B (describe classifications of assets and markets;) C. Asset and Market classes (describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes;)

Question 1

Asset Classes

Answer 1

Currencies: a country’s money. Traded on spot markets (immediate delivery: 3 days or less), sometimes futures and forwards markets. (US, EU, JPY, GBP, CAN)

Commodities: physical goods (industrial inputs, agricultural products, precious metals)

Securities: -Debt securities>fixed income (promises to pay money in the future as bonds, notes, mortgages, Commerical paper, CD’s, repurchase agreements):MM instruments are short term, -Equity, Public (primary issue, secondary trade), Private (not for sale on a public exchange and not subject to regulation.)

Equities Represents ownership in a firm as stocks, preferred stocks, warrants are “securities issued by a corporation that allow the warrant holders to buy a security issued by that corporation at the exercise price,”
, pooled investments ( mutual funds, ETF’s, limited partnership interests, unit funds, depository receipts)

Contracts: “A contract is an agreement among traders to do something in the future” “The values of most contracts depend on the value of an underlying asset. The underlying asset may be a commodity, a security, an index representing the values of other instruments, a currency pair or basket, or other contracts.” “Contracts provide for some physical or cash settlement in the future.” “Financial analysts classify contracts by whether they are physical (delivery of petroleum, lumber, gold) or financial (“option contracts, and contracts on interest rates, stock indices, currencies, and credit default swaps.”) based on the nature of the underlying asset. If the underlying asset is a physical product, the contract is a physical; otherwise, the contract is a financial”

Fwd Contracts

Futures Contracts

Swaps

Options

Insurance Contracts

Question 2

Contracts

Answer 2

• Contracts are agreements whose
values depend on the values of
underlying assets.
• Forward contracts, futures contracts,
swaps, options contracts, insurance
contracts

Question 3

Fwd Contracts

Answer 3

• Agreements to trade something in the
future
• Counterparty risk is the risk that your
counterparty will fail to honor the
contract.

Customized instruments, not standardized

Question 4

Futures Contracts

Answer 4

• A futures contract is a forward contract
where a clearinghouse guarantees the
performance of all traders
• The clearinghouse acts as the buyer to
all sellers and the seller to all buyers.
• A buyer can sell to any seller to net out.
• Traders often use futures contracts to
hedge risks.

Futures are forward contracts that trade on exchanges and have standardized terms, in contrast with forward contracts, which are customized instruments

A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Futures contracts trade on organized exchanges and are more liquid than forward contracts.

“A futures contract is a standardized forward contract for which a clearinghouse guarantees the performance of all traders. The buyer of a futures contract is the side that will take physical delivery or its cash equivalent. The seller of a futures contract is the side that is liable for the delivery or its cash equivalent. A clearinghouse is an organization that ensures that no trader is harmed if another trader fails to honor the contract. In effect, the clearinghouse acts as the buyer for every seller and as the seller for every buyer. “Futures contracts have vastly improved the efficiency of forward contracting mar- kets. Traders can trade standardized futures contracts with anyone without worrying about counterparty risk, and they can close their positions by arranging offsetting trades. Hedgers for whom the terms of the standard contract are not ideal generally still use the futures markets because the contracts embody most of the price risk that concerns them. They simply offset (close out) their futures positions, at the same time they enter spot contracts on which they make or take ultimate delivery.”

“To protect against defaults, futures clearinghouses require that all participants post with the clearinghouse an amount of money known as initial margin when they enter a contract. The clearinghouse then settles the margin accounts on a daily basis. All participants who have lost on their contracts that day will have the amount of their losses deducted from their margin by the clearinghouse. The clearinghouse similarly increases margins for all participants who gained on that day. Participants whose margins drop below the required maintenance margin must replenish their accounts. If a participant does not provide sufficient additional margin when required, the participant’s broker will immediately trade to offset the participant’s position. These variation margin payments ensure that the liabilities associated with futures contracts do not grow large.”

Question 5

Swaps

Answer 5

• A swap is an agreement to swap cash
flows on a periodic basis.
• Usually one cash flow is fixed, the
other various according to the value of
some underlying asset or index.

