5. Derivatives and alternative investments

Question 1

What is a derivative? And what are the 4 main types

5.1 Derivatives

Answer 1

Derivatives are investment vehicles that derive their value from another underlying asset,
such as shares or commodities.
* They allow the investor to invest in an asset, without directly exposing themselves to the risk associated with it or actually owning it

Examples
* Warrants
* Options
* Futures
* Contracts of difference

Question 2

What is a commodity?

Answer 2

Raw materials that come out of the ground or grow on it – oil, gold, wheat, etc.

Commodities buyers tend to use commodity derivatives rather than buying the commodity
itself. This allows them to hedge against future price increases and secure future supplies.

Question 3

Types of derivative - what is an option? What opportunity does it present to the investor?

Where are they traded? What does ‘lapse’ mean in this context?

Answer 3

A financial instrument that gives the owner the right, but not the obligation, to buy or sell an asset at a fixed price within a set timeframe.

Options are allowed to lapse - the option expires without the owner exercising it. Typically when it is not financially beneficial to exercise the option.

Options provide the opportunity to gamble:
* If the underlying asset price increases in the option period, the call option is likely to enable a large profit to be made.
* In a falling market a put option could produce a profit or limit losses.

Options are traded on the London International Financial Futures and Options Exchange (LIFFE)

Question 4

Options - what is the strike price, expiry date, and premium?

Answer 4

Strike Price
* The set price the option entitles the owner to

Expiry date
* The term set out in which the option is valid for or until

Premium
* The price paid for the option

Question 5

What is a Call option

Answer 5

A call option gives the holder the right to buy the asset at a fixed price – known as the strike price.

Question 6

What is a Put option

Answer 6

A put option gives the holder the right to sell at a fixed price known as the strike price.

Question 7

Three terms are used to explain the position of the option in relation to the underlying asset value:

Explain what they mean for the investor…

Answer 7

In the money - Profit situation - the value of the underlying asset is higher than the strike price for a call option, or lower for a put option.

At the money - Asset value = strike price

Out of the money - Value of underlying asset is lower than the strike price for a call option, and higher for a put option

Question 8

Use of options to ‘Hedge’

Answer 8

An investment strategy to limit losses.

Example
* If the investor believes the value of the stock they own may decrease, they can purchase a put option which would allow them to profit from the drop in value.
* If instead, the stock rises, their only loss is the premium of the option, which may be offset by the increased value of the stock

Question 9

What does ‘Shorting’ refer to?

Answer 9

Shorting is the term used when a fund manager uses put options to profit from a drop in a share’s

involves selling shares that the fund manager does not own, with the expectation that the price will drop, allowing them to buy the shares back at a lower price and profit from the difference.

Question 10

What are Futures?

Answer 10

Futures are exchange‑traded forward contracts.

Very similar to options, however, they do not have the ability to lapse the investor must exercise the right to buy or sell on the specified date.
* Unlike options, both parties are obliged to complete
the agreement on the expiry date.
* However, the investor can close out

Question 11

What does closing out mean within futures

Two ways to do so

Answer 11

Future investors must exercise their right to buy/sell or they can close out. This means they wipe this obligation. This can be done by:

• Selling the contrat on for its current market value
• Agreeing with the other party to the future to cancel it in return for a compensating payment reflecting the change in its value since the parties entered the contract.

Question 12

What tax applies to Options and Futures?

Answer 12

CGT

Question 13

What is a Warrant? - Corporate Warrant? Tax?

Answer 13

A warrant is a financial product similar to options and comes in a number of forms:

Corporate warrants
* Gives the holder the right to buy a share in the company at a set price within a set time period or date
* This is known as the exercise date
* Time period usually much longer than options (can be several years)
* Usually allows the holder to purchase a number of shares based on the proportion of shares already held.
* Once warrant actioned, the company issues new shares, devaluing the shares in current circulation.
* Shares purchased via corporate warrant are subject to Stamp duty of 0.5%
* CGT on disposal

Question 14

Covered Warrants?

Answer 14

Known as a form of securitised derivative

Can only be missed by financial institutions and not companies. And can deal with:
* Individual Shares
* Baskets of shares
* Index warrants - warrant relating to the performance of an index (such as FTSE 100)
* Sectors of the Stock market or Currencies

Like options and Futures, covered warrants:
* Call covered warrant
* Put covered warrant
* Sold at bid price
* Bought at Offer price

Question 15

Options and Covered Warrants can be organised as European or American. Explain the difference?

