Chapter 9: Investment Management Flashcards
Types of risk pt1
- Market/systematic risk = a whole mkt or part of it will rise or fall in certain conditions
- Inaltion risk
- Interest rate risk
- Reinvestment risk = investor cannot invest maturing assets at the same rate as before due to price rises
- Exchange rate risk
- Political/legal risk = changes in law/governance restrict investment
- Regulatory risk = change in regulations restriciting operations
- Default risk
- Liquidity risk = not being able to sell quickly or get the desired price for an investment due to illiquidity.
Quantifying risks
Can provide:
* Forward looking forecasts = predict the liklihood of risks occuring and their impact on the business financially.
* backward looking = looks at previous events and losses and their frequency
Equities risk profile
Considered risky compared to bonds, money mkt instruments. With added risk increases return
Equity risk premium = total return over a period - risk free rate in the same period
Equity total return in 2023= 10% and rfr = 4%, equity risk premium=6%
Money mkts risk profile
Short term, low risk, deliver fixed income but have limited scope for capital growth. High liquidity.
Prices become erratic in times of financial crisis.
Debt instruments risk profile
Attractive to investors due to fixed income provided to investors in a coupon.
exposed to
* interest rate risk
* Default/credit risk.
Overseas equities and bonds risk exposures
- Currency risk - exchange rates might change causing gains/losses on investments that have been bought in a foreign currency to the home currency of the investor
- country risk - risk of political/legal change in the foreign country of investment
Types of investment risk
- Market/systematic risk
- Specific risk = a factor that alters the price of a specific instrument e.g. apple stock after announcing poor earning
- Interest rate risk
- Inflation risk - errodes value of cash/reduces pruchasing power
Diversification and laddering
Diversification by asset: Holding assets that yeild uncorrlated returns. for example cash, bonds, equities and ETFs, derivatives, real estate etc.
Diversification by maturity: aka ‘laddering’ - holding fixed income securities with varying maturity dates. Reduces reinvestment and interest rate risk as the maturity will be spread across a number of different time periods.
Hedging
Buying or selling instruments (usually derivatives) to reduce exposure to mkt fluctuations by taking the opposite position to the position in the portfolio (buy a short when a long is in the portfolio).
Examples are futures, forwards, puts, calls.
Hedging with futures
Futures are cheaper and more efficient than other hedging options and also provide less portfolio disruption.
However the shortfalls are:
* Futures might not be able to immitate the exact risk characteristics of the portfolio position effecitively - e.g. some mkts don’t sell futures or using FTSE to hedge for emerging mkts ETFs doesn’t work.
* Hard to know when to enter/exit the hedge position.
* Operational and regulatory considerations of using futures
Hedging with options - define wasting asset
Purchase put options on long positions which give the right to sell the position at a predefined price if the price falls. This also allows for the investor to benefit from upside gains.
The price of the options contract will increase as the underlying asset price falls
Purchasing put options is an additional expense to fund managers as options charge a premium to buy the contract. This premium is called a ‘wasting asset’. If the fund manager wants to continue to protect the portfolio, they will roll the option onwhich will add further cost.
Despite the additional cost of buying options, the benefit on keeping the overall return of the portfolio positive is preferred. The options premiums are charged against the cash portfolio.
There are additional regulatory considerations with options.
Hedging with contracts for difference (CFDs)
They do not grant ownership of the underlying asset to the CFD holder. The CFD will track the price of the underlying asset so the holder benefits from gains or losses but does not own the underlying asset
CFDs are derivative contracts.
The investor can use leverage to buy these positions as they are margin traded so they can be bought for a fraction of the underlying value.
CFDs provide gains for the investor if the price falls similar to an option and retain a cash position. CFDs are very flexible instruments.
CFD commission charges
CFDs charge comission for each purchase as well as a % of the profit spread and a funding/financing charge. They are subject to a daily financing charge which is usually linked to an index like SOFA.
CFDs are subject to a commission fee on equities that is based on a set % of the size of each trade.
CFD buyers are required to maintain a margin instead of collateral. If the position is leveraged the margins/margin calls can be far greater in times of downturn.
2 types of CFD margin
- Initial = normally between 5-30% of the contract price for stocks and 1% for indicies and FX.
- Variation or maintenance margin = CFD is marked to market and if the position has moved adversely and the initial margin has already been used up the variation margin will be rquested. this is an additional margin.
