Investments 2 Quiz #2

Front 1

an agreement to purchase (or sell) an asset at a later date for a price set today – the current price of the futures contract in the market

Back 1

futures contract

Front 2

_____ (Going _____) a Futures Contract obligates you to take delivery of the underlying asset (assuming you do not sell your contract prior to expiration).

Back 2

Purchasing, Long

Front 3

_____ (Going _____) a Futures Contract obligates you to deliver the underlying asset (assuming you do not cover – buy-back – your contract prior to expiration.

Back 3

Selling, Short

Front 4

Many futures contracts do not require the delivery of the underlying asset, but are _____-settled at expiration. Even those that are set up for delivery are often closed out with __________ prior to the contract’s expiration. According to the book Derivatives Demystified – “Over all the exchanges, it is estimated that fewer than 4% of futures contracts ever reach delivery, in some cases fewer than 1%”

Back 4

cash, reversing trades

Front 5

The underlying ______ for a Futures Contract can take many forms such as:
- Stock Market Indices
- Grains
- Livestock
- Metals
- Fuels
- Currencies
- Bonds
- Weather (obviously a cash-settled contract)
- etc.

Back 5

asset

Front 6

Futures Markets:

There has been significant consolidation in the futures exchange arena over the last few years. A few years ago, the three biggest exchanges were the Chicago Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange. In July 2007, the CBOT and CME merged to form the _____. In August 2008, the CME Group and NYMEX merged so now all three exchanges are one company – The _____

Back 6

CME Group (x2)

Front 7

Futures Markets:
Traditional “_________” trading on Organized Exchanges is largely being replaced by electronic trading. For the 3rd quarter of 2010, only about 12% of trading volume was done over open outcry.

Back 7

Open Outcry

Front 8

Serve as a “Middleman” between buyers and sellers of contracts to facilitate
_______ specifications
_______ procedures
_______

Back 8

contract, trading, settlement

Front 9

Futures Contracts are purchased on ______ (referred to as “performance bonds” by the exchanges).

Back 9

margin

Front 10

Exchanges set the ______ ______ requirements and these are updated regularly based on the ______ of the underlying asset.

Back 10

minimum margin, volatility

Front 11

Futures positions are “____________” on a daily basis which adds to or subtracts from your margin balance.

Back 11

marked-to-market

Front 12

When margin falls below maintenance requirements, it must be brought back up to _____ margin or the position will be _______.

Back 12

initial, liquidated

Front 13

Note that “margin” with respect to futures is different than margin with respect to stocks. With stocks, margin means you are borrowing money from your broker (using your stock as collateral) to buy more stock. With futures, you are not borrowing money, but putting up a “________ deposit”.

Back 13

good faith

Front 14

_______ (with futures) involves the use of a futures contract to offset a natural risk exposure.

Back 14

Hedging

Front 15

_______ (with futures) involves the use of a futures contract to create a risk exposure in an attempt to earn a profit

Back 15

Speculating

Front 16

A bond or preferred stock that is convertible into common stock AT THE OPTION OF THE HOLDER.

Back 16

convertible securities

Front 17

Convertible securities are a bond or preferred stock that is convertible into common stock at the _____ of the holder.

Back 17

option

Front 18

We can think of a convertible bond as a ____ + a _____ option on the underlying stock

Back 18

bond, call

Front 19

With convertible securities, the _________ Ratio tells us how many shares of stock each bond can be converted into.

Back 19

conversion

Front 20

In regards to convertible securities, the _______ Price is the price at which the bond can be converted into common shares.

Back 20

conversion

Front 21

Value of a Convertible Bond:
____________ is what the bond would be worth right now if it was converted into shares of common stock

Back 21

Conversion Value

Front 22

Value of a Convertible Bond:
___________represents what the bond would be worth if it was an ordinary (non-convertible) bond.

Back 22

Pure Bond Value

Front 23

Value of a Convertible Bond:
The __________ represents the percentage to which the market value of the bond is greater than the conversion value.

Back 23

conversion premium

Front 24

Value of a Convertible Bond:
The __________ represents the percentage that the bond price could fall if the convertibility feature was deemed worthless.

Back 24

downside risk

Front 25

Investor Issues with Convertible Bonds:
- _____ Conversions (Step-up provisions or call provisions)
- _____ Yields due to potential upside from call option
- _____ to convert?

