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THE ASSOCIATE PROFESSIONAL RISK


MANAGER (APRM) HANDBOOK
















Alan Anderson, Ph.D.
Western Connecticut State University
ECI Risk Training
http://www.aprmtraining.com


CHAPTER 3: AN INTRODUCTION TO FINANCIAL


MARKETS


CHAPTER OBJECTIVES:

• Understand the different types of money market instruments
• Understand the basic characteristics of bond markets
• Understand the basic characteristics of equity (stock) markets
• Understand the basic characteristics of foreign exchange markets
• Understand the basic characteristics of futures markets
• Understand the basic characteristics of over-the-counter (OTC) markets
• Understand the basic characteristics of commodities markets
• Understand the basic characteristics of energy markets


3.1 INTRODUCTION

Financial markets can be classified as organized exchanges and over-the-counter
(OTC) markets. An organized exchange is a physical location where trading takes place;
for example, the New York Stock Exchange. Exchanges offer several services,
including:

• standardized financial products


• price information
• protection from counterparty risk (the risk of non-performance by one party
to an agreement)
• matching buyers with sellers at agreed-upon prices

The over-the-counter (OTC) markets consist of direct buying and selling between
counterparties. OTC markets provide access to a wider array of financial assets than
exchanges, but do not protect investors from counterparty risk.

The following financial markets are covered in this chapter:

• Money markets
• Bond markets
• Stock markets
• Foreign exchange markets
• Futures markets
• Commodities markets
• Energy markets

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3.2 THE MONEY MARKET



In the money market, highly liquid, short-term interest-bearing instruments are bought
and sold. These instruments provide short-term liquidity to the financial system. Some
of the instruments that trade in the money market include:

• repurchase agreements (repos)


• commercial paper
• bankers’ acceptances
• federal funds
• Treasury bills
• negotiable Certificates of Deposit
• eurodollar deposits

3.2.1 REPURCHASE AGREEMENTS (REPOS)

A repurchase agreement (repo) is a short-term collateralized loan. The borrower sells a


liquid security, such as a Treasury bill, to a lender with an agreement to repurchase it at a
slightly higher price. The difference between the sale and repurchase price represents the
interest paid by the borrower. From the perspective of the lender, this transaction is
known as a reverse repurchase agreement (reverse repo).

3.2.2 COMMERCIAL PAPER

Commercial paper is a promissory note that is not collateralized with any assets; it is a
promise to repay borrowed funds. Typically, commercial paper has a short maturity (270
days or less); it is sold to investors at a discount from face value and redeemed at face
value. Commercial paper represents a major source of short-term funds to corporations;
issuing commercial paper is often cheaper than borrowing directly from banks.

3.2.3 BANKERS’ ACCEPTANCES

Banker’s Acceptances are discount instruments that have traditionally been used to
finance international trade. A Banker’s Acceptance is equivalent to a post-dated check;
once the bank accepts it, it can be resold to investors as an obligation of the bank.

3.2.4 FEDERAL FUNDS

The federal funds market is a source of short-term funds for banks. Banks are required
by the Federal Reserve System to hold a fixed percentage of their deposits in the form of
reserves to ensure the safety of the banking system. Since these reserves do not pay any
interest, banks with excess reserves will lend them to banks that hold insufficient

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reserves. The rate of interest charged by banks in this market is known as the federal
funds rate. The Fed sets a target for the fed funds rate; currently, this target is a range
between 0% and 0.25%. The fed funds target is one of the primary tools of monetary
policy.

3.2.5 TREASURY BILLS

A Treasury bill is a short-term obligation of the U.S. government. Treasury bills mature
in one year or less, and are sold at a discount from face value; at maturity, they are
redeemed at face value. The difference between the discounted price and the face value
is the capital gain earned by investors.

3.2.6 NEGOTIABLE CERTIFICATES OF DEPOSIT

A certificate of deposit (CD) is a time deposit held with a bank; unlike a savings
account, the depositor agrees to hold funds with the bank for a specified period of time.
A CD pays more interest than a savings account, but early withdrawal results in
significant penalties. Negotiable Certificates of Deposit can be resold by banks to
investors in the secondary market.

