Chapter 1 Flashcards
Which of the following bonds is likely to display the least volatility?
ALonger dated BZero coupon CNon-investment grade DHigh coupon
The correct answer is: D - High coupon
Explanation
Long dated, low coupon and junk bonds are all higher volatility bonds.
[1047092] Investing in high coupon gilts is the most tax effective for which of the following situations?
AAn individual who does not pay income tax BAn individual who pays a high level of tax on income CMaking a large capital gain on the gilts DMaking a small capital gain on the gilts
The correct answer is: A - An individual who does not pay income tax
Explanation
Since bonds do not suffer capital gains tax, the investor is not concerned about the tax implicatons of selling the bond and making a capital gain.
Coupon income is taxable however, and thus the most tax effective situation is where high coupons can be received and the investor pays no tax on income. Foreign investors will often not pay tax on UK investment income.
[1017525] What measure of inflation is used currently with index-linked gilts?
ACPI 3 months prior BRPI 3 months prior CCPI 8 months prior DRPI 8 months prior
The correct answer is: B - RPI 3 months prior
Explanation
Index-linked gilts are linked to the retail prices index (RPI). However, to give an element of predictability about the cash flows an investor will receive, the RPI measure used is the one 3 months prior to the payment.
It should be noted that before 2004 the government used an RPI measure 8 months prior to the payment date, and gilts issued before this time still use this method.
[1069946] An activist shareholder will use their equity stake to put pressure on the management in order to achieve their aims. Which of the following statements are TRUE?
IThe shareholder may want to increase their equity value through cost savings
IIThe shareholder may want to influence the outcome of corporate resolutions
IIIThe shareholder activism may take the form of litigation
IVThe shareholder’s aims are always financial in nature
AI,II only BI,II and III only CI,III and IV only DII,III and IV only
The correct answer is: B - I,II and III only
Explanation
The activist may have aims that regard environmental concerns or ethical breaches, which are of a non-financial nature.
[1017541] Which is the most risky debt?
ABB rated debt BC rated debt CCC rated debt DB rated debt
The correct answer is: B - C rated debt
Explanation
In Standard and Poors ratings C rated debt is the most risky. It is worth noting that all of these would be considered speculative grade or junk.
[1017543] To be able to use the DMO to buy gilts, investors must first become?
AAccredited investors BAnnexed investors CApproved investors DAccepted investors
The correct answer is: C - Approved investors
Explanation
The retail gilt purchase and sale service is operated by a firm called Computershare. In order to access Computershare, and investor must become approved. This simply means going through a process similar to anti-money laundering procedures.
[1049142] Which of the following are the two main types of money market fund?
AConstant Net Asset Value and Constant Net Repayment BAccumulating Net Asset Value and Accumulating Net Repayment CConstant Net Asset Value and Accumulating Net Asset Value DConstant Net Repayment and Accumulating Net Repayment
The correct answer is: C - Constant Net Asset Value and Accumulating Net Asset Value
Explanation
Constant Net Asset Value (CNAV) and Accumulating Net Value are the two types of money market fund.
[1017544] Which of the following is incorrect in relation to investors buying gilts from the DMO’s Gilt Purchase and Sale Service?
AIt is operated by Computershare BIt is an execution only service CInvestors specify the nominal amount to buy DThe investor cannot specify the price
The correct answer is: C - Investors specify the nominal amount to buy
Explanation
As gilts will rarely be issued at their nominal value, The purchase and sale service run by Computershare needs to ensure that investors can afford the gilts that they wish to buy. For this reason investors specify the market value, not the nominal value.
[1024406] If the government issues a 2.5% index-linked gilt, how would the coupon paid be assessed?
AThe coupon plus the change in the RPI BThe coupon only - it is the capital that is adjusted for inflation CThe change in the RPI up to the coupon rate DThe coupon less the change in the RPI
The correct answer is: A - The coupon plus the change in the RPI
Explanation
The coupon is adjusted upwards by the change in the RPI, as well as the capital.
[1049149] What is a cap rate used for?
