Chapter 3 · Asset Classes & Financial Markets

The money market is the market for SHORT-DATED debt instruments — typically less than one year to maturity. Used by governments, banks and corporates for short-term financing and for managing liquidity.

Three core money-market instruments to memorise by ISSUER:

T-bills don't pay a coupon — instead they're issued at a discount to par and redeem at par. The investor's return is the difference between the price paid and the par value received at maturity.

A money market fund (MMF) is a pooled vehicle holding T-bills, CDs, commercial paper and other short-dated instruments. Three things to remember:

• Capital preservation is the primary aim — not return
• Daily liquidity — most allow same-day or T+1 redemption
• Low but real risk — MMFs CAN lose money in stress (eg, 2008 "breaking the buck") if their holdings default or face liquidity withdrawal

A repo (sale and repurchase agreement) is a short-term loan secured by securities: the borrower "sells" securities to the lender with an agreement to "repurchase" them at a slightly higher price on a near-future date. The price difference is effectively the interest.

Repos are how banks fund themselves overnight and how central banks add/withdraw liquidity. The repo market sits at the heart of modern financial plumbing.

In some jurisdictions (eg, eurozone, Japan, Switzerland during the 2010s) central banks have set policy rates BELOW zero — meaning depositors PAY to keep money with the bank. Used as an unconventional tool to discourage saving and encourage spending/lending.

Implication for retail: most banks don't pass negative rates onto small savers (they'd just withdraw cash). But corporate deposits and large institutional deposits often DO pay negative rates.

In a quote like EUR/USD 1.1640 / 1.1660:

• EUR is the BASE currency (always 1 unit of)
• USD is the QUOTE (or counter) currency
• 1.1640 = bid (price the dealer will BUY the base for)
• 1.1660 = offer/ask (price the dealer will SELL the base for)
• Spread = offer − bid = 0.0020 = 20 pips

Standard spot FX settlement for major currencies = T+2 (two business days after trade date). Exception: USD/CAD settles T+1.

Forwards settle on the agreed forward date (eg, 1m, 3m, 6m forward).

Covered interest rate parity (CIP) ties spot and forward FX rates to the interest-rate differential. The intuition: if you could earn higher risk-free rates in one currency, you could borrow in the lower one, convert at spot, invest at the higher rate, and lock in the conversion back via a forward — a risk-free arbitrage. The forward rate adjusts to eliminate this opportunity.

Where i_base is the interest rate of the base currency and i_quote is the interest rate of the quote (counter) currency. Adjust rates pro-rata for the forward period (eg, divide by 2 for 6 months, by 4 for 3 months).

• Issuer — the borrower (government, corporate, supranational)
• Nominal / par value — face value (eg, $1,000). What the bond redeems at maturity.
• Coupon — periodic interest payment, expressed as % of par
• Maturity — date when principal is repaid
• Market price — current trading price, expressed as a % of par (eg, 102 = $1,020)
• Credit rating — issuer's creditworthiness (AAA = highest, D = default)

This is the most-tested concept in bonds. When market interest rates RISE, bond prices FALL — and vice versa. Why? An existing bond with a 3% coupon is less attractive when new bonds offer 5%; the only way to make the old bond competitive is for its price to drop until its yield matches the new market level.

Implication for portfolios: in a rising-rate environment, your bond holdings can lose substantial market value (even if the issuer is rock-solid and will repay at par at maturity).

Three yield measures the exam tests:

• Flat (running) yield = annual coupon / market price. Income return only — ignores capital gain/loss to redemption.
• Gross redemption yield (GRY) / Yield to maturity (YTM) = the discount rate that makes the PV of all future coupons + redemption equal to today's price. Captures BOTH coupon income AND any capital gain/loss if held to redemption.
• Net redemption yield = YTM after tax.

When market yields move, bond prices move TO ALIGN their YTM with the market:

• Coupon > market yield → bond trades at a premium (above par). YTM < flat yield (because of the pull-to-par capital loss).
• Coupon = market yield → bond trades AT par. YTM = flat yield = coupon.
• Coupon < market yield → bond trades at a discount (below par). YTM > flat yield (because of pull-to-par capital gain).

The yield curve plots the YTMs of bonds with different maturities (usually government bonds of the same issuer). Three shapes:

• Normal (upward sloping) — longer maturities yield more. Investors demand a term premium for tying money up longer. Healthy economy.
• Flat — yields similar across maturities. Often a transitional phase, signalling uncertainty.
• Inverted — long yields BELOW short yields. Markets expect future rate cuts. Strong historical predictor of recession.

The three major rating agencies — S&P, Moody's, Fitch — score issuer/issue credit on letter scales. Memorise the investment-grade cutoff:

• Investment grade: AAA, AA, A, BBB (down to BBB−)
• Speculative / high-yield / "junk": BB+ and below

BBB− is the lowest investment-grade rating. Drop below that and many institutional investors are forced to sell (mandate restrictions), causing what's called a "fallen angel" event.

