Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

AF Flash Cards > Section 2 - Cash and Fixed Interest Securities > Flashcards

Section 2 - Cash and Fixed Interest Securities Flashcards

1
Q

What are the benefits and drawbacks of holding monies in cash?

A
  • Offers high level of security but little inflation protection
  • Pays regular interest at prevailing rate - paid gross
  • No investment risk
  • Return comprises interest/no potential for capital growth
  • Liquid funds - easy access
  • Higher rate of interest for reduced access
  • Advertised interest rate often called nominal rate
  • Annualised rate allows for frequency of payment - AER or effective rate
  • With identical nominal rates - the more frequently interest is compounded - better for client
  • Annual rate = (1 + r) n
  • r = nominal rate of interest and n refers to number of interest payment periods
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What are the risks to look out for when investing in cash?

A
  • Creditworthiness of deposit taking institution. Assess by studying: tier one capital ratio, credit ratings (Standard & Poor’s and Moody’s) and credit default swap rates. Financial Services Compensation Scheme (FSCS) - 100% of first £85,000
  • Inflation erodes purchasing power
  • Interest rates fluctuate and re-investment risk (rates available for maturing money)
  • Exchange rate movements for foreign currencies & offshore accounts - caution required regarding supervisory structures/compensation schemes/collapsing currencies
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

Explain the principles of an Instant Access Account

A

Variable interest rates/lower than other accounts
Immediate withdrawals
Higher rates on post, phone and internet accounts

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Explain the principles of an Restricted Access Account

A

Higher rates of interest
Fixed or variable rates
Notice or term deposit accounts/(time deposits)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Explain the principles of an Foreign currency Account

A

Account in another currency
Instant access or fixed term
Higher levels of deposit required

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Explain the principles of Offshore Accounts

A

Available from UK branches of offshore banks
Higher rates of interest than UK accounts

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Explain the principles of a Cash ISA

A

Tax free for UK residents 16+
Maximum £20,000
Withdrawals made and replaced/ don’t count towards £20,000
£100+ interest when gift from parents - taxed on parents

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What is a help to buy ISA

A
  • A cash ISA for first time buyers
  • Government bonus when savings used to buy first home
  • For each £200 saved £50 bonus is made - maximum of £3,000
  • Available on homes up to £450,000 in London and £250,000 elsewhere
  • Maximum initial deposit £1,200 - maximum monthly savings £200
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Name tax free products that are available to new customers

A

Direct ISA/Junior ISA (can only be opened online or by phone/ transfers from other providers not allowed)
Premium Bonds

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Name Growth Bonds that are available to new customers

A

Guaranteed Growth Bonds (fixed terms of 1 or 3 years with different fixed rates, available online only)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Name Income Bonds that are available to new customers

A

Income Bonds (monthly income with variable interest for over 16’s with no withdrawal penalty)
Guaranteed Income Bonds (fixed term of 2, 3 or 5 years with different fixed rates, available online only)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Name Savings accounts that are available to new customers

A

Investment account (postal account for over 16’s with immediate withdrawals - parents can open an account for under 16’s)
Direct Saver (online or phone account for over 16’s with no withdrawal restrictions)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

How do money market investments operate

A
  • Banks/building societies and governments lend and borrow from each other
  • Require high liquidity but want to earn on cash reserves
  • Limited private investment
  • Allows borrowers to obtain funds for fixed period at a fixed price
  • Allows lenders instant access to funds
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What are treasury bills

A

Issued by government to finance daily cash flow
Routinely issued at weekly auctions
1, 3 & 6-month maturities
No interest paid - issued below par and repaid at par on maturity
Government backed and highly liquid

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What are certificates of deposit

A

Receipts from banks for deposits placed with them
Fixed rates of interest & fixed term (can trade prior to maturity)
Interest paid at maturity Interest rate depends on
market rates & bank’s credit
rating

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What are commercial bills/paper

A

Short-term negotiable debt instruments
Issued at discount to maturity value
Unsecured Reduced liquidity

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What are investment vehicles

A
  • Specialised market trading in high denominations so limited private investment
  • Collective money market instruments available to private investors, but need to understand underlying investments
  • Returns are lower for pure cash than short-term instruments
  • Charges - take into account when comparing against pure cash investments
  • Risks - credit, inflation & interest rate risk (also possible currency risk)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

What are fixed interest securities

A
  • Issued by government, companies or other bodies to raise money for long-term borrowing
  • Bond owner receives regular interest and repayment of capital at maturity
  • Negotiable - can trade
  • Fixed interest - borrower pays fixed rate for duration of loan
  • Debt instrument
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

what are the characteristics of fixed interest securities

A
  • Fixed rate of interest
  • Fixed redemption value (par)
  • Fixed redemption date
  • Pricing - traded on par value, mid-market price quoted in FT (represents mid-point between buying & selling)
  • Clean price - ignores accrued interest
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

in relation to a fixed interest securities, how is the accrued interest method paid

