Chapter 1: Analyse the characteristics, inherent risks, behaviour and correlation of asset classes. Flashcards
In exam - Approx 17 standard questions, 11 multiple choice
Name the 4 main types of asset classes
Cash
Fixed interest securities
Equities
Property
What are the personal savings allowance (PSA) for:
- Basic rate taxpayer
- Higher rate taxpayer
- Additional rate taxpayer
Basic - £1,000
Higher - £500
Additional - £0
What is a money market investment?
A ‘money market investment’ is essentially a short-term loan to the Government, a bank or some other organisation. These investments often pay very low rates of interest because of their short-term nature.
What is a fixed-interest security?
Fixed-interest securities or ‘bonds’, are issued by governments, companies and other official bodies as a way of raising money to finance their longer-term borrowing requirements.
What does Price at redemption (PAR) mean?
The fixed value that investors will receive at the end of the term
What are Bonds and GILTS?
Negotiable fixed-interest long-term debt instruments…
- tradable investments (negotiable)
- that pay a fixed return (fixed interest)
over a period of 20 to 30 years (long-term) - A loan to someone (debt instruments).
Explain the 4 parts of the below stock certificate:
Sainsbury’s 6% 2029 £100
1) The investment is a corporate bond, as it is a loan to
Sainsbury’s.
2) There is 6 % interest payment per year. This is referred to as
the stock’s coupon
3) The maturity date is 2029: also known as the redemption
date
4) The amount of money that will be repaid in 2029 is £100.
This is the PAR value or clean price
What is the formula to calculate the interest yield?
Coupon ÷ Clean Price x 100
Keira is buying some Tesco 4% with 16 years left to run. The current clean price is £127.86.
What is the interest yield?
The interest yield is:
4 x 100
/
12.86
= 3.13%
Connor is buying some Guinness 8% with six years left to run. The current clean price is £116.85
What is the interest yield?
The interest yield is:
8.0 x 100 ÷ 116.85
= 6.85%
What is the difference between redemption yield and interest yield?
The redemption yield takes into account the gain or loss that would be experienced by the holder of the bond at maturity.
How do you work out the redemption yield? (5 steps)
The steps involved in this calculation are:
- Work out the ‘normal’ interest yield (you may be provided this in the exam)
- Work out the capital gain or loss at redemption (-100)
- Divide the capital gain or loss by the number of years until redemption, to work out the gain or loss per year
- Convert the yearly gain or loss into an income yield (positive or negative)
- Add or subtract the gain or loss to the ‘normal’ interest yield
Keira has an interest yield of 3.13% from her Tesco 4% stock.
The clean price is £127.86 & there are 16 years to redemption,
What is the redemption yield?
There are 16 years to redemption, so the capital loss each year is £27.86 / 16 = £1.74.
As a percentage of the price paid, the loss is -1.74 x 100 / 127.86 = -1.36%
Subtracting this from the interest yield of 3.13% means the redemption yield is: 3.13% -1.36% = 1.77%.
Conor has an interest yield of 6.85% from his Guinness 8% stock.
We also know that he would make a loss of £16.85 at maturity as the clean price is £116.85. There are 6 years to redemption
There are 6 years to redemption, so the loss each year is 16.85 / 6 = £2.81.
As a percentage of the price paid, the loss is -2.81 x 100 = -2.40%.
116.85
Subtracting this from the interest yield of 6.85% means the redemption yield is: 6.85% - 2.40% = 4.45%.
Using the information below, calculate the income (or running) yield and redemption yield.
Tessa has just bought a gilt, Treasury 5% with four years remaining until redemption. The clean price is £113.87.
Income Yield:
£5 ÷ £113.87 x 100 = 4.39% Income Yield
Redemption yield :
£113.87 - £100.00 = £13.87 loss,
divided by 4 years remaining = -£3.47 per annum
-3.47 ÷ £113.87 x100 =3.05%
4.39% - 3.05% = 1.34%
What are the risks associated with fixed interest securities?
- 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.
- Liquidity risk: The ability to sell at a given time.
What are the 2 types of risks that generally impact on the supply and demand price of bonds?
