Financial instruments can be classified into following types -
Equity is kind of ownership in the company, it takes form of shares. Share possess owenship. There are basically two types of shares, as follows -
Common share is the most common method of providing stocks in a company. The
characteristic feature of this stock is that the holder of is entitled to voting rights as well as the dividends.
Important point to note is that there is no guarantee of dividends
There are various flavors of common shares like Class A and Class B. Class A and Class B shares are
shares that are issued at different point of time with slightly different characteristics. These characteristics
mainly deal with the voting rights, which differ across these classes.
b) Preference Shares -
Preference Share is the stock in which the owner has a guaranteed dividend payment at a specified rate.
Preference Share has features of both equity and debt securities. It represents ownership in a corporation,
but it does not have the voting rights as common stocks Although preferred stock does not typically have
the same growth potential as common stock, it does have two distinct advantages over common
stockholders.
No dividends can be paid to common shareholders before obligations to preferred shareholders are met
Preferred stock also has priority claims over common stock; that is, if a company declares bankruptcy, the
preferred stock holders are paid before common shareholders. These are also known as preference
shares.
The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt for a
specified number of foreign shares owned by an American bank. ADRs trade like shares, either on a U.S.
Exchange or Over the Counter. The owner of an ADR has voting rights and also has the right to receive
any declared dividends. An example would be Infosys ADRs that are traded in NASDAQ
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.
Options value depends on the value of an underlying investment. The underlying investment can be a stock, an index, a currency, a commodity, or any number of other securities. There are two kinds of options:
Call Options and Put Options.
4.1.1 Call Options
Call options are options to buy a stock at a specific price on or before a certain date (Expiration Date). Call options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option Premium, secures the investor the right to buy that certain stock at a specified price
(Strike price) on or before the expiration date.
Profit in call option = Actual Price – Strike price – cost of option
4.2.2 Put Option
A put option provides the holder with the right to sell shares of the underlying stock at the strike price at the maturity date.
A call option is in-the-money when the stock price is above the strike price and out-of-the-money when
the stock price is below the strike price. For put options, the reverse is true. When the stock price and
strike price are equal, both types of options are considered at-the-money.
Also Options are classified based on their underlying assets:
A stock option is a contract that guarantees the investor, who has purchased it the right, but not the
obligation, to buy or sell shares of the underlying stock at a fixed price prior to a certain date. The
buyer of an option is known as the holder and the seller is called the writer. If the option contract is
exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to
the appropriate party or settling in cash.
An Index option is a contract that guarantees the investor, who has purchased it the right, but not the
obligation, to buy or sell the underlying index at a fixed price prior to a certain date.
Based on the methods of exercising the options, they are divided into following two parts:
A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the delivery does not occur. Instead, before the contract expires, the holder usually settles his position by paying or receiving the difference between the current market price of the underlying asset and the price
stipulated in the contract.
Futures are risky investment vehicles that are appropriate for only the smallest percentage of highly
advanced investors. They are sometimes used as a hedge by investors with the resources to devote a
small percentage of their assets to such a dangerous venture. Futures trading should almost never be
attempted by individual investors.
Futures contracts are purchased when the investor expects the price of the underlying security to rise.This is known as going long. Because he has purchased the obligation to buy goods at the current price,
the holder will profit if the price goes up, allowing him to sell his futures contract for a profit or take
delivery of the goods on the future date at the lower price.
The opposite of going long is going short. In this case, the holder acquires the obligation to sell the
underlying commodity at the current price. He will profit if the price declines before the future date.
Hedgers trade futures for the purpose of keeping price risk in check. Because the price for a future
transaction can be set in the present, the fluctuations in the interim can be avoided.
If the price goes up,the holder will be buying at a discount. If the price goes down, he will miss out on the new lower price.Hedging with futures can even be used to protect against unfavourable interest rate adjustments.
- Equity
- Debt (or Fixed Income)
- Hybrids
- Derivatives
1. Equity -
Equity is kind of ownership in the company, it takes form of shares. Share possess owenship. There are basically two types of shares, as follows -
a) Common Shares
b) Preference Shares
a) Common Shares -
characteristic feature of this stock is that the holder of is entitled to voting rights as well as the dividends.
