FM comprises of a group of people or FM Obj •Aggregation & allocation of capital; • Regulation-exogenous constraint-translate laws into

institutions who come together to search and Aggregation & allocation of risk – Diversification, rules& regulations & ensure their compliance; Set
transact, in an organized or unorganized setup, Hedging; •Liquidity and consumption smoothing - guardrails for financial market ops; create level playing
field for participants; Protect small, unsophisticated
to achieve some financial objectives through Moving consumption over time through saving and
participants; Guard against fraud or market
exchange of money and/or assets (financial or borrowing, enabling conversion of assets to cash;
manipulation. Financial innovation endo opp. -Address
real), using standardized or custom contracts •Separation of ownership and control; a latent need in the real economy; •Efficient
that are enforceable under a defined set of Supporting F/W 1. Accounting 2. Legal/Regulatory – aggregation or disaggregation of resources and risks;
rules and regulations. B + U → Both Exo & Property rights & enforacbility; speed & fairness in •Efficient matching; Price-Good mkt produces good
Endo U → Exo; DM → Time & Cost IM → Price adjudication; Ask – Higher than bid; Lowest price price, good estimates of expected risk & returns for
discovery, Transparency, Stability, Reliability among sellers; Bid – Highest price among buyers participants; Returns only for “Undiversifiable risk”
Informed Traders- Trade when prices differ Dealers – Buy from sellers at bid & sell to buyers at offer; Limit orders-Post when liquidity is costly (large (CAPM)
spread); Market orders-Demand immediacy & opp.
from estimates of fundamental values; action they set bid-ask (price); provide liquidity/immediacy to to fill at or better than specified price; offers liquidity to To trade; buy at or above offer; sell at or
makes prices more efficient; higher proportion impatient traders; small size-mkt makers; large size-block mkt orders & opp. To trade; Little price impact; Priority – below bid; Price impact (moves prices as
of public info, lower prop. Of IT. Places mkt facilitators; profit by trading with UT; Primary – Price (Buy (sell) LO with highest (lowest) price); execution can happen at multiple prices);
orders to take adv. Of pvt. Info quickly; Rational Responses-•Information asymmetry- Moral Secondary – Size/Time- Meaningful only if tick size is If there are lot of informed traders, spread
Value/News/Tech traders/arbitrager Parasitic
hazard (incentive compatible contracts); Adverse large; New LO – 1. Behind mkt (below bid/above offer) 2. increases; lot of uninf. Trades, mkt moves
Traders – trade when they expect others to
selection (signalling mechanism, 3rd party credit rating) At the mkt 3. Inside the mkt (B/w bid & offer); 2&3 around a lot; vol. increases;
trade; Real info(Order anticipators)– 1. Short
squeeze 2. Front runners; False info(Bluffers)- •Externalities (proper tax structure) Irrational -1. marketable; LO – Buy at or below LP; sell at or above LP; Cost of trading – RT trade = (offer-bid); One
leg = 0.5* (offer-bid); Mkt orders pay the
Price manipulators; Profit at expense of both IT Individual bias- •Anchoring & framing bias •Loss aversion Limit buy – selling put option; Limit sell – selling call
& UT; Profit motivated-Spec&Dealers (disposition effect – sell assets that increased in value & option; with zero premium; value depends on Tick size; cost for demanding & LO earn the spread
Speculators
Order driven–mkt
IT, UT&Parasitic
- •Traders place orders; keep assets that lost value); 2.Group bias •Herding Post LO when liquidity is costly & MO when it is cheap for supplying liquidity
Price Discovery-1. With trading -Resets after every (Spead) Spread compensates dealers for 1. Inventory Holding and ad
•Orders are arranged in queues using priority
trade/order; traders reveal info. Through their costs 2. Adverse selection component – Losses due to tradin
rules;•Buyers and sellers are matched in
order & trade; IT buy (sell) when prices are low
batches (uniform prices) or continuous with IT; higher the proportion of IT, higher the AS componen
(high);P(A/B)=P(B/A)*P(A)/P(B/A); Post-trade Prob.
