J10 Flashcards
Gaining trust requires what three skills
1) earning trust
2) giving advice effectively
3) building relationships
what is critical yield?
Rate of return needed to meet the objective, based on a given level of investment
what is stochastic modelling?
Asset allocation based on an economic model. The aim of these models is to predict probable outcomes for different investments depending on a range of assumptions
what may clients be categorised as?
1) retail client
2) professional client
3) eligible counterparty
Where a firm proposes to manage investments for a retail client, what info must it provide?
1) method and frequency of valuation of the investments
2) details of any delegation of discretionary management
3) specification of any benchmark against which the portfolio will be compared
4) types of investments that might be included and types of transaction that may be carried out
5) clients investment objectives
what must benchmarks be?
Meaningful and provide appropriate indication to the client of what performance could have been achieved based on their objectives and types of investment in their portfolio
What is a black swan event?
It is a rare event with severe consequences, used to describe any event that is unexpected, difficult to predict and has severe negative effects
three elements of risk assessment
1) risk tolerance
2) risk perception
3) risk capacity
what is risk tolerance?
degree of uncertainty that an investor can handle in regard to a negative change in the value of their portfolio
what is risk perception?
subjective view that clients have on the characteristics and severity of risk
Four objectives of investing
1) capital preservation
2) capital appreciation
3) current income
4) total return
what are some investment constraints?
1) time horizon
2) liquidity
3) tax
4) any legal and regulatory factors
5) any unique needs and preferences
3 types of esg
1) positive
2) negative
3) responsible ownership
what is a net assets statement?
It is a statement of what the client owns and owes at any particular time
what are lifetime cash flow projections?
provide year by year summaries of cash paid to (and out by) the client, showing those years in which there is a surplus or deficit
AER formula
(1+r/n)n - 1
What is a tier one capital ratio?
This is the ratio that regulatory authorities use to judge the adequacy of a banks capital position
what is a credit default swap?
cost of insuring a bank against default using a CDS, which is a derivative that enables an organisation to protect itself against the risk of default by passing that exposure on to someone else
How much capital must banks maintain under basel rules?
At least 8%
Timeframe for FSCS Payout?
Within 7 days for most, more complex within 20 working days
Protection status for deposits with uk authorised banks held in an EEA Branch?
No longer protected by the FSCS, but may be protected by the depositor protection regime in each EEA country but will depend on that countries rules
what are treasury bills?
Issued by governments to finance their short-term cash needs
In the UK, this is managed by the DMO
issued at weekly auctions, with maturities of one, three or six months
what are certificates of deposit?
Receipts from banks for deposits placed with them
Deposits have fixed rate interest, usually related to a reference such as SONIA
most CDs issued with maturities of one to three months and interest is paid on maturity
what is commercial paper?
short term money market funding instrument issued by companies to fund day to day cash flows
Issued at discount to maturity, with typical maturities between 30 and 90 days
Higher risks involved so higher returns
What are short term money market funds?
invested in short term debt, and money market instruments and have a weighted average maturity of no more than 60 days and a weighted average life of no more than 120 days
Stable NAV
what are normal money market funds?
aims to make slightly higher returns than short term, invest with extended periods of 6-12 months
fluctuating NAV
what does mid market bond price mean?
mid point between the bid and offer price quoted in the markets, investor would pay higher price to purchase (offer price) and receive lower price on sale (bid price)
how are gilts classified?
shorts = up to 7 years before redemption
mediums = 7 to 15 years
longs = over 15 years
what are medium term notes?
standard corporate bonds that are usually issued as part of a programme of bond issues. They are usually defined as having maturities ranging from 9 months to 5 years
what are eurobonds?
large international bonds, denominated in a currency different from financial centre in which they are issued
Foreign bond names?
Yankee - USA
Samurai - Japan
Bulldog - UK
Matador - Spain
Conversion premium / discount for convertible bonds
market price of convertible stock / (conversion ratio x market price of ordinary shares) - 1 x 100
Interest yield formula
Coupon / clean price x 100
redemption yield
1) calculate interest yield
2) work out difference between what they paid and PAR, divide this by the number of years to redemption, then divide this figure by market price
3) + or minus this off flat yield
what causes inverted or reverse yield curves
investor expectations that interest rates will fall in the short term
What is non investment grade for moody’s, S&P and fitch?
