IAD Level 2 - Mock 6

Question 1

Consider the following information about four funds:
Fund A: return = 17.68%; volatility = 8.65%; sharpe measure = 0.48
Fund B: return = 16.58%; volatility = 5.55%; sharpe measure = 0.51
Fund C: return = 14.81%; volatility = 10.10%; sharpe measure = 0.47
Fund D: return = 17.15%; volatility = 7.77%; sharpe measure = 0.53

Which fund has the highest risk-adjusted return?
A. Fund A
B. Fund B
C. Fund C
D. Fund D

Answer 1

D. Fund D.

The Sharpe measure is a measure of risk-adjusted return. The higher the value, the better the risk-adjusted return.
The other data is not relevant to the question.

Question 2

Which of the following is likely to worsen the UK’s balance of trade deficit?
I. A rise in interest rates
II. An increase in capital investment in the UK from foreign investors
III. A fall in the value of the pound

A. I and II
B. I only
C. II only
D. I, II and III

Answer 2

A. I and II.

An increase in interest rates may lead to increases in foreign investment in the UK which increases the demand for sterling, increasing the value of sterling, making UK exports more expensive for foreign buyers, reducing UK exports and worsening the UK balance of trade.
An increase in capital investment in the UK has the same effect, causing an increased demand for sterling, etc.
A fall in the value of the pound has the opposite effect. UK exports become relatively cheaper and so exports increase, so reducing the balance of trade deficit.

Question 3

A client is looking for access to the widest choice of assets and providers. Which of the following is most appropriate?

A. Wrap
B. Tied agent
C. Multi-tied agent
D. High-street bank

Answer 3

A. Wrap.

The wrap gives much more flexibility. The others are restricted in one way or another.

Question 4

A long-standing client is a non-UK resident, UK domiciled individual. Which of the following would be true of his investments held in the UK?

A. Liable to income tax and capital gains tax
B. Not liable to any UK tax
C. Liable to UK income tax only
D. Liable to UK capital gains tax only

Answer 4

C. Liable to UK income tax only.

Only UK residents pay capital gains tax in the UK.

Question 5

John, a higher rate taxpayer, has investments in two funds. The related income from these funds is given below:
A HMRC reporting fund: Americas’ balanced equity fund, dividend = £780.
A UK based fund: Ajax OEIC, debt focus, dividend = £140.

What is the tax that John has to pay on this income? Assume that all allowances have already been used.
A. £230
B. £281.50
C. £319.25
D. £299

Answer 5

C. £319.25.

A mutual fund that invests in debt would have its dividends treated as interest for purposes of tax. This would be the case with the Ajax OEIC.
For the Americas’ fund, we will calculate tax on its income as equity the actual distributions from such a reporting fund are paid gross, therefore the UK investor will have to declare both the actual distributions received plus their reportable income in excess of the sums distributed, the full tax rate will apply.
Americas’ fund dividend tax: £780 x 33.75% = £263.25
Ajax OEIC dividend tax = £140 x 40% = £56
Total tax = £319.25

Question 6

Tim invests £5,000 in an ISA account paying 5% pa interest, which is applied quarterly. How much will the deposit be worth after two years?

A. £5,522.43
B. £5,534.56
C. £5,540.00
D. £5,541.34

Answer 6

A. £5,522.43.

This is a non-annual compounding question.
First, we need to adjust the interest rate and the compounding period for quarterly payments:
5% / 4 = 1.25%.
Two years x 4 = 8 periods.
The formula to calculate the ‘terminal amount’ is:
PV x (1 + r)^n = TV. 5,000 x 1.0125^8 = £5,522.43.

Question 7

David earns £54,000 per year and his wife, Lisa, works part-time in a body repair workshop earning £18,500. The couple have recently inherited a windfall of £80,000 cash.
Assuming that David has made the maximum pension fund contributions in previous years, which of the following is the maximum percentage of this windfall that David could put into his personal pension, gaining full tax advantage?

