Chapter 2 - Understand the behaviour, performance, risk profile and correlation of key investment types

Question 1

Risks associated with Savings Accounts

Answer 1

• No investment risk
• Exposed to default risk
• No capital growth other than interest that accumulates which is variable or flexible

Question 2

Annual Equivalent Rate (AER) example

Answer 2

AER = (1 + R/N)N -1
R = Rate of Interest
N = Number of periods interest is paid

Example:
Investment A offer 1% compounded quarterly. Investment B also offers 1% compounded six-monthly(bi-annual). Which is better?

Investment A
(1 + 0.0025%)4P – 1 x 100 = 1.00375% (1.0038%)

Investment B
(1 + 0.0050)2P – 1 x 100 = 1.0025% (1.003%)

Question 3

What is Credit Risk?

Answer 3

Credit Risk is the risk of a bank of building society defaulting.

Question 4

What is Tier One Capital Ratio?

Answer 4

The ratio that regulatory authorities use to judge the adequacy of the bank’s capital position.

The higher the percentage the greater the strength of the bank

Question 5

Are Deposits in Gibraltar covered? (FSCS)

Answer 5

Yes

European Economic Area (EEA), Channel Islands and Isle of Man are not covered by FSCS

Question 6

What are Money Market Instruments?

Answer 6

They allow governments, banks and companies short term funds at low interest rates.

These include:
Time Deposits
Treasury Bills
Certificates of deposit
Commercial paper
Bankers acceptances
Bills of exchange

Question 7

What are Treasury Bills?

Answer 7

Treasury Bills are issued by governments to finance their short-term cash needs.

Maturities of one, three or six months.

Minimum - £500,000

Question 8

What are Certificates of Deposit?

Answer 8

Certificates of deposit (CD) are receipts from banks for deposits placed with them.

Deposits are fixed rate linked with Sterling Overnight Interest Average (SONIA) previously it was London Inter-bank Offered Rate (LIBOR)

Maturities of one to three months and interest is paid on maturity.

Question 9

What are Commercial Paper?

Answer 9

Commercial Paper is short-term money market funding issued by companies to fund their day-to-day cash flows - similar to treasury bills.

Maturities between 30 and 90 days

Question 10

What are the two types of Money Market Funds?

Answer 10

Short-term money market fund
They are invested in short term debt and have a weighted average maturity of no more than 60 days and an average life of no more than 120 days.

Standard money market funds
Aim to achieve slightly higher returns investing in assets with extended maturity periods of size and twelve months.

Question 11

What is a Bond?

Answer 11

Debt investments are financial instruments that give a right to interest, and the repayment of capital on loans made to governments and companies.

Question 12

Alternative names of bonds?

Answer 12

Fixed interest or fixed-income securities or debt securities.

Question 13

What is a Gilt?

Answer 13

In the UK government sector, bonds are known as Gilts.

In the international sector they are Eurobonds.

In the Corporate sector they are called Debentures, loan stock or loan notes.

Question 14

Three key features of a Bond?

Answer 14

Issuers name - Identifies who is liable for the interest payments and repayment of principal

The Coupon - Interest rate payable and if it is fixed for the life of the stock - Most bonds pay twice a year.

Maturity Date - Identifies the year in which the issuer will repay the nominal value of the bond to the investor.

Question 15

What are Conventional Gilts?

Answer 15

Fixed coupon
Single repayment date
Interest paid every six months
Issued 7 March September or 7 June December
Now called Treasury Gilts

Question 16

What are Index-Linked Gilts?

Answer 16

Index-linked gilts are those where the interest payments and the redemption amount are increased by the amount of inflation over the life of the bond

Interest paid every six months
RPI (CPIH) linked

Question 17

Gilt STRIPS

Answer 17

STRIPS is the acronym for “Separate Trading of Registered Interest and Principal Securities”

A stripped gilt is one that is separated into its individual coupon payments and its redemption payment

Question 17

What is the difference between a Floating Charge and Fixed Charge?

Answer 17

Fixed Charge is a legal charge specifically placed on one or a number of companies fixed or permanent assets

Floating Charges places a more general charge on those assets that continually flow through the business.

Question 18

What is a Eurobond?

Answer 18

Eurobonds give issuers the ability to tap potential lenders internationally, rather than just domestically and make bond issued at short notice.

Question 19

What is a Foreign Bond?