- Unsystematic risk; Specific or commercial risk that affect a particular stock.
- Market or systematic risk; Risks that affect the whole market.
What sort of events drive systemic/market risk?
- Economic issues: for example the credit crisis.
- Economic growth: fuelling inflation and rising interest rates.
- World events: 9/11 or the covid-19 outbreak.
- Natural disasters: tsunami in Asia.
- Elections or political turmoil.
Who issues GILTS
The Debt Management Office (DMO)
What timeframe does the The Debt Management Office (DMO) classify the following GILTS:
Shorts
Mediums
Longs
Shorts - Less than 7 years
Mediums - Between 7-15 years
Longs - Over 15 years
What index is used in regard to ‘Index linked GILTS’?
Retail Price Index (RPI)
With index-linked GILTS, what is adjusted, in line with
inflation?
Interest payments and the capital at redemption. Should RPI fall, then the interest and capital will also fall. Investors are protected against the value of their investments being eroded by inflation, however coupons on index linked GILTS tend to be much lower than on non- index linked stocks.
What are the 2 categories that bonds are generally split into?
- Investment grade bonds:
anything higher than BBB- from Standard & Poor’s, or BaaB from Moody’s, are considered to have an extremely low risk of default. - Sub-Investment grade bonds:
These are below the above thresholds and therefore considered to have a significantly higher risk of default. These are often termed as ‘junk bonds’ or high-yield bonds.
If a company’s credit rating is marked down, what do you think would happen to the market price of its bonds?
They will fall, as they are seen as riskier investments.
This will drive up the yield, rewarding investors for taking the added risk.
If the coupon was lower, and the period to redemption was longer, would this mean the price is more or less volatile?
More volatile.
- The longer the period, the more likely it will be affected by world events and companies running into difficulty.
- Also, there is a longer term until you get repaid.
If the coupon was higher, and the period to redemption was shorter, would this mean the price is more or less volatile?
- The higher the coupon and the shorter the period to redemption, then the less volatile the bond price.
- The higher the coupon the less likely any such changes will undermine the returns.
How are interest payments and capital at redemption calculated, for index-linked GILTS?
- Interest payments are revised in line with monthly changes over previous 6 months
- Capital repayment reflects changes in RPI from date of issue, to date of redemption
What is the difference between GILTS issued before September 2005, and after?
- GILTS issued prior to September 2005 use RPI figures from the period eight months prior to each coupon payment date
- While those issued after this date use RPI figures from the period three months prior to each coupon payment date.
This is known as ‘indexation lag’.
On the 1st August 2016, a new issue of index-linked GILTS was released.
George purchased some of the issued GILTS.
How will his coupon RPI uplift be calculated if income is paid twice a year on the 1st January and 1st July?
- At each 6-month coupon date, the interest figure will be adjusted, based on how the RPI rate compares to the ‘base’ RPI that existed when the gilt was issued.
- The RPI figure used is the rate 3-months before both the coupon date and the issue date.
So, for the coupon paid to George on the 1st January 2017, the interest rate would be adjusted by a factor based on how the RPI figure on 1st May 2016 (i.e. 3-months before issue) compares with the RPI figure on the 1st October 2016 (i.e. 3-months before the coupon date).
How are Index-Linked GILTS taxed?
- Income paid is taxable including any inflation uplift.
- Any gains made are CGT free including any inflation uplift.
What is the difference between Corporate Bonds and GILTS?
- They are riskier, with a higher chance of default.
- Prices are more volatile.
- They can be more difficult to trade, particularly smaller company bonds.
- The difference between the buying and selling price is greater.
- The creditworthiness of the companies changes more regularly.
- Yields are often greater to reflect the higher risks being taken.
What are the 2 types of corporate bonds?
- secured, where a charge is taken over the firm’s assets and in the event of default the assets can be used to repay the loan
- unsecured which obviously carry more risk.
Which type of corporate bond would typically pay the better return: secured or unsecured?
An unsecured corporate bond.
Investors would want to be rewarded for the higher risk they take.
What happens on the strips market?