Moody’s = BA
S&P and Fitch = BB
what is modified duration?
used to calculate how sensitive a bond is to changes in interest rates
Formula for modified duration
duration / (1+GRY)
what are offers for subscription?
special form of tender offer for sale, issuer seeks bids above minimum subscription level, but does not commit to go through with it unless minimum subscription is met
what are placing?
fastest and cheapest method of issuing new shares, often used as a supplementary method to an offer for sale
issuing company decides on price and company calls directly on big institutions and makes a sales presentation
what are open offers?
similar to a rights issue, but rights cannot be traded
what are bonus issues?
involves company issuing further shares, to its existing shareholders without raising any new funds
a bonus issue is used to make companies share capital more in line with its worth, and reduce share price to make it more marketable
company issues new shares and pays for them out of capital reserves, so shares are fully paid to shareholders,
what are share splits?
It is the process whereby a company splits the par value, for example changing £1 ordinary shares to 50p ordinary shares
Rental yield formula
annual rental income / price of property x 100
What is a derivative?
Very simply a financial instrument that is based on some other asset, known as an underlying asset
what is a future?
exchange traded contract to buy or sell an asset at a specified date for a certain price
what is an option?
gives holder the right but not the obligation to buy or sell asset at specified price
what is a swap?
agreement between two parties to exchange a series of cash flows over a period of time - most common is interest rate swap
what is the FTSE 100 index future?
based upon Ftse 100 index,
what is the FTSE 100 index future?
based upon Ftse 100 index,
what are STIR futures?
based on short term interest rates such as three month SONIA
what is a call option?
the right to buy at the exercise price if they choose
what is a put option?
the right to sell at the exercise price if they choose
when do call and put options have intrinsic value
call = if strike price is lower than current price
put = if strike price is higher than current price
what is a warrant?
A type of long term call option, holder has the right but not the obligation to buy shares at a fixed price at a predetermined rate
produce no income and represent geared investment with potentially high level of risk and reward
what is a covered warrant?
Type of option. issued by financial institutions such as banks,
the writer of the covered option, will often cover or hedge its exposure by either buying underlying stock or taking out futures or options on an exchange
They differ from traditional options because they are always cash settled - never any delivery of underlying asset and the maximum loss that an investor can make is the amount invested
Four broad categories of hedge fund strategy:
1) Long/short funds
2) Relative value funds
3) event-driven funds
4) tactical trading funds
what are long/short funds in hedge funds?
invest in equity and or bond instruments, combine long investments with short sales of individual securities and derivatives to reduce market exposure
This strategy is most popular
What are relative value funds?
often said to adopt market neutral strategies, managers rely on arbitrage to produce returns
involves identifying and exploiting pricing anomalies
what are event driven funds?
use the price movements arising from anticipated corporate events to achieve their returns
What is tactical trading hedge fund strategy?
relatively small part of the hedge fund universe. trade in currencies, bonds, equities and or commodities with largest funds having sets of dedicated teams in each area
Advantages of hedge funds
1) Diversification
2) Volatility
3) Expertise
Disadvantages of hedge funds
1) lack of regulation and protection
2) high minimum investments
3) complexity
4) volatility
what are structured products?
investment plans where the return is delivered at a defined point and is dependent on the performance of an index or asset and the terms of participation in the terms
The three types are:
1) structured deposits
2) capital protected products
3) capital at risk products
what are structured deposits?
designed to return investors original capital as a minimum at maturity
what are capital protected products?
Designed to return at least the original capital, regardless of how badly the stock market or underlying measure performs
unlike structured deposits they don’t benefit from FSCS protection if third party defaults
Rarely been on offer
What are capital at risk products?
have the potential to produce much higher returns, but will give rise to a loss at maturity if underlying investment performs poorly
typically include a barrier that protects capital until stock market falls by a certain amount e.g 35%
3 elements of the simplest capital protected products?
1) a zero coupon to provide repayment of capital at maturity
2) derivatives - options used to provide returns linked to the referenced class
3) charges - covers admin, custodian and management charges
what is an income plan structured deposits?
designed to provide stream of income payments paying monthly, quarterly or half yearly
4 ways to invest in commodities?
1) buying commodity directly
2) investing in companies that produce natural resources
3) investment through collective investment scheme or ETF
4) investment through derivatives
Advantages of commodities investment
1) spreads risk by diversifying investments
2) prices tend to not move in same direction as other asset classes
3) allows investor to include exposure to specific areas to take advantage of opportunities
4) hedge against inflation
Disadvantages of commodities
1). demand affected by business cycle
2) imbalances in supply and demand frequently occur leading to bull and bear markets
3) commodities are volatile
4) no income produced and storage costs
what are VCTS?
