Introduction to Capital Markets

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 What makes a market?

P
E Agents who need money, agents who are willing to invest
O money and intermediaries who bring these people
P together
L
E

P
R
O How can money be raised? There are numerous different
D ways of performing this particular trick. Having raised or
U
C invested money, how can agents manage the subsequent
T risk?
S

P
L How are deals executed? Are assets freely transferable? Is
A there a physical market place?
C
E
S

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 Why do Markets matter?
Below are some key operations the financial markets:

Price discovery and Capital

Asset Valuation Opportunities

Markets bring together buyers and

sellers and provides „Price Discovery‟ for Equities, debt and other financial
individual assets. This in turn allows instruments enable firms and
overall valuation of asset portfolios. government to raise money for building
new factories, invest in public work, etc.

Investment
Opportunities

Agents who don‟t need money now, can

invest their surplus cash to generate a
return and to build up a future asset
portfolio
Short Term Financial Risk
financing Management

Companies require working capital; Agents are often exposed to risk in the
money to pay now for inventory, wages, form of market movements. Markets
and so on. If they are conducting provide protection against changes in
business in overseas market , they asset values. Example- Derivatives
require the ability to exchange different market
currencies.
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 Components of a Market
1) Participants:
 Agents raising money such as corporate looking for future capital to expand or
government utilizing short term financial markets for working capital.
 Agents investing money such as mutual fund purchasing equities.
 Market intermediaries who bring borrowers and investors together such as an
Investment Bank.
 Regulators who overseas the integrity of Financial Markets.

2) Products:
 Securities or contractual agreements
 Debt or Equity
 Money Market/Capital Market Instruments
 Exchange Traded or OTC
Some examples of financial products being Equities, bonds, FX, commodities, Derivatives, etc

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 Components of Market continued….
3) Market Places:
 Stock Exchange:
A stock exchange, share market or bourse is a corporation or mutual
organization which provides facilities for stock brokers and traders, to trade
company stocks and other securities
 Over-the-counter (OTC):
OTC trading is to trade financial instruments such as stocks, bonds,
commodities or derivatives directly between two parties

Stock Exchange OTC

• Organized market with specific and • Deals are negotiated in opaque
detailed trading rules “market”
• Exchange defines the rules of the game • Dealer market where brokers and
and enforces them dealers make two-way markets
• Highly transparent • Sometimes brokered
• Quotes and prices are available very • Often lacks “transparency”, esp. for
rapidly by numerous services customized and new transaction prices
• Less credit risk • “Plain vanilla” products are more
standardized
• More credit risk
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 Classification of Markets

Securities Market

Money Market Capital Market

In Money Market, the financial In Capital Market, the financial

instruments used are those instruments used are those
associated with short term associated with long term
investments or borrowings of funds, investments or borrowings, for
for instance, the raising of cash to instance, the raising of cash
pay for an imminent shipment of through sales of equity to fund the
goods and services. future acquisitions of one
company by another.

A major distinction encountered in financial Markets is that between Money

Markets and Capital Markets. Broadly speaking, the difference is a function of the time
horizon.

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 Introduction to Capital Markets

The Capital Markets consists of a primary market, a secondary market and an infrastructure that
facilitates each.

Global Intermediaries

Primary Market
Issuers Investment banks facilitate creation of capital assets by Investors
matching those who need to secure capital (issuers) with
providers of funding (investors)

Secondary Market
Financial institutions sell and trade securities to
maximize performance of a portfolio of assets
consistent with an investor‟s investment objectives
Investors Investors
Market Infrastructure
Shared industry services facilitate the trading,
movement, settlement and safekeeping of securities

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 Primary Market
Primary market comprises of Issuers, Investment Banks and Investors

Issuers Investment Banks Investors

Require capital and are Provide corporate finance services and Invest capital for future returns.
willing to offer securities to originate and trade equity and debt.
others in order to obtain Serve as an intermediary between • High net worth individuals
these funds. Securities issuers and investors, mainly by • Government bodies
could be stocks, bonds, underwriting. • Institutions
options, warrants, etc. • Insurance companies
• Deutsche Bank
• Goldman Sachs
• Corporations • Merrill Lynch
• Morgan Stanley
• Government bodies • Nomura
• Small and medium • UBS
enterprises

Primary Market is usually synonymous with IPO.

