Questions: Ch 10-13 Flashcards
Your friend has received a letter from her financial adviser recommending she
invest a regular monthly amount into a new series of open-ended pooled funds
covering the major overseas markets. Your friend already has a small portfolio of
overseas shares and asks your opinion.
Outline the issues that your friend ought to consider, including the regulatory
implications of her enquiry.
Issues to consider include:
* Why invest overseas . Match liabilities (unlikely) or to increase returns/
reduce risk by diversification into industries/companies not available
domestically and to increase universe of stocks generally to access “best in
class”.
- discuss briefly the structure of overseas economies/markets as appropriate, i.e.
strength of currency, level of market, etc. - Problems include currency risk (could be hedged at a cost which might be
more acceptable to a collective) and increased expertise/ knowledge required.
General list of problems as per pp 168 & 169 of notes where applicable in this
case. - Benefits of collective investment include greater efficiency, specialist skills,
overseas custodian, possible hedging, rand cost averaging and consequent
smoothing of returns - Disadvantages: loss of control over which stocks/markets (inconsistent with
individual’s needs e.g. for income), higher charges, limited to manager’s style
and competitive aspirations, legal restrictions on fund e.g. maximum
exposures, need to hold cash within fund, dealing frequency and costs - Taxation . may or may not be better vs. individual position, need to look at
relative tax status of fund on income and capital gains, scope to recover taxes,
levies and duties payable - Other considerations: what to do with existing holdings, when does fund
start, who are other investors, what is size of funds expected, what are
abilities of managers, why increase overseas now, advantages/limitations of
open ended unit trusts/oeics v investment trusts - It is assumed that I am licensed to give advice or if not that I make this clear
before outlining the issues
Your friend has received a letter from her financial adviser recommending she
invest a regular monthly amount into a new series of open-ended pooled funds
covering the major overseas markets. Your friend already has a small portfolio of
overseas shares and asks your opinion.
Outline the issues that your friend ought to consider, including the regulatory
implications of her enquiry.
Issues to consider include:
* Why invest overseas . Match liabilities (unlikely) or to increase returns/
reduce risk by diversification into industries/companies not available
domestically and to increase universe of stocks generally to access “best in
class”.
- discuss briefly the structure of overseas economies/markets as appropriate, i.e.
strength of currency, level of market, etc. - Problems include currency risk (could be hedged at a cost which might be
more acceptable to a collective) and increased expertise/ knowledge required.
General list of problems as per pp 168 & 169 of notes where applicable in this
case. - Benefits of collective investment include greater efficiency, specialist skills,
overseas custodian, possible hedging, rand cost averaging and consequent
smoothing of returns - Disadvantages: loss of control over which stocks/markets (inconsistent with
individual’s needs e.g. for income), higher charges, limited to manager’s style
and competitive aspirations, legal restrictions on fund e.g. maximum
exposures, need to hold cash within fund, dealing frequency and costs - Taxation . may or may not be better vs. individual position, need to look at
relative tax status of fund on income and capital gains, scope to recover taxes,
levies and duties payable - Other considerations: what to do with existing holdings, when does fund
start, who are other investors, what is size of funds expected, what are
abilities of managers, why increase overseas now, advantages/limitations of
open ended unit trusts/oeics v investment trusts - It is assumed that I am licensed to give advice or if not that I make this clear
before outlining the issues
2005 T2
Briefly describe five modelling techniques a fund manager investing in different
asset classes can use to arrive at an appropriate investment strategy. Assume an
active management approach. [5]
The manager can track the equity index by holding all the shares in the index
according to their index weights. Normally this would not be done for the whole
market index but for a portion, e.g. the ALSI 40 in SA or the FTSE 100 in
Britain.
The index can be tracked by constructing a portfolio which closely resembles the
index, through using sampling techniques which would result in a low tracking
error.
The particular index could be mirrored by buying index futures, which would
depend upon whether price = fair value. Needs to be rolled over from time to
time.
Buying an exchange traded fund (EFT) such as Satrix 40 in SA.
Matching the index through a sample of shares based upon the same PE ratio, DY
and premium to NAV, with a Beta of 1.
