Fixed Income Securities Overview

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Questions and Answers

What does the performance of a derivative depend on?

The underlying asset's performance (correct)

Market demand for derivatives

The seller's risk assessment

The legal contract terms

Which characteristic of derivatives allows investors to control a large position with a smaller amount of capital?

Low transaction costs

High leverage (correct)

High liquidity

Volatility

Which feature is characteristic of an exchange traded derivatives market?

Informal trading atmosphere

Low regulation

Daily settlement of positions (correct)

Highly customized contracts

Which of the following is NOT considered an underlying asset for derivatives?

Real estate Signup and view all the answers

What is the role of the clearing house in the derivatives market?

To verify transactions and record trading participants Signup and view all the answers

What is a key feature of forward commitments in derivatives?

They lock a price for future transactions Signup and view all the answers

Which option defines the term 'initial margin' in derivatives trading?

Amount deposited to cover potential losses Signup and view all the answers

Which of the following best describes a contingent claim in derivatives?

The right to buy/sell based on a predetermined price Signup and view all the answers

What is a key characteristic of the over the counter (OTC) derivatives market?

Customizable agreements between parties Signup and view all the answers

In which market structure are derivatives commonly traded?

Exchanges Signup and view all the answers

What does 'mark-to-market' refer to in the context of derivatives trading?

Adjusting the margin deposit daily based on market conditions Signup and view all the answers

What is a characteristic of derivatives that provides protection against loss?

Risk transfer Signup and view all the answers

What is the implication of a derivative contract 'at maturity'?

The underlying asset must be physically delivered or settled in cash Signup and view all the answers

Which of the following is considered a derivative type that gives the obligation to buy or sell at a future date?

Futures Signup and view all the answers

Which of the following is a potential risk feature of the over the counter derivatives market?

High degree of risk due to low regulation Signup and view all the answers

Which actor primarily engages in the over-the-counter derivatives market?

Banks from international swaps and derivatives associations Signup and view all the answers

What strategy aims to profit from price discrepancies between a convertible bond and its underlying components?

Fixed Income Convertible Arbitrage Signup and view all the answers

Which of the following describes the essential characteristic of equity hedge strategies?

Hedging against market risk while profiting from individual securities Signup and view all the answers

In the context of derivatives, what are underlying assets typically associated with?

Claims on company assets and monetary units Signup and view all the answers

What is the main function of volatility strategies in financial markets?

Using options to manage or speculate on market volatility Signup and view all the answers

What characterizes the market structure of derivatives compared to cash or spot markets?

Derivatives derive their value from underlying assets, while cash markets trade the assets themselves. Signup and view all the answers

How do multi-strategy approaches function in trading?

They trade across various asset classes and instruments to exploit relative value. Signup and view all the answers

What is a key aspect of fixed income general strategies?

Profiting from differences along the yield curve Signup and view all the answers

Which option best describes fundamental analysis in relation to equity hedge strategies?

Examining financial statements to determine a security's intrinsic value Signup and view all the answers

Study Notes

Fixed Income

Fixed income securities are instruments used by governments, companies, and other issuers to borrow money from investors.
Fixed income securities are the same as debt securities and bonds.
Investors need to understand bond features, legal/regulatory and tax considerations, and contingency provisions when investing in a bond.
Bond issuers can be governmental entities, corporate issuers (financial and non-financial), or special legal entities that securitize assets to create Asset-Backed Securities.
Fixed income securities have various maturities, from short-term (money market) to longer-term (capital markets/perpetuities).
Par value is the amount issuers agree to repay bondholders at maturity. Bond prices are quoted as a percentage of their par value.
Coupon rates and payment frequencies vary, often semi-annually for government and corporate bonds in the U.S. Yield to Maturity (YTM) considers the time value of money (TVM).
Bond denomination currency is important. If the currency is not liquid, or is very volatile compared to major currencies, that can be a concern.

Dual Currency Bonds

A dual currency bond has coupon payments in one currency and principal repayment in another.
This is used to reduce currency risk or for speculation.

Bond Indenture

A legal contract outlining bond characteristics, issuer obligations, and rights of bondholders.
It includes collateral, credit enhancements, and covenants if applicable.

Secured Bonds

Secured bonds are backed by assets or financial guarantees.
Bondholders have seniority ranking, meaning secured bonds are paid before unsecured ones.
Types of collateral backing include collateral trust bonds, equipment trust certificates, and covered bonds.