A
  • Interest is paid twice yearly, but accrues daily
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

what is cum dividend

A

Cum dividend - purchaser receives full 6 months’ interest (but pays accrued interest up to settlement date to seller)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

what is ex-dividend

A

Ex-dividend - where seller receives 6 months’ interest (but price adjusted to reflect this)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

what is the dirty price

A

Dirty price is the clean price +/- interest adjustment

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

what happens on the bond primary market

A

o Government issue new gilts weekly
o Investors submit bids for price & quantity
o Other companies issue less frequently & use investment banks to manage

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

what happens on the bond secondary market

A

o Used for subsequent trading after issue
o Three sterling markets; Government sector, Corporate sector, Sterling loans to foreign borrowers

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

what happens on a currency market

A

o Eurobond market (international bonds)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

which is more accurate, redemption yield or running yield

A
  • Redemption yield is more accurate as considers income and gain/loss at maturity
  • If redemption yield is less than interest yield there will be a capital loss at maturity
  • However, this ignores tax
  • No CGT on gilts and most corporate bonds for individual investors.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

what are the risks of a bond?

A
  • Interest Rate - when interest rates fall capital values rise and vice versa
  • Liquidity - trade infrequently
  • Inflation - erodes capital values (bond prices tend to fall if rate of inflation is speeding up)
  • Currency - exchange rate movements for global bonds
  • Default
    o Issuer may not pay interest or capital at maturity (Governments are most secure due to creditworthiness and ability to raise money to pay debt)
    o Credit ratings: investment grade (S&P BBB- or higher /Moody’s Baa3 or higher)
    o Sub-investment grade (junk bond) (volatile)
  • Market/Systematic Risk - economic factors or government actions
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

What is a normal yield curve?

A

Rising positive curve, higher yields for longer terms

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

what is a flat yield curve

A

Income similar for long & short term
If economic factors are stable and no radical changes to expected inflation or interest rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

what is an inverted / reverse yield curve

A

Yields on longer-term bonds are less than short-term bonds Caused by supply and demand or when investors expect short- term increases to interest rates but lower long-term rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
32
Q

Debt Management office short definition

A

Less than 7 years

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
33
Q

Debt Management office medium definition

A

7 - 15 years

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
34
Q

Debt Management office long definition

A

Over 15 years

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
35
Q

How do index linked gilts operate

A
  • Interest & capital repayment adjusted with inflation (using RPI)
  • Lower yields than conventional stock
  • Profits on disposal are CGT exempt but interest is taxable
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
36
Q

what is the repo market

A
  • Sale & repurchase agreement
  • One party agrees to sell gilts to another party
  • With a formal agreement to repurchase equivalent securities at an agreed price on a specified future date
  • Transfer of assets - but operates as form of short-term lending
  • Bank of England uses repo market to influence interest rates
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
37
Q

what is the strips market

A
  • Separating conventional gilts into interest (coupon) and redemption payments
  • Which are then traded in their own right
  • A 5-year gilt can be stripped to make 11 separate securities (5 x 2 coupon payments + 1 redemption payment = 11)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
38
Q

how do corporate bonds operate compared to gilts

A
  • Allows companies to borrow money for long periods at fixed rate of interest
    o Greater risk than gilts so higher yields
    o Prices typically more volatile
    o Liquidity issues for lower quality bonds
    o Wider spread on buying & selling prices
    o Credit ratings can change/affect prices
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
39
Q

what is a secured corporate bond

A

Charge on certain assets of the company

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
40
Q

what is a unsecured corporate bond

A

Higher yield due to higher risk Holders rank alongside other creditors in
liquidation

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
41
Q

what are debentures

A
  • Written acknowledgement of debt
  • Established by trust deed
  • Fixed - charged over specific asset
  • Floating - general charge over company asset
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
42
Q

What are convertible loan stock?

A
  • Offers holders the option of converting to ordinary shares
  • Conversion dates and rates are specified.
  • In the event of conversion CGT is chargeable
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
43
Q

What are floating rate notes

A
  • Securities paying rate of interest linked to money market rate e.g. LIBOR
  • Rate expressed in basis points above LIBOR’s 6-month average
  • Interest normally paid half yearly or yearly
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
44
Q

What are Permanent Interest Bearing Securities (PIBS)

A
  • Issued by building societies
  • Perpetual subordinated bonds (PSBs) originally issued by building societies that have now converted to banks
    o Issuer has no obligation to redeem (they are undated)
    o Particularly sensitive to interest rates
    o Do not qualify for compensation under FSCS
    o Rank behind all other creditors in the event of liquidation
    o Interest payable is non-cumulative
    o Interest is paid gross half yearly
    o Exempt from CGT
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
45
Q

For each £200 saved in a Help to Buy ISA, how much bonus will the government add and what is the maximum bonus?

