Financial System Flashcards
(198 cards)
1
Q
What is a bond?
A
A long term security that makes regular interest payments, known as coupons, and pays its face value at maturity
2
Q
What are the primary roles of the bond market?
A
- Enhance the flow of funds
- Price discovery
- Reveal long-term interest rates
3
Q
What types of entities typically issue bonds?
A
- Commonwealth government
- State governments
- Companies (particularly financial institutions)
- Foreign entities
4
Q
What is meant by ‘default free interest rates’?
A
Interest rates revealed by trading in Treasury bonds, with the three year and 10 year yields being benchmark rates
5
Q
What is a characteristic of most Australian bonds?
A
They have low credit risk as indicated by their high ratings
6
Q
What is the significance of credit spreads?
A
They show the margin above the default free rate a borrower has to pay because of their credit rating
7
Q
How are bonds traded in the bond market?
A
Through a wholesale, OTC market where dealers operate according to AFMA protocols
8
Q
What is the settlement period for bond transactions?
A
T + 2 basis
9
Q
What are Treasury bonds?
A
Bonds issued by the government that provide benefits to the financial system, including price discovery of default free rates
10
Q
What are semi-government bonds?
A
Bonds issued by state borrowing authorities for the state government or their agencies, with yields exceeding those on Treasury bonds
11
Q
What are kangaroo bonds?
A
Bonds issued by highly rated supranational, sovereign, and quasi-sovereign entities not based in Australia
12
Q
What is the main purpose of mortgage backed securities (MBSs)?
A
To fund property loans, mostly residential properties
13
Q
What is reinvestment risk?
A
The risk of reinvesting the coupons at a lower yield than the purchase yield
14
Q
What is the Fisher equation?
A
r = rreal + pe, where r is the market yield, rreal is the real interest rate, and pe is the expected long term inflation rate
15
Q
What are the three general shapes of yield curves?
A
- Normal
- Inverse
- Flat
16
Q
What do spot interest rates represent?
A
The current rate of interest for a range of terms
17
Q
What is a forward interest rate?
A
An interest rate that commences at a future date and extends for a specified term
18
Q
What does the unbiased expectations hypothesis suggest?
A
Expectations of future spot rates determine forward rates and thus decide the yield curve’s slope
19
Q
What is the liquidity premium theory?
A
It argues that yield curves include a price risk premium as well as expectations
20
Q
What is the risk for borrowers when borrowing using money market securities?
A
The risk that interest rates will be higher than expected, reducing proceeds from a security issue
21
Q
What is the risk for lenders when investing in NCDs?
A
The risk of a fall in interest rates prior to the investment
22
Q
What are interest rate derivatives?
A
Instruments whose value is linked to the value of another financial instrument, market variable or index
23
Q
What is an FRA?
A
A contract with a bank that establishes a forward interest rate for a specified future date
24
Q
What does a 1:4 FRA @ 5.00% signify?
A
Sets a rate of 5% for 3 months starting in one month
25
What is an FRA?
A contract with a bank that establishes a forward interest rate for a specified future date on a nominal principal for a set period
## Footnote
FRAs are defined by their starting and finishing months, such as a 1:4 FRA @ 5.00% for 3 months starting in one month.
26
What are the main advantages of FRAs?
* Meet each client’s requirements
* Convenient to arrange due to standard documentation
* Pose low default risk on the settlement payment
## Footnote
FRAs do not have a secondary market.
27
What is the financing decision in a firm?
The relative use of debt and equity in financing its operations.
28
What does equity represent in a company?
Funds supplied to the business by its owners.
29
What is venture capital?
Equity invested by patient, risk-taking investors in aspiring growth businesses.
30
What does 'investment ready' mean for a firm?
* Achieved substantial size
* Effective management structure
* Can produce regular financial reports
* Potential for profitable operations
31
What are ordinary shares?
* Represent ownership of a company
* Typically have no maturity date
* Can have their ownership transferred
* Are limited liability when fully paid
* Entitle owners to a share of profits (dividends)
* Entitle owners to vote in company elections
* Have potential for capital gains
32
What are the sources of return for an investor in ordinary shares?
* Dividend payments
* Capital gains and losses from changes in market value
33
What are preference shares?
* Represent ownership of a company
* Pay a promised dividend with priority over ordinary dividends
* Have restricted voting rights
* Can have features like non-participating, cumulative, converting, redeemable
34
How do we assess share value?
Through fundamental analysis and technical analysis.
35
What is the P/E ratio?
Current period share price divided by reported earnings per share for the most recent year.
36
What is Gordon’s dividend growth model?
The value of a share is equal to the present value of its expected future payments, considering the dividend stream as a perpetuity.
37
What is the Capital Asset Pricing Model (CAPM)?
A model used to estimate the required return on equity.
38
What is an IPO?
The first issue of shares to the public by a company for the purpose of listing on an exchange.
39
What are the advantages of going public?
* Additional equity enhances financial strength
* Gives investors liquidity
* Enhances capacity to remunerate management and employees
40
What are the disadvantages of going public?
* The process is expensive
* Continuing owners experience dilution
* Agency costs due to separation of ownership and management
* May encourage short-term performance bias
41
What is the underpricing phenomenon in IPOs?
When the IPO issue price is less than the closing price on the first day of listing, resulting in 'money left on the table.'
42
What are rights issues?
The issue of rights to existing shareholders to purchase newly issued shares in the company to raise additional share capital.
43
What are dividend reinvestment plans (DRP)?
Plans that allow shareholders to reinvest dividends automatically in additional shares instead of receiving cash payments.
44
What is the main function of a share market?
To organize the trading in corporate securities, principally shares.
45
What was the ASX's status in 1998?
Demutualised and became a listed company (Australian Stock Exchange Limited).
46
What is the basic function of a share market?
To organise the trading in corporate securities – principally shares.
47
What is Australia's main share market?
Australian Securities Exchange (ASX).
48
When was the ASX demutualised and became a listed company?
1998.
49
What significant merger occurred in 2006 involving the ASX?
Merged with Sydney Futures Exchange.
50
What does the ASX determine and enforce?
Rules for listed securities and brokers.
51
As a secondary market, what liquidity features does the ASX provide?
* Provides investors with liquidity
* Facilitates the flow of funds by pooling equity investments
* Performs price discovery.
52
What is price discovery in the context of the share market?
Determining buying and selling prices for investors and valuing the equity of listed companies.
53
How does market discipline relate to corporate governance?
Changes in share price influence the behaviour of senior management.
54
What risk does a low share price pose to a company's management?
Risk of takeover.
55
What are the admission rules for a company's securities?
* A company must have a constitution
* New issues cannot disadvantage existing security holders
* A prospectus must be lodged with ASIC
* Trusts must be registered
* There must be a minimum number of shareholders
* The company must satisfy either the profits or the assets test.
56
What is the primary requirement of listing rules for companies?
Continuous disclosure of price sensitive information.
57
What is the trading time for the ASX?
10am to 4pm each business day.
58
What does an automated-trading system (ATS) replace?
Open-outcry trading.
59
What is a limit order?
Specifies the amount of security to buy/sell at a maximum buying or minimum selling price.
60
What is an at-market order?
Specifies security and quantity but uses the best available price from the market.
61
What does the term 'T+2' mean in settlement?
Trades are settled two business days after the trade date.
62
How is liquidity characterized between large-cap and smaller firms?
Large-cap companies are much more liquid.
63
What do share price indices (SPIs) contribute to?
Price discovery by revealing general price movements in share markets.
64
What is the market capitalisation requirement for index inclusion?
Based on market capitalisation, liquidity, and free float.
65
What are the components of the Dow Jones index?
* McDonald's
* Visa
* Boeing
* Johnson & Johnson
* Procter & Gamble
* Walmart
* NIKE
* Disney.
66
What is the All Ordinaries Index?
Includes the 500 largest companies listed on the ASX and is market-capitalisation weighted.
67
What is the primary function of Chi-X?
To provide an alternative exchange for high-frequency and wholesale share trades.
68
What are dark pools used for?
To trade very large parcels of shares privately.
69
What is high-frequency trading?
Computerised trading that executes trades more quickly than possible manually.
70
What was the US 'flash crash'?
A sudden fall in the Dow Jones index of about 1,000 points triggered by a trading algorithm.
71
What is a Contract for Difference (CFD)?
A contract where the seller pays the buyer the difference in asset price at the start and end of the contract.
72
What is the minimum contribution rate for superannuation in Australia?
9.5% of income.
73
What is the purpose of superannuation funds?
To generate retirement income from contributions made during a person's working life.
74
What are the main forms of superannuation schemes?
* Accumulation schemes
* Defined benefit schemes.
75
What is the primary purpose of superannuation?
To create ‘self funded’ retirement income and reduce reliance on government’s pension
76
When was superannuation made compulsory in Australia?
1992
77
What is the minimum contribution percentage for superannuation?
9.5%
78
What tax rate applies to superannuation funds?
Concessional tax rate
79
Can superannuation funds be withdrawn early?
No
80
What are the two main forms of superannuation schemes?
* Accumulation schemes
* Defined benefit schemes
81
What is an accumulation scheme?
Produces a lump sum based on contributions and investment earnings
82
What is a defined benefit scheme?
Commits to pay a specified benefit to the retiree
83
How are superannuation schemes constituted?
As trusts
84
What is the role of trustees in superannuation schemes?
To manage the scheme in the interests of its members
85
What fiduciary duty do trustees have?
Duty of care to the scheme’s members
86
What risks do trustees not guarantee?
Returns
87
Which authority supervises trustees of superannuation schemes?
APRA
88
What are some activities conducted by superannuation schemes?
* Attracting members
* Collecting contributions
* Determining asset allocations
* Outsourcing investment management
* Paying benefits
* Charging fees
89
What is the nature of investment return on superannuation assets?
Volatile, posing investment risk for contributors
90
What factors affect the amount accumulated by retirement in superannuation?
* Amount of contributions
* Compounding of returns
* Rate of return earned
91
What is the future value (F) of a single sum using compound interest?
F = P(1 + r)^n
92
What is the impact of compounding in superannuation funds?
Returns compound because they cannot be withdrawn prior to retirement
93
How does a higher rate of earnings affect compounding?
Increases the impact of compounding
94
What types of schemes comprise the superannuation industry?
* Not for profit schemes (corporate, public service, industry)
* For profit schemes (retail)
* Self managed funds (SMSFs)
95
What are the characteristics of retail schemes?
Historically achieved lower returns due to higher fees
96
How many members can self managed superannuation funds (SMSFs) have?
Up to four members
97
What is the primary purpose of SMSFs?
To provide retirement income for its members
98
What are public unit trusts?
ASIC regulated collective investment schemes that raise funds by selling units to the public
99
What do property trusts invest in?
Large properties like shopping centres
100
What is the nature of equity trusts?
Invest in shares listed on major exchanges
101
What are exchange traded funds (ETFs)?
Listed, pooled investments that aim to match benchmark index returns
102
What characterizes hedge funds?
Use complex investment strategies and high levels of debt
103
Who primarily invests in hedge funds?
Institutional and high net worth investors
104
What is the goal of private equity funds?
To buy companies, improve performance, and resell at a profit
105
What are the two broad approaches to investment management?
* Active investment management
* Passive investment management
106
What does active investment management seek to achieve?
Above average returns
107
What are the two main methods of assessing asset value in active management?
* Technical analysis
* Fundamental analysis
108
What does technical analysis focus on?
Historical data to predict future price movements
109
What does fundamental analysis involve?
Calculating an asset’s value as the present value of expected future payments
110
What is the goal of passive investment management?
To replicate returns of a benchmark index
111
What are some characteristics of futures contracts?
* Specified quantity
* Set price
* Future delivery date
112
What distinguishes forward contracts from futures contracts?
* Customised vs Standardised
* OTC markets vs Organised exchanges
* Higher vs Limited credit risk
113
What is the long position in futures contracts?
The obligation to buy the contract item at the agreed price
114
What is the short position in futures contracts?
The obligation to sell the contract item at the agreed price
115
What does cash settlement in futures contracts allow?
Closing-out positions without physical delivery
116
What happens when a trader closes out their position before settlement?
They incur a profit or loss based on the difference in contract prices
117
What is a reversing trade in futures?
A transaction where one party cancels their position by entering an opposite trade.
118
What happens when Nick sells one June 2023 wheat contract at $165 per ton?
Nick's long position is cancelled out, and he no longer has an open futures position.
119
How much will the clearinghouse pay Nick after he cancels his position?
$720
## Footnote
Calculated as ($165 – $129) × 20.
120
What are the two main roles of the futures market?
* The risk-transfer function
* The price discovery function
121
What is the risk-transfer function in futures markets?
It manages the risk associated with volatile agricultural commodity prices and financial variables.
122
What can traders of futures contracts do?
* Hedge an exposure to adverse movements in future spot values
* Speculate on anticipated movements in the spot price
123
What is the profit scenario for a long position in futures?
Profits by a rise in the value of the contract item.
124
What is the profit scenario for a short position in futures?
Profits from a fall in the value of the contract item.
125
How does a wheat farmer hedge against price decreases?
By selling wheat futures contracts (short futures contract).
126
How does a bread manufacturer hedge against price increases?
By buying wheat futures contracts (long futures contract).
127
What does the price discovery function do in futures markets?
Establishes forward prices as long as contracts are actively traded.
128
What is a characteristic of high liquidity in financial futures?
* Very low cost of trading contracts
* Limited amount of settlement dates
* Standardised contracts
129
What is the contract unit for the SPI futures contract?
$25 per index point for the S&P/ASX 200.
130
What is the settlement day for SPI futures?
The third Thursday of the settlement month.
131
What is the profit scenario for a long position in SPI futures?
Profits from an increase in the futures price.
132
What is the risk associated with a long position in SPI futures?
Risks making a loss if the futures price decreases.
133
What is the profit scenario for a short position in SPI futures?
Profits from a decrease in the futures price.
134
What is the risk associated with a short position in SPI futures?
Risks making a loss if the futures price increases.
135
What is the contract unit for a BAB futures contract?
90-day BABs with a face value of A$1 million.
136
How is the price of BAB futures quoted?
100.00 minus the annual % yield to 2 decimal places.
137
What is the profit scenario for a long position in BAB futures?
Profits from an increase in the futures price (decrease in interest rates).
138
What is the risk associated with a long position in BAB futures?
Risks making a loss if the futures price decreases (if interest rates increase).
139
What can BAB futures be used for?
To create an offsetting position to hedge exposure to higher-than-expected rates.
140
What distinguishes BAB futures from FRAs?
* BAB futures: Standardised contracts, actively traded
* FRAs: Tailored contracts, no secondary market
141
What is the ASX futures market?
Australia’s futures market that enforces trading rules for fairness and order.
142
What is the function of the clearinghouse in futures trading?
Manages default risk and organizes the settlement of trades.
143
What types of participants are there in futures markets?
* Hedgers
* Speculators
* Arbitrageurs
144
What is an option?
A contract that provides the holder the right (but not the obligation) to exercise it.
145
What is a call option?
An option that gives the holder the right to buy the contract item at the exercise price.
146
What is a put option?
An option that gives the holder the right to sell the contract item at the exercise price.
147
What does the buyer of a call option have?
The right to buy at the exercise price.
148
What is the obligation of the seller of a call option?
To sell at the exercise price if exercised.
149
What happens if the spot price is greater than the exercise price at expiry?
The option is in-the-money and can be exercised.
150
What is the loss for the holder of an out-of-the-money call option?
Limited to the premium paid.
151
What are the two types of options based on exercise timing?
* European Options: Exercise only at expiry
* American Options: Exercise anytime before expiry
152
What is the intrinsic value of a call option?
Maximum of (S – X) or 0.
153
What is the exercise decision for a call option at expiry?
* In-the-money (S > X): Exercise
* Out-of-the-money (S < X): Do not exercise
154
What is the risk associated with buying call options?
Loss of the premium if S ≤ X at expiry.
155
What does a call option lock in for a buyer?
A maximum forward buying price (X + premium).
156
What is the return on a call option if the spot share price at expiry is $40?
+100% return
## Footnote
This indicates the potential profit for the holder of a call option when the market price exceeds the exercise price.
157
What happens to a call option if the share price falls below the exercise price?
The call is abandoned and the lower spot price is paid (plus the premium loss)
## Footnote
This is a risk associated with buying call options.
158
What is the intrinsic value formula for a long call option?
Vcall = maximum of (S – X) or zero
## Footnote
S represents the spot price and X represents the exercise price.
159
What factors determine an option's value (premium/price)?
* Spot price (S)
* Exercise price (X)
* Time to expiration
* Expected volatility of spot price
* Interest rate
* Interest & dividends
## Footnote
These factors collectively influence the pricing of options.
160
What is the breakdown of an option's value?
An option’s value = Intrinsic Value + Time Value
## Footnote
The intrinsic value is the value if exercised, while the time value is the present value of the probability of favorable price movements.
161
True or False: An option is a wasting security.
True
## Footnote
This means that as time passes, the time value of the option decreases.
162
What does a higher volatility imply for option pricing?
Higher volatility → Higher probability of favourable price movements → Higher option price
## Footnote
Volatility is a key factor in determining the potential profitability of options.
163
What is the maximum intrinsic value for a put option when S < X?
Vput = maximum of (X – S) or zero
## Footnote
This indicates that puts gain value when the spot price is below the exercise price.
164
What are the main functions of foreign exchange (FX) markets?
* Facilitate cross-currency payments
* Reveal the value of currencies
* Allow traders to manage their FX risks
## Footnote
These functions are essential for international trade and finance.
165
What is an exchange rate?
The price of one currency in terms of another
## Footnote
Exchange rates fluctuate based on supply and demand in the FX markets.
166
What is the trade-weighted index (TWI)?
It values the AUD against an index of foreign currencies weighted according to their role in trade
## Footnote
TWI provides a broader measure of the AUD's value compared to bilateral exchange rates.
167
What is a spot contract in FX transactions?
An agreement to exchange currencies in two days (T+2) based on the agreed spot exchange rate
## Footnote
Spot contracts are common in FX trading for immediate currency exchanges.
168
What is the formula for calculating the forward exchange rate?
Forward exchange rate = Spot rate adjusted for delayed settlement
| Forward Rate = Spot Rate × (1 + i_domestic) / (1 + i_foreign)
## Footnote
This calculation accounts for differences in interest rates between the two currencies.
169
What is an FX swap?
A combination of two FX contracts (with different settlement dates) taken simultaneously
## Footnote
FX swaps are used for managing FX risk by exchanging currencies at agreed rates.
170
What does the term 'currency appreciation' mean?
An increase in the value of one currency relative to another
## Footnote
For example, if AUD/NZD increases, it indicates that the AUD has appreciated against the NZD.
171
What is the main risk associated with floating exchange rates?
Businesses face FX risk due to exchange rate fluctuations
## Footnote
Understanding FX risk management is crucial for companies operating internationally.
172
What is the spot rate?
The current exchange rate at which a currency can be bought or sold for immediate delivery
## Footnote
The spot rate is essential for understanding real-time currency transactions.
173
What is the effect of not using an FX swap?
Exposed to exchange rate risk
## Footnote
Without an FX swap, businesses face potential losses due to currency fluctuations.
174
What is the purpose of FX risk management?
To manage exposure to fluctuations in exchange rates
## Footnote
Businesses need to mitigate risks associated with floating exchange rates.
175
How can exchange rates vary daily?
They move randomly day-to-day
## Footnote
This unpredictability necessitates risk management strategies.
176
What happens if AUD/USD falls from 0.6700 to 0.6600?
The AUD cost of buying USD10m increases by AUD226,142
## Footnote
This illustrates the financial impact of exchange rate fluctuations.
177
What is FX risk exposure for importers?
Risk if AUD depreciates
## Footnote
Importers face higher costs when the local currency weakens.
178
What is FX risk exposure for exporters?
Risk if AUD appreciates
## Footnote
Exporters receive less in local currency if the local currency strengthens.
179
What is the risk for foreign loan borrowers?
Risk if AUD depreciates
## Footnote
Borrowers may face higher repayment costs in local currency if it weakens.
180
What is the risk for foreign investors?
Risk if AUD appreciates
## Footnote
Investors may receive lower returns when converting back to their home currency.
181
What is an example of an FX risk for an importer of European cars?
Pay in EUR, sell AUD; AUD depreciation raises AUD price of cars
## Footnote
This scenario highlights direct exposure to currency fluctuations.
182
What is an advantage of hedging FX risk?
Removes possibility of unexpected losses
## Footnote
Hedging provides certainty in financial planning.
183
What is a disadvantage of hedging FX risk?
Forfeits potential gains from favorable exchange rate movements
## Footnote
Businesses may miss out on beneficial currency shifts.
184
What tools do businesses use to hedge FX exposures?
Forward FX contracts and FX swaps
## Footnote
These instruments help manage future exchange rate uncertainties.
185
What does hedging eliminate?
Uncertainty of future FX transactions
## Footnote
It reduces the risk of adverse financial outcomes.
186
What is the spot rate and forward rate for an exporter receiving USD20m?
Spot rate: AUD/USD 0.6710; 90-day forward rate: AUD/USD 0.6635
## Footnote
These rates determine the potential revenue for the exporter.
187
What is the effective interest cost when hedging a USD loan with an FX swap?
Becomes the local AUD interest rate
## Footnote
Hedging can negate the benefits of lower USD interest rates.
188
What percentage of FX transactions are spot transactions?
35%
## Footnote
This indicates the volume of immediate currency exchanges in the market.
189
What percentage of FX transactions are swap transactions?
53%
## Footnote
Swaps are a significant part of FX trading, indicating a preference for managing risk.
190
Who are the primary counterparties in the Australian FX market?
* Overseas banks 75%
* Local banks 21%
* Others (importers, exporters, fund managers) 4%
## Footnote
This distribution shows the dominance of foreign banks in FX trading.
191
What is the time zone advantage for Australia's FX market?
Allows for 24-hour trading
## Footnote
This benefit attracts global traders and enhances market liquidity.
192
What is Purchasing Power Parity (PPP)?
Long-run theory that trade flows force adjustments so comparable goods cost the same
## Footnote
The 'Big Mac index' is a common example used to illustrate PPP.
193
What does an increase in terms of trade indicate?
Greater demand for exports and rising currency value
## Footnote
This is particularly relevant for commodity-exporting countries like Australia.
194
What is the formula for terms of trade?
Terms of Trade = Export Prices / Import Prices
## Footnote
This formula helps analyze a country's trade performance.
195
What does the current account balance reflect?
Value of exports/imports including financial transfers
## Footnote
It provides insight into a country's trade and financial health.
196
What does the Reserve Bank of Australia do when the AUD is misaligned?
Intervenes by buying or selling AUD
## Footnote
This action aims to stabilize the currency's value.
197
What is the main focus of dealers in the FX market?
Intra-day price movements
## Footnote
Short-term trading strategies dominate FX trading rather than long-term forecasts.
198
What is a key challenge in forecasting exchange rates?
Exchange rates are volatile and random
## Footnote
This unpredictability complicates long-term economic predictions.
