Classification of Financial Markets: Organised Markets

There are standardised rules and regulations to be followed and all transactions are under strict supervision and control by
various regulatory bodies such as SEBI, RBI, IRDA, etc. This results in high degree of institutionalization and a huge spread
with the types of instruments.

Types of Organised Market: - 1.Capital Market

2. Money Market

1. Capital Market

It is a market for financial assets which have a long or indefinite maturity. It includes securities with long term maturity (i.e.
above one year). The types of Capital Market are:

A. Industrial Securities Market

It comprises of the most popular instruments i.e. Equity shares, Preference shares, bonds and debentures. It is a market
where industrial concerns raise their capital by issuing appropriate instruments. It is further sub-divided into two:-

1. Primary Market (New issue market)

2. Secondary Market (Stock Exchange)

Primary Market

It is also known as the new issues market, it deals with those securities which are issued to the public for the first time.
Primary market facilitates capital formation. There are three ways in which a company may raise capital in a primary market.
They are :-

(i) Public Issue (ii) Rights Issue (iii) Private Placement

Public issue is the most common of these. It is done through sale of securities by a company for the first time. When an
existing company wants to raise funds, securities are first offered to its existing shareholders , this is called as rights issue.
Private placement is a way of selling securities privately to a small group, which according to SEBI shouldn't exceed 50
investors.

Secondary Market

It is a market for securities which were previously issued in the primary market. These securities are quoted on various stock
exchanges. These stock exchanges are regulated under the Securities Contracts (Regulation) Act, 1956 and the regulatory
body is Securities Exchange Board of India (SEBI). The principal stock exchange in India is the Bombay Stock Exchange
(BSE).

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B. Government Securities Market

It is also called gilt Edged Securities market. It is a market where government securities (G-secs) are traded. In India there
are many kinds of G-secs are traded. G-secs are sold through Public Debt Office of the RBI. They offer a good source of
raising inexpensive finance for the government exchequer and the interest on these securities affect pricing and yields in the
market.

C. Long Term Loans Market

Commercial banks and development banks play a significant role in this market by supplying long term loans to corporate
customers. It is classified into 3 categories:

(i) Term Loans Market

(ii) Mortgages

(iii) Financial Guarantees Market.

2. Money Market

It is the market for dealing with financial assets and securities which have maturity period of up to one year. It is sub-divided
into four parts:

A. Call Money Market

It is a market for extremely short period loans from say one day to 14 days. So, it is highly liquid. The loans are repayable on
demand at the option of the lender or borrower. The interest rates vary from centre-to-centre and time-to-time and sensitive
to changes in demand and supply of loans.

B. Commercial bills market

It is a market for Bills of Exchange arising out of genuine trade transactions. This deals with discounting of bills before due
date. In India, the bill market is under-developed. There are no specialised agencies for discounting bills.

C. Treasury bills market

T-bills as they are commonly referred to, are issued by the government. It is highly liquid because of the repayment
guaranteed by the Government. There are two types of t-bills i.e. regular and ad-hoc (ad- hoc are issued in favour of RBI
only). T-bills have a maturity period of 91 days or 182 days or 364 days. State Governments do not issue T-bills. They are
issued at discount and redeemed at par. Treasury Bills (short term securities) are sold through auctions

D. Short-term loan market

These are the loans given to corporate customers for meeting their working capital requirements. Loans are given in the form
of cash credit and overdraft.

Classification of Financial Markets: A Guide to B-School Placements - See more at:

After the Overview of the Financial Markets and Key Players in Financial Markets, here is our next offering on Financial
Markets - Classification of Financial Markets.

Financial markets in India may be classified broadly on the basis of:

New issue of securities

Maturity period

Types of financial instruments

We will also briefly explain the differences between Exchange Traded Contracts and Over the Counter Contracts in this article.