Initial Public Offering (IPO) – IPO refers to first sale of stock by private company to the public
– sometimes called ‘going public’. IPO first came into everyday parlance during late 1990s

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 Secondary Market

Type Description Examples

In addition to executing trades for its AG Edwards
clients, also provides them with Deutsche Bank
Broker / Dealer Full research, planning and advice services. Merrill Lynch
Trade equity and/or Service Full Service Brokers charge higher fees
debt for retail and/or Brokers Shinko Securities
institutional accounts for these additional services and value
the personal relationships with clients. UBS

• Provide market access & execution services Provide low cost market access to Ameritrade
• Brokers find trading partners for customers and primarily self-directed clients. Charles Schwab
negotiate transaction prices acceptable to both Discount Historically focused bare-bones Cortal Consors
parties of the trade for a fee. Brokers features (via online & phone channels),
but increasingly introducing advanced E*Trade Financial
• Dealers are firms or individuals who act as the
principal in a securities transaction. research and planning tools.

Managed pooled investments, such as Deutsche Bank

Asset / Investment mutual funds and unit investment Fidelity
Manager Fund trusts. Customers will then buy and sell Merrill Lynch
Manage retail and Managers units of that fund.
institutional assets for UBS
clients for a fee Vanguard

• Develop investment strategies and make Develops a strategy for a portfolio for a Allianz Dresdner
investment decisions specific individual or institution. Makes Merrill Lynch
• Asset Management Services‟ typically referred Investment investment decisions on behalf of their
Managers Sanford Bernstein
to in the context of Institutional Investors. clients.
Various Private Banks
and Independents
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 Market Infrastructure

Provide a vehicle for the trading of securities by members for their own accounts
and their customers’ accounts. Can be physical locations, over-the-counter (OTC)
and electronic communication networks (ECNs).
Exchange/ECN
• NYSE Euronext • NASDAQ • MarketAxess
• CME
• LSE • TSE
• Deutsche Borse

Facilitate the validation, delivery and settlement of securities transactions.

Clearing House/ Affiliated with exchanges.
Clearer • Clearstream • Crest • DTCC - NSCC
• Euroclear • Pershing

Store physical securities. Trades involving the securities are made and accounts
at the depository are debited and credited, but the physical securities are not
Depository moved.
• Crest • DTCC - DTC • Euroclear

Provide back-office services (clearing and settlement, recordkeeping and

safekeeping) for other institutions. Ancillary services include foreign exchange
execution, cash management, securities lending, accounting, performance
measurement and customized reporting.
Custodian
• Bank of New York • JPMorgan Chase • Societe Generale
• BNP Paribas • HSBC • State Street

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 How they are integrated
Primary Market Secondary Market Market Infrastructure
(Investment Banking) (Sales and Trading) (Execution/Settlement/Safekeeping)

Exchange
Investors (Lenders) Broker/Dealer
Provide vehicle for the trading
Invest capital for future Trade equity and/or debt of securities by members for
returns. for retail and/or
institutional accounts. their own accounts and their
customers‟ accounts.

Clearing Agency
Facilitate the validation, delivery
Investment Bank and settlement of securities
Asset/Investment Manager transactions.
Provide corporate Manage retail and
finance services and institutional assets for
originate and trade clients for a fee.
equity and debt.
Depository
Store physical securities.

Issuers (Borrowers) Custodian

Require capital and are Holds and safeguards an
willing to offer securities individual, or institution‟s
to others in order to assets.
obtain these funds.

