Questions Flashcards
State four drawbacks of using the Sharpe ratio in investment planning.
- Need to consider other factors/trends over time/do not consider in isolation
- Can be distorted by fund/manager’s strategy.
- Assumes normal distribution of returns/reliant upon standard deviation.
- Can be distorted by illiquidity/volatility/trading frequency/costs.
Explain three relative differences between what is measured by alpha and beta.
• Beta measures market risk;
• alpha measures difference between actual return and expected return (implied
by Beta)/not explained by CAPM.
• Beta explained by movements/correlation/in relation to market;
• alpha not explained by movements in market.
• Beta measures volatility;
• alpha measures manager value/stock-picking.
Explain briefly the main drawbacks of holding a fund that invests on a single theme or thematic basis.
- Smaller investment universe/fewer managers with experience.
- Costs likely to be higher.
- Dealing frequency of fund/illiquidity of underlying holdings.
- Lack of common terminology/inconsistent application.
- Higher volatility/beta.
- Lack of diversification/greater non-systematic risk.
- Risk of fund closure/short lived/implementation risk/theme being closed.
Identify the main differences between an interim and a final dividend.
- Interim declared during financial year/before AGM.
- Final declared after financial year/at AGM.
- Interim declared by board.
- Final declared by shareholders.
- Interim can be revoked.
- Final cannot be revoked.
- Interim only if Articles expressly permit.
- Final not subject to Articles/right of shareholders.
Describe briefly Macaulay duration.
- Weighted;
- average term/number of years;
- discounted/present value of;
- all cash flows/coupons + redemption value;
- from a bond.
Explain briefly what is measured by modified duration.
- Measures sensitivity of;
- a bond’s price;
- yield to maturity/redemption yield/interest rates.
State four changes that could be made within the client’s fixed interest portfolio in the event of an anticipated recession.
Increase duration
Decrease high yield
Increase investment grade/gilts/cash/short dated bonds.
Use derivatives.
Describe briefly what standard deviation measures.
- Volatility/dispersion of returns;
- through variation in;
- actual return;
- against mean return.
State four limitations of using alpha to measure a fund’s performance.
- Doesn’t explain source/reason for outperformance.
- Assumes CAPM/market/benchmark/risk-free rate/ is suitable/correct.
- Relative to beta/assumes beta is correct measure of risk.
- Ignores costs/charges.
- Only suited to comparing equity/similar funds.
Identify four drawbacks of using a Stochastic modelling tool.
- Assumptions/inputs not correct/unrealistic.
- Ignores sequencing risk.
- Over-reliance/over confidence.
- Difficult to understand/too complex.
- Output is unrealistic/unattainable/expected return not accurate.
- Doesn’t factor in client circumstance.
State the two main Asset headings within the balance sheet of a company’s accounts and list two categories of assets that would be found under each heading.
Fixed/non current assets
• Tangible (plant, buildings etc.). • Intangible/goodwill.
• Investments.
Current assets
• Stock/inventory.
• Cash.
• Trade receivables/debtors/prepaid expenses.
State the three main components of the UK’s capital account.
- Investments/assets.
- Loans/borrowing.
- Foreign currency reserves.
State the principal purpose of a capital account surplus within the UK’s balance
- To finance/fund;
- a current account;
- deficit.
Describe briefly what is meant by the term ‘Beta’ according to CAPM
Beta measures the sensitivity to market risk of a share or portfolio
The market has a beta of 1.0
According to CAPM, the average beta of shares in the market is 1 and would be expected to move exactly in line with the market
A share with a beta of less than 1 will rise and fall more slowly than the speed of the market
A share with a beta of more than 1 is more volatile than the market
Outline the assumptions that CAPM is made on
Investors are rational and risk averse
All investors have the same holding period
The market comprises of many buyers and sellers and no individual can affect market price
Information is free and simultaneously available to all investors
Unlimited amounts of money can be borrowed or lent by investors at the risk free rate
All investments are liquid
There are no taxes, no transaction costs and no restrictions on short selling
Outline why investors sometimes behave irrationally as explained by behavioural finance
Loss aversion/prospect theory
Investors take profits
Reluctance to realise losses
Made more distressed by prospective losses than they are made happy by equivalent gains
Reluctance to accept an error of judgment has been made
Tendency to believe current trends will continue indefintely
Fear of missing out/the herd instinct
Over confidence/under reaction
Emotional reasons/attachment
Unit Trust assets held by? and managed by?
Held by Trustees and invested by managers
OEIC assets held by?
Independent Depositary
Describe the four main stages of the business cycle and the effects of these on businesses and unemployment.
