Derivative Markets Overview
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Questions and Answers

What was a significant factor contributing to the decline in derivative activity from 2013 to 2019?

  • Enhanced regulatory frameworks globally
  • Increased interest rates
  • The implementation of the Volcker Rule (correct)
  • Rising demand for equity securities

Which agency is responsible for regulating financial instruments like derivatives?

  • Securities and Exchange Commission (SEC)
  • Capital Market Authority (CMA) (correct)
  • Federal Reserve
  • Commodities Futures Trading Commission (CFTC)

How did derivative markets change from 1992 to 2013?

  • They remained relatively stable without much growth
  • They showed tremendous growth (correct)
  • They experienced a substantial decline in transactions
  • They were reclassified as equity markets

What is the primary claim of the Capital Market Authority (CMA) regarding securities issues?

<p>Information should be fully and fairly disclosed (D)</p> Signup and view all the answers

What characteristic of derivative markets is highlighted in the content?

<p>They can also be the riskiest financial security (D)</p> Signup and view all the answers

What was the total value of trading in futures and forwards in 2008?

<p>$45,599 (A)</p> Signup and view all the answers

Which type of financial institutions primarily focuses on brokerage and trading activities?

<p>Securities firms (D)</p> Signup and view all the answers

In which year did the value of swaps exceed $130,000 million for the first time?

<p>2008 (A)</p> Signup and view all the answers

What was the total value of options trading in 2016?

<p>$44,134 (C)</p> Signup and view all the answers

What is a primary function of commercial banks?

<p>Managing deposits and loans (C)</p> Signup and view all the answers

Which year saw the lowest trading value in credit derivatives among the given data?

<p>2016 (D)</p> Signup and view all the answers

What was the total trading value across all types in 2000?

<p>$40,544 million (C)</p> Signup and view all the answers

Which statement accurately describes the actions of stockholders and managers regarding trading?

<p>They do not trade on inside information about their firms. (A)</p> Signup and view all the answers

What distinguishes finance companies from depository institutions?

<p>Finance companies make loans without accepting deposits. (C)</p> Signup and view all the answers

Which type of financial institution primarily focuses on protecting against adverse events?

<p>Insurance companies (D)</p> Signup and view all the answers

What type of loans do thrifts primarily offer?

<p>Real estate loans primarily (B)</p> Signup and view all the answers

How do pension funds accumulate funds for retirement?

<p>By pooling financial resources and investing tax-exempt (B)</p> Signup and view all the answers

Which of the following accurately describes the role of investment funds?

<p>They pool resources and invest them in diversified portfolios. (D)</p> Signup and view all the answers

What primary service do FinTechs provide in the financial industry?

<p>Remote financial services competing with traditional methods. (C)</p> Signup and view all the answers

What type of financial liabilities do finance companies typically have?

<p>Subordinate notes and debentures (B)</p> Signup and view all the answers

What is a defining feature of insurance companies compared to other financial institutions?

<p>They protect individuals and corporations from adverse events. (D)</p> Signup and view all the answers

What is the term structure of interest rates mainly concerned with?

<p>The relationship between market yields and term to maturity (B)</p> Signup and view all the answers

What does a positive maturity premium indicate?

<p>Long-term securities have a higher required yield than short-term securities (C)</p> Signup and view all the answers

Why is a dollar received today worth more than a dollar received in the future?

<p>Due to inflation reducing future purchasing power (A)</p> Signup and view all the answers

What primarily causes changes in required interest rates for securities?

<p>The term to maturity of the security (D)</p> Signup and view all the answers

If the maturity premium is zero, what does this suggest about the yields of long- and short-term securities?

<p>Long-term securities yield exactly the same as short-term securities (D)</p> Signup and view all the answers

How does the time value of money impact the present value of a security investment?

<p>Present value decreases when interest rates increase (D)</p> Signup and view all the answers

What does the yield curve represent?

<p>A graphical representation of interest rates over time (A)</p> Signup and view all the answers

Which of the following correctly describes the concept of intrinsic value as it relates to present value?

<p>It is calculated by discounting future cash flows back to today's dollars (C)</p> Signup and view all the answers

What is the minimum denomination for publicly traded corporate bonds?

<p>$1,000 (D)</p> Signup and view all the answers

How frequently do coupon-paying corporate bonds generally pay interest?

