Key Exam Questions Flashcards
When are Financial Institutions exposed to:
-Credit Counterparty Risk
-Wrong Way Risk
-Contango/Backwardation
-Basis Risk
Credit Counterparty Risk:
financial institution engages in transactions where a counterparty may fail to meet its obligations
Ex: Derivative, Loans.
Wrong Way Risk: Chance of party defaulting increases as your exposure to them increases.
Example: A financial institution enters a credit default swap (CDS) with a counterparty that is heavily exposed to the same underlying reference entity. If the reference entity defaults, the counterparty might also default, increasing losses.
Contango and Backwardation:
Contango: Futures prices are higher than the spot price (Mainly Commodity Market)
Risk: an institution hedges by rolling over futures contracts, it incurs a loss on each roll
Backwardation: Futures prices are lower than the spot price.
Risk: Institutions may benefit from positive roll yields.
Basis Risk: when the price of a hedge instrument does not move perfectly in tandem with the price of the underlying asset or liability being hedged.
Problem: Hedge ineffectiveness.
Residual financial losses despite hedging
What is the ISDA & What do they do?
The ISDA (International Swaps and Derivatives Association) is a global organization that sets standards for the derivatives market.
Standardize Contracts: Create standardized legal documentation for trading derivatives.
Reduce Risk: Promote practices and frameworks to manage risks in derivatives trading.
Advocate for Market Efficiency: Work with regulators and market participants to improve transparency and stability in financial markets.
Discuss Quantitative Tightening regarding:
(i) Economic growth
(ii) Consumer price inflation
(iii) Asset prices
(iv) Pension schemes
(i) Economic Growth:
QT reduces the money supply and raises interest rates.
Higher borrowing costs decrease consumer spending and business investment.
Reduced demand and investment can slow down overall economic activity.
Lower GDP growth, especially if the economy is already sensitive to interest rates.
May lead to slower recovery after periods of strong economic growth.
(ii) Consumer Price Inflation:
QT reduces inflation by tightening the money supply.
Higher interest rates make borrowing more expensive, reducing demand.
Reduced demand helps ease price increases for goods and services.
Likely to lower inflation over time.
Aims to control demand-driven inflation.
(iii) Asset Prices:
Lower demand for assets like bonds and equities can decrease prices.
Higher interest rates make riskier assets less attractive.
Bond yields may rise as central banks reduce asset purchases.
Stock and real estate prices may decline during QT periods.
Overall market volatility may increase as a result of QT.
(iv) Pension Schemes:
Lower asset prices (stocks, bonds, real estate) could reduce the value of pension fund portfolios.
Higher bond yields may improve returns on fixed-income investments.
Negative impact if pension funds hold significant equity or real estate investments.
Positive impact from higher bond yields, improving returns for certain pension assets.
Overall effect depends on the fund’s asset allocation
Brief History of Derivatives Market
Origins in Chicago (Mid-1800s):
- Grain prices were highly volatile, causing risk for farmers (low prices during good harvests) and purchasers (high prices during poor harvests).
- “To arrive” contracts were introduced, allowing farmers and buyers to agree on prices in advance, reducing risk for both parties.
Modern Financial Derivatives (1970s Onward):
-Financial derivatives gained popularity and grew rapidly.
-Chicago became a global hub for derivatives trading, with major exchanges like the Chicago Mercantile Exchange and Chicago Board Options Exchange.
Current Derivatives Market:
-Derivatives markets are among the largest in the world.
-Difficult to measure due to the mix of exchange-traded and over-the-counter (OTC) derivatives.
Importance of ISDA in derivatives market
Standardized Framework: ISDA agreements provide a globally recognized legal framework for derivatives transactions, reducing complexity and ensuring consistency across contracts.
Counterparty Risk Mitigation: They include provisions for netting and collateral management, which minimize credit exposure and reduce the risk of significant losses if a counterparty defaults.
Legal Certainty and Enforceability: Master Agreement clearly defines rights and obligations, ensuring that transactions are enforceable across jurisdictions, even during legal disputes or bankruptcy.
Facilitating Global Trade: Widely adopted in international markets, ISDA agreements support cross-border trading by addressing jurisdictional differences and enhancing trust between counterparties.
Psychological Concept of Ego
The part of the individual’s psyche which shapes their perception of the world. Degree of Self Regard
Filter in which an individual’s see’s the world, influencing how they interpret different events.
Principal Aims of Regulation
- Correct market inefficiencies and to promote efficient and orderly markets.
- Protect consumers of financial products.
- Maintain confidence in the financial system.
- Help reduce financial crime
Explain the merits and potential problems that can arise from spread betting.
Merits:
- Generally exempt from CGT.
-Usually lower fees than direct investments
-Gain large leverage, potential for larger returns
Problems:
-High Risks of losses - Amplified
-Overtrading - Lower fees
Suggest
a psychologically astute approach that you could use when applying technical analysis in practice.
- Investigate methods that have worked in the past using previous price data.
-Construct own strategy based on analysis. Minimize risk by stop losses etc.
-Seek evidence that may contradict technical interpretation
Describe the aim of an algorithmic trading platform
-Automate Trade Execution: Uses pre-programmed algorithms to automatically execute trades based on predefined rules such as price, volume, timing, or other market conditions.
-Reduce Costs: Minimizes manual intervention, lowering transaction and operational costs by executing trades more efficiently.
-Enhance Speed and Accuracy: Executes trades faster and with greater precision than human traders, capitalizing on fleeting market opportunities.
Reduce Human Bias: Eliminates emotional decision-making, ensuring consistency and discipline in executing investment strategies.
Quantitative Ways to Assess AT
Execution Quality:
-Measure Latency & Price Impact
-Ensure AT works efficiently
Cost Efficiency:
-Examine Operational Costs
-Cost per trade
Reduce costs to become more competeitive
Explain Nous, Logos & Pyr
Nous:
Imagination for reality/ mind’s eye
An individual’s mental picture of the world
Logos:
Logic/Rational Thinking
Condition mental picture of nous
Pyr:
Fire in the belly
Impilse/drive
Explain Quantitative Easing
The central bank prints new money.
- It uses the money to purchase assets – mainly bonds and corporate bonds but also equities (purchases may be made indirectly by buying ETFs of the relevant assets).
- This causes asset prices to rise in each of these
markets – and bond yields to fall
EMIR
European Market Infrastructure Regulation
-Improve Transparency & Stability in OTC Derivatives
Features: - Ensure contracts are cleard
-Requires reporting of derivative contracts
MiFID II
Markets in Financial Instruments Derivavtites II
-iMPROVES TRANSPARENCY & MARKET EFFICIENCY
Protect Investors
-Purpose rules for AT