Classification of Financial Markets

2
1. Based on New Issue

Primary Market

In a primary market, securities are issued directly to the buyers. It can also be defined as a market in which newly issued
securities are offered to the public in the form of:

IPO (Initial Public Offering): Issue of shares to investors by a company which is not listed on an exchange, i.e., a
private company becoming public.

FPO (Follow-on Public Offer): Issue of shares to investors by a public company which is already listed on an
exchange.

Rights Issue: Providing existing shareholders an option to purchase new shares issued by the company at a
predetermined price proportionate to the number of shares owned by the company.

These are the financial markets where investors can get a first crack at a new security issuance. The issuing company
receives cash proceeds from the sale, which it then utilizes to fund operations or expand its business.

Secondary Market

In a secondary market, securities issued in the primary market are traded through an exchange or over the counter. For
example, Company A issues fresh shares in the primary market, some of which is picked up by investor X. Now X wants to
sell off these shares and exit the market. Since these shares cannot be sold back to the issuer (company A), X will have to go
to the secondary market and find a buyer (another investor) for these shares and sell them at a price acceptable to both, the
buyer and seller.

A secondary financial market provides an exit option to the holder of the security. It brings together investors wishing to sell
and investors willing to buy, and in the process discovers a market price determined by the level of supply and demand at
any given moment. It can also be defined as securities markets in which existing securities that have previously been issued
are resold. If the trade happens on a recognized exchange, then it is called an Exchange Traded Contract. If the trade
happens as a bilateral transaction between two parties, outside the exchange, it is called Over the Counter (OTC). The term
OTC market was most likely coined from the off-Wall Street trading which peaked during the great bull market of the 1920s,
where shares were sold over-the-counter in shops!

- See more at: http://www.careeranna.com/classification-of-financial-markets/#sthash.P3Rf60VO.dpuf

Exchange Traded and Over the Counter Contracts

The difference between Exchange Traded Contracts and Over the Counter Contracts is provided below.

Exchange Traded Contracts Over The Counter Contracts

Contracts are routed through the exchange. Exchange Contracts are between two parties.
plays the role of an intermediary and assumes the
counter-partys position. However, if for a bid, there is no
matching offer, the trade does not go through.

Parties must be a member of an exchange (or utilize a Parties can trade over the telephone and are not required
member of the exchange) in order to trade. to pay any membership fees.

Governance is maintained by the exchange (using their Governance is via a legal contract per trade, and is
rules & regulations), which are strictly regulated. generally via ISDA for derivatives.

Liquidity is high due to standardization of instruments. Tailored contracts mean less liquidity.

Exchange assumes the position of counterparty and hence Counterparty risk is the credit risk
the credit risk is minimized

Pricing readily available & competitive Pricing difficult to obtain & less competitive

2. Based on Maturity Period

The money market is the financial market for shorter-term securities (financial instruments dealing with debt and equity
products are often referred to as securities), generally those with one year or less remaining to maturity. Banks, corporations
and government bodies fund short-term deficits and invest short-term surpluses in money markets.

Capital Markets

The capital market is the financial market for longer term securities, generally those with more than one year to maturity. The
major function of capital markets is to generate capital for issuers and to provide a marketplace where these securities can be
traded. The instruments used to raise capital can be broadly divided into debt (bonds and notes) and equity.

3. Based on types of Financial Instruments

Equities / Stock Markets

Equity markets are those in which shares are issued and traded. Most equity instruments are traded on stock exchanges. Also
known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to
capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance.

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Bond / Debt Markets

A bond is nothing more than a loan. The issuer of the bond is a borrower while the subscriber to the bond is the lender. The
issuer promises to pay a periodic interest and return the principal on maturity. Bonds are traded on the exchange or over the
counter. The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants
buy and sell debt securities, usually in the form of bonds.

Foreign Exchange / Currency Markets

The foreign exchange market (Forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market
for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of
different types of buyers and sellers around the clock. Main participants are central banks, commercial and investment banks,
hedge funds, pension funds, corporations and private speculators.

