Off-exchange market, financial instruments 16th October 2008 Off-exchange market n Off-exchange market exists in organize or unorganized form. n Its operations are limited by directions or rules but there are more moderate then in exchange market. n Off-exchange market is a competitor of exchange market. Off-exchange market n Existence and function of off-exchange market is determined by several circumstance: q Strict conditions for quotation of financial instruments in exchange market. For instruments that do not fulfill quotation in exchange market is off-exchange market alternative way for trading, liquidity and pricing of issued instruments. q Trading in stock exchange is determined by schedule. After exchange hours is possible to trade only in off-exchange markets (some of them trading 24/7). q Off-exchange market uses as a competitive tool q lower transactional payments, or q favorable trading conditions for particular investors (ARIEL, TRADEPOINT, etc. – trading system for institutional investors with lower transactional costs). NASDAQ n Organized off-exchange market in USA is supported by electronic system NASDAQ (National Association of Security Dealers Automated Quotations) –quote driven system. n Nowadays in NASDAQ is traded with q More than 3000 stock emissions q More than 2000 debt emissions n There is more than 500.000 traders and about 500 market makers. NASDAQ n Trading system in NASDAQ works in several levels. q Lower level (the cheapest) – offers the flow of information through information agencies Reuters or Quatron. There are no to disposal of information about quotation of market makers. q Upper level – information about quotations of market makers. It is possible to trade with them. q Top level (the most expensive and the larges) - function as a market maker, bids and offers in which market maker must trade. NASDAQ n Conditions for quotation in NASDAQ q Minimal volume of emission – 4 millions USD q Minimal number of public trade securities in emission: n 100.000 securities – segment of small companies n 500.000 securities Specific market segments in NASDAQ n Nasdaq National Market q More strict condition for trading q More traded securities – blue chips n SmallCap Market q Segment for small, new starting companies n SOES (Small Order Execution System) q Trading to 1000 securities q Guarantee of the best price in the market n Nasdaq International q Trading in standard (London) time n NASDAQ Canada, NASDAQ Japan, NASDAQ Europe. Investment instruments and their characteristic n Investment instrument q Asset that brings claim for future revenue. q Revenue is in the form of: n Dividends n Coupon payments n Interests n Exchange rate profits Financial instruments n Stocks q Long term security without maturity day. q Type of stocks n Primary stocks q most widespread and most traded n Prior stocks q Limited voting rights, priority for dividends q In USA two types of prior stocks. Common and cumulative prior stocks. q Common prior stocks – dividends only if company gets profit. q Cumulative prior stocks – lower dividend payment but commutation of dividend payment claims in years when company get loss. Cumulated claims from bad years are paid out in good years. Financial instruments n Bonds q Debtor security with right to redemption of amount due and duty of issuer to settle a claim. q Maturity day is fixed. q Short-term bonds – several months q Long-term bonds – till 30 years q Issuer of bonds undertakes to q redeem face-value of bond and q pays coupon payments in regular intervals. q Coupon payment has several forms: n Fix interest rate n Difference between face value and emission price n Variable interest rate derivates from different interest rates or revenues, foreign exchange rates, etc. Financial instruments n Types of bonds q Straight Coupon Bonds n The oldest type o bond. n It is also known as a Vanilla Bond. n Purchase of this bond investor gets right to fixed coupon payment and face value that are paid in same moment in maturity day. n For investor is this type of bond profitable in non-inflation settings and in time of interest rate decrease. n For issuer is this type of bond profitable in inflation settings and in time of interest rate increase. Financial instruments n Floating Rate Notes – FRN q Bonds with floating coupon payment. q The high of coupon payment is very often derived from determine referential value (PRIBOR, LIBOR, BRIBOR, etc.). q Interbank referential rate is only starting point for coupon payment. To this variable level is very often crediting fixed premium (6M PRIBOR + 0,1%). q Coupon payment imitates with delay the development of market interest rates. Investor participate in the growth and decline in market interest rate (risk and chance). Financial instruments n In same types of FRN there are strictly defined borders for movements of coupon payments. q Floor FRN minimal border for decline of coupon payment. q Cap FRN maximal border for growth of coupon payment. q Minimax FRN maximal and minimal border q Droplock FRN in interest rate decline under determine border FRA is converted into Straight Coupon Bond. Financial instruments n Zero Coupon Bonds q Bonds without coupon payment. q This type of bond is issued with discount it means that issue price is lower than face value. q In the maturity day is paid back face value. q The profit for investor is difference between issue price and face value. n Index-Linked Bonds q Coupon payment is determined by development of some index - wages, prices, oil or some market index. n With real indexing q Development of index-linked