ACalculating the market capitalisation of a constituent of an index BEstimating the capital expenditure of a firm CValuing a commercial property DEstimating the maximum interest rate payable on a loan
The correct answer is: C - Valuing a commercial property
Explanation
A Cap Rate is used to value a commercial property. It is estimated from comparable properties that have been sold recently. It is used in conjunction with a commercial property’s net operating income to work out its value. The idea is that the property is worth a multiple of its income generating capacity.
[1069948] Which of the following are the correct components of enterprise value (EV)?
AEV = Market capitalisation + Market value of preferred shares + Market value of debt + Cash BEV = Market capitalisation + Market value of preferred shares + Market value of debt - Cash CEV = Market capitalisation - Market value of preferred shares + Market value of debt + Cash DEV = Market capitalisation + Market value of preferred shares - Market value of debt + Cash
The correct answer is: B - EV = Market capitalisation + Market value of preferred shares + Market value of debt - Cash
Explanation
EV is often considered as a cost of taking over the company. It would require buying out all the stakeholders, such as the owners and creditors. However, the new owner would inherit the cash position of the company, enabling them to pay off some of the debt. That is why the cash is subtracted from the value of the securities.
[1017566] In relation to equities, the record date usually falls on what day of the week?
AMonday BWednesday CThursday DFriday
The correct answer is: D - Friday
Explanation
For companies trading on the London Stock Exchange, the company registrar will check who is entitled to dividends on the record date. This is typically a Friday. The share will go ex-dividend on the Thursday immediately preceding this day.
[1017519] Convertible Gilts allow the holder to convert the bond in to what type of financial instrument?
AAnother gilt BAn ordinary share CA corporate bond DA call option
The correct answer is: A - Another gilt
Explanation
Convertible gilts give the holder of the gilt the choice to convert it into another gilt or receive the redemption payment on the redemption date.
[1017535] Lesley Watson holds a 6% Treasury 2034, trading at a price of £85. What is the interest yield?
A3% B3.5% C6% D7%
The correct answer is: D - 7%
Explanation
The interest yield is the income yield on the the bond. It express the the amount paid in the coupon as a percentage of the price an investor would have to pay for the bond. When thinking about the coupon, remember that the nominal value (against which the coupon is set) is always assumed to be £100.
The simplest way to calculate the interest yield is:
6/85 = 7%.
[1049150] Which of the following does not result in any diversification benefits?
APerfect negative correlation BImperfect negative correlation CPerfect positive correlation DImperfect positive correlation
The correct answer is: C - Perfect positive correlation
Explanation
No diversification benefits arise if assets move perfectly in synch together.
[1056976] Which of the following is the best description of a yield curve
AA historical time chart of a yield on a particular bond BA cross sectional chart of yields of different bonds of different issuers at a point in time CA snapshot of all yields of different bonds by the same issuer at a point in time DA snapshot of yields of different bonds with the same maturity from different issuers at a point in time
The correct answer is: C - A snapshot of all yields of different bonds by the same issuer at a point in time
Explanation
A yield curve must not be confused with a historical time series chart of a yield on a particular bond;
instead it is a snapshot of all the yields on a series of different maturity bonds, issued by the same issuer at one point in time.
[1017528] Permanent interest bearing shares are issued by what type of organisation?
ABanks BBuilding Societies CInsurance Companies DOpen Ended Investment Companies
The correct answer is: B - Building Societies
Explanation
Remember a building society is a mutual fund and does not offer genuine shares. Permanent interest bearing shares (PIBS) are a form of fixed-income security and can be traded on the London Stock Exchange (LSE). They rank lower than other creditors of the building society and are perpetuities (they have no redemption date).
[1056975] Jeremy Murray is a financial advisor who is trying to make sense of modified duration. He notices that the latest issue of Gilts by the DMO is currently priced at £103.25, with a modifed duration of 3.5%.
If Jeremy anticipates correctly that government yields will rise by 1% due to inflationary pressure in the economy, what price will the bonds change to?
