Quiz: Market Participants

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6 questions to check your understanding of the chapter “Market Participants”. 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

   Which of the following does a securities company do as a broker?

   1. A.Buys Nikkei 225 Futures on its own judgment and with its own funds, and sells them if the price rises
   2. B.Keeps quoting buy and sell prices on the exchange for its own account as a market maker
   3. C.Places a futures order received from a customer on the exchange as an order on the customer's behalf
   4. D.Enters into an interest rate swap with a customer and receives the fixed rate as the customer's counterparty
   Answer and explanation

   Answer: C

   A broker does not become the counterparty to a trade; it passes customers' orders on to the exchange. Only trading participants and similar firms can trade futures on an exchange. Securities companies and similar firms therefore place other investors' orders on the exchange as orders on the customers' behalf. As a hypothetical example, suppose a securities company buys 1 unit of Nikkei 225 Futures (the Nikkei 225 value multiplied by 1,000 yen) at 30,000 on a customer's order and later sells it at 31,000 or 29,000. The 1 million yen difference belongs to the customer, whether it is a gain or a loss.

   The other three are things a dealer does for its own account (with its own funds and bearing its own profit or loss). The gain or loss on futures bought on the company's own judgment and with its own funds belongs to the securities company. When a trade is matched against a market maker's quote, the trade is for the market maker's account. Acting as a customer's counterparty in an OTC interest rate swap and receiving the fixed rate is also a dealer's role, and the dealer loses out if rates rise. Unlike a broker, a dealer can gain or lose from market moves until the hedge is in place.

   Learn more: Dealers and Brokers

2. Question 2

   As a hypothetical example, Company A expects to receive export proceeds of USD 1 million in three months. It entered into an FX forward with a bank to sell USD 1 million at 150 yen per dollar. Its exports then fell to USD 700,000, so Company A decided to buy the missing USD 300,000 at that day's rate in three months and deliver them. If the rate on that day is 160 yen per dollar, what is the gain or loss on the missing USD 300,000?

   1. A.A loss of 7 million yen
   2. B.A loss of 10 million yen
   3. C.Zero
   4. D.A loss of 3 million yen
   Answer and explanation

   Answer: D

   Even if the actual business turns out smaller than the hedge, the FX forward obligation remains as it is. Company A pays 300,000 × 160 = 48 million yen to buy the dollars. It receives 300,000 × 150 = 45 million yen by selling them under the FX forward, a net loss of 3 million yen. If the rate were 140 yen per dollar, it would pay 42 million yen for the dollars and sell them for 45 million yen, a gain of 3 million yen.

   The USD 700,000 of export proceeds can be converted at the FX forward's 150 yen, so the only loss left is the 3 million yen on the missing USD 300,000.

   A loss of 7 million yen multiplies the 10-yen difference between 160 yen and 150 yen by the USD 700,000 of export proceeds instead of the missing USD 300,000. A loss of 10 million yen multiplies the same 10 yen by the whole USD 1 million. Zero is the answer you get if you assume the obligation goes away for the amount by which exports fell. An FX forward generally cannot be canceled before maturity, and a cancellation settlement payment may be required if Company A cancels for its own reasons.

   Learn more: How Corporates Use Derivatives

3. Question 3

   As a hypothetical example, a life insurer, which is an institutional investor, holds USD 100 million of US Treasuries. When the current rate is 150 yen per dollar, it enters into an FX forward to sell USD 100 million in one year at 147 yen per dollar. Assume the dollar price of the bonds does not change, and ignore interest. If the rate in one year is 140 yen per dollar, what is the gain or loss on the FX forward?

   1. A.A loss of 0.3 billion yen
   2. B.A gain of 0.7 billion yen
   3. C.A gain of 1.0 billion yen
   4. D.A loss of 0.7 billion yen
   Answer and explanation

   Answer: B

   Under the FX forward, the insurer can sell dollars worth 140 yen for 147 yen, so the gain is USD 100 million × (147 − 140) = 0.7 billion yen. Without the hedge, the yen value falls from 15.0 billion yen to 14.0 billion yen, a drop of 1.0 billion yen. Adding the gain on the FX forward gives 14.7 billion yen. If the rate instead moves to 170 yen per dollar (a weaker yen), the FX forward produces a loss of 2.3 billion yen, and the total is again 14.7 billion yen. Currency hedging, which reduces currency risk in this way, prevents losses from a stronger yen, but in exchange it also gives up gains from a weaker yen.