manner(may diff. prices) Quote Driven – Spread, therefore spread rises; Eg: IT proportion rises just be
EV after buy order = P(High/Buy)* VH+ P(Low/Buy)*
Dealers supply all liquidity; they set bid-offer & earnings announcement to make use of pvt.info with them,
VL → ASK EV after sell order = P(High/Sell)* VH+
no wait time for traders; competition affects spread rises; IH cost rises just before mkt closes as dealers lik
P(Low/Sell) *VL → BID; 2. W/o trading – Resets
spread; monopoly/ collusion widens spread; go home flat;
after new info; Eg: Mkt opening SELL
need capital to manage inventory; most like to Measures of Price Discovery: 1. PIN 2. Adverse selection com
go home flat; inventory risk – acc. Of either 2 Types - 1. Over time within same mkt 2. Across
of spread 3. Vector auto regression 4. Information shares 5.
buy/sell only; uses price as lever to attract the mkt at same time; Variance ratios
side he wants; Amihud’s Illiquidity – Upper bound diagram Transaction Costs •Contractual cost (commissions
Market is Liquid if 1. uninformed traders Factors affecting liquidity - •Security characteristics - Volume of shares needed to and fees); •Market impact - Difference between
can(Who) 2. quickly(Immediacy) 3. buy or sell ▫Degree of asymmetric information; Large cap (more move prices by 1%. For trade price and underlying fundamental value at the
(Symmetry) 4. large size(Depth) 5. at low uninf. Traders) vs small cap; •Trader characteristics - Reliance, 1 Mn. Shares. For time of trade; •Fundamental value is an imaginary
transaction cost(Width) Dimensions – Width ▫Informed or uninformed (more liquid); •Market small company, it will be variable, but proxies can be used Eg: •Average of bid
(CPU), Depth – size at given cost, Immediacy – structure- ▫Competitive markets ▫Incentives for lesser. Upper bound for and offer (mid-quote) just before trade, etc. Loss in
Time to org. a trade, Resiliency – Time taken by traders who offer liquidity; •Recent trade history - transacting any company’ Commonality – Stocks profitability & Lost opp. cost (for larger orders);
mkt to bounce back from an uninformed trade; ▫Order imbalances; Liquidity measure - Volume- stock – concave curve; that are liquid and Liquidity & CoC – Expected higher returns for less
Given more time, we can find 1. Better prices based: •Absolute trading volume •Turnover •Trading beyond inflection, better off suddenly become liquid stocks; small cap stocks – high spread- less
& greater sizes; P(trade) = f(Size, Cost, Time); frequency •Amihud’s Illiquidity Measure Price-based: moving to take over market illiquid, because of liquid – high returns; IPOs with higher secondary
E(Cost) = f(Size, Time); E(Time) = f(Size, Cost); •Variance ratios; Cost-based: •Bid-ask spreads instead of trading in contagion mkt liquidity, have lower under-pricing; Liquidity is
E(Size) = f(Cost, Time); (quoted & effective) •Depth •Market impact secondary mkt. systematic risk that cant be diversified
Volatility - Unexpected change in price (total volatility) 1. Measuring Volatility from historic data- Implied Volatility–Forward looking; Circuit Breakers - Primary:•Trading
due to new information about the underlying fundamentals 1. Standard deviation of price changes inferred by equating observed mkt halts upon breaches in price/index
– fundamental volatility or good volatility; “Permanent” (returns) 2. High-Low Range 3. Garman- price to its theoretical price, not limits; ▫Freeze trading (coordinated
effect on prices (therefore are not “mean-reverting”) 2. due Klass Estimator (H-L-C-O estimator) directly observable; Why smiled vol?1. ITM Call across venues); Secondary: •Trans.
to temporary trading pressures- transitory volatility or bad 4.Percentage of days (in a rolling period) Because of assumed distribution in taxes, •Increased margins,•Unwind
volatility; “Temporary” effect on prices (therefore are when prices went up or down by ‘x’ % model to calculate implied vol 2. Risk positions; Individual Stocks – 1.
