Untitled Deck Flashcards
(208 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
Who are the primary issuers of bonds?
A
- Commonwealth government
- State governments
- Companies (particularly financial institutions)
- Foreign entities
3
Q
What are the roles of the bond market?
A
- Enhance the flow of funds
- Price discovery
- Inform borrowers and investors about long-term interest rates
4
Q
What is price discovery in the bond market?
A
The process of revealing the level of long-term default-free interest rates and credit spreads.
5
Q
What are default-free interest rates?
A
Interest rates revealed by trading in Treasury bonds, with the three-year and ten-year yields being benchmark rates.
6
Q
What is the significance of credit risk premiums?
A
They indicate the size of credit risk premiums, showing the margin above the default-free rate a borrower has to pay due to their credit rating.
7
Q
What is the settlement arrangement for bond trading?
A
Settlement is arranged by Austraclear on a T + 2 basis.
8
Q
What types of bonds are included in Australian bond issues?
A
- Treasury bonds
- Semi government bonds
- Non government bonds
- Financials
- Non resident bonds
- Mortgage backed securities
- Non financial companies
9
Q
What is a Treasury bond?
A
A fixed rate bond issued by the government, identified by its coupon rate and maturity date.
10
Q
How are Treasury bonds issued?
A
Issued by the Australian Office for Financial Management (AOFM) via a tender process on Yieldbroker.
11
Q
What are semi government bonds?
A
Bonds issued by state borrowing authorities for state or territory governments, with yields exceeding those on Treasury bonds.
12
Q
Define non government bonds financials.
A
Bonds mainly issued by major banks, typically floating rate medium-term notes.
13
Q
What are kangaroo bonds?
A
Bonds issued by highly rated supranational, sovereign, and quasi sovereign entities not based in Australia.
14
Q
What are mortgage backed securities (MBSs)?
A
Securities that fund property loans, mostly for residential properties.
15
Q
What are credit ratings?
A
Ratings that provide an informed opinion about the credit risk of a security from a ratings agency.
16
Q
What is reinvestment risk?
A
The risk of reinvesting the coupons at a lower yield than the purchase yield.
17
Q
What is the Fisher equation?
A
It represents the relationship between bond yields and expected inflation.
18
Q
What are the three generalised yield curve shapes?
A
- Normal
- Inverse
- Flat
19
Q
What are spot interest rates?
A
The current rate of interest for a range of terms.
20
Q
What is a forward interest rate?
A
An interest rate that commences at a future date and extends for a specified term.
21
Q
What is the unbiased expectations hypothesis?
A
A theory that states expectations of future spot rates determine forward rates and thus decide the yield curve’s slope.
22
Q
What does the liquidity premium theory argue?
A
Yield curves include a price risk premium as well as expectations.
23
Q
What is the risk for borrowers when planning to borrow using money market securities?
A
Interest rates being higher than expected would reduce the proceeds from a security issue.
24
Q
What is the risk for lenders when investing in NCDs?
A
A fall in interest rates prior to the investment.
25
What are interest rate derivatives?
Instruments whose value is linked to the value of another financial instrument, market variable or index.
26
What is a forward rate agreement (FRA)?
A contract with a bank that establishes a forward interest rate for a specified future date.
27
What is an FRA?
An FRA is 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
FRA stands for Forward Rate Agreement.
28
How is an FRA defined?
An FRA is defined by its starting and finishing months, e.g., a 1:4 FRA @ 5.00% sets a rate of 5% for 3 months (90 days) starting in one month.
29
What are the key specifications in FRA documentation?
Key specifications include:
* Settlement date
* Term of the rate
* Amount on which the rate applies
* Whether it is a borrowing or lending rate
* Cash settlement equation
30
What are the main advantages of FRAs?
Advantages include:
* Meet client requirements ('made to measure')
* Convenient to arrange due to standard documentation
* Pose low default risk (on the settlement payment)
31
What is a limitation of FRAs?
FRAs do not have a secondary market.
32
What does the financing decision refer to?
The financing decision refers to a firm’s relative use of debt and equity in financing its operations.
33
What is equity in the context of financing?
Equity is the funds supplied to the business by its owners.
34
What are the payment priorities for equity suppliers?
Payments to equity suppliers are not a binding commitment and have the lowest payment priority (they are residual).
35
What is venture capital?
Venture capital is equity invested by patient, risk-taking investors in aspiring growth businesses.
36
What does it mean for a firm to be 'investment ready'?
A firm is investment ready if it has:
* Achieved substantial size
* An effective management structure
* Can produce regular financial reports
* Potential for profitable operations.
37
What are ordinary shares?
