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AF1100 – Financial Institutions

Tutorial Questions – Week 2

Question 1 – Identify six money market instruments (i.e. financial assets traded in the money market and briefly discuss their characteristics.

If you look at different sources of information or different countries, there will be different lists of money market products indicated, so here is a (non-exhaustive) list of the main products:

Treasury Bills: the most popular instrument, with varying short-term maturities, normally between 14 and 364 days (varies from country to country, they are issued at a discount meaning the issues receives a lower amount than the face value and on maturity it pays back the face value.

Commercial bills: essentially a bill of exchange associated with the trade of goods. The seller draws (or issues via its bank) the commercial bill, which the buyer accepts confirming they will make payment on the agreed date. The advantage for the seller is that the bill is a marketable financial instrument, so they will be able to get paid as and when they need by selling the bill.

Certificates of Deposit: also known as CDs, they are negotiable term deposits accepted by commercial banks. The receiving institutions agrees to pay interest on a deposit in return for the depositor guaranteed the money will be left untouched for the period of the CD. Normally it is issued through a promissory note and the maturities are between 3 months and 1 year in the money market (CDs can also be used as a longer-term product).

Commercial Paper: short term unsecured debt instrument issued normally by companies to finance working capital (short term) needs. As Treasury bills, CP tends to be issued at a discount, with no interest payments while in existence and the full principal payable at maturity.

Call Money: short term (normally from overnight to 14 days) interest-paying loan between financial institutions which, as indicated by its name, is payable on demand. Call money does not have a maturity date or payment schedule and instead the lender will call the loan as and when they want and will receive principal and interest at that time.

Question 2 – The table below is an extract from existing Government Bonds (Gilts).


Issuer


Coupon (%)


Maturity


Price


HM Treasury

GBP | GB00BM8Z2S21 | BM8Z2S2

0.875

31 July 2033

92.275


HM Treasury

GBP | GB00BMGR2791 | BMGR279

0.125

31 January 2024

97.370


Treasury 0.5% GILT 22/07/22 GBP1

GBP | GB00BD0PCK97 | BD0PCK9

0.500

22 July 2022

99.900


Treasury 0.75% GILT 22/07/23 GBP0.01

GBP | GB00BF0HZ991 | BF0HZ99

0.750

22 July 2023

99.130


Treasury 1,5/8% 22/10/2028

GBP | GB00BFX0ZL78 | BFX0ZL7

1.625

22 October 2028

101.140


Treasury 1.25% 2027

GBP | GB00BDRHNP05 | BDRHNP0

1.250

22 July 2027

99.100

Answer the following questions:

1. What is the meaning of each of the columns above?

Column 1 indicates the issuer (UK Treasury), the currency and the code of the bonds/gilts

Column 2 is the coupon rate, i.e. the interest rate that applies to the face value of the bond to calculate the cash payment.

Column 3 is the date at which the bond expires or matures, i.e. when the principal is repaid by the issuer to the investor that owns them at the time.

(in reality, the information included in columns 2 and 3 is also included in column 1)

Column 4 has the bond price.

2. Why is one bond selling above £100 and all others selling below?

In the UK the face value of bonds is normally £100 and bond prices are a function of two interest rates: the coupon rate and the yield to maturity. If the coupon rate (indicative of the return you are receiving) is lower than the yield to maturity (which reflects the return you want to receive), then you are receiving less than you want, so you’ll be willing to pay less than the face value and the bond is selling “at a discount”. This is the case with all bar the 5th gilt, meaning the return required by investors to invest in short to medium term gilts is above 1.25%. The only bond selling “at a premium”, i.e. with a price above £100 is the one maturing in October 2028, which has a coupon rate of 1.625%, indicating that the yield to maturity of these bonds is below the coupon rate, so investors are willing to pay more than the face value to buy this gilt.

3. Considering the issuer is the same, why is the coupon rate different from bond to bond?

The coupon rate is fixed at the time the bond is issued and in, the majority of instances, it is a reflection of the rate being offered by bonds of similar level of risk on the market at the time of issue. As such, over time (especially for long term bonds, where market interest rates have longer to change) some coupon rates will be very different from the market interest rates.

Question 3 – From the screenshot below (taken from yahoo finance, containing data for a company listed in the London Stock Market), identify six pieces of information relevant for an investor.

A screenshot such as this has a lot of information, so it is hard to identify the most relevant, but some are essential in order to understand the others, so the most fundamental are:

· Name of the company: Diageo

· Current share price: 3,632 (don’t forget to always quote the units when referring to any number…so)

· Currency is GBp, sometimes mentioned as GBX, not GBP as prices are quoted in pence, so this price is £36.32

· Volume is the number of shares traded today and the average is the daily average

· Market cap is the value of the company, calculated as share price times number of shares

· 52-week range in the highest and lowest price over the last year, from where you can conclude that the current price is somewhere in the middle, closer to the highest (see chart)

The second column contains information that is particularly relevant for investors, such as the beta (measure of market risk), P/E ratio (indicator of markets expectations regarding company’s future performance) and forward dividend and yield (expected dividend and return received on dividend alone, i.e. if share price did not change)

Question 4 – The screen shot below is taken from the Bank of England’s website:

Based on it, answer the following questions:

1. If this was the exchange rate at which you could buy and sell currencies, if you went to the bank with £1, how many Canadian dollars would you be able to buy?

£1 would allow you to buy 1.7258 Canadian dollars

2. If this was the exchange rate at which you could buy and sell currencies, if you went to the bank with €1, how many pounds would you be able to buy?