Important point to note is that there is no guarantee of dividends
There are various flavors of common shares like Class A and Class B. Class A and Class B shares are
shares that are issued at different point of time with slightly different characteristics. These characteristics
mainly deal with the voting rights, which differ across these classes.
b) Preference Shares -
Preference Share is the stock in which the owner has a guaranteed dividend payment at a specified rate.
Preference Share has features of both equity and debt securities. It represents ownership in a corporation,
but it does not have the voting rights as common stocks Although preferred stock does not typically have
the same growth potential as common stock, it does have two distinct advantages over common
stockholders.
No dividends can be paid to common shareholders before obligations to preferred shareholders are met
Preferred stock also has priority claims over common stock; that is, if a company declares bankruptcy, the
preferred stock holders are paid before common shareholders. These are also known as preference
shares.
American Depository Receipts (ADR) -
specified number of foreign shares owned by an American bank. ADRs trade like shares, either on a U.S.
Exchange or Over the Counter. The owner of an ADR has voting rights and also has the right to receive
any declared dividends. An example would be Infosys ADRs that are traded in NASDAQ
2. Fixed Income - Debt
Fixed income instruments are those instruments that offer a fixed amount of money for a specified period
of time. In other words, the amount of income to be received is known before hand to an investor.
2.1 Bonds
Bonds are the loans taken by governments or corporate. Typically a bond pays a fixed rate at a prespecified
amount of time.
Some of the basic terminology with regard to bond is as follows -
1. Par Value/Face Value
The principal amount that is returned at the end of the maturity is known as the Par value. It is also
known as the principal or face value. Par value will vary depending on the type of bond. When the
bond matures and the lump sum is returned, the debt obligation is complete.
2. Coupon Rate
It is the annual rate of interest on the bond's face value that a bond's issuer promises to pay the
bondholder. The interest rate is calculated upon the par value of the bond. The coupon is determined
at time of issuing the bond and is usually expressed as an annual percentage of the par value of the
bond. Payments usually occur every six months, but this can vary. If two bonds with equal maturities
and face values pay out different coupons, the prices of these bonds will behave differently in the
secondary market. For example, the bond with a lower coupon rate will be less expensive because
the bondholder is going to be getting more of his/her return from the return of principal at maturity
than will the holder of a bond with a higher coupon. There are some bonds that do not pay out any
coupons; these are called zero-coupon bonds
3. Maturity period/Term to maturity
Maturity is the date on which the principal value of a bond becomes due and payable in
full to the holder. Time to maturity is the time between now and when the bond matures.
Maturities range significantly, from 1 month for some municipal notes to 40+ years for some corporate
bonds.
of three types. Treasuries are highly liquid and have the lowest risk.
3. Treasury bonds: These are the bonds, which mature after ten years.
3.1 Convertible bonds
Convertible Bonds are instruments that can be converted into a specified number of shares of stock after a specified number of days. However, till the time of conversion the bonds continue to pay coupons.
3.2 Warrants
Warrants are a type of security that gives the holder the option to buy a preferred or a common stock at a specified price within a specified time. Warrants are call options – variants of equity. For example, a company is planning to issue bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so they “sweeten” the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire worthless.
In case, warrants are exercised, new securities are issued.
Government Bonds
When a government borrows money they are called as treasury instruments. Treasury instruments can beof three types. Treasuries are highly liquid and have the lowest risk.
- Treasury bills (T-bills): These instruments mature with in a year. Thus these are short-term loans.
3. Treasury bonds: These are the bonds, which mature after ten years.
3. Hybrids
Hybrids are securities, which combine the characteristics of equity and debt.
3.1 Convertible bonds
Convertible Bonds are instruments that can be converted into a specified number of shares of stock after a specified number of days. However, till the time of conversion the bonds continue to pay coupons.
3.2 Warrants
Warrants are a type of security that gives the holder the option to buy a preferred or a common stock at a specified price within a specified time. Warrants are call options – variants of equity. For example, a company is planning to issue bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so they “sweeten” the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire worthless.