A
  • A £50 bonus is added for every £200 saved - up to a maximum of £3,000
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
46
Q

What do governments use to finance their short-term cash requirements?

A
  • Treasury bills
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
47
Q

In relation to fixed interest securities, what does the term ‘cum dividend’ mean?

A
  • This is where the buyer receives the full 6 months’ interest
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
48
Q

Why is the redemption yield a more accurate calculation than the interest yield?

A
  • Because it considers income as well as the gain or loss at maturity
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
49
Q

What is meant by a ‘floating charge’?

A
  • This is a general charge over any of the company’s assets (as opposed to fixed)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
50
Q

Lynn would like to give her granddaughter £50,000 in three years’ time to help with her university fees. The assets she intends to use for this purpose currently have a value of
£45,000. Calculate how much it will be worth in three years with a 6% growth rate

A

Future Value (FV) = Present value PV x (1 +r)n
You should be putting this into a single line on your scientific calculator.
£45,000 x (1 + 0.06) ^ 3 = £53,595.72
This is a £3,595.72 surplus.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
51
Q

A cash flow of £1,000 receivable in five years’ time has a present value of £712.99. What interest rate has been used to calculate the present value? (3)

A

This uses a variation of the future value calculation used in Question 1. It can be quickly manipulated using algebra – for more information on how this is done, please refer to the Investment Calculations video or check the example below.
The easiest way to do this calculation is simply to remember the manipulated formula. If you do this enough, it’s like second nature:

n √ (FV / PV) – 1 = r

The √ in the formula is not the “normal” square root key on your calculator. You are looking for the “nth root”, not the “square root”. On your calculator it should look like “x√”

So for this calculation, we do the following: 5 √ (£1,000 / £712.99) – 1 = 0.07, or 7%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
52
Q

If you borrow £200,000 today with an interest rate fixed at 5.45% and repayment terms over 25 years by monthly instalments: How much will be paid annually each year? (4)

A

In order to calculate the value of each annual mortgage payment (P), the annuity formula must be used with the following numbers:

r = 5.45% (which when written as a decimal = 0.0545) n = 25 (years)
A = £200,000

1 − ( 1 + 𝑟 ) −𝑛
𝑃 𝑟 = 𝐴

This may look scary, but it’s not. It’s just an extended version of the FV calculation used in Question 1. So let’s work through it.

1 – ( 1 + 0.0545 ) ^-25 = 0.735
And we know r is 0.0545 So 0.735 / 0.0545 = 13.48

At this point, we know that P x 13.48 = £200,000. We can use algebra to easily flip this around:
£200,000 / 13.48 = P = £14,837.20

(Your answer may be slightly different depending on how you round – show your workings in the exam and always show your final answer to 2DP.)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
53
Q

A cash flow of £1,000 receivable in five years’ time has a present value of £712.99. What interest rate has been used to calculate the present value? (Using Algebra)

A

Using algebra, we can take the following steps:
FV = PV ( 1 + r ) ^n
£1,000 = £712.99 ( 1 + r ) ^5
£1,000 / £712.99 = ( 1 + r ) ^5 1.4 = ( 1 + r ) ^5
5 √ 1.4 = 1 + r
1.07 = 1 + r
1.07 – 1 = r
0.7 = r

Why not go back through this calculation now you know the answer? For example, take the third row of the calculation: £1,000 / £712.99 = ( 1 + r ) ^5
We can now confirm: £1,000 / £712.99 = 1.4. But we can also confirm ( 1 + 0.07 ) ^ 5 also = 1.4.

54
Q

£10,000 is placed into a deposit account which pays 5% pa, and at the end of each year the investor withdraws £2,000. What would be the balance in the account at the end of three years

A

The manual way
£10,000 ( 1 + 0.05 ) = £10,500 - £2,000 = £8,500
£8,500 ( 1 + 0.05 ) = £8,925 - £2,000 = £6,925
£6,925 ( 1 + 0.05 ) = £7,271 - £2,000 = £5,271.25

The formulaic way
First, we need to calculate the PV of the £2,000pa annuity. The formula is detailed in the previous question.

1 – ( 1 + 0.05 ) ^-3 = 0.136162
/ 0.05 = 2.7232
X £2,000 = A = £5,446.50

We now need to work out how much the remainder (£10,000 less the PV annuity) is worth when compounded over 3 years at 5%:

£10,000 - £5,446.50 = £4,553.50
£4,553.50 ( 1 + 0.05 ) ^n = £5,271.25

55
Q

A credit card agreement quotes an effective annual percentage rate of 26%. What is the monthly rate?

