Chapter 1 / Model Answers Flashcards
State and explain the two central principles of the CAPM
1) Non-systematic risk is not rewarded because this can be diversified against
2) The sensitivity to systematic risk dictates the expected return
State four benefits and four drawbacks of using CAPM
Benefits:
1) easy to calculate
2) robust and trusted
3) allows for systematic risk
4) ignores non-systematic risk
5) output is the expected return which makes it easy to compare
Drawbacks:
1) Risk-free rate may not be suitable
2) Assumptions can be unrealistic
3) Assumes beta is the correct measure of market risk
4) Beta is unstable
5) Doesn’t include costs and charges
6) assumes single holding period
7) theoretical and simplistic as its single factor
Describe briefly what is measured by Macauley duration
It is the weighted average time in years for the purchase price to be repaid by cash flows/coupons and the redemption value
Describe briefly what is meant by modified duration
It is the sensitivity of a bonds price to changes in interest rate
State three factors to be aware of when assessing Macauley duration figures across different bond funds
1) can be used to compare funds
2) affected by the coupon price
3) less accurate as change in yield increases
4) Assumes linear relationship between interest rate and bond price
5) May not reflect fund style
Identify five main economic factors that may result in an increase in interest rates
1) Business / economic cycle
2) expansion fiscal policy
3) tightening monetary policy
4) Quantitative tightening
5) Rising inflation
6) currency weakness
7) market forces
Identify three main risks specific to investing in equities on a passive basis using ETFs and state one reason for each risk identified;
1) Market/systematic risk - limited protection in a falling market as it will follow the market down
2) Style risk - Replication strategy may cause underperformance / tracking error
3) Counterparty risk - failure of counterparty provider
State six fund related factors that need to be considered when deciding whether to invest solely on an active basis
1) costs / charges
2) fund / style / objective / mandate
3) alpha / outperformance
4) volatility / standard deviation
5) sharpe / information ratio
6) investment house reputation
7) manager experience
8) dividends / yield
Identify five potential economic consequences of the current account and capital account being in a deficit over the medium to long term
1) Rising interest rates
2) Economy growth falls
3) Currency devaluation
4) Capital flight out of the uk
5) unemployment rises
6) increase borrowing
7) inflation increases
State the main conditions that must be met for a property fund to qualify as a PAIF
1) at least 60% of net income must be from the property business
2) value of property must be at least 60% of total assets
3) must pay three types of income
4) shares widely held
5) no corporate investor holding 10% or more of NAV
Describe the investor biases of herding and the endowment effect
Herding:
- following others
- fear of missing out
- ignore price, greater fool theory
Endowment effect:
- greater value as inherited
- retain unsuitable investments due to emotional attachment
- fear of selling
Identify three benefits of investing in a thematic based specialist fund
1) Potential higher returns
2) Expertise of fund manager
3) Invest in early stage companies
4) diversification
Identify five likely reasons why a company has fallen in value
1) Economic / business cycle downturn
2) increase in interest rates
3) higher volatility
4) poor stock picking
5) sector rotation
6) one off event
7) liquidity
List four main types of socially responsible investing, excluding ESG
1) positive screening
2) negative screening
3) impact / microfinance
4) sharia-compliant / religious
State two examples within each category of ESG criteria for investing
Environmental:
- reduction of pollution
- climate change / renewable energy
- conservation
Social:
- Human rights / education
- Employee working conditions
- Charities
Governance:
- accounting practices
- board diversity
- conflicts of interest
State two benefits and two drawbacks of using the Sharpe ratio in investment planning
Benefits:
- compare different funds
- shows risk-adjusted return
- identify if returns are from excess risk
Drawbacks:
- Need to consider other factors
- can be distorted by fund
- assumes normal distribution of returns
- doesn’t take into account costs
Describe the definition and objective of a volatility managed fund
target a specified return while limiting volatility using diversification of asset classes to produce higher risk adjusted returns
why might a volatility managed fund be suitable?