“3.4.3 Swap Contracts
A swap contract is an agreement to exchange payments of periodic cash flows that depend on future asset prices or interest rates. For example, in a typical interest rate swap, at periodic intervals, one party makes fixed cash payments to the counterparty in exchange for variable cash payments from the counterparty. The variable payments are based on a pre-specified variable interest rate such as the London Interbank Offered Rate (LIBOR). This swap effectively exchanges fixed interest payments for variable interest payments. Because the variable rate is set in the future, the cash flows for this contract are uncertain when the parties enter the contract.
Investment managers often enter interest rate swaps when they own a fixed long- term income stream that they want to convert to a cash flow that varies with current short-term interest rates, or vice versa. The conversion may allow them to substantially reduce the total interest rate risk to which they are exposed. Hedgers often use swap contracts to manage risks.
In a commodity swap, one party typically makes fixed payments in exchange for payments that depend on future prices of a commodity such as oil. In a currency swap, the parties exchange payments denominated in different currencies. The pay- ments may be fixed, or they may vary depending on future interest rates in the two countries. In an equity swap, the parties exchange fixed cash payments for payments that depend on the returns to a stock or a stock index.”

Question 6

Important Swaps Examples***

Answer 6

• Interest rate swaps exchange fixed for
variable interest cash flows .
• Commodity swaps exchange fixed
payments for payments based on
commodity prices.
• Equity swaps exchange fixed payments
for payments based on security
returns.

Question 7

Insurance Contracts

Answer 7

• Insurance contracts are agreements to
provide compensation in the event of a
loss.
• People use insurance contracts to
hedge their risks.

Question 8

Options Contracts

Answer 8

An option contract gives the holder the
option to buy or sell an underlying
instrument at a fixed price at or before
some point in the future.
– Call options are options to buy.
– Put options are options to sell.
• The fixed price is called the strike price.
• Options mature on their expiration
dates.
• Options values depend on volatility.

“An option contract allows the holder (the purchaser) of the option to buy or sell, depending on the type of option, an underlying instrument at a specified price at or before a specified date in the future. Those that do buy or sell are said to exercise their contracts. An option to buy is a call option, and an option to sell is a put option. The specified price is called the strike price (exercise price). If the holders can exercise their contracts only when they mature, they are European-style contracts. If they can exercise the contracts earlier, they are American-style contracts. Many exchanges list standardized option contracts on individual stocks, stock indices, futures contracts, currencies, swaps, and precious metals. Institutions also trade many customized option contracts with dealers in the over-the-counter derivative market.
Option holders generally will exercise call options if the strike price is below the market price of the underlying instrument, in which case, they will be able to buy at a lower price than the market price. Similarly, they will exercise put options if the strike price is above the underlying instrument price so that they sell at a higher price than the market price. Otherwise, option holders allow their options to expire as worthless.
The price that traders pay for an option is the option premium. Options can be quite expensive because, unlike forward and futures contracts, they do not impose any liability on the holder. The premium compensates the sellers of options—called option writers—for giving the call option holders the right to potentially buy below market prices and put option holders the right to potentially sell above market prices. Because the writers must trade if the holders exercise their options, option contracts may impose substantial liabilities on the writers.”

Question 9

Market Classes

Answer 9

Primary: When issuers sell securities to investors Secondary: When investors sell securities to others

Spot: Those that trade for immediate delivery, Forward

Money (markets): Trade debt instruments maturing in 1 year or less, Capital (markets): trade instruments of longer duration “whose values depend on the credit-worthiness of the issuers and on payments of interest or dividends that will be made in the future and may be uncertain”

Traditional (investment markets): include all publicly traded debts and equities and shares in pooled investment vehicles that hold publicly traded debts and/or equities. “
Alternative (investment markets) “ include hedge funds, private equi- ties (including venture capital), commodities, real estate securities and real estate properties, securitized debts, operating leases, machinery, collectibles, and precious gems. “

Question 10

Primary Markets

Answer 10

The markets in
which companies raise new capital
from investors by issuing (selling)
securities.

Question 11

Secondary Markets

Answer 11

the markets in
which seasoned issues trade.

Question 12

Spot Markets

Answer 12

markets for
immediate delivery, generally of
commodities.

$SP index = spot price, future and options Price can be bought but you can’t play the spot index itself

Question 13

Forward Markets

Answer 13

markets in which
delivery is deferred into the future.

“A forward contract is an agreement to trade the underlying asset in the future at a price agreed upon today.”

“two problems limit their usefulness for many market participants. The first problem is counterparty risk. Counterparty risk is the risk that the other party to a contract will fail to honor the terms of the contract.”

