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CIDA Examination

Certified Investments and Derivatives Auditor

QuestionAnswer
define: LIBOR London Interbank Offered Rate: The Libor is the average interest rate that leading banks in London charge when lending to other banks.
define: ISDA International Swaps and Derivatives Association
What has the ISDA done? The ISDA is a trade organization of participants in the market for over-the-counter derivatives. It is headquartered in New York, and has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions.
Difference between strattle and strangle? a strangle is like a strattle except that it uses 2 strike prices (one for buy and another for put) rather than the same strike for both. all w/ same expiration date (see Barings Bank case)
What did Nick Gleason of Berrings Bank do? He used a strangle options strategy...
5 Areas of Math 1. Bond Values 2. Call Current Yields 3. Gain/L of Fwd / Future Contracts 4. Options (calc. intrinsic value) 5. Resets w/Swaps
1/3 hard questions on strategies to hedge a particular situation Focus on reason (hedge or speculation)
Pick up #2 pencils and a sharpener GET OVER WEEKEND
Reuben: Rtn Exam by 5/22 Reuben: Rtn Exam by 5/22 - or invalid
What are 2A7 and 28E Money Market Mutual Fund Rules TBD
Dodd-Frank (1-2 questions on it) TBD - Will require clearing of OTC derivatives and also recently defined what a swap is. (4/25, p4)
Current: Know what interest rates are now and where they have been and where going See Online and WSJ
What is the Federal Reserve's discount rate? The rate banks can borrow money from the Fed to satisfy reserves (vs. fed fund rate - diff)
What is the Federal Funds Rate? The rate that banks can borrow from another bank which has surplus reserves. This is preferred since they don't want the Fed to know.
Focus on slides See slides
What is the Eurozone? an economic and monetary union (EMU) of 17 European Union (EU) member states that have adopted the euro (€) as their common currency and sole legal tender.
def: REMICs Real Estate Mortgage Investment Conduits (very like CMOs) are special purpose VEHICLE used for the pooling of mortgage loans and issuance of mortgage-backed securities.
def: Re-REMICS In order to extract some higher ratings for regulatory risk-capital purposes, several REMICs were turned into re-securitized real estate mortgage investment conduits (re-REMICs) (the better legacy "toxic" assets were re-securitized
def: CMO vs REMIC The term CMO technically refers to a security issued by specific type of legal entity dealing in residential mortgages, but investors also frequently refer to deals put together using other types of entities such as REMICs as CMO
def: Counterparty Risk known as default risk, is the risk that an organization does not pay out on a bond, credit derivative, trade credit insurance or payment protection insurance contract, or other trade or transaction when it is supposed to.
def: Sovereign risk government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees
def: Credit default swap a financial swap agreement that the seller will compensate buyer if loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.
test Q: When was the last time that oil prices > $100 barrel and what was the gov'ts concern? 2008 it exceeded $100 ... The gov't was concerned that speculators were back in the market. New controls were put in place (e.g. limits on # of contracts)+there is OTC mkt (huge) w/fin settlement (not delivery usual)
What is a major risk for agricultural Weather risk
What are gold and silver used for usually as a safe haven
name some alternative investments hedge funds private equity opportunistic funds (e.g. real estate partnerships) NOTE: HF recently have had to register w/SEC unless complete private investments)
MF Global (there will be question on this....) what happened when how who involved current state
Will OTC go to central clearing? likely if Obama reelected
What was Excelon's D scandal Virtual Swap through ISO (4/25, p7) Big fine was announced ... know details (similar to Barley's)
Know UBS case what happened when who result current situation
Constellation Energy case Know details
What is FX Foreign exchange market. exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading determines the relative values of different currencies.
What happened at CALIPERS? explain situation
What was the FX currency scandal? explain situation (note: rubber trades, accused ...) 4/25,p7
Cheasapeake Situation explain
IMPORTANT: see pg 7: Case Studies to know See list with references to Bks #1 and #2
Def: Asset allocation investment strategy balance risk versus reward by adjusting the percentage of each asset in an investment portfolio-justification i asset rtns not perfectly correlated (-1 perfect Nl hedge, +1 perfect positive hedge), synthetic h w/ Derivatives forcing h
What is a natural hedge an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses)
What is a hedge? investment position intended to offset potential losses that may be incurred by a companion investment.
What can a hedge be constructed with? from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.
What is tenor of a bond? The amount of time left for the repayment of a loan or contract or the initial term length of a loan. Tenor can be expressed in years, months or days.
Dodd-Frank (1-2 questions Explain it and provisions (SBk, pp. 8-11)
What is the contagion effect? scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy (called Global Systemic risk
With the Contagion effect (Global Systemic Risk). When this happens what do all correlations do? They all go to 1.
What is the problem with the Efficient Frontier and Modern Portfolio Theory? Relies on math models with have historical information (data can be bad under curve)
How is risk/reward usually measured? from the spread to treasury (theoretically riskless) e.g. IBM is .75 basis points of yield from yield of Treasuries
Test question strategy ... often works pick up the highest level in the question: "Who's resonsible for level of risk in Co:.. Ans: BoD (not traders: they have policy approved by the BoD)
def: Liquid asset? 13 months or less of max maturity (moneym rules: 2A7) ... Can be easily converted to cash
What are the terms of risk free securities? T-Bill 1 year or less (note 1 yr issuance suspended) T-Note: 1-10 years T-Bond: 10 to 30 years (30 can be suspended but is not now)
def: TIPS Treasury Inflation Protected Securities - bond or note's face value is adjusted upwards with the CPI-U, and a real yield is applied to the adjusted principal to let the investor always outperform the inflation rate and protect purchasing power.
Are TIPS free from risk? if not, what kind of risk still applies Free from "credit" default risk but Interest Rate Risk still applies
How do "trading" investment policies work (how applied and to whom) IPs direct through delegation of authority (note: trades are not authorized in advance). These can be applied to trading desks (and not to individuals). Eg. Who is authorized, what commodities, what limits, which counterparties...
def: DTC or DTCC Depository Trust & Clearing Corp - world’s largest post-trade financial services company. set up to provide efficient / safe for buyers and sellers to make exchange, and thus "clear and settle" transactions. It also provides central custody of securities.
