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FCA Paper 2: Derivatives > CH2: Underlying Markets > Flashcards

CH2: Underlying Markets Flashcards

12/100 questions

1
Q

What are underlying markets

A

Cash markets

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2
Q

3 main interest rate benchmarks

A
  • Sterling Overnight Index Average (SONIA) - Overnight interest rate paid by banks fr unsecured GBP transactions.
    Calculated by: major fin institutions send details of all transactions from the previous day before 07:00 GMT, bank checks the info is valid, publishes SONIA at 09:00 GMT
  • Euro Short Term Rate (€STR) - EU version of SONIA. Based on overnight unsecured borrowing exceeding €1 million by banks in the EU from the previous TARGET2 business day
  • Secured Overnight Finance Rate (SOFR) - USD denominated IR for loans and derivatives. based on the 1 day repo rate on US treasuries.
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3
Q

Risk implications of unsecured short term IRs

A

These markets are based on confidence with little guarantee that the amount due will be paid.
* If confidence is lost, the cost of borrowing will increase substantially if it is available at all, which causes huge issues for firms relying on short term financing.

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4
Q

Treasury bills - UK and US maturity period

A

AKA T-Bills or promissory notes.
* Issued by several governments (issued by DMO in the UK) to cover liquidity requirements.
* 91 day maturity period typically, some are at 182 days - UK
* In the US, 28 day, 3 and 6 month T bills are issued.
* Zero coupon, issued at discount to par, redeemed at full nomianl value. Used to measure risk free rate.

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5
Q

Certificates of Deposit

A
  • CDs are promissory notes from banks
  • Offered to investors with savings deposits paying a fixed IR if the investor redeems the certificate in a set amount of time.
  • Withdrawing the funds early = pentaly for the investor
  • maturities most common between 3 and 6 months
  • Recieve nominal + interest rate at maturity
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6
Q

Commercial papers

A
  • CPs issued by large fin institutions as a short term borrowing facility.
  • Unsecured
  • 2-9 months maturity with min denominations of $500K
  • IR paid depends on market conditions and the issuing firm’s credit rating
  • US has the largest CP market
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7
Q

F

Foreign Exchange

A
  • Global OTC global currency market
  • 24 hour trading in weekdays until 21:00 on Friday
  • London, NY and Tokyo are global hubs
  • Huge trading volumes, high liquidity
  • geopgraphically dispersed
  • broad variety of factors affecting exchange rates
    *
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8
Q

The spot FX market

A
  • OTC
  • T+2 settlement in wholesale mkts
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9
Q

Forward FX market

A
  • Priced using the forward rate which considers the spot rate, length of the contract and interest rate differentials between the base and quote using STIR
  • Mainly used to specualte on IR movements due to the impact of IR differentials in pricing
  • Quoted using forward points. Forward points are subtracted from the base:quote spot bid/offer prices.
  • Quoted as (bid points,offer points) and the bid points will always be a bigger deduction than the offer points - AKA discount for forward delivery
  • When the base is more expensive than the quote in the future the forward points are added to the spot rate AKA premium for fwd delivery
  • Designed to elimate arbitrage between a fwd contract and trading spot and holding the currency
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10
Q

Forward contracts use in reducing translation risk

A

translation risk = risk of loss when converting a foreign currency back into the domestic currency due to exchange rate movements.

Forwards lock in the price of the currency now for the future so will eliminate this risk.

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11
Q

Premiums and discounts

A
  • Interest rate parity suggests that teh currency with the higher IRs will have the weaker exhange rate in the forward market compared to the spot mkt.
  • Premium and discount refer to whether the forward is greater/lesser than the spot rate
    *
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12
Q

Non deliverable forwards (NDFs)- time period, fixing date, settlement date

A
  • Cash settled short term forward FX contract on a thinly traded/non convertible foreign currency
  • The profit and loss is determined by taking the difference between the agreed exchange rate at the start of the contract and the spot rate on teh settlement date.

All NDFs have the 2:
1. Fixing date - date when the difference between the prevailing mkt exchange rate and agrred exchange rate is calculated (price of the contract is fixed)
2. Settleemnt date - payment of the difference is made to the party in profit.

typically quoted between 1 month and 1 year and settled in USD (GBP and EUR are optional).

gives access to less traded currencies like chinese Yuan.

