Fin 4324 Exam 2 workbook problems

What are capital markets, and how do bond markets fit into the definition of capital markets?

Equity (stocks) and debt (notes, bonds, and mortgages) instruments with maturities of more than one year trade in capital markets.

Bond markets are a key part of capital markets, providing a place where governments, corporations, and municipalities raise long-term funding by issuing debt securities.

What are the differences among T-bills, T-notes, and T-bonds?

T-bills: Maturities of less than 1 year; sold at discount; no coupons.

T-notes: Maturities of 2–10 years; pay semiannual coupons.

T-bonds: Maturities >10 years (up to 30 years); pay semiannual coupons.

What is a STRIPS? Who would invest in a STRIPS?

Treasury securities where coupons and principal are “stripped” and sold separately as zero-coupon bonds.

Typical investors: (Pension funds and life insurers) They need guaranteed lump-sum payments in the future to meet obligations like retirement payouts or policy claims. They often prefer the principal portion

What are the advantages and disadvantages of investing in TIPS bonds?

Advantages: Principal adjusts with inflation; provides real return; safe (backed by U.S. gov’t).

Disadvantages: Lower yields than regular Treasuries; taxable inflation adjustments; may underperform in low-inflation environments.

Describe the process through which T-notes and T-bonds are issued in the primary markets.

Issued via Treasury auctions (competitive or noncompetitive bidding).

Competitive bidders specify yield; noncompetitive bidders accept market yield. Auctions are conducted electronically by the U.S. Treasury.

What is the difference between general obligation bonds and revenue bonds?

General Obligation (GO) Bonds: These bonds are backed by the "full faith and credit" of the issuing state or local government. The issuer promises to use all of its financial resources, including its taxation powers, to repay the bond.

Revenue Bonds: These bonds are sold to finance a specific revenue-generating project (e.g., a toll highway, public utility) and are backed by the cash flows from that project. If the project's revenue is insufficient to make payments, the bond may go into default, as general tax revenues are not pledged. Consequently, revenue bonds are generally considered riskier than GO bonds.

Why would a municipal bond issuer want to purchase third-party insurance on the bond payments?

Insurance reduces default risk by guaranteeing payments.

Leads to higher bond ratings and lower borrowing costs.

How does a firm commitment underwriting differ from best-efforts underwriting?

Firm commitment: Underwriter buys the entire issue and resells it — issuer guaranteed proceeds.

Best-efforts: Underwriter only agrees to try to sell as much as possible — no guarantee.

What is a bond indenture?

The legal contract outlining the terms of the bond: coupon, maturity, covenants, collateral, rights, and obligations.

What is the difference between bearer bonds and registered bonds?

Bearer Bonds: These bonds have physical coupons attached. To receive an interest payment, the holder (bearer) of the bond must present the coupon to the issuer (or get it "clipped"). Ownership is not recorded, making them less secure.

• Registered Bonds: The issuer maintains an electronic record of the bond's owner. Coupon payments are automatically mailed or wire-transferred to the registered owner. Registered bonds have largely replaced bearer bonds in the United States due to their greater security.

What is the difference between term bonds and serial bonds?

Term Bonds: The entire issue of bonds matures on a single date. Most corporate bonds are term bonds.

• Serial Bonds: The issue contains multiple maturity dates, with a portion of the total principal being paid off on each date. This structure allows the issuer to spread out principal repayments over time. Most municipal bonds are serial bonds.

Which type of bond—a mortgage bond, a debenture, or a subordinated debenture—generally has the:

Mortgage bond: Backed by collateral; least risk to bondholder.

Debenture: Unsecured; moderate risk.

Subordinated debenture: Paid only after other debts; highest cost to issuer & highest yield to bondholder.

What is a convertible bond? Is a convertible bond more or less attractive to a bondholder than a nonconvertible bond?

Convertible bond: Can be exchanged for issuer’s stock.

More attractive to bondholders (upside potential), so typically has lower yield than nonconvertible.

What is a callable bond? Is a call provision more or less attractive to a bondholder than a noncallable bond?

Callable bond: Issuer can redeem early, usually if interest rates fall.

Less attractive to bondholders (risk of reinvestment at lower rates), so callable bonds must offer higher yields.

