2.1 Capital Market Segmentation

In order to understand the stock market you must understand where the capital market is situated. The capital market forms part of what we call the financial markets. It is through these markets that company management can access a wide range of financial instruments. The proper funding of a company is essential to the development of its business and to its prosperity. The financial markets stimulate saving and investment through a mechanism in which supply and demand of savers and investors come together. Financial markets embrace the capital market (also known as the securities market) as well as the money market, the indirect securities market and the derivatives market.

Financial Markets

The capital market includes two distinct markets, the primary and the secondary markets.
The primary market trades in primary securities, at the moment of their creation, that is, whenever there are new issues of shares and bonds. The securities in this case are placed directly with the end investors. The secondary market, in turn, includes the stock markets where the securities generated via the primary markets are subsequently traded.

The capital market therefore plays two major roles:
a primary role: to provide new capital for a business or for other activities, usually taking the form of a share or bond issue; and
a secondary role involving trade in securities that have already been issued.

2.2 Stock Market: definition and importance

The stock market has not always existed, as we know it today, an organised and highly developed capital market where securities are traded with varying degrees of risk, liquidity and profitability. The activity of the stock markets or exchanges has its roots in the act of "exchanging", a fundamental part of economic activity, born of the division of labour and developed over the ages. In the past the places where merchants met and carried out their transactions were the historic forerunners of the Commodity, Securities and Foreign-exchange Markets. The first Stock Exchange appeared in Antwerp in 1531, though it only dealt in purely speculative business (wagers on the arrival of ships, games of fortune, for example) and in financial operations strictly limited to loans. The first real Exchange appeared in Amsterdam during the 16th century.

A stock market is no more than a capital market in which shares representing the equity of companies (issued previously on the primary market) are traded. Stock markets are therefore structured markets provided with the legal instruments required to allow them to carry out transactions involving the purchase and sale of securities transparently and in a secured form. The main functions of the stock markets are therefore:
The formation of the price of securities on the market;
The channelling of demand to the primary market;
The valuation of securities; and
Ensuring and providing liquidity for securities.

Each stock exchange generally has two distinct markets, the official market and a second market, while there may also be an unlisted market. Admission to listing on each of these markets has requirements of differing degree, the demands decreasing from the official market to the unlisted market. Securities listed on the official market can be traded on any national stock exchange while those admitted to listing on the other markets can only be traded on the market to which they were admitted to listing.
The aim of the creation of the second market is to simplify access to the stock exchange of securities issued particularly by small and medium enterprises. Therefore the demands are reduced compared to the official market (with regard both to the conditions of admission and to the information to be provided). For this reason such markets are sometimes known as baby markets.
The unlisted market is aimed at transactions involving securities that do not have the necessary conditions to be listed on the official market or on the second market. The prices practised on the unlisted market cannot be considered as listed prices for any legal purpose.
The following securities can be admitted to trading on the stock markets:
Domestic and foreign public funds and similar securities;
Shares and bonds issued by domestic and foreign companies;
Equity paper;
Closed-ended investment fund units;
Other legally tradable securities, and
Rights and warrants attached to the said securities.

2.3 General Organisation of the Stock Markets

2.3.1 The importance of MarketMakers: Dealers vs. Brokers

Financial intermediation is fundamental in any economy. It consists of the activity of certain economic agents who channel funds made available by savers to investors. This allows funding in small sums to be placed under better conditions of security and liquidity. Securities can only be traded on any organised secondary market, under penalty of being deemed null and void, through a financial intermediary authorised to operate in such markets. Within the scope of the securities' markets, 'financial intermediaries' are deemed to be natural or corporate persons legally entitled to carry on one or more activities involving securities. The various categories of financial intermediary operating on the securities' market include:
Brokers;
Dealers;
Banks;
Securities investment fund management companies; and
Asset-management companies.

