Flashcards
Financial Markets
Cards in this deck (123)
- 1What is financial market? Was DARF ein financial market sein?- Dealing with arrangements for trading financial claims
- Allowing financing and investing
- Representing set of arrangements
- Facilitating flow of funds - 23 Functions of Financial Markets- price discovery
- trading
- execution of agreements - 3What is a MMS? WALOMSegment of Financial Market where securities with high liquidity and short maturity are traded
- whole sale markets
- active secondary markets
- low default risk
- OTC markets
- mature in less than a year, usually 120 days - 43 Functions of Money Market S M L- storage for surplus funds
- meets investment or deposit outflows
- low cost sources of funds
= facilitate transfer of short term funds from individuals, corporations, or governments with excess funds to those with deficient funds - 5Types of MMS- Government Bonds
- Commercial Papers
- NCDs
- Repos
- Federal Funds
- Banker's Acceptances - 6What are Treasury Bills?US government backed bonds
- liquid
- no credit risk
- short maturity 28, 91, 182 day sold weekly through auction; 1yr sold monthly
- strong secondary market, sold through govt security dealers
- minimum $1000 and multiples - 7What are Gilts?UK government bond --> liability in sterling
- conventional gilt: semiannual coupon, principal+final coupon; prices quoted in $ 100 nominal
- index-linked gilt: adjusted in line with UK Retail Price index; half the annual real coupon + adjustment factor
- other types 1% - 8What are Commercial Papers? 3 Benefits- short-term debt instrument issued by credit worthy companies
- used by financial and non-financial companies to provide credit for their customers i.e. General Motors for cars
- alternative to short bank loans
- minimum $ 100,000 typically multiples of $ 1 million
- relatively low default risk because mostly backed up with line of credit with bank; line of credit reduces risk to investors and thus financing costs to firms; line of credit offers right but not obligation
- maturity 1-270 days
- high yields - 9What are NCDs?= Term securities because maturity date is specified (Demand deposits can be withdrawn any time)
= Bearer instrument; whoever holds the instrument at maturity date gets principal+interest
- short term source of fund issued by commercial banks
- maturity 1-4 months
- low risk
- higher premium than T-bill because less liquid and less safe
- minimum $ 100,000 but $ 1 million is more common - 10Repos and reverse repos= selling securities for a short term loan, agreeing to repurchase at maturity at areed price
= short term collateralised loan
i.e. CB and Fed use repos for monetary policies buying/selling T-bills
- low risk
- low interest rate
- maturity 1-15 days
- $ 10 million - 11Definiton of IMM- established 1972
- main purpose is to trade currency futures outside their country of denomination to facilitate increased: international trade, flow of funds, country regulations - 12Definition of EurocurrencyEuro = external, offshore
Eurocurrency = currenciy held in banks outside of the country where it is denominated - 133 misunderstandings of Eurocurrency market- not a market based solely in Europe
not a part of forex market where European currencies are traded
not part of forex market where Euro is traded - 14Uses of Eurocurrency market- circumvent domestic regulations, tax laws and interest rates (although PPP Theory: once considering exchange rates, any profits from escaping diminish)
- lower borrowing cost
- higher rates on deposits
- still remain profitable
GRAPH: narrower interest rate spread - 15Competitive Disadvantages of domestic MM- regulations: minimum reserve requirement, paying deposit insurance premiums
- smaller EoS
- more tax costs
- higher asset/liability management costs
- can only act as intermediaries, therefore additional costs
- interest controls - 16Why do money markets have low default risk?- short term source of funding for large denominations
therefore can generally be funded by highly trustworthy issuers with low risk of defaulting
- short maturity offers less interest rate risk
therefore less impact on security value - 17Why do participants in IMM gain?- GRAPH: show narrow spread
- Comparative advantages of Eurobanks
- Conclusion of escaping domestic regulation - 18Foreign Exchange Rate QuotationBase/Terms
= amount of terms per one unit of base
= direct or price quotation for terms currency
= indirect or volume quotation for base currency - 19Wholesale Market Quotation Convention- London forex wholesale market: £ is base currency
- unless with €: € is base currency - 20Definition of bid price Definition of offer / ask priceBid price = at which market makers buy the asset/ denominator curreny
