cisi unit 2 securities ed16 (onscreen)

Knowledge | Skills | Conduct

PREMIER TRAINING PARTNER APPROVED WORKBOOK

Chartered Institute for Securities and Investment Capital Markets Programme

Securities Slide PackEdition 16 (22/03/2021)


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CISI Capital Markets ProgrammeSecurities

1


Administration

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Introduction to Fitch Learning

2


Please take note of the following:

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• Phone 0845 072 7620; email [email protected] Fitch Learning Safeguarding email: [email protected] Helpdesk

Course Etiquette

3


The securities examination• Exam structure

- Computer based testing • CISI demo at www.cisi.org/CBTDemo/index.htm

- Onscreen calculator/physical calculator- 100 comprehension multi-choice questions (plus 10 trial questions) - No negative marking

• Timings- 2 hours – plus time added for any trial questions

• Pass Mark- 70%

• Results- Immediate – pass or fail- Raw scores available on CISI website

• CISI Integrity Matters test- Completed at least 24 hours before the first paper of the Capital Markets Programme

The Securities ExamExam ResultsNormal results, pass, marginal fail and fail will be handed to you at the end of your exam.The CISI also release raw pass marks to candidates the day after they sit the exam. Normally, you are able to select your preference on who can see your results. You will receive a link on your exam confirmation to your CISI web pages (MyCISI) to set this preference, you will then need to click on student registration form. The preference remains for all subsequent CISI exams, but you are able to change it at any time.Note: Where employers are paying for your exams, there is typically a requirement to release the scores to the employer and to Fitch Learning as the Accredited Training Provider.

4


Study materials on your online portal

• Study Planner• Readings

- Manual- Checkpoint

• Questions- Chapter questions- Mock exams- Final Study Questions- Email-a-day

• Tutor recordings• Other tools

- Diagnostic reporting- Pass prediction- Helpdesk

The Tools to Pass

5


The Tools to PassSupport

• Delegate helpdesk

• Support by email: [email protected]

• Tutor email and mobile

Further InformationLogging a helpdesk queryWhen logging a helpdesk query, the more information you give, the better a tutor’s help can be.

It can also lead to a much quicker resolution to your query. Please also ensure you quote the seven-digit number next to any of our questions that you ask about.

6


The Tools to PassFitch Learning App

• Study wherever you are

• FL Login. Download material. Test your knowledge. Watch recordings

• Note: Mock exams are not available on the app. This is to encourage exam conditions for effective exam practice.

7


• Chapter 1 – The Financial Services Industry (3 questions) (Home Study, slides in appendix)

• Chapter 2 – Asset Classes (27 questions)- Part 1 – Equity Types and Features- Part 2 – Debt Types and Features- Part 3 – Debt Valuation- Part 4 – Money Markets and Foreign Exchange- Part 5 – Collective Investments- Part 6 – Property

• Chapter 3 – Markets (1 question)

• Chapter 4 – Primary Markets (14 questions)- Part 7 – Participants and Types of Offer

• Chapter 6 – Corporate Actions (7 questions)- Part 8 – Corporate Actions, Share Capital and Changes to Share Ownership

Question WeightingsHome StudySome sections are marked HOME STUDY. You will need to review specific videos on the online portal for these sections. Each HOME STUDY section will clearly direct you to the appropriate video. For example:

You can find the video for this on you online study portal:Debt Instruments > Video > Chapter 2 – Other bond valuation considerations

8


• Chapter 5 – Secondary Markets (15 questions)- Part 9 – Principal Characteristics- Part 10 – Equity Markets- Part 11 – Fixed Income Markets

• Chapter 7 – Clearing and Settlement (8 questions)- Part 12 – Activities

• Chapter 8 – Accounting Analysis (14 questions)- Part 13 – Company Accounts- Part 14 – Financial Statement Analysis

• Chapter 9 – Risk and Reward (11 questions)- Part 15 – Investment Management and Institutional Investment

Question WeightingsSlide notationThe course divides the information into the chapters from the manual. However, to ensure a more fluid presentation and prevent unnecessary repetition, section within chapters are not always sequential. On rare occasions, there may also be movements between chapters.To ensure easy cross referencing with the manual, the slide pack uses the following notation.

9


The Financial Services Industry

3 questions

.

Chapter 1

Home StudyThis sections is marked HOME STUDY. You will need to review specific videos on the online portal for this section.

You can find the video for this on you online study portal:The Financial Services Industry > Video > Chapter 1 – The financial services industry

10


Financial Services Industry (HOME STUDY)

• Retail businesses versus professional businesses

• Financial services for the retail sector

• Financial Services for the professional sector

• Basic differences between shares and bonds

Chapter OverviewHome Study

11

Further InformationOn the left is a summary slide of markets and participants. Please note:• A HNWI is a High Net Worth Individual • 3rd Party Vendors include Bloomberg, Reuters, Third Party

Administrators, IT Consultants, Lawyers, etc.


Features of financial markets

Financial markets move capital from those that have it to those that need it.

The Financial Services Industry – Summary

Products:Deposits/LoansForeign exchangeEquitiesBondsDerivativesAlternativesStructured

Methods:Exchange-tradedOTC

Issuers

Fund

s££

£

Investors/ Lenders

£££Cash products

Primary market

• Retail• HNW/Private Client• Institutions

• Companies• Governments• Local Authorities

Secondary markets

Bank

s an

d br

oker

s (s

ell s

ide)

Banks

£££Asse

t m

anag

ers

(b

uy s

ide)

£££ Borrowers• Retail• HNW/Private Client• Companies

£££

Products,researchand services

Third-party vendors

Advice and arrangement

Home Study

12


Professional sector

• Markets- Equity- Bond- Foreign exchange

• Insurance

• Fund management

• Investment banks- Trading as principal or agent- Banking - Market making- Research

• Corporate finance and advice• Investment management

• Custodian banks

1.2/4 Professional and Retail BusinessHome Study

13


Retail sector

• Retail banking

• Pensions

• Insurance

• Investment services

• Custodians

• Financial planning and wealth management

1.3 Professional and Retail BusinessHome Study

14


1.1 Equities and bondsDebt vs. equity

Debt Equity

Creditor vs. shareholder Creditor Shareholder

Who gets paid first

• Debt holders get paid before shareholders

• Senior secured debtors get paid first

• Unsecured holders, junior and subordinated debtors get paid in order of priority

• Shareholders get paid after debt holders

• Preference shareholders get paid before ordinary shareholders

Investor risk Less risky than equity as paid firstMore risky than debt as

dividends are not guaranteed and are last in line to be paid

Investor returns Lower expected returns due to lower risk

Higher expected returns due to higher risk

Home Study

15


Financial Services Industry

• Retail businesses versus professional businesses

• Financial services for the retail sector

• Financial Services for the professional sector

• Basic differences between shares and bonds

Chapter ReviewHome Study

16


Asset Classes

27 questions

Chapter 2

17

Asset ClassesPart 1: Equity: Types and Features

18


Shares

• The advantages and disadvantages to issuers and investors of - Ordinary share- Preference shares

Other securities

• The principal characteristics of depositary receipts

• The rights, uses and differences between warrants and covered warrants

Section Overview

19


A company issues shares in order to raise capital. The investors buy a share in the company’s success.

Shareholders:

2.1.1 Equity: Why Issue?

£60

£40

Company

SHARESInvestor 1

Investor 2SHARES

Further InformationAuthorised share capitalAuthorised share capital is the maximum amount of capital that can be raised through share issue.

Issued share capitalIssued share capital is the number of shares the company has allotted to shareholders.

Nominal valueThe fixed legal value of a share. An accounting term.

Market CapitalisationNumber of shares in issue multiplied by the market price of the share.

Free floatAll shares being held by investors other than:• Owners holding 5% or more of all shares• Restricted stocks• Insider holdings

20

Further Information Ordinary sharesA and B ordinary shares • Different classes of shares created to separate ownership and controlRedeemable Shares• Offered by a company to shareholders that may be bought back by the

company at its election. Companies are permitted to issue ordinary shares that can be redeemed, as long as conventional non-redeemable ordinary shares are also in issue.

Partly Paid • Each ordinary share has a nominal value, which represents the minimum

amount that the company must receive from subscribers on the issue of the shares. Occasionally, the company may not demand all of the nominal value at issue, with the shares then referred to as being partly paid.

Preference sharesCumulative • The right to receive that dividend is rolled over into the next periodParticipating• Opportunity for further dividend Redeemable• The right for the issuer to buy back the sharesConvertible• The right to convert into ordinary shares• Zero dividend – pay no income, redeemed by shareholder above the price at

which they were issued


Types of equity

Companies may issue more than just ordinary shares.

2.1.1-2 Ordinary and Preference Shares

Features Ordinary shares Preferred shares

Priority 2nd 1st

Dividends Variable Fixed

Voting Yes No

Special features• A shares/B shares• Redeemable• Partly paid

• Cumulative• Participating• Convertible• Redeemable

21


Summary

2.1.1-2 Ordinary and Preference Shares

Advantage DisadvantageCompany Raise capital

Servicing varies with performanceDiscretionary paymentsNo redemption

Sacrifice control• ActivismReputationPotentially high payout

Investor Return linked to performancePotential gain as well as incomeOwnership rights

Low ranking• Risk capitalPotential volatility caused by unrelated factors

Keeping on TargetA company announces an increase in the dividend that it will pay out to shareholders in response to continued profit growth. Assuming all of the following shares are in issue, which of the following is least likely to benefit from this increase?

A. Participating preference shareholderB. Ordinary shareholderC. Convertible preference shareholderD. Redeemable preference shareholder

22

Further InformationAmerican Depository ReceiptsAmerican Depository Receipts (ADRs) are used by non-US companies in order to encourage US Dollar investors to buy an equity stake. ADR: features• US$ denominated and US$ dividend• Bearer document (American form)• Settlement T+2 • Rights issues: ADR holders receive cash• Bonus issues: alters number of sharesPre-release (grey market rules)An ADR, or issuing an ADR, secured by cash collateral rather than deposited securities and can be issued in a pre-release format for up to three months (US$ collateral required)


ADRs: Features

Brit plc will pay dividends in sterling to Bank A. Bank A will convert them into US dollars and pass them on to the ADR holder.

2.7.1 American and Global Depositary Receipts

BANK ABRIT plc

ADRs

$$$$s££££s

SHARES

USAUK

US dollar investor

Answer to question on previous slide: D

All of the other shares can benefit through an increase in dividend, either directly or indirectly.

23


Summary

• Note- ADRs are denominated in dollars can be traded anywhere in the world- GDRs are usually denominated in dollars or euros

2.7.1 American and Global Depositary Receipts

Advantage DisadvantageCompany Raise capital internationally Lack of transparency on

beneficial ownership

Investor Access to overseas companies• Domestic currency• Domestic market

FX risk added to market riskBenefits may differ depending on the terms of the DR

Keeping on TargetIn a depositary receipt issuance which of the following would the holder of a depositary receipt NEVER receive?

A. The right to receive a dividend paymentB. The right to voteC. The right to subscribe to new shares in proportion to their existing share

holdingsD. The right to sell the depositary receipts in the secondary market

24


Background

• Right to subscribe for new shares from a company at a fixed price on a future date

• Not part of ordinary share capital of company

Issuance

• Typically issued as a sweetener with other investments (e.g. corporate debt)

• Detachable or non-detachable form

Conversion premium

Conversion premium = Warrant price + Exercise price - Current share price

2.7.2 WarrantsHintsIf the conversion figure were a negative, the warrant would be trading at a discount.

Answer to question on previous slide:

C: DR holders do not get the opportunity to take part in rights issues.

25


Warrants Covered warrants Options

Issued by Companies Investment banks Writer

Shares deliveredNew shares

Potential dilutionExisting shares

No dilutionExisting shares

No dilution

Maturity Normally >1 year Normally < 1year Normally < 1year

Traded on LSE/OTC LSEDerivativesexchange

TypesRight to buy theunderlying share

only

Call and putwarrants

available (right tobuy and sell)

Call and put options available (right to

buy and sell)

Exercise/ Settlement

Physically settled contracts

Cash andphysically settled

contracts available

Cash and physically settled contracts

available

2.7.2 WarrantsCovered warrants: A comparison with traditional warrants

HintsOn exercise, warrants create new shares whereas options and covered warrants are exercised into existing shares.

26


Summary

2.7.2 Warrants


Delay sacrificing controlDelay paying dividendsMakes another security more attractive

On exercise• Dilution of ownership• Issue equity below market

price– Potentially well below

Investor Exposure to a share at a fraction of the price• Gearing/leverage

No votes or dividendsPotentially worthless if the share price does not exceed the exercise price

Keeping on TargetWith respect to the issuing company, which of the following would be considered a benefit to issuing warrants rather ordinary shares?

A. They may be able to issue shares at a higher price in the future, whilst still generating some income today

B. They will be able to ensure their employees are more motivated to work harder

C. It will allow the company to recall these warrants at any time in the future preventing possible dilution of ownership

D. They will be able to gain additional income when the warrants are traded in the secondary market

27


Shares

• The advantages and disadvantages to issuers and investors of - Ordinary share- Preference shares

• Other securities

• The principal characteristics of depositary receipts

• The rights, uses and differences between warrants and covered warrants

Section Review

Answer to question on previous slide: A

They may be able to issue shares at a higher price in the future, whilst still generating some income today

28

Asset ClassesPart 2: Debt: Types and Features

29


Government Debt

• Know the principal features and characteristics of- Conventional government debt- Index-linked government debt- Strip market- Emerging and frontier markets

Corporate Debt

• The principal features and uses of- Secured debt- Unsecured debt- Credit ratings- Eurobonds

Section Overview

30


Debt types: Summary

Debt: Types and Features

Capital

Debt(companies and governments)

Bank Loan(companies only)

Debt Securities(companies and governments)

Billsmaturities < 1 year

Bondmaturities > 1 year

Equity(companies only)

31

Further InformationCharacteristicsName – to act as an identifier.Coupon – generally paid semi-annually and the quoted coupon of a gilt represents the annual amount of interest paid per £100 nominal value. Coupons are taxable (subject to income tax for individuals); however, tax is not normally deducted from the coupon payment. Therefore it is referred to as being a gross coupon.Redemption – the redemption date is the specified date on which the capital is repaid by the DMO. Normally, redemption is at par, i.e. £100 for each £100 nominal value held. All remaining stock must be repaid on the redemption date.Benchmarking – the yield available on UK gilts is considered the risk-free rate for sterling denominated bonds – UK gilts are effectively credit risk-free.


Features of bonds

2.3.1 Bonds: Features

CouponExpressed as an annual percentage of the nominal value

NameThe name given at issue

The capital payment the holder receives at redemption

RedemptionThe year when the gilt is repaid

6½ PER CENT TREASURY STOCK 20X8GBX00001144KK00

Security Code

HOLDING NUMBER

555 - XZ333333

122

CERTIFICATE NUMBER

555 -XZ333333£100.00******

MR FREDERICK BLOGGS24a ACACIA AVENUE ARBINGER SURREY SSY 345

-

No transfer in whole or part of this holding represented by this certificate will be registered until this certificate has been The stock is transferable in multiples of 1p

CHIEF REGISTRARBANK OF ENGLAND

Expressed as an annual percentage of the nominal value

The name given at issue

Nominal valueThe capital payment the holder receives at redemption

The year when the gilt is repaid

GBX00001144KK00

Security Code

HOLDING NUMBER

555 - XZ333333 -


-

GBX00001144KK00

Security Code

HOLDING NUMBER

555 - XZ333333 -


delivered to the Bank of England

ONE HUNDRED POUNDS 61/2 PER CENT TREASURY STOCK 20X8 17 JUNE 2018

IMPORTANT: The Bank of England should be notified immediately of any change of address of any of the above stockholders

Interest payable half-yearly on 7 June and 7 DecemberRepayable at par on the 7 December 20X8

Principal and interest charged on the National Loan Fund, with recourse to the Consolidated Fund of the United Kingdom

THIS IS TO CERTIFY THAT THE ABOVE-NAMED IS/ARE THE REGISTERED HOLDER(S) OF

32


Government bonds

Categories of bond

• Index-linked: Coupon and redemption linked to an inflation index- Inflation protected- Return during zero inflation

2.3.1-2 Government Bonds: Features

Index-linked Conventional

Government bond

Further InformationInflation indicesRPI – Retail Prices Index: An average change in the prices of household goods and services.CPI – Consumer Prices Index: Based on an EU-wide formula to allow international comparison. Used by the MPC.PPI – Producer Prices Index: Looks at goods and services further up the production chain, at the wholesale level.