3.2.7 EURODOLLARS

A eurodollar deposit is a dollar deposit held outside of the borders of the United States.
Eurodollar deposits are not subject to U.S. banking regulations, and as a result, typically
offer higher interest rates than domestic deposits. A eurodollar is an example of a
eurocurrency, which is any currency held outside of the country of origin. For example,
a eurosterling deposit is a British pound deposit held outside of the U.K.

3.3 BOND MARKETS

In the bond market, interest-bearing instruments with maturities of more than one year
are traded. Bonds are less liquid than money market instruments, but offer higher rates of
return to investors. Bonds provide a regular stream of interest payments and are
redeemed at their face value. Some of the instruments that trade in the bond market
include:

• Treasury notes and bonds


• US Agency bonds
• municipal bonds
• corporate bonds
• eurobonds
• foreign bonds

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3.3.1 TREASURY NOTES AND BONDS

Treasury notes are obligations of the U.S. government; they have maturities of two to
ten years. Treasury notes make regular interest payments to investors, known as
coupons. At maturity, Treasury notes are redeemed at their face value. Treasury bonds
are similar to Treasury notes, except that they have maturities of twenty to thirty years.

3.3.2 U.S. AGENCY BONDS

Several U.S. agencies raise funds by issuing their own bonds. These include:

• Government National Mortgage Association (GNMA) or “Ginnie Mae”


• Federal National Mortgage Association (FNMA) or “Fannie Mae”
• Federal Home Loan Mortgage Corporation (FHLMC) or “Freddie Mac”
• Federal Home Loan Bank System (FHLB)

Ginnie Mae, Fannie Mae and Freddie Mac issue bonds in order to acquire mortgages
from issuing banks. The cash flows from these mortgages are pooled and distributed to
investors through securities known as mortgage-backed securities (MBS.) A MBS is
structured to provide periodic interest and principal payments to investors.

3.3.3 MUNICIPAL BONDS

Municipal bonds are issued by state and city governments to finance local projects, such
as schools, roads, bridges, etc. These bonds pay very low coupon rates, but they also
provide tax benefits to investors. As a result, municipal bonds tend to be purchased by
wealthy investors.

3.3.4 CORPORATE BONDS

Corporations can raise capital by issuing debt, which mainly takes the form of corporate
bonds. The other major sources of capital are equity (stocks) and retained earnings,
which are profits that are not paid out as dividends to stockholders. While raising capital
through the issuance of corporate bonds is riskier than issuing equity, it does provide one
major advantage: the interest is tax-deductible. Debt also increases the leverage of the
corporation, which increases potential profits.

Corporate bonds typically have long maturities, up to thirty years, and are issued as
coupon-bearing instruments. They are redeemed at face value at maturity. The coupon
rates offered by corporate bonds are directly related to the default risk of the issuer; i.e.,
the risk that the corporation will not be able to make coupon and/or principal payments in
a timely manner. Ratings agencies, such as Standard and Poor’s and Moody’s, provide
credit ratings for corporate borrowers as well as municipal and sovereign governments.

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3.3.5 EUROBONDS

A eurobond is issued in a currency other than the local currency. For example, if a
French corporation issues a dollar bond in Germany, this is considered to be a eurobond.
Eurobonds provide the issuer with the flexibility to raise capital in any desired currency.
They also provide tax advantages to investors.

3.3.6 FOREIGN BONDS

A foreign bond is issued in the domestic currency by a foreign entity. For example, if a
British corporation issues a dollar bond in the U.S., this is considered to be a foreign
bond. Several foreign bonds have their own nicknames:

• Yankee bond: a dollar bond issued in the U.S.


• Bulldog bond: a pound bond issued in the U.K.
• Samurai bond: a yen bond issued in Japan

3.4 STOCK (EQUITY) MARKETS

Stock is issued by corporations in order to raise capital. The two basic types of stock are:

• common stock
• preferred stock

Common stock provides partial ownership of the corporation to investors, along with
voting rights. Owners of preferred stock do not have any voting rights, but will receive
any dividends issued by the corporation before the common stock holders. In the event
of the bankruptcy of the firm, preferred stock holders must be paid off before the
common stock holders.

