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Chapter 2: Underlying Markets

Money Markets

Cash deposits and loans out to 12 months (Has a life of less than 12 months)

Inter-bank market:

  • Development in short-term rates market
  • UK = SONIA - Sterling overnight index average based on unsecured overnight borrowing published by the Bank of England
  • US = SOFR - Secured overnight financing rate based on an overnight repo rate
  • Eurozone = ESTR - Euro short-term rate based on the previous day's unsecured overnight borrowing settled through Target2


Money Market Instruments:

  • Treasury Bills (UK T-bills)
  • Issued by the Debt Management Office (DMO) on behalf of the UK Government
  • Short-term unsecured debt
  • One to twelve months
  • Zero-coupon
  • Issued at discount redeemed at par
  • Minimum market denomination = £25,000
  • Benchmark risk-free rate
  • Government = Least risk investment compared to lending to a company
  • Commerical Paper
  • Issued by companies
  • Short-term unsecured debt
  • Two to nine months
  • Zero-coupon
  • Issued at discount redeemed at par
  • Typically high denominations
  • E.g. $500,000
  • US is the biggest market


To remember :

Treasury Bills = Issued by DMO/UK Government, One - Twelve Months & Minimum Market Denomination = £25,000

To remember :

Commercial Paper = Issued by Companies, Two - Nine Months, High Denominations = $500,000

  • Certificate of deposit (CDs)
  • Promissory note (Issued by banks and other financial institutions
  • Purchased at nominal value and redeemed with interest
  • Fixed Term
  • Three and Six Months are most common
  • Early redemption incurs a penalty
  • Certificate shows the money at the bank, for period and interest rate
  • If money is required before end of period, CD can be sold on the money market


Foreign Exchange

FX: Background:

  • 100% OTC market
  • Big players - Major international banks
  • Spot market = Cash Market - T+2
  • Forward market = Anything that is greater than T+2
  • London largest centre (By some distance)
  • Dollar is the major currency


Cross Rates:

  • Two less known/used currency pairs
  • Cross through the dollar to exchange


Two-Way Prices

  • Which ever currency is quoted first is the 1 value
  • GBP/USD
  • GBP = £1
  • All FX is quoted to 5 figures
  • The last two digits are the pips


Bonds


Government bonds:

  • Debt instruments
  • UK Gov Bonds = Gilts
  • T-Bills - Good for 3, 6, 9, 12 months
  • 5, 10 years +, you would use Gilts
  • Loan to the government


Nominal Value (Face value, Par Value, Redempton Value)

  • Quoted per £100
  • The capital payment the holder receives at redemption


Coupon:

  • The interest
  • Expressed as an annual percentage of the nominal value
  • Paid semi annually


Name:

  • The name given at issue
  • E.g. 6 1/2 Per Cent Treasury Stock 2048


Redemption:

  • The year when the gilt is repaid


Gilts:

  • Index-Linked
  • Coupon and redemption linked to RPI
  • Inflation protection
  • RPI = Retail Prices Index
  • No default risk
  • Small coupons, due to the low risk


  • Non Index-Linked (Conventional Bonds)
  • Has fixed coupon
  • Fixed redemption value
  • Fixed redemption date
  • Shorts, Mediums, Long, or Undated bonds
  • Undated bonds or Unredemables - Are redeemed at the discretion of the issuer


Strips Market: (Seperate Trading of Registered Interest + Principal)

  • Turn conventional bond turn into a lot of zero coupon bonds


Overseas Government Bonds:


Yield Curves:


  • Yield of a bond, plotted against Maturity of a bond
  • Upward Tilting = Normal
  • Due to Liquidity Preference Theory
  • Markets prefer liquid assets
  • Markets expect to be paid to wait


  • Downward sloping or inverted
  • Expect interest rates to fall
  • Expectation of recession

Definitions

Yield Curve
Looks at the yield of the bond market, taking a snapshot of the yield structure over the maturity of the bond market

Yield Spreads:

  • The difference between the yield on one investment and the yield on another investment
  • The other investment is typically a benchmark
  • Interest rate benchmark (SONIA, LIBOR)
  • Government Bond
  • Position on the swap curve
  • Measured in basis points (0.01%)


Example: A


Equities

Ordinary Shares:

  • Common Stock
  • Variable dividends based on profits
  • Voting rights
  • Pre-emption rights


Preference Shares:

  • Fixed dividend paid before ordinary share dividends
  • Generally no voting rights
  • Can be activated if preference dividend is in arrears
  • Forms:
  • Cumulative
  • The right to receive that dividend is rolled over into the next period
  • Covertible
  • The right to convert into ordinary shares
  • Participating
  • Opportunity for further dividend (Varible dividend)
  • Redeemable
  • The right for the issuer to buy back the shares


Warrants:

  • Right to subscribe for new shares from a company at a fixed price on a future data
  • Not part of ordinary share capital of company
  • E.g. Right to buy 100 new shares in "Company" for £1.20 in 2030
  • This has been issued by the company, unlike options, in years not months
  • Warrents don't increase share capital until exercised


Issuance:

  • Typically issued as a sweetener with other investments (e.g. corporate debt)
  • Detachable or non-detachable form


Valuation Techniques:

  • Dividend Discount Model - E.g. Gordon's Growth Model
  • Calculates the share's value based on discounting future dividends
  • Similar to calculating the present value of a bond
  • Look at dividends and discount them to present value


  • Earnings per share
  • An indicator of the company's profitability from the point of view of a shareholder
  • Earnings growth is a key metric in equity valuation
  • How much profit did each share actually generate
  • Sustainable growth = good


  • Price/earnings Ratio
  • Considers the earnings per share in relation to the share price
  • The result is multiple that can be used to compare with companies in similar sectors or with the company's historic multiples
  • Divide the earnings per share by price, gives a comparable number against other similar companies

To remember :

Higher Price/Earnings Ratio = Higher the Valuation

  • Net Asset Value per Share
  • Typically used for investment vechles
  • Considers the value of the company after liabilities have been met i.e. net assets
  • Useful for companies with tangible assets such as plant property and equipment

Definitions

Dividend Discount Model
Tries to price of the share
Earnings per Share
Tries to give us an idea if a company has sustainable growth
Price/earnings Ratio
A mutiple we can compare with other companies
Net Asset Value per Share
If we were to buy the whole companies assets and pay off the liabilities, what would shareholders have left.


Corporate Actions:

  • Rights Issue
  • Company wishes to raise further capital by issuing more shares
  • Has to offer it to existing shareholders first
  • Usually at a discount on a pro-rata basis
  • Share price likely to fall afterwards due to the discount given


  • Bonus Issue
  • Issues new shares free of charge to existing shareholders
  • The objective is to lower the share price to increase liquidity / marketability


  • Stock Split
  • An alternative to a bonus issue if a company is not able to issue new shares
  • Existing share are split to increase into a greater number
  • Results in lowering of nominal value and also share price
  • Mergers
  • Two companies combgine to create a new and joint organisation


  • Acquisitions
  • One company has taken the action to buy another company's shares to gain legal control
  • Could be friendly or hostile
  • Not set rules as to the effect on company's valuation


  • Share buyback
  • A company uses spare cash or additional borrowing to buy back its own shares#
  • Methods
  • Tender process - price is typically set above market price
  • Open market purchase
  • Effect
  • Returns cash to shareholders
  • Reduces outstanding stock
  • Increases share price


Commodities and Exotics

CME Group
Chicago Board ofTrade - For Agricultural and Soft Commodities, Gold, Metals ,Chicago Mercantile Exchange - For Energy Products including Gas oil, Crude oil and Natural Gas
Euronext Derivatives
Soft Commodities (E.g. Cocoa, Sugar, Coffee) & Agricultural Commodities (Wheat, Corn, Barley)
,
ICE
Crude oil, refined energy products, natural gas, and soft commodities, such as cotton, cococa, coffee & wood
,
Dubai Mercantile Exchange
Crude Oil - (Remember NOT GOLD)
,
LME (London Metal Exchange)
Base metals, steel billet, minor metals (cobalt and molybdenum), and some precious metals
,
Tokyo Commodities Exchange
Base metals, oil and rubber
,
Shanghai Metal Exchange
Base metals
,
Multi Commodity Exchange (MCX) Mumbai
Soft and agricultural commodities, gold, ferrous and base metals, and energy
,
New York Mercantile Exchange (Part of CME)
Metals and Energy Contracts
,
European Climate Exchange
Environmental Contracts

Definitions

Agricultural
Corn, Wheat, Oats, Soybean Oil, Rapeseed and Wool
Dairy
Butter, Dry Milk, Milk and Whey
Livestock
Cattle, Hogs, and Pork Bellies
Softs
Cocoa, Coffee, Orange Juice, and Sugar


Agricultural Markets: Influences on Supply and Demand

Supply:

  • Land
  • Natural Factors: Weather, Disease
  • Production Costs: Technology, Location
  • Government Intervention: Subsidies, Tariffs
  • Transport and Storage