What is the settlement period for trading of securities (in the US) T+3
What is the DTC composed of? Established in 1999, the DTCC is a holding company consisting of 5 clearing corporations and 1 depository, making it the world's largest financial services corporation dealing in post trade transactions.
def: nominal yield coupon yield is the yearly total of coupons (or interest) paid divided by the Principal (Face) Value of the bond.
def: current yield (of a bond) coupon payments divided by the bond's spot market price
def: yield to maturity (of a bond) the IRR on the bond's cash flows: the purchase price, the coupons received and the principal at maturity.
def: SWIFT Society for Worldwide Interbank Financial Telecommunication ...network that enables financial institutions worldwide to send and receive information about financial transactions in a secure, standardised and reliable environment.
def: contract solidified at the time of trade "firm commitment"
Can controls prevent rogue trading? RT, difficult to prevent. Must have controls to detect this timely. (e.g. fwds, swaps are difficult to detect same day.
How long has the middle office been around? relatively new, since early 1990s (Middle office is risk management office)
What functions does the middle office perform? Risk Measurement (-market risk, -credit risk) Mark to Market valuation/pricing Management Reporting/Risk Limits (compliance e.g. policy limits)
What should the front office NOT be doing? NOT pricing securities (if then RM or MO should validate before becomes effective NOT negotiating (ISDA contracts)
Is it acceptable for head of risk management to report to head of trading? NO. ... should report to CFO or Chief Risk Officer
def: ISDA contract most commonly used master contract for OTC derivative transactions internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly.
def: ISDA International Swaps and Derivatives Assn. trade org of participants for over-the-counter derivatives. has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions
def: more about ISDA master agreement The ISDA Master Agreement is typically used between a derivatives dealer and counterparty for derivatives trades. set out the basic trading terms; each subsequent trade is recorded in a Confir that references Master Agreement
More about middle office structure In larger firms MO may be separate from the credit risk oversight function.
What is Back Office responsible for? Trade settlement Working with custodian Reporting (regulatory, financial) Accounting Exposure monitoring (? check.. s/b MO I thought)
What is a "bullet" bond? no call, no sinker, no optionality, no prepayment (i.e. just vanilla)
What is counterparty risk a subcomponent of? credit risk
What does a "normal" yield to maturity curve look like? ..and what are its characteristics like an upside down cup and flattening out to the right. (It is NOT inverted, NOT flattened.
def: repo agreement vs. reverse repo sale of securities w agreement to buy back later at greater price. Diff is interest (called repo rate) Seller is borrower. .Reverse Repo is from the buyer's point of view in this transaction
Will test on figuring yield to worst (that is to first call of bond) ...
Name different types of risk Credit (default) risk Reinvestment Risk Extension risk Inflation risk General Market risk Interest rate risk Sector risk
Inverted yield to maturity curve (anomoly) when short-end is higher, (e.g. when Fed acts to increase T-bill rate, via discount rate, and long-end of curve lags)
Q: If you are money mgr w/$ in an inverted curve where would you invest? Short term
Q: What is the spread to treasuries The yield above treasuries (generally this spread is greater for lower rated instruments)
Q: How much reliance is placed on rating agencies? Not as much as in the past. Firms have their own methods with RA as only 1 input
def: credit default swaps financial swap agreement-seller will compensate buyer if loan default/other credit event. Can be naked (w/o holding underlying instrument). Called swap but looks like option.
Why keep ST Investments? .operational needs .less risky than mt or lt .can convert to $$ .need for opportunities
When do/can money market instruments settle? money market same day .treasuries, next day . bills, same day .global securities, can be longer (e.g. T+3)
How are treasury bills issued? ..at a discount from par at auction which leads to price .low transaction cost .traded using their yield rather than price .calculated using 360 day year .annual rate of rtn is: (360/days to maturity) x (redemption value-purchase price/purchase price)
What are the maturities of T bills .4 weeks .90 days .182 days .1 year (not being issued at this time)
Q: Are CDs traded in market? yes, large ones are traded
What are Eurodollars? time deposits in $$ deposited in banks o/s US (no foreign currency risk) .min deposits are large (e.g. $1 million with <1 year maturity) .risker than domestic CDs so higher yield .mkt is less liquid than domestic CDs .>6month term .see pp33- (more)
def: Commercial Paper .if>270 days must register w/SEC (so less) . .
What risk do CDs have? ... describe credit risk (primarily) with the bank on deposit .insur only to $250k .transf cr risk (but not guaranteed) . less liq (penalty for early w/d)
What are the risks with Eurodollars? No currency risk but soverign risk
What is a Yankee CD? What is a Yankee bond? YCD=$$denominated in domestic mkt in foreign bank YBond=Bond issued in US by foreign borrower .sovereign risk if litigation in f country. also cr risk with f company
Explain the rating program for CP (Commercial Paper) Q on Test: (p36) .Top (A1+, A1,P1, F1) .Second (A2, P2, F2) .Third (A3,P3,F3) ..each has +, neutral or -. .S&P (A), Moodys (P), Fitch (F)
For CP: What is the basis pt diff between top and second tier Usually .75 basis points (.75%)
CP elements of good CP investment program .credit risk reports .approved CP program . limits in any 1 name, any 1 family, any 1 industry .quality limit (# in 2nd tier) . What SOD in CP if BO can trade, acctg, wire, settle (cause FO doesn't want to do it -- not exciting enough)
def: SEC 2A7 (under securities act of 1940) restricts quality, maturity, diversity of mm investments. fund buys highest rated debt <13 months & maintain a wtd aver m of 60 days or less + not invest more than 5% in any one issuer, except for government securities and repurc agree.NAV=$1
def: Breaking the bank? (ref: MM.Funds) When NAV<$1. History in 2008 Primary Reserve Fund broke then Feds gave $250k guarantee which was then extended to banks. Now MM don't have guar but banks still do
Repo and Reverse Repo (questions are being missed here) see Redbook pp.=214-217. test on textbook terminology. These average 50 basis points over CP. Different from securities lending ... See Friday notes discussion on this.
