Chapter 1 - Cash Investments & Fixed Securities Flashcards
Interest rates are usually (5, common sense), if offering higher interest rate has what rules and pens include (loss of interest for what and during what)
Risks presented by cash deposits include
- credit, returns, rates and foreign
Interest rate applied to deposit is usually;
- flat rate, fixed or variable, paid gross of income tax, dependant on term or notice and subject to pens for early withdrawals.
If offering higher interest rate may need notice period or min balance to avoid penalties. Pens that can be imposed include;
- loss of interest differentials provided for larger or longer terms deposits
- loss of interest for the period of notice on account.
Risks presented by cash deposits include;
- varying creditworthiness
- inflation reduces returns meaning real return could be negative
- rates may fluctuate
- Deposits in foreign currencies are subject to exchange rate movements.
Default risk for cash accounts - need to consider what
Creditworthiness - what do credit ratings assess and give and indication of what?
FSCS - max comp and key points
- limits, several accounts, joint, subsidiary, EEA, timescales of payment
Inflation risk - interest rates and inflation means what
Interest rate risk - what is it (variable)
Reinvestment risk - what is it (fixed term deposits)
Need to consider creditworthiness and FSCS coverage.
Creditworthiness - credit ratings assess default risk associated with bonds issued by Gov and companies + indication of banks stability and ability to repay debt.
FSCS - 100% up to £85k for deposits per authorised institute. Key points;
- limits apply for each investor
- investor with several accounts with same bank cannot recover more than those holding monies in one account.
- joint account holders get £85k each
- if subsidiary then only first £85k protected.
- does not cover outside EEA, Isle of Man or Channel Islands.
- Aim to pay compensation within 7 days of defaulting but can take more time - if more complex then paid within 20 days.
Inflation risk - UK interest rates have been much lower than rate of inflation so even short term deposit holders risk erosion.
Interest rate risk - interest rate is implicit and rate can change based on base rate.
Reinvestment risk - fixed term deposits carry this as if interest rates high at start but low at the end, may not be able to secure same level of interest for reinvestment. Many pensioners in 2009 faced this due to falling interest rates.
Offshore accounts - cash investments in foreign currency provide what (2) and actual return depends on. Common dangers;
- higher rates, strong and supervisors
Needs to consider when choosing offshore
- market, volatility, variability, repay-ability and compensation
Suitable for those
- liabilities and speculate
Offshore accounts - cash investments in foreign currency provide income and should maintain capital value but only in the foreign currency. Actual return depends on exchange rate. Common dangers include;
- high rates of interest usually offered by high inflation countries with potentially collapsing currencies.
- strong currencies fluctuate and may not provide compensation for lower interest rates.
- some countries do not have same supervisory structure as UK meaning defaulting can cause issues.
Should consider;
- expected movements in the market
- volatility of currencies pasts value against major currencies
- changes in interest rates
- ability of deposit-taking body to repay capital when it matures
- if there are statutory compensation schemes.
Foreign currencies suitable for those;
- those who have liabilities in that currency
- investors who want to speculate on exchange rates while earning income.
Instant access accounts - main characteristics
- withdrawals, rates, higher rates when
Teaser rate account may
- bonus, limits and other products
Main characteristics;
- withdraw cash immediately, rates are variable and can be significantly lower than deposit accounts, higher rates usually on postal, telephone or online accounts.
If there is a short delay cannot be considered instant unless they have a cash card - if no card then referred to as easy access.
Teaser rate accounts may
-offer short term bonuses, low limits on how much can be deposited to earn best rate or require parallel investments in other products.
Restricted Access Accounts - main characteristics
- higher rates than what and rates available are what
Notice accounts
- rate and accessibility, withdrawals, penalties, longer notice accounts and rates
Term Deposit accounts
- who offer with what type of rates and accessibility, interest rates, income and money markets
Structured Deposits
- interest based on, how return is offered, risk and inflation
Main characteristics;
- higher rates than instant access and usually highest rates available for cash investments
- higher risk due to changes in credit rating, rate elsewhere and inflation.
Notice accounts;
- pays higher variable rate for less accessibility
- notice period for withdrawing money
- penalties for early access and usually interest during period of notice
- interest rates may be cut for longer notice accounts and therefore stuck.
Term Deposit accounts;
- banks offer these usually with 1 to 5 year fixed rates but no or limited access.
- provide higher interest for those willing to leave alone for fixed period.
- suitable for certainty of income but not good for access.
- rates offered are driven by money markets and can be higher or lower than variable rates.
Structured deposits
- pay interest based on performance of an equity index (usually FTSE 100).
- typically offer return over a fixed term which is greater of amount initially invested or % of change in FTSE 100
- risk-free way of participating in stock market but usually longer term commitment meaning inflation may have an effect.
ISA flexibility rules - what is it
NS&I Direct ISA - DISA & JISA how opened and managed, transfers, flexi rules.
NS&I Income Bonds - income, rate and risk, age, encash, interest paid
NS&I Bank Accounts- two types and how opened
NS&I Savings Certs - available to who
Guaranteed income - terms and rates, min amount, interest paid when and how renewed
Guaranteed - terms and rates, min amount, interest and tax, renewed
ISA flexibility rules - if withdrawal made can be replaced in the same tax year but if not then cant.
