Investments Topic 5 - Derivatives and Alternative Investments

Question 1

what are Derivatives

Answer 1

investment instruments that derive their value based on an underlying asset such as shares or commodities. This is so you can have exposure to the price fluctuations of the asset without the risk to capital

Question 2

Main types of derivative

Answer 2

• Options
• Futures
• Warrants
• Contracts for difference

Question 3

1. Hard commodities
2. Soft commodities

Answer 3

1. mined or dug up - gold, iron, silver etc. Traded on London Metal Exchange
2. grown or harvested - salt, sugar, coffee etc. Traded on London International Financial Futures and Options Exchange (LIFFE)

Question 4

Options

Answer 4

Provides the holder the right to buy/sell shares at a fixed price within a certain time period – known as the expiry date.

Question 5

Call option

Answer 5

gives the holder the right to BUY at a fixed price; known as the strike price

Question 6

Put option

Answer 6

gives the holder the right to SELL at a fixed price; known as the strike price

Question 7

2 styles of option

Answer 7

• European – only allows holder to exercise the option to buy or sell on expiry date
• American – allows holder to exercise any time before the expiry date

Question 8

Hedging is

Answer 8

a form of protection that can be done on the investors own back. If they already hold shares and they expect them to go down, then you can get a put option on the shares. If they go down, then they are in the money from the price movement. If the share doesn’t decrease in value, then you will lose the premiums but more than likely benefit from the increase in share prices.

Question 9

Shorting

Answer 9

when a fund manager uses put options to profit from a share’s falling prices

Question 10

Futures

Answer 10

Similar in principle to options, but instead both parties MUST exercise their rights on a specified date. Can be bought and sold on the futures exchange.

Question 11

Most holders of futures ‘close out’ before the expiry date, which means they wipe out their obligation to deliver or take delivery of the assets. This can be achieved by

Answer 11

• Selling the contract on for its current market value
• Agreeing with the other to cancel the future and pay the other party a cash settlement equal to the value of the trade

Question 12

In Futures, Both parties must put down a margin deposit which is

Answer 12

a small percentage of the contract which shows that they are able to fulfil their side of the bargain. This must be left with their broker or bank.

Question 13

Corporate warrants

Answer 13

• Issued by companies and investment trusts
• Gives holder of current shares the right to buy more shares at a specified date at a specific ratio (1 share for every 3 shares)
• Holding period longer than options – several years
• When the holder exercises the right, more shares are issued – diluting value of shares
• Can be bought and sold on the stock exchange until exercise date
• Stamp duty reserve tax at 0.5% and disposal means CGT liability

Question 14

Covered warrants Can only be issued by financial institutions and provide a range of underlying assets such as:

Answer 14

• Individual shares
• Baskets of shares
• Stock indices (FTSE 100)
• Sectors of the stock market or currencies

Question 15

Covered warrants are Sold on the

Answer 15

London stock exchange

Question 16

The conversion ratio (also called parity) is how many warrants are required

Answer 16

to cover 1 unit of the underlying asset.

Question 17

Generating profits from warrants can be done by:

Answer 17

• Exercising the warrant at expiry date if the share price is high enough
• Selling the warrant in the market before the expiry date (closing out)

Question 18

The price of a warrant before expiry is sensitive to a number of factors:

Answer 18

• Changes in asset value
• Volatility – increase in market volatility increases warrant’s value
• Time to expiry
• Dividend yields
• Interest rates

Question 19

Contract for differences (CFDs)

Answer 19

An agreement between 2 parties to settle the difference between the opening and closing prices of a share on the contract closing.
* The contracts have no expiry date
* Holder of the CFD is subject to interest charge every night
* Charge is linked to Libor rates and based on number of shares multiplied by the closing price

Question 20

Long trade in CFDs

Answer 20

allows individual to buy shares at a fixed price in the future (call) and if a dividend is paid, the holder of the CFD will get part of the payment

Question 21

Short trade in CFDs

Answer 21

allows individual to sell shares at fixed price (put) if dividend is paid, they will be liable to the provider.

Question 22

Main differences between trading CFDs and shares:

Answer 22

• Investor trades on the margin – trades for a fraction of the price
• Allows investors to make a profit in a falling market

Question 23

Private equity is

Answer 23

a medium to long-term investment that is essentially what they do on dragons den – small companies require an injection of cash and in return they will give you shares of the company.

Question 24

Private equity investors can crystallise gains by:
(Dragon’s Den)

Answer 24

• Selling shares back to the company’s management
• Sell holding to another investor
• Sell holding to another company
• If the company achieves stock market listing, sell holding on the market

Question 25

Hedge funds are

Answer 25

privately owned companies who are generally much bigger than the standard retail investor, and retail investors cannot get access to these.They are kept relatively secret and there is no publication on what is traded, number etc. and the term hedge fund has no common definition.

Question 26

Hedge funds typically use the principle of absolute returns which is where

Answer 26

the manager does not hold bonds, shares etc. for a long period, but instead aims to make profits over the long term but in every market scenario while maintaining low levels of volatility.

Question 27

Hedge fund managers will typically use... to build up exposure to assets that they could typically not afford

Answer 27

Derivatives

Question 28

Hedge fund investment strategies include the following

Answer 28

* Using long and short equity plays – buying shares/derivatives of assets they feel have potential, but also using long and short trading to cover themselves * Relative value – comparing assets and their prices to get a fair price, this can find the best value product where you can take the long position, and use the short position on any expensive assets to hedge effectively * Opportunity – looking for profitable events by following news and world stories * Trading strategies – using knowledge to take a position on future movements of stock, commodity etc.

Question 29

Buying gold comes in 2 forms

Answer 29

Bars and coins

Question 30

Investing in gold is almost pointless for the retail investor due to

Answer 30

the amounts and availability and is best to do so through a commodity unit or OEIC. Gold has no correlation to equities whatsoever and is relatively stable and safe.