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13
Q

Interest rate parity and forward fx rates rules and relationship with IRs

A

Due to arbitrage, IR and spot FX rates are directly linked. If IRs are not reflected in forward rates there will be a guaranteed profi for an investor.

  • Higher IR currency in the pair is sold at discount in the fwd market
  • Lower IR currency is sold at premium in the fwd mkt

If the contract is less than a year you need to consider day count conventions (30/actual etc).

Inflation can also affect FX spot and fwd prices but is usually considered in the IR of a country so only shocks really affect the exchange rate

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14
Q

Currency pair day count conventions for EUR and USD

A
  • EUR and USD both use Actual/360
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15
Q

Forward rate calculation

A

Forward rate=
1+(IR of quote x period of time)
Spot rate X —————————————-
1+(IR of base x period of time)

P61 is example

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16
Q

Government bonds -

A

Issued by govts to finance the shortfall in their budget. Called Public sector net cash requirement in the UK (PSNCR).

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17
Q

UK GOV bonds - name of bond, coupon freq., maturity, settlement time

A
  • Gilts
  • Coupon = semi annual
  • Maturity=up to 50 years
  • Settlement T+1

Have also issued green gilts in 2021 to finance public projects with positiive environmental benefit

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18
Q

US GOV bonds - name of bond, coupon freq., maturity, settlement time

A
  • Name - T-bills and T-bonds
  • Coupon - Tbills= up to 10 years, T-bonds=over 10.
  • Coupon = semi annual
  • T+1 settlement
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19
Q

France GOV bonds - name of bond, coupon freq., maturity, settlement time

A
  • Name - OATs
  • Annual coupon
  • Up to 50 years maturity
  • T+2 settlement
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20
Q

Germany GOV bonds - name of bond, coupon freq., maturity, settlement time

A
  • Name - schatz, bobl, bund
  • Coupon is annual
  • Maturity
    1. Schatz = 1.75-2.25 years
    2. Bobl= (4.5-5.5 years)
    3. Bund = 8.5 - 10.5 years
  • Settles T+2
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21
Q

Italy GOV bonds - name of bond, coupon freq., maturity, settlement time

A
  • Name = BTP
  • Semi annual coupon
  • 3-30 year maturity
  • T+2 settlement
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22
Q

Japan GOV bonds - name of bond, coupon freq., maturity, settlement time

A
  • Name = Japanese govt bond (JGBs)
  • Semi annual coupon
  • maturity
    1. long = 10 years is most common
    2. Super long = 20 years
  • Settlement is T+1 domestically and T+3 cross border with other countries
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23
Q

Government bonds maturity classifications

A

govt bonds are classified by their remaining date until maturity. In some markets:
* Short bonds = less than 7 years until maturity
* Medium = 7-15 years
* Long = 15+ years

Exact classifications vary by country as some countries have century bonds (100 years to maturity) and others have undated bonds that do not mature.

24
Q

Floating rate notes and Index linked

A
  • FRNs - coupon is linked to the current interest rates
  • Index linked bonds - coupon and nominal increase in line with an inflation index like the CPI or RPI.

ILBs have an indexation lag meaning the coupon/nominal of the bond reflects the inflation rate of a previous time period. This is useful as it allows the bond to be adjusted in it’s final coupon interest leg (for gilts, the last 6 months).

In the UK, gilts issued before 2005 have a 8 month indexation lag. After 2005 is 3 months

Inlfation will noot be refelcted in the final stages of the interest period.

25
Q

Sovereign Euorbonds - why beneficial

A

Issued by govts in any currency other than the issuing country’s domestic currency.

These are beneficial for countries with high IRs and allows them to pay the lower rate associated with anotehrr currency

26
Q

Credit ratings

A

See page 65 for inv grade, speculative and default scors

27
Q

Yield spreads

A
  • Compares the difference in quoted rate of return of 2 bonds with similar maturity times
  • Calculated by subtracting the yeild from Bond A from the yeild on bond B.
  • Show the level of risk in investing in 1 bond over another. wider spread=greater risk
    *
28
Q

The yield curve for bonds

A
  • GRY on the x-axis and time to maturity on the y.
  • Shows the relationship between returns/coupon rates and the length of the bonds
  • normal yeild curve - investors have a liquidity prefernce so accept lower IRs on short term bonds in return for liquidity. They demand higher IR on longer dated bonds.
  • inverted yeild curve - downward sloping where IRs on short dated bonds exceed long dated due to an expected significant IR cut in the future. Investors prefer the returns over liquidity
  • horrizontal yield curve - short term and long term rates are the same, happens when a govt temporarily raises short term IRs and the market does not reflect the change in mid/long term.
29
Q

