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Introduction to Securities and Investments > Chapter 6: Derivatives > Flashcards

Chapter 6: Derivatives Flashcards

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SIE Exam flashcards
1
Q

what products does derivatives trading take place in?

A

financial instruments, indices, metals, energy and other assets

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2
Q

what is a derivative?

A

a financial instrument whose price is based on the price of another asset (known as an underlying asset or ‘the underlying’)

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3
Q

what are derivatives used for?

A

heding, anticipating future cash flows, asset allocation change and arbitrage

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4
Q

what is heding?

A

reducing the impact of adverse price movements on a portfolio’s value (done by selling a sufficient number of futures contracts or installing put options)

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5
Q

what is the anticipation of future cashflows in relation to derivatives?

A

if a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to fix the price at which it will be bought, and this will then offset the risk that will arise by the time that the cash flow is received.

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6
Q

what are asset allocation changes in relation to derivatives?

A

changes of asset allocation of a fund, takes advantage of anticipated short-term directional market movements of to implement a change in strategy, derivatives can be used rather than exchanging securities within the portfolio

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7
Q

what is arbitage?

A

the process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets, a profit may be able to be accrued if there is a price difference between the two.

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8
Q

can futures contracts be traded on an exchange?

A

yes

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9
Q

what is a future?

A

an agreement between a buyer and seller, legally binding obligation between two parties. buy agrees to pay prespecified price for a specific amount of goods to be delivered at a given date, seller agrees to provide the goods at the given date in exchange for the amount of money agreed upon

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10
Q

what are the two distinct features of futures contracts trading?

A

it is exchange traded (e.g., ICE Europe in London or CME in the US), it is dealt on standardised terms (the exchange specifies the quality of the underlying asset, the quantity of the good underlying each trade, the future date and the delivery date)

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11
Q

what is the meaning of being in a long position?

A

term used for the position of the buyer in the future contract, if a person is ‘long’, they are committed to buying the underlying asset at the prespecified price at the set future date

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12
Q

what is the meaning of being in a short position?

A

term used for the seller in the future contract, if they are short, they are committed to selling the underlying asset at the prespecified price at the set future date

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13
Q

what does the open mean in a futures contract?

A

the initial trade for the future contract. a market participant ‘opens’ a trade when they first enter into the contract

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14
Q

what is the meaning of a future contract being closed prior to maturity?

A

when the buyer of the future contract sells the contract in before the delivery date. if this doesn’t happen the asset will be delivered at the set date for the set price.

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15
Q

what is the meaning of covered?

A

when the seller of the underlying asset is actually in possession of the asset being sold for physical delivery

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16
Q

what is the meaning of naked?

A

when the seller of the asset is not actually in possession of asset that is needed for physical delivery once the maturity date of the contract reaches

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17
Q

what is an option in a futures contract?

A

gives the buyer in a derivative contract the option but not the obligation to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price on or before a prespecified future date or between two specified dates. the seller will grant this option to the buyer in exchange of the payment of a premium.

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17
Q

how are options traded?

A

can be traded on an exchange under standardised terms or OTC if investors want to trade outside the exchange terms

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18
Q

what is a call option?

A

when the buyer has the right to buy the asset at the exercise price. the seller is obliged to deliver if the buyer exercises this option

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19
Q

what is a put option?

A

when the buyer has the right to sell the underlying asset at the exercise price, the seller of the asset is obliged to take delivery and pay the exercise price if the original buyer exercises this option

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20
Q

what are interest rate swaps?

A

an agreement to exchange one set of cash flows from one to another to replace floating interest with fixed interest, commonly used to switch financing from one currency to another or to replace floating with fixed interest, OTC derivative

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21
Q

what are the ‘legs; of an interest rate swap consisting of?

A

one leg is the payment of a fixed interest rate and the other is a payment of a floating interest rate

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22
Q

what are interest rate swaps used for?

A

typically to hedge exposure to interest chnage

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23
Q

what are credit derivatives (credit default swaps)?

A

instruments whose value depends on agreed credit events relating to a third party e.g., if the credit rating for that company changes or if the cost of funds for that company changes in the market

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24
Q

what is the prupose of credit derivatives?

A

they enable an organisation to protect itself against unwanted credit exposure by passing this exposure onto someone else, can be used to increase credit exposure in return for income

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25
Q

what takes place in a credit default swap?

