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FCA 2: Derivatives > Underlying Markets > Flashcards

Underlying Markets Flashcards

1
Q

what is the purpose of money markets?

A

to provide short-term liquidity and provide a temporary safe haven for investment funds

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2
Q

what instruments are within the money market?

A

cash, short-term deposits and other instruments
that mature within one year of issue

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3
Q

What is SONIA?

A

Sterling overnight index averaged

overnight interest rate paid by banks for unsecured transactions in the London Sterling market. offers a benchmark interest rate for financial transactions

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4
Q

who calculates SONIA and how is it calculated?

A

BOE calculates it by collecting IR data from major FIs trading short-term-sterling rates by 7am, they then format and runs checks to make sure its sensible and it’s published at 9am

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5
Q

what is the ESTR

A

European Equivalent of SONIA, indicates wholesale euro unsecured borrowing costs of banks in the eurozone

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6
Q

what is SOFR?

A

secured overnight finance rate, benchmark interest rate for dollar-denominated derivatives and loans. broad measure of he cost of borrowing cash overnight which is based on a single repo rate for US Treasuries and is published each business day

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7
Q

what are the main risks faced by those trading money market contracts?

A

credit risk and counterparty risk

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7
Q

what is a certificate of deposit?

A

a promissory note issued by banks and other financial institutions. savings-type deposit offered to investors that pays a fixed interest rate if the investor redeems the certificate after a set amount of time. commonly mature at 3 and 6 month

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8
Q

what are treasury bills?

A

also known as promissory notes, typically issued with a maturity of 91 days although they can also be 182-day maturity. issued at a discount to their nominal/par value and redeemed at

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9
Q

why do CDs sometimes have a higher yield than T-bills?

A

to reflect their slightly higher credit risk

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10
Q

what is commercial paper?

A

issued by large financial and non-financial institutions as a short term borrowing facility- debt is unsecured, backed by unused bank credit lines- denominated in minimums of US$500k

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11
Q

what is the spot FX market?

A

involves the exchange of one currency for another at an agreed rate, settled T+2

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12
Q

What does the spot quote GBP/USD=1.3010/15 mean?

A
  • 1.3010 is the bid for GBP, quoting bank will buy sterling and sell dollars at this rate
  • 1.3015 is the offer for GBP – here the quoting bank will sell sterling and buy dollars. At this rate,
    sterling is more expensive
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13
Q

what is a forward in the FX market?

A

company may wish to lock in an exchange rate in advance- forward rate is based on the spot rate and the interest rate differentials between the two currencies for the length of the forward

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14
Q

what are the market conventions when quoting forward points?

A

when the forward points decrease, the bid decrease is greater than the offer decrease- described as a discount for forward delivery

when the forward points quote increases, the base currency is more expensive than the counter currency in the future, the points would be added to the spot rate- described as a premium for forward delivery

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15
Q

how is the necessary premium or discount calculated by banks?

A

by considering the relevant short-term interest rates

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16
Q

why is arbitrage uncommon in forward markets?

A

the deep liquidity rarely allows for opportunities to arbitrage geographic interest rate differentials for a prolonged period of time

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17
Q

what are the potential uses of forward markets?

A

speculators to speculate on expected changes in the difference between interest rates and portfolio management to hedge transaction risk

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18
Q

what is translation risk?

A

possibility that foreign-currency denominated assets on a company’s balance sheets (or portfolios in this case) will decline in value purely due to FX translation back to the domestic
currency.

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19
Q

what do premiums and discounts mean in relation to forward rates?

A

whether the forward rates are higher or lower than the spot rates, premium means the forward price of the base is higher, discount means its lower

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20
Q

what soes a bigger spread in the forward market mean?

A

compensation for the increased risk in the forward market

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21
Q

what is an NDF?

A

Non-Deliverable Forwards, cash-settled, short-term forward FX contract on a thinly traded or non-convertible international currency.

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22
Q

what two factors do all NDFs have?

A

Fixing date: date at which the difference between the prevailing market exchange rate and the agreed-upon exchange rate is calculated,

settlement date: date by which the payment of the difference is due to the party receiving payment

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23
Q

how are NDFs commonly quoted?

A

for periods of time between one month and one year, normally quoted and settled in USD but EUR and GBP are also common

24
Q

why are NDFs popular?

A

popular instrument for corporations seeking to gain exposure to or hedge positions in foreign currencies that
are not fully convertible or countries with currency controls.

25
Q

what must be considered when calculating forward FX rates for periods of less than one year?

A

have to take into account
the different day count conventions of the different currencies’ money markets

26
Q

how is the forward rate calculated?

A

= spot rate x [(1+(n x r1)/1+(n x r2)]

where r1 is the interest rate for the traded currency, r2 is the interest rate for the base currency and n is the period in question

e.g., 6-month EUR/USD forward rate= 1.1800 x [1+( (186/360) x 0.005)] / [1+((186/360) x 0.002)] = 1.1818

27
Q

how do inflation and interest rates correlate in terms of FX markets?

