Quiz: Origins and Market Development

This is a draft, shown for review before publication.

6 questions to check your understanding of the chapter “Origins and Market Development”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   In the Edo-period Dojima Rice Exchange, choaimai akinai was the trading of representative grades of rice on the books. How was it settled in principle?

   1. A.Rice and payment were handed over within 4 days of each trade
   2. B.At expiry, the buyer received rice tickets and exchanged them for rice
   3. C.It was settled by the difference between the sale and purchase, without delivering rice
   4. D.For each trade, the physical rice was inspected and settled
   Answer and explanation

   Answer: C

   In choaimai akinai, trades were recorded on the books and settled by the difference, without moving rice or payment each time. Delivery of the physical rice was the exception.

   Shomai akinai, the trading of rice tickets, required delivery within 4 days and was settled by physical delivery. If you confuse the two markets, the first option becomes easy to choose. Exchanging rice tickets for rice at expiry, and inspecting the physical rice before settling, are not how choaimai akinai was settled.

   Learn more: The Dojima Rice Exchange

2. Question 2

   In 1925, the Chicago Board of Trade (CBOT) established a clearing corporation. Before that, its clearinghouse had handled the settlement of members' trades. Compared with that clearinghouse, what was different about the clearing corporation?

   1. A.It was the first mechanism to reduce the effort of settlement by netting members' receipts and payments against each other
   2. B.It was the first to take over settlement of a trade when a member could not pay
   3. C.It was the first mechanism to punish members who broke their promises by shutting them out of the trading floor
   4. D.It was the first to require members to deposit margin to ensure that trades were honored
   Answer and explanation

   Answer: B

   Members bought shares in the clearing corporation and deposited margin, and when a member could not pay, the clearing corporation took over settlement. If losses exceeded the margin, they were covered from the clearing corporation's capital. The 1925 clearing corporation corresponds to a central counterparty that becomes the counterparty to every trade on the exchange.

   Netting of payments and receipts was the work of the earlier clearinghouse. That clearinghouse had made no commitment to take over settlement when a member could not pay. Shutting members out of the trading floor was a penalty used in the early days. Rules requiring initial margin and variation margin had already been adopted by around 1873.

   Learn more: The Development of Futures Exchanges

3. Question 3

   Futures on the S&P 500 stock index became tradable on an exchange because of what development?

   1. A.Rules on the grades of grain to be delivered were put in place
   2. B.The exchange made standardized contracts the unit of trading
   3. C.A clearinghouse that netted members' receipts and payments against each other was established
   4. D.A method of settling only the difference at expiry was adopted
   Answer and explanation

   Answer: D

   Eurodollar futures were a contract that adopted cash settlement: at expiry, only the difference is settled, with no delivery of the underlying. Cash settlement made futures possible on things that cannot be delivered, such as equity index futures. Futures on the S&P 500 began trading on the International Monetary Market (IMM) in 1982.

   The rules on grades were put in place after the exchange was founded, together with rules on trading conduct for grain. Making standardized contracts the unit of trading was what the options listed by the Chicago Board Options Exchange did. A clearinghouse that nets receipts and payments is a mechanism to reduce the effort of settlement. That is a separate matter from why futures on things that cannot be delivered became possible.

   Learn more: The Development of Futures Exchanges

4. Question 4

   What did the research of Black and Scholes, and of Merton, published in 1973 show?

   1. A.Valuing an option does not require a risk premium, because it is already included in the stock price
   2. B.With the interest rate set at zero and stock prices allowed to go negative, a valuation that fits reality is possible
   3. C.Every input to the formula, including volatility, can be observed directly in the market
   4. D.A risk-free position can be kept without changing the ratio of stock to options, even while the stock price moves a lot
   Answer and explanation

   Answer: A

   Before 1973, options were valued by discounting the expected value of the option at expiry back to the present, and the discount rate required a risk premium. This extra return reflects investors' attitude toward risk, so it was hard to observe. The three showed that a risk-free position can be built by combining the stock and the option, and so a risk premium is not needed. The risk premium does not disappear; it is already included in the stock price.

   Setting the interest rate at zero and allowing stock prices to go negative were the assumptions of Bachelier's 1900 formula, which did not fit reality. Among the inputs to the formula, volatility is the only one that cannot be observed directly. A risk-free position can be built while the stock price moves only a little. When the stock price or the remaining time changes, the ratio of the combination has to change as well.

   Learn more: The Arrival of Black-Scholes

5. Question 5

   What was the background to the transaction that the World Bank and IBM entered into in 1981?

   1. A.US dollar interest rates were lower than Swiss franc rates, and IBM wanted to borrow in US dollars
   2. B.IBM had borrowed large amounts of currencies in which the World Bank's borrowing had reached its limit
   3. C.The US government had limited the World Bank's US dollar borrowing, and the limit had been reached
   4. D.The World Bank and IBM wanted to exchange fixed-rate and floating-rate payments
   Answer and explanation

   Answer: B

   At the time, Swiss franc and Deutsche mark interest rates were roughly half of US dollar rates. The World Bank's borrowers wanted these currencies, but the governments of both countries limited the World Bank's borrowing, and the limits had been reached. IBM had borrowed large amounts of these currencies and wanted to increase its US dollars. Through Salomon Brothers, IBM exchanged the currencies it had borrowed for the World Bank's US dollars. The World Bank describes this as the first formal currency swap in the world.

   It was the Swiss franc and the Deutsche mark, not the US dollar, whose interest rates were low. It was the governments of Switzerland and Germany, not the United States, that limited the borrowing. An interest rate swap, which exchanges fixed-rate and floating-rate payments, is a different transaction from a currency swap. The World Bank had carried one out by the end of 1985.

   Learn more: The Swap Market and ISDA

6. Question 6

   Several Lehman Brothers dealing entities failed in September 2008. What did a law firm's 2009 commentary say the failures highlighted about many 1992 versions of the ISDA Master Agreement?

   1. A.That a method of collecting market quotations to calculate the payment is difficult when markets are disrupted
   2. B.That the legal effect of netting provisions was still not certain in each country
   3. C.That there is a gap between agreeing the terms of a trade and signing the contract
   4. D.That many major dealers had not agreed to amend to the 2002 version's calculation method
   Answer and explanation

   Answer: A

   Many 1992 versions required a method that collects market quotations to calculate the payment (Market Quotation). The failures of 2008 and the turmoil that followed highlighted that this method is difficult when markets are disrupted.

   The close-out netting provision was first included in the 1987 master agreement. Its effectiveness was debated around the world, and legislation was enacted afterward. The gap before signing is a legal concern from 1987 that standardized contract documents may have eased. In August 2008, nearly all the major dealers had entered into an agreement to amend their 1992 agreements with one another to use the 2002 version's Close-out Amount method.

   Learn more: The Swap Market and ISDA