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I. Global Financial Market as a part of Global Financial System The global financial system (GFS) is the financial system which consists of institutions and regulators that act at the international level. The main players are the global institutions, such as International Monetary Fund and Bank for International Settlements, national agencies and government departments, e.g. central banks and finance ministries, private institutions acting on the global scale, e.g., banks and hedge funds, and regional institutions, e.g., Eurozone. But GFS it is not only institutions. It conveys (moves) resources from lenders to borrowers, and transfers risks from those who wish to avoid them to those who are willing to take them. It’s a complex interactive system. Events in one component may influence others components and can have significant repercussions elsewhere. There are also complex interactions between financial system and economy – a malfunction of the financial system can cause a malfunction of the economy, and viceversa. The system is still evolving and developing. To understand it, it’s necessary to know essence and meaning of elements of financial system. Functions of GFS transfer capital from those who own it but do not wish to use it to those who wish to use it but do not own it. transfer risk from those who wish to limit their exposure to it, to those who are willing to accept it. The main elements of Global Financial System are as follows: I. Legal norms (global, national and regional level) II. Financial Institutions III. Money, Capital IV. Financial Markets (essence, role, meaning, importance, function, elements, segments) V. VI. Financial Instruments Techniques and mechanisms These elements are related to each other. The link between law and finance is inextricable. It is not to possible to think of a financial system and financial instruments or services and activity of financial institutions without a legal system which supports them. The main participants of the system execute these main functions of financial system using financial instruments. They can function as issuers of this instruments or as financial intermediaries. Financial instruments represent many promises (for payment),e.g. to make fixed payments (which are represented by bonds); to pay dividends (which are represented by shares; to provide retirement income (which are represented by pension agreements); to bear some of the costs of accidents or financial losses (which are represented by insurance policies), to provide a cash flow, such as mortgage repayments (which are represented by securitised assets) and many other less or more sophisticated promises which are represented by derivatives. The financial system includes specialized markets, that enable trade of financial instruments. The functioning of particular segments of financial market are regulated by custom, rules and legislation, Important institution on global financial markets 1. International institutions: 1.1. The International Monetary Fund keeps account of international balance of payments accounts of member states. The IMF acts as a lender of last resort for members in financial difficult situations, e.g., currency crisis, problems in balance of payment and debt default. Membership is based on quotas, or the amount of money a country provides to the fund relative to the size of its role in the international trading system; 1.2. The World Bank aims to provide funding, take up credit risk or offer favourable (good) terms to development projects mostly in developing countries. The other multilateral development banks and other international financial institutions also play specific regional or functional roles. 1.3. The Bank for International Settlements, the intergovernmental organization for central banks worldwide. It has two subsidiary (dependent) bodies - the Basel Committee on Banking Supervision, and the Financial Stability Board. 1.4. The World Federation of Exchanges, the organization brings together the most developed stock markets in the world 1.5. The Institute of International Finance, which includes most of the world's largest commercial banks and investment banks (in private sector). 2. Government institutions: 2.1. Finance Ministries: they pass the laws and regulations for financial markets, and set the tax burden for private players, e.g., banks, funds and exchanges. They are closely tied (though in most countries independent) to central banks that issue government debt, set interest rates and deposit requirements, and intervene in the foreign exchange market. 