Derivatives Market

Derivative markets are geared toward the buying and selling of derivatives. Derivatives are financial instruments that derive
their value from the value of an underlying asset. The underlying asset can be in many forms including, commodities,
mortgages, stocks, bonds, currency stock index, interest rates or even the weather. Derivatives are either traded on the
exchange or over the counter.

We hope that you got some insights into classification of financial markets based on different dimensions. We will continue to
focus on different types of financial markets, viz., money markets, capital markets, forex markets, etc. in our subsequent
articles. Please feel free to share your feedback through comments.

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Chapter 3: Financial Instruments, Financial Markets, and Financial
Institutions
Well-functioning financial markets are an essential part of any modern healthy economy. It is through
these markets that funds are offered by the lenders/savers who have excess funds and purchased by the
borrowers/spenders who need those funds. These borrowers and lenders may meet directly (known as
direct finance) or through financial intermediaries (known as indirect finance). The diagram on page 24
says it all:

Lenders and borrowers meet directly (the blue arrows at the bottom) or through a financial intermediary
(the orange arrows at the top). Through these markets the funds flow that allow for the development of
new products/ideas, the expansion of the production of existing products, and consumer spending on "big
ticket" items like houses, cars, and college tuition. Without these markets, firms may be unable to expand
production or invent new products and consumers will be unable to afford certain products.

Financial Instruments

The transfer of available funds takes place through the buying and selling of financial instruments or
securities. Your book offers the following definition of a financial instrument (36):

A financial instrument is the written legal obligation of one party to transfer something of value, usually
money, to another party at some future date, under certain conditions.

This is a mouthful, but breaking it down, we see several key features. First, this is a binding, enforceable
contract under the rule of law, protecting potential buyers. Second, there is the transfer of value between
two parties, where a party can be a bank, insurance company, a government, a firm, or an individual. The
future dates may be very specific (like a monthly mortgage payment) or may be quite uncertain and
depend on certain events (like an insurance policy).

Financial instruments, like money, can function as a means of payment or a store of value. As a means of
payment, financial instruments fall well short of money in terms of liquidity, divisibility, and acceptance.
However, they are considered better stores of value since they allow for greater increases in wealth over
time, but with higher levels of risk. A third function of these instruments is risk transfer. For certain
instruments, buyers are shifting risk to the seller, and are basically paying the seller to assume certain
risks. Insurance policies are a prime example of this.

Most financial instruments are standardized in that they have the same obligations and contract for buyers.
Google stock shares are the same obligation, regardless of buyer. Car loan and mortgage loans contracts
use uniform legal language, differing only in specific loan amounts and terms. This standardization
reduces costs (since the same types of contracts are used over and over) and makes it easier for buyers and
sellers to trade these instruments over and over. In addition to this standardization, financial instruments
must provide certain relevant information about the issuer, the characteristics and the risks of the security.
This information requirement is a way to even the playing field among different parties and reduce unfair
advantages.
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Back in chapter 1, I mention that the size, timing and certainty of cash flows are all important in
determining the value of a financial instrument:

How much is promised? $1000? $10,000? $1 million? The larger amount promised, the greater the value.
When is it promised? In 30 days? 1 year? Over 10 years? The sooner the payments are promised, the
greater the value.

How likely is it the payments will be made? How creditworthy is the issuer of the financial instument? If
the issuer is the U.S. government, payment is considered a certainty. If the issuer is my brother-in-law, well
good luck with that... The more certain the payments, the greater the value.

Under what conditions are the payments made? For some instruments, payment is contingent on an
event, like a fire, or car accident. The more needed the payment, the greater the value.

Pages 43-44 go over some common financial instruments.

Financial Markets

There is not one financial market, but rather many markets, each dealing with a particular type of
financial instrument. But all financial markets perform crucial functions. By providing a mechanism for
quickly and cheap buying and selling of securities, financial markets offer liquidity. Financial markets
allow the interaction of buyers and sellers to determine the price and the price conveys important
information about the prospects of the issuer. Finally, financial markets are the mechanism for buying and
selling the instruments that transfer risks between buyers and sellers.