<p>Semiannually (D)</p> Signup and view all the answers

What is the purpose of bond rating agencies?

<p>To help reduce costs in assessing municipal bond issuers (B)</p> Signup and view all the answers

What is a bond indenture?

<p>A legal contract for bond issuance (C)</p> Signup and view all the answers

What distinguishes bearer bonds from registered bonds?

<p>Bearer bonds have coupons attached for interest payments (B)</p> Signup and view all the answers

What are mortgage bonds issued to finance?

<p>Specific projects pledged as collateral (B)</p> Signup and view all the answers

How are subordinated debentures characterized?

<p>Junior in rights to mortgage bonds (A)</p> Signup and view all the answers

What is the key difference between term bonds and serial bonds?

<p>Serial bonds mature on a single date (D)</p> Signup and view all the answers

What is the primary purpose of issuing bonds?

<p>To raise funds for long-term operations (C)</p> Signup and view all the answers

Which of the following describes Treasury bonds?

<p>They have original maturities over 10 years (A)</p> Signup and view all the answers

What happens if a bond issuer fails to meet repayment terms?

<p>Bondholders have a claim on the issuer’s assets (A)</p> Signup and view all the answers

What is the minimum denomination for treasury notes and bonds?

<p>$100 (C)</p> Signup and view all the answers

Which of the following is NOT a type of bond mentioned?

<p>Investment bonds (C)</p> Signup and view all the answers

What is characteristic of the secondary market for T-notes and T-bonds?

<p>They trade in very active markets (C)</p> Signup and view all the answers

What is one risk associated with T-notes and T-bonds?

<p>They are subject to price fluctuations (C)</p> Signup and view all the answers

How often do T-notes and T-bonds pay interest?

<p>Semi-annually (A)</p> Signup and view all the answers

Derivative markets are considered the least risky type of financial security markets.

<p>False (B)</p> Signup and view all the answers

There was tremendous growth in derivative activity from 1992 to 2013.

<p>True (A)</p> Signup and view all the answers

The Volcker Rule was implemented in 2019 and caused a decline in derivative activity.

<p>False (B)</p> Signup and view all the answers

The Capital Market Authority (CMA) claims that information on securities issues should be fully disclosed to investors.

<p>True (A)</p> Signup and view all the answers

The trading value in derivatives showed consistent growth every year from 2013 to 2019.

<p>False (B)</p> Signup and view all the answers

A negotiable CD can only be traded once before it matures.

<p>False (B)</p> Signup and view all the answers

Foreign exporters often prefer that banks act as guarantors for payment before sending goods.

<p>True (A)</p> Signup and view all the answers

Bearer instruments allow only the original buyer to receive the principal and interest upon maturity.

<p>False (B)</p> Signup and view all the answers

U.S. money markets are the smallest and least active in the world.

<p>False (B)</p> Signup and view all the answers

The growth of money markets includes U.S. money market securities being bought and sold by foreign investors.

<p>True (A)</p> Signup and view all the answers

Banker's acceptances are typically sold at face value.

<p>False (B)</p> Signup and view all the answers

Foreign money market securities have no impact on the U.S. money markets.

<p>False (B)</p> Signup and view all the answers

The principal and interest from a CD are paid out to whoever holds it at the time of maturity.

<p>True (A)</p> Signup and view all the answers

The foreign exchange market allows for the exchange of commodities rather than currencies.

<p>False (B)</p> Signup and view all the answers

Derivative securities have payoffs that are linked to the performance of other financial instruments.

<p>True (A)</p> Signup and view all the answers

In 2008, new issues in the primary market were valued at approximately $1,068.0 billion.

<p>True (A)</p> Signup and view all the answers

Foreign exchange risk refers to the stability of a country's currency against foreign investments.

<p>False (B)</p> Signup and view all the answers

Derivatives are typically traded in capital markets rather than derivative security markets.

<p>False (B)</p> Signup and view all the answers

The U.S. dollar’s value on foreign investments is determined solely by domestic market conditions.

<p>False (B)</p> Signup and view all the answers

The primary market for instruments with maturities of more than one year recovered by 2018.

<p>False (B)</p> Signup and view all the answers

Payments for derivative securities can occur at a specified price on a future date.

<p>True (A)</p> Signup and view all the answers

Municipal bond issuers always provide accessible and inexpensive information to investors.