Sell Buy Market Infrastructure

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 Type of Techniques

• Hedge: Hedging is a strategy designed to minimize exposure to an unwanted

business risk, while still allowing the business to profit from an investment activity.
Hence, hedgers are mainly interested in protecting themselves against adverse price
changes
- want to avoid risk

• Speculate: speculation, involves the buying, holding, selling, and short-selling of

stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any
valuable financial instrument to profit from fluctuations in its price as opposed to
buying it for use
• Hence, Speculators hope to make money in the markets by betting on the
direction of prices “accept” risk

• Arbitrage: arbitrage is the practice of taking advantage of a price differential between

two or more markets: a combination of matching deals are struck that capitalize upon
the imbalance, the profit being the difference between the market prices.
• Hence, arbitrageurs usually lock into risk-less profit by simultaneously entering
into transactions in two or more markets

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 Regulatory and Compliance Laws Impacting
Capital Markets

• MiFID (The Markets in Financial Instruments Directive): Provides one passport for investment firms
and provision of investment services across the European Union for all impacted products on the
basis of a single authorization (Transparency is a major theme, particularly in regards to investor
protection.)

• Regulation NMS: Intends to improve and modernize markets through greater connectivity as they
stop operating in the worlds of both manual and electronic trading and forces greater technological
innovation

• Basel II Accord: Imposes new standards for risk measurement, capital adequacy and transparency,
requiring greater consistency and integrity in a firm's information systems

• U.S.A. Patriot Act, Know Your Customer (KYC) and 3rd Money Laundering Directive: Expands
existing regulations against fraud and money laundering, requiring stronger verification and
tracking processes

• U.K. Money Laundering: Requires due diligence procedures for institutions issuing credit or
allowing customers to open accounts

• Sarbanes-Oxley: Prescribes new controls to ensure the honesty and transparency of company
financial statements and business controls, requiring prompt and accurate processing of accounting

• International Accounting Standards (IAS): Requires new levels of disclosure to prevent off-balance
sheet activities and other forms of fraudulent accounting

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 Introduction to Equities

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 Introduction- Investing

• What is Investment?

The money you earn is partly spent and the rest saved for meeting future expenses. Instead of keeping
the savings idle you may like to use savings in order to get return on it in the future. This is called
Investment.

• Why should one invest?

One needs to invest to:

– earn return on your idle resources
– generate a specified sum of money for a specific goal in life
– make a provision for an uncertain future

• What are various options available for investment?

– Physical assets like real estate, gold/jewellery, commodities etc.

– Financial assets such as fixed deposits with banks, small saving instruments with post offices,
insurance/provident/pension fund etc. or securities market related instruments like shares, bonds,
debentures etc.

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 Introduction - Equities

What is equity??

- Equity generally means the ownership interest in a corporation.

Why Equity??

For Corporate:
- Equities finance the purchase of long-term assets, such as machines and factories.

For Investors:
- Have a claim to the future profits generated by the purchased assets.
- Equities or shares can be easily traded (sold) to other investors in the stock market and are thus
said to be liquid, or readily converted to cash.

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 Characteristics
The characteristics of the stock are:

• Limited Liability
– Which means that as an owner of a stock, you are not personally liable if the company is not able to pay
its debts A type of liability that does not exceed the initial amount a person invested into a partnership.
Limited liability protects a partner's personal assets from being liquidated should the company become
insolvent.

• Voting Privileges
– The right of a stockholder to vote on matters of corporate policy as well as on who is to compose the
board of directors.

• Lower priority of claims in bankruptcy

– In case of bankruptcy, creditors are paid first, the shareholders get whatever is left with preferred
shareholders having preference over common shareholders.

• Dividends
– A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its
shareholders . Dividends may be in the form of cash, stock or property.

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 Types - Equities

• Common Stock :

– Common stock acts as a unit of ownership in the company‟s profits and usually carries voting
rights that can be exercised in corporate decisions.
– Types of Common Stock are:
• Utility Stocks – Represent Ownership in Public Utility Companies
• Blue Chips- Stocks of largest Corporations
• Established Growth- Stocks of companies that are showing solid profitability
• Penny Stocks- Stocks of companies that have very little growth.

