KRITHIKA M

ASSISTANT PROFESSOR
STG FGC CHINAKURALI.

MODULE NO 1:- CONCEPT OF INVESTMENT

INTRODUCTION
The term ‘investing’ could be associated with different activities, but the common target in
these activities is to ‘employ’ the money (funds) during the time period seeking to enhance the
investor’s wealth. Investment is the act of allocating resources, typically money, with the
expectation of generating income or profit over time. It plays a critical role in personal
finance, economic development, and wealth creation by enabling individuals and institutions to
grow their capital and achieve financial goals.
MEANING OF INVESTMENT
Investment is an employment of funds on assets in the aim of earning income or capital
appreciation. Investment activity involves the use of funds or savings for acquisition of assets
& further creation of assets.
Definition of Investment:
According to keyness “investment is defined as the addition of the value of the capital
equipment which has resulted from the productive activity of the period”.

INVESTMENT ATTRIBUTES/QUALITIES/CHARACTERISTICS INCLUDE:

1. Return Potential: Investors typically seek investments that offer the potential for attractive
returns. This can include capital appreciation, dividend income, interest payments, rental
income, or other forms of financial gain.
2. Risk Profile: Every investment carries a certain level of risk, which refers to the likelihood
of loss or variability in returns. Investors assess the risk-return tradeoff to determine whether
an investment aligns with their risk tolerance and financial goals.
3. Liquidity: Liquidity refers to the ease with which an investment can be bought or sold in
the market without significantly impacting its price. Investments with high liquidity are more
easily converted into cash, providing flexibility for investors to adjust their portfolios as
needed.
4. Time Horizon: Different investments have varying time horizons, which refers to the
length of time over which an investor expects to hold the investment before realizing its
returns. Investors match their investment choices with their specific time horizon, whether
short-term, medium-term, or long-term.
5. Diversification Potential: Diversification involves spreading investment capital across a
range of assets or asset classes to reduce overall portfolio risk. Investments with low
correlation to each other provide diversification benefits, helping investors mitigate the
impact of market volatility.

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 6. Tax Efficiency: Tax considerations play a significant role in investment decisions.
Investors seek investments that offer tax advantages or favorable tax treatment, such as tax-
deferred growth, taxexempt income, or capital gains tax benefits.
7. Costs and Fees: Investors evaluate the costs associated with an investment, including
transaction fees, management fees, expense ratios, and other expenses. Lower costs can
enhance investment returns over time.
8. Transparency and Governance: Investors prefer investments with transparent and well-
regulated markets, clear financial reporting, and strong corporate governance practices.
Transparency and governance contribute to investor confidence and reduce the risk of fraud or
misconduct.
9. Inflation Hedge: Some investments provide protection against inflation by preserving or
increasing purchasing power over time. Assets such as real estate, commodities, inflation-
linked bonds, and dividend-paying stocks may serve as effective inflation hedges.
10. Social and Environmental Impact: Increasingly, investors consider the social and
environmental impact of their investments, seeking opportunities that align with their values
and sustainability goals. Socially responsible investing (SRI) and environmental, social, and
governance (ESG) criteria are important considerations for many investors.

Types of investments

Investments can be broadly classified based on the asset class, risk level, and purpose. Below are
the primary types of investments:

1. Stocks (Equities)

 Definition: Shares that represent ownership in a company.

 Returns: Dividends (profits distributed to shareholders) and capital gains (increase in
share price).
 Risk: High volatility but potential for high returns.
 Example: Buying shares of companies like Apple, Amazon, or Tesla.

2. Bonds (Fixed Income)

 Definition: Debt instruments where you lend money to governments, corporations, or

municipalities, which promise to pay interest and return the principal at maturity.
 Returns: Fixed periodic interest payments and principal repayment.
 Risk: Lower than stocks but varies based on the issuer’s creditworthiness.
 Example: Government bonds, corporate bonds, or municipal bonds.

3. Real Estate

 Definition: Investment in physical property like land, residential homes, or

commercial buildings.
 Returns: Rental income and property appreciation.

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  Risk: Requires significant capital and may face market-specific risks (e.g., economic
downturns).
 Example: Purchasing a rental property or investing through Real Estate Investment
Trusts (REITs).

