Chapter 4 Flashcards

Question

What is the 'Discount' for money market instruments

Answer 1

These are discount instruments or zero-coupon bonds (ZCBs). Issued at a discount to its face value and repaid at face value at maturity. Investor’s return is the difference between the discounted purchase price and the face value of the security. Types include Treasury bills; bankers’ acceptances; and most commercial paper.

Answer 2

Government bonds may be stripped into its underlying cash flows (each individual interest payment plus the single redemption payment), called separate trading of registered interest and principal securities (STRIPS). Each strip is then traded as a separate zero coupon bond (ZCB) with a known nominal redemption value. As each ZCB is purchased at a discount to this redemption value, the entire return is in the form of a capital gain.

Answer 3

Government bonds (among other types of bond) are traditionally categorised as either: Shorts – conventional-dated bonds with up to seven years remaining to redemption. Mediums – conventional-dated bonds with between seven and 15 years remaining to maturity. Longs – conventional-dated bonds with more than 15 years remaining to redemption.

Answer 4

The higher the premium, the more the convertible loan stock will behave like a conventional stock, whereas the lower the premium the nearer the loan stock will be to conversion, and therefore the closer its price movements will be to that of the company's equity

Answer 5

'Mezzanine Financing' is a combination of debt and equity financing that fill the gap between senior debt and equity in a company. It gives investors the right to convert the debt into an equity interest in the company

Answer 6

'Mezzanine Financing' is unsecured debt

Answer 7

An option is a contract that gives the buyer the right, but not the obligation, to sell or buy a particular asset at a particular price, on or before a specified date

Answer 8

The writer of an option contract, also known as the seller, is the party who agrees to be obligated to buy or sell the underlying asset at a specified price (strike price) and date (expiration date) if the option buyer exercises their right.

Answer 9

A warrant gives its holder the right to buy a company’s shares over the life of the warrant at a fixed exercise price, which is usually at a premium over its current price at the time the warrant is issued. It is often issued by the company on which the warrant is based or another private party. Warrants are commonly attached to a corporate bond but, unlike convertible bonds, the bond itself continues to exist if the warrant is exercised.

Answer 10

The delta of an option is a measure of the sensitivity of the option’s price to changes in the price of the underlying asset. Simplistically, it can be calculated by measuring the change in an option premium brought about by a small change in the price of the underlying. This would be done using option pricing models such as Black-Scholes.

Answer 11

A future is a legal agreement between two parties to make or take delivery of a specific quantity and quality of a specified asset on a fixed future date at a price agreed today. Futures are often described as futures contracts because they are traded on organised exchange.

Answer 12

Gamma is the measure of how delta changes (the rate of change of delta) with respect to movements in the price of the underlying. It is small when the option is either deep ITM, or far OTM.

Answer 13

Vega is a measure of how a 1% change in implied volatility affects an option’s price. Vega is always positive for long options positions (both calls and puts). It is greatest for ATM options. The further that an option goes to ITM or OTM, the smaller the vega will become. Time increases the effect of changes in volatility upon an option’s value. Therefore, vega is higher for long-dated options than short-dated options, and falls as an option approaches its expiration date.

Answer 14

Theta is the measure of the rate of decline of an option’s value due to the passage of time. Theta represents how much an option’s value will change as one day passes and its underlying asset’s price remains steady. Theta can also represent the time decay on the value of an option.

Answer 15

Long calls and long puts always have negative theta. Short calls and short puts always have positive theta.

Answer 16

Currency swaps are simply interest rate swaps made in two different currencies that require an exchange of the loan principal at the beginning and at the end of the swap period.

Answer 17

Historic volatility Future volatility Implied volatility

Answer 18

Fixed-to-floating – fixed rate into floating rate, which is the most commonly traded and most liquid type of interest rate swap. Also known as a coupon or vanilla swap.

Answer 19

Any FX contract that matures one day beyond the normal spot date (T+2) is considered a forward deal.

Answer 20

Physical assets or future of a deep ITM call - +1 ATM call - +0.5 Far OTM call or a far OTM put - 0 ATM put - -0.5 Deep ITM put - -1

Answer 21

The price/earnings ratio (PER, PE ratio or P/E ratio) measures how highly investors value a company in its ability to grow its income stream. A company with a high PER ratio relative to its sector average reflects investors’ expectations that it will achieve above-average growth; alternatively, its stock could be overvalued. By contrast, a low PER ratio indicates that investors expect the company to achieve below average growth in its future earnings, or that its stock is undervalued.

Answer 22

A Z-score analysis is generally considered a more detailed way of establishing whether a company is dangerously close to becoming insolvent. A Z-score analysis is undertaken to determine the probability of a company going into liquidation within a two-year period by analysing such factors as the company’s gearing and sales mix and distilling these into a statistical Z-score. If negative, this implies that a company’s insolvency is imminent.

Answer 23

- a specific amount of time must have elapsed since the shares were issued - the profits have to exceed a certain level, or - other classes of shareholders have to have been paid a predetermined level of dividend, before the owners of these shares can be paid

Answer 24

These shares are often referred to as B shares or even C shares.

Answer 25

Preference shares rank ahead of ordinary shares for the payment of dividends and capital repayment in the event the company is liquidated. They are usually only entitled to a fixed rate of dividend based on the nominal value of the shares, so a 6% preference of £1 share will pay a net annual dividend of 6p per share. The dividend is payable only if the company makes sufficient profits and the board of directors declares the dividend payment. Most preference shares in issue are cumulative, which means they are entitled to receive all dividend arrears from prior years before the company can pay its ordinary shareholders a dividend. Normally, they do not carry voting rights except when the dividend is in arrears.

Answer 26

The usual term of a Treasury Bill is 91 days and redemption value of £100

Answer 27

Up to 5 years