Modified duration estimates the % change in a bond's price for a 1% (100bp) change in yield.

Example: a bond with modified duration of 6 will lose ~6% if yields rise 1%, and gain ~6% if yields fall 1%.

What drives duration higher:

• Longer maturity (more cash flows are further in the future)
• Lower coupon (more weight on the distant principal payment)
• Lower yield (PV factors compress less)

Zero-coupon bonds have the highest duration of all — equal to their maturity.

Owning bricks-and-mortar directly. Pros: tangible asset, rental income, low correlation with equities, inflation hedge. Cons:

• Illiquid — sales take months
• Indivisible / lumpy — hard to "buy a bit" of a building
• High transaction costs — stamp duty, legal fees, agent fees can total 5–10%+
• Ongoing costs — maintenance, insurance, vacancies
• Concentration risk — a single building exposes you to one location, one tenant

A REIT is an exchange-listed company that holds and manages a portfolio of property assets. Two huge advantages:

• Liquid — buy/sell on the exchange like any other share
• Tax-efficient — qualifying REITs must distribute most of their rental profits to shareholders, and those profits escape REIT-level corporation tax (taxed in shareholders' hands instead)

REITs give you property exposure with diversification (many properties) and daily pricing — at the cost that their share price often moves more with equity markets than with the underlying property values.

Open-ended property funds (eg, daily-dealing unit trusts) have a structural problem: they offer DAILY liquidity but invest in ILLIQUID property. In normal markets this works; in stressed markets, redemption surges can force the fund to suspend dealing because it can't sell buildings fast enough.

This has happened repeatedly in UK property funds (notably after the 2016 Brexit vote and during COVID). Closed-ended REITs avoid this — investors who want out sell their shares to other investors, not to the fund itself.

Holders of ordinary (common) shares are the company's ultimate owners. They have:

• Voting rights at the AGM (one share, one vote, typically)
• Residual claim on profits (dividends) and on assets if the company is wound up — AFTER all creditors and preference shareholders are paid
• Pre-emption rights in many jurisdictions — first right to subscribe for new shares to avoid dilution

Highest risk in the capital structure, but highest upside.

Preference shares pay a fixed dividend and rank ahead of ordinary shares for both dividend payments and capital on winding up. But they typically carry no voting rights.

Variations:

• Cumulative preference — missed dividends accumulate and must be paid before any ordinary dividend
• Participating preference — gets fixed dividend PLUS a share in extra distributions in good years
• Convertible preference — convertible into ordinary shares
• Redeemable preference — issuer can redeem at a future date

An American Depositary Receipt (ADR) is a certificate issued by a US bank representing a specified number of shares in a foreign company. ADRs trade on US exchanges in USD — letting US investors buy foreign companies without dealing in foreign currency or foreign settlement.

A Global Depositary Receipt (GDR) is the international equivalent — issued outside the US, often trading on the London or Luxembourg exchanges. GDRs traded on the LSE conventionally settle in USD.

A warrant is a negotiable security issued by a company that gives the holder the RIGHT (not obligation) to buy a specified number of the company's ordinary shares at a fixed price by a future date.

Differs from a call option in two important ways:

• Warrants are issued by the company itself, so exercise creates NEW shares (dilutive)
• Warrants are typically long-dated (years rather than months)

Covered warrants are similar but issued by financial institutions, not the underlying company — typically referencing an existing share or basket.

Two ways trading venues match buyers and sellers — and a favourite exam distinction.

Two ways a firm can execute a client's trade:

Regulators require firms executing client orders to take "all sufficient steps" to obtain the BEST POSSIBLE RESULT. Best execution is NOT just about the lowest price — factors include:

• Price
• Costs (commissions, fees, settlement costs)
• Speed of execution
• Likelihood of execution (in volatile markets, a quoted price may not be achievable)
• Likelihood of settlement
• Size and nature of the order
• Any other relevant consideration

T = trade date. T+2 = settles two business days later. Standard equity settlement in most markets is T+2; FX is also typically T+2; some markets (US equities) have moved to T+1; instant/atomic settlement (T+0) is technically possible but rare for traditional markets.

DvP is a settlement mechanism where the securities and the corresponding payment are exchanged SIMULTANEOUSLY. This eliminates "principal risk" — the risk that you deliver securities but never receive payment (or vice versa).

DvP is the global standard for securities settlement; the alternative (free-of-payment, where security and cash move separately) exposes one party to default by the other in the brief window between the two legs.

A CCP sits between the original buyer and seller of a trade, becoming the buyer to every seller and the seller to every buyer. This is called novation. The CCP then nets exposures and requires margin from both sides.