Answer 19

Foreign Bonds are debt instruments that are issued by foreign borrowers in domestic bond market of another country.

Question 20

What are Convertible Bonds?

Answer 20

They give the investor the right to convert the bond into a pre-defined number of ordinary shares in the issuing company, on a set date or dates between a range of set dates, prior to the bonds maturity.

Question 21

Convertible Premium Discount Calculation

Answer 21

Convertible Bond - Nominal 100 - Price £1.10 - Market Value £110
Ordinary Shares - Nominal 25 - Price £4.00 - Market Value £100

Market Price of convertible stock / conversion ratio
x market price of ordinary shares - 1 x 100

(£110 / 25 x £4.00 - 1) x100 = 10%

Question 22

How to calculate the Interest Yield?

Answer 22

Coupon / clean price x 100

Interest Rate of Coupon - 2%
Clean price (price paid) - £106.39

2 / 106.39 x 100 = 1.88%

Question 23

Investor has a holding of £1,000 “6% Treasury Stock 2028” which is priced at £107.38. What is the interest yield?

Answer 23

6 / 107.38 x 100 = 5.587% (5.59%)

Question 24

What are interest yields also called?

Answer 24

Running yield
Income yield
Flat yield

Question 25

How to calculate the Redemption Yield?

Answer 25

Step 1 - Calculate the interest yield
Step 2 - Work out if there is a gain or a loss (value above or below par)
Step 3 - Divide this by the number of years to maturity.
Step 4 - Interest yield - the above value = Redemption value

Question 26

Katherine bought £1,000 nominal of gilt carrying an 8% coupon that is to be repaid in 4 years time. Current price is £124.27 (£1,242.70).
What is the redemption yield?

Answer 26

Interest yield
8% / 124.27 x 100 = 6.44%

Redemption Yield
1,000 - 1242.70 = -242.70 / 4 = -60.675
-60.675 / 1242.70 x 100 = -4.88%

Interest Yield - Redemption Yield
6.44 - -4.88 = 1.56%

Question 27

What is normal yield curve?

Answer 27

Starts off lower but gradually grows over time, more for long term investments.

Question 28

What is a flat yield curve?

Answer 28

Tends to appear when markets are stagnating and potentially sloping into an inverted curve.

Question 29

What are the main risks associated with holding government or corporate bonds?

Answer 29

Credit Risk - risk that the interest payments and the repayment of capital might not be made

Market/price risk - movements in interest rates have a significant impact on value of bond holdings

Inflation risk - risk of inflation to rise unexpectedly, will impact real value of coupon and redemption figures.

Liquidity risk - Unable to move/trade should the client require the funds urgently.

Exchange rate risk - where bonds are in different currency, adverse exchange rate movements can affect this.

Question 30

What is the difference between Ordinary and Preference shares?

Answer 30

Ordinary
Higher risk - last to be paid in the event of liquidation
Have the rights to share profits of company
Right to attend and vote at company meetings

Preference
Less risky
Fixed dividend each year aslong as company has sufficient profits, paid before ordinary shareholders
No right to attend or vote at company meetings

Question 31

What are the different types of ordinary shares?

Answer 31

A Shares - Participate in profits and dividends but are non-voting shares

B Shares - Usually redeemable shares issued as part of a capital return

Deferred shares - Issued by founders of the company and only pay a dividend after a certain period or once all other dividends are paid.

Question 32

What Basic rights does a Shareholder have?

Answer 32

Receive annual accounts and be notified of annual general meetings
Able to attend company meetings and vote
Receive a share in the profits of the company
Right to a surplus on winding up once liabilities are paid

Question 33

What Statutory rights does a shareholder have?

Answer 33

Companies hold annual general meetings at least once a year

Shareholders with more than 10% voting rights can call extraordinary meetings

Shareholders with 5% of more can propose resolutions.

Any shareholder can petition the court on the grounds that affairs of the company have been conducted in a manner unfairly.

Question 34

What is The Primary Market?

Answer 34

Where bonds are issued for the first time.

Question 35

What is the Secondary Market?

Answer 35

A market that can trade bonds that have already been released.

Question 36

What are Rights Issues?

Answer 36

Companies may come back to the stock market at any time to raise share capital.

Question 37

What is Bonus Issues?

Answer 37

This involves the company issuing further shares to existing shareholders WITHOUT raising new funds.

Question 38

What are Share Splits?

Answer 38

When businesses split current shares into more shares (more shares but same cost)