Page 74 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Unit 4: Indian Capital Market

Foreign Currency Convertible Bonds (FCCBs) Notes

A convertible bond is a mix between a debt and equity instrument. It is a bond having regular
coupon and principal payments, but these bonds also give the bondholder the option to convert
the bond into stock. FCCB is issued in a currency different than the issuer's domestic currency.
The investors receive the safety of guaranteed payments on the bond and are also able to take
advantage of any large price appreciation in the company's stock. Due to the equity side of the
bond, which adds value, the coupon payments on the bond are lower for the company, thereby
reducing its debt-financing costs.

Derivatives

A derivative is a financial instrument whose characteristics and value depend upon the
characteristics and value of some underlying asset typically commodity, bond, equity, currency,
index, event etc. Advanced investors sometimes purchase or sell derivatives to manage the risk
associated with the underlying security, to protect against fluctuations in value, or to profit
from periods of inactivity or decline. Derivatives are often leveraged, such that a small movement
in the underlying value can cause a large difference in the value of the derivative.
Derivatives are usually broadly categorised by:
1. The relationship between the underlying and the derivative (e.g. forward, option, swap).

2. The type of underlying (e.g. equity derivatives, foreign exchange derivatives and credit
derivatives).
3. The market in which they trade (e.g., exchange traded or over-the-counter) futures.

A financial contract obligating the buyer to purchase an asset, (or the seller to sell an asset), such
as a physical commodity or a financial instrument, at a predetermined future date and price.
Futures contracts detail the quality and quantity of the underlying asset; they are standardized
to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery
of the asset, while others are settled in cash. The futures markets are characterized by the ability
to use very high leverage relative to stock markets.
Some of the most popular assets on which futures contracts are available are equity stocks,
indices, commodities and currency.

Options

A financial derivative that represents a contract sold by one party (option writer) to another
party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call)
or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a
certain period of time or on a specific date (exercise date).

A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is
called 'strike price'. It should be noted that while the holder of the call option has a right to
demand sale of asset from the seller, the seller has only the obligation and not the right.

Example: If the buyer wants to buy the asset, the seller has to sell it. He does not have a
right. Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the
buyer.

Here the buyer has the right to sell and the seller has the obligation to buy. So in any options
contract, the right to exercise the option is vested with the buyer of the contract. The seller of the

LOVELY PROFESSIONAL UNIVERSITY 69