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IFT Notes for Level I CFA® Program

R36 Market Organization and Structure

Part 2


 

3.  Assets and Contracts

3.1.     Classifications of Assets and Contracts

Classification criteria:    
Based on the underlying Financial assets: Means by which individuals hold claim on real assets and future income generated by these assets, e.g., securities like stocks and bonds. Real assets: Include physical assets like real estate, equipment, commodities, and other assets.
Based on the nature of claim by financial securities Debt securities: Periodic interest payments made on borrowed funds that might be collateralized. Equity securities: Represent ownership positions and claim on the future cash flows of the business.
Based on where the securities are traded Publicly traded: These securities trade in public markets through exchanges or dealers and are subject to regulatory oversight. Privately traded: These securities are not traded in public markets. They are often not subject to regulation.
Based on delivery Spot market: Markets for immediate delivery of assets. Forward market: Contracts that call for future delivery of assets and include forwards, futures, and options.
Based on the underlying of the derivative contract Financial derivative contract: These contracts draw their value from financial assets like equities, equity indexes, debt, and other assets. Physical derivative contract: These contracts draw their value from real assets like commodities.
Based on issuance of security Primary market: Issuers sell securities directly to investors. Secondary market: Investors buy and sell securities among themselves.
Based on maturity Money market: Securities with maturities of one year or less. Capital market: Securities that have more than one year maturity or equities that do not have any maturity.
Based on the type of investment markets Traditional investment markets: Includes all publicly traded debt and equities. Alternative investment markets: Includes hedge funds, private equity, commodities, real estate, and precious gems that are hard to trade and value.

3.2.     Securities

Securities can be broadly classified into:

Fixed Income:

Refers to debt securities where the borrower is obligated to pay interest and principal at a pre-determined schedule. They might be collateralized, i.e., investors have claim of certain physical assets in case of a default.

The different types are:

  • Bonds: Long-term debts.
  • Notes: Intermediate-term debts.
  • Bank borrowings: Long- to short-term involving revolving credit lines and other debt instruments.
  • Convertible: Debt can be exchanged for a specified number of equity shares.

Equity:

Refers to ownership claims by investors in companies.

The different types are:

  • Common shareholders: They have a residual claim over any assets and income after all the senior securities have been paid.
  • Preferred shareholders: They are paid scheduled dividends before the common shareholders.
  • Warrants: They give the holder a right to buy the firm’s security at a price, called the exercise price, within a specified time period. (similar to options)

Pooled investments:

Pooled investments include mutual funds, trusts, exchange traded funds (ETFs), and hedge funds. They issue securities to represent the shared ownership in the assets. Money from several investors is pooled together to be managed by a professional money manager according to a specific investment strategy. The advantage of investing in pooled vehicles is to benefit from the investment management services of managers and from diversification opportunities. Pooled vehicles may be open-ended or close-ended.

3.3.     Currencies

Currencies are monies issued by national monetary authorities. Reserve currencies such as dollar and euro are currencies that national central banks around the world hold in large quantities. Currencies trade in foreign exchange markets, spot markets, forward markets, or futures markets.

3.4.     Contracts

A contract is an agreement between traders to perform some action in the future that can either be settled physically or in cash.

Based on the underlying asset, contracts can be further classified into:

  • Physical contract: If contracts are based on physical assets like crude oil, wheat, gold, or any other commodity, then it is a physical contract.
  • Financial contract: If contracts are based on financial assets such as indexes, interest rates, and currencies, then they are called financial contracts.

Contracts for Difference (CFD) allow people to speculate on the price of an underlying asset. The buyer benefits if the price of the underlying asset increases. These are derivative contracts because their value is derived from the underlying asset. They are generally settled in cash.

The major types of contracts (also termed as derivatives) are:

Forward contract:

It is an agreement to trade the underlying asset at a future date at a pre-specified price. It is not standardized and is not traded on exchanges or in dealer markets.

Futures contract:

It is a standardized forward contract for which amount, asset characteristics and delivery date are the same. Standardization ensures higher liquidity.

Swap contract:

It is an agreement to swap payments of one asset for the other. The different types are:

  • Interest rate swap: Floating rate payments are swapped for fixed-rate payments for a specified period.
  • Currency swap: Currency amount swapped for another currency for a specified period.
  • Equity swap: Returns earned on one investment are swapped for the other.

Options:

Contracts that give the holder a right, but not the obligation, to buy/sell an underlying security at a specified price at or before a specific date. The different types are:

  • Call options: Buyer gets the right but not the obligation to buy the underlying security. The seller of the call option gets the premium upfront but has to the sell the security if the buyer exercises his option to buy.
  • Put options: Buyer gets the right but not the obligation to sell the underlying security. The seller of the put option gets the premium upfront but has to the buy the security if the buyer exercises his option to sell.

Credit default swaps:

Contracts that offer insurance to bondholders. They make payments to a bondholder if a borrower defaults on its bonds.

3.5.     Commodities

Commodities include precious metals, energy products, industrial metals, agricultural products, and carbon credits. They trade in spot, forward, and futures markets. They are traded in spot markets for immediate delivery and in forwards and futures markets for future delivery.

3.6.     Real Assets

Real assets are tangible assets such as real estate, machinery, and airplanes which are normally held by operating companies. Real assets are unique, illiquid, and costly to manage. They are attractive to investors for two reasons:

  • Low correlation with other investments.
  • Income and tax benefits to investors.


Equity Market Organization and Structure Part 2