Explain the meaning of a sinking fund provision on a bond issue.

Requires the issuer to periodically retire a portion of debt before maturity.

Protects investors by reducing default risk, but can limit upside if bonds are called back early.

What is the difference between an investment-grade bond and a junk bond?

Investment grade: Rated BBB/Baa or higher; low default risk.

Junk bond: Rated below BBB/Baa; higher default risk, but higher yield

What happens to the fair present value of a bond when the required rate of return on the bond increases?

Price falls (inverse relationship between yield and bond price).

All else equal, which bond’s price is more affected by a change in interest rates—a short-term bond or a longer-term bond? Why?

Longer-term bonds are more affected due to greater duration (more sensitivity to rate changes).

Discuss the issues surrounding credit rating firms during the financial crisis.

Overly optimistic ratings on mortgage-backed securities.

Conflicts of interest (paid by issuers).

Investors over-relied on ratings, contributing to systemic risk.

How do bond ratings and interest rate spreads on bonds differ? Which measure is considered by many investors to be a more comprehensive measure of risk? Why?

Bond ratings: Expert opinions on credit risk, updated infrequently.

Spreads: Market-determined difference between yields on risky bonds vs. Treasuries.

Spreads are more comprehensive because they reflect real-time market perceptions of risk

Describe the major bond market participants.

Major Issuers:

◦ Governments: The federal government (through the U.S. Treasury) issues T-notes and T-bonds. State and local governments issue municipal bonds.

◦ Corporations: Issue corporate bonds to fund long-term operations and capital expenditures.

• Major Purchasers:

◦ Households: Invest in bonds directly and indirectly through institutions.

◦ Businesses: Includes both non-financial and financial firms.

◦ Government Units: Invest in various types of bonds.

◦ Foreign Investors: A significant purchaser of U.S. debt, especially Treasury securities.

◦ Financial Firms (Business Financial): This group, which includes banks, insurance companies, and mutual funds, is the largest holder of municipal and corporate bonds.

What is the difference between a Eurobond, sovereign bond, and a foreign bond?

Eurobond: A long-term bond issued and sold outside the country of the currency in which it is denominated.

Foreign Bond: A long-term bond issued by a firm or government outside of its home country but denominated in the currency of the country in which it is issued.

Sovereign Bond: Bonds issued by national governments, usually denominated in their own or foreign currencies.

Why are mortgage markets studied as a separate capital market?

Mortgage markets are unique compared to other capital markets (like stocks and bonds) for four main reasons:

• Collateral: Mortgages are backed by specific real property. Lenders can take ownership of the property if the borrower defaults. Most other securities offer only a general claim on the issuer's assets.

• Size: Primary mortgages do not have a standard size or denomination; each is customized to the borrower's needs. Bonds are typically in standard units like $1,000.

• Investors: Primary mortgages usually involve a single investor, like a bank. Stocks and bonds are often held by thousands of investors.

• Borrower Information: Information on individual mortgage borrowers is less extensive and generally unaudited compared to the regulated, publicly available information on corporations that issue stocks and bonds

What are the four major categories of mortgages and what percentage of the overall market does each entail?

• Home mortgages – ~75%

• Multifamily dwellings – ~5–6%

• Commercial mortgages – ~17%

• Farm mortgages – <2%

What is the purpose of putting a lien against a piece of property? (LG 7-3)

A lien is a public record attached to the title of a property that serves as security for a mortgage loan.

• Purpose for the Lender: The primary purpose of a lien is to give the financial institution (the lender) the legal right to sell the property if the borrower defaults on the loan or falls behind on payments

Explain the difference between a federally insured mortgage and a conventional mortgage.

Federally Insured (FHA/VA):

◦ Repayment is guaranteed by a federal agency.

◦ Allows for very low or zero down payment.

◦ Maximum loan size is limited.

Conventional:

◦ Not federally guaranteed.

◦ Requires Private Mortgage Insurance (PMI) if the down payment is less than 20%.

◦ Secondary market buyers (Fannie Mae/Freddie Mac) won't purchase uninsured loans with a loan-to-value ratio over 80%.