4. Mutual Funds

 Definition: Pooled funds collected from many investors to invest in diversified

portfolios of stocks, bonds, or other securities.
 Returns: Vary based on the performance of underlying assets.
 Risk: Medium; diversified to reduce individual asset risk.
 Example: Index funds or sector-specific funds.

5. Exchange-Traded Funds (ETFs)

 Definition: Similar to mutual funds but traded on stock exchanges like individual
stocks.
 Returns: Depend on the performance of tracked assets or indices.
 Risk: Medium; typically lower than individual stocks.
 Example: ETFs tracking the S&P 500 or commodities.

6. Commodities

 Definition: Physical goods such as gold, silver, oil, or agricultural products.

 Returns: Driven by market demand and supply fluctuations.
 Risk: High due to volatility in global markets and geopolitical events.
 Example: Investing in gold, crude oil, or wheat futures.

7. Cryptocurrency

 Definition: Digital or virtual currencies based on blockchain technology.

 Returns: High potential returns but extremely volatile.
 Risk: High; prone to market manipulation, regulatory uncertainty, and security
concerns.
 Example: Bitcoin, Ethereum, or Ripple.

8. Savings Accounts and Fixed Deposits

 Definition: Safe, low-risk options offered by banks for saving money.

 Returns: Fixed interest rates, typically lower than inflation-adjusted growth.
 Risk: Minimal, as they are often insured by government programs.
 Example: Fixed deposit accounts or high-yield savings accounts.

9. Alternative Investments

 Definition: Non-traditional investment options that offer diversification.

 Examples:
o Private Equity: Investing in private companies.
o Hedge Funds: Professionally managed funds using advanced strategies.
o Venture Capital: Investments in startups or early-stage companies.

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 o Collectibles: Art, antiques, rare coins, or wine.

10. Retirement Accounts

 Definition: Investment accounts designed to save for retirement, often with tax
benefits.
 Examples:
o National Pension Scheme (NPS) or Public Provident Fund (PPF) in other
regions.
 Returns: Vary based on the underlying investments within the account.
 Risk: Depends on chosen assets; generally medium to low.

11. Derivatives

 Definition: Financial instruments whose value is derived from underlying assets like
stocks, bonds, or commodities.
 Examples:
o Futures and options contracts.
o Swaps and forwards.
 Risk: High, as they are speculative and often leveraged.

ECOMONIC V/S FINANCIAL INVESTMENT

Economic Investment vs. Financial Investment

Both economic investment and financial investment involve allocating resources for future
benefits, but they differ significantly in their focus, purpose, and implications. Here's a
detailed comparison:

1. Economic Investment

Economic investment refers to the allocation of resources (capital, labor, or materials) toward
creating or improving physical assets that contribute to production and economic growth.

Examples

 Building a factory or manufacturing plant.

 Purchasing machinery or equipment.
 Developing infrastructure like roads, bridges, or power plants.
 Research and development (R&D) activities.

Purpose

 To enhance productive capacity.

 To drive long-term economic growth.
 To increase goods and services output in an economy.

Key Characteristics

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  Physical Assets: Focuses on tangible goods that contribute directly to production.
 Economic Growth: Directly impacts GDP and national development.
 Long-Term Focus: Often involves significant planning and a long time horizon for
returns.
 Real Investment: Deals with actual goods and services.

Impact

 Leads to job creation.

 Enhances the overall productivity of an economy.
 Contributes to technological advancements and innovation.

2. Financial Investment

Financial investment involves the allocation of money into financial instruments or assets with
the expectation of earning returns, such as interest, dividends, or capital appreciation.

Examples

 Buying stocks, bonds, or mutual funds.

 Investing in real estate for speculative purposes.
 Depositing money in a savings account.
 Purchasing cryptocurrencies.

Purpose

 To generate wealth or income for the investor.

 To achieve specific financial goals, such as retirement or education funding.

Key Characteristics

 Monetary Assets: Focuses on financial instruments rather than physical goods.

 Personal/Institutional Growth: Benefits individual or corporate investors rather than
directly contributing to national productivity.
 Short to Long-Term Focus: Time horizons vary depending on the asset type.
 Speculative Nature: Sometimes involves higher risks for higher returns.

