Chapter 7 Flashcards
What is the formula for standard deviation?
sqrt((Sum(r-rbar)^2)/n)
When it comes to probabilities, what % of the outcomes is:
1 standard deviation from the mean?
1.65 standard deviation from the mean?
1.96 standard deviation from the mean?
2.58 standard deviation from the mean?
68.3%
90%
95%
99%
Who developed modern portfolio theory?
This was Markowitz
What was Markowitz modern portfolio theory all about?
It is about how diversification can maximise returns for a given level of return.
What are the assumptions of the modern portfolio theory?
It assumes that all investors are risk averse, rational, and also perfectly diversified in their assets.
What is the efficient frontier?
The efficient frontier is the most efficient combination of assets that will maximise returns for a given level of risk
What are the X and Y axis of the efficient frontier?
The Y axis is the expected return and the x axis is the standard deviation
What concept do we have to use to identify the optimal set of assets for an investor?
We will use utility.
We use utility to understand which sets of assets are the most suitable for a specific investor.
Who introduced the risk free asset into modern portfolio theory?
Sharpe introduced the risk free asset.
What changes to efficient frontier did the introduction of the risk free asset bring?
As we introduce the risk free asset into the efficient frontier graph, we will see that instead of the linear capital allocation line starting at 0, it will now start at an expected return that is higher than 0%
Why did Sharpe say that all investors will choose the CML market portfolio?
He said so as that for regardless of the risk attitude of the investor, they will receive higher returns than being on any other portfolio.
The optimal portfolio is always tangent to the efficient frontier.
How do we work out the slope of the CAL?
This is the Sharpe ratio!
(Rp-Rf)/(stdv(m))
What two risk components does assets have (broadly)?
Systematic and unsystematic risk
Which statistical method is used to ensure that we have diversification benefits?
We use covariance, and we want assets that have a low covariance with one another
What is the formula for covariance?
(SDa)(SDb)(correlation coefficient)
What does the efficient market hypothises weak form mean?
This means that all prices reflect all past market information.
It is not possible to predict future price changes based on past price changes. Price changes are random
What is a random walk?
An random walk is the theory that yesterdays returns can not explain tomorrows returns.
What does the efficient market hypothises semi-strong form mean?
This means that prices reflect all past market and publicly available information and that stock prices will react to news and adjust to a new level (instantly)
This means that it is not possible to beat the market by using fundemental analysis
What does the Efficient markets hypothesis strong form mean?
This means that all public and private information is reflected in the prices.
What does CAPM measure?
It measures systematic risk of the portfolio compared to the benchmark portfolio
What beta does the market protfolio have by default?
A beta of 1
What is the CAPM formula?
E(r) = Rf + Bp(Rm-Rf)
What are the axis of the securities market line?
The Y axis is expected return and the X axis is the beta
What do we use to produce the securities market line?
We use the CAPM formula
What is the slope of the securities market line?
It is the treynor ratio:
(Rp-Rf)/Bp
If a return is below the SML is this good or bad, and why?
THis is bad as it means that we are getting a lower return for a given level of risk.
What are the assumptions of CAPM?
Investors are rational and risk averse
Markets are perfectly liquid
All securities are fairly valued
All market participants can borrow and lend unlimited amounts at the risk free rate
All market participants are well diversitied
No taxes or transaction costs
What are the limitations of CAPM?
Single period (one year) model
Diversified portfolio only
The models assumptions are its biggest limitation
Market risk can be difficult to establish
Poor predictor of investment returns
What is the R-squared if the correlation coefficient is 0.9?
Correlation coefficient ^ 2 = R^2
0.9^2 = 0.81%
What is the Jensen’s measure/alpha and what does it tell us?
The Jensen’s measure/alpha is a way to see if the return we received is more or less than what we should have expected from the CAPM.
Jensen measure = Rp - Rcapm
If Jensen’s measure is positive we have outperformed and if it is below, we have underperformed
What is the information ratio?
The information ratio is a way to measure the skill of a fund manager. If it has a high value (high expected excess returns and low SD of excess returns) it shows that the fund manager is consistent in their investment returns.
The formula is:
Expected excess returns / SD of excess returns
What is the Sharpe Ratio?
The sharpe ratio is a reward to variability ratio (also the slope of the CML).
It measures the excess return above the risk free rate a portfolio achieves per unit of risk:
Sharpe = (“Mean return to the portfolio” - “Mean risk free rate”)/”Standard deviation of the portfolio”
What is the Treynor ratio?
The treynor ratio isa reward to variability ratio and is also the slope of the SML.
It is a measure of the excess return above the risk free rate a portfolio achieves per unit of systematic risk.
Treynor = (“Mean return of portfolio”-“Mean risk free rate”)/”Portfolio Beta”
What are the three main portfolio return calculations in PCIAM?
- Holding period return
- Money weighted rate of return
- Time weighted rate of return
What is the holding period of return?
The holding period of return is just a simple return calculation (what we had at the beginning compared to the end and express it as a %)
This does not account for time value of money, and is not time sensitive (return could be over days, months, or years and it would not make a difference)
What is the time weighted rate of return?
This return calculation is a geometric calculation that removes the impact of cash flows on the return calculation
Which portfolio return calculation is most often used to assess a fund manager?
The Time weighted rate of return
What is the formula for the holding period return?
HPR = (dividend (Value end - Value start))/Value start) * 100
How do we calculate the Time weighted rate of return?
We find the return for each period and multiply it with one another to get the geometric return
How do we calculate the money weighted rate of return?
(“Ending value of investment”-“Opening value”-“Further investment”)/”opening value of investment” + “”% part it has been part of the total investment time”*Further investment”)
What is a structured product?
This is a pre-packaged investment based on assets and is designed to provide highly customised risk/return period.
What is the normal term of a structured product?
They are normally fixed term wth a lock in period of commonly 5 years.
How does structured index trackers work?
It replicated the performance of the underlying indices and will pay out interest if the indices are above a predetermined level.
What is special about a reverse tracker (structure products)?
If the underlying index falls, the tracker will rise
What is special about an accelerated tracker (Structured products)?
The investor participates in a multiple of index growth
What is an capital protected tracker?
This product has a guaranteed return on the investors original investment, plus a return linked to the performance of an underlying asset
What is a structured capital at risk product( SCaRPs)
This is a fixed income product where capital is at risk. It is the same as holding short term bonds and writing equity put options.
What are the disadvantages of structured products?
Complex (questionable suitability) due to their use of derivatives
No dividend or voting rights as derivatives are used
In capped products investors will not benefit fully from a rally
If no gain is achieved, capital is returned affected by inflation
They are inflexible
Illiquid
Expensive
Lack of pricing transparency
High risk (counterparty risk, market risk, liquidity risk, gearing risk, and volatility risk, no FSCS protection.
What are the two main categories of pooled investments?
Open ended and close ended
What are teh advntages of collective investment vehicles?
Time and admin to manage portfolio
expertise to construct and monitor portfolio
exonomies of scale
diversification
more accessible investments
What are the disadvantages of collective investment vehicles?
Cost (initial charge and fund management cost)
Mismatch between SAA and fund AA
Concentration risk
Lack of control
Star managers
How are the following 4 funds prices?
1. Unit trust
2. OEIC
3. ETF
4. ITC
- Dual
- Single
- Dual
- Dual
How are the following 4 funds defined in terms of being a trust or a company?
1. Unit trust
2. OEIC
3. ETF
4. ITC
- Trust
- Company
- Company
- Company
Which of the following 4 are open ended and close ended?
1. Unit trust
2. OEIC
3. ETF
4. ITC
- Open-Ended
- Open-Ended
- Open-Ended
- Closed Ended
Which ones of the following are open ended Investment schemes?
1. Unit trust
2. OEIC
3. ETF
4. ITC
Unit Trust, OEIC, and ETF. ITC is not an open ended company
Which of the funds below are traded on the primary and secondary market?
- Unit trust
- OEIC
- ETF
- ITC
- Primary
- Primary
- Secondary
- Secondary
How are unit trusts taxed?
They pay corporation tax on certain income, but dividend income, interest income, and capital gains are not taxed.
Income, dividend, and capital gains are taxed on a personal level.
What are the structural differences between a unit trust and an open ended investment company?
Open ended investment company has a depositary instead of a trustee
It has shares instead of units
And rather than having a manager as with a unit trust we have an Authorised corporate director
How does an ETF differentiate itself from an open ended fund or an OEIC?
Since an ETF is exchange traded on the LSE, it has real time pricing which makes it cheaper and therefore trades closer to its nav. There are low charges (no initial fees/stamp duty), and it can be shorted and/or leveraged
What are the disadvantages of an ETF?
Restricted by the index
counterparty risk for synthetic ETF
currency risk
and short/leveraged risk and investor not understanding this
How much of their income does an investment trust need to distribute?
At least 85%
What is the single holding restriction of investment trusts?
To not hold more than 15% of their investment in any single company
For investment trusts, how is the fund taxed and how is the investor taxed?
The fund is taxed on taxable income at the corporate tax rate
Investors are taxed the same as a conventional share
What are the requirements for a REIT?
The property letting business needs to be ring fenced whilst other business does not.
As for the ring fenced business:
1. At least 75% of the total profits must come from this business
2. Minimum of three separate properties (mnax of 40% of fund in one company)
3. Minimum interest cover of 1.25
90% of the rental profits myst be distributed as either cash or stock dividend
If a REIT meets all of its ring fenced and property income dividend requirements, what are its tax rules?
For the property business:
Excempt from corporation tax and property dividends are paid net of 20% tax (and is further treated as non-savings income)
For non property business:
Subject to corporation tax
Dividends are treated like normal dividends
What is an innovative finance ISA?
An innovative finance ISA is an ISA where the asset is a peer-to-peer loan instead of traditional assets.
It usually goes to crowdfunding debentues
What is the maximum contribution of a lifetime ISA?
The maximum contribution is £4,000
What is the uplift on a lifeting ISA?
The uplift is 25%
£4,000 maximum contribution ends up being £5,000
What is the total maximum of a lifetime ISA?
£20,000
What is the maximum property price if one is to use their Lifetime ISA?
£450,000
From what age can a lifetime ISA be used for retirement?
Age 60
What is the age limits for starting a lifetime ISA?
18-39
What is the penalty for taking lifetime ISA funds before age if 60 not for a property?
25%
What is the subscription limit for a junior ISA?
£9,000
What are the conditions for a company to quality for the enterprise investment scheme?
Company must have total assets of less than £15m before issue and have fiewer than 250 full time employees at the time the shares are issued
What are tax incentives for an EIS?
30% income tax relief (maximum investment of £1,000,000 p.a.),
no capital gains tax on profits from disposal of shares
No restriction on use of capital losses
Shares must be held for three years
EIS deferral relief
What are the main differences between EIS and VCT?
Diversification: EIS no diversification and VCT yes
IT: EIS 30% tax relief max £1m per year, VCT 30% relief on £200k pa
CGT: EIS 100% relief on gain + utilise losses, VCT is exempt from CGT gains and cannot offset losses
deferral relief: EIS gains can be rolled into new EIS, cannot do this for VCT
IHT: EIS has 100% business relief but VCT has no IHT benefits
Holding period: To receive the benefits and EIS needs to be held for 3 years whilst a VCT needs to be held for 5 years
Why does EIS have business relief but VCT does not?
When it comes to IHT, EIS has business relief as the examiner assumes that we are invested directly in an unlisted company. As a VCT is a listed company we would not qualify for business relief.
What are the three main types of life assurance?
Term assurance
Whole of life assurance
Endowment
What are the differences between term assurance, whole of life assurance, and an endowment?
A term assurance is for a specific term, a whole of life policy has a payout of the sum assured on the death of the life assured, and an endowment is a combination of term assurane and whole of life policy
A life assurance product has loading attached to it. What does this mean?
