2024-25 Chapter 2: Cash, Money Markets and Foreign Exchange (39 questions)

Question 1

These deposit-taking institution must be formally authorised to be able to accept deposits under the Banking Act 1987 and the Financial Services and Markets Act 2000 (FSMA 2000).

As long as the saver’s money is held with an authorised deposit-taker then it will qualify for the Financial Services Compensation Scheme (FSCS).

Question 2

Cash is a stable, fixed-value asset. Its face value doesn’t increase, unlike stocks or real estate that can appreciate over time.

You don’t “sell” cash for more than you bought it, so there’s no opportunity for capital appreciation. Hence no capital growth for cash

Question 3

One of the key differentiators, when comparing savings accounts, is whether they are instant access or restricted access accounts, or structured accounts. This will affect the rate offered by the provider.

Answer 3

Structured deposits/accounts

Rather than offering a set interest rate, structured deposits link the return on a deposit to the performance of a stock market index, such as the FTSE 100 index.

Question 4

Accounts cannot be classified as instant-access unless they truly offer instant access to monies deposited.

Answer 4

They can offer ‘teaser rates’ where they have higher rates for an initial period, after which rates are reduced, or rates that are only higher whilst other ‘conditions’ are fulfilled. This is ‘frowned upon’ by the regulator.

Question 5

What is the 5% rule for cash ISA

Answer 5

the investment must return at least 95% within a 5 year period. Otherwise it must be held in a stocks and shares ISA

EXAMPLE :

Suitable cash ISA investments include:

UK bank and building society deposit accounts.
Units or shares in authorised collective investment schemes such as unit trusts, OEICS, UCITS and life assurance policies (more about these in Chapter 6).
NS&I Cash ISA products.
Stakeholder cash deposit (short term) products.

Question 6

Tax free NS&I

Answer 6

Remember PICK

Premium bonds
ISA
Saving certificates
Kid accounts

Everything else is taxable and pays interest gross

Question 7

2.4: Risks associated with Cash Investments

Outline and explain each

Answer 7

Default risk: the creditworthiness of the firm you save with.

Inflation risk: the impact of inflation.

Interest-rate risk: the uncertainty of interest rate movements.

Currency risk: exchange rate movements, if saving overseas.

Reinvestment risk: the likelihood of ‘similar deals’ being available at the end of a fixed term investment.

Question 8

What is the money market?

What is a money market investment?

Answer 8

A place where institutions such as governments, banks and building societies, and companies lend to and borrow from each other.

They are usually high-value transactions, over relatively short terms, typically less than one year.

A ‘money market investment’ is therefore essentially a short-term loan to the Government, a bank or some other company or organisation. ie, an investment on the money market

Question 9

What is the The Interbank Market

Answer 9

A specialised market where commercial banks lend and borrow between each other for periods of up to 1 year in a variety of different currencies. The market is key for a smooth-running financial system as it allows banks to manage their daily liquidity positions easily. basically a members only version of the main money market

In the London interbank market, interest on loans is charged at the Sterling Overnight Index Average Rate or SONIA.

Question 10

2.5.2: Money Market Instruments

The main types of money market instruments are:

LEAST RISKY - Repos
-Treasury Bills
-Bankers Acceptances
-Certificates of deposits
MOST RISKY - Commercial Paper

Answer 10

2.5.2 included description of each

Question 11

Most money market instruments are issued in ‘bearer’ form.

Answer 11

The original investor or ‘lender’ will receive a confirmation of their investment / loan in the form of a bill or certificate. That proof of ownership means that they will be the person who receives the money back at the end of the loan term.

If they want money back before the end of the term, they can sell the proof of ownership to someone else on the secondary market. The new owner, if they don’t sell on again, will be the one who receives the funds at the end of the loan term.

Question 12

The money market involves huge amounts of money and is generally not within the reach of an individual investor. What is the minimum investment?

So, how do individual investors still get involved in the money markets?

Answer 12

£500,000 would be the minimum investment for an individual. Most often it is banks, insurance companies, and pension / collective investment funds that invest in money market investments.

Individual investors can get involved through ‘collectives’. These collectives are known as money market funds

Question 13

What is the difference between money market funds and money market accounts?

Answer 13

Money market funds - a type of collective investment that allows individual investors to invest into different money market instruments without having to commit a huge amount of cash themselves

Money market accounts - Set up by banks and offer individuals competitive interest rates linked to money market returns. Usually fixed term and have high minimum investment levels (ie £50k)

Question 14

In relation to money market funds, In 2012, new rules were brought in to ensure clients are clear about the type of money market fund they are investing in, details of which can be found in the FCA’s Collective Investment Scheme Sourcebook (COLL).

