Chapter 3: Financial Assets and Markets

Question 1

What are the characteristics of a fixed-term cash deposit account?

Answer 1

Investor ties up money for fixed period of time, with a fixed period of notice. Investor gets higher rate of interest than immediate access accounts.

Question 2

What are the characteristics of an instant access cash deposit account?

Answer 2

Earn the lowest rates of interest

Question 3

What are the characteristics of a cash deposit?

Answer 3

Return = interest income. Amount invested (capital) repaid in full at end of investment term.

Question 4

What are the advantages of investing in cash?

Answer 4

Liquidity, use as a savings vehicle and for interest returns, relative safety as not exposed to market volatility

Question 5

What are the disadvantages of investing in cash?

Answer 5

Risk that bank/savings institution may default, inflation reduces real return earned, interest rates vary so returns will vary, if global interest rates are low returns can be negative or flat.

Question 6

What is the difference between a capital market instrument and a money market instrument?

Answer 6

Money Market instrument = short-dated negotiable security. Capital Market instrument = long-term provider of finance for companies, through investment in bonds or shares.

Question 7

What is the definition of a Treasury Bill?

Answer 7

a money market instrument, usually issued weekly by or on behalf of governments, money used to meet government’s short-term borrowing needs

Question 8

What are the features of a Treasury Bill?

Answer 8

non-interest bearing/zero-coupon, issued at a discount to par. Return is difference between the discounted price they paid and what they receive at maturity

Question 9

What is the definition of a Certificate of Deposit (CD)?

Answer 9

issued by banks in return for deposited money, trade-able deposit accounts - traded on a secondary market.

Question 10

What are the features of a Certificate of Deposit (CD)?

Answer 10

Short-term marketable instrument, maturity of up to 5 years. Most have periods of less than 6 months. Interest can be fixed or variable, may also be zero-coupon

Question 11

What is the definition of a Commercial Paper (CP)?

Answer 11

Corporate equivalent of a Treasury Bill. Used by large companies to meet short-term borrowing needs. Ability to issue is agreed with bank in advance.

Question 12

What are the features of a Commercial Paper?

Answer 12

Can have different maturities and be in different currencies. Zero coupon - issued at discount to par value

Question 13

What is the definition of a Money Market Fund?

Answer 13

a mutual fund - pools investors’ money to invest in short-term debt instruments such as Treasury Bills and Commercial Paper

Question 14

What are the advantages of investing in money market instruments?

Answer 14

short-term = low risk way to generate returns, preserve nominal value of amount invested, limited exposure to market risk

Question 15

What are the disadvantages of investing in money market instruments?

Answer 15

only good for short-term, short-term interest rates fluctuate = price volatility

Question 16

What are the advantages of Money market (deposit) accounts?

Answer 16

can offer higher returns than standard retail deposit account. Safety net of depositor protection scheme.

Question 17

What are the disadvantages of Money market (deposit) accounts?

Answer 17

higher returns only achieved with large investments.

Question 18

What are the advantages of Money market funds?

Answer 18

can produce greater returns due to pooled nature, can access better rates than smaller deposits

Question 19

What are the disadvantages of Money market funds?

Answer 19

not protected by depositor protection scheme.

Question 20

What are the characteristics of residential property investment?

Answer 20

range of investment opportunities - second homes, holiday homes, buy-to-let, short renewable leases, landlord responsible for repairs, returns are linked to increase in house prices

Question 21

What are the characteristics of commercial property investment?

Answer 21

size of investment required means direct investment in commercial property is limited to property companies and institutional investors, long-term contracts, tenant responsible for repairs, returns from rental income

Question 22

What are the characteristics of indirect property investment?

Answer 22

indirect exposure via a mutual fund, property bonds issued by insurance companies, or shares in publicly quoted property companies. Makes property more accessible to those running smaller diversified portfolios. Property funds can impose moratoriums.

Question 23

What are the advantages of investing in property?

Answer 23

low volatility, reliable stream of income, diversification benefits due to low correlation with other asset classes

Question 24

What are the disadvantages of investing in property?

Answer 24

can be subject to prolonged downturns, lack of liquidity, high maintenance costs, high transaction costs on transfer, risk of commercial property with no tenant = no rental income, only suitable for long term investing institutions such as pension funds

Question 25

What is the basic structure of the Foreign Exchange (FX) market?

Answer 25

trading of one currency for another, 24-hour due to time zones. LDN is worlds largest FX market. Trading is done in pairs - one currency bought and one sold. OTC market - brokers and dealers negotiate directly. Large international banks and central banks are major participants.

Question 26

What is a Currency Quote?

Answer 26

first is base currency, second is counter/quote. Base = 1 EG. EUR:USD = 1:1.1250/60. Market maker or FX trader will quote a bid and ask price.

Question 27

How are FX transactions settled?

Answer 27

made through CLS Bank or worldwide international banking system. CLS Bank is a specialist bank, owned by many of worlds largest FIs, used to settle FX trans between member banks using system called ‘payment-vs-payment’. Trades can also be settled directly by participants, as banks hold accounts with each other.

Question 28

What is a Spot transaction?

Answer 28

spot rate = rate for exchange with immediate effect. Spot trades usually settled 2 business days after transaction date (T+2)

Question 29

What is a Forward transaction?

Answer 29

money exchanges hands at agreed future date. Exchange rate agreed, transaction goes ahead on that regardless of market rates at that time.

Question 30

What is a Future?

Answer 30

standardised version of a forward, traded on derivatives exchanges in standard sizes and maturity dates

Question 31

What is a Currency Swap?

Answer 31

type of forward trans, two parties exchange currencies for a certain length of time and agree to reverse the trans at a later date. Traded OTC - negotiated individually

Question 32

What is the formula for calculating a forward exchange rate?

Answer 32

Forward rate=spot rate X ((1+quote currency short-term rate)/(1+base currency short-term rate))

Question 33

How do you calculate a forward exchange rate?

Answer 33

Interest rates are annual so divide them to fit the length of the forward (eg. divide by 4 for a 3 month forward). Convert rates into decimals (divide by 100). Input values into formula.