Part 1

Question 1

What are the differences between Forward and futures

Answer 1

Futures

1. Exchange traded
2. Standardised
3. index futures are available highly marketable delivery price determined openly on the market
4. Clearing house guarantee so no credit risk
5. Margin Can be closed out prior to maturity

Forwards

1. Over the counter
2. tailored
3. Normally based on specific security
4. no or poor marketability
5. delivery price negotiated privately
6. no clearing house or CCP so credit risk
7. usually no margin
8. difficult to close out

Question 2

Trading process of futures

Answer 2

a) This is the collateral that each party must hold to an exchange traded derivative must deposit with the clearing house. This will act as a cushion
b) An initial margin is deposited by the parties
c) This is changed on a daily basis to ensure that clearing house exposure to credit risk is controlled
d) The process of daily margin changes is known as marking to market
e) Fall in value is topped up with additional payments of variation margin, to enable clearing house to continue to give its guarantees
f) The risk of default tend to increase if the market moves against you
g) The parties will be required to maintain the margin throughout the duration of the contract
i) This is controlling the credit via mark to market If the markets move significantly, it can be closed halting trading allowing traders to collect their margins

Question 3

Role of the clearing house

Answer 3

a) Counter party to all trades
b) Guarantor
c) Register of all deals
d) Holder of deposit margin
e) Facilitator of the marketing process

Question 4

List out all Money Markets and market instruments

Answer 4

1. T- Bills
2. Commercial paper
3. Repos
   
   • Investors buys something with the agreement that the debtor will buy it back at a higher price
   1. Government agency bonds
4. Bank time deposits
   
   1. Bank where you cannot withdraw until a certain time
5. Bankers acceptance
   
   1. Tradable invoice

Question 5

Types of swaps

Answer 5

1. Currency (Underlying nonminal is exchanged)
2. Par swap
   
   • An agreement between two parties, A and B, where B agrees to pay to A cashflows equal to interest at a predetermined fixed rate…
   • ..,on a notional principal…
   • …for a number of years.
   • At the same time, A agrees to pay to B cashflows equal to interest at a floating rate…
   • …on the same notional principal for the same period of time.
   • Puttable
3. RPI (Inflation and fixed)
4. Interest rate (fixed and floating)
5. Equity(stock/index and fixed)
   
   1. Swapping variable income from equities for fixed income based on bonds
6. Step Up
   
   1. Principle increase in predetermined way
7. Extendable
   
   1. A swap in which one party has the option to extend the life of the swap beyond a specified period
8. 9. Cross(x) Currency (fixed, floating, currency nominal)
9. Constant maturity (fixed and floating interest rate based on alonger term assets)
10. LPI vs RPI
11. Variance/Volitility
    
    1. exchange a fixed rate in return for experience in variance or volatility or price changes for a reference asset
12. Asset &Amortising (Fixed and floating)
13. Total Return
    
    1. total return from one asset swapped for total return on another
    2. Normally structured to equal zero
    3. In the absence of credit risk the value is the difference between the return on each side of the swap
    4. Enable diversification by swapping one type of exposure for another without phyically swapping underyling assets
14. Swapitons and Swaps

Question 6

Why does corporate debt have a higher yield than government yield

Answer 6

1. Compensation for expected defaults
2. The possibility that investors may expect future defaults to exceed historic levels
3. Compensation for the risk of higher defaults, i.e. a credit risk premium
4. A residual that includes the compensation for the liquidity risk - typical referred to as an illquidity premiums

Quantifying this involves techniques such as the use of option pricing models, using equity volatility to estimate the risk of default and use of credit default swaps to estimate the market premium for credit risk

Question 7

What are the type of hedge funds

Answer 7

Global

Event driven

Market neutral

Multi strategy

Question 8

Why is it difficult to measure the success of hedge funds

Answer 8

Survivorship bias

arises when data doesnt realistically reflect survivors and failures. Means average returns ovverestimating and volatility underestimated