Quoted vehicles that aim to encourage investment in smaller unlisted UK companies, and companies listed on AIM
Pooled investments but difficult to sell due to liquidity issues
VCT Tax benefits
Dividend relief - exempt for up to £200,000
Income tax relief - 30% up to £200,000
disposal relief - capital gains made on disposal of shares in a VCT are free of CGT
EIS Tax benefits
- income tax relief at 30%
- maximum investment £2,000,000 (if £1,000,000 goes into knowledge intensive)
- CGT can be deferred by reinvesting gains
- IHT relief after 2 years
- no cgt charge on EIS Share profits
What are SEIS?
Tax advantaged venture capital scheme, similar to EIS, focused on even smaller companies than EIS
Tax treatment of SEIS?
- income tax relief up to maximum of £200,000 per year - given at rate of 50%
- cgt relief - can exempt 50% and defer other 50% of gain
- potential IHT relief after two years
what are business angels?
private investors who invest directly in private companies in return for an equity stake and perhaps seat on the companies board
4 types of ISA
1) cash
2) stocks and shares
3) innovative finance
4) lifetime ISA
LISA limit per year
4,000
7 fund sectors
1) mixed-asset funds
2) distribution funds
3) uk equity funds
4) overseas equity funds
5) fixed-interest funds
6) property funds
7) other funds
What are the two steps in asset allocation?
1) deciding the benchmark for the portfolio
2) making active investment decisions around the benchmark, often referred to as dynamic or tactical asset allocation
what data is needed to run an optimisation model?
1) returns of each asset classes
2) standard deviation of each asset class
3) correlations between each pair
issues with optimisation
1) forecasts for risk return and correlation if used may be incorrect
2) historical data for risk, return and correlation if used may be a poor indicator of the future
3) correlation in extreme market conditions is very different to normal conditions
4) transaction costs are often not incorporated
5) appropriate measure of risk is assumed to be standard deviation based on normal distributions
what is stochastic modelling?
applies mathematical technique to generate a probabilistic assessment of returns and volatility
generates thousands of outcomes based on probability
what should benchmarks be?
1) specified in advance
2) appropriate to managers investment approach and style
3) measurable so value can be calculated on a frequent basis
4) unambiguous in its construction
5) reflective of managers current investment options
what is value?
oldest style - based on premise that rigorous analysis can identify businesses whose value is greater than their market price.
what is GAARP?
based on finding companies with a long term sustainable advantage, in terms of business franchise, quality of management, technology or other factord
what is momentum?
aims to capitalise on existing trends in the market
what is momentum?
aims to capitalise on existing trends in the market
what is a centralised and decentralised approach?
centralised - a firm has an agreed investment policy that all of its investment managers follow
decentralised - a firm gives discretion to its investment managers to operate freely
what does CASS require?
1) make adequate arrangements to safeguard clients ownership rights, especially in the event of insolvency
2) prevent use of safe custody assets belonging to a client on the firms own account expect with clients consent
3) introduce adequate organisational arrangements to minimise the risk of loss
what is omnibus?
investments are all held in one account whereas designated is a designated account
what is legal entity identifier?
unique identifier for persons that are legal entities or structures, it is a code that is unique to that legal entity or structure and must be obtained if they wish the firm to act on their instructions
what are some of trustees duties under common law?
- exercise due diligence and prudence in exercising a power of investment
- demonstrate professional expertise
- act impartially
- administer trust property in best interest
- make trust productive e.g grow
- obtain advice where required
what is standard investment criteria?
imposes duty on trustees to have regard to the need for diversification and suitability
who can NMPIs be marketed too?
1) certified high net worth individuals
2) certified sophisticated investors
3) self certified sophisticated investors
Graham’s values test
1) adequate size
2) strong financial condition
3) earnings stability
4) dividend record
5) earnings growth
6) moderate price to earnings ratio
7) moderate ratio of price to assets
what is full replication?
requires each constituent of the index to be tracked in accordance with its index weighting. Most expensive method and only suitable for big portfolios
what is stratified sampling?
requires representative sample is securities from each sector of the index to be held, this method is less expensive than full replication but the lack of statistical analysis renders it subjective with potential bias
what is optimisation?
costs less than fully replicating index, but statistically more complex. uses sophisticated computer modelling technique to find a representative sample of those securities that mimic broad characteristics of index tracked
what is synthetic replication?
involves fund manager entering into a swap - an OTC derivative - with a market counterparty to exchange returns on index for payment
what are the three ways economic activity can be measured?
1) by the total income paid by firms to individuals
2) by individuals total expenditure on firms output
3) by the value of total output generated by firms
How is GDP calculated?