What are the 3 types of repos (repurchase agreements)? 1. Overnight (called buy/sell arrangement) pay mkt rate 2. Term Repo - for fixed # of days. 3. Open Repo - pay back with x days notification, like variable rate loan, resets interest daily baswed on repo rate (pay mkt rate) --read Wiki and pp214-217
Study repo notes 4/25 pp17-21... risky area Orange Cty lost billions here
Repos Read 105 case in Book2 ...
What are the requirements for Repos? 1. Over Collateralize (a must) .. haircut of 102% AAA to 107% BBB 2. Accepter will/should mark-to-market daily (this may margin call you) 3. Take delivery of collateral (DTC reregisters in lender's name) 4. Master Agreement (w/std terms-check no neg ch
Repos: Diff btw tri-party agreement and Global Master agreements see 4/25 notes pg 19/ .Triparty (you-party==all others) .global master you=w/each party separately like ISDA
Read about Orange County and repos (Inverse Floaters) see 4/25 pg20 + wiki etc. ....
Repo (e.g. policy) 3 Restrictions: time, quality, strategy. EG Policy: Only invest out 2x repo term (90 --> 180 days)
Q: Do all fixed income securities have inverse relationship to interest rates? no, only fixed coupon. Variable don't
Q: Diff between fundamental and technical analysis Fund (co stats, govt stats, GDP) Tech (charts, computer stats)
def: Total Return Price changes+income+-changes in currency valuation
def: Flight to quality people want to get out of any security with credit risk. Price of Treasuries rises
Note: Every bond has 100 points, exam will work with 32nds ... note this
def: accretion vs. amortization accretion-increase in value over time of bond bought at a discount .amortization - decrease ...
Barb's bond method of calculation 1. Calc the value of a point first (bonds have 100 points so 32/32 is 1 point) 4/26, p2
S&P and Fitch rating breakpoint is: BBB- and above is investment or high grade. BB+ and below is High Yield or speculative grade.
What are the three major types of Bond classes (p.68) Senior bonds-w/highest claims Subordinated bonds-senior bonds are first (these can have collateral, can suspend int payments for 5 years for hardship - rating agency will scrutinize though Debentures-no collateral, only creditworthiness
Diff btw: .Bonds w/sinking funds .Bonds with Sinkers .General Obligation Bond .Revenue/Income Bond .B w/sinking - period pmts to Trust w inter earned back to municip (investment pol agreed to with investors).Goal to retire bond early .B w/sinker - pay principal to investors over life of bonds .GOB - backed by municipality .R/I-backed w project reven
Q: Which bond gives more exposure to reinvestment risk, assuming call on corporate bond Ans: Call bond since hae to reinvet all at once (vs. sinking bond)
Q: What is a partial call bond? Random method of calling seleced CUSIPs in partial call ... causes reinvestment risk
NOTE: Start at 4/26 page 4/ tomorrow ...
Read the 2 articles in Redbook 1 on (1) AllFirst Financial and (2) Alternative Investments ....
The Fed has how many district banks? and How many Board members 12 and 7, then each of the 12 has a chairman and 9 member board.
def: Fed discount rate rate Fed charges member banks to borrow money
def: Fed funds rate rate one member bank charges another member bank to fulfill its reserve requirements (banks must keep fed funds on deposit with FedReserve based on amount of deposits held)
def: broker (vs. dealer) bring buyers and sellers together for a commission but never position the securities.
def: dealer (vs. broker) makes markets in mm instruments as well as capital markets. Make markets to other dealers as well as investors, by quoting a bid and asked price he is prepared to b and s at. When d trades he is principal, when acts for investor he is an agent.
def: bid price vs. ask price .bid-price buyer is willing to pay for a security .ask-price seller is willing to accept for a security
Name the major categories of ST investments A. Treasury Bills B. Agency Securities C. Certificates of Deposits (Domestic, Eurodollar, and Yankee) D. Commercial Paper E. Banker's Acceptance F. Repurchase Agreements G. Fed Funds H. Money Market Mutual Funds
What happened with Bear Stearns in 2008 ...
What happened with Lehman Brothers ... plus this was a factor in causing Prime Reserve MM fund to break the buck...
def: T-Bills denominations of 1,000 to 5 million. issued in 4 week, 3 month and 6 month maturities. Sold at auction and mkt determines yield .sold at discount so bear no interest .figured on a 360 day basis. yield= (discount/face v) x (360/days remaining to maturit
def: credit risk risk that borrower will default on their obligations to investor
What are the 2 types of agency securities A. GSEs (Gov't Sponsored Enterprises) B. Federal Related Institutions . Agencies NOT auctioned (mkt'd by Fed of NY) .GSEs owned by shareholders
def: CDs certificates of deposit - old std varieties: 1, 3, 5 month terms; however, must be more than 14 days and can be 5-7 years; sold at face, int pd at maturity. .Eurodollar .Yankee
describe CP commercial paper- unsecured debt fr corps/banks, rates fixed, 1-2 points below prime rate, sold at discount, exempt fr SEC regs if matur <270 days. .very few defaults (e.g Penn Central 1970=def on $82 million>rating stds tightened) .direct or via broker
What are the two CP rating tiers? Top Tier: A1+, P1,F1 Second Tier: A2,P2,B2 NOTE: during tight economic times spreads between 1 and 2 tier widen to get investors to invest in 2nd tier .PLUS there is CP in a B category called junk CP however supply is very limited
CP: Adv/Disadv Adv: high cr rating bring lower cost of capital, wide range of maturity gives flexibility, tradability=exit options. .disad=only high q companies, issue=down cr rating, admin, bank line still may be necessary
CP: Audit points (how to, remember, etc.) .review investment policy governing CP .make sure guidelines are being followed (limits on % in single company, or must be on approve listing) .credit deteriorations must be communicated immediately to traders .review list of cr standing of co's on lis
def: Banker's Acceptance like a postdated check. ST credit arrangement used by busineses to finance transactions esp w firms in foreign countries. Purchaser requests their bank to issue a letter of credit on their behalf authorizing the seller to draw a time draft
def (detail): repo like secured loan but title to securities passes to buyer. Coupons falling due while repo buyer owns securities are to seller. Buyer of transaction = Reverse Repo. !Legally single transaction (if counterp insolvency) Not disposal (for tax purposes)
2 types of money funds 1. Institutional - high minimums, corp,gov, fiduciaries 2. Retail - individuals (what we normally think of when we consider mm funds
What are the 4 securities markets (in general) Primary, Secondary, Third, Fourth 1. Primary Offerings (use underwriters) 2. Secondary-trading after they have been issued 3. OTC trades for listed securities 4. transactions directly between institutions w/o dealer
def: stated maturity the last day that a debt security will be valid (then expires) (Redbk, 3-5)
def: bullet bond all principal is paid back at maturity (vs. sinking fund bond where principal is paid back over time)
How many basis points are there in 1% 100
Are municipal bonds tax free Sort of. Their interest is free from Federal taxation and free from tax in the state they were issued in; however, the capital gains are still taxable.