The main organisations that provide share purchase and sale services are the dealers and the brokers. The difference between these two types of company lies essentially in the kind of operations they are entitled to carry out on the market, namely, underwriting securities in public offerings, providing custodian services, holding securities in their own trading accounts, etc., and in their share capital. These companies are members of a Stock Exchange and their principal business is the purchase and sale of securities on behalf of their clients. In some countries these companies - the larger ones - can also play the role of marketmakers. Since they deal in securities for their own account they have large quantities of securities in their own portfolios and they define prices in light of supply and demand. Broker companies focus their business on the purchase and sale of securities on behalf of their clients. Nowadays, a dealer can be part of a large financial group or an independent company specialised in private clients. The main activities of Dealers and Brokers consist of: Dealing or execution: this is the basic service involving the purchase and sale of shares for those not requiring advice or assistance in their financial planning;
Dealing in securities for their own account;
Prospecting investors to underwrite, sell or carry out other operations on securities;
Placing securities on the primary market;
Organisation, registration, launch and execution of take-over bids;
Opening and handling securities' custody account, keeping record of dematerialised securities, and providing services in respect of the rights inherent in such securities;
Portfolio management;
Creation and management of securities investment funds; and
Consultancy.

2.3.2 Types of Orders

A mandate concerning the purchase and sale on any securities on the stockmarket is known as a market order.
A market order must contain the following:
The identity of the Principal;
The nature of the deal (purchase or sale);
The nature, category, quantity and issuer of the securities to be traded;
The type of operation and the conditions governing the deal;
The type of order as far as price is concerned;
The validity-date of the order;
The date on which the order is placed; and
The stock exchange on which it should be executed, provided that the securities do not have to be traded on the national dealing system and that they are listed on more than one exchange.
When given directly to the broker who is to implement it, the order shall also specify:
In case of a selling order for securities in custody or for dematerialised securities registered at another financial intermediary meeting the established conditions, the identity of the mentioned intermediary and the number of the respective custody account or registration; In case of a purchase order, the identity of the accredited financial intermediary and the number of the account and of the custody account or registry to which the principal wishes the securities to be purchased to be credited; and
in case of a purchase order and if the aforementioned account does not exist or the client does not want to use it, the identity of the accredited financial intermediary with which the securities should be deposited or registered, unless the client wants them to be deposited or registered with the broker concerned.

With regard to price, the classes of the market orders are as follows:

'At best', when no limit is stated for the purchase or sale price;

'With a price limit', when the maximum or minimum price is stipulated at which the Principal is prepared to buy or to sell, respectively; With a price limit and the mention 'stop', when the Principal, in the case of a purchase order, becomes a purchaser as soon as the price matches or exceeds the established price limit, and, in the case of a selling order, as soon as the price matches or falls below the price limit. In either event, as from the moment the stated price is reached the order becomes a simple order with a price limit or 'at best', depending on whether or not a second price limit has been stipulated; and

'Matched', when the principal places a purchase order and sale order at the same time in respect of different securities, stipulating that the execution of the one is dependent on the execution of the other, with the possibility of stipulating which should be executed first. With regard to validity, market orders may be:
For a given term, which may be restricted to the market session on the day the order is placed or to the session next following, though the term may never exceed 45 days; and
With no restriction as to date, it being understood that the order remains in effect until the last session of the month in which it is received.
The Principal is responsible for indicating the term of the validity of the order.

Market orders may be given to and received by brokers at any time, either prior to the beginning of or during market sessions. However, it may be that a purchase or sale order given to the broker or financial intermediary cannot be met during the next session due to a lack of securities, despite the efforts made to fulfil the order. There are additional difficulties in case of orders with limits, for it may well be that the limits established in the order are not achieved on that particular day. Without prejudice to the special rules governing the dealing system in question, market orders may be altered or cancelled by the Principal at any time, provided that they have not yet been executed. Entities (brokers or other financial intermediaries) receiving a market order involving a spot operation shall obtain the following from the Principal prior to executing or passing on the order in question:

In case of a selling order, delivery of the securities to be sold, provided they are certificated securities and are not deposited, or, if they are dematerialised, registered or deposited securities; such information may be required by the broker to verify the availability of the securities concerned and to secure their release from the financial intermediary where they are registered or deposited; and in case of a buying order, the sum required to pay for the purchase.

Should a broker or other financial intermediary receive an order involving the execution of an operation, the broker or intermediary shall demand the Principal the provision, of a performance bond required to execute the operation.
Non-delivery of the securities, the information or the money, as well as lack of their transmission by the financial intermediary receiving the order, as referred to above, releases the broker from the obligation to fulfil the order. Under penalty of not being executed, market orders should be given in writing, or immediately reduced to writing in the case of verbal orders. Orders given by means of duly-approved forms are considered as being given in writing, as are those sent by telex, fax or other similar, appropriate means of communication. With regard to each operation executed on the stock market, the broker is to draw up, sign and hand to the appropriate stock exchange personnel a note stating the value of the deal, the quantity of securities traded and the respective price. For each market order executed, the broker shall, within 24 hours, issue purchase or sale notes, which must contain the following information:
Name of the broker;
Name of the Principal;
Issuer, nature and category of the securities in question and quantities transacted;
Type and mode of the operation;
Date on which the operation was undertaken and number of the operation note;
Value of the transaction; and
Amount of brokerage fees and other charges to be levied.