Question 3 (06 st2)
A charitable trust has a portfolio of assets, mainly invested in conventional
government bonds and equities. The only liability of the trust is to pay an annual prize
for the best new published book. The prize money has traditionally increased each
year in line with inflation.
(i) Describe two methods of valuing the trust’s assets and the implications of each for
the valuation of the liabilities. (6)
The chairman of the trust has expressed an interest in moving assets from
conventional bonds into index-linked bonds.
(ii) State the formula for deriving the expected return on conventional bonds from the
return on index-linked bonds. Define any symbols used. (2)
(iii) Discuss the circumstances in which it would be appropriate for the trust to choose
index-linked bonds over conventional bonds. (8)
[16]
(i) It is vital that the valuations of the trusts’ assets and liabilities are consistent.
Either the assets can be valued at market value and the liabilities valued at appropriate market-based
discount rate,
or both assets and liabilities could be valued using the same interest rate,which would normally be the long-term expected return on the assets.
It will be necessary to make certain assumptions such as allowing for dividend growth on the equities.
Any market value will imply an expected rate of return that is linked to the riskiness of the
asset. Because the portfolio contains both equities and bonds, using a single discount rate to
value all assets may therefore be inappropriate because of the different extent of risk.
Different discount rates could therefore be used depending on the riskiness, marketability and
term of the assets.
It may be difficult or impractical to establish a market related valuation basis for
liabilities
(ii)
The expected return on the conventional bonds can be taken to be the gross redemption yield (GRY).
(iii) The trust needs to decide whether it wants to plan for future prizes to be increased in line
with inflation.
If so, does it wish to anticipate the future increases by matching the liabilities on this basis. One way of doing this would be a move to index-linked securities.
This may not be a perfect match if the securities used a different inflation index to that
used for the prize.
Conventional bond yields will rise (i.e. price will fall) relative to index-linked bonds if investors expectations for future inflation rise or if the size of the inflation risk premium rises.
Under these circumstances, real yields and prices of index-linked bonds will not necessarily change.
Thus, if the trust s investment manager expects future inflation to be higher than that implied by the difference between nominal and real yields in the market,
index-linked bonds would be more attractive than conventional bonds.
The investment manager may also have a different view of the inflation risk premium. If
inflation is negative or very low he may prefer to keep the prize money unchanged and
therefore conventional bonds would match the liabilities.
Index linked bonds need to be available in the country and currency concerned, and to
have a spread of durations available for matching liabilities.
GRY = real yield on index-linked bonds + expected inflation + inflation risk premium.
Briefly define the following types of collective investment vehicles:
investment trusts,
unit trusts,
open-ended investment companies. (6)
You are a director of a unit trust management company offering a range of domestic unit trusts. Market research has suggested there will be a demand should your company offer international funds, particularly a global equity fund.
(ii) Outline the primary advantages and problems for your company of increasing the
range of funds in this way.
i) Investment trusts:
closed-ended, not trusts but public companies, can raise loan and equity capital,
price set by supply and demand.
Unit trusts:
open-ended,
trusts in a legal sense and not subject to company law,
price is set by calculating net asset value, regulated in terms of types of investment s they can hold.
Open-ended investment companies:
They are open-ended, units are priced at NAV,
governed by company law, no bid-offer spread,
explicit entry and exit charges.
(ii) Advantages:
_ increased funds under management (good for profitability and industry profile)
_ potentially profitable business (there is existing demand)
_ potentially improved return for clients from overseas assets
_ improved asset diversification (no longer dependent upon demand for domestic products only)
Problems:
The problems outlined on page 169 of course notes, ALSO
_ seed capital required, will need initial asset pool to start product working
_ potentially lower return (and hence, lower income)
_ cost of marketing and launch of product
_ cost of regulation, reporting and other on-going administrative functions (to get full
marks some of the above have to be given in addition to the problems on page 169).
Question 1 (2007 ST2)
An institutional investor is considering purchasing a clothing factory. A recent report published by a local bank indicated that industrial property prices have risen rapidly in the last two years (based on an index that they publish). The analysts at the bank believe that this trend is likely to continue.
(i) Outline the problems with property indices. (5)
(ii) Describe the factors the investor would need to consider in making the investment decision, including the factors that may have influenced the
recent growth in industrial property prices. (9)
(i)
Each property is unique, making valuation more difficult.
