Summer 2021 Exam

Question 1

If a rating agency increases the probability of default on a bond by one grade, this can be expected to result in a promised yield to maturity:

a. equal to zero.
b. equal to the expected yield.
c. greater than the expected yield.
d. less than the expected yield.

Answer 1

c. greater than the expected yield.

Question 2

What are the aims of the UN Sustainable Development Goals (UN SDGs)?

Answer 2

To make economies more productive, socially inclusive, and environmentally conscious

Question 3

In company law, a derivative action is:

Answer 3

where a shareholder, in place of the company, brings a claim against a director of the company for negligence, default or breach of duty or breach of trust.

Question 4

For an employed UK tax payer with a portfolio of directly held FTSE 100 shares:

Answer 4

two different CGT rates may apply to realised gains in the same year.

Question 5

Hilary makes a direct purchase of single listed AIM regular trading company shares for cash, sells some FTSE 100 shares, and buys some convertible bonds. Which stamp duty was she liable, if any?

Answer 5

Stamp Duty Reserve Tax.

Question 6

A real estate investment trust (REIT) has property rental income of £5,000,000. To gain full tax benefits, what is the minimum that must be distributed?

Answer 6

£4,500,000.

Question 7

The main purpose of the January 2020 revision to the UK Stewardship Code is to

Answer 7

strengthen governance, transparency, and reporting.

Question 8

A company has earnings per share of 16p, dividend per share of 4p, used one quarter of earnings to buyback shares, and has a share price of 200p. The company has a:

Answer 8

total yield of 4%.

Question 9

A company has earnings per share of 2p, dividend per share of 1p, and a share price of 10p. The company has a:

Answer 9

dividend cover of 2.

Question 10

In order to remain a FTSE 350 company director, the UK Corporate Governance Code requires existing directors to stand for re-election:

Answer 10

annually.

Question 11

The January 2020 revision to the UK Stewardship Code did not integrate:

a. the UN Principles for Responsible Investment.
b. the EU Shareholder Rights Directive.
c. the Paris Agreement on climate change.
d. extensive investor and stakeholder feedback.

Answer 11

c. the Paris Agreement on climate change

Question 12

An investment portfolio not within a tax wrapper and with an acquisition value of £400,000 was disposed of for £450,000 without incurring any CGT liability. There were no offsetting losses. The portfolio consisted entirely of:

Answer 12

gilts and venture capital trust (VCT) shares purchased at issue.

Question 13

A common concern about green bonds is:

Answer 13

the definition of green has not yet been properly defined.

Question 14

A decrease in investors’ risk aversion is represented on the security market line (SML) by:

Answer 14

a change in slope of the line.

Question 15

Which is not a test of the semi-strong form of the efficient market hypothesis?

Answer 15

Serial correlation in stock returns.

Question 16

A company has a current price of USD25 a share, an expected growth rate in perpetuity of 4% and expected dividend per share next year (D1) of USD1. You have a required rate of return of 5%. The expected return minus the required return is equal to:

Answer 16

3%.

Question 17

According to the Green Bond Principles, which is not an eligible capital project for capital raising?

Answer 17

Automotive.

Question 18

A factor portfolio has:

Answer 18

a factor sensitivity of one to a particular factor and zero to all other factors.

Question 19

A corporate bond with a par value of £100,000 has a default probability of 5% and a predicted recovery rate of 60%. The bond’s expected loss is:

Answer 19

£2,000

Question 20

Which is not a UN Sustainable Development Goal?

a. Life on land.
b. Zero hunger.
c. Gender equality.
d. Zero inequality.

Answer 20

d. Zero inequality.

Question 21

Expected asset class investment returns are a key input into multi-asset portfolio construction. Give three key techniques used to derive expected asset class returns.

Answer 21

• Averaging simulations
• Sampling technique and adjust
• Use models

Question 22

How do you use averaging simulations to get the expected return of an asset class?

Answer 22

• Use historic returns
• Simulate possible returns by jumbling the sequence
• Average out the outcomes from simulations

Question 23

How do you use sampling to get the expected