• Preferred Stock:

– Differs from common stock in that it typically does not carry voting rights but is legally entitled
to receive a certain level of dividend payments before any dividends can be issued to other
shareholders

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 Equity linked securities
Right
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing
holdings. The price at which the new shares are issued is generally much less than the prevailing
market price for the shares.
Example- Company XYZ : Outstanding Shares = 1000 ,You Own 100 shares. Hence your ownership =
10%. XYZ issues additional 200 shares, now your ownership= 8.3% ((100/1200) x 100). To retain your
10% interest, you will have to buy another 20 shares of XYZ. What can XYZ offer you?

Warrant:
Warrant is a security that entitles the holder to buy stock of the company that issued it at a specified
price, which is usually higher than the stock price at time of issue.
The investors purchasing warrants cannot make an immediate profit from using them to buy stock. For
the warrants to become valuable, the common stock must appreciate in value. Warrants are therefore
issued to enhance the future value of the stock to the holder.

ADR/ GDR: An American Depositary Receipt (or ADR) represents ownership in the shares of a
foreign company trading on US financial markets. The stock of many non-US companies trades on US
exchanges through the use of ADRs. ADRs enable US investors to buy shares in foreign companies
without undertaking cross-border transactions.

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 Stock Index

• A stock market index is a listing of stock and a statistic reflecting the composite value of
its components.

Examples:
– Dow Jones Industrial Average (DJIA)
– NYSE Composite Index
– S&P 500 Composite Stock Price Index
– Nasdaq-100 Index
Uses:
– Stock index is an easy means of tracking the stock market. Index shows how good or the bad is the
market.
– Stock index is used to measure the performance of the investment portfolio

Suppose an Index contains two stocks, A and B. A has a market capitalization* of Rs 1000 crore and B
has a market capitalization of Rs 3000 crore. Then we attach a weight of ¼ to the movements in A and
3/4 to the movements in B.
*Market Capitalization - It is company's outstanding shares multiplied by the current market price of one share

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 Stock Quotations
The following is an example of how a hypothetical stock might be quoted in a financial newspaper-

52 week High/Low – Stocks highest/Lowest price during past year

HYP – Stocks ticker symbol
Div – Indicates dividend per share paid to shareholders based on last dividend declaration
Yield % - It is the dividend yield i.e annual dividends per share divided by current price per share.
P/E – Price earning ratio which is the current price per share divided by earnings per share (EPS) for last year.
(EPS is portion of company‟s profit allocated to each outstanding shares.
Vol 100s – Refers to the total amount of shares traded during previous day listed in 100s. Hence in the above table, there
were 105200 (1052 * 100) HYP shares traded.
High/Low – Refers to the highest/lowest price paid for the stock the previous day.
Close – Last traded price recorded when market closed on the previous day.
Chg – Refers to the changes in the stocks prices from the previous day closing price. +ve means a stock is „on the up‟.

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 Trade Execution
5)The two NYSE brokers obtain quotes for GE stock on exchanges electronic market data
system
8)Brokers send their orders to the floor brokers and compete with other brokers to get the best
price for their customers
10) Within 3 days Chris and Cathy are sent confirmation of their trades by the brokerage firms

1) Chris decides to invest in the

stock market 2) Cathy decides to sell 100
shares of GE stock
3) Having recd advice from NYSE 4) Cathy asks her NYSE broker for a
member broker , Chris decides quote on GE stock
to purchase GE stock
7) Cathy tells her broker to sell 100
6) Chris tells his broker to purchase stocks of GE
100 stocks of GE
11) Chris settles his a/c within 3 days by submitting 12) Cathy’s a/c is credited within 3 days with the
payment to his brokerage a/c. proceeds from the sales of the shares minus any
commissions.

9) Once the trades are executed the specialist workstation sends notice to the brokerage
firm. The transaction is reported around the world in seconds

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 Question and Answer
What questions do you have?

