1) Can you describe the different types of Equity Derivatives ?
Exchange - Single Stock Options
Exchange - Single Stock Futures
Exchange - Equity Index Options
Exchange - Equity Index Futures
Exchange - Options on Equity Index Futures
OTC - Warrants
OTC - Contracts for Difference (type of equity swap)
OTC - Equity Return Swaps
OTC - Equity Index Return Swaps
2) What exchanges are Equity Derivatives traded on ?
CME Group - Chicago Mercantile Exchange
3) What is a Share ?
Also known as equity or stock.
An ordinary share is an instrument that a company can use to raise money.
If the company gets into financial trouble, the shareholders are the last people to get any money back.
4) What is a Preference Share ?
A preference share is the same as a normal share except in the event of liquidation they are paid out earlier.
Dividends for preference shares are set at a specific rate.
There are two categories:
Cumulative - if the company does not pay a dividend then the amount if owed to them
Non-Cumulative - if the company does not pay a dividend then the amount is lost.
5) What are the different types of Preference Shares ?
Participating - can benefit from a larger dividend
Convertible - can be converted to ordinary shares
Callable - company can buy back the shares at a later date
6) Why would someone buy a Share ?
To become part owner of the company and to share in the risks and rewards of the company's operations.
In the hope that the share price increases so they can make money (from capital gains)
In the hope that the dividend increases as the company becomes more profitable.
To give them the right to vote at the AGM.
7) What affects the price of an equity ?
Inflation and Deflation
8) What effect would an increase in interest rates have on the price on an equity ?
When interest rates go up the risk ssociated with equities goes up.
When interest rates go up credit card and mortgage interest rates go up. This means people have less disposable income which means they spend less so businesses will see a drop in revenue.
When interest rates go up businesses have to pay more to borrow money. This can slow down the growth of the company and result in a drop in earnings.
When interest rates go up the estimated future cash flows will drop which will result in a lower share price.
If enough companies experience a drop in share price then the equity indices will also drop.
9) What aspects do you have to consider when buying and selling Equities ?
Profitability of the company, price to earnings ratio, earnings growth, dividend history, return on equity, return on invested capital.
10) Who decides what the dividend is ?
The company decides but it must have the shareholders approval.
11) Does a company have to pay a dividend ?
12) If the company made a loss could they still pay a dividend ?
13) Can you give some examples of corporate actions ?
(Rights Issue) - Company issues more shares to existing shareholders (at a discount) and is used to raise money
(Stock Split) - Company offers a 2-for-1 to lower its share price and increase liquidity
(Buy Back) - Company buys a lot of its own shares to reduce the number in circulation and therefore hoping to increase the share price.
(Merger) - One company surrenders its stock to another company
(Acquisition) - One company buys a majority stake in another company
(Spin Off) - Part of the company is separated as an independent business
14) What does Ex-Dividend mean ?
When a dividend is going to be paid there is a point where the shareholder loses the entitlement to the dividend.
15) What normally happens to the share price when an equity does Ex-Dividend ?
The share price falls to offset the disadvantage of not getting the dividend.
16) What is the difference between an Index and a Benchmark ?
Index - is a statistical tool designed to measure performance over time.
Benchmark - is an index that serves as the measurement yardstick for a portfolio by comparing portfolio characteristics such as returns, risk, component weights and exposure to sectors, styles and other factors to the benchmark.
17) What is an Equity Index ?
This is a basket of individual shares that are put together as a single unit.
18) Can you describe the different methods used to construct equity indexes ?
Float Weighted - (cap weighted) components are weighted according to the total market value of their outstanding shares.
Price Weighted - (share weighted) affected by changes in price (not that common)
Equally Weighted - every stock has the same weight regardless of size
Market Cap Weighted - (value weighted) market capitalisation weighted includes all the shares (very uncommon)
19) Can you give some examples of different types of Equity Indexes ?
S&P 500 - float weighted
FTSE 100 - float weighted
Dow Jones Industrial Average - price weighted
Nikkei 225 - price weighted
S&P 500 Equal Weight - equally weighted
20) What is a Contract for Difference ?
This can be thought of as an equity swap traded on margin.
Allows speculation on share price movements without the need for ownership
A contract to deliver the difference between the current value and the value when the contract was made
This allows speculation without having to own the asset
Traded in most countries except the US
Always traded on margin accounts and has significant counterparty risk
21) What is a Warrant ?
Traded on exchanges but have liquidity risk.
Long Term instruments
Frequently attached to bonds or preferred stock, used to enhance the yield and make the bond or stock more attractive
Used by companies as a sweetener for an equity or bond issue
Very popular in Canada and Hong Kong.
22) What is the difference between a warrant and a depository reciept ?
23) What is a Quanto Equity ?
A foreign equity that is traded as a local equity without a currency translation.
24) Can you describe a Single Stock Option ?
The right but not the obligation to buy (or sell) a quantity of stock at a set price before an expiry date.
Traded on exchanges they have transparency and liquidity.
25) What is the difference between a Single Stock Option and a Warrant ?
Warrants are issued by the company itself.
Warrants usually have longer maturity periods, years rather than months.
Warrants cause dilution because the company is obliged to issue new stock.
26) Can you describe a Single Stock Future ?
A contract to deliver 100 shares on a specific date in the future.
The price is based on the price of the underlying plus the cost of carry minus any dividends.
Provides investors with good leverage.
27) What is an Equity Index Future ?
This is a forward contract where the underlying is an equity index.
S&P 500 Future - the value of the contract is $250 multiplied by the value of the S&P 500 index.
S&P 500 Emini Future - the value of the contract is $50 multiplied by the value of the S&P 500 index.
28) What is an Equity Return Swap ?
Also known as total return swap, cash settled equity swap.
An agreement between two parties to swap the total return from an equity (dividends and capital gain) for a regular fixed or floating cash flow.
29) What is an Equity Index Option ?
This is an option to buy or sell a quantity of an equity index for cash settlement.
S&P 500 Option (SPX) - the value of the contract is the value of the S&P 500 index.
S&P 500 Mini Option (XSP) - the value of the contract is 10% of the value of the S&P 500 index.
30) What effect would an increase in interest rates have on the price of an equity ?
When interest rates increase it becomes more expensive to borrow money and also causes an increase in prices which reduces the supply of money.
This makes is more expensive for companies to borrow and therefore slows down their growth.
If the company experiences a drop in earnings then the stock price will fall.
If enough companies experience a decline then the equity indices will also fall.
With a lower expectation for growth there will be less share price appreciation making equities less desirable and more risky.
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