Chapter 3 - Introduction to Financial Markets

8/14/2019 Chapter 3 - Introduction to Financial Markets

1/23

THE ASSOCIATE PROFESSIONAL RISKMANAGER (APRM) HANDBOOK

Alan Anderson, Ph.D.Western Connecticut State University

ECI Risk Traininghttp://www.aprmtraining.com


2/23

(c) ECI Risk Training 2009 2

CHAPTER 3: AN INTRODUCTION TO FINANCIALMARKETS

CHAPTER OBJECTIVES:

Understand the different types of money market instruments Understand the basic characteristics of bond markets Understand the basic characteristics of equity (stock) markets Understand the basic characteristics of foreign exchange markets Understand the basic characteristics of futures markets Understand the basic characteristics of over-the-counter (OTC) markets Understand the basic characteristics of commodities markets Understand the basic characteristics of energy markets

3.1 INTRODUCTION

Financial markets can be classified as organized exchanges and over-the-counter(OTC) markets. An organized exchange is a physical location where trading takes place;for example, the New York Stock Exchange. Exchanges offer several services,including:

standardized financial products price information protection from counterparty risk (the risk of non-performance by one partyto an agreement) matching buyers with sellers at agreed-upon prices

The over-the-counter (OTC) markets consist of direct buying and selling betweencounterparties. OTC markets provide access to a wider array of financial assets thanexchanges, but do not protect investors from counterparty risk.

The following financial markets are covered in this chapter:

Money markets Bond markets Stock markets Foreign exchange markets Futures markets Commodities markets Energy markets


3/23


3.2 THE MONEY MARKET

In the money market, highly liquid, short-term interest-bearing instruments are boughtand sold. These instruments provide short-term liquidity to the financial system. Someof the instruments that trade in the money market include:

repurchase agreements (repos) commercial paper bankers acceptances federal funds Treasury bills negotiable Certificates of Deposit eurodollar deposits

3.2.1 REPURCHASE AGREEMENTS (REPOS)

A repurchase agreement (repo) is a short-term collateralized loan. The borrower sells aliquid security, such as a Treasury bill, to a lender with an agreement to repurchase it at aslightly higher price. The difference between the sale and repurchase price represents theinterest paid by the borrower. From the perspective of the lender, this transaction isknown as a reverse repurchase agreement (reverse repo).

3.2.2 COMMERCIAL PAPER

Commercial paper is a promissory note that is not collateralized with any assets; it is apromise to repay borrowed funds. Typically, commercial paper has a short maturity (270days or less); it is sold to investors at a discount from face value and redeemed at facevalue. Commercial paper represents a major source of short-term funds to corporations;issuing commercial paper is often cheaper than borrowing directly from banks.

3.2.3 BANKERS ACCEPTANCES

Bankers Acceptances are discount instruments that have traditionally been used tofinance international trade. A Bankers Acceptance is equivalent to a post-dated check;once the bank accepts it, it can be resold to investors as an obligation of the bank.

3.2.4 FEDERAL FUNDS

The federal funds market is a source of short-term funds for banks. Banks are requiredby the Federal Reserve System to hold a fixed percentage of their deposits in the form ofreserves to ensure the safety of the banking system. Since these reserves do not pay anyinterest, banks with excess reserves will lend them to banks that hold insufficient


4/23


reserves. The rate of interest charged by banks in this market is known as the federalfunds rate. The Fed sets a target for the fed funds rate; currently, this target is a rangebetween 0% and 0.25%. The fed funds target is one of the primary tools ofmonetarypolicy.

3.2.5 TREASURY BILLS

A Treasury bill is a short-term obligation of the U.S. government. Treasury bills maturein one year or less, and are sold at a discount from face value; at maturity, they areredeemed at face value. The difference between the discounted price and the face valueis the capital gain earned by investors.

3.2.6 NEGOTIABLE CERTIFICATES OF DEPOSIT

A certificate of deposit (CD) is a time deposit held with a bank; unlike a savingsaccount, the depositor agrees to hold funds with the bank for a specified period of time.A CD pays more interest than a savings account, but early withdrawal results insignificant penalties. Negotiable Certificates of Deposit can be resold by banks toinvestors in the secondary market.