<p>False (B)</p> Signup and view all the answers

A bond indenture outlines the specific rights and obligations of both the bond issuer and the bondholders.

<p>True (A)</p> Signup and view all the answers

Bearer bonds require holders to present interest coupons for payments to the issuer.

<p>True (A)</p> Signup and view all the answers

Debentures are secured by specific assets of the issuing company.

<p>False (B)</p> Signup and view all the answers

Term bonds are structured to mature on multiple dates.

<p>False (B)</p> Signup and view all the answers

Subordinated debentures take priority over regular debentures in terms of claims on assets.

<p>False (B)</p> Signup and view all the answers

Mortgage bonds are typically related to financing broader corporate projects without collateral.

<p>False (B)</p> Signup and view all the answers

Registered bonds send coupon payments directly to the bond issuer.

<p>False (B)</p> Signup and view all the answers

When domestic economic conditions result in stagnation, the demand for funds decreases.

<p>True (A)</p> Signup and view all the answers

Inflation is measured using the Gross Domestic Product (GDP) index.

<p>False (B)</p> Signup and view all the answers

Higher inflation levels typically lead to higher interest rates.

<p>True (A)</p> Signup and view all the answers

Default risk refers to the likelihood that a security issuer will fulfill all of their payment obligations.

<p>False (B)</p> Signup and view all the answers

Liquidity risk affects the determination of interest rates for individual securities.

<p>True (A)</p> Signup and view all the answers

The higher the default risk, the lower the interest rate demanded by buyers.

<p>False (B)</p> Signup and view all the answers

The producer price index (PPI) measures changes in the average price level of a basket of consumer goods.

<p>False (B)</p> Signup and view all the answers

Interest rates are not influenced by liquidity risk when assessing individual securities.

<p>False (B)</p> Signup and view all the answers

The principal value of a TIPS bond increases every six months based on the percentage change in the CPI.

<p>True (A)</p> Signup and view all the answers

TIPS and fixed principal bonds both pay interest annually.

<p>False (B)</p> Signup and view all the answers

STRIPS allow investors to receive periodic coupon payments separately from the final principal payment.

<p>True (A)</p> Signup and view all the answers

Investors in TIPS do not see their investment value change over time.

<p>False (B)</p> Signup and view all the answers

The U.S. Treasury sells STRIPS directly to investors.

<p>False (B)</p> Signup and view all the answers

The interest payments on TIPS are based on a fixed principal value.

<p>False (B)</p> Signup and view all the answers

Accrued interest refers to the interest earned on a bond since the last coupon payment.

<p>True (A)</p> Signup and view all the answers

The final payment on a TIPS bond is always less than the initial principal investment.

<p>False (B)</p> Signup and view all the answers

Flashcards

Derivative Securities

Financial instruments that derive their value from an underlying asset, such as stocks, bonds, or commodities.

Volcker Rule

A rule that limits the amount of risk commercial banks can take on through trading and investing.

Foreign Currency Conversion

The process of converting a non-U.S. dollar cash flow into U.S. dollars.

Capital Market Authority (CMA)

The authority responsible for regulating securities issues in a country. Aiming to ensure full and fair disclosure for investors.

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Derivative Activity Trends

A significant increase in derivative activity occurred between 1992 and 2013, followed by a sharp decrease from 2013 to 2019 due to the Volcker Rule.

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Commercial banks

Institutions that accept deposits and make loans, with deposits as their primary liability.

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Securities firms and investment banks

Institutions that facilitate the issuance of securities and engage in brokerage and trading activities.

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Transferring funds

A process where entities with surplus funds transfer them to entities experiencing a shortage of funds.

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Swaps

An agreement to exchange a set of cash flows at specific future dates.

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Options

A contract giving the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price.

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Credit derivatives

Contracts that derive their value from the creditworthiness of an underlying entity.

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Futures and forwards

Contracts that involve buying or selling commodities or financial instruments at a future date.

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Insider trading

The practice of trading securities based on non-public information about a company.

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Depository Institutions

Financial institutions, like banks and credit unions, that accept deposits from individuals and businesses and make loans.

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Finance Companies

Financial institutions that specialize in loans like consumer loans (cars, mortgages, etc.), commercial loans (business loans), and real estate loans.

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Thrifts

They offer a similar range of services as commercial banks, but often specialize in specific areas like real estate or consumer loans. They are also considered depository institutions.