2.3.3 Types of trading systems. Differences

Since the stock market is a market where securities are freely traded, prices move with supply and demand. Although there are some restrictions on stock markets, most markets approach efficiency by virtue of almost perfect competition. The listed prices are the prices fixed on the official and on the second market. The trading systems to be used on the stock market are established by the Securities Market Commission, which should be guided by the objective of ensuring maximisation of trading volumes, adequate pricing and transparent operations.
The allowable trading systems are:
a) Trading based on one or more daily calls; and
b) Continuous trading.
In both cases, the submission of bids by the brokers can now be done via computer. Securities admitted to listing on the official market must be traded on a nation-wide system underpinned by an IT network linking the country's stock markets.

2.3.4 Physical and financial settlement

A custodian is entrusted with the registration and control of fungible securities. All issues of certificated securities and all issues of securities admitted to listing on the stock market must be registered. The registration of other issues with the custodian is optional. The relationship between the custodian and investors is indirect, taking place solely via member Financial Intermediaries.
Membership requires that, in addition to possessing the required technical conditions providing security and efficiency, the intermediary is registered with the Securities Market Commission and that it has an account with the Central Bank.
To fulfil its main objective, the Centre undertakes several tasks:
Registration and control of securities;
Movement of the securities between accounts;
Deposit and withdrawal of certificated securities;
Exercise of rights of a corporate nature, namely changes to the share capital of companies, payment of returns and amortisation of securities; and
Management of a system interlinking the Financial Intermediaries, the Issuers and other entities, particularly the Stock Markets and the Central Bank.

Settlement and Compensation System:
Immediately after deals are made, the trading system transmits the information to the Specification System for the Financial Intermediaries to indicate the accounts to be used to settle each purchase or sale. At the end of "D+1" this information concerning the deals on "D" is sent to the Settlement System.
There the compensation is effected, by account and by security, in respect of purchases and sales undertaken on "D". On the basis of quantities not compensated, settlement notes are generated for processing on "D+n" (n=number of days, different in each country). On this date, based on the quantity of securities existing in the accounts, information is also generated for the Financial Intermediaries (FIs) in respect of default of physical settlement. This process also generates a forecast of the amounts to be settled financially on "D+n" at the Central Bank.
In the daily processing on "D+n" debits are processed via the accounts of the FIs at the custodian in respect of the sales entered in the notes, as are the credits. These remain available to settle notes from other markets or, otherwise, the credits are blocked until financial settlement takes place. The amounts to be settled financially are then calculated, by stock market operation, including the value of the operation itself, the stock-market charges, and accrued interest and tax, if applicable.
 

2.3.5 Institutions governing and supervising the market

All markets need governing and supervision by an independent entity, the securities authority. Its duties include the regulation, supervision, monitoring and promotion of the securities markets and of the activity of the agents involved therein, either directly or indirectly. The securities authority also advises the Government and the Finance Minister in all matters related to the securities markets and co-operates with the respective authorities of other countries.
The securities authority operates in vast areas of the financial sector. On the one hand, it is responsible for regulating and supervising operations involving securities and the respective markets (primary and secondary, both on the stock markets and otherwise) and for regulating and supervising the derivatives markets; on the other hand, the securities authority is also charged with regulating and supervising securities intermediation business, that is, the investment services directly or indirectly linked to securities, as well as the financial intermediaries that carry on such activities on a professional basis.
This intermediation business includes:

Accepting and/or executing orders to subscribe to or trade securities;
Trading in securities for the intermediary's own account;
Market making;
Prospecting for investors;
Placing securities;
Services linked to the organisation, registration and launch of take-over bids and public offerings;
Opening, handling and managing securities accounts;
Management of securities portfolios;
Setting up and managing securities and real-estate investment funds;
Acting as the depositary of investment fund securities; and
Advisory services, on an individual basis, concerning investment in securities.