“mean-reverting”; cause negative price serial correlation; LT volatility = ST volatility *sqrt(𝑇) char. Changes when Deep in ITM/OTM Strike Price
Price limits 2. Qty limits

CIV – Pools savings across investors and invests in Open ended - buy & sell units on a continuously; NAV = Daily value of all assets/no. of units O/s MF Fees/Expenses What you can see easily 1. TER -
a wide variety of assets with varying risks; allow investors to enter & exit as per convenience; - Disclosed daily; investor enter/exit at recent NAV ▫Asset management fee - Capped at 2.25%for equity
economies of scale & scope & professional mgmt. # of outstanding units goes up or down every time MF alpha = MF return –Benchmark return, (for funds &2% for debt funds on AUM; Additional 0.30%
Types - Actively managed - •Mutual funds, fund house sells or repurchases the existing units index MF, we call this “tracking error”); Sources - trail fee for rural penetration; Various admin fees; All
•Hedge funds •RE investment funds • VC funds • Closed ended - unit capital of closed-ended funds •Security selection – high SS component in alpha commissions to be paid only as trail and only out of the
PE funds; Passively managed - •Index funds - is fixed & they sell a specific number of units, but •Market timing- choosing when to allocate which scheme funds; 2. Entry and exit loads; What you
tracks a particular market index •ETFs- Listed on list closed-ended fund on exchange; trade at asset •Superior execution – minimize costs like cannot see easily – 1. Trading commissions that are
exchanges just like stocks, they are highly liquid: premium or discount to the NAV depending on mkt impact •Lower cost structure; Risks - 1. Mkt deducted from NAV - Capped at 12bps for cash & 5bps
can be bought & sold throughout the trading day the investors’ expectations; risk (systematic) 2. Investment 3. Asset & fund liq. for derivatives, 2. Admin expenses deducted from NAV
Advertised vs Actual returns - weighted avg. Hedge Funds – Zero capital by balancing long- HF Additional sources of Alpha – 1. Relative valuation 2. Event
HF
return – captures timing of entry of new investors short, risk-free returns. Commingled and prediction 3. Liquidity provision; Benchmark return for HF is LIBOR
– this is what investors should care for; simple Separately managed funds – Based on whether HF (because of risk-free return); HF Fee – Base 2% of AUM; Perf based
geometric avg return – does not capture that; Read more at: – 20% of profits; Watermarks – FM can only take incentives (perf
pools investors’ funds and manages collectively or
Portfolio churning – Agency costs of 1. Fund individually manages; (SMF enables investor to based) only if previous losses are covered; Extra risks in HF – 1.
//economictimes.indiatimes.com/articleshow/150 MF – in single liquid asset class
Cpty risk – MF trade in Exchange Traded instruments, so they have
managers 2. Distributors; Tracking error – Origin – quickly take over the underlying assets in case HF
78666.cms?from=mdr&utm_source=contentofint clearing houses. But HF trade in instruments for which there is no
1. Management fee (no mgmt. fee for index) 2. performance goes bad. But for a FM, SMF adds
erest&utm_medium=text&utm_campaign=cppst market/less liquid. So high, cpty risk; 2. Leverage risk – For 1 unit
Reconstitution of index (Lag by FM to track the cost as he has to manage investor individually). HF MF – mainly in long only strategies
same); Closeted fund – Sold as active but actually NAV not disclosed daily, maybe quarterly; of capital, balance sheet is 7-14 times; Prime brokers – PB provide
index; Style/Scope drifts; Window dressing perf- Why should company seek public mkt? Trade off capital and other services (Advisory, brokerage, clearing). Problem
Sensitivity to good perf. Is less than that of bad b/w capital & control. Issues with Private Equity with PB – Ramifications would be much higher if a large PB drops
Read more at:
perf. MF moves assets from good performing Weak regulatory & informational env. for PE; out of an asset→ PB are heavily regulated. Mandate Drift – Inv.
schemes to bad ones search costs are high – pre-transactional info.