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 Introduction to Debt Instruments

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 Introduction

• What is a ‘Debt Instrument’?

– Debt instrument represents a contract whereby one party lends money to another on pre-
determined terms with regards to rate and periodicity of interest, repayment of principal amount by
the borrower to the lender. This in financial term is usually called as Bond.

• Why Debt Instruments?

For Companies
– Companies can raise large amount from the public by issuing debt instruments than taking loans
from the banks
For Investors
– Debt Instruments are more secured than the Equities as the returns are definite for most of the time
– Debt instruments act as risk less investment option for people seeking retirement benefits
– When money is needed for a specific purpose in the relatively near future, fixed-income securities
are likely the best investment because they earn interest and they have guaranteed return of the
invested amount.

Risk Profile: Low. Less risky than equities because the investor knows the exact amount that
will be paid at the end of maturity.

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 Types of Bonds

Government bonds Municipal Bonds

Government Bonds are issued These Bonds are issued by the
by the Central Government and local governments for the
are highly secured. The
different types of Bonds based developmental purposes.
on the maturity are: Returns from these bonds are
• Bills - debt securities maturing usually tax free.
in less than one year.
• Notes - debt securities .
maturing in one to 10 years.
• Bonds - debt securities
maturing in more than 10 years.

Corporate bonds Zero Coupon bonds

Bonds that are issued by the This is a type of bond that
corporate and usually carry makes no coupon payments but
higher interest rate..
instead is issued at a
considerable discount to par
value.
.

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 Features of a Bond

Principal – It is the amount that issuer borrows and agrees to repay the bondholder on the maturity
date. Also referred as par value, face value or maturity value. The denomination of principal varies
depending on the life of the bond.

Coupon – As the bondholder effectively lends the bond issuer a sum of money, the issuer must offer a
rate of interest as a form of compensation. This rate of interest usually comes in the form of regular
payment referred as Coupon.
Coupon payments are generally made on a semi-annual or annual basis depending on the
type of bond. Though bonds pay a fixed interest through their life, floating rate notes (FRNs) are an
exception. The coupon rates of these fluctuate in line with a pre-determined market reference rate.
Also another exception is Zero coupon bonds which we will cover later.

Price – It is dependent on number of factors including market current rates, credit quality, maturity and
supply demand. Newly issued bonds generally sell at (or near) their par value.
The bonds that trade above their „par value‟ is said to trade at a „premium‟ and those that trade
below their par value are said to trade at a „Discount‟.

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 Features of a Bond
continued…
Maturity – Maturity of a bond is the length of
time before it expires.
Debt Securities with a term of less than
one year are generally classified as Money Market
instruments. Bonds are generally issued with
maturity up to 10 years. Bonds with maturities of
less than 10 years are referred to as „Notes‟ in
some markets.
The longer the term to maturity of a
bond, the greater the yield required by investors as
longer term bonds are more exposed to factors
adversely affecting their price.

Example – If you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years.

What is your return?

1. You will receive a total of $80 ($1,000*8%) of interest per year for the next 10 years.
2. If the interest payment is semi-annually, you'll receive two payments of $40 a year for 10 years.
3. When the bond matures after a decade, you'll get your $1,000 back.

Yield – The yield is the rate of return received from investing in the bond and is based on the price paid
for the bond and the coupon (interest) payment.
Current Yield = Annual coupon/Price

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 Features of a Bond
continued…
Today Two years later

What effect do you think the rise

in Interest rates will have on the
yield on Harry’s bond?

If Harry wants to sell this bond,

will you as an investor pay USD
For example, imagine Harry buys a Two years later, interest rates have 1000 for a bond with a 5%
bond for USD 1000. It has a 10 year risen and the bond issuer is now coupon when a new bond from
maturity and pays interest of 5% per issuing similar bonds with a coupon of the same issuer is available with
year. 8% an 8% coupon?

As a result, Harry will have to sell the bond for a lower price that will offer buyers the same
yield as if they purchased a new bond from the issuer.