2.2. Central Banks The important functions of Central Banks are as follows: Sole right of bank notes issue. The Central Bank in every country, now, has the sole authorities to issue bank notes and coins and also special types of bonds. Bank of the State. The Central Bank is banker to the government. It also acts as financial agents for the government (eg in the case of purchasing and selling the gold and foreign exchange). Bank of banks. The Central Bank acts as a banker to the commercial banks. It is the lender of the last resort (eg the Central Bank helps commercial banks in times of crisis). The Central Bank acts as a clearing house. It enables the realization of settlements of mutual obligations among different commercial banks. Stabilizing and control functions of CB: Regulation of the amount of money in circulation and credit Regulation of the financial system and the capital market Creating employment in the country, Care about a favorable inflation, Care about the achievement of a favorable balance of payment. Many External functions participating and operation with foreign or international financial bodies, contract all kinds of credits abroad, issuing securities and place them abroad, granting credits to international or foreign states, central banks, banks and financial institutions, managing and disposition of its foreign currency reserves in the country or abroad. The Statistical functions. The Central Bank has to publish the main national macroeconomic data, (concerning monetary policy, banking system, currency, balance of payments, national accounts... 3. Private participants: Commercial banks Hedge funds and Private Equity Pension funds Insurance companies – restore loss, spread risk Mutual funds Commercial banks functions: Acceptance of Deposits Types of deposits: times deposits (e.g. fixed deposits, Recurring Deposits, Cash Certificates), demand deposits called also current deposits, saving deposits. They are passive banking operations - through which banks form a financial resource for future and use it in an active banking operations Making loans (granting loans) and advances. The forms of lending money: Cash credit. In this type of credit scheme, banks advance loans to its customers on the basis of bonds, inventories and other approved securities, Overdrafts - Banks advance loans to its customer’s up to a certain amount through over-drafts, if there are no deposits in the current account. For these banks demand a security from the customers and charge very high rate of interest. Discounting of Bills. This is the most prevalent and important method of advancing loans to the traders for short-term purposes. Under this system, banks advance loans to the traders and business firms by discounting their bills. In this way, businessmen get loans on the basis of their bills of exchange before the time of their maturity. They are active banking operations - through which banks place their available financial resources Intermediate operations. Clearing operatio ns, settlements. Performance of individual customers' orders for a fee - the commission. Investment of Funds. The banks invest their surplus funds in many types of securities - e.g. Government securities (treasury bills, national savings certificate etc.) and other securities. Additional operations - Banks can: collect cheques, drafts, bills make payment for their clients and at times accept the bills of exchange, pay insurance premium of their customers, purchase and sell securities, arrange to send money from one place to another. Additional operations - Banks can rent the lockers for the safe custody of valuable assets of their customers such as gold, silver, legal documents ,etc., give reference for their customers, collect necessary and useful statistics relating to trade and industry. sell and purchase foreign exchange. Players active in the stock-, bond-, foreign exchange-, derivatives- and commodities-markets, and investment banking Mutual funds They are very popular type of investments, especially for the passive investor. The main advantages of mutual funds are: management of money by professionalists, diversification of portfolio (different financial instruments), risk mitigation, accessibility for many investors, liquidity, ... Hedge funds and Private Equity They are alternative ways of risky long-term investment which cannot be correlated with financial market represented by traditional financial instruments. From the other hand it is a possibility for long term financing for many enterprises (for example new and modern). Pension Funds The main function of pension fund is to enable the employed people to live a comfortable life when they finish their regular work. The pension fund helps the working employees to save money to keep the same standard of living after their retirement. Pension funds can invest in hedge funds and in private equity. II. A. Changes in the value of the capital in the time (of a single amount) The simple capitalizing the interest or The Simply Interest This method as the name suggests is quite simple. The result of simple capitalizing is just original principal and interest on it. I = Capital x rate% x time and Interest (I) is calculated by multiplying Capital times the Rate times the Time Exercise 1. 