A

Using pounds and pence
We know that an AER of 26% means that if we start by owing £100 at the start of the year, we’ll end up owing £126 at the end of the year. As such, we can use a simple r calculation:
12 √ (£126 / £100) – 1 = 0.0194, or 1.94%

Without using pounds and pence
Using the following formula: n √ (1 + APR) – 1 = r
This is a variation of the r formula we used above, but we’re using percentages and rates rather than pounds and pence.
12 √ ( 1 + 0.26 ) – 1 = 0.0194, or 1.94%

56
Q

What is the formula for calculating an APR/AER from a monthly rate:

A

APR = (1 + monthly rate)12 -1

If the annual percentage rate was already known, the monthly rate would be calculated by using the following formula:
Monthly rate = 12√1+APR - 1

57
Q

Interest is being charged on a monthly loan at a nominal annual rate of 6%, what is the (APR)?

A

APR = (1 + 0.06/12)12 – 1 = 6.17% [2 decimal places, always!]

58
Q

Which pays a better return: 4% every 3 months or 4% pa paid monthly?

A

a) Every 3 months (quarterly) = [(1+0.04/4)4 – 1] x100% = 4.06%
b) Monthly return = [(1+ 0.04/12)12 – 1] = 4.07%

59
Q

What are the money markets?

A

The money markets are the market for short-term credit, loans and deposits with an original maturity of less than one year. Institutions can borrow funds if they have a cash flow problem, or deposit funds if they have a surplus. Deposits range from overnight to 12 months. These funds may either be in the form of a straightforward cash deposit or loan, or an instrument such as a bill or a certificate of deposit.

60
Q

In order to resolve any shortages (short, or over-lent) or surpluses (long or has excess cash) of cash that arise, the banks have a borrowing / lending market amongst themselves called?

A

the inter-bank market

61
Q

What is the inter bank market?

A

The inter-bank market is a market where two-way prices are made between participating banks

banks raise the shortfalls and lay off the surpluses generated in each period by their customers’ activities (normally unsecured and for amounts in excess of
£500k).

62
Q

the difference between the two way prices on the inter bank market is called?

A

Spread

63
Q

What is the two way price made up of?

A

The two-way price will be made up of a BID (to buy) rate, which is the rate the bank will pay for deposits received, and an OFFER (offering/selling) rate, which is the rate the bank charges for loans made. The bid rate is always lower than the offer. The difference between the two is called the SPREAD.

64
Q

How do platforms make their margin (Spread)

A

they charge a margin on selling/buying (using their platform – which could be anything from eBay to Betfair to Cofunds to Standard Life; they charge a spread or margin on each transaction for ‘trading’ using their platform.

65
Q

What can the government use to borrow short term loans on the money markets?

A

Treasury Bills

66
Q

where are Treasury bills issued?

A

Through the DMO at weekly auctions
T-bills are issued at a discount and redeemed at their face value, or par; there is no coupon.
The DMO (Debt management office) issues T-bills every Friday. Interested parties submit a price, and if they are successful they pay the price they submitted; this is called a competitive auction.
T-bills may be purchased from the DMO at issue and redeemed at the end of the redemption period. Alternatively it is possible to buy (or sell) them second hand on the money markets.

67
Q

What is the maturity terms on Tbills and minimum investment?

A

one month, three months or six months (usually a minimum of £500,000 nominal purchase).

68
Q

what is the sequence / calculation of of return on T-bill

A

DMO issues a 91day T-bill with face value £100k (100k is the final return) Investor pays 98.5k (initial investment cost)
Investor holds bill to redemption

Receives £100k (and £1.5k in growth over the 91 days, from the initial investment)

This would be the equivalent of receiving £1.5k ‘interest’ every 91 days (on an initial deposit of £98.5k); this is 365/91 x 1.5k/98.5k = 6.11% pa
This is a ‘simple’ method.

A more accurate method could be to apply the AER formulae over the period to get an annualised comparable figure. In this case, it would be compounded 365/91 times per annum.

69
Q

What is commercial paper?

A

corporate unsecured short dated debt is called Commercial Paper (CP) and have typical maturities of between 30 and 90 days. All of these money market transactions are done via the money markets – effectively trading paper as cash equivalent, but written on their own terms.

70
Q

What do Money market funds primarily invest in?

A

Money Market Funds (MMFs) are collective investments which invest primarily in cash and short-term debt such as treasury bills, certificates of deposit, and commercial paper. They allow private investors to access these wholesale assets and, given the size of the collective investment, the potential for a higher interest rate.

71
Q

Is commercial paper considered low risk?

A

Yes, commercial paper is considered very low risk because of the credit worthiness of the issuer and the short-term nature of the debt (typically under 1 year).

72
Q

How are certificate of deposits issued and what do they represent?

A

A CD is issued when an investor places some money for a given term with a bank at an agreed interest rate (usually linked to the LIBOR/SONIA rate, but with a discount because they are ‘tradable’); they represent a deposit (not a loan), pay interest (at end of term) and typical maturities range between one and three months.

73
Q

Name two credit rating agencies?

A

S & P, Moody’s & Fitch

74
Q

What are credit default swap rates?