A. 100%
B. 63%
C. 50%
D. 40%

Answer 7

D. 40%.

The maximum that David will receive as tax relief is 100% of annual earnings up to a maximum gross contribution of £40,000. 20% of this will be tax relief so David’s contribution will be £40,000 x 0.8 = £32,000. This is 40% of the windfall.

Further explanation:

Tax payers can get tax relief on up to £40,000 of pension contributions. This is a gross (pre-tax) figure.

If someone puts money into a personal pension from net (taxed) money, they will receive 20% tax rebate direct into their pension from HMRC. E.g. if they put in 8,000 net, HMRC will top it up to 10,000 (i.e. they have added back the 20% tax).

HMRC will always add basic rate regardless of your tax band. If you are a higher rate taxpayer, you need to claim the rest directly from HMRC.

Question 8

An investor buys 2,000 shares for a total consideration of £9,000. The issuing company then does a 1:10 rights issue at a subscription price of £5. The investor takes up all of his allotted shares. Sometime later he sells his shares for £5.30 each, incurring a sales fee of £13.75.

Using only the information given, calculate the investor’s profit on this investment.
A. £1,586.75
B. £1,646.25
C. £1,746.75
D. £1,750.00

Answer 8

B. £1,646.25.

The original shares were bought for £4.50 each (£9000 / 2000 shares). In the 1:10 rights issue he bought 200 new shares at £5 each. A further investment of £1,000. The total investment is £10,000.
Proceeds from the sale are £5.30 x 2200 shares (less costs) = £11,660 - 13.75 = 11,646.25.
Profit = 11,646.25 - 10,000 = 1,646.25.

Question 9

An annuity pays £150 per year in arrears for 7 years. What is the present value of this annuity assuming a discount rate of 6%?

A. £807.23
B. £817.52
C. £837.36
D. £887.60

Answer 9

£837.36

Use the annuity formula to solve:
PV = PMT x 1/r x (1 - 1/(1+r)^n)
…where PV is the answer we seek, PMT is the payment received, r = 6% and n = 7 years.
PV = £150 x 1/0.06 x (1 - 1/(1.06)^7)
PV = £837.36

Question 10

The main principles of arbitrage pricing theory are:

A. Use of R squared, Alpha and Beta to predict portfolio returns
B. Use of regression, risk premiums and Beta factors to estimate return
C. Use of stochastic modelling using historic information to generate potential returns
D. Using a deterministic approach to stock selection in order to generate excess returns within a portfolio

Answer 10

B. Use of regression, risk premiums and Beta factors to estimate return.

APT is a more recent theory than CAPM which adopts a more complex multi-factor approach than relying on a single Beta.

Question 11

Which of the following is NOT true of technical and fundamental anaysis?

A. Fundamental analysis uses real data
B. Technical analysis aims to produce a value that can be compared with a market value
C. Unlike fundamental analysis, technical analysis is not concerned whether a stock is undervalued
D. Technical analysis uses statistical data generated by the market such as historic prices and volumes

Answer 11

B. FUNDAMENTAL analysis aims to produce a value that can be compared with a market value.

Question 12

Consider the following scenarios:
Martin is accused of being in breach of contract.
Sand Ltd wishes to borrow money to fund a new venture.
Godfrey wishes to buy a car on credit.

Which of the following would NOT be true?
A. Martin would be considered in breach of contract even if he was drunk when the breach occurred
B. Sand Ltd would only be allowed to borrow if it is permitted to do so in their constitution
C. Godfrey would be permitted to buy a car on credit if he was registered bankrupt
D. Only Sand Ltd is considered a legal person in contract law

Answer 12

D. All three are legal persons.

If Martin had been drunk on entering into the contract and the other party had known that this would lead to Martin being unable to understand his obligations, then the contract would be void. However, breach of contract when drunk does not void the contract.
Bankruptcy does not prevent someone getting credit, although the credit may be difficult to find.

Question 13

Consider the three following property transactions:
Andy purchases a buy-to-let residential property, then leases it out.
Martin leases a residential property.
Sarah leases a commercial property.