bonds is determined by changes in real asst prices. q During growth of inflation the price of most real assets is growing this bonds retain value in high inflation conditions. n With financial indexing q Development of index-linked bonds is determined by changes in financial instruments prices e.g. stock index. q Example – bear and bull index linked bond – in German capital market Financial instruments n Mortgages bonds n Municipal bonds n Convertible bonds q This bond links classical bonds rights with right to convert this bond into another n Bond or n stock of the same issuing company q Investor into this convertible bond must decide in particular day if n converts bond into another instrument or n retains bond till maturity when takes face value and regular coupon payments. Financial instruments n The coupon payments of this bond are lower than in case of standard bonds. n In situation when investors assume that stocks of issuing company are underestimate and expected growth in their price. Financial instruments n Subordinated bonds special type of bonds in case of liquidation or bankrupt the claims of owner of subordinated bonds will be satisfied after satisfaction of all other claims. n The best know subordinated bonds are follows: q Junk Bonds n Bonds of poor quality n Rating in level of speculative (Ba, BB, B) n Issued by q companies where occur decline in financial situation – Fallen Angels or q young, starting companies with high risk profile n Junk Bonds q High risk but also above-average revenue q The value of Junk Bonds reacts to sensitive in economy cycle Financial instruments q Callable Bond n According to predefined conditions can be withdraw in undetermined day by issuer or investors. q Perpetuity Bond n Without maturity n Coupon payments for unlimited period n Issued usually by government Rating n Revenue that is expected from particular bond is derive from level of risk related with particular bond. n For appreciation of credit risk is used rating. n Credit risk – depends on issuer and his possibility to repay obligation. n Rating offer information how is particular subject able to fulfill one’s engagements in time and in full extent. Rating n First rating is related with debenture bonds of railway companies in USA. Made in 1909 by John Moody. n In 1914 first rating company Moody’s Investor Service. n In 1916 rating company Standard & Poor’s. n The development of rating from the 1960’s-70’s in USA and 1970’s – 1980’s in Europe. n The first activities was related with rating of debenture bonds and bill of exchange. n Nowadays rating companies carry out rating of q Bonds, mortgages, derivatives or instruments as a result of securitization. q Companies, cities, countries, etc. List of Ratings Financial instruments n Options Options are financial instrument which give the holder the right, but not the obligation, to buy (call) or to sell (put) an underlying asset at a predetermined price (exercise price or strike price) on or up to a certain date (European or American exercise style). Financial instruments n Underlying assets q The option derives its price from the value of an underlying asset. This can be a q stock, q index, q basket or any other financial asset. n A basket is a group of two or more assets, such as shares or indices. n Usually baskets have an investment theme, commonly a region or a sector (such as shares of banking or telecommunications companies). Financial instruments n European and American style q Options can be classified as a European or American style according to holder may use its right to receive payment. q European style holder can use its right only in particular predetermined maturity day. q American style holder can use its right on any business day till particular predetermined maturity day. Financial instruments n First option exchange was established in 1973 in Chicago. q Chicago Board Options Exchange q About 60 % of all option trades is in North America q About 30 % in Europe and the rest is Asia n According to embodied right q Call Option – right to buy underlying q Put Option – right to sell underlying q Premium q The price of option Financial instruments n Motions to use options – Speculation • bear or bull market trend – Hedging, especially • Interest rate risk • Exchange rate risk Financial instruments n Call option q A call option is an financial instrument which gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (exercise price or strike price) on or up to a specified date (European or American style). q A call option gives the holder the possibility to benefit from an increase in the value of the underlying asset, while limiting potential losses to the premium paid. Financial instruments • A put option is a financial instrument which gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (exercise price or strike price) on or up to a specified date (European or American style). • A put option gives the holder the possibility to benefit from a decrease in the value of the underlying asset, while limiting potential losses to the premium paid. Financial instruments • In case of put or call options there are different expectations between buyer and seller. • According to character of trade: – Exchange trading options – Off-exchange trading options • Exchange trading options are traded together with financial futures in derivative exchanges from the 1970's. All options parameters are standardized: – Underlying, exercise price, maturity day • Off-exchange trading options are designed according to investor requirements, esp. to hedge against risks. Financial instruments • Warrants A call warrant is a tradable security which gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (exercise price or strike price) . • A put warrant is a tradable security which gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (exercise price or strike price). Financial instruments • Warrants are in some characteristics similar to options but there are also differences: – Warrant is security issued by one issuer – Option is not security and it is issued by more persons. – Warrants are traded in spot markets, are not under strong standardization and offer several types of underlying. – Options are traded in future exchanges, are under strong regulations and types of underlying are limited. – Warrants has duration several years – Option has duration several mounts – Number of issued warrants is fixed determined – Number of options is daily changeable. – According to right dominates call warrants – Number of call and put options are almost similar Financial instruments • Warrants has been traded since 1850's. • The interest of investors has increase since the 1980's. • Motivations to use warrants – Hedging of current low price of financial instrument for future buy. – Hedging of current high price of financial instrument for future sell. – Speculation for future bull or bear market – leverage effect. • Leverage effect – Investor profit from warrant investment can rise in some conditions quicker than profit in particular rising underlying. – The reason is that investor invest less money in warrant then is direct investment in underlying. – But leverage effect works in both ways in decline of underlying the decline in warrant price is higher. Financial futures • Financial futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. 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. • A futures contract gives the holder the obligation to buy or sell which differs from an options contract. • Financial futures contracts are not issued but it is necessary to meet buyer and sell of contract their contract is according to parameters and conditions similar. – This process is called as a matching. • Financial instruments n Real assets – Financial instruments in physical, material form. n Advantages of investment in real assets – Hedging again inflation – Diversification in portfolio – Hedging against political uncertainty – Revenues n Disadvantages – High transactional costs • Spread between bid and offer about 20-25% in financial assets spread about 0,5-2 %. – Non-existence of liquid and effective market – Volatility of revenues in short time period Financial instruments • Precious metals, especially – Gold, platinum, palladium and silver – The revenues from precious metals are volatile and investment in precious metal is related with higher risk. • Investments in gold instruments – Nowadays in the world there is about 150 000 tunes of gold, yearly is mined about 1600-2000 tunes. – Investment n gold instruments are in form of • Direct investment -goldbrick, ingot • Indirect investment - “paper gold” - stocks of mining companies, gold bonds, etc. Financial instruments • Direct investment – Centers: London, Zurich, NY, Hong-Kong, etc. – Spot or future trades – Spot trades • Physical buy of goldbrick, ingots with delivery till 2 days • Investor can gold takes physically or deposit in bank -> gets certificate about proprietorship. • With spot trading of gold are related storage and insurance costs about 2-3% per year. • Standard goldbrick weights 400 troy ounce (12,44 kg) and it is called bar. • For retail investors are created tola bars on Ten tola bars with weight about several grams. Financial instruments – Future trades in form of • Gold swaps, gold loans and gold forward sales • Traded in OTC markets • Main traders: gold producers, central banks and dealers. • Gold loans – Financing of gold mining, used since 1982. Before gold mining a mining company borrow gold that sell and moneys uses for gold mining financing. – Mined out gold is used as a payment for loan. • Forward sales are used by mining companies to sell gold that will be mined in several years. – Main purpose is a hedging against decline in gold price. – Forward sales are mediated by banks called bullion banks. – This bank borrows (usually from central bank) gold in volume that is expected to be mined and sell then in spot market. – Money from transaction are deposited in money market. – Several mounts later mining company returns mined gold together with interest payment to central bank. – Mining company bets back financial resources from activity in money market together with interest payments minus interest payments paid central bank and provision for bullion bank.. Financial instruments – Investing in stocks of gold mining companies • The value of gold mining companies is determined by development of price of gold. • Movements of these stocks are determined by leverage effect it means that 1% change in price of gold effect several percentage change in price of gold mining companies stocks. • Beside price of gold these stocks are determined by – Mining costs, political and economical situation in the country, labour costs, etc. – Gold bonds • Index bonds that developments related with development of price of gold. • The best know – France government issue – Pinay and Giscard. Financial instruments • Diamonds – The most of diamond supply is under control of South African company DeBeers Consolidate Mines Limited that • keep 1/3 of all diamond mine. • Control about 75 % of world trade with not-cutted diamonds. • Real Estates • Arts