Chapter 4: Asset Markets

Question 1

List 7 different markets that are of interest to institutional investors on which assets are bought and sold.

Answer 1

Institutional asset markets

1. stock markets (primary and secondary)
2. bond markets (primary and secondary)
3. property markets
4. money markets
5. commodity markets
6. foreign exchange markets
7. derivative markets.

Question 2

Describe ‘quote-driven’ markets.

Answer 2

Quote-driven markets

In a quote-driven market, the asset buyer or seller will buy or sell from a market maker, who will typically quote a bid-offer price to them.
The bid-offer price is the price at which the market maker is prepared to buy or sell a given quantity of securities.
The market maker will also usually specify the maximum size of order that they are willing to transact at those prices too. If the party wants to buy, they will pay the offer price of the market maker. If the party wants to sell, they can sell to the market maker at the bid price quoted.

The difference between the bid and the offer price is referred to as the spread and is the profit made by the market maker, assuming they can transact the opposite trade at the same bid-offer price.
The size of the spread is an indication of the liquidity of the asset being traded.

Most trading, apart from in equities, is conducted in quote-driven markets, eg most bonds, currencies and commodities are traded in quote-driven markets.

Question 3

Describe ‘order-driven’ markets.

Answer 3

Order-driven markets (equities)

In an order-driven system, there is a rules-based matching system that is used to execute trades based on orders submitted to the system. Buyers will enter buy orders into an order queue (a particular quantity at a particular price) and sellers do likewise with their sell orders. If a buy order specifies a price that is higher than the lowest sell order price in the system, a trade is executed; similarly if a sell order’s price is lower than the highest bid order, a trade is executed.

The systems therefore give priority to the highest priced buy orders and lowest priced sell orders. When there are multiple orders at the same prices, precedence is usually given to orders that are displayed (rather than hidden) and precedence given to earlier orders over later ones, ie the first orders submitted at a particular price are filled first.

Order-driven markets can be run by exchanges or by brokerages or by what are referred to as alternative trading systems.

Question 4

Describe a ‘broker market’ and an ‘auction market’.

Answer 4

Broker market

In a broker market, a broker is hired to find a seller of the asset and receives a commission for the service.
These are mostly used when finding a seller is difficult, ie where there are poor quote-driven systems or no order-driven systems with adequate liquidity. They can be used, for example, for very big deals in a stock or a bond, or for property, art and other alternative investments. The commission is the profit that the broker makes using their expert knowledge of the market and client network.

Auction market
Some assets are sold by auction, eg property and bonds in their primary markets.

Question 5

Outline the four most common ways that a trade can be entered onto a market (either on a system or with an intermediary).

Answer 5

Order types

1. market order
   – to execute the transaction immediately at the best market price
2. limit order
   – similar to a market order, but limited to a specific high price when buying or a specific low price when selling
3. stop orders
   – an order to be filled immediately when a specific price trades in the market
4. hidden orders
   – are orders exposed only to brokers which cannot be disclosed to other traders.

Question 6

List six different ways that the validity of an order on a market can be specified.

Answer 6

Six ways to specify the validity of an order

1. good-till-cancelled (GTC)
   – an order that is valid until it is cancelled
2. good-till-xxx date
   – an order that is valid until a specified date and/or time
3. fill or kill
   – an order that has to be transacted immediately in full, or is cancelled
4. immediate or cancel
   – an order that has to be transacted immediately, in part or full, after which any unfilled parts of the order are cancelled
5. good on close
   – can only be filled at the close of the market
6. good on open
   – can only be filled at the open of the market.

Question 7

List the issues that are typically experienced when making investments in overseas markets.

(#MTV CATERPILLAR).

Answer 7

Overseas market issues
(#MTV CATERPILLAR)

Mismatching domestic liabilities
Taxation (may not be able to recover withholding taxes paid) Volatility of currency, particularly if hedging domestic liabilities

Custodian needed that can handle overseas settlement
Additional administration required
Time delays
Expenses incurred / expertise needed
Regulation poor in foreign markets
Political instability Information harder to obtain (and less of it) Language difficulties
Liquidity problems in overseas markets
Accounting differences
Restrictions on foreign ownership / repatriation problems.

Question 8

List four problems that arise from investing in unquoted markets.

Answer 8

Unquoted market problems

1. poor marketability
   – The fact that unquoted shares are not listed on a stock exchange means that the shares are unmarketable. An investor holding an unquoted share will probably have difficulty in finding a buyer if he wants to sell. Having found a buyer, dealing costs will be much higher than for quoted shares.
2. lack of information
   – There is much less publicly available information about unquoted companies than about listed ones.
3. uncertain valuation
   – Because of the lack of a regular market and limited publicly available information, it is difficult to put a fair value on unquoted shares.
4. risk
   – The combination of the factors described above, plus the fact that unquoted companies tend to be smaller than listed companies, makes investing in unquoted shares much riskier than investing in listed shares.