1) in line with ATR
2) provides diversification
3) could reduce market risk
4) sufficient time horizon
5) known level of target volatility
State five main admin benefits of consolidating investments into a platform
1) In one place
2) Access to tools
3) Auto ISA
4) Consolidated tax statement
5) less admin
6) 24/7 view online
Explain the drawbacks of using ROCE as a metric when making comparisons
Roce is a single metric
affected by one off factors so can be distorted by high cash
Calculates return for all sources not just shareholders
Difference between an interim and final dividend
1) Interim declared during financial year, final declared after financial year
2) interim declared by board, final declared by shareholders
3) interim can be revoked, final cannot be revoked
4) interim only if articles expressly permit, final not subject to article
Describe the tax benefits and qualifying rules of an EIS, including time limits for deferral relief (exclude income tax)
Deferral/rollover relief:
- for upto 1 year before
- 3 years after
- sale of business / disposal
- can invest up to £1,000,000 / if knowledge intensive £2,000,000
- original gain deferred
- without time limit
- gain on EIS exempt from CGT
- if held for 3 years
- loss relief available against capital or income
- exempt from IHT if held for 2 years
Identify six main risks of investing in a global emerging markets equities fund and provide one reason for each risk
1) Currency - adverse exchange rate movement
2) economic - different stage of business / economic cycle at the same time
3) concentration - index composition may be different
4) political - political decisions / instability
5) liquidity - may not be able to divest quickly at a fair price
6) governance / regulatory - lower accounting standard and less corporate governance
7) manager - may not have local knowledge / experience in geography
State the options available at the maturity of index linked savings certificates
1) renew at new term of same length
2) renew at a new term of different length
3) cash it in
How is the total maturity value of index linked savings certificates calculated
- the original value
- plus interest
- plus inflation
- using CPI
Identify four main benefits of investing in NS&I products
- No market risk
- Accessible / highly liquid
- guaranteed government backed
- above £85,000 FSCS limit
- No charges
Outline the tax treatment of Green Savings Bonds
- All interest is taxable at marginal rate of income tax at maturity
- Taxed as savings income - PSA available?
Describe the main characteristics of a value based investment style
1) Bottom up
2) Uses fundamental analysis to find
3) stocks that are undervalued / mispriced
4) Low PE or
5) high dividend yield
6) potential for re-rating
7) often contrarian
8) long term view
Calculate Time Weighted Return
1) Step 1 is V1 / V0
2) x by
3) step 2 is V2 / V1 + C
4) - 1 x 100
Explain why you would use the TWR rather than the MWR when evaluating performance of the fund
- Better for comparing funds
- Not influenced by cash flow / timing
- as outside of manager control
- focuses on individual manager / performance
- TWR compounds multiple sub-periods / shows change over entire period
Describe briefly the main functions of the ACD in respect of the structure and operation of an OEIC
- Compliance and regulatory reporting
- Responsible for pricing / valuations
- Appoints / oversees manager
- Buys / sells shares
- Maintains shareholder register
- Maintains liquidity
- Prepares accounts
Describe briefly the main functions of the depositary in respect of the structure and operation of an OEIC
- Acts as custodian
- Safeguards assets
- Collects / pays income distributions
- Monitors ACD
- on investment / borrowing limits
- deals with any wind up of the fund
Explain briefly the tax treatment of dividends paid from a VCT and from a SEIS
VCT:
- tax-free
SEIS:
- dividend allowance available - first £500 tax-free
- 8.75%, 33,75%, 39.35%.