3.5 STOCK INDICES

A stock index is a numerical value that represents the average value of a collection of
stocks. Two of the best-known stock indices are:

• Dow Jones Industrial Average (DJIA)


• Standard and Poor’s 500 (S&P 500)

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3.5.1 DOW JONES INDUSTRIAL AVERAGE (DJIA)

The Dow Jones Industrial Average is calculated from a collection of 30 stocks. The
DJIA assigns a weight to the price of each stock that reflects previous stock splits. The
composition of the DJIA is changed periodically; most recently, General Motors and
Citigroup were replaced by Cisco and Travelers on June 8, 2009.

3.5.2 STANDARD AND POOR’S (S&P) 500

The S&P 500 is a weighted average of the market capitalizations of the 500 largest U.S.
stocks. The market capitalization of a corporation can be computed by multiplying the
stock price by the number of outstanding shares.

3.6 PRIMARY VS. SECONDARY MARKETS

New stocks are issued in the primary market. In this market, corporations sell new shares
of stock directly to securities dealers, who assume responsibility for reselling the stocks
to investors. The process of selling newly issued stocks to investors is known as
underwriting; the sale of stock that has not been previously issued is known as an initial
public offering (IPO). A private placement is a direct sale of stock to investors without
the use of an underwriter. Existing shares of stock are traded among investors in the
secondary market.

3.7 EXCHANGE TRADED VS. OVER-THE-COUNTER (OTC)

Stocks may be bought and sold through organized exchanges, such as the New York
Stock Exchange (NYSE). They may also be bought and sold through regional
exchanges, such as the Philadelphia Stock Exchange (PHLX). Stocks may be traded in
the over-the-counter (OTC) market, in which broker/dealers buy and sell among
themselves.

3.7.1 BID-ASK SPREADS

The bid price of a stock is the price at which an investor can sell a stock. The ask price
of a stock is the price at which an investor can buy a stock. The difference between the
bid and the ask prices is known as the bid-ask spread; this is the source of profits for
broker-dealers.

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3.7.2 BUYING ON MARGIN

Investors may buy stock with borrowed funds; this is known as buying on margin.
Buying on margin magnifies the potential gains and losses of an investor. For an
example, suppose an investor buys a share of stock that costs $100 by borrowing $90 and
paying $10. If the price of the stock rises to $110, the investor has earned a $10 profit, or
100% of his investment. If the investor did not buy the stock on margin, his rate of return
would have been 10%. On the downside, if the price of the stock falls to $90, the
investor has suffered a loss of $10, or 100%, compared with a loss of 10% if he did not
buy the stock on margin.

3.7.3 LEVERAGE

Leverage refers to a situation where an investment is financed with borrowing; buying


stock on margin is an example of a leveraged investment. When a corporation raises
capital by issuing debt, it is also engaging in leverage. A leveraged investment is riskier
than an unleveraged investment.

3.7.4 SHORT SELLING

If an investor expects the price of a stock to decline, he can short sell the stock. This
involves borrowing shares of the stock from a broker, selling the shares and promising to
replace them at a specified time in the future. If the price of the stock declines, the
investor profits by repurchasing it at a reduced price and then returning the shares to their
owner. If the price of the stock rises, the investor must repurchase the shares at a higher
price, thereby suffering losses. The short-seller must pay any dividends that accrue to the
owner of the stock until the shares are returned.

3.8 THE FOREIGN EXCHANGE MARKET

The foreign exchange market is a network of commercial banks that trade nearly $2
trillion worth of currencies each day; this is known as the interbank market. Trading
takes place virtually 24 hours a day.

3.8.1 EXCHANGE RATE QUOTES

The price of one currency in terms of another is called an exchange rate. For example,
the following exchange rates were quoted in the Wall Street Journal on June 1, 2009:

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$1.6443/£
¥96.62/$
$1.4158/€

where:
£ = the British pound
¥ = the Japanese yen
€ = the euro, which is the common currency of the members of the
Eurozone

Exchange rates can be quoted in two different ways:

1) Units of domestic currency per unit of foreign currency. For example, $1.6443/£ is the
dollar price of a British pound. This quote is in direct (American) terms.