Which of the following is true?
A. Andy and Martin only will be responsible for the upkeep of their property
B. Martin will be more exposed to void periods than Sarah
C. Sarah will typically have a longer lease than Martin
D. Andy and Sarah will not need to pay for maintenance of the property

Answer 13

C. Sarah will typically have a longer lease than Martin.

Commercial leases are typically longer than those on residential property.
The lessor of residential property (Andy) and the lessee of commercial property (Sarah) are typically responsible for the upkeep (maintenance) of the property, so Martin is not responsible for upkeep as the lessee of the residential property.
Andy is the only one generating income on the property, so is the only one exposed to void periods.

Question 14

Your client, an inexperienced investor, makes regular monthly payments of £200 per month into an investment vehicle for six months. The vehicle then publishes a return for the last 12 months of 8%. During this period the market returned 6%. Your client has made a return of 10% on his investment so far. Your client, impressed with his return, now wants to increase his monthly contributions to £400, funding half from income and half from borrowing at 3%.

What would you advise?
A. Recommend the strategy. The investor’s return is higher than the market by 4%, which exceeds the borrowing.
B. Recommend the strategy. Using leverage to enhance returns is a good strategy.
C. Recommend against the strategy. Borrowing to invest is an intrinsically risky strategy.
D. Recommend against the strategy. The investor has been lucky with his timing and the long-term trend may be less favourable.

Answer 14

D. Recommend against the strategy. The investor has been lucky with his timing and the long-term trend may be less favourable.

Your client’s return over the six months did not reflect the annual return of the vehicle, and, as an inexperienced investor, caution should be advised.

Question 15

Martin places a sum of money on deposit in a 30-day notice account offering 4.5% pa. Interest on the notice account accrues monthly.
Fiona places a sum of money on deposit in a three-month fixed-term account offering 4.4% pa. Interest on the term account accrues daily.
Assume 365 days in a year.

Assuming both Martin and Fiona hold their money on account for a full three months, and both withdraw their funds according to the conditions of the account (incurring no penalties), which of the following is true?

A. Taking into consideration compounding, Fiona will have received a better return on her money than Martin
B. At inception, Martin benefited from a greater flexibility regarding access to his money without penalty
C. If the rate of inflation during the period was an annualised 3.5%, neither made a real return on their deposit
D. The longer Fiona held the money in her account, the less liquid her account would be

Answer 15

B. At inception, Martin benefited from a greater flexibility regarding access to his money without penalty.

Martin only needs to give 30 days’ notice. Fiona needs to wait until the maturity of the account in three months. However, the longer Fiona holds the money in the account, the closer the maturity date and the more liquid the account becomes.
Even taking compounding into consideration, Martin gets a better rate of return than Fiona.
Martin gets 4.5% pa. To calculate the annual effective rate (AER), we would do as follows:
4.5 / 12 = 0.375
This is the period rate for Martin.
Martin’s AER is:
(1.00375^12) - 1 = 4.59% AER
Fiona gets 4.4% pa. To calculate the AER, we do as follows:
4.4 / 365 = 0.01205
This is the period rate for Fiona.
Fiona’s AER is:
(1.0001205^365) - 1 = 4.5% AER
Clearly given these rates of return, both make a real return: i.e. one that beats the inflation rate.

Question 16

Hilary invests in a ten-year life company bond. She contributes £200,000 in the first year, £40,000 in second year and £60,000 in third year.
During these contribution years she makes no withdrawals for the fund. How much can she withdraw at the end of year 3 without triggering an immediate tax charge?

A. £15,000
B. £30,000
C. £37,000
D. £45,000

Answer 16

C. £37,000.

The allowance on life company bonds is for 5% of the accumulated premiums and these can roll on for the time they have been invested. The amount rolled on is as follows:
Year 1: £200,000 x 5% = £10,000
Year 2: £200,000 x 5% + £40,000 x 5% = £12,000
Year 3: £200,000 x 5% + £40,000 x 5% + £60,000 x 5% = £15,000
The total Hilary would be able to withdraw at the end of year three without an immediate tax charge is
£10,000 + £12,000 + £15,000 = £37,000.
Tax is deferred to a chargeable event.