A

the party buying credit protection makes periodic payments to a second party (the seller), the buyer receives an agreed compensation if there is a credit even relating to some third party. if this occurs, the seller makes a predetermined payment to the buyer and the CDS terminates. i.e., the holder of the bond (CDS buyer) can take out protection on the risk of the issuer of the bond (the debt issuer) defaulting by paying a premium to a counterparty.

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26
Q

what are the characteristics of derivatives and commodity markets?

A

physical trading of commodities happens side by side with trading of derivatives. physical market concerns itself with procuring, transporting and consuming real commodities. dominated by major international trading houses, govts and major producers and consumers. derivatives markets exist in parallel and serve to provide a price-fixing mechanism whereby all stakeholders in the physical markets can hedge market risk

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27
Q

what are the different groups of derivatives and how are they traded?

A

OTC derivatives and exchange-traded derivatives. OTC derivatives are negotiated and traded privately between parties without the use of an exchange (includes interest rate swaps, forward rate agreements). OTC is the larger of the two. ETDs ae standardised and traded on an organised exchange. exchange ensures that all trades will be eventually settled and does this by requiring all parties to post a margin (proportion of the value of the trade) for all trades

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28
Q

what is ICE futures Europe?

A

the main exchange for trading financial derivatives products in the UK, including futures and options on interest rates and bonds, equity indices, individual equities

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29
Q

what is Eurex?

A

the world’s leading international derivatives exchange and is based in Frankfurt. trading is fully computerised on the Eurex platform

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30
Q

what is the intercontinental exchange (ICE)

A

Operates the electronic global futures and OTC marketplace for trading energy and commodity contracts. ICE futures Europe is the leading energy futures and options exchange and is a subsidiary of ICE, world’s largest derivatives exchange operator

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31
Q

what is the LME?

A

London Metal Exchange, world premier non-ferrous metals market. trading takes place 3 ways: through open outcry trading in the ‘ring’, through an inter-office telephone market and through LME Select, the exchange’s electronic trading platform

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32
Q

what are the advantages of investing in derivatives markets?

A

enables the ability to agree a price for a good today for future delivery which can remove the uncertainty of what price will be achieved for the producer and the risk of lack of supply, investment firms can hedge risk associated with a portfolio or an individual stock, offers the ability to speculate on a wide range of assets and markets (can make large bets on price movements using derivatives)

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33
Q

what are the disadvantages of using derivatives?

A

can involve the investor losing more money than their initial outlay (potentially unlimited losses), thrive on price volatility (need professional investment knowledge and skills, risk of default with a counterparty (lots of risk assessment needed)

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34
Q

where does the UK come in terms of asset management?

A

second-largest asset management centre after the US and the largest centre for investment management in Europe

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35
Q

what are important questions to consider when making investments?

A

reasoning, capital needed, returns, risk, asset classes, diversification of the portfolio, need for income in the present or the future.

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36
Q

what is direct investment?

A

when an individual personally buys shares in a company

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37
Q

what is indirect investment?

A

when an individual buys a stake in an investment fund that invests in the shares of a range of different types of companies

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38
Q

what are CISs?

A

collective investment schemes, pool the resources of a large number of investors with the aim of pursuing a common investment objective.

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39
Q

what are the benefits of collective investment?

A

economies of scale, diversification, professional management, investment strategies which might be inaccessible otherwise, regulatory oversight, tax deferral

40
Q

what fees ar charged by fund managers to investors?

A

fees to become involved in the CIS, needed to cover salaries, tech, research, dealings and management

41
Q

what is the active management investment strategy?

A

seeks to outperform a predetermined benchmark over a specified time period, employs fundamental and technical analysis to assist in the forecasting of future events, usually higher charges than passive funds, focuses on economic and industry trends

42
Q

what is taken into account in ‘bottom up’ investment?

A

analysis of a company’s net assets, future profitability and cash flow and other company-specific indicators that are taken into account

43
Q

what is growth investing (bottom up)?

A

picking the shares of companies that present oppurtunities to grow significantly in the long term

44
Q

what is value investing (bottom up)?

A

picking the shares of companies that are undervalued relative to their present and future profits or cash flows

45
Q

what is momentum investing (bottom up)?

A

picking the shares whose share price is rising on the basis that this rise will continue

46
Q

what is contrarian investing (bottom up)?

A

picking shares that are out of favour and may have ‘hidden’ value

47
Q

what is passive management investment strategy?