In case, warrants are exercised, new securities are issued.
4. Derivatives
A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, foreign exchange, commodity or any other item.
4.1 Options
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.
Options value depends on the value of an underlying investment. The underlying investment can be a stock, an index, a currency, a commodity, or any number of other securities. There are two kinds of options:
Call Options and Put Options.
4.1.1 Call Options
Call options are options to buy a stock at a specific price on or before a certain date (Expiration Date). Call options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option Premium, secures the investor the right to buy that certain stock at a specified price
(Strike price) on or before the expiration date.
Profit in call option = Actual Price – Strike price – cost of option
4.2.2 Put Option
A put option provides the holder with the right to sell shares of the underlying stock at the strike price at the maturity date.
Option Classification -
Options are classified as in-the-money, out-of-the-money or at-the-money.A call option is in-the-money when the stock price is above the strike price and out-of-the-money when
the stock price is below the strike price. For put options, the reverse is true. When the stock price and
strike price are equal, both types of options are considered at-the-money.
Also Options are classified based on their underlying assets:
- Stock option
A stock option is a contract that guarantees the investor, who has purchased it the right, but not the
obligation, to buy or sell shares of the underlying stock at a fixed price prior to a certain date. The
buyer of an option is known as the holder and the seller is called the writer. If the option contract is
exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to
the appropriate party or settling in cash.
- Index Options
An Index option is a contract that guarantees the investor, who has purchased it the right, but not the
obligation, to buy or sell the underlying index at a fixed price prior to a certain date.
Based on the methods of exercising the options, they are divided into following two parts:
- American options: The holder may exercise an American style option at any point between the time of
- European options: A European style option, on the other hand, cannot be exercised until expiration.
- Asian options: These options can be exercised only on few selective dates as agreed upon
4.2 Forwards and Futures
4.2.1 Financial Futures
stipulated in the contract.
Futures are risky investment vehicles that are appropriate for only the smallest percentage of highly
advanced investors. They are sometimes used as a hedge by investors with the resources to devote a
small percentage of their assets to such a dangerous venture. Futures trading should almost never be
attempted by individual investors.
- Futures Trading
Futures contracts are purchased when the investor expects the price of the underlying security to rise.This is known as going long. Because he has purchased the obligation to buy goods at the current price,the holder will profit if the price goes up, allowing him to sell his futures contract for a profit or take
delivery of the goods on the future date at the lower price.
The opposite of going long is going short. In this case, the holder acquires the obligation to sell the
underlying commodity at the current price. He will profit if the price declines before the future date.
Hedgers trade futures for the purpose of keeping price risk in check. Because the price for a future
transaction can be set in the present, the fluctuations in the interim can be avoided.
If the price goes up,the holder will be buying at a discount. If the price goes down, he will miss out on the new lower price.Hedging with futures can even be used to protect against unfavourable interest rate adjustments.
4.2.2 Forward Contracts
The mechanism of forward contract is the same as the ones of a futures contract. The only difference is
that the forward contract is not traded on an exchange. A forward contract is a direct agreement between
two investors. A forward contract is more flexible than the futures contract because the two parties can
agree on all the characteristics of the contract (underlying amount, delivery date, delivery place,etc.)
4.3 Swaps
Swaps are agreements between at least two counter-parties to exchange cash flows in the future
according to a pre-specified formula.
Interest rate swap is the exchange of one set of cash flows for another. A pre-set index, notional amount
and set of dates of exchange determine each set of cash flows. The most common type of interest rate
swap is the exchange of fixed rate flows for floating rate flows.
Currency swap is a swap contract in which two counterparties agree to exchange principal and interest
denominated in different currencies based on an agreed-upon currency exchange rate.
according to a pre-specified formula.
- Interest Rate Swaps
Interest rate swap is the exchange of one set of cash flows for another. A pre-set index, notional amount
and set of dates of exchange determine each set of cash flows. The most common type of interest rate
swap is the exchange of fixed rate flows for floating rate flows.
- Currency Swaps
Currency swap is a swap contract in which two counterparties agree to exchange principal and interest
denominated in different currencies based on an agreed-upon currency exchange rate.
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