Lesson 2

Question 1

2.1.1 Outline the major asset classes held and Canadian pension funds. Provide an example for each major asset class

Answer 1

1. Equities: stocks
2. Fixed income securities: bonds

3. Alternative assets: real estate, infrastructure, hedge funds, venture-capital, bitcoin
Some investors may consider investments in private capital under their equity class others may consider an alternative. The more alternative investment, in general, the less liquid.

4. Derivatives: Calls and puts

Question 2

2.2.1.a Differentiate between the money market and the capital market

Answer 2

The money market includes short term, marketable, liquid, low risk debt securities. Money market instruments are sometimes called cash equivalents. And example is treasury bills or commercial papers or bankers acceptances

Capital markets include long-term riskier security such a stocks and bonds. These types of security or more diverse than those found in the money market and include those with maturities greater than one year

Question 3

2.2.2 Outline basic characteristics of T-bills

Answer 3

T bills are short term, highly liquid government securities.

Investors by T-bills at a discount from the stated face value. At maturity and hold received a payment of the face value.

The difference between the purchase price in the face value constitutes the investors earnings.

T-bills are purchased primarily by chartered Bank ‘s, investment dealers, the Bank of Canada and individuals who obtain them on the secondary market from a government securities dealer

Question 4

2.2.3 Identify the primary reason pension plans invest in money market instruments

Answer 4

Pension plans invest in money market instruments to meet liquidity needs.

T-bills are easily converted to cash and saw that low transaction cost with not much price risk.

Holding low risk securities is often regarded as equivalent to holding cash

Question 5

2.2.4. Outline basic characteristics of certificates of deposits and bearer deposit notes

Answer 5

A certificate of deposit CD is a time deposit with a chartered Bank. Time deposit may not be withdrawn on demand.

The bank pays interest and principal to the deposit or at the end of the fixed term deposit.

Although CDs are not transferrable in Canada, some bank time deposits issued and denominations greater than $100,000 are negotiable. They can be sold to another investor. These marketable CDs are known as BDN

Question 6

2.2.5 Outline basic characteristics of a commercial paper

Answer 6

Commercial paper is a short term unsecured debt issued by a large corporation. It is typically used to finance accounts receivable, inventories, and short term liabilities. The debt is usually issued at a discount, reflecting prevailing market interest rates.

Commercial paper is often backed by a line of credit. Maturity typically ranges from one month to one year. Maturities longer than one year must be registered with the relevant securities commissions so are rarely issued. Most have a denomination of at least $50,000.

Many firms issue commercial paper with the intent of rolling it over at maturity. Almost all commercial paper is rated for credit quality by rating agencies

Question 7

2.2.5 Outline basic characteristics of bankers acceptances and identify where they are most widely used

Answer 7

Bankers acceptances are money market instruments that consist of an order to a bank by customer to pay fixed amount at a future date typically within six months. For a fee the bank endorses the payment as excepted assuming responsibility for ultimate payment to the holder of the acceptance.

Since this allows the holder of the acceptance to substitute the banks credit for the customers they are usually used in foreign trade where the credit worthiness of one trader is unknown to the trading partner.

Question 8

2.2.7 Outline basic characteristics of re-purchase agreements

Answer 8

Re-purchase agreements are short term, often overnight, sales of government securities with an agreement to re-purchase the securities at a slightly higher price.

Basically the dealer takes out a one day loan from the investor and the security service collateral the price increase is overnight interest

Question 9

2.2.8 Outline basic characteristics of mortgage backed securities MBS

Answer 9

A MBS is either an ownership claim in a pool of mortgages on residential or commercial properties or an obligation secured by such a pool.

These claims represent securitization of mortgage loans. Mortgage loans are purchased from banks and other lenders and then assigned to a trust that assembles the loans into pools for receiving the mortgage interest.