Explain the difference between a fixed-rate mortgage and an adjustable-rate mortgage. Include a discussion of mortgage borrowers’ versus mortgage lenders’ preferences for each.

Fixed-rate mortgage: Interest rate stays constant for the life of the loan.

Adjustable-rate mortgage (ARM): Interest rate changes with market conditions after an initial period.

Preferences: Borrowers prefer fixed rates for predictability, while lenders prefer ARMs to reduce interest rate risk.

What are the benefits and drawbacks to a mortgage borrower when refinancing a mortgage? (LG 7-3)

Benefits: Lower interest rates, smaller monthly payments, shorter loan term, or access to equity.

Drawbacks: Closing costs, fees, and the risk that the borrower may not stay in the home long enough to recover the costs.

What are “points” on a mortgage? What factors does a mortgage borrower need to consider when deciding whether or not to take points on a mortgage?

Points: Upfront fees (1 point = 1% of the loan amount) paid to lower the mortgage’s interest rate.

Borrowers must consider: How long they plan to stay in the home, whether they have enough cash upfront, and the break-even period for cost savings.

What is a jumbo mortgage?

A loan larger than the conforming limits set by FNMA and FHLMC. These cannot be purchased by GSEs and typically carry higher interest rates.

What is a subprime mortgage? What instrumental role did these mortgages play in the recent financial crisis?

A mortgage made to borrowers with poor credit or high debt-to-income ratios. Subprime loans contributed to the 2007–2009 financial crisis when widespread defaults caused massive losses on mortgage-backed securities.

What is an option ARM? What are the different options available with this type of mortgage?

An adjustable-rate mortgage that lets borrowers choose their monthly payment type:

What are the different payment options?

1. Minimum Payment: The lowest and riskiest option. Can lead to negative amortization if the payment doesn't cover the full interest cost.

2. Interest-Only Payment: The borrower pays only the interest accrued for that month. Monthly payments increase substantially when the interest-only period ends.

3. 30-Year Fully Amortizing Payment: A standard payment of both principal and interest calculated to pay off the loan over 30 years.

4. 15-Year Fully Amortizing Payment: A higher payment of principal and interest designed to pay off the loan on an accelerated 15-year schedule

How did the U.S. secondary mortgage markets evolve? 

They started small and local but grew nationally to provide liquidity. The creation of FNMA, GNMA, and FHLMC allowed lenders to sell mortgages, get cash back, and make new loans, turning mortgages into tradable securities.

What is a mortgage sale? How does a mortgage sale differ from the securitization of a mortgage?

Mortgage sale: The originator sells whole mortgages directly to another institution.

Securitization: Mortgages are pooled and used to back securities sold to investors.

What is a pass-through security?

A mortgage-backed security where cash flows (principal and interest) from borrowers are passed through to investors after servicing fees are deducted.

How did mortgage-backed securities contribute to the recent financial crisis?

They bundled risky subprime loans with higher-quality loans. When defaults surged, the value of these securities collapsed, spreading losses throughout the global financial system.

What is the Government National Mortgage Association? How does this organization play a role in secondary mortgage markets?

GNMA plays a crucial role by making mortgages a safer and more attractive investment for the secondary market. It does this in two main ways:

1. Sponsoring Mortgage-Backed Securities (MBS): Ginnie Mae sponsors programs that allow financial institutions (like banks and mortgage companies) to pool eligible mortgages and issue pass-through securities backed by them.

◦ It only supports pools of mortgages that are already insured by a government agency, such as the FHA or VA.

2. Providing "Timing Insurance": Ginnie Mae's most important function is to guarantee the timely payment of principal and interest from the mortgage servicer to the investors who own the mortgage-backed securities.

◦ This guarantee protects investors if the original mortgage borrowers are late on payments or default, making Ginnie Mae securities a very low-risk investment

What is the Federal National Mortgage Association? How does this organization play a role in secondary mortgage markets?

FNMA is a major and active participant in creating a secondary market for mortgages. Its key roles include:

1. Purchasing Mortgages: Fannie Mae buys packages of mortgages from primary lenders like banks and thrifts. This removes the loans from the lenders' balance sheets, freeing up capital and reducing their risk.

