Equities/Stocks

Question 1

What are preference shares?

Answer 1

Preference shares are a hybrid security with elements of both debt and equity. Although they are technically a form of equity investment, they also have characteristics of debt, particularly that they pay a fixed income. Preference shares have legal priority (known as seniority) over ordinary shares in respect of earnings and, in the event of bankruptcy, in respect of assets. Preferred stock also tends to have credit ratings and ranks above equities in the capital structure.

Question 2

Characteristics of Preference Shares:

Answer 2

1. Are non-voting, except in certain circumstances such as when their dividends have not been paid
2. Pay a fixed dividend each year, the amount being set when they are first issued and which has to be paid before dividends on ordinary shares can be paid
3. Rank ahead of ordinary shares in terms of being paid back if the company is wound up, and
4. Can be outstanding for a limited period of time if they are convertible or redeemable.

Question 3

What is a dividend?

Answer 3

A dividend is the return that an investor gets for providing the risk capital for a business. Companies pay dividends out of their profits, which form part of their distributable reserves. These are the post-tax profits made over the life of a company, in excess of dividends paid.

Question 4

What is Dividend Yield?

Answer 4

Most recent dividend as a percentage of current share price.

Question 5

How to calculate dividend yield?

Answer 5

Dividend (in percentage)/ share price x 100

Question 6

What are Capital Gains ?

Answer 6

Capital gains can be made on shares if their prices increase over time. If an investor purchased a share for US$3, and two years later that share price has risen to US$5, then the investor has made a US$2 capital gain. If they do not sell the share, then the gain is described as being unrealised, and they run the risk of the share price falling before they realise the share and ‘bank’ their profits.

Question 7

Shareholder Benefits

Answer 7

Some companies provide perks to shareholders, such as a telecoms company offering its shareholders a discounted price on their mobile phones or a shipping company offering cheap ferry tickets. Such benefits can be a pleasant bonus for small investors, but are not normally a big factor in investment decisions.

Question 8

Right to Subscribe for New Shares

Answer 8

Companies are typically able to issue new shares to anyone, but the consequence is dilution of control for existing shareholders. Pre-emption rights give existing shareholders in companies the right to subscribe for new shares. This means that, unless the shareholders agree to permit the company to issue shares to others, they will be given the option to subscribe for any new share offering before it is offered to the wider public, and in many cases they receive some compensation if they decide not to do so.

Question 9

Rights Issue

Answer 9

The issue of new ordinary shares to a company’s shareholders in proportion to each shareholder’s existing shareholding, usually at a price deeply discounted to that prevailing in the market.

Question 10

Right to Vote

Answer 10

Ordinary shareholders have the right to vote on matters presented to them at company meetings. This would include the right to vote on proposed dividends “and other matters, such as the appointment, or reappointment, of directors.
The votes are normally allocated on the basis of one share = one vote.
The votes are cast in one of two ways:

1. The individual shareholder can attend the company meeting and vote.
2. The individual shareholder can appoint someone else to vote on their behalf – this is commonly referred to as voting by proxy.

Question 11

Price and Market Risk

Answer 11

Price risk is the risk that share prices in general might fall. Even though the company involved might maintain dividend payments, investors could face a loss of capital. Market-wide falls in equity prices occur, unfortunately, on a fairly frequent basis.

Question 12

Liquidity Risk

Answer 12

Liquidity risk is the risk that shares may be difficult to sell at a reasonable price. This, typically, occurs in respect of shares in ‘thinly traded’ companies – smaller companies, or those that do not have much trading activity. It can also happen, to a lesser degree, when share prices in general are falling, in which case the spread between the bid price (the price at which dealers will buy shares) and the offer price (the price at which dealers will sell shares) may widen.
Shares in smaller companies tend to have a greater liquidity risk than shares in larger companies – smaller companies also tend to have a wider price spread than larger, more actively-traded companies.