€1 would allow you to buy 1/1.1930 or £0.8382 i.e. 83.82p

3. If you went to your local bank and pay tourist exchange rates, how many Japanese yens do you think you would be able to buy with £100?

These are the “central” exchange rates, so if the bank used this same rate to buy and sell currencies, they would not make any revenue on the transactions. As such, a spread is added and subtracted to generate the actual exchange rate at which a transaction will take place. In interbanking trade, this spread might be 1 to 5 pips (1 pip is one hundredth of one percent), but for tourist rates, it will be a lot more, so you might be able to buy yens at something like 156.1316.

Question 5 – The table below represents a list of share options currently available for trade. Answer the following questions:

1. What is a share option?

A share option is a derivative financial asset by which the buyer acquires the right (but not the obligation) to buy (call) or sell (putt) the underlying stock at a predetermined date (the maturity or settlement date) at an agreed exercise price.

The seller of the option will need to do what the buyer decides to do, and the buyer will exercise or not exercise the option on the following circumstances:

· Call – a call is bought when you expect the price of the underlying share to go up but are not certain, so you don’t want to commit the full funds of buying the share while still benefitting if your expectations are correct. By buying the call, you simply commit the price of the call, and at the exercise date, if the price has gone up, you exercise the call and sell the share at the higher market price, thus making a profit. If the share price has gone down, you let the option lapse without exercise and your maximum loss is the option price, whereas if you had bought the share, your loss could have been much larger. The seller of the call enters this trade as their expectation is that the share price will go down, and therefore if they are right, the option will not be exercised and they profit from the option price they received

· Put – the opposite happens, that is the buyer of the option expects the price to go down and will profit by buying the share at a lower price in the market and sell it at a higher price by exercising the option, whereas the seller of the option (who will be required to buy the underlying share, if the buyer of the option so desires) expects the share price will go up, and so the option will not be exercised.

2. What companies do you think the first two options on the list are?

These will be Apple and Tesla

3. What is the meaning of last?

The last is the most recent share price at which the underlying share traded when this table was created, which is normally at the end of the trading day.

4. What are the meanings of “Put” and “Call”?

As mentioned in part 1 above, a call is an option that gives the buyer the right to buy while a put is an option that gives the buyer the right to sell the underlying asset.



Most Active Options

Symbol

Last

Change

%Chg

IV Rank

Options Vol

Put/Call Vol

Time


AAPL

168.88

+0.24

+0.14%

55.82%

923,775

0.76

02/14/22


TSLA

875.76

+15.76

+1.83%

47.43%

693,822

0.80

02/14/22


AMD

114.27

+1.09

+0.96%

75.41%

387,043

0.54

02/14/22


FB

217.70

-1.85

-0.84%

86.16%

244,560

0.51

02/14/22


CVX

136.67

-2.14

-1.54%

60.21%

241,044

0.07

02/14/22


BAC

47.42

-0.50

-1.04%

70.13%

231,262

0.54

02/14/22


AMC

17.75

-1.06

-5.64%

11.60%

205,138

0.42

02/14/22


NVDA

242.67

+3.18

+1.33%

80.26%

201,068

0.55

02/14/22

This was not asked, but a brief explanation of the meaning of each of these columns, in the order they are shown:

· Share ticker of the underlying share

· Last share price of the underlying share when the table was created

· Change in share price versus previous day

· Same in percentage

· A measure of current volatility of the underlying share versus the largest and smallest volatility value in the last year. A value of 100% means the current volatility is the highest within the last year

· Number of share options traded during the day

· Mix of puts and calls traded. For Apple for example, the figure means for every 100 calls traded, 76 puts were also traded

· The date when the table refers to. This is data from the USA, so don’t forget the date standard is mm/dd/yy

Question 6 – On the following link (Soybean Futures Contract Specs – CME Group) you will be able to access currently traded soybean future contracts. Access the information on the site, and answer the following questions:

1. What is the meaning of “soybean futures”?

Any future is an agreement to buy or sell the underlying asset, at an agreed price and at an agreed date. That is also the case here, where the future is an agreement to buy (one party) and sell (another party) the amount of soybeans set out in the future contract. If you look at the specs section of the link above, you will find the contract if for 5,000 bushels or approximately 136 metric tons and that is the amount of soybeans expected to be traded at maturity.

2. What is the price of a soybean future?

At the time I prepared these solutions, the price was 1,603.4 cents per bushel, but this price is constantly being updated as trading happens.

3. Who would be interested in buying and selling soybean futures?

As with any other future, there are two types of investors buying them:

· Hedgers, i.e. someone with a “position” (for example a company that uses soybeans to put in cans, mis with other vegetables, prepare ready-made meals, etc, who is going to need the beans in the future) and who wants to reduce their risk. In this case, they will fix today the price at which they will buy the soybeans in the future.

· Speculators, who don’t have any position but expect certain price movements and wants to take advantage of those movements. Someone who expects prices to go up, buys futures, so that they can buy the soybeans at the agreed future price and sell in the market at the time at a higher price, thus making a profit. Someone who expects the price to go down will instead sell the future and profit from buying in the market at a lower price and sell by executing the contract

Given that the majority of trade in commodity futures is now done by speculators who don’t need the underlying commodity, most of the contracts are not exercised at maturity but rather settled beforehand with no exchange of the underlying asset, but just by exchange of the monetary profit/loss of the contract.

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