This is a higher permium than normal due to age, occupation or health issues
What are the six types of term assurance?
Level term assurance , increasing assurance, renewable, convertible term, decreasing, family income benefit, and unit linked
What are the differences between a level term assurance and an increasing assurance?
A level term assurance has the same assurance for the whole period whilst an increasing assurance offsets the impact of future inflation
What is special about a convertible term assurance?
This allows the policy holder to convert to a whole of life or endowment contract
When would we use a convertible term assurance?
When the whole of life or endowment contract was too expensive at the get go
What are the different whole of life assurance policies?
Non profit, with profit, low cost policies and unit linked policies
When it comes to the term, what is different between an endowment and a whole of life policy?
An endowment is over a term whilst a whole of life policy is for life
What are the features needed for a life product to be qualifying?
It needs to be over 10 years or more
premiums at least annually
sum assured not less than 75% of premiums payable over the term
Premiums paiud in any one year not more than twice those paid in any other year
Premium paid in one year not more than 1/8 paid over the term
What is a SPLAB?
Single premium insurance bond
What are the different types of SPLABs?
Guaranteed income bonds, guaranteed growth bonds, offshore bonds, and capital redemption bonds
Who are capital redemption bonds polular with and why?
It is popular with companies. This is due to them having a maximum fixed term of 99 years (instead of duration of life with life assurance bonds) and they can therefore be good for protecting against directors/etc dying and insuring against this. It allows directors to come and go but the insurance to stay in place regardless
What are the tax rules on life annuties?
The return of capital element is tax free but the interest element is taxed as savings income recieved net of BRT
What is IPI insurance used for?
IPI provides income when a person is unable to work for a prolonged period due to sickness or incapacity
What are the eight bullet points we need to cover when assessing protection products in the exam?
- Suitability
- Price
- Features
- Charges
- Cancellation rights
- Tax implications
- Quality of service
- Investment choice and performance
When deferring the state pension, what is the minimum deferrment period?
nine weeks
What % increase will the state pension increase with if someone defers it for 1 year? What % will it increase with if someone defers it for its minimum deferment period?
5.8% for a year
1% for 9 weeks (minimum deferment period)
How many qualifying years is needed for the full state pension?
35 years
What is special about stakeholder pensions to make them accessible to “the masses”?
Limited charges and minimum contributions start at a low £20
Why did a lot of pension providers stop offering stakeholder pensions?
They were not commercially viable and they preferred branding their PPP as “stakeholder friendly” as the contributions were higher
What is the maximum net pension contribution per annum for a non earner?
2,880 (3600 gross *0.8)
What is the current annual allowance for pensions?
£60,000 gross
What is the minimum tapered annual allowance?
£10,000
How many years can the unused annual allowance be carried forward?
3 years.
What is the money purchase annual allowance?
The MPAA is triggered when an individual takes income from the pension. It limits the amount an individual can contribute into their pensions to £10,000
What is the maximum contribution after the MPAA has been triggered?
£10,000
For pension purposes, what is the difference between threshold income and adjusted income?
Threshold income is the total income net of member pension contributions
Adjusted income is the total income gross of all pension contributions
What is the adjusted income at which the annual pension contribution allowance will be tapered and at what value will the entire allowance be gone?
It starts tapering at £260,000 of adjusted income and at £360,000 it will end up at a minimum of £10,000. It will never go completely away
What is the threshold income at which the annual pension contribution allowance will be tapered and at what value will the entire allowance be gone?
It starts tapering at £200,000 of adjusted income and at £300,000 it will end up at a minimum of £10,000. It will never go completely away
What are the benefit crystallisation events?
Retirement
Taking a pension or lump sum
Reaching the age of 75
Death benefit being paid
How do they decide on the defined benefit value for lifetime allowance purposes?
They find the “deemed” total value of the scheme and then multiply it by 20
When an SSAS lends from the scheme to the sponsoring employer, what are the conditions that needs to be met?
No more than 50% of the scheme assets can be lent
SSAS must charge interest at a minimum rate of 1% over the average base rate
Maximum term of the loan is 5 years