The trust securitize is the pool by selling MBS to the investing public. Although the mortgages are non-marketable the MBS may be traded on the secondary market

Question 10

2.3.1 Explain the difference between bond equivalent yield used to quote yelled on T-bills and the effective annual yield on a T-bill

Answer 10

Rather than report table prices, financial pages report bond equivalent yields.

The bond equivalent yield is calculated using an annual percentage rate [APR] method. The bills discount from par value is annualized on the basis of a 365 day year.

This differs from the effective annual yield which is calculated using compound interest

Question 11

Briefly explain why a T-bills bond equivalent yield is not an accurate measure of effective annual rate of return for T-bills with the maturity of less than one year

Answer 11

The bond equivalent is not an accurate measure of the effective annual rate of return for T-bills with the maturity of less than one year.

The annualized Tatian technique used in the bond discount rate formula applies simple interest rather than compound interest.

Multiplication by 365/n does not account for the ability to earn interest on interest, which is the essence of compounding. The discrepancy in return is greater for a 91 day bill and disappears for one year bill

Question 12

2.3.3 The investment manager of a corporate pension fund has purchased a T-bill with 182 days to maturity at a price of $9600 per $10,000 face value. Calculate the bond equivalent yield for the T-bill

Answer 12

8.36%

Question 13

2.3.5 Explain how the formula used to calculate bank discount yield for US T bills differs from the formula used to calculate bond equivalent yields for Canadian T bills and what this means for investors

Answer 13

The calculation of the bank discount yield for US T bills uses a 360 day year and the par value of 1000 in the denominator instead of the price [P]. To properly compare the returns for Canadian and US T bills, the same formula needs to be used for both

Question 14

2.3.6 Security eight is a three month, $10,000 T bill selling at $9764.

Security be is a six month, $10,000 T-bill selling at $9539.

Indicate whether security A or security be offers a higher effective and annual yield

Answer 14

A: 10.04%
B: 9.89%

Question 15

2.4.1.a Describe the characteristics of government of Canada bonds

Answer 15

They are longer-term marketable debt securities with varying maturity’s up to 40 years.

They are generally non-callable and make semi annual coupon payments that are set at a competitive level to ensure purchase at par.

They are considered part of the money market when their term becomes less than three years

Question 16

2.4.1.b Describe the characteristics of provincial bonds as compared to government of Canada bonds

Answer 16

Provincial bonds have a variety of maturities and coupon rates. They are considered extremely safe although not as safe as government of Canada bonds. Because of this their yields tend to be higher

Question 17

2.4.1.c Describe the characteristics of corporate bonds

Answer 17

They typically pay semi annual coupons over their term to maturity and return the face value to the bondholder at maturity.

Corporate bonds come with options attached.
The most significant difference between corporate bonds and government bonds is the degree of risk.

Question 18

2.4.1.d Define callable bonds

Answer 18

Callable bonds give the issuing firm the option to re-purchase of the bond from the holder at a stipulated call price

Question 19

2.4.1.e Define retractable bonds

Answer 19

Retractable bonds give the bondholder the option to redeem the bonds earlier than the stated maturity date

Question 20

2.4.1.f Define extendible bonds

Answer 20

Extendible bonds give the bone told her the option to redeem the bond later than the maturity date

Question 21

2.4.1.g Define convertible bonds

Answer 21

Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock

Question 22

2.4.2.a Defined the term principal in the context of bonds

Answer 22

Principal is the amount the bond issue or agrees to pay on the date of maturity. Other terms for principal our denomination and face value. A bond’s principal is not necessarily equal to the current market price of the bond

Question 23

2.4.2.b Defined the term “term to maturity” in the context of bonds

Answer 23

Term to maturity is the time between when the bonds issued and when it matures. Maturity the bond issue or must redeem the bond by repaying the bondholder the bonds face value

Question 24

2.4.2.c

Defined the term coupon rate in the context of bonds

Answer 24

Coupon rate is the income an investor receives over the bonds term to maturity as a percentage of the bonds face value