A

index tracking, or constructing a portfolio in such a way that it will track, or mimic the performance of a recognised index

48
Q

what are the advantages of passive investment management?

A

few active portfolio managers consistently outperform benchmark equity indices, charges will be significantly lower than actively managed funds, less expensive to run, lower ratio of staff and lower turnover

49
Q

what are the disadvantages of passive investing?

A

affected by the need to manage cash flows and rebalancing the portfolio to reflect the index weightings, may not meet all investors objectives, follow the index down in a bear market

50
Q

what is core satellite management?

A

a mixture of indexing and active investment i.e., 80% passive management and then fine-tuning this with a number of finely tuned managed funds or individual securities

51
Q

what are smart-beta funds?

A

funds that take into account other factors such as value or growth when creating an index they will track

52
Q

what are UK gilt funds?

A

95% of their assets are in sterling-denominated, govt backed securities, with at least 80% in UK govt securities

53
Q

what are UK index-linked guilts?

A

95% of assets in sterling denominated, govt backed index-linked securities

54
Q

what are corporate bonds?

A

funds with at least 80% invested in sterling-denominated triple BB-minus or above corporate bond securities, excludes convertibles, preference shares and permanent interest-bearing shares

55
Q

what are £ strategic bonds?

A

funds which invest at least 80% of their assets in sterling-denominated, fixed interest securities, excludes convertibles, preference shares or PIBs

56
Q

what are £ high yeild?

A

Invest at least 80% of their assets in sterling-denominated, fixed interest securities and at least 50% of their assets in below BBB-minus fixed-interest securities

57
Q

what are UCITs?

A

series of EU regulations designed to facilitate the promotion of funds to retail investors across the EU.

58
Q

What is the aim of UCITs?

A

create a framework for cross-border sales of investment funds throughout the EU as long as firms stay within their home country regulation when engaging in cross border sales

59
Q

what is NURs?

A

non-UCITs retail schemes, funds that are deemed by the UK regulator to be suitable for retail investors but do not meet more prescriptive rules of UCITs directives

60
Q

what is a unit trust?

A

a CIS in the form of a trust in which the trustee is the legal owner of the underlying assets and unitholders are the beneficial owners, investors pay into the trust in exchange for units. manager may outsource their decision making to a separate investment manager

61
Q

why are unit trusts described at open-ended CISs?

A

they grow as more investors buy into the fund and shrink as they remove their resources

62
Q

how are units traded in a unit trust?

A

the manager provides a market for the units, dealing with investors who want to buy or sell, manager also carries out daily pricing of the units based on the net asset value of the underlying constituents

63
Q

what is the role of the unit trustee?

A

they are the legal owner of the assets in the trust and they protect the interest of the beneficiaries of the trust.

64
Q

what are AUTs?

A

authorised unit trusts, the trustees here are companies subject to special regulation, all part of global banking groups

65
Q

what is an OIEC?

A

Open-ended investment company. referred to as Investment companies with variable capital by the FCA, requirement that an ACD (authorised corporate director and a depository are appointed responsible for BAU management. investments held by an independent depository, similar to a trustee in an AUT

66
Q

what are SICAVs?

A

luxembourg companies investment companies with with variable capital, set up there with asset management firms to be distributed further afeild

67
Q

what is the price that AUTs or OEICs are based on?

A

the value of the funds underlying investments, authorised fund manager has flexibility to quote prices as single or dual-priced

68
Q

what is single pricing?

A

use of mid-market prices of the underlying assets to produce a single price

69
Q

what is dual pricing?

A

uses the markets bid and asking price of the underlying assets to produce a seperate price for the buying and selling of shares and units

70
Q

what is a dilution levy?

A

a way of recouping losses when single pricing is adopted which then provides the ability to recoup expenses within the spread by applying a separate charge on purchases or redemptions.

71
Q

What charges to investors in CISs have to pay?

A

initial charge, annual management charge (AMC), other less explicit costs such as audit costs and other costs that fund managers are entitled to charge. brokers commission, legal fees, fees for specialist tax advice.

72
Q

what is an OCF?

A

ongoing charges fixture which UCITs are required to publish, includes all expenses incurred by UCITs also includes costs for outsourced services as well, does not include any initial or exit charges and performance fees.

73
Q

what are the ways that investors can buy or sell units?