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Insurance Companies

Financial institutions that provide insurance, protecting individuals and companies from financial losses due to specific events.

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Life Insurance

Insurance that covers you from losses due to death, illness, or retirement.

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Property-Casualty Insurance

Insurance that covers you from losses due to accidents, theft, fire, or other unexpected events that can damage your property.

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Investment Funds

Financial institutions that manage money collected from individuals and companies and invest it in a diverse portfolio of assets.

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Pension Funds

Financial institutions that provide retirement plans for individuals and companies. They accumulate contributions and invest them for future payouts during retirement.

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Minimum denomination of corporate bonds

The minimum amount of money that can be invested in a publicly traded corporate bond.

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Frequency of corporate bond interest payments

Interest payments on corporate bonds are typically made twice a year.

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What is a bond indenture?

A legal document outlining the rights and responsibilities of both the bond issuer and the bondholders.

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What are bond covenants?

These are rules and limitations placed on the bond issuer and bondholders.

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What are bearer bonds?

Bonds that have coupons attached to them, which the holder presents to the issuer for interest payments when due; ownership is not recorded by the issuer.

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What are registered bonds?

Bonds where the owner is registered with the issuer, and coupon payments are mailed to the registered owner.

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What are debentures?

Bonds backed only by the general creditworthiness of the issuing firm.

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What are subordinated debentures?

Bonds that are unsecured and have lower priority in claims than mortgage bonds and regular debentures.

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Term Structure of Interest Rates

The relationship between interest rates and the maturity of a security. It essentially compares yields on securities with different maturities, assuming other factors like default risk and liquidity risk are the same.

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Maturity Premium

The difference in required yields between long-term and short-term securities. It reflects the additional compensation investors demand for holding longer-term assets.

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Yield Curve

A graphic representation of the term structure of interest rates. It plots yields of securities with different maturities, showing their relationships.

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Upward Sloping Yield Curve

A yield curve where long-term interest rates are higher than short-term rates. This is often considered the 'normal' shape.

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Inverted Yield Curve

A yield curve where short-term interest rates are higher than long-term rates. This can be a sign of economic slowdown or recession.

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Flat Yield Curve

A yield curve where interest rates are relatively flat across different maturities. This suggests investors expect little change in future interest rates.

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Time Value of Money

The concept that a dollar received today is worth more than a dollar received in the future. This is due to the potential to invest that dollar today and earn a return.

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Present Value

The current value of a future cash flow, discounted back to the present using an appropriate interest rate. Represents the investment's true worth considering the time value of money.

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What are bonds?

Bonds are long-term debt securities issued by corporations or government entities to raise funds for financing long-term operations.

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Who are the key players in the bond market?

Major participants in the bond market include corporations who issue bonds, governments who issue bonds, individuals who invest in bonds, and institutional investors like pension funds and mutual funds.

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What are bond proceeds used for?

The proceeds from a bond issue are used to finance the long-term operations of the bond issuer. This includes projects, expansion, or general funding needs.

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What types of securities are traded in international bond markets?

The types of securities traded in international bond markets include government bonds, corporate bonds, and other debt securities, often issued in multiple currencies.

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What are the implications of bond issuer default?

If a bond issuer fails to meet its repayment terms, the bondholder has a claim on the assets of the bond issuer. This means the bondholder can potentially recover some of their investment if the issuer defaults.

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What are T-notes and T-bonds?

Treasury notes and bonds, also known as T-notes and T-bonds, are issued by the US Treasury to finance government operations.

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What are the maturities and interest payments of T-notes and T-bonds?

T-notes have maturities from 1 to 10 years, while T-bonds have maturities over 10 years. Both pay interest semi-annually.

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What is the risk associated with T-notes and T-bonds?

T-notes and T-bonds are considered relatively safe investments because they are backed by the US government, but they are not completely risk-free due to potential price fluctuations.

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Foreign Exchange Market

The global market where currencies of different countries are exchanged.

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Foreign Exchange Risk

The risk that cash flows from foreign investments will be affected by changes in the exchange rate between the foreign currency and the US dollar.

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Derivative Security

A financial security whose payoff is linked to another previously issued security, like a stock or bond.

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Derivative

A financial instrument traded in derivative security markets that involves an agreement to exchange a specific quantity of an asset or cash flow at a set price and date in the future.