A£106.86 B£104.28 C£102.22 D£99.64
The correct answer is: D - £99.64
Explanation
You don’t need to be able to calculate new bond prices accurately to be able to answer this question. It is testing the meaning of ‘modified duration’. If modified duration is quoted at 3.5%, this is telling you that a 1% change in yield is going to cause a 3.5% change in price. And if yield increases, bond prices fall. And that is all you need to know to answer this question, without picking up your calculator.
Look carefully at the four answers. The answer can’t be A or B, since if the price starts at £103.25, then the answer must be lower than this (since yield has risen). The price falls by approximately £3.50 (you can do this in your head without calculating anything) - so the answer can’t be C as this is far too close to the start point. So, D must be the answer.
If you would like this proving to you, you can work this out accurately to calculate the new bond price:
% change in price of bond = -(Modified duration x % change in the yield),
(There is an inverse relationship between prices and yields. As a result we have a minus sign attached to the right hand side of the formula.)
% change in price of bond = -(3.5 * 1%) = -3.5%
New bond price = £103.25 * (1-0,035) = £99.64
[1017166] Which of the following are key risks of deposits?
IInflation risk
IIOperational risk
AI only BII only CBoth DNeither
The correct answer is: C - Both
Explanation
Both of these are risks of deposits.
[1017545] Which of the following is/are correct regarding buying gilts direct from the DMO at Auction?
IWith a non-competitive bid, the price is not known in advance
IIWith a successful non-competitive bid, the investor’s application will be met in full
AI only BII only CBoth DNeither
The correct answer is: C - Both
Explanation
Non-competitive bids are exactly as the name suggests. Everyone gets the gilts that they bid for and everyone pays the same price for the gilts. However, this price cannot be calculated until after the competitive auction has been completed.
[1017565] Jennifer Spears phones her broker to sell £12,000 worth of shares in a UK company, Fashion plc. Assuming her broker charges 1% commission, what will her total cost be for this transaction?
A£120 B£121 C£180 D£181
The correct answer is: B - £121
Commission 1% = £120
Plus Takeover Panel Levy (as the transaction is above £10,000) £1 = £121 total.
This is a sale, so no stamp duty is due.
[1017558] Space Trek plc has profits of £2.5m, from which £2m is retained and £0.5m is paid in dividends. Assuming there are 1m shares in issue, what is the dividend cover?
A3 B4 C5 D6
The correct answer is: C - 5
Explanation
There are two ways the examiner can ask you to calculate dividend cover, although both are essentially the same. The first could be:
Dividend cover = earnings per share/dividend per shre
The second is the one used by this question:
Dividend cover = profits / total dividends paid
Dividend Cover = £2.5m / £0.5m = 5x
[1049145] Which of the following is a form of acquisition finance?
AVenture Capital BGrowth Capital CDistressed Investment DLeveraged Buyout
The correct answer is: D - Leveraged Buyout
Explanation
Leveraged buyouts involve a financial sponsor agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt which ultimately looks to the cash flows of the acquisition target to make interest and principal payments.
[1052590] Consider the following scenarios.
Huw buys shares through an initial public offer Frederick subscribes for shares through a rights issue Mary receives shares in a bonus issue
Which of the following is untrue?
AFrederick and Mary will typically find their share price fall BMary does not need to pay for any new shares CThe bonus issue alone will not cause any redistribution in ownership DThe new shares received by Mary would have been underwritten
The correct answer is: D - The new shares received by Mary would have been underwritten
Explanation
Mary receives shares for free in the bonus issue. As the company is not raising any new capital, underwriting is not necessary. All of the other statements are true.
An initial public offer is where the company issues shares to the public for the first time. This causes a redistribution of ownership from the initial owners - generally the directors - to the new subscribers of the shares. A rights issue is where existing shareholders have the right to subscribe to new shares in the company at a discounted price. If all shareholders take up their rights, there is no redistribution of ownership. Often, however, some shareholders choose not to take up their rights. Bonus issues give existing shareholders new shares free of charge. This has no impact on ownership, it does not raise new capital for the company, but it does reduce the share price.
[4088883] Which of the following is the best definition of a non-fungible token?