Explain briefly reinvestment relief in respect of investment into a new SEIS
- 50% of gain exempt
- up to a maximum £50,000
- must receive / qualify for income tax relief
Explain briefly disposal relief in respect of reinvestment into a new SEIS
- gain exempt
- if shares held for / after 3 years
- must have qualified for income tax relief
- applies to loss or gain
Calculate information ratio
1) Return - benchmark return
2) Divide this by tracking error
Main benefits offered by segmentation of the onshore bond
- can encash whole segment
- may keep as BRT / maximises top slicing
- defers gains
- takes into account investment performance
- can reduce chargeable gains
- can assign gifts
Describe regular withdrawal facility of onshore bonds
- Up to 5% per annum
- of the original investment
- cumulative / carried forward
- deemed as return of capital
- tax-deferred
- to 20 years
- corporation tax paid internally
- 20% BRT deemed paid
Describe briefly the basic principle and objective of top slicing relief
- Divided excess gain
- By number of policy years
- In order to give average yearly gain
- In order to reduce / mitigate
- higher rate tax liability
Identify the main differences between an unfettered fund of funds and a manager of managers fund
- FOF is multiple funds, MOM is single fund
- FOF has additional charges / MOM does not
- FOF has to sell the fund / MOM switches only one manager
- FOF has no control over mandate / MOM has more control over
- FOF is less transparent / MOM is more transparent
- FOF affected by capacity / MOM does not impact external managers capacity
State the main component parts of the UKs current account
- Goods / visible trades
- Services / invisible trades
- Investment Income
- Payments of transfers
State the main component parts of the UK’s capital account
- Foreign investments / assets
- Foreign loans / borrowings
- Foreign currency / reserves
Describe briefly three ways in which a current account deficit could be balanced out
- met by capital account surplus
- foreign investments / loans
- sale of foreign currency reserves
- central bank intervention
Explain the limitations of relying on dividend cover and yield
- Dividend information is historical
- Dividend not fixed / can change
- can be distorted by one off factors
- could reduced by share buybacks
- dividend allowance is low and dividend tax can increase
- ignores capital value
Identify 8 factors that could affect the share price of a company
- Economic Outlook
- Changes in legislation
- Change in sector sentiment / competition
- Corporate event
- Market sentiment
- Takeover speculation
- change in management
- accounting issue
- inclusion / removal from an index
Three advantages of owning direct equity compared to collectives
- Greater potential growth
- No ongoing costs
- Greater control
- Direct link between share price and return
Explain the main objectives of the rebalancing process
- realign return to original asset allocation
- to match ATR / CFL
- correct portfolio style
- take profits and sell outperforming funds
- top up buy underperforming funds
- invest inflows / new money
- maintain / increase cash
- ensure income can be maintained where applicable
- utilise tax allowances
Explain briefly the aim of MPT and how it is achieved
- Maximum return
- For given level of risk
- Via diversification
- of imperfectly correlated
- asset classes
State the key assumptions upon which MPT is based
- Investors are rational
- and risk adverse
- returns are normally distributed
- based on historical data
- investors have access to all information
- market is efficient
- unlimited borrowing at risk free rate
- no costs
Explain briefly the main benefits of diversification within a portfolio
- Reduce systematic risk
- Can remove non-systematic risk
- Gain exposure to different asset classes
- increase stability of returns
Describe briefly what is measured by standard deviation
- volatility
- through variation in
- actual return
- against mean
Outline the main differences between the CPI and RPI
CPI:
- key inflation measure / BOE target
- National statistic
- Lower than RPI
- Used by government in payment of state benefits
- Excludes housing costs
RPI:
- Used for index-linked gilts
- Not a national statistic
- Higher than CPI
- Includes housing costs
Describe briefly the main differences between broad and narrow money
Broad includes:
- lending activities
- and accounts of UK residents
Narrow includes:
- operational deposits with the BOE
Broad = indicator of economy
Narrow = indicator of consumer confidence
Identify the likely economic consequences of a sustained increase in the UK money supply
- Greater transmission of money
- Increased borrowing
- Increase in inflation
- Tightening monetary policy
Three drawbacks of using ROE as a measure of company performance
- Only shows returns on shareholder funds
- ignores borrowing
- difficult to compare with other companies
State five non-financial factors that can affect ATR
- Expertise / experience / knowledge / understanding
- Age / state of health
- Investor psychology
- Society / media
- Political / economic outlook
State four ways in which capacity for loss can be mitigated
- Invest only what you can afford to lose
- Reduce ATR / lower risk investments
- Hold sufficient cash to cover the potential loss
- Discussion and understanding in advance
- Establish actual risk able to take
- avoid over-reliance on tools
Identify two investor biases and the reasons for these
Overconfidence:
- overestimates own ability / knowledge