Selection bias

arises because funds with good history more likely to apply for inclusion in database, and may reflect backfilling of good past performance. Means average returns overestimate and volatility underestimated

Marking to market bias - most of the assets are illiquid. They either use their own estimate or the latest price for valuaiton. The use of stale price could lead to under estimation of true variance and correlation

Question 9

What are the types of PE

Answer 9

Venture

1. Capital for business in the conceptual stage or where the products are not developed and revenues and/or profits may not have been achieved

Leverage buyouts

1. Equity capital for acquisation or refinancing of a large company

Development -

1. Provision of growth or expansin working capital for mature business in need of Product extension and/or market expansion
2. Restructuring capital - provisioin of new equity for financially or operationally distressed companies

Question 10

When would inveseting in PE be appropriate

Answer 10

1. High investment return
   
   1. as compensation for high default risk and low marketability
   2. due to inefficient pricing
   3. due to high incentivised management
   4. because returns are highly leveraged
2. Low correlation with existing investments

Question 11

What are central banks mainly involved in

Answer 11

Regulation

Implementation of government borrowing

Intervention in currency market

Printing money

Tax

Question 12

Who are the main investors

Answer 12

Household

Financial intermediaries

Business

Foreign investors

Question 13

How to government influence the economy

Answer 13

1. Monetary policy
2. Fiscal
3. National debt level
4. Exchange rate
5. Prices and income
6. Interest rate
   
   • Affects income of individuals
   • Business investments and economic growth
   • Corporate profitability

Question 14

Describe the characteristics of ETF

Answer 14

Exchange Traded Funds (ETFs) are the ‘closed-ended’ investment trust equivalents of lndex Funds.
An ETF represents shares of ownership of a unit investment trust…
…which holds portfolios of stocks, bonds, currencies or commodities.
The investor purchases the shares on a stock exchange in a process identical to the purchase or sale of any other listed stock.
An important characteristic of an ETF is the opportunity for arbitrage by exploiting any difference between ETF prices and those of the underlying assets…
…however as usual, the actions of arbitrageurs result in ETF prices that are kept very close to the Net Asset Value of the underlying securities.
The ETF’s performance tracks an underlying index, which it is designed to

Question 15

lssues that differentiate between different types of loan include:

Answer 15

1. Commitment - whether there is prior commitment by the lender to advance funds when required (often requiring payment of a commitment fee to the lender).
2. Maturity - the term for which the lending is made.
3. Rate of interest - this may be either fixed or floating.
4. Security - whether the loan is to be secured against assets (either fixed or liquid assets).

Question 16

Issues with investing in Hedge funds

Answer 16

1. the sponsor believes that hedge funds are too risky, and wishes to limit the amount of risk in the fund
2. the fund wishes to limit the amounts invested in any unregulated investment.
3. There may be indirect limits imposed that restrict investment in hedge funds because:
   
   1. if there are restrictions on the pension scheme short-selling, then it would not be permitted to invest indirectly in a fund which short-sells assets
   2. if there are restrictions on the use of derivatives, then it would not be permitted to invest indirectly in a fund that uses derivatives.
4. High fees compared to other investments, and double layers of fees for investing in ‘fund of funds’
5. Lack of expertise in selecting the right hedge fund
6. No investment (or limited investment) in any equity-style investment. This would be the case if the fund was pursuing a liability-driven or bond-based approach
7. Knowledge of negative events in the past (such as Madoff)
8. Lack of liquidity and marketability, due to the fact that hedge funds often only allow investment or dis-investment on certain prescribed dates.