Question 9

List five types (or categories) of venture capital investment.

Answer 9

Five types of venture capital investment

1. small companies, often in the very early stages of their growth (often referred to as ‘start ups’)
2. longer established companies that need to raise capital for the next stage of their growth (‘development capital’)
3. management buy-outs or buy-ins, often involving non-core subsidiaries of diversified companies
4. public to private transactions, often by smaller listed companies
5. from SP5, restructuring capital is another type whereby companies that are in trouble and cannot raise finance from existing capital providers, raise money through private equity markets in a restructuring exercise.

Question 10

List six typical requirements in order for a company to be listed on an exchange.

Answer 10

Six requirements to be listed on an exchange

1. a minimum market capitalisation
2. sufficient operating history, usually a minimum of three years of annual accounts
3. sufficient financial resources
4. compliance with the corporate governance code
5. having a minimum of 25% of the company’s shares held publicly
6. ultimately obtaining approval by the stock exchange.

Question 11

Describe a repurchase agreement (repo).

Answer 11

Repurchase agreement

In a repo transaction, the bonds to be received as collateral may not be specified precisely – in what is known as a ‘general collateral’ or GC repo – or may reference a particular bond – in what is known as a ‘specific’ repo.

In the case of a specific repo, legal title to the securities passes from the seller to the buyer.

The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate.

Coupons falling due while the repo buyer owns the securities can be passed directly to the borrower although this is counter-intuitive as legal ownership lies with the lender.

They are legally recognised as a single transaction and not as a disposal and a repurchase for tax purposes.

Repo transactions may be transacted under standardised documents based on the Global Master Repurchase Agreement (GMRA).

Repo transactions will in most cases be subject to daily collateralisation to remove credit exposure between the counterparties.

The counterparties may agree to apply a haircut to the value placed on the collateral, to mitigate market risk on the stock in the event of a default by the seller.

Question 12

Describe the following types of bonds:

1. foreign bonds
2. green bonds
3. Eurobonds

Answer 12

Foreign bonds
These are bonds issued in the local currency on a local stock exchange by an overseas company.
The issuer has to comply with local listing rules and provide financial information in a format that is consistent with domestic issuers.

Green bonds (sometimes called ‘climate bonds’)
These are bonds where the money raised is ring-fenced to carry out green or environmentally-friendly projects.
They are typically ‘on balance sheet’, but suffer from a difficulty in determining that the funds have been used for the purposes that were claimed.

Eurobonds
These are issued internationally by a group of banks that underwrite the issue and market it to their clients.
The bonds are not issued on a stock exchange. Issues are typically large and marketable, settle through Euroclear or Cedel, and can be in a range of international currencies.

Question 13

Define the following ratios that are used when credit rating a corporate bond:
* current ratio
* quick ratio
* income (or interest) cover
* asset cover.

Answer 13

Current ratio and quick ratio

Current ratio
= current assets / current liabilities

Quick ratio
= (cash + short term securities + trade receivables) / current liabilities

or

= (current assets - inventories) / current liabilities

Income cover and asset cover

Income cover
= profit before tax interest (PBIT) / (interest payable on bond +any prior ranking bonds)

Asset cover
= (total assets - current liabilities - intangibles) / (nominal of bond + any prior ranking bonds)

Question 14

List six examples of restrictive covenants that might be placed on a bond by investors.

Answer 14

Restrictive covenants

1. prohibition on the issue of further senior debt unless the ratio of senior debt to the value of net book assets is within a specified limit
2. prohibition on issuing any further debt if the level of gearing is too high
3. prohibition on issuing further secured debt without giving equal treatment to existing unsecured bonds
4. restrictions on the amount of dividends that the company may pay
5. restrictions on disposals of assets by the company
6. restrictions on the nature of business of the company.

Question 15

Outline seven characteristics of infrastructure investments.

Answer 15

Seven characteristics of infrastructure investments

1. the activity has high development costs (barriers to entry) which offers some protection for investors
2. long term
3. single purpose often with a monopoly
4. finite participation (the asset reverts to government after the investment period)
5. government regulation or oversight
6. may be index-linked or ‘real’ in nature
7. very specific risks which makes it hard to achieve a diversified portfolio

They are also typically good credit quality, and very unmarketable (from SP5).