The securities authority is responsible for supervising these activities, whether carried out by investment companies or by banks. However, the prudential supervision of financial intermediaries (banks and investment companies), designed to safeguard their stability and financial health, is entrusted to another entity (the Central Bank). It should, however, be noted that the securities authority is responsible for the supervision of securities and real-estate investment funds.

The aims of the securities authority activity, within the framework of the working of the market and of free competition between the various economic agents, include the following:

• To contribute to country's economic development by perfecting the disintermediated fund transfer market;
• To contribute to the consolidation of an efficient national financial industry; and
• To protect the investor public when placing or thinking of placing savings or available funds on the securities markets or, in general making use of the investment services provided by the financial intermediaries.

These aims are achieved by:

• Increasing the transparency of the primary and secondary markets, stimulating the disclosure of sufficient, objective, true and timely information;
• Increasing the integrity of the markets, in particularly to preventing misleading or fraudulent operations and those in which inside information and price-manipulation is employed;
• Support and adequate promote the organisation and working of the securities and derivatives market, including the efficiency and stability of the compensation and settlement systems; and
• The promotion of high standards in the professional provision of investment services.

The securities authority does not authorise the prices or quantities to be traded, nor does it, generally speaking, interfere in the merit of the operations or in the business proceedings.

2.4 Investment Opportunities on the Stock Market

2.4.1 Shares

A share represents a fraction of the share capital of a joint stock limited liability company, and it gives entitlement to the income and assets of the company in question.
Ordinary shares generally entitle the shareholder to vote in the election of the management and in other matters decided at general meetings, either directly or by means of a proxy.
Preference shares do not grant voting rights but have priority entitlement to the company's assets and income (dividends, for example).

Investment in shares depends essentially on three variables: liquidity, risk and returns.
On analysing a share, attention is given to several aspects related to the economy in general: the sector in which the company does its business; its economic and financial situation; the business outlook for the company and for the sector; and the potential to generate growing profits and cash-flow, among others. It is also essential that an analysis of market quotations be undertaken.

2.4.2 Bonds

A bond is a financial instrument (debt) that obliges the issuer (debtor) to repay the investor (bondholder) the sum lent plus interest over a given period of time. Bonds are fixed-income instruments, in which the income obtained is the interest, irrespective of the company's performance.
Bonds may be issued by public or private companies and by the State or quasi-state organisations such as municipalities. A bond comprises the nominal interest rate (or coupon), the par value, the issue value, the reimbursement value and the method of amortisation. The par value of a bond is the amount that the issuer will normally have to repay to investors on maturity. This amount is also called nominal value or face value, and it is on the basis of this amount that interest is calculated. The coupon, or coupon rate, is the interest rate that the issuer has promised to pay to the bondholders. The interval at which the interest is paid can vary, but is usually half-yearly or yearly. When bonds are issued all the data concerning the issue must be shown on a term sheet.

Bonds involve several kinds of risk:
- Interest-rate risk - when interest rates change, the value of the bond varies in inverse proportion to the behaviour of the interest rate;
- Price risk - the longer the life of a bond the greater the interest-rate risk and, consequently, the risk of variation of the price of the bond;
- Country risk, Political risk and Liquidity risk are other risks to be taken into consideration. All these risks can be summarised in the form of a rating notation. The rating is an indicator of the probability of timely payment by the issuer of the interest and principal of a given loan. Rating notations are awarded by independent entities, the best-known international agencies being Moody's and Standards & Poor's.
 

2.4.3 Warrants

Convertible bonds have given rise to the so-called with-warrants bonds. The idea was to divide the product into its two components: a classic bond usually issued with a lower coupon (which could provide tax advantages) and - by way of compensation - a right to subscribe to shares (the warrant) entitling the investor to take part in a share capital increase (should he so desire) to be undertaken at a future time, usually under attractive conditions.

With-warrants bonds give entitlement to subscribe to shares at a future date at a previously established price (exercise price). On exercising the right (warrant) the bondholder acquires the right to become a shareholder too, that is, as from a given time he will have two kinds of relation with the issuer company, that of a bondholder (creditor) and that of a shareholder. These bonds entitle their holders to negotiate the warrants separately from the bond itself. Warrant-holders are not entitled to vote at general meetings nor do they receive a dividend, the only income being the interest on the bond. The value of a warrant depends on the number of shares to which it gives entitlement, on the present price of the shares and on the price of the exercise of the right.

