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Business Planning: Banking > Chapter 2 - Securities And Other Investments > Flashcards

Chapter 2 - Securities And Other Investments Flashcards

1
Q

What are the main characteristics of Equity securities (Income, Capital Repayment, Security, Negotiation and Influence)

A

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

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2
Q

Define public company

A

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

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3
Q

What are the two primary markets on the London Stock Exchange

A

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
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4
Q

Define liquidity in the context of equity securities

A

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

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5
Q

What are the two types of equity markets and their advantage

A
  1. 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
  2. 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
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6
Q

Who are the main investors in the UK for long term and short term investments

A

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
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7
Q

What are the four main value methods for equity securities

A
  1. Multiple based valuations
    Using a market derived multiple (based on other companies in the sector) and multiplying earnings, EBIT, EBOTDA by this multiple
  2. Asset based
    Using property and other investments
    OR for a trading company using future earnings and cash flows
  3. 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
  4. Cash based
    PV of future cash flows - discounted using cost of capital
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8
Q

What are other factors that influences share prices

A
  • 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
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9
Q

Why may a business issue debt rather than use bank lending?

A

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

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10
Q

What are the main characteristics of Equity securities (Income, Capital Repayment, Security, Negotiation and Influence)

A

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

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11
Q

What are the different types of coupons?

A
  1. 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
  2. Zero coupon - No coupon, so bonds are issued at a discount to provide acceptable return
  3. Stepped coupon - coupons that escalates at a predetermined rate over the life of the bond
  4. 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
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12
Q

What are the different variety of redemption terms for corporate bonds?

A
  1. Bullets - single redemption date
  2. Options - give the right to redeem early. Callable (gives the issuer the right) and Putable (gives the holder the right)
  3. Serial note - proportion of capital is repaid along with the interest
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13
Q

What are the two types of securitisation (legal charges) for corporate bonds?

A

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

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14
Q

What are the markets for corporate debt?

A
  1. UK domestic debt market - bonds are listed on the LSE
  2. 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
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15
Q

Who are the investors for corporate bonds?

A

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

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16
Q

What are the factors affecting valuation for corporate debt?

A

Terms of the bond

Credit ratings

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17
Q

Define hybrid securities?

Give three main examples

A

Securities which have some characteristics of both equity and debt

  1. Preference shares
  2. Convertibles (bonds/shares)
  3. Debt with equity warrants
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18
Q

What are preference shares and their features?

A

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

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19
Q

Explain the following features of convertibles:
Convertible ratio
Convertible price
Valuation (straight and conversion value)
Market conversion price
Market conversion premium

A

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

20
Q

Define a warrant aka equity sweetener

A

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

21
Q

What are the difference between warrants and traded options

A

The exercise of a warrant will lead to the issue of new shares by the issuing company. Whereas trading options related to existing shares

22
Q

How are warrants different to covered warrants

A

Covered warrants are sold to investors by banks and the bank may hedge or cover their exposure by purchasing the underlying investment

23
Q

How can the value of a warrant be broken down?

A
  1. Intrinsic value - the gain from utilising the warrant based on current share price
  2. Time value - the potential future gain if the share price increases over the lifetime of the warrant
24
Q

What are government bonds called?
Who used to issue them?
Who issues them now and what is there responsibility?

A

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)

25
Q

How does the DMO define the different redemption dates or maturities of gilts

A 
Shorts = gilts with 7 years or less
Mediums = gilts with between 7 and 15 years
Longs = gilts with  over 15 years
26
Q

What are the different types of gilts

A 
Straight gilts
Variable coupon gilts
Index-linked stocks
Strips
Foreign currency UK Government debt issues
27
Q

What is the main advantage of a variable coupon gilts (or floating rate bonds)?

A

Coupon rate is always at a fair level so price remains at or around par - so it protects nominal value of the investment

28
Q

What is the main advantage of index-linked gilts?

A

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.

29
Q

What does Strips stands for and what does these gilts do?

A

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

30
Q

What is the main purpose of foreign currency UK gov debt issues?

A

To finance the foreign currency reserves at the bank of england

31
Q

What is the market for gilts?

A

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

32
Q

How does the DMO act as a regulator of gilts?

A

Ensure the market is solvent, liquid and fair
So issue gilts to fund PSMCR
They control who has access the the market

33
Q

What is the role of GEMM?

A

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

34
Q

What is sub-sovereign debt?

A

Debt issued by government bodies below a national level

Bonds issued by supranational organisations

35
Q

What is a supranational entity?

A

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

36
Q

What makes gilts attractive to investors?

A 
Considered:
Lower risk (than equities and debt)
Less volatile than equities
May be used to speculate movement that is expected with interest rates
37
Q

Value of a bond =

A

Sum of the fixed future coupon cash flows, final coupon and redemption proceeds at maturity, discounted at the investor’s rate of return

38
Q

Internal rate of return

A

= future cash flow/market price

39
Q

What happens when the coupon rate is equal to the interest rate?

A

The bond will be valued at par

40
Q

Formula for the price of a strip

A

Price = £100/(1+r)^n
r –> semi-annual GRY
n –> number of 1/2 years to redemption

41
Q

Why is valuing a floating rate bond different?

A

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

42
Q

Define flat yield and give the formula

A

The annual cash return generated by an investment as a percentage of the cash price

= Annual coupon/Market price

43
Q

Uses and limitations of a flat yield

A

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

44
Q

Define Gross Redemption Yield and how is it calculated

A

A measure of the overall return from a bond over its life.

Can be calculated as the internal rate of return through interpolation

45
Q

What are the benefits and limitations of Gross Redemption Yield

A

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

46
Q

What are the different risk factors affecting bond valuation?

A

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

Business Planning: Banking (7 decks)

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