Answer 15

European options and covered warrants give the owner the right to buy/sell on a specific date

American options and warrants allow the owner to buy/sell at any time during the exercise period

American style are typically more expensive due to its added flexibility

Question 16

Two ways an investor can make a profit from a covered warrent?

Answer 16

By exercising the warrant at the expiry date if the share price is higher than the exercise price plus the premium paid

By selling the warrant in the market before the expiry date. This is known as ‘closing out’.
* The majority of warrant holders close out their position before the expiry date. The market price is based on the intrinsic value of the warrant plus a factor for the time remaining until expiry.

Question 17

The Price of a warrant before expiry can be affected by…

Name 5 variables that affect warrant price

Answer 17

Changes in asset values - A rise in the asset price will lead to a rise in the value of a call option, and a fall in the value of a put option. A Fall in the value of the asset will have the opposite effect

Volatility – an increase in market volatility will result in a rise in the warrant’s value and vice versa.

Time to expiry – the value of the warrant will decrease the nearer it is to the expiry date

Dividend yields– an increase in dividend yield will result in a fall in the value of a call option and an increase in a put option. A decrease in dividend yield will result in an increase in the value of a call option and a decrease in the value of a put option.

Interest rates – an increase in interest rates will lead to an increase in the value of a call option and a decrease in the value of a put option. A decrease in interest rates will lead to a decrease in the value of a call option and an increase in the value of a put option.

Question 18

Taxation of warrants?

Answer 18

• Subject to CGT on gains upon disposal - in the same way shares are
• Warrants do not produce dividends or interest so no income tax payable
• Stamp duty reserve tax payable at 0.5% (0% if settlement is in cash)

Question 20

What is a Contract for differences (CFD)

Answer 20

Agreement where two parties settle the difference between the oepning and closing prices of a share at the clost of the contract, which is open-ended.

CFDs allow the investor to gain exposure to shares without paying full price for them initially (a 10-25% deposit is required).

• Commission is paid on buying and selling the CFD, Based on the value of the shares rather than the CFDs and is typically 0.25%

CFD have no expiry date. The holder of a long CFD will be charged an interest every night that it is kept open.

Question 21

Explain the two types of CFD

Answer 21

Contract of differences can be organised:

Long trade - The CFD allows the investor to buy shares at a fixed price in the future (like a call option)
* If a dividend is paid on the share while a long position is open, the hodler of the CFD will receive part of the dividend payment.

Short trade - The CFD allows the individual to sell the shares at a fixed price (like a put option).
* If a dividend is paid while the investor holds a short position, they will be liable to pay it to the provider.

Question 22

Key difference between CFDs and Options+Warrants+Futures

Answer 22

CFDs do not have an expiry date - the holder can keep the contract open for as long as they wish.

However, holders of a long CFD will be charged interest for each night that it is kept. With the rate varying from lender to lender but often based on a reference rate, such as SONIA (Sterling overnight index average)

The holder of a short CFD will be paid interst on the same basis.

Question 23

What is meant by CFDs being ‘open-ended’

Answer 23

It means that CFDs do not have an expiry date

The investor can keep their holding open as long as they wish, however, their profit/loss position may be worsened if they continue to hold.

Reminder - the investor’s net profit will be difference between the current price (at close of contract) and the fixed price, after adding both commission and financing costs (such as CGT, Stamp duty, and any interest/charges due for the duration of the hold of CFD).

Question 24

CFD and share trading are similar, what are some key differences that make CFDs an attractive alternative to shares?

Answer 24

CFDs:
* Allow the investor to make a proft in rising or falling markets by trading long or short.
* Setting of stop losses - the price by which the position is automatically closed to limit losses.
* The investor trades on the margin, which means that only a percentage of the full share value is paid when opening the position.
* This allows the investor to gain access to more shares than their capital would secure if they bought the real shares. This is known as gearing and will increase proportional gains made when compared with actually trading the shares. Conversely, gearing will exaggerate losses compared to trading in the shares.
* If the investor keeps their position open, they must maintain the margin. This means that they must increase their deposit if the share price moves against them; this is known as a ‘margin call’.

Question 25

With CFD trading, what is a ‘margin call’?

Answer 25

A margin call is when an investor must add more money to their account to maintain their position because the share price has moved against them.
* The margin can be though of as a ‘deposit’. (usually 10-25% of the current value of the shares) required to trade with a CFD

If the value of the position drops, the investor’s deposit is no longer enough to cover the required margin, so they need to increase it to keep the position open.

