Chapter Four

Financial market in the Financial System

4. Introduction
Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income. This function is
shown schematically in Figure 1. Those who have saved and are lending funds, the lender-
savers, are at the left, and those who must borrow funds to finance their spending, the borrower-
spenders, are at the right. The principal lender-savers are households, but business enterprises
and the government (particularly state and local government), as well as foreigners and their
governments, sometimes also find themselves with excess funds and so lend them out. The most
important borrower-spenders are businesses and the government (particularly the federal
government), but households and foreigners also borrow to finance their purchases of cars,
furniture, and houses. The arrows show that funds flow from lender-savers to borrower-spenders
via two routes. In direct finance (the route at the bottom of Figure 1), borrowers borrow funds
directly from lenders in financial markets by selling them securities.
Financial market allow funds to move from people who lack productive investment opportunities
to people who have such opportunities. Thus financial markets are critical for producing an
efficient allocation of capital, which contributes to higher production and efficiency for the
overall economy. Well-functioning financial markets also directly improve the well-being of
consumers by allowing them to time their purchases better. They provide funds to young people
to buy what they need and can eventually afford without forcing them to wait until they have
saved up the entire purchase price. Financial markets that are operating efficiently improve the
economic welfare of everyone in the society

Figure 1: fund flow in financial system

4.1 Types of Financial Market

Each financial market was created to meet the preferences of particular participant. For example
some participant may want to invest for a short period whereas other participant may want to
invest for a long period.

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Some participant may want to bear high level of risk whereas others want to avoid risk. Some of
them may want to borrow whereas others may want to issue stocks. Hence there are many types
of financial market and each of the can be distinguished by their maturity structures and trading
structures of their securities.
4.1.1 Primary versus secondary market
A) Primary market
Primary market is a market under which newly issued securities (initial public offering) are
traded. Primary market provides funds to initial issuer and facilitates a new issue of securities.
Features of primary market
 In this market, the flow of funds is from savers to borrowers (industries), hence, it helps
directly in the capital formation of the country. The money collected from this market is
generally used by the companies to modernize the plant, machinery and buildings, for
extending business, and for setting up new business unit.
 It Is Related With New Issues
 It Has No Particular Place
 It comes before Secondary Market
Methods of raising capital in the primary market:
a) Public Issue -Sale of bonds or stock to the general public. Securities are sold to
hundreds, and often thousands, of investors under a formal contract overseen by federal
and state regulatory authorities. When a company issues securities to the general public,
it is usually uses the services of an investment banker. Investment Banker -- A financial
institution that underwrites (purchases at a fixed price on a fixed date) new securities for
resale Investment banker receives an underwriting spread when acting as a middleman in
bringing together providers and consumers of investment capital.
b) Private Placement: Under this method, the company sells securities to the institutional
investors or brokers instead of selling them to the general public. They, in turn, sell these
securities to the selected clients at a higher price. This method is preferred as it is a
cheaper method of raising funds as compared to a public issue.
c) Right Issue: This method is used by those companies who have already issued their
shares. When an existing company issues new shares, first of all it invites its existing
shareholders. This issue is called the right issue. In this case, the shareholder has the right
either to accept the offer for himself or assign a part or all of his right in favour of another
person.
B) Secondary Market
Secondary market is a market in which previously issued securities are traded. In secondary
market ownership is transferred from seller to buyer of the instruments. The issuance of new
corporate stock or Treasury bill is primary market transaction, whereas the sale of existing
corporate stock or Treasury bill is a secondary market.

Features of Secondary market

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  It comes after primary market.
 Some of secondary market has a particular place.
 The fund flows from investors to investors.
Structure of secondary market
 Organized markets (Auction): are those which have a physical location where all
trading takes place. Has a building where securities trade. There are so many organized
exchanges throughout the world. For example, the NYSE, Amex, and NYSE, London
Stock exchange, Tokyo Stock Exchange are organized markets.
 Over –the- Counter (OTC) markets: do not have physical locations. Instead, they are
characterized by networks of dealers who are connected by telephone or computer
networks. Have no central location. The NASDAQ is an example of an OTC market.