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Foreign Exchange Risk

The sensitivity of cash flows on foreign investments to changes in the foreign currency's value in terms of dollars.

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Foreign Exchange Market

The global market for exchanging currencies of different countries.

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Derivative Security

A financial security whose value is derived from another underlying asset, such as a stock, bond, or commodity.

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Derivative Security Market

The market where derivatives are traded.

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What is a derivative security?

A financial instrument whose value is derived from an underlying asset, like stocks, bonds, or commodities.

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What is foreign currency conversion?

The process of converting a non-US dollar cash flow into US dollars.

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What happened to derivatives activity after 2013?

The Volcker Rule aimed to curb risky trading by commercial banks.

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Who oversees financial instrument regulations?

The Capital Market Authority (CMA) regulates securities issuance to ensure transparency and fairness for investors.

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What is the trend in derivative activity?

The trend showed significant growth in derivative activity until 2013, but a sharp decrease followed.

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Inflation

The continual increase in the price level of a basket of goods and services.

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Default Risk

The risk that a security issuer may not make promised interest and principal payments.

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Liquidity Risk

The risk associated with the ease of converting a security into cash.

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Bond Covenants

Rules and limitations placed on the bond issuer and bondholders, outlined in the bond indenture.

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Negotiable CDs

A negotiable CD represents a time deposit that can be bought and sold in secondary markets, meaning the original owner doesn't have to hold it until maturity.

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Banker's Acceptances

They act as a guarantor for payment to the foreign exporter, ensuring payment even if the domestic importer fails to pay.

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Banks in International Trade

Banks play a crucial role in international trade by providing financial instruments that mitigate risk and facilitate global transactions.

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U.S. Money Markets: Global Significance

U.S. money markets are the largest and most active in the world due to their liquidity and sophistication.

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Global Money Market Growth

Money markets operate globally, with foreign investors participating in U.S. markets and foreign money market securities gaining prominence.

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Role of Banks in International Trade

Foreign exporters rely on banks to guarantee payment in international trade, ensuring they receive funds even in case of importer default.

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Banker's Acceptances: Discounted Basis

These instruments represent promises to pay a certain amount of money on a specific date, and they are sold at a discount to their face value.

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Bearer Instruments

Bearer instruments are financial instruments where ownership is not recorded, and the holder at maturity receives the principal and interest.

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What is the minimum denomination for corporate bonds?

The minimum amount of money required to invest in a publicly traded corporate bond.

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How often do corporate bonds pay interest?

Corporate bonds typically pay interest to bondholders twice a year.

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What are Treasury Inflation-Protected Securities (TIPS)?

Treasury Inflation-Protected Securities (TIPS) are a type of U.S. Treasury bond that adjusts its principal value and interest payments based on inflation, as measured by the Consumer Price Index (CPI). Investors buy TIPS to protect their investments from inflation's eroding power.

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What are STRIPS?

STRIPS (Separate Trading of Registered Interest and Principal Securities) are zero-coupon Treasury securities where interest payments and the principal payment are separated and traded individually. The U.S. Treasury doesn't directly sell STRIPS; they are created by financial institutions through a process called 'stripping.'

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What is accrued interest?

Accrued interest refers to the interest earned but not yet paid on a bond between coupon payment dates. When you buy a bond between coupon payments, you pay the seller the accrued interest, representing the interest earned since the last payment.

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How does the principal value of a TIPS bond change?

The principal value of a TIPS bond can increase or decrease every six months based on the inflation or deflation rate as measured by the CPI. This means its principal value rises with inflation, protecting investors from purchasing power loss.

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How are payments on a TIPS bond adjusted?

Semi-annual coupon payments and the final principal payment of a TIPS bond are based on the inflation-adjusted principal value. This means the payments are larger than the original coupons in periods of inflation and smaller in periods of deflation.

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Why would someone invest in TIPS?

Investors who want to earn a return on their investments that keeps pace with inflation over time prefer TIPS. In other words, they want to protect their investments from the eroding effects of inflation.

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Who sells STRIPS?

The U.S. Treasury does not directly sell STRIPS. Financial institutions create them by separating the coupon payments and principal payment of a Treasury bond and selling them individually to investors. This process is known as 'stripping.'

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Study Notes

Chapter One: Introduction

  • Learning Goals: Differentiate between primary and secondary markets, money and capital markets, foreign exchange markets, and derivatives markets. Understand financial institutions, their services, risks, and regulation.