Ordinary shares represent ownership of a company, typically have no maturity date, and entitle owners to a share of profits and voting rights.
38
What are the sources of return for an investor in ordinary shares?
Sources of return include:
* Dividend payments
* Capital gains and losses from changes in market value.
39
What are preference shares?
Preference shares also represent ownership of a company but pay a promised dividend with priority over ordinary dividends and have restricted voting rights.
40
What are the two broad approaches to assessing share value?
The two broad approaches are:
* Fundamental analysis
* Technical analysis.
41
What is fundamental analysis?
Fundamental analysis attempts to calculate share value as the present value of future payments, considering risks involved.
42
What is the P/E ratio?
P/E = current period share price divided by reported earnings per share for the most recent year.
43
What does a high P/E ratio indicate?
A high P/E ratio indicates the market is optimistic about the firm's future growth prospects.
44
What is Gordon’s dividend growth model?
Gordon’s dividend growth model states that the value of a share should equal the present value of its expected future dividend payments.
45
What is the Capital Asset Pricing Model (CAPM) used for?
CAPM is used to estimate the required return on equity.
46
What is an IPO?
An IPO raises additional equity capital to fund growth and allows owners to sell some or all of their investment.
47
What are the advantages of going public?
Advantages include:
* Enhanced financial strength
* Provides investors with liquidity
* Increases capacity to remunerate management and employees.
48
What is the underpricing phenomenon in IPOs?
Underpricing occurs when the IPO issue price is less than the closing price on the first day of listing, resulting in 'money left on the table'.
49
What are rights issues?
Rights issues involve granting existing shareholders the right to purchase newly issued shares to raise additional capital.
50
What are the advantages of private placements of new shares?
Advantages include:
* Quick and cheap process
* Higher price per share than rights issues
* Can be made to supportive investors.
51
What is a dividend reinvestment plan (DRP)?
A DRP allows shareholders to reinvest dividends automatically in additional shares instead of receiving cash payments.
52
What is the basic function of a share market?
The basic function of a share market is to organize trading in corporate securities, principally shares.
53
What is the basic function of a share market?
To organise the trading in corporate securities – principally shares.
54
What is Australia’s main share market?
ASX (Australian Securities Exchange).
55
What significant event occurred in the Australian share market in 1987?
Amalgamation of state-based exchanges.
56
What happened to the ASX in 1998?
It demutualised and became a listed company (Australian Stock Exchange Limited).
57
What was a key development for the ASX in 2006?
Merged with Sydney Futures Exchange and was renamed Australian Securities Exchange.
58
What are the types of securities traded on the ASX?
* Ordinary shares
* Preference shares
* Units in listed trusts
* Corporate bonds
* Options
* Warrants
* CFDs
59
What role does the share market play as a secondary market?
* Provides investors with liquidity
* Facilitates the flow of funds by pooling equity investments
* Performs price discovery
60
Define price discovery in the context of the share market.
The process by which the market determines buying and selling prices for investors.
61
What does corporate governance refer to?
The process of decision making by a company’s top management and how they are held responsible.
62
How does market discipline affect senior management?
Changes in share price influence the behaviour of senior management.
63
What risks does a low share price pose to a company's management?
Exposes management to the risk of takeover.
64
List 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
* Minimum number of shareholders
* Must satisfy either the profits or the assets test
65
What is the role of ASIC in relation to the ASX?
ASIC is the supervisory body ensuring compliance with listing rules.
66
What are limit orders?
Orders specifying the amount of security to buy or sell at a maximum buying or minimum selling price.
67
What is an at-market order?
An order specifying the security and quantity to buy or sell at the best available price.
68
What does T+2 mean in the context of electronic settlement?
Trades are settled two business days after the trade date.
69
What are share price indices (SPIs) used for?
To reveal general price movements in share markets and measure the performance of individual shares.
70
What are the criteria for index inclusion of a share?
* Market capitalisation
* Liquidity
* Free float (percentage of shares available for trading)
71
What is a price-weighted index?
An index where the weight of each security is determined by its price relative to the sum of all prices.
72
Describe high-frequency trading.
Computerised trading that executes trades more quickly than manual trading using fast computers and algorithms.
73
What was the US 'flash crash'?
A significant drop in the Dow Jones index triggered by a trading algorithm leading to rapid price declines.
74
What is a Contract for Difference (CFD)?
A contract where the seller pays the buyer the difference between the price of an asset at contract start and its value when closed.
75
What is the minimum contribution rate for superannuation in Australia?
9.5% of income.
76
What are the main forms of superannuation schemes?
* Accumulation schemes
* Defined benefit schemes
77
What is an accumulation scheme?
Produces a lump sum based on contributions and investment earnings, with risks borne by contributors.
78
What is a defined benefit scheme?
Commits to pay a specified benefit, regardless of the size of contributions or investment performance.
79
What are dark pools in share trading?
Private trading venues that allow large share trades to occur without immediate market visibility.
80
What is the role of Chi-X in relation to the ASX?
An alternative exchange in Australia providing trading services for wholesale and algorithmic traders.
81
What is the minimum contribution rate for superannuation in Australia as of now?
9.5% of income
## Footnote
This percentage is subject to change based on legislation.
82
What are the two main forms of superannuation schemes?
* Accumulation schemes
* Defined benefit schemes
83
What is the primary risk borne by contributors in accumulation schemes?
Investment and survivorship risk
84
What is the fiduciary duty of trustees in superannuation schemes?
To manage the scheme in the interests of its members
85
True or False: Trustees of superannuation schemes guarantee returns.
False
86
What activities are included in the operations of superannuation schemes?
* Attracting members
* Collecting contributions
* Determining asset allocations
* Investing funds
* Paying benefits to eligible members
* Charging fees
87
What is the nature of returns on superannuation assets?
Volatile, posing investment risk for contributors
88
What factors determine the amount accumulated by retirement in superannuation?
* Amount of contributions
* Compounding of returns
* Rate of return earned
89
What is the impact of compounding on superannuation funds?
Returns compound because they cannot be withdrawn prior to retirement
90
What distinguishes not-for-profit superannuation schemes?
* Established by employers (corporate or public service schemes)
* Established by trade unions (industry schemes)
91
What is a key characteristic of self-managed superannuation funds (SMSFs)?
Trusts with up to four members who must be trustees
92
What are public unit trusts?
ASIC regulated collective investment schemes that raise funds by selling units to the public
93
How do property trusts operate?
* Acquire large properties
* Usually closed-ended
* Most are ASX listed
94
What is a key feature of equity trusts?
Invest in shares listed on major exchanges like the ASX
95
What is the primary goal of hedge funds?
To use complex investment strategies and high levels of debt for high returns
96
What are the two broad approaches to investment management?
* Active investment management
* Passive investment management
97
What is the aim of active investment management?
To achieve above-average returns
98
What does technical analysis focus on?
Historical data to predict future asset price movements
99
What is fundamental analysis?
Calculating an asset's value as the present value of expected future payments
100
What is the difference between active and passive investment management?
* Active: Seeks to outperform the market
* Passive: Replicates returns of a benchmark index
101
What is the performance measurement challenge for investment managers?
Assessing returns relative to risks taken
102
What is a forward contract?
An agreement to buy or sell an asset at a specific price at a future date
103
What differentiates futures contracts from forward contracts?
* Standardised contracts
* Traded on organised exchanges
104
What type of position does the buyer have in a futures contract?
Long position
105
What happens when a trader closes out their position in a futures contract?
They take an offsetting position resulting in a profit or loss
106
What role does the clearinghouse play in futures trading?
Acts as a counterparty to limit credit risk
107
What is cash settlement in futures contracts?
Closing out contracts without physical delivery, usually resulting in a cash payment
108
What position does Nick hold when he sells a wheat contract at $165 per ton?
Nick has a short position
## Footnote
A short position is when a trader sells a futures contract expecting the price will fall.
109
What is the payment Nick receives from the clearinghouse after selling the wheat contract?
$720
## Footnote
The payment is calculated as ($165 – $129) × 20.
110
What are the two main roles of the futures market?
* The risk-transfer function
* The price discovery function
111
What is the risk-transfer function in futures markets?
It manages the risk associated with volatile agricultural commodity prices and financial variables.
112
How can traders of futures contracts hedge their exposure?
By taking positions that offset adverse movements in future spot values.
113
What is the financial outcome for a long position in futures contracts?
Profits from a rise in the value of the contract item.
114
What is the financial outcome for a short position in futures contracts?
Profits from a fall in the value of the contract item.
115
What is a hedging example involving a wheat farmer?
A wheat farmer sells wheat futures contracts to hedge against a decrease in future wheat spot prices.
116
What is the profit/loss situation for a bread manufacturer hedging with long futures contracts?
Profit if wheat prices rise.
117
What is the price discovery function in futures markets?
It establishes forward prices as long as the contracts are actively traded.
118
What factors contribute to high liquidity in financial futures?
* Very low cost of trading contracts
* Limited number of settlement dates
* Standardised contracts
119
What is the contract unit for the SPI futures contract?
$25 per index point for the S&P/ASX 200.
120
What is the settlement day for SPI futures contracts?