3.2.7 EURODOLLARS

A eurodollar deposit is a dollar deposit held outside of the borders of the United States.Eurodollar deposits are not subject to U.S. banking regulations, and as a result, typically

offer higher interest rates than domestic deposits. A eurodollar is an example of aeurocurrency, which is any currency held outside of the country of origin. For example,a eurosterling deposit is a British pound deposit held outside of the U.K.

3.3 BOND MARKETS

In the bond market, interest-bearing instruments with maturities of more than one yearare traded. Bonds are less liquid than money market instruments, but offer higher rates ofreturn to investors. Bonds provide a regular stream of interest payments and areredeemed at their face value. Some of the instruments that trade in the bond market

include:

Treasury notes and bonds US Agency bonds municipal bonds corporate bonds eurobonds foreign bonds


5/23


3.3.1 TREASURY NOTES AND BONDS

Treasury notes are obligations of the U.S. government; they have maturities of two toten years. Treasury notes make regular interest payments to investors, known ascoupons. At maturity, Treasury notes are redeemed at their face value. Treasury bonds

are similar to Treasury notes, except that they have maturities of twenty to thirty years.

3.3.2 U.S. AGENCY BONDS

Several U.S. agencies raise funds by issuing their own bonds. These include:

Government National Mortgage Association (GNMA) or Ginnie Mae Federal National Mortgage Association (FNMA) or Fannie Mae Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac Federal Home Loan Bank System (FHLB)

Ginnie Mae, Fannie Mae and Freddie Mac issue bonds in order to acquire mortgagesfrom issuing banks. The cash flows from these mortgages are pooled and distributed toinvestors through securities known as mortgage-backed securities (MBS.) A MBS isstructured to provide periodic interest and principal payments to investors.

3.3.3 MUNICIPAL BONDS

Municipal bonds are issued by state and city governments to finance local projects, suchas schools, roads, bridges, etc. These bonds pay very low coupon rates, but they also

provide tax benefits to investors. As a result, municipal bonds tend to be purchased bywealthy investors.

3.3.4 CORPORATE BONDS

Corporations can raise capital by issuing debt, which mainly takes the form ofcorporatebonds. The other major sources of capital are equity (stocks) and retained earnings,which are profits that are not paid out as dividends to stockholders. While raising capitalthrough the issuance of corporate bonds is riskier than issuing equity, it does provide onemajor advantage: the interest is tax-deductible. Debt also increases the leverage of the

corporation, which increases potential profits.

Corporate bonds typically have long maturities, up to thirty years, and are issued ascoupon-bearing instruments. They are redeemed at face value at maturity. The couponrates offered by corporate bonds are directly related to the default risk of the issuer; i.e.,the risk that the corporation will not be able to make coupon and/or principal payments ina timely manner. Ratings agencies, such as Standard and Poors and Moodys, providecredit ratings for corporate borrowers as well as municipal and sovereign governments.


6/23


3.3.5 EUROBONDS

A eurobond is issued in a currency other than the local currency. For example, if aFrench corporation issues a dollar bond in Germany, this is considered to be a eurobond.Eurobonds provide the issuer with the flexibility to raise capital in any desired currency.

They also provide tax advantages to investors.

3.3.6 FOREIGN BONDS

A foreign bond is issued in the domestic currency by a foreign entity. For example, if aBritish corporation issues a dollar bond in the U.S., this is considered to be a foreignbond. Several foreign bonds have their own nicknames:

Yankee bond: a dollar bond issued in the U.S. Bulldog bond: a pound bond issued in the U.K. Samurai bond: a yen bond issued in Japan

3.4 STOCK (EQUITY) MARKETS

Stock is issued by corporations in order to raise capital. The two basic types of stock are:

common stock preferred stock

Common stock provides partial ownership of the corporation to investors, along with

voting rights. Owners ofpreferred stock do not have any voting rights, but will receiveany dividends issued by the corporation before the common stock holders. In the eventof the bankruptcy of the firm, preferred stock holders must be paid off before thecommon stock holders.