- using economic data as own research
Herding:
- following friends advice
- Fear of missing out
State four ways in which an EIS provides greater tax planning opportunities than a stocks and shares ISA
- Higher investment limit - can invest up to £1million or £2million in knowledge intensive
- can carry back to previous tax year
- 30% income tax relief
- CGT deferral relief available
- IHT / business relief available
- loss relief available
Describe briefly the objective of gearing in an investment trust
- To increase available funds
- Without using cash or going to shareholders
- To increase exposure to other assets
- To increase returns
Explain possible consequences of an investment trust increasing its gearing
- Higher volatility
- Gains / losses magnified
- Increased sensitivity to interest rates
- Increased borrowing costs
- Forced seller if borrowing limits exceeded
- Change in investor sentiment
Explain what is meant by an investment trust trading at a discount
- Share price is below the NAV value
Identify five possible reasons why a fund would trade at a discount to its NAV
- Holds unlisted securities
- Sector out of favour
- Manager out of favour
- Poor recent trust performance
- Ejection from index
- Level of gearing
Explain briefly how tactical asset allocation differs from strategic asset allocation
- strategic is long term / tactical is short term
- strategic has fixed asset allocation / tactical varies the allocation
- strategic reviewed less frequently / tactical reviewed more frequently
- strategic trades less frequently / tactical trades more frequently
- tactical aims to take advantage of market movement
Describe five actions to reduce sequencing risk
- work longer / defer retirement date
- reduce level of income
- take natural income only
- change income frequency
- purchase annuity
- reduce equities
- buy higher yield assets
- hold sufficient cash
State three benefits of owning a gilt based collective fund compared to owning them directly
- invest across range of maturities / durations
- invest across a range of coupons
- fund manager expertise
- less administration
- able to access gilts at issue
state three drawbacks of owning gilt collective fund rather than owning directly
- higher ongoing charges
- annual interest / redemption yield not known
- less / no control
- potential CGT on sale
- manager may underperform
- investor protector limit subject to £85,000
Identify three reasons why index-linked gilt prices would fall when inflation itself is rising
- interest rates increase faster than inflation
- actual inflation exceeds expected inflation
- expectation of lower inflation in future
- indexation lag
- UK downgraded
- index-linked coupons are a small part of overall return
- increased supply
Outline the effects of increases in interest rates on conventional fixed interest securities
- Fixed coupon less attractive
- so price / capital value falls
- yield rises
- longer dated bonds see larger falls
- lower coupon bonds see larger falls
State the main objectives of quantitative tightening
- slow economy down
- reduce liquidity
- raise interest rates
- reduce inflation
Explain the consequences of a central bank implementing QT
- Increased supply of bonds causes prices to fall
- and yields to rise
- borrowing becomes more expensive
- savings rates increase
- inflation comes down
- lenders unable to lend as much
Identify four main factors that would cause the UK yield curve to steepen
- sell off in long dated gilts
- expectation of higher inflation
- excessive economic growth
- expansionary fiscal policy
- QT
- market shock
Discuss investor protection for GILT funds and direct gilts
- Gilt fund covered up to £85,000 by FSCS
- Direct gilts backed by government
- without limit
- however still subject to credit risk
Outline nine factors to consider when conducting annual review
1) change in circumstances / needs
2) change in health
3) assets / emergency funds
4) liabilities
5) tax allowances
6) changes in legislation
7) performance against benchmark
8) ongoing suitability
9) ATR / CFL
10) ESG
11) level of service
12) market / economic outlook
13) any additional capital
Describe what beta represents and what it measures
- Beta represents market / systematic risk
- a measure of volatility
- movement / correlation to
- the market
Explain limitations of using beta as a measure of risk
- Only measures market risks and ignores other factors
- assumes risk free rate is correct
- not consistent over time
- not an accurate predictor of future return
Identify the main differences between GAARP and growth investing
- Lower P/E ratios than growth
- avoid excessive valuation
- GAARP is not pure growth
What are the two main risk adjusted ratios used to analyse actively managed funds and what do they measure? (excluding alpha)
Sharpe ratio:
- excess return for every unit of risk taken
- excess return over standard deviation
Information ratio:
- excess return over benchmark
- consistency of manager
State the main rules a fund must adhere to in order to qualify as a REIT
1) UK- resident / listed
2) closed-ended / only one share class
3) property rental business at least 75% of total gross profits and of total value of assets
4) interest on borrowing must be covered at least 125% by rental profits
5) distributes at least 90% of exempt profits within 12 months of accounting period
Two types of payment within a REIT and tax treatment of these
PID:
- paid net of 20% BRT
- could be subject to further tax if HR or ART
- PSA?