33

Further InformationLiability driven investors, such as pension funds, often use bonds to meet their liabilities. However, this can lead to reinvestment risk. Reinvestment risk is where the investor may not receive a required rate of return when reinvesting coupon payments. This is often avoided through cash-flow matching, or dedication. Dedication is where the investor matches the maturity of cash-flows to the liabilities. The simplest way to do this is use a zero-coupon bond.As STRIPS function like zero-coupon bonds, they provide a useful tool in this strategy.


Strips market – developed in US and UK treasury market

• Case study: UK Gilts designated as strippable by the Debt Management Office

• Permitted parties:- GEMMS- HM Treasury- Bank of England

• A five-year strippable gilt may be stripped into 11 zero-coupon bonds

• Investors can precisely match their liabilities, removing any reinvestment risk

2.3.3 Separate Trading of Registered Interest and Principal of Securities

34


International government bonds

• Significant increase in the issuance of government bonds in emerging/frontier markets- E.g. Emerging – Brazil, Russia, India, China, South Africa, Indonesia, Mexico, Turkey

and Malaysia. Frontier – Bangladesh, Bahrain, Mauritius and Sri Lanka.

2.3.4 International Government Bonds

France Germany UK (Gilts) USA (T-bonds) Japan (JGBs)

Legal form Bearer Bearer Registered Registered Registered or bearer

Life when issued (yrs)

OATs 2-50 Schatz: Up to 2Bobl: 5Bund: 10-30

Short < 7Medium 7-15Long > 15

T-notes: 2-10T-bonds: >10

Maturities 2-40Long: 10 (most common)Superlong: 20

Coupons Annual Annual Semi-annual Semi-annual Semi-annual

Settlement time

T+2 T+2 T+1 T+1 T+1

35

Further InformationDebenturesIn the UK, a secured debt transaction is called a debenture, whereas in the US the term debenture generally refers to a loan agreement with no security at all. In the US, the term asset-backed security is more commonly used for secured issues. In the US secured debt is commonly known as an asset backed security (ABS).Fixed Charge Over Assets – a fixed charge is security over a certain specific company asset, e.g. a building or land, and is the most common form of security for debentures. A mortgage charge is a type of fixed charge.Floating Charge Over Assets – a floating charge is security over a class of assets, e.g. plant and machinery, fixtures and fittings, trade debtors.

Unsecured DebtThe examiner may use the term ‘loan stock’ to describe unsecured debt instruments.


Corporate bonds: Security

2.4.1 Corporate Bonds: Features

Corporate Bonds

Secured debt securities

Fixed charge over assets

Floating charge over assets

Unsecured debt securities

36


Asset-backed securities/Covered bonds

• Bonds secured by a pool of assets, e.g. property, loans

• Who owns the pool determines the type of bond- Pool owned by the originator

• Covered bond

- Pool owned by a special purpose vehicle (SPV)• Asset backed security

• Underlying assets securitised

Secured debt (debentures)/asset-backed securities

Trust deed

• Empowers the trustee alone to act on behalf of debenture holders - Ensures organised action and parity of treatment through a single entity

2.4.1 Secured DebtFurther InformationTypes of Trustee

Note trusteeThe note trustee is appointed to represent the interests of holders of issues of securities, while providing guidance to the issuer.Security trusteeWhere bonds are secured (debentures) the security is protected by the trustee for the benefit secured parties. The governing documents dictate the order of priority of payments among the entitled parties.Share trusteeThe share trustee holds the shares in an issuing Special Purpose Vehicle (SPV) in order to ensure off-balance-sheet treatment for the originator of the transaction. Sometimes these SPVs are domiciled in offshore jurisdictions.Successor trusteeThis role played by a trustee is provided for banks which need to resign because of conflicts of interest (especially in connection with defaulted or bankrupt issues) or when work requirements exceed the bank’s capacity.

37


Unsecured debt

• Convertible bonds- Converts into stock of the issuer

• Exchangeable bonds- Converts into stock of another, usually subsidiary of the issuer

• Guaranteed bonds- Credit enhancement based on the credit rating of a third party

• Floating rate notes (FRNs)- Coupon floats in line with market interest rates- Trade near par- Capital protection

• Payment in kind notes (PIK)- Generally subordinated debt- Zero coupon bonds that are issued at a substantial discount to their face value

2.4.2 Unsecured DebtHintsUnsecured corporate debt has a typical life of 7-30 years.

Keeping on TargetA controlling shareholder knows that the company needs to raise capital but is not prepared to accept any dilution of ownership. Which of the following would be most suitable for the company to issue?

A. Convertible bondsB. Preference sharesC. Ordinary sharesD. Zero coupon bonds

38


Types of eurobonds• Definition

- International bonds- Bearer documents- Issued in a eurocurrency - Any currency other than the currency of the market on which it is issued

Dealing and settlement• Typically OTC but some exchange-traded• Regulated by International Capital Markets Association (ICMA)

- Trades reported and matched through TRAX- Settlement: T+2 (if settled through Euroclear/Clearstream)

• Gross annual coupon• Day-count convention for accrued interest

- 30/360Immobilisation• As bearer documents, eurobonds are often held in depositaries (immobilised)

- Euroclear/Clearstream

2.6.1 EurobondsFurther InformationListing eurobonds – a London listing of a eurobond consists of admission to listing by the United Kingdom Listing Authority (UKLA) – a division of the Financial Conduct Authority (FCA), and admission to trading on a recognised investment exchange such as the London Stock Exchange.

Eurobond variantsStraight or plain vanilla – fixed coupon eurobonds or bullet bonds normally pay the coupons once a year. Zero Coupon Bonds (ZCBs) – no coupon. Issued at a discount and redeemed at par value.Floating rate eurobonds (FRN/VRN) – bonds where the coupon rate varies. The rate is adjusted in line with published market interest rates. The published interest rates that are normally used are LIBOR and Euribor.Stepped bonds – Coupon increases over the life of the bond.

Keeping on TargetWhich of the following would be the best description of a eurobond?

A. A French company issuing euro denominated bond issued in FrankfurtB. The Debt Management Office issuing a dollar denominated bond in the UKC. The Bank of England issuing a dollar denominated bond in the UKD. A European company issuing a Australian dollar bond in Australia


Zero coupon bonds

39


Impact of security

9.1.11 Debt Seniority

1. Liquidator

2. Fixed charge holders

3. Preferential creditors (e.g. employees)

4. Floating charge holders

5. Unsecured creditors (e.g. trade creditors and the Government)

6. Subordinated loan stock

7. Preference shareholders (nominal value only except

participating shares)

8. Ordinary shareholders

CR

EDIT

OR

SO

WN

ERS

Further InformationImpact of securityThe impact of security is significant when a company becomes insolvent or is wound up. All classes of debt rank more highly than equity (i.e. debt is paid back before equity). However, not all types of debt are equal – some are senior (take priority), whilst others are subordinate.

Further Information Mezzanine debtThe mezzanine level of debt will rank below other forms of debt but above the equity in a liquidation. An example is a payment-in-kind noteGuaranteed bonds and Convertible bondsThese will rank alongside other unsecured bonds.

Answer to question on previous slide: C

There are two possible answers to this question. The Debt Management Office issuing a dollar denominated bond in the UK is more commonly known as a sovereign bond. Which means the Bank of England issuing a dollar denominated bond in the UK is the best answer.

40


Overall risk of bonds

2.4.3 Credit Ratings

Bond in default

Standard & Poor’s

AAA

AA

A

BBB

BB

B

CCC

CC

C

D

Moody’s

Aaa

Aa

A

Baa

Ba

B

Caa

Ca

C

Investment grade

Speculative grade

Fitch

AAA

AA

A

BBB

BB

B

CCC

D

Further InformationThe CISI Workbook also mentions Regional Credit Rating Agencies and names:• Japan Credit Rating Agency• Global Credit Rating (for Africa)

Keeping on TargetThe credit rating of a particular corporate bond has changed from BBB- to BB+, what is the likely effect on the bond?

A. Increase in price, increase in yieldB. Decrease in price, decrease in yieldC. Increase in price, decrease in yieldD. Decrease in price, increase in yield

41


Summary

Debt: Types and Features


No sacrifice of controlKnown obligationsPaid from pre-tax profitCheaper to finance

Obligation to pay regardless of performanceRedemptionsDefault can lead to significant repercussions

Investor Known paymentsPriority in paymentSome debt is default risk free

Lower returnNot all debt is default risk free


Decrease in price, increase in yield. The change describes a downgrade.

42


Government Debt

• Know the principal features and characteristics of- Conventional government debt- Index-linked government debt- Strip market- Emerging and frontier markets

Corporate Debt

• The principal features and uses of- Secured debt- Unsecured debt- Credit ratings- Eurobonds

Section Review

43

Asset ClassesPart 3: Debt Valuation

44


Debt Instruments

• Uses and limitations of yields calculations

• Calculate- Interest income- Conversion premiums- Flat yield- Accrued interest- Spreads- Present value of a bond

• The role of the yield curve and the relevance of negative interest rates

Section Overview

45


Flat yield

• Uses:- Income-seeking non-taxpayers- Irredeemable bonds

2.2.2 Yields

%100priceMarket

couponannualGrossyieldFlat x

HintsThe examiner can also use the following terms for the flat yield: • Interest yield• Running yield• Simple yield

Keeping on TargetA gilt is priced at £9.00 above its nominal value. If the coupon is 3 1/2%, what is the flat-yield?

A. 3.21%B. 3.35%C. 3.5%D. 3.85%

46


Gross redemption yield (GRY)

• Considers annual return due to income and gain through to redemption

• AKA Yield to maturity (YTM)

Example:

An investor purchases an eight-year 7% coupon bond at a market price of £95.00 (per £100 nominal). The gross redemption yield is calculated as follows:

Net redemption yield

• Considers the impact of tax on the YTM

2.2.2 Yields

8.1%

++

Gross redemption yield

Profit / Loss at redemption

Flat yield (coupon income)

%.% 70100£95(£5 Profit / 8 years) =x

7.4%100%£95£7 =x

Keeping on TargetWhich one of the following is the best approximation of the gross redemption yield of an 8% two-year government bond with a current price of £103?

A. 6.3%B. 7.8%C. 9.2%D. 10.7%

HintsThe coupon received from most bonds is generally taxable, but any gain made on redemption (or subsequent sale) is not taxable. This makes bonds with a low coupon attractive to higher rate taxpayers, as the price may be lower than par, resulting in a part of the return coming in the form of a tax-free capital gain.

Answer to the question on the previous slide = A

FY = £3.50 / 109 = 3.21%

47


Discounting

• A bond is a series of future cashflows

• Discounting these cash flows at a required rate allows us to price the bond at a present value of those cashflows

Example:

The value of a two-year 6.5% coupon bond using 4.5% interest rates:

2.2.6 The Present Value of a Bond

£103.74

0.045)(1£106.50

0.045)(1£6.50

r1val£red£coupon

r1£couponbondofValue

2

n


As the bond is trading above par, the GRY will be less than the coupon rate. A is the only possible answer.

Keeping on TargetThe present value of the following bond with a 4% annual coupon with two years to maturity and a prevailing discount rate of 2.75% is:

A. £98.51B. £100C. £102.40D. £104.28

HintsA company's debt is valued by calculating the payoffs that debt holders can expect to receive, taking into account the risk of default.

48


Clean vs. dirty prices

2.2.3 Accrued Interest

Price

Coupon paid date

Time

Dirty price

Clean price

Ex coupon date

Cum coupon period

6 months

Ex c

oupo

n pe

riod

Cum coupon period

Answer to the question on the previous slide = CThe present value of the first year’s cash flow

£4 / 1.0275 = £3.89.The present value of the second year’s cash flow

£104 / (1.02752) = £98.51.The price of the bond is the sum of the present values.

£3.89 + £98.51 = £102.40

HintsThe ex-coupon period for a UK gilt is typically 7 business days. Bearer bonds generally do not have ex-coupon periods.

49


Clean vs. dirty prices

Example:

You buy £10,000 nominal of an 8% bond for settlement on 6 July for a clean price of £105. If the coupon payment date is 1 April, calculate the dirty price payable on settlement using an actual/365 day-count convention.

A. £10,690

B. £10,700

C. £10,710

D. £10,720

2.2.3 Accrued InterestHintAccrued interest𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑓𝑟𝑜𝑚 𝑙𝑎𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡) / (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑)

Keeping on TargetA 3% Gilt is quoted at £98.00, there has been 66 days after its last half-yearly coupon payment, how much would it cost to buy the bond?

A. £98.00B. £98.54C. £99.08D. £100.00

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Spreads and benchmarks

• Difference between the yield on one investment and the yield on another- Measured in basis points (0.01%)

Inter-bank market

• LIBOR: London inter-bank offered rate

• LIBID: London inter-bank bid rate

Examples of spreads

• Spread to government securities- Default spreads

• Spread to LIBOR

• Spread to swap rates

2.2.4 Pricing BenchmarkKeeping on TargetA bond is trading at a 1.5% premium to its benchmark bond. The rate for three-month LIBOR is 3.97% and the yield on benchmark bond is 3.5%. What is the spread of the bond to LIBOR?

A. 500bpB. 197bpC. 150bpD. 103bp

Further InformationBenchmark Interest ratesLIBOR is becoming less popular and is being replaced by many for other interest rate benchmarks. The most prevalent are:SONIA – Sterling Overnight Index Average: Published by the Bank of England and based on the actual overnight rates banks borrow money.SOFR – Secured Overnight Financing Rate: Published by the Federal Reserve and based on actual overnight Treasury repo market.

Answer to the question on the previous slide = BAccrued interest = 66days / 365 days x £3.00 = £0.54Dirty price = £98.00 + £0.54 = £98.54

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Simple interest

Calculate simple interest income on corporate debt:

• Corporate bond paying 6% coupon maturing in 20 years

• Market price is £108 per £100 nominal

• Investor buys bonds at a market price of £4,320

Convertible loan stock

Calculate the conversion premium:

• Convertible trading at £125 per £100NV

• Conversion terms £100NV = 50 shares

• Current share price £2.30

2.2.3 Interest and Conversion Premium

Keeping on TargetA company has issued convertible loan stock which can convert into 80 ordinary shares per £100 nominal. The convertible is trading at £160 and the ordinary shares at 180p per share. What is the conversion premium as a percentage?

A. 10%B. 11.1%C. 20%D. 22.2%

HintsThe conversion ratio – the number of shares that each £100 of nominal value of the bonds can convert into.

Conversion ratio = Nominal valueConversion price of shares

Answer to the questions on the previous slide = DAs the bond is trading at a premium of 1.5% over the benchmark of 3.5%, its yield must be 5% (3.5% + 1.5%). As LIBOR is 3.97%, the difference to the bond yield is 5% - 3.97% = 1.03% or 103bp.

52


Factors affecting bond prices

• Interest rates

• Time to redemption

2.2.2 Yields

PRICE

£100(nominal value)

Pull to redemption

TIME0 Redemption date

PRICE

£100(nominal value)

Pull to redemption

TIME0 Redemption date

When interest rates rise bond prices fall:

When interest rates fall bond prices rise:

INTEREST RATESBOND PRICES


When interest rates rise bond prices fall:

When interest rates fall bond prices rise:



Answer to the question on the previous slide = B Effective price of share via convertible debt (£160 / 80 shares) = £2.Actual share price £1.80.Conversion premium is 20p (£2.00 - £1.80), or expressed as a percentage of share price, (£0.20 / £1.80) 11.1%.

53


Overall risk of bonds

• Modified duration- Measure of volatility

• Approximate percentage change in a bond’s price for a 1% change in interest rates

- Bonds with higher modified duration will be more volatile

2.2.2 Yields

Long-dated low coupon bond is most volatile

Keeping on TargetModified duration shows the expected change in a bond's price, given a specified change in interest rates. Which of the following is most likely?

A. The lower the modified duration, the more the price of that instrument will move

B. The higher the modified duration, the more the price of that instrument will move

C. The higher the modified duration, the less the price of that instrument will move

D. The higher the modified duration, the less of an effect the interest change will have on the bond's price.

54


Yield curves: Background

• The yields currently available to investors across different time horizons

2.2.5 Yield Curves

MaturityYi

eld

Normal/upward Inverted

Maturity

Yiel

d

Liquidity preference Expectation of falling rates

Further InformationInflation and the yield curve• Yield curves show the nominal yield• Real yield curves show inflation-adjusted yields and can be observed by

looking at the yield curve for index-linked instrument• The difference between the nominal yield curve and the real yield curve

reveals an expectation of inflation

Keeping on TargetWhich of the following would determine the shape of a normal yield curve?