A GILT is stripped down into:
- a series of interest payments
- a redemption payment
They can all be sold separately, zero coupon instruments trading at a discount to their face value
A ten-year GILT can be stripped down into 21 separate securities, what are they?
- 20 strips being the half yearly interest payments
- The redemption payment at the end of term
What is an equity?
- A share in a company, as a shareholder you part own the company
- Entitled to share of the profits
What are the risks associtated with cash?
- 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.
Cash ISA rules
- Available to individuals aged 16 and over.
- Maximum annual limit is £20,000.
- No minimum amount
- Withdrawals are available at any time without the loss of tax-free interest.
When a security is involved, what is a corporate bond known as?
A Debenture, which means ‘Written acknowledgement of debt’
If a debenture is secured by a fixed charge, what does this mean?
A Debenture means ‘Written acknowledgement of debt’, usually involves a security as collaterall
- It is a charge over specific assets of the company (often
land or buildings). - This means the sale of the asset is restricted.
- Higher priority for payment than floating charge
- Preferred by investors
If a debenture is secured by a floating charge, what does this mean?
- This is a a general charge over any of the company assets,
- This means the company can still deal with or sell
their assets. - Lower priority than a fixed charge
- Preferred by firms
- Ranks alongside ordinary creditors if the firm defaults on its financial obligations
Convertible Loan stock
- Unsecured loan stock
- Interest is paid on the loan, often at a low rate
- Gains liable to CGT
Floating note rates
- Interest return linked to money markets
- Average LIBOR rate or SONIA is used to calculate return
Permanent interest-bearing shares (PIBS)
- Issued by building societies & traded on stock market
- Undated stocks, higher risk due to no redemption date
- Not covered under FSCS
- Ranks behind ALL depositors and creditors if liquidation
- Interest paid gross, half yearly
- Subject to income tax
Perpetual subordinated bonds (PSBs)
- Any building society that demutualises (becomes a PLC and issues shares) will convert all their RIBS to PSBs.
- They essentially stay the same as RIBS.
- PSBs cannot be issued by Banks.
- It is purely previous building society stock that has been converted.
Companies raise money by issuing shares, so they make their money on which market?
Primary market…
Primary is new issues, secondary is where subsequent deals are brokered.
Once issued, the company makes no money through the secondary market. Profits and losses in the secondary market belong to the individuals and organisations trading the shares.
How is Stamp duty (paper) calculated?
0.5% of purchase price, rounded up to the nearest £5
So £2,500 purchase x 0.5% = £12.50
Rounded up to nearest £5 is £15…
How is Stamp duty Reserve Tax (SDRT) (paperless) calculated?
0.5% of purchase price, rounded to nearest penny.
So £12,500 purchase x0.5% = £62.50
No rounding required so total is £62.50
What is the total amount of Stamp Duty/Stamp Duty Reserve Tax payable from the following deals?
- Cuthbert buys £12,500 worth of Lloyds Bank Shares by Crest
- Diane buys £5,000 worth of BP shares by Crest
- Kelly sells £20,000 worth of Tesco shares by Crest
- Abdul buys £23,500 worth of Teatotal shares by Paper
Cuthbert £12,500 x 0.5% = £62.50
Diane £5,000 x 0.5% = £25.00
Kelly £0.00 (No stamp duty on a sale)
Abdul £23,500 x 0.5% = £117.50 - rounded up to £120.00
Total £207.50
Remember - SD & SDRT are only on purchases of shares, not selling!
What rights do a purchase of an ordinary usually grant an investor?
- A right to the share in the profits (via dividends, optional by company)
- A right to vote at company meetings
Definition of Dividend allowance
The amount of dividends earns before having to pay any tax
What is the current Dividend allowance?
£1000 (23/24)
Will be £500 in 24/25
What are the tax rate % after the Dividend allowance has been reached for:
Basic rate
Higher rate
Additional rate
Basic - 7.5%
Higher - 32.5%
Additional - 38.1%
Taxable on top of earned/savings income
Paid via self assessment
Casey is the sole director of CAS Training Ltd. Her remuneration from CAS involves her taking a small salary topped up with dividends from the business and as such, she has fully utilised her dividend allowance (DA). She is a basic rate taxpayer.