NS&I Direct ISA
- Direct ISA only online or by phone
- JISA only managed online
- Transfers from other providers not permitted
- Not adopted flexible ISA rules.
NS&I Income Bonds
- pay monthly income at variable rate with no risk
- must be 16 or over
- no notice period or penalty for withdrawals/encashment
- interest paid gross but taxable and can be set against savers allowance.
NS&I Bank Accounts
- two types - investment account by post only
- direct saver opened online or over the phone
NS&I savings certificates
- only available to those with maturing certificates and not on general sale
Guaranteed income bonds
- fixed terms of 1, 2, 3 ad 5 years and rates differ for each.
- minimum renewal amount is £500
- interest paid once a month
- renewed online, post or phone.
Guaranteed Growth Bonds
- as above first for all except interest
- interest paid gross but taxable and set against savings allowance.
Money Market Investments - markets where who do what?, how long can term be and via what, private investing is what but can do what to get involved? And issuers use to…
Treasury bills
- issued by who and why
- managed by who and why
- issued how and with what terms
- Treasury Bill Primary Participants and min amount
- how does one make money with it and interest is what
- backed by who, term, liquidity and risk
Money markets are wholesale markets where banks, Gov and other lend to and borrow from each other. Borrowing can be few hours to several months via short-term debt instruments. Private investing is limited but can get involved through collective investment vehicles.
Allow issuers to raise funds for short-term period for low interest rates.
Treasury bills - issued by Gov to finance short term cash needs
- managed by DMO and uses treasury bill market to manage Gov’s daily cash flow needs.
- Issued at weekly auctions with terms of 1, 3, 6 or 12 months (non of these) and can also issue on ad hoc basis.
- Public must purchase through Treasury Bill Primary Participants and purchase minimum of £500,000
- Do not pay interest but are issued at price lower than face value and when matured Gov pays par value. Interest is the difference between the purchase price and maturity value.
- Backed by UK Gov, short-term, highly liquid and risk free.
Certificates of Deposit - what are they, type of interest rate and linked to + maturity, how to access funds, why do banks issue, yields less than what and why + depend on, term and interest paid when
Commercial Bills - what are they, liquidity compared to treasury bills and how operate, maturity term, credit ratings and yields
- These are receipts from banks for deposits placed with them.
- Deposits usually carry fixed interest rate linked to LIBOR + fixed maturity.
- Can be traded to access funds.
- Banks issue these to raise funds to finance business activities
- Yields are less than ordinary deposit due to ability to trade and access capital. Depend on market rates and credit rating of bank issuing.
- Usually 1-3 months with interest paid on maturity.
Commercial Bills
- short-term negotiable instruments issued by companies to fund day-to-day cash flows.
- Less liquid than treasury bills but operate similarly.
- Issued at discount to their maturity value
- Maturity in 30-90 days
- Unsecured and issued by companies with high credit ratings.
- Yields typically higher than treasury bills due to higher risk and illiquidity.
Investment Vehicles - who uses this, EU rules to ensure what and MM funds are subject to what rules (asset, duration and controls).
Weighted average maturity and life length - short term MM and standard funds
What need to assess if suitable for client
- returns, charges, liquidity, underlying portfolio, fund management team
Returns from MM funds
- vary on what, pure cash assets vs commercail bills or ST debt instruments and returns are…
Risks
- usual risks for cash investments? (3/4) and funds and credit risk
Used for private investors. Rules across EU to ensure investors are clear on what type of money market they are investing in. MM funds must meet set of rules that shows clearly type of asset, duration and controls.
Short term MM funds - weighted average maturity of no more than 60 days and life of no more than 120 days.
Standard MM funds - as above but 6 and 12 months
To assess if suitable for client should assess;
- returns on MM funds compared to other cash based investments
- charges and their impact on returns
- how long it takes to realise assets if client needs access to funds
- assets contained in the underlying portfolio and risk level of fund
- fund management team experience
Returns from MM funds
- vary depending on underlying portfolio
- if fund invested in pure cash assets then lower return generated compared to one invested in commercial bills and short-term debt instruments. Return on MM not competitive.
Risks
- credit, inflation and interest risk and maybe currency risk
- funds are affected by credit risk differently
Fixed interest securities - issued by who and why, regular payments and capital, encashment and sold how.
Brief description of Negotiable, fixed interest, long term and debt instrument.
How do companies raise long term finance and why (3)
- banks, market and price of borrowing
Characteristics of bonds
- fixed rate, redemption value and date known as
Issued by Gov to fund longer term borrowing requirements and owner of fixed interest security gets regular payments along with capital at maturity. Can’t be cashed in before maturity date but can be sold on stock market. FIS can be described as negotiable, FI, LT debt instruments.
Negotiable - FIS are free to sell on
Fixed interest - borrower committed to pay interest at fixed rate
Long term - run between 2 and 30 years
Debt Instrument - financial instruments that represent debt
Companies often raise long term finance they need by issuing bonds to capital markets rather than borrowing from banks as;
- banks cannot meet amount or term required
- bond market offers wider range of lenders to tap into
- Bonds are often cheapest method to borrow money.
