Section 1

Question 1

Describe the types of ‘margin’ a clearing house takes. (4)

Answer 1

Margin is the collateral that each party to a futures contract must deposit with the clearing house. It acts as a cushion against potential losses, which parties may suffer due to adverse price movements.

When the contract is first struck, initial margin is deposited. It is changed on a daily basis through additional payments of variation margin.

The process of daily margin requirement changes are known as marking to market.

Question 2

What is open interest? (1)

Answer 2

The number of contracts outstanding at any one time is known as open interest.

Question 3

What are price limits? (1)

Answer 3

To ensure prices move in an orderly fashion, a clearing house may limit the price of a contract moving in one day. This helps protect the clearing house from excessive credit risk.

Question 4

What is the payoff from a long position in a forward contract? (1)

Answer 4

S(T) - K

Where K is delivery price and S(T) is spot price at maturity

Question 5

Name 6 money market instruments - lending (3)

Answer 5

Treasury Bills
Commercial Paper
Repos
Government Agency Securities
Certificates of deposit
Eligible Bills

Question 6

How can companies raise money in money markets?

Answer 6

• International bank loans
• Commercial paper
• Eligible bills
• Bridging loan from bank
• Evergreen credit from a bank
• Arranging term loan from a bank
• Revolving credit from a bank

Question 7

Name the four issues that differentiate between types of loan

Answer 7

• Commitment - whether there is prior commitment by the lender to advance funds when required
• Maturity
• Rate of Interest - may be fixed or floating
• Security - whether the loan is to be secured against assets

Question 8

The excess yield on corporate bonds over treasury bonds is typically decomposed into four components. Name them.

Answer 8

1. Compensation for expected defaults
2. 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.

Question 9

Name three credit derivatives.

Answer 9

1. Credit Default Swaps
2. Total Return Swaps
3. Credit Spread Options

Question 10

Describe Credit Default Swaps.

Answer 10

A CDS is a contract that provides a payment if a credit event occurs. Such events include bankruptcy, a rating downgrade, repudiation (issuers cancels all payments), failure to pay a coupon, cross-default (a credit event occurs on another security issued).

There are two ways to settle a claim under a CDS.

1. Pure cash payment, representing the fall in market price of the defaulted security (which can be difficult to determine).
2. Exchange of both cash and a security (physical settlement). The seller pays the buyer the full notional amount, in return for the defaulted security.

Question 11

Describe Total Return Swaps.

Answer 11

The total return from one asset is swapped for the total return on another. These enable financial institutions to achieve diversification by swapping one type of exposure for another.

In the absence of counterparty credit risk, the value of the total return swap is the difference between the values of the assets generating returns on each side of the swap. It is normally structured so that the initial value is zero.

Question 12

What is the definition of private debt?

Answer 12

Private Debt is a debt capital market transaction that generally has covenant features similar to a bank loan and is often used as an alternative to bank funding.

It is not actively traded and will typically be marketed to a smaller number of buy and hold investors. Tends to be issued in US$.

Question 13

Reasons for issuing private debt.

Answer 13

Although issuer almost inevitably cedes covenants to investors, this is more than compensated by the fact it is able to isse debt capital without acquiring a formal long-term debt rating.

For treasurer, it represents a major capital source with relatively competitive pricing. It therefore allows treasurer to fee up credit lines with relationship banks.

Question 14

Define “asset-backed securities” and “ “securitisation”

Answer 14

ABS - result from securitisation of a revenue generating asset held by the borrower.

Securitisation - the issue of securities, usually bonds, where the bonds are serviced and repaid exclusively out of a defined element of future cashflow owned by the borrower.

SECURITISATION CONVERTS A BUNDLE OF ASSETS INTO A FINANCIAL INSTRUMENT.

Question 15

Name 3 classes of securitised assets

Answer 15

1. Mortgage Backed Securities (MBS)
2. Credit Card Receivables (CCABS)
3. Collaterised loan, bond and debt obligations (CLO, CBO and CDOs)