Chapter 2: Underlying Markets

Question 1

Why do money markets exist?

Answer 1

Banks will have a surplus or deficit of cash

Question 2

What is the SONIA and what is it used for?

Answer 2

Sterling Overnight Index Average
Rate for unsecured transactions in London sterling market

Question 3

How does the BoE calculate SONIA?

Answer 3

Financial institutions will send details of their transactions of short term rates
BoE validates this data

Question 4

What is €STR and what is it used for?

Answer 4

Euro Short-Term Rate
European SONIA, based on TARGET2 transactions

Question 5

What is TARGET2?

Answer 5

Trans-European Automated Real-Time Gross Settlement Express Transfer System
Settlement/Payments system

Question 6

What is the SOFR and what is it used for?

Answer 6

Secured Overnight Financing Rate
Benchmark interest rate for dollar-denominated derivatives and loans
Based on repo rate for USTs, since 2018

Question 7

What are T-bills?

Answer 7

Treasury bills
Short term debt issued by governments

Question 8

Why are T-bills sometimes called promissory notes?

Answer 8

Backed by the promise of a government

Question 9

What is a certificate of deposit?

Answer 9

Promissory note from financial institution if investors put their money away for set amount of time

Question 10

What minimums do CP usually have?

Answer 10

$500k

Question 11

What is spot FX settlement time?

Answer 11

T+2

Question 12

What is used to calculate forward rates?

Answer 12

Spot rate and interest rate differentials

Question 13

What is a non deliverable forwards?

Answer 13

Cash settled, short term FX contract on a thinly traded or non-convertible international currency

Question 14

How is profit or loss calculated on an Non-Deliverable forwards?

Answer 14

Difference between agreed exchange rate and spot rate at the time of settlement

Question 15

What do all NDFs have?

Answer 15

fixing date - date which the difference between market and agreed rate is calculated
settlement date - date by which the payment of the difference is due

Question 16

What is a common time period for NDFs?

Answer 16

one month - a year

Question 17

What are NDFs usually traded against?

Answer 17

Illiquid currencies or those with currency controls e.g. CNY
Settled in USD, or EUR/GBP

Question 18

What is interest rate parity?

Answer 18

The theory that forward rates are in line with relative interest rates, else arbitrage would be possible

Question 19

How can the link between relative interest rates and FX be summarised?

Answer 19

Higher interest rate currency = Discount in the forward foreign exchange market
Lower interest rate currency = Premium in the forward foreign exchange market

Question 20

What needs to be taken into account when calculating FX rates of less than one year?

Answer 20

Day count conventions

Question 21

What is the formula for forward rate?

Answer 21

Spot rate *
(period * interest rate traded currency + 1) / (period * interest rate base currency + 1)

Question 22

How would you calculate the premium or discount?

Answer 22

forward rate - spot rate

Question 23

What is the settlement period of French, German and Italian bonds?

Answer 23

T+2

Question 24

Which bonds have annual coupon frequencies?

Answer 24

French and German

Question 25

What is the difference between floating rate and index linked bonds?

Answer 25

Index linked - RPI/CPI etc Floating rate - SONIA / SOFR

Question 26

What is indexation lag?

Answer 26

Protects against inflation for the last interest period of a bonds life

Question 27

Why may an emerging market country issue bonds in EUR or USD?

Answer 27

Lower interest rates than home currency

Question 28

What are bonds issued by governments in other than their home currency called?

Answer 28

Sovereign eurobonds

Question 29

What is the yield spread?

Answer 29

Difference between the quoted rates of return of two different bonds that have similar maturities

Question 30

What does the yield curve show?

Answer 30

The yields available to investors over different maturities of the same bond

Question 31

Why is the yield curve curved? (2)

Answer 31

Liquidity preference Shorter-dated bonds have higher liquidity Investors prefer higher liquidity so are willing to accept a lower yield Risk Other risks increase over time such as inflation or default

Question 32

When does an inverted yield curve arise?

Answer 32

Yields on short dated > yields on higher dated bonds Occurs when there is an expectation of a reduction in interest rates at some stage in the future

Question 33

Where can bonds be listed (3)

Answer 33

Exchanges ECNs (electronic communication networks) Decentralised dealer based OTC markets

Question 34

Where is most volume traded for bonds?

Answer 34

Decentralised dealer based OTC markets

Question 35

How are dividends paid on bearer shares?

Answer 35

Holder clips a coupon from certificate and submits it to the paying agent

Question 36

What is a partly paid share?

Answer 36

One where only a portion of the purchase price has been paid to the issuing company Firms directors can call up capital from investors

Question 37

What do preference shareholders receive preference on?

Answer 37

Dividends and capital repayment

Question 38

What is a participating preference share?

Answer 38

Allows shareholder to receive any excess dividend if company makes more money

Question 39

What is a convertible preference share?

Answer 39

Preferential rights with the option to convert their holding into ordinary shares at a future date/price

Question 40

Why may a warrant conversion ratio be adjusted?

Answer 40

To account for any corporate actions that change share structure

Question 41

How does Gordons growth model calculate share value?

Answer 41

Forecasting future dividend payments, assuming a constant growth rate

Question 42

What is the Gordons growth model?

Answer 42

A valuation technique

Question 43

What is the Gordons growth model formula?

Answer 43

price = next year dividend / (cost of equity capital - constant growth rate)

Question 44

What is the formula for EPS?

Answer 44

net income - dividends on preferreds / number of ordinary shares

Question 45

What is the calculation for NAV?

Answer 45

assets - liabilities

Question 46

What is the earnings yield calculation?

Answer 46

Earnings yield (%) = EPS / market price

Question 47

Where does NAV not work?

Answer 47

Companies where value is made from people skills e.g. Law firms, architecture firms

Question 48

What are the three main categories of commodity?

Answer 48

Agricultural and softs - sources of calories and cash crops (softs) e.g. coffee, sugar Energy Minerals - inc. precious metals

Question 49

What is carry cost called for commodities and what can it include?

Answer 49

Holding cost Warehousing, spoilage, interest, taxes

Question 50

What 3 factors is crude oil defined by?

Answer 50

* Field of origin – for example, Brent, West Texas, Dubai, or Oman. * Density – ie, low density or ‘light’, high density or ‘heavy’. * Sulphur content – ie, low sulphur or ‘sweet’ (ie, sulphur content below 0.5%), high sulphur or ‘sour’ (ie, sulphur content above 0.5%).

Question 51

What is the difference between WTI and Brent?

Answer 51

WTI is a stored oil contract, where someone must nominate a US storage facility Brent you nominate a port for delivery

Question 52

What is the difference between coins and tokens in crypto?

Answer 52

Coins have their own blockchain Tokens reside on existing blockchain

Question 53

How are weather derivatives measured?

Answer 53

Using HDDs or CDDs heating degree days or cooling degree days

Question 54

What is the VIX based on?

Answer 54

IV of the SP500

Question 55

What emission contracts can be traded?

Answer 55

Carbon dioxide, sulphur dioxide, methane, nitrogen dioxide

Question 56

What are freight derivatives?

Answer 56

Financial contracts based on the future levels of freight rates Mostly OTC