The market value of a property is only known for certain when the property changes hands.
Estimation of value is a subjective and expensive process.
Valuations will be carried out at different points in time.
Sales of certain types of investment property are relatively infrequent, so there is no up-dated information regarding the true value of the property.
The prices agreed between buyers and sellers of properties are normally treated with a degree of confidentiality.
The heterogeneity of property magnifies the problems of obtaining price data. It
is difficult to group properties into usefully homogeneous groups and still obtain
sufficient price data for each group.
Using surveyor’s valuations instead of the actual sale prices also has problems:
Subjectivity – different surveyors would give different values for the same property
Cost – it can be time consuming and expensive
Circular – the indices would be based too heavily on the surveyor’s views, but the surveyors would form their views on the trends of the indices.
A number of brokers and analysts produce property indices, but they are very specific.
The constitution and calculation of the index needs to be assessed carefully before it can be used with confidence.
(ii) Factors that may have influenced recent growth:
Economic factors e.g. lower interest rates (i.e. reduced cost of borrowing),
economic growth
Sentiment
The relative prices of property compared to other regions
investor preferences
the price relative to other investment classes
supply factors
Factors informing investment decision:
The economic outlook – particularly economic growth and interest rates
The outlook for the sector(e.g. clothing manufacturing may be susceptible to
cheap imports from other countries)
features of the individual property e.g. particular location, potential for use for
other purposes, existence of a long-term tenant
rent potential
risk of voids
the investment needs of the investor e.g. attitude to risk, liabilities (i.e. is the
investment a suitable match) , the need for liquidity
the investor’s existing portfolio (including size of the portfolio)
Expenses associated with the investment
Tax status of the investor and tax on the investment
Impact on the diversification of the portfolio
The way in which the index is calculated and the rationale provided in the bank
report
Any regulatory restrictions
Question 7 (07 st2)
(i) List the key differences between an investment trust and a unit trust. (4)
(ii) Explain why an investment trust would typically have a more volatile share price than the offer price of a unit trust. (4)
ITC: Closed-ended
UT: Open ended
ITC: Price may be above or below NAV of underlying asset
UT: Always priced at NAV
ITC: Company - governed by company law
UT: Trust - governed by trust law
ITC: Price may be more volatile due to discount varying over time
UT: No discount, so volatility follows underlying only
ITC: Can borrow (gearing possible)
UT: Not permitted/limited borrowing
ITC: Shares traded on a stock exchange
UT: Units bought and sold by trust manager
(ii)
Discount.
The discount will vary over time, due to market sentiment about the managers and
their investment style.
Marketability.
Investment trust shares are often less liquid than the underlying investments, whereas the unit trust manager guarantees that units will always be marketable (with a few exceptions, e.g. property unit trusts).
Unquoted investments.
Investment trusts typically have higher holdings in unquoted or unmarketable assets, for which market values are not readily available.
Gearing.
Investment trusts are often geared, so they will have a higher volatility than the value of
the underlying assets.
Closed vehicle.
When demand is rising for a particular investment trust, new shares cannot be created unlike in a unit trust where the manager would issue new units. The converse also applies when a trust falls out of favour. This creates additional volatility.
Question 1 (2008, st2)
(i) State how the returns achieved from short-term and long-term fixed-interest government bonds would compare with the original expectations:
(a) if inflation turns out to be lower than expected
(b) if yields are falling more than expected (4)
(ii) In a particular country, over the last ten years government bonds have outperformed property. Suggest possible reasons for this. (7)
[11]
(i) Nominal yield = risk free yield + expected future inflation + inflation risk premium.