100 I=10 110 PV 1 year FV What is the annual Interest Rate and annual Discount Rate? Construction of Interest Rate and Discount Rate Interest Rate The annual interest rate is the annual interest divided by the capital (PV). It also can by calculated on the basis on discount rate as discount rate divided by 100% (or 1) minus the discount rate (taking into account the time. Discount Rate The annual discount rate is the annual interest divided by the capital including that Interest (FV). It also can be calculated on the basis on the Interest Rate as: Interest I = Capital x Interest Rate x time => I = PV x r x t I = FV x d x t or Exercise 2. What simple interest rate is equivalent to the simple discount rate 7.5% in discounting an amount a) in 12 months, b) in 6 months? The longer the duration means the greater the difference between the interest rate and the discount rate. Futures Value (FV) - Simple Interest FV = PV + I I = PV x r x t PV – principal, Present value amount (e.g. the amount of a single deposit made at the present time, a present account balance, the present cost of an item, etc.) FV – amount, Future value amount, the amount that the present value will grow to (e.g. the account balance in the future) r - interest rate per period t - time (1+rt) – simple accumulation factor We have four components. If you know any three of these four components, you will be able to calculate the unknown component. And the transformation of the main formula Present Value (PV) – Simple Interest (using interest rate r) PV calculations can show how much money to invest right now in return for given cash amounts to be received in the future. PV - principal FV - amount r - interest rate t - time I - interest earned Present Value Factor ( also Discount Factor) - Simple Interest Present Value (PV) – Simple Interest (using discount rate d) PV = FV(1-dt) Exercise 3. You can use deposit as a way to earn money. You want to invest $1500 in deposit and this deposit earns 6% simple interest per year (on its purchase price). How much will it earn in interest and the balance of the account after a) 2 years ? b) 5 months ? Exercise 4. Find the unknown quantity for an account that earns simple interest. FV = $555 PV = $500 t = 2 years r=? Exercise 5. Find the unknown quantity for an account that earns simple interest. FV = $6050 PV = $5500 t= ? r = 5% Nominal Interest Rates vs. Real Interest Rates A nominal interest rate has not been adjusted for inflation. A real interest rate has been adjusted for inflation. Approximately: But it is not exact result. The exact relationship between nominal interest rate, real interest rates and rate of inflation is represented by formula: Exercise 6. Find the real interest rate (approximate and exact result). Year CPI i rnominal rreal (approximate) rreal (exact) 0 100 - - - - 1 110 15% 2 120 13% 3 115 8% II. B. The compound capitalizing the interest or the compound the Interest The "com" in compound also means a bit more “com”plicated. The result of compound capitalizing are original principal and interest on principal and also interest on the accumulated interest. Calculating future value FV PV - principal FV - amount r - interest rate per period. For example, if interest is to be compounded monthly, then a rate of 6% per year will be restated to be 0,5% per month n - number of compounding periods. Number of time periods that interest will be added and compounded over the life of the deposit Exercise 1. A single amount of $10,000 will be deposited into an account for one year. The depositor may select one of three accounts and each of the accounts pays interest of 4% per year. But these accounts differ in frequency of interest compounding. a) Account 1. Interest is compounded annually. b) Account 2. Interest is compounded semiannually c) Account 3. Interest is compounded quarterly What is the future value on each of these accounts. Number of PV r per period of year capitalization account number of r per number period in period of period the year ( r) (n) accumulation factor FV Account 1 Account 2 Account 3 Try to find FV in the case when amount of $10,000 will be deposited into an account for two years. Number of account PV r per period of year capitalization number of r per number period in period of period the year ( r) (n) accumulation factor FV Account 1 Account 2 Account 3 Try to find FV in the case when amount of $10,000 will be deposited into an account for half year. Number of account Account 1 PV r per period of year capitalization number of r per number period in period of period the year ( r) (n) accumulation factor FV Account 2 Account 3 Exercise 2. The bank offers an interest rate of 8% per year on a savings account. A person deposits $2,000 in the bank. How much money will be in his account at the end of ten year, If a) the saving account is compounded quarterly ? b) the saving account is compounded quarterly ? c) the saving account is compounded monthly ? d) the saving account is compounded once every two years ? Calculating parameters PV, r, n The restate the formula allows to get following parameters: PV, r, n (Compounded Interest. And the transformation of formula: III. Global Financial Market Financial market is a market in which people and entities can trade financial instruments, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include for example precious metals or agricultural goods. Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one "place", thus making it easier for them to find each other. More often it is a virtual space. (On the margin) In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them. Financial markets facilitate: The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) Price discovery The transfer of liquidity (in the money markets) – creating the liquidity of economic entities International trade (in the currency markets) Global transactions with integration of financial markets and are used to match those who want capital to those who have it. There are many types of financial market: (characteristics, meaning) Classifications (and criteria): 1. Maturity term of financial instruments Money market - short-term instruments maturing within a period of one year are traded in money market Capital market - include long term instruments, transactions. Capital market deals with longer maturity financial assets (and claims) Table1. The main differences between money market and capital market Criteria Money market Capital market Maturity period of Short – term instruments Long-term instruments instruments Main types of instruments inter-corporate deposits, Securities, long-term bonds, certificate of deposits, mutual funds units treasury bills, commercial papers, commercial bills Typical participants/entities large institutional investors, Also small individual investor commercial banks, mutual fu Size of market Financial Centers nds, and corporate bodies Wholesale market London, NY, Tokyo Lower value of transactions NY, London, Tokyo, Frankfurt, Amsterdam, Paris Local range: Paris, Milan, Brussels, Zurich, Frankfurt, Amsterdam A. Difference and demarcation between money market and capital market is made on the basis of maturity period of instruments and claims. CM include long-term financial instruments having maturity of more than one year ( short-term instruments only). A. Capital market includes trading in securities, mutual fund units and government debt instruments. On the other hand money market facilitates dealings in shortterm financial instruments such as inter-corporate deposits, certificate of deposits, treasury bonds, commercial papers, commercial bills, etc. B. Money market is a wholesale. On capital market the value of individual transactions may be lower. C. The main money markets in the world are London, NY, Tokyo and local range markets as Paris, Milan, Brussels, Zurich, Frankfurt, Amsterdam. The main capital markets are NY, London, Tokyo and Frankfurt, Amsterdam, Paris D. The money market is not institutionalized. There are no stock exchanges on money market. There are many stock exchanges on capital market. E. Function: Functions of Money Market and Capital Market a. Money Market (MM) The major functions of Money Market : MM provides help to Trade and Industry. MM provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry. MM helps in keeping a short-term liquidity in financial institutions and nonfinancial enterprises. The main function of MM are: – Transfer of short-term funds from borrower to lender, – Provide a good (satisfactory) return of funds, – Create a possibility to manage of liquidity in financial institutions and enterprises. MM performs also functions to States, governments and monetary authorities (additional function). MM makes it easy to keep a balance between the demand for and supply of money for short term monetary transactions. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc. It provides a mechanism for an effective implementation of the monetary policy. Money market makes available investment possibilities (avenues) for short term period. It helps in generating savings and investments in the economy. It is possible by issuing treasury bills in order to raise short loans. However this does not lead to increases in the prices. b. Capital Market 1. Capital market is an important source for mobilizing idle savings from the economy. It mobilizes funds from people for further investments in the productive channels of economy. In that sense it activate the ideal monetary resources and puts them in proper investments. 2. Capital market helps in capital accumulation. Capital formation is net addition to the existing stock of capital in the economy. Through mobilization of ideal resources it generates savings; the mobilized savings are made available to various segments such as agriculture, industry, etc. This helps in increasing capital formation. 3. Capital market supplies resources for longer periods of time. Thus it provides an investment possibilities (avenue) for people who wish to invest resources for a long period of time. It provides suitable interest rate returns also to investors. Instruments such as bonds, equities, units of mutual funds, insurance policies, etc. definitely provides diverse investment avenue for the public. 4. Capital market can increase production and productivity in the national economy. As it makes funds available for long period of time, the financial requirements of business houses are met by the capital market. It helps in research and development. This helps in, increasing production and productivity in economy by generation of employment and development of infrastructure. 5. Capital markets not only helps in fund mobilization, but it also helps in proper allocation of these resources. It can have regulation over the resources so that it can direct funds in a qualitative manner. 6. Capital market provides various types of services. It includes long term and medium term loans to industry, underwriting services, consultancy services, export finance, etc. These services help the manufacturing sector in a large spectrum. 