Question 13

Issuer Risk

Answer 13

This is the risk that the issuer collapses and the ordinary shares become worthless.

Question 14

Foreign Exchange Risk

Answer 14

This is the risk that currency price movements will have a negative effect on the value of an investment.

Question 15

Corporate Actions

Answer 15

A corporate action occurs when a company does something that affects its share capital or its bonds.

Question 16

What are the three types of corporate actions?

Answer 16

1. A mandatory corporate action is one mandated by the company, not requiring any intervention from the shareholders or bondholders. The most obvious example of a mandatory corporate action is the payment of a dividend, since all shareholders automatically receive the dividend.
2. A mandatory corporate action with options is an action that has some sort of default option that will ccur if the shareholder does not intervene. However, until the date at which the default option occurs, the individual shareholders are given the choice to select another option. An example of a mandatory corporate action with options is a rights issue (detailed below).
3. A voluntary corporate action is an action that requires the shareholder to make a decision. An example is a takeover bid – if the company is being bid for, each individual shareholder will need to choose whether to accept the offer or not.

Question 17

Define Rights Issues

Answer 17

A rights issue can be defined as an offer of new shares to existing shareholders, pro rata to their initial holdings. Since it is an offer and the shareholders have a choice, rights issues are examples of a ‘mandatory with options’ type of corporate action.

Question 18

Open Offers

Answer 18

An open offer is made to existing shareholders and gives the holders the opportunity to subscribe for additional shares in the company, normally in proportion to their holdings. In this way it is similar to a rights issue, but the difference is that the right to buy the offered securities is not transferable and so cannot be sold.

Question 19

Bonus Issue

Answer 19

A bonus issue (also known as a scrip or capitalisation issue) is a corporate action where the company gives existing shareholders extra shares without them having to subscribe any further funds.

Question 20

Stock Splits and Reverse Stock Splits

Answer 20

A stock split involves sub-dividing or splitting each share into a number of shares. For example, a company with shares having a nominal value of US$5 each and a market price of US$10 may have a split whereby each share is divided into five shares, each with a nominal value of US$1. In theory, the market price of each new share should be US$2 (US$10 ÷ 5).
One of the main motivations for doing this is to reduce the per unit price of each share to make them more marketable. This is typically done in cases where the share price has risen significantly, thus becoming unaffordable for investors. A reverse split or consolidation is the opposite of a split: shares are combined or consolidated. For example, a company with a share price of US$0.10 may consolidate ten shares into one. The market price of each new share should then be US$1 (US$0.10 x 10). A company may do this if the share price has fallen to a low level and they wish to make their shares more marketable.

Question 21

Dividends

Answer 21

Dividends are an example of a mandatory corporate action and represent the part of a company’s profit that is passed to its shareholders.

Question 22

Cum-dividend

Answer 22

Meaning with dividend, this indicates that a company is paying out dividends in the near future.

Question 23

Ex-dividend

Answer 23

The period during which the purchase of shares or bonds (on which a dividend or coupon payment has been declared) does not entitle the new holder to this next dividend or interest payment.

Question 24

Takeovers and Mergers

Answer 24

Companies seeking to expand can grow organically or by buying other companies. In a takeover, which may be friendly or hostile, one company (the predator) seeks to acquire another company (the target).
In a successful takeover, the predator company will have acquired more than 50% of the shares of the target company. When the predator holds more than half of the shares of the target company, the predator is described as having gained control of the target company. Usually, the predator company will look to buy all of the shares in the target company, perhaps for cash, but usually using its own shares, or a mixture of cash and shares.”
A merger is a similar transaction and occurs when the two companies agree to merge their interests. However, in a merger it is usual for one company to exchange new shares for the shares of the other. As a result, the two companies effectively merge to form a bigger entity.

Question 25

Primary Market

Answer 25

The function of a stock exchange in bringing securities to the market and raising funds.

Primary markets exist to raise capital and enable surplus funds to be matched with investment opportunities.