(a) Real returns would rise for both short and long-term bonds. √√
Nominal returns would rise more for long-term than short-term because capital appreciation
would be greater. √√
(b) Real returns would fall because expected future inflation and risk premium would be
constant. √√
Nominal returns would rise for both because of price appreciation. √√
Possible reasons why government bonds have outperformed property include:
A change in the supply of bonds√ (reduced supply would drive up prices) √
a change in the supply of appropriate properties√
A change in the demand for bonds drawing up the price √
A change in the demand for properties √
√ for example of why demand might change (such as change in sentiment)
a change in taxes on either bonds or property√ - affecting after tax returns√ and demand√
lower economic growth leading to lower rental demand for property√ and lower rental increases√
lower inflation leading to lower rental increases√. A lower inflationary environment usually means less inflation uncertainty which would increase the
demand for bonds√
a change in investment regulations√ e.g. increased requirement for pension
funds to match their liabilities would increase demand for bonds√ (other
examples are acceptable)
a change in planning regulations which makes property management more difficult√
Question 2 (08 st2)
A fund that only invests in overseas equities is expanding the range of countries in its portfolio. It
is considering including African countries.
(i) Discuss possible reasons for including African countries in its portfolio. (3)
(ii) List the points it should consider before investing in a particular African country.(5)
(iii) State, with an example, one additional factor that it needs to take into account
when investing in small economies. (2)
[10]
(i) Stock markets in African countries are more risky markets√.
They should offer higher returns than developed markets to reflect the additional risk√.
Recent economic growth has been high√ – this is expected to continue due to the boom in
resources√.
In addition, possible market inefficiencies also generate opportunities for profitable investment√.
The economies and markets of many smaller countries are less interdependent than those of
the major economic powers√.
Therefore investment in African markets may provide diversification√.
Competitor funds may be similarly invested, and this fund wants to be in the pack √.
African markets will differ from each other in practice but points to consider will
generally include the following:
current market valuation√
possibility of high or volatile economic growth rate√
currency stability and strength√
level of marketability√
degree of political stability√
market regulation√
restrictions on foreign investment such as exchange controls√
range of companies available√
communication problems such as language or time delays√
availability and quality of information and accounting standards. √
withholding taxes could be more of an issue√
expertise in these markets√
extra costs such as custody fees√
the extent of additional diversity generated. √
(iii) State, with an example, one additional factor that it needs to take into account
when investing in small economies.
(iii) Markets in small economies can be affected by the enormous flows of money generated
by changes in sentiment of international investors√√.
For example, domestic factors in the
US that cause investors to repatriate funds, can completely swamp economic fundamentals in
determining the level of local markets√√.
Question 6 (08 st2)
(i) Explain why market value is not always suitable to use when valuing an asset. (4)
(ii) Describe the following methods of valuing an asset:
(a) Book value
(b) Smoothed market value
(c) Discounted cash flow value
(d) Value resulting from a stochastic model
(e) Arbitrage value (7)
(iii) Outline the circumstances in which each of the methods in (ii) could be used. (5)
[16]
Frequently assets may be valued alongside liabilities. It is necessary to adopt a method that
values assets and liabilities on a consistent basis.
Depending on the method used to value the
liabilities, market value will not be suitable for this purpose For example, volatility of market
values may be an issue.√ √
The market value depends on the circumstances surrounding the transaction. √
A market value requires a willing buyer and a willing seller. When either the buyer or the
seller is not willing the market price will be distorted, for example when there is the forced
sale of a large volume of assets. √√
There may be no market in the assets concerned, and thus no market value may be available.
√
The market value equates buyers and sellers at the margin, normally of a small part of any
stock issued. These circumstances may not give a good value for a large holding. √√
Accounting or other regulations may require another value e.g. book value or amortised book
value to be used. √√
(ii) Describe the following methods of valuing an asset:
(a) Book value
(b) Smoothed market value
(c) Discounted cash flow value
(d) Value resulting from a stochastic model
(e) Arbitrage value (7)
(ii)
(a) Book value: historic book value the price originally paid for the asset. √
Written up or written down book value is historic book value adjusted periodically for
movements in value. √
(b) Smoothed market value: where market values are available they can be smoothed √
(for example by taking some form of moving average over a specified period) to remove daily
fluctuations√.
Smoothing would be over a short period — days or weeks. √
(c) Discounted cash flow: this method involves discounting the expected future cashflows
from an investment√.
It has the advantage of being easily made consistent with the basis used to value an investor’s liabilities. √
However, it relies on the assessment of a suitable discount rate, which is straightforward
where the assets are government guaranteed fixed interest stocks but is less so otherwise.√
Assumptions are needed for default rates. √
Where cash flows are uncertain, such as for equities, property and inflation linked securities,
further assumptions have to be made. √
(d) Stochastic models: these are an extension of the discounted cash flow method in which
the future cash flows, interest rates or both are treated as random variables. √
The results from a stochastic model are a distribution of values from which the expected
value or other statistic can be determined√.