Offer price = at which market makers sell the asset/ denominator currency - 21What is the spread?= difference between bid and offer prices NOT profit unless bid & offer are simultaneously executed
- very thin in wholesale market as large volume
- wider spread for corporate customers
- very large in holiday exchanges - 22Law of One Price LOP= price of identical goods should be the same throughout the world irrelevant of the producing country, assuming very low transportation costs and trade barriers
- 233 Determinants of Exchange Rates- Law of One Price
- PPP Theory --> in LR LOPR
- LR factors: relative price levels, trade barriers, preference for domestic vs. foreign goods, productivity - 245 functions of forex market PASST- protection from forex risk exposure
- arbitrage: window of opportunity
- speculation facilitation
- setting exchange rates
- transfer of purchasing power - 25Definiton of PPPinflation changes will impact exchange rate changes so that the same good in 2 countries are the same amount when expressed in same currencies
- 26Golden forex rule= Market maker takes more of a currency when buying it than giving up when selling it
- 27Market price of MM SecurityPm = Par / (1+k)^n
k = required return rate
n = time to maturity - 28What are bonds?= market intermediated financial claims
= long term debt securities, fixed income securities, typically 10-30 years maturity date
- borrowing agreement = indenture stating lender's rights and and privileges and borrower's obligations
- issued in primary market through telecommunication network
Define:
term to maturity
face value
coupon rate
coupon - 294 types of bonds- Treasury bonds
- Federal bonds
- Municipal bonds
- Corporate bonds - 302 Ownership structures of bonds- Bearer bonds = where coupon clips attached, sent to issuer to receive coupon payments
- Registered bonds = issuer automatically sends coupon payments - 31T-Bond characteristics- $ 1000 denominations
- maturity is greater than 10 years
- active OTC secondary market
- coupon taxed by fed gov as ordinary income but it is exempt from state and local taxes - 323 Types of T Bonds- STRIPS
- TIPS
- Savings Bond - 33Value of debt security (bond)= PV of future cash flows, using a discount rate that relects the investor's required return rate
As market interest rate rises, the investor's required return rate rises.
Discounted value of bond payment decreases = lower PV - 34Determinants of bond pricesfactors that influence interest rate movements
- economic growth
- money supply
- oil prices
- also changes in credit risk - 35Sensitivity of bond holdings to potential changes in required rate of return- bond price elasticity and duration
GRAPH: Change bond price to change YTM
other things being equal, more sensitive to interest rate movements when:
- longer maturity time
- lower coupon payments
- lower YTM
An increase and decrease in a bond's YTM do not have same magnitude on price change due to convexity - 36Makliel's bond pricing relationship Homer and Liebowitz property- bond price and YTM are inversely related
- curve is convex
- sensitivity to interest rate changes increases with longer maturity at a decreasing rate
- sensitivity to interest rate changes increases with lower coupon rate
- sensitivity to interest rate changes increases with lower YTM - 37Definition and Explanation of Makliel's fifth ruleDefinition: price sensitivity increases with lower coupon rates and VICE VERSA
Explanation:
- higher coupon rate bonds have higher proportion of value tied to coupons instead of par value
- coupon portfolio more heavily weighted toward earlier payments
- earlier payments are less sensitive as price sensitivity increases with increasing maturity
--> higher value of cash flows tied to less sensitive part
higher coupon rate = lower price sensitivity - 38Macaulay's durationeffective bond maturity = weighted average of the times to each coupon or principal payment made by the bond i.e. duration
weight = proportion of the total bond value accounted for by that payment
--> PV of cash flow at time t / bond price
sum of weights = 1 = bond price - 39What is Duration as a key concept in fixed income portfolio management?- simple summary statistic
- essential tool
- measure of the interest rate sensitivity of a portfolio - 40Macaulay's duration formula= weighted average of the times until receipt of each of the bond's payments
= sum of t x weights at t - 41Modified Durationchange in interest rates are reflected in inverse bond price change due to its change in YTM y
change p / p = -D x [change(1+y)/(1+y)]
more commonly D* = D/(1+y)
change (1+y) = change y