Question 26

Secondary Market

Answer 26

Marketplace of trading in existing securities.
Secondary markets allow the primary market to function efficiently by facilitating a two-way trade in issued securities.

Question 27

Stock Exchange

Answer 27

A stock exchange is an organised marketplace for issuing and trading securities by members of that exchange. Each exchange has its own rules and regulations for companies seeking a listing, and continuing obligations for those already listed. All stock exchanges provide both a primary and a secondary market.

Question 28

What are the advantages of Listing ?

Answer 28

1. Capital – an IPO provides the possibility of raising capital and, once listed, further offers of shares are much easier to make. If the shares being offered to the public are those of the company’s original founders, then the IPO offers them an exit route and a means to convert their holdings into cash.
2. Takeovers – a listed company could use its shares as payment to acquire the shares of other companies as part of a takeover or merger.
3. Status – being a listed company should help the business in marketing itself to customers, suppliers and potential employees.
4. Employees – stock options to key staff are a way of providing incentives and retaining employees, and options to buy listed company shares that are easily sold in the market are even more attractive.

Question 29

What are the disadvantages of Listing?

Answer 29

1. Regulation – listed companies must govern themselves in a more open way than private ones and provide detailed and timely information on their financial situation and progress.
2. Takeovers – listed companies are at risk of being taken over themselves.
3. Short-termism – shareholders of listed companies tend to exert pressure on the company to reach short-term goals, rather than being more patient and looking for longer-term investment and growth.
4. Cost – in addition to the costs of listing, eg, corporate advisory, legal, accounting and listing fees, companies must meet continuing expenses associated with listing and enhanced disclosure requirements

Question 30

ADRs

Answer 30

American depositary receipts (ADRs) were introduced in 1927 and were originally designed to enable US investors to hold overseas shares without the high dealing costs and settlement delays associated with overseas equity transactions.
An ADR is dollar-denominated and issued in bearer form, with a depository bank as the registered shareholder. They confer the same shareholder rights as if the shares had been purchased directly.

Question 31

What is a Stock Exchange?

Answer 31

A stock exchange is an organised marketplace for the issuing and trading of securities by members of that exchange. Stock exchanges have been around for hundreds of years and can be found in major cities across the world.

Question 32

Quote Driven

Answer 32

1. Quote Driven trading system employ market makers to provide two way, or bid an offer, prices during the trading day in particular securities, regardless of market conditions. Market makers make a profit, or turn through this price spread.
2. Compared to electronic order-driven systems, many practitioners argue that quote-driven systems provide liquidity to the market when trading would otherwise dry up.
3. NASDAQ is an example of a quote-driven, equity trading system.

Question 33

Order-Driven

Answer 33

1. An order driven market is one that employs either an electronic order book, such as LSE’s SETS (stock exchange electronic trading service), or an auction process, such as that on the NYSE floor to match buyers with sellers.
2. In both cases, buyers and sellers are matched in strict chronological order by price and the quantity if shares being traded, and do not require market makers.
3. In order-driven systems, stock exchange member firms (investment banks and brokers) input orders via computer terminals. These orders may be for the member firms themselves, or for their clients.
4. Very simply, the way the system operates is that these orders will be added to the buy queue or the sell queue, or executed immediately. Investors who add their order to the relevant queue are prepared to hold out for the price they want.
5. Those seeking immediate execution will trade against the queue of buyers (if they are selling) or against the sellers’ queue (if they are buying).

Question 34

What are the main uses of market indices?

Answer 34

1. To act as a market barometer. Most equity indices provide a comprehensive record of historic price movements, thereby facilitating the assessment of trends. Plotted graphically, these price movements may be of particular interest to technical analysts and momentum investors by assisting in identifying the right point to buy or sell securities, an approach referred to as ‘market timing’.
2. To assist in performance measurement. Most equity indices can be used as performance benchmarks against which portfolio performance can be judged.
3. To act as the basis for index tracker funds, exchange-traded funds (ETFs), index derivatives and other index-related products.
4. To support portfolio management research and asset allocation decisions.