Question 25

2.4.2.d Defined the term coupon payment in the context of bonds

Answer 25

A coupon payment is a regular and fixed interest payment that the bond issuer pays the bond holder. Usually on a semi annual basis

Question 26

2.4.2.e Defined the term duration in the context of bonds

Answer 26

The duration is a useful measure of the sensitivity of a bond price to a change in interest rates. It is a complicated calculation involving present value, yield, coupon, financial maturity and call features. Duration is expressed in years. The longer the duration of the bond of the greater the bond sensitivity to interest rates

Question 27

2.4.3

Explain the significance of “par“, “discount” and “premium“ in the context of bonds

Answer 27

Face value is also known as par value or simply part. Discount and premium prefer to have the current trading price of a bond relates to his face value,

If the current price is the same as face value the bond is trading at par. If the current price is lower it is trading at discount if it is higher it is trading at a premium

Question 28

2.4.4.a Describe the key risks associated with bonds [5]

Answer 28

1. Inflation risk. The possibility the purchasing power of the bond will not be maintained because the bonds rate of return does not cover the loss of purchasing power due to inflation
2. Default risk
3. Interest rate risk. The possibility a change in market interest rates will negatively affect the price of the bond
4. Call risk [for callable bonds]. The possibility that the issue or route will redeem the bond before maturity. Usually happens when interest rates are low.
5. Reinvestment risk. The chance future proceeds from current investments will have to be reinvested at a lower interest rate

Question 29

2.4.4.b Describe how investors can use bond reading services to set the credit worthiness of bonds

Answer 29

Investors can assess the credit worthiness of bonds using information developed by independent organizations that rate bonds for example standard and pours and dominion bond rating service.

Reading firms use different designations consisting of upper and lower case letters to identify bonds level of risk. The highest rated bonds indicated an issue or is financially strong where is the lowest level indicate a higher level of risk the lower the level the lower the credit quality

Question 30

2.4.5 Explain the concept of yield curve as it applies to fixed income investments and describe a normal yield curve

Answer 30

Are you curve is a plot line that plus the interest rate of bonds with different maturity dates but equal credit quality at a set point in time.

A normal yield curve shows that bonds with bong maturity have higher yields then shorter term bonds due to interest rate risk associated with time

Question 31

2.4.6 Explain how yield to maturity on Canadian Bonds has reported

Answer 31

Yield to maturity on Canadian Vons is quoted on an annual percentage rate basis rather than as an effective annual yield.

This is calculated by determining the semi annual yield and then doubling it

Question 32

2.5.1.a Describe the basic characteristics of common stock [2]

Answer 32

The two most important characteristics of common stock as an investment or it’s residual claim and it’s limited liability features

Question 33

2.5.1.b Define common stock

Answer 33

Common stocks, also known as equities, or shares issued by publicly traded corporations seeking to raise cash to build or expand operations or for other reasons.

Its share of common stock in titles its owner to share in the financial benefits of ownership as well as to one vote on matters of corporate governance

Question 34

2.5.1.c As it relates to come in stocks Define residual claim

Answer 34

Residual claim is where in a liquidation of corporations assets, shareholders have a claim to the residual. The residual is what is left after all other claimants have been paid.

Common shareholders are last in line of all those who have a claim on the assets and income of a corporation. For corporation not in liquidation shareholders of a claim to part of the operating income left over after interest and taxes have been paid..

Question 35

2.5.1.d As it relates to come in stocks to find limited liability

Answer 35

With limited liability of the greatest amount shareholders can lose in the event of the failure of a corporation is their original investment

Question 36

2.5.2

Differentiate between common stock and preferred stock

Answer 36

Holders of common stock have ownership interest, can attend shareholder meetings, and have a right to vote on the election of directors.

Holders of preferred shares of the same ownership interest as common stockholders but they do not have the right to vote. In exchange for giving up this right, they are given preferred claim over common shareholders to any dividends declared by a corporation.