In practice, computer simulation would usually be
used to perform the calculations. √
(e) Arbitrage value: arbitrage value is a means of obtaining a proxy market value and is
calculated by replicating the investment with a combination of other investments √
and applying the condition that in an efficient market the values must be equal. √
(iii) Outline the circumstances in which each of the methods in (ii) could be used. (5)
[16]
(a) Book value is often used for fixed assets in published accounts. √
Companies other than financial product providers often use book value (written down if
necessary) for all accounting purposes. √
(b) Smoothed market value: This method can be used where markets are volatile, in particular
where values are driven by sentiment rather than underlying fundamentals√.
This may be suitable if the objection to market value is its volatility. √
(c) Discounted cash flow: this method is most commonly used when the cash flows from
assets and liabilities are certain√ and they can be discounted at the same interest rate√.
It is the most straightforward tool where it is necessary to compare asset and liability values. √
(d) Stochastic models are particularly appropriate in complicated cases where future cash
flows are dependent on the exercise of options√, for example the option to wind up an
investment trust in certain financial circumstances√.
Options can exist in either assets or liabilities. √
(e) Arbitrage value is often used in the valuation of derivatives√.
Question 1 (09 st2)
(i) Explain why market value is not always suitable to use when valuing a liability. [4]
(ii) Briefly describe the following methods of valuing a liability (make sure to mention each
method’s major drawback):
(a) Discounted cash flow value
(b) Market related approach [4]
Total [8]
(i)
It is necessary to adopt a method that values assets and liabilities on a consistent basis. Depending
on the method used to value the assets, market value will not be suitable for this purpose. For
example, volatility of market values may be an issue.
A market value requires a willing buyer and a willing seller. When either the buyer or the seller is not willing the market price will be distorted,
for example when there is the forced sale.
There may be no equivalent market value for the liabilities concerned, and thus no market value may
be available.
Accounting or other regulations may require another value, e.g. book value or discounted cash flow.
(ii)
(a) Discounted cash flow:
this method involves discounting the expected future cashflows of the liability.
It relies on the assessment of a suitable discount rate, which is straightforward if the same method is used to discount the cashflows of the assets and only one discount rate is used.
The biggest problem will be if there is no suitable discount rate or the assets are valued at market value and not on a discounting basis.
(b) Market related approach:
this method involves setting up a portfolio of assets that will replicate the profile of the liabilities.
The matching portfolio of assets is then valued and that same value is then placed on the liabilities.
It has major drawback that if there is no asset
available to match the profile of the liability, then you have no method of determining that
liabilities value.
Question One (09 st3)
(i) Discuss the characteristics which will influence the credit rating of a new
bond issue.(5)
(i)
Character and ability of the borrower. √
Knowledge of the borrower, its principles and ability to repay any loan will be the main driver behind any credit rating. √
Purpose of the loan. A loan taken to fund investment in infrastructure will be seen more favourably than a loan to cover cashflow difficulties. √
Amount of the loan. The size of the loan in particular compared to the stated purpose and significance relative to the size of the lender will affect the perceived credit risk. √
Repayment of the loan. How certain is the source of repayment and what safety margin is built into projections and assumptions. Does the borrower
have free cashflow to cover loan repayments? √√
Past practice. If the borrower has defaulted on a payment the credit rating will be lower. √
Other counterparties. The borrower may be exposed to other creditors
(customers with outstanding credit, or companies with outstanding tax bills).
The quality of these other creditors will impact on projected cashflow and
security. √√
The size of existing bonds relative to the size of the issuer will impact on the security of any new issue. If any existing bonds have higher priority, for
example if they are secured on specific assets, then this will decrease the security of any subsequent bond issue. √√
Exposure to other risks. Exposure to market, currency and operational risks will affect the security of any loan as these will influence the range of scenarios under which the loan can, or cannot, be repaid. √√
Future developments. There may be other events in the future which could impact on the borrower. For example fears of an economic downturn may spark concerns on the security of government debt. √√
