Chapter 2: Asset Classes Flashcards
What two categories can Equities be divided into?
Ordinary and Preference shares
What are ordinary and preference shares known as in the US?
Common stock, and preferred stock.
What are redeemable shares?
Offered to shareholders, company can purchase them back at any time.
What are preference shares?
Less risk than ordinary, rank above in bankruptcy
Generally do not have voting rights
Receive fixed dividend
What are preference shares sometimes known as?
Hybrid securities, as they can have characteristics similar to bonds
What order is preference, ordinary and debtholders paid out in during bankruptcy?
Debt
Pref
Ord
How are dividends decided?
Proposed by directors
Ratified by shareholders during AGM
What can a proxy do?
Vote on behalf of shareholders
What is the nominal value of ordinary shares?
Represents the minimum amount that a company must receive from subscribers upon issue of the shares.
What are the types of preference shares? (5)
Cumulative
Participating
Redeemable
Convertible
Zero Coupon
shares can have any combination of these
What is a cumulative preference share?
Paid dividend and any unpaid dividends from previous years
(how can dividends be unpaid??)
What is a participating preference share?
Preference shares have fixed dividend, participating gives them the opportunity to participate in higher distributions and other liquidation events.
What are redeemable preference shares?
Company can buy back the shares at agreed price in future.
Liability for the company, counts as debt.
What is a convertible preference share?
Shareholder has right, not obligation to convert to ordinary shares
Can provide exposure to upside
What is a zero coupon preference share?
Pay no dividend, but they can redeem at a price above what they are issued
What does SOFR stand for?
Secured Overnight Financing Rate
What are bonds that are linked to interest rates called?
Floating-rate notes (FRNs)
What are bonds that are linked to inflation called?
“Index-linked”
What is a yield?
The measure of the percentage return that an investment provides.
What are the 3 ways to calculate a bond yield?
Flat yield
Gross redemption yield (GRY)
Net redemption yield (NRY)
What is flat yield also known as?
Interest or running yield
How do you calculate the flat yield?
annual coupon / price
How can flat yield be used to see the relationship between interest rates and prices?
As interest rates increase, investors want an equivalent yield on bonds.
As they have an inverse relationship, and the coupon is fixed - the price must fall and vice versa
What is Gross Redemption Yield sometimes known as?
Yield to Maturity (YTM)
What does Gross Redemption Yield not take into consideration?
Taxation
How is the GRY calculated?
Takes into account yield including redemption amount.
What is the NRY?
Net Redemption Yield
What does NRY take into account that GRY does not?
Taxation
What does modified duration measure?
Volatility
What is modified duration?
Expected change in price, given a change in interest rates.
Usually measured percent change per 1% change in the interest rate
What is the formula for modified duration?
(modified duration / 100) * price * percentage change
don’t forget it is inversely proportional
What is a convertible bond?
Give the holder the right to covert bond into ordinary shares
When would the investor choose to convert bonds into ordinary shares?
If the value of the shares exceeds the redemption value of the bond
Why would convertible bonds trade at a premium to their share value?
They provide downside protection in the form of redemption value if shares do not perform well, and interest payments
Similar to an option
How is conversion premium percentage calculated?
Premium / share conversion value
What is the conversion ratio calculation?
nominal value / conversion price of shares
E.g. £100 nominal convert to shares at £5 each = 20 shares
What are the 3 downsides of flat yield?
Ignores redemption flow, incomplete picture of returns
Ignores timing of cash flow, time value of money overlooked
If it is a FRN, the return will vary
What is the flat price sometimes known as?
Clean price
How often do most bonds pay out?
Semi-annually
When is the bond price equal to the flat price?
On settlement dates where the interest is paid
What do you use to calculate the bond price between payment dates?
Using accrued interest
What is the formula for accrued interest?
Coupon payment * (number of days since last payment / number of days between payments)
What is the dirty price?
Clean price + accrued interest
What is the flat price?
What is listed in bond tables for prices
How are months treated with ACT/360 or ACT/365 calculation?