Question 26

Taxation of Contract of differences?

Answer 26

• Not subject to stamp duty reserve tax.
• Any gains made will be subject to CGT in the same way as shares. Losses can be set against CGT.

Question 27

What is a Private equity investment

Answer 27

An investment that provides a medium‑ to long‑term committed investment in return for an equity stake (shares) in an unquoted company that offers the potential for high growth once an injection of capital has been given.

Simple example - the investors in BBC’s Dragon’s Den

Includes:
* Venture captial
* Management buy-outs
* Management buy-ins

Question 28

What is a ‘business angel’

5.3 Private equity

Answer 28

Private equity firms and private indiviudals who are prepared to invest in unqouted companies that require a capital injection.

Question 29

How can a private equity investor crystallise gains? I.e Exit/close their position or investment?

Answer 29

• Selling the shares back to the company’s management through a buy‑back arrangement
• Selling the holding to another investor (perhaps another private equity firm)
• Selling the holding to another company – known as a trade sale
• Selling the holding on the open market when the company achieves a stock market listing.

Question 30

What is a hedge fund? Why might they not be suitable for the average investor?

Answer 30

A privately owned investment company - definition generally regarded as difficult to nail.

They operate on the investment philosophy of absolute returns - the investment return depends on the fund manager’s skill rather than underlying markets.

Not suitable for the average investor
* Often require high minimum investment amounts
* High-risk, complex strategies
* Lack of Liquidity - HF often have ‘lock-up’ periods
* Less regulation - based offshore
* High fees

Question 31

Name and explain 4 investment strategies that hedge funds might use

Bonus: Name 8 other alternative strategies

Answer 31

Long and short Equity Plays - Use of derivaties to profit or ‘hedge’.

Relative value - analysing and comparing differences in the prices of similar assets to establish a fair value for each. Having completed the assessment, the fund will buy (long position) the ‘better value’ asset and take a short position on the more expensive asset in order to benefit from any reduction in price.

Oppurtunity - looking for profitable investments by assessing corporate events and news

Trading Strategies - where the manager takes a position on the way in which a particular stock, commodity or currency will move and makes investments accordingly.

Others:
Market Neutral, Merger arbitrage, converitble arbitrage, capital structure arbitrage, Fixed-income arbitrage, Event driven, Global macro, short only

Question 32

What does ‘arbitrage’ mean

Answer 32

Arbitrage is a trading strategy where an investor takes advantage of price differences in different markets for the same asset. The goal is to make a profit by simultaneously buying the asset in one market where the price is lower and selling it in another market where the price is higher.

For example, if a stock is trading for £100 on one exchange and £102 on another, an arbitrage trader could buy the stock at £100 and immediately sell it for £102, earning a £2 profit per share, minus transaction costs.

Question 33

Gold as an investment? Considerations…

Best way for a small investor to invest in gold?

5.5 Alternative investments

Answer 33

• Seen as impractical, due to dealing amounts and availability
• Value holds during economic downturn
• No correlation between gold value and equity values

Some considerations include the following:
* Recently, demand has outstripped supply, leading to increased prices.
* Gold is a favoured investment during economic troubles.
* Demand increases when oil prices rise and the dollar weakens.
* Gold can be a way of diversifying an investment portfolio.
* Gold reached a peak in 1980, after which prices weakened, recovering only in the past few years.
* Selling activity by central banks can drive down prices.

The smaller investor may be best served by investing in gold through a **commodity unit trust or OEIC **(Topic 10).

Question 34

Art as an investment? Considerations…

Benchmark art trade index?

Answer 34

• Investment in art requires a great deal of capital, often even to buy one painting.
• Art is illiquid in that it cannot be sold quickly in order to raise funds.
• Prices can fluctuate.
• Investors require a high level of expertise.
• Forgeries can enter the market and require expert scrutiny.
• Demand is subjective and often driven by a limited number of collectors, who are often searching for particular pieces or artists.
• Buying and selling costs tend to be quite high, which reduces the overall gains made.

Benchmark index:
* Sotheby’s Mei/Moses All Art Index

Question 35

What is KFLII?

Answer 35

Knight Frank Luxury Investment Index (KFLII) tracks the value of ten “investments of passion”

An index that tracks the performance growth of alternative investmentes such as art, classic cards, watches, wine, whisky, etc.