  • Why Study Financial Markets? Markets and institutions play a crucial role in allocating capital. Understanding how money flows is essential for managers and investors in domestic and international contexts.

Primary versus Secondary Markets

  • Primary Markets: Corporations raise funds through issuing new financial instruments (stocks, bonds). Initial Public Offerings (IPOs) are examples of primary market transactions.

  • Secondary Markets: Markets where existing financial instruments are traded after their initial issuance. These markets offer liquidity, pricing information, and low transaction costs.

Primary and Secondary Market Transfer of Funds Timeline

  • Primary Markets: Funds are acquired by issuing securities.
  • Secondary Markets: Funds are transferred via buying and selling securities.

Why Study Financial Markets (cont'd)

  • Financial Markets: Structures where funds move through the economy, including primary and secondary markets, and money and capital markets.

How were primary markets affected by the financial crisis?

  • Financial Crisis Impact: Significant decrease in primary market sales—from $2,389.1 billion to $1,068.0 billion in 2008. The decline in sales has not yet recovered.

Money versus Capital Markets

  • Money Markets: Short-term (one year or less) debt securities. Lower risk and price fluctuation compared to capital markets.

  • Capital Markets: Debt (bonds) and equity (stocks) instruments with maturities greater than one year. High potential for price fluctuation.

Foreign Exchange Markets

  • Foreign Exchange Market: Worldwide market for trading currencies.
  • Foreign Exchange Risk: Sensitivity of foreign investments' cash flows to currency value fluctuations.

Derivative Security Markets

  • Derivative Securities: Payoffs linked to other securities (e.g., futures, options, swaps).
  • Derivative Security Markets: Trading venue for derivative securities, often more complex and potentially riskier than other financial markets. Derivative security activity saw significant growth between 1992 and 2013, followed by a decrease around 2014 due to changes in financial regulation. Data in the original document shows growth from $9,877 billion in 2000 to $46,165 billion in 2019 for derivative contracts held by commercial banks.

Financial Market Regulation

  • Financial Instruments Regulation: Agencies like the Capital Market Authority (CMA) regulate financial instruments to ensure fair disclosure to investors and prohibit insider trading. Regulation specifically aims at ensuring transparency and preventing the use of inside information.

Overview of Financial Institutions

  • Financial Institutions: Transfer funds between surplus and deficit entities.
  • Types: Commercial banks, thrifts, insurance companies, securities firms, finance companies, investment funds, pension funds, fintechs are examples.

Types of Financial Institutions (cont'd)

  • Commercial Banks: Primarily provide loans and accept deposits.
  • Thrifts: Offer similar services like commercial banks but mainly focus on real estate or consumer loans.
  • Insurance Companies: Protect individuals and corporations from financial risk.
  • Securities Firms, Investment Banks: Assist firms in issuing securities, and perform brokerage and trading activities.
  • Finance Companies: Lend to people and businesses, but they don't take deposits.
  • Investment Funds: Pool funds from many sources to invest in a diversified portfolio of assets.
  • Pension Funds: Offer savings plans for retirement, often tax-exempt.
  • Fintechs: Utilize technology to offer financial services and compete with traditional methods.

Risks Incurred by Financial Institutions

  • Default Risk: Failure to repay debt is a constant risk for financial institutions.
  • Foreign Exchange Risk/Country Risk: Risk for institutions with international operations.
  • Interest Rate Risk: Risk associated with mismatched maturities of assets and liabilities.
  • Market/Asset Price Risk: Risk for institutions that actively trade assets.
  • Off-Balance Sheet Risk: Risk associated with contingent assets and liabilities.
  • Liquidity Risk: Risk that assets cannot be converted into cash quickly.
  • Technology and Operational Risk: Risks associated with technology use and systems.
  • Insolvency Risk: Risk when a bank's capital stock is insufficient to cover losses.

Benefits of Financial Institutions (cont'd)

  • Monitoring Costs: Lower average costs due to economies of scale.
  • Liquidity and Price Risk: Offer better liquidity and price risk to those with insufficient funds.
  • Transaction Cost Services: Efficiency gains associated with pooling and investing resources.
  • Maturity Intermediation: Better managing mismatched maturities of assets and liabilities

Chapter Two: Determinants of Interest Rates

  • Learning Goals: Understand who the main suppliers and demanders of loanable funds are, how equilibrium interest rates are determined, factors that shift supply and demand curves, determinants for individual securities, and how time value of money relates to interest rates.