change p / p = -D* x change y - 425 Determinants of DurationTimes to maturity are not perfect measures of duration nature of bond
Rule 1: for zero-coupon bond, duration = time to maturity
Rule 2: higher bond duration when lower coupon rate, given constant maturity
Rule 3: higher bond duration when higher time to maturity, given constant coupon rate
Rule 4: higher bong duration when lower YTM
Rule 5: duration of a level perpetuity = (1+y) / y - 43Convexity= rate of change of slope of the bond price - YTM curve
duration is straight line where slope = modified duration of the bond at its initial YTM
--> underestimates bond price increase as YTM decreases and vice versa - 44Zero Coupon Bond- does not pay interest
- issued at a discount to its face value
- holder receives capital gain at maturity solely from difference between issue price and payment of par value - 45International bond market segmentsforeign bond = foreign borrower issuing bond in national capital market in that nation's currency
Eurobond = issuing bond and selling it in countries outside of denominated country - 46Types of corporate bonds- exchangable bonds
- convertible bonds
- callable bonds
- secured bonds
- unsecured bonds - 47What are equities?= market intermediated financial claims
= ownership stake in issuers' company
- claims in form of increased stock prices or issued dividends
- exposed to large gains AND losses - 48Ordinary Shares- dividend payments are discretionary
- shareholder only paid after all creditors
- shareholder takes limited liability risk which means in case of default, shareholders are allowed a share of net asset value after all creditors are paid
- no maturity date, thus never have to be repaid by issuer
privileges: voting on dividend amount, elect Board of Director, appoint accountant, change companies constitution
"principal/agent problem" - 49Differences between preference shares and ordinary shares1. preference shareholders have fixed dividend payments, priority is before ordinary shareholders
2. claim on assets behind creditors and bondholder but before ordinary shareholders
3. do not have voting rights
4. preference share are cumulative, therefore dividends can be carried into next year
5. price of preference share is relatively stable because dividend is fixed - 50Difference between preference share and bond- less risk than issuing bond b/c dividends can be omitted
BUT if omitted, investors will be reluctant to make new investment
- higher cost than bond as dividend is not tax deductible, whereas bond interest payments are
BUT no maturity date therefore represents permanent source of funding - 513 Types of Preference Share- Redeemable: issuer company will buy them back at future date
- Participating: entitled to additional dividends if left over after ordinary are paid off
- Convertible: into ordinary - 52Share valuesface/nominal value = value issued, printed on share certificate
when sold at par = sold at face value
market value = current price, traded on stock exchange
issued at a premium
sold at discount = sold at below nominal value - 53market capitalisation= number of shares * market price per share
- proxy of company size
OR
- proxy of whole stock market size when measuring the total MC of all listed firms - 54Dividend Yield DY= annual dividends per share / market price per share
= return on investment for a stock
investors cannot judge a share solely by share price
need to look at DY - 55P/E ratioprofits are divided into dividends and retained earnings
= ratio of a company's current share price to its retained earnings per share
= market capitalisation per share/earnings per share
can only be compared against own company's historical PE or to other companies in same industry - 563 biggest developed stock market by % and their dominant markets1. USA 45%:
NASDAQ, NYSE, ASE
2. Europe 27%:
UK, Germany, France
3. Japan 10%
Tokyo, Osaka - 57Definition of stock market liberalisationBekaert and Harvey 2002: a government decision to allow foreigners to purchase stocks in that country's stock market
Additionally, other liberalisation decisions: macreconomic policy reforms, opening of trading sectors,... - 58How did emerging stock markets form?late 1980s: capital market liberalisation
1990s: capital flows to emerging markets increased and changed composition
2000s: stock market liberalisation: lower cost and share risk
LatAm and Asia have equity markets with bigger market value than some smaller equity markets in developed countries - 59Definition of "emerging"needs to meet at least one of two:
- located in a low or middle income economy defined by World Bank
- investable market capitalisation (equity) is low relative to its most recent Gross National Income (GNI) figures - 602 functions of primary market- issue new shares