Each month treated normally, regardless of leap year (Feb is 28 not 29)
In which calculation method are leap years taken into account?
ACT/ACT
What is a spread in bond markets?
The difference between two yields
How many basis points in 1%?
100
What are the 3 main bonds benchmarks?
Gov bond yields
Swap rates (exchanging FRN for fixed market)
Published reference rates e.g. LIBOR, now SOFR
How does the risk of a bond usually affect the spread over benchmark?
Higher risk is higher spread
How is the yield curve plotted?
Government bonds of different maturities
Yield on y axis, time to maturity on x axis
Yield curve is the line of best fit
What does a conventional yield curve look like?
Increasing, lower risk in short dated so will be a lower yield
Short dated have more liquidity
When would a yield curve invert?
When investors expect significant interest rate reductions in future
Often interpreted as a sign of economic slowdown as reducing rates means there is a low demand for credit
Which countries (4) and Central Banks (1) have attempted negative yields?
Denmark, Sweden, Switzerland, Japan
European Central Bank (ECB)
What is the intention behind negative yields?
Discourage saving, to encourage lending and spending to boost the economy
Why haven’t negative interest rates been widely adopted?
Bank depositors would switch to cash, which affects central bank profitability and control
Impact long term investments
Encourages “yield-chasing”, investment in riskier bonds / other speculative investments
How can you compare nominal yields and real yields?
Compare yields on inflation linked instruments to normal
E.g. index-linked GILTs. US Treasury Inflation Protected Securities (TIPS)
How would central bank concern about inflation affect medium and long dated govvy bonds?
Cause a fall, as they would increase short-term rates to counteract inflationary pressures
How can the time value of money be illustrated?
Taking account the prevailing rate if interest
$100 received in 1 year in 5% rate environment is worth 100/1.05
95.24
This is called the present value
What is the calculation for present value of a future payment?
receivable after n years, interest rate = r
1/(1+r)^n = discount rate
What nominal are governments bonds usually quoted on?
100 units of the currency’s nominal value e.g. $100
What is the ex-dividend period?
A period where a bond is dealt without entitlement to the impending coupon payment
What is the ex-dividend period for most gilts?
7 days
What is the cum-dividend period?
Period where bonds are dealt with coupon entitlement
What are ILGs?
Index-Linked Gilts
What examples of indexes do linked bonds follow? (2)
RPI - Retail Price Index
CPI - Consumer Price Index
Is the principal repayment affected in index-linked bonds?
Yes
How do US TIPS achieve index linking?
Adjusting the principal outstanding on the bond using CPI
Coupon is based on the fixed coupon set at issue multiplied by the adjusted principal
At maturity investor is paid the greater of the adjusted principal and the original principal
What index is being used for ILGs?
RPI
Industry convention, in prospectus for older gilts
What is a deflation floor?
Some government bonds guarantee that the redemption payment will not be less than the original value
US, France
Does the UK government offer a deflation floor?
No
When was the eight month trailing RPI changed to 3 months for Index linked gilts?
2005
How do you calculate the real interest rate?
[(1 + nominal interest rate) / (1 + inflation rate)] - 1
What was the short-term interest rate at the start of the 80’s in response to high inflation in the 70’s in the US/UK?
20%
When was the RPI changed to the CPI?
2003
What is the CPI-based inflation target?
2%
What does the PPI measure?
Inflationary pressures at an earlier stage in the production process
e.g. raw materials and other inputs
What does PPI stand for?
Producer prices indices
What is the main UK measures of inflation?
CPI - 2%
Who sets the CPI-based inflation target?
BoE Monetary Policy Committee MPC
What are ZCBs?
Zero Coupon Bonds
What does STRIPs stand for?
Separate Trading of Registered Interest and Principal of Securities
What does a STRIP involve?
Trading the interest and principal of a GILT separately
How many separate securities can a 2 year GILT be stripped into?
5
4 x coupon
1 x redemption
Who can strip eligible gilts in the UK?
GEMMs - gilt-edged market makers
BoE
What does GEMMs stand for
Gilt-edged market makers
What is the purpose of STRIPs?
Allows investors to precisely match liabilities
E.g. coupon comes in when they need to pay something
What is reconstitution?
Exchanging STRIPS for a conventional GILT, with the DMO as counterparty
What is the maturity of;
T-bonds
T-notes
T-bills
T-bonds >10 years
T-notes 2-10 years
T-bills <1 year
What is the different maturity names of Gilts?
0-7 years - “short-dated”
1-15 years - “medium-dated”
>15 years - “long dated”
What is BRICS?
Main emerging markets
Brazil, Russia, India, China and South Africa
How can corporate debt be divided? 2 sections
Money borrowed from banks
Money borrowed from investors (bonds)
What is less risky, debt finance or equity finance?
Debt finance, has to be paid before dividends/buy-backs
What are the two ways of securing debt?
Fixed charge - Debt carries charge over a single company asset
Floating charge - Debt secured against a group of company assets
What are asset-backed securities?
Bonds that are backed by a particular pool of assets
What does ABSs stand for?
Asset-backed securities
What are some examples of ABSs?
Mortgage loans, credit card receivables, car loans
What does securitisation stand for?
Packaging financial instruments together to create a security
What does MBSs stand for?
Mortgage backed securities
How do firms such as Fannie Mae and Freddie Mac operate?
Government firms that buy qualifying mortgage loans and securitise them and issue bonds to investors
How can ABSs and MBSs be subdivided?
Into tranches, with each tranche having a specific priority in relation to interest and principal payments.
Why do payment dates differ across ABSs?
Different products in each one, e.g. credit card, mortgage
What does SPV stand for?
Special Purpose Vehicle
How is a SPV structured?
It is a trust, and the originator of the assets (e.g. bank granting loans) sells the loans to the SPV and the SPV issues the asset-backed bonds
What is the purpose of an SPV? (2)
Separate entity to the originator of the assets, assets leave the originators financial statements and replaced by cash.
As SPV is stand-alone entity, it remains intact even if originator goes bankrupt - increases creditworthiness of the ABSs.
What is the process of assets being exchanged for cash in an originators balance sheet?
Off-balance-sheet arangement
What is the bankruptcy protection of an SPV sometimes known as?
“bankruptcy-remote”
What is a covered bond?
Asset-backed bond where no SPV is created, the originators assets “cover” the bondholder
What can an originator do in times of crisis? E.g. 08
Transfer the troubled assets back to its balance sheet to become covered bonds
How do European covered bonds differ?
Usually kept on balance sheet of the originator rather than transferred to an SPV.
What is a secured debt transaction known as in the UK?
Debenture
What is a secured loan known as in the US?
ABS
What does a debenture refer to in the US?
Loan agreement with no security
What happens when a corporation issues secured debt to a large number of people?
A trustee is appointed
What are the 4 main UK trustee roles?
Note trustee
Security trustee
Share trustee
Successor trustee
What is a Note trustee?
Appointed to represent the interests of holders of the securities
Provide guidance to the issuer
What is a Security trustee?
For issues secured by securities, the trustee is charged in favour of the trustee for the benefit of the secured parties.
Documents will dictate how it is paid out
What is a Share trustee?
Holds the shares in an issuing SPV in order to ensure off-balance-sheet treatment for the originator
Sometimes SPVs are domiciled off-shore
What is a Successor trustee?
Provided for banks who need to resign due to conflicts of interest or capacity issues
What is the benefit of a trustee?
Single entity that acts on behalf of shareholders, rather than a many individual actions. Organised action.
Reduction in costs
What is a representation of the interests of the bondholders?
Trustee assigned to represent the interests of bondholders, makes security more marketable
paid for by issuer
What will a corporate trustee do?
Make sure that the issuer is sticking to all its covenants from it’s issuance documents
e.g. debt ratios, bonds issued
What are the 3 tiers of debt?
Senior
Sub-ordinated
Mezzanine
What is senior debt?
Paid first, usually has strict covenants
Can be secured, has the lowest interest rate
What is subordinated debt?
2nd in line, higher interest rate
less stringent requirements
What is mezzanine debt?
High risk subordinated debt, ranks behind unsecured debt.
High interest rate
Interest can be skipped and added to the principal outstanding
Can include warrants/options so lender can get equity returns
What is payment in kind, a.k.a PIK?
Interest that is deferred until principal repayment
Who is paid first between unsecured debtholders and shareholders?
Unsecured debtholders, lenders always paid firsty
What is guaranteed debt?
Guarantee provided by someone other than the issuer.
Usually parent company
What is the benefit of convertible bonds to the issuer?
Lower cost of debt and possibility of avoiding repayment if lender converts
What did the LIBOR represent?
The average rate at which banks offer loans to other banks
Why was the LIBOR administration changed to the FCA?
Banks were manipulating the rate
What are the two new rates in the UK and US?
SONIA - Sterling Overnight Index Average
SOFR - Secured Overnight Financing Rate
What to FRNs usually add to benchmark rates?
A fixed margin, e.g. 175 bps - 1.75%
What are the 3 prominent rating agencies?
Standard and Poor’s
Moody’s
Fitch Ratings
Why has regulatory oversight of credit rating agencies increased?
Rated junk bonds highly during the 2008 GFC
What are the two categories of bond rating?
Investment grade
Non-investment grade/speculative
How can issues be credit-enhanced to gain a higher credit rating?
Insurance scheme that pays out if issuer not able to
What is gross vs net interest
Gross - pre-tax
Net - post-tax
What are the two prime examples of money market instruments?
T-bills, Commercial paper (CP)
What are the risks in investing in cash?
Credit risk
Inflation risk
How to T-bills produce return?
No coupon, discount to repayment
Why do issuers take care to not miss CP payments?
Even delay by one day can lead to bankruptcy proceedings
What is the most common CP term?
3 months
What are the two methods of issuing CP?
Direct to buy-and-hold investors, e.g. money market funds
Sell paper to a dealer who sells the paper in the market
What is it called when companies issue paper direct to investors?
Direct paper
How much would issuers save issuing direct paper?
5 bps (0.05%)
What does rolling form of debt mean?
New issues fund the retirement of old issues
What is the main risk for CP?
Refinancing/rollover risk
Companies are not able to reissue CP
What is a repo?
Sale and repurchase agreement
It involves an initial sale of a financial instrument and, at the same time, a contractual agreement that the seller will subsequently buy back the same financial instrument for a specified price at a set future date.
Why would a participant enter into a repo transaction?
Lower the cost of borrowing by offering government securities as collateral
Why would a participant enter a reverse-repo transaction?
Loaning out excess cash with bonds as collateral
When may a market-making firm enter a reverse repo?
When it has sold bonds short, and needs to locate bonds in order to fulfill its settlement obligations
How does the DMO assist in the smooth running of GILT markets?
Standing order repo facility.
Allows GEMMs to enter into reverse repo transactions to cover short positions created by market making
How do GEMMs access the standing repo facility and what is the minimum amount?
Sign documentation, request any amount above £5m nominal
What is a repo equivalent to?
Short-term secured loan
What is a Eurobond?
Bonds that are issued and sold outside of their home country
currency does not need to be the euro
What currency does a Eurobond need to be?
Any, just different to the home currency from the place where they are issued
e.g. UK Eurobond cannot be pound sterling
What do Eurobonds allow corporations to do?
Issue debt without being restricted to their own domestic market
Provide investors access to invest in markets/currencies outside their home countries
What are the 3 steps to issuing a Eurobond?
- Issuer appoints lead manager (investment bank), underwrites and establishes details
- Lead manager establishes a syndicate
- Syndicate distributes bonds to its client base
In what form are Eurobonds issued?
Bearer form
How often are Eurobond coupons paid?
1x / year
What is it called when a bearer bond is deposited in a CSD?
Immobilised
What CSDs are Eurobonds settled through? (2)
Euroclear & Clearstream
What is a GDR?
Global Depository Receipt
How do depository banks assist in DRs?
Issuer will supply the ords to the depository bank
Depository bank will then sell DRs to external investors
Cash proceeds are then provided to the issuer
What is grey market trading in terms of DRs?