2. Creating Mortgage-Backed Securities (MBS): It pools the mortgages it purchases and issues mortgage-backed securities (MBSs), which are then sold to investors like life insurers or pension funds.

3. Guaranteeing Payments: FNMA guarantees the full and timely payment of interest and principal on the MBSs it issues, which makes them a more secure and attractive investment.

4. Securitizing Various Loan Types: Unlike Ginnie Mae, Fannie Mae securitizes both federally insured (FHA/VA) and conventional mortgage loans

How has the U.S. government’s sponsorship of FNMA and FHLMC affected their operations? Describe the problems these two GSEs have experienced over the last 15 years

Government sponsorship gave them funding advantages and expanded their mortgage role. However, they took excessive risks in subprime and Alt-A loans, faced large losses during the financial crisis, and were placed under government conservatorship.

Describe a collateralized mortgage obligation. How is a CMO created? 

A CMO is a mortgage-backed security that pools mortgages and divides them into tranches with different risk and maturity profiles. Cash flows are structured so that senior tranches are paid first, redistributing risk

What is a mortgage-backed bond? Why do financial institutions issue MBBs?

A mortgage-backed bond (MBB) is a bond collateralized by mortgages, but investors do not directly own the mortgages. Financial institutions issue them to raise funds while keeping mortgages on their balance sheets.

Who are the major participants in the mortgage markets?

Originators: Commercial banks, thrifts, mortgage bankers

Investors: Commercial banks, insurance companies, pension funds, investment banks

Government-sponsored enterprises: FNMA, FHLMC, GNMA

Why are stock markets the most watched and reported of the financial security markets?

• Economic Predictors: Stock market movements are sometimes seen as predictors of future economic activity. Stock prices are one of the 10 variables in the index of leading economic indicators used by the Federal Reserve.

• Widespread Ownership: Corporate stocks are the most widely held of all financial securities, with most individuals owning them directly or indirectly through pension and mutual funds. As a result, many people's personal wealth fluctuates with the stock market

What are some characteristics associated with dividends paid on common stock?

• Discretionary: Payments are discretionary, meaning they are not guaranteed. The board of directors of the issuing firm determines the payment and size of dividends.

• No Legal Recourse: Common stockholders have no legal recourse if dividend payments are missed, even if the company is profitable. A corporation does not default if it misses a dividend payment to common stockholders.

• Double Taxation: Dividends are taxed twice—once at the corporate level (as they are not tax-deductible for the firm) and once at the personal level for the investor.

• Profit Sharing: Dividends represent a stockholder's right to share in the firm’s profits, but only after interest is paid to bondholders and taxes are paid

What is meant by “common stockholders have a residual claim on the issuing firm’s assets”?

In case of liquidation, common stockholders are last in line to receive assets, after creditors and preferred stockholders.

They only receive what remains after all obligations are paid.

What is a dual-class firm? Why do firms issue dual classes of common stock?

Definition: A firm with two or more classes of common stock outstanding.

• Purpose: To assign different voting and/or dividend rights to each class. This allows founders or insiders to maintain control while raising capital from the public.

• Example: One class may have superior voting rights (e.g., 1 vote per share), while another has limited or no voting rights but may receive higher dividends to compensate

Difference between nonparticipating and participating preferred stock:

• Nonparticipating preferred stock: Receives a fixed dividend only.

• Participating preferred stock: Receives fixed dividends plus a share of additional profits if the company does well.

Difference between cumulative and noncumulative preferred stock:

Cumulative: Missed dividends accumulate and must be paid before common stockholders receive dividends.

Noncumulative: Missed dividends do not accumulate; they are lost.

Describe the registration process for a new stock issue:

• File a registration statement with the SEC (includes company info, financials, risks).

• SEC reviews for accuracy and disclosure, not investment quality.

• After approval, the stock is offered to the public via an IPO or secondary offering.

Trends in the growth of major U.S. stock exchanges:

Exchanges have consolidated, with NYSE and NASDAQ dominating.

Growth in electronic trading and high-volume transactions.

Market capitalization has increased significantly over decades.

Who are the major regulators of the stock markets?

SEC (Securities and Exchange Commission): Main regulator.