A

relatives rates of inflation may affect forward rates but interest rates should reflect domestic inflation expectations in a country.

28
Q

what is a bond?

A

a debt instrument where the borrower is obliged to pay coupon payments at predetermined dates and repay the principal at a later date to the holder

29
Q

what are the different bond maturity date classifications?

A
  • short – less than seven years remaining
  • medium – seven to 15 years remaining
  • long – greater than 15 years remaining
30
Q

what is a yield spread and how is it calaculated?

A

way of comparing the yields of two financial instruments, difference between the quoted rate of return. calculated by subtracting the yield of one from another

31
Q

what do the normal / inverted yield curves capture?

A

normal: investors have a liquidity preference, accept lower yield for shorter period

inverted: investors do not have a liquidity preference, would want higher yield over a longer period

32
Q

what are the principal rights of an ordinary/preference shareholder?

A
  • dividends
  • capital repayment- they are the last to be repaid though
  • voting rights
33
Q

what are partly paid shares?

A

when only a portion of the purchase price is paid to the issuing company, balance is payable in one or more installments

34
Q

what are the different types of preference shares?

A
  • cumulative/non-cumulative
  • participating
  • redeemable
  • convertible
35
Q

what are warrants?

A

equity warrant gives its holder the right to buy a company’s shares/bond over the life of the warrant at a fixed exercise price, usually at a premium over its current price at the time the warrant is issued.

36
Q

what does the attachment of a warrant mean for coupon payments on bond?

A

lower coupon payments, lower coupon represents the premium the investor pays for the warrant

37
Q

what is the strike price in relation to warrants?

A

the amount that must be paid in order to exercise the warrant (put or call)

38
Q

what is the conversation ratio in terms of warrants?

A

number of warrants needed in order to buy/sell one investment unit- if the conversion ratio is high, the price of the share will be low and vice versa

39
Q

what is the GGM?

A

Gordon Growth model, aka dividend discount model- attempts to determines a shares value based on the forecasts of it’s future dividend payments, assumes they will grow at a constant rate, uses a discount rate to take into present value of future dividends payment stream

40
Q

what is the GGM formula?

A

P= D1 / (r-g)

where P is the share price, D1 is the value of next year’s divided, r is the cost of equity and g is the constant growth rate

e.g., P = $2 / (0.07 - 0.03) = $50

41
Q

what is EPS and how is it calculated?

A

Earnings Per Share, the portion of a company’s net income that is available to ordinary shareholders.

EPS= (Net Income for the financial year- Dividends on preferred shares)/ Number of ordinary shares

42
Q

what is the earnings yield and how is it calculated?

A

indicator of company’s comparative strength of earnings against that of another

= EPS/ share price

43
Q

what is the P/E ratio and how is it calculated?

A

relationship between a company’s share price and its EPS, tells investors how much a company is worth.

= share price/EPS

44
Q

why is the P/E ratio a useful tool in equities?

A
  • relevance
  • comparisons
  • it can show how risky the market believes an investment in the company’s
45
Q

what is the NAV per share?

A

calculating the total net asset value of the company and dividing this by the number of ordinary shares in issue

46
Q

what is the NAV?

A

net asset value, everything it owns, less everything it owes

= assets-liabilities

47
Q

what are the different types of corporate actions?

A
  • rights issue
  • bonus issue
  • stock split
  • M&A
  • share buybacks
48
Q

what are the three broad categories of commodities?

A
  • agriculturals and softs
  • energy
  • minerals
49
Q

what are the factors that influence the price of soft commodities?

A
  • demand (how much countries need that commodity)
  • supply (commodity that is being provided to the market)
50
Q

what factors influence the price of metals?

A
  • availability of raw materials and cost of extraction and production
  • demand from the underlying users of the metal
51
Q

what are the factors that influence the price of oil and gas?

A
  • supply is finite
  • demand and energy needs
  • political crises
  • weather and unexpected shocks
52
Q

what are the three factors that define crude oil?

A
  • field of origin
  • density
  • sulphur content
53
Q

what is the strategic factor of producer organisations?

A

they can influence a commodities price as they may agree and maintain a minimum price, leads to an oligopoly

54
Q

what is a weather derivative?

A

a contract that can enable business to protect themselves against losses caused by unexpected shifts in weather conditions- main influences are the short and long-term weather forecasts

55
Q

what are emissions contracts?

A

contracts that set a price for a set amount of emissions allotment, influenced by the growing concerns on emissions

56
Q

what are freight derivatives?

A

container freight swap agreements based on the future level of freight rates

57
Q

what is the role of volatility assets?

A

traded contracts in relation to the variance and price movements of assets through swaps, underlying will generally be indexes e.g., S&P500

58
Q
A

FCA 2: Derivatives (9 decks)

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