3.5 STOCK INDICES

A stock index is a numerical value that represents the average value of a collection ofstocks. Two of the best-known stock indices are:

Dow Jones Industrial Average (DJIA) Standard and Poors 500 (S&P 500)


7/23


3.5.1 DOW JONES INDUSTRIAL AVERAGE (DJIA)

The Dow Jones Industrial Average is calculated from a collection of 30 stocks. TheDJIA assigns a weight to the price of each stock that reflects previous stock splits. The

composition of the DJIA is changed periodically; most recently, General Motors andCitigroup were replaced by Cisco and Travelers on June 8, 2009.

3.5.2 STANDARD AND POORS (S&P) 500

The S&P 500 is a weighted average of the market capitalizations of the 500 largest U.S.stocks. The market capitalization of a corporation can be computed by multiplying thestock price by the number of outstanding shares.

3.6 PRIMARY VS. SECONDARY MARKETS

New stocks are issued in the primary market. In this market, corporations sell new sharesof stock directly to securities dealers, who assume responsibility for reselling the stocksto investors. The process of selling newly issued stocks to investors is known asunderwriting; the sale of stock that has not been previously issued is known as an initialpublic offering (IPO). A private placement is a direct sale of stock to investors withoutthe use of an underwriter. Existing shares of stock are traded among investors in thesecondary market.

3.7 EXCHANGE TRADED VS. OVER-THE-COUNTER (OTC)

Stocks may be bought and sold through organized exchanges, such as the New YorkStock Exchange (NYSE). They may also be bought and sold through regionalexchanges, such as the Philadelphia Stock Exchange (PHLX). Stocks may be traded inthe over-the-counter (OTC) market, in which broker/dealers buy and sell amongthemselves.

3.7.1 BID-ASK SPREADS

The bid price of a stock is the price at which an investor can sell a stock. The ask priceof a stock is the price at which an investor can buy a stock. The difference between thebid and the ask prices is known as the bid-ask spread; this is the source of profits forbroker-dealers.


8/23


3.7.2 BUYING ON MARGIN

Investors may buy stock with borrowed funds; this is known as buying on margin.Buying on margin magnifies the potential gains and losses of an investor. For an

example, suppose an investor buys a share of stock that costs $100 by borrowing $90 andpaying $10. If the price of the stock rises to $110, the investor has earned a $10 profit, or100% of his investment. If the investor did not buy the stock on margin, his rate of returnwould have been 10%. On the downside, if the price of the stock falls to $90, theinvestor has suffered a loss of $10, or 100%, compared with a loss of 10% if he did notbuy the stock on margin.

3.7.3 LEVERAGE

Leverage refers to a situation where an investment is financed with borrowing; buying

stock on margin is an example of a leveraged investment. When a corporation raisescapital by issuing debt, it is also engaging in leverage. A leveraged investment is riskierthan an unleveraged investment.

3.7.4 SHORT SELLING

If an investor expects the price of a stock to decline, he can short sell the stock. Thisinvolves borrowing shares of the stock from a broker, selling the shares and promising toreplace them at a specified time in the future. If the price of the stock declines, theinvestor profits by repurchasing it at a reduced price and then returning the shares to their

owner. If the price of the stock rises, the investor must repurchase the shares at a higherprice, thereby suffering losses. The short-seller must pay any dividends that accrue to theowner of the stock until the shares are returned.

3.8 THE FOREIGN EXCHANGE MARKET

The foreign exchange market is a network of commercial banks that trade nearly $2trillion worth of currencies each day; this is known as the interbank market. Tradingtakes place virtually 24 hours a day.

3.8.1 EXCHANGE RATE QUOTES

The price of one currency in terms of another is called an exchange rate. For example,the following exchange rates were quoted in the Wall Street Journal on June 1, 2009:


9/23


10/23


3.8.2 APPRECIATION VS. DEPRECIATION

With flexible (floating) exchange rates, the values of currencies change on a continuousbasis; some currencies strengthen while others weaken. When a currency strengthensrelative to another currency, it has appreciated. When a currency weakens relative to

another currency, it has depreciated.

