Concept of Derivatives

Hedging – is a strategy used to minimize exposure to an unwanted business risk in volatile economies. A hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment eg. a buyer of a equipment and a seller trading

Hedge Funds : very similar to mutual funds but we hedge the risk by different strategies such as having a portfolio of both equally riskier stocks. Also the SEC regulations are lenient and you dont have to register your hedge fund company. 

Derivative – A financial instrument whose value is derived from value of an underlying variable. The variable here can be based on different types of assets such as commodities, equities or stocks, bonds, interest rates, exchange rates or even indexes e.g. stock market index, consumer price index.

Ex: On every thanks giving you want turkeys. But sometimes they run out of turkeys just before thankgiving. so you make contract with the seller that here is x amount and you promise me to deliver the turkey on thankgiving. So here that note/contract is called as derivative (derived from an underliner which in this case is turkey)

Deviatives are traded just like the underlying variable. There are 3 types of Derivatives.
1. Options (in option you reserve the right of not buying the turkeys for a contract made sometime in past) so this is hedging. you pay a fee for making that contract.
2. Futures (the above turkey example)
3. Swaps (interest rates are very floating so you make a contract to swap the interest rate with a fixed rate and so irrespective of the unpredictable interest rate you pay a stable fixed interest rate.)

so in all the types there is an under-liner (gold, silver, weather, stocks, equity, etc)
One use of derivatives is to be used as a tool to transfer risk by taking the opposite position in the underlying asset. For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.

Derivative Trading: So these contracts/derivatives (could be anything futures, options or swaps) are trader either over an exchange or over the counter.So now these contracts are traded just like the stocks in exchanges. Because the underlying variable which in our example was turkey can be of more demand in future and the derivative holder if trades that in exchange he might get more than what he paid to the seller of turkey thus making a profit. 

Secularization – a process that involves pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors

Mortgage-backed security – an asset-backed security whose cash flows are backed by the principal and interest payments of a pool of mortgage loans

Stock Trading Order Types

 1. Market Order – place order and expect to trade at the current market price. For immediate execution. No constraints at all.

2. Limit Order – I want this order to be executed at this price or better. Putting some constraints.

3. Short Order – selling shares of a stock you don’t own. You own a margin account which allows you to borrow shares and sell them at market price.  Let’s say you borrow shares and sell them at the current price and save that money in the bank and then you wait for the share price to go down. Now you can buy those shares with the money you had and return to the person from whom you borrowed. So you make the profit from the difference which is basically what is left in your bank.

4. Stop Limit – provides a safety net to limit our losses. Once the stock price reaches a bottom limit you set then when the stock price hit that bottom limit it turns into market order and it will execute.

5. Stop Orders – you can keep an upper threshold for you stock which mean once the stock rises to a particular price you set it turn into a market order and can be executed.

6. IOC - immediate or cancel it. If you can execute it then immediately cancel it.

7. TIF (Time in Force) – so the order sits there until the order is cancelled it.

Quantitative Easing - is that a solution?

So what runs the economy? Its simple. Money runs the economy. So in a down economy where banks are out of money to lend people someone has to pump money in the economy so that the flow gets going. Central Bank does it. Central Bank prints money and buys the financial assets such as government bonds and corporate bonds called as open market operations. Thus this process creates enough revenues for the bank to start lending money to people.

Quantitative Easing is a monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate/ discount rate are close to zero.

The Federal reserve Board manages the interest rate environment through monetary policy as mentioned above "Quantitative Easing". An interest rate cut or down to zero means that the economy is in recession. Lowering interest rates allows people to spend more and also Federal Reserve indulges into open market transactions by buying government debt from banks and supplies money to Banks.

How NSE Works?

Getting straight to an example:

Lets say you own a private company that makes shoes. The demand for your shoes increases and you estimate that you need more working capital to meet the demand. So you plan to turn your company into a corporation and go public. You go to the state government to get a charter and permit to form a corporation. Now you would go to an investment bank and show your project report and capital requirement estimation. The investment bank promises to help to sell your shares. Then you and your banker would go to SEC in Washington  for getting an approval on the authenticity of the corporation. After the SEC approval your banker gives you the required capital investment in exchange for shares. The investment bank now sells the common stock of the shoe corporation and you expand your production to meet the demand. The people who now own the common stock are proportionate owners of your corporation's assets and they elect the board of directors for the company. These board directors monitors the functioning of the company and decides upon the dividends to be paid to the stock holders from the earnings of the new expanded company. 

Now lets say your company is really doing well and the demand increases more and you are in need for more capital. One way is to issue more shares and raise capital and the other way is that the stock holders elects a president and send him to New York stock exchange to see if they could qualify to be listed in the exchange and could allow trading of its securities. The selection committee then makes the through examination of the company's records and further business capabilities. Once it is approved the securities are now traded nation wide. Now if someone wants to buy your company's shares you would contact your broker and he contact his partner in the exchange and tries to negotiate on a price with someone who is interested in selling your company's shares. This is how the stocks are traded.