60 Things You Should Know to Pass HKSI Paper 7 – Financial Markets

TOPIC 1 – THE GLOBAL FINANCIAL SYSTEM

1. Participants in the Global Financial System

• As well as a variety of commercial participants, the global financial system includes the following supranational organizations and multilateral agencies playing a critical role:
  • International Monetary Fund (IMF): headquartered in Washington DC, the IMF provides the global public good of financial stability, helping growth of international trade, exchange rate stability and an open system of international payments. The IMF lends foreign exchange on a temporary basis to countries, when needed
  • Bank for International Settlements (BIS): promotes international cooperation among central banks, acting as a prime counterparty in their financial transactions. Headquartered in Basel, Switzerland with representative offices in Hong Kong and Mexico City. Perceived as bank for central banks
  • The World Bank: founded in 1944, is the world’s largest source of development assistance. It works in more than 100 developing economies providing finance and ideas to improve living standards and eliminate the worst forms of poverty
  • The Organisation for Economic Co-operation and Development (OECD): helps governments tackle the economic, social and governance challenges of a global economy. Its work covers macroeconomics, trade, education, development, science and innovation
  • World Trade Organization (WTO): is an international body dealing with the global rules of trade between nations. As of July 2019, there were 164 members, with Hong Kong joining in 1995 and China in 2001
  • Asian Development Bank: established in 1966 as a regional development bank focusing on Asian emerging economies. Aims to reduce poverty in Asia Pacific through inclusive economic growth, environmentally sustainable growth and regional integration.  Japan and the US have the strongest influence
  • Asian Infrastructure Investment Bank: proposed by China in 2013, the AIIB is headquartered in Beijing and supports infrastructure development in the Asia Pacific region. As of 2019, AIIB has 70 members as well as 27 prospective members from around the world.  It aims to cooperate with China’s Belt and Road Initiative (BRI) to strengthen economic connection among BRI countries

[To access practice questions for this topic, go to Examinator.online – Paper 7]

2. Money and the Banking System

• Money acts as a:
  • Means of storing wealth
  • Medium of exchange
  • Unit against which to value other goods and services
• Money needs to be durable, storable and portable
• There are 3 classifications to describe the quantity of money in an economy:
  • M1: all notes and coins in circulation, plus customers’ demand deposits placed with licensed banks (narrow money)
  • M2: M1 plus savings and term deposits with licensed banks
  • M3: M2 plus deposits in other financial institutions (broad money)
• Banks are financial intermediaries facilitating the flow of funds in the banking system by carrying out the following functions:
  • Mobilization of funds: both wholesale and retails funds
  • Investment opportunities: allow investors to save money and manage their investment portfolios
  • Implementation of monetary policy: most governments implement monetary policy through the banking system

[To access practice questions for this topic, go to Examinator.online – Paper 7]

3. Economic Cycles

• Economies go through periods of boom and bust, involving four stages:
  • Peak to contraction: there is a decrease in economic growth, driven by falling investment and industrial production
  • Contraction to trough: a fall in inflation and private consumption expenditure is accompanied by an increase in unemployment
  • Trough to expansion: economic recovery occurs with a fall in interest rates and an increase in investment activity
  • Expansion to peak: continued economic growth leads to increases in household and business spending, with higher inflation and low unemployment

[To access practice questions for this topic, go to Examinator.online – Paper 7]

4. Globalization and Technology

• Development of the global economy has been helped by sophisticated modern technology, enabling efficient and speedy mobilization of funds across borders
• A disadvantage of these developments is the encouragement of speculative capital inflows and outflows leading to economic and financial instability
• An example of this disadvantage was the Asian financial crisis of 1997-98 brought about by massive short-term speculative capital flows
• A growing and diverse number of participants can gain access to up-to-date financial news and information from around the world
• Increased accessibility to global financial markets has influenced the nature and function of financial regulation and has led to the development of new niche markets and products to provide opportunities for higher returns, given the reduction in arbitrage opportunities

[To access practice questions for this topic, go to Examinator.online – Paper 7]

TOPIC 2 – FINANCIAL SYSTEM IN HONG KONG

5. Currency Board System and the Exchange Fund

• The Financial Secretary sets monetary policy objectives, while the HKMA is responsible for achieving those objectives
• Currently, Hong Kong’s monetary policy objective is currency stability, defined as:

A stable external exchange value of the currency against the US dollar, at around HKD7.8 to USD1, through monetary structure characterized by Currency Board arrangements, requiring the Hong Kong dollar Monetary Base to be at least 100 per cent backed, and changes in it to be 100 per cent matched, by corresponding changes in the US dollar reserves held in the Exchange Fund at the fixed exchange rate of HKD7.8 to USD1

• Exchange rate stability is maintained via a market-induced interest rate adjustment mechanism
• The linked exchange rate means that Hong Kong interest rates need to follow US interest rates to maintain the peg, thereby giving the HKMA little scope to influence interest rates

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 6. Central Bank and Liquidity Management

• The HKMA acts as the lender of last resort and, therefore, can be considered an intermediary in the financial system
• The HKMA provides liquidity to banks (referred to as AIs in the Banking Ordinance and AFIs in the Securities and Futures Ordinance)
• There are three tiers of AIs in Hong Kong:
  • Licensed banks: min paid-up capital of HK$300 million; can take all types of deposits without restriction
  • Restricted license banks: min paid-up capital of HK$100 million; can only take time deposits of HKD500,000 or more without restriction on term to maturity
  • Deposit taking companies: min paid-up capital of HK$25 million; can only take time deposits of HKD100,000 or more with original term to maturity not less than three months
• HKMA operates a discount window whereby fully licensed banks and restricted licensed banks can obtain overnight liquidity to cover shortfalls by entering into repurchase agreements (repos)
• Under repo arrangements, banks can sell high quality assets, such as Exchange Fund Notes (EFNs), to the HKMA, promising to buy them back at an agreed price at a future date
• The HKMA’s provision of short-term liquidity is vital to the stability and credibility of the financial system

[To access practice questions for this topic, go to Examinator.online – Paper 7]

7. Payment Systems

• HKMA oversees the banking sector payment systems
• The Real Time Gross Settlement System (RTGS) settles all gross positions of banks in the financial system. Both licensed and restricted license banks are included in the RTGS
• AIs maintain settlement accounts with the HKMA and payment obligations are cleared on a continuous, deal by deal basis
• HKMA operates the Central Moneymarkets Unit (CMU) which is the electronic clearing and settlement system for Exchange Fund Bills and Notes and other debt securities
• An interface between the RTGS and the CMU allows repurchase agreements to be electronically transacted

[To access practice questions for this topic, go to Examinator.online – Paper 7]

8. Securities and Futures Commission (SFC)

• The SFC was established in 1989, with the role to administer the laws governing the securities and futures markets in Hong Kong, and to facilitate and encourage the development of these markets
• The SFC’s objectives, as stated in the Securities and Future Ordinance, are to:
  • Maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the industry;
  • Promote understanding by the public of financial services, including the operation and functioning of the industry;
  • Provide protection to the investing public; minimize crime and misconduct in the industry; and reduce systemic risks in the industry; and
  • Assist the Financial Secretary in maintaining the financial stability of Hong Kong by taking appropriate steps in relation to the industry

[To access practice questions for this topic, go to Examinator.online – Paper 7]

9. Authorized Institutions

Licensed Banks

• Need to have paid-up capital of HKD300 million. Banking services provided include:
• Current and savings accounts
• Time deposits
• Loans and overdrafts
• Syndicated lending
• Leasing
• Mortgages
• Trade finance
• Securities and commodities dealing
• Securities margin financing
• Leveraged foreign exchange trading
• Money market operations
• Investment products for private banking clients (eg equity-linked notes)

Restricted Licensed Banks

• Need to have paid-up capital of HKD100 million, generally branches or subsidiaries of foreign banks and authorized to accept minimum deposits of HKD500,000. Activities, which are mainly investment banking, include:
• Securities and futures dealing
• Securities margin financing
• Leveraged foreign exchange trading
• Syndicated lending/corporate financing
• Money and debt market trading

Deposit-Taking Companies

• Need to have paid-up capital of HKD25 million and usually wholly owned by licensed banks. Can take minimum deposits of HKD100,000.  Specialized services provided include:
• Mortgage and commercial loans
• Trade finance
• Credit cards
• Insurance
• Trustee services
• Investment and treasury operations

[To access practice questions for this topic, go to Examinator.online – Paper 7]

10. Government Policies

Monetary Policy

• Involves government actions to influence the supply and cost of money
• Tight monetary policy usually involves higher interest rates reducing the supply of money, whereas loose monetary policy is the reverse
• Usually carried out by a separate institution – in Hong Kong it is the HKMA
• Hong Kong’s monetary policy is limited due to the linked exchange rate system
• Two approaches to implementing monetary policy:

• • Direct approach: controlling interest rates; limiting lending; and establishing reserve deposit requirements – used in developing economies
  • Market-based approach: use of open market operations (eg quantitative easing) – used in well-developed, free-enterprise economies

Fiscal Policy

• Deals with taxation and government expenditure
• Expansionary fiscal policy is designed to energize a sluggish economy through reduced taxation and/or increased government spending thereby increasing household and business spending
• Contractionary fiscal policy is designed to dampen an overheating economy through increased taxation and/or reduced government spending thereby reducing household and business spending

[To access practice questions for this topic, go to Examinator.online – Paper 7]

11.The US Economy

• As a major trading and investment partner, the US economy has a significant impact on the Hong Kong economy
• US direct investment to Hong Kong is predominantly concentrated in the finance and insurance industries
• As previously noted, the HK dollar is directly linked to the US dollar, with any changes in US interest rates being directly reflected in changes to Hong Kong interest rates

[To access practice questions for this topic, go to Examinator.online – Paper 7]

TOPIC 3 – THE EQUITY MARKET

12. Equity Financing

• Raising equity capital can be for a number of reasons:
  • Start-up capital: funds for starting a new business
  • Expansion capital: funds to expand a current business
  • Recapitalization: funds to restructure a company’s capital, usually involving replacement of debt with equity

[To access practice questions for this topic, go to Examinator.online – Paper 7]

13. Methods of Raising Equity Finance

• Methods include:
  • Initial Public Offering (IPO): raising funds from the public with the resulting shares being listed on a stock market
  • Rights issue: additional equity capital is raised from existing shareholders at a fixed price within a specified period of time
  • Private placement: shares are offered to a specific class of investors without a public offering
  • Dividend investment plan: existing shareholders invest their dividends in further shares providing an ongoing source of equity finance
  • Equity warrants: gives holders the right to purchase shares at a specified price within a particular period of time. Sometimes referred to as subscription warrants
  • Retained earnings: business earnings not distributed to shareholders, available to finance expansion
  • Private equity: equity raised from high net worth individuals or private funds where a public IPO is not feasible. Often used by immature high-growth companies
  • Venture capital: a form of private equity used to fund early stage-businesses

[To access practice questions for this topic, go to Examinator.online – Paper 7]

14. Rights Issues

• A new share issue that is offered to existing shareholders
• Renounceable rights issues allow shareholders to sell their entitlement to subscribe to the new issue
• Non-renounceable rights issues can be exercised or they will lapse if not taken up. There is no right to sell the entitlement
• The number of rights is pro-rated on the existing number of shares held – e.g. a 1 for 3 rights issue will provide one new share for every three shares currently held
• A rights issue subscription price will always be set below the current market price, providing existing shareholders with an incentive to subscribe
• The theoretical price that rights can be sold for is a function of entitlement and subscription, and illustrated by the following example:

Example – theoretical price of rights to a share issue

Charlie holds 200 shares worth HKD2.00 each before a 1 for 4 rights issue is announced, with a subscription price of HKD1.00 per share.  That is, for every four shares held by Charlie, he is entitled to subscribe for one additional share at a price of HKD1.00 per share

** See Paper 7 Bits and Bytes for exam tips on answering Rights Issue questions

[To access practice questions for this topic, go to Examinator.online – Paper 7]

15. Bonus Issues

• Similar to rights issues, however there are no conditions imposed upon shareholders. That is, the shares are issued “for free”, and illustrated by the following example:

Example – theoretical price per share after bonus issue

Charlie holds 200 shares worth HKD2.00 each immediately before a 1 for 4 bonus issue. The price per share immediately after the bonus issue is shown below.

Net effect is an increase in number of shares held and a proportionate decrease in share price

** See Paper 7 Bits and Bytes for exam tips on answering Bonus Issue questions

[To access practice questions for this topic, go to Examinator.online – Paper 7]

16. The Stock Exchange

• The term “stock exchange” refers to the actual infrastructure allowing the trading of stocks. It can be physical and/or electronic
• For shares to be traded on a stock market, they must first be listed. There are two types of listing:
  • Main board listing: publicly listed companies with proven profitability records and size that justify a listing (Main Board of the SEHK)
  • Secondary board listing: smaller companies that do not qualify for a main board listing (GEM)
• Advantages of being listed:
  • Potential to increase capital base
  • Access to a liquid secondary market with instant pricing
  • Increased corporate profile
  • Enhanced employee loyalty, with share offerings as part of remuneration
• Disadvantages of being listed:
  • Spread of ownership
  • Onerous reporting requirements
  • Increased administrative costs

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 17. Privatization of Government-Owned Companies

• The alteration of the legal and management structure of a government-owned company or statutory body to permit private ownership
• The resulting shares may be sold to private entities or listed on a stock exchange, in part or in full
• Government objectives in privatizing companies include:
  • Improving competitiveness and economic efficiency
  • Reducing levels of public debt/increasing public revenue
  • Broadening share ownership
  • Encouraging shareholder scrutiny of management
• Privatization can benefit an economy by:
  • Improving economic competition and efficiency
  • Guiding idle private sector savings into productive investments
  • Creating new finance sources for companies
  • Moving government assets to the private sector where they can be managed more efficiently
• Privatization of a government monopoly will involve industry restructuring to make it work
• Examples of Hong Kong government privatizations are the listing of the MTR Corporation in October 2000 and the Link Real Estate Investment Trust (The Link) in November 2005

[To access practice questions for this topic, go to Examinator.online – Paper 7]

18. Structure of the Stock Market

• Since 30 April 2018, SEHK permits pre-profit/revenue companies to list on the Main Board, subject to certain criteria in the MBLR
• As at August 2019, 2,392 companies were listed on the Main Board with a market capitalization of HKD30 trillion
• Types of securities listed on the SEHK include:
  • Equity securities (ordinary, preference and equity warrants)
  • Debt securities (government and HKMC)
  • Derivatives (derivative warrants, CBBC)
  • Trusts and funds (ETFs and REITs)
• HKEx entered into a Pilot Programme in May 2000 whereby a number of securities listed on NASDAQ and the NYSE are also listed on the SEHK
• Naked short selling is prohibited by the Securities and Futures Ordinance
• The Hang Seng Index was publicly launched on 24 November 1969 with 100 being set as at 31 July 1964
• As at July 2019, the HSI comprised 50 stocks which accounted for 56.6% of total market cap
• The Growth Enterprise Market (GEM) offers small and mid-sized companies an avenue to raise capital. Companies are not required to have a record of profitability, however they must have a positive cash flow of at least HK$30 million in aggregate for the two preceding financial years.  GEM caters for professional and sophisticated investors, operating on the basis of buyer beware
• Securities margin financing is a common Hong Kong practice whereby finance is provided to purchase securities using existing securities as collateral

[To access practice questions for this topic, go to Examinator.online – Paper 7]

19. Stock Connect Quotas

• There are daily quotas for the value of shares traded on both the Northbound and Soutbound links of Stock Connect. The quotas are expected to be expanded as the program evolves.
• The current Northbound trading link quota is:
  • daily quota of Rmb52 billion; and
• The current Southbound trading link quota is:
  • daily quota of Rmb42 billion
• Daily quotas are calculated on a “net buy” basis
  • Sell trades increase the available quota. Investors are always allowed to sell their cross-border securities.  The daily quota is reset to zero at the beginning of each trading day
  • Buy trades are subject to availability in the respective quotas

[To access practice questions for this topic, go to Examinator.online – Paper 7]

TOPIC4 – THE DEBT MARKET

20. Characteristics of Debt

• Different categories of debt have the following characteristics:
  • Short-term or long-term: debt timeframe is also known as debt maturity. Debt issued with a maturity of one year or less is considered short-term; debt issued with a maturity of more than one year is considered long-term
  • Calculation of interest: calculation depends on: whether the rate is fixed or floating; payment period frequency; and simple vs compound
  • Secured or unsecured: a secured loan will give debt holders access to assets of the borrower if the borrower defaults, whereas an unsecured loan has no security guarantee
  • Repayment structure: principal can amortize over time or be repaid at maturity. Interest can be repaid over the period of the loan or added to the capital and repaid at a later date
  • Currency: may be domestic or foreign. Types of foreign debt issued in domestic currency are known as foreign bonds, including:
    • Yankee bonds: US dollar denominated debt issued by non-US issuers in the US
    • Bulldog bonds: GBP sterling denominated bonds issued by non-UK issuers in the UK
    • Samurai bonds: Japanese denominated bonds issued by non-Japanese issuers in Japan
    • Panda bonds: RMB denominated bonds issued by non-Chinese issuers in mainland China

[To access practice questions for this topic, go to Examinator.online – Paper 7]

21. Simple Interest

• Interest is calculated on a constant principal amount throughout period of loan

Formula:  Interest earned over a number of periods

= loan principal x interest rate per period x number of periods

Simple Interest Example

Calculate the amount of simple interest and the total amount obtained at maturity on a deposit of HKD500,000 after four years with an interest rate of 3%

Answer

Interest  = 500,000 x 3% x 4 years

= HKD60,000

Deposit at maturity = 500,000 + 60,000

=  HKD560,000

[To access practice questions for this topic, go to Examinator.online – Paper 7]

22. Compound Interest

• Interest is calculated assuming all interest income earned is reinvested at the same interest rate and with the principal growing each period
•  Amount received at maturity = loan principal x [1 + (int rate per period/int payments per period)]^{periods x payments per period}

Compound Interest Example

HKD10,000 is invested for three years at a compound interest rate of 10% per annum.  What will the deposit be worth at the end of the three-year period and how much interest will have been earned?

Answer

FV  = 10,000 x (1 + (0.10/1)^{3 x 1}

= 10,000 x 1.1³

= HKD13,310

Interest  = 13,310 – 10,000

= HKD3,310

[To access practice questions for this topic, go to Examinator.online – Paper 7]

23. Quoting Interest Rates

• There are three common methods of quoting interests:
  • Nominal interest rates: the most common method where no account is taken of compounding
  • Real interest rates: does not include the inflation element of nominal interest rates

(1 + nominal rate) = (1 + real rate) x (1 + inflation rate)

• • Effective interest rates: includes the effect of compounding. To compare nominal interest rates with different compounding periods, the following formula is used:

Effective interest rate = loan principal x [1 + (nominal int rate/int payments per year)]^{payments per year}

[To access practice questions for this topic, go to Examinator.online – Paper 7]

24. Categorization of Bonds

• There are three types of bonds, which are a form of fixed income securities:
  • Fixed rate bonds: the coupon (interest payment) on a fixed rate bond remains constant throughout the life of the bond. Cash flows paid to investors can be predetermined providing a regular income.  Most common type in Hong Kong
  • Floating rate bonds: the coupon is based on a reference rate, such as HIBOR. The bond’s interest rate is reset at regular intervals to reflect changes in the underlying reference rate
  • Zero coupon bonds: no coupons are paid during the life of the bond. These bonds are issued at a discount to face value with the full principal being repaid on maturity

[To access practice questions for this topic, go to Examinator.online – Paper 7]

25. Pricing of Zero Coupon Debt Securities

• Zero coupon debt securities are issued at a discount to face value and are redeemed at face value, thereby providing a capital gain. As the name suggests, no coupons are paid
• The implied interest rate of the security is referred to as the yield
• A zero-coupon bond with a face value of HK$100, with three years to maturity, providing an annual yield of 5%, will be priced at HK$86.38

PV =  100/(1 + 0.05)³

      = 86.38

To access practice questions for this topic, go to Examinator.online – Paper 7]

26. Pricing of Coupon Debt Securities

• The price/value of a coupon security is the sum of the present values of all future cash flows
• Future cash flows comprise of coupon payments and the principal repayment
• A three-year 10% coupon bond, with a face value of HK$100, providing a yield of 8% will be priced at HK$105.17

[To access practice questions for this topic, go to Examinator.online – Paper 7]

27. Yield versus Price

• The yield of a security is its effective annual return expressed as a percentage of the current market price and is determined by a number of factors, including:
  • Risk profile: the higher the risk of a security, the higher the risk premium within the yield, resulting in a lower price
  • Term: investors who invest for the longer term, expect a higher return (yield) to compensate for lack of liquidity and opportunity cost
  • Taxation: securities offering tax benefits will trade at lower yield as they are more attractive than similar securities without benefits
• Remember: The higher the yield, the lower the price, and the lower the yield, the higher the price

[To access practice questions for this topic, go to Examinator.online – Paper 7]

28. What is the Yield Curve?

• The yield curve is a line plotting the yields of selected benchmark securities of the same type, with different maturities from short- to long-term
• Yield curves are considered by country and by market and are used to forecast the future direction of interest rates and inflation
• Benchmark securities selected are usually highly rated government-issued debt securities, such as US treasury bonds
• Non-government securities, such as corporate debt, are considered to be higher risk than government securities. Yields will be above those of government debt reflecting a premium that compensates investors for the higher risk

Positive or Normal

Yield increases with an increase in term to maturity.  The longer the term, the greater the uncertainty, the higher the required return.  Consistent with expectations of rising inflation.

Negative or Inverse

Opposite to the positive yield curve where longer term interest rates are expected to be lower than current and short-term interest rates.

Flat

Can reflect expectations of stable interest rates or the transition from a positive to a negative yield curve, or vice versa.

[To access practice questions for this topic, go to Examinator.online – Paper 7]

29. Repurchase Agreements

• One party sells securities to another in return for cash, with an agreement to repurchase equivalent securities at an agreed (higher) price, on an agreed future date
• The repo buyer (who sells the securities) is able to source funds to cover any liquidity shortfall
• A repo can be thought of as a short-term secured loan with collateral
• Widely used by central banks and the money market to relieve money market shortages
• In Hong Kong, banks can obtain temporary liquidity from the HKMA (discount window) by using repos with EFBs and EFNs as collateral

[To access practice questions for this topic, go to Examinator.online – Paper 7]

30. Structured Finance and Securitized Debt

• There are three sectors of the structured finance market:
  • Securitization: takes assets, such as individual mortgages, and repackages the underlying the cash flows into relatively liquid securities. The market consists of mortgage-backed securities (MBS) and asset-backed securities (ABS). Although the government is keen to develop this market, progress has been slow
  • Collateralized debt obligations (CDOs): a series of underlying loan products repackaged into a number of security tranches with different characteristics
  • Asset-backed commercial paper: a wide variety of debt backs the issuance of commercial paper

[To access practice questions for this topic, go to Examinator.online – Paper 7]

31. Short-term Debt Securities

• Interbank placement funds: large amounts of cash move between AIs and the HKMA on a daily basis, with AIs being major participants in the interbank money market. HIBOR, which is set at 11.00am each day, is an average of the quoted yields from 20 selected AIs, and is given for 1-month, 3-month and 6-month tenors
• Government bills: Exchange Fund Bills issued by the HKMA through the Exchange Fund. Yields for 91-day, 182-day and 364-day bills are considered as Hong Kong’s risk-free rates
• Negotiable certificates of deposit: AIs issue certificates of deposit (CDs) to certify particular amounts of money deposited with them. As AIs are the issuers, they are considered low-risk instruments.  Holders are entitled to the money on deposit at maturity, which may range from a few days to six months
• Bankers’ acceptances: or bills of exchange are issued by individuals/corporations and accepted by banks. A bank agrees to pay a bill’s face value to the holder at the bill’s maturity
• Commercial bills: issued by corporations and accepted by banks. Used to finance working capital or business expansion.  Tend to trade at higher yields than bankers’ acceptances
• Promissory notes/commercial papers: agreements to repay certain amounts of money at specified future dates (usually less than six months). Only involve two parties: issuers and holders

[To access practice questions for this topic, go to Examinator.online – Paper 7]

TOPIC 5 – THE FOREIGN EXCHANGE AND DERIVATIVES MARKETS

32. The Foreign Exchange Market

• The foreign exchange market is the world’s largest global financial market
• Also referred to as the forex or FX market
• An OTC market which is traded 24 hours a day without any specific geographic location
• Trades covering currencies at current exchange rates are known as the spot market; currencies traded for delivery at a future date at an agreed rate are known as the forward market
• Participants in the FX market quoting prices for currencies are known as dealers or traders
• The majority of currencies in the FX market are quoted against the US dollar
• When a pair of currencies are quoted against each other without reference to the US dollar, the quote is known as a cross rate
• If the USD:HKD rate is quoted as 7.80, this means USD1 = HKD7.80

[To access practice questions for this topic, go to Examinator.online – Paper 7]

33. Exchange Rate Regimes

• Floating rates: a currency’s value is determined by market supply and demand
• Fixed rates: a government/monetary authority sets a fixed rate of exchange with another currency and will intervene in the FX markets to ensure that the fixed rate is maintained
• Linked rates: a type of fixed rate regime where the local currency is linked (or pegged) to a particular foreign currency. Usually, there is a trading range around the target rate, which is monitored by the government/monetary authority.  The HK dollar has a linked exchange rate with the US dollar

The Hong Kong Currency Board System

• Note issuing banks deposit equivalent amount of US dollars with the HKMA for issuing HK dollar notes
• Therefore, the Hong Kong monetary base is fully backed by US dollars

[To access practice questions for this topic, go to Examinator.online – Paper 7]

34. Calculating Currency Forward Exchange Rates

• Currency forwards are agreements to buy or sell a quantity of currency for delivery at some time in the future, at an exchange rate fixed at the time of the agreement
• Forward rate = Spot rate x [(1 + interest rate of numerator country)/(1 + interest rate of denominator country)]

Currency Forward Exchange Rate Example

Calculate the forward exchange rate with the following information:

• GBP/USD spot rate: 1.35
• UK interest rate: 3% pa
• US interest rate: 0.75% pa

Answer

F        = 1.35 x (1 + 0.0075)/(1 + 0.03)

= 1.32

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 35. Functions of Derivatives

• There are four functions of derivatives:
  • Risk management: a “price” can be fixed now protecting (hedging) against future adverse price movements
  • Reduction in borrowing costs: interest rate derivatives are used to reduce borrowing costs
  • Increased flexibility: dealers/traders are able to choose between trading derivatives or the underlying assets, providing trading strategy flexibility
  • Arbitrage: locking in to a risk-free profit, thereby keeping markets accurately priced
• Derivatives are a zero-sum game where one party will gain and the other will lose

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 36. Exchange-Traded vs Over-The- Counter Derivatives

• Exchange-traded derivatives are traded on an organized exchange. The oldest commodity exchange in the United States is the Chicago Board of Trade (CBOT), which trades agricultural commodity futures such as, corn, oats and soybeans, as well as financial derivatives
• The most common exchange-traded derivative is the future
• Examples of exchange-traded derivatives are:
  • Index futures and options: value derived from a stock market index
  • Warrants: value usually derived from underlying stocks
  • Stock futures and options: value derived from underlying stocks
  • Treasury bill futures and options: value derived from underlying benchmark treasury bills
  • Treasury bond futures and options: value derived from underlying benchmark treasury bonds
• As with any exchange-traded transaction, counterparty risk is eliminated as the exchange will act as counterparty to both buyer and seller
• Over-the-counter (OTC) derivatives dominate the derivatives market, with much higher volumes than the exchange-traded market
• Unlike standardized exchange-traded derivatives, OTC derivatives are tailor-made/customised to the requirements of the counterparties

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 37. Futures

• An agreement to buy or sell an underlying asset at a specified price and future date
• Exchange traded with standardized features
• Initial margin is paid at the beginning of the contract, with margin calls following, if the position loses sufficient money – daily marking to market will trigger margin calls
• Futures are usually closed out, prior to expiry, with a buy being cancelled by a sell and vice versa. A small number are settled by physical delivery

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 38. Forwards

• Two parties agree to buy and sell an asset at an agreed price, at an agreed time in the future
• Unlike futures, forward contracts are traded OTC and terms are not standardized
• There are no margin/collateral requirements to assure contract performance, resulting in credit (counterparty) risk
• Forward rate agreements (FRAs) are forward contracts between two parties that lock them into an agreed fixed interest rate over a stated period of time

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 39. Swaps

• Two parties agree to exchange (swap) income streams derived from a portfolio of assets or liabilities
• The most popular types are interest rate swaps and currency swaps, which are traded OTC and are highly customized
• With interest rate swaps, loan principals are not swapped and net interest is exchanged between parties
• With currency swaps, principals are swapped and gross interest payments are exchanged

** See Paper 7 Bits and Bytes for exam tips on answering Swaps questions

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 40. Options

• A call option is the right to buy an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
• A put option is the right to sell an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
• Taking up the right is known as exercising the option
• The seller (writer) of an option has an obligation to sell/buy when the option is exercised by the buyer (holder)
• Unlike futures and forwards, the buyer of an option has no obligation to sell or buy the underlying asset, but will exercise if it is profitable to do so
• The price paid to purchase an option is known as the option premium and is paid to the option seller
• Examples of exchange-traded options are: options on shares; options on indices; and options on futures
• Examples of OTC options are: interest rate options; currency options; and exotic options
• A swaption is an option to enter into a swap agreement

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 41. Exotic Derivatives

• Exotic derivatives available in Hong Kong include:
  • Structured notes have features similar to options or swaps. An example would be the Accumulator on stocks, which is a contract to buy stocks at specified intervals at a fixed strike price, subject to a “knock out” terminating the contract
  • Equity-linked notes (ELNs) have features of both options and debt
  • HIBOR-linked deposits, which are linked to HIBOR, have features of both options and debt

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 42. Exchange-Traded Derivatives

• Contracts traded on the Hong Kong Futures Exchange are:
  • Equity and index derivatives: equity derivatives include stock futures and stock options. Index derivatives include:
    • • HSI futures and options
      • Mini-HSI futures and options
      • HSCEI futures and options
      • Mini-HSCEI futures
      • Dividend futures
      • HSI Volatility Index futures (VHSI)
    • Global fund managers use HSI index futures and options to hedge or speculate on the direction of the Hong Kong market
    • Mini-HSI derivatives are smaller versions of HSI products designed for retail investors with a multiplier of HKD10 instead of HKD50 per index point
    • HSCEI derivatives are offered by HKEx to meet the growing needs of investors interested in China related securities
    • Dividend futures is the dividend payoff from stock index constituents for one calendar year
    • VHSI futures allow investors to manage volatility risk in HSI or Hong Kong’s stock market in general

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 43. Trading and Settlement of Derivatives

• The trading and settlement of derivatives in Hong Kong can be summarized as follows:
  • A derivatives trade (futures and options) is matched using HKATS (Hong Kong Automated Trading System)
  • The trade is registered with SEOCH/HKCC through an Exchange Participant with clearing rights
  • The HKCC/SEOCH assumes the role of counterparty between buyers and sellers, known as novation, thereby eliminating any counterparty risk
  • Initial margin is the minimum required level of margin set by the HKFE. Firms may set higher margin levels for their clients
  • Maintenance margin represents the minimum amount of protection against potential losses at which the HKFE participant will allow its clients to carry a position or a portfolio. If the margin falls below the maintenance level, the account must be re-margined back to the initial margin level
  • Cash-settled contracts are cleared and settled by HKCC
  • Physical delivery involves the seller of a contract physically delivering the underlying asset to the buyer. The HKCC must be informed

[To access practice questions for this topic, go to Examinator.online – Paper 7]

TOPIC 6 – FINANCIAL RISK MANAGEMENT

44. Fundamental Risk Management Techniques

• Risk management involves identifying and evaluating risk, followed by implementation of risk management techniques to minimise risk exposure
• Fundamental risk management techniques are:
  • Risk avoidance: particular activities, which could result in loss, can be avoided. An example would be avoiding the business of securities margin financing
  • Risk reduction: techniques can be employed to reduce potential risk. An example would be buying foreign currency forward to lock into an exchange rate now for future settlement
  • Risk transfer: usually, at a cost, risk can be transferred. An example is taking out an insurance policy
  • Risk retention: the cost of the above three techniques may be prohibitive, making risk unavoidable. An example could be remaining exposed to foreign currency movements, allowing gains as well as losses

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 45. Types of Financial Risk

• Credit risk is the chance that a counterparty does not honour a legal obligation. This could be defaulting on a debt repayment or not honouring a forward contract commitment.  Also referred to as counterparty risk
• Settlement risk is the risk that a transaction does not settle as intended, in terms of timing
• Market risk is the risk of loss due to unfavourable movements in market prices, including stock prices, interest rates, currency rates and commodity prices
• Basis risk is the risk of loss from derivative and asset prices being unaligned
• Liquidity risk is the risk of loss from an inability to sell at fair market value due to a shortage of available buyers
• Operational risk is the risk of loss from failures or faults in processes, procedures or trading and settlement systems

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 46. Other Risks

• Legal risk is the risk of loss from unenforceability of contracts
• Reputational risk is the risk of loss from reputational damage
• Strategic risk is the risk of loss from implementing, or not implementing, new initiatives or strategies
• Systemic risk is the risk of loss from the breakdown of an entire system, eg the clearing and settlement system of the securities market

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 47. Identifying Risk

• The main requirement for identifying risk is an understanding of the business. Unintended losses can often be put down to poor understanding of a business, thereby making it difficult to know where the underlying risks lie

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 48. Measuring Risk

• Risk is measured using the mathematical concept of standard deviation, which measures dispersion around an expected value
• Standard deviation is the square root of the variance. Variance is calculated by applying probabilities to different possible returns in relation to the expected return

** See Paper 7 Bits and Bytes for exam tips on answering risk computational questions

[To access practice questions for this topic, go to Examinator.online – Paper 7]

49.Calculation of Expected Return

ER  =  Ʃ p_ir_i

• ER   =  expected return
• p_i      =  probability of return i
• r_i      =  % return i

Example

Dead Certainty Limited has the following return probabilities for the next year.  Calculate the expected return

Solution

** See Paper 7 Bits and Bytes for exam tips on answering expected return computational questions

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 50. Measuring Market Risk

• There are a number of market risk measures, including:
  • Value at Risk (VaR): a popular measure of market risk used to calculate, at specified confidence levels, the likely change in the value of a portfolio of securities from a change in market conditions. VaR indicates the maximum daily loss likely to occur at, say, a 99% confidence level
  • Stress testing: involves testing a portfolio of securities to observe how it performs when particular market changes occur
  • Duration: measures the sensitivity of bond prices to changes in interest rates, taking into account yields, maturity dates and coupon cash flows
    • Duration approximates to the percentage bond price change from a 1% change in interest rates
    • The higher the yield, the lower the duration
    • The greater the time to maturity, the higher the duration
    • The higher the coupon, the lower the duration
  • Dollar value per basis point: measures the change in value of a debt security for a 0.01% change in yield (ie a single basis point)
  • Option sensitivity measures: measure the sensitivity of an option price to changes in time to expiry, volatility and security prices

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 51. Credit Ratings

• Credit rating agencies (CRAs) assign credit ratings to debt issuers, based on their ability to repay their debts
• Moody’s, S&P and Fitch are the major CRAs
• With debt issues on the increase, investors increasingly use published CRA ratings to help with investment decisions

Credit Rating and the Sub-Prime Crisis

• In 2007/2008, the credit ratings of collateralized debt obligations (CDOs) were of high investment quality when the underlying assets were of very poor quality
• Rating models were found to be deficient as they did not account for the default probability among sub-prime lenders or have considered the change in property prices

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 52. Novation

• Novation is used by securities exchanges to minimize credit (counterparty) risk
• In Hong Kong, for example, the securities clearing house will act as the counterparty, as buyer or seller, to each purchase/sale transaction completed on the stock exchange
• Each transaction is honoured by the clearing house as it is backed by a compensation fund made up of brokers’ contributions, a bank guarantee and an insurance policy

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 53. Financial Risk Management Techniques

• Using derivatives: derivatives can be used to manage traded market risk. Through credit default swaps, they can also be used to manage credit risk
• Exposure netting: used by global corporations and fund managers, this technique involves setting off gains in one asset against losses in another. Parties can avoid making full settlement by netting off exposures
• Documentation: an important credit risk management tool for corporations. An example is the global master agreement covering OTC derivative transactions produced by the International Swaps and Derivatives Association (ISDA)
• Securities margin financing: securities are provided as collateral and marked-to-market on a daily basis. If the investor reaches a particular collateral loss threshold, payment is required to reduce the shortfall to zero
• Mark-to-market: book/collateral value is adjusted to reflect its current market value
• Role of market makers: market makers promote market liquidity, thereby minimizing traded market risk
• Limit setting: securities exchanges set limits as a means of managing market and credit risks

[To access practice questions for this topic, go to Examinator.online – Paper 7]

TOPIC 7 – APPLICATIONS IN THE FINANCIAL SECTOR

 54. What is Corporate Finance?

• Application of a range of economic and financial principles to maximize the overall value of a business
• An art more than a science
• Financial solutions for companies are tailored to meet the individual company’s specific strategic and financial needs
• Helps companies achieve their goals, a major one of which is maximizing the wealth or overall value of the business
• Critical to the financial and securities markets which depend upon corporations’ need for cash
• Professionals work with different companies to help them achieve the optimum financial solutions for their particular needs

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 55. The Work of Corporate Finance Professionals

• The work involved includes:
  • Providing strategic and financial advice to corporations
  • Valuing companies, specific assets or specific company securities
  • Raising capital in the form of debt, equity and hybrid combinations
  • Lending to companies
  • Business and financial restructuring
  • Advising on merger and acquisition strategies
• To perform the work, individuals require a high level of local and international financial/legal/taxation knowledge, including:
  • Accounting and financial analysis
  • Corporate and securities law
  • Taxation
  • International experience

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 56. What is Asset Management?

• Assets managed by investment professionals
• The assets are managed funds, also known as collective, pooled or investment funds
• Managed funds include: unit trusts, mutual funds, retirement or corporate funds and private equity funds
• Investment professionals (fund or asset managers) invest the pooled monies in assets such as equities, debt securities, real estate and/or cash
• Hong Kong attracts fund managers for many reasons, including:
  • Central location in Asia
  • Clear and respected regulatory regime
  • Just and equitable legal system
  • English language and administration skills
  • Simple and low-tax system
  • A route to the mass market of mainland China
  • A world class communications system
  • A highly liquid stock market
  • A deep pool of professionals supporting the fund management industry

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 57. Why is Asset Management Important?

• Individual savings are held in pension funds, unit trusts and mutual funds
• According to the Investment Fund Fact Book 2014, mutual funds worldwide involved the management of USD30 trillion in total net assets. Accordingly, decisions made by large global fund managers can affect particular stocks, market sectors or entire countries
• Fund managers can invest in a broader range of investments than individuals can
• Key benefits of managed funds are access to professional investment management services and diversification
• The SFC has set standards on diversification in the Code on Unit Trusts and Mutual Funds, which include the following requirements:
  • A fund is limited to holding 10% of total net assets in the securities of a single issuer
  • A fund is limited to holding 10% of the ordinary shares of a single issuer

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 58.The Work of Asset Management Professionals

• The work involved includes:
  • Developing asset allocation strategies
  • Analysing past, and forecasting future, performance of markets, companies and securities
  • Analysing all publicly available information on specific companies
  • Valuation of securities
  • Buying/selling large amounts of securities at best prices
  • Monitoring performance of and managing exposure to specific securities
• To perform the work, individuals require a high level of local and international financial knowledge, including:
  • Macro- and micro-economic analysis, including global economic and political analysis
  • Statistical and quantitative analysis
  • Accounting knowledge and financial analysis skills
  • Valuation of a wide variety of financial assets
  • Finance and investment portfolio theory

[To access practice questions for this topic, go to Examinator.online – Paper 7]

59.What is Financial Advising?

• A process to help individuals identify and achieve their personal and financial goals through a comprehensive financial plan
• Financial advising (aka financial planning) is an ongoing process of relating a client’s changing needs and financial position to the changing environment
• Financial products provide different risk/return combinations and it is a financial planner’s job to match financial strategies and actions to a client’s goals. These goals can include:
  • Enjoy a particular level of income or savings
  • Achieve a certain asset value or return on asset
  • Save/invest within an acceptable risk level
  • Achieve liquidity and flexibility needs
  • Maximize after-tax returns within acceptable risk levels
• It is a structured process to help individuals and families meet their financial goals and objectives
• Accumulated savings of the baby boomer generation, members of whom are enjoying increased life longevity, has stimulated demand for financial advisory services
• Increased international mobility has placed more emphasis on international tax planning
• Increased sophistication of investment products requires individuals to source expert investment advice
• The wealth creation phase helps clients accumulate savings for retirement, while providing finance for all forms of family expenditure
• The wealth protection phase helps clients who are reaching or have reached retirement, to live the lifestyle that they planned for

[To access practice questions for this topic, go to Examinator.online – Paper 7]

 60.The Work of Financial Advisers

• The work involved includes:
  • Establishing a client’s current financial position
  • Establishing a client’s short- medium- and long-term goals and objectives
  • Preparing an investment strategy and risk recommendations to meet client objectives
  • Selection of investment and insurance products relevant to a client’s investment strategy
  • Presenting and implementing the investment plan
  • Ongoing monitoring and management of client investments and expectations

[To access practice questions for this topic, go to Examinator.online – Paper 7]