2) Units of foreign currency per unit of domestic currency. For example, ¥96.62/$ is the
yen price of a U.S. dollar. This quote is in indirect (European) terms.

A cross exchange rate is an exchange rate that does not include the U.S. dollar. For
example, the cross exchange rate between the euro and the pound can be obtained as
follows:

Using the Wall Street Journal quotes of June 1, 2009:

($1.6443/£) / ($1.4158/€)
= €1.1614/£

Foreign exchange quotes actually consist of two numbers. The bid price is the price at
which a bank will buy a currency. The ask (offer) price is the price at which a bank will
sell a currency. The difference between the bid and ask price is called the bid-ask
spread. This represents the source of profits to foreign exchange dealers.

EXAMPLE

If a bank quotes the dollar/pound exchange rate as 1.6433/53, then the bid price is
$1.6433/£ and the ask price is $1.6453/£. The bank will buy pounds at $1.6433/£ and sell
pounds at $1.6453/£. In this case, the bid-ask spread is:

$1.6453/£ - $1.6433/£ = $0.0020/£

Foreign exchange quotes shown in the Wall Street Journal and other newspapers
represent the midpoint of bid-ask quotes for large interbank transactions ($1 million or
more).

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3.8.2 APPRECIATION VS. DEPRECIATION

With flexible (floating) exchange rates, the values of currencies change on a continuous
basis; some currencies strengthen while others weaken. When a currency strengthens
relative to another currency, it has appreciated. When a currency weakens relative to
another currency, it has depreciated.

EXAMPLE

Suppose the dollar/pound exchange rate rises from $1.6443/£ to $1.6500/£. Since it now
takes more dollars to buy one pound, the dollar has weakened against the pound; i.e., the
pound has appreciated and the dollar has depreciated.

EXAMPLE

Suppose the yen/dollar exchange rate rises from 96.62 ¥/$ to 97.00 ¥/$. Since it now
takes more yen to buy one dollar, the yen has weakened against the dollar; i.e., the dollar
has appreciated and the yen has depreciated.

3.8.3 SPOT VS. FORWARD EXCHANGE RATES

The price of a currency that will be delivered immediately is known as a spot exchange
rate. A forward exchange rate is the price of a currency that will be delivered at a
specified time in the future.

EXAMPLE

The following quotes for the British pound were taken from the Wall Street Journal of
June 1, 2009:

Spot $1.6443/£
1-month forward $1.6442/£
3-months forward $1.6438/£
6-months forward $1.6434/£

These quotes show that:

• pounds may be purchased for immediate delivery at a price of $1.6443/£


• pounds may be purchased for delivery in one month at a price of $1.6442/£
• pounds may be purchased for delivery in three months at a price of $1.6438/£
• pounds may be purchased for delivery in six months at a price of $1.6434/£

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3.8.4 INTEREST RATE PARITY

The relationship between spot and forward rates is determined by interest rates. This
relationship is known as interest rate parity. If this relationship is violated, arbitrage
profits can be earned. The interest rate parity condition is:

where:

F is the n-day forward exchange rate ($/foreign currency)


E is the spot exchange rate ($/foreign currency)
RD is the n-day domestic eurocurrency rate
RF is the n-day foreign eurocurrency rate

3.8.5 DETERMINANTS OF EXCHANGE RATES

Several economic variables determine the value of exchange rates. In the short run,
exchange rates are heavily influenced by:

• domestic interest rates


• foreign interest rates
• investor expectations

If a country’s interest rates rise, in the short run its currency tends to appreciate, and vice
versa. If investors expect a currency to appreciate in the future, this tends to strengthen
the currency and vice versa. In the long run, exchange rates are also determined by:

• inflation
• GDP growth
• trade surpluses or deficits

3.8.6 CENTRAL BANK INTERVENTION

Central banks may periodically intervene in foreign exchange markets to strengthen or


weaken their own currencies. A central bank may intervene to strengthen its own
currency if its inflation rate is rising rapidly. A central bank may intervene to weaken its

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own currency to stimulate exports and discourage imports, thereby reducing domestic
unemployment.