FINRA (Financial Industry Regulatory Authority): Oversees broker-dealers.

Federal Reserve and CFTC have some oversight for derivatives and systemic risk.

What is a market order vs. a limit order?

• Market order: Buy/sell immediately at the best available price.

• Limit order: Buy/sell only at a specified price or better; may not execute immediately.

Circuit breakers in stock trading:

Temporary trading halts triggered when the market falls too sharply, e.g., S&P 500 drops by a set percentage.

Purpose: Prevent panic selling and allow time for rational decisions.

Limit up–limit down rules

Definition: Limit up-limit down (LULD) rules are trading curbs that halt trading on individual stocks if the stock's price moves outside a specified price band

Aim: Reduce excessive volatility.

Flash trading, naked access, and dark pool trading

• Flash Trading: For a fee, traders can see incoming buy or sell orders milliseconds before they are available to the general market. This advance notice allows for rapid analysis and high-frequency trading ahead of the public. Critics argue it creates an unfair market, while exchanges claim it adds liquidity. The SEC proposed banning it in 2009.

• Naked Access: Allows traders to rapidly buy and sell stocks directly on exchanges using a broker's computer code, often without exchanges or regulators knowing who is making the trades. This practice shaves microseconds off trade times. The SEC banned naked access trading in late 2010 due to concerns it could destabilize markets if rapid-fire trades go wrong.

• Dark Pools of Liquidity: These are trading networks that provide liquidity but do not display trades on order books. They are often used by institutional traders who want to buy or sell large blocks of shares without revealing their intentions to the broader market. In 2013, the SEC approved rules requiring dark pools to disclose more details about their trading activity.

Major U.S. stock market indexes:

Dow Jones Industrial Average (DJIA)

S&P 500

NASDAQ Composite

Russell 2000

Difference between price-weighted and value-weighted indexes:

• Price-Weighted Index: Sums the stock prices of the companies and divides by a divisor.

    ◦ Effect: Higher-priced stocks have a greater impact.

    ◦ Example: Dow Jones Industrial Average (DJIA).

• Value-Weighted Index: Sums the total market values (stock price × shares outstanding) of all companies.

    ◦ Effect: Companies with larger market capitalizations have a greater impact.

    ◦ Examples: NYSE Composite, S&P 500, NASDAQ Composite, and Wilshire 5000

Major holders of corporate stock:

Individual investors

Institutional investors (mutual funds, pension funds)

Insiders (executives, founders)

Are stock market indexes accurate predictors of economic activity?

Not always; indexes reflect market sentiment more than actual economic performance.

Short-term movements can be misleading.

Three forms of stock market efficiency:

Weak-form efficiency: Prices reflect all past trading information.

Semi-strong efficiency: Prices reflect all public information.

Strong-form efficiency: Prices reflect all information, public and private.

Countries/regions with the largest stock markets:

United States (NYSE, NASDAQ)

China (Shanghai, Shenzhen)

Japan (Tokyo)

Others: UK (London), EU (Euronext)

What is an ADR and how is it created?

ADR (American Depositary Receipt): Represents shares of a foreign company traded in the U.S.

Created by a U.S. bank purchasing foreign shares and issuing ADRs on U.S. exchanges.

What are foreign exchange markets and foreign exchange rates? Why are they important?

Foreign Exchange (FX) Markets: Global, decentralized markets where currencies are bought and sold.

Foreign Exchange Rates: The price of one currency in terms of another (e.g., $1 = £0.74).

Importance to Financial Managers and Investors:

Helps in pricing international investments.

Affects profitability when revenues/costs are in different currencies.

Critical for managing FX risk due to exchange rate volatility.

Impacts investment returns when converting back to home currency.

If the Swiss franc is expected to depreciate relative to the U.S. dollar in the near future, would a U.S.-based FI in Bern City prefer to be net long or net short in its asset positions?

If the Swiss franc is expected to depreciate, a U.S.-based financial institution in Bern should prefer to be net short in Swiss franc assets.

Why? A net long position means more assets in francs → when the franc loses value, the USD-equivalent value drops.

Being net short means more liabilities in francs, which become cheaper to repay when the franc depreciates.

How are foreign exchange markets open 24 hours per day?