What (again) are the 2 types of municipal bonds General Obligation - backed by full faith and credit/taxing authority of the issuer. and 2. Revenue bonds - pay only if specific project generates enough revenue.
What is one of the biggest disadvantages of zero-coupon bonds? IRS sez you pay taxes on imputed interest!
What is diff between std mortgage backed securities and CMOs? collateralized mortgage obligations (CMOs) divide the investors into classes (tranches/slices) for ST, MT,or LT with principal pymts first to the ST tranch investors. Some agency backed with gov't guarantee so no default risk
def: asset backed security security whose value and income is derived from and backed by a pool of underlying assets (e.g. credit cards, auto loans, student loans ... [plus exotics]) Generally ST loans (vs. mortgages)
How are the tranches of asset backed securities divided? Into quality tranches (vs. maturities - in MBS)
What is the price of an asset backed security usually quoted as as a spread to a corresponding swap rate (Redbk 3-12)... understand this one.
Re: Bonds - What is yield to worst? a comparison of yields, to maturity, to call, to put ... with this being the lowest yield
The agreement that fed and state gov'ts have with each other to not tax interest from each other's bonds is called? Mutual reciprocity
Q: The Risk that a callable bond is exposed to (for investors) includes reinvestment risk
Zeros issued directly from the US Treasury are called STRIPS
US Treasury notes and bonds are coupon bonds that pay interest how often? semi-annually
What is the formula for the bond equivalent yield? BEY? (365 x DR)/{360 - (DR x DTM)} where: DR-discount rate DTM-days to maturity PA-principal amount --- in RED 3-33 egs??
Q: When a bond's price goes from 102 to 103 it is said to have moved . one basis point . 100%
When an issuer is no longer paying interest on the bond, this is called a FLAT
Q: The measure of a bond price volatility in years is referred to as Duration
Q: The treasury yield curve plots YTM
Q: _____ is part of a co's after-tax earnings that its BOD decides to distribute to shareholders Cash dividends
Q: Technical term used to describe a stock whose price has fallen quickly and sharply Oversold market
Q: Name of normal settlement method 1. Trade plus three 2. Regular way settlement
def: What is a derivative? financial arrangement between parties whose payments or value is derives from the performance of some agreed-upon, underlying benchmark
What are the 4 basic types of derivative instruments in the markets? 1. forwards 2. futures 3. options 4. swaps
Describe an option type contract gives buyers the right, but not the obligation to buy or sell an asset at a preset price over a specified period. The option's price (premium) is usually a small percentage of the underlying asset's value.
Describe forward type contracts price fixing agreements that saddle the buyer with same risks as owning asset but at reduced cost. Normally no $ chgs hands until delivery date. Can be pre-settled in $ (most often in fin mkt). physical settlement usual for commodities
Xchg traded securities (adv/dis) Adv: std contracts, liquidity in securities, limits counterparty risk by guaranteeing performance Disadv: less flexibility, public nature, less diversity in instruments, more cost
OTC traded securities (adv/dis) Adv: more flexibility in types of contracts available (customizable), more privacy Disadv: lower liquidity, more counterparty risk, mkt values on OTC contracts not readily available.
What is hedging vs. speculating Hedging involves reducing risk through a passive strategy. Speculation is aggressive strategy to increase future cash flows by accepting more risk
def: Leverage (simple definition) playing with money you don't have
Q: Factors contributing to derivative disasters include all except Exchange trade limit YES TO: speculation, leverage, illiquidity, and lack of internal controls
Major contributors to the orange cty disaster were all but GREED Yes to: leverage, illiquidity, lack of internal controls, lack of Board of supervisors oversight
Features of forward type contracts include all of the following except Asymmetrical Risk Profile Yes to: obligations of both parties, counterparty risk when OTC, leveraged instruments
Features of option type contracts include all but LOSS can be unlimited for both buyer and seller Yes to: buyers have rights and sellers obligations, counterparty risk when OTC, and asymmetrical risk profile
Swaps and fwds are forward type contracts and futures and options are option type contracts False
def: Forward Contracts OTC contracts between buyer and seller where buyer agrees to exchange some amount of a valued item from the seller, at a contract price agreed upon today, with delivery at a designated time in the future.
Why is a forward contract a price fixing mechanism? because it locks in the price you will either pay or receive on an underlying asset in the future.
What are the risks in a forward contract? 1. opportunities are limited (for a better deal if one comes along) 2. Counterparty risk that the performance of either party might not happen (see you in court.. "I'm not buying, or delivering that!"
What is the notional on a forward contract? the volume on the hedge (e.g. the number of bushels of wheat or barrels of oil to be traded at an agreed upon price)
What is cash settlement? (e.g. in forward contracts) When two counterparties settle in cash (rather than in physical delivery) diff btw agreed upon price and spot price today. This is very common.
Forward contracts-some advantages/disadvantages Adv: flexible terms, can be cash settled Dis: not as liquid and may be difficult to get out of. Note: collateral is not required but may be requested as part of deal. MtM not usual but may be necessary for risk mgmt if mechanism is in place.
Is a forward contract an obligation? Yes
Fwd contract- what type of pay off profile? Symmetric payoff profile. Underlying asset should offset gain or loss in an effective hedge
What is the difference between forward contracts and futures contracts? In fwds it is OTC negotiation with a wide range of contractual possibilities. With Future contracts the buyer or seller forms an agreement with an established futures exchange to take (or make) delivery of a specified amount of item in future at price.