Question 17

What are the main features of infrasture asset

Answer 17

lnfrastructure assets are generally characterised by:

• high development costs
• high barriers to entry .
• long lives

They are generally managed and financed on a long-term basis. Historically it was seen as the role of government to fund and manage these assets for the good of the population.

lnfrastructure assets display a number of characteristics that distinguish them from more traditional equity or debt investments:

1. The assets themselves tend to be single purpose in nature, such as a gas pipeline, toll road or hospital.
2. The private investor’s participation in the asset is often for a finite period. This is generally a function of the agreement the investor has made with the government authority, or a function of the natural useful life of the asset.
3. lnfrastructure assets are characterised by their long lives. ln fact the capital invested in these projects is often referred to as ‘patient’ capital, in that the initial development involves high upfront capital costs with payback occurring over the asset’s generally lengthy life.
4. One of the key characteristics of infrastructure assets, and what can make them particularly attractive as investments, is that they tend to be, or exhibit the characteristics of, natural monopolies. Under a natural monopoly, economies of scale are such that the unit cost of a product will only be minimised if a single firm produces the entire industry output.
5. This environment has the potential to weaken market forces, particularly when there are few, if any, alternative suppliers of the infrastructure. ln this case, firms operating in a natural monopoly, protected from new competitors by the high barriers to entry, may be able to earn abnormal profits by charging higher prices

As a result of these monopolistic characteristics, infrastructure assets tend to be subject to varying degrees of government regulation, depending largely on the degree of natural monopoly This is not necessarily to the detriment of investors in infrastructure, as it provides a level of certainty regarding the income streams that will flow from the asset.

The asset specific risks encompass risks pertaining to the design, construction and operation of the infrastructure asset. The asset class risks include:

1. Market conditions
2. regulatory risk and polical risk

The asset specific risks will largely depend on the maturity of the asset. For example, in the construction phase, there is considerable risk associated with the construction process.

Although infrastructure assets vary in terms of the level of regulation they face, this regulation generally results in income streams that exhibit low growth. To compensate investors for this, infrastructure investments tend to be higher yielding than equity investments.

ln terms of capital values, this stable, high yield results in infrastructure assets displaying a lower level of price volatility than equity investments over the longer term. lt also acts as a support to the price of infrastructure assets in periods of poor returns in the broader equity market. As such, infrastructure is often referred to as a’defensive’asset.

Forecast returns from individual infrastructure investments vary depending on the characteristics of the underlying asset, its maturity, risk and taxation treatment in the context of the prevailing macro environment. Over the longer term, as industry structures and regulatory regimes mature, the listed infrastructure sector will most likely behave like a hybrid between an equity and a bond.

Question 18

What is ETF

Answer 18

1. Exchange Traded Funds (ETFs) are the ‘closed-ended’ investment trust equivalents of lndex Funds.
2. An ETF represents shares of ownership of a unit investment trust…
3. …which holds portfolios of stocks, bonds, currencies or commodities.
4. The investor purchases the shares on a stock exchange in a process identical to the purchase or sale of any other listed stock.
5. An important characteristic of an ETF is the opportunity for arbitrage by exploiting any difference between ETF prices and those of the underlying assets…
6. …however as usual, the actions of arbitrageurs result in ETF prices that are kept very close to the Net Asset Value of the underlying securities.
7. The ETF’s performance tracks an underlying index, which it is designed to replicate.
8. ETFs will not exactly replicate index performance due to tracking error.
9. ETF management fees are typically low.

Question 19

What are the key characteristics of hedge fund

Answer 19

1. Hedge funds typically have less restrictions on:
   
   1. borrowing
   2. short-selling
   3. the use of derivatives
2. than more regulated vehicles such as mutual funds (or unit trusts or investment trusts).
3. Hedge funds are characterised by:
   
   1. the placing of many aggressive positions on different assets
   2. a high level of borrowing, …
   3. … given the limited size of the capital of the funds compared to the size of the individual investments.
   4. . a mix of investments for which the price movements would be expected mostly to cancel each other out, …
   5. … except for the positive non-market effect the hedge fund is looking for. .
   6. a willingness to trade in derivatives, commodities and non-income bearing securities. .
   7. a higher risk tolerance than other funds o a wide spectrum of investment strategies
4. Other characteristics of hedge funds typically include: . opaqueness
   
   1. illiquidity and
   2. high fees.