Company liquidations - capital seniority and liquidation ranking+preference
Liquidation ranking = priority order that the different tiers of owners in teh capital strcuture recieve capital in the event of liquidation
- Debt ranks over equity and there are sub seniorities of debt
- After debt is paid pref shares are paid next - recieveing par value of their shares before any capital is given to ordinary shareholders.
Liquidation preference = amount that needs to be paid to pref shareholders before ordianry shareholders. Expressed as a multiple of the orignal price of the pref shares = 2X liquidity pref on $3 shares means the pref holder will get $6
Debt Seniority
- Senior - first dibs on capital from liquidation
- Subordinated - rank below senior but yields a higher interest for the higher risk
- Mezzanine and payment in kind - more risk than subordinated so offers greater interest. Can be raised in a multitude of ways:
1. Payment in Kind (PIK) notes - have a quoted coupon but the coupon is only paid once the bond matures so the coupon is rolled over for the duration of the bond.
2. Can have convertability clause to give the mex debt holder the right to convert the bond into shares to avoid the firm from paying sucha high IR
Pension funds
- Approved by tax authorities and can accumilate income without capital gains tax.
Divided into 2 mian buckets
* Defined benefit scheme - pays you based on how long you’ve been at the firm and the salary you were on.
* Final salary - pays you your final salary at that firm every year until you kick the bucket.
Life assurance businesses - 4 types
Main types of life assurance business are:
1. Term assurance policies - pay out if the person dies before the end of the set policy in return for a fixed premium.
2. Whole of life policy - pay out of death (regardless of when) in return for a regular premium
3. endowment policy - Term assurance but the payout is related to an underlying portfolio’s performance.
4. Single premium life assurance bonds - single premium instruments with a heavy investment focus similar to teh above.
Can focus on higher risk investments like equities due to long time horizons.
Subject to tax usually.
Usually avoid money market instruments.
General insurance funds and banks - what securities do they prioritise
Both invest in the short term, general insurance for car, home insurance etc and banks with spare cash at the end of a business day.
They both prioritise short term low risk investments in money markets and not in equities.
Regulated mutual funds
Poole investments that can be regulated (authorised) or unregulated (unauthorised). Only regulated funds can be freely marketed whereas unregulated funds can only be marketed to institutional/appropriate investors.
They provide benefits to investors with large amounts of invested capital as they lower the mgmt cost.
Hedge funds
Unregulated/unauthorised investment vehicles that invest in some spicy meatballs like derivatives that link to their strategy.
Can take short positions as well as long and can employ leverage to boost returns.
Referred to as absolute return vehicles as the aim is to provide positive returns to investors regardless of mkt conditions.
Cannot be freely marketed and have limited reporting requirements. Only available to UHNWIs or institutional clients due to high min. investments and lock up periods.
Soverign Wealth Funds - what are they and common objectives
SWFs are govt owned investment funds that are funded from balance of payments surpluses, proceeds from privatisations of once public services, fiscal surpluses and export reciepts.
High risk tolerance with focus on returns over liquidity.
Common SWF objectives:
* Protect/stabilise the budget and economy from excess volatility in revenues/exports
* Diversify from non renewable commodity exports
* Earn greater returns than on FX reserves
* Dissipate unwated liquidity from monetary authorities.
* Increase savings for future use
* Fund social and economic development
* Promote sustianable long term capital growth
Global SWF AuM as of DEC 2022 = $11.3 trillion USD
Requirements for PLCs to share price sensitive info - examples of pips and sips
Listed companies need to share any information with mkt particiapnts that might affect the share price with the public in a timely manner.
Required by the EU transparency directive and companies normally satisfy this by informing a primary information provider (PIP) (an example of a UK PIP is the LSE’s **regulatory news service (RNS) **.
PIPs receive the info and then share it out with secondary information providers (SIPs) like bloomberg, reuters, refinitv etc. This is then distributed to the public and fund managers etc.
Active management of investment portfolios
- Fund manager sets a stratergy that is designed to outperform an equivalent ETF - e.g. long short US large cap fund to make more return than S&P
- Portfolios use more intricate methods of constructing portfolios by doing research, quant analysis and trying to anticipate future macro economic trends
- Only a minority of actively managed funds ever actually outperform their benchmakred indexes