EXAMPLE

Suppose the dollar/pound exchange rate rises from $1.6443/ to $1.6500/. Since it nowtakes more dollars to buy one pound, the dollar has weakened against the pound; i.e., thepound has appreciated and the dollar has depreciated.

EXAMPLE

Suppose the yen/dollar exchange rate rises from 96.62 /$ to 97.00 /$. Since it nowtakes more yen to buy one dollar, the yen has weakened against the dollar; i.e., the dollarhas appreciated and the yen has depreciated.

3.8.3 SPOT VS. FORWARD EXCHANGE RATES

The price of a currency that will be delivered immediately is known as a spot exchangerate. A forward exchange rate is the price of a currency that will be delivered at aspecified time in the future.

EXAMPLE

The following quotes for the British pound were taken from the Wall Street Journal ofJune 1, 2009:

Spot $1.6443/1-month forward $1.6442/3-months forward $1.6438/6-months forward $1.6434/

These quotes show that:

pounds may be purchased for immediate delivery at a price of $1.6443/ pounds may be purchased for delivery in one month at a price of $1.6442/ pounds may be purchased for delivery in three months at a price of $1.6438/ pounds may be purchased for delivery in six months at a price of $1.6434/


11/23


3.8.4 INTEREST RATE PARITY

The relationship between spot and forward rates is determined by interest rates. Thisrelationship is known as interest rate parity. If this relationship is violated, arbitrageprofits can be earned. The interest rate parity condition is:

where:

F is the n-day forward exchange rate ($/foreign currency)E is the spot exchange rate ($/foreign currency)RD is the n-day domestic eurocurrency rateRF is the n-day foreign eurocurrency rate

3.8.5 DETERMINANTS OF EXCHANGE RATES

Several economic variables determine the value of exchange rates. In the short run,exchange rates are heavily influenced by:

domestic interest rates foreign interest rates investor expectations

If a countrys interest rates rise, in the short run its currency tends to appreciate, and viceversa. If investors expect a currency to appreciate in the future, this tends to strengthenthe currency and vice versa. In the long run, exchange rates are also determined by:

inflation GDP growth trade surpluses or deficits

3.8.6 CENTRAL BANK INTERVENTION

Central banks may periodically intervene in foreign exchange markets to strengthen orweaken their own currencies. A central bank may intervene to strengthen its owncurrency if its inflation rate is rising rapidly. A central bank may intervene to weaken its


12/23


own currency to stimulate exports and discourage imports, thereby reducing domesticunemployment.

3.9 FUTURES MARKETS

Futures contracts are traded on an organized exchange, such as the Chicago MercantileExchange (CME). Each exchange has its own clearinghouse. A clearinghouse performstwo vital functions:

clears all trades acts as a counterparty to all trades

The clearinghouse ensures that payments are credited to the appropriate parties. Theclearinghouse also ensures that there is a seller for each buyer and vice versa.

Three of the most important types of orders that investors may place through a futuresexchange are:

market order stop order limit order

3.9.1 MARKET ORDER

A market order is used to buy or sell a futures contract at the current market price.

3.9.2 STOP ORDER

A stop order is used to minimize potential losses. A stop order becomes a market orderat a specified price; for a buy stop order, this price is higher than the current market price.The objective is to buy the contract before it becomes more expensive. For a sell stoporder, this price is lower than the current market price. The objective is to sell thecontract before it becomes cheaper.

3.9.3 LIMIT ORDER

A limit order is designed to set a ceiling on the price that will be paid for a contract, or afloor on the price that will be received for a contract. A buy limit is set lower than thecurrent market price, and a sell limit is set higher than the current market price.


13/23


3.9.4 MARKING TO MARKET

One of the most important methods used by a futures exchange to minimize credit lossesis the marking to market requirement. An investor who enters into a futures contractdeposits funds into a margin account; these funds are known as initial margin. The

investor may be required to add funds if the value of his position declines; these funds areknown as variation margin.