3.9 FUTURES MARKETS

Futures contracts are traded on an organized exchange, such as the Chicago Mercantile
Exchange (CME). Each exchange has its own clearinghouse. A clearinghouse performs
two vital functions:

• clears all trades


• acts as a counterparty to all trades

The clearinghouse ensures that payments are credited to the appropriate parties. The
clearinghouse also ensures that there is a seller for each buyer and vice versa.

Three of the most important types of orders that investors may place through a futures
exchange are:

• market order
• stop order
• limit order

3.9.1 MARKET ORDER

A market order is used to buy or sell a futures contract at the current market price.

3.9.2 STOP ORDER

A stop order is used to minimize potential losses. A stop order becomes a market order
at a specified price; for a buy stop order, this price is higher than the current market price.
The objective is to buy the contract before it becomes more expensive. For a sell stop
order, this price is lower than the current market price. The objective is to sell the
contract before it becomes cheaper.

3.9.3 LIMIT ORDER

A limit order is designed to set a ceiling on the price that will be paid for a contract, or a
floor on the price that will be received for a contract. A buy limit is set lower than the
current market price, and a sell limit is set higher than the current market price.

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3.9.4 MARKING TO MARKET

One of the most important methods used by a futures exchange to minimize credit losses
is the marking to market requirement. An investor who enters into a futures contract
deposits funds into a margin account; these funds are known as initial margin. The
investor may be required to add funds if the value of his position declines; these funds are
known as variation margin.

EXAMPLE

A U.S. corporation decides to buy 62,500 British pounds for delivery in one month
through a futures contract with the Chicago Mercantile Exchange. Assume that the one-
month futures price for British pounds is $1.80/£ and that the initial margin of $3,000 is
required by the Chicago Mercantile Exchange. If the margin account falls below $2,000,
further margin will be required to restore the account to the $3,000 level. This $2,000
threshold is known as maintenance margin. If the margin account rises above $3,000,
the investor may withdraw the surplus. Since the contract is written on 62,500 British
pounds, each one-cent change in the exchange rate causes the futures contract to gain or
lose $625 in value. Assume that the investor does not withdraw surplus funds from his
margin account. The following table shows the pattern of cash flows over the remaining
life of the contract (22 business days):

DAY FUTURES GAIN/LOSS GAIN/LOSS MARGIN MARGIN


PRICE TO DATE ACCOUNT CALL
($/£) BALANCE
**** $1.80 **** **** $3,000 ****
1 $1.81 $625 $625 $3,625
2 $1.80 ($625) $0 $3,000
3 $1.79 ($625) ($625) $2,375
4 $1.78 ($625) ($1,250) $3,000 $1,250
5 $1.79 $625 ($625) $3,625

At the end of trading on Day 4, the holder of the long position had a margin account
balance of $1,750, triggering a margin call of $1,250 (needed to bring the account
balance back up to $3,000).

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DAY FUTURES GAIN/LOSS GAIN/LOSS MARGIN MARGIN


PRICE TO DATE ACCOUNT CALL
($/£) BALANCE
6 $1.80 $625 $0 $4,250
7 $1.80 $0 $0 $4,250
8 $1.81 $625 $625 $4,875
9 $1.82 $625 $1,250 $5,500
10 $1.82 $0 $1,250 $5,500
11 $1.81 ($625) $625 $4,875

DAY FUTURES GAIN/LOSS GAIN/LOSS MARGIN MARGIN


PRICE TO DATE ACCOUNT CALL
($/£) BALANCE
12 $1.80 ($625) $0 $4,250
13 $1.78 ($1,250) ($1,250) $3,000
14 $1.79 $625 ($625) $3,625
15 $1.76 ($1,875) ($2,500) $3,000 $1,250
16 $1.77 $625 ($1,875) $3,625
17 $1.79 $1,250 ($625) $4,875