7. Capital market is place where the investment avenue is continuously available for long term investment. This is a liquid market as it makes fund available on continuous basis. Both buyers and seller can easily buy and sell securities as they are continuously available. Basically capital market transactions are related to the stock exchanges. Thus marketability in the capital market becomes easy. F. Possibilities of investment Possibilities of investment at money market: – direct investment - it can be realized using money market instruments (typically for institutional investors due to large size of transactions). – investment in money market funds - it can be realize indirectly using shares in funds (e.g. mutual fund units) which specialize in investment in money market instruments. – "saving" in money market account - it can be realized by using one of offers of banks or other financial institutions (e.g. financial unions). This type of account can be opened as a savings account. Possibilities of investment at Capital market 2. Geographical range criterion a. Global market b. International market (e.g. Regional, Financial Market Group: Asian emerging markets, BRIC countries Brazil, Russia, India and China) c. National market Regardless of the kind of market, each of them can be divided by money market and capital market, primary market and secondary market, and so on. 3. Criterion: the seller of financial instrument (the issuer or the investor) Primary market – the issuer of instrument is the seller Secondary market – the investor, which purchased the instrument earlier (on primary or secondary market) is the seller. Primary Market The Primary Market is also called the new issue market. It’s market where securities are created and where firms (the issuer) sell new stocks and bonds to the public for the first time (Initial Public Offerings - IPO). The transactions in primary markets transactions are carried out between issuers and investors. Usually, these securities are sold by investment banks who handle the offering directly to their customers or to the customers of their selling groups. If the offering is a hot item, then the investment banks may restrict the sale to their best customers. Generally, the investment banks (underwriters) determine the initial price of the stocks or bonds (issue price). The main service functions of primary market are related to issuance of financial instruments: organization and conducting the new issue. On the primary market, each security can be sold only once, and the process to create series of new shares or bonds is often very long due to regulatory requirements. When securities are sold on the primary market, the main recipient of funds is the company issuing the securities. Primary markets act as a source of new funds for the company issuing the stocks or bonds. Underwriters often reserve for themselves and their important clients a portion of the primary shares as part of their commission. Money market (MM) is the market where money and it’s equivalent are traded. Because money is synonym of liquidity, MM provides liquidity funding for the global financial system. The money market is component of the financial market for assets involved in short term borrowing and lending with maturities no longer than one year. Trading on this market involves: inter-corporate deposits, certificate of deposits, treasury bills, repurchase agreement, commercial papers, commercial bills. These short-time financial instruments are commonly called "papers”. On the money market act financial institutions and dealers who want either to borrow or lend the money (for short time). On this market financial institutions and governments manage their short term cash needs. The core of the MM is the interbank market. Banks borrowing and lending to other participants using short time financial instruments (e.g. commercial papers, repurchase agreement and similar instruments). Secondary Market The secondary market (also called aftermarket) is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold. It means, that it is the market in which securities are traded after they are initially offered in the primary markets. That means, that secondary markets allow investors to buy and sell existing securities. The transactions in secondary market transactions are carried out among investors. On the secondary markets, there is no limit on the number of times a security can be traded, and the process is usually very quick. With the rise of strategies such as high frequency trading, a single security could in theory be traded thousands of times within a single hour. The secondary market is where the stocks and bonds and other securities held by investors are sold, usually through organized stock exchanges or in the over-the-counter market. The prices of the securities in the secondary market are determined by supply and demand (equalizing supply with demand). When a transaction is conducted on the secondary market, the investor (individual or mutual fund) that owns and sells a security receives the money. Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount. ... Sometimes the classification arises as the result of many criteria 4. Criterion: the specificity of the instrument (and maturity term of financial instruments) 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. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. (Future markets, which provide standardized forward contracts for trading products at some future date; see also forward market) Foreign exchange markets, which facilitate the trading of foreign exchange. It can be also specified: Credit Markets, a marketplace for the exchange of debt securities and short-term commercial paper, for those who do not have access to money market and capital market Insurance markets, which facilitate the redistribution of various risks. Commodity markets, which facilitate the trading of commodities. 