Characteristics of bonds;
- fixed rate of interest known as coupon
- fixed redemption value known as the par value
- repaid after a fixed period at the redemption date
FIS - Pricing - how traded, what will vary before redemption, Nominal and par value determines
-price and interest
- Trading - why aren’t prices quotes in major newspapers exact
- mid market prices and clean prices (what are they)
Bonds are traded by their nominal (value is £100 for a bond) or par value i.e. face value.
Before redemption, the market price of £100 nominal will vary and may be above or below par value. The nominal or par value determines;
- price bond will be redeemed at redemption date
- amount of interest received.
Trading
Prices are quoted in Financial Times and others but these are not exact prices as;
- mid-market prices (mid point between buying and selling prices
- Clean prices and ignore value of accrued interest. Interest on bonds are calc’d daily and must be added to or subtracted from the clean price to get price of bond.
FIS - Accrued Interest - when paid and accrued
Cum Dividend
- receives what, compensate, price
Ex Dividend
- when payments made, if purchased when what happens, price adjustment, clean price deduction
Interest paid biannually but accrued daily.
Cum Dividend - purchaser receives full six months interest even if owned less than this period.
- Purchaser then has to compensate seller for interest they were entitled.
- Buyer pays clean price plus interest accrued.
Ex Dividend - interest payments made to registered holder 7 days before interest payment date.
- if bond purchased after that time but before payment date then is bought without dividend and full six months will be paid to seller.
- if buying like this, deprived of interest from date of purchase to interest payment date and price adjusted to reflect this.
- interest where buyer owned bond but paid to seller is deducted from clean price.
Bond markets - Primary Markets - largest issuer in UK? And what process? Key features to this process
- price and quantity + paying
- non-competitive bids
Who issue less frequently and appoint who to handle? Key features;
- issue and coupon, bids and final terms
Secondary Markets - purpose? 4 major markets
Eurobond - what is it, how named and liquidity of market
Gov are largest issuer of bonds in the UK and use an auction process. Key features are;
- large investors put in bid at price and quantity they want and if successful pay this price.
- Can submit non-competitive bids for up to£500k and if successful allocated stock at average accepted price.
Companies less frequent and appoint investment bank to handle. Key features include;
- issue and coupon are marketed to investors
- investors place bids to buy bonds
- final terms are agreed and issued with 24 hours to accept.
Secondary Market - once bond issued any subsequent trading takes place in secondary market. Trading activity takes place over 4 major markets;
- Government sector - Gov is biggest borrower in bond market
- Corp Sector - UK companies have become major borrowers
- Sterling loans to foreign borrowers - as stated
- Eurobond - international bond denominated in a currency different to that of country it was issued. E.g. Eurobond in USA in Japanese Yen -would be known as euroyen bond. Issue and turnover is high and therefore very liquid market.
Bond Yields - Interest yield - formula
Can be misleading as may produce what depending on what
- may trade how for what values due to reacting to (3)
- bond will trade above par when (coupon, interest rates and credit)
Redemption Yield - takes into account what compared to IY( Income and capital and maturity), Formula, if RY lower than IY causes what, private investor usefulness and taxation
Interest yield = coupon or nominal yield/clean price*100
Can be misleading as bonds may produce capital gain or loss depending on price at which they were purchased;
- Bonds may trade above or below nominal or par value as they react to economic climate, interest rate changes and creditworthiness.
- if coupon is higher than current interest rates and issuer has strong credit rating, bond will trade above par.
Redemption Yield - more accurate than above as takes into account income payments from bond and capital gain or loss if holding to maturity.
Formula - interest yield +or- (gain or loss to maturity/years to maturity)/clean price*100
- Where RY is lower than IY there will be a capital loss if bond held to redemption date.
- Not useful for private investor as does not take into account any tax payable.
- capital gains tax free but income is taxed
FIS - Risks - interest rate risk (when fall capital value… & fluctuations)
- liquidity risk, inflation, currency, default (all simple)
Factors affecting bond prices - interest rates, demand and affect on yield and price movements affect on selling
Volatility of Bonds - when more volatile? (Coupon, redemption period and non IG), rationale for the above (cash flow and interest rate movements)
Key risks;
Interest rate risk
- when IR’s fall, capital value rises and vice versa
- long term bonds fluctuate more than shorter term securities
Liquidity risk - can be difficult to sell at an acceptable price
Inflation risk - returns on conventional bonds can be eroded but can get index linked.
Currency risk - movements in exchange rate can effect value of holdings.
Default risk - issuer may not meet obligation to pay interest or capital.
Factors affecting bond prices
- when interest rate rises, bond prices fall due to reduced demand. As coupon is fixed, the yield is adjusted upwards. Also counts vice versa.
- investor will make capital gain or loss if selling before redemption.
- Lower the coupon, the more volatile the bond
- Longer period to redemption, more volatile
- Non IG bonds more volatile that IG bonds
Rationale behind the above = greater amount of cash flow from more volatile bonds are received later in bonds life and they are exposed to interest rate movements for a longer period.