Corporate bonds

A
  • Maturities of at least 12 months (usually)
  • Can be issued in any currency and listed on major exchanges or electronic communications network (ECNs). Despite this, most corp bonds are traded OTC.
  • Pay higher coupons than govt debt due to higher default risk
30
Q

Ordinary shares (equity) rights

A
  • Recieve dividends when paid
  • Repaid last if a company is wound up
  • Voting rights
  • Advanced notice of company meetings
  • Right to subscribe to a rights issue (pre-emption rights)
  • sell or transfer shares without restriction
31
Q

Partially paid shares

A
  • Investors buy a companies shares for less than their true value.
  • The company is able to request investors pay the remaining amount at a later date to provide further funding for the company
32
Q

Preference shares rights

A
  • recieve dividends first, before ordinary shares
  • Repaid their capital before oridnary share holders if the firms goes tits up
  • do not carry voting rights
33
Q

Different types of pref shares

A
  • Cumulative/non-cumulative - pays holders previous years unpaid dividends .
  • Participating - holders participate to recieve more dividend payment. This is made after the normal dividend payment is made to pref holders.
  • Redeemable - the issuing firm can repay the shareholders a pre determined price at a specified future date or dates
  • Convertible - offers preferential rights and the option to convert into ordinary shares
34
Q

Warrants - conversion ratio, sold with what other instruments

A

Gives the holder the option to buy a firm’s underlying shares at a fixed priced, which is usually more than the cost of the share at the time of issue.
* usually traded privately but some exchanges trade them like HK stock exchange and Deutsche Boerse
* Usually sold alongside a corporate bond. If exercised the corporate bond will continue to exist (unlike convertible bonds). The attachment of a warrant, usually justifies a lower coupon on the corp bond and almost represents a premium for the option of the warrant
* Classified as american (exercised at any date) or European (exercised on expiry date only)
* Conversion ratio=number of warrants required to buy one share. For example if it is 3:1, you need 3 warrants to buy 1 share.
* High conversion ratio=low share price
* Can be adjusted to reflect corporate actions
* Mainly OTC

35
Q

Gordon Growth Model (GGM) valuation method - calc and disadvantage

A

AKA dividend discount model. Tries to determine a share’s value based on he forecasts of it’s future dividend payments, assuming they grow at a constant rate. uses a discount rate to calculate present value.

Share value = Value of next year’s dividend /
(constant cost of equity capital - constant growth rate in perpetuity)

Can make mistakes as firms rearely grow at a constant rate and making assumptions for the discount rate are tough and subjective.

36
Q

Earnings per share calculation

A

EPS = Net income for the financial year - dividends on pref shares /
Number of ordinary shares in issue

Measures a firms profitiability as a whole and not just dividend payments as firms can retain profits, making dividends innacurate mesaure of performance.

37
Q

earnings yield calculation

A

Earnings yeild % = EPS / Share price

Measurs comparitive strength of earnings compared to other firms

38
Q

PE ratio

A

PE ratio = Market price per share / EPS

Useful because
* Can be more useful to analyse a share’s performance based on it’s earnings than the dividend
* Useful for comparing 2 companies
* Shows how risky the shares are to invest in, i.e. a low PE ratio indicates that a company is struggling and recovery is uncertain. High PE ratio shows a low market perception of risk

Price to book and price to cashflow ratios are similar

39
Q

Net asset value per share

A

NAV= Assets - Liabilities
*everything is owns-everything it owes

NAV per share= (assets-liabilities) / No. ordinary shares in issue.

Can be innaccurate if a company has a lot of money tied up in employing people, marketing, skills etc as they are not recorded as assets so industries like this have lower NAV/share.