Third Thursday of the settlement month.
121
What does a long position in SPI futures profit from?
An increase in the futures price.
122
What does a short position in SPI futures profit from?
A decrease in the futures price.
123
How can SPI futures contracts be used?
* Hedge the risk of a decrease in the index
* Speculate on increases or decreases in the index
124
What is the contract unit for BAB futures contracts?
90-day BABs with a face value of A$1 million.
125
What is the price quotation for BAB futures contracts?
100.00 minus the annual % yield to 2 decimal places.
126
What does a long position in BAB futures profit from?
An increase in the futures price (a decrease in interest rates).
127
What does a short position in BAB futures profit from?
A decrease in the futures price (an increase in interest rates).
128
How do BAB futures serve as a hedge instrument?
By selling BAB futures to offset exposure to higher-than-expected interest rates.
129
What is the difference between BAB futures and FRAs?
* BAB futures: Standardised contracts, actively traded
* FRAs: Tailored contracts, no secondary market
130
What is the ASX futures market previously known as?
Sydney Futures Exchange.
131
What types of futures are predominantly traded on the ASX?
* 30-day inter-bank cash rate futures
* 90-day BAB futures
* 3-year and 10-year bond futures
* SPI futures
132
What is the role of the ASX clearinghouse?
To manage default risk and settle transactions.
133
What are initial margins in futures trading?
Amounts required from both buyer and seller when a position is first traded.
134
What is daily resettlement in futures markets?
Further daily margin payments required when the balance in a margin account falls below maintenance level.
135
Who are the three types of participants in futures markets?
* Hedgers
* Speculators
* Arbitrageurs
136
What is an option contract?
A contract that provides its holder with the right (but not the obligation) to exercise.
137
What does a call option allow its holder to do?
Buy the contract item at the exercise (strike) price.
138
What does a put option allow its holder to do?
Sell the contract item at the exercise (strike) price.
139
What is the intrinsic value of a call option?
Maximum of (S – X) or 0.
140
What happens if the spot price at expiry is less than the strike price for a call option?
The option is out-of-the-money and is not exercised.
141
What are the two types of option forms?
* European Options: Exercise only at expiry
* American Options: Exercise anytime before expiry
142
What does buying a call option entail?
Paying the premium and hoping to sell the option later at a higher price.
143
What is the risk involved in buying call options?
Loss of the premium if the spot price is less than or equal to the strike price at expiry.
144
What is the potential return for a trader buying a call if the spot price is $40?
+100% return.
145
What is the exercise decision for an option at expiry?
* In-the-money (S > X) → Exercise
* Out-of-the-money (S < X) → Do not exercise
146
What is the return on a call option when the share value is $40?
+100% return
147
What does buying calls offer?
High upside, but high risk
148
What does a call option lock in?
A maximum forward buying price (X + premium)
149
What happens if the share price falls when holding a call option?
The call is abandoned and the lower spot price is paid (plus the premium loss)
150
What is the total cost if BHP trades at $40 with a $35 call option and a $2.50 premium?
$37.50 ($35 + $2.50)
151
What is the obligation of a short call?
Obligation to sell
152
What is the best outcome for the seller of a call?
Option expires worthless, keeping the premium
153
What is the intrinsic value of a long call option?
Vcall = maximum of (S – X) or zero
154
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
155
What is intrinsic value?
Value if exercised, or zero
156
What happens to the time value of an option as time passes?
It decreases
157
What increases the intrinsic value of a call option?
* Higher share prices (S) if S > X
* Lower exercise prices (X)
158
How does time to expiration affect an option's time value?
The longer the time to expiry, the greater its time value
159
What is the formula for finding time value?
Market Price = Intrinsic Value + Time Value
160
What happens to a holder of an in-the-money option at expiry?
* Exercise the option → captures intrinsic value only
* Close out the position → captures intrinsic + time value
161
What is a put option?
A contract to sell the underlying asset at the exercise price
162
What is the intrinsic value for a put option?
Vput = maximum of (X – S) or zero
163
What is the main function of foreign exchange (FX) markets?
* Facilitate cross-currency payments
* Reveal the value of currencies
* Allow traders to manage their FX risks
164
What is an exchange rate?
The price of one currency in terms of another
165
What is the trade-weighted index (TWI)?
Values the AUD against an index of foreign currencies weighted by their role in trade
166
What occurred prior to 1970 regarding currency values?
Currencies had fixed values tied to another currency or gold
167
What do businesses prefer regarding exchange rates?
A stable exchange rate
168
What is the difference between an indirect and direct quote?
* Indirect quote: expressed in domestic currency
* Direct quote: expressed in foreign currency
169
What happens to the AUD when AUD/NZD increases from 1.0700 to 1.0800?