FX markets span multiple time zones (e.g., Asia, Europe, U.S.).

As one market closes, another opens—creating a 24-hour continuous trading cycle.

What is the spot market for FX? What is the forward market for FX? What is the position of being net long in a currency?

Spot Market: Immediate currency exchange (typically settles in 2 business days).

Forward Market: Contracts to exchange currency at a future date at a set rate.

Net Long: Holding more of a currency in assets than liabilities; profit if currency appreciates.

What motivates FI managers to hedge foreign currency exposures? What are the limitations to hedging foreign currency exposures?

Motivations:

Protect profits from exchange rate swings.

Reduce earnings volatility.

Improve planning and forecasting.

Limitations:

Cost of hedging tools (e.g., forwards, options).

Imperfect hedges (not all exposure can be covered).

Complexity and management attention required.

What are the two primary methods of hedging FX risk for an FI? What conditions are necessary to achieve a perfect hedge through on-balance-sheet hedging? What are the advantages and disadvantages of off-balance-sheet hedging in comparison to on-balance-sheet hedging?

• Two methods:

  1. On-balance-sheet hedging: Match assets and liabilities in the same currency.

  2. Off-balance-sheet hedging: Use derivatives like forwards, options, swaps.

• Perfect hedge (on-balance-sheet):

  • Assets and liabilities must match in currency, size, and maturity.

• Advantages (off-balance-sheet):

  • Flexibility, no need to restructure balance sheet.

• Disadvantages:

  • Costs (premiums, spreads).

  • Exposure to counterparty risk and market volatility.

If international capital markets are well integrated and operate efficiently, will FIs be exposed to foreign exchange risk? What are the sources of foreign exchange risk for FIs?

Yes, FIs can still be exposed to FX risk even in efficient markets.

Sources:

Mismatch in currency of assets and liabilities.

Unexpected FX rate changes.

Economic and political events impacting currency values.

What are the major foreign exchange trading activities performed by financial institutions?

1. Commercial Trade: Buying/selling foreign currencies for customers to complete international trade transactions.

2. Investment: Buying/selling foreign currencies for customers (or the FI itself) to invest in foreign real and financial assets.

3. Hedging: Buying/selling foreign currencies to offset FX risk for customers or the FI itself.

4. Speculation: Taking open (unhedged) positions in currencies to profit from anticipating future movements in FX rates

What is the implication for cross-border trades if it can be shown that interest rate parity is maintained consistently across different markets and different currencies?

It implies no arbitrage opportunities in international interest rate and currency markets.

Ensures fair pricing across borders.

Cross-border investments become more predictable and efficient.

What is the purchasing power parity theorem?

PPP states that in the long run, exchange rates adjust so that identical goods cost the same in different countries.

Based on the law of one price.

Explain the concept of interest rate parity. What does this concept imply about the long-run profit opportunities from investing in international markets? What market conditions must prevail for the concept to be valid?

• Interest Rate Parity (IRP): The difference in interest rates between two countries is offset by the forward exchange rate.

• Implies no arbitrage profits from international interest rate differentials.

• Conditions:

  • Free capital flow.

  • No transaction costs.

  • Liquid and efficient markets.

What are some reasons why interest rate parity may not hold in spite of the economic forces that should ensure the equilibrium relationship?

• Regulatory and government intervention

• Restrictions on capital movements

• Trade barriers and tariffs

Why has the United States held a trade deficit for most of the 1990s and 2000s? Make sure you distinguish between the imports versus exports of goods and services

• Goods: The U.S. imports more goods than it exports.

• Services: U.S. has a services surplus, but not enough to offset the goods deficit.

• Driven by consumer demand, global supply chains, and a strong dollar.

Why must the current account balance equal the value of the capital plus financial account balance (in opposite sign)?

• This is a fundamental rule in the balance of payments.

• If a country runs a current account deficit (more imports), it must finance it through capital/financial account surplus (e.g., foreign investment).

• Ensures that total payments = total receipts across accounts.

What is a derivative security?

a financial instrument whose value is based on the value of an underlying asset such as stocks, bonds, interest rates, commodities, or currencies. Common types include futures, options, and swaps.