A. Credit ratingB. LiquidityC. Risk free rateD. Maturity

HintsNegative YieldsWhere investors are paying to lend money. Occurring in some government bond markets, where the uncertainty of the economic climate in general creates an increased desire to put money somewhere safe – even if you have to pay for it.

Answer to the question on the previous slide = B

55


Debt Instruments

• Uses and limitations of yields calculations

• Calculate- Interest income- Conversion premiums- Flat yield- Accrued interest- Spreads- Present value of a bond

• The role of the yield curve and the relevance of negative interest rates

Section Review

Answer to the question on the previous slide = B The shape of a normal yield curve captures the fact that investors have a liquidity preference: they prefer more rather than less liquidity. Because of this, they are willing to accept a lower yield on more liquid, short-dated government bonds, and demand a higher yield on less liquid, longer-dated government bonds.

56

Asset ClassesPart 4: Money Markets and Foreign Exchange

57


Section OverviewCash Assets• Uses, advantages and disadvantages

of cash• Features and characteristics of

Treasury bills• Features and uses of commercial

paper• Purpose and characteristics of the

repo market

Foreign Exchange• Principal features and uses of spot,

forward and cross trades• Factors that affect FX rates• Calculate forward settlement prices

using- Pip adjustments- Interest rate parity

• Characteristics of crypto currencies

58


Cash deposit

• Liquidity and rates of interest- Why hold cash?

• Liquidity – instant access, fast access e.g. short-notice• Emergency funds, planned spending, security• No volatility – safe• Generates income as a rate of interest

- Fixed or variable

- Risks• Potential default of the deposit taker

- Financial Services Compensation Scheme• Inflation and tax reducing returns

- Real returns after tax can be negative• Interest rates changes affecting returns

2.5.1. Cash DepositsFurther Information

Cash deposit accountsInterest returns on cash can be affected by the size and term of the deposit:• Larger deposits and longer terms attract higher rates of interest

Depositing cash overseasAdditional risk including• FX risk• Withholding tax• Exchange controls restricting repatriation

59

Keeping on TargetAn investor is concerned that there could be another financial crisis and is looking to use a 'flight to safety' approach using UK government T-bills. Which of the following is the correct observation about the period leading up to the crisis?

A. The redemption value is likely to increase due to the UK government trying to control money supply

B. The yields achievable on the T-bills are likely to fall and possibly become negative

C. Corporates are likely to be crowded out as the government issues more T-bills to satisfy demand

D. The central bank will need to manage the FX rate to ensure the currency does depreciate dramatically

Further InformationIssuance processTreasury bill issues in the UK are known as ‘tenders’, held by the DMO at the end of the week (usually a Friday). These tenders are open to bids from eligible bidders which include all of the major banks. The bids are tendered competitively – the highest prices bid win and if successful participants pay the price they bid.


Government bills

Treasury bills

• Short-term unsecured debt- 1 month to 12 months

• Zero-coupon- Issued at discount redeemed

at par

• Benchmark risk-free rate

2.5.2 Treasury BillsMinimum

denomination UK

T-Bill : £25,000

DMO

1. Treasury issues a 90-day T-Bill with a face value of

£100,000

2. Investor pays £98,500 for the bill (after deducting a £1,500 discount, which is approx 3

months’ interest at 6% pa)

3. Investor holds theT-bill for the entire 90-

day period

4. Investor redeems T-bill and receives the full face value. The difference between this and the

£98,500 originally paid is the investor’s return.

60

Further InformationCP issued is up to 270 days in the US, whereas it could be up to 1 year in the UK.

Commercial paper programmeAn on-going programme where the issuer advertises the rates at which it is willing to issue paper for various terms. Buyers can purchase the paper whenever they have funds to invest. Programmes may be promoted by dealers, in which case the paper is called dealer paper. Larger issuers, especially finance companies, have the market presence to issue their paper directly to investors. Their paper is called direct paper.


Commercial paper

• Features- Discount security by companies- Unsecured, short term debt

• Up to 1 year (typically 3 months)

• CP programme- Usually a rolling programme,

not all at once

• Issuance- Direct paper

• Buy and hold investor

- Dealer paper• Promotion of programmes

2.5.3 Commercial Paper

HintsRollover riskWhere a company uses a new issue of CPs to pay off the existing CPs, it rolls over the debt. The risk associated with being unable to issue enough CPs to cover the existing issue is called rollover risk.

Answer to the question on the previous slide = B During a financial crisis, many institutions want to replace all their other money market holdings with the shortest-duration T-bills. This can have the perverse consequence, on extreme occasions, of making such instruments, which are priced on a discount basis, yield a negative return or at a rate which is far below that which would normally be expected. The desire to move into such short-term paper during moments of crisis is referred to as a flight to safety.

61


Repo market

There are two components to a repo:

1. The sale:

2. The repurchase:

• The difference between the sale and repurchase price (£1,000 - £900 = £100) is the ‘repo rate’. It is, in effect, the interest paid for borrowing money.

2.5.4 Repo Market

Tripartite repos also available

£1,000

GILT

£900

GILT

Further InformationTerms of a repoAn open repo is where there is no fixed time for repurchase. Maturity dates in excess of overnight are called term repos.Repos may be used as a method of borrowing funds (using gilts as collateral) and reverse repos to cover a short position taken on by a market maker in the course of its market making activities.

Keeping on Target Which of the following is the best definition of the repo rate?

A. It is the difference between the amount of cash paid over at the start of the agreement and the amount paid over at the end expressed as a percentage

B. It is the amount of cash paid over at the end of the agreement expressed as a fee

C. It is the difference between the amount of collateral handed over at the start of the agreement and the amount paid over at the end expressed as a percentage

D. It is an interest rate set by the central bank as a benchmark for all borrowing opportunities

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Further Information1.8.3 Factors affecting foreign exchange rates Supply and demand for sterling (GBP)Demand• Exporting goods: overseas markets need sterling to pay for UK goods• Foreign investment: overseas investors want to invest capital into the UK• SpeculationSupply• Importing goods: converting sterling into an overseas currency will increase

supply of sterling• Investing overseas: UK residents want to invest capital into overseas assets • SpeculationImpact• More demand for the currency increases its value

- Can reduce exports and foreign investment• More supply of a currency will diminish its value

- Can reduce imports as overseas goods look expensiveCurrency rate management by the central bankOther factorsRelease of key economic data (or forward guidance) by central banks and governments can have a significant effect on the FX market. For example, when the US Labour Department issues its monthly employment data, (the Non-Farms Payroll (NFP) report), on the first Friday of each month at 8:30 Eastern time.


FX: Background

• OTC market

• Major international banks

• Spot market and forward market

FX: Exchange rate quotation

• Base currency

• Counter/quote currency

Cross rates

• Any foreign currency rate which does not involve the US dollar

2.8.1 Introduction to Foreign Exchange

GBP 1 = USD 1.3900USD 1 = HKD 7.7560

Answer to the question on the previous slide = AThe repo involves the movement of an amount of cash paid over by a participant at the start of the repo, which will be less than the amount paid over at the end of the repo period. The difference between the two amounts, expressed as a percentage, is the effective interest rate on the repo transaction. It is usually referred to as the 'repo rate'.

63


FX spot markets: Introduction

• Standard settlement T+2

FX: Two-way prices

2.8.2 FX Spot Markets

GBP against USD spot rate please

GBP against USD for spot is 1.5010 / 1.5015

Keeping on TargetA company wishes to exchange $250,000 into GBP at a spot rate of 1.4505/15USD. How much will the company receive?

64


Spot GBP= USD 1.5110Forward adjustment -28Outright forward rate GBP 1 = USD 1.5082

Spot GBP = USD 1.5110Forward adjustment +40Outright forward rate GBP 1 = USD 1.5150

Forward rate pip adjustment

• Generally- Pips are either added to or subtracted from the spot rate:

- Forward rates can expressed as a two way pip adjustment to the spot’s bid and offer

2.8.2 Forward FX Rates

Answer to the question on the previous slideBuying or selling base? Buying, therefore offer rate.$250,000 / 1.4515 = 172,235.18 GBP

Keeping on Target The current spot price is £1 : $1.4785 - $1.4815. If the forward adjustment is expressed as a premium 0.90 cents – 0.87 cents, at the 3 month forward rate how many dollars will £1 buy?

A. $1.4695B. $1.4728C. $1.4875D. $1.4902

Further InformationCarry tradeA carry trade in FX involves the borrowing of funds in a currency where the rate of interest is relatively low and then purchasing securities, often government bonds, which have relatively high yields.

65


Interest rate parity (IRP)

Arbitrage-free method of pricing FX forwards

2.8.2 Forward FX Rates

Answer to the question on the previous slide = AThis shows an alternative method used in the exam. The 0.90 isdeducted from the quoted spot bid rate to arrive at the forward rate aswe are looking to sell GBP and buy USD, therefore £1 will buy fewerdollars in three months’ time. As it is quoted in cents, unlike the spotrate, which is quoted in dollars, 0.90 cents are 0.0090 dollars. So,$1.4785 - $0.0090 = $1.4695

Keeping on Target Interest rate parity: summaryWhere:

• F = the forward rate• S = the spot rate• r variable r base = the interest rates for each currency variable and base

The spot rate is currently 1EUR : 0.8900GBP. An investor wishes to takeout a six-month forward and wants an idea of what rate to expect. He notes that the interest rates in the UK are higher, at 4% pa, than they are in the Eurozone, which are 2% pa. Using interest rate parity, what six-month forward rate would he get?

A. 0.8988 GBPB. 0.8813 GBPC. 0.9075 GBPD. 0.8729 GBP

Purchasing power parity

It works in a similar way, using similar concepts except it uses inflation rather than interest rates

66


Features• Money outside the control of governments and central banks

- Encryption technology used to control supply and record transfers and ownership- Example include Bitcoin, Litecoin, Dogecoin and Ethereum

Investment• Investors need a digital wallet

• Methods of acquiring cryptocurrency- Buy it with fiat money- Earn it through browsing and posting- Crypto mining

• Risks- Volatility- Decentralised and not reserve-backed- Largely unregulated- Operational risk and hacking

2.8.3. CryptocurrenciesHintsThe problem of scalabilityCrypto mining is energy intensive and the cost of mining can often exceed the currency earned.

Answer to the question on the previous slide = ARemember to deannualise the rates:Base: EUR = 2% pa / 2 = 1% over the six-month periodVariable: UK = 4% pa / 2 = 2% over the six-month periodCalculationForward = 1.02/1.01 x 0.89 = 0.8988

67


Distributed ledger

• A centralised ledger of transactions with a decentralised network of computers all holding copies of exactly the same ledger, commonly associated with cryptocurrencies

• Advantages:- Produces a trustworthy and reliable record- Prevents a single point of failure as numerous nodes are used - Very difficult to hack, because of the use of multiple nodes.- Removes the costs and delays caused by the need to maintain and update a single

central database.

7.8 Distributed Ledger Technology

68


Section ReviewCash Assets• Uses, advantages and disadvantages

of cash• Features and characteristics of

Treasury bills• Features and uses of commercial

paper• Purpose and characteristics of the

repo market

Foreign Exchange• Principal features and uses of spot,

forward and cross trades• Factors that affect FX rates• Calculate forward settlement prices

using- Pip adjustments- Interest rate parity

• Characteristics of crypto currencies

69

Asset ClassesPart 5: Collective Investments

70


Collective Investments • Regulated vs Unregulated CIS• Open-ended vs closed ended funds• Exchange-traded funds vs trading

direct with the management• Trust-based funds vs companies vs

private equity

Structured products (HOME STUDY)• The key features and components • The pay-out structures and risks

Property (HOME STUDY)• Understand the risk and rewards of

property investment- Direct investment- Real estate investment trusts- Open-ended investment companies

Section Overview

71


Introduction• A collective investment is an arrangement that enables a number of investors to

'pool' their assets and have these professionally managed by an independent manager

• Differing objectives: - Income, capital growth, combination of the two

• Advantages of collective investments- Many investors are not able to:

• Allocate the time to manage their own portfolios• Have the expertise to construct, monitor and adjust their portfolios• Benefit from economies of scale• Diversify as easily as with pooled investments

• Disadvantages of collective investments- Costs - Initial charge + Ongoing fund management costs- Risk returns are not guaranteed- Lack of control – investor loses their choice of individual investments

Collective Investments

72


Regulated and unregulated collective investment

3. Fund Regulations

Collective investment schemes in the UK

Regulated Unregulated (UCIS)(e.g. hedge funds)

Recognised

Overseas funds

e.g. UCITS

Authorised

Domestic Funds

Restrictions on investment powers fall

Restrictions on marketing increases

Further InformationRisks of UCISUnregulated schemes are deemed to be at greater risk than regulated funds due to the increased flexibility afforded over the investment portfolio. This can include:• Less liquidity in the assets which can lead to lock-in periods for investors.• Larger more concentrated positions creating less diversified portfolios.• Can be highly geared with greater use of debt and derivatives.• Little supervision of the fund in respect of regular reporting to the regulator

creating a greater risk of fraud and conflicts of interest.• Most unregulated schemes are actively managed and this can lead to

higher charges. Performance fees can greatly increase the cost to the investor

• Generally based offshore adding currency and geopolitical risk to the investment

73


Unit trust OEIC Inv. trust

Legal structure Trust Company Company

Open or closed Open-ended Open-ended Closed-ended

Holdings Units Shares Shares

Supervision Trustee Depositary Independent auditors

Managed Fund manager Authorised corporate director Fund manager

Investment rules Defined rules Defined rules Flexibility

Borrowing powers Limited ability to borrow

Limited ability to borrow

Can borrow –leverage/gearing

Price system Bid – offer (dual) Single Bid – offer (dual)

Value NAV NAV Market sentiment

Summary

74

Further Information Trust vs Company• The key difference between the legal structure of Unit Trust and Open-

Ended Investment Company (OEIC)– Unit holders are the beneficiaries of the portfolio of assets– Shareholders are the beneficiaries of the company

• Shares/units can be:– Income/distribution– Accumulation

Private equity• Typically set up as a partnership

– Invest in specialist investment and growth companies– Seek to influence the investee companies– High levels of debt is common– Typically illiquid


Open-Ended Funds

• Pricing of units/shares- Units/shares are not transferable

• No secondary market• Trades performed with the

management- The portfolio is valued once every

business day - the valuation point - Price based on net asset value

(NAV) per unit/share• Single pricing• Two-way pricing

2.9.2 Open-Ended and Closed-Ended

£

£

Portfolio

Trustee/Depositary

Units/Shares

£

Open-endedFund

Unit Trust Manager

Authorised Corporate Director

(ACD)

• Costs- Initial charges- Ongoing management charges- Exit charges – typically for a limited period only Hints

One of the major disadvantages of collective investment schemes is a lack of transparency in pricing. The true value of a unit is assessed only once a day.If the manager prices on a forward basis, the investor does not know the cost of the unit until the purchase is made at the next valuation point.

75


Investment trust companies (ITCs)

Features

• A company not a trust

• Shares trade on a secondary market- Ordinary shares- Preference shares

• Closed-ended

• Can use gearing

ITCs: Buying and selling shares

• Prices dictated by supply and demand

• Can trade at a premium or discount to net asset value (NAV)

2.9.2 Investment Trusts

Cash – primary offer only

Shares – primary offer only

ITC Fund(Closed-ended)

Portfolio

Further InformationOpen-ended vs. closed-endedClosed-ended vehicles can:• Invest in unquoted private companies as well as quoted companies• Provide venture capital to new companies or companies requiring new

funds for expansion• Borrow money to help them achieve their objectives

Further InformationVenture Capital TrustsThese are closed-ended vehicles which invest in relatively new/start-up companies. VCTs are structured like investment trusts and traded on the London Stock Exchange.

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Exchange-traded products

• Incorporated as an ICVC, but tradable on the secondary markets

• Characteristics:- Open-ended

• Trades at NAV

- Traded on the secondary markets • Real-time pricing

- Tracker or index funds • Diversified and low costs

- ‘Short’ shares can give an inverse performance to the index- Leveraged shares can give accelerated performance

• Only authorised participants can participate in the primary market- Buying or selling shares ‘in kind’ with baskets of the underlying securities

• An adaptation of ETFs is exchange-traded commodities (ETCs)

2.9.2 Exchange-traded Funds

Keeping on Target 1An investor takes a long position in an leveraged inverse index tracker fund. Which of the following best describes the likely performance?