We can classify financial markets into narrower categories based on the type of assets traded, their
characteristics, or even the location of markets.

Primary vs. Secondary Markets

The primary market is like the new car market. The financial instruments sold in the primary market are
brand new, or new issues. They are sold to the buyer by the issuer. The secondary market is like the used
car market (or as car dealers like to say "previously-owned vehicle"). The securities sold in the secondary
market are being resold by previous buyers for the second, tenth, or fortieth time.

Financial intermediaries play a role in both markets. In the primary market, investment banks assist a
business in selling a new issue to the public. Investment banks underwrite new securities, meaning that
they buy the new issue from the business and sell it to the public. Investment banks charge fees for this
service, along with any profits from reselling the issue at a higher price. Underwriting is big business. The
largest underwriters of new equity securities include Merril Lynch, Salomon Smith Barney, and Goldman
Sachs.

Even in the secondary market, financial intermediaries are an important part of a well-functioning market.
Securities brokers facilitate trade by match buyers with sellers. For this they charge a commission on
each match (or trade).

Securities dealers act as the buyer and seller by continuously quoting a price at which they will buy a
security (the bid price) and the price at which they will sell the security (the ask price). The bid price is

6
lower than the ask price (the difference is known as the bid-ask spread), and this is how dealers make
their money. Dealers own an inventory of the securities in which they deal. Since dealers stand ready to be
the buyer or seller for a security, dealers are said to "make a market" in that security, and dealers are often
referred to as "market-makers". If a buyer is looking for a seller, the dealer acts as the seller. If a seller is
looking for a buyer, the dealer acts as a buyer. This way there is always a buyer and seller, so there is
always a market.

Why have a secondary market? Keep in mind that the better the secondary market, the better the primary
market. Why? Because if securities are easily bought and sold, then they will be more popular in the first
place. The ease of which a security is converted to cash is known as its liquidity. High liquidity is
considered a good feature. If, for example, Microsoft stock is easy to buy and sell in the secondary market
(highly liquid) then it will be popular in the primary market.

Exchanges vs. OTC Markets

Secondary markets can be classified by where or how the trading of securities takes place. When buying
and selling occurs in a central, physical location, then securities are traded on an exchange. The New
York Stock Exchange is probably the best-known example. The NYSE had an average daily volume of
over 1 billion shares traded. London and Tokyo also have large exchanges. The NYSE depends on a
specialist system, where a firm is charged with maintaining an orderly market for each individual stock
traded on the exchange.

The alternative to an exchange is trading by geographically dispersed buyers and sellers, linked by
computer. This is known as an over-the-counter (OTC) market. The name originated from pre-computer
days when securities and money were literally exchanged over countertops by buyers and sellers. Today
OTC markets link buyers and sellers electroncially through dealers. The OTC markets depend on dealers
who make a market in various securities. Debt securities are traded in OTC markets (although some bond
trading does occur on the NYSE), while stocks are traded on exchanges and large OTC markets, like the
NASDAQ. The largest companies typically have their stocks trade on an exchange, but overall the
NASDAQ has a larger transaction volume.

ECNs or electronic communication networks offer yet a third option for buyers and seller to find each
other directly with no dealer or broker. Examples include Instinet and Archipelago.

In the Spring of 2005 the NYSE announced a merger between the NYSE and Archipelago. It has yet to be
approved, but it will be interesting to see how this will affect the specialist system. Some argue it will be
phased out in favor of electronic order matching.

Debt vs. Equity vs. Derivative Markets

Recall that debt instruments, like a bond or a bank loan, involve a promise by the borrower (the
seller/issuer of the debt instrument) to pay the lender (the owner/buyer of the debt instrument) fixed
payments at specified intervals until a final date. The time until all payments are made is known as the
maturity of a debt security. For example, most mortgages have a maturity of 30 years when first created.
We can further classify the debt market by maturity:

Short-term debt securities have a maturity of up to 1 year. This part of the debt market is also known as
the money market.
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 Intermediate-term debt securities have a maturity of between 1 and 10 years.

