Common markets questions

Markets superdays mix quick-fire technical questions with discussion of what is happening in the world. Interviewers want to see that you can reason from a mechanism to a direction to a rough size, and that you know the limits of your answer. This lesson collects the questions that come up most, with a structure and numbers for each.

A structure for any "what happens if" question

• Mechanism: what links the event to the price
• Direction: up or down, and for which instruments
• Size: which parts of the market move most, with a rough number if you can
• Caveat: what is already priced in, and what could make you wrong

For example: "UK inflation comes in well above forecast." Mechanism: markets expect more Bank Rate rises. Direction: gilt yields up, especially at the short end, and sterling may strengthen. Size: two-year yields move more than thirty-year yields, so the curve may flatten. Caveat: if the surprise came from volatile items, markets may shrug it off, and if growth fears dominate, sterling could fall instead.

Bonds: duration, DV01 and convexity

Modified duration estimates the percentage price change for a one percentage point change in yield. DV01, the dollar value of a basis point (in sterling markets people still say DV01 or PV01), is the change in value in money for a one basis point move. Traders think in DV01 because it adds up across positions.

Duration is a straight-line estimate. The true price-yield relationship curves, which is convexity. For an ordinary bond, convexity means prices rise a little more than duration predicts when yields fall, and fall a little less when yields rise. Long-dated bonds have the most convexity.

The yield curve

The 2s10s spread is the ten-year yield minus the two-year yield, in basis points. If it widens, the curve has steepened; if it narrows, it has flattened. A bull steepener is when yields fall and short yields fall more, often because markets expect rate cuts. A bear flattener is when yields rise and short yields rise more, often because markets expect rate rises. An inverted curve, with short yields above long ones, has historically often come before a slowdown.

FX

Forward FX rates follow from interest rates, a relationship called covered interest parity.

The forward is not a forecast. It simply reflects the interest you give up or gain by holding one currency rather than the other. Borrowing in a low-yielding currency to invest in a higher-yielding one is a carry trade: it earns the rate difference as long as the exchange rate does not move against you by more.

In a sudden risk-off move, investors tend to buy the safest assets. Government bonds such as US Treasuries and gilts often rally, the US dollar, Swiss franc and Japanese yen tend to strengthen, and higher-risk currencies weaken. These are tendencies rather than rules, and a crisis that starts in the UK itself can see gilts and sterling fall together.

Equity index futures

Buying a future instead of the shares saves the cost of financing the shares, but gives up the dividends. So the fair value of an index future is roughly:

Options: what moves the price

Put-call parity links European calls and puts with the same strike and expiry on a non-dividend-paying share: call − put = share price − present value of the strike. If a call costs 45p, the share is at 520p and the present value of the strike is 490p, the put should cost 45 − 520 + 490 = 15p. If it trades elsewhere, you could lock in a risk-free profit.

Pitch me a trade

• The view, in one sentence, and why the market has it wrong
• The instrument that expresses it most directly, and why
• The catalyst that could make it work, and the time frame
• The risks, where you would get out, and how you would size it

Keep the trade simple and specific. "I would receive two-year sterling swaps, because I think markets are pricing too few Bank Rate cuts given weakening wage growth" is better than a vague view on the economy. Being honest about what would change your mind shows the risk awareness desks look for.