Credit Enhancement

Structural features of bond issues or financial guarantees from third parties.
Examples include subordination/credit tranching, overcollateralization, and reserve accounts.

Covenants

Promises (commitments) in a bond that certain actions will or will not be taken.
Examples include restrictions on debt, negative pledges, distribution restrictions, and restrictions on investments.

Bond Indentures

Legal documents detailing bond's practices and regulations. Includes components, collateral, credit, and covenants.

Yield to Maturity (YTM)

The internal rate of return (IRR) on a bond if held to maturity.
It reflects the annual return to an investor holding a bond until its maturity.
YTM is inversely related to bond price; as price increases, YTM falls and vice-versa.

Critical Assumptions in YTM

Investor holds the bond until maturity.
The issuer doesn't default.
Reinvestment rate is equivalent to YTM.

Effective Duration

An alternative approach to estimate interest rate risk of a bond.
Calculates the actual change in duration of bonds.
Useful when dealing with bonds with embedded options or complex structures.

Convexity

Measures how the price sensitivity to interest rate changes changes as interest rates move.
It refines the estimations that considers the non-linear relationship and is more accurate for large interest rate changes versus a more basic duration calculation of price changes.

Equity

Companies have four life cycle stages: Embryonic/Early/Seed, Growth, Mature, and Decline.
Companies in the seed stage are characterized by low to no profit, high need of capital, and/or no or low activity.
Companies in the Growth stage have activity, high need of money to grow, or increase activity, overcome entry barriers, expanding teams, or maintain profit.
Companies in the Mature stage are characterized by well-established activity, high competition; high profits, or low need of money.
Companies in the Decline stage are characterized by declining activity, no profit, or firing teams.

Venture Capital

Venture capital is a high-risk and potentially high-return investment (0.9x average). Companies in the venture capital stage are still risky with a significant probability of bankruptcy (approx 90%). Liquidity and valuation risk are also significant concerns.
A valuation is performed to evaluate the startup, compared to (public) market values, and due diligence.

Alternative Funds

Alternative funds include private equity, hedge funds, real estate funds, commodity funds, and infrastructure funds.
Funds generally operate as partnerships with a general partner and limited partners.
The general partner is rewarded by incentive fees or carried interest.

Listed Funds

Listed funds have an active or passive investment strategy, are traded on a stock exchange (e.g. ETF).
The active strategy generally involves selecting assets, and/or portfolio re-balancing by an asset manager.
The passive strategy generally involves following a particular benchmark.

Hedge Funds

Hedge funds generally have limited information, transparency, and regulatory oversight.
Active investment strategies involve leverage and derivatives and aggressive use across asset classes and regions.

Event-Driven Strategies

Hedge fund strategy that seeks profit from short-term events like mergers, acquisitions, or significant changes in the targeted company.

Relative Value Strategies

Profit from price discrepancies between assets having relatively similar properties or characteristics.

Merger Arbitrage

Take long positions in company being acquired and short positions in company making the acquisition. Profit from price discrepancies when companies are being acquired.

Distressed Capital

Companies in distress have structural negative net income and uncertain activity.
Companies may be divesting to survive, so using a discounted-cash flow valuation method is challenging.

Derivatives

Financial instruments whose value is derived from an underlying asset (e.g., equity, fixed income, commodities).
Characteristics of derivatives include high leverage, low transaction costs, high liquidity, and use for risk transfer (with some risk).
Derivatives can be categorized by underlying assets (equity, fixed income, currencies, commodities, and indexes) and options (long/short puts/calls).
Valuation can be performed by calculating a mathematical value using inputs such as spot prices, future rates, and other economic or risk factors.
Derivatives have different strategies for individuals to invest, such as long call, long put, short call, and short put options.
Trading occurs in exchange markets or over the counter (non-standardized, customized).
Features of exchange-traded markets include standardization, liquidity, efficient clearing operations, transparency, and credit quality.
Clearing houses verify transactions and perform daily settlement of positions.
Features of over-the-counter markets include customization, flexibility (less regulated), and informal nature.

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Description

This quiz explores the essentials of fixed income securities, including their features, types, and the considerations that investors must keep in mind. It covers topics such as bond issuers, coupon rates, and the relevance of Yield to Maturity (YTM). Perfect for anyone looking to understand the fundamentals of debt securities.