DAY FUTURES GAIN/LOSS GAIN/LOSS MARGIN MARGIN


PRICE TO DATE ACCOUNT CALL
($/£) BALANCE
18 $1.80 $625 $0 $5,500
19 $1.81 $625 $625 $6,125
20 $1.80 ($625) $0 $5,500
21 $1.79 ($625) ($625) $4,875
22 $1.79 $0 ($625) $4,875

At the end of the month (22 business days), the holder of the long position pays the
futures price on the final day of the contract ($1.79/£) for a total of $111,875. The holder
of the long position has accumulated a loss of $625 in his margin account for a total cost
of $112,500 = $1.80/£.

Equivalently, the holder of the short position receives $1.79/£ for a total of $111,875. The
holder of the short position has accumulated a gain of $625 in his margin account,
receiving a total of $112,500 = $1.80/£.

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3.9.5 FUTURES OPTIONS

An option may be written on a futures contract; this is known as a futures option. If a


futures call option is exercised, the owner receives a long position in a futures contract
plus the difference between the futures price and the strike price of the option.

If a futures put option is exercised, the owner receives a short position in a futures
contract plus the difference between the strike price of the option and the futures price.

3.10 COMMODITIES MARKETS

A commodity is a good that has highly standardized properties. The four basic types of
commodities are:

1) metals – base metals, precious metals


2) soft goods – cocoa, sugar, coffee
3) grains and oilseeds – wheat, barley, soybeans
4) livestock and other – pork bellies, orange juice

3.10.1 COMMODITY FORWARDS

In commodity markets, spot transactions may take place over a period of 2-45 days, so
they can be treated as short-maturity forward transactions.

3.10.2 SPOT-FORWARD PRICING RELATIONSHIP

The relationship between the spot and forward price of a commodity is:

F = S(1 + r + u – y)

where:

S = spot price
F = forward price
r = interest rate
u = storage costs
y = convenience yield

r + u – y is known as the cost of carry; this refers to the cost of holding the commodity
net of the convenience yield, which measures the benefit of immediate access to the
commodity.

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With most forward contracts, the forward price is greater than the spot price and rises
with maturity; this is known as contango. With commodity forwards, this can be
reversed. When the forward price is less than the spot price and falls with maturity, this
is known as normal backwardation. Contango is the usual situation for storable
commodities that have a positive cost of carry. Contango may indicate an expectation of
future shortages. Normal backwardation may indicate an expectation of current
shortages.

3.11 ENERGY MARKETS

The energy markets enable trading of electricity, crude oil, home heating oil, jet fuel,
coal, etc. Both spot and futures contracts are traded through the over-the-counter market
and organized exchanges, such as the New York Mercantile Exchange (NYMEX).

The major energy futures contracts include: light sweet crude oil, heating oil, gasoline,
Brent crude oil. Energy futures options are also traded with a variety of different
features. Some of these are:

average price options – the strike price or the spot price can be set equal to the average
price of the underlying asset computed at specified points in time

calendar spread options – the payoff to the option depends on the difference in the price
of the underlying asset on two different dates

crack spread options – the payoff to the option depends on the difference in the price of
crude and refined energy products

The following energy derivatives are traded in the over-the-counter markets:

• forward contracts
• option
• swaps

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CHAPTER 3 KEY CONCEPTS



1) Financial markets are organized as either organized exchanges or over-the-counter
(OTC) markets. Exchanges provide standardized products and protection from
counterparty risk, while over-the-counter markets provide flexibility to investors.

2) The money market consists of short-term, highly liquid, interest-bearing securities.


These include Treasury bills, repurchase agreements (repos), eurodollar deposits and
commercial paper.

3) The bond market consists of longer-term, less liquid interest-bearing securities, such
as Treasury bonds, municipal bonds and corporate bonds.

4) The stock market consists of two basic types of securities: common stock and
preferred stock. Common stock provides partial ownership to investors, along with
voting rights. Preferred stock is usually purchased in order to earn dividends.

