Chapter 3 - Alternative investments and derivatives

Question 1

structured deposits

Answer 1

• not a product itself, but a wrapper designed to meet a specific returns linked to a deposit which will pay interest
• return of capital not linked to underlying asset

Question 2

capital protected products (deposit based structured products)

Answer 2

• return of capital is not linked as capital is not at risk
• costs associated with capital protection resitricts amount avaible to spend on call options

Question 3

capital at risk products (investment based structured products)

with hard protection

and with soft protection

Answer 3

• return of capital is not guarenteed and is linked to underlying asset performance - only invetsment based structured products risk original capital
• more protection decreases potential for profit (and vice versa)
• hard protection = potential loss expressed as a %, for example, 75% hard protectoin barrier means a max potential loss of 25%
• soft protection = capital is secure providing undelrying asset or index does not fall below a pre-determined barrier. for example, capital is secure provedied FTSE does not fall by 50% from opening level

Question 4

likely reason why a fund manager will hold futures in a portfolio

Answer 4

• relatively cheap way of taking a position compared to buying direct holdings
• sale of an equity holding may affect the market price - less likely to happen with derivatives
• they incur lower dealing costs

Question 5

warrants

Answer 5

• traditional warrants are issued by companies, such as investment trusts, and are tarded on the LSE
• geared investement with potentially high risk/reward
• long term call option - holder has the right, but not the obligation, to buy shares at a predetermined date, or period
• choice of selling the warrants separately from their shares or buying extra shares shares by excersing the warrants. not worthwile if the excersie price exceeds market price

Question 6

structured products characteristics

Answer 6

elements of a structured deposit

• zero-coupon bond - provide repayemnt of capital at maturity
• derivatives - provide returns linked to asset
• charges - covers admin, custodian and management charges
• a portion invested is placed in each of the above

other

• stated fixed term. five or six years, these are acceptable for ISA investment
• kick-out allows for early maturity, granted underlying index is not below the starting level
• withdrawals are permittes, although at a charge
• return of capital or income (rarely both)
• meant to be held to maturity. banks may create a market allowing the asset to be realised- charges may be levied

Question 7

hedge funds types and methods of investing

Answer 7

pure hedge funds

• long/short funds - invest in equity and/or bond instruments, combined with short sales of individual securities and derivatives
• relative value funds - manager rely on arbitrage to produce returns. identifying and exploiting pricing anomalies
• event-driven funds - use the price movements arising from anticipated corporate events
• tactical trading funds - trade in currencies, bonds, equities and/or commodities. may use long/short

fund of hedge funds

• work on the basis that they spread risk. rely on managers to perform due diligence and analysis

Question 8

hedge funds

characteristics

Answer 8

• non-traditional investment methods
• based offshore. freedom to invest in a wider range of investments, lower regulatory oversight, beneficial tex treatment and lower costs
• most are non-reporting funds - UK

characteristics

• do not adopt a long-only strategy. they seek higher risk-adjusted rates of return
• limited or even negative correlation with the markets they operate in. even when markets are falling, they can achieve positive returns (the opposite can also be true)
• some, but not all, use gearing or leverage
• significantly higher fees. 1 -2% initial, 2% annual and 20% for performance.

Question 9

hedge funds risks

Answer 9

• investment risk - understanding of investment strategy employed, together with the level of risks it is prepared to accept and the risk controls
• gearing - funds borrowing against the value of the portfolio (300% to 400%) or using derivatives
• manager risk - funds are opaque by nature, and you rely on the IM to produce above-average returns. creates the risk for fraudulent activity
• liquidity risk - investment into less traditional assets exacerbates liquidity risk
• encashment risk - most value their portfolios quarterly or monthly. notice may need to be given before the next valuation point, there is an implicit delay between the instruction and actual sale
• regulatory risk - typically established offshore with light regulatory regimes. regulators worldwide are considering greater controls for hedge funds and short selling