What are the differences among a spot contract, a forward contract, and a futures contract

Spot contract: Immediate purchase or sale of an asset (settled "on the spot").

Forward contract: Customized, OTC agreement to buy/sell an asset at a future date at a set price.

Futures contract: Standardized agreement traded on an exchange to buy/sell an asset at a future date and price.

What are the functions of floor brokers and professional traders on the futures exchanges? 

Floor brokers: Execute orders for customers on the exchange floor.

Professional traders: Trade for their own accounts (speculators) or to profit from temporary price differences (arbitrageurs).

What is the purpose of requiring a margin on a futures or option transaction? What is the difference between an initial margin and a maintenance margin?

Margin is money you put down to make sure you can cover losses.

Initial margin: What you pay to start.

Maintenance margin: The minimum amount you must keep; if it drops, you’ll need to add more money (margin call).

When is a futures or option trader in a long versus a short position in the derivative contract?

Long position: You’re buying or betting the price will go up.

Short position: You’re selling or betting the price will go down

What is the meaning of a Treasury bond futures price quote of 103-13?

It means the price is 103 and 13/32 of 100. That equals 103.40625.

If you think five-year Treasury note prices will fall between January 11, 2023, and June 2023, what type of futures position would you take?

Take a short position to make money if prices fall.

If you think stock prices will fall between January 2023 and March 2023, what type of position would you take in the March E-Mini S&P 500 Index futures contract? What happens if stock prices actually rise?

Take a short position. If stocks go up, you will lose money.

What is an option? How does an option differ from a forward or futures contract?

An option gives you the right, but not the obligation to buy or sell something at a set price.

Futures/forwards are obligations to buy or sell.

What must happen to the price of the underlying T-bond futures contract for the purchaser of a call option on T-bond futures to make money? How does the writer of the call option make money?

Buyer makes money if the price goes up.

Writer makes money if the price stays below the strike — they keep the premium.

What must happen to the price of the underlying stock for the purchaser of a put option on the stock to make money? How does the writer of the put option make money?

Buyer makes money if the stock price goes down.

Writer makes money if the price stays above the strike — they keep the premium.

What factors affect the value of an option?

• The spot price of the underlying asset

• The exercise price on the option

• The option’s exercise date (or time to maturity)

• Price volatility of the underlying asset

• The risk-free rate of interest

CFTC (Commodity Futures Trading Commission)

NFA (National Futures Association)

SEC (Securities and Exchange Commission — for options on stocks)

Commodity Futures Trading Commission (CFTC): Has exclusive jurisdiction over all exchange-traded derivative securities, regulating all national futures exchanges as well as futures and options contracts.

• Securities and Exchange Commission (SEC): Regulates all securities traded on national securities exchanges, including some exchange-traded derivatives.

• Bank Regulators (Federal Reserve, FDIC, Comptroller of the Currency): Issue guidelines for banks trading in futures and forwards

What is a swap

A swap is a deal where two people or companies agree to exchange payments, often to manage risk.

What is the difference between an interest rate swap and a currency swap?

Interest rate swap: Exchange fixed vs. floating interest payments.

Currency swap: Exchange payments in different currencies (like dollars for euros).

Which party is the swap buyer and which is the swap seller in an interest rate swap transaction?

Buyer: Pays fixed, receives floating.

Seller: Pays floating, receives fixed.

A commercial bank has fixed-rate, long-term loans in its asset portfolio and variable-rate CDs in its liability portfolio. Bank managers believe interest rates will increase in the future. What side of a fixed–floating rate swap would the commercial bank need to take to protect against this interest rate risk?

The bank should pay fixed and receive floating — this protects it if rates rise.

An American firm has British pound–denominated accounts payable on its balance sheet. Managers believe the exchange rate of British pounds to U.S. dollars will depreciate before the accounts will be paid. What type of currency swap should the firm enter?

Enter a swap to lock in today’s exchange rate — so the firm avoids paying more if the pound gets weaker.

What are the differences between a cap, a floor, and a collar? When would a firm enter any of these derivative security positions?

Cap: Sets a maximum interest rate.

Floor: Sets a minimum interest rate.

Collar: Sets both a max and min.

Firms use them to protect against rates going too high or too low.