EXAMPLE

A U.S. corporation decides to buy 62,500 British pounds for delivery in one monththrough a futures contract with the Chicago Mercantile Exchange. Assume that the one-month futures price for British pounds is $1.80/ and that the initial margin of $3,000 isrequired by the Chicago Mercantile Exchange. If the margin account falls below $2,000,further margin will be required to restore the account to the $3,000 level. This $2,000

threshold is known as maintenance margin. If the margin account rises above $3,000,the investor may withdraw the surplus. Since the contract is written on 62,500 Britishpounds, each one-cent change in the exchange rate causes the futures contract to gain orlose $625 in value. Assume that the investor does not withdraw surplus funds from hismargin account. The following table shows the pattern of cash flows over the remaininglife of the contract (22 business days):

DAY FUTURESPRICE

($/)

GAIN/LOSS GAIN/LOSSTO DATE

MARGINACCOUNTBALANCE

MARGINCALL

**** $1.80 **** **** $3,000 ****1 $1.81 $625 $625 $3,625

2 $1.80 ($625) $0 $3,000

3 $1.79 ($625) ($625) $2,375

4 $1.78 ($625) ($1,250) $3,000 $1,250

5 $1.79 $625 ($625) $3,625

At the end of trading on Day 4, the holder of the long position had a margin accountbalance of $1,750, triggering a margin call of $1,250 (needed to bring the accountbalance back up to $3,000).


14/23


DAY FUTURESPRICE

($/)



MARGINCALL

6 $1.80 $625 $0 $4,2507 $1.80 $0 $0 $4,2508 $1.81 $625 $625 $4,875

9 $1.82 $625 $1,250 $5,500

10 $1.82 $0 $1,250 $5,500

11 $1.81 ($625) $625 $4,875

DAY FUTURESPRICE

($/)



MARGINCALL

12 $1.80 ($625) $0 $4,25013 $1.78 ($1,250) ($1,250) $3,000

14 $1.79 $625 ($625) $3,625

15 $1.76 ($1,875) ($2,500) $3,000 $1,250

16 $1.77 $625 ($1,875) $3,625

17 $1.79 $1,250 ($625) $4,875

DAY FUTURESPRICE

($/)



MARGINCALL

18 $1.80 $625 $0 $5,50019 $1.81 $625 $625 $6,125

20 $1.80 ($625) $0 $5,500

21 $1.79 ($625) ($625) $4,875

22 $1.79 $0 ($625) $4,875

At the end of the month (22 business days), the holder of the long position pays thefutures price on the final day of the contract ($1.79/) for a total of $111,875. The holderof the long position has accumulated a loss of $625 in his margin account for a total costof $112,500 = $1.80/.

Equivalently, the holder of the short position receives $1.79/ for a total of $111,875. Theholder of the short position has accumulated a gain of $625 in his margin account,receiving a total of $112,500 = $1.80/.


15/23


16/23


With most forward contracts, the forward price is greater than the spot price and riseswith maturity; this is known as contango. With commodity forwards, this can bereversed. When the forward price is less than the spot price and falls with maturity, thisis known as normal backwardation. Contango is the usual situation for storablecommodities that have a positive cost of carry. Contango may indicate an expectation of

future shortages. Normal backwardation may indicate an expectation of currentshortages.

3.11 ENERGY MARKETS

The energy markets enable trading of electricity, crude oil, home heating oil, jet fuel,coal, etc. Both spot and futures contracts are traded through the over-the-counter marketand organized exchanges, such as the New York Mercantile Exchange (NYMEX).

The major energy futures contracts include: light sweet crude oil, heating oil, gasoline,

Brent crude oil. Energy futures options are also traded with a variety of differentfeatures. Some of these are:

average price options the strike price or the spot price can be set equal to the averageprice of the underlying asset computed at specified points in time

calendar spread options the payoff to the option depends on the difference in the priceof the underlying asset on two different dates

crack spread options the payoff to the option depends on the difference in the price ofcrude and refined energy products

The following energy derivatives are traded in the over-the-counter markets:

forward contracts option swaps


17/23


CHAPTER 3 KEY CONCEPTS

1) Financial markets are organized as either organized exchanges or over-the-counter(OTC) markets. Exchanges provide standardized products and protection fromcounterparty risk, while over-the-counter markets provide flexibility to investors.