When DR is created, Depository Bank receives confirmation that they will receive the shares in future
Even if they don’t have the shares yet they can create and sell DRs
This can be done for 3 months before the purchase of the ORDs
How are DRs registered?
The ORDs are in the name of the depository bank
DRs are transferable as bearer securities
How do dividends work with DRs?
Depository Bank acts as an intermediary
Will receive proceeds as registered owner of the ORDs
Distribute to DR holders
What are NVDRs?
Non-voting DRs
e.g. Thailand
Form of capital control
How can an investor sell their DRs?
To another investor as DRs, or as underlying shares in home market
Latter involves cancelling the DR with Depository Bank. ORDs are then re-issued. Can be done due to lack of liquidity.
What do warrants allow investors to do?
Purchase shares in a company at a fixed price over a period
Why would a company issue warrants?
Receive income from selling warrant
Receive income if investor purchases shares with the warrant
What is a covered warrant?
Issued by firms, rather than the companies
Call warrants and put warrants
Traded on the LSE
What is the conversion premium of warrants?
(warrant price + exercise price) - share price
What is it called when the conversion premium is negative?
Conversion discount
What are the two types of real estate?
Residential and Commercial
Who is responsible for repairs in commercial tenancies
Tenant
What is the diversification benefit of property?
Usually low correlation with traditional and alternative asset classes
What is the liquidity downside of real estate mutual funds?
Property funds can bring in measures to limit outflows in times of crisis
E.g. 12-month moratoria on redemptions
What is the main tax feature of REITs?
Prevents double taxation
What is double taxation?
If investor held company shares, company pays corporation tax and the investor would be liable to any tax on dividends
How do REITs prevent double taxation?
REITs do not pay corporation tax
What are the (2) tax-exempt conditions for REITs?
Must contain at least 3 single rental properties, with none being >40% of value
REIT must distribute at least 90% of rental profits by dividend
Why might an investor be able to invest in through a REIT but not individually?
Commercial property
What risks do REITs alleviate?
Lack of diversification
Liquidity risk
How is a REIT fund structured?
Closed-ended fund
Shares traded similar to company shares
What is an open ended fund?
Collective funds utilising investors money to buy portfolios of investments
Investors are given units in the fund
What are the two types of FX transaction?
Spot
Forward
What is a spot and when is it settled?
Immediate conversion of currency at agreed price
Within 2 working days
How do FX dealers profit?
Between the bid and the ask, spread
What is a forward transaction?
Deal agreed for a future date at a set exchange rate
What two camps do FX users fall into?
International trade
Planning for future cash flows with forwards to hedge currency movements
Speculation
Investors making predictions on future moves
How are FX pairs quoted?
base currency / counter currency
E.g. USD/GBP
Base is always quoted in one unit
What is the counter currency sometimes known as?
Quote currency
How do market markets / dealers quote currencies?
Using a bid.ask
E.g. EUR/USD, the quote might be 0.9937 / 39. So if you want to buy
€100,000, then you will need to pay the higher of the two prices and deliver $99,390; if you want to sell €100,000, then you get the lower of the two prices and receive $99,370.
What is a cross rate?
A currency rate that does not include the USD
E.g. GBP/JPY
What is the exception to the cross rate terminology?
GBP/EUR
Why would the cross rate be of interest to companies?
If they do a lot of trade with another country and receive payment in that currency
What is a stepped bond
A bond that has a coupon that increases over time
How would a GBP USD spot quote bid ask be quoted?
GBP/USD spot rate 1.555 - 1.1645
How would a forward be quoted?
three-month forward 1.00-0.97c pm
What does the pm stand for in a forward?
Premium
What is the premium quoted in?
cents/pennies
What does dis stand for in a forward?
Discount
What is rational pricing?
Asset prices will reflect the arbitrage-free price of asset, as any deviation is arbitraged away
What does interest rate parity say should be true for future and spot markets?
Spot and future prices incorporate any interest rate differentials between the two. If not then there will be opportunity for risk-free arbitrage return.
