Chapter 2 ;asset classes and financial instruments

Question 1

fixed income instruments are financial contracts with a fix duration and fixed periodical payments which the borrower promises to pay to the lender.

money market?

capital market?

Answer 1

Money market: Money market instruments with a duration of less than one year.* Banks use the money market to balance and manage their liquidity.* Commercial banks conduct money market transactions with each other on the interbank market.

Capital market: Bonds with a duration of more than one year.

Question 2

Money market debt register claims (MMDRCs)

Answer 2

MMDRCs are money market instruments with which the Swiss Confederation raises short-term funds. MMDRCs have become firmly established in the Swiss money market. As a rule, maturities range from three to twelve months. Interest on MMDRCs is paid on a discount basis, i.e. the debt register claims are issued below or above par (where par is equivalent to 100%) and repaid at nominal value. MMDRC issues are effected in the form of auctions, which are carried out by the SNB, as banker to the Confederation.

Question 3

Repo transaction

Answer 3

In a repo transaction, the cash taker sells securities to the cash provider and simultaneously agrees to repurchase securities of the same type and quantity at a later date.

(kısa dönemli bir menkul kıymetin belirli bir dönem sonunda ilk satıcısı tarafından geri alınmasını öngören bir satış işlemidir. ) Repurchase price is higher than the original price because there is interest rate.(repo rate)

The interest rate used is called the repo rate. Repo transactions are an important SNB(swiss national bank) monetary policy instrument for managing liquidity in the money market. The SNB only accepts securities which it defines as collateral eligible.

Question 4

Certificates od Deposit (CD)

Answer 4

A CD is a time deposit with a bank. The bank pays interest and principals to the depo- sitor only at the end of the fixed term of the CD. CDs are insured for up to USD 100,000. Short-term CDs are highly marketable, although the market significantly thins out for maturities of three months or more. Maturity: typically 13 days minimum.

Question 5

Commercial Papers (CP)

Answer 5

Short-term unsecured debt issued by large corporations and financial institutions. Large, well-known companies often issue their own short-term unsecured debt notes directly to the public, rather than borrowing from banks. Maturities: up to 270 days. CPs are considered to be of rather high quality. The yield on CPs depends on time to maturity and credit rating.

Question 6

Federal Funds

Answer 6

These are funds in the accounts of commercial banks at the FED. Each member bank of the FED is required to maintain a minimum balance in a reserve account with the FED. Overnight loans from one bank to another one are arranged at a rate of interest called the Federal funds rate.

Federal funds can then be lent to other commercial banks with insufficient reserves. These loans are made at a relatively low interest rate, called the federal funds rate or overnight rate, and they typically have an extremely short duration: overnight. Federal funds help commercial banks meet their daily reserve requirements.

Question 7

LIBOR

(London Interbank Offered Rate)

Answer 7

The LIBOR is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. LIBOR comes in 15 maturities (from overnight to 12 months) and in 10 different currencies.
LIBOR is watched closely, as the LIBOR rate is used as a base rate (benchmark) by banks and other financial institutions. Rises and falls in the LIBOR interest rates can therefore have consequences for the interest rates on all sorts of banking products such as savings accounts, mortgages and loans.

Question 8

Bond market

Private sector;

Answer 8

Corporate Bonds

Securitized bonds (mortgage-backed securities)

“Eurobonds”: major topic in the EU (public debt issues); bonds issued in the currency of one country, but sold in other national markets. Example: the Eurodollar market refers to USD bonds sold outside the US.

Question 9

Bond Market

Sovereign Bonds;

Answer 9

Bonds issued by governments (Switzerland) / treasuries (US) often serve as benchmarks, based on volume, liquidity and quality. Example: 10-year government bond in Switzerland.

Question 10

Sovereign Bonds;

Treasury bond

Treasury notes

Municipal bonds

Answer 10

Treasury Bonds T-bonds are issued by the Treasury with maturities ranging from 10 to 30 years. They are issued in denominations of USD 1,000 or more.

