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Financial Markets

Financial markets refer to markets where players can trade securities. Trades can take place electronically or physical places like exchanges and counters. The

  • Capital markets are long-term finances and trade for more than a year. They provide businesses and governments with long-term funding.
  • Money markets are short-term finances and trade for less than a year. They provide businesses with credit and liquidity over a short-term to meet working capital requirements.

Alternative Assets | Assets that are considered out of the mainstream assets such as debt and equity.

  • Capiital Assets: Claims on future cash flow of businesses. Eg. private equity, hedge funds
  • Consumable Assets: Assets that are consumed as part of a production cycle. They do not generate cashflow on their own. Eg. grains, livestock, metals, energy products.
  • Store Value Assets: Assets that preserve wealth during economic uncertainty. Eg. gold and art collections.

Ask price | The minimum price an investor is willing to sell a security for.

Bid price | The maximum price an investor is willing to pay for a security.

Basis points | Bips or bps are equivalent to 0.01%. An decrease of 5 bips from 3.05% of interest rates brings it to a new 3.00%.

Caps | A cap is an interest rate derivative contract that protects the holder from rising rates of an underlying instrument.

Floor | A floor is the counterpart of a cap. It protects the holder from falling interest rates below a specified rate.

Drawdown | A drawdown is the difference between the peak (highest point) and trough (lowest point) of a price expressed in percentage. It can also be the difference between two peaks across time. Drawdowns are used to calculate risks of an investment.

Trade date | The date the order is executed. The price of the security is valued on the trade date but paid on the settlement date. For example, an investor decides to buy company ABC's shares priced at USD7 today, on T+2, he pays the seller that price even if the share price increases 2 days later.

Settlement date | The date the buyer must pay the seller. The security bought is transferred from the seller to the buyer. This date marks the legal ownership of the new owner.

  • T+1: If the trade date is on Monday, the settlement date is on Tuesday.
  • T+2: If the trade date is on Monday, the settlement date is on Wednesday.
  • T+3: If the trade date is on Thursday and Friday is a public holiday, the settlement date is on the following Wednesday.

Market order | A market order is an instruction an investor gives a broker to buy or sell a security at the best possible price. The investor trusts the broker to act in his best interest. This order is best used in high volatility markets.

Limit order | A limit order is an instruction an investor gives a broker to buy or sell a security at a target price. Investors may have a goal in mind. They also have control over the price execution.

Stop order | Stop orders are similar to limit orders, with the added sentiment of avoiding losses. It works for both buy and sell. A stop order to buy is placed if prices continue rising above a certain threshold. A stop order to sell is placed if prices fall below a certain level to avoid losses.

Margin call | A margin call is made when an investor's required minimum holdings in a margin account fall below a threshold. In margin investments, an investor borrows money to magnify his profits. But when the prices of his investments fall, the broker (borrower) can make a margin call without consulting the investor to sell the investment to bring the account back up to the minumum requirement.

Arbitrage | Arbitrage is a trading strategy that seeks to profit from temporary small differences in asset prices. The difference in price is the result of market inefficiencies. The two types of arbitrage are pure and risk arbitrage. Pure arbitrage are often executed by bots that look out for similar assets in different markets. Risk arbitrage takes advantage of speculative prices, often in the case of mergers and acquisitions.

Arbitrage funds | Arbitrage funds are mutual funds that use arbitrage to exploit small differences between the cash (now) and futures contracts. It purchases stocks now and immediately resells them for a small profit in the futures market. Large volumes must be traded to make any substantial gains.

Market value | The price of a security is bought or sold at in the marketplace.

Notional value | Notional value is the total value the asset in a leveraged position. It is used in derivatives, options and currency exchanges.

Capital markets

Capital markets are markets that connect investor funds and institutions that need them. Investors enter capital markets with the intention of growing money they own, whereas institutions borrow funds for business expansion and day-to-day operations. Capital markets are divided in to two markets.

  • Primary markets: These are markets where institutions offer securities to investors for the first time, like an Initial Public Offering (IPO). This is the only time where institutions receive the money. New securities issued are also part of the primary market.
  • Secondary markets: This market is where investors trade securities already issued. Secondary markets are overseen by regulators like the SEC. Institutions do not receive additional funds here.

Securities | Securities are negotiable financial instruments that hold monetary value. Types of securities:

  • Equity security: Ownership of a company in the form of stocks.
  • Debt security: Representation of money that is borrowed and must be repaid. Examples are bonds, certificate of deposits, collatarised securities.
  • Hybrid security: A combination of equity and debt securities. Examples are equity warrants, convertible bonds, and preferrence shares.

Current yield | The current yield of the bond is the returns a bond gives against its current price. The current yield can be used to compare its returns with other bonds. The higher the current yield, the better the returns.

Current interest = Annual interest / Current price

Junk bonds | Junk bonds are poorly rated and are issued by companies that are at risk of default in return for higher interest rates. Investors buy junk bonds to increase their overall returns which are otherwise difficult to achieve.