4.1.2 Money market versus Capital market

A) Money Market
Money market is markets in which financial asset which have a maturity of one year or less is
traded. Money market channels short-term fund. It provides liquidity for investors. Capital
market is a market in which financial assets which have a maturity of more than one year are
traded.
Money Market Instruments
Money market instrument is an instrument with a maturity of one year or less. They are issued by
Treasury, corporation, and financial intermediaries who wish to obtain short-term debt. The U.S
Treasury issue money market securities (Treasury bills) to finance its short term deficit. Money
market securities include; Treasury bills, commercial paper, negotiable certificate of deposit,
repurchase agreements, federal funds and bankers’ acceptance.
a) Treasury Bills (T-Bills)
T-bills are short –term obligations of government issued to cover current government budget
deficit/ shortfalls and to refinance maturing government debts. T-bills are also used by the
Federal Reserve as a tool in conducting monetary policy through open market operation. T-bills
are sold through an auction process. T-bills are issued with a maturity of 2, 4,7,14 and 28 weeks.
Investment in T-bills is attractive for investors because it is default risk free due to it is backed
by government and it is liquid.
Treasury bill Yields
Treasury bills are sold on discount basis rather than directly paying interest on T-bills (the
coupon rate is zero), the government issues T-bill at a discount from their par (face) value. The
return comes from the difference b/n the purchase price paid for the T-bill and the face value
received at maturity.
Return of T-bill = (Maturity value – Purchase price) / purchase price* Number of
days/maturity period of the securities.

For example investors who want annualized return of 7% on T-bills of $10,000 par value pay
9,345.79.

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 PV = PV/1+r
= 10,000/ 1.07
= 9,345.79 The value of T-bill is the present value of its par value.
b) Commercial paper
Commercial paper is an unsecured short –term promissory note issued by a corporation to raise
short- term cash, often to finance working capital requirements. Commercial papers are issued by
strong- credit rating companies. Corporations can raise large amount of funds by issuing lower
interest rate (than bank loans). Commercial papers are issued at minimum denomination of
$100,000 and its maturity generally ranges of 1 to 270 days. However, the most common
maturities are 20 and 45 days.
Commercial paper is usually held from the time of issue until maturity by investors. Thus, there
is not an active secondary market for commercial papers because of its unsecured debt.

Commercial paper is sold to investors either directly using the issuers’ own sales force or
indirectly through brokers and dealers such as major bank subsidiaries and specialized in
investment banking activities and investment banks underwriting the issues.

Like Treasury bills, yields on commercial papers are quoted on a discount basis-the discount
return to commercial paper holders is the annualized percentage difference b/n the price paid for
the paper and price at which the paper is redeemed. Commercial paper must offer premium
above T-bills as a compensation for default risk.

c) Negotiable certificate of deposit(NCDs):

A negotiable certificate of deposit(CD) is a bank issued time deposit that specifies an interest
rate and maturity date and is negotiable(salable ) in the secondary market. A negotiable CD is a
bearer instrument- who ever holds the CD when it matures receives the principal and interest.
A negotiable CD can be traded any number of times in secondary markets, therefore, the original
buyer is not necessarily the owner at maturity. Negotiable CDs have a denomination that ranges
from $100,000 to $10million. $1million is the most common denomination. The large
denominations make negotiable CDs to large for most individuals to buy; however, negotiable
CDs are often purchased by money market mutual funds, which pool funds of individual
investors and allow this group to indirectly purchase negotiable CDs. Negotiable CDs maturities
range from two weeks to one year with most having maturity of one to four months.
The Trading Process for Negotiable Certificate of Deposit
Banks issuing negotiable CDs post a set of rates for the most popular maturities of their
negotiable CDs normally 1, 2, 3, 6 and 12months, then subject to its funding needs, the bank tries
to hold them as investments rather than sell them to the secondary market. In some cases, the
bank and the CD investor directly negotiate a rate, the maturity and the size of the CD.
The secondary market for negotiable CDs allows investors to buy existing negotiable CDs rather
than new issues because it is not very active market.

Negotiable CD yield:

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Negotiable CD rates are negotiated b/n the bank and the CD buyer. Large well known banks can
offer CDs at slightly lower rates than smaller, less well known banks. This is due partly to the
lower perceived default risk and greater marketability of well-known banks.
d) Repurchase Agreements(Repo or RP):
It is an agreement involving the sale of securities by one party to another with a promise to
repurchase the securities at a specified price and on a specified date in the future. Thus, a
repurchase agreement is essentially a collateralized Fed funds loan with the collateral backing in
the form of securities. The securities used most often in Repos are U.S treasury securities (e.g T-
bills) and government securities. A reverse repurchase agreement (Reverse repo) is an
agreement involving the purchase of securities by one party from another with the promise to sell
them back at a given date in the future. The titles repo and reverse repo can be applied to the
same transaction. Whether a transaction is termed as repo or a reverse repo generally depends on
which party initiates the transaction.
The Trading Process for Repurchase Agreements:
Repurchase agreements can be arranged by either directly b/n two parties or with the help of
brokers and dealers.
Repurchase agreement yields:
Because treasury securities back repurchase agreements are low credit risk investments and have
lower interest rates than uncollateralized Fed funds, the yield on repurchase agreement is
calculated as;
iRA =PF-Po/Po× 360/h
PF= repurchase price of the securities (equal to the selling price plus interest paid on the
repurchase agreement).
po= selling price of the securities
h= number of days until the repo matures

Example , suppose a bank enters a reverse repurchase agreement in which it agrees to buy
treasury securities from one of its correspondent banks at a price of $10,000,000, with the
promise to sell the securities back at a price $10,008,548($10,000,000 plus interest of $8548)
after 5 days. The yield on this repo to the bank is calculated as;

iRA=10,008,548-10,000,000/10,000,000×5/360 = 6.15%
e) Federal Funds

Federal funds (Fed funds) are short term funds transferred b/n financial institutions, usually for a
period of one day. The financial institution that borrows Fed funds incurs liability on its balance
sheet “Federal funds purchased” while the institution that lends the Fed funds records an asset
“Federal fund sold”, overnight(or one day) interest rate for borrowing Fed funds is the federal
funds rate.

Federal funds yield:

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Federal funds are single payment loans –they pay interest only once at maturity. Fed funds
transactions take the form of short -term (mostly overnight) unsecured loan.
Trading in the federal fund market:
Commercial banks conduct the vast majority of transactions in the Fed funds market. This is
because Fed fund transactions are created by banks borrowing and lending excess reserves held
at their Federal Reserve Bank using Fed wire, the Federal Reserve’s wire transfer network, to
complete the transaction. Banks with excess reserves lend Fed funds while banks with deficient
reserve borrow Fed funds.
Federal funds transactions can be initiated by either the lending or the borrowing bank, with
negotiations b/n any pair of commercial banks taking place directly over the telephone, through
Fed funds brokers who charge a small fee for bringing two parties to fed funds together.

Example, Chase bank has excess reserve of $75million and it needs to sell the excess reserve to
those corresponding bank (Bank of America) who needs to purchase the Fed funds overnight at a
given Fed fund rate to finance its deficit reserve requirement.
f) Banker’s Acceptances:
A banker’s acceptance indicates that a bank accepts responsibility for future payments. Banker’s
acceptances are commonly used for international trade transactions. An exporter that is sending
goods to an importer whose credit rating is not known will often prefer that a bank act as a
guarantor. The bank, therefore, facilitates the transaction by stamping ACCEPTED on a draft
which obligates the payment on a specified point in time. In turn, the importer will pay the bank
what is owed to the exporter along with a fee to the bank for guaranteeing the payment.
Trading Process for Banker’s Acceptance:
Exporters can hold a banker’s acceptance until the date at which payment is to be made. But they
frequently sell the acceptance before then at a discount to obtain cash immediately. The investor
who purchases the acceptance then receives the payment guaranteed by the bank in the future.
The investors return on a banker’s acceptance like that on commercial paper, is derived from the
difference b/n discounted price paid for the acceptance and the amount to be received in the
future. Banker’s acceptances are payable to the bearer at the maturity and their maturities often
range from 30 to 270 days.
The denomination of banker’s acceptances are determined by the size of the original transaction
b/n the domestic importer and foreign exporter but in the secondary markets, banker’s
acceptances are often bundled and traded in round lots, mainly of $100,000 and $500,000.

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Figure-2: Banker Acceptance Life Cycle

B) Capital Market
Capital market securities are long-term securities issued by corporations and governments. Here
“long-term securities” refers to securities with original maturities greater than 1 year and
perpetual securities (those with no maturity). There are two types of capital market securities:
those that represent shares of ownership interest, also called equity, issued by corporations, and
those that represent indebtedness, issued by corporations and by the U.S. and state and local
governments.
a. Equity
The equity of a corporation is referred to as “stock”; ownership of stock is represented by shares.
Investors who own stock are referred to as shareholders. Every corporation has common stock,
and some corporations have another type of stock, preferred stock, as well.
Common stock is the most basic ownership interest in a corporation. Common shareholders are
the residual owners of the firm. If the business is liquidated, the common shareholders can claim
the business’ assets, but only those assets that remain after all other claimants have been
satisfied.
Since common stock represents ownership of the corporation, and since the corporation has a
perpetual life, common stock is a perpetual security; it has no maturity.

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Common shareholders may receive cash payments—dividends—from the corporation. They may
also receive a return on their investment in the form of increased value of their stock as the
corporation prospers and grows.
Preferred stock also represents ownership interest in a corporation and, like common stock, is a
perpetual security. However, preferred stock differs from common stock in several important
ways. First, preferred shareholders are usually promised a fixed annual dividend, whereas
common shareholders receive what the board of directors decides to distribute. And although the
corporation is not legally bound to pay the preferred stock’s dividend, preferred shareholders
must be paid their dividends before any common dividends are paid. Second, preferred
shareholders are not residual owners; their claim on a liquidated corporation takes precedence
over that of common shareholders.
And finally, preferred shareholders generally do not have a say in corporate matters, whereas
common stockholders have the right to vote for members of the board of directors and on major
issues.
b. Debt
A capital market debt obligation is a financial instrument whereby the borrower promises to
repay the face amount of the obligation by the maturity date and, in most cases, to make periodic
interest payments to the holder of the debt obligation, referred to as the lender. These debt
obligations can be broken into two categories: bank loans and debt securities.
While at one time, bank loans were not considered capital market instruments, in recent years a
market for the buying and selling of these debt obligations has developed. One form of bank loan
that is bought and sold in the market is a syndicated bank loan. This is a loan in which a group
(or syndicate) of banks provides funds to the borrower. The need for a group of banks arises
because the amount sought by a borrower may be too large for any one bank to be exposed to the
credit risk of that borrower.
Debt securities include (1) bonds, (2) notes, (3) medium-term notes, and (4) asset-backed
securities. The distinction between a bond and a note has to do with the number of years until the
obligation matures when the security is originally issued. Historically, a note is a debt security
with a maturity at issuance of 10 years or less; a bond is a debt security with a maturity greater
than10 years. The distinction between a note and a medium-term note has nothing to do with the
maturity but rather the way the security is issued.
Features of bond
• Nominal, principal or face amount — the amount on which the issuer pays interest, and
which, most commonly, has to be repaid at the end of the term.
• Issue price — the price at which investors buy the bonds when they are first issued,
which will typically be approximately equal to the nominal amount. The net proceeds that
the issuer receives are thus the issue price, less issuance fees.
• Maturity date — the date on which the issuer has to repay the nominal amount.
• Coupon: the interest rate that the issuer pays to the bond holders. Usually this rate is
fixed throughout the life of the bond.

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 It can also vary with a money market index, such as LIBOR,(London Inter-bank
Offered Rate) is a daily reference rate  based on the interest rates at which banks
borrow unsecured funds from other banks in the London wholesale money market) or it
can be even more exotic.
• Coupon dates: the dates on which the issuer pays the coupon to the bond holders. In the
U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that
they pay a coupon every six months.
• Call ability: some bonds give the issuer the right to repay the bond before the maturity
date on the call dates; these bonds are referred to as callable bonds.
• Put ability: some bonds give the holder the right to force the issuer to repay the bond
before the maturity date on the put dates.
Types of Bonds
• Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
• Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of
interest, such as LIBOR  (London Inter-bank Offered Rate is a daily reference rate
based on the interest rates at which banks borrow unsecured funds from other banks in
the London wholesale money market) For example the coupon may be defined as three
month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically
every one or three months.
• Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to
par value, so that the interest is effectively rolled up to maturity. The bondholder receives
the full principal amount on the redemption date.
• Inflation linked bonds, in which the principal amount and the interest payments are
indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a
comparable maturity. However, as the principal amount grows, the payments increase
with inflation.
• Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date.
The most famous of these are the UK Consols, which are also known as Treasury
Annuities or Undated Treasuries.
• Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded
by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest
payments, and the principal upon maturity, are sent to the registered owner.
• Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or
their agencies.
• 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. Often they are
registered by a number to prevent counterfeiting, but may be traded like cash.

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4.1.3 Derivative Market
Starting in the 1970s and increasingly in the 1980s and 1990s, the world became a riskier place
for the financial institutions. Swings in interest rates widened, and the bond and stock markets
went through some episodes of increased volatility. As a result of these developments, managers
of financial institutions became more concerned with reducing the risk their institutions faced.
Given the greater demand for risk reduction, the process of financial innovation came to the
rescue by producing new financial instruments that help financial institution managers manage
risk better. These instruments, called financial derivatives, have payoffs that are linked to
previously issued securities and are extremely useful risk reduction tools.
In this section, we look at the most important financial derivatives that managers of financial
institutions use to reduce risk: forward contracts, financial futures, options, and swaps. We
examine not only how markets for each of these financial derivatives work but also how they can
be used by financial institutions to manage risk. We also study financial derivatives because they
have become an important source of profits for financial institutions, particularly larger banks,
which, as we saw in Chapter 2, have found their traditional business declining
A. Future Contract
A futures contract is a legal agreement between a buyer and a seller in which:
 The buyer agrees to take delivery of something at a specified price at the end of a
designated period of time.
 The seller agrees to make delivery of something at a specified price at the end of a
designated period of time.
Of course, no one buys or sells anything when entering into a futures contract. Rather, those who
enter into a contract agree to buy or sell a specific amount of a specific item at a specified future
date. When we speak of the “buyer” or the “seller” of a contract, we are simply adopting the
jargon of the futures market, which refers to parties of the contract in terms of the future
obligation they are committing themselves to.
Let’s look closely at the key elements of this contract. The price at which the parties agree to
transact in the future is called the futures price. The designated date at which the parties must
transact is called the settlement date or delivery date. The “something” that the parties agree to
exchange is called the underlying.
To illustrate, suppose a futures contract is traded on an exchange where the underlying to be
bought or sold is asset XYZ, and the settlement is three months from now. Assume further that
Bob buys this futures contract, and Sally sells this futures contract, and the price at which they
agree to transact in the future is $100. Then $100 is the futures price. At the settlement date,
Sally will deliver asset XYZ to Bob. Bob will give Sally $100, the futures price.
When an investor takes a position in the market by buying a futures contract (or agreeing to buy
at the future date), the investor is said to be in a long position or to be long futures. If, instead,
the investor’s opening position is the sale of a futures contract (which means the contractual
obligation to sell something in the future), the investor is said to be in a short position or short
futures.

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The buyer of a futures contract will realize a profit if the futures price increases; the seller of a
futures contract will realize a profit if the futures price decreases. For example, suppose that one
month after Bob and Sally take their positions in the futures contract, the futures price of asset
XYZ increases to $120. Bob, the buyer of the futures contract, could then sell the futures
contract and realize a profit of $20. Effectively, at the settlement date, he has agreed to buy asset
XYZ for $100 and has agreed to sell asset XYZ for $120. Sally, the seller of the futures contract,
will realize a loss of $20. If the futures price falls to $40 and Sally buys back the contract at $40,
she realizes a profit of $60 because she agreed to sell asset XYZ for $100 and now can buy it for
$40. Bob would realize a loss of $60. Thus, if the futures price decreases, the buyer of the futures
contract realizes a loss while the seller of the futures contract realizes a profit.
Associated with every futures exchange is a clearinghouse, which performs several functions.
One of these functions is to guarantee that the two parties to the transaction will perform.
Because of the clearinghouse, the two parties need not worry about the financial strength and
integrity of the other party taking the opposite side of the contract. After initial execution of an
order, the relationship between the two parties ends. The clearinghouse interposes itself as the
buyer for every sale and as the seller for every purchase. Thus, the two parties are then free to
liquidate their positions without involving the other party in the original contract, and without
worry that the other party may default.
B. Forward Contract
A forward contract, just like a futures contract, is an agreement for the future delivery of the
underlying at a specified price at the end of a designated period of time. Futures contracts are
standardized agreements as to the delivery date (or month) and quality of the deliverable, and are
traded on organized exchanges. A forward contract differs in that it is usually none standardized
(that is, the terms of each contract are negotiated individually between buyer and seller), there is
no clearinghouse, and secondary markets are often nonexistent or extremely thin. Unlike a
futures contract, which is an exchange traded product, a forward contract is an over-the-counter
instrument.
Because there is no clearinghouse that guarantees the performance of a counterparty in a forward
contract, the parties to a forward contract are exposed to counterparty risk, the risk that the other
party to the transaction will fail to perform.
C. Options
An option is a contract that permits its holder to trade some asset at a fixed price, should the
holder elect to do so. A contract that permits you to purchase an asset is known as a call option;
one that permits you to sell it is known as a put option. Options can be written either to permit
exercise on a given date or over a given time interval. Instruments that can only be exercised on
a given date are called European options; those that can be exercised any time within a given
interval are called American options. Like forwards, options offer a way of dividing up the
payoffs to risky assets. A forward contract requires you to trade whether asset prices increase or
decrease, while an options contract permits you to trade should you elect to do so.
Options are exercised at the choice of the holder, meaning the holder need only exercise the
option when it is profitable to do so.
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Option is classified in to two; call option and put option. Exercising a call option will be
profitable if the underlying asset price rises above the call exercise price, exercising a put option
will be profitable if the underlying asset price falls below the put exercise price.
Risk and Return Characteristics of Options
Here we illustrate the risk and return characteristics of the four basic option positions—buying a
call option, selling a call option, buying a put option, and selling a put option. The illustrations
assume that each option position is held to the expiration date and not exercised early. Also, to
simplify the illustrations, we ignore transactions costs.
1. Buying Call Options
The purchase of a call option creates a position referred to as a long call position. To illustrate
this position, assume that there is a call option on Asset X that expires in one month and has an
exercise price of $60. The option price is $2. What is the profit or loss for the investor who
purchases this call option and holds it to the expiration date?
The profit and loss from the strategy will depend on the price of Asset X at the expiration date. A
number of outcomes are possible.
If the price of Asset X at the expiration date is less than $60 (the option price), then the
investor will not exercise the option. It would be foolish to pay the option writer $60
when Asset X can be purchased in the market at a lower price. In this case, the option
buyer loses the entire option price of $2. Notice, however, that this is the maximum loss
that the option buyer will realize regardless of how low Asset X’s price declines.
If Asset X’s price is equal to $60 at the expiration date, there is again no economic value
in exercising the option. As in the case where the price is less than $60, the buyer of the
call option will lose the entire option price, $2.
If Asset X’s price is more than $60 but less than $62 at the expiration date, the option
buyer will exercise the option. By exercising, the option buyer can purchase Asset X for
$60 (the exercise price) and sell it in the market for the higher price. Suppose, for
example, that Asset X’s price is $61 at the expiration date. The buyer of the call option
will realize a $1 gain by exercising the option. Of course, the cost of purchasing the call
option was $2, so $1 is lost on this position. By failing to exercise the option, the investor
loses $2 instead of only $1.
If Asset X’s price at the expiration date is equal to $62, the investor will exercise the
option. In this case, the investor breaks even, realizing a gain of $2 that offsets the cost of
the option, $2.
If Asset X’s price at the expiration date is more than $62, the investor will exercise the
option and realize a profit. For example, if the price is $70, exercising the option will
generate a profit on Asset X of $10. Reducing this gain by the cost of the option, $2, and
the investor will realize a net profit from this position of $8.

2. Writing (Selling) Call Options

The writer of a call option is said to be in a short call position. To illustrate the option seller’s
(i.e., writer’s) position, we use the same call option we used to illustrate buying a call option.
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The profit and loss profile of the short call position (that is, the position of the call option writer)
is the mirror image of the profit and loss profile of the long call position (the position of the call
option buyer). That is, the profit of the short call position for any given price for Asset X at the
expiration date is the same as the loss of the long call position. Consequently, the maximum
profit that the short call position can produce is the option price. The maximum loss is not
limited because it is the highest price reached by Asset X on or the expiration date, less the
option price; this price can be indefinitely high.
3. Buying Put Options
The buying of a put option creates a financial position referred to as a long put position. To
illustrate this position, we assume a hypothetical put option on one unit of Asset X with one
month to maturity and an exercise price of $60. Assume the put option is selling for $2. The
profit or loss for this position at the expiration date depends on the market price of Asset X. The
possible outcomes are:
If Asset X’s price is greater than $60, the buyer of the put option will not exercise it
because exercising would mean selling Asset X to the writer for a price that is less than
the market price. A loss of $2 (the option price) will result in this case from buying the
put option. Once again, the option price represents the maximum loss to which the buyer
of the put option is exposed.
If the price of Asset X at expiration is equal to $60, the put will not be exercised, leaving
the put buyer with a loss equal to the option price of $2.
Any price for Asset X that is less than $60 but greater than $58 will result in a loss;
exercising the put option, however, limits the loss to less than the option price of $2. For
example, suppose that the price is $59 at the expiration date. By exercising the option, the
option buyer will realize a loss of $1. This is because the buyer of the put option can sell
Asset X, purchased in the market for $59, to the writer for $60, realizing a gain of $1.
Deducting the $2 cost of the option results in a loss of $1.
At a $58 price for Asset X at the expiration date, the put buyer will break even. The
investor will realize a gain of $2 by selling Asset X to the writer of the option for $60,
offsetting the cost of the option ($2).
If Asset X’s price is below $58 at the expiration date, the long put position (the put
buyer) will realize a profit. For example, suppose the price falls at expiration to $46. The
long put position will produce a profit of $12: a gain of $14 for exercising the put option
less the $2 option price.
4. Writing (Selling) Put Options
Writing a put option creates a position referred to as a short put position. The profit and loss
profile for a short put option is the mirror image of the long put option.
The maximum profit from this position is the option price. The loss would be as large as the
exercise price less the option price. The theoretical maximum loss can be substantial should the
price of the underlying fall; at the extreme, if the price were to fall all the way to zero, the loss
would be as large as the exercise price less the option price.
D. Swaps
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A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic
payments. The dollar amount of the payments exchanged is based on some predetermined dollar
principal, which is called the notional principal amount or simply notional amount. The dollar
amount each counterparty pays to the other is the agreed-upon periodic rate times the notional
amount. The only dollars that are exchanged between the parties are the agreed-upon payments,
not the notional amount. A swap is an over-the-counter contract. Hence, the counterparties to a
swap are exposed to counterparty risk.
Types of Swaps
The two types of swaps typically used are interest rate swaps and currency swaps. We illustrate
these types of swaps in this section.
Interest Rate Swap
In an interest rate swap, the counterparties swap payments in the same currency based on an
interest rate. For example, one of the counterparties can pay a fixed interest rate and the other
party a floating interest rate. The floating interest rate is commonly referred to as the reference
rate. For example, suppose the counterparties to a swap agreement are Farm Equip Corporation
(a manufacturing firm) and PNC Bank. The notional amount of this swap is $100 million and the
term of the swap is five years. Every year for the next five years, Farm Equip Corporation agrees
to pay PNC Bank 9% per year, while PNC Bank agrees to pay Farm Equip Corporation the one-
year LIBOR as the reference rate. This means that every year, Farm Equip Corporation will pay
$9 million (9% times $100 million) to PNC Bank. The amount PNC Bank will pay Farm Equip
Corporation depends on LIBOR. For example, one-year LIBOR is 6%, PNC Bank will pay Farm
Equip Corporation $6 million (6% times $100 million).
Currency Swaps
Currency swaps are used to manage exchange rate risk. In a currency swap, two counterparties
exchange the interest and principal payments on loans in different currencies. The counterparties
agree to a set exchange rate, a set maturity, and a set schedule to pay interest and principal. By
fixing the exchange rate for the transaction, both counterparties hedge the risk of unfavorable
exchange rate fluctuations.
For example, a British company may need to borrow US dollars. But the only rate it can get on a
dollar loan is too high. At the same time, a US company needs to borrow pounds, but the only
rate it can get on a loan in pounds is too high. The British company, however, can borrow
pounds at an attractive interest rate and the US Company can borrow dollars at an attractive
interest rate. So the two companies decide to enter into a currency swap agreement.

The US Company borrows dollars cheaply and then lends them to the British company.
Meanwhile, the British company borrows pounds cheaply and lends them to the US Company.
Through the swap agreement, both companies end up benefiting from the other company’s
attractive home-currency borrowing rate. It is a win-win situation.
4.1.4 Foreign exchange Market
The foreign exchange market, or the "FX" market, is where the buying and selling of different
currencies takes place. The price of one currency in terms of another is called an exchange rate.
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Foreign exchange consists of trading one type of currency for another. Unlike other financial
markets, the FX market has no physical location and no central exchange. It operates "over the
counter" through a global network of banks, corporations and individuals trading one currency
for another. The FX market is the world's largest financial market, operating 24 hours a day with
enormous amounts of money traded on a daily basis.
In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate)
between two currencies specifies how much one currency is worth in terms of the other. An
exchange rate quotation is given by stating the number of units of "term currency" or "price
currency" that can be bought in terms of 1 unit currency (also called base currency).
 Direct quotation: 1 foreign currency unit = x home currency units
 Indirect quotation: 1 home currency unit = x foreign currency units
Financial instruments of Forex
 Spot rate
A spot foreign exchange rate is the rate of a foreign exchange contract for immediate delivery
(usually within two days). The spot rate represents the price that a buyer expects to pay for
foreign currency in another currency. These contracts are typically used for immediate
requirements, such as property purchases and deposits, deposits on cards, etc. This trade
represents a ―direct exchange‖ between two currencies, has the shortest time frame, involves
cash rather than a contract; and interest is not included in the agreed-upon transaction. Spot has
the largest share by volume in FX transactions among all instruments.
 Forward rate
One way to deal with the Forex risk is to engage in a forward transaction. In this transaction,
money does not actually change hands until some agreed upon future date. A buyer and seller
agree on an exchange rate for any date in the future, and the transaction occurs on that date,
regardless of what the market rates are then. The duration of the trade can be a few days, months
or years.
 Swaps
The most common type of forward transaction is the currency swap. In a swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later
date. These are not standardized contracts and are not traded through an exchange.

Suppose a U.S. company needs 15 million Japanese yen for a three-month investment in Japan. It
may agree to a rate of 150 yen to a dollar and swap $100,000 with a company willing to swap 15
million yen for three months. After three months, the U.S. Company returns the 15 million yen to
the other company and gets back $100,000, with adjustments made for interest rate differentials.
 Future
Foreign currency futures are forward transactions with standard contract sizes and maturity dates
for example, 500,000 British pounds for next November at an agreed rate. Futures are
standardized and are usually traded on an exchange created for this purpose. The average

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contract length is roughly 3 months. Futures contracts are usually inclusive of any interest
amounts.
 Option rate
A foreign exchange option (commonly shortened to just FX option) is a derivative where the
owner has the right but not the obligation to exchange money denominated in one currency into
another currency at a pre-agreed exchange rate on a specified date. The FX options market is the
deepest, largest and most liquid market for options of any kind. This type of transaction allows
the owner more flexibility than a swap or futures contract.
 Option to buy currency called Call option
 Option to sell currency called Put option

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