Question 16

Outline the pros and cons of infrastructure investment from the perspective of the investor.

Answer 16

Pros and cons of infrastructure investment for the investor

Pros:
1. reasonably secure, often backed by government or local authority payment streams

2. long term, and often index-linked
3. higher return than equivalent government index-linked or fixed income bonds

Cons:
1. exposed to regulatory and political risk

2. unmarketable and hard to value
3. difficult to obtain a diversified portfolio without significant size
4. risky in the early stage / build stage of the project
5. complex, requiring expertise, and requiring a great deal of management time and effort to manage a portfolio.

Question 17

List the five main categories into which commodity investments can be classified.

Answer 17

Five main categories of commodity investment

1. precious metals
2. base metals
3. meat & livestock
4. agricultural
5. energy

Question 18

Explain the difference between puttable and callable bonds
(from Subject SP5).

Answer 18

Puttable and callable bonds

Puttable bonds give holder option to redeem them early (ie sell them back to issuer) at predetermined price on specified dates in future.

Callable bonds give issuer option to redeem them early (ie buy them back from holder) at predetermined price on specified dates in future.

Question 19

Define the term private equity and describe its two main forms.

Answer 19

Private equity

1. Investment in unquoted companies not listed on stock exchange.
   Instead shares issued and traded privately.
2. No immediate exit route via secondary market.

Two main forms

1. Venture capital – capital for businesses in conceptual stage or where products are not developed and revenues and/or profits not achieved.
2. Leveraged buy-outs – equity capital for acquisition or refinancing of larger company. Typically, this involves buying out shareholders of an existing public company and de-listing it. Acquisition often funded largely by borrowing, if buyers have insufficient personal funds.

Question 20

Describe two other situations (in Subject SP5) where equity finance may be raised privately.

Answer 20

Two other situations where equity finance may be raised privately

1. Where private company requires development capital – in order to fund growth or expansion of business in need of product extension and/or market expansion.

Development capital may be provided en-route to public issue once company sufficiently large and profitable. Can be used to fund organic growth, ie expansion of existing lines of production, or new projects in different markets.

2. Where a financially or operationally distressed company requires restructuring capital, in order to carry out restructuring of its finances (liabilities) or assets.

Question 21

Define the term hedge fund and explain how they have less restrictions than more regulated vehicles such as mutual funds.

Answer 21

Hedge funds

A hedge fund can be defined as an investment fund that aims to meet high or absolute returns by investing across a number of asset classes or financial instruments.

Hedge funds typically have less restrictions on:
1. borrowing
2. short-selling
3. the use of derivatives than more regulated vehicles such as mutual funds.

This allows for investment strategies that differ significantly from the long-only, non-leveraged strategies traditionally followed by investors.

Question 22

List five other features that originally characterised hedge funds.

Answer 22

Five other features that originally characterised hedge funds

1. the placing of many aggressive positions on different assets
2. a high level of borrowing given the limited size of the capital of the funds compared to the size of the individual investments.
3. a mix of investments for which the price movements would be expected mostly to cancel each other out, except for the positive effect the hedge fund is looking for.
4. a willingness to trade in derivatives, commodities and non-income bearing securities.
5. a higher risk tolerance than other funds.

Question 23

Describe the four main classes of hedge funds.

Answer 23

Hedge funds

1. global macro funds
   – concentrate on macroeconomic changes around the world.
2. event-driven funds
   – trade either distressed securities or securities of companies involved in mergers and acquisitions (risk arbitrage).
3. market-neutral funds
   – enter simultaneously into long and short positions, while trying to exploit individual price movements.
4. multi-strategy funds
   – a combination of the above.

Question 24

Describe the three biases that influence hedge fund performance data.

Answer 24

Biases that influence hedge fund performance data

1. Survivorship bias – arises when data doesn’t realistically reflect survivors and failures. Means average returns overestimated and volatility underestimated.
2. Selection bias – arises because funds with good history more likely to apply for inclusion in databases, and may reflect backfilling of good past performance. Means average returns overestimated and volatility underestimated.
3. Marking to market bias – since underlying securities may be relatively illiquid, funds typically use either latest reported price or own estimate of current market price for valuation. Use of ‘stale’ prices can lead to underestimation of true variances and correlation.

Question 25

Explain why claims of hedge fund superior performance can be questioned.

Answer 25

Why hedge fund out-performance can be questioned

Claims of hedge fund superior performance can be questioned since return distributions are far from normal – many of them tend to be negatively skewed.

As a result, standard measures of performance such as a portfolio’s alpha (the excess return that cannot be explained by the fund’s beta) and its Sharpe ratio will be biased upwards.

Question 26

Outline the typical level and structure of a hedge fund’s management fees.

Answer 26

Hedge fund management fees

1. Most hedge funds charge fixed annual fee of 1–2%, plus incentive fee of 15–25% of annual fund return over some benchmark.
2. Funds of hedge funds charge similar fees and, although they generally obtain rebates from managers they invest in, extra layer of fees puts substantial pressures on fund-of-funds performance.

Question 27

List two potential advantages and five potential disadvantages of investing in hedge funds.

Answer 27

Potential advantages of investing in hedge funds

1. possibility of high returns
2. low correlation with other investments

Potential disadvantages of investing in hedge funds
1. high levels of fees
2. lock-in and/or notice periods
3. limited regulation means lack of protection
4. lack of information/transparency
5. maximum/minimum investment sizes

Question 28

Give four headings under which the key features of hedge funds can be summarised (#MOPS).

Answer 28

Four headings for key features of hedge funds (#MOPS)

1. Management
2. Operations (eg legal structure, tax jurisdiction, fees, lock-in periods)
3. Past performance
4. Strategies (eg short selling, gearing) and investments

Question 29

Explain how the specification of a futures contract for a commodity differs from that of a futures contract based on an investment index.

Answer 29

Specification of a commodity futures contract

The specification of a commodity futures contract is considerably more complex than that of a contract for a future based on an investment index.

It will be necessary to specify:
1. contract size
2. delivery dates
3. quality of the product
4. method of packaging
5. package size
6. delivery site
7. method of resolving disputes about quality.

Question 30

Discuss the suitability of commodities as an investment class for institutional investors.

Answer 30

Advantages/disadvantages of commodities

Advantages:
1. commodities offer significant real returns that are produced by doing real economic work within the economy
2. returns accrue to the long-only investor without the need for active management
3. in periods of poor returns, commodities have produced higher returns than any other asset class used by institutional investors
4. unlike other asset classes, commodities are concerned with short-term supply and demand and short-term risk.

Disadvantages:
1. no strong historical evidence for a real return from commodities
2. the markets are volatile, being driven by a number of factors unrelated to the underlying economic factors that affect institutional liabilities

Question 31

Explain what insurance-linked securities are and why an insurer might find them useful.

Answer 31

Insurance-linked securities and why they are useful

Insurance-linked securities (ILS)
– securities whose return depends on the occurrence of a specific insurance event, which can be either related to non-life (eg catastrophe bonds) or life risks.

From an insurer’s perspective, ILS offer the ability to transfer risks from its balance sheet to investors in return for payment of a risk premium.

Question 32

Outline the process for creating a catastrophe bond.

Answer 32

Process for creating a catastrophe bond

1. The ceding insurance company establishes a special purpose vehicle in a tax-efficient jurisdiction.
2. The SPV establishes a reinsurance agreement with the sponsoring insurance company.
3. The SPV issues a note to investors; this note has default provisions that mirror the terms of the reinsurance agreement.
4. The proceeds from the note sale are invested in money-market instruments within a segregated collateral account.
5. If no trigger events occur during the risk period, the SPV returns the principal to investors with the final coupon payment. If trigger events occur, the assets of the SPV are first used to meet the insurer’s losses, before any return of principal (if any).

Question 33

Explain what is meant by a structured product in the context of investment.

Answer 33

Structured products

A structured product is a pre-packaged investment strategy in the form of a single investment. A typical structured product will consist of two components:

1. A note – essentially a zero-coupon debt security that provides capital protection
2. A derivative component that provides exposure to one or several underlying assets such as equities, commodities, FX or interest rates.

Question 34

Discuss the suitability of structured products as an investment class for institutional investors over direct investment in the underlying derivatives.

Answer 34

Advantages/disadvantages of structured products

Advantages:
1. practical
– investors may be unable to invest themselves in the underlying derivatives.

2. legal
   – designed to satisfy legal or regulatory requirements
3. tax
   – tax treatment may be more favourable
4. accounting
   – may be structured to avoid income statement volatility from the underlying derivatives

Disadvantages:
1. pricing
– difficult to assess whether a quoted price is competitive

2. costs
   – distribution costs are generally not explicit and are normally implicit in the quoted price.

Question 35

List ten alternatives to government bonds.

Answer 35

Alternatives to government bonds

1. Agency bonds
2. Investment grade corporate bonds
3. High yield bonds
4. Convertible bonds
5. Distressed debt
6. Event-linked bonds
7. Interest rate and inflation swaps
8. Credit default swaps
9. Mortgage Backed Securities (MBS)
10. Asset Backed Securities (ABS)