By adding together the total value of all goods and services produced domestically during a calendar year
when is the economy contracting?
when level of GDP falls compared with previous quarter
when is economy in a recession?
two successive quarters of declining GDP
when is economy expanding?
When GDP rises compared with previous quarter
common formula for GDP
C + I + G + (X-M)
4 stages of economic cycle
1) recovery
2) boom
3) slowdown or contraction
4) recession
what is the public sector net cash requirement?
Difference between governments expenditure and revenue receipts
what are leading indicators?
usually change before the economy as a whole changes, for example stock markets
what are coincident indicators?
change at approximately the same time as the economy and so provide information on the current state, GDP, industrial production and retail sales are examples of
what are lagging indicators?
usually change after the economy does. Unemployment is an example
what are the two components of balance of payments?
1) current account - deal with imports and exports of goods and services
2) capital and financial account - deals with foreign investments in the UK and UK investment abroad
what does the current account consist of?
1) visible trades - exports and imports of goods such as oils, agricultural products, other raw materials, machinery and transport equipment, computers, white goods and clothing
2) invisible trades - exports and imports of services such as international transport, travel, tourism and financial and business services
What four parts does the current account divide into?
Trade in goods
Trade in services
Investment income
Transfer payments
what does capital account measure?
all movement in and out of the country for investment
what does financial account measure?
covers transactions that result in a change of ownership of financial assets and liabilities between a countries residents and non residents
what are the UKs official reserves made up of?
foreign currencies
gold
IMF special drawing rights
UKs reserves tranche position
what happens if real exchange rate rises?
domestic goods become more expensive relative to foreign goods adversely affecting domestic production
what happens if real exchange rate falls?
domestic goods become relatively cheaper and demand for them increases
what is fiscal policy?
use of government spending and taxation to influence both the level of demand in the economy and the level of economic activity
what is monetary policy?
attempts to stabilise the economy by controlling interest rates and the supply of money
What is M0?
Narrow money, includes:
- notes and coins in circulation
- banks operational deposits with Bank of England
Reflects changes in economic cycle, but does not cause them as it has little effect on total national output or inflation
It is an indicator of consumer spending and retail sales
Growth in M0 indicates that consumer spending is buoyant
A contraction in M0 suggests consumers are behaving more cautiously
What is M4?
Broad money
includes notes and coins in circulation, plus all instant access and time deposit accounts of UK residents with UK banks and building societies
Includes deposits created by banks and building societies through their lending activities as well as deposits lodged in accounts by savers
Acts as an economic indicator:
- an increase in demand for loans will be reflected in a faster growth in M4
- rapid growth in money circulating in the economy is often interpreted as a build up of inflationary pressures
what is the MPc?
set interest rate strategy
meet 8 times a year and have 9 members
five from within the bank and four external
what is quantitative easing?
involved injection money directly into economy by purchasing government bonds from investors
what is quantitative tightening?
a process under which banks sell bonds previously acquired under QE and or allow their holdings to mature without replacement
what is cost push inflation?
if firms face increased costs and inelastic demand for their output, the likelihood is that these rising costs will be passed onto the end consumers
consumers will in turn demand higher wages from firms causing a wage price spiral to develop
what is demand pull inflation?
when the economy is operating beyond its full employment level of output, prices are pulled up as a result of an inflationary gap emerging
this excess demand can often stem from the optimism that accompanies rising prices
what is disinflation?
occurs when there is a decrease in the rate of inflation, with disinflation the prices of goods and services are still rising but there is a slowing of the rate at which they increase
what is deflation?
opposite of inflation and occurs as prices decline over time and the inflation rate becomes negative
consumers become reluctant to spend and buy items as they know they will be cheaper in the future
what is stagflation?
combination of stagnant growth, and inflation,
what is systematic risk?
also known as market risk, refers to the risk that there might be events that lead to a change in expected returns in the stock market generally. Affects the whole system and cannot be diversified against
what is non systematic risk?
also known as investment specific risk, it is the risk that there might be a change in expected returns as a result of some event or circumstance to a particular company or industry sector
can be diversified against
what is default risk?
refers to an issuer defaulting on their obligations to pay interest and capital
what is downgrade risk?
the risk that the market anticipates that a credit rating agency is going to downgrade a bond
what is credit spread risk?
if investors become nervous, there is a flight to quality. this means bonds issued by corporates will tend to underperform bonds issued by governments
what is credit spread risk?