Why not always use futures if they will limit counterparty risk (vs. forwards) Futures are much less flexible with std contracts. Only item that can be negotiated is price and notional (# of contracts)
Futures vs. options Difference is that w/options, the buyer has the right but not the obligation whereas the writer (seller of options) takes on an obligation. w/Futures both have obligation
What is the difference between floor brokers and floor traders in a commodities exchange trading futures? FB: are agents transacting for third parties on a small commission .FTraders-use their exchange membership to buy and sell futures contracts for their own account. Advants to them are immediate access to infor and small commissions
Can anyone person or firm offer futures contracts for purchase or sale? Not unless the contracts are traded on one of the regulated futures exchanges and the person/firm is registered with the CF trading commission (CFTC)
What is the "normal" % for margin requirements for a futures contract? usually 2 - 10 %. A margin payment is a good faith deposit as a way to guarantee fulfillment of the contract and is not related to the asset underlying the contract.
What is another name for a margin call variance margin is another name for "called" margin
Future follow a pay as you go strategy while forwards are merely settled at maturity (T/F?) true
The price of futures contracts is truly a ______. consensus price based on opinions and many factors including expectations, legislation, actual price movements and other factors.
What is convergence? At delivery there can be no discrpancy between the spot price and futures price for a given security (or commodity)... and the closer we are to delivery the more convergence we get.
What forces the cash and existing futures price to converge Arbitrage (of buying and selling between the future and spot markets)
What does the term "basis" refer to? difference between cash price and futures price (can be positive or negative)
What does cost-to-carry refer to with regard to futures? the net cost of owning an investment over a stipulated time period Components may include: storage, insurance, transportation and financing (only financing if financial future)
A long hedge would be used by someone who is_____ short the actual commodity. Eg. an exporter who has promised delivery in several months at an agreed upon price could engage in a long hedge.
When is a short hedge used? when you are long the actual commodity (underlying) ... to hedge against a price drop
What is asset liability management minimize exposure to price risk by holding appropriate combination of assets in relationship to liabilities. 5-32
Explain Duration and Convexity ... (? related to capturing interest rate risk)
What is a hedge ratio? the number of hedging instruments necessary to fully hedge one unit of the cash position (If it takes 2 units of 5 year t-note futures to offset the risk exposure from 1 unit of a corp bon then the hedge ratio is 2:1
The players of the forward AND futures markets are: ALL of the below in both cases: .hedgers .speculators .arbitrageurs
Q: A buyer of a forward contract locks in the price____ for a specified underlying to be delivered in the future PAID what will be paid in the future (missed 5-40)
Q: If you hedged jet fuel by entering into a heating oil contract on the exchange what type of risk could you incur??? Product basis risk (NOT: locational basis, locational counterparty, or product operational risk) ...
Basis Risk arises because of imperfect hedging. Explain more ... arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative, or because of a mismatch between the expiration date of the futures and the actual selling date of the asset.
When do options expire? on the Sat following the 3rd Friday of the month in which they can be exercised
What is the most an option writer will EVER receive on writing an option the premium received
Diff btw an american and european style option? American can be exercised by the holder at any time after purchase. E. can only be exercised on the expiration date (note: all exch traded are american except interest on CBOE)
What is naked option 1. position not offset by ownership of underlying OR 2. an offsetting position. Term used to describe the position of the party short the option (i.e. the seller/writer)
def: Short call (option) position of seller/writer who has sold righ to buy underlying from seller/writer at strike p in exch for premium
def: Long call (option) position of buyer/holder who purchased right to buy underlying at price and pd premium for the right
def: Short put position of seller/writer who has sold right to sell underlying to seller/writer at price in exch for option premium
def: Long put position of buyer/holder who purchased right to sell underlying at prices and pd premium for right
def: straddle (per book 6-14) sale of a put and call WITHOUT ownership of the underlying (risky)
What are the factors in options premium pricing .price of underlying .time to expiration .volatility of underlying .exercise price .interest rates
(options) what is "intrinsic" value? relationship of market price to strike price
def: option premium components are:... intrinsic value + time value SO options are worth more in trade on exchange than if you exercised as long as they haven't expired!!
(options). What is time decay? less value as the option approaches expiration
If interest rates increase what does the value of a call option do? ... what about a put option? increase ... decrease
(options) What is the Delta? the change in the option price for a small change in the underlying stock price. (it ranges from 0 to 1 and defines how much option changes for each one dollar change in stock price) ... ref'd to as OPTIONS HEDGE RATIO
Explain the Greeks in various option pricing models: Delta: option sensitivity to chg in underlying .Theta: Chg in option p due to time .Vega: change in option p due to chg in volatility underlying .gamma: change in option delta w/ chg inunderlying .rho: chg p -int rates. generally not senstive to i r
def: An option adjusted spread (6-24) yield diff between XYZ's option adjusted yield and a Treasury bond of the same duration (6-24)
def: caps and floors protect purchasers against adverse interest rate movements in one direction while retaining the upside potential for i rates to move favorably in the other (outside range creates payment)
def: collar combination of cap and floor (egs: buy cap and sell floor = long a collar; buy floor and sell cap=short a collar)
def: corridor protects buyer from modest rate increase. purchase 1 cap and sale of second cap at higher strike price
what are the 4 option exercise styles? (we've mentioned 2 in the past) American - exercise anytime .European - exercise once at expiration .Bermudan - can exercise at several discrete points before expiration (also called a Bermuda) .Asian - value determined by avg price of underlying over L of option to expiration
more about strangles. what is long strangle trader vs. short strangle trader? long s.t. buys puts and calls while .short s.t. sells the two options. The sst is betting stock prices stay within a fairly wide band. for seller max loss is unlimited and profit potential is 2 premiums (see 6-29/-30)!!
def: bull spread combo of options designed to profit if price of underlying goods rises. call options (see 6-30 to study this)
def: bear spread see 6-31 to study this
def: butterfly options see 6-31 to study this (combination of bull and bear spread)
give examples of exotic options .look back options .asian options .barrier options .rainbow options ... BEWARE of securities and strategies that involve writing options b/c WRITING OPTIONS involves the MOST risk!!!!!!!!