She also owns shares in British Gas and has received a dividend of £100 from them.
What is her tax liability?
As a basic rate taxpayer, this will generate a 7.5% liability
£100 x 7.5% = £7.50
Tony is a higher rate taxpayer and Phil an additional rate taxpayer. Both have fully utilised their dividend allowances.
They have both recently received £1,000 dividend payments from their shares in ABC Plc and have enquired what their respective tax liabilities will be.
Tony, as a higher rate taxpayer will have a 32.5% liability to be paid through self-assessment so £1,000 x 32.5% = £325.
Phil, as an additional rate taxpayer will have a 38.1% liability to be paid through self-assessment so £1,000 x 38.1% = £381.
Why would companies offer different types of shares, e.g. A shares and B shares?
Dividends must be paid equally in proportion to their shareholding. Offering different shares with different rules can attract investment and reward shareholders with different levels of dividends
What is a Cumulative share
Any ‘missed dividend’ must be made-up in future years. When it is made-up, it must be paid before any other dividend payments are made to ordinary shareholders.
What is a Non-cumulative share
- Any missed dividends do not have to be made up.
- The investor loses their right to the dividend at the end of the financial year, if not paid by the company
What is a Participating share
- Pay a fixed rate of dividend
- Allows the holder to receive a share in company profits
- Receive an additional dividend that is usually a proportion of any ordinary dividend declared
What is a Redeemable share
- A temporary source of finance for the company
- Many have no redemption date
- Dividends are paid until repurchased by company
What is a Convertible share
- Can be converted into ordinary shares by the holder at pre-set dates on pre-set terms
- A rising ordinary share price will drive the option holder to convert
David, Jeff and Alice all have preference shares.
- David is entitled to a fixed dividend that if not paid must be made up in future years.
- Jeff is entitled to both a fixed dividend plus a share in the company’s profits.
- Alice is entitled to a fixed dividend which is lost if it is not paid by the company within a financial year.
What types of preference shares do these investors have?
David - Cumulative
Jeff - Participating
Alive - Cumulative
What are the risks associated with Equity investment?
- Equity Capital Risk: Risk to capital, due to market forces.
- Market Risk: The impact of ‘wider market forces’.
- Share Dividend volatility: Dividends are uncertain.
- Liquidity Risk: The ability to sell at a given time.
- Currency Risk: Exchange rate movements, if dealing in overseas equities.
- Counterparty Risk: The risk that a counterparty will not pay what it is obliged to.
What % protected are Investment bonds from insolvency?
90% with no upper limit
What are the 4 main FTSE indices?
- FTSE All-Share index
An aggregation of FTSE 100, FTSE 250 and FTSE Small Cap. - FTSE 100 Index
Consists of 100 largest UK companies
Revised Quarterly - FTSE 250 Index
The next 250 largest companies
Two versions exist, 1 with investment trusts and 1 without - FTSE 350 Index
A combination of the 100 and 250
What do the following USA indices consist of?
- Dow Jones
- Standard and Poor’s composite (S&P)
- Nasdaq
Dow Jones
- Main US Index, 30 companies
Standard and Poor’s composite (S&P)
- 500 companies, weighed index
Nasdaq
- Smaller companies often in tech areas
What do the following Japanese indices consist of?
Nikkei 225
TOPIX
Nikkei 225
-Most widely used index, average of 225 stocks. Non-weighted
TOPIX
- Represents the whole Japanese market
What is the German index called?
DAX 30
Germany’s 30 largest quoted companies, weighted and real time
What is the Hong Kong index called?
Hang Seng Index
Hong Kong’s main index. A weighted index of a sample of Hong Kong stocks.
What is the French index called?
CAC 40
The main French index, real time and weighted.
What is the South African index called?
FTSE/JSE
Africa’s largest stock market, real time and weighted.
What is the Australian index called?
S&P All Ordinaries
Australia’s main index
David wants to review the investment performance of Japanese shares. Which of the following indices should he look at?
A) CAC 40 and the Hang Seng.