The dividends payable and preferred shares is usually fixed and cumulative. Therefore if a corporation chooses not to pay a dividend in a given. Preferred shareholders receive both their past and present dividends the next time a dividend is declared before a dividend is distributed to come and shareholders.

Question 37

2.5.3 Explain the terms large-cap stocks, mid-cap stocks and, small-cap stocks

Answer 37

Market capitalization is the monetary value of the company equal to the number of outstanding shares multiplied by the price of the stock.

Cap is often used to categorize companies and is short for capitalization. There is no universally excepted definition of what constitutes large cap.

In Canada shares of companies with a market cap of $1 billion or greater or commonly considered large-cap Medi-Cab is about $500 million-$1 billion and small cap is less than $500 million

Question 38

2.5.4 Differentiate between a growth stock and the value stock

Answer 38

A growth stock is a share in a company that has experienced or is expected to experience above average growth in earnings.

A value stock is a share that is considered to be undervalued because it is trading in the market at a lower price relative to fundamentals [dividends, earnings, sales etc.]

Value stocks often have a high dividend yield, a low price to book value, and low price to earnings ratio

Investors buy the stocks because they believe they are financially sound and their value increase once the market recognizes companies potential

Question 39

2.6.1 Explain how the value of derivative instruments is determined

Answer 39

Derivative instruments provide payoffs that depend on the value of other assets, such as commodity prices or bond in stock prices, or on market index value.

They have no direct value in and of themselves. Their value is derived from, or contingent on, the value of other assets. They are sometimes called contingent claims.

Options and future contracts or examples of derivatives

Question 40

2.6.2.a Explain what I call option is

Answer 40

A call option gives the investor the ability to purchase a certain number of shares at a certain price at a certain time. If the price of the stock is above the price at which the investor is able to purchase shares they may do so and then sell those shares at a profit.

If the price of the shares is less than the price that the investor may purchase the shares for they will lead to the auction expire without being exercised

Question 41

2.6.2.b Explain what a put option is

Answer 41

He put option gives an investor the option to sell a certain number of shares at a certain price at a certain time.

If the price of the stock is below the price of the investor me so that they will sell and exercise the option in order to make a profit.

Question 42

2.6.3 Use an example to contrast the long and short position in a futures contract

Answer 42

In the futures contracts to parties agree on the price of an asset and agree to either sell or buy that asset at a future appointment time.

The investors who agrees to sell the stock is said to have a long position the investor who agrees to buy the stock is said to have a short position

Question 43

2.7.1.a List 4 major categories of alternative investments

Answer 43

1. Infrastructure
2. Real estate
3. Private equity
4. Hedge funds

Question 44

2.7.1.b As it relates to alternative investments what are examples of infrastructure

Answer 44

Investment in the building the facilities and systems that provide for his ID is economic and social needs. Examples are hospitals, roads, water, utilities, power generation, airports and bridges

Question 45

2.7.1.c As it relates to an alternative investment what is real estate. Give three strategies for investment in real estate.

Answer 45

Real estate is investment in commercial real estate building such as offices, shopping malls, factories and warehouses. Investment strategies fall under three categories core, value add, and opportunistic.

Course strategies are investment in prime properties with good quality tenants that generate a steady rental income.

Value add strategies focus on properties that are below prime properties because of some imperfections that need upgrading upgrading and then selling for profit or renting out.

Opportunistic strategies focus on properties training at a significant discount discount or that need significant development

Question 46

2.7.1.d As the category of alternative investment Define private equity

Answer 46

Private equity is an investment in companies not listed on a public stock exchange. Venture-capital is a common private equity strategy.

Venture capitalists provide equity backing to start up companies that often have an unproven business model or developing technology

Question 47

2.7.1.e As a category of alternative investment describe hedge funds

Answer 47

Hedge funds as an investment strategy is one that institutional form offsets market risk of taking a long position on a promising stock by taking a short position in another stock that has a negative outlook.