A

CDS (credit default swap) rates are the cost of insuring a bank debt default by using credit default swap. Most major UK banks have CDS rates of between 100 and 300 bips. Any higher would indicate the market considers there to be higher risk of default

75
Q

who runs the settlement of money market transactions

A

The transfer and settlement of most money market instruments take place through the Central money markets Office (CMO) system run by CREST.

76
Q

Money Market Fund Risks

A

credit risk, inflation risk and interest rate risk and there maybe also currency risk where they are issued as non- sterling denominated.

77
Q

What is inflation risk?

A

Inflation risk is the risk of money losing value as inflation increases. But in recent time, deflation has been the concern

78
Q

What is Deflation?

A

Deflation is described as: A decrease in the price level of goods and services, or when the annual inflation rate is below 0%.
With deflation, interest payments become more expensive in real terms over time. The loan value, in effect, increases. The value of the interest increases in real terms.
Maturity value is greater in real terms. Fixed interest prices pushed up.

Individuals defer purchases (as the price is expected to be lower in the future) reducing turnover and profit for companies and downward pressure on share price.

79
Q

The key ‘deflationary’ points are:

A

Fall in demand/reduction in economic activity. Greater tendency to save/borrow less.
Debt increases in value

80
Q

what are debt securities?

A

Debt securities are financial instruments that give the owners’ rights to interest and repayment of capital on loans made to governments and companies.

They are more commonly known as bonds and can have redemption periods of up to 30 years (pension fund demand has led to a call for 50 year issues and recent 55 year bond issues were quickly over-subscribed by £12billion).

81
Q

What are GILTS primarily used for

A

Companies and governments need cash to operate and cash income does not always cover their cash expenditure. Both must raise additional ‘capital’ to fund shortfalls.

Capital is usually categorised into debt and equity

Debt involves borrowing money with a firm commitment to repay both the capital and associated interest; governments cannot raise equity capital, therefore debt is their only option.
UK Government gilts and Treasury bills (dealt with under Topic 2) are issued by the DMO (Debt Management Office)

82
Q

What are gilt-edged market makers (GEMMs)

A

The gilt-edged market makers (GEMMs) are market makers who set up and deal in the primary markets for gilts (via DMO) in the UK Government debt securities. Gilt-edged securities form a large part (@ 65%) of national debt, with the remaining (35%) being funded by NS&I, short-term borrowing from the Bank of England and overseas borrowings.

83
Q

How are GILTS sold?

A

Gilts are auctioned (offered for sale) on regular dates by DMO

Non-competitive bids

Successful non-competitive bids are accepted in full at the weighted average price at which competitive bids have been accepted.
Syndicated offerings

This is where the DMO appoints a group of banks to manage the sale of the gilt on its behalf.

84
Q

What is a competitive GILT auction

A

Competitive bids must be for one amount at one price and bonds are sold to those whose competitive bids are at or above the lowest price the DMO is prepared to accept.
The result is that not all gilts are sold at the same price.

85
Q

What are non competitive bids at the Gilt Auction?

A

Successful non-competitive bids are accepted in full at the weighted average price at which competitive bids have been accepted.

86
Q

What is a TAP in reference to GILTS

A

In a TAP the DMO passes the gilts onto GEMMs who issue them directly into the secondary market; initially the gilts are still issued to GEMMs, who tender prices to the DMO.

87
Q

Describe GILTS

A

Shorts <7 years to redemption, Medium 7-15 and Long >15 Nominal (par) value (=£100 on redemption)
Interest rate (coupon described as an annual % of nominal value £100 paid semi-annual 6 months apart and paid gross of income tax)
Redemption date (year £100 capital is repaid) with undated/irredeemable gilts effectively being cashed in by the government at any time.

88
Q

Describe Index Linked GILTS

A

Index-linked bonds have coupons AND redemption values which are linked to the UK Retail Price Index (RPI) or CPI – depending on the index being used or being issued by HM Government (these calculations can be very complicated and you will never get asked to calculate one, but you do need to understand that both the coupon and par value are index- linked).

89
Q

What is the Break-Even Inflation Rate

A

The break-even inflation rate is the rate of inflation that gives the same real net redemption yield for an index-linked gilt and a comparison conventional gilt of similar maturity for investors of a given tax rate (ie. BRT, HRT or ART).

ABOVE the break-even rate the index-linked gilt gives the better return.
BELOW the break-even rate the conventional gilt provides the better return

90
Q

What is the STRIPS market?

A

STRIPS stands for ‘Separate Trading of Registered Interest and Principal of Securities’.

These gilts can be stripped into their coupons and final redemption amount, both traded separately. These individual parts are both registered securities.
Each strip forms the equivalent of a zero-coupon bond. It will trade at a discount to its face value, with the size of the discount being determined by prevailing interest rates and time.

Only those gilts that have been designated by the DMO as ‘strippable’ are eligible for the STRIPS market (not all gilts are eligible).