What CCPs do:

• Concentrate and net counterparty risk in one well-capitalised entity
• Manage default risk via initial margin, variation margin, and a default fund
• Simplify post-trade processing

What CCPs DO NOT do: remove market risk (you can still lose money if prices move against you), guarantee returns, or give investment advice.

A CSD is the central electronic registry where dematerialised securities are held. Examples: CREST (UK), Euroclear, Clearstream, DTC (US).

Dematerialised securities exist only as electronic records — no paper certificates. Standard for modern markets. Eliminates risk of certificate loss, simplifies settlement, makes corporate actions efficient.

Bearer securities (the historical alternative) transferred by physical delivery — possession of the certificate constituted ownership. Now rare due to AML concerns; losing the certificate effectively meant losing the asset.

A custodian holds client assets in safekeeping, settles trades, collects income and processes corporate actions. They DO NOT make investment decisions or trade as principal.

Key protection: segregation of client assets from the custodian's own assets — so if the custodian fails, client securities are protected from the custodian's creditors.

A futures contract is a standardised, exchange-traded agreement to buy or sell an underlying asset at a specified price on a specified future date. Both parties are obligated to perform.

Key features:

• Standardised contract sizes, expiry dates, deliverable specs
• Exchange-traded, centrally cleared via a CCP
• Margined daily (variation margin) — gains/losses settled each day
• Most positions closed out before delivery — actual physical delivery is rare

Long futures position: obligation to BUY the underlying at the agreed price on delivery date. Profits if the underlying RISES above the contract price.

Short futures position: obligation to SELL the underlying at the agreed price on delivery date. Profits if the underlying FALLS below the contract price.

To close out: take the OPPOSITE position. Closed a long? Sell a future. Closed a short? Buy a future. Closing out before expiry means no physical delivery happens.

An option gives the holder the RIGHT, but not the obligation, to buy or sell the underlying at a specified strike price by a specified expiry.

Compare the strike price to the underlying's current price:

A swap is an OTC derivative where two parties exchange a series of periodic cash flows based on a notional principal. Common types:

• Interest rate swap — exchange fixed for floating-rate interest payments. The notional is NOT typically exchanged — only the interest cash flows are.
• Currency swap — exchange interest (and sometimes principal) in two different currencies
• Equity swap — exchange dividend/return on an equity for a cash rate
• Commodity swap — exchange floating commodity price for fixed

Short-run commodity prices are driven primarily by physical supply and demand — weather, storage costs, transport bottlenecks, geopolitics. Macroeconomic forces (interest rates, currency moves) matter, but less than for financial assets.

Gold has historically been treated as a store of value in periods of:

• High inflation
• Currency debasement
• Geopolitical stress
• Financial crises

Drawbacks: no income (no dividend, no coupon), storage and insurance costs, can underperform other assets for long stretches.

The shape of the commodity futures curve:

• Contango — futures prices ABOVE the spot price (upward-sloping curve). Often reflects storage and financing costs ("cost of carry"). Commodity ETFs that roll futures contracts incur a "negative roll yield" in contango — a drag on returns.
• Backwardation — futures prices BELOW the spot price (downward-sloping curve). Often signals tight near-term supply or strong physical demand. Positive roll yield for long-only commodity funds.

Bitcoin is a decentralised digital asset secured by cryptography, with transactions recorded on a public distributed ledger (the blockchain). It has no central issuer, no central bank backing, and is not legal tender in most jurisdictions.

Other cryptocurrencies (eg, Ethereum) support smart contracts and decentralised applications. Thousands of crypto assets exist.

Investment risks:

• Extreme volatility
• Limited and evolving regulation
• Custody risk (exchange hacks, lost keys)
• Limited investor protection compared with regulated securities
• Use in illicit activity attracts regulatory scrutiny

Stablecoins are crypto-assets designed to maintain a stable value, usually by pegging to a fiat currency (most commonly the US dollar). Examples: USDT (Tether), USDC, DAI.

They can be backed by:

• Fiat reserves (cash and short-dated government securities)
• Crypto collateral (over-collateralised in another crypto)
• Algorithmic mechanisms (designed to maintain the peg via supply adjustments — historically the most fragile design)

Key concerns: the quality and transparency of reserves, redemption confidence at the peg, issuer credit risk, and regulatory uncertainty. Stablecoins have depegged in stress (eg, USDC briefly during the SVB crisis in 2023; TerraUSD collapsed entirely in 2022).

A CBDC is digital fiat money issued by a central bank — distinct from cryptocurrencies (no central issuer) and stablecoins (private issuer pegged to fiat). Several central banks have launched or are piloting CBDCs (eg, China's digital yuan, the ECB's exploratory digital euro project).

Potential benefits: faster payments, financial inclusion, programmability. Concerns: surveillance, disintermediation of commercial banks.