- raise new finance - 613 methods of issuing new shares- IPO: issuer enters into contract with underwriter for commission to sell shares to public (or underwriter buys them), needs to issue a prospectus, hire securities law firm
if "over-subscribed": applicants scaled down or picked by ballot
if "under-subscribed": underwriter buys at offer price
- Placement: for smaller companies where the sponsor (bank, broker) contacts major investment institutions asking them to buy some shares
(+) cheaper and selected pool
- Rights Issue: offer shares (by sending a Provisional Allotment Letter) to existing shareholders at a discount price, number of offered shares depends on how many they already hold
possible outcome: accept offer and sell letter to another investor or keep letter or do nothing - 622 functions of secondary market- liquidity: increasing the turnover ratio = transactions over time period / stock market size
- share valuation: to get a fair market price, indicates how company is performing - 63Secondary market trading systems of past and presentPast: OTC and exchange
Present: ECN
(+) speed
(+) wide coverage and time flexibility
(+) saves time and money
(+) exchange of feedback for transparency
(+) managing global operation
(-) volume of data (but big data)
(-) dependency on technology
(-) portability and compatibility - 642 types of ECN trading systems- dealer markets ("old-book"): electronic version of the exchange
- auction markets (automatic "order-book"): exchange has a central computer which operates an electronic order book; buy and sell orders are entered into a terminal linked to central computer - 65Definition of order book= electronic list of buy and sell orders by price level
= dynamic and constantly updated through out the day, therefore at any time there is a price available
- shows order imbalances
- provides short term stock market direction - 66Impact of valuation of investment decisioninvestors invest in undervalued stocks and sell holdings of overvalued stocks
- 672 different schools of stock valuation1. Fundamental analysis (Graham, Buffett): relies on fundamental economic factors and financial characteristics;
value investing;
suitable for long term;
looking at balance sheet, cash flow statements, income statements etc.
2. Technical analysis: charting trends, historical moving averages etc.; "black magic"; criticised by EFM which states market price is always right--> all past information has been accounted for and cant predict future movements;
used for short term trading - 68Definition and logic of PE Methodvaluation per share = expected earnings per share x mean industry PE ratio
where mean PE ratio is based on expected rather than recent earning of all publicly traded competitors in industry
logic: implicitly assumes that growth of firm will be similar to that of industry - 69Problems and Limitations of PE method- different forecast models with various previous years in time series models --> earnings forecast not the same
- investors disagree on measures of earnings i.e. excluding one time expenses
- disagreement on which firms represent the industry average i.e. composition and weighting
Limitation: inaccurate valuation if
- error in forecasting earnings
- choosing industry composite --> increases in PE ratio may be sign of irrational optimism of stock market
reliability over time is not certain - 70Formula of One-period discount modelP0: current stock price
D1: dividends at end of year 1
P1: stock price at end of year 1
ke: required rate of return on investment equity - 71Dividend Discount Modeldeveloped by JB Williams 1931
- accounts for uncertainty by allowing Dt to be revised in response to revised expectations about a firm's cash flows
therefore PV of stock = D/k
BUT dividends are not expected to remain constant forever
- 72Gordon Growth Modelassuming dividends expected to grow at constant rate g
limitation: if firms retain earnings rather than distributing i.e. IT stocks retain earnings to support growth
- 73Similarities and differences between PE and Dividend Discount ModelPE ratio: driven by mean multiple of competitors stock price relative to earnings expections + own earning expectations
Dividend Discount: driven by required return rate and growth rate
BUT
PE ratio influenced by required return rate and growth rate of competitors
inverse relationship between required rate of return and value
positive relationship between growth rate and value - 74Free Cash Flow Model- based on PV of future cash flows
- suitable for firms with no dividends
1. estimate free cash flows
2. subtract existing liabilities
2. divide value of firm by number of shares = value per share
limitation: difficulty to obtain accurate estimate of FCF per period - 75What is the required rate of return?= return that reflects the risk-free interest rate plus a risk premium
- used to value firm based on discounted cash flows
1. CAPM
2. APT - 76Market vs idiosyncratic riskMarket risk = systematic or nondiversifiable
- general market condition changes
- same impact on all assets
Idiosyncratic = unsystematic or diversifiable
- individual firm level changes i.e. leadership
- can be reduced by mixing portfolio - 77Definition and Formula of CAPM= based upon Markowitz 1952 on diversification and portfolio theory
by Sharpe, Lintner, Mossin
= states that only systematic risk is important bc unsystematic risk can be avoided by diversifying portfolio
Expected return of an asset = influenced by risk-free rate, market return rate and covariance between asset and market
(measured by sensitivity beta)
bigger beta: more sensitive to market condition
smaller beta: electricity, water as inelastic demand
Beta measures quarterly or monthly systematic risk and sensitivity of stock return to the market's overall return - 786 Assumptions behind CAPM1. rational expectations
2. single-period investment horizon
3. perfect, frictionless markets: no transaction cost, no income tax, stock prices not affected by actions, infinitely divisible assets
4. unrestricted lending or borrowing at risk-free rate
5. investments are limited to a universe of publicly traded financial assets
6. homogeneous expectations - 79Limitations of CAPM- suggests that returns and beta are positively correlated BUT Fama and French find otherwise
--> is beta driving force behind stock returns?
- Roll's critique: impossible to create a true market portfolio --> CAPM uses index i.e S&P 500
- Chan and Lakonishok: supports CAPM role of beta as a measurement of correlation to market volatility; high beta have high volatility - 80Definition and 3 key propositions of Arbitrage Pricing Theory (APT) Stephen Ross 1976expected return of security i =
risk-free rate + risk premium for bearing systematic risks
lambda = extra expected return required because of security;s sensitivity to jth factor
= suggests that stock price is influenced by market but also additional factors i.e. economic growth, inflation
in equilibrium, expected returns on assets are linearly related to covariance between asset returns and market
1. factor model
2. sufficient securities to eliminiate idiosyncratic risk by diversifying portfolio
3. arbitrage opportunities are not persistent
- 81Principal strength of the APT- no arbitrage conditions should hold for any subset of securities
- not necessary to identify a market portfolio --> Roll's critique
- derives relative prices for a set of securities of interest rather than whoole population of risky assets
(+) systematic risk can arise from many sources, thus better to leave out
(+) allows for factors other than market to influence expected returns of assets - 82Benefits and Disadvantages of CAPM related to APT(+) more well defined but could possibly be (-) as APT allows investors to include whatever factors they believe are relevant
(-) CAPM assumes implictly that each stock has the same relative sensitivity to each systematic risk
(-)CAPM may ignore the subtle differences between indviidual differences between individual securities - 834 Types of Stock Price Determinants1. economic factors
2. firm specific factors
3. institutional factors
4. behavioural finance factors - 84Examples of economic factors on stock prices- economic growth i.e. employment rate GDP, retail sale, income
--> increases expected demand and future cash flows
- inflation rate, exchange rate, risk-free interest rate - 85Examples of firm specific factors on stock prices- industry sales forecasts
- new competitors (industrial concentration ratio for competition level)
- price movements
- changes in dividend policy
- M & A
- expectations of new policies - 86Examples of institutional factors on stock prices- stock capitalisation over GDP: market size effect as this shows the extent of companies using stock market relative to their economy
= number of opportunities to diversify
- value of traded stock relative to GDP (TG)
bc it captures the willingness of investors to take part in stock market - 87Examples of behavioural factors on stock prices- against EFM hypotheses
- suggests behavioural bias affects stock prices
- herding, benchwagon effect
- investor sentiment due to calendar effects - 88What are derivatives?= financial instrument deriving its value from an underlying asset
- promise to transfer ownership of underlying asset at a specificied time, place, price
traded at
1. exchanges: outcry or electronic
2. OTC: more regulated after 2008, traded on SEFs - 89FOREX risk- transaction exposure (pay-off diagram!)
- translation exposure
- economic exposure - 90Definition and features of forwards= principal risk management tool
- binding agreement where obligated to exchange asset at fixed exchange rate on some specified date in future (two days before delivery)
(+) OTC tailor made: amount and maturities
(-) not favourable commissions, only for smaller value transactions suitable
opposite payoff profile to transaction risk - 91+ and - of OTC(+) tailor made agreements, flexible
(-) unregulated BUT after 2008 improved transparency, market efficiency --> SEFs
(-) higher default risk - 92Offsetting forward contract= close out original forward contract by forward sale of same amount currency
- decline in value of one asset is offset by increase in value of the other - 93Types of forwards1. outright forward = physical delivery
2. NDF = no physical delivery of two currencies involved
- currency forward (foreign exchange)
- forward rate agreement FRA (interest rate) --> contract rate, notional principal, contract period, value day - 94History of derivative markets1600s: Osaka rice commodity trading
1848: CBOT
1851: earliest forward contract on corn
1919: CME
1972: CME first foreign currency future
1971: CBOE started trading options
1977: put options
1982: LIFFE
2002: LIFFE bought by Euronext
--> Euronext Liffe comprises Amsterdam, Brussels, London, Paris - 95Global OTC derivatives by asset class in % 2010interest rate contracts 83%
forex contracts 10%
credit derivatives 5%
commodity contracts 1%
equity linked contracts 1% - 964 Types of Traders- dealers: trading on behalf of clients
- hedgers: risk averse investors, limiting their potential gains and losses
- speculators: purposely taking a market position betting on direction, can be scalpers, day traders or position traders
- arbitrageurs: taking window opportunity of 2 markets of same asset at same time with price differences - 97Definition and Features of Futures= a legally binding agreement between two parties to buy or sell a specified quantity of some specified underlying asset at a specified price on some specified date in the future
- standardised in terms of amount (£62,500) and quarterly maturity date
- traded on exchange until 3rd week delivery month Monday
- nearly always closed out
- initial margin and variation margin --> higher maintenance
- minimum price = tick - 983 Trading systems of Futures Markets1. open outcry: trading on floor, write details on tickets
2. runners: collect tickets and submit to exchange
3. LIFFE CONECT: electronic network bid via computers - 99Forwards vs Futures - trade location - contract - delivery - settlement - credit risk= both buy/sell asset at a given price in the future date
Forwards
- private agreements between two parties
- counterparty risk
- high market search cost
- once agreed, inflexible, illiquid
- settlement occurs at end
- mainly for hedgers
Futures:
- clearing house as counterparty guaranteeing fulfilment
-margin system, marked-to-market daily
- for speculators
- mostly closed out pre-maturity
- standardised contracts: transparent pricing, easily sold and bought, more liquid - 100How to hedge with futures?1. number of contracts
2. delivery date close to receivable to reduce exposure
3. if receivable currency depreciates, buy futures at future rate
4. trades agains Clearing House
5. first transaction: receivable sold to bankers at spot rate
6. second transaction: closes out futre position early by selling future contract at changed future rate:
- tick value= contract size x tick size
- #ticks gained per contract= diff in future rates / tick size
gain on future trading= #ticks x tick value x # contracts
- convert to domestic currency at spot rate
- add to receivable
7. closing out and remove funds in margin account - 101Relationship between future price and spot priceas delivery time approaches, future price converges to spot price
- arbitrage opportunity
- when exploited, this window closes
- at delivery time both prices are almost same - 1021. Initial margin 2. Maintenance margin 3. Variation margin1. deposited at time of entering contract
2. set at lower than initial margin (usually 75%) which is minimum amount to be kept, otherwise contract is closed
3. additional deposit top up from maintenance to initial margin - 103Margin requirementshigher asset variability, higher margin levels
- depends on objectives of trader:
bona fide hedger subject to lower margin requirements than speculator - 104Clearing house= intermediary in future transactions and has number of members
clearing house member is required to provide initial margin reflecting total number of contracts that are being cleared - 105Patterns of Futures Prices- normal market / contango: prices increase with longer maturity ---> gold, wheat, live cattle
- inverted market / backwardation: prices decrease with longer maturity
mix of both: crude oil, corn, soybeans - 106Types of Orderstypes of orders:
- market oder: carried out immediately at best price available
(-) threat of market fluctuations between placing and settling especially for large orders
- limit order: can only be executed at specified price or at one more favourable to investor
(+) for highly volatile or low volume stock
- stop-loss order: executed at particular price or less-favourable price, used to close out position if unfavourable price movement takes place
- stop-limit order: stop price and limit price specified
- market-if-touched MIT order: once price is hit, executed at best available price
- market-not-held order: traded as market order but executed at broker;s discretion
-time-of-day order
- open order
- fill or kill, all or none - 1073 Categories of Options1. Call Option: right but not obligation to buy underlying asset at a specified time for strike price
Put Option: right but not obligation to sell underlying asset at a specified time for strike price
2. American Option: can be exercised at several times up to maturity
European Option: only exercised at maturity date
3. Stock Option: underlying asset is common stock of corporation
expiration date= Saturday of third week of expiration month
last trading day third Friday of expiration month
- have January, February or March cycle - 108History of options on Exchange Traded Markets1972: Equity options started on CBOE
1982: ET currency options stated in PHLX
1985: Interest rate options started on CME - 109ET options vs OTC optionsrelationship between option writer and holder
- OTC = counterparty risk falls entirely on option holder
- ET = OCC removes default risk like clearing house in futures - 110Uses of options before futures and forwards- protect against forex loss but allowing profit gains if market moves in favourable direction
- uncertain whether we need the foreign currency and thus reserve right to execute - 1114 option basic positionsLong Call: exercise when Spot > Strike for cost of Strike price and buying asset: Profit = Spot - Strike
Long Put: exercise when Spot < Strike for receiving of Strike price and selling asset: Profit = Strike - Spot
Short Call: counterparty decides whether to buy or not; receive strike price; Loss = -(Spot-Strike)
Short Put: counterparty decides whether to sell or not; pay strike price; Loss = -(Strike-Spot) - 112Determinants of option price1. current stock price (positive to call)
2. strike price (negative to call)
3. time to expiration (American only, positive to call and put)
4. volatility (positive to call and put)
5. risk-free rate (positive to call)
6. amount of future dividends (negative to call)
bc downside risk is limited already, 4 and 5 actually depend on PV of cash outflow - 113What are Spreads?= trading strategy that involves taking a position in two or more options of the same type
- 114Bull spreads Payoff diagramsa) using call options:
buying call option with a lower strike price and selling call option with higher strike
same expiration date
limits investor upside and downside risk
gives up some upside potential
but gains premium of selling option
b) using put options - 115Bear spreadsa) using call options
b) using put options - 116Underlying Assets of Options- Stock Options
- Foreign Currency Options
- Index Options
- Futures Options - 117What is a swap?= OTC agreement between two companies to exchange cash flows in the future
- defines dates when the cash flows are to be paid and the way in which they are to be calculated - 1182 types of swap facilitators1. Swap broker:
- information intermediary with client base
- does not take financial position and receives a service fee
2. Swap dealer:
- not facilitator, also acts as counterparty
- IB and derivative units of commercial banking firms - 119Risks of Swap Dealers- Default risk: builds swap book where individual swaps offset each other
- Basis risk: risk that normal relationship between two floating rates might change
- Mismatch risk: needs dont fit between dealer and other party ie frequency of payments, maturity
- Interest rate risk: impact of swap book value change due to interest rate changes - 120Interest rate swapCompany A agrees to pay cash flow of company B equal to fixed rate interest on notional principal for fixed time
Company A receives floating rate interest on same notional principal for same fixed time - 121Motivation for SwapComparative advantage of some companies when borrowing in fixed rate markets, whereas other companies have it in floating rate markets
- 122Currency Swap= transform a loan/investment denominated in one currency into a loan in another currency
- 123Plain vanilla currency swap1. each borrows where it has comparative advantage
2. exchange principals
3. pay interest on those principals to the other company
4. return principals
5. companies return loan
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- Flashcards on Financial Markets, created by geniehuang on 08/12/2014.
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