Perpetual bond | A perpetual bond is a bond that pays interest forever. With no maturity date, perpetual bonds do not allow investors to withdraw its principal. Governments and corporations may be the only participants in this deal.

Callable bond | Issuers of callable bonds reserve the right to return investors the bond principals and stop interest payments for the remaining years. Issuers like governments use callable bonds to maintain flexibility in case interest rates drop in the future.

Formosa bonds | Bonds that are issued by Taiwan but denominated in a foreign currency.

Dirty price | The price of a bond that includes the accrued interest. Markets trade bonds at both dirty prices (European markets) and clean prices (US markets).

Clean price | The price of the bond without its coupon payments. On the day the coupon is matured, the clean and dirty price of a bond will be the same.

Accrued interest | Accrued interest (bonds) is the price of the bond plus the coupons that have matured. Accrued interest (accounting) in corporate finances is the income earned even before it has received it in cash.

PNC5 | PNC5 is OCBC's perpetial non-callable 5 basis, which is a callable bond at every 6 mopnths.

Exchange Traded Funds | ETFs are designed to track the performance of a security they are designed for. An ETF tracking the oil industry for example, will have oil company stocks and oil commodities in its basket. ETFs are usually sold as unit trusts, allowing retail investors to gain exposure to whole industries by purchasing a portion of the ETF.

Factors that impact an ETF's performance are:

  • Yearly fees: Issuers usually charge a percentage of the total holdings annually.
  • Transaction fees: Issuers can charge a percentage or a fixed fee per batch of ETF bought.
  • Basket make-up: ETFs can consist of investments that are concentrated or diversified in a specific industry. Concentrated baskets can be more sensitive to changes in the industry.
  • Liquidity: A larger difference in the bid and ask price can indicate low liquidity in an ETF.

S&P 500 | The S&P the indication of the US equities market which includes 500 of the top companies that captures 80% of the available market capitalisation.

SP500 Index = Market capitalisation of all SP500 stocks / Index Divisor

Market capitalisation is the total number of shares held by shareholders (outstanding shares) x current share price.

Spiders | Standard & Poor's depository receipts (SPDR) or Spiders are ETFs that tracks the S&P500's performance. Each share trades at approximately 10% of the S&P's dollar value.

Money markets

Repurchase agreements | Repos are short-term debt that issuers, like government institutions, sell in the form of Treasury Bills (T-bills) to raise money. The securities are repurchased from the investor the next day or the following week with interest. Repos are low-risk because of the duration of the loan. Repos are from the sellers perspective - the party that needs the funds.

Reverse repo | Reverse repos are issued from the buyer's perspective. The buying bank may have excess cash that it wants to monetize in a short period of time. The buying bank purchases the stock of the seller (borrower) as a collaterised overnight loan. In the event the seller defaults (unable to pay back), the buying bank is liquidated to cover the buying bank's losses.

Commodity markets

Commodities are basic goods that are interchangeable with other commodities of the same type. Commodities are extracted in its basic form and brought to a minimum value before being sold to manufacturers.

Types of commodities:

  • Metals: gold, silver, iron
  • Energy: crude oil, heating oil, natural gas, gasoline
  • Livestock and meat: pork bellies, live cattle
  • Agriculture: corn, wheat, soybeans, coffee, cotton

Derivatives markets

Options | Options can be stocks, bonds, ETFs, or mutual funds that give the buyer of the option to exercise his right to buy

Call option | A buyer with a call option has the right, but not the obligation to buy a stock at the strike price. If the price of stock rises, the buyer makes a profit by purchasing them at a lower price when the options was written. He then sells the stocks at the high price in the market for a profit. If the price falls, the buyer can choose to let the contract expire. Options come at a high premium because of the risk the seller takes.

Put option | A seller with a put option has the right, but not the obligation to sell a stock at the strike price. If the price of a stock falls, the seller can sell the stock at the higher price it was before it fell. If the price rises, the seller can choose to let the option expire and sell the stock in the market instead. Like call options, put options have high premiums too.

Strike price | The price at which a derivative can be excercised in the future. In a call option, the strike price is the price at which the buyer can purchase a security. In a put option, the strike price is the price at which the seller can sell a security.

Swaps | A swap allows two parties to exchange financial instruments to align themselves with their respective interests. Interest rates, cashflows, commodities, and debt can be swapped.

Currency swap | Currency swaps involve at least two currencies. Two companies from two countries each need to take a loan in the other country. Banks however, charge high interest rates to foreign companies. The two companies can both take local loans and swap the interest rates with each other and enjoy local interest rates.

Credit default swap | A CDS acts like an insurance for a financial instrument. If an investor is afraid that a loan he gave out might default, he can buy a CDS to shift the risk to other parties. If the loan defaults and the investor fails to get his capital back, the CDS issuer repays the investor his losses. The party that takes on the risk will charge an on-going premium.

Interest rate swap | Interest rate swaps work the same as currency swaps. The difference is that interest rate swaps deal with swaps in the same currency.