Demand:

  • Wealth
  • Growth
  • Tastes


Base Metals

Definitions

Copper
Electrics, building
Aluminium
Aerospace, packaging, kitchen equipment, windows, car manufacture, construction, canning
Zinc
Galvanising, production of brass
Nickel
Production of stainless steel and other alloys
Lead
Batteries, buildings
Tin
Packaging, pewter

Precious

Definitions

Gold
Jewellery, electronics, investments, dentistry
Silver
Jewellery, electronics, photography, dentistry

Base and Precious Metals: Influences on Supply and Demand

Supply:

  • Availability
  • Cost of extraction/production
  • Government Intervention: Subsidies, tariffs
  • Transport & Storage
  • Scrap and Secondary Markets


Demand:

  • Economic Growth/Decline
  • Substitutes

Energy

Definitions

Crude Oil
Fuel & Plastics - Brent, Dubai, West Texas
Natural Gas
Fuel & Manufacturing - Worldwide
Electricity
Can be priced by time of day. Produced from the two above.

Energy Markets: Supply and Demand

Supply:

  • Availability
  • Natural Disasters
  • Costs of Discovery and Extraction
  • Government Intervention: Political Unrest
  • Organisation of Petroleum Exporting Counties (OPEC)
  • Transport and Storage


Demand:

  • Consumption
  • Economic Expansion
  • Economic Forecasts


Crude Oil (Potential Questions):

  • Field
  • E.g Brent, Dubai, West Texas (Name of the Oil Field)
  • Light or Heavy
  • Light pours like water
  • Heavy pours like ketchup
  • Light Good
  • Heavy Bad
  • Measure = A.P.I.
  • Sweat or Sour
  • Sweat is good
  • Sour is bad
  • Sulphur content (Less than 1% is Sweat, Above 1% is Sour)

Other Commodities (Exotics)

Freight:

  • E.g. Baltic Dry Index


Weather:

  • Heating Degree Days (HDD)
  • Cooling Degree Days (CDD)


Emissions:

  • Caps
  • Credits


Cryptocurrencies:

  • Bitcoin
  • Question: What is a Cryptocurrency
  • Non-Central Bank type Entity


Hybrids:

  • Combine two different derivatives in one contract
  • E.g. Swaption = Interest Rate Swap + Option

Chapter 2: Underlying Markets

Money Markets

Cash deposits and loans out to 12 months (Has a life of less than 12 months)

Inter-bank market:

  • Development in short-term rates market
  • UK = SONIA - Sterling overnight index average based on unsecured overnight borrowing published by the Bank of England
  • US = SOFR - Secured overnight financing rate based on an overnight repo rate
  • Eurozone = ESTR - Euro short-term rate based on the previous day's unsecured overnight borrowing settled through Target2


Money Market Instruments:

  • Treasury Bills (UK T-bills)
  • Issued by the Debt Management Office (DMO) on behalf of the UK Government
  • Short-term unsecured debt
  • One to twelve months
  • Zero-coupon
  • Issued at discount redeemed at par
  • Minimum market denomination = £25,000
  • Benchmark risk-free rate
  • Government = Least risk investment compared to lending to a company
  • Commerical Paper
  • Issued by companies
  • Short-term unsecured debt
  • Two to nine months
  • Zero-coupon
  • Issued at discount redeemed at par
  • Typically high denominations
  • E.g. $500,000
  • US is the biggest market


To remember :

Treasury Bills = Issued by DMO/UK Government, One - Twelve Months & Minimum Market Denomination = £25,000

To remember :

Commercial Paper = Issued by Companies, Two - Nine Months, High Denominations = $500,000

  • Certificate of deposit (CDs)
  • Promissory note (Issued by banks and other financial institutions
  • Purchased at nominal value and redeemed with interest
  • Fixed Term
  • Three and Six Months are most common
  • Early redemption incurs a penalty
  • Certificate shows the money at the bank, for period and interest rate
  • If money is required before end of period, CD can be sold on the money market


Foreign Exchange

FX: Background:

  • 100% OTC market
  • Big players - Major international banks
  • Spot market = Cash Market - T+2
  • Forward market = Anything that is greater than T+2
  • London largest centre (By some distance)
  • Dollar is the major currency


Cross Rates:

  • Two less known/used currency pairs
  • Cross through the dollar to exchange


Two-Way Prices

  • Which ever currency is quoted first is the 1 value
  • GBP/USD
  • GBP = £1
  • All FX is quoted to 5 figures
  • The last two digits are the pips


Bonds


Government bonds:

  • Debt instruments
  • UK Gov Bonds = Gilts
  • T-Bills - Good for 3, 6, 9, 12 months
  • 5, 10 years +, you would use Gilts
  • Loan to the government


Nominal Value (Face value, Par Value, Redempton Value)

  • Quoted per £100
  • The capital payment the holder receives at redemption


Coupon:

  • The interest
  • Expressed as an annual percentage of the nominal value
  • Paid semi annually


Name:

  • The name given at issue
  • E.g. 6 1/2 Per Cent Treasury Stock 2048


Redemption:

  • The year when the gilt is repaid


Gilts:

  • Index-Linked
  • Coupon and redemption linked to RPI
  • Inflation protection
  • RPI = Retail Prices Index
  • No default risk
  • Small coupons, due to the low risk


  • Non Index-Linked (Conventional Bonds)
  • Has fixed coupon
  • Fixed redemption value
  • Fixed redemption date
  • Shorts, Mediums, Long, or Undated bonds
  • Undated bonds or Unredemables - Are redeemed at the discretion of the issuer


Strips Market: (Seperate Trading of Registered Interest + Principal)

  • Turn conventional bond turn into a lot of zero coupon bonds


Overseas Government Bonds:


Yield Curves:


  • Yield of a bond, plotted against Maturity of a bond
  • Upward Tilting = Normal
  • Due to Liquidity Preference Theory
  • Markets prefer liquid assets
  • Markets expect to be paid to wait


  • Downward sloping or inverted
  • Expect interest rates to fall
  • Expectation of recession

Definitions

Yield Curve
Looks at the yield of the bond market, taking a snapshot of the yield structure over the maturity of the bond market

Yield Spreads:

  • The difference between the yield on one investment and the yield on another investment
  • The other investment is typically a benchmark
  • Interest rate benchmark (SONIA, LIBOR)
  • Government Bond
  • Position on the swap curve
  • Measured in basis points (0.01%)


Example: A


Equities

Ordinary Shares:

  • Common Stock
  • Variable dividends based on profits
  • Voting rights
  • Pre-emption rights


Preference Shares:

  • Fixed dividend paid before ordinary share dividends
  • Generally no voting rights
  • Can be activated if preference dividend is in arrears
  • Forms:
  • Cumulative
  • The right to receive that dividend is rolled over into the next period
  • Covertible
  • The right to convert into ordinary shares
  • Participating
  • Opportunity for further dividend (Varible dividend)
  • Redeemable
  • The right for the issuer to buy back the shares


Warrants:

  • Right to subscribe for new shares from a company at a fixed price on a future data
  • Not part of ordinary share capital of company
  • E.g. Right to buy 100 new shares in "Company" for £1.20 in 2030
  • This has been issued by the company, unlike options, in years not months
  • Warrents don't increase share capital until exercised


Issuance:

  • Typically issued as a sweetener with other investments (e.g. corporate debt)
  • Detachable or non-detachable form


Valuation Techniques:

  • Dividend Discount Model - E.g. Gordon's Growth Model
  • Calculates the share's value based on discounting future dividends
  • Similar to calculating the present value of a bond
  • Look at dividends and discount them to present value


  • Earnings per share
  • An indicator of the company's profitability from the point of view of a shareholder
  • Earnings growth is a key metric in equity valuation
  • How much profit did each share actually generate
  • Sustainable growth = good


  • Price/earnings Ratio
  • Considers the earnings per share in relation to the share price
  • The result is multiple that can be used to compare with companies in similar sectors or with the company's historic multiples
  • Divide the earnings per share by price, gives a comparable number against other similar companies

To remember :

Higher Price/Earnings Ratio = Higher the Valuation

  • Net Asset Value per Share
  • Typically used for investment vechles
  • Considers the value of the company after liabilities have been met i.e. net assets
  • Useful for companies with tangible assets such as plant property and equipment

Definitions

Dividend Discount Model
Tries to price of the share
Earnings per Share
Tries to give us an idea if a company has sustainable growth
Price/earnings Ratio
A mutiple we can compare with other companies
Net Asset Value per Share
If we were to buy the whole companies assets and pay off the liabilities, what would shareholders have left.