Recession
Unemployment is near its peak as businesses have contracted
Entrants to the labour market find it hard to find jobs.
Expansion or upswing
Sales start to rise
Unemployment falls.
Boom or peak
Businesses are operating at full capacity
Unemployment is at its lowest
Contraction or slowdown
Sales are falling
Unemployment is rising
State and briefly explain the three different types of unemployment
Frictional - caused by changes in the economy that lead to qualified jobseekers being
temporarily unmatched with jobs because of lack of knowledge, time needed to arrange
interviews etc.
Structural - caused by structural changes to the economy such as declines in industries
leaving people unemployed and not qualified for other jobs.
Cyclical - caused by changes in the overall level of economic activity and often associated
with the business cycle.
State four ways a company can return money to investors other than paying an annual dividend.
Special dividends
Share buy backs via the market
Tender issue to repurchase shares
Wind up/sell company
Explain the purpose of using a benchmark in the investment process
Sets asset allocation
Independent agreed basis
To manage risk expectations
To measure relative performance to benchmark/performance or added value by the fund manager
Describe briefly four main elements of fundamental analysis and technical analysis
Fundamental analysis
Analyse company.
Analyse industry.
Analyse accounting ratios.
Calculate whether share is over or under valued.
Technical analysis
Analyse past share prices.
Identify trends /patterns in share prices.
Using charts or mechanical trading rules.
Make decisions independent of other information about company.
Explain why the Bank of England may not raise interest rates even if inflation exceeds their target
Future economic uncertainty
High levels of debt, both corporate and personal
Exchange rate concerns/effect on trade
Increase in inflation deemed to be temporary
Explain the longer-term effects on the economy if the Government eased monetary policy to reduce short-term interest rates.
Long-term interest rates should reduce
Asset (bond, equities & property) prices should increase
Lower interest rates will mean more people are willing to spend and borrow
People dependent on interest income will become worse off
Borrowers will become better off
Businesses will invest more as the margin between their investment returns and interest rates payable widens
Explain what is meant by inelastic demand
Changes in price have little or no effect on the levels of demand
Explain the implication of elastic demand for the profitability of goods
When goods have elastic demand a small price decrease would lead to a large increase in demand
Assuming adequate supply for the product and a reasonable profit margin
Then profitability should increase substantial with a small price decrease
Or should decrease substantially with a small price increase
List five characteristics of perfect competition
All firms in the market produce identical products
Large number of firms in the market
Each firm is small in relation to the market
No exit or entry barriers
The market is transparent and all transactions are known
Explain how the Bank of England generally sets short term interest rates
The BoE raises interest rates by selling Treasury Bills and Gilts via the repo market
this withdraws physical money from the financial system
They cut interest rates by buying back bonds and bills
This injects money into the financial system
Describe how the BoE eases monetary policy and the effect this has on the economy
The BoE reduces short term interest rates to ease monetary policy
This should bring down long term interest rates
This will lease to rising asset prices, increasing wealth of people and increasing their willingness to spend and borrow
The result of this is increased economic activity
Describe the four main performance measures used when analysing company accounts
Profitability - measures the rate of profits being earned in relation to sales, assets and equity invested
Volatility - measures how sensitive profits are to change in markets
Liquidity - measures wether the company can easily pay its way
Operational efficiency - measures weather the management are making efficient use of the company’s resources
Explain the term capacity for loss
The ability/degree/level/scope;
to absorb/withstand;
any negative investment event.
Adverse effect/materially detrimental;
on lifestyle/standard of living.
List the non financial factors that can influence an investors attitude to risk
Previous experiences.
Time horizon/age/state of health/dependants.
Client objectives/ethical/religious views.
Investor psychology/perception.
Framing.
Society/collective mood/political/economic environment.
Describe the key principles of Modern Portfolio Theory, in respect of the construction of an investment portfolio.
A diversified portfolio;
of non/un/imperfectly correlated.
Investors are risk adverse.
Maximum return;
for given/set risk.
Efficient frontier;
uses expected return of each asset.
Standard deviation/normal distribution (of each asset);
to produce optimal portfolio.
Systematic risk cannot be removed/can be reduced.
Non-systematic risk can be removed.
Sensitivity to the market is expressed by beta is market risk.
Five benefits and five drawbacks of transferring assets to a platform compared to holding directly
Benefits Everything in one place/consolidated valuations/reporting. Less admin/paperwork. Income flexibility. I pre-funding/cash account. Access to institutional/clean share classes. Access to tools. Discounted/lower fund charges.
Drawbacks
May pay exit charges.