Dividend:
- paid gross
- state Dividend rate applicable
- state dividend allowance available
Outline tax treatment of bond income
- Upto 5% per annum
- of the original investment
- tax-deferred / no immediate liability
- as return of capital
- is cumulative for 20 years until surrender / death
GIA Income position:
- Depends on the exposure, if fixed interest this is interest which is paid gross. PSA potentially available and taxable at marginal rate
- If GIA is equity based, this would be dividend income. DA could be used. Taxable at dividend rates
Identify four benefits of investing via a GIA compared to an onshore bond
- Wider range of investments
- No internal / underlying taxation
- Gains assessed to CGT which is a lower rate than income tax
- CGT annual exemption
- CGT liability extinguished on death
- Auto ISA available
- Simple to understand
Describe briefly what is measured by Macauley duration
- Weighted
- average term
- in years
- for purchase price to be paid back
- by cash flows and
- redemption value
Explain briefly how macauley duration would be used within a fixed interest portfolio
- portfolio immunisation / liability matching
- predict returns
- hedge out interest rate risk
Explain briefly how modified duration would be used within a fixed interest portfolio
- Reduce / measure interest rate risk and sensitivity
- Reduce / manage duration risk
Identify five economic or market factors that would likely cause an increase in the duration of a fixed interest fund
- Peak interest inflation rates and bond yields
- attractive entry point
- reduction in net issuance
- central bank action
Describe the main characteristics of growth and value investment strategies
Value:
- Aims to identify undervalued stocks
- considers out of favour stocks
- places greater emphasis on dividends
- looks at fundamentals of company
- assumes market is not efficient
- assumes mean reversion
- tends to be longer term
Growth:
- aims to sending stocks with potential for above average share price growth
- Higher growth rate in EPS
- tends to ignore valuation and fundamental analysis
- tends to focus on high PE
- place lower reliance on dividends
Explain the objective of regression analysis and identify two ways in which it can be applied in investment planning
- predicts one variables based upon information from another variable
- analyse portfolio performance to identify investment style
- calculate historical data
- calculate correlation
- impact of economic changes
Explain what is measured by the r-squared value in respect of the fund
- percentage changes in the fund that can be explained by movement in the benchmark
- identifies suitability
- can identify beta and alpha from a funds composition
Three drawbacks of using MWR
- influenced by cash flows
- that are outside of managers control
- not suitable for comparing portfolios
- does not show fund managers skill
identify four main risks of investing in structured products and state one example of each type of risk
1) Accessibility - can not sell
2) counterparty - derivatives provider may default
3) index - may not provide expected returns
4) Reinvestment - may have to reinvest on worse terms
4) capital - return may be less than amount invested
5) income - no participation in dividends
Outline the main features of NS&I income bonds
- paid gross
- monthly
- but taxed as savings income
- minimum investment £500
- maximum investment £1,000,000
- can invest jointly
- instant access
- interest must be paid out / cannot accumulate
- interest rate is variable
State four benefits of using CAPM
- model is easy to use / calculate
- robust / proven
- accounts for systematic risk
- assumes non-systematic risk has been removed
- output is the expected return so can be used to compare funds
Outline three main differences between a fund of funds service and a managed portfolio service
- FOF is one fund, MPS is a collection of funds
- FOF trades within fund, MPS trades as the investor
- FOF does not create CGT on fund switches / MPS does
- FOF investor has control / MPS investor has no control over CGT
Identify five provider related factors that an adviser would take into consideration when evaluating a DFM service
- past performance
- investment objective
- manager expertise
- cost
- minimum investment
- financial strength
- use of high risk assets
- choice of custodian
Identify four main risks of using a DFM service compared to investing in a FOF
- higher costs
- service may incur tax liability
- duplication with non-
DFM portfolio - DFM acts outside its mandate
- Regulatory issues
Identify and explain briefly the four main investor return objectives
1) capital preservation - minimise loss after inflation
2) capital appreciation - through capital gains
3) current income - focus on investments that generate interest / dividend
4) Total return - through combination of income and capital gains
State five main client related factors that impact investment returns and a portfolios capability to achieve its objectives
- time horizon
- requirement for income / capital
- tax position
- availability of allowances and reliefs
