behind the scenes, always complying with the rules laid out by SEBI and ensure an effortless and smooth experience for your transactions in the stock market.

6. Regulators: A Regulator or regulatory authority amends and approves different laws, and makes sure that no broker or the company is indulged in fraudulent activities.

Now coming to some basic terminologies involved in the stock market:

1. Initial public offering (IPO) :

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors.

Various Steps Involved in an Initial Public Offering (IPO) are hiring an investment bank, or banks, discuss the offering and determine the timing of the filing, pricing the IPO, allocate shares to the investors, etc.

2. Stock Market Indices:

A stock index can be considered as a measure of the stock market, or a subset of the stock market, that helps investors compare current price levels with past prices to analyze the market performance. It is generally calculated from the prices of selected stocks. E.g. Sensex and Nifty are the two most important stock market indices in India. They are the benchmark indices. Various types of indices are based on weighting methods like the price weighting based indices, market-capitalization weighting based indices, and also on the basis of the coverage like the Country Coverage indices, Global Coverage indices, etc.

What’s the difference between Trading and Investment?

1.Trading involves identifying market trends and then quickly buying or selling stocks to book profits whereas investing is based on buying stocks of a company after carefully analyzing the business of a company.

2. In the case of trading, missing the right time to enter or exit may lead to a loss. When it comes to investment, no need to time the market or to get bothered by short term market volatility. Trading involves short-term strategies to maximize returns daily, monthly, or quarterly. Investors are more likely to ride out short term losses, while traders will attempt to make transactions that can help them profit quickly from fluctuating markets.

The relation between the Fundamental and Technical Analysis can be seen as:

Both methods are used for forecasting future trends in stock prices based on the analysis. Fundamental analysis evaluates securities by attempting to measure their intrinsic value and the technical analysis differs from fundamental analysis, in that traders look to statistical trends in the stock’s price and volume.

Now coming to the Derivatives, what are the derivatives, and also what are the advantages?

A derivative is a contract between two parties which derives its value or price from an underlying asset. The most common types of derivatives are futures, options, forwards, and swaps. It is a financial instrument that derives its value or price from the underlying assets. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies.

It is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. The four most common examples of derivative instruments are Forwards, Futures, Options, and Swaps.

Mode of Derivatives are:

OTC (Over-the-counter)which are the contracts that are traded directly between two parties, without an exchange or the intermediary, and ETD (Exchange-traded) which are the standardized contracts such as futures and options that are traded or transacted on an organized futures exchange.

Advantages of Derivatives:

1. Hedging and risk management: Capital protection can only be done via hedging. Hedging reduces the risk of adverse price movements in the asset by taking an offsetting position in the related security, such as in futures or options markets.

2. Lower transaction costs: Derivatives help to reduce market transaction costs as they act as a risk management tool.

3. Transfer of Risk: In derivatives, risk can be transferred from one party to another party who is willing to bear it.