What are weather derivatives contracts of? difference (not contracts of indemnity!!) settle against an index of weather events and payout is regardless of actual loss
How do Weather derivatives work and what are important terms? Weather D's payout w/European options (at end) based on Cooling Degree Days (CDD) or Heating Degree Days (HDD) .. against these measures and often up to a set limit based on the option contracts. Can help e.g. power companies that pay out w weather.
OPTIONS CHAPTER you need to memorize the terms and esp the combos of buys and sells for one strategy (since they will be tested) as well as what is symmetrical and asymmetrical ....
What are 4 broad categories of swaps? 1. interest rate swaps 2. currency swaps 3. commodity swaps 4. credit default swaps
What are some other swap derivatives outside of the 4 broad categories? . puttable s . callable s . swaptions . weather swaps
def: Tax swap e.g. selling an issue that has undergvone a capital loss and replacing it with comparable obligation 7-1
def: Swap In simplest form: periodic exchange (swap) of payments between 2 counterparties for a specified period of time (can be based on e.g. interest rates, currency rates, commodity prices, credit default rates, stock indices, temp, rainfall)
Where are Swaps traded OTC only (not on exchange)
Are Swaps contract and if so, what kind Yes, they are forward obligation contracts so BOTH parties are obligated to perform. Payoff profile is symmetrical in nature (like forwards and futures)
Do Swaps have opportunity cost involved? Yes, you give up your downside at the give-up of upside
How are swaps and exchanges related? While Swaps are traded OTC, exchanges have set up mechanisms to clear swaps through clearing agents/brokers so they are margined, MtM and protected from counterparty risk (if xchg is used)
What is one of the big requirements of Dodd-Frank? that OTC derivatives be celared via "exchange-like" clearing systems!!
Are there "rights" in a plain vanilla swap? No, not in a plain vanilla swap
def: ISDA International Swap and Derivatives Assn .record swap volume .helps standardize contracts between parties
What is the mission of the ISDA? .Mission- regulatory/legislative affairs, standard contracts (Swap master agreements), ensure enforeceability of the netting provisions - reducing credit risks arising, tax and acctg disclosures, mkt surveys
Egs of what Swaps allow players to do EGs . trade liabilities . swap fixed assets for floating assets via interest rate swaps on the asset side
Do Swaps change the original contracts? No
What is the typical maturity range? 1 month (commodity) to 10 years (financial)
Swaps (what risk is often increase) counterparty risk
Swaps - What is dealer spread? the fee that is collected by the broker fro standing in the middle of the 2 counterparties and guaranteeing peformance. If they are market makers until a counterp is found they will often hedge (+you'll have to put up collateral and they will MtM.
Can you reverse out of a swap position? Yes, but its not easy and is usually expensive. Better to take an offsetting position if you can.
Swaps: What is another name for maturity date? tenor date
Interest rate swaps: What is a basis swap floating/floating swap
Interest rate swap: What is a coupon swap? fixed/floating swap
I rate swaps: What is the swap spread? the spread that is added to the fixed rate
When does a swap take effect after its trade date 2 days later on its settlement date which is when interest begins accruing (Unless, it is a forward swap where terms are agreed to but don't take effect until sometime in the future)
What is a non-par swap requires exchange of $ at the outset
def: Swaption gives the buyer the right, but not the obligation, to buy(call) or sell(put) a swap. Note that the premiums involved can be expensive. ref: 7-24
Are swaps symmetrical? yes ... (but not swaptions ... until and if the swaption becomes a swap.. ie. exercise of the right ...)
def: currency swap exchange of principal and interest payments on a loan in one currency for p and FIXED rate payment on an equivalent loan in another currency.
Currency swap. What happens at beg of contract? what happens at end? Beg: physically exch the 2 diff currencies in the amount of the notional principal End: at maturity exch the physical currencies back in the same notional amount (regardless of spot at the time) b/c they have a need for the foreign currency. 7-28
Why do currency swaps instead of borrowing from a bank? Takes advantage of comparative advantage where each company has a relative advantage in its own market.. and they take advantage of this through this mechanism.
What is comparative advantage for companies it is their relative advantage (given their rating and reputation in their own industry, area, or country, that allows them to get the best rates. They can take advantage of this (monetarize it) through various swaps (but counterparty r!)
What is the ISDA Master Agreement? ISDA-MA is typically used between 2 derivatives counterparties when discussing a trade. It can be single or multiple currency combined w schedule of terms. Confirms then reference it (SHOULD!)
Explain ISDA master agreements and netting All transactions under an ISDA Master Agreement can be netted for periodic payment
What do the ISDA Master Agreement and all the confirmations form A single agreement
Def: Amortizing swap used to hedge amortizing assets or to replicate the cash flows of mortgage products
def: Differential swap exch of floating rate cash flows based on rates in two different countries denominated in a single currency
def: Fwd swap swap with a deferred effective date
def: callable/ puttable swap allows termination of swap at point in future with no penalty but premium paid either up front or by altering the underlying fixed rate. CALLABLE: fixed rate payer can terminate PUTTABLE: f r receiver can terminate -- Optionality
Mortgage Backed Securities-Chapter 8: conventional pass-thrus called private label were also called (8-6) whole loans
MBS: prepayment causes investment yield uncertainty. Yields are affected as follows by prepayments. If Mortgage security is at a discount, premium, or par..: 1. At discount, prepay =higher yield and shorter life 2. premium=prepay low yield 3. if par prepay not affect yield bu affect overall total rate of rtn b/c investor will have to invest at lower or higher rates
What is negative convexity (re: MBS) prices fall when interest rates rise but price appreciation limited in declining i rate environment b/c of prepayments
MBS: Contraction risk (def) limited upside potential as investor must reinvest proceeds at lower interest rate
MBS: Extension risk adverse consequence of rising mort rates when homeowners don't prepay and opportunity cost for investors is lost
MBS/Passthroughs: What three common models were developed to estimate the actual retur from passthroughs (given prepayments) ref: 8-10 1. Single Monthly Mortality (SMM) 2. Conditional Prepayment Rates (CPR) 3. The Public Securities Association Prepayment Standard Model (PSA)
What are most all CMOs issued in the form of? REMICS - real estate mortgage investment conduits or MBS Strips.