5. Numerous and kinds of items of trade – general market and specialized market There are both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). IV. Financial Instruments Classifications: There are many classifications of financial instruments in the literature. They using different criteria. In general financial instruments (securities) could be categorized into: debt securities (e.g. bonds) Debt items can be classified by maturity. There are short and long term: short-term debt is one year or less, long term debt is more than one year. In some classifications are specified short-term, medium-term and long term maturity. In these cases medium-term maturity that is, two (sometimes three) years or less, but more than one year. The next classification of debt instruments divide them also on variable - rate instruments and fixed-rate instruments. This is the supplementary breakdown. equity securities (e.g. stocks) Stocks can be either common stock or preferred stock. derivative contracts (e.g. forward, futures, options, swaps) Stocks vs. Bonds Stocks/shares and bonds are financial instruments for investors to obtain a return and for companies to raise capital. They both are instruments of capital market. But there are many differences between them. STOCKS Stocks of a company are offered at the time of an IPO (Initial Public Offering) or later equity sales. IPO is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Stocks can be either common stock or preferred stock. The value of stocks corresponds to the value of the company and therefore, stock price fluctuates depending upon how the market values the company. Stocks are risky instrument. Types of shares/stocks Ordinary shares. Most companies have just ordinary shares. They give one vote per share, are entitled to participate equally in dividends and, if the company is wound up, share in the assets (proceeds) of the company after all the debts have been paid. Preference shares. They usually have a preferential right to a fixed amount of dividend. They may also have a priority on return of capital on a winding up. Preference share are often non-voting. Non-voting shares. Non-voting shares carry no rights to attend general meetings or vote. Such share are widely used to issue to employees so that some of their remuneration can be paid as dividends, which can be more tax-efficient for the company and the employee. This type of shares are also sometimes issue for members of the main shareholders' families. Voting shares, dividend shares, capital shares. Sometimes three classes of shares are created with class 'A' having all the voting rights, class 'B' having all the dividend rights and class 'C' having all the capital rights. It is then possible for the different shareholders to have different percentages of the rights for these purposes. Management shares. A class of shares carrying extra voting rights so as to retain control of the company in particular hands. BONDS Bonds are loans offered at a fixed interest rate. Corporate bonds. They are issue when company believes that it can raise capital cheaper by borrowing money from banks (interest-paying corporate bonds). Generally bonds are "safer" than stocks because of lower volatility, Additionally, some of them are zero-risky (Treasury bonds) or very low risky (some municipal bonds). But It should be noted that there is always a chance that company will be unable to repay bond-holders. In that sense, bonds are not "risk-free". Types of Bonds Treasury bonds (T-Bonds) and treasury notes (T-Notes) vs treasury bills T-Bills). They are government debt issued by Departments of the Treasury in particular country. All of treasury securities are often called simply as “Treasuries”. The most important treasury securities: treasury bills (T-Bills), treasury bonds (T-Bonds), treasury notes (T-Notes) differ in the length until maturity: Treasury bills are issued for terms less than a year. Treasury notes are usually issued for 2, 3, 5, and 10 years. Treasury bonds are issued for longer than ten years (even for several decades). All of them are also often referred as "Treasury bonds" (especially T-Notes). They are very safe financial instrument (zero risk instrument) with not very high return. Sometimes are also issued Treasury Inflation Protected Securities (TIPS). Classification: Marketable bonds – can be transferred through market sales. They are heavily traded on secondary market and are usually very liquid (e.g. treasury bond). Non-marketable – are issued to subscribers and cannot be transferred through market sales (e.g. State and Local Government Series (SLGS), saving bonds) In today's financial markets, the distinction between stocks and shares has been somewhat blurred. Generally, these words are used alternately to refer to the pieces of paper that denote ownership in a particular company, called stock certificates. However, the difference between the two words comes from the context in which they are used. For example, "stock" is a general term used to describe the ownership certificates of any company, in