AA homogenous tangible asset BA homogenous intangible asset CA unique tangible asset DA unique intangible asset
The correct answer is: D - A unique intangible asset
Explanation
Generally, with alternative investments, investors end up with a tangible item such as a painting, an antique or a collection of coins. Non-fungible tokens (NFTs) are like physical collectors’ items, except they are digital. More specifically, NFTs are unique digital tokens in the blockchain network. Each NFT can be associated with a particular digit asset and a licence to use that asset for a specific purpose.
[1053543] Value and growth approaches to investing in equity tend to be considered as alternative and incompatible approaches. However, there is a reconciling approach that attempts to capture both aspects in the approach to stock selection. What is this approach commonly known as?
AGARP BQuantitative investing CCAPM DLong/short strategies
The correct answer is: A - GARP
Explanation
GARP is an acronym for ‘Growth At a Reasonable Price’ and commonly uses the P/E ratio combined with growth to compare available shares using PEG ratios.
[1017529] Which of the following is incorrect in relation to Permanent Interest Bearing Shares?
APIBS have a fixed redemption date BPIBS holders are not covered by the Financial Services Compensation Scheme CPIBS are traded on the London Stock Exchange DPIBS can be converted into a Perpetual Subordinated Bond on demutualisation
The correct answer is: A - PIBS have a fixed redemption date
Explanation
Remember a building society is a mutual fund and does not offer genuine shares. Permanent interest bearing shares (PIBS) are a form of fixed-income security and can be traded on the London Stock Exchange (LSE). They rank lower than other creditors of the building society and are perpetuities (they have no redemption date).
[1052591] Consider the following scenarios.
Harvey invests in a short-dated, AAA rated government bond
Sonia invests in a high yield bond
Fiona invests in a secured corporate bond
Peter invests in a floating rate note
Using only the information available, which of the following is NOT true?
ABoth Fiona and Harvey have a claim on the issuers’ assets in the case of default BOf the four investors, Harvey and Fiona are more likely to receive income until redemption CThe issuer of Sonia’s investment has a high probability of default DOf the four investors, Harvey and Peter are exposed to lower levels of capital fluctuations
The correct answer is: A - Both Fiona and Harvey have a claim on the issuers’ assets in the case of default
Explanation
Only Fiona, with a secured bond, has a claim on the issuers assets. This makes it less likely that the issuer will default - a case that is also evident in the AAA rated government bond. Sonia’s bond is high risk and more likely to default than any other here. Due to the short life of the government bond and the floating coupon on Peter’s bond, these two will have very low price volatility.
[1017503] James Knight sees a quoted rate of 6% pa for a deposit account that has interest paid quarterly. What is the annual equivalent rate?
A1.06% B1.06136% C6% D6.136%
The correct answer is: D - 6.136%
Explanation
Any rate quoted pa is a simple interest rate for the year. This interest rate is paid quarterly, so to calculate the annual equivalent rate (AER) we would need to work out the period rate and then compound the the rate for the year.
Period rate
There are 4 three-month periods in a year, so:
6% / 4 = 1.5%
Compound rate
(1.015^4) - 1 = 0.06136 or 6.136%.
[1017549] In the event of liquidation, what is the correct priority of payment: first to last?
ASubordinated debt, preference shares, senior debt, ordinary shares BPreference shares, senior debt, subordinated debt, ordinary shares CPreference shares, ordinary shares, senior debt, subordinated debt DSenior debt, subordinated debt, preference shares, ordinary shares
The correct answer is: D - Senior debt, subordinated debt, preference shares, ordinary shares
Explanation
These priorities show the order the liquidators will consider when paying out funds to creditors and owners.
[1017552] Which of the following UK indices is most liquid?
AFTSE All share BFTSE 100 CFTSE 250 DFTSE 350
The correct answer is: B - FTSE 100
Explanation
FTSE 100 is made up of high profile (blue chip) companies that are the biggest and most liquid.
The FTSE 250 is often called the FTSE mid-cap, and contains the next 250 companies.
The FTSE 350 is the FTSE 100 and 250 combined.
The FTSE All Share adds to the FTSE 350 with the FTSE small-cap.
As we move down the indices, liquidity tends to fall.