91
Q

What is the key feature of a zero

A

The key feature of a ‘Zero’ is that it has a fixed maturity date with a fixed return (dependant on the cost on investment and final ‘par’ value return). The rate at which the assets have to grow annually to provide the redemption price at the maturity date is called the ‘hurdle rate’. This can be positive or negative.

92
Q

What are the general features of overseas government bonds

A

The general features of overseas government bonds and the markets they trade in vary from country to country – but, effectively all operate on the same basic principles.

93
Q

what re the 3 major bond markets in the UK

A

Gilts issued through the Treasury by DMO (including repo market)

*Sterling loans to foreign borrowers

*Eurobond market which deals with foreign currency loans to UK and foreign governments and companies, this allows institutions who receive earnings in foreign currencies to keep the income in that currency

94
Q

what is the euro bond market?

A

Eurobond market which deals with foreign currency loans to UK and foreign governments and companies, this allows institutions who receive earnings in foreign currencies to keep the income in that currency

95
Q

What is the Repo Market?

A

A repurchase agreement (also known as a repo or sale and repurchase agreement) allows a borrower to use a financial security (gilt) as collateral for a cash loan at a fixed rate of interest. The analogy of the pawn broker is a good one here – the pawn broker will ‘lend’ money against the collateral of the goods and return them at some point in the future.

96
Q

What is a GILT Repo?

A

A gilt repo is a contract in which the seller of gilts (in this case the DMO, who are selling gilt- edged debt/bonds) agree to sell and buy back at a future specified time and price (which could be very short time scale).

Here, the gilt repo is a means of borrowing, using the gilt as security (accessing the gilt capital for a fixed period – where the gilt capital is secure).

A repo contract is where the borrower (in the gilt market this would be DMO), agrees immediately (part of the same contact) to sell the security (gilt) to a lender and also agrees to buy the same security from the same lender at a fixed price at some later date.

97
Q

What is an advantage of the GILT repo market?

A

The advantage of the gilt repos is that holders (of the gilt) are able to raise finance (cash) against the security of the gilts and potentially accessing cheap short-term finance.

98
Q

what is the euro bond market?

A

Eurobonds are international bond issues outside any particular jurisdiction. For example, a US dollar Eurobond could be issued anywhere in the world, except for the US. As such, a better name for it might be an international bond. They are a way for an organisation to issue debt without being restricted to their own domestic market. They are generally issued via a syndicate of international banks

99
Q

What are corporate bonds?

A

Corporate bonds are debt securities where the issuing company promises to repay the capital (at end of term) and interest to the holders throughout the term. The method commonly used for issuing corporate bonds is a PLACING. This takes very much the same form as a placing in equity issues, with underwriting of corporate bond issues common.
The description of a corporate bond is very much like a gilt with interest fixed or variable rate and terms of redemption (and provisions for early repayment/demand for early repayment or convertibility) is set out within the terms of issue.

100
Q

What is a domestic bond?

A

A domestic bond refers to one in which the nationality of the issuer, the denomination of the bond and the country of issue are the same. For example, a sterling denominated bond issued in London by a UK company.

101
Q

What is a foreign bond?

A

A foreign bond is one in which the nationality of the issuer is different to that of the denomination of the bond and the country of issue, for example, a sterling bond issued in London by a US company (known as BULLDOGS on the UK market).

102
Q

What are the risks of foreign bonds?

A
  • Credit / default risk: non-payment of interest or capital at redemption
  • Economic risk: different countries = different economies = different risks (Greece versus Germany?)
  • Foreign exchange / currency risk: negative currency exchange movements
  • Interest rate risk: the inverse relationship between bond prices and interest rates
  • Liquidity risk: is it possible to sell a specific amount, at the price you want and at the time you want to?
  • Political risk: political instability can be a major factor (Venezuela?)
103
Q

What is a international eurobond?

A

An international bond (EUROBOND) is a security where the denomination of the bond and the country of issue are all different. For example, a company issuing dollar bonds in Paris and Tokyo, or a company issuing yen bonds in Frankfurt and Dublin

Eurobonds are issued in the currency and country where the issuer finds it cheapest to raise the finance, and then swapped into the currency the issuer wants.

104
Q

What is a debenture? In terms of corporate bonds

A

A debenture is a document which acknowledges a company’s indebtedness to a third party, and in particular to secured debt instruments. That is, secured corporate bonds would be called debentures – secured on defined assets

105
Q

What is loan stock? In terms of corporate bonds

A

the term loan stock refers to unsecured corporate bonds (but, maybe guaranteed in some other way).

106
Q

What is a asset backed security?

A

An asset-backed security (ABS) is a financial instrument secured by a pool of assets such as property or loans. They are issued by companies specially created for the purpose and are a separate legal entity from the original owner of the underlying assets. This leaves them unaffected by any bankruptcy risk in the original owner.

Cash flows from the pool of underlying assets (e.g. rental income or mortgage income) are distributed on a pro-rata basis to the holders of the ABS. This is called a securitisation

107
Q

What are mortgage backed securities?

