Chapter 16 - Unit pricing

Question 1

Define an internal unit-linked fund (3)

Answer 1

• Consists of a clearly identifiable set of assets, for example equities, property, fixed-interest securities and deposits.
• Fund is divided into equal units consisting of identical sub-sets of fund’s assets and liabilities.
• Responsibility for unit pricing rests with company, subject to any relevant policy conditions.

Question 2

State the basic equity principle of unit pricing for an internal unit-linked fund

Answer 2

• The interests of unit-holders not involved in a unit transaction should be unaffected by that transaction.
• Creation/cancellation of units should not given rise to change in NAV per unit

Question 3

Define:

(1) Appropriation price

(2) Expropriation price

Answer 3

Appropriation price

• NAV of fund on an offer basis
  amount of money per unit put into a unit-linked fund for each new unit appropriated i.e. created, such that the net asset value per unit is the same after as before the appropriation.
  therefore, it is the price at which the company will create a unit

Expropriation price

• NAV of fund on a bid basis
  amount of money taken out of a unit-linked fund for each unit expropriated cancelled, such that the net asset value per unit is the same after as before the expropriation.
  therefore, it is the price at which a company will cancel units
• reflecting the best price at which the underlying asset can be sold, taking into account relevant dealing expenses

Question 4

Outline how the appropriation price is calculated (5)

Answer 4

• The market ‘offer price’ value of assets held by fund plus the expenses and any duty that would be incurred in the purchase
• Plus the value of any current assets, such as cash on deposit or investments sold but not yet settled
• less the value of any liabilities, such as investments purchased but not yet settled or loans to the fund
• plus any accrued income, such as interest income frm fixed-interest securities and deposits , net of any outgo
• less any allowance/accrual for tax, if applicable

This gives a net asset value of the fund on an ‘offer basis’. Dividing the number of units existing at the valuation date i.e. before any new units are created, gives the appropriate price.

Question 5

Explain how the calculation of the expropriation price differs from that of the appropriating price (2)

Answer 5

• Main difference is that starting point is the proceeds that would be received from selling the assets in the fund
• This requires that the investments of the fund are valued on a market ‘bid basis’, and that the expenses that would be incurred in the sale are deducted.

Question 6

Outline the difference between an offer basis and a bid basis, and which basis is used in practice?

Answer 6

Offer basis
used for fund expansion
marginal transaction involving creation of units
money put into fund = net number units being created * appropriation price

Bid basis
used for fund contraction
marginal transaction involving cancellation of units
money taken out of fund = net number units cancelled * expropriation price

Companies more likely practice broad equity approach under which basis is only changed if there is a significant movement against existing basis
e.g. significant inflow for fund currently priced on bid (expropriation) basis**

Question 7

Describe the 2 main adjustments that are likely to be made to either the appropriation price or the expropriation price in order to determine the offer price and bid price used when dealing with policyholders (2)

Answer 7

• Initial charges
  companies may want to make a charge to contribute towards initial expenses, including any commission and possibly profit
  offer price is then taken as appropriation/expropriation price plus the initial charge and the bid price as the appropriation/expropriation price
  initial charge may also be referred to as bid/offer spread
• Rounding
  it is normal to quote prices rounded to a certain number of decimal places