Treasury Notes T-note maturities range up to 10 years. They are issued by the Treasury in denominations of USD 1,000 or more, like treasury bonds.

Municipal Bonds Bond issued by a local government, or their agencies. Potential issuers include cities, counties, redevelopment agencies, public utility districts etc. Municipal bonds may be general obligations of the issuer or secured by specified revenues.

Question 11

Private sector bonds;

Answer 11

Fixed-rate bonds: straight bonds; most common form Floating rate bonds: bonds with coupon rates periodically reset according to a specified market rate

Zero-Coupon bonds: no coupon; no current interest payment, but lower issue price

High-yield bonds: speculative bonds; S&P rating at BB+ or lower => non-investment grade, therefore high coupon

Catastrophe bonds: these bonds are a way to transfer the catastrophe risk from insurance companies to the capital market => insurance-linked securities

Question 12

Asset backed securities (ABS)

Answer 12

ABS are pools of loans that are packaged and sold as securities – a process known as “securitization”. The type of loans that are typically securitized are credit card receivables, auto loans, home equity loans, student loans, and even loans for boats or recreational vehicles.

A financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt.

The purpose of ABS is to convert previously non-liquid assets into fixed-interest, tradable securities.

Question 13

Commercial MBS (CMBS)

Answer 13

are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely pre-payable.

Question 14

Residential MBS (RMBS)

Answer 14

pass-through MBS backed by mortgages on residential property.

Question 15

Credit Spreads

Answer 15

Credit spreads represent the difference in yield between any type of bond, and a US treasury of the same maturity. Corporate bonds, which carry a risk of default, yield more than US Treasury Bonds, which carry no risk of default.

Credit spread of a particular security is often quoted in relation to the yield on a “risk-free” benchmark security or to a “risk-free” reference rate.

**Credit spreads measure the typical risk of the credit market. **

Question 16

Bond Credit Ratings

Answer 16

..assess the credit worthiness of a company’s debt issues. Private independent rating services such as S&P, Moody’s and Fitch evaluate bond issuer’s ability to pay a bond’s principal and interest in a timely fashion.

AAA and AA: High credit-quality, investment grade
AA and

BBB: Medium credit- quality, investment grade
BB, B, CCC, CC, C: Low credit- quality (non-investment grade)

Question 17

Stocks Equities represent ownership in a corporation, contrary to bonds.

Answer 17

Characteristics:

1. Residual claims: stockholders are the last in line of all those who have a claim on the assets and income limited liability
2. Limited liability: the most shareholders can lose in event of failure of the corporation is their original investment.
   Two key types of shares

=> Bearer shares: holder = owner

=> Registered shares: issued and registered in the name of the shareholder

Question 18

Key Shareholder Rights

Answer 18

• *Property rights** Most important right in this group is the right to a dividend. Just as well, the share- holders have the right to the liquidation proceeds upon dissolution of the AG.
• *Participation rights** The most essential participation right is the right to vote at the general meeting of shareholders (AGM). The shareholder has the right to personal participation to the AGM (or to be represented), the right to speak at the AGM as well as the right to have an item placed on the Agenda. Every shareholder has to be invited in due time and has to receive an agenda. Significant shareholders have the right to call for an EGM and to have their requests placed on the Agenda for the EGM.
• *Protection and information rights** Shareholders have the right to see the Annual Report as well as the Audit Report, to ask questions to the board of directors (BoD) at the AGM and, under certain conditions, to inspect further documents of the company. Additionally, the shareholders of a Swiss AG have various protection rights, such as the investor lawsuit against the BoD, if the BoD has acted contrary to duty, or the right to appeal against decisions taken by the General Meeting in violation of the law or the Articles of Association.
• *Right to perpetuation of percentage** of shares held If the company issues additional shares, existing shareholders have the right to subscribe for these new shares in proportion to their shareholding quota in the company. For instance, if the shareholder holds 25% of the company’s shares, he is entitled to 25% of the newly issued shares.