When the two positions are combined and if the companies are in the same industry and have similar characteristics, the combined position is at least partially insulated from the general movement of the overall stock market.

The term hedge funds encompasses a wide range of strategies that investors must assess relative to their investment objectives and risk tolerances

Question 48

2.7.2 List three basic reasons pension plans consider alternative investments

Answer 48

1. Greater diversification
2. Return enhancement
3. Risk mitigation/hedging

Question 49

2.7.3.a Outline some of the fee issues for pension plans associated with alternative investments

Answer 49

Alternative investments tend to be managed at a much higher fee scale than traditional long-term fixed income and equity investments.

Typical fee structures include a management fee between 1% and 2% plus an additional performance fee.

Performance fees are typically between 10% and 20% of all out of performance above a specific hurdle rate.

Question 50

2.7.3.b Outline some of the illiquidity issues for pension plans associated with alternative investments

Answer 50

Alternative assets are often less liquid for traditional fixed income and equity investments.

Illiquidity poses two problems. First if a pension plan trustees are not satisfied for performance investment managers may be harder to terminate so due diligence is critical.

Second illiquidity makes it difficult to quickly change strategy. Well this may be an advantage to truly long-term investors, investors must assess the time horizon and the impact of illiquidity on the pension plans overall risk profile.

Question 51

2.7.3.c Outline the manager selection issues for pension plans associated with alternative investments

Answer 51

The pool of skilled alternative investment managers is limited.

Selecting managers with strong backgrounds, including experience, organizational stability, risk management processes, and an alignment of interest, is challenging

Question 52

2.7.4 Describe 4 advantages of infrastructure of an investment option

Answer 52

1. Stable demand profile. Many infrastructure projects are monopolistic or have high barriers to entry
2. Yield cash flow payments. A significant portion of returns is paid out as an ongoing cash flow which can be used to provide pension payments for retired members
3. Inflation protection, the revenue stream is often link to inflation if there is a general increase in prices the fees charged to the end-user of the infrastructure project can be increased
4. Low return correlations with traditional assets such as equity and fixed income. This makes infrastructure an excellent diversification tool

Question 53

2.7.5 List 7 disadvantages of infrastructure as an investment option

Answer 53

1. Illiquidity
2. Leverage and interest rate risk
3. Fees, can be high relative to return potential
4. Construction risk. The risk of delays or running over budget on Greenfield projects
5. Operational risk. Risk the day-to-day operations and maintenance will be less efficient or more costly
6. Regulatory/political risk.
7. Currency risk. Foreign investments are typically denominated in US dollars or euros leaving Canadian investors open to fluctuations in exchange risk

Question 54

2.7.6 Describe the advantages of real estate as an investment option [3)

Answer 54

1. Low return correlations with traditional fixed income and equity
2. Yield, the steady income earned is one of the most appealing aspects of investing in real estate. Historically, core real estate investments have had a yield in the range of 5% to 7%.
3. For market opportunities. The Canadian real estate market represents a small weight within the global real estate. The addition of a foreign real estate mandate can increase overall diversification by gaining access to cities, locations, industries, and types of properties not necessarily available in Canada

Question 55

2.7.7 Describe three disadvantages of real estate as an investment option

Answer 55

1. Vacancy risk. Tenant demand can rise and fall with the economy
2. Leverage risk. Most commercial properties use mortgages to varying degrees. Core investment strategies tend to have the most conservative use of that (25% to 50%) while value and opportunistic strategies mean mortgage up to 75% of property value.
3. Fees and other expenses. Cora strategies typically charge only a management fee while value add and opportunistic strategies also chart performance space. Some fees charged by managers such as acquisition, disposition, and financing fees, may be embedded and not clearly identified

Question 56

2.7.8 List 4 advantages of private equity as an investment option

Answer 56

1. Return enhancement. Investors allocate assets to private equities primarily because of the potential for higher returns
2. Larger opportunity set. Because private businesses make up the vast majority of companies globally, they provide a much larger set of potential investments to choose from
3. Focus on longer-term success
4. Impact of the credit crisis. The credit crisis has caused large institutional investors to reduce their private equity exposure creating an opportunity for medium term investments.