Long-term debt securities have a maturity of 10 years or more.

Equity instruments, like shares of common stock, are claims on the earnings and assets of a corporation. If
you own 5% of the shares of a company, then you are entitles to 5% of the earnings and assets of that
company once creditors are satisfied. Equity securities differ from debt in that

the size and timing of the payments are not fixed. Some equities securities entitle the owner to periodic
payments (known as dividends) but these payments are not guaranteed. This means that equity holders
benefit from a firm's profitability in a way that debt holders do not.
there is no maturity date for equity securities so they are considered long-term securities.

stock holders are considered residual claimants in the event of bankruptcy. This means that all debt
holders must be paid first before stock holders receive anything. This makes equity securities somewhat
riskier than debt securities. For example, many internet startups went bankrupt in 2001. The assets were
sold but did not even cover all of the debts so stock holders got nothing. zip. zero. nada.

Derivatives markets trade securities that derive there value from other underlying assets. The derivatives
markets is primarily a way for buyers and sellers to transfer risks that occur due to fluctuating asset prices.
This market has seen tremendous growth in the past two decades.

Financial Institutions

Financial intermediaries can be subdivided into three categories based on their liabilities (how they get
their funds) and their assets (how they use their funds).

Depository Institutions

These institutions are often collectively referred to as banks. All institutions in this category accept
deposits and make loans. We will focus on this group because they play a large role in monetary policy.

Commercial banks' primary liabilities are deposits (checking accounts, savings accounts and CDs) and
their primary assets include commercial loans, consumer loans, mortgages, U.S. government bonds,
municipal bonds. They are the largest type of financial intermediary, as measured by the total value of
their assets. (See table 2, page 36.)

Savings and Loan Associations were created in the 1930s and originally restricted to offering savings
accounts and CDs and making mortgage loans. In the 1980s these restrictions were relaxed to allow
greater asset and liability choices, making S&Ls very similar to commercial banks. Mutual Savings
banks are very similar to S&Ls, with the only distinction being that mutual savings banks are owned by
the depositors.

Credit Unions are the smallest of the depository institutions. They take deposits and primarily make
consumer loans. Credit unions are distinguished by two features: They are nonprofit and credit union
membership is organized around a particular group, such as company employees, a union, or even a
church parish.

8
Nondepository Institutions

Life insurance companies receive premiums in return for protection from the risk of death. Mortality
rates are predictable, so the timing and size of payouts for these companies are also predictable. Life
insurance companies also sell a variety of investment products as well, such as annuities and guaranteed
investments contracts (GICs). Life insurance companies are the largest buyer of corporate bonds, and
invest heavily in mortgages as well. They hold very little stock or municipal bonds.

Fire and casualty insurance companies receive premiums in return for protection from the risk of
property damage/loss, liability, and disability. The size and time of their payouts are less predictable, since
natural disasters such as a major earthquake or bad hurricane season can greatly affect the amount of
property damage that occurs in a given year. Because of this, their assets are more liquid than life
insurance companies. They hold municipal bonds, corporate bonds, stocks, and U.S. government bonds.

Pension funds may be privately-sponsored or government-sponsored, but in either case they provide
retirement income in return for contributions from employees and employers during their working years.
Pension funds receive very favorable tax treatment at the federal level. Again, the payouts are predictable,
so assets are long term such as corporate bonds and stocks.

Finance companies have taken much of the consumer and commercial loan business away from
depository institutions. These companies raise funds by issuing commercial paper (they do NOT accept
deposits). They then use these funds to make business loans, construction loans, auto loans and other
consumer loans. For example, all 3 major U.S. auto companies, GM, Ford, and Chrysler have finance
companies to help consumers finance auto purchases. Other finance companies specialize in credit cards.