- ATR and CFL
- investor psychology
State the three main types of benchmarks and describe briefly the purpose of each type
Constraint - used to limit the construction of a portfolio
Target - used to match / exceed performance
Comparator - used to compare performance / risk
Outline briefly the main differences between current and non-current assets on a companies balance sheet
- current is short term - within 12 months. non-current is more than 12 months
- current used for day to day operations, non-current used for longer term revenue generation
- current easier to value at market value only
- current taxed as revenue, non current taxed as capital
State two categories of assets that would be found under each of the current and non current headings of a companies balance sheet
Current:
- stock/inventory
- cash/bank deposits
- trade receivables
Non-current:
- tangible
- intangible
- investments
Identify three differences in the main listing criteria between AIM and the UK main market
- AIM no minimum market capitalisation
- AIM no minimum earnings
- AIM no minimum free float
- AIM no admission document
- AIM nominated advisor whereas main needs a market listing sponsor
Describe briefly have a market capitalisation weighted index is constructed
- sum of
- share price multiplied by
- shares outstanding
- of all constituents
- adjusted for free float
Identify the stages of the economic cycle and explain briefly how cyclical stocks normally perform within each phase
Recession - share prices begin to improve
Recovery - share prices normally experience a strong upswing
Boom - share prices start to falter
Slow down - share prices fall
State four ways in which a low Bank of England Base Rate may stimulate consumer spending
- Reduced savings rate may reduce incentive to save
- Low rates will mean cheaper borrowing
- This gives more disposable income
- Increasing asset prices increase wealth
Explain why the bank of england may decide not to raise interest rates, even if inflation is still above their targets
- may deem inflation to be temporary
- could be future economic uncertainty such as war
- high levels of corporate and personal debt so would be a risk to debtors
- high rates may cause exchange rate concerns
- may not impact on some types of inflation (e.g inflation caused by rising commodity prices such as fuel)
What is bond duration?
Sensitivity to movements in interest rates
how can the modified duration of a portfolio be reduced?
holding fewer longer term and more shorter term GILTS or corporate bonds
Describe the key differences between M0 and M4 as measures of money supply
M0:
- includes notes and coins in circulation plus operational deposits at the bank of england
- narrow money
- indicator of consumer spending
M4:
- includes all of M0 plus deposits created by lending / all bank accounts
- broad money
- indicator of economy
Explain briefly how the bank of england could reduce money supply and state the effect on interest rates
- could reduce the money supply by selling securities
- this would increase the supply of securities and reduce the velocity of the money
- this reduces the price of securities
- leading to higher yields so interest rates will rise
Identify four economic factors which could result in the depreciation of sterling
1) Decreasing UK interest rates in comparison to other countries
2) Declining productivity
3) Increasing money supply faster than productivity
4) Higher relative inflation than other countries
5) Current account deficit
6) Capital account surplus
Explain the likely impact a depreciation in the value of sterling would have on the rate of inflation in the UK
- It would rise
- Imports are now more expensive
- Aggregate demand increase
State the three components of the UKs capital account
- Investments / assets
- Loans / borrowing
- Foreign currency reserves
State the principal purpose of a capital account surplus within the UKs balance of payments
- To finance / fund a current account deficit
Explain briefly the macro-economic role of financial investment within the economy
- Stimulates demand / spending
- by increasing aggregated demand
- increases productivity / output
- and business investment
Explain the potential impact of rising interest rates upon fixed interest securities and equities
- Fixed interest yields would rise
- and their capital value would fall
- equities would suffer from higher costs of debt
- this would lead to falling dividends
List three advantages and disadvantages of investing in an IPO compared to an established limited company
Advantages:
- shares may be priced at an attractive level to ensure good take up
- low cost / no dealing commission
- limited supply, large institutions may be unable to obtain all the shares they require and create demand after IPO so share price may go up
Disadvantages:
- no track record for share price
- companies come to IPO at a time favourable to existing owners
- less onerous reporting requirements
- allocation might be scaled back if oversubscribed
- short term price volatility after listing
What are financial bubbles?