CMO is divided up into _____ tranches (french: slices) which are short, medium, or lt investments... NOTE: prepayment risks cannot be eliminated, only redistributed
CMOs: In addition to plain vanilla CMOs what other types of CMO deals were there: 1. PAC Bond 2. TACs 3. Companion or Support Tranche 4. Floating Rate/Inverse FR -
CMO: def: PAC Bond tranche 1. PAC-bond that amortizes w/sinking fund w/in broad range of prepayment rates. Has a fixed priuncipal payment schedulethat must be met before other tranches receive principal payments
CMO: def: TAC tranche 2. TAC - like one sided PAC if prepayment rates risk up to level or fall to a limit (but not both).. for call protection or extension protection, but not both. PACs take priority if present
CMO: def: Companion or support tranches lower priority than PAC or TAC tranches and they are the "shock absorbers" in CMO structure. Higher yield
CMO: def: Floating rate tranch tranches that have a floating rate with a cap and floor to ensure weighted average coupon of all CMO bonds does not exceed the WAC of the underlying collateral. (NOTE: Super floaters - floating rates change based on formula) Inverse Floaters-rates invers
MBS Strips: What are these, what are the 2 components? 1. Principal Only (PO) - sold at a discount, yield is dependent on prepayments since time value of money 2. Interest Only (IO) - sold at discount, if prepayments they may lose out on all/portion of investment!! Liquidity is problem w/IO+POs
Non-agency CMOSs (def) Loans not meeting certain size and credit criteria, referred to an non-conforming, can serve as collateral for private label mortgage bonds(whole loan CMOs).-subject to credit and interest rate risk
Agency CMOs (def) meet certain size and credit criteria, can be insured against losses by GSE govt spons enterp. THESE are subject to interest rate risk (not cr r)
See Ch 8 questions ...
See Ch 7 questions ...
See Ch 9 questions ...
def: Value at Risk (VAR) how much institution stands to lose at any point based on estimated volatility and correlations of their financial assets (9-57)
What are 3 types of methods to predict interest prepayments (CMOs) 1. Single Monthly Mortality (SMM) 2. Conditional Prepayment Rates (CPR) 3. The Public Standards Model (PSA)-- PSA most used
def: morbidity vs. mortality sick vs. die
CMOs: Which are GSEs egs Fannie Mae and Freddie Mac (not Ginnie Mae which is backed)
CMOs: Which orgs are backed by US Gov't Ginnie Mae (not Fannie Mae or Freddie Mac - which are sponsored but not guaranteed)
Do non-Agency CMOs have credit risk? yes
When will a superfloater Tranche do well? When interest rates go up (mneumonic - superball bounces up)
What are CMO IO (interest only tranches) a beautiful natural hedge against? Beautiful natural hedge against Fixed Coupon Bond Portfolio
Can an IO tranche lose their investment? yes
Can a PO tranche lose their investment no
ABS: CARDs -- underlying asset? Credit Cards
ABS: Which type has the highest default? Home Equity Loans
What are Tranches based on? not based on? Based on Quality Not based on maturity
Q: 1-2 questions on CDOs ... see book/ internet
Q: A CLO is a securitization of what? leveraged bank loans
VAR: What are the 3 approaches to calculate VAR? 1. Variance- covariance. 2. Historical Simulation 3. Monte Carlo Simulation (biggest problem, don't review enough passes)
def: Asset Liability Methods DURATION APPROACH converts any series of cash flows (assets or liabilities) into a single measure for purposes of measuring price sensitivity for interest rate changes
def: Alt-A Borrower no one is above them to verify income (e.g. sole proprietor) - non-verifiable income
def: Liar Loan When information is falsified for Loan
Q: What are risks associated with international investing? .political .currency .market .information
def: Bifurcation (accounting requirement) Splitting of one element into two (eg. international investment split into 1. owning foreign company and 2. owning foreign currency
Q: How is the YTM yield to maturity different from the current yield? YTM takes into account that you can reinvest income from coupons. It allows comparison of diff bonds (with diff coupons and maturities). Assumes being able to reinvest income at a rate equal to YTM
Q: Compare CY to YTM when Bond is: at 100, premium, discount 100:Coup=CY=YTM PR:Coup>CY>YTM DIS:C<CY<YTM
When comparing yields of different bonds always use each's: yield to worst
With stocks investments what is the biggest risk? Capital risk (p112). loss due to devaluing the stock
Stocks: What is systemic risk risk associated with movement of overall market. Diversification can not help here
What happened with UBS and Exch Traded Funds (EFTs)? Fraud b/c overseas EFTs are not exchange traded and confirmations were delayed (15-30 days)
def: EFTs investment vehicles that REPRESENT mutual fund, index, gold ... ADV ease of getting in and out, exch traded so no counterparty risk, fees low DISADV: commissions .... (see other flashcard)
Q: What are the risks of global EFTs Controlled in US (DTC settles) but not "there" in Europe uncontrolled
term: CDS Credit Default Swap
term: CRM Credit Risk Manager (barb sez hot demand: write your own ticket here)
Again def: derivatives financial arrangements between parties whose payments or value is derived from the performance of some agreed-upon, underlying benchmark
What are the 4 categories of derivatives forwards futures options swaps
Note: how do look at the characteristics of derivatives.. you should 1. Bifurcate 2. Price separately
term: True form speculation? =you do not have the underlying
term: notional =amount
Arbitrage: what is simultaneous purchase or sale of same instrument/commodity in different markets
See lots of notes on Derivative Markets (pp 149-151) ....
term: spark traders trade electricity against nl gas
term: crack traders trade crude oil to unleaded gasoline
term: frac traders trade methane nl gas to liquid nl gas
term: fx traders trade foreign currency
Q: What is basis trading? trading 2 st indices against each other
Q: What is regulated/non-reg (futures, fwd, swap) futures are regulated forwards and swaps are not regulated
Q: What is a CSA one of 4 optional parts of ISDA master agreement: Credit Support Agreement: defines the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from "in the money" derivative positions
Q: What other exchanges does the Chicago Board of Trade own? NYMEX COMEX Chicago Board of MERC -- CBOT is NOT a true derivatives exchange
What does an exchange do primarily (important function)? stands in the middle being a buyer for every seller and a seller for every buyer
Q(10 questions) will come from types of contracts and where they are traded see pp. 149-151
Q: What is the diff between trading on an exchange and on ICE? Sometimes on ICE trade through ICE-Trust or bilateral so ICE Trades CAN HAVE counterparty risk.