Securties firms include brokers, investment banking/underwriting and mutual funds. Mutual funds sell
shares to individuals and use those funds to purchase and manage a diversified portfolio of stocks and/or
bonds. The value of the shares fluctuates with the value of the underlying portfolio. Why not just buy
stock directly? Because through mutual funds, investors can diversify with little initial capital, receive
professional management of their investments, and save on transactions costs. These advantages explain
why the number of mutual funds has grown from less than 500 in 1980 to over 6000 today. Mutual funds
vary according to their investment objectives and the type of securities they hold. Some funds focus on a
particular sector, like technology or health care, while some focus on U.S. government bonds or municipal
bonds. Money market mutual funds have features like both a mutual fund and a checking account.
These funds sell shares, fixed at a price of $1, and use those shares to buy money market instruments.
These funds then pay regular dividends in the form of additional shares. These funds also have restricted
check writing privileges. They operate like an interest bearing checking account with a large minimum
deposit. They have taken away funds from banks by competing for depositors.

GSEs or Government-sponsored enterprises are federal credit agencies that were created to supply
credit to farmers or home buyers or even for student loans. Examples of these include Fannie Mae (home
mortages) and Sallie Mae (studens loans). Note that these two enterprises are not government agencies,
but are privately held firms created through government charters and special access to government
services.

9
Financial Instruments

Financial instruments are legal agreements that require one party to pay money or something else of value
or to promise to pay under stipulated conditions to a counterparty in exchange for the payment of interest, for
the acquisition of rights, for premiums, or for indemnification against risk. In exchange for the payment of the
money, the counterparty hopes to profit by receiving interest, capital gains, premiums, or indemnification for a
loss event.

A financial instrument can be an actual document, such as a stock certificate or a loan contract, but,
increasingly, financial instruments that have been standardized are stored in an electronic book-entry system as
a record, and the parties to the contract are also recorded. For instance, United States Treasuries are stored
electronically in a book-entry system maintained by the Federal Reserve.

Some common financial instruments include checks, which transfer money from the payer, the writer of the
check, to the payee, the receiver of the check. Stocks are issued by companies to raise money from investors.
The investors pay for the stock, thereby giving money to the company, in exchange for an ownership interest in
the company. Bonds are financial instruments that allow investors to lend money to the bond issuer for a
stipulated amount of interest over a specified period.

Financial instruments can also be used by traders to either speculate about future prices, index levels, or
interest rates, or some other financial measure, or to hedge financial risk. The 2 parties to these kinds of
instruments are speculators and hedgers. Speculators attempt to predict future prices or some other financial
measure, then buying or selling the financial instruments that would yield a profit if their view of the future
should be correct. In other words, speculators bet about future prices or some other financial measure. For
instance, if a speculator thought that the price of XYZ stock was going to go up, then he could buy a call option
for the stock, which would be profitable if the stock does go up. If the option expires worthless, then the loss to
the speculator is less than the loss that would have been incurred from actually owning the stock. Hedgers
attempt to mitigate financial risk by buying or selling the financial instruments whose value would vary
inversely with the hedged risk. For instance, if the owner of XYZ stock feared that the price might go down, but
didn't want to sell before a specific time for tax purposes, then she could buy a put on the stock that would
increase in value as the stock declined in value. If the stock goes up, then the put expires worthless, but the
loss of the put premium would probably be less than the loss incurred if the stock declined.

Types of Financial Instruments

There are many types of financial instruments. Many instruments are custom agreements that the parties tailor
to their own needs. However, many financial instruments are based on standardized contracts that have
predetermined characteristics.

Some of the most common examples of financial instruments include the following:

Exchanges of money for future interest payments and repayment of principal.

o Asset-Backed Securities. Lenders pool their loans together and sell them to investors. The
lenders receive an immediate lump-sum payment and the investors receive the payments of
interest and principal from the underlying loan pool.