A. If the index rises the investor will gain at the same rateB. If the index rises the investor will gain at an accelerated rateC. If the index falls the investor will gain at the same rateD. If the index falls the investor will gain at an accelerated rate

Keeping on Target 2Where can authorised participants buy exchange traded funds (ETFs) directly from a fund manager?

A. In the secondary marketB. In the open market without restrictionsC. In the primary marketD. Through creation units via a retail broker

HintsWhen tracking an index, the providers of ETFs can use either physical or synthetic replication to ensure their ETFs mimic their designated indices as accurately as possible.Physical – where the ETF provider owns the constituents of the index being tracked. Can lead to higher charges.Synthetic – ETF provider receives the total return on an index through a derivative (e.g. a swap). Increases counterparty risk.

77

Asset ClassesPart 6: Structured Products and Property

Answer to previous Keeping on Target 2 question = COnly authorised participants (typically large institutional investors) actually buy or sell shares of an ETF directly from/to the fund manager, and then only in creation units – large blocks of tens of thousands of ETF shares – which are usually exchanged in kind with baskets of the underlying securities, this would be known as the primary market.

Answer to previous Keeping on Target 1 question = DThe investor buys (goes long) a share in a leveraged fund. The fund’s gearing increases the rate at which profits or losses are made. The fund is an inverse fund (sometimes called a short fund) and gives returns opposite to the index: i.e. if the index rises, the share value falls, and vice versa.

Home StudyThis sections is marked HOME STUDY. You will need to review specific videos on the online portal for this section.

You can find the video for this on you online study portal:Collective Investments > Video > Chapter 4 – Structured ProductsCollective Investments > Video > Chapter 4 – Property

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Features of structured products

• Combining two or more individual financial instruments- Typically a bond and a derivative

• Tailored to offer specific risk reward profiles that traditional assets may not offer, for example:- They may offer growth with low risk or high risk income- They run for a defined term e.g. 18 month to 7 years- Defined risk and return

• Two broad categories- Structured deposit – returns on deposit linked to the performance of another asset- Structured investment

2.10.1. Structured Products Home Study

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Structured investments – three broad types

• Capital protected product- For example, a zero coupon bond combined with a long option position.

• The discount on the zero coupon bond funds the purchase of the option• The option could be linked to any asset• No income from the underlying asset

• Capital at risk product- AKA accelerated tracker- Gives leveraged participation but sacrifices capital protection

• Buffer zone product- Offers participation in the return on an asset- Negative returns protected to a predetermined level, e.g. 20%- Full exposure to loss if predetermined level is breached

2.10.3. Pay-out StructuresHome Study

Further Information Other pay-out structures

• Callable – the product can mature early• Range accruals payoff – the longer the referenced asset remains within a

set range the higher the payout• Averaging levels – based on an average price of the underlying asset• Lookback – the holder can choose the most advantageous price over the life

of the product on which to base the payout• Cash or nothing payoff – using binary options with a fixed cash payout, but

only if a set condition is reached• Quantity adjusting (Quantos) – to gain exposure to foreign assets but

eliminate the FX risk

80


Advantages and risk of structured products

2.10.4. Risks

Advantage DisadvantageStructure products

Flexible risk return• Principle protected• Return enhancedReduced volatilityOffshore

Credit risk on the bondCounterparty risk on the derivativeProvider risk on the product itselfInflation riskOften needs to be held to maturityCharges can be highCall risk

Further Information Call risk

• Some products have auto-call features (or kick-out triggers) that terminate the product early. This could prevent further profit or prevent recovery from loss.

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Methods of property investment

2.7.3 Property

Advantage DisadvantageDirect Low volatility

Income and gainReal asset

IlliquidityTransaction and maintenance costsCyclical values and depreciation

Real estate investment trust

Real-time pricing on an exchangeLiquidity of a shareTax transparent vehicleEligible for ISAs, pensions, etc.

Can behave like a share in the short-termInvestor taxed as property income

Open ended property funds

Reflect the NAV of the property portfolioInvestors trade direct with the management company –liquidity

Management costs can erode returnsCan be subject to moratoria

Further Information Differences between residential and commercial property investment

Residential property

Commercial property

Direct investmentSecond homes, holiday homes,

buy-to-let

Large initial outlay restricts

investment to institutional investors

Tenancies Typically short renewable leases

Long-term contracts

Repairs Landlord responsible

Tenant responsible

Returns Rent linked to house prices

Rent linked to income potential

82


Collective Investments • Regulated vs Unregulated CIS• Open-ended vs closed ended funds• Exchange-traded funds vs trading

direct with the management• Trust-based funds vs companies vs

private equity

Structured products (HOME STUDY)• The key features and components • The pay-out structures and risks

Property (Home study)• Understand the risk and rewards of

property investment- Direct investment- Real estate investment trusts- Open-ended investment companies

Section Review

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Markets

1 question

Chapter 3

Home StudyThis section is marked HOME STUDY. You will need to review specific videos on the online portal for this section.

You can find the video for this on you online study portal:Markets > Video > Chapter 3 – Markets

84

Markets

Home Study

85

Further Information Dilutive vs non-dilutiveNon-dilutive – where shares are brought to the market from the issued share capital but not part of the free float. E.g. directors selling their own shares to investors.Dilutive – where a company’s board of directors agrees to increase the share float for the purpose of selling more equity in the company.

Keeping on TargetFrontier and emerging market equities trade mostly on:

A. Over the counter venuesB. Multi-lateral trading facilitiesC. Organised trading facilitiesD. Stock exchanges

HintsNot all primary market activities raise money for the issuer. A non-dilutive issue, for example, where founders sell on their own shares only raises money for the founders selling their shares.


Primary vs. secondary

• Primary market- Initial public offer/primary offer

• The first sale of stock by a company to the public

- Follow-on/secondary offer• Dilutive vs non-dilutive

• Secondary market- Existing securities are traded between investors- Stock exchanges provide a central market place

• Enhances liquidity

• Regulation- In both primary and secondary markets issuers are regulated, primarily in respect of

governance and transparency- Firms that assist in issuing securities and firms that trade securities are also regulated

3.1.1 Primary and Secondary MarketsHome Study

86

Answer to previous Keeping on Target question: DThe term ‘frontier markets’ is commonly used to describe the smaller and less accessible equity markets. These equities are still investable on stock exchanges as also are the securities of emerging markets..


Primary Markets

14 questions

Chapter 4

87

Primary MarketsPart 7: Participants and Types of Offer

88


Types of offer• The purpose and structure of• An initial public offer• A follow on issue• An offer for sale• Selective marketing (placing)• Introductions• Exchangeable/convertible bond

offering

Participants involved• Participants in a syndicate group• The role of advisors• The issuer’s obligations

• The purpose and practice of • Underwriting• Stabilisation

Stock exchanges (see secondary markets)• The roles and regulations• The admissions criteria

Bond offerings• The different types of issuer• The methods of issue• The role of the origination team

Section Overview

89


Stages

• Decision- Appointment of an underwriting firm- Creation of origination team

• Preparation of prospectus- Marketing to investors

• Prospectus• A prospectus is a detailed document providing potential investors with the information required

to make an informed decision on the company and its shares. It is required whenever a company issues securities in order to raise capital from the public.

• Sale of securities

4.1.1 Initial Public Offer

90

HintsLegal advisers and reporting accountants provide due diligence for the prospectus.

Keeping on TargetA company is in the process of issuing its shares and there is an origination team working on their behalf. Who would assess the best method for bringing the company to the market? A. Legal advisorB. Reporting accountantC. Corporate brokerD. Sponsor


Origination team

• A range of advisers working with the lead manager to help the company place its new issue of shares/bonds:- Sponsor (listing agent)

• Assesses the company’s suitability for listing• Assesses the best method of bringing the company to market• Co-ordinates the production of the prospectus

- Legal advisors• Ensues all relevant matters are covered in the prospectus

- Public relations• To created a positive perception of the company

- Accountants• Validates the financial statements in the prospectus

- Corporate broker• The interface between the company and the market• Advises the company on current market conditions

4.2.1 Listing Advisers

91

Further InformationKey definitionsUnderwriting firm (typically an investment bank) – helps a company determine what type of security to issue, the best offering price and the time to bring it to the market, and acts as sponsor/advisor for the issuance of securities.Lead manager – a firm who is given the responsibility to co-ordinate the issuance of securities through a syndicate. Generally the sponsor.Co-manager – a firm who has been appointed by the lead manager to assist in the issuance.Co-lead manager – firms who have been given joint responsibility to co-ordinate the issue of securities and are usually in different geographical areasIssuing house – (usually an investment bank) invites applications from the public at a slightly higher price than the issuing house has paid the issuing company through an offer document.Bookrunner – a firm who is given the role to co-ordinate the overall level of investor demand. Typically the lead manager.Underwriter – a firm (or syndicate of firms) who guarantees a minimum level of proceeds from a share issue.

Answer to question on the previous slide: DThe role of the sponsor includes assessing the company’s suitability for listing, the best method of bringing the company to the market, and co-ordinating the production of the prospectus.


Syndicate group

4.2.2 The Syndicate Group

Co-lead Manager£

PENSION FUND

WEALTHY INDIVIDUAL

SHARES

£

SHARES

£

SHARES

£

SHARESISSUING COMPANY

INSURANCE COMPANY

£

SHARES

£

SHARES

SYNDICATE

£

PENSION FUND

WEALTHY INDIVIDUAL

SHARES

£

SHARES

£

SHARES

£

SHARESISSUING COMPANY

INSURANCE COMPANY

£

SHARES

£

SHARES

Co-lead Manager

Co-lead Manager

Keeping on TargetAn investment bank has successfully completed a book-build for a company wishing to issue shares. What does this suggest?

A. They have allocated available shares to willing buyersB. They have discovered insufficient demand for the sharesC. They have guaranteed the issueD. They have applied to the listing authority for market acceptance

92

Further Information StabilisationStabilisation is the process where a lead manager in an issue purchases stock in the secondary market in order to support the price of the issue. Regulations typically require clear disclosure of stabilisation to the market.

HintsThe structure of an offering of a convertible or exchangeable bond mirrors that of equities – the issuer will set a base amount of bonds it wishes to issue and perhaps retain a greenshoe, reserving the right to issue more if demand is strong.


Underwriting

• Purpose- Means of guaranteeing a minimum level of proceeds from a share issue- Used in all situations where share issues are generating proceeds (‘marketing

operations’)

• Underwritten vs. best efforts

• Structure- Base deal - Greenshoe (over-allocation option)

• No limit on number of underwriters

Stabilisation

• Where a lead manager in an issue purchases stock in the secondary market to support the issue price

4.2.3/4 Underwriting and Stabilisation

Answer to question on the previous slide: AA successful completion of the book build suggests all shares have been allocated

93

Further InformationPricing the issueFixed price offer Where the price is fixed just below a point at which it is believed there would be full subscription, to encourage an active secondary market.Tender offer Book building process where minimum price is set and investors respond with prices and volumes they would be prepared to pay.


Offer for subscription

Offer for sale

4.1.3/4 Offers

Company A

£

Shares

Investor

IssuingHouse

Company

Shares

££££££

Shares

Investor

94

HintsListing without a prospectusOfferings made to the general public typically require a prospectus.Issuers are exempt from the obligation to produce a prospectus where offers made are to sophisticated or qualified investors.

Further InformationIntroductionMay be undertaken by a company that is already quoted on an overseas stock exchange and is seeking to expand its potential shareholder base on another exchange.


Placing – for qualified investors

• Selective marketing technique: Cheaper than offer for sale

• Book building

Introduction

• A company obtains a listing without issuing new share capital

4.1.5/6 Selective Marketing and Introductions

Small investors would not be offered shares in a placing.

Wealthy individuals

Institutions and wealthy individualswould be offered shares in a placing.

£

£

95

Further InformationAgency bondsSome government sponsored entities also issue bonds. As they are backed by the government, they are considered safe investments.

In the US, examples include:• Government National Mortgage Association (Ginnie Mae)• Federal Home Loan Mortgage Corporation (Freddie Mac)• Federal National Mortgage Association (Fannie Mae) • Student Loan Marketing Association (Sallie Mae)

Note: Fannie Mae and Freddie Mac now come under the conservatorship of the US Treasury and a public underwriting of their entire obligations.

HintsMunicipal bonds are attractive to many investors because the interest income is exempt from federal income tax, and in many cases, state and local taxes.


Types of bond issuer

• Governments

• Supranational bonds- E.g. World Bank

• Municipal bonds- E.g. States or local authorities

• Agency bonds- Government sponsored agencies

• E.g. Federal Home Loans Bank in US

• Special purpose vehicles

• Corporate

4.4.1 Types of Bond Issuer

96

Keeping on Target An auction is offered to raise £100m nominal value at a market price of £101 per £100 nominal.

ABC offers £102.50 for £50m nominalDCF offers £101.75 for £50m nominalGHI offers £101.50 for £50m nominal

Who would be successful and what is the price they will pay?

A tender is offered to raise £100m nominal value at a market price of £101 per £100 nominal.

ABC offers £102.50 for £50m nominalDCF offers £101.75 for £50m nominalGHI offers £101.50 for £50m nominal

Who would be successful and what is the price they will pay?

Further InformationNon-competitive bidsGovernments may issue a smaller tranche of the debt using a non-competitive process. Non-competitive bids are allotted at theweighted average price of the accepted price bids.


Government issues

• UK Government gilts: Issue – Debt Management Office (DMO)- Competitive: Bids for ≥ £1,000,000 nominal

• French and German Government auction – bid pricing system

• US Government Auctions – tender style (single price auction)- The United States Department of the Treasury – Federal Reserve

4.4.2 Bond Issuance

97

Further InformationThe stages of a typical bond issue include some or all of the following:• Pitching: investment bank(s) interested in managing the issue make a

pitch – a presentation to the issuer.• Indicative bid: an indication given by the investment bank to the issuer

regarding how much the bond issue might raise.• Mandate announcement: the announcement of the bank(s) given the

mandate to manage the bond issue.• Credit rating: the investment bank will try to obtain a favourable credit

rating for the issue from a rating agency. The success of the issue and the interest rate required by investors depend on the credit rating of the bond.

• Roadshow: a series of meetings with potential investors and brokers, conducted by a company and its underwriter, to market the issue.

• Listing• Syndication

Answer to the first question on the previous slide

Auction = ABC is successful and pays £102.50; DCF is successful and pays £101.75 and GHI is unsuccessful.

Tender = ABC is successful and pays £101.75; DCF is successful and pays £101.75 and GHI is unsuccessful.


Corporate issues

• There is typically a need to raise debt capital regularly to fund developments in the business

• This can be done through- Scheduled programmes

• Arrangement with a bank to borrow money rather than issue bonds

- Shelf registration• Single registration covers multiple issues

- Up to two years• Typically used in US with medium-term notes (MTN)

• Sometimes companies may issue MTNs in response to client requests- Reverse enquiry

4.3.2 Bond Issuance

98


Types of offer• The purpose and structure of• An initial public offer• A follow on issue• An offer for sale• Selective marketing (placing)• Introductions• Exchangeable/convertible bond

offering

Participants involved• Participants in a syndicate group• The role of advisors• The issuer’s obligations

• The purpose and practice of • Underwriting• Stabilisation

Stock exchanges (see secondary markets)• The roles and regulations• The admissions criteria

Bond offerings• The different types of issuer• The methods of issue• The role of the origination team

Section Review

99


Capital Adjustments

7 questions

Chapter 6

100

Capital AdjustmentsPart 8: Corporate Actions and Share Capital and Changes to Ownership

101


Income events• The main types of equity and bond

payments• The concepts and requirements of

cum/ex dividend payments (from Chapter 7)

Capital events• The main types of bond repayment

events• Characteristics and rationale for capital

restructuring• Calculate the impact on the share price

of- Bonus issue- Stock split- Reverse split

Capital raising events• The characteristics of a rights issue• Calculate

- Ex-rights price- Maximum subscription at nil cost- Nil paid p[rice

Share capital and changes to ownership• Purpose of share buy-backs• Purpose of stakebuilding• Characteristics of takeovers and

mergers

Section Overview

102

Keeping on TargetWhere a bond issuer has set aside a certain amount each year to buy back a certain number of bonds which are deemed callable, they would have set up a:

A. Sinking FundB. Medium-term note programmeC. Scheduled shelf registration programmeD. Swimming fund


Income events

• Coupons from bonds- Fixed- Floating rate bonds

• Dividends from equities- Ordinary shares – variable- Preference shares – fixed

Capital events

• Redemption of bonds- Callable and putable issues- Bullet issue – fixed repayment of

capital at end- Sinking funds – where the principal is

paid in part before final redemption date

• Shares- Rights issues- Bonus issues- Splits and consolidations

6.1.2/3 Introduction

103

Answer to question on previous slide: AA sinking fund involves the issuer setting aside a certain amount each year. A sinking fund approach may be combined with a bond issue that is callable. A callable bond is one where the issuer has the right, at specified points during the bond's life, to redeem some, or all, of the bonds at a pre-agreed amount, often at par value. Obviously, a call provision will give the issuer the ability to redeem a bond early if it is relatively expensive tax.