Corporate Actions:

  • Rights Issue
  • Company wishes to raise further capital by issuing more shares
  • Has to offer it to existing shareholders first
  • Usually at a discount on a pro-rata basis
  • Share price likely to fall afterwards due to the discount given


  • Bonus Issue
  • Issues new shares free of charge to existing shareholders
  • The objective is to lower the share price to increase liquidity / marketability


  • Stock Split
  • An alternative to a bonus issue if a company is not able to issue new shares
  • Existing share are split to increase into a greater number
  • Results in lowering of nominal value and also share price
  • Mergers
  • Two companies combgine to create a new and joint organisation


  • Acquisitions
  • One company has taken the action to buy another company's shares to gain legal control
  • Could be friendly or hostile
  • Not set rules as to the effect on company's valuation


  • Share buyback
  • A company uses spare cash or additional borrowing to buy back its own shares#
  • Methods
  • Tender process - price is typically set above market price
  • Open market purchase
  • Effect
  • Returns cash to shareholders
  • Reduces outstanding stock
  • Increases share price


Commodities and Exotics

CME Group
Chicago Board ofTrade - For Agricultural and Soft Commodities, Gold, Metals ,Chicago Mercantile Exchange - For Energy Products including Gas oil, Crude oil and Natural Gas
Euronext Derivatives
Soft Commodities (E.g. Cocoa, Sugar, Coffee) & Agricultural Commodities (Wheat, Corn, Barley)
,
ICE
Crude oil, refined energy products, natural gas, and soft commodities, such as cotton, cococa, coffee & wood
,
Dubai Mercantile Exchange
Crude Oil - (Remember NOT GOLD)
,
LME (London Metal Exchange)
Base metals, steel billet, minor metals (cobalt and molybdenum), and some precious metals
,
Tokyo Commodities Exchange
Base metals, oil and rubber
,
Shanghai Metal Exchange
Base metals
,
Multi Commodity Exchange (MCX) Mumbai
Soft and agricultural commodities, gold, ferrous and base metals, and energy
,
New York Mercantile Exchange (Part of CME)
Metals and Energy Contracts
,
European Climate Exchange
Environmental Contracts

Definitions

Agricultural
Corn, Wheat, Oats, Soybean Oil, Rapeseed and Wool
Dairy
Butter, Dry Milk, Milk and Whey
Livestock
Cattle, Hogs, and Pork Bellies
Softs
Cocoa, Coffee, Orange Juice, and Sugar


Agricultural Markets: Influences on Supply and Demand

Supply:

  • Land
  • Natural Factors: Weather, Disease
  • Production Costs: Technology, Location
  • Government Intervention: Subsidies, Tariffs
  • Transport and Storage


Demand:

  • Wealth
  • Growth
  • Tastes


Base Metals

Definitions

Copper
Electrics, building
Aluminium
Aerospace, packaging, kitchen equipment, windows, car manufacture, construction, canning
Zinc
Galvanising, production of brass
Nickel
Production of stainless steel and other alloys
Lead
Batteries, buildings
Tin
Packaging, pewter

Precious

Definitions

Gold
Jewellery, electronics, investments, dentistry
Silver
Jewellery, electronics, photography, dentistry

Base and Precious Metals: Influences on Supply and Demand

Supply:

  • Availability
  • Cost of extraction/production
  • Government Intervention: Subsidies, tariffs
  • Transport & Storage
  • Scrap and Secondary Markets


Demand:

  • Economic Growth/Decline
  • Substitutes

Energy

Definitions

Crude Oil
Fuel & Plastics - Brent, Dubai, West Texas
Natural Gas
Fuel & Manufacturing - Worldwide
Electricity
Can be priced by time of day. Produced from the two above.

Energy Markets: Supply and Demand

Supply:

  • Availability
  • Natural Disasters
  • Costs of Discovery and Extraction
  • Government Intervention: Political Unrest
  • Organisation of Petroleum Exporting Counties (OPEC)
  • Transport and Storage


Demand:

  • Consumption
  • Economic Expansion
  • Economic Forecasts


Crude Oil (Potential Questions):

  • Field
  • E.g Brent, Dubai, West Texas (Name of the Oil Field)
  • Light or Heavy
  • Light pours like water
  • Heavy pours like ketchup
  • Light Good
  • Heavy Bad
  • Measure = A.P.I.
  • Sweat or Sour
  • Sweat is good
  • Sour is bad
  • Sulphur content (Less than 1% is Sweat, Above 1% is Sour)

Other Commodities (Exotics)

Freight:

  • E.g. Baltic Dry Index


Weather:

  • Heating Degree Days (HDD)
  • Cooling Degree Days (CDD)


Emissions:

  • Caps
  • Credits


Cryptocurrencies:

  • Bitcoin
  • Question: What is a Cryptocurrency
  • Non-Central Bank type Entity


Hybrids:

  • Combine two different derivatives in one contract
  • E.g. Swaption = Interest Rate Swap + Option
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