2) The money market consists of short-term, highly liquid, interest-bearing securities.These include Treasury bills, repurchase agreements (repos), eurodollar deposits andcommercial paper.

3) The bond market consists of longer-term, less liquid interest-bearing securities, suchas Treasury bonds, municipal bonds and corporate bonds.

4) The stock market consists of two basic types of securities: common stock andpreferred stock. Common stock provides partial ownership to investors, along withvoting rights. Preferred stock is usually purchased in order to earn dividends.

5) A stock index is an average value of a collection of stocks. Two of the best-knownstock indices are the Dow Jones Industrial Average (DJIA) and the Standard andPoor's 500 (S&P 500).

6) Newly-issued securities are sold directly from issuers to dealers in the primarymarket; previously-issued securities are traded in the secondary market.

7) The foreign exchange market is a network of banks that trade national currencies. Aspot exchange rate is the price of a currency that is delivered immediately; a forwardexchange rate is the price of a currency that will be delivered in the future. Spot and

forward exchange rates are related through a relationship known as interest rate parity.

8) Futures contracts are traded through organized exchanges; each exchange'sclearinghouse guarantees the performance of all contracts. Futures contracts are marked-to-market each day. A market order is an order to buy or sell a contract at the currencymarket rice. A stop order is an order that becomes a market order at a pre-specifiedprice. A limit order is an order that establishes a maximum price at which a contractwill be bought, or a minimum price at which a contract will be sold.

9) A commodity is a good that has highly standardized properties. Commodities can beclassified as metals, soft goods, grains and oilseeds and livestock/other. The forward

price of a commodity depends on the cost of carry; this is based on the interest rate,storage costs and convenience yield.

10) Electricity, crude oil, home heating oil and other types of energy can be tradedthrough organized exchanges or the over-the-counter market. Several types of energyderivatives exist, including average price options, calendar spread options and crackspread options.


18/23


CHAPTER 3 PROBLEMS

1) What is one of the main advantages of trading through organized exchanges?a) investors are protected from price riskb) hedging price risk is easier

c) investors are protected from counterparty riskd) all of the above

2) The money market:a) consists of long-term interest-bearing instrumentsb) includes Treasury notesc) includes Treasury bondsd) includes Treasury bills

3) With a repurchase agreement:a) the lender sells a liquid security to a borrower and then repurchases it at a slightly

higher priceb) the lender sells a liquid security to a borrower and then repurchases it at a slightlylower pricec) the borrower sells a liquid security to a lender and then repurchases it at a slightlyhigher priced) the borrower sells a liquid security to a lender and then repurchases it at a slightlylower price

4) Commercial papera) has a maturity of up to one yearb) offers interest rates that are greater than those charged for bank loans

c) is sold at a discount and redeemed at face valued) is collateralized by Treasury securities

5) The federal funds ratea) is directly controlled by the Federal Reserve Systemb) is the rate charged by banks to their best corporate customersc) is the rate paid by banks for loans of reservesd) is the rate at which the Federal Reserve will lend funds to the banking system

6) A Treasury billa) is a discount instrument

b) has a maturity of up to one yearc) is issued by the U.S. governmentd) all of the above


19/23


7) A eurodollar deposita) is a dollar deposit held in a European bankb) is a dollar deposit held in the United Statesc) is a dollar deposit held outside of the United States

d) is subject to all U.S. banking regulations

8) A Treasury bonda) is a discount instrumentb) has a maturity of up to one yearc) is issued by the U.S. governmentd) all of the above

9) Municipal bondsa) are issued by state and local governmentsb) are taxed at a very favorable rate

c) offer low coupon rates to investorsd) all of the above

10) If a U.S. corporation issues a dollar-denominated bond in Japan, this is known as:a) a eurobondb) a foreign bondc) a eurodollar bondd) a yen bond

11) If a U.S. corporation issues a yen-denominated bond in Japan, this is known as:a) a eurobond

b) a foreign bondc) a eurodollar bondd) a yen bond

12) Which of the following is true?a) a bid price is the price at which an investor may buy a stockb) an ask price is the price at which an investor may buy a stockc) a bid price is the price at which an investor may sell a stockd) the bid-ask spread represents the interest rate paid by stock brokers to the FederalReserve System

13) Short selling a stocka) enables investors to profit from rising stock pricesb) enables investors to profit from falling stock pricesc) enables investors to profit from both rising and falling stock pricesd) is illegal in the United States


20/23


14) Which of the following is a cross exchange rate?a) $1.6443/b) 0.6081/$c) 1.1614/

d)

1.1614/$

15) If the dollar/pound exchange rate is currently $1.6443/, which of the following istrue?a) if the exchange rate rises to $1.6555/, the dollar has appreciatedb) if the exchange rate rises to $1.6555/, the pound has appreciatedc) if the exchange rate falls to $1.63371/, the dollar has depreciatedd) none of the above

16) Interest rate paritya) shows the relationship between the interest rates in two countries

b) shows the relationship between the inflation rates in two countriesc) shows the relationship between the spot and forward exchange rated) shows the relationship between two forward exchange rates of different maturities

17) Which of the following can influence exchange rates?a) inflationb) interest ratesc) trade surplusesd) all of the above

18) A market order

a) is used to buy or sell a futures contract at the current market priceb) is used to minimize potential lossesc) is used to set a ceiling on the price that will be paid for a futures contractd) none of the above

19) Which of the following is true?a) the funds initially deposited into a margin account are known as variation marginb) the funds initially deposited into a margin account are known as initial marginc) additional margin may be required if the value of a futures position increasesd) both futures and forward contracts are marked to market

20) A futures optiona) enables investors to buy an option in the futureb) enables investors to sell an option in the futurec) enables investors to buy a futures contract with an optiond) enables investors to buy an option with a futures contract


21/23


21) Cost of carry equals:a) interest rate + storage costs + convenience yieldb) interest rate storage costs convenience yieldc) interest rate - storage costs + convenience yield

d) interest rate + storage costs convenience yield

22) A crack spread optiona) has a payoff that depends on the difference between the price of oil and natural gasb) has a payoff that depends on the difference between the price of oil and electricityc) has a payoff that depends on the difference between the price of crude oil and refinedproductsd) has a payoff that depends on the difference between the price of crude oil and naturalgas

23) Which of the following is true?

a) counterparty risk refers to the risk of non-performance by a part to a contractb) assets traded through organized exchanges are not subject to counterparty riskc) assets traded through the over-the-counter market are subject to counterparty riskd) all of the above

24) With a reverse repurchase agreement (repo):a) the lender buys a liquid security from a borrower and then sells it back at a slightlyhigher priceb) the lender buys a liquid security from a borrower and then sells it back at a slightlylower pricec) the borrower buys a liquid security from a lender and then sells it back at a slightly

higher priced) the borrower buys a liquid security from a lender and then sells it back at a slightlylower price

25) An example of an agency bond is:a) a Treasury billb) a Treasury notec) a Treasury bondd) none of the above

26) A stop order

a) automatically becomes a market order after a fixed interval of timeb) becomes a market order at a specified pricec) becomes a limit order at a specified priced) none of the above


22/23


27) For an investor with a long futures position,a) a rising futures price may lead to a margin callb) a falling futures price may lead to a margin callc) the position may be unwound by entering into a long futures position on the same asset

but with a different maturityd) the position may be unwound by entering into a long futures position on the samematurity but with a different asset

28) A limit ordera) is automatically executed once the futures price fallsb) is automatically executed once the futures price risesc) becomes a market order once the futures price risesd) none of the above

29) For a commodity with a positive cost of carry,

a) the spot price exceeds the forward priceb) the forward price exceeds the spot pricec) the spot and forward price are equald) none of the above

30) Which of the following is an instrument of monetary policy?a) the Treasury bill yieldb) the federal funds rate targetc) LIBORd) none of the above


23/23

CHAPTER 3 SOLUTIONS

1) C2) D3) C

4) C5) C6) D7) C8) C9) D10) C11) B12) B13) B14) C

15) B16) C17) D18) A19) B20) C21) D22) C23) D24) A25) D

26) B27) B28) D29) B30) B

Documents

Chapter 3 - Introduction to Financial Markets