Question 17

A fund manager’s portfolio has a Beta of -0.5. What does this indicate?

A. It will mimic the market movements
B. It has less volatility than the market
C. It will give lower than market returns
D. It will give better than market returns

Answer 17

B. It has less volatility than the market.

A Beta of less than 1 shows a portfolio that is less volatile than the market.
With a Beta of -0.5, the portfolio will give a lower return in a rising market, but a better return in a falling market.

Question 18

Ania, a basic rate taxpayer, owns £130,000 nominal value of 3.25% coupon gilts. If this is the only interest income generated which of the following is true?

A. The gilts will pay the coupon net of 20% tax but there will be no further tax liability on the income
B. The gilts will pay the coupon net of 20% tax and there will be a further tax liability on the income of 20%
C. The gilts will pay coupon gross and there will be a tax liability on the income of 20%
D. The gilts will pay coupon gross and there will be no tax liability on the income

Answer 18

C. The gilts will pay coupon gross and there will be a tax liability on the income of 20%.

The gilts will pay interest gross and there will be a tax liability on the income.
This is because the coupon paid (£130,000 x 3.25% = £4,225) is above the personal savings allowance of £1,000 for basic rate taxpayers.

Question 19

A portfolio is valued at £50,250 at the beginning of June and grows in value to £53,800 by 15 June.
A further cash inflow of £2,250 is then received into the fund on 15 June.
At 30 June, the fund had increased to £58,100.

What is the time-weighted rate of return?
A. 15.62%
B. 13.28%
C. 11.72%
D. 10.98%

Answer 19

D. 10.98%.

Period 1 return (1 June to 15 June). £53,800 / £50,250 = 1.0706: i.e. 7.06%.
Period 2 return (15 June to 30 June). £58,100 / £56,050 = 1.0366: i.e. 3.66%.
Overall time-weighted return = 1.0706 x 1.0366 = 1.1098: i.e. 10.98%.

The investment has grown compounded, so the values are multiplied.

Question 20

Your client is interested in IHT planning including the use of trusts. As part of your discussions you talk through a range of allowances and exemptions.

Which of the following is/are INCORRECT?
I. There is no pre-owned assets tax (POAT) on the first £5,000 pa
II. There is a rate applicable to trustees (RAT) on the first £1,000 pa
III. Trusts usually receive a CGT allowance of £12,300

A. I and III
B. II and III
C. II only
D. III only

Answer 20

D. III only.

Although assets that generate less than £5,000 p.a benefit are exempt from POAT, those assets that generate more than £5,000 p.a are subject to POAT on the total income (including the first £5,000).
The RAT exemption is £1,000 pa.
The CGT exemption for trusts is normally half the allowance for individuals.

Question 21

Consider the following commercial property investments:
Property A: Cost of property = £330,000 Gross rent per year = £23,100 Agent fees per year = £1,900 Net operation income = £17,300
Property B: Cost of property = £425,000 Gross rent per year = £34,100 Agent fees per year = £2,800 Net operation income = £24,500

What is difference between the cap rates of the two properties?
A. 1.23
B. 1.02
C. 0.94
D. 0.52

Answer 21

D. 0.52.

Cap rate = NOI / cost of property.
Cap rate for property A = £17,300 / £330,000 = 5.24%.
Cap rate for property B = £24,500 / £425,000 = 5.76%. The difference is 0.52%.

Question 22

Bob pays national insurance contributions class 2 and Mary does not. Which of the following could explain this?

