The Derivatives Market in Context

Question 1

The 6 elements of the financial system:

Answer 1

Ultimate lenders and borrowers
Financial Intermediaries
Financial Instruments
Creation of money
Financial Markets
Price discovery

Question 2

4 Categories of the economy:

Answer 2

Household sector
Corporate sector
Government sector
Foreign sector

Question 3

Financial Intermediaries

Answer 3

Exist because there is a conflict between lenders and borrowers in terms of the financial requirements (Term, risk, volume, etc.).
They solve this divergence of requirements and perform many other functions such as lessening risk, creating a payment system, monetary policy, etc.
They interpose themselves between the lenders and borrowers.

Question 4

Spot financial market

Answer 4

Markets for debt and equity instruments which is settled as soon as possible.

Question 5

Primary markets

Answer 5

Issue of new securities.

Issuers (borrowers) receive money from the lenders (investors).

Question 6

Secondary Markets

Answer 6

Markets that exist for the trading for already existing marketable securities.
Money flows from buyers to sellers.

Question 7

2 Types of financial markets

Answer 7

Share Market

Debt Market

Question 8

The Lenders and borrowers

Answer 8

The non-financial economic units that undertake the lending and borrowing process.

Question 9

Financial Instruments

Answer 9

They are created to satisfy the financial requirements of the various participants; these instruments may be marketable (e.g. treasury bills) or non-marketable (retirement annuity).

Question 10

Creation of money

Answer 10

When credit is demanded; banks have the unique ability to create money by extending credit / loans.

Question 11

Financial Markets

Answer 11

The institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.

Question 12

Price Discovery

Answer 12

The price of equity and the price of money / debt (the rate of interest) are “discovered” (made and determined) in the financial markets. Prices have an allocation of funds function.

Question 13

Debt Market

Answer 13

The market where debt instruments are issued and exchanged.
Interest is paid hence other name: interest-bearing market.
Also called the fixed-interest market.

Question 14

2 Typed of debt market

Answer 14

Money Market (Short term debt)
Bond Market (Marketable long term debt)

Question 15

The Money Market encompasses the following markets:

Answer 15

• Markets in the short-term debt securities of ultimate borrowers.
• Markets in the short-term deposit securities of banks.
• Markets in the short-term deposit securities of the central bank (bank notes and coins and securities issued for monetary policy purposes).
• Interbank market between private sector banks (the interbank rate is discovered here).
• Interbank market between the central bank and the private sector banks (accommodation/loans to the banks at the repo rate).
• Interbank market between the private sector banks and the central bank (reserves required to be held at no interest).

Question 16

Equity/Share Market

Answer 16

Market of issuing and trading of shares. The term equity refers to the capital of a company.

Question 17

3 Parts of the equity market:

Answer 17

• Ordinary shares
• Preference shares
• Retained Profits

Question 18

Ordinary shares

Answer 18

These shares are permanent capital in the sense that they represent a share in the ownership of a company.

Question 19

Preference shares

Answer 19

These shares are long-term capital if they have a maturity date (they usually do), or permanent capital if they are perpetual, i.e. have no maturity date.

Question 20

Short-Selling

Answer 20

The sale of a security spot and buying it back spot when deemed propitious. In order to do this, the seller has to borrow the security from a scrip lender.
The scrip lender charges the scrip borrower a fee for the service.

Question 21

Scrip

Answer 21

The term used in the past for physical securities when securities registries were not electronic.

Question 22

Motivation for short-selling

Answer 22

To profit from a decline in price.

Question 23

Two risks to consider when short-selling:

Answer 23

• If the spot price of the security rises, the short-seller will make a loss.
• If the liquidity of the market (high turnover in a market means good or efficient price discovery) deteriorates after the spot sale, it may be difficult to purchase the security, with price implications.

Question 24

The Yield curve

Answer 24

Representation of the relationship between interest rates and term to maturity.

Question 25

Derivatives

Answer 25

Contracts between two parties to buy, sell or exchange (optional or obligatory) a standard or non-standard quantity and quality of an asset or cash flow at a pre-determined price on or before a specified date in the future.

Question 26

Financial markets consist of four distinct markets: the debt markets, the equity market, the foreign exchange market and the derivatives market.
True or false?

Answer 26

False. Derivatives are found in all the financial markets and it is not a market on its own.

Question 27

Prices in derivatives markets are not as volatile as prices in spot markets. True or false?

Answer 27

False. Derivatives derive their values from that of the underlying instruments and will therefore reflect the changes in the prices of the latter.

Question 28

Derivatives are found in both formalised (exchange) markets and informal (OTC) markets. True or false?

Answer 28

True

Question 29

Define a ‘derivative’?

Answer 29

Derivatives are contracts between two parties to exchange a standard or nonstandard quantity and quality of an asset or cash flow at a pre-determined price at a specified date in the future.