Investment Process Quiz

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Questions and Answers

What do bondholders receive in exchange for lending money to the issuer?

Residual claims on assets

Regular interest payments (correct)

Voting rights

A share of ownership in the firm

What distinguishes stocks from bonds?

Stockholders have voting rights, while bondholders do not. (correct)

Stocks represent loan agreements, while bonds represent ownership.

Bonds provide equity in a firm, while stocks provide fixed interest.

Stocks have higher repayment obligations than bonds.

In the event of a company's bankruptcy, which group has the highest claim on its assets?

Employees

Tax authorities

Bondholders (correct)

Shareholders

What is the primary function of a call option?

To purchase an asset at a predetermined price Signup and view all the answers

Which of the following is NOT classified as a main derivative?

Stocks Signup and view all the answers

What situation would prompt a trader to buy call options?

To speculate on rising asset prices Signup and view all the answers

What happens to a corporate stockholder in case of bankruptcy?

They risk losing only the value of their stock. Signup and view all the answers

If the spot price of an underlying asset is 150 SAR and the strike price of a call option is 160 SAR, what is the trader's condition?

Out of the money situation Signup and view all the answers

What is the primary purpose of a put option for a trader?

To protect against falling prices Signup and view all the answers

In a futures contract, what is the essential obligation of the trader?

To buy or sell the asset at a future date Signup and view all the answers

What distinguishes options from futures contracts?

Options grant rights without obligations while futures impose obligations Signup and view all the answers

If the spot price of an asset is 170 SAR and the strike price of a put option is 160 SAR with a premium of 5 SAR, what would be the trader's profit if the asset's price falls to 150 SAR?

10 SAR Signup and view all the answers

What is the typical financial arrangement in a swap contract?

Swapping fixed rate payments for variable rate payments Signup and view all the answers

A trader sells a call option while the spot price of the underlying asset remains below the strike price. What is the outcome for the trader?

They gain from the premium received without further obligation Signup and view all the answers

What typically occurs when a trader purchases a put option?

They gain the right to sell the asset at the strike price if it's beneficial Signup and view all the answers

When comparing options trading to futures trading, which statement is accurate?

Options require a premium upfront; futures do not Signup and view all the answers

What is the primary characteristic of the money market?

It primarily deals with short-term debts. Signup and view all the answers

Which instrument is usually issued at a discount and returns the face amount at maturity?

Treasury bills Signup and view all the answers

In money market transactions, what is the primary purpose of the Fed funds rate?

To determine the interest rates on very short-term loans. Signup and view all the answers

Certificates of deposit (CDs) may not be withdrawn on demand. What is the consequence of this feature?

They are fixed-term deposits that pay at maturity. Signup and view all the answers

What distinguishes the bond market from the money market?

The bond market involves longer-term debt instruments. Signup and view all the answers

Which of the following is true about commercial paper?

It represents short-term debt issued by large firms. Signup and view all the answers

What is a key feature of sukuks compared to traditional bonds?

Sukuks are compliant with Sharia law. Signup and view all the answers

Which of these markets is not part of the capital market?

Money markets Signup and view all the answers

What type of payment do cash flows from bonds typically represent?

Coupon payments Signup and view all the answers

What is the primary role of LIBOR in financial markets?

To serve as a benchmark for interbank lending rates. Signup and view all the answers

Study Notes

Process of Building Investment

Investment decisions involve two key steps: asset allocation and security selection.
Asset allocation determines the proportion of funds to be invested in different asset classes (e.g., bank accounts, financial markets, real estate).
Security selection involves choosing specific assets within each asset class.

Financial Markets

Financial markets are categorized into money markets and capital markets.

Money Market

The money market is a subsector of the fixed-income market dealing with short-term debt instruments.
Money market instruments are characterized by high liquidity, low risk, and often have large denominations.
Examples of money market instruments include Treasury bills, certificates of deposit, and commercial paper.

Treasury Bills

The government issues Treasury bills to raise funds.
Treasury bills are short-term government securities sold at a discount from their face value.
They mature within 52 weeks.
Treasury bills are known for their high liquidity, low transaction costs, and low risk.

Certificates of Deposit (CDs)

CDs are time deposits offered by banks with a fixed maturity date.
Funds deposited in CDs cannot be withdrawn on demand.
The bank pays the depositor the principal amount plus interest only at the end of the maturity term.