Ex-dividend

Ex-dividend date

7.6.1 Cum- and Ex-Dividend

The buyer of the security will be entitled to receive the next dividend payment

The buyer of the security will not be entitled to the next dividend payment.

Entitlement to the next dividend payment remains with the seller.

EX-DIV

DATE

CUM -DIV PERIOD EX -EX -DIV PERIOD

104

Further InformationRecord dateThe record (books closed) date is the date on which a company inspects the register of members in order to establish which shareholders will be sent the dividend.Special ex-date tradeA trade where the share is bought/sold without the dividend that takes place in the cum-div period. It is permitted for up to 10 days before the ex-div date.Special cum-div tradeA trade where the share is bought/sold with the dividend that takes place in the ex-div period. It is permitted up to the day before the dividend payment date.

Keeping on TargetWhy would an investor want to trade special-ex?A. To avoid capital gains taxB. To reduce regulatory reporting requirementsC. To receive a dividend they would otherwise not be entitled toD. To avoid income tax


Record date

Special periods

• Special ex-date

• Special cum-bargains


(Usually a Thursday)Company proposes a dividend

Record date

(Friday)

EX-DIV

DATE

CUM -DIV PERIOD EX -DIV PERIOD

105

Further InformationClaim GenerationA trade occurs cum-dividend, but the settlement is delayed until after the record date. On the dividend payment date, the company will pay the dividend to the selling investor instead of the buyer, as it will use the name of the registered holder on the record date to determine the recipient of the dividend. The buyer’s broker will then make the claim.

Keeping on TargetAn investor bought shares 'cum’, but there was a delay in settlement until after the record date. Upon the dividend payment date, which of the following describes the appropriate process?A. Buying investor's firm will need to arrange for the dividend claim to be

madeB. Selling investor's firm will inform the buyer and pay the dividendC. Buying investor will claim directly from the previous registered ownerD. Buying investor will claim the dividend from the LSE

Answer to question on previous slide: DThe motivation for investors buying or selling with or without the dividend entitlement tends to be related to tax. Dividend income is normally subject to income tax, so selling the right to the dividend may avoid some income tax.


Claim generation

How a claim may arise


(Thursday)Company proposes a dividend

Record date

(Friday)

Special ex date

(XD – 10 business

days)

EX-DIV

DATE

CUM -DIV PERIOD EX -DIV PERIOD

Dividend payment

date

Trade date

106

Further InformationRights issueA rights issue is an attractive way for a company to raise new finance for the following reasons:• There is no dilution of shareholders’ interest (assuming they take up

their rights)• The issue is at a discount to the current market price to make it attractive• A shareholder who does not want to subscribe more cash and take up

their rights can sell them• Such issues are generally underwritten

It is possible for shareholders to waive pre-emption rights through a special resolution at a general meeting of UK-listed companies. Even in these situations, it is considered best practice to limit such issuance to 5% in any single year unless the resolution state otherwise.


It is the buyer's firm that will make the claim from the seller's firm.


6.3.1 Rights IssueFeatures of a rights issue

• A follow on issue of shares giving existing shareholders the right to subscribe to more shares in proportion to their existing holding- Mitigates the risk of diluting ownership- Share typically offered at a discount to current market price

Example

• A company does a 1:4 rights issue at a subscription cost of £1.50 each share. If the current share price is £1.75, what is the theoretical ex-rights price?

- Before the rights issue: 4 shares @ £1.75 each = £7.00- During rights issue: 1 share @ £1.50 each = £1.50- After rights issue: 5 shares = £8.50

The theoretical ex-rights price = £8.50 / 5 shares = £1.70 per share.

107

Hints Open OfferAn open offer is very similar to a rights issue, but the investor are not permitted to sell their rights nil-paid. Instead they have only two choices:• Take the rights• Allow the rights to lapse

Hints Pre-emptive rightsEvery existing shareholder will receive a provisional allotment letter indicating the new shares they have the right to buy.

The shareholder has four choices:• Take up the rights• Sell the rights• Split the rights• Allow the rights to lapseThe investor will normally get at least 10 business days to make their choice.Knowledge | Skills | Conduct

6.3.1 Nil-Paid ValueTheoretical nil-paid price

• An investor may choose to sell their rights nil-paid

Theoretical nil paid price = Theoretical ex-rights price - Subscription price

• Using the details from the previous example the price received for the right would be

Theoretical nil paid price: £1.70 - £1.50 = 20p

Keeping on TargetAn investor is holding 1500 shares with a nominal value of £1. A company goes through a 1 for 3 rights issue where the shares are currently trading at £1.80. The subscription cost for the new shares is £1.25. How much would they investor receive if they sold all of their rights?

A. £875.00B. £618.75C: £206.25D. £68.75

108

Keeping on Target 2A company announces a rights issue where an existing shareholder is allocated 1000 rights. If the cost of purchasing the new shares is £0.40 and the nil paid value of the right is £0.10, how many shares will they be able to purchase at nil cost?A. 100 sharesB. 200 sharesC. 250 sharesD. 400 shares

HintsWhen calculating maximum subscription at nil cost:

Sell more rights to buy fewer shares.

Keeping on Target 1An individual holds 2,100 shares in X Plc. The cum-rights share price is £6 when the company performs a 1:3 rights issue. The subscription price is £5. What is the maximum subscription at nil cost?A. 609 sharesB. 273 sharesC. 700 sharesD. 91 shares


Maximum subscription at nil cost

• An investor may choose to sell a portion of the rights available and use the funds raised to finance the take-up of the remaining rights- AKA tail swallowing

6.3.1 Maximum Nil-paid Rights

pricerights-exTheoreticalpriceSubscriptionavailable xrightsofNumbersoldbetorightsofNumber

Answer to the first question on the previous slide = C

Calculate the TERP:(3 x £1.80 + 1 x £1.25) / 4 = £1.6625Calculate the nil paid price per share£1.6625 - £1.25 = £0.4125Total nil paid price500 rights x £0.4125 = £206.25

109

Answer to the first question on the previous slide = D

2,100 shares will give the shareholder 700 rights as it is 1:3 rights issue. The formula to calculate the number of rights that need to be sold is Subscription price / Ex-rights price x No of rights.

Answer to the second question on the previous slide = B

If the nil paid value of the right is 10p and the new shares cost 40p then the investor will need to use 4 rights to buy 1 new share, so they would need to sell 800 of their rights to generate enough income to buy 200 shares. 800 x £0.10 = £80 of income to equal 200 x £0.40 = an £80 cost.


Features of a bonus/scrip issue

• A follow on issue of shares to existing shareholders in proportion to their existing holding- Share issued free of charge- Significantly dilutes the share price

Example

• A company performs a 1:2 scrip issue. If the current share price is £15 per share, what is the theoretical ex-scrip price?- Before the scrip issue 2 shares @ £15.00 each = £30.00- During the scrip issue 1 share @ no cost = £0.00- After the scrip issue 3 shares = £30.00

• The theoretical ex-scrip price = £30 / 3 shares = £10 per share

6.2.3 Scrip or Bonus IssuesKeeping on TargetA company announces 2:3 bonus issue if the ex-scrip price is £1.38 what was

the cum-scrip price?

A. £0.83B. £1.47C. £2.30D. £3.83

110

Answer to the question on the previous slide: CEx-scrip price is £1.38Investor will have at least 5 shares if they took part in the issue – three original shares plus two new shares.£1.38 x 5 shares = £6.90The investor’s original 3 shares would have been worth:£6.90 / 3 shares = £2.30

HintsWhen a company issues new shares, the nominal value of each share must be covered in the share capital account; even if no new capital has been raised. This value is often referred to as the called-up share capital.


Alterations in share capital

Any adjustment to the issued shares affects these accounts, e.g.:

• Issue of new shares- Share capital increases- Share premium increases

• Bonus issue vs. stock split

6.2.3 Stock Split and Scrip Issue

Bonus Stock split Reverse Split

Effect on the market

Share price Reduced Reduced Increased

Number Increased Increased Reduced

Effect on the Statement of

Financial Position

Nominal value Remains the same Lowered Increases

Called-up share capital Rises Remains the

sameRemains the

same

Share premium account Falls Remains the

sameRemains the

same

111

Keeping on TargetWhich of the following does not lead to an increase in the number of shares issued by a company?A. Rights issueB. Capitalisation issueC. Stock splitD. A call on partly paid shares


Share buy-backs: Background

• A company uses its own money to buy back shares from existing investors

• Reasons for company buy-backs:- To rationalise its capital structure- To substitute dividend payouts with share repurchases- To deploy excess cash flow and return it to shareholders

• Approval required from shareholders

• Methods of company buy-backs:- Block trades- Accelerated book-building- Best efforts

• Back stop price – maximum purchase price

- Bought deal

6.4.1 Share Buy-backs

112

Answer to question on previous slide: DA call on partly paid shares requires investors who already hold the shares to make further payments to the company.

Further InformationFCA’s Disclosure and Transparency Rules• Notifiable interest = 3% or more of its shares. Triggers an obligation to

inform the company – Once above 3%, notification required if the holding rises or falls through

a whole percentage point.Indirect exposure to shares, such as options on shares and contracts for differences (CFDs) are included in these disclosure requirements.

Keeping on Target A company has acquired the shares of another company resulting in takeover proceedings. Which of the following would be the minimum percentage where the takeover will be considered successful?

A. 30%B. 50%C. 75%D. 100%


Stake building: Background

• An investor may want to buy a stake in a company because:- They merely want to own the shares- They are building a strategic link- They are attempting to acquire the target company

• Acquire more than 30% or more of the shares in a company, then takeover or merger proceedings will be announced to the market

• If more than 50% is acquired, the takeover was successful

• A merger is where two similar sized companies come together

6.4.2/3 Stake Building

Further InformationDawn RaidA direct acquisition technique. Acquirer (predator) instructs brokers to purchase shares in a target company as soon as the market open. The purpose is to take legal control before public disclosures need to be made.

113


Income events• The main types of equity and bond

payments• The concepts and requirements of

cum/ex dividend payments (from Chapter 7)

Capital events• The main types of bond repayment

events• Characteristics and rationale for capital

restructuring• Calculate the impact on the share price

of- Bonus issue- Stock split- Reverse split

Capital raising events• The characteristics of a rights issue• Calculate

- Ex-rights price- Maximum subscription at nil cost- Nil paid p[rice

Share capital and changes to ownership• Purpose of share buy-backs• Purpose of stakebuilding• Characteristics of takeovers and

mergers

Section Review

Answer to the question on the previous slide = CAn acquisition of another company is achieved by purchasing more than 50% of the shares, and thereby gaining control of the votes and the company. It is usual to talk in terms of the acquiring company being the predator or offeror and the company being acquired as the target or offeree.

114


Secondary Markets

15 questions

Chapter 5

115

Secondary MarketsPart 9: Principal Characteristics

116


Trading venues• Characteristics and practices

- Developed- Emerging and frontier

• Purpose and main features of - Exchanges- Alternative trading venues

Methods of trading and participants• Order driven vs quote driven• Functions and obligation of key

participants• Algorithmic trading

Stock exchanges• Regulatory framework and admissions

criteria (from chapter 4)• Rules, procedures and requirements

Section Overview

117

Further InformationMajor Exchanges Worldwide

China – unusual market structureA shares traded on Shanghai and Shenzhen exchanges and subject to restrictionsH shares are mainland Chinese companies listed in Hong Kong

Exchange Country Trading system

DeutscheBörse

Germany Electronic

LSE UK Electronic

NASDAQ US Electronic

NYSE US Electronic with some open outcry

Euronext Europe Electronic

TSE Japan Electronic


Exchanges: Purpose

• Central location for buyers and sellers to meet- Facilitate trading

• Members and traded companies regulated- Gives greater confidence in the market

• Transparency- Price discovery mechanisms

Developed markets

• Offer sophisticated formal markets

• High degree of regulation

Underdeveloped markets

• Lower degree of sophistication

5.1.1 Features of Stock Exchanges

118

Further InformationJunior Market Admissions UK Alternative Investment Market (AIM)The main requirements for a company’s shares to be admitted to the AIM are twofold:1. That there is no restriction on the transferability of the shares.2. That the AIM company appoints two experts to assist it:

a. The nominated adviser – as seen, the nomad can be thought of as an exchange expert, advising the company on all aspects of AIM Listing Rules and compliance.

b. The broker – AIM companies’ shares are usually less liquid than those of fully listed companies; it is the broker’s job to ensure that there is a market in the company’s shares, to facilitate trading in those shares and to provide ongoing information about the company to interested parties.

As with the Official List, the LSE imposes similar continuing obligations on AIM companies. There are also certain other aspects in relation to AIM companies and their broker and nominated adviser:• The broker and adviser can be the same firm; they are often firms of

stockbrokers or accountants.• If a company ceases, at any time, to have a broker or adviser, then the

firm’s shares are suspended from trading.• If the company is without a broker or adviser for a period of one month it is

removed from AIM.


Typical conditions for listing on a main market

• Public traded companies- Freely transferable shares- Minimum free float

• Protection against dilution of ownership- E.g. pre-emption rights and restriction on shares issued through warrants and

convertibles

• Minimum market value and/or number of shares brought to market

• Established trading record- Typically three years in Europe

• Production of a prospectus

• Ability to meet ongoing requirements- E.g. disclosure requirements around price sensitive information

4.3.1 Admissions Criteria for Listing

119

Hints

Multilateral trading facility (MTF) is a European term. In the US they refer to this type of system as an Electronic Communication Network (ECN) or Alternative Trading System (ATS).

Hints

Liquidity rebateAn incentive offered to market makers by MTF and other platform providers to encourage the use of their platforms.


5.1.1 Alternative Trading SystemsDescription Operator Regulation Users Benefits

MTF Crossing network (matching engine) for equities

Market operator Treated as an exchangeDefined rules for members

Banks, mutual funds, insurance companies

Alternative to exchanges

OTF Crossing network (matching engine) for bonds and derivatives

Investment firms and private organisations

Treated as an exchangeDefined rules for clients

Banks, mutual funds, insurance companies

Alternative to exchanges

Off-exchange transactions

Dark Pool Exchange traded liquidity with OTC confidentiality through hidden orders

Investment firms and private organisations

Considered OTC unless volumes are large then treated as an MTF

Funds Reducing market impact of large orders, better pricing, lower execution costs

Systematic internalisers

Investment bank facilitates cross trades but in principal

Investment banks

The investment bank takes the role of central counterparty

Investment banks and their clients

120


Quote-driven

• Price controlled by price makers (market makers)

• Bid/offer spreads- Firm prices up to a specified level

• Screen- and phone-based

Order-driven

• Prices determined by buy orders and sell orders

• Orders awaiting execution placed on order book

• Electronic trading

5.2.1 Order vs. Quote-drivenKeeping on TargetWhich of the following is a feature of a quote-driven market rather than an order-driven market?

A. Automatic execution of ordersB. Market makers matching client ordersC. Market makers obliged to quote pricesD. Buyers and sellers negotiating prices

121

HintsAlthough the IDB acts as an agent between two firms it settles the transaction as if it were principal. However, it does not hope to make profits from price rises or falls by taking a position in the market.


5.2.2 ParticipantsMarket participants

• Brokers- Act as agent for a client

• Dealers- Act as principal for their own account

• Dual capacity- Are able to act as agent and principal

• Market Makers- Must provide prices at which it is willing to buy and sell a minimum number of its chosen shares

throughout the course of the trading day

• Acting as an inter-dealer broker


122


Stock lending

• Temporary transfer of securities with an agreement to return equivalent securities to the lender at pre-agreed time- Securities driven or cash driven

Stock borrowing and lending intermediary

• After the market maker has sold the shares ‘short’, it will borrow stock via an SBLI so that it can settle its position with the investor

7.8.1 Stock Lending

Investor

1000 shares

(Commission) (Fee)

1000 shares

In ABCIn ABC

Market maker- Sells ‘short’ 1000 ABC

shares

SBLI Pension Fund

Further InformationStock lending

Effect on a lender’s rights:

• Title of security passes to the borrower

• Borrower receives dividends/coupons

• Benefits of corporate actions passed on to the lender

• Voting rights lost (unless stock recalled in good time)

Stock lending agreement

• Sets out how the benefits of the lent securities will be passed back to the lender e.g. manufactured dividend

Global Master Securities Lending Agreement

• Sets out legally binding contracts in a standardised format for participants

• Reviewed regularly

Keeping on TargetIn a stock borrowing and lending agreement, the borrower will provide collateral to the lender. Where the fee has been has been quoted as a rebate this would mean, it is where:

A. traders who put in limit orders receive a small rebate from the exchange because they are regarded as having contributed to liquidity in the stock

B. the borrower has paid too much in transaction costs and taxes and this money is paid back as a rebate to the borrower

C. cash has been placed as collateral and, as the lender earns interest that accrues on the cash, an agreed rate will rebated to the borrower

D. collateral of a significant credit rating has been offered up by the borrower, meaning if the borrower should default the collateral will easily cover the loss

123

Further InformationPotential criticisms of high frequency trading include seeing the traders as ‘vultures’ exploiting the genuine, longer term investors and given their dominance of market turnover, the impact they can have on pricing.High frequency trading has also been criticised for the systemic risks that it can create. In the event of extreme price movements on one exchange, the arbitrage trades automatically placed by the high frequency traders can rapidly spread the price movements to other exchanges where the sameinstruments, or related instruments, are traded.


Algorithmic trading

• Developed due to the arrival of electronic trading systems- Reasons for popularity

• Removing the emotion of trading• Preservation of discipline• Speed, accuracy and reduced costs

• Helped develop high frequency trading- Originally used by small, specialist firms and now frequently used by hedge funds and

the large investment banks

• Flash crashes

5.2.3 Algorithmic Trading

HintsLatency and co-locationHFT work on speed and latency can be an issue. The further the signal has to travel, the longer it takes. Co-location is where the trader gets as close to the exchange as possible to minimize data transmission time.


Cash has been placed as collateral and, as the lender earns interest that accrues on the cash, an agreed rate will rebated to the borrower

124


Trading venues• Characteristics and practices

- Developed- Emerging and frontier

• Purpose and main features of - Exchanges- Alternative trading venues

Methods of trading and participants• Order driven vs quote driven• Functions and obligation of key

participants• Algorithmic trading


criteria (from chapter 4)• Rules, procedures and requirements

Section Review

125

Secondary MarketsPart 10: Order Book Trading

126



criteria (from chapter 4)• Rules, procedures and requirements• Order types• Function of a central counterparty• Costs and charges and stamp duty.

Indices (HOME STUDY)• Types and purpose of indices

Section Overview

127


Order book trading

• Fully automatic trading- Execution, Matching, Reporting- Straight-through processing to settlement

• Trading halts- The exchange can prohibit any transaction for any reason

• Typical reason is suspension of listing

- Members must gain permission to trade in a suspended security- The length of the halt is at the discretion of the exchange

• Transparency of member orders- Members only can view the order book- Order priority

• Price, then time

- No minimum/maximum order size

5.3.1 Rules and Procedures

128

Further InformationAuctionsAuction activity is visible to all members. The random start is to prevent manipulation. The price assessed by the uncrossing algorithm becomes the opening price for the security. During the course of the uncrossing, addition, amendment or deletion of orders is not permitted.Interruption to automatic execution – if the price of a trade is significantly different from the last automated trade (this can be anything from 5% to 25%), automatic execution can be suspended. Trading would restart with an intra-day auction.


Sample order book: Trading day

4.3.1 Opening Auctions and Automatic Execution

TRADING DAY

MATCHING

MATCHING

CONTINUOUS ORDER BOOK

TRADING

A U C T I O N

A U C T I

O N

5.00pm4.30pm8.00am7.50am

HOUSE-KEEPING PERIOD

4.35pm

Opening auction call period

Member firms enter orders

No automatic execution

Closing auction call period. Member

firms enter ordersNo automatic

execution

Member firms may delete, but not add

new ordersNo automatic

execution

129

Further InformationIceberg order allows an order to be partially hidden from the market view.Upon entry of the order, the participant specifies:• The total order size • The visible 'peak' size (the maximum volume that will be shown to the

market at any time) Matching orders will execute against the visible peak. The system automatically brings in the next tranche onto the order book as a new order. This will continue until the order has been exhausted or until deleted.

HintsEach time a new tranche of an iceberg order is revealed a new time stamp is given to the order.


Continuous order book trading

Limit order

• Anonymous

• Iceberg

5.3.2 Order Types

Tesco TSCO Currency GBX

5,000 210 - 214 3,000

5,000 210

1,000 209

11,000 208

3,000 207

2,000 206

214 3,000

215 5,000

216 7,000

217 6,000

218 1,000Tesco TSCO Currency GBX

1,000 209 - 210 1,000

1,000 209

11,000 208

3,000 207

2,000 206

210 1,000

214 3,000

215 5,000

216 7,000

217 6,000

218 1,000

LIMIT ORDER:

Sell 6,000 at 210 limit

Note: The touch price now reflects the new offer at 210

Example

130



Market order

5.3.2 Order Types

MARKET ORDER:

Buy 8,000 at market


11,000 208 - 210 1,000

11,000 208

3,000 207

2,000 206

210 1,000

214 3,000

215 5,000

216 7,000

217 6,000

218 1,000Tesco TSCO Currency GBX

11,000 208 - 215 1,000

11,000 208

3,000 207

2,000 206

215 1,000

216 7,000

217 6,000

218 1,000

Example

131



Execute and eliminate order

5.3.2 Order Types

EXECUTE & ELIMINATE:

Sell 2,000 at 209 limit

Note: Remaining unexecuted 1,000 is cancelled


1,000 209 - 210 1,000

1,000 209

11,000 208

3,000 207

2,000 206

210 1,000

214 3,000

215 5,000

216 7,000

217 6,000

218 1,000


11,000 208 - 210 1,000

11,000 208

3,000 207

2,000 206

210 1,000

214 3,000

215 5,000

216 7,000

217 6,000

218 1,000

Example

132



• Fill or kill order

• All or nothing

5.3.2 Order Types

FILL OR KILL:

Buy 2,000 at 215 limit fill or kill


11,000 208 - 215 1,000

11,000 208

3,000 207

2,000 206

215 1,000

216 7,000

217 6,000

218 1,000


11,000 208 - 215 1,000

11,000 208

3,000 207

2,000 206

215 1,000

216 7,000

217 6,000

218 1,000Order cannot be executed, order book remains unaltered.

Example

Summary

HintsWhere a fill or kill order requires immediate execution, all or nothing can remain on the book for the day.

Limit price required?

Partial execution allowed?

Unexecuted portion

added to order book?

Limit Yes Yes Yes

Execute and eliminate Yes Yes No

Market order No Yes No

Fill or kill Yes No No

133


Novation

5.3.3 Central Counterparty Service

1. Initial trade

2. Novation

Buyer(Clearing member)

DEAL

Seller(Clearing member)

SellBuy Buy SellCCP

Further InformationBenefits of a Central Counterparty (CCP)• Reduced counterparty risk• Providing total anonymity• Reduced administration• Facilitates netting• Improved pricing (due to anonymity)

134


Costs of trading

• Broker’s commission – commission is typically based on a set percentage of the value of the securities being purchased or sold. If little or no advice is being offered, the firm is described as a discount broker.

• Account fees – brokers also tend to charge account fees to their ongoing customers.

• Exchange fees, regulatory, clearing fees taxes.

5.3.4 Cost of tradingFurther InformationExchange fees, regulatory, clearing fees taxes – there are typically minor charges that are either subsumed within the brokers’ commissions, or added separately to cover the charges the stock exchange makes per transaction, charges to contribute to the clearing system and, in many jurisdictions, some form of tax such as the UK’s stamp duty or stamp duty reserve tax.

Keeping on TargetWhich of the following is most likely to be true of a discount broker?A. They charge lower fees for the same services as other brokersB. They charge lower fees for more restricted services as other brokersC. They offer the same services for a higher cost than other brokersD. They offer fewer services for the same cost as other brokers

135


Indices: Headline news

• A simple way of summarising market movements

• Benchmarks to track (passive) or outperform (active)- Free-float adjusted for better accuracy

Indices: Return

• Price return - Only the price of the components considered

• Total return index - Calculates the performance of a group of stocks assuming that dividends are reinvested into the index constituents

• Net total return - As above but after the deduction of withholding tax

5.4.1 Stock Indices

Further InformationIndices: TypesNationalRepresents the performance of a stock market of a given nation and reflects investor sentiment on the state of the economy e.g. Wilshire Index – USInternationalIndices representing multiple economies, e.g. MSCI WorldSectorIndices that track the performance of specific sectors

The examiner only expects you to know these definitions, not examples

Home StudyThis section is marked HOME STUDY. You will need to review specific videos on the online portal for this section.

You can find the video for this on you online study portal:Asset classes – Equities > Video > Chapter 2 – Indices

Answer to previous Keeping on Target question: BWhere a broker is offering little or no investment advice, perhaps providing their services over the internet, the firm is described as a discount broker and the fees will be lower.

136


Indices: Weighting

• Price weighted- Assumes an equal number of shares in each constituent stock

• E.g. DJIA, Nikkei 225

- Highest share price has greatest influence- Needs adjusting for splits, consolidations, etc.

• Market value-weighted- Assumes a proportionate value investment in each constituent stock

• E.g. S&P, Nasdaq, FTSE, MSCI

- Highest market capitalisation has greatest influence

5.4.1 Stock Indices

Further InformationDow Jones Divisor: As the DJIA is price weighted, splits, consolidations, spin-offs, etc. can have a significant impact on the value of the index. The divisor is an adjustment to ensure that such events do not alter the numerical value of the DJIA.

DJIA = Σpd

where:p = the prices of the component stocksd = the Dow divisor.

The present divisor, after many adjustments, is less than one, meaning the index is larger than the sum of the prices of the components.

Home Study

137


5.4.1 Stock IndicesIndices: Summary

Geographical scope Name Composition

UK

FTSE 100 100

FTSE All-shareRepresenting 98-99% of UK

marketcapitalisation

US

Dow JonesIndustrial Average 30

Nasdaq Composite Over 3,200

Standard and Poor 500 500

Home Study

138


5.4.1 Stock IndicesIndices: Summary

Geographical scope Name Composition

Japan Nikkei Stock 225

Hong Kong/China Hang Seng 50 (Variable)

Europe Eurofirst 300 300

Germany DAX 30

France CAC 40

Global Markets STOXX 600

Global Markets MSCI 1700

Home Study

139



criteria (from chapter 4)• Rules, procedures and requirements• Order types• Function of a central counterparty• Costs and charges and stamp duty.

Indices (HOME STUDY)• Types and purpose of indices

Section Review

140

Secondary MarketsPart 11: Fixed Income Markets

Home StudySome sections are marked HOME STUDY. You will need to review specific videos on the online portal for these sections. Each HOME STUDY section will clearly direct you to the appropriate video. For example:

You can find the video for this on you online study portal:Secondary Markets > Video > Chapter 5 – Fixed Income Markets

141


Government bonds (HOME STUDY)• Functions and obligations of key

participants

Corporate bonds (HOME STUDY)• Characteristics of the market• Dealing methods• Systems and trends• Factors that influence bond prices

Section OverviewHome Study

142


Issuing Agencies

• UK – Debt Management Office

• US – Federal Reserve

• Japan – Ministry of Finance

• Eurozone – Federal Governments

Trading

• Negative yield consequences

• Primary dealers – to participate in the primary auctions and to provide liquidity in the secondary market

• Other participants:- These would be the same as those found in the equity markets

5.5.1 Participants in Government Bond MarketsHome Study

143


Corporate bonds

Dealing

• Typically decentralised- Direct telephone contact- Indirect via inter-dealer systems

• Increasing use of electronic multi-dealer trading platforms: - B2B – Brokertec, eSpeed and MTS Cash- B2C – MTS BondVision and TradeWeb - OTC ‘request for quote’ systems – investors request quotes from a number of dealers

simultaneously

• Exchange-traded – order book for retail bonds

Quotation methods

• Price

• Yield – mostly corporate bonds

5.7.1 Corporate BondsHome Study

Keeping on TargetWhy is it important that 'request for quote' systems run alongside the dealer to-customer market?

A. To cater for large volumesB. To avoid volatilityC. To compensate for inflation riskD. To achieve better prices

144


Government bonds (HOME STUDY)• Functions and obligations of key

participants

Corporate bonds (HOME STUDY)• Characteristics of the market• Dealing methods• Systems and trends• Factors that influence bond prices

Section Review


145


Clearing and Settlement

8 questions

Chapter 7

146

Clearing and SettlementPart 12: Activities

147


Activities• The main stages of clearing and

settlement• Three models of DvP• Custody and custodians• Prime brokers (from chapter 5)• Registered title and nominee accounts• Continuous linked settlement in the FX

market

Stock borrowing and lending (covered in chapter 5)• Uses, requirements and implications• Stock borrowing and lending

intermediaries

Section Review

148

Summary of settlementAll securities settle T+2 except:

Further Information

Equity Bonds Others

New Issues T+1 Gilts T+1 (cash) Repo T+0

Certificated T+10 US T-Bonds T+1 Money Market T+1

JGBs T+1 F/X Forward > T+2


Three stages of clearing and settlement• Pre-settlement and clearing

- Executions of trade- Matching of trade details- Confirmation of payment and delivery obligations- Potential use of clearing houses as central counterparty

• Settlement- Legal title transferred to the buyer- Cash value of securities transferred to the seller- Potential use of a central securities depositary, e.g. Euroclear UK and Ireland

• Post settlement- Managing any settlement failures- Accounting for the settled trades

7.1.1 Introduction to Settlement Systems

149


Settlement models that fulfil DvP requirements• Organising delivery vs. payment

- Model 1 – Gross, simultaneous settlement of securities and funds• Electronic book-entry transfer of securities and funds on a trade-by-trade gross basis • Final transfer of securities (delivery) occurring at the same time as final transfer of funds

(payment)• Mostly used in Europe

- Model 2 – Gross settlement of securities followed by net settlement of funds • Electronic book-entry transfer of securities on a trade-by-trade gross basis• Net settlement of funds at the end of the processing cycle• Final transfer of securities (delivery) occurs before the final transfer of funds (payment) • Used in the US and popular in emerging markets

- Model 3 – Net simultaneous settlement of securities and funds• Electronic book-entry transfer both securities and funds on a net basis• Final net transfer of securities (delivery) occurring at the same time as final net transfer of funds

(payment)

7.2.1 Settlement Models

150


Services• Safekeeping

- Primary responsibility is to ensure that client assets are fully protected at all times• Segregation of assets

• Administration- Facilitate delivery vs. payment (DvP)- Corporate actions- Links with registrars- Provides market information- Links with regulators

Types of custodian• Global custody

- Manages custody arrangements across the full range of foreign markets in which they have invested assets

• Sub-custody- Where a local agent is appointed to provide settlement and custody services for assets that a

global custodian holds on behalf of clients in a foreign market

• Local custodian- Market specialist operating in the same market as the custody assets trade

7.3.1 CustodianshipFurther InformationWhen an institutional investor invests in securities, it will commonly employ the services of a custodian to administer these securities by:• Providing safe keeping of the investor’s assets in the local market• Making appropriate arrangements for delivery and receipt of cash and

securities to support settlement of the investor’s trading activities in that market

• Providing market information to the investor on developments and reforms within that market

• Collecting income payments, such as dividend income and interest paid on debt securities n the local market• Managing the client’s cash flows• Monitoring and managing entitlements through corporate actions and

voting rights held by the investor in the local market• Managing tax reclaims and other tax services in the local market• Ensuring that securities are registered and that transfer of legal title on

securities transactions proceeds effectively• Ensuring that reporting obligations to the regulatory authorities, and to

other relevant bodies, are discharged effectively

Further InformationRegional CustodianA regional custodian is able to provide agent bank services across multiple markets in a region.

Keeping on TargetWhere there is a sub-custody agreement, which of the following describes the correct set of relationships?