  • Interest Rate Fundamentals: Nominal interest rates directly impact security values in money and capital markets. Interest rate changes affect individual, business, and government decisions.

Loanable Funds Theory

  • Loanable Funds Theory: Explains interest rates as the result of supply and demand.
  • Supply of Loanable Funds: Driven by entities providing funds, growing with rising interest rates (reward for supply).
  • Demand for Loanable Funds: Driven by users seeking funds, growing with declining interest rates.

Factors Causing Shifts in Loanable Fund Supply and Demand

  • Factors Affecting Supply: Include wealth of suppliers, risk of financial securities, near-term spending needs, global economic conditions, monetary policies.
  • Factors Affecting Demand: Include utility of borrowed funds, spending needs, economic conditions.

Determinants of Interest Rates for Individual Securities

  • Inflation: Higher inflation leads to higher interest rate expectations.
  • Liquidity Risk: Higher liquidity risk leads to higher interest rates.
  • Default Risk: Higher default risk leads to higher interest rates.
  • Special Provisions or Covenants: Covenants affecting the security's value or ability to repay lead to corresponding interest changes.
  • Term to Maturity: Bond maturity differences require differing interest rates.

Time Value of Money

  • Time Value of Money: A dollar received now is more valuable than a dollar received in the future.
  • Present Value: Current value of a future payment.
  • Future Value: Value of an investment at a future date. Calculation of present and future value involves interest rates and time.

Chapter 3: Money Markets

  • Money Markets: Trading venue for short-term (less than one year) debt instruments.
  • Money Market Instruments: Treasury bills, fed funds, repurchase agreements, commercial paper, negotiable certificates of deposit (CDs), banker’s acceptances. Money market instruments are usually very large denominations, have low default risk, and have less than one year to maturity.

Chapter 4: Bond Markets

  • Bond Markets: Trading place for long-term debt obligations.
  • Bond Types: Treasury notes, Treasury bonds, municipal bonds, corporate bonds, TIPS

Treasury Notes and Bonds

  • Treasury Notes and Bonds: Issued by the U.S. Treasury.
  • Treasury Notes: Maturities range from 1 to 10 years. Coupons are paid semi-annually.
  • Treasury Bonds: Maturities exceed 10 years.

Treasury Inflation-Protected Securities (TIPS)

  • TIPS: Special U.S. Treasury securities that protect investors from inflation.

Primary and Secondary Market Trading in Treasury Notes and Bonds

  • Treasury Auctions: The process for selling securities.
  • Secondary Market: Trading of existing securities after their initial issuance.
  • Broker/Dealer Trading: The primary method of securities trading in the secondary market.

Municipal Bonds

  • Municipal Bonds: Issued by state and local governments
  • General Obligation (GO) Bonds: Backed by the government.
  • Revenue Bonds: Backed by specific revenue streams.

Corporate Bonds

  • Corporate Bonds: Long-term obligations issued by corporations.
  • Bond Characteristics: Bearer or registered, term or serial, different types of bond provisions (mortgage bonds, debentures, subordinated debentures, convertible bonds, bonds with warrants, callable bonds, sinking fund provisions).
  • Trading Process: Similar to many other securities, involving a primary sale and secondary trading for existing issues.

Bond Ratings and Interest Rate Spreads

  • Bond Ratings: Agencies like Moody's, S&P, and Fitch rate bonds based on risk.
  • Interest Rate Spreads: Reflect the risk premiums added to bonds across varying rating classes.

Bond Market Participants

  • Bond Market Participants: Federal/state/local governments, corporations issue, while households, businesses, etc., purchase bonds.

International Aspects of Bond Markets

  • International Bond Markets: Include Eurobonds, foreign bonds, and sovereign bonds. Variations exist in terms of the country of issuance versus the currency of the issue.
  • Sovereign Bonds: Government-issued bonds denominated in a different currency.

Bond Market in KSA

  • Bond Market in KSA: Trading venues for local bond issues. Trading is over-the-counter and not necessarily on an organized exchange.

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This quiz explores the significant trends and regulatory aspects of derivative markets from 1992 to 2019. It covers questions related to trading values, market changes, and the roles of financial institutions. Test your knowledge on derivatives and their impact in the financial sector.

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