How would you calculate the forward rate for GBP/USD?
spot rate * [(1+US$ short-term interest rate) / (1 + UK£ short-term interest rate)]
What do you need to remember when doing forward rate calculations?
The interest rate is calculated on an annual basis, e.g. for 3 month forward, need to divide by 4.
As per what agreement were exchange rates fixed?
1944 Bretton Woods
When did fixed exchange rates end?
1970’s
Abandonment of convertibility into Gold, Aug 1971
What does PPP stand for?
Purchasing Power Parity
What does PPP refer to?
Purchasing Power Parity is the theory that currencies should have equal purchasing power.
What is the most widely traded currency pair, per BIS?
USD/EUR
What is a carry trade in FX?
Borrowing of funds where interest is low, and purchasing relatively high yield government bonds.
What is the definition of a CIS? (3)
- invests in transferable securities
- is publicly marketed, and
- is open-ended.
What are some examples of unregulated CISs?
Golf courses in Mexico, Wine in France etc…
What is an open-ended fund?
One that can issue and redeem shares in the scheme at any time
What are some examples of open ended funds around the world? (3)
US Mutual Funds
UK’s open-ended investment companies (OEICs)
Europe’s sociétés d’investissement à capital variable (SICAVs)
What is a closed-ended fund?
Set number of shares are issued, and then it is traded on the secondary market
Investment trusts/companies
What are the two major forms of open ended funds?
Unit trusts
OEICs
What is a unit trust?
Professionally managed collective investment fund
Investors buy units, which represent a specified fraction
What is an AUT?
Authorised unit trust, allowed to be marketed to the investing public.
What is the role of a trustee in an OEIC?
Protect the interests of the unitholders
Essentially beneficiaries
What is the role of a manager in an OEIC?
Marketing the trust
Managing the assets
Maintaining record of units
How it the NAV calculated? (3 parts)
- the value of the trust’s listed investments at mid-market prices
- the value of its unlisted investments at the directors’ valuation, and
- cash and other net current assets
What can closed ended funds do that OEICs can’t? (3)
Invest in private companies
Provide venture capital
Borrow money
What is tracking impact?
The effect that these index funds have on the market, e.g. when a new company is added to SP500
What are ETNs, Exchange Traded Notes?
Senior debt noes issued by banks
How can retail investors access Private Equity?
Through closed ended funds
What are structured products?
Investments which provide a return based on the performance of an underlying asset, usually index
What is the structured product time range?
18 months - 7 years
Do structured deposits and investments benefit from FSCS?
No, only deposits do - investments do now
What are the two types of structured investment?
Capital at risk (SCaRPs, Structured Capital at Risk Products)
Principal-protected investments
What is the soft floor?
Where an investor in a SCaRP will get most/all of their money back if an index does not fall by a certain amount
What is a precipice bond?
Pay a set level of income over a set period
Precipice is that if a reference index falls by more than a certain level the capital will suffer an equivalent loss
How are structured products made up?
Will be different asset classes. E.g. a bond (protects investor principal) and a derivative (higher returns)
What does a callable structured product mean?
The product can mature early if it reaches a certain level
What is it called when structured products pay-off the underlying stays within a certain range?
range accruals pay-off
What is an averaging value structured product?
Return is based on the average value of the underlying over a time period
Can help protect against last short term dips when selling
What is a lookback feature in structured products?
Can realise the returns based on the highest percentage rise of the underlying
What are cash or nothing pay-offs?
The return is either paid or not based on in a particular event occurs, e.g. above x price
What is quantity adjusting (Quantos) structured prodducts?
Protect against currency risk
What is the yield curve a visual representation of?
Term structure of interest rates, rates from the same issuer across different maturities
Why would a investors be willing to get a lower yield for longer term bonds? (Inverted yield curve)
They believe interest rates will be lower then
Which countries pay annual coupons?
France / Germany
Which countries have T+2 settlement on bonds?
France / Germany
What are the the names for German bond maturity?
Bund - >10 year
Bobl - 5 years
Schatz - Up to 2 years