Question 57

2.7.9 List three disadvantages of private equity as an investment option

Answer 57

1. Access to top private equity managers becomes very important.
2. Illiquidity. Private equity funds can be very illiquid forcing investors to a 10 year or greater investment timeframe
3. Impact of J curve on returns during the investment period. Private equity funds can take a number of years to get fully invested. It is common to lose value during the initial investment. As management fees and costs of pursuing deal that’s a road investor capital. The majority of private equity returns are earned after the investment. Known as the J curve

Question 58

2.7.10

Describe the characteristics of hedge funds

Answer 58

A wide range of strategies make it possible to find a strategy that will meet most objectives, whether it is diversification return enhancement or both.

Many conservative hedge fund strategies offer volatility somewhere between traditional fixed income and equity profile. Hedge fund strategies that stand out is being most suited for institutional strategies are long/short fixed income, long/short equity and global macro.

Fixed income and equity strategies have flexibility whereas global macro investment strategies use the views on the global economy to make investment in stocks bonds and currencies

Question 59

2.7.11 List for disadvantages of hedge funds as an investment option

Answer 59

1. Exposure to currency risk as most hedge funds are not denominated in Canadian dump
2. Exposure to leverage risk, most investment strategies used leverage to varying degrees but hedging techniques have a substantial amount of leverage
3. Exposure to liquidity risk
4. Exposure to prime broker risk

Question 60

2.7.11.b In relation to a disadvantage of a hedge fund as an investment option Define exposure to liquidity risk

Answer 60

Many hedge funds have an initial lock up. During which investors are unable to redeem their investment.

Liquidity risk is a primary concern with strategies have short investor lock up. Combined with underlying illiquid investments that the hedge fund may not be able to sell quickly enough to meet investor liquidity demands.

In some cases hedge funds enact gates that prevent investors from a demon capital for a certain period. Without gates a fun would have to sell the most liquid assets to supply liquidity for those investors who depart early which would leave less liquid assets to be held by investors who did not redeem quickly

Question 61

2.7.11.c In relation to a disadvantage of a hedge fund as an investment option define exposure to prime broker risk

Answer 61

Hedge funds use prime brokers as custodians of their funds to provide that for leverage Anticipada securities too short sale

In market this location, prime brokers can move aggressively to protect the capital they have learned to a hedge fund, potentially withdrawing funding lines during periods of severe market stress

This can cause forced sales at the worst possible times if the hedge fund doesn’t have a longer-term financing in place and/or long notice. It’s for changes in margin and requirements

Question 62

2.8.1 Identify the most prominent stock market indices in Canada and the United States

Answer 62

The S&P/TSX comp is it index is the best known stock market indicator in Canada. It contains 270 of the largest securities traded on the TSX. It is constructed to reflect an investment in each company proportional to its total market capitalization and gives more weight to large highly valued stocks

The DJIA is the best known market indicator in the US. It contains 30 large blue chip corporations. This is a price weighted index which is a stock index in which each stock influences the index in proportion to its price per share.

Question 63

2.8.2 Identify the purpose of bond market indices, and outline one of the problems associated with using these indices

Answer 63

Bond market indices measure the performance of various categories of bonds.

These indices are computed monthly and measure total returns as the sum of capital gains plus interest income drive from the bonds during the month

One problem with these indices is that the true rates of return on many bones are difficult to compute because the in frequency with which the bonds trade make it difficult to obtain reliable up-to-date prices. In practice prices are often estimated from bond valuation models