- Financial bubbles can happen when investors lose sight of fundamental values and buy shares or other assets simply because they expect prices will continue to rise.
This is known as ‘The greater fool’ theory, i.e. you rely on a greater fool than yourself to purchase your shares at a higher value.
what is a bull and bear market?
Bull market = a buoyant, confident and rising market
Bear market = a tentative and falling market
what is globalisation?
The process by which businesses or other organisations develop international
influence or start operating on an international scale.
Pros to globalisation
• Investors can participate in global market trends by investing in multinational funds or companies.
• Companies can access low-cost labour and materials, which may not be available in the UK.
• Fund managers can use high-yielding stocks as part of their portfolio diversification strategies.
Cons of globalisation
• Globalisation puts the low-skilled, labour-intensive industries in the developed world at a disadvantage against the developing world.
• The political landscape of the country is likely to mirror its economic prospects, so investors need to keep an eye on world events.
what happens in recession?
- If we see GDP going down over two consecutive quarters, the country
is said to be in a recession. - In a recession, companies have low profits, and their output is weak. Many have to cease trading, so unemployment rises.
- In a recession, inflation is low. People aren’t spending, so banks tend to
cut interest rates to try to stimulate spending and growth.
what happens in recovery?
- If GDP is higher than the previous quarter, then the economy is expanding.
- The recovery phase is where an economy moves out of recession.
- People start to spend more, as optimism grows.
- Profits rise, and interest rates are kept low to stimulate further growth.
- Inflation remains low but can start to rise.
- Equity growth is at its quickest in this phase.
what is boom?
- Strong demand justifies rising prices for many products.
- Inflation rises as the public spend their new-found wealth. There is a feel-
good factor.
-But… the more inflation rises, the more the economy starts to ‘overheat’.
- Interest rate rises are necessary to dampen demand and stop the expansion.
- The economy is growing at its fastest during this part of the overall cycle
what is slowdown?
- High interest rates start to have an effect.
- The economy starts to slow down, and sales are slow, but inflation can remain high.
- Central banks are reluctant to cut interest rates.
- However, consumers become more cautious, and start to delay major purchases.
- This causes problems for companies and
unemployment rises.
What happens to PSNCR at each stage of the economic cycle?
Recession = Tax income is weak, unemployment grows so PSNCR grows
Recovery = Tax income rises, unemployment falls, so does PSNCR
Boom = Tax revenues are at their highest, PSNCR is at its lowest
Slowdown = Tax income reduces so
PSNCR starts to grow
what happens to fixed interest during boom?
An expanding economy means higher prices,
generating inflation and higher interest rates
A contracting economy usually means interest rates are cut
Fixed-interest Securities will need higher yields to compete, so their prices fall
what happens to fixed interest during recession
Contracting economy usually means interest rates are cut
Income from fixed interest securities usually becomes pretty attractive so prices rise
what happens to equities during the economic cycle?
• The price of equities in general rises and falls in line with the economy but they are
often one step ahead of the cycle.
• They grow at their fastest during the expansion phase, falter during the boom, fall
fastest during the contraction and start to pick up during the recession, as interest
rates are cut.
what is fiscal and monetary policy?
fiscal = government spending and taxation
monetary = influencing interest rates and money supply
What is the MPC?
• Monetary policy committee, part of bank of england
- set interest rates, meet 8 times a year
What is M0?
- Narrow money
- notes and coins in circulation
- plus banks operational deposits with the bank of england
- reflects changes in economic cycle but doesn’t cause them
- growth in M0 indicates consumer spending is buoyant
- reduction means lower spending
what is M4 broad money?
- notes and coins in circulation, banks operational deposits and all instant access accounts with UK banks and building societies and all time deposit accounts
- m4 is increased by bank loans, as they put money into banks when loan agreed
what is quantitative easing?
- Generate or create money electronically. It is often referred to as ‘printing money’ but
that is not technically true. A press of a button is all it takes. - The ‘new’ money is used to buy back some of the GILTS that have been sold to the
public. In reality, it is usually the banks that hold these. - Buying back the loans puts money into the public domain and the public then spend it.
