Chapter 2 - Securities And Other Investments Flashcards
What are the main characteristics of Equity securities (Income, Capital Repayment, Security, Negotiation and Influence)
Income: Ordinary shareholders are entitled to a dividend which has been proposed and then approved
Capital Repayment: Only entitles when the company is wound up
Security: Shareholders have no specific security and are the first people to lose. It’s risk finance
Negotiation: Shares can be freely negotiated or sold on
Influence: They can vote at general meetings and control over directors
Define public company
Any company whose legal status allows shares to be sold to the public. They can either acquire a listing on the stock exchange (listed) or unlisted
What are the two primary markets on the London Stock Exchange
Main market
Alternative Investment Market (AIM)
AIM is the LSE’s global marker for growing companies.
- Has a less demanding admission criteria
- It doesn’t require a three year reading record
- Doesn’t require a certain percentage of shares to be in public hands
Define liquidity in the context of equity securities
The existence of a market where security can be bought and sold at a reasonable price and size
Unlisted public company shares are considered illiquid
What are the two types of equity markets and their advantage
- Quote Driven
Forms act as market makers and give two way prices also known as quote prices (bid-offer)
Advantage: ensures a degree of liquidity - Order Driven
Buyers and sellers display prices that they are prepared to trade at. The market becomes an order book which matches buyers to sellers
Advantage: Greater transparency which shows true demand and supply
Who are the main investors in the UK for long term and short term investments
Long term:
- Investing institutions e.g. pension funds, insurance companies
- Collective investment schemes e.g unit trusts
Short term:
- Hedge funds
- Banks in proprietary trading
What are the four main value methods for equity securities
- Multiple based valuations
Using a market derived multiple (based on other companies in the sector) and multiplying earnings, EBIT, EBOTDA by this multiple - Asset based
Using property and other investments
OR for a trading company using future earnings and cash flows - Adjusted earnings
Economic Value added = Profit adjusted into Net Operating Profit after tax - capital charge
EVA is discounted and the sum of these PV = Market Value Added - Cash based
PV of future cash flows - discounted using cost of capital
What are other factors that influences share prices
- Media or analysts recommendations
- Behaviour of market makers and speculators - little activity may cause them to stimulate the market or short selling to drop prices
- Newsflow and sentiment
- Economic Data e.g. announcement of results, profit warnings
- Non-financial news e.g. wars, terrorism, political events, negative PR
Why may a business issue debt rather than use bank lending?
1) Bank lending has restrictive debt covenants that debt issues don’t have
2) Cheaper finance
3) Has ability to raise larger sums
4) Equity linked features attached to a debt issue may reduce interest costs
What are the main characteristics of Equity securities (Income, Capital Repayment, Security, Negotiation and Influence)
Income: Corporate debt pays the holder interest at a specific rate with a specified frequency (coupon)
Capital Repayment: Corporate bonds are usually redeemable. At maturity/redemption date the holder receives the nominal/redemption value
Security: Companies have the ability to issue debt which is secured against the company’s assets
Negotiation: Can be freely sold to other holders. It’s not actively traded like equities.
Influence: Holders of corporate bonds are creditors (not owners) so the have no vote
What are the different types of coupons?
- Floating rate notes - coupons that vary in line with a benchmark rate of interest e.g. LIBOR or LIMEAN. Has a reference rate and a margin
- Zero coupon - No coupon, so bonds are issued at a discount to provide acceptable return
- Stepped coupon - coupons that escalates at a predetermined rate over the life of the bond
- Drop lock - coupon that is allowed to float until it reaches a set minimum, then it locks into being a fixe coupon bond at that minimum interest rate
What are the different variety of redemption terms for corporate bonds?
- Bullets - single redemption date
- Options - give the right to redeem early. Callable (gives the issuer the right) and Putable (gives the holder the right)
- Serial note - proportion of capital is repaid along with the interest
What are the two types of securitisation (legal charges) for corporate bonds?
Fixed charge: Secured against an identifiable asset of the company. A specific asset e.g. land, building. Company loses the right to dispose this asset.
Floating charge: Secured against the assets in general and the company still has full rights over the assets until there is a default
What are the markets for corporate debt?
- UK domestic debt market - bonds are listed on the LSE
- Eurobond market - International bond issue sold in a currency other than its own. May be the choice for large companies with international recognition and high credit ratings
Who are the investors for corporate bonds?
Due to the predictable cash flows, bonds are attractive to:
Pension funs
Insurance companies
Unit trusts and other collective investment schemes
Do to the price being less volatile, bonds attract:
Speculative investors
What are the factors affecting valuation for corporate debt?
Terms of the bond
Credit ratings
Define hybrid securities?
Give three main examples
Securities which have some characteristics of both equity and debt
- Preference shares
- Convertibles (bonds/shares)
- Debt with equity warrants
What are preference shares and their features?
Shares that offer a fixed percentage dividend
Features:
Don’t receive voting rights (unlike ordinary)
Must be paid when ordinary dividends are paid
Dividend payment not guaranteed
Some are cumulative - so arrears must be paid before ordinary is paid out
No security but rank ahead of ordinary shares
Explain the following features of convertibles:
Convertible ratio
Convertible price
Valuation (straight and conversion value)
Market conversion price
Market conversion premium
Convertible ratio = how many shares a bond can be converted into
Convertible price = par value / conversion price
If not issued at par, it is based on issue price
Valuation:
Straight value = PV of all the future cash flows from the bond as debt.
So the value of the convertible bond as debt alone.
Conversion/Parity value = Stock price x conversion ration
Value of the convertible bond as equity if conversion were to take place immediately
Market conversion price = current MV of the convertible / conversion ratio
Market conversion premium = how much the MV conversion price > current share price
Define a warrant aka equity sweetener
An instrument giving the holder the right to buy new shares in the company at a specified price on or before a specified date.
Warrants are a separable option to acquire shares and can be traded as a separate instrument
What are the difference between warrants and traded options
The exercise of a warrant will lead to the issue of new shares by the issuing company. Whereas trading options related to existing shares
How are warrants different to covered warrants
Covered warrants are sold to investors by banks and the bank may hedge or cover their exposure by purchasing the underlying investment
How can the value of a warrant be broken down?
- Intrinsic value - the gain from utilising the warrant based on current share price
- Time value - the potential future gain if the share price increases over the lifetime of the warrant
What are government bonds called?
Who used to issue them?
Who issues them now and what is there responsibility?
Gilts
Bank of England
Debt Management Office and their responsibility is to ensure that the government is able to borrow the money to fund Public Sector Net Cash Requirement (PSNCR)
How does the DMO define the different redemption dates or maturities of gilts
Shorts = gilts with 7 years or less Mediums = gilts with between 7 and 15 years Longs = gilts with over 15 years
What are the different types of gilts
Straight gilts Variable coupon gilts Index-linked stocks Strips Foreign currency UK Government debt issues
What is the main advantage of a variable coupon gilts (or floating rate bonds)?
Coupon rate is always at a fair level so price remains at or around par - so it protects nominal value of the investment
What is the main advantage of index-linked gilts?
Protects the value from inflation that will erode the value in real terms. Does this by increasing the value of the coupons and redemption proceeds.
What does Strips stands for and what does these gilts do?
Separately Traded Registered Interest and Principal of Securities
Allows the trading of the gilt cash flows (coupons) and/or redemption proceeds individually, rather than the whole bond
What is the main purpose of foreign currency UK gov debt issues?
To finance the foreign currency reserves at the bank of england
What is the market for gilts?
Used to be traded on the floor of LSE
Now traded in a telephone-driven market by Gilt-Edged Market makers or the electronic Order book for Retail Bonds
How does the DMO act as a regulator of gilts?
Ensure the market is solvent, liquid and fair
So issue gilts to fund PSMCR
They control who has access the the market
What is the role of GEMM?
Ensure bid-offer quotes exist at all times for all gilts. They make a market of all conventional gilts at a size deemed appropriate by the DMO
What is sub-sovereign debt?
Debt issued by government bodies below a national level
Bonds issued by supranational organisations
What is a supranational entity?
The result of a combination of several central governments with the objective of promoting economic development e.g. World Bank, European Investment Bank, Asian Development Bank
What makes gilts attractive to investors?
Considered: Lower risk (than equities and debt) Less volatile than equities May be used to speculate movement that is expected with interest rates
Value of a bond =
Sum of the fixed future coupon cash flows, final coupon and redemption proceeds at maturity, discounted at the investor’s rate of return
Internal rate of return
= future cash flow/market price
What happens when the coupon rate is equal to the interest rate?
The bond will be valued at par
Formula for the price of a strip
Price = £100/(1+r)^n
r –> semi-annual GRY
n –> number of 1/2 years to redemption
Why is valuing a floating rate bond different?
The coupon rate is generally reset at each payment date to prevailing market rates. To ensure the price of the FRN is always close to par.
So value is at par. Assume bond will be sold at next reset date at par and then discount the resultant cash flows
Define flat yield and give the formula
The annual cash return generated by an investment as a percentage of the cash price
= Annual coupon/Market price
Uses and limitations of a flat yield
Uses: Assesses annual income return when dealing with irredeemables or the investor’s priority is short term cash returns
Limitations: Potential gains and losses are excluded from the calculation. It also ignores the timing of any cash flows and time value of money and ignores that for some bonds coupons may vary
Define Gross Redemption Yield and how is it calculated
A measure of the overall return from a bond over its life.
Can be calculated as the internal rate of return through interpolation
What are the benefits and limitations of Gross Redemption Yield
Benefits: Considers cash returns and their timing. A more realistic measure of the expected overall return at a point in time
Limitations: Assumes that interest rates remain constant throughout the period. If rates change the returns will be different from the GRY
What are the different risk factors affecting bond valuation?
Credit and default risk - risk of issuer defaulting on its obligations to pay coupons and the principal
Inflation rate - inflation eroding the value
Liquidity and Marketability Risk - relates to the ease with which an issue can be sold in the market
Issue specific risk - factors specific to the issuer e.g. options
Currency Risk - risk of currency movements impacting the value of returns
Interest Rate Risk