Additional platform charges/pay for services not used.
Unnecessary functionality/too complex solution.
May have to sell assets.
Time out of market.
Risk of platform failure/outage.
Unable to hold alternative income products.
Identify the three main categories of benchmark used by fund managers
Constraint
Target
Comparator
Key differences between M0 and M4 as measures of money supply
M4 includes deposits created by lending/all bank accounts.
MO includes operational deposits at the Bank of England
M4 is broad money.
MO is narrow money.
M4 is indicator of economy.
MO is indicator of consumer spending/retail sales.
Describe the general limitations of using investment ratios when analysing a company’s financial performance
Credibility of the source of information/manipulation.
Use different accounting policies/conventions/company may change accounting policy.
Masked by exceptional/one-off items.
Data may be obsolete/historical/not reflect current/future trading.
Affected/masked by macro trends.
Not considered in isolation/other factors.
Can’t compare across sectors.
Identify factors that could affect a companies share price
Economic outlook. Political/changes in legislation/tax/regulation changes. Investor sentiment/broker or credit rating change/demand & supply. Takeover activity. Profit/earnings expectation. Capital event. Dividend expectation! Quality/change of management. Competitors. Fraud. Inclusion/removal from index.
Describe what a momentum investment style is
Identify trend. Trend accelerating/continuing. Sell before trend ends. Ignores intrinsic value/fundamentals. Generally, short term.
Describe what a contrarian investment style is
Consensus usually wrong.
Returns from going against the herd/ market sentimen
Positive when outlook negative/out of favour.
Price less than intrinsic value/undervalued.
Generally, long term.
Explain three main differences between sharpe ratio and the information ratio
IR uses benchmark: Sharpe uses risk-free return. IR is relative/can compare funds; Sharpe is absolute. IR measures consistency over time; Sharpe does not. IR uses tracking error; Sharpe uses standard deviation.
State the main rules a fund must adhere to in order to qualify as a REIT
UK resident/listed Closed ended/only one share class At least 75% of profits; at least 75% of total assets; relate to property rental/ring-fenced business. Interest/borrowing coverage; at least 125%. At least 90% of profits; paid out/distributed; within 12 months/one year.
Briefly describe sequencing risk
Effect of volatility/fluctuation; on the order: and timing/frequency of withdrawals; and sustainability of income; and impact on capital value. Effect greater in early years.
Identify three implications to a company paying out an uncovered dividend
May have to cut/reduce dividend;
unless one off/bad year.
Use reserves/future profits.
May borrow/raise capital.
State the main forms of ethical investment
Positive screening/engagement.
CSR/SRI/Sharia finance/responsible.
ESG.
Impact.
State the main conditions that must be met for a property fund to qualify as a property authorised investment fund (PAIF).
At least 60%; of income:
from exempt property business.
Value of property assets must be at least 60% of total assets.
Shares widely held.
No corporate investor;
holding 10% (or more of net asset value).
Explain four potential drawbacks of using Socially Responsible Investing other than investment performance.
Less diversification due to avoiding certain areas/fewer investment opportunities.
More expensive.
Approach differs/not consistent/not aligned with John’s Socially Responsible Investment (SRI) view.
Less research available.
Higher risk/higher tracking error/risk not aligned with John’s attitude to risk.
Screening rules out growth/income.
Describe briefly what is meant by current account and capital account
Current account
Imports minus;
exports/balance of payments;
in goods & services;
plus receipt from overseas income generating assets.
Capital account
Movement of all monies/assets;
into country;
out of country.
Identify two aspects of personal taxation that would change if a couple were to get married and state how each could result in potential tax savings.
Inheritance Tax;
unlimited spousal exemption/transferable nil rate band.
Capital Gains Tax;
inter spousal disposal exempt.
Income Tax;
marriage allowance/transfer of £1,250/10% of Personal Allowance.
Explain what is meant by the standard deviation of returns
It is a measure of the volatility of returns
It measures how widely the actual return of investment varies around its average return
An investment which stays close to its expected return is said to have a low standard of deviation
An investment which fluctuates wildly has a high standard of deviation
It is a measure based on past experience
And a useful tool to identify the range of returns investments are likely to make in the
Explain the term active investment management and state two advantages and two disadvantages of this type
An investment strategy using analysis
In an attempt to achieve above average or superior risk adjusted returns
Advantages
Informed investment decisions based on expierence and analysis of market
Possibility of higher returns than index which portfolio benchmarked against
Disadvantages
Higher fees and operating costs
Stock/sector analysis may not produce the right selections and portfolio could outperform