A. The client is the client of the global custodian, who is the client of the local custodian

B. The client is the client of the local custodian, who is the agent of the global custodian

C. The client is the client of both the local and global custodian equallyD. The client is the client of the global custodian, whereas the local

custodian is the agent of the global custodian

151


Prime broker

• Prime brokerage is the generic name for a bundled package of services offered by investment banks to hedge funds

• Typical services include- Stock lending and borrowing- Leveraged trade execution- Cash management- Core settlement

• Manage delivery and payment on transactions

- Custody• Safekeeping and administration of assets

- Rehypothecation• The use of a client’s collateral for own purposes

5.2.4 Prime Broker Services


152


• Bearer securities- Legal owner is the holder of the investment

• Registered securities- Legal owner recorded on a central register

• Nominee accounts

7.4/5 Ownership and Title Documents

XYZ plc:Register of shareholders

Pooled Designated

Corporate NomineeHybrid account

All investors grouped together

XYZ plc owns the nomineeAll

investors grouped together

Investors are divided

into named

accounts

DDD BrokersNominee Company

Register of Members

Further InformationNominee accountsPooled nominee• Investor’s shares pooled with those of other investors• Broker’s nominee name appears on the register of members• AKA omnibus accountDesignated nominee• Investor’s shares held in separate pool• An individual designation appears on the register of membersSole nominee• Single nominee name per client is used on the registerCorporate nominee• The company itself holds shares within a single entry • Forward single dividends to each individual and other perks

Keeping on TargetYour client, Jenny, has stated that she does not wish to participate in an auto-stock lending programme. To comply with Jenny's wishes her shares would be held within which of the following nominee accounts?:

A. A pooled nominee accountB. The firm's own accountC. An omnibus nominee accountD. A designated nominee account

153


Gross FX settlement and Herstatt risk

• Gross settlement: The entire value of each deal is paid to the other party

• Herstatt risk: The risk that a bank pays its counterparties and fails to receive a payment in return

Net FX settlement using continuous linked settlement (CLS)

• CLS: A cross-currency settlement system operated by CLS Bank

• Benefits:- Payment vs. payment- More certainty about end-of-day cash positions- The volume and value of payments is reduced- Errors are minimised

• Payments made through Bank of England via CHAPS

7.7.1 Continuous Linked SettlementFurther InformationCLS summary


154


Activities• The main stages of clearing and

settlement• Three models of DvP• Custody and custodians• Prime brokers (from chapter 5)• Registered title and nominee accounts• Continuous linked settlement in the FX

market

Stock borrowing and lending (covered in chapter 5)• Uses, requirements and implications• Stock borrowing and lending

intermediaries

Section Review

155


Accounting Analysis

14 questions

Chapter 8

156

Accounting AnalysisPart 13: Company Accounts

157


Basic Principles• Purpose and uses of financial

statements• Five components of financial

statements• The need for standards• Group accounts

Statement of Financial Position• Purpose, format and contents• Depreciation vs amortisation• Share capital vs capital reserves vs

revenue reserves

Income Statement• Purpose, format and main contents• Capital vs revenue expenditure

Cash Flow Statement• Purpose and format under IAS7• Profit vs cash• Free cash flow

Additional Information• Other sources of information

- Annual report- Auditor’s report

Section Overview

158


Statement of Financial Position (IAS1) – Balance sheet

Income statement

Cash flow statement – Statement of cash flows (IAS1)

Additional reports

• Independent auditor’s report

• Notes to the accounts

• Shareholder information

• Reports to analyse corporate performance- Strategic report- Stakeholder review- Financial review- Directors remuneration

8.1.1 The Purpose of Financial StatementsFurther InformationAdditional informationIn addition to the statements opposite, companies may also produce:• Statement of other comprehensive income• Statement of changes in equity• Comparative figures from the previous year’s financial statements• Explanatory notes to accompany certain individual statements of financial

position and profit and loss account items• Disclosure of the company’s accounting policies

159


Accounting standards

• The form and content of company financial statements are prescribed by laws and mandatory accounting standards - Generally accepted accounting principles (GAAP)- Often country specific

International Accounting Standards Board (IASB)

• To achieve transparent and comparable financial statements to global accounting standards- International financial reporting standards (IFRS)- International accounting standards (IAS)

Listing rules

• Many exchanges will require additional disclosure by traded companies- Interim report

8.1.2 Accounting RegulationsHintsDue to the range of accounting standards across the world, it can be difficult to compare companies internationally.

160


Statement of Financial Position: Example

8.2.1 Format of Statement of Financial Position

XYZ plcSFP as at 31 March 20X2

20X2 £’000

ASSETSNon-current assets• Intangible 275• Tangible (at NBV) 59,628• Investments 726Total non-current assets 60,629Current assets• Inventories 41,121• Trade receivables 9,235• Other current assets

‒ Prepayments 1,101• Cash and cash equivalents 8,972Total current assets 60,429TOTAL ASSETS 121,058

HintsThe Accounting EquationThe balance sheet leads to the accounting equation:

Assets = Equity + LiabilitiesOr

Non-current assets + Current assets = Capital + Reserves + Liabilities

161


XYZ plcSFP as at 31 March 20X2

EQUITY AND LIABILITIESCapital and reserves• Share capital 11,365• Share premium 20,340• Revaluation reserve 14,216• Retained earnings 20,976Total equity 66,897Liabilities:Non-current liabilities• Long-term borrowings 25,694• Long-term provisions 3,230Total non-current liabilities 28,924Current liabilities• Trade and other payables

‒ Trade payables 22,778‒ Accruals 1,568

• Short-term borrowing 891Total current liabilities 25,237Total liabilities 54,161TOTAL EQUITY AND LIABILITIES 121,058

8.2.1 Format of Statement of Financial Position

162


Non-current assets (fixed assets)

• Typically assets intended to be used by the business for more than one year

• Intangible non-current assets- Expected to generate future revenue but have no physical substance

• Goodwill• Trademarks• Patents

• Tangible non-current assets- Expected to generate future revenue and have physical substance

• Property, plant and equipment (PPE)• Valued at net book value (NBV)

• Non-current asset investments- Generally shares in other companies intended to be held for greater than one year

8.2.2 AssetsFurther InformationNon-current investments would include investment in associate companies.

An associate company is created when share ownership lies from 20% to 50%.A subsidiary company is created when share ownership lies above 50%, where the subsidiary’s balance sheet is consolidated with that of the parent.

163


Current assets

• Assets held for conversion into cash

• Inventory (stock)- Raw materials- Work-in-progress- Finished goods

• Trade receivables (debtors)- The amount the company is owed on the statement date

• Trade debtors• Prepayments

• Cash

8.2.2 AssetsHintsInventory is valued prudently at the lower of cost and net realisable value.

164


Share capital and share premium account

• Share capital- Nominal value of total shares in issue

• Share premium- Any excess above the nominal value raised on issue

Reserves

• The amount belonging to shareholders that is retained by the company

• Revaluation reserve- Created when a company revalues its assets from cost to market value

• Retained earnings (profit and loss reserve)- Running total of retained earnings

8.2.4 EquityLinksImpact of bonus issues and share splits on capital and reserves.

Bonus Stock split

Effect on the market

Share price Reduced Reduced

Number Increased Increased

Effect on the balance sheet

Nominal value Remains the same Lowered

Called-up share capital Rises Remains the

same

Share premium account

Falls Remains the same

Keeping on Target Which of the below is true in describing capital reserves and revenue reserves?A. Revenue reserves includes capital raised above the nominal valueB. Revenue reserves are the undistributed profits of the companyC. Capital reserves can't be used to pay dividends without shareholder

approval, but revenue reserves can be used anytimeD. Capital reserves are the undistributed profits of the company

165

Keeping on Target On a company's statement of financial position, there may be liabilities based on past events for which there is an obligation, but the exact amount is yet to be established. How is this commonly referred to?

A. ProvisionB. Past activityC. Estimated expenseD. Estimated liability

Answer to question on previous slide: BThe revenue reserve is the accumulated retained earnings of the company, which is distributable to shareholders. Capital reserves include revaluation reserves and the share premium account. They are not distributable to the company's shareholders in the form of dividends. The share premium account can, however, be converted into a bonus issue of ordinary shares.


Liabilities

• Current liabilities- Amount owed by the company and due for payment within one year

• Trade payables (creditors)• Accruals

- Expenses not yet invoiced

• Non-current liabilities- Amount owed by the company and due for payment after one year

• Long-term bank loans• Bonds issued by the company• Provisions

- E.g. Doubtful debt

8.2.5 Liabilities

166

Keeping on Target Fabulous plc buys a new machine for a cost of £60,000. The company expects the machine to have a useful life of 10 years after which it is expected to have a scrap value of £2,000. The employee operating the machine receives a salary of £12,000 per year. Calculate the value of the machine on the statement of financial position at the end of the first year.

A. £55,400B. £54,200C. £5,800D. £4,600

Answer to question on previous slides: ASuch provisions may arise as a result of the company undergoing a restructuring, for example. Given the uncertainty surrounding the extent of such liabilities, companies are required to create a realistic and prudent estimate of the monetary amount of the obligation, once it is committed to taking a certain course of action.


Depreciation

• Tangible non-current assets recorded on statement of financial position at net book value (NBV)- NBV = Cost - Accumulated depreciation

• Annual depreciation charge- Straight line method

• Freehold land - Not depreciated

8.2.3 Depreciation and Amortisation

life useful Expectedvalue residual expected - cost Original ondepreciati Annual

167

Further Information IAS 33 requires the earnings per share ratio and the diluted earnings per share to be shown at the foot of the income statement.


Income statement: Example

8.3.1 Contents of Income Statement

XYZ plc

Income statement for the year ended 31 March 20X2Discontinued Continuing Total

operations operations

20X2 20X2 20X2£000 £000 £000

Revenue 988 60,403 61,391Cost of sales (896) (40,691) (41,587)Gross profit 92 19,712 19,804Distribution (38) (3.446) (3,484)Administration (49) (5,169) (5,218)Operating profit 5 11,097 11,102Exceptional items (77) (77)Finance costs/income (300)Profit before tax 10,725Corporation tax payable (1,901)Net Income 8,824

NotesEarnings per share – 14.7 pence - Diluted EPS – 13.4

Answer to previous Keeping on Target question = BThe question is looking for the net book value (NBV) after one year. NBV = cost - accumulated depreciationAnnual depreciation = (cost of asset - residual value) / useful life. Therefore the salary of the employee is irrelevant.Annual depreciation = (60,000 - 2,000) / 10 = £5,800NBV = 60,000 - 5,800

= 54,200

168

Keeping on TargetA company undertakes a three-year project. The project will incur an upfront cost of £9,000 and will generate an income of £4,000 in the first year and in each of the two following years, generating a total revenue of £12,000 over the three years. What is the company likely to reflect on the income statement at the end of the first year?

A. £5,000 lossB. £3,000 lossC. £1,000 profitD. £3,000 profit


Revenue (Turnover)

• Income generated by a company from selling its goods and services

• Recognised at point of sale

• Recognition can be apportioned over several accounting periods for long term contracts

Cost of sales (cost of goods sold)

• Costs directly associated with the cost of producing a product or service

Other operating costs

• More general costs of running a business- Selling - Distribution- Administrative expenses

Operating profits

• Profit before interest and tax (PBIT)

8.3.1 Contents of Income Statement

169

Answer to the question on the previous slide = CThe cost of £9,000 can be apportioned over the life of the project, so £3,000 per year. If the income generated is £4,000, this makes a profit of £1,000 at the end of each year.


Capital vs. revenue expenditure

• Expenditure- Money spent by the company

• Capital expenditure- Money spent to buy non-current assets- Reflected on the statement of financial position

• E.g. Purchase of property, purchase of plant and machinery

• Revenue expenditure- Immediately impacts the income statement

• E.g. Wages, rent, professional fees

8.3.2 Capital and Revenue Expenditure

170

Further Information Free cash flowThe cash available after all expenses and reinvestments needed to maintain the operating capacity of the business have been made. Enterprise cash flow (free cash flow to the firm)• The free cash flow before considering payments made to any of the

providers of finance to the firm (both debt and equity holders)• Comparable cash flow irrespective of capital structureEquity cash flow (free cash flow to equity)• This is a measure of how much cash can be paid to the equity

shareholders of the company after all expenses, reinvestment and debt repayment

• Includes all debts related cash flows

Further Information Profit Versus CashBecause of the difficulty in arriving at free cash flow from the cash flow statement, many users calculate a free cash flow figure from the income statement.This is generally arrived at by taking the operating profit from the income statement, then making adjustments. For example:• Non-cash expenses (such as depreciation) are added back to profits• Any increase in current assets, or decrease in current liabilities, must be

subtracted from profits• Any decrease in current assets, or increase in current liabilities, must be

added to profits


Cash flow: Example

• Operating activities are revenue producing activities of the entity

• Investing activities are the acquisition and disposal of non-current assets and not included in cash equivalents

• Financing activities are activities resulting in changes in the size and composition of equity capital and borrowing of the entity

8.4.1 Cash Flow StatementXYZ plc Cash Flow Statement for the Year Ended 20X2

20X2 £’000

Operating activitiesCash receipts from customers XCash paid to suppliers and employees (X)Income taxes paid (X)Net cash from operating activities X

Investing activitiesInterest received XDividends received XProceeds on disposal of non-current assets XPurchases of non-current assets (X)Net cash used in investing activities (X)

Financing activitiesEquity dividends paid (X)Repayment of debt (X)Proceeds on issue of bonds or equities XBank loans raised XIncrease/(decrease) in bank overdrafts XNet cash from financing activities XNet increase/(decrease) in cash and cash equivalents X

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Group: Example

The group consists of:

H Ltd – Holding company

A Ltd – Subsidiary of H Ltd

B Ltd – Subsidiary of H Ltd (20% minority interest)

C Ltd – Indirect subsidiary of H Ltd (40% minority interest)

8.1.3 Group Accounts

H Ltd

C Ltd

80% 100%

60%B Ltd A Ltd

Further InformationConsolidating the accounts if the subsidiary is not entirely owned:• 100% of the assets, liabilities, revenues and expenses of the subsidiary

added• Minority interest in shareholders’ funds on the statement of financial

position• Minority interest in the income statement after income tax expense

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Basic Principles• Purpose and uses of financial

statements• Five components of financial

statements• The need for standards• Group accounts

Statement of Financial Position• Purpose, format and contents• Depreciation vs amortisation• Share capital vs capital reserves vs

revenue reserves

Income Statement• Purpose, format and main contents• Capital vs revenue expenditure

Cash Flow Statement• Purpose and format under IAS7• Profit vs cash• Free cash flow

Additional Information• Other sources of information

- Annual report- Auditor’s report

Section Review

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Accounting AnalysisPart 14: Financial Statement Analysis

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Financial Statement Analysis

• Purpose and limitations of ratio analysis- Informed decisions- Influence on share price

• Be able to calculate all ratios presented

Section Overview

175


Earnings per share (EPS)

Calculate

Where:

Profit attributable to ordinary shareholders =

Calculate

Diluted earnings per share

8.5.4 Investors’ Ratios

Profit available to ordinary shareholdersNumber of ordinary shares

Profit after tax XLess: Preference dividends (X)Less: Minority interest (X)Profit available to the owners of the parent X

EPS =

Further InformationThe purpose of publishing a separate figure for diluted earnings per share is to warn shareholders of potential future changes in the earnings per share figure as a result of events that actually may have, or theoretically could have, taken place.

Diluted EPS

Earnings per share that considers all potentially dilutive instruments in the number of ordinary shares, e.g.

• Convertible preference shares• Convertible bonds• Warrants

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Historic price-earnings ratio (P/E ratio)

Calculate

Interpretation

• High P/E ratio may indicate high growth prospects


shareperEarningsshareperpriceMarket

ratioPE

Further InformationTrailing P/E ratioIgnore one-off events, such as windfalls or exceptional itemsProspective P/E RatioInstead of using the historic EPS of the company, the prospective P/E ratio uses the current financial year’s forecast.

Keeping on TargetA company's shares have a nominal value of 20p and a share price of 360p. If the PE ratio is 24, what is the EPS?

A. 15pB. 6.7pC. 11.25pD. 18p

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EV/EBITDA

Calculate

Where:

EV = Enterprise value = Market value of debt + Market value of equity

EBITDA = Earnings before interest, tax, depreciation + Amortisation


EV/EBITDAEBITDA

EV EV/EBITDAEBITDA

EV

LinksEV/EBITDA, like P/E ratio, gives an idea of how highly a company is valued, but allows comparability between companies irrespective of capital structure.

Keeping on Target An analyst is making comparisons between companies' enterprise value relative to earnings before interest, tax, depreciation and amortisation. Which of the following would NOT be a factor they will consider?

A. A company's total revenues less expensesB. A valuation that considers holders of both equity and debtC. The true cash earnings of the companyD. The open market cost purchasing the entire company

Answer to the question on the previous slide = A15p

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LinksThe dividend yield is an income yield, like the flat yield on a bond.

Answer to the question on the previous slide = CCare must be taken as EBITDA does not truly represent cash earnings: it leaves out the cash required to fund working capital and the replacement of old equipment, which can be significant.