Question 20

short-term borrowing facilitated by banks

(Tribe)

Answer 20

1. bankers’acceptances and eligible bills o
2. term loans .
3. evergreen credit kinda like an overdraft facility (permission to borrow up to a specified limit, with no fixed maturity) .
4. revolving credit (similar to evergreen credit, but with a fixed maturity of up to 3 years)
5. bridging loans (advances to be repaid from specified income)
6. o international bank loans o
7. factoring
   
   1. Selling account recievables

Question 21

features that differentiate the forms of short-term borrow

Answer 21

Commitment - whether there is prior commitment by the lender to advance funds when required (often requiring payment of a commitment fee to the lender).

Maturity - the term for which the lending is made.

Rate of interest - this may be either fixed or floating.

Security - whether the loan is to be secured against assets (either fixed or liquid assets).

Question 22

Factors impacting the interest rate

Answer 22

Term

loan size

credit risk

nature of interest rate - variable or fixed

Question 23

Role of margins

Answer 23

1. Margin is the collateral that each party to an exchange-traded derivative must deposit with the clearing house.
2. It acts as a cushion against potential losses, which the parties may suffer from future adverse price movements.
3. When a transaction is first struck, initial margin is deposited by the broker with the clearing house.
4. It is changed on a daily basis through additional payments of variation margin. This variation margin ensures that the clearing house’s exposure to counterparty risk is controlled.
5. The exposure can increase after the contract is struck through subsequent adverse price movements.

Question 24

How does the margin system work

Answer 24

1. When a futures contract is opened each party to a futures contract must deposit a sum of money in an interest bearing account with teh clearing house - initial margin
2. This is calculated as being the maximum daily loss tha the investor is expeted to suffer given the inital derivative positions that have been undertaken, based ona model
3. As time progresses, the underlying asset price, and hence the value of the future is likely to change
4. The marking to market process involves a dialy calculation of the market value of a trader’s position. The profit of loss made by the trader is credited to or debited from their margin account
5. this amount can be removed in full at the end of the term of the futures contract
6. if the margin account falls below a critical level before then (known as the maintenance level), the trader will have to post additional margin to bring the margin up to hte inital margin level
7. These extra margin payments are known as variation margin
8. Where margin levels rise substantially above the inital margin can be wirthdrawn from teh account
9. the process of marking to market means that the profit or loss on future is realised over a perod of time rather than simply at the delivery date
10. if the market moves substantially in either direction, the market may be closed or limit up or limit down adn the margins will be re-assessed intra day by the clearing house

Question 25

How does marging system limit credit risk

Answer 25

1. Following registration of a trade, each party has a contractual obligation to the clearing house rather than the the original counter party
2. In turn the clearing house guarantees each side of the original margin
3. by standing between the two parties the clearing house removes the immediate credit risk of individual participants to each other
4. However, it is important tha the ability of the clearing house to honour its positions is not vulnerable to default by one of more traders
5. Iniital margin is a cushion for the clearing house against potential losses that it would suffer in the event of default by one of the original parities to the trade
6. The daily marking for market and margin calls ensures that the amount of each margin account is maintained at an appropriate level
7. The clearing house also limits its exposure by ensuring the it only deals with top quality traders, and there are conditions set for who can open a margin account and trade with the clearing house

Question 26

How to construct a catastrophe bond

Answer 26

The ceding insurance company establishes a special purpose vehicle in a tax efficient jurisdiction

The SPV estbalishes a reinsurance agreement with the sponsoring insurance company

The SPV issues a note to investors; this note has default provisions that mirror the terms of the reinsurance agreement

The proceeds from teh note sale are invested inmoney market instruments within a segregated collateral account

If no trigger events occur during the risk period, the SPV returns the principal to investors with the final coupon payment

If the trigger event occur, the assets of the SPV are first used to meet the insurer’s losses before any return of principlal