Chapter 2: Underlying Markets Flashcards
Why do money markets exist?
Banks will have a surplus or deficit of cash
What is the SONIA and what is it used for?
Sterling Overnight Index Average
Rate for unsecured transactions in London sterling market
How does the BoE calculate SONIA?
Financial institutions will send details of their transactions of short term rates
BoE validates this data
What is €STR and what is it used for?
Euro Short-Term Rate
European SONIA, based on TARGET2 transactions
What is TARGET2?
Trans-European Automated Real-Time Gross Settlement Express Transfer System
Settlement/Payments system
What is the SOFR and what is it used for?
Secured Overnight Financing Rate
Benchmark interest rate for dollar-denominated derivatives and loans
Based on repo rate for USTs, since 2018
What are T-bills?
Treasury bills
Short term debt issued by governments
Why are T-bills sometimes called promissory notes?
Backed by the promise of a government
What is a certificate of deposit?
Promissory note from financial institution if investors put their money away for set amount of time
What minimums do CP usually have?
$500k
What is spot FX settlement time?
T+2
What is used to calculate forward rates?
Spot rate and interest rate differentials
What is a non deliverable forwards?
Cash settled, short term FX contract on a thinly traded or non-convertible international currency
How is profit or loss calculated on an Non-Deliverable forwards?
Difference between agreed exchange rate and spot rate at the time of settlement
What do all NDFs have?
fixing date - date which the difference between market and agreed rate is calculated
settlement date - date by which the payment of the difference is due
What is a common time period for NDFs?
one month - a year
What are NDFs usually traded against?
Illiquid currencies or those with currency controls e.g. CNY
Settled in USD, or EUR/GBP
What is interest rate parity?
The theory that forward rates are in line with relative interest rates, else arbitrage would be possible
How can the link between relative interest rates and FX be summarised?
Higher interest rate currency = Discount in the forward foreign exchange market
Lower interest rate currency = Premium in the forward foreign exchange market
What needs to be taken into account when calculating FX rates of less than one year?
Day count conventions
What is the formula for forward rate?
Spot rate *
(period * interest rate traded currency + 1) / (period * interest rate base currency + 1)
How would you calculate the premium or discount?
forward rate - spot rate
What is the settlement period of French, German and Italian bonds?
T+2
Which bonds have annual coupon frequencies?
French and German
What is the difference between floating rate and index linked bonds?
Index linked - RPI/CPI etc
Floating rate - SONIA / SOFR
What is indexation lag?
Protects against inflation for the last interest period of a bonds life
Why may an emerging market country issue bonds in EUR or USD?
Lower interest rates than home currency
What are bonds issued by governments in other than their home currency called?
Sovereign eurobonds
What is the yield spread?
Difference between the quoted rates of return of two different bonds that have similar maturities
What does the yield curve show?
The yields available to investors over different maturities of the same bond
Why is the yield curve curved? (2)
Liquidity preference
Shorter-dated bonds have higher liquidity
Investors prefer higher liquidity so are willing to accept a lower yield
Risk
Other risks increase over time such as inflation or default
When does an inverted yield curve arise?
Yields on short dated > yields on higher dated bonds
Occurs when there is an expectation of a reduction in interest rates at some stage in the future
Where can bonds be listed (3)
Exchanges
ECNs (electronic communication networks)
Decentralised dealer based OTC markets
Where is most volume traded for bonds?
Decentralised dealer based OTC markets
How are dividends paid on bearer shares?
Holder clips a coupon from certificate and submits it to the paying agent
What is a partly paid share?
One where only a portion of the purchase price has been paid to the issuing company
Firms directors can call up capital from investors
What do preference shareholders receive preference on?
Dividends and capital repayment
What is a participating preference share?
Allows shareholder to receive any excess dividend if company makes more money
What is a convertible preference share?
Preferential rights with the option to convert their holding into ordinary shares at a future date/price
Why may a warrant conversion ratio be adjusted?
To account for any corporate actions that change share structure
How does Gordons growth model calculate share value?
Forecasting future dividend payments, assuming a constant growth rate
What is the Gordons growth model?
A valuation technique
What is the Gordons growth model formula?
price = next year dividend / (cost of equity capital - constant growth rate)
What is the formula for EPS?
net income - dividends on preferreds / number of ordinary shares
What is the calculation for NAV?
assets - liabilities
What is the earnings yield calculation?
Earnings yield (%) = EPS / market price
Where does NAV not work?
Companies where value is made from people skills e.g.
Law firms, architecture firms
What are the three main categories of commodity?
Agricultural and softs - sources of calories and cash crops (softs) e.g. coffee, sugar
Energy
Minerals - inc. precious metals
What is carry cost called for commodities and what can it include?
Holding cost
Warehousing, spoilage, interest, taxes
What 3 factors is crude oil defined by?
- Field of origin – for example, Brent, West Texas, Dubai, or Oman.
- Density – ie, low density or ‘light’, high density or ‘heavy’.
- Sulphur content – ie, low sulphur or ‘sweet’ (ie, sulphur content below 0.5%), high sulphur or ‘sour’
(ie, sulphur content above 0.5%).
What is the difference between WTI and Brent?
WTI is a stored oil contract, where someone must nominate a US storage facility
Brent you nominate a port for delivery
What is the difference between coins and tokens in crypto?
Coins have their own blockchain
Tokens reside on existing blockchain
How are weather derivatives measured?
Using HDDs or CDDs
heating degree days or cooling degree days
What is the VIX based on?
IV of the SP500
What emission contracts can be traded?
Carbon dioxide, sulphur dioxide, methane, nitrogen dioxide
What are freight derivatives?
Financial contracts based on the future levels of freight rates
Mostly OTC