B) Hang Seng and the NASDAQ.
C) Nikkei and the TOPIX.
D) NIKKEI 225 and the Dow Jones.
C -
The NIKKEI 225 and the TOPIX are examples of Japanese indices.
What is the mortgage market review? (MMR)
Came into effect in March 2014, made it more difficult to borrow money, with tighter rules and regulations
Risks associated with property investment
- Liquidity Risk: The ability to sell at a given time or realise cash quickly.
- Management Risk: Skills and funds required to run the business.
- Void Risk: The risk that the property will be vacant.
What is Rental Yield
Expresses value of the rental income as a percentage of the total property price, should include expenses of purchase such as solicitor fees and Stamp duty
Split into two types:
Headline gross rental Yield
Net Yield
Joe pays £480,000 for a flat in Clapham. He then rents it out for £1,350 per month.
His gross rental yield on that basis would be:
- £1,350 x 12 months = £16,200
- £16,200 / £480,000 x 100 = 3.38% gross rental yield.
Another variation on the gross rental yield calculation would be to factor in the cost of purchase. If we assume that Joe paid £20k for associated costs.
On that basis the calculation would be; £16,200 £500,000 (£480,000 + £20,000) x 100 = 3.24%
Joe pays £480,000 for a Flat in Clapham and rents it out for £1,350 per month. His management agent charges 10% annually. He paid £20,000 in purchase costs.
Calculate his net yield.
- £1,350x 12 months = £16,200
- £16,200 - £1,620 (10% management charges) = £14,580
- £14,580 / £500,000 (£480,000 + £20,000) x 100 = 2.92% net yield.
As his actual expenses are in excess of the £1,000 property allowance, he is likely to want to deduct these,
providing added income tax relief.
Rupert wants to know his gross rental yield from his flat in Mayfair.
- He bought it for £945,000 including all costs of purchase and has a mortgage for £340,000.
- His tenant Clarissa pays £6,000 per calendar month.
£6,000 x 12 = £72,000 per annum
£72,000 / £945,000 = 0.07619
x 100 = 7.62%
Sachin wants to know his gross rental yield from his house in Halifax.
- He bought it for £83,000 including all costs of purchase and has a mortgage of £61,000.
- His tenant Sophie pays £450 per calendar month.
£450 x 12 = £5,400 per annum
£5,400 / £83,000 = 0.06506
x 100 = 6.51%
The mortgage part of the Q is a red herring and irrelevant. Only need to worry about the overall cost & the rent price
What is Stamp duty Land tax?
A tax on land transactions and is payable by the individual who acquires the land.
It is often the highest of all the costs associated with buying a house.
There is no SDLT on sales of property, only purchases.
Not applicable to first time buyers
What are the SDLT Net present value (NPV) thresholds?
No SDLT is charged on leases until the Net Present Value (NPV) exceeds the £125,000 residential property threshold or the £150,000 commercial property threshold.
Andy is renting a residential property in Chelsea for £2,500 per month and has a lease for 5 years. Ignoring any inflation adjustments, calculate the Stamp Duty Land Tax that Andy will
need to pay.
- £2,500 x 12 months x 5 years = £150,000
- This means that there is a £25,000 rental excess over the £125,000 threshold
- £25,000 x 1% = £250 Stamp Duty Land Tax due.
How is SDLT calculated on property purchases?
The buyer pays a percentage of the cost of the purchase amount in SDLT.
The transaction cost is multiplied by the relevant percentage in each band, which is based on the property purchase price.
SDLT key points
- It is an extra charge for the purchaser of a property.
- The seller does not pay SDLT.
- It cannot be avoided through property exchange.
- SDLT rates change once the property value exceeds any threshold by £1.
- If a property is exactly on a threshold it will fall into the lower rate, so £250,000 is in the 2% band.
- If a property exceeds the threshold by £1 or more, it falls into the higher rate e.g. £250,001 falls into the 5% band.
- Different rates apply for residential and non-residential property purchases, but the calculation is the same.
- New rules apply for first-time buyers who buy property below £500,000.
Inflation affects which asset classes?
Cash & fixed interest