Look at centralized clearing (pp 152-4) ...
If you produce something you are naturally ____ long (so to hedge go short)
If you need something, you are naturally _____ short (so to hedge go long/buy)
Where are Forwards and futures traded Fwd: OTC (can clear on exchange) Fut: on exchange
Qs: What Ds are used for commodities Forwards and futures
Qs: What Ds are used for stocks options (typically)
Qs: what Ds are used for interest rates swaps
Q!: def: Basis basis (also called the differential) is the difference between two prices when trying to hedge (e.g. timing, locations, produce). Basis risk is when the prices move in different directions
Q: def: Basis Risk when the difference between two prices moves in different directions
Note: which are most often delivered vs settled (commodity contract / financial) C: delivered F: settled
Who posts margin in an option contact (buyer or seller or both) only the seller of an option posts margin
Who posts margin in a futures contract both parties
Why do 99% of futures contracts settle? because of basis risk (differential between) 4/27, pg4
Example problems: Short hedge in power - basis neutral (p172) ...
Example problems: Interest rate futures (P167) ...
def: locational basis risk differences between the spot price at the futures contract delivery point and the spot price at a different location (locational basis)
def: basis(p176) differential at any time between cash price and futures price (basis=cash price-futures price)
def: basis risk (p176) Basis risk is the uncertainty as to whether the cash-futures differential will widen or narrow between the time a hedge position is implemented and liquidated. Basis risk may reflect differences in time, quality, or location.
def: convergence refers to the fact that at delivery there can be no discrepancy between the spot and futures price for a given commodity. If difference then arbitrageurs would act to bring the prices together.
def: negative basis (vs. positive basis) Negative: when future price is above the cash price Positive: when the future price is below the cash price!!
def: contago market condition for forward or futures contract (applies to price to time curve) market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity.
def: backwardation market condition for forward or futures contract (applies to price to time curve) market condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity.
Q: Why are most options cash settled? you can always sell an option to get the remaining time value out of it (rather than exercise it)
NOTE: Q(10-20) on case studies ... will name and then ask questions ...
Can covered call writing be considered a hedge? yes, for income, but it is not a good hedge.
term: "protective" same as covered
What are 2 option pricing models? 1. Black scholes 2. binomial
what is extrinsic value (vs. intrinsic) extrinsic is the time value element. Premium = intrinsic + extrinsic
What is the most popular weather derivative? Windspeed
Know diff btw corridor and collar ... see slides (206)
What is a currency swap called in different currencies cross-currency swap
Don't spend time on credit derivatives ... 1 - 2 questions only here
When type of swap actual exchanges money A FX foreign currency swap (once at beginning and once at end)
What is the most popular swap interest rate swap
Q(20-30%) of exam is on Chapter 9 - Infrastructure ....!!
Case Study, What happened: Orange Country Leverage via reverse repos, inverse floaters(1.7 billion). Borrow short and lend long, then interest rates rose ... margin calls. secured fully pd, pool 77%
Case Study, What happened: Barings Bank Options (1.4 billion): Strangle (sold puts and calls to generate premium income). Kobe earthquake caused Nikkei to plunge. Could not meet margin calls. Lack of SOD. Access to BO, covered tracks. No stop loss limits.
Case Study, What happened: Metallgesellschaft Energy Forwards(1 billion). Bought forwards to sell oil 5-10 years into future. Hedged with 2 year futures to buy oil. When price of oil dropped ... margin calls. LT revenue not yet in. Also counterparty defaults
Case Study, What happened: Amaranth Hedge Funds Energy Futures/Leverage (6.5 billion): Made concentrated energy trades on direction of Natural Gas expecting more hurricanes, for 2nd year, but prices fell due to glut. Got squeezed b other traders, Margin calls. Tried to manipulate prices,failed.
Case Study, What happened: Allfirst FX Fwds in YEN(691 million). Made real trades (fwds)one way and ficticious trades (options) the other to give appearance of hedging. Failure of BO to confirm trades. Was allowed to trade on vacation. Manipulated VAR model
Case Study, What happened: Societe Generale Stock Index Futures(7.2 billion). Made real trades one way and ficticious trades the other to balance the books. Knew how to circumvent BO controls. Poor IT controls. Rarely took vacation.
Case Study, What happened: LTCM Illiquid Porfolio and Leverage(4.6 billion): BalSht was concentrated and when mkt dropped 50% b/c of flight to quality in 1998, couldn't sell illiquid positions. Misjudged and VAR model was too relied on which didn't predict. Lack stress testing/r limits
Case Study, What happened: Proctor & Gamble Interest Rate Swaps(195 million). Entered into 2 swaps with Bankers Trust where they would floating rates. Rates increased dramatically causing the losses
Case Study, What happened: UBS Bank EFTs(2.3 billion). Made real trades on one side and ficticious trades on other side to look like EFT trades matching of opposite position. Got away b/c EFT mkt overseas not traded on exchange and confirmations not created/timely. BO did n verbally confirm
Case Study, What happened: Stanford Financial CD Interest rates too good to be true(loss__). False rates brought in money and managers spent lavishly. No BO to speak of.
Case Study, What happened: Bernie Madoff Interest Rate Swaps in Ponzi Scheme (loss TBD: 64 billion in holdings __billions lost). Crash in mkt, investors tried but could not w/d their money. Many red flags including little objective external oversight. Covered w/ds with other people's money.
Case Study, What happened: Constellation Energy Mar,2012 Market manipulation. Pay $135 civil penalty and $110 in unjust profits total $245 million fine by FERC. Allegation of market manipulation and settlement
Case Study, What happened: Chesapeake Energy Many years of hedging as Nl Gas prices fell and funds were put into expansion. Finally, no hedges were available as gas prices too low and company fully exposed
Forward Exam Points Sheet ...
Futures Exam Points Sheet ...
Options Exam Points Sheet ...
SWAPS Exam Points Sheet ...
Created by: federma007