- This boosts the economy, but can cause inflation and price increases as demand
increases.
what is cost push and demand pull inflation?
“Cost-push” = refers to rising prices caused by increased production costs like higher wages or raw material prices, essentially pushing prices up due to a decrease in aggregate supply,
“demand-pull inflation” occurs when prices rise because consumer demand exceeds the available supply of goods and services, effectively “pulling” prices higher due to increased aggregate demand
what is RPI
Retail Prices Index (RPI) uses the price of a notional ‘basket of goods’, representing the goods and services that are purchased by most households in the UK.
RPI has no official or government measurement attached to it, but it is still published, mainly due to the fact
that a lot of financial services products and investment plans are historically linked to it, but it no longer has any real relevance as a statistical index for the economy
What is CPI?
- For the last 16 years or so, CPI has been the main measure used in the UK.
- It is a basket of goods, but it represents different consumer groups from RPI.
- Perhaps the biggest difference between RPI and CPI is that CPI does not include mortgage and housing costs. The UK’s use of CPI came about as part of the UK joining the EU.
- It tried to factor in the fact that fewer Europeans own their own houses compared to UK home-ownership rates, thereby making pan- European indices more ‘comparable’.
- CPI is the index used by the Bank of England as their target.
what is CPIH
In 2017, a variant of CPI; CPIH, became the UK’s most important and useful
measure for the UK. CPIH does include housing costs, but this is still a different
basket of goods from RPI.
Effects of inflation
• delays in production, as supply cannot keep up with demand.
• increases in demand for imported goods and services.
• increases in wage demands.
• rises in interest rates (normally).
• cuts in public expenditure.
• tax increases.
• devaluation of sterling.
• reduction in exports.
State four ways in which a low Bank of England base rate may stimulate consumer
spending. (4 marks)
• Reduced savings rate may reduce incentive to save
• Low rates will mean cheaper borrowing / lower mortgage costs
• This gives more disposable income / encourages borrowing
• Increasing asset prices increase wealth / feel good factor
Explain why the Bank of England may decide not to raise interest rates, even if inflation is still above their target (4 marks)
• They may deem inflation rates to be temporary / they anticipate that the factors causing inflation
will fall out of the annual calculation and it will return inflation to its target of its own accord
• There is future economic uncertainty e.g. Ukraine War / to ensure economic stability
• There are high levels of corporate and personal debt, so higher rates would be a risk to debtors
• High rates may cause exchange rate concerns and have a subsequent effect on trade
• Increasing interest rates may not impact on some types of inflation (e.g. inflation caused by rising
commodity prices such as fuel or grain)
Different types of credit risk
1) Default risk
2) Downgrade risk
3) Credit spread risk
4) Counterparty risk
5) Bail-in risk
2 assets impacted most by liquidity risk
Property - buying process is slow, lot of hoops to jump through
Private equity - difficult to value a business,
Identify four key economic factors which could result in the depreciation of sterling. (4 marks)
• Decreasing UK interest rates in comparison to other countries.
• Declining productivity / DGP faster than money supply.
• Increasing money supply faster than productivity.
• Higher relative inflation than other countries.
• Current account deficit / negative balance of payments.
• Capital account surplus.
Explain, giving your reasons, the likely impact a depreciation in the value of sterling would have on the rate of inflation in the UK. (3 marks)
• It would rise.
• Imports more expensive / cost of imported raw materials increase / costs push inflation.
• Aggregate demand increases / higher exports / demand pulls inflation.
what does the current account consist of?
The current account consists of two trades:
• The visible trade:
imports and exports of actual goods and commodities such as oil, agricultural products, clothing and computers.
• The invisible trade:
imports and exports of financial and business services, travel, tourism and transport services.
what is the capital account?
The capital account records all movement into and out of the country for investment.
State the three main components of the UK’s capital account.
- investments / assets
- loans / borrowings
- foreign currency reserves
State the principal purpose of a capital account surplus within the UK’s balance of payments. (3 marks)
• To finance / fund
• a current account
• deficit
Explain briefly the macro-economic role of financial investment within the economy. (4 marks)
• Stimulates demand / spending
• by increasing aggregated demand
• Increases productivity / output
• and business investment.