//economictimes.indiatimes.com/articleshow/150 might have a mandate based on home country regulations
Equity – Valued as going concern, Residual claims Asymmetry is high (networks & reln. Mitigate Underwriter -Buys securities from the issuer and Quiet Period
78666.cms?from=mdr&utm_source=contentofint
(payoff similar to call option, strike price = debt) adverse selection); Agency cost are high – Due sells them to the public; Firm-commitment &
erest&utm_medium=text&utm_campaign=cppst
Valuation 1. Based on historic values – Book/ diligence, mgmt. control, contract to mitigate Best efforts; Services- Certification, Book build &
replacement/liquidation – Only diff. b/w moral hazard; liquidity costs are high – exit Allocation, Price stabilization, Market making &
replacement and liq. values is replacement is strategy is through buyouts or public offers); key Administrative; Book Build – Process to gauge Investor Protection – Regulatory constraints
results on PE demand, investors provide qty & price they are
calculated as going concern. Higher than liq. Value Read more at:: On avg, they don’t create excess
2. Fundaments/Intrinsic – DCF, Dividend 3. Mkt returns (to the market). There is persistence in willing to pay to construct demand curve. Open
the above-average performance of some funds. book building – Demand curve is shared with
prices-price multiple(comparable); Intermediaries //economictimes.indiatimes.com/articleshow/150
PE investors in US can also trade unregistered investors pre-IPO. Enables transparency, Initial underpricing = Closing Price at Day 1 – Offer Price
•Info about issuer- Underwriter, Analysts, Brokers, 78666.cms?from=mdr&utm_source=contentofint Innovation in Equity Mkts – 1. Mkt design 2. Instruments –
securities in secondary markets. Trading in PIPEs beneficial for companies as it provides actual
Exchanges, Regulator; •Info about investors - erest&utm_medium=text&utm_campaign=cppst demand, but it forces IT to reveal their pvt. Info. Single stock & Basket of stocks 3. Intermediary – Low cost
(Pvt Inv. In Pub. Equity) through organized mkts
Book runners, Brokers; •Other- Registrar, Banker Typically, UW take 7% of deal as commission brokerage; Quality -Cost, Volatility, Resilience
Issues & Mitigation – Adv. Selection – Abuses-Alloc. In exchange for Fixed Income – Securities with less than 1 year are MM Securities Repo mkt - •Lending/Borrowing by RBI to SGLclub banks and
Analyst report, credit rating; open- commitment to buy in open mkt FI Mkt refers to life > 1 year. Mkt determines price, implies yield; primary dealers through LAF (Liquidity Adjustment Facility);
book building; reputation; exchange (laddering); In exchange for higher YCSPR = LT rate – ST rate of same issuer; CrSPR = Diff b/w yields of •Secured through G-secs(including SDLs); •Used by RBI to control
certification; Moral hazard – commission; in exchange for other same maturity b/w 2 issuers – govt and corporate; Risks: 1. Credit liquidity; 1 week to 15 days; CBLO - same as repo except it is
promotor lockups; fines & punish favours (spinning); optimism by affili 2. Inflation 3. Reinv. 4. Liquidity 5. FX risks; Info Agents – about open to non-banks & other non- SGLclub banks; Exchange traded;
ment; quiet period; Agency problems ated analysts; inequitable treatment issuer - •Underwriters; •Credit rating agencies; •Bond market CMB & T-Bills – To ease/contract liquidity; through auctions as
analysts (buyside and sellside); Info Agents – about demand - discount to face value (implied yield); CoD – Banks rise money
– Disclosure; reputation; fines; of flipping; misuse of IPO proceeds
•Investment bankers/book runners; •Brokers;•Dealers (primary quickly to meet short term liquidity mismatches; directly or at
Primary mkt for G-secs U/w will take Eurobonds - Issuers of one
and secondary market);•Exchanges and trading systems (through discount to face value (implied yield); Commercial Papers –
remaining bonds at RBI specified yieldnationality to investors of other
dissemination of trades/orders)•Investment advisors; Unsecured borrowing by corporates, requires credit rating;
Auctions are publicized & restricted nationalities (offshore mkt); Outside
4 ways to trade Sec mkt – OTC with primary dealers/FI; RBIs NDS directly or at discount to face value; to raise working capital &
to select - Large dealers allowed in juris. of any single country; Most
for SGLclub; CCIL’s NDS-OM for others; WDM segments of stock bridge financing – to meet delays in bank loans;
return for making active secondary Eurobonds are dollar-denominated
exchanges for FIs and retail investors; T+1 settle. through CCIL for Innovation – 1. Structured Products 2. Securitization – Taking a
market & provide gov with market Bond Indices – Duration controlled; large pool of debt instruments & making a security from it; 3.
G-secs & ICCL & NSCCL for corporates; Importance of trade
intel. Retail investors allowed in US; Fixing rate for OTC traded securities; New instruments & mkt.