Impact

 Promotes capital formation by channeling funds to businesses and governments.

 May lead to wealth inequality if speculative investments dominate productive ones.
 Drives financial market activities and liquidity.

Key Differences

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Aspect Economic Investment Financial Investment

Focus Physical assets contributing to Financial assets for wealth accumulation.

production.
Boosts economic productivity and Generates income or wealth for the
Purpose
growth. investor.
Examples Building factories, infrastructure.
Buying stocks, bonds, or mutual funds.
Contributes to GDP and job creation. Influences financial markets and capital
Impact
allocation.
Typically lower but longer-term Varies widely; can be high-risk or low-
Risk
returns. risk.
Time Horizon Long-term, focused on sustainability.Short-term to long-term, depending on the
goal.

Interrelation

Economic and financial investments often complement each other. For instance:

 Financial investments by individuals or institutions may provide funding for

economic investments, such as building infrastructure or expanding businesses.
 Economic growth driven by economic investments can enhance the returns on
financial investments, as companies grow and markets flourish.

Understanding these distinctions is essential for making informed decisions in both personal finance
and policymaking.

INVESTMENT AND SPECULATION

Much investing activity contains an element of speculation, and it is hard to imagine the
functioning of an equity market in which speculation was entirely absent. Despite that,
speculation and investment are, to my mind, quite distinct activities economically. While
there are a number of reasonable definitions one could give for these activities, over the
years I have found it useful to think in terms of the following for them:

Investment: The deployment of capital to perform an economic service for which a rational
counterparty should be willing to pay.

Speculation: The deployment of capital to achieve an expected gain based on an investor’s

prediction of how future prices will differ from the market’s expectations.

1. Investment
Investment refers to the process of committing money or resources to an asset or project with

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the expectation of earning steady returns or generating wealth over a long period. It involves
careful planning and analysis to minimize risks and ensure financial security.

 Key Features:
o Focuses on long-term wealth creation.
o Aims for moderate and steady returns.
o Involves lower risk due to diversification and research.

Example:
Buying government bonds or investing in mutual funds for retirement savings.

2. Speculation
Speculation involves taking high risks by trading in assets or financial instruments with the
primary aim of earning substantial profits over a short time. It is based on price fluctuations
rather than intrinsic value.

 Key Features:
o Short-term focus on quick gains.
o High-risk activity with uncertain outcomes.
o Often driven by market trends, rumors, or sentiment.

Example:
Day trading in volatile stocks or cryptocurrencies like Bitcoin to profit from price swings.

KEY DIFFERENCES

Investment Speculation
Short-term bets on financial
Definition Money allocation for an asset purchase.
assets to gain quickly.
The investor’s main objective is to achieve small The speculator seeks to
Aim recurring returns in the long term, such as the achieve small profits in the
payment of dividends. short term.
Speculators usually change
Generally, the investor keeps the assets in his
assets in the short term, in
Time portfolio for a long time, years and even a
minutes, hours, or a few
lifetime.
days.
Thorough analysis of fundamental factors,
Technical analysis mainly
including company ratios, competitive and
Analysis combined with fundamental
industry conditions, and technical factors
and market sentiment.
throughout the asset’s history.
Income Certainty
Stable. Erratic.

High risk. The higher the risk,

Moderate risk. The lower the risk, the lower the
Risks the higher the potential
return.
gains.

FEATURES OF GOOD INVESTMENT

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1. Safety of Principal

 A good investment safeguards the original capital against potential losses.

 While some risk is inevitable, it should be manageable and minimized through proper
research and diversification.
 Example: Government bonds or insured savings accounts offer high safety.

2. Adequate Returns

 The investment should generate returns that are competitive and sufficient to meet the
investor's goals.
 Returns should also outpace inflation to ensure real growth in purchasing power over
time.
 Example: Real estate or equity investments typically provide returns that grow over
the long term.

3. Liquidity

 A good investment allows the investor to convert it into cash easily when needed.
 High liquidity ensures access to funds in emergencies or to meet short-term financial
needs.
 Example: Stocks and mutual funds are more liquid compared to real estate or fixed
deposits.