“liquidity. Trading out of a forward contract is very difficult because it can only be done with the consent of the other party. The liquidity problem ensures that forward contracts tend to be executed only among participants for whom delivery is economically efficient and quite certain at the time of contracting so that both parties will want to arrange for delivery.”

-Futures may mitigate FWD contract risk

Question 14

Money Markets (instruments < 1 year)

Answer 14

Markets for Very Short Term Debt Instruments

“Money markets” generally refers to markets for debt securities maturing in one year or less

Question 15

Capital Markets ( > 1 year instruments)

Answer 15

the markets that
provide capital to companies.

A securities exchange where traders buy and sell long-term government bonds from and to other traders

An arbitrary distinction between money markets and capital markets, because firms sell MM instruments to provide capital to companies.

Capital markets refer to markets for equities and for debt securities with maturities greater than one year

Question 16

Traditional Markets

Answer 16

Securities Markets

Question 17

Alternative Markets

Answer 17

commodities, real estate, insurance
contracts, hedge funds, … . Refer to LOS B…

Question 18

Financial Assets

Answer 18

Stocks, Bonds, Derivatives, Currencies

Question 19

The major types of assets

Answer 19

securities, currencies, contracts, commodities, and real assets.

Question 20

Security Assets include

Answer 20

fixed income (e.g., bonds, notes, commercial paper),

equity (common stock, preferred stock, warrants),

and pooled investment vehicles (mutual funds (can find depository receipts),

exchange-traded funds (can find depository receipts), hedge funds, asset-backed securities).

Question 21

Example 5: Asset and Market Classification

“The investment policy of a mutual fund only permits the fund to invest in pub- lic equities traded in secondary markets. Would the fund be able to purchase:
1 Common stock of a company that trades on a large stock exchange?
2 Common stock of a public company that trades only through dealers?
3 A government bond?
4 A single stock futures contract?
5 Common stock sold for the first time by a properly registered public company?
6 Shares in a privately held bank with €10 billion of capital?”

Answer 21

“Solution to 1:
Yes. Common stock is equity. Those common stocks that trade on large exchanges invariably are public equities that trade in secondary markets.
Solution to 2:
Yes. Dealer markets are secondary markets and the security is a public equity.
Solution to 3:
No. Although government bonds are public securities, they are not equities. They are debt securities.
Solution to 4:
No. Although the underlying instruments for single stock futures are invariably public equities, single stock futures are derivative contracts, not equities.
Solution to 5:
No. The fund would not be able to buy these shares because a purchase from the issuer would be in the primary market. The fund would have to wait until it could buy the shares from someone other than the issuer.
Solution to 6:
No. These shares are private equities, not public equities. The public prominence of the company does not make its securities pub”

Question 22

Example 6: Securities

“Securities
What factors distinguish fixed-income securities from equities?”

Answer 22

“Fixed-income securities generate income on a regular schedule. They derive their value from the promise to pay a scheduled cash flow. The most common fixed-income securities are promises made by people, companies, and govern- ments to repay loans.
Equities represent residual ownership in companies after all other claims— including any fixed-income liabilities of the company—have been satisfied. For corporations, the claims of preferred equities typically have priority over the claims of common equities. Common equities have the residual ownership in corporations.”

Question 23

Ex 7:

“Contracts for Difference
Contracts for difference (CFD) allow people to speculate on price changes for an underlying asset, such as a common stock or an index. Dealers generally sell CFDs to their clients. When the clients sell the CFDs back to their dealer, they receive any appreciation in the underlying asset’s price between the time of purchase and sale (open and close) of the contract. If the underlying asset’s price drops over this interval, the client pays the dealer the difference.
1 Are contracts for difference derivative contracts?
2 Are contracts for difference based on copper prices cash settled or physi- cally settled?”

Answer 23

“Solution to 1:
Contracts for difference are derivative contracts because their values are derived from changes in the prices of the underlying asset on which they are based.
Solution to 2:
All contracts for difference are cash settled contracts regardless of the under- lying asset on which they are based because they settle in cash and not in the underlying asset.”

Question 24

Ex 8 “Hedging Gold Production”
“An Indonesian gold producer invests in a mine expansion project on the expec- tation that gold prices will remain at or above 35,000 rupiah per gram when the new project starts producing ore.
1 What risks does the gold producer face with respect to the price of gold? 2 How might the gold producer hedge its gold price risk?”