Question 19

American Depositary Receipt (ADR)

Answer 19

ADRs are certificates traded in the US markets that represent ownership in shares of a foreign company. ADRs were created to make it easier for non-US firms to satisfy US registration requirements. Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares of the foreign corporation. Sponsored ADRs: initiated by their issuer

Unsponsored ADRs: initiated by a US custodian bank
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Question 20

Traditional Index Forms

Answer 20

Price-weighted: Dow Jones Industrial, Nikkei Capitalization-weighted: S&P 500, Nasdaq Composite Free-float weighted: SMI, FTSE 100, MSCI World Performance-Indices: SPI, DAX

Question 21

Comparison of DJIA/SMI(swiss market index)

Answer 21

Number of stocks

• SMIR Blue Chip Index: 20 securities

• DJIA: 30 US securities (NYSE).
Weightings

• SMI: Calculation based on Laspeyres (weighted arithmetic mean) via a defined selection of securities => market capitalization is being taken into consideration. • DJIA: price-weighted. Calculation: add up the stock prices of all the components and then divide that by the DJIA divisor (adjustments for splits, spin-offs).
Dividends

• SMIR: a not dividend-adjusted price index
• DJIA: a not dividend-adjusted price index

Question 22

Derivative instruments

Answer 22

• *Futures:** Futures are forward transactions. They call for delivery of an asset at a specified delivery or maturity date for an agreed-upon price, to be paid at contract maturity. The terms of the transactions are standardized.
• *Options: **The buyer of a call / put option has the right (no commitment) to purchase/sell an asset for a specified price, called the exercise or strike price at any time to and including the option‘s expiration date. For this right, a premium has to be paid

Question 23

Futures

Answer 23

Financial Futures contract: is similar to a forward contract in that it specifies that a financial instrument is to be exchanges at a future date for a specified price. It differs from a forward contract in several ways that overcome the liquidity and default problems of forward markets. Standardisation:

• Quality • Quantity • Due date • Settlement terms • Collaterals requested
Advantage: fungibility (convertibility); secondary markets

Question 24

Futures (2)

Answer 24

The futures contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. As a result, market transparency is rather high.
• The settlement takes place via a physical delivery or via cash settlement (which is more common).
• Futures positions are being re-valued on a daily basis.
• Margins: in order to minimize credit risk to the exchange, traders must post a margin. The initial margin (see chapter 3) is the equity required to initiate a futures position.
• Unlike with an option, both parties of a futures contract must fulfil the contract on the delivery date

Question 25

Options

4 different positions

Answer 25

Question 26

option price=

Answer 26

Option price = intrinsic value + time value.

Question 27

intrinsic value of option

Answer 27

Intrinsic value: can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option’s price that is not lost due to the passage of time.

• Intrinsic value call = Price underlying - exercise price,

if > 0, otherwise 0

• Intrinsic value put = Exercise price - price underlying, if > 0, otherwise 0

An option with an intrinsic value is „in-the-money“.

An option with no intrinsic value is „out-of-the-money“

Question 28

time value of option

Answer 28

An option’s time value is dependent upon the length of time remaining to exercise the option, as well as the volatility of the underlying security’s market price. The time value of an option decreases as its expiration date approaches and becomes worthless after that date.  Time value = Option price - intrinsic value

Question 29

european option

Answer 29

European option: Exercise will take place at a specific day.

Question 30

american option

Answer 30

American option: An option which can be exercised at any time between the purchase date and the expiration date. Most options in the U.S. are of this type. This is the opposite of a European-style option, which can only be exercised on the date of expiration.

Question 31

Option price is being determined by

Answer 31

• Volatility
• Price of the underlying
• Strike price
• Risk-free rate
• Term (life) of the option
• Dividend payment of the underlying

Question 32

call option definition

“buy”

Answer 32

It may help you to remember that a call option gives you the right to “call in” (buy) an asset. You profit on a call when the underlying asset increases in price.