4. Diversification

 A good investment should allow for diversification, spreading risk across various
asset classes or industries to minimize the impact of market fluctuations.
 Example: Mutual funds or ETFs often provide built-in diversification.

5. Consistent Income

 Investments should generate regular and stable income, particularly for those seeking
financial security.
 Example: Bonds or dividend-paying stocks can provide steady income streams.

6. Potential for Growth (Capital Appreciation)

 A good investment has the potential to increase in value over time, contributing to
long-term wealth creation.
 Example: Equity investments in growing companies or property in a developing area.

7. Tax Efficiency

 Investments that offer tax benefits or reduce tax liability can significantly enhance
returns.
 Example: Tax-saving mutual funds, retirement accounts, or government-backed tax-
free bonds.

8. Alignment with Financial Goals

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  A good investment matches the investor's financial goals, risk tolerance, and time
horizon.
 Example: Short-term goals may require liquid assets, while long-term goals favor
growth-oriented investments.

9. Inflation Protection

 A good investment ensures that returns keep pace with or exceed inflation, preserving
the purchasing power of the capital.
 Example: Investments in equities or real estate often act as a hedge against inflation.

10. Low Cost and Fees

 High costs, such as transaction fees or management charges, can eat into returns. A
good investment should have low associated costs.
 Example: Index funds are known for their low expense ratios.

11. Risk-Adjusted Returns

 A good investment provides returns proportional to the level of risk taken.

 Investors should evaluate whether the potential returns justify the risk involved.
 Example: Blue-chip stocks often provide reliable returns with lower risk compared to
small-cap stocks.

12. Transparency and Simplicity

 Investments should be transparent, with clear terms and conditions.

 Simplicity in understanding the investment product minimizes misunderstandings and
unforeseen risks.
 Example: Direct stock investments are straightforward compared to complex
derivatives.

14. Flexibility

 A good investment allows flexibility to adapt to changing financial circumstances or

market conditions.
 Example: Open-ended mutual funds enable investors to add or withdraw funds easily.

INVESTMENT PROCESS

The investment process is a systematic approach to managing finances, selecting appropriate assets,
and achieving financial goals. It involves a series of steps that help investors make informed and
strategic decisions. Below is a detailed explanation of the steps involved in the investment
process:

1. Establishing Investment Goals

 Objective: Define the purpose of the investment and set clear, measurable goals.

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  Types of Goals:
o Short-term: Saving for a vacation or an emergency fund.
o Medium-term: Purchasing a car or funding education.
o Long-term: Retirement planning or wealth creation.
 Factors to Consider:
o Time horizon.
o Risk tolerance.
o Desired returns.

2. Assessing Financial Position

 Objective: Evaluate your current financial situation to determine the amount available
for investment.
 Steps:
o Analyze income, expenses, and savings.
o Ensure you have an emergency fund (3–6 months of living expenses).
o Manage and reduce high-interest debts before investing.
 Outcome: Understand how much capital can be allocated to investments.

3. Determining Risk Tolerance

 Objective: Identify your ability and willingness to handle financial losses.

 Factors Influencing Risk Tolerance:
o Age: Younger investors can generally take more risks due to a longer
investment horizon.
o Income and Savings: Higher income and savings allow for greater risk-taking.
o Psychological Comfort: Some investors prefer stability, even at the cost of
lower returns.
 Types of Risk Tolerance:
o Conservative: Low risk, steady returns (e.g., bonds, fixed deposits).
o Moderate: Balanced risk and returns (e.g., mutual funds, ETFs).
o Aggressive: High risk, high returns (e.g., stocks, cryptocurrencies).

4. Developing an Investment Plan

 Objective: Create a roadmap that aligns your goals, time horizon, and risk tolerance.
 Components:
o Asset Allocation: Distribute investments across asset classes (stocks, bonds,
real estate, etc.) to diversify risk.
o Investment Style: Decide between active management (frequent monitoring
and trading) or passive management (buy-and-hold strategy).
o Budgeting: Determine how much to invest regularly (e.g., through SIPs or
lump-sum investments).

5. Conducting Market Research

 Objective: Analyze and evaluate potential investment opportunities.

 Steps:
o Study market trends, economic indicators, and industry performance.