5) A stock index is an average value of a collection of stocks. Two of the best-known


stock indices are the Dow Jones Industrial Average (DJIA) and the Standard and
Poor's 500 (S&P 500).

6) Newly-issued securities are sold directly from issuers to dealers in the primary
market; previously-issued securities are traded in the secondary market.

7) The foreign exchange market is a network of banks that trade national currencies. A
spot exchange rate is the price of a currency that is delivered immediately; a forward
exchange rate is the price of a currency that will be delivered in the future. Spot and
forward exchange rates are related through a relationship known as interest rate parity.

8) Futures contracts are traded through organized exchanges; each exchange's


clearinghouse guarantees the performance of all contracts. Futures contracts are marked-
to-market each day. A market order is an order to buy or sell a contract at the currency
market rice. A stop order is an order that becomes a market order at a pre-specified
price. A limit order is an order that establishes a maximum price at which a contract
will be bought, or a minimum price at which a contract will be sold.

9) A commodity is a good that has highly standardized properties. Commodities can be


classified as metals, soft goods, grains and oilseeds and livestock/other. The forward
price of a commodity depends on the cost of carry; this is based on the interest rate,
storage costs and convenience yield.

10) Electricity, crude oil, home heating oil and other types of energy can be traded
through organized exchanges or the over-the-counter market. Several types of energy
derivatives exist, including average price options, calendar spread options and crack
spread options.

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CHAPTER 3 PROBLEMS

1) What is one of the main advantages of trading through organized exchanges?
a) investors are protected from price risk
b) hedging price risk is easier
c) investors are protected from counterparty risk
d) all of the above

2) The money market:


a) consists of long-term interest-bearing instruments
b) includes Treasury notes
c) includes Treasury bonds
d) includes Treasury bills

3) With a repurchase agreement:


a) the lender sells a liquid security to a borrower and then repurchases it at a slightly
higher price
b) the lender sells a liquid security to a borrower and then repurchases it at a slightly
lower price
c) the borrower sells a liquid security to a lender and then repurchases it at a slightly
higher price
d) the borrower sells a liquid security to a lender and then repurchases it at a slightly
lower price

4) Commercial paper
a) has a maturity of up to one year
b) offers interest rates that are greater than those charged for bank loans
c) is sold at a discount and redeemed at face value
d) is collateralized by Treasury securities

5) The federal funds rate


a) is directly controlled by the Federal Reserve System
b) is the rate charged by banks to their best corporate customers
c) is the rate paid by banks for loans of reserves
d) is the rate at which the Federal Reserve will lend funds to the banking system

6) A Treasury bill
a) is a discount instrument
b) has a maturity of up to one year
c) is issued by the U.S. government
d) all of the above

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7) A eurodollar deposit
a) is a dollar deposit held in a European bank
b) is a dollar deposit held in the United States
c) is a dollar deposit held outside of the United States
d) is subject to all U.S. banking regulations

8) A Treasury bond
a) is a discount instrument
b) has a maturity of up to one year
c) is issued by the U.S. government
d) all of the above

9) Municipal bonds
a) are issued by state and local governments
b) are taxed at a very favorable rate
c) offer low coupon rates to investors
d) all of the above

10) If a U.S. corporation issues a dollar-denominated bond in Japan, this is known as:
a) a eurobond
b) a foreign bond
c) a eurodollar bond
d) a yen bond

11) If a U.S. corporation issues a yen-denominated bond in Japan, this is known as:
a) a eurobond
b) a foreign bond
c) a eurodollar bond
d) a yen bond

12) Which of the following is true?


a) a bid price is the price at which an investor may buy a stock
b) an ask price is the price at which an investor may buy a stock
c) a bid price is the price at which an investor may sell a stock
d) the bid-ask spread represents the interest rate paid by stock brokers to the Federal
Reserve System

13) Short selling a stock


a) enables investors to profit from rising stock prices
b) enables investors to profit from falling stock prices
c) enables investors to profit from both rising and falling stock prices
d) is illegal in the United States

(c) ECI Risk Training 2009 19



14) Which of the following is a cross exchange rate?