if investors become nervous, there is a flight to quality. this means bonds issued by corporates will tend to underperform bonds issued by governments
what is counterparty risk?
refers to a situation in which the organisation with which an investment is placed, or the counterparty to a transaction fails
what is bail in risk?
governments and or central banks and institutions bailed out financial institutions at a cost to taxpayers;
with a bail in those with money in the bank may see their balance reduced
what is liquidity risk?
risk faced by investors when they are forced to sell a security at a price below its fair value due to a lack of liquidity
what is liquidity risk?
risk faced by investors when they are forced to sell a security at a price below its fair value due to a lack of liquidity
what is event risk?
refers to issuer of a security being unable to pay interest or repay capital or suffering a fall in value due to:
- a major unexpected events such as industrial disaster
- corporate change (such as takeover)
- regulatory change
what is gearing risk?
gearing risk is because gearing magnifies potential losses and gains
safety first ratio
expected return - threshold acceptable returns / standard deviation
what is modern portfolio theory?
reflects the way in which portfolios can be constructed to maximise returns and minimise risk
what is standard deviation?
measures how widely the actual return on an investment varies around its average or expected return. The greater the standard deviation, the greater the volatility
what is hedging?
means protecting an existing investment position by taking another position that will increase in value if existing position falls in value
what is the efficient frontier?
describes relationship between the return that can be expected from a portfolio and the risk of the portfolio as measured by the standard deviation
efficient frontier plots the risk reward profiles of various portfolios and shows the best return that can be expected for a given level of risk
limitations of efficient frontier
- it assumes standard deviation is the correct measure of risk and assumes assets have normally distributed returns
- investors may have concerns such as ethical preferences which add constraints
- inputs rely on historical data
- model doesn’t include transaction costs
how many securities are sufficient for diversification?
15 to 20
CAPM calculation
1) market return - risk free return
2) times this by the beta
3) add the risk free return back in
CAPM Assumptions
- investors are rational and risk averse
- all investors have an identical holding period
- market comprises many buyers and sellers
- no taxes, transaction costs and no restrictions
- information is free and is simultaneously available
- all investors can borrow and lend unlimited amounts of money at risk free rate
- quantity of risky securities in the market is fixed
limitations of CAPM
1) what to use as risk free rate
2) what is the market portfolio
3) the suitability of beta
what is fama and french model?
expands CAPM by adding factors for company size and value in addition to the market risk factor of CAPM.
Fama and french identified two types of company securities that tend to do better than the market as a whole:
1) small caps tend to outperform large cap stocks
2) value stocks (those with a high book value to price ratio) tended to outperform growth stocks
what is arbitrage pricing theory?
general theory of asset pricing that has become influential in the pricing of securities
it is based on the idea that a securities return can be predicted using the relationship between the security and a number of common risk factors, where sensitivity to changes in each factor is represented by a factor specific beta
what influences security returns?
1) unanticipated inflation
2) changes in the expected level of industrial production
3) changes in default risk premium on bonds
4) unanticipated changes in the return of long term government bonds over treasury bills
what is weak from EMH?
states that current security prices fully reflect all past price and trading volume information, and future prices cannot be predicted by analysing this type of historical data
what is semi strong efficiency?
states that security prices adjust to all publicly available information very rapidly and in an unbiased ways, so that excess returns cannot be earned by trading on that information.
what is strong form efficiency?
states that security prices reflect all the information that any investor can acquire, in this form, all information includes not only public information, but also private information typically held by corporate insiders
what is prospect theory?
deals with the idea that people don’t always behave rationally, particularly with respect to risk tolerance when facing a loss or making a profit
what is regret?
investors may be less willing to sell a losing investment because it is showing a loss
Holding period return
D + v1 - v0 / v0
Formula for relative return
return - benchmark return
Money weighted rate of return formula
If contributions:
1) D + V1 - V0 - C
2) Divide this by
3) V0 + (C x n/12)
If withdrawals:
1) D + V1 - V0 + C
2) Divide this by
3) V0 - (C x n/12)
time weighed rate of return
v1 / v0 x v2 / (v1 + c) - 1
time weighed rate of return
v1 / v0 x v2 / (v1 + c) - 1
sharpe ratio formula
return on the investment - risk free return / standard deviation
alpha formula
[Risk free + beta (market return - risk free return)]
information ratio formula
return - benchmark return / tracking error
Interest yield formula
coupon / clean price x 100
what is a statement of financial position?
shows the assets and liabilities of a company and can be seen as a list of resources
also known as a balance sheet
straight line depreciation formula
original cost - expected residual value / expected useful life