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 o Evaluate individual assets based on factors like historical performance,
management quality, and future prospects.
o Seek professional advice or use financial tools for detailed analysis.
 Outcome: Select assets that match your financial objectives and risk profile.

6. Portfolio Construction

 Objective: Build a diversified portfolio that optimizes risk and return.

 Steps:
o Select assets across different sectors, industries, and asset classes.
o Balance the portfolio with a mix of high-risk and low-risk investments.
o Allocate funds based on the investment plan and goals.
 Example: A young investor may allocate 70% to equities, 20% to bonds, and 10% to
cash.

7. Monitoring and Reviewing Investments

 Objective: Regularly track the performance of your portfolio and make necessary
adjustments.
 Steps:
o Compare actual returns with expected performance.
o Reassess goals and risk tolerance based on life changes (e.g., marriage, job
change, or retirement).
o Adjust asset allocation to stay aligned with financial objectives.
 Frequency: Reviews can be quarterly, semi-annual, or annual.

8. Rebalancing the Portfolio

 Objective: Restore the portfolio to its original asset allocation to maintain desired risk
levels.
 Steps:
o Sell overperforming assets to reduce exposure.
o Invest in underperforming or undervalued assets to regain balance.
o Ensure diversification remains intact.
 Example: If equities outperform and constitute 80% of a portfolio intended to have
70% equities, rebalancing is required.

9. Evaluating Outcomes

 Objective: Measure the success of your investment strategy over time.

 Steps:
o Analyze overall returns and compare them with benchmarks or market
averages.
o Assess whether financial goals are being achieved within the expected
timeline.
o Learn from past mistakes and refine your investment approach.
 Outcome: A more effective investment process for future decisions.

10. Continuous Education

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  Objective: Stay informed about market developments, new investment opportunities,
and evolving strategies.
 Steps:
o Read financial news, attend seminars, or consult financial advisors.
o Understand regulatory changes that may affect investments.
o Regularly update knowledge about tax benefits, emerging markets, and
economic policies.

Summary of the Investment Process

1. Define financial goals.

2. Assess your financial position and risk tolerance.
3. Create a detailed investment plan and allocate assets.
4. Conduct thorough research and select appropriate investments.
5. Construct a diversified portfolio.
6. Monitor, review, and rebalance regularly.
7. Evaluate outcomes and learn from the results.

This systematic process ensures that investments align with goals, minimize risks, and maximize
returns over time.

FINANCIAL INSTRUMENTS

INTRODUCTION

Financial instruments are monetary contracts between parties. They can be created, traded,
modified and settled. They can be cash (currency), evidence of an ownership, interest in an entity
or a contractual right to receive or deliver in the form of currency (forex); debt (bonds, loans);
equity (shares); or derivatives (options, futures, forwards).

Financial instruments may be categorized by "asset class" depending on whether they are foreign
exchange-based (reflecting foreign exchange instruments and transactions), equity- based
(reflecting ownership of the issuing entity) or debt-based (reflecting a loan the investor has
made to the issuing entity). If the instrument is debt it can be further categorized into short-
term (less than one year) or long-term.

MEANINGs

Financial instruments are contracts for monetary assets that can be purchased, traded, created,
modified, or settled for. In terms of contracts, there is a contractual obligation between
involved parties during a financial instrument transaction.

For example, if a company were to pay cash for a bond, another party is obligated to deliver a
financial instrument for the transaction to be fully completed. One company is obligated to
provide cash, while the other is obligated to provide the bond.

Functions of Financial Instruments

1. Raising Capital: Help governments and corporations fund operations or projects.

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 2. Risk Management: Derivative instruments mitigate market risks.
3. Liquidity: Enable quick conversion of assets to cash.
4. Wealth Creation: Provide returns in the form of interest, dividends, or capital gains.
5. Market Operations: Facilitate trading in financial markets, contributing to market
efficiency.

Characteristics of Financial Instruments

1. Marketability: The ease with which they can be bought or sold in the market.
2. Return Potential: Ability to generate income or capital gains.
3. Risk Level: Varies from low (e.g., government bonds) to high (e.g., derivatives,
cryptocurrencies).
4. Liquidity: Some instruments, like shares, are highly liquid, while others, like real
estate, are less so.
5. Maturity Period: Can range from short-term (e.g., T-bills) to long-term (e.g., bonds).