Back 25

Forced, Lower, When

Front 26

Corporate Issues with Convertible Bonds:
- _____ Interest Cost
- Potential for ______

Back 26

Lower, Dilution

Front 27

A ______ contract represents the agreement to take delivery (if you are buying or “____” the contract) or deliver (if you or selling or “_____” the contract) an underlying asset for a price agreed upon _____. Note that a futures differs from an option in the sense that a futures contract is an ______. You have to either honor your agreement at expiration or “reverse” it prior to expiration (by selling if you are “long” or by buying if you are “short”).

Back 27

futures, long, short, today, obligation

Front 28

Do you have to take delivery or deliver the commodity if you are a party to a futures contract?
There are three possibilities. One, you can _____ your trade. If you are long a contract and then you later sell that contract, you have taken care of your obligation. Two, some contracts are “____ settled.” For instance, when dealing with the DJIA futures, you do not actually deliver or take delivery of the shares, but pay (or receive) a cash value based on the value of the DJIA. If you do not reverse your trade prior to expiration and it is not a cash- settled contract, then you are expected to deliver or take delivery of the underlying asset. Typically the contract will be very specific with respect to accepted delivery terms.

Back 28

reverse, cash

Front 29

________ refers to the process of offsetting a natural risk exposure. A common tool for hedging is the use of _____ contracts such as a futures contract.

Back 29

Hedging, derivative

Front 30

Hedging doesn't make a company more _______, just less _______.

Back 30

profitable, risky

Front 31

Why is there substantial leverage in commodity investments?

The leverage comes from the ______. Since investors only put up margin equivalent to a small percentage of the contracts value, they can experience large percentage _________ relative to their initial investment.

Back 31

margin, gains & losses

Front 32

Margin on futures contracts represents a “_________” deposit to cover any losses you might incur on your position. As it is not a ____, you are not paying interest. Also, the margin requirements are much different in that futures usually require a less than __% margin balance giving more than a ____ leverage factor.

Back 32

good faith, loan, 10%, 10-1

Front 33

Indicate some factors that might influence the price of wheat in the commodities market.

It is primarily about _____ and _____. Anything that impacts supply or demand for wheat is going to impact the price of the futures contracts. Some examples include weather, population growth (global, not just in the US), pest control, global incomes, land usage for farming, etc.

Back 33

supply, demand

Front 34

Another factor that comes into play with options is the “cost of carry.” As the futures price should be equal to the ____ price + the cost of _____, _______ fees, ________ charges and ________ costs would also impact the cost of wheat futures. The higher these fees were, the more ______ the futures price would be relative to the spot (cash) price of wheat.

Back 34

spot, carry, storage, interest, delivery, expensive

Front 35

A daily ______ limit is designed to limit the amount that the contracts price can change over the course of a single trading day.

Back 35

trading

Front 36

Trading limits serve two purposes. The most important is with respect to _____ accounts. The purpose of margin on futures is to protect the exchange from _____. If the margin balance falls to a negative value, there is no longer any default _______ in place for the exchange. Therefore, price limits help ensure that the price does not fall so rapidly as to create a negative margin balance. A second purpose of price limits is _______. If we feel that markets are less than 100% efficient and that some investors may fall victim to “herd behavior,” a price limit can create a “circuit breaker” to allow investors to regroup and reevaluate their positions.

Back 36

margin, defaults, protection, behavioral

Front 37

What is meant by "marked-to-market?"
Futures positions are “marked-to-market” each day. What we mean by that is that each person involved in a futures contract (whether long or short) must put up a _____ balance. The margin balance is based on the _____ of that specific contract. Each day, _____ from the futures position are added to the margin balance and _______ are subtracted from the margin balance. As long as the margin balance stays above a pre-set “maintenance margin,” no action is required by the trader. However, if the balance falls below the maintenance margin, the trader must put in more money. The purpose of the marked-to-market approach is to makes sure that losses do not get so large that the trader defaults on their obligations.

Back 37

margin, volatility, profits, losses

Front 38

Convertible securities are sometimes called a _______ security because they offer some of the upsides of bonds as well as some of the upsides of stocks.

Back 38

hybrid

Front 39

When you buy a convertible, you get the _____ payment associated with a bond and the _____ protection of knowing that as long as the company doesn't go bankrupt, you will get the $1000 par value at maturity.