A

directly with the fund manager, via their broker or financial adviser, through a fund supermarket or platform

74
Q

how does the trading of units take place?

A

either bought from or sold to the Authorised fund manager, no active secondary market except between investors

75
Q

how are units in AUTs and OEICs bought?

A

bought from managers themselves and not the stock market

76
Q

what is a fund supermarket/platform?

A

an organisation that specialises in offering investors easy access to a range of unit trusts and OEICs from different providers, based around an internet platform, takes an processes the orders on investors behalf

77
Q

how does settlement take place?

A

directly with each fund group, they will record ownership of the relevant number of units of shares in the funds register, when an investor wishes to sell, they will instruct the fund manager, they then have t+4 to settle from the receipt of the instruction

78
Q

how are orders carried out and what is EMX?

A

likely they use a systems platform to place orders with the fund. EMX is used to enter, aggregate and send orders to fund groups, will also send a dealing confirmation

79
Q

what is an ITC?

A

a company (Investment Trust Company) that will invest in a diversified range of investments, allowing shareholders to diversify and lessen their risk. number of shares likely to remain fixed, therefore they are close-ended.

80
Q

what happens if an investment company have more than one type of share?

A

they are known as split-capital investment trusts, issue both ordinary shares and preference shares

81
Q

what are REITs?

A

real estate investment trusts, investment companies that pool investors funds to invest in commercial property and possibly residential property. provide access to propeerty returns without the previous disadvantage of double taxation

82
Q

what are the characteristics of REITs?

A

investors have access to professional property investment and are provided with new oppurtunities such as the ability to invest in commercial property, removes the further risk from holding direct property, namely liquidity risk. close ended, quoted on the LSE

83
Q

what is gearing?

A

allows investment companies to borrow more money on a long-term basis by taking out bank loans and/or issuing bonds, allows them to invest borrowed money in stocks and shares, can improve returns or exacerbate losses.

84
Q

what is the price of an investment trust share based on?

A

how much someone is willing to pay for it, the value of the underlying investments determined on a per share basis referred to as the NAV, but the actual price is driven by supply and demand so it may be below or above this value.

85
Q

what is it described as when the investment trust share pice is above/below the NAV?

A

Above= premium
below= discount

86
Q

what sort of value do ITC company shares generally trade at?

A

discount to their NAV, discount is a function of the markets view of the quality of the management of the investment portfolio (smaller discount ot a premium when the ITC is nearing windup or about to undergo corporate activity

87
Q

how are shares in ITCs bought and sold?

A

through the LSE using the SETs trading system or via a retail service provider (RSP)

88
Q

what is an ETF and what are it’s characteristics?

A

investment fund designed to track a particular index, typically a stock market index, open-ended and gets bigger as more ppl invest and smaller w more withdrawals

89
Q

what method of investment do ETFs use?

A

passive investment management

90
Q

what are the different types of index replication?

A

full replication (each constituent tracked to hold in accordance with it’s index weighting), stratified sampling (representative sample of securities from each sector of the index to be held subjective due to lack of statistical analysis), optimisation (sophisticated computer modelling to find a representative sample of securities)

91
Q

what is synthetic replication in ETFs?

A

when the fund manager enters a swap with a market counterparty to exchange the returns on the index for a payment

92
Q

what does the ETF price reflect?

A

the value of the investments in the fund, investors return is in the form of dividends paid by the ETF

93
Q

what charges do ETFs exhibit?

A

spread between the buy and sell price, annual management charge, stockbrokers commission when buying and selling

94
Q

what is the aim of traditional absolute return hedge funds?

A

attempt to profit regardless of the general movements of the market, by carefully selecting a combination of asset classes, including derivatives and by holding both long and short positions

95
Q

what are the common aspects of hedge funds?

A

most are established as unauthorised and unregulated, can’t be marketed to private individuals/retail investors, high investment entry levels (£1m), investment flexibility, utilise gearing, engage with one main wholesale broker (prime broker), initial ‘lock in period’ in terms of liquidity, levy performance related fees to investors

96
Q

what is private equity?

A

medium to long-term finance provided in return for an equity stake in potential high-growth companies, returns dependant on growth and profitability of the business

97
Q

how can PE firm realise their capital gains?

A

selling shares back to the management of the invested in company, selling shares to another investor, a trade sale (selling their shares to another PE firm), company achieving stock market listing

98
Q

how do PE firms raise capital?

A

mainly from large investing institutions

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