MONEY MARKET AND CAPITAL MARKET INSTRUMENTS

Money market and capital market are two segments of the financial markets where different types
of financial instruments are traded. They serve different purposes and cater to different needs
of investors and borrowers.

Money Market Instruments

The money market deals with short-term borrowing and lending, typically for periods of one year
or less. The instruments in the money market are considered low-risk and are used for liquidity
management. Some of the key money market instruments include:

1. Treasury Bills (T-Bills):

o Short-term government securities with maturities of 91, 182, or 364 days.
o Sold at a discount to their face value, and the government pays the full face
value at maturity.
2. Commercial Paper (CP):
o Unsecured, short-term promissory notes issued by corporations to meet short-
term financing needs.
o Typically, these have maturities ranging from 1 to 270 days.
3. Certificates of Deposit (CD):
o Time deposits offered by banks with specific maturity dates (usually ranging
from a few weeks to a year).
o They pay interest at a fixed rate and can be negotiable or non-negotiable.
4. Repurchase Agreements (Repos):
o Short-term loans secured by government securities.
o The seller agrees to repurchase the securities at a higher price at a specified
time.
5. Interbank Loans:
o Loans that banks make to each other in the overnight market to maintain
liquidity.

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 oTypically, these are short-term and based on the overnight interest rate (e.g.,
LIBOR).
6. Money Market Funds:
o Mutual funds that invest in short-term, high-quality debt instruments such as
T-Bills, CDs, and commercial papers.

Capital Market Instruments

The capital market involves long-term borrowing and lending, with securities having maturities
longer than one year. These instruments cater to the financing needs of businesses and
governments for capital expenditures and growth. Capital market instruments include:

1. Equity Shares (Stocks):

o Ownership shares in a company. Investors in stocks have voting rights and
may receive dividends.
o Stocks can be traded on stock exchanges like the NYSE or NASDAQ.
2. Bonds:
o Debt instruments issued by corporations, municipalities, or governments to
raise capital.
o Bonds can be long-term (10 years or more) and pay fixed or variable interest.
The principal amount is repaid at maturity.
3. Debentures:
o Similar to bonds, but they are unsecured, meaning they are not backed by
specific assets.
o They typically offer higher interest rates to compensate for the additional risk.
4. Convertible Securities:
o Bonds or preferred stocks that can be converted into a predetermined number
of common stock shares at the investor's option.
o This provides the benefit of fixed income with the potential for equity
appreciation.
5. Preferred Stocks:
o Hybrid securities that have characteristics of both equity and debt.
o Investors receive fixed dividends, but preferred shareholders do not typically
have voting rights.
6. Government Securities:
o Bonds or other debt instruments issued by the government to fund its
expenditures.
o These securities typically offer low yields but are considered low-risk
investments.
7. Municipal Bonds:
o Debt securities issued by local government entities (cities, counties, etc.) to
finance projects like infrastructure development.
o These bonds may be tax-exempt, providing an advantage to certain investors.
8. Asset-Backed Securities (ABS):
o Bonds or securities backed by a pool of assets, such as mortgages, car loans,
or credit card receivables.
o These instruments allow for the diversification of risk among various types of
assets.

Parameters Money Market Capital Market

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 Function Short-term credit Long-term credit facilities
facilities
Market Type Informal Regulated/ formal
Purpose For working capital To turn into a part of the asset base of the
requirements organisation
Categories None Primary and Secondary
Transaction Over the counter Exchange
Type
Instruments CDs, T-Bills, Stocks and bonds
Commercial Papers,
etc.
Liquidity More liquid than the Less liquid than the money market
capital market
Maturity Between 1 day and 1 No particular time period
Tenure year
Risk Low High
Duration of Short term Long term
Investment
Participants Banks and similar Underwriters, insurance companies, mutual
financial institutions funds, retail investors, stockbrokers, stock
exchanges, etc.
Returns Consistent Market-linked

DERIVATIES

Derivatives are financial contracts whose value is linked to the value of an underlying asset.
They are complex financial instruments that are used for various purposes, including
speculation, hedging and getting access to additional assets or markets.

MEANING

Derivatives are financial instruments whose value is derived from the value of an underlying
asset, index, or benchmark. These contracts allow parties to hedge risk, speculate on price
movements, or obtain exposure to assets or markets without directly owning them.

Types of Derivatives:

There are several types of derivatives based on how they are structured and used. The most
common types include:

1. Forward Contracts:
o A forward contract is an agreement between two parties to buy or sell an asset
at a specific future date for a price agreed upon today.

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 o These contracts are typically customizable and traded over-the-counter (OTC),
meaning they are not standardized and are not traded on an exchange.
o Example: A farmer and a buyer may agree to a forward contract to sell wheat
at a fixed price at harvest time.
2. Futures Contracts:
o A futures contract is similar to a forward contract but is standardized and
traded on an exchange (such as the Chicago Mercantile Exchange).
o These contracts obligate the buyer to purchase (or the seller to sell) the asset at
a specific date in the future, at a price agreed upon when the contract is made.
o Example: A futures contract on crude oil, where the buyer agrees to purchase
oil at a certain price on a specific future date.
3. Options Contracts:
o An option gives the holder the right (but not the obligation) to buy or sell an
underlying asset at a predetermined price (strike price) before or on a specific
expiration date.
o There are two types of options:
 Call Options: The right to buy the asset.
 Put Options: The right to sell the asset.
o Options can be traded on exchanges (like the Chicago Board Options
Exchange) or over-the-counter (OTC).
o Example: A stock option allowing an investor to buy shares of a company at a
specified price before a certain date.
4. Swaps:
o A swap is a derivative contract in which two parties agree to exchange cash
flows or other financial instruments based on some underlying asset or index.
o The most common types of swaps include:
 Interest Rate Swaps: Exchange fixed interest payments for floating
interest payments.
 Currency Swaps: Exchange cash flows in one currency for cash flows
in another currency.
 Commodity Swaps: Exchange cash flows based on the price of a
commodity, such as oil or gold.
o Example: An interest rate swap where one party pays a fixed interest rate on a
principal amount, and the other party pays a floating interest rate.

Uses of Derivatives:

1. Hedging:
o Derivatives are commonly used for risk management, where investors or
companies use them to hedge against price fluctuations in assets, interest rates,
or foreign exchange rates.
o For example, an airline may use fuel futures contracts to hedge against rising
fuel prices.
2. Speculation:
o Speculators use derivatives to bet on the direction of price movements of the
underlying assets. They seek to profit from price changes without owning the
underlying asset.
o Example: A trader may buy a futures contract on gold if they expect its price
to rise.
3. Arbitrage:

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 o Arbitrage involves exploiting price discrepancies between markets or
instruments to generate a risk-free profit. Derivatives can be used in arbitrage
strategies.
o Example: A trader might use derivatives to take advantage of different prices
for the same asset on two different exchanges.
4. Access to Assets:
o Derivatives can provide exposure to markets or assets that are difficult to
access directly, such as foreign currencies or commodities.
o Example: An investor who does not want to directly buy physical gold might
use a gold futures contract to gain exposure to gold prices.

Advantages of Derivatives:

1. Leverage: Derivatives often allow traders to control a larger position with a smaller
investment (known as leverage), increasing both potential returns and risks.
2. Risk Management: They provide a mechanism for managing and mitigating risk,
especially in volatile markets.
3. Market Efficiency: Derivatives can help improve market efficiency by ensuring that
prices reflect all available information and by facilitating price discovery.

Disadvantages of Derivatives:

1. Complexity: Derivatives can be complex and difficult to understand, especially for

retail investors.
2. Leverage Risks: While leverage can enhance returns, it can also magnify losses,
leading to significant financial risk.
3. Counterparty Risk: Since some derivatives are traded OTC, there is a risk that the
counterparty might default on the contract.
4. Market Risk: Derivatives can be subject to market risk, where adverse movements in
the underlying asset can result in substantial losses.

Examples of Derivative Markets:

 Chicago Mercantile Exchange (CME): A leading exchange for futures and options
trading.
 London International Financial Futures Exchange (LIFFE): Known for futures
contracts on interest rates and commodities.
 Over-the-counter (OTC) Markets: Many derivatives, especially forwards and
swaps, are traded privately between parties rather than on exchanges.

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