disclosure for price discovery (e.g. TRACE in the US);
Currency mkts-Relative value mkt; reflects D&S Futures- like fwds; but MTM daily; exchange Whenever mkt illiquiduity rises, EBS volume rises; IT are now moving to elec. Systems for FX trading; Price
of a country’s o/p to another (PPP); IR Parity- traded standardiized; Risks – political & IR; discovery & Liquidity are in elec. Platform; Pips – 4 decimals (1/10000); Offshore mkts – 1. in less liquid
reserves; Transactions are conducted as if base currency; 2. taxes/ regulatory rstrictions on limits of qty & disclosures; 3. CB can intervene in onshore mkt &
FX swaps Exchange of two currencies on specific currency is being transacted; buy INR & sell prevent currency from reflecting true value → no CB in offshore, true price reflects in offshore mkts → price
date at rate agreed to at the time of contract & USD→transact at bid (give up USD); sell INR & discovery happens here for most currencies; Non deliverables are always OTC;
reverse exchange of same two currencies on buy USD → transact at ask (get paid USD); EUR, FX Trading Strategies – Carry trade; Currency momentum (buy winner & sell loser); Contrarian; short term –
future date at a rate agreed to at the time of the GBP, AUD, NZD where base is not USD; cross currency arbitrage (Inefficiencies in triangulation because of temporary liquidity or distortions), Intraday
contract; Currency swaps - Exchange of fixed or Intermediaries-Commercial banks, Sell side mean reversion; Innovation - New order types (TWAP, Fix close); New trading platforms (bank platforms,
floating interest payments in two different firms (act as brokers/dealers); buy side firms; ECNs like Hot Spot) to take advantage of technology & buy side needs to maintain anonymity - Use of PB;
currencies over the lifetime of the contract. analysts; info. Providers; exchanges & Trading Increased use of technology - Growth of algorithmic trading and HFT & Order management systems
Equal principal based on the initial spot rate is systems; Setllement; custodians; data vendors accommodating spot + swaps trades; Growth of cash-settled currency futures, especially in emerging
exchanged at beginning and close of contract. (Reuters/ Bloomberg); economies - Increase in retail participation; Increase in data transp.-Prices & qt & order book (inv. Demand)
Commodities – Swaps - floating-leg component Valuation Factos – D &S, Nature, Cost of storage & funding; Volume – Total trading activity; OI-Total # of conrcats O/S. Contago→Gold→upward sloping YC.
is held by the consumer of comm, or institution Liq. imbalance, corenering, insider trade (weak reg. till Vol & OI both increase→new players coming→asymmetry FP = SP + [Cost of fin.+storage+insurance
willing to pay fixed price for comm. fixed-leg is recent); comm price → uptick from 2016→1. Supply high volume/OI → high speculation; low→ buy & hold; A +transportation]; CoCarry >0→FP> SP;
held by the producer of the comm who agrees shocks 2. Impact of ETF & others funds; Futures Flow → buys 1 contract from B→V=1; OI=1. A sells 1 contract to Backawardation→Downward sloping
to pay a floating rate, which is determined by Investor places order with FCM (responsible for C→V=2; OI=1;C buys 1 more contract from D→V=3; OI = 2; YC→Premium for holding today than
the spot market price of the underlying comm. maintaining margins)→passes order to floor/ exchange High Liq mkts (gold)→high leverage allowed→potential for tomo→uncertainity in availability(supply
End result is consumer of comm gets broker→ trades with another broker (representing another damge by single player is limited; less liquid→less leverage; shokcs)→oil→ conevenience yield→
guaranteed price over specified period of time, customer) or prop trader (representing themselves)→Each FP-SP correlation low in India→FP&SP don’t move FP=SP+CoC-CY; → CoC-Cy <0 → FP<SP;
& producer is hedged position, protected from party is obligated to the exchange rather than to each together → contracts no standardized as much in 𝐹𝑃=𝑆𝑃∗𝑒xp (𝑟+𝑦−𝑢)𝑇 →r-fin.cost, y–
price decline; consumer buys comm. From spot other through Clearing House→MTM through adjustment west(quality concern, but does not fully explain). Spread storage, u- CY; FP will converge with SP
market with received floating payment. of margins→Settlement by offset(fin) or delivery (comm.) Trading→profit from inter-contract arbitrage due to low as time to maturity decreases→
clearing costs→ Inter mkt→Brent-WTI, Govts bond spread; Contango→FP decrease over time;
Within mkt→ Crack (crude-gasoline), crude-NG, crush (soya Backwardation → FP increase over time;
bean-meal/oil), calendar (3m-12m) spreads; Basis = SP -FP

1 Period 1 Period 2
2 Beginning fund value 10 20
3 New inflows 80
4 Return 10 -40
5 End fund value 20 60
6 # units 1 5
7 Opening NAV 10 20
8 Closing NAV 20 12
9 Return 100% -40%
10 Average return 9.54%
11 Average return for Investor 1 9.54%
12 Average return for Investor 2 -40.00%
13 Weighted average -34.50%
14 C13*(B2/(B2+C3))+C14*(C3/(B2+C3))
15 ((1+B10)*(1+C10))^0.5-1