Commercial Paper

Large firms issue short-term debt directly to the public in the form of commercial paper, rather than borrowing from banks.

Money Market: Interbank Rates

The Fed funds rate is the interest rate on short-term loans between financial institutions in the United States.
The London Interbank Offered Rate (LIBOR) is the benchmark interest rate at which banks in London lend to each other.
LIBOR rates are widely used for transactions involving several currencies, including GBP, yen, and euros.
EURIBOR, EONIA, and ESTER are key interest rates for banks in the Eurozone.
The Saudi Arabian Interbank Offered Rate (SAIBOR) is the benchmark rate for interbank lending in Saudi Arabia.

Capital Markets

The capital market consists of bond/sukuk markets, equity markets, and derivative markets.

Bond/Sukuk Market

The bond market deals with longer-term debt instruments compared to those traded in the money market.
Bonds can be issued by corporations (corporate bonds) or governments (treasury bonds).
Bonds offer fixed-income payments, known as coupon payments.
Sukuk are Sharia-compliant financial instruments that provide fixed returns and priority of repayment in case of bankruptcy.

Stocks (Equities)

Stocks represent ownership shares in a firm.
Shareholders have voting rights and receive dividends (common stocks vs. preferred stocks).
Shareholders have a residual claim on the firm's assets in case of bankruptcy, receiving any remaining value after other creditors are paid.
Shareholders benefit from limited liability; they are only responsible for the amount invested and are not personally liable for the firm's obligations.

Derivative Markets

Derivatives are financial instruments whose value is derived from the value of other underlying assets (e.g., stocks, bonds, exchange rates, commodities).
Key types of derivatives include options, futures, and swaps.

Call Option

A call option grants the buyer the right to purchase an asset for a specified price (exercise or strike price) on or before a certain expiration date.

Put Option

A put option grants the buyer the right to sell an asset for a specified price (exercise price) on or before a certain expiration date.

Profits and Losses: Buyer Call Option

A trader who wants to hedge against rising prices buys call options.
Example: The spot price of an asset is 150 SAR, the strike price is 160 SAR, and the premium is 5 SAR.
The buyer profits if the spot price exceeds the strike price at maturity. The profit is calculated as: (Spot price - Strike price - Premium) X The Number of Units.
The buyer incurs a loss if the spot price is below the strike price at maturity. The loss is capped at the premium.

Profits and Losses: Seller Call Option

A seller of a call option expects the price of the underlying asset to decline.
The seller receives the premium.
The seller incurs a loss if the spot price exceeds the strike price at maturity. The loss is potentially unlimited as the spot price can rise infinitely.
The seller makes a profit if the spot price is below the strike price at maturity. The profit is capped at the premium.

Profits and Losses: Buyer Put Option

A trader who wants to hedge against falling prices buys put options.
Example: The spot price of an asset is 170 SAR, the strike price is 160 SAR, and the premium is 5 SAR.
The buyer profits if the spot price falls below the strike price at maturity. The profit is calculated as: (Strike price - Spot price - Premium) X The Number of Units.
The buyer incurs a loss if the spot price is above the strike price at maturity. The loss is capped at the premium.

Profits and Losses: Seller Put Option

A seller of a put option expects the price of the underlying asset to rise.
The seller receives the premium.
The seller incurs a loss if the spot price falls below the strike price at maturity. The loss is potentially unlimited as the spot price can fall infinitely.
The seller makes a profit if the spot price is above the strike price at maturity. The profit is capped at the premium.

Futures Contracts

Futures contracts obligate traders to buy or sell an asset at an agreed-upon price on a specified date.
Unlike options, futures contracts require a mandatory purchase or sale of the asset, not just the right to do so.
Futures contracts have no premium; instead, a margin account is used to cover potential losses.
Profits and Losses in Futures are calculated as (Closing Price - Initial Price) X The Number of Units.

Swaps

Swaps are contracts where two parties exchange the cash flows or values of different assets.
Examples include fixed-for-variable rate swaps, where one party pays a fixed interest rate and receives a variable rate, and vice versa.

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Description

Test your knowledge on the process of building investments. This quiz covers key concepts like asset allocation, security selection, and different financial markets, including money markets and Treasury bills. Challenge yourself to understand the intricacies of short-term debt instruments and their characteristics.