Dividend yield

Calculate

Interpretation

• Low dividend yield may indicate high future growth


%100shareperpriceMarket

shareperDividendyieldGross dividend xFurther Information

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Further Information Dividend cover gives an investor an idea of how likely it is to maintain the current level of dividend. The higher the dividend cover, the more likely a company is able to sustain that level of dividend.


Dividend cover

Calculate


Can have a dividend cover

< 1

shareper Dividendshareper Earningscover Gross dividend =

Keeping on TargetThe nominal value of a share is a £1.00. The earnings per share is 15p. The dividend per share is 5p and the current market price is £1.60. What is the dividend cover?

A. 20xB. 10.7xC. 6.7xD. 3x

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Further InformationGearingOne interpretation of this ratio is the risk to shareholder dividends. As dividends are discretionary, and interest on debt is obligatory.Another interpretation the ability of the company to borrow more. The more highly geared the company is, the less likely it will be able to borrow more.

Interest coverHow easily a company can pay interest expenses on outstanding debt? The lower the ratio, the more the company is burdened by debt expense.

Hints

Net debt to equityThis ratio removes cash and short-term investments from the debt figure on the debt/equity ratio.


Profit before interest and tax

%100fundsshareholder’sEquity

)overdraftsandsharespref.(includingdebtbearingInterest

Debt/equity ratio x

Interest ExpenseInterest cover ratio

Gearing (or debt/equity)

Calculate

Interest cover

Calculate

8.5.3 Financial Gearing Ratios

Keeping on TargetA company has operating profit of $20m, net assets are $50m, interest bearing debt is $15m and the interest expense is $0.75m. Calculate the interest cover of the company.A. 26.7xB. 3.75%C. 30%D. 4.7x

Answer to the question on the previous slide = DDividend cover = EPS/Div = 15p/5p = 3x

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Keeping on TargetWhat is the value of the cash of a business if a company has a quick ratio of 1.5, inventories of £25,000, receivables are £12,500 and current liabilities are £30,000?

A. £12,500B. £32,500C. £7,500D. £15,000


Current ratio

Calculate

Quick ratio/acid test

Calculate

Current liabilitiesCurrent assets

Current ratio

8.6.4 Liquidity Ratios

Current liabilities(Current assets – inventory)

Quick ratio

Answer to the question on the previous slide = AInterest cover = PBIT / interest expense = 20m / 0.75m = 26.7x

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HintsRemember the accounting equation?

Total assets = Equity + LiabilitiesIn the slide:

Capital employed = Total assets – Current liabilitiesAccording to the accounting equation:

Total assets - Current liabilities = Equity + Non-current liabilitiesThe examiner can use either side of the equation to define capital employed.


Return on Capital Employed: Calculate

Where:

• Capital employed = Total assets - Current liabilities

• PBIT = Profit before interest and tax

Return on Equity: Calculate

8.5.2 Operating/Profitability Ratios

employedCapitalprofitsOperating(ROCE)employedcapitalonReturn x 100

Shareholders’ EquityNet Income(ROE)equityonReturn x 100

Answer to the question on the previous slide = BQuick ratio = (receivables + cash) / current liabilities1.5 = (£12,500 + cash) / £30,000Cash must be £32,500

Further InformationReturn on AssetsThe manual describes return on assets as the same as return on capital employed..

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Gross/Operating profit margin

𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏𝑷𝒓𝒐𝒇𝒊𝒕𝑹𝒆𝒗𝒆𝒏𝒖𝒆

• Gross profit margin - The percentage of revenues the company converts to profit after considering the costs

of sales

• Operating profit margin - The percentage of revenues the company convert to profit after considering costs of

sales and other operating costs

8.5.2 Operating/Profitability Ratios

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• The purpose of ratio analysis is: - To assist in assessing business performance

• Meaningful relationships between numbers contained within company financial statements, can be identified

- To summarise financial information into an easily understandable form- To identify trends, strengths and weaknesses by comparing the ratios to those of:

• The same company in prior periods• Other similar companies• Sector averages and• Market averages

• The limitations of ratio analysis: - As financial statements contain historic data, ratios are not predictive - Different accounting methods and practices may make it difficult to draw comparisons

• Particularly internationally- Significant judgement is needed when performing ratio analysis

• Leads to divergence of opinion


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• Purpose and limitations of ratio analysis- Informed decisions- Influence on share price

• Be able to calculate all ratios presented

Section Review

186


Risk and Reward

11 questions

Chapter 9

187

Risk and RewardPart 15: Investment Management and Institutional Investment

188


Investment management (Home study)• Basics of risk and reward• Risks and rewards of investments in:

- Equity instruments- Money Market instruments- Debt instruments- Overseas investment

• Risks facing investors• Optimising risk/return

- Diversification

Investment management• Advantages and disadvantages of:

- Active management- Passive management

• The role of ESG investing• The role of hedging• Ranking in liquidation (covered in

Chapter 2)

Institutional Investment Advice• Requirements of differing institutions• Regulatory information and financial

communications

Section Overview

189


Risk and reward• Risk and potential reward

- Positively correlated• Low risk investments provide lower expected returns and a lower possibility of loss• Higher risk investments have the potential for higher returns, and a greater possibility of loss

Required return• Required return = risk free rate + risk premium

- Risk free rate? Government bond yields- Risk premium? Additional return for takin on more risk

• More risk = Higher risk premium

Diversification• An investment management technique to optimise the risk/reward trade-off

• Combining securities that are not perfectly positively correlated- By asset class- By sector- By location, etc.

9.1.1 Risk and RewardHome StudySome sections are marked HOME STUDY. You will need to review specific videos on the online portal for these sections. Each HOME STUDY section will clearly direct you to the appropriate video. For example:

You can find the video for this on you online study portal:Risk and Reward > Video > Chapter 9 – Types of Risk and Risk Management

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HintsSummary


Two general portfolio risk considerations

• Systematic risks (market risk)- Economic, political and global events that impact on markets – hard to predict

• Liquidity – in a crisis liquidity dries up, e.g. a bank failure• Interest rates – impact on markets, and on consumer spending of gearing• Inflation – erodes savings, around 3% inflation has led to lower interest rates• Currency – will we make or lose money when we convert the foreign currency back to sterling?

• Unsystematic risks (specific risk)- Business risks – (internal business risks)

• Products – successful vs. unsuccessful; labour relations – strikes, disputes; costs of raw materials; strength of balance sheet

- Industry risks – (industry sectors)• Affect an industry as a whole not only a company (tariffs and trade barriers)

- Management risks • Calibre of the management

- Financial risks• Related to the level of debt financing in the capital structure

9.1.1 Risk and Reward

Keeping on Target Which one of the following could be considered an example of an unsystematic risk?

A. The change of a company's price relative to the market revenues less expenses

B. A political crisisC. The costs of goods and services changingD. A profit warning from a single company

Cannot be reduced by diversification

Measured by beta

Total Risk

SpecificUnsystematic

SystematicMarket

May be eliminated by diversification

β

Home Study

191


Other risks investors face

• Inflation risk – Inflation will erode returns or purchasing power

• Interest rate risk – Changes in interest rates will affect prices

• Reinvestment risk – Changes in interest rates will affect the reinvestment returns

• Default risk – An investor may find that a company from which s/he has purchased a security could become insolvent

• Liquidity risk – During stressful periods this liquidity can diminish and it can become much harder to sell a security readily

• Exchange rate risk – Any investor who purchases securities which are denominated in a foreign currency may suffer (or benefit) from changes in the exchange rates

• Political and legal risk – Particularly relevant when investing overseas

9.1.1 Risk and Reward

Further InformationQuantifying riskForward-looking – based on forecasts and probabilitiesBackward-looking – analysing historic trends or observed returns

Answer to the question on the previous slide = DA specific (or unsystematic) risk is that something adverse impacts the value of a particular investment, but the adverse impact is not market-wide. An obvious example is a company's management making some sort of error –perhaps producing a defective product with resultant impact on profits and customer goodwill. Specific risk can be diversified away by holding many investments.

Keeping on Target The analysis of risk and return is best done in which of the following ways?

A. Backward-looking analysis of historic returns and forward-looking forecasts

B. Correlations of returns and capital asset pricing modelC. Alpha and beta analysisD. Political risks and interest rate sensitivities

Home Study

192


Investment risk profiles

9.1.2-5 Risk/Reward Profile

Low High

High

Low

Leveraged securities

Equities

Bank accounts

Ret

urn

Risk

Corporate bonds

Government bonds

Collective investment schemes

Answer to the question on the previous slide = AIn order to assess the risk and expected returns from particular opportunities, an investor needs to conduct an analysis of the forecasts for the economy and the forecasts for particular companies and/or sectors and undertake a risk analysis of the possible outcomes, and their likelihood, which could adversely affect these forecasts. Forward-looking forecasts and probabilities assess the likelihood of each possible state of the world occurring and estimate the returns and values arising given that particular outcome. Backward-looking analyses tend to study historically observed returns and associated frequencies on the assumption that this past data will be representative of the future.

LinksImpact of security

Home Study

193


Hedging strategies

• Hedging strategies largely remove the price risk of an investment, but they will also have an impact on the performance

9.1.8 Hedging Using Derivatives

Future Option Contract for Difference (CFD)

Long underlying position

Short future(short hedge)

Long put(protective put)

Short position

Short underlying position

Long future(long hedge)

Long call(protective call)

Long position

Impact on performance

Can eliminate gains on positions

Premium reduces performance

Can eliminate gains on positions

Further Information

FutureA future is an agreement to buy or sell an asset on a fixed future date for a price agreed today.OptionAn option gives the holder the right to buy (call) or sell (put) an asset on (or before) a fixed future date at a fixed price. The holder will pay to get these rights – a premium.Contracts for difference (CFD)A CFD is a cash-settled derivative giving exposure to the returns on an asset without ownership of the assetCFDs are margin traded. This gives exposure to the asset at a fraction of the price.

Keeping on Target Hedging with the use of derivatives is a strategy that helps investors with:A. Protecting against lossesB. Removing or reducing their upsideC. Increasing their exposure to assetsD. Taking short positions

Home Study

194

LinksPassive fund management - TrackingWe met tracker funds when looking at exchange-traded funds (ETFs). Methods of tracking• Replication

‒ Buying all the shares in the benchmark with the correct weighting• Synthetic

‒ Buying futures that represent the benchmark

Synthetic replication may reduce costs and any possibility of tracking error, but it exposes the investor to the risk of the derivative provider being able to meet their obligations.


The efficient markets hypothesis (EMH)

• In an efficient market information about assets is freely available, has been correctly interpreted and properly priced on the markets

• Passive management- Consistent with the idea that markets are efficient- Attempts to track rather than outperform the markets

• Active management- Seek out inefficiencies in the markets- Attempts to outperform the markets

9.1.9 Active and Passive Investment Management

Answer to previous Keeping on Target question: ADerivatives can be used in many ways to achieve many different things. When used for hedging, it is about reducing their risk to investments by protecting the downside.

195


9.1.8/9 Active and Passive Investment ManagementActive vs. passive

Advantage DisadvantageActive Choice of investments

• Exploit less efficient segments of the markets

• Avoid specific (riskier?) sections of the market

Higher than market return

Key person risk• Manager may move on• Manager may make bad

choicesCosts

Passive Reflects the market as a whole• Diversified portfolio• Collective opinionLower costs

Lack of control over individual investmentsReturn equal market returns• Positive and negative• No chance for alpha

Further InformationSmart BetaInstead of using a market index, smart beta funds will use alternative weighting methods, such as dividends paid, sales revenue or cash flow generated. Once the benchmark is created, it is tracked passively.

196


9.1.8/9 Active and Passive Investment ManagementActive bond portfolio management• Anomaly switching

- Exploiting mispricing in the bond market

• Policy switching- Exploiting market shifts caused by, for example, interest rate movements

• Inter-market switch- Trading on the spread between a bond and its benchmark

• Riding the yield curve- Buying a longer-term bond than required and selling it before maturity

Hints

Easier question on bond portfolio management simply ask which is passive/active

Active Passive

Anomaly SwitchingPolicy switchingInter-market switchRiding the yield curve

ImmunisationDuration matchingDedicationCash matching

197


9.1.8/9 Active and Passive Investment ManagementPassive bond portfolio management• Cash matched/dedicated portfolios

- Matching cash flow of bonds to the liabilities

• Duration matching/immunisation- Matching the duration of bonds to the liability

Further Information

ImmunisationBullet immunisation – bonds with durations close to the timing of the liability.Barbell immunisation – bonds that have equal weightings either side of the liability. E.g. 10 year liability met with 50% 8 year duration bonds and 50% 12 year duration bonds.Ladder immunisation – a variety of bonds with different durations either side of the liability. The weighted average duration will be the same as the liability.

HintsLaddering is a term used to describe diversification of a bond portfolio by maturity date.

198


Environmental, Social and Governance Factors

• Environmental, social and governance, also known as responsible investing (RI), socially responsible investing (SRI) or sustainable investing

• Issues:- Environment

• For example, sustainable use of natural resources, recyclability, reduction of pollution - Social

• For example, equal opportunities and training for employees, supporting the supply chain through fair pay, providing opportunities in the community

- Governance • For example, boards that are balanced in race and gender, corporate transparency where there

is environmental and social impact, accountability where it is owed

• Greenwashing:- Making misleading environmental claims for marketing purposes with the aim of

improving their reputation to attract environmentally and socially aware consumers, employees and investors, thereby increasing profits

9.1.10 ESG Investing

Cannot be reduced by diversification

Measured by beta

Total Risk

SpecificUnsystematic

SystematicMarket

May be eliminated by diversification

β

HintsSummary

199


9.2.1 Institutional Investment Advice

Investment horizon

Proportion of equity

investments

Proportion of money market investments

Risk profile

Pension fund Long-term High Low High

Life assurance fund Long-term High Low High

General insurance fund Short-term Low High Low

Bank Short-term Low High Low

Investment horizon Strategies Risk profile

Hedge fund Short-termArbitrageGeared

Long/short strategiesHigh

HintsDefined benefit pension funds and insurance companies are liability driven investors (LDI). Liabilities can be real (affected by inflation) or nominal (a pre-determined amount).

Keeping on Target Money market funds aim to achieve maximum returns while minimising credit, market and liquidity risks. These funds typically invest in:

A. Government securities, short-term bonds, commercial paper, repurchase agreements or even other money market funds

B. T-bills, medium-term bonds, commercial paper, repurchase agreements or even stock lending agreements

C. T-bills, medium-term bonds, commercial paper, repurchase agreements or even enterprise investment schemes

D. Government securities, long-term bonds, commercial paper, repurchase agreements or even cross currency swaps

200


9.2.2 Regulatory Information and Financial Communications

Publication

• Reported trades published on the Stock Exchange

• Disclosure of price-sensitive information shown on primary information services- For example, LSEs Regulatory News Service

• Secondary information providers then disseminate the information to the wider financial community- Examples include:

• Bloomberg• Thomson Reuters• Dow Jones

Answer from previous page: AMoney market funds are managed funds that invest in short-term, low-risk credit securities. They aim to achieve maximum returns while minimisingcredit, market and liquidity risks. They typically invest in assets such as government securities, short-term bonds, commercial paper (CP), repurchase agreements or even other money market funds.

201


Investment management (Home study)• Basics of risk and reward• Risks and rewards of investments in:

- Equity instruments- Money Market instruments- Debt instruments- Overseas investment

• Risks facing investors• Optimising risk/return

- Diversification

Investment management• Advantages and disadvantages of:

- Active management- Passive management

• The role of ESG investing• The role of hedging• Ranking in liquidation (covered in Ch2)

Institutional Investment Advice• Requirements of differing institutions• Regulatory information and financial

communications

Section Review

202


Following your course, you will receive an email containing an evaluation form. Please take the time to complete this and return it by email – your feedback is really important to us.

Many thanks,

Andy Bennett

Head of Regulatory Exam Training

Course EvaluationsHintsMethod to passPreparing to pass – study methods• Read each chapter of the text, make notes/mind maps®• Test your understanding of each chapter with practice questions• Re-read the text – you’ll learn more every time you re-read it• Complete all practice questions and mock exams, ideally twice (>80%)• Complete additional questions, ideally twice (>80%)In the exam – techniques• Remember the hard work has already been done• Read the questions carefully• Rule out wrong answers• Come back to more difficult questions later on• If you’ve read the question correctly, your first thought is generally the

right answer• Be wary of changing answers• You can do it – believe in yourself• Enjoy your celebrations when you pass

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