As the above example

illustrates, the yield and
price of a bond are
inversely related – when
interest rates rise, bond
prices fall and vice versa.

Yield to maturity – YTM is an enhanced measure which takes into account the following -
- Coupon payments on the bond all the way to maturity
- Time value of money
- any capital gain/loss that will be realized by holding the bond until maturity

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 Credit Rating
• An assessment of the credit worthiness of individuals and corporations. It is based upon the
history of borrowing and repayment, as well as the availability of assets and extent of liabilities.

• Measuring the ability and willingness of an entity - which could be a person, a corporation, a
security or a country - to keep its financial commitments or its debt, credit ratings are essential
tools to make some investment decisions.

• There are three top agencies that deal in credit ratings for the investment world. These are:
Moody's, Standard and Poor's (S&P's) and Fitch IBCA.

Rating Chart – Moody’s and S&P

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 Question and Answer
What questions do you have?

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 Introduction to Derivatives (Forwards and Futures)

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 Introduction
• Derivatives are synthetic instruments

• They derive value from an underlying asset class

• Asset classes range from financial instruments to commodities

to even classes such as weather and industrial effluents

• However the common underlying theme of derivatives is that

they are leveraged products

• The derivative market has its own dynamics

• This is because the participants in the derivative market do not always hold positions in the underlying
instrument and have different intentions on their positions.

• Exchange-traded derivative- Is listed and traded on an organized derivatives exchange, with the
exchange acting as an intermediary (central counterparty) to the transaction.
• OTC derivative- Is a customized, privately negotiated contract that is traded directly between
counterparties, without going through an exchange or other intermediary.

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 Types of Derivatives

Equity Derivatives
Underlying is equity (Individual or group of equity stocks)

Interest Rates Derivatives

Underlying can be bonds, debt securities etc

Currency Derivatives
These are currency pairs

Commodities Derivatives
Underlying are different commodities like gold, silver, steel, food grains and even spices.

Exotic Derivatives
Weather Derivatives-Underlying is the weather of a particular area

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 Classification of Derivatives

•Forwards
•Futures
•Swaps
•Options

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 Derivatives Applications and Risks
Some of the most important uses of Derivatives are-
• Hedging- Derivatives provide an efficient method for end users to better hedge and manage their
exposures to fluctuations in market prices/rates. Hedging generally involves entering into a transaction
where the gains/losses from the 'hedge' will offset the gains/losses in the 'core' position.

• Speculation- Derivatives can be used by speculators who are simply looking to make profits if an asset
price moves in the direction expected.

• Arbitrage- Arbitrage is an attempt to make risk-free profits from temporary price discrepancies that may
exist within or between markets.

Risks Associated with Derivatives

Derivatives are distinctly more complex than traditional financial instruments, such as stocks, bonds, loans,
bank deposits, and so on. Derivatives risks are not 'fundamentally different' to those that exist anyway in
financial markets (principally market, credit, and operational risk) however the manner in which these risks
manifest themselves in derivatives transactions can be significantly different.

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 Forwards
Spot Price- The spot price is the price of an asset for Now 2 Days Later
immediate delivery.
Forward Contract - A forward contract is a customized
contract between the buyer and the seller where
settlement takes place on a specific date in future at a
price agreed today.

Features of Forward Contract

•Forward contracts are traded in the over-the-
counter (OTC) market and the onus is on both the
parties to implement the contract.
Now 6 Months Later
•Credit Risk is there as it is an OTC trade
•The buyer (long position) of a forward contract is
obligated to:
a. Take delivery of the asset at the maturity
date.
b. Pay the agreed-upon price at the maturity
date.
•The seller (short position) of a forward contract is
obligated to:
a. Deliver the asset at the maturity date.
b. Accept the agreed-upon price at the
maturity date

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 Futures

Futures contract is a standardized contract, traded on a

futures exchange, to buy or sell a certain underlying Now 3 Months Later
instrument at a certain date in the future, at a specified
price.