Very useful for companies with lots of assets

40
Q

Types of corporate action

A
  • Rights issue - offer made to exisiting shareholders to purchase additional shares in the company at a discounted price. Rights are transferable. Seen by the market as an emergency cash grab but can be used to reduce dilution of shareholders etc.
  • Bonus issue - AKA capitalisation/script issue - new shares are issued to exisiting share holder, they do not have to buy them. Given more shares as an alternative to paying dividends sometimes. Short term price fall but = liquidity in the long run
  • Stock split - increaes the number of shares in the market by a specific ratio e.g. 2:1 which reduce the price by the same ratio. This can make expensive shares more marketable
  • Reverse stock split - share price is too low and share are combined in a set ratio e.g. 1:2, increasing the price. Distressed companies can do this to avoid delisting
  • Mergers and acquisitions - hostile takeovers are more expensive
  • Share buy-backs - uses spare cash or borrrows it to buy it’s own shares. done in an announced tender (more expensive) or in the mkt. This lifts the market price as the supply of shares shrinks
41
Q

Commodities - 3 main groups

A

Raw or primary product split into 3 catagories
1. Agriculture and softs - wheat, corn, livestock. Softs are not considered staple sources of food, coffee, sugar, cocoa, cotton
2. Energy - crude oil and refined products, O&G, renewable energy
3. Minerals - refined metals, precious metals

Some commodity prices are affecting by third party factors like weather and growing cycles etc.

42
Q

Main commodity derivative markets

A
  • CME group - CBOT for agri, COMEX for gold and base metals, NYMEX for O&G. electronic trading platform=globex
  • Euronext derivatives - agri
  • Dubai Mercantile exchange - crude oil, jet kerosene, fuel oil
  • ICE - crude oil, iron ore, refined energy, naturla gas, softs
  • LME - Base metals and some precious, steel rebar, electric vehicle related metals and minor metals like cobalt
  • TOCOM (tokyo commod ex)- base metals, oil, rubber
  • Dailian commod ex (DCE) - coking coal, coke, iron ore, plastics
  • MCX (india) - soft and agri, gold, ferrous metals, base metals, energy
  • Shanghai futures ex - all metal types, inndustrial inputs (rubber), energy
  • Jakarta futures ex (indonesia) - gold, palm oil, coffee, cocoa
  • European climate exchange (ECX) - environmental contracts
43
Q

Softs and agricultural commods

A

Influenced mainly by supply and demand.
* Demand is driven by certain nations having a deficit of a certain commodity. wealth of a country, economic growth and consumer tatses also have a large impact here
* Supply is the amount of the commod available in the mkt. based on weather, gorwing cycles, crop yeild for softs

The greater numebr/diversity of sources of a commodity makes supply more stable.

Govt/political factors can affect S+D, like indian sugar export subsidies.

44
Q

Base and precious metals

A

Trading for base/precious metal derivatives is concentrated into the LME, CME group and teh Shanghai Futures Exchange (SHFE) which compete with pricing on an increasing number of metals.
* Prices are driven by S+D
* Supply is affected by availability of the raw material, cost of extraction compared to profit, taxes and regional restrictios
* Deamand drivers - underlying uses for the metals (e.g. electric cars have boosted lithium demand), global econ and trade cycles, producers of the materrals also use the derivs mkt to hedge against price movements in production.

  • Have holding/warehousing costs associated with taking delivery.
  • Packaging metals like tin and aluminium are influenced by other alternatives like plastics
45
Q

Ferrous and non-ferrous metal examples

A

Ferrous
* Iron ore - makes stell
* Steel (hot-rolled coil) - construction/manufacturing
* Steel (rebar) - construction

Non-ferrous
* Aluminium
* Cobalt - lithium ion batteries
* Copper - electrics
* gold - computers, electrics
* lead - batteries
* molybdenum - steelmaking
* Nickel - producing stainless steel/other alloys
* palladium - catalytic converters
* platinum - cars, medical stuff
* silver - jewlery, computers
* tin - packaging
* zinc - galvanising, brass production

46
Q

Oil and gas - what is the largest O&G Mkt

A
  • Oil is both crude and in refined forms
  • Supply is finite - countries with excess export to countries with deficits. OPEC is an organisation that can control supply in the market
  • Demand is driven by consumption and energy needs
  • ICE is europes largest O&G exchange
  • political circumstances have a large impact as well
47
Q

Crude oil - 3 main classifying features

A
  • Field of origin - e.g. Brent, West Texas, Dubai, Oman
  • Density - low denisty=light, high density is heavy
  • Sulphur content - low sulphur (0.5% or less sulphur)=sweet, high sulphur = sour (more than 0.5%)