a) $1.6443/£
b) £0.6081/$
c) €1.1614/£
d) €1.1614/$

15) If the dollar/pound exchange rate is currently $1.6443/£, which of the following is
true?
a) if the exchange rate rises to $1.6555/£, the dollar has appreciated
b) if the exchange rate rises to $1.6555/£, the pound has appreciated
c) if the exchange rate falls to $1.63371/£, the dollar has depreciated
d) none of the above

16) Interest rate parity


a) shows the relationship between the interest rates in two countries
b) shows the relationship between the inflation rates in two countries
c) shows the relationship between the spot and forward exchange rate
d) shows the relationship between two forward exchange rates of different maturities

17) Which of the following can influence exchange rates?


a) inflation
b) interest rates
c) trade surpluses
d) all of the above

18) A market order


a) is used to buy or sell a futures contract at the current market price
b) is used to minimize potential losses
c) is used to set a ceiling on the price that will be paid for a futures contract
d) none of the above

19) Which of the following is true?


a) the funds initially deposited into a margin account are known as variation margin
b) the funds initially deposited into a margin account are known as initial margin
c) additional margin may be required if the value of a futures position increases
d) both futures and forward contracts are marked to market

20) A futures option


a) enables investors to buy an option in the future
b) enables investors to sell an option in the future
c) enables investors to buy a futures contract with an option
d) enables investors to buy an option with a futures contract

(c) ECI Risk Training 2009 20



21) Cost of carry equals:


a) interest rate + storage costs + convenience yield
b) interest rate – storage costs – convenience yield
c) interest rate - storage costs + convenience yield
d) interest rate + storage costs – convenience yield

22) A crack spread option


a) has a payoff that depends on the difference between the price of oil and natural gas
b) has a payoff that depends on the difference between the price of oil and electricity
c) has a payoff that depends on the difference between the price of crude oil and refined
products
d) has a payoff that depends on the difference between the price of crude oil and natural
gas

23) Which of the following is true?


a) counterparty risk refers to the risk of non-performance by a part to a contract
b) assets traded through organized exchanges are not subject to counterparty risk
c) assets traded through the over-the-counter market are subject to counterparty risk
d) all of the above

24) With a reverse repurchase agreement (repo):


a) the lender buys a liquid security from a borrower and then sells it back at a slightly
higher price
b) the lender buys a liquid security from a borrower and then sells it back at a slightly
lower price
c) the borrower buys a liquid security from a lender and then sells it back at a slightly
higher price
d) the borrower buys a liquid security from a lender and then sells it back at a slightly
lower price

25) An example of an agency bond is:


a) a Treasury bill
b) a Treasury note
c) a Treasury bond
d) none of the above

26) A stop order


a) automatically becomes a market order after a fixed interval of time
b) becomes a market order at a specified price
c) becomes a limit order at a specified price
d) none of the above

(c) ECI Risk Training 2009 21



27) For an investor with a long futures position,


a) a rising futures price may lead to a margin call
b) a falling futures price may lead to a margin call
c) the position may be unwound by entering into a long futures position on the same asset
but with a different maturity
d) the position may be unwound by entering into a long futures position on the same
maturity but with a different asset

28) A limit order


a) is automatically executed once the futures price falls
b) is automatically executed once the futures price rises
c) becomes a market order once the futures price rises
d) none of the above

29) For a commodity with a positive cost of carry,


a) the spot price exceeds the forward price
b) the forward price exceeds the spot price
c) the spot and forward price are equal
d) none of the above

30) Which of the following is an instrument of monetary policy?


a) the Treasury bill yield
b) the federal funds rate target
c) LIBOR
d) none of the above

(c) ECI Risk Training 2009 22



CHAPTER 3 SOLUTIONS

1) C
2) D
3) C
4) C
5) C
6) D
7) C
8) C
9) D
10) C
11) B
12) B
13) B
14) C
15) B
16) C
17) D
18) A
19) B
20) C
21) D
22) C
23) D
24) A
25) D
26) B
27) B
28) D
29) B
30) B

(c) ECI Risk Training 2009 23