   A gain of 1.0 billion yen assumes the dollars can be sold at today's rate of 150 yen. The FX forward rate is set by the current rate and the difference between the two currencies' interest rates. When dollar interest rates are higher than yen rates, the yen is stronger at the forward rate than at the current rate (fewer yen per dollar). The 147 yen in this example assumes this, and the 0.3 billion yen difference from today's 150 yen is the hedging cost. A loss of 0.3 billion yen counts only this hedging cost. A loss of 0.7 billion yen reverses the direction of the gain or loss.

   Learn more: How Institutional Investors Use Derivatives

4. Question 4

   As a hypothetical example, a pension fund with 1 trillion yen of assets holds 20 billion yen more domestic equities than its target. It sells that 20 billion yen of equities to bring its asset allocation back to the target. Because it takes several days to finish selling the stocks, the fund first sells 20 billion yen of equity index futures. It buys the futures back once it has finished selling the stocks. Assuming the stocks held and the futures move by the same percentage and ignoring fees, which statement about this futures trade is correct?

   1. A.The futures make no gain or loss however prices move, and only the sale proceeds change
   2. B.If stock prices fall before the sale is finished, the sale proceeds fall and the futures also make a loss
   3. C.If stock prices rise before the sale is finished, the stocks sell for more but the futures make a loss
   4. D.It keeps the gain when stock prices rise and prevents only the loss from a fall
   Answer and explanation

   Answer: C

   The futures sold in advance offset the effect of price moves until the stocks are sold. If stock prices rise 5%, the proceeds from selling the stocks rise to 21.0 billion yen. The futures make a loss of 1.0 billion yen, so the total is 20.0 billion yen. If stock prices fall 5%, the proceeds fall to 19.0 billion yen, but the futures make a gain of 1.0 billion yen, and the total is again 20.0 billion yen. The fund can restore its allocation at an amount close to the stock prices at the time it decided to sell, but it gives up any gain from prices rising afterward.

   Saying the futures make no gain or loss overlooks that futures that were sold also gain or lose in the opposite direction to stock prices. Saying the futures also make a loss when prices fall reverses the direction of the gain or loss on futures that were sold. Saying the gain from a rise is kept overlooks the loss on the futures. A trade that seeks profit by expecting prices to fall is speculation. The futures in this example are a temporary substitute for selling the stocks. Some investors, such as Japan's Government Pension Investment Fund (GPIF), use equity index futures only as a temporary substitute for selling assets they hold, and do not trade them for speculative purposes.

   Learn more: How Institutional Investors Use Derivatives

5. Question 5

   As a hypothetical example, Bank A has a 10 billion yen loan at a fixed rate of 2.0%, funded by deposits. It resets the deposit rate every year to the same level as that year's benchmark rate. Bank A enters into an interest rate swap with a notional amount of 10 billion yen, paying a fixed rate of 1.5% and receiving the benchmark rate. In a year when the benchmark rate is 1.0%, what is the net amount on the swap?

   1. A.A payment of 50 million yen
   2. B.A payment of 150 million yen
   3. C.A payment of 100 million yen
   4. D.Zero
   Answer and explanation

   Answer: A

   Bank A pays the fixed rate of 1.5% and receives the benchmark rate of 1.0%, so it pays the net 0.5%. 0.5% of 10 billion yen is 50 million yen. That year, the loan interest is 200 million yen and the deposit interest is 100 million yen. The interest margin without the swap is 100 million yen. Subtracting the 50 million yen paid on the swap leaves a margin of 50 million yen. In a year when the benchmark rate rises to 2.5%, the swap brings in 100 million yen, and even though the deposit interest rises to 250 million yen, the margin is the same 50 million yen.

   A payment of 150 million yen counts only the fixed rate of 1.5% that Bank A pays, without subtracting the benchmark rate it receives. A payment of 100 million yen is the amount of that year's deposit interest, not the net amount on the swap. Zero applies to a year when the benchmark rate equals the fixed rate, 1.5%.

   Learn more: How Regional Banks Use Derivatives

6. Question 6

   Which of the following terms refers to the leverage a hedge fund creates by using derivatives to build positions that move with the underlying asset?

   1. A.Financial leverage
   2. B.Synthetic leverage
   3. C.Gross leverage
   Answer and explanation

   Answer: B

   The Financial Stability Board (FSB) divides leverage into financial leverage and synthetic leverage. Leverage created by positions built with derivatives is synthetic leverage. It lets a fund hold positions larger than its capital with little cash on hand.

   Financial leverage means enlarging positions by raising funds through borrowing, repos and similar means, not through derivatives. Gross leverage is not a type of leverage but a way of expressing its size: the gross positions, excluding cash and similar items, divided by net assets. The gross ratio does not reflect offsetting or hedged positions, so for trades that combine buys and sells it can look larger than the actual risk.

   Learn more: How Hedge Funds Use Derivatives