The international maritime organisation (IMO) has lowered the global limit on sulphur fuel oil (AKA bunker fuel) has been lowered from 3.5% to 0.5% to try and reduce emmissions

48
Q

Delivery features of O&G for WTI futures

A
  • For West Texas Intermediate futures contracts, the investor has to name a warehouse/storage facility within the US instead of a port.
  • In 2021 WTI had an incident where storage facilities were very scarce so storage prices were very high. Investors had to be sure to close out futures prior to expiration to avoid huge storage costs.
    *
49
Q

OPEC and other ‘producer organisation’ groups

A
  • Opec is a cartel where an oligopoly has member firms that collude to fix a minimum price.
  • OPEC have an agreed production limit to ensure this price is maintained and their success is based on members adhering to this.
  • Countries refusing to sell/buy from other countries can impact the price of oil. e.g. russian gas/oil embargo
50
Q

Natural gas main futures contracts and facts

A
  • CME Henry Hub
  • ICE dutch TTF
  • ICE UK NBP
  • natural gas has seen high price volatility since Russia/Iran sanctions from the West have limited supply of the resource.
51
Q

Electricity futures exchanges

A
  • Traded on ICE and CME group.
  • Usually grouped with energy futures but they are different as they are manufactured products essentially. Pricing is different as well
52
Q

Crypto assets

A
  • Crypto can be cryptocurrencies or Non-fungible tokens (NFTs).
  • Cryptocurrency is a virtual currency that is decentralised, operating through a distributed ledger (blockchain) where transactions are verified and mining occurs.
  • Started to become more regulated since 2016. In 2018 the SEC and CFTC required registration of crypto exchanges operating in the US.
  • CME launched bitcoin futures in 2017 and options on futures in 2020. Ether futures were created in 2021.
53
Q

6 main crypto currencies and coins/tokens differences

A
  1. Bitcoin - BTC
  2. Litecoin - LTC
  3. Ehtereum - ETH
  4. Ripple - XRP
  5. Bitcoin cash
  6. Ethereum classic

2 types of cryptocurrency are coins and tokens. Coins have their own blockchain and tokens have an algorithm that sit on top of the blockchain.

NFTs are recent developments and represent an digital asset that are designed to be rare and therefore derive their value from that.

54
Q

Weather dereivatives

A
  • Contracts that enable businesses to hedge against loss caused by unexpected losses from weather conditions.
  • The buyer buys the underlying weather index measured in heating degree days (HDDs) or cooling degree days (CDDs) which measures how hot/cold the temperature is on a given future date.
  • Settlement price of the underlying weather index is equal to the month’s HDD or CDD value multiplied by $20.
  • Weather forecasts influence prices short term and unexpected weather shocks the markets
  • First released in 1997 but due to demand was issued on many exchanges in 1999
55
Q

Emissions derivatives

A
  • Growing environmental concerns have caused many exchanges have contracts for carbon dioxide, sulphur dioxide, methane and nitrogen dioxide emissions.
  • Contracts set a price for a set amount of emmissions allotments
  • CO2 emission allowances are the most popular contract, called carboon credit ceritificates.
  • An example of CO2 contracts are European Union Allowances allow the holder to emit 1 tonne of CO2.
  • ICE offers trading EUA futures as well as physically delivered California (US) carbon offseet futures
  • CME trades Global Emissions Offset Futures
  • As regulations on emissions get strciter, the price is expected to rise
56
Q

Freight derivatives - FFAs, 4 CHs.

A
  • freight forward agreements (FFAs), container freight swaps and options are examples of derivatives with the UA being freight rates or an equivalent freight rate index
  • FFAs are traded OTC through brokers on Forward Freight Agreement Brokers Association (FFABA) but screen trading has become more popular.
  • Supported by 4 clearing hoouses: NOS clearing, ICE futures EU, NYMEX, SGX
  • Primarily used by ship owners/operators, oil companies, trading firms and grain houses to hedge freight rate risk - earnings from selling freight based on the underlying freight rate prices
57
Q

Volatility index

A
  • CBOE introduced the volatility index (VIX) as a market indicator of volatility based on the market’s view of the S&P 100 index options
  • In 2003 the UA on the VIX was changed to the SP500
  • 2004 - CBOE launched VIX futures which inspired other volatility futures/options
  • Variance swaps began in 2000 as well as other exchange traded products

FCA Paper 2: Derivatives (9 decks)

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