Exchanges of money for possible capital gains or interest.

o Stocks. A company sells ownership interests in the form of stock to buyers of the stock.

o Funds. Includes mutual funds, exchange-traded funds, real estate investment trusts, hedge
funds, and many other funds. The fund buys other securities earning interest and capital gains
which increases the share price of the fund. Investors of the fund may also receive interest
payments.

10
 Exchanges of money for possible capital gains or to offset risk.

o Options and Futures. Options and futures are bought and sold either for capital gains or to
limit risk. For instance, the holder of XYZ stock may buy a put, which gives the holder of the put
the right to sell XYZ stock for a specific price, called the strike price. Hence, the put increases in
value as the underlying stock declines. The seller of the put receives money, called the
premium, for the promise to buy XYZ stock at the strike price before the expiration date if the
put buyer exercises her rights. The put seller, of course, hopes that the stock stays above the
strike price so that the put expires worthless. In this case, the put seller gets to keep the
premium as a capital gain.

o Currency. Currency trading, likewise, is done for capital gains or to offset risk. It can also be
used to earn interest, as is done in the carry trade. For instance, if a trader believed that the
Euro was going to decline with respect to the United States dollar, then he could buy dollars
with Euros, which is the same thing as selling Euros for dollars. If the Euro does decline with the
respect to the dollar, then the trader can close the position by buying more Euros with the
dollars received in the opening trade.

Exchanges of money for protection against risk.

o Insurance. Insurance contracts promise to pay for a loss event in exchange for a premium. For
instance, a car owner buys car insurance so that he will be compensated for a financial loss that
occurs as the result of an accident.

Primitive Securities and Financial Derivatives

A custom agreement can better suit the needs of the parties involved; however, such instruments are
extremely illiquid precisely because they are tailored to specific parties. Furthermore, such instruments would
take time for anyone to completely understand the details, which would be necessary to assess the profit
potential and risk. The solution to this illiquidity is to create financial instruments based on standardized
contracts with standard terms and conditions.

Such financial instruments are called securities, which can be easily traded in financial markets, such as
organized exchanges and in the over-the-counter market. Furthermore, they are more easily stored in an
electronic book-entry system, which saves the cost of storing and transporting the instruments for clearing and
settlement. Examples of securities include stocks, bonds, options, and futures.

Securities are classified as to whether they are based on real assets or on other securities or some other
benchmark. Primitive securities are based on real assets or on the promise or performance of the issuer. For
example, bonds are based on the issuer's ability to pay interest and principal and stocks depend on the
performance of the company that issued the stock. Financial derivatives are based on the underlying asset
which consists of other financial instruments or some benchmark, such as stock indexes, interest rates, or
credit events. For example, the value of stock options depends on the price of the underlying stock, and
mortgage-backed securities depend on an underlying pool of mortgages.

Valuation of Financial Instruments

The value of any financial instrument depends on how much it is expected to pay, the likelihood of payment,
and the present value of the payment.

Obviously, the greater the expected return of the instrument, the greater its value. This is why the stock of a
fast-growing company is highly valued, for instance.

A financial instrument that has less risk will have a higher value than a similar instrument that has more risk
the greater the risk, the more it lowers the value of the security because risk requires compensation. This is
why United States Treasuries which have virtually no credit default risk command higher prices (lower yields)
than junk bonds with the same principal. So an investor would pay less money for a junk bond with a $1,000

11
principal than for a Treasury with the same $1,000 principal and coupon rate since there is a much greater risk
that the junk bond may default. So, by paying less money for the junk bond, the junk bond pays a higher yield.

The present value of a payment is determined by when the payment will be made. The greater the amount of
time until payment, the less the present value of the security, and, hence, the lower its value. So a zero coupon
bond that was going to pay its $1,000 principal 1 year from now will obviously have a greater value than a zero
that will pay its principal 10 years from now.

12