general, and "shares" refers to a the ownership certificates of a particular company. Financial Instruments (Derivatives) Forwards vs. Futures Because these instruments are the function of an underlying asset, they are considered a derivative product. Futures contracts are standardized instruments transacted through brokerage firms on the exchange to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The terms of a futures contract include: delivery places and dates, volume, technical specifications, and trading and credit procedures and they are standardized for each type of contract. They have a form of an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a specified price. Forward contracts are not traded at the stock exchange and are therefore regarded as over-the-counter (OTC) instruments. Forward contracts are very popular because they are unregulated by the government, they provide privacy to both the buyer and seller, and they can be customized to meet both the buyer's and seller's specific needs. In the case of forwards contracts all the terms of the contract are privately negotiated between parties. They can be keyed to almost any conceivable underlying asset or measure. The settlement date, notional amount of the contract and settlement form (cash or physical) are entirely up to the parties to the contract. Futures Forwards Definition Standardized contract to buy or sell a certain underlying instrument at a certain date in the future, at a specified price The agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a specified price. Contract Maturity Future contracts may not necessarily mature by delivery of commodity. Forward contracts generally mature by delivering the commodity Stock -exchanges OTC Terms of trade Standardized delivery places and dates, volume, technical specifications, trading and credit procedures, standardized for each type of contract. All the terms of the contract are privately negotiated between parties. Structure & Purpose Standardized. Initial margin payment required. Usually used for speculation. Transaction method Institutional guarantee Quoted and traded on the Exchange Government regulated market Clearing House Customized to customer needs. Usually no initial payment required. Usually used for hedging. Negotiated directly by the buyer and seller Not regulated Counterparty risk Low Place of trading (trading venues) Market regulation The contracting parties High Options Option is a contract that gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified prices (strike price) on or before a specified date (expiration date). The seller has the corresponding obligation to fulfill the transaction – that is to sell or buy – if the buyer (owner) "exercises" the option. The buyer pays a premium to the seller for this right. An option that conveys to the owner the right to buy something at a specific price is referred to as a call; an option that conveys the right of the owner to sell something at a specific price is referred to as a put. Both are commonly traded, but for clarity, the call option is more frequently discussed. Types of options: I. Call option - an agreement that gives an investor the right (but not the obligation) to buy an specified asset at a specified price (the strike price) within a specific time period (the expiration date). Put option - an agreement that gives an investor the right (but not the obligation) to sell an specified asset at a specified price within a specific time period. Options Description The effect of position/type of transaction Premium Long call The right (not obligation) to buy The obligation to realize the decision of buyer (sell) The right to sell The obligation to realize the decision of buyer (sell) Buy - Sell + Sell Buy + Short call Long put Short put II. European option – an option that may only be exercised on expiration American option – an option that may be exercised on any trading day on or before expiry. Exercises (Use financial functions) 1. If you plan to save $300 annually for 10 years and the interest rate is 15%, what is the future value? 2. If you want to buy a bike in 4 years that costs $ 500 and you can save $150 per year, what interest rate would you need? 3. If you invest $1,000 per year in a stock portfolio with a return of 8%, how much would you expect to have in 7 years? 4. How long would it take you to save $1,000 if you invested $200 per year, and the interest rate is 10%? 5. If you need $10,000 to pay for your first year of graduate school in 3 years and you get an interest rate of 9%, how much must you invest each of the next three years? 6. If 6 years ago you invested $500 and received an interest rate of 4% (compounded monthly), how much would you now have? 7. You borrowed $100 from a friend, who said you need to pay back $300 in 5 years, what rate are you being charged if it is compounded weekly? 8. How many years would it take you to have $2,500 if you saved $100 each month at 15%? 9. To have $6000 in 7 years what interest rate would you need if you saved $200 every quarter? 10. If you win a lottery worth $1,000,000 payable in 15 years and the interest rate is 8% (compounded annually),what is this worth today? Compounded quarterly? Compounded monthly? Compounded weekly? A. Compounded annually B. Compounded quarterly? C. Compounded monthly? D. Compounded weekly?