These products are offered jointly on the primary market (that is, at the time of issue of the loan), though they subsequently follow quite different paths: the bond component is listed as a bond and the warrant on the rights market (that is, on the unlisted market). Following purchase of the joint package and depending on their objective, investors may sell the part in which they are not interested, either the bond or the warrant. That is to say that the warrant can be detached from the bond.

2.4.4 Equity Paper and Unit Trusts (Mutual Funds)

Equity Paper is essentially securities representing loans contracted by statutory corporations and joint-stock limited liability companies the majority of whose share capital is state-owned. This instrument lies somewhere between bonds and shares. The returns on these securities consist of a fixed part and a variable part. The fixed part is calculated on the basis of an interest rate (indexor) determined in advance at the time of issue. The variable part may be calculated on the basis of turnover, net profits or other economic or financial variables. Equity Paper provides issuer companies with stable long-term funding, often at a cost lower than a long-term bank loan or bond issue. For investors it provides competitive returns, compared to bonds and shares, taking the investment risk into account.
The units of unit trust represent the unit value of a portfolio, in the case of a securities fund (mutual fund). On acquiring units in an equity fund, the investor is, as it were, acquiring a small fraction of each share that makes up the fund. In this indirect way the investment is diversified. The fund is managed by professionals and requires less market supervision by the investor.

2.4.5 Subscription Rights

A subscription right is a privilege granted to the shareholders of a company, giving entitlement to subscribe to a new share or bond issue before the offering to the general public. The right can usually be freely traded on the stock market, its value calculated on the basis of the number of shares to which it gives entitlement and of the current price of the shares. When exercised, subscription rights carry the associated liquidity risk since the conversion of the right into shares is not usually immediate and the investor cannot negotiate the shares to which he is entitled during a certain period. However, on acquiring the rights the investor is ensured the required number of shares, and this is an advantage in issues for which demand is heavy. Subscription rights differ from incorporation rights in that their holders have to pay a price for their shares (though lower than the market price).
Incorporation rights grant the investor the right to acquire new shares, the only cost being the cost of the rights themselves.

2.5 Market performance: Market Indices and Overall Indices

When analysing shares investors should take into account several macro and micro-economic indicators, such as the performance of prices, comparison with the average performance of the market and of the sector, and the calculation of the risk-coefficient of a share in relation to the market. These are some of the analyses commonly undertaken by capital market operators and by some investors, particularly institutional investors.

On analysing a market, market indices are generally employed. These indices represent a basket of shares whose individual weighting largely depends on the market capitalisation of the company in question. They reflect the combined performance of the major listed companies and, as in the case of shares, their performance over time should also be analysed. They constitute a general measure of the trends of the market as a whole. Market indices thus help to see whether a given share is outperforming or under performing the market.

We can therefore make a distinction between sector and overall indices.
Market Sectors Indices:
Whatever the share that was chosen, it will be included in a given sector of the economy, as can easily be seen in the pages of the specialised press. Grouping companies by sector provides an important tool to compare the various companies operating in the same sector. Overall Indices:
The best-know indices are the Dow Jones and S&P500 (in America), FTSE, CAC, DAX, AEX, IBEX, BVL39, PSI20, MIB30, HEX, OM (Europe), Bovespa (Brazil), Nikkei and Hang Seng (Asia). These indices are followed daily to determine the trend of the market. Their composition differs and it is therefore possible to see the Dow Jones in positive territory while the S&P500 is down.

The overall indices reflect the overall performance of the market as a whole. However, within the whole the shares of companies in different sectors can and generally do perform differently. This is shown in the sector indices, which reflect the average movement of the shares in the sector in question. All these indices help investors to decide whether a particular share is worth buying, whether it is the time to sell and how the share portfolio has performed in relation to the market.

When all these indices are used we can analyse a share's relative performance. As one begins to follow the stock market more closely it will be seen that the professionals talk a lot about the relative performance of shares and about the global trend. One will hear comments such as "this share is under-valued", "that share is over-valued", or different sectors or companies "need re-rating". Investors obviously want to buy shares that can be expected to outperform the market - that is, to be better than the other shares. The indices referred to above constitute the measure of comparison, or benchmark, against which we can determine the individual performance of each particular share - and they also help to identify those shares that could be "better than the others".

2.6 The Derivatives Market

2.6.1 Origins and history

The basic principle of future operations (I contract today and deliver later) has very remote origins. There are strong indications that the concept existed in 2000 BC, when merchants of what is now the state of Bahrain received goods to barter in India, with a fairly long period between the date a contract was entered into and the date on which it was performed. This principle was later found throughout the Graeco-Roman world. Here, in addition to the characteristic deferral of delivery of the merchandise, the markets had a certain sophistication in that there were proper times and places to carry out the exchange, and monetary standards were employed. During the 16th century, when the feasibility had been demonstrated of transactions without the physical presence of the merchandise and based on standard sample, there appeared in England permanent locations where primary goods and manufactured goods were traded throughout the whole year. The best example is the Royal Exchange, which appeared in 1570. Later, as a result of increasing product specialisation, this gave rise to a number of exchanges that came to be known as the London Commodity Exchange.

It was, however, in feudal Japan of the 17th century that the true origins of the futures market can be found, for here were found the first records of the existence of an organised futures trade in merchandise. During this period, the feudal lords and the great rural landowners received from their tenants, in exchange for the use of the land, payment in kind, under the form of a share of the rice harvest. Needing liquidity throughout the whole year and not just at the time these payments were made, the landlords began to issue and sell receipts representing the goods. These receipts were acquired by merchants who, in this way, ensured in advance the purchase, at a given price, of the amount of rice that they required. The development of these markets was so important that, at the end of the 17th century, the rice market at Dojima dealt only in futures contracts. Culminating the growing affirmation of this kind of market, the Japanese government recognised the rice market-involving book trading at the end of the 18th century, marking the beginning of the first official futures market. The rules and principles governing this market, that is the standardisation and the predetermined duration of the contracts, the prohibition of extending their maturities, the registration and settlement of operations though a Clearing House and the obligation of all those involved in the market establishing a credit line through s Clearing House of their choice are still applied to the futures market. A curious point was that until 1869 physical delivery of the products was not allowed, the market operating solely through financial settlement of the contracts.

In parallel, the beginning of the 19th century saw, in the United States, the development of a number of exchanges that were to become world leaders. These were mostly located in New York and Chicago, cities which, given their excellent location, made their mark as the prime centres for the domestic and international trade of the United States. In the wake of the appearance of several farm-produce markets in the United States as from the start of the 19th century, the CBOT (Chicago Board of Trade) was set up in 1848. This association was mainly involved in organising the commodities markets and it came to be especially active in trading in farm produce, particularly maize and wheat. In an endeavour to minimise the risks assumed by the various parties involved in the commodities markets - good harvests/ low prices (risk for producers), poor harvests/ high prices (risk for consumers) - a warehousing sector was developed in an endeavour to stabilise supply through increasingly careful stock management, and contracts were introduced calling for deferred delivery. At an early stage, therefore, these markets dealt both in spot trading and in forward trading. The latter allowed the needs of producers to be satisfied (sales hedgers), to the extent that they now had access to an instrument that allowed them to ensure the price at which they could place their production, while the needs of the buyers (purchase hedgers) were satisfied in that they were able to establish in advance the prices at which they bought.

However, there continued to be a group whose interests were not covered by this type of trading. This group consisted of the speculators, those who, better or worse informed of the characteristics of production cycles, had expectations as to the future evolution of prices, and accordingly assumed the risks of the business as a means of earning a profit if their expectations came about. They were not interested in getting involved in the physical marketing of the merchandise. Satisfaction of the interests of this group required the appearance of instruments, which because of their standardisation and flexibility could let them move into and out of the market with ease. Their role would provide the market with greater liquidity and, consequently, bring benefits to all those involved.

For such a system to work, the contracts had to be standardised in a manner such that it was immaterial whether one contract or another was negotiated. Whatever the circumstance, the same quantity and quality were to be delivered. Thus, and with a view to meeting the needs of those involved, contracts appeared that were standardised in terms of:

• Quantity;
• Quality - with a pre-established price compensation for minimal variations around the standard quality;
• Time - the maturity date of the contracts was standard, usually linked to the production cycles of the production underlying the contracts; and
• Place of delivery - possibly with delivery split between different places, with adjustment of prices, which was also standardised, subject to transport costs.

These contracts were such a success that brokers, who fully underwrote the risks of their customers, came to be concerned about their financial integrity because of the possibility that a part of their customers would not honour their commitments, leaving the brokers to bear the losses. Such losses could be unbearable because of the large number of deals (or, to be more exact, of the large number of positions open at any given time). To cover such risks, Clearing Houses and guarantee funds were set up, to which brokers paid subscriptions. Additionally, to guarantee the integrity of the system in the event of non-compliance, safety schemes (margins) were also created, in a way that the parties put up a certain sum by way of guarantee of compliance to their obligations. At the same time, the daily adjustment (mark to market) system was introduced which, by allowing the daily realisation of potential gains and losses, substantially reduced the Clearing Houses' risk exposure. In this way, the basic principles had been created upon which the modern futures markets are based.

During the early period there were several cases of market manipulation, and cases were known where some agents were able to manipulate the market through concentration of positions and consequent reduction of liquidity, giving the market an image of poor credibility. This meant that the authorities were somewhat reluctant to grant recognition to the system. It is not surprising, that only in 1992 the federal government in the United States did recognise and regulate the futures market, through the Grain Futures Act.
A new landmark was established in these markets during the 70s, with the introduction of financial futures in the United States. This resulted in the increase of the volume of futures contract deals to unheard-of levels. The adoption of derivatives by those involved in the financial markets in the United States was greatly stimulated by rising inflation rates and by the progressive deregulation of interest rates. A group of economic agents particularly affected by both these phenomena involved the commodity traders, to the extent that volatility of spot prices had increased and, at the same time, the relation between the prices for future dates was now affected by interest-rate volatility.

Following the announcement of the end of the gold standard and the subsequent collapse of the Breton Woods agreement (1971-73) which was based on a regime of fixed exchange rates, the climate propitious to interest rates volatility and increases were further enhanced. The commodities markets saw an increased need for risk cover and, at the same time, the providers of financial services began to feel a need for instruments that could hedge interest- and inflation-rate variation risks. It was against this background that the first financial derivatives market appeared in 1972, the International Money Market, created by the CME (Chicago Mercantile Exchange). It began by listing futures contracts on currencies. In October 1975, the CBOT launched the first contract on long-term interest rates. During the first three months trading amounted to 20,000 contracts

Over the next two decades trading in futures and options increased remarkably and spread across the various continents, while multiple new contracts were introduced. The number of transactions grew apace, certainly linked to the fact that they satisfied important economic needs (the essence, moreover, of their creation).
The eighties, in particular, saw a veritable boom in the derivative markets, beginning with the creation of LIFFE (United Kingdom) in 1982. Since 1984 40 exchanges have been set up in 20 countries - most recently in Hungary (1993). Today, there are some 90 financial and commodity derivatives markets operating in 30 countries in every continent.
Another sign of the growing interest in derivatives trading was the extraordinary increase in the volume of contracts negotiated on the organised markets, which, in 1993, exceeded for the first time the billion contracts per annum mark. That year, too, saw for the first time the number of contracts exchanged in the United States being overtaken by the rest of the world, though the largest markets continued to be American (CBOT and CME). Indeed, both in the European and Asian markets the volume of contracts negotiated has seen considerable increase.

2.6.2 Importance of the derivatives market

Derivatives markets have been hugely successful throughout the world since the seventies, mainly owing to the increased volatility of the spot markets.
The most varied assets have felt this increased risk:

• In currencies, due to the great instability of exchange rates;
• In bonds, due to the variability of interest rates; and
• In equities, due to the market risk (which cannot be eliminated through diversification).

Financial futures allow (within certain limits and, as a rule, only in the short term) the cover of the financial risks mentioned above, while fostering speculation as to the direction of the variation of prices. This means that risk can be transferred from the more risk-averse investors to speculators more willing to accept high exposure to risk. Financial options also allow risk-cover and speculation and provide new vehicles to set up hedging and speculation strategies allowing speculation on volatility itself as well as on prices. These instruments therefore provide new opportunities for investors who can use them in the management of their portfolios, either to reduce their exposure to given risks or, on the contrary, to increase it by leveraging it. The derivatives markets appeared as the organised form of forward operations. They are an alternative to the over-the-counter markets from which they have conquered market niches and segments. Derivatives markets provide a natural advantage in that they provide a secondary market for derivative products. They thus provide operators with an easy, fast exit from the positions that they originally set up.

2.6.3 Futures contracts

A Future is a standard contract exchanged between two parties (a buyer and a seller) with the intervention of an exchange, in which one party engages to buy (the buyer or the holder of the buying position) and the other to sell (the seller or holder of the selling position) a given quantity and quality of a good (merchandise) or financial instrument (financial asset), at a price fixed at the present (the moment when the contract is entered into, that is, when the position is opened), for delivery at a specific place and time in the future. The essential objectives of such a contract are:

• On the one hand, to provide buyers and sellers with cover against price fluctuations, ensuring a future transaction at a price established today, allowing such operators to eliminate the price risk; and
• On the other hand, since there is usually no natural balance between forward buyers and sellers, futures contracts allow speculators to take positions with merely speculative purposes, that is, they can wager on rising prices (by opening buying positions) or on falling prices (by opening selling positions).

Futures contracts thus allow the transfer of risks from economic agents whose normal business involves taking positions in certain assets (real or financial) to other operators - the speculators - whose vocation is to assume risks with a view to securing a profit when prices move in the right direction. When compared to forward contracts, futures contracts reduce trading costs and have neither credit- nor liquidity-risks. Nevertheless (owing to the fact that they are negotiated via an exchange), futures have restrictions as to the time when they can be negotiated, require guarantee deposits (margins), and are subject to special risks, resulting from the fact that, of necessity, they are standardised contracts thus can only be negotiated on the exchange which ensures their liquidity.

2.6.4 Options Contracts

Options contracts are divided into call options and put options. Call options are contracts that grant their holder the right (but not the obligation) to buy, on or up to maturity, the asset for the consideration inherent to the exercise price. Put options, in turn, grant their holder the right (but not the obligation) to sell, on or up to maturity, the asset for the consideration inherent to the exercise price. It should be borne in mind that call and put options are quite distinct contracts, traded separately, and they do not constitute the opposite sides of the same operation. Each one has its own buyer and its own seller. An options contract is an agreement whereby the buyer acquires the right to buy (call option) or to sell (put option) a certain quantity of a given good or financial instrument at a fixed price (exercise price) on a pre-determine date (European-style options) or during the period to maturity (American-style options), paying for this a given consideration (the premium). The seller has the obligation to sell or buy the said asset, under the established conditions, in the event of the buyer deciding to exercise his right.

The following table summarises the differences between call and put options, as far as the rights and duties of each party (buyer and seller) to the deal:

As with a futures contract or forward contract, the fundamental objective of an options contract is to allow economic agents to fix the price of a deal today that will only be executed in the future. It happens that, in this case, there is an imbalance between the obligations of the selling side and of the buying side of the contract. In the other types of contract each party assumes symmetric obligations (though possibly reversible), while in options contracts the buyer acquires only a right (and not an obligation), whereas the seller is in the position of having to meet an obligation should the buyer decide to exercise his right. In other words, the buyer of the contract is entitled to demand of the seller a certain action (the purchase or sale of a good), while the seller is obliged to be at the disposal of the buyer to buy or sell the good, as the case may be, when the buyer so decides. The seller is therefore subjected to the will of the buyer of the option, and, ultimately, it is the buyer who decides whether the transaction (covered by the contract) goes ahead or not.

Naturally, as the reader will already have understood, the seller will only agree to enter into an options contract if there is a monetary reward provided by the buyer for the imbalance of the obligations and rights awarded to each. Otherwise, an options contract would be heavily one-sided and, unless for altruistic reasons, no seller would enter into such a contract. Indeed, the buyer of an option pays the seller of the option a price (called the "premium") that represents the monetary sum that the seller requires in consideration of the state of subjection in which he is placed. On the other hand, since the buyer of the option is entitled to decide whether or not he will exercise the purchase or sale underlying the contract he is restricting his potential loss to the value of the premium paid for the option. This means that if, at the time of exercise, the buyer of the option is able to undertake the deal at a price better than the prevailing spot price he will not exercise the option and will merely lose the premium. If, on the contrary, the spot price is less attractive then the buyer of the option will exercise it, and take the inherent gains.

In simple terms it could be said that, when compared to all other kinds of forward trading, options enable one of the parties to restrict potential losses without sacrificing possible gains. This is the major - though not the only - factor distinguishing options from futures and it is the main reason for the success of this instrument, despite the fact that it is a relative newcomer. Indeed, trading in options on organised markets began just in 1973; however, since then, the number of markets dealing in options has risen sharply. There are now 28 markets in America, 19 in Europe, 9 in Asia and 4 in Oceania in which options transactions have been institutionalised.



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