Back 39

coupon, downside

Front 40

When you buy a convertible, you get paid {Before/After} preferred and common stockholders in the priority of claims.

Back 40

before

Front 41

The downside of ordinary bonds is that if the company does extremely well you do not get to participate in the upside. However, with convertible bonds, you get the upside potential of owning stocks because if the stock price rises significantly, you can convert your bond into shares of _____.

Back 41

common stock.

Front 42

Why would an investor be interested in convertible securities?
- _____ Payments
- _____ Protection (Bond will be worth par value at maturity)
- _____ Priority of Claims than Preferred/Common Stock
- _____ Potential of Common Stock if the Stock Price rises significantly

Back 42

coupon, downside, higher, upside

Front 43

What are the disadvantages of investing in convertible securities?
- The coupon payments on convertibles tend to be _____ than the coupon payments on ordinary bonds.
- Convertible bonds are often _____(junior) debt and a little lower in the priority of claims than regular bonds.
- While convertibles offer some of the upside associated with stocks, they typically will not pay as much as stocks when stock prices rise, because the convertible bond is typically purchased at a _____ to the conversion value and that will shrink as time goes by - time decay - and as the conversion value increases.

Back 43

lower
subordinated
premium

Front 44

an estimate of what the bond would be worth if investors deemed the conversion feature worthless

Back 44

pure bond value

Front 45

The pure bond value tells us what our _____ is if the company's stock price falls significantly.

Back 45

downside

Front 46

For bonds that have conversion premiums in excess of 100 percent, what can you generally infer about the stock price?
If the conversion premium is in excess of 100%, this means that the stock price is relatively _____ compared to the conversion price. In essence, investors are valuing the bond more off its _____ value rather than the ability to _____. The "call options" are deep {out of/in} - the-money.

Back 46

low
pure bond
convert
out of

Front 47

How does the volatility of a stock influence the conversion premium?

Remember that the value of a convertible bond is equal to the _____ value + a _____ option. Therefore, all the factors that influence the value of a call option (stock price, exercise price, volatility, risk-free rate, and time to maturity) will influence the value of a convertible bond. Mote that the exercise price is essentially just the conversion price and the number of options is essentially just the conversion ratio. Also, note that wile an increase in the risk-free rate will cause the value of the option to increase, it will likely have a _____ impact on the pure bond value. The net impact on the value of the convertible bond will depend on many factors including the time to maturity and the value of the option relative to _____ value.

Back 47

pure bond, call, negative, pure bond

Front 48

Why do corporations use convertible bonds?

The primary advantage is that it allows the firm to lower their ____ cost associated with debt. Because investors like the upside associated with convertibles, they typically will accept a ____ yield-to-maturity on the bond. This lowers the interest cost for the firm and increases profitability. The primary downside is that if the firm does well and the stock price rises enough to be convertible this will result in dilution (lowering ____ per share).

Back 48

interest
lower
earnings

Front 49

Interest rates rise causing the pure bond value to drop (the PBV would drop by more than the Bond Price because the bond price is somewhat supported by the conversion value). This will cause the downside risk to {INCREASE/DECREASE}.

Back 49

decrease

Front 50

The downside risk of a convertible bond will decrease if the stock price goes ____ causing the Bond Price to increase (the pure bond value would not change as it is not sensitive to the stock price.

Back 50

up

Front 51

While a minor factor, if the volatility of the underlying stock is increased dramatically this could also lead to a ____ downside risk as it would raise the value of the convertible bond (bond + call option) without impacting the pure bond value.

Back 51

higher

Front 52

The conversion premium is similar to the ____ on an option. As the option becomes further in-the-money, the conversion premium will ____. Also the volatility of the stock, the risk-free rate, and the time to maturity will also influence the conversion premium.

Back 52

speculative premium
fall

Front 53

What would you expect to happen to the conversion premium and the downside risk for a typical convertible bond as the time to maturity declines (assuming stock price and interest rates remain constant)?

As the time to maturity declines this time decay should ______ the conversion premium. With respect to the pure bond value, remember that the market price for a convertible bond is equal to the pure bond value + call option. All else equal, as the time to maturity draws closer, the time decay will ______ the value of the call option. This will cause the difference between the ______ price and the ______ to shrink, lowering the ______ risk. Therefore, all else equal, we should expect the conversion premium and the downside risk to ______ as the time to maturity declines.

Back 53

lower
lower
market price
pure bond value
downside
shrink