CMFAS M6a Quiz Key Note Set 1

Financial assets may be broadly classified as money market securities, capital market securities and derivative securities.

Money market instruments are short-term debt instruments issued by governments, financial institutions and corporations that are highly liquid and less risky.

No, as debt securities or fixed income securities are borrowings by the issuers. The holder of a debt security lends a certain amount of money, called the principal, to the issuer. In return, the issuer agrees to make periodic interest payments, and at the maturity date, to return the principal.

Futures, forwards, swaps and options are the most basic types of derivatives. Besides basic derivatives, there are also a wide range of more complex or “exotic” derivatives, which are created by combining different types of derivatives or creating additional features to a traditional derivatives product.

After expiry, each contract will be settled, either by physical delivery (typically for commodity underlying assets) or by a cash settlement (typically for financial underlying assets). Once a trade is executed between a buyer and seller on the exchange, it is recorded with the exchange’s clearing house. The contracts are ultimately not between the original buyer and the original seller, but between the holders at expiry and the exchange, who acts as a guarantor that the trade will be settled as originally intended, using pooled initial margin from both sides of the trade.

Since OTC derivatives are often tailored instruments created by the bank or intermediary for their clients, the OTC derivatives market is largely unregulated with respect to disclosure of information between the parties. 

The contracts are privately negotiated between the buyer and seller, and transactions are confirmed and settled bilaterally between the counterparties.

Typical uses of derivatives include:
• Hedging or insuring against risk;
• Speculating, or adopting a view on the future direction of the market;
• Arbitraging, or taking advantage of price differentials between two or more markets to make a profit;
• Changing the nature of an asset or liability to meet specific needs that cannot be met from the standardized financial instruments available in the markets; or
• Creating synthetic positions without incurring the costs of buying or selling the underlying assets.

Common derivative products include:
• Forwards
• Futures
• Swaps
• Options
• Warrants

Popular structured products include:
• Structured notes
• Structured funds
• Structured exchange-traded funds
• Structured investment-linked products

Barrier options, knock-out products, swaptions, structured notes and structured funds are examples of complex or exotic derivatives.

Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as political, (elections, war), economic (recessions, bankruptcies), socio-cultural (disruptive societies, ethnic tensions) and environmental (pollution, deforestation) can all have a major effect on supply and demand and, as a result, the present and future price of commodities and financial assets.

For consumers and buyers of commodities, hedging with futures helps to reduce the final cost to consumers by lowering the risk of manufacturers raising the prices of key supplies due to the volatility in the spot market.

The futures contract itself has no inherent value and is determined by movements in the price and underlying value of some other asset or commodity.

Futures have a finite life and an expiration date. Unlike shares or tangible commodities like gold, which can exist forever, futures contracts cease to exist after they expire. Hence, the market direction and time horizon are important considerations for the futures investor.

Futures

• A futures contract is standardized according to quality, quantity, delivery time and place.
• Futures contracts are traded in a futures exchange, with price discovery through an auction-like process. Trading occurs on the exchange trading floor or an electronic trading platform.
• Mark-to-market procedures are followed as per the requirements of the futures exchange.
• As futures exchange is the counterparty for the futures contract, there is no counterparty risk.

Forwards

• Forward contracts are negotiated directly between a buyer and a seller on mutually agreed terms.
• Forward contracts are traded OTC, with no active secondary market. Settlement terms may vary from contract to contract.
• Forwards typically have no interim partial settlements.
• Exposed to counterparty risk and may lead to losses if the other party defaults.
  
  

Some of the terms contained in a binding contract include:

• Contract size
• Contract months
• Trading hours
• Minimum price fluctuation
• Daily price limits
• Last trading day
• Settlement basis
• Final settlement price

All parties involved in a futures transaction need to know the contract’s basic information, which includes:

• Description and standard size or denomination of the underlying asset
• Contract value
• Tick size
• Price limits
• Mark-to-market procedures
• Margin call procedures

A tick is defined as:

• The minimum price movement of a trading instrument;
• The minimum increment in which prices can change; and
• What each price movement is worth in terms of dollars.

A cash-and-carry arbitrage occurs when a trader:

• Borrows money
• Sells futures contract
• Buys the underlying commodity
• Delivers the commodity against the futures contract
• Recovers the money and pays off the loan

A reverse cash-and-carry arbitrage occurs when a trader:

• Sells short the commodity
• Lends money received from short sale
• Buys futures contract
• Accepts delivery from futures contract
• Uses the commodity received to cover the short sale

The size and duration of basis in the market of a futures contract is influenced by:

• Cost / return of carry
• Time to maturity
• Yield curve changes
• Relative liquidity of cash & futures markets
• Market rates versus administered rates
• Expectations of market participants
• Differences in coupons between fixed income instruments

The futures contract and its underlying assetmay not exactlymatch the asset being hedged because:

• The underlying asset in the futures contract is not completely identical;
• The hedger may be uncertain about the exact date when the asset will be bought or sold; and
• The hedge may require the futures contract to be sold before the delivery month.

When investors use leverage to trade in futures contracts, they have to comply with mark-to-market procedures, which involves putting up an initial margin, monitoring the amount of the maintenance margin, and if the balance falls below this minimum amount, putting up an additional margin.

Buyer/seller of futures contracts can settle in the following ways:

• Delivery or Hold to Expiry
• Offset Position
• Roll Position

The relationship between futures prices and spot prices can be summarised in terms of cost of carry. Cost of carry includes financial costs and economic costs. The cost of carry model assumes that arbitrage between the cash market and the futures market eliminates all imperfections in pricing.

The main participants in the futures markets are:
1. Hedgers
2. Speculators
3. MarketMakers
4. Proprietary Trading Firms
5. Arbitrageurs
6. PortfolioManagers
7. Hedge Funds

The main investment and trading strategies used in the futures markets are:

• Outright trades
• Hedging
• Basis trades
• Spread trades

Yea, as this would be one of the arbitrage trading strategy called basis trading because it aims to profit off very small basis point changes in value between two securities.

Margin requirements tend to be lower due to themore risk adverse nature of spread trades. However, a spread may be vulnerable to both legs moving in the opposite direction of what the trader may have anticipated, therefore resulting in losses.

A butterfly spread is a neutral trading strategy that contains 4 legs combining bull and bear spreads. In a bull spread, the investor seeks to profit from a rise in the underlying asset’s price while in a bear spread, a profit is made from a fall in the price. A near term bull spread and a longer term bear spread may be combined, or vice versa.