Chapter 1 - Introduction to Financial Markets

Question 1

What are the four main functions of the financial services industry?

Answer 1

i) financial INTERMEDIATION
ii) pooling and managing RISK
iii) Provision of payment and settlement services; MARKET MAKING
iv) PORTFOLIO MANAGEMENT

Question 2

What are the main types of financial institution?

Answer 2

1) Central banks
2) deposit institutions
3) investment institutions

Question 3

What are is the role of Government? (four things according to the CFA)

Answer 3

1) market failure - provision of certain goods: defence, green infrastructure etc.
2) Regulation to protect consumers - preventing fraud
3) improving distribution of capital - taxes and benefits
4) maintaining economic stability - ironing out the troughs in employment and unemployment by using fiscal policy

Question 4

What is the difference between a real asset and a financial asset?

Answer 4

A real asset is something material (gold, a house, aluminium)
A financial asset is a claim representing the right to some return (like a security or bond)

Question 5

The securities markets do 4 things, what are they?

Answer 5

1) raise capital for businesses
2) transfer risk for investors
3) price discovery - markets dictate best price
4) creating liquidity - allowing people to sell their shares if need be

Question 6

What is the difference between primary and secondary markets

Answer 6

primary = initial sale of security
secondary = where all subsequent trading happens

Question 7

What is a round-trip transaction cost?

Answer 7

total cost of doing a transaction: the costs are taxes, commissions, and the bid-ask spread

Question 8

What is an Order-Driven System?

Answer 8

All buyers and sellers display prices at which they wish to buy and sell (you can see the best price available)

Question 9

What is a Quote-Driven system?

Answer 9

You can only see the prices that ‘market makers’ (brokers) display

Question 10

What is SETS?

Answer 10

SETS is the LSE’s order-driven system (FTSE 100, FTSE 250 and FTSE Small cap constituents). It is order-driven, and there is no trade floor anymore

Question 11

What is SEAQ?

Answer 11

LSE’s quote-driven system for fixed-interest securities and AIM securities

Question 12

What is SETSqx?

Answer 12

Hybrid = for less liquid stocks. Periodic auction book along with quote-driven market

Question 13

UK government bonds, or ‘gilts’, are issued by which department of the Treasury?

Answer 13

Debt Management Office - DMO

Question 14

How are corporate bonds issued?

Answer 14

Either by a open offer or private placement

Question 15

What is dual-listing?

Answer 15

When two corporations function as a single operating business but retain separate legal identities and stock exchange listings

Question 16

What is an OTC market?

Answer 16

Over the Counter market involves trading in a decentralised way rather than on an exchange. Much less transparency

Question 17

How are payments settled in the UK market?

What is the difference in time for settling equities and gilts?

Answer 17

CREST is the LSE’s electronic settlement system, which settles on:
T+1 = Bonds
T+2 = Equities

Question 18

Which body determines who gets listed on the Official List?

Answer 18

The Financial Conduct Authority (FCA)

Question 19

What requirements must a company fulfil to get on the main market?

Answer 19

1) at least 3 years of published accounts

2) over £700,000 of listed stock or £200,000 of debt securities

Question 20

What is an AIM, and how is it regulated?

Answer 20

Alternative Investment Markets are regulated by the LSE - there is no minimum requirement for size, trading record, or shares in public hands

Question 21

Information disclosure - who must declare share interests?

Answer 21

Directors, major shareholders (over 3%), concert parties

Question 22

What is the corporate governance system in the UK?

Answer 22

Instead of direct regulation, the UK has traditionally stressed the importance of internal controls and the role of financial reporting and accountability, rather than external legislation

Question 23

How often must every public company hold an AGM?

Answer 23

Within 6 months of the end of their financial year. The interval between AGMs must not be more than 15 months

Question 24

What are meetings outside of AGMs called, and what are the rules around how they are called?

Answer 24

‘General meetings’ are called by giving not less than 14 calendar days’ written notice. Companies must communicate with their shareholders electronically

Question 25

Must members attend AGM?

Answer 25

No, they can appoint a ‘proxy’ to attend and vote on their behalf

Question 26

How does government bond trading happen in other countries?

Answer 26

Happens OTC, settlement via central bank - corporate bonds are often listed and traded through central clearing depositary systems associated with local exchanges

Question 27

What are the two main systems for settling Eurobond transactions?

Answer 27

Euroclear and Clearstream. Trades must be confirmed T+1 and settled T+2

Question 28

What is the Principal-agent problem?

Answer 28

The person owning the thing, has a different set of priorities to the person who is a ‘specialist’ in servicing that thing. e.g. repairing a car, providing advice. The gap in information and objectives between the ‘principal’ and ‘agent’ is the problem.
In finance this is a problem of “ownership”, shareholders, and “control”, managers

Question 29

What are the solutions to the principal agent problem?

Answer 29

a) align interest of managers and owners through remuneration of the former in share or stock options
b) board of directors looking after shareholder interests
c) external control through active pressure or threat of takeover

Question 30

What is Liquidity Risk?

Answer 30

Liquidity risk stems from the lack of marketability of an investment that can’t be bought or sold quickly enough to prevent or minimize a loss. It’s typically reflected in unusually wide bid-ask spreads or large price movements.

Question 31

What is a Unit Trust?

Answer 31

A Unit Trust (“mutual fund” in US) pools investments into a single fund and pays any profits straight back to the ‘unit’ (each unit commensurate with amount invested) owners. They are set up under a ‘trust deed’

Question 32

What is a fixed-income security?

Answer 32

An investment that provides a return in the form of fixed periodic interest payments - and the return of principal at maturity. e.g. a bond

Question 33

What are ‘Dark Pools’?

Answer 33

A dark pool is a privately organized financial forum or exchange for trading securities.
Dark pools allow institutional investors to trade without exposure to devaluation - large blocks of shares

Question 34

What is ‘disintermediation’?

Answer 34

Removal of the middlemen from a supply-chain or decision-making process

Question 35

What is the Pension Protection Fund (PPF)?

Answer 35

Fund protecting Defined Benefit pensions in the event that the company becomes insolvent.

• if the have NOT retired (or retired early) they get 90%
• if they have already retired they get 100%

Question 36

What is an OEIC?

Answer 36

Open Ended Investment Company - Investment fund structured to invest in stocks and other securities. The fund’s shares are listed on the LSE

Question 37

How will companies issue a “profit warning”?

Answer 37

Through a regulatory information service

Question 38

At an AGM, who can launch a poll?

Answer 38

3 members, irrespective of the size of their voting share