Answer 24

“Solution to 1:
The gold producer faces the risk that the price of gold could fall below 35,000 rupiah before it can sell its new production. If so, the investment in the expan- sion project will be less profitable than expected, and may even generate losses for the mine.”
“Solution to 2:
The gold producer could hedge the gold price risk by selling gold forward, hopefully at a price near 35,000 rupiah. Even if the price of gold falls, the gold producer would get paid the contract price.”

Question 25

Example 9
“Futures Margin
NYMEX’s Light Sweet Crude Oil futures contract specifies the delivery of 1,000 barrels of West Texas Intermediate (WTI) Crude Oil when the contract finally settles. A broker requires that its clients post an initial overnight margin of $7,763 per contract and an overnight maintenance margin of $5,750 per contract. A client buys ten contracts at $75 per barrel through this broker. On the next day, the contract settles for $72 per barrel. How much additional margin will the client have to provide to his broker?”

Answer 25

“Solution:
The client lost three dollars per barrel (he is the side committed to take delivery or its cash equivalent at $75 per barrel).This results in a $3,000 loss on each of his 10 contracts, and a total loss of $30,000. His initial margin of $77,630 is reduced by $30,000 leaving $47,630 in his margin account. Because his account has dropped below the maintenance margin requirement of $57,500, the client will get a margin call. The client must provide an additional $30,000 = $77,630 – $47,630 to replenish his margin account; the account is replenished to the amount of the initial margin. The client will only receive another margin call if his account drops to below $57,500 again.”

Question 26

Ex 10 “Forward and Futures Contracts
What feature most distinguishes futures contracts from forward contracts?”

Answer 26

“A futures contract is a standardized forward contract for which a clearinghouse guarantees the performance of all buyers and sellers. The clearinghouse reduces the counterparty risk problem. The clearinghouse allows a buyer who has bought a contract from one person and sold the same contract to another person to net out the two obligations so that she is no longer liable for either side of the contract; the positions are closed. The ability to trade futures contracts provides liquidity in futures contracts compared with forward contracts.”

Question 27

Ex 11”Swap and Forward Contracts
What feature most distinguishes a swap contract from a cash-settled forward contract?”

Answer 27

“Solution:
Both contracts provide for the exchange of cash payments in the future. A forward contract only has a single cash payment at the end that depends on an underlying price or index at the end. In contrast, a swap contract has several scheduled periodic payments, each of which depends on an underlying price or index at the time of the payment.”

Question 28

Ex 12 “Option and Forward Contracts
What feature most distinguishes option contracts from forward contracts?”

Answer 28

“Solution:
The holder of an option contract has the right, but not the obligation, to buy (for a call option) or sell (for a put option) the underlying instrument at some time in the future. The writer of an option contract must trade the underlying instrument if the holder exercises the option.
In contrast, the two parties to a forward contract must trade the underlying instrument (or its equivalent value for a cash-settled contract) at some time in the future if either party wants to settle the contract.”

Question 29

Ex 13 Assets and Contracts

“Consider the following assets and contracts:
Bank deposits Certificates of deposit Common stocks Corporate bonds Currencies Exchange-traded funds Lumber forward contracts Crude oil futures contracts Gold
Hedge funds Master limited partnership interests Mortgages Mutual funds Stock option contracts Preferred stocks Real estate parcels Interest rate swaps Treasury notes
1 Which of these represent ownership in corporations?
2 Which of these are debt instruments?
3 Which of these are created by traders rather than by issuers?
4 Which of these are pooled investment vehicles?
5 Which of these are real assets?
6 Which of these would a home builder most likely use to hedge construc- tion costs?
7 Which of these would a corporation trade when moving cash balances among various countries?”

Answer 29

“Solution to 1:
Common and preferred stocks represent ownership in corporations.
Solution to 2:
Bank deposits, certificates of deposit, corporate bonds, mortgages, and Treasury notes are all debt instruments. They respectively represent loans made to banks, corporations, mortgagees (typically real estate owners), and the Treasury.
Solution to 3:
Lumber forward contracts, crude oil futures contracts, stock option contracts, and interest rate swaps are created when the seller sells them to a buyer.
Solution to 4:
Exchange-traded funds, hedge funds, and mutual funds are pooled investment vehicles. They represent shared ownership in a portfolio of other assets.
Solution to 5:
Real estate parcels are real assets.
Solution to 6:
A builder would buy lumber forward contracts to lock in the price of lumber needed to build homes.
Solution to 7:
Corporations often trade currencies when moving cash from one country to another.”