A. Mary is self employed; Bob is not
B. Mary generates £5,000 of income; Bob generates £8,000
C. Mary is a basic rate taxpayer; Bob is higher rate
D. Bob has not chosen to make voluntary contributions

Answer 22

B. Mary generates £5,000 of income; Bob generates £8,000.

NIC class 2 is paid by the self-employed, currently £2.85 per week. However, it is only compulsory for those who generate above £6,025 pa. If earnings are less than that, a certificate of small earnings can be applied for and an exemption to payment claimed.

Question 23

A put option on ABC share has a strike of 90 and a premium of 5. Assuming an underlying price of 89, which of the following is correct?

Statement one: the option is in-the-money.
Statement two: the option has a time value of 4.
Statement three: the option has no intrinsic value.

A. Statements one and two
B. Statements two and three
C. Statements one and three
D. Statement one only

Answer 23

A. Statements one and two.

The put option has a strike of 90 and a premium of 5.
When the underlying falls below 90, it is in-the-money, but only breaks even when the price falls to 85.
At a price of 89 it has an intrinsic value of 1 and a time value of 4.
Premium = intrinsic value + time value
So if the premium is 5 and the intrinsic value is 1, the time value must be 4.

Question 24

You are giving advice on four structured products. Assuming all other elements are identical, which of the following characteristics would you suggest to your client has the MOST risk?

A. Many counterparties, where the product is fully collateralised with high quality debt
B. A single counterparty, where the product is collateralised with sovereign debt
C. Many counterparties, where the product is collateralised with AA rated debt
D. Many counterparties, where the product is collateralised with BB rated debt

Answer 24

B. A single counterparty, where the product is collateralised with sovereign debt.

The returns offered by structured products are only as good as the credit quality of the issuer. Even if the cash flows and the principal come from stable investments, the products themselves are legally considered to be the issuer’s liability. The more this counterparty risk is concentrated on single institutions the more risk there is.

Question 25

Which of the following is/are true of REITs?
I. No single shareholder may hold 5% or more of the voting rights
II. Investors in REITs do not pay dividend income tax on any dividends
III. REITs must distribute exactly 90% of their profits

A. I, II and III
B. I and III
C. II and III
D. II only

Answer 25

D. II only.

REITs must distribute a minimum of 90% of their profits. They could distribute more than 90% if they wish.
No single shareholder is allowed to hold more than 10% of the voting rights.
REITs were introduced into the UK in 2007.

Question 26

A client, Daniel Murphy, has purchased a buy-to-let residential property for £180,000.
The costs associated with the purchase were £3,200.
Monthly rent will be £850 and he expects ongoing expenses to be 15% of rental income per year.
The estimate is that there will be 10% void periods.

Calculate the annual rental yield for Daniel.
A. 4.34%
B. 4.26%
C. 5.01%
D. 5.1%

Answer 26

B. 4.26%.

Cost of property including buying cost = 183200.
Gross annual rent = 850 x 12 = 10200.
Less void period = 0.9 x 10200 = 9180.
Less expenses = 0.85 x 9180 = 7803.
Yield = 7803/183200 = 4.26%.

Question 27

An experienced high net worth investor purchases £125,000 of nominal value of a corporate bond issue with Energy Exploration plc, an ‘A’ rated company. The market price paid by the investor for this holding is £143,500.
Energy Exploration has agreed an 8.25% semi-annual coupon for this unsecured loan stock. The investor compares the expected flat-yield with the gross redemption yield before investing.

Which of the following is/are CORRECT?
I. The first coupon payment will be £5,898.75
II. The GRY for the bond will be lower than the flat-yield

A. I only
B. II only
C. Both
D. Neither

Answer 27

B. II only.

Annual coupon payment = coupon % x nominal value.
Annual coupon payment = £125,000 x 8.25%.
Annual coupon payment = £10,312.50.
Semi-annual coupon = £10,312.50 / 2 = £5,156.25.
GRY vs. flat-yield.
Bonds that are bought above par will incur a capital loss if held to redemption. This has the effect of the GRY being lower than the flat yield.
Bonds that are bought below par will provide a capital gain if held to redemption. This has the opposite effect of the GRY being higher than the flat yield.