Question 35

Holding shares in registered form

Answer 35

Holding shares in registered form involves the investor’s name being recorded on the share register and, often, the investor being issued with a share certificate to reflect their ownership. However, many companies which issue registered shares now do so on a non-certificated basis.

Question 36

Holding shares in bearer form

Answer 36

As the name suggests, the person who holds, or is the ‘bearer’ of, the shares is the owner. Ownership passes by transfer of the share certificate to the new owner. This adds a degree of risk to holding shares in that loss of the certificate might result in loss of the person’s investment. As a result, holding bearer shares is relatively rare, especially in the UK. In addition, bearer shares are regarded unfavourably by the regulatory authorities owing to the opportunities they offer for money laundering. Consequently, they are usually immobilised in depositories such as Euroclear, or by their local country registries.

Question 37

What is clearing?

Answer 37

Clearing is the process through which the obligations held by buyer and seller to a trade are defined and legally formalised. In simple terms, this procedure establishes what each of the counterparties expects to receive when the trade is settled. It also defines the obligations each must fulfil, in terms of delivering securities or funds, for the trade to settle successfully.

Question 38

The clearing process includes:

Answer 38

1. Recording key trade information so that counterparties can agree on the trade’s terms.
2. Formalising the legal obligation between counterparties.
3. Matching and confirming trade details.
4. Agreeing procedures for settling the transaction.
5. Calculating settlement obligations and sending out settlement instructions to the brokers, custodians and central securities depository (CSD).
6. Managing margin and making margin calls. (Margin relates to collateral paid to the clearing agent by counterparties to guarantee their positions against default up to settlement.)

Question 39

What is Novation?

Answer 39

The alternative is to clear trades using a central counterparty (CCP). A CCP interposes itself between the counterparties to a trade, becoming the buyer to every seller and the seller to every buyer. As a result, the buyer and seller interact with the CCP and remain anonymous to one another. This process is known as ‘novation’.

Question 40

What is settlement?

Answer 40

Settlement is the final phase of the trading process, and the generally accepted method is delivery versus payment (DvP), which requires the simultaneous exchange of stock and cash.

Question 41

What are the features of a cumulative preference share?

Answer 41

Cumulative preference shares pay a fixed rate of return. If the company does not earn sufficient profits in one year to pay the dividend on the shares, then this rolls over into the following year and assuming the company makes sufficient profits then the arrears are paid.

Question 42

When a shareholder appoints someone to vote on their behalf at a company meeting, what is it referred to as?

Answer 42

A shareholder is entitled to attend and vote at company meetings or can appoint someone to do so in their place. That person is known as a proxy and the process is known as proxy voting.

Question 43

What options are available to an investor in a rights issue?

Answer 43

An investor can choose to take up the rights issue by paying the required amount in return for the new shares. Alternatively, they may choose to sell all of the rights or see part to take up the balance. If they take no action, then the rights lapse which usually involves the company selling the rights and distributing any proceeds.

Question 44

Under what type of corporate action would an investor receive additional shares without making any payment?

Answer 44

A bonus issue is a type of corporate action where the investor receives further shares without making any payments. An alternative is a Stock split.

Question 45

What is the key characteristic of an order-driven trading system?

Answer 45

The key characteristic of an order-driven system is that the system automatically matches buyers and sellers.

Question 46

What is the function of a stock market index?

Answer 46

The primary function of a stock market index is to provide an indication of how the market is performing. They have other uses as well such as allowing investment performances to be compared or providing the base for products such as exchange traded funds (EFTs).

Question 47

The CAC 40 index relates to which markets?

Answer 47

French market

Question 48

What is the meaning of DvP?

Answer 48

DvP stands for delivery versus payment and is the standard method used to settle stock market trades.