Features
•The future date is called the delivery date or
final settlement date.
•The pre-set price is called the futures price.
•The price of the underlying asset on the delivery
date is called the settlement price
•Futures contract are settled on the Mark to
Market basis and hence credit risk is minimal

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 Comparison: Futures Vs Forwards
Forwards Futures
• Forwards are customized as they are • Futures are standardized as they are traded
negotiated between two parties over exchange
• Credit risk is there as it is a contract • Credit risk is not present as it is traded over
between two parties an exchange
• Liquidity is not there. Prices are not • Liquidity is there in almost all the contracts.
transparent Prices are transparent
• Squaring off cannot be done easily with • Squaring off can be done by taking opposite
another forward contract position

Example -

A currency forward contract in the forex market would allow to lock in the price at which an entity can
buy or sell a currency on a future date. These contracts cannot be transferred.
Whereas a currency futures contract is a transferable contract that specifies the price at which a
specified currency can be bought or sold at a future date. These contracts are marked –to- market
daily, hence investors can by closing out their position - exit from their obligation to buy or sell the
currency prior to the contract‟s delivery date.

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 Introduction to Options

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 Option
Options are financial instruments that convey the right, but not the obligation, to engage in a future
transaction on some underlying security. It can be exchange traded or over-the counter (OTC).

Example-
Harry is positive about the WidgetCorp stock which is
currently trading at USD 100.However, he is highly risk
averse. In view of this uncertainty, he pays USD 5 to
Sally for an option. This option gives him right but not
the obligation to buy one stock of WidgetCorp for USD
110 in a weeks time.

At the end of the week, Harry can exercise the option. He will do so on the basis of three possible
situations-
1. Stock price rises - If the stock price goes up to USD 120, say, then Harry will exercise his
option i.e he will buy the share from sally at USD 110 and then he can either hold the position
or sell it in the market at 120USD thereby making a profit of USD 5.
2. Stock price falls - If the stock price falls to USD 90, say, then Harry will ignore the option. He
can directly buy a share from the market or leave the stock as it is.
3. Stock price rise slightly - If the stock price rises to 111, say, then Harry will still exercise his
option as this would be still cheaper for him to go to market and spending USD 111.

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 Option Terminology

Call Option – A call option gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
Put Option – A Put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.
Option price/premium – Option price/premium is the price which the option buyer pays to the
option.
Expiration Date – The date specified in the options contract is known as the expiration date , the
exercise date, the strike date or the maturity
Strike Price – The price specified in the options contract is known as the strike price or the exercise
price.
Buyer of the option – The buyer of an option is the one who by paying the option premium buys
the right but not the obligation to exercise his option on the seller/writer
Writer of the option – The writer of a call/put is the one who receives the option premium and is
thereby obliged to sell/buy the asset if the buyer exercises on him.
Long ( or Long Position) – The buying of an options contract. For example, an owner of shares in
McDonald's Corp. is said to be "long McDonald's" or "has a long position in McDonald's".
Short ( or Short Position) – The sale (also known as „writing‟) of an options contract.

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 Options

Hence, considering the above example again –

- Harry is the buyer of the option and Sally the writer.
- The premium Harry pays Sally for the option is USD 5.
- The strike price of the option is USD 110.
- The expiration date for the option is one week from today.
- Harry holds the long position by buying the option and sally holds the short
position by selling the option.

Options and Financial Markets

Options are found in almost every major financial market.
Securities: Call and Put options can be purchased on shares traded on all major stock
exchange. Options can also be bought on government and corporate bonds.
Indexes and Futures Contract- Options can be bought on indexes (e.g. Equity index- S&P
500)
Commodities- Options are available on both soft commodities such as grain and hard
commodities such as precious metal.
FX-Options can be bought to hedge against currency fluctuations.

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 Option Pay-off

Long Call Short Call

Long Put Short Put

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 Option Styles

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 expiration

Bermudan Option: An option that may be

exercised only on specified dates on or before
expiration

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 Question and Answer
What questions do you have?

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