Total Return Swap | A TRS is a swap agreement that transfers market and credits risks between two parties. The first party, the payer owns an underlying asset and pays the appreciation and coupons to the receiver. In return, the receiver pays the payer a set fee, usually tied to the LIBOR. This allows the receiver to take a long position - receiving capital gains and coupons without owning the asset. Hedge funds usually enter TRS as the receiver.

Credit linked note | A CLN is a security with an embeded credit default swap. Risks of the security are shifted from the buyer of the CLN to other investors for an on-going premium.

Equity linked note | An ELNs are fixed income securities with added potential returns. The most common version combines bonds and call options. This provides investors with the security of not losing money but locks their money in at opportunity cost.

Valuation adjustment (XVA) | XVAs are adjustments made to derivatives contracts to account for account funding, credit risks and regulatory costs. After adjustment, the derivatives will be traded at a new price.

  • Credit valuation adjustment (CVA): Adjustment to account for counterparty default risk.
  • Funding valuation adjustment (FVA): Adjustment to add funding cost.
  • Debit valuation adjustment (DVA): Adjustment to account for own default risk.

Futures markets

Futures contract obligates a buyer to buy or a seller to sell financial instrument on future date for a predetermined price. Parties enter futures contracts to hedge against market risks. A wheat farmer can enter a futures contract to sell wheat at a fixed price in case it falls in the future. A bakery on the other hand can enter a futures contract to buy wheat at a fixed price in case it rises in the future.

Futures are different from forwards contracts in that futures contracts are more standardised, while forwards contracts can be privately negotiated. Forwards contracts do not trade on exchanges but on OTC, making it harder for investors to reach.

Foreign exchange markets

Forex terminology can be confusing especially when it comes to forex quotes. In forex quotes, the buy and sell is from the forex broker's perspective.

Bid | The max price the forex broker is willing to buy. You are selling your currency.

Ask | The min price the forex broker is willing to sell. You are purchasing the currency.

Pips | The smallest unit of a currency - the last two digits. This is also the spread between the bid and ask price.

USD/MYR = 4.2005/10

  • USD is the base currency
  • MYR is the quote currency
  • 1 USD is buying at MYR 4.2005
  • 1 USD is selling at MYR 4.2010
  • The currency pair is trading at 5 pips

Currency carry trade | A currency carry trade is a strategy that uses currency from a country with low interest rates to buy a currency from a higher interest yielding country. The two country currencies are usually a stable pair like the AUD/JPU and NZD/JPY. This works similar to a shorting the market. For example, a trader can use JPY with 0% interest and convert them into AUD to buy bonds yielding 4%. This gives the trader 'free money' to invest with. A fall in the AUD or rise in JPY can cause huge losses.

Spot markets

The spot market is where the value of the securities or commodities are traded immediately. This is in contrast to the futures market where the trades values take place at a future date. Spot markets can also cater to goods sold immediately but ownership is transacted at a later date like crude oil. A company may buy crude oil at the current price but only have the oil delivered in the following month.

TOD | Payment and transaction will be executed on the same day of the order.

TOM | Payment and transaction will be executed 1 day after the order. The rate quoted is today.

Spot | Payment and transaction will be executed 2 days after the order. The rate quoted is today. Default method of transaction.

Spot rate | The immediate purchase price of a currency, commodity, or security. Spot rates are usually posted on exchanges.

Forwards | Payments and transaction will be executed anywhere after 2 days but before a year after the order. The rate quoted is today.

Non-Deliverable Forwards | An NDF is a forwards contract, usually short-term, between two parties to settle a profit or loss by taking the difference between the agreed rate and the spot rate of a foreign currency. Corporations use NDFs off-shore to hedge against illiquid currencies where the country does not allow the currency to be exchanged.

Terms

Proprietary trading | Financial firms or commercial banks that engage in prop trading invest directly in the market for profit rather than earning commission from clients.

Long | A trader owns the shares he intends to sell. This position is used in a bull market. He speculates that stock prices will rise in the future.

Short | A trader sells borrowed stocks he does not own. The trader will need to buy the stocks back in the future to return to the owner with interest. This position is used in a bear market. He sells high, speculating that the prices will fall and repurchase them at a lower price. If the stock price rises, the trader makes a loss in buying the borrowed shares to return them.

Haircut | A haircut has two definitions with respect to market makers and loans.

  • Market makers: A haircut is the small difference between the buy and sell price of a securities in a stagnant market. An investor may buy a stock for $10 and sell them for $10.05 to make a small profit of 5 cents per stock - the haircut.
  • Loans: Securities used as a collatoral for a debt may be devalued slightly to provide a cushion for the lender in case the price of the stocks fall. The devaluation is called the haircut. An investment bank may devalue a borrower's share price used as collateral from $100 to $80.

Fund Transfer Pricing | FTP is a system used to assess the overall company's profitability with every additional funding.

Underwriting | The process whereby an investor or institution takes on a financial risk for a fee. Underwriting can be done for insurance, loans, and securities.