It appreciates against the NZD
170
What is a spot contract in FX?
An agreement for currency exchange in two days (T+2) based on the agreed spot exchange rate
171
What are forward contracts in FX?
Agreements for currency exchange at any time after the spot settlement date of T+2
172
What is the purpose of FX swaps?
To manage FX risk by exchanging currencies at an agreed rate and returning them at a forward rate
173
What is the impact of floating exchange rates on businesses?
They must use FX risk management instruments due to random exchange rate movements
174
What is the effect of a fall in AUD/USD from 0.6700 to 0.6600?
The AUD cost of buying USD10m increases by AUD226,142
175
What is the impact of an FX swap on exchange rate risk?
With an FX swap → manage FX risk.
## Footnote
Without an FX swap, businesses are exposed to exchange rate risk.
176
Why is FX risk management needed?
Switch to floating exchange rates requires businesses to use FX risk management instruments.
## Footnote
Exchange rates move randomly day-to-day.
177
What happens if AUD/USD falls from 0.6700 to 0.6600?
AUD cost of buying USD10m would increase by AUD226,142.
178
What are the situations that expose businesses to FX risk?
* Importers (foreign payments) - Risk if AUD depreciates
* Exporters (foreign receipts) - Risk if AUD appreciates
* Foreign loan borrowers - Risk if AUD depreciates
* Foreign investors/lenders - Risk if AUD appreciates
179
How does an importer of European cars face FX risk?
Pay in EUR, sell AUD. If AUD depreciates, AUD price of cars rises.
180
What risk does a US investor in Australian shares face?
If AUD depreciates when repatriating funds, USD return falls.
181
What are the advantages of hedging FX risk?
* Removes possibility of unexpected losses.
182
What are the disadvantages of hedging FX risk?
* Forfeits potential gains from favourable exchange rate movements
* Effective cost/return becomes the domestic interest rate.
183
What instruments do businesses use to manage or hedge FX exposures?
* Forward FX contracts
* FX swaps
184
What is the effect of hedging on future FX transactions?
Removes the uncertainty of future FX transactions.
185
What is an example of an exporter using a forward contract?
Exporter due to receive USD20m in 3 months with a spot rate of AUD/USD 0.6710 and a 90-day forward rate of AUD/USD 0.6635.
186
What is the cost of a USD loan hedged with an FX swap?
* Comprises the US interest rate
* Plus swap points offsetting AUD and USD interest rate differentials.
187
What does hedging with an FX swap remove?
Removes the advantage of the lower USD interest rate.
188
What percentage of FX transactions are spot transactions?
35%.
189
What percentage of FX transactions are forward transactions?
12%.
190
What percentage of FX transactions are swap transactions?
53%.
191
What is the definition of the spot market?
Currencies traded for immediate delivery.
192
What is the definition of the forward market?
Contracts to buy/sell currencies for future delivery.
193
What is the definition of swap transactions?
Involve a package of a spot and forward contract.
194
What is the primary counterparty in the Australian FX market?
Overseas banks 75%.
195
What is the time zone advantage of Australia’s FX market?
Allows for 24-hour trading.
196
What is the primary electronic broking system used in FX trading?
Anonymous bids/offers displayed and matched.
197
What is the advantage of electronic broking systems in FX trading?
* Transparent price discovery
* Lower cost and narrower spreads
* Integration of front & back-office functions.
198
What is the importance of the Australian FX market?
Positive relationship of AUD with global commodity prices makes AUD popular with speculators and hedgers.
199
What is the Purchasing Power Parity (PPP) also known as?
The ‘Big Mac index’ of exchange rates.
200
What does the Purchasing Power Parity predict regarding inflation rates?
If inflation is higher in one country, that currency is expected to depreciate.
201
What does the Interest Rate Parity (IRP) theory state?
Exchange rates offset differences in interest rates to equalise effective rates.
202
What happens to currency appreciation in countries with lower interest rates?
Currency appreciation expected.
203
What is the formula for Terms of Trade?
Terms of Trade = Export Prices / Import Prices.
204
What does an increasing terms of trade indicate?
Greater demand for exports leading to rising currency value.
205
What is the Current Account Balance?
Value of exports/imports including financial transfers.
206
What action does the Reserve Bank of Australia (RBA) take when AUD is misaligned?
* Buys AUD (sells USD) when AUD undervalued
* Sells AUD (buys USD) when AUD overvalued.
207
What do dealers focus on for forecasting exchange rates?
Intra-day price movements, not long-term forecasts.
208
True or False: Exchange rates are highly predictable.
False.