Money market funds are now split into two types:
Money market funds & Short term Money market funds

Answer 14

Money market funds - changing NAV - income received by fund can be used to increase price of units

Short term Money market funds - Fixed NAV. To keep NAV constant accrued income must be paid out to investors or are used to buy more units in the scheme

Question 15

Money market investments are subject to the same risks as all cash investments. True or false

Answer 15

True

The fact that money market funds are generally well-diversified can lessen overall default risk, but the actual extent will depend on the individual credit ratings of the institutions offering each type of money market instrument. The term for this is ‘Credit Risk’. It applies to the individual companies the money is lent to.

Question 16

Comparing savings accounts and money market instrument investments (through money market funds) for retail investors:

Answer 16

Investors must consider the associated risks between a savings account and a money market instrument in relation to the potential rewards, and assess whether any extra risk is worth it.

The factors to consider in determining the suitability of a money market investment for a client include:

returns in relation to other cash investments - is it worth the extra risk?
charges and their effect on overall returns - again is it worth it on a cost / return analysis basis?
accessibility of assets; is the return worth any reduced ease of access?
the degree of risk of the underlying assets.
the experience of the fund management team.

Question 17

What is the forex market?

What is the FX market?

Answer 17

Both are names for the foreign exchange market

The Foreign Exchange, FX or Forex market is where currencies are traded.

Question 18

Currency trading

KEY PARTS TO REMEMBER

In your exam, you will get questions where you either need to calculate:

the amount of currency you can buy or sell to another currency, or

the profit or loss on a trade

Answer 18

All currency trading involves buying one currency and selling another currency at the same time at a set rate of exchange. Exchange rates are therefore always quoted as currency pairs e.g., US dollars versus the Japanese yen.

Each currency is assigned a 3-letter code. ie, us dollar = USD, EURO = EUR etc

Example of Currency pair = USD/EUR
In this case it means, for every 1 unit of USD you get x amount of EUR

Within each currency pair:

The first currency is called the base currency. The value of the base currency is always 1.

The second currency is called the quote or counter currency.

To go from base currency to quote currency multiple by FX rate

To go from quote currency to base currency divide by FX rate

If the exchange rate increases e.g. GBP/USD increases from 1.25 to 1.26 then it means we get more of the counter currency per one unit of the base currency.

If FX rate increase base currency strengthens and counter currency weakens

If FX rate falls base currency decreases or weakens and counter currency strengthens

FX rates are complicated further by the fact that dealers will quote two rates;

the rate at which they will buy the base currency / sell the counter currency (the bid price) and
the rate that at which they will sell the base currency / buy the counter currency (the ask or offer price). Dealers make their money from the bid/ask spread

The first part of any quote is known as the ‘big figure’ and the last part (the fourth decimal point) is known as the ‘pip’. Currencies are often just quoted in pips as this is the element of the quote that is likely to be changing rapidly.

If we want to sell £ to buy $ we need to look at the rate the dealer/bank is selling $ to buy £ (just think opposites)

If on the other hand, we have $ and we want to buy £, then we need to look at the rate where the dealer will buy dollars and sell sterling.

If we are selling the base currency, use the bid rate (because bank buys base at the bid) and if we are buying the base, use the offer/ask rate

The bank buys the base currency at the bid rate and sells the base currency at the ask rate

Question 19

Currencies can either be traded on the spot market or the forward market

Tell me the difference

Calculating forward rates

For the exam, you need to be able to calculate the FX forward rates

Answer 19

The spot market is for those who require immediate delivery of currency. They want it ‘on the spot’!

That said, ‘immediate’ in this case generally means two business days after the trade date. That is when the trade actually settles i.e., when the trader will pay an amount in one currency and at the same time take delivery of the other.

This date is often abbreviated to T+2 (trade date + 2 days) and can be known as the settlement date or value date (of course it can. In financial services why have one name when you can have two!)

The forward market is for the buying and selling of currencies at some point in the future – usually more than 3 business days after the trade date.

No money will be exchanged on the spot date (unless a collateral payment is required) and settlement will take place on the forward date.

The forward rate will not be the same as the spot rate and the difference between the two rates represents the interest rate differential between the two currencies involved. It is not a prediction or expectation of where rates will actually be in the future but should be thought of as an exchange rate that we can lock in today for a set date in the future.

The main uses for FX forwards are for hedging and speculation

IMPORTANT

Calculating forward rates

For the exam, you need to be able to calculate the FX forward rates