A

A mortgage backed security (MBS) is a securitised pool of underlying home loans. They are used by retail banks to securitise the cash flows from mortgages that would otherwise be receivable over, normally, a 25 year term.

108
Q

The main risks involved with Gilts and corporate bonds

A
  • Credit risk: interest payments and repayment of the bond may not be made
  • Market risk: inverse relationship between bond prices and interest rates
  • Inflation risk: real value of bond coupon & redemption repayment
  • Liquidity risk: bonds not easily traded
  • Exchange rate risk: bonds denominated in different currencies
109
Q

The 3 key risks that go to make up a bond ‘price’:

A

Credit risk

Credit rating agencies make an assessment when first issued (and throughout the term of the bond) and are divided into Investment Grade (various grades) or Non-Investment Grade (junk bonds). For example, using S&P ratings, anything less than a BBB is junk.
(I suspect that a farming co-operative offering a fruit box as a coupon, could be put into the category of ‘junk bonds? These type of bond/debt arrangements are now, apparently, very popular with start-ups and SME’s looking for investment)

Market risk

The income/coupon from a bond remains unchanged throughout the term. Yields vary to reflect interest rates rising or falling by a fall or rise in its capital value (par=100).
(Fruit boxes could also be susceptible to a number of other, as yet unquantifiable biological risks as well….!)

Volatility/Sensitivity

Bond prices will not all change by the same amount when interest rates or yields change – they are all made up of different coupons and terms. The measure used to calculate how sensitive the bond is to changes in interest rates or yield, is known as duration or modified duration (see more on that in the next section).

110
Q

In connection with a portfolio of UK gilts, describe four relevant risks, explaining each in a way appropriate to a UK-based private-client investor, including ways that the risk might be reduced

A

Interest rate risk/duration risk
Reinvestment risk
Default risk
Downgrade risk
Systematic risk
Liquidity risk
Political risk

111
Q

Calculate the net redemption yield for a higher rate tax payer on the Treasury 3.75% 2055 (33 years to redemption) with a current clean price of £151.64

A

Flat yield
£3.75 / £151.64 = 2.47% x 0.6 = 1.48%

GRY
£51.64 loss on redemption
/ 33 years = 1.56%
/£151.64 = 1.03%

1.48 – 1.03 = 0.45%

112
Q

a. Explain in what is meant by the term “duration” in a way suitable for a private client investor

A
  • The amount of time
  • In years
  • Required to regain the cost of a fixed interest security
  • Taking into account flat yield/coupon
  • And return of capital on redemption
  • For every 1% movement in interest rates (up or down) the bond value will move by the value of its modified duration in the opposite direction.
  • The higher a bond’s duration, the more sensitive it is to interest rate changes.
  • However, due to convexity, duration is likely to underestimate rises in value and overestimate falls in value.
113
Q

b. If a Gilt with a modified duration of 12.5 is currently selling for £132.50, what would a 0.1% rise in yield (or in other words an interest rate increase) be expected to do to the current selling price of this bond?

A
  • It would reduce the value of the bond
  • By 12.5 / 10 = 1.25%
  • From £132.50 by £1.65625 down to £130.84.
114
Q

What is Interest rate risk / Duration Risk in relation to bonds / gilts

A

When interest rates rise, the prices of fixed interest bonds, such as gilts, will fall – this is your see-saw correlation effect. When interest rates rise (or fall), the prices of longer- dated gilts, will fall (or rise) by a greater proportion, as defined by your modified duration calc.

115
Q

What is Reinvestment risk in relation to gilts

A

This is the risk that as one gilt
matures, you can’t reinvest
back into another gilt giving the
same rate of interest due to
changes in the market and
interest rates. This is of
particular concern to investors
relying on income who have
gotten used to a certain level
of income and can now no
longer continue that level of
income without taking on more
risk.

116
Q

what is Default risk

A

This is the risk that the government defaults on either
its coupon to you, or on the return of capital at maturity.
This is a very low risk with gilts. However, the UK was
downgraded to an AA credit rating after the Brexit vote by
S&P, and some governments such as Russia, Greece, and
Argentina have defaulted in the past.

117
Q

what is downgrade risk

A

This is the risk that the UK’s
credit rating is downgraded,
which could increase yields on
existing bonds as investors
demand a higher return for the
higher perceived default risk.
The UK was downgraded to
AA by S&P shortly after the
Brexit vote, following by Fitch
and Moody’s, although it
should be noted that impact
was minimal in the markets on
these occasions.

118
Q

what is Systematic risk

A

This is the risk of a global
crisis causing most/all asset
classes to fall together, with
converging correlation
coefficients (trying saying that
three times fast!) such as we
saw in 2008. However, it’s
important to note that UK gilts
were fairly stable during the
crisis, while corporate bonds
tanked.

119
Q

what is liquidity risk

A

The possibility that an
investor may not be able
to buy or sell an
investment as and when
desired or in sufficient
quantities.

120
Q

What is political risk

A

A change in government policy could reduce the real return on gilts, for example, by the removal of the personal savings allowance, or an increase in income tax.

121
Q

what is inflation risk

A

Conventional gilts pay interest and redemption of the nominal capital in fixed amounts of pounds. These payments are eroded in terms of purchasing power by inflation over the holding period to maturity. If the government expands the money supply with continued QE, this could be a longer term risk.

122
Q

Calculate the net redemption yield for a higher rate tax payer on the Treasury 3.75% 2055 (33 years to redemption) with a current clean price of £151.64

A

Flat yield
£3.75 / £151.64 = 2.47% x 0.6 = 1.48%

GRY
£51.64 loss on redemption
/ 33 years = 1.56%
/£151.64 = 1.03%

1.48 – 1.03 = 0.45%

123
Q

Explain in what is meant by the term “duration” in a way suitable for a private client investor

A
  • The amount of time
  • In years
  • Required to regain the cost of a fixed interest security
  • Taking into account flat yield/coupon
  • And return of capital on redemption
  • For every 1% movement in interest rates (up or down) the bond value will move by the value of its modified duration in the opposite direction.
  • The higher a bond’s duration, the more sensitive it is to interest rate changes.
  • However, due to convexity, duration is likely to underestimate rises in value and overestimate falls in value
124
Q

If a Gilt with a modified duration of 12.5 is currently selling for £132.50, what would a 0.1% rise in yield (or in other words an interest rate increase) be expected to do to the current selling price of this bond?

A
  • It would reduce the value of the bond
  • By 12.5 / 10 = 1.25%
  • From £132.50 by £1.65625 down to £130.84.
125
Q

Describe three different types of IPO

A
  1. Fixed price: a fixed price is stated and offered on that basis (sometimes this initial price is set low to encourage take up)
  2. Tender: investors make bids and applications with the highest bids accepted (and normally all purchased at same price)
  3. Placing: similar to an offer, but where the shares are only offered to selected investors (pension funds, investment houses)
126
Q

In the following two examples, describe whether you would hold, sell or buy and explain your reasons why:

ABC has just paid a dividend of 6p. The expected growth rate of its dividends is anticipated to be 7%. Investors are expecting a return of 10% and the current market price of ABC shares is 195p

A

I’m going to use Gordon’s Growth Model (GGM) to calculate the share prices, which is a method of share valuation using dividend flows. The following formula is used:

So in the case of the above:

6p / (0.10 – 0.07) = 200p

If I were a value manager, I would buy/hold because the current share price suggests the shares are undervalued.
Other valuation methods are also tested. You will also need to understand how to calculate share price based on net asset value (NAV) and Earnings Growth (PEG ratio). You need to have an awareness of the Shareholder Value model, but as far as I’m aware, you don’t need to know how to calculate this.

127
Q

XYZ has just paid a dividend of 5p. The expected growth rate of its dividends is anticipated to be 12%. Investors are expecting a return of 15% and the current market price of ABC shares is 200p.

Calculate the GGM and decide whether to hold or sell the share

A

5p / (0.15 – 0.12) = 166.67p

If I were a value investment manager, I might sell this share because it’s currently priced at 200p and GGM is suggesting its value is only 166.67p, and thus is overvalued.

128
Q

what are the drawbacks of Gordon’s growth model

A
  • It assumes constant growth in dividend per share, which is rare for companies.
  • It bases the valuation on dividend flow, which therefore renders it less useful for valuing smaller “growth” oriented stocks.
  • If the required return is less than the dividend growth rate, the result is a negative value
  • If the required return is equal to the divided growth rate, the model also collapses due to the share value being theoretically infinite. On my Casio fx-82MS, it says “Math Error”
129
Q

Best bank is offering an account which will pay a nominal 6.1% (compounded quarterly) or a nominal 6% (compounded monthly). Assuming all else is equal, what is the best account?

A

Straight AER calculations:
Account A: (1+ 0.061 / 4)^4 – 1 = 6.24%
Account B: (1+ 0.06 / 12)^12 – 1 = 6.17%

The quarterly account (Account A) therefore delivers the stronger returns in this case.

130
Q

Explain what Modified Duration (MD) quantifies

A
  • Duration represents the time it takes
  • In years
  • For a bond investor to recover their initial investment
  • Taking into account coupon/interest payments
  • And the capital repayment on redemption
  • It is used as a measure of the bond’s sensitivity to interest rates,
  • For every 1% change in interest rates, bond prices will move the opposite way by the amount of their Modified Duration.
  • The formula is as follows:

Macaulay duration Modified Duration = (1 + GRY)

  • Due to convexity, Modified Duration will tend to underestimate rises in value and overestimate falls in value.

AF Flash Cards (3 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions