Equity

Question 1

Precedence order

Answer 1

1. Price: Higher bid or lower ask orders get priority.
2. Display: Visible orders have precedence over hidden orders.
3. Time: Among similar orders, the one placed first is executed first.

Question 2

Forwards vs Futures

Answer 2

Both are derivative contracts to buy or sell an asset at a future date, but:
- Forwards: Customized contracts between two parties, traded OTC.
- Futures: Standardized contracts, traded on exchanges, and thus are subject to daily settlement and margin requirements.

Question 3

Stop Buy-Stop Loss

Answer 3

• Stop Buy Order: An order to buy a security once its price exceeds a particular point, ensuring a buy only on an upward trend.
• Stop Loss Order: An order placed to sell a security when it reaches a certain price to limit an investor’s loss.

Question 4

Short Put

Answer 4

Position: Selling a put option.

Market Outlook: Bullish or neutral. The seller believes the underlying asset’s price will stay above the option’s strike price until expiration.

Profit/Loss: The seller profits from the premium received for selling the option. The risk is potentially significant if the market moves against the position, as the seller may be required to buy the underlying asset at the strike price, which could be much higher than the market value.

Rationale: Investors sell puts when they are willing to own the underlying asset at the strike price, considering it a favorable purchase point, or simply to earn premium income if they believe the asset’s price will not fall below the strike price.

Question 5

Long Put

Answer 5

Position: Buying a put option.

Market Outlook: Bearish. The buyer believes the underlying asset’s price will fall below the strike price by expiration.

Profit/Loss: The buyer’s maximum loss is limited to the premium paid for the option. The profit potential is significant if the underlying asset’s price falls well below the strike price, less the premium paid.

Rationale: Investors buy puts as a form of insurance against a decline in the asset’s price or to speculate on the asset’s price falling without the risk of short selling the asset directly.

Question 6

Short Call

Answer 6

Position: Selling a call option.
Market Outlook: Bearish or neutral. The seller bets that the underlying asset’s price will not exceed the option’s strike price by expiration.
Profit/Loss: The seller profits by the amount of the premium received. The risk is potentially unlimited, as there is no cap on how high the asset’s price can rise, and the seller must sell the asset at the strike price if the option is exercised.
Rationale: An investor might sell calls to generate income through premiums if they believe the stock price will remain below the strike price or are willing to sell the stock at the strike price.

Question 7

Long Call

Answer 7

Position: Buying a call option.

Market Outlook: Bullish. The buyer expects the underlying asset’s price to rise above the strike price by the option’s expiration.

Profit/Loss: The buyer’s risk is limited to the premium paid for the option. The profit potential is unlimited, as any increase in the asset’s price above the strike price (plus the premium paid) could result in profit.

Rationale: Buying calls is a leveraged way to profit from the anticipated increase in the price of the underlying asset without having to purchase the asset outright.

Question 8

Securitized Debt

Answer 8

Securitization is the process of pooling various types of debt—mortgages, car loans, or credit card debt—into a consolidated financial instrument that is sold to investors. The cash flow from the debt pool pays the investors.

Question 9

Margin Call

Answer 9

A margin call occurs when the value of an investor’s margin account falls below the broker’s required amount. The formula to determine the margin call price is:

Question 10

Seasoned offering

Answer 10

Sale of securities by a company that has already undergone an IPO.

Question 11

Shelf Offering

Answer 11

A regulatory provision allowing an issuer to register a new issue of securities without selling the entire issue at once.

Question 12

Callable Shares

Answer 12

Can be redeemed by the issuer before the maturity date.

Question 13

Putable Shares

Answer 13

Holders can sell shares back to the issuing company at a predetermined price.

Question 14

Porter’s Five Forces

Answer 14

A framework for analyzing a company’s competitive environment. The forces include competitive rivalry, supplier power, buyer power, threat of substitution, and the threat of new entry.

Question 15

PESTLE Analysis

Answer 15

Examines external factors affecting a business—Political, Economic, Social, Technological, Legal, and Environmental.

Question 16

Validity

Answer 16

Definition: Validity refers to the conditions under which a trade or order remains active or enforceable. It is a critical aspect of order management in trading, dictating how long an order can stay open before it is either filled or cancelled.

Types: Common types of validity include “Day” orders, which expire at the end of the trading day if not filled; “Good-Till-Cancelled” (GTC) orders, which remain active until they are filled or explicitly cancelled by the trader; and “Immediate or Cancel” (IOC) orders, which must be filled immediately to the extent possible, with any unfilled portion being cancelled.

Purpose: Validity conditions allow traders to better manage their trading strategies and risks by specifying the timeframe in which their orders can execute.

Question 17

Clearing

Answer 17

Definition: Clearing is the process of updating accounts of the trading parties and arranging for the transfer of money and securities. It is an essential step in the trade lifecycle that occurs after trading and before settlement.

Process: Clearing involves identifying the obligations of each party (how much and what is to be bought/sold), arranging for the transfer of securities and money, and ensuring that the correct amounts are exchanged. Clearinghouses or central counterparties (CCPs) often facilitate this process to manage the risk of one party defaulting on their obligations.

Purpose: The clearing process mitigates counterparty risk, ensures the accuracy of trade records, and prepares for the final settlement of transactions.

Question 18

Execution

Answer 18

Definition: Execution is the process by which an order is matched with an opposing order and completed, resulting in a legal agreement between the buyer and seller to exchange the securities for cash at the agreed price.

Mechanism: Execution can occur on various platforms, including exchanges and over-the-counter (OTC) markets. The specifics of how orders are matched can vary depending on the trading venue’s rules and the type of orders submitted.

Outcome: Once an order is executed, both the buyer and seller are legally bound to complete the transaction at the specified price and terms. The details of the executed trade are then reported, and the trade moves to the clearing stage.

Question 19

Market Efficiency

Answer 19

• Weak Efficiency: Prices reflect all past market data.
• Semi-Strong Efficiency: Prices reflect all publicly available information.
• Strong Efficiency: Prices reflect all information, public and private.

Question 20

Gordon growth model for intrinsic value

Answer 20

Question 21

Gordon growth for P/E ratio

Answer 21

Question 22

Gordon growth model for required rate of return

Answer 22

Question 23

Operating Leverage

Answer 23

Operating Leverage describes the extent to which a company can increase its profits by increasing sales. A company with high operating leverage will see a more significant increase in profitability from a sales increase because its fixed costs will remain constant while revenue grows. High operating leverage indicates that a company has a high proportion of fixed costs to variable costs. It’s not represented by a single formula but is demonstrated through the effect on net income when sales volume changes.

Question 24

Contribution Margin

Answer 24

Contribution Margin represents the incremental money generated for each product/unit sold after covering variable costs. It is a measure of the profitability of individual products and can be calculated using the formula:

Question 25

Primary dealer

Answer 25

Question 26

Broker dealer

Answer 26

A broker-dealer is a person or a firm in the financial services sector that is licensed to engage in the buying and selling of securities for its own account or on behalf of its clients. This dual role encompasses the functions of both a broker and a dealer, hence the name “broker-dealer.”

Question 27

Uniform Pricing Rule

Answer 27

Definition: This term often relates to the practice of selling goods or services at the same price to all buyers. In the context of securities exchanges, it could refer to a rule where all market participants receive the same price in a transaction when that transaction is executed at a particular time.

Application: It is applied in stock exchanges during the matching of orders in the market, where all trades at the same time for the same security are executed at the same price, regardless of the order size or the participant initiating the trade. OFTEN IN CALL MARKETS.

Question 28

Discriminatory Pricing Rule

Answer 28

In continuous trading markets, the discriminatory pricing rule is used. This rule sets the price according to the limit price of the first standing order.

Question 29

Brokered Market

Answer 29

Brokers match their clients’ trades for rare and illiquid instruments, as these wouldn’t attract many orders in traditional markets. This market involves a small number of individuals or institutions making trades.

Question 30

Derivative pricing rule

Answer 30

Crossing networks, which pair buyers and sellers using prices from other markets, use the derivative pricing rule. Typically, this means using the midpoint between the best bid and ask quotes for the underlying asset.

Question 31

Order-Driven Markets

Answer 31

Order-driven markets arrange trades using rules to match buy orders to sell orders submitted by customers or dealers. Almost all exchanges use order-driven trading systems, and every automated trading system is an order-driven system. Two sets of rules characterize order-driven market mechanisms: order matching rules, which match buy and sell orders, and trade pricing rules, which determine the price of the matched trades.

Question 32

Quote-Driven Markets/Over-the-Counter (OTC) Markets

Answer 32

In quote-driven markets, customers trade at prices quoted by dealers who generally work for commercial banks, investment banks, broker-dealers, or trading houses. Most trades in these markets are conducted through proprietary computer communications networks or by phone.

Question 33

Money markets

Answer 33

Purpose: The money market is where short-term funds are borrowed and lent, typically for periods of a year or less.

Instruments: Common instruments include treasury bills, commercial paper, certificates of deposit, repos (repurchase agreements), and short-term government and corporate bonds.

Liquidity: Money market instruments are highly liquid due to their short maturities.

Risk: Generally considered lower risk because of the short-term nature of the investments.

Participants: Includes banks, financial institutions, governments, corporations, and other institutional investors.

Function: Used for managing short-term liquidity needs by both borrowers and lenders.

Question 34

Capital Markets

Answer 34

Purpose: Capital markets are used for the raising of long-term funds, typically with maturities exceeding one year.

Instruments: Includes long-term securities like bonds, debentures, and stocks (equities).

Liquidity: Varies, but equity instruments (stocks) are generally quite liquid, while long-term debt (bonds) can vary in liquidity.

Risk: Higher risk relative to money markets due to longer-term exposure and the higher uncertainty associated with long-term investments.

Participants: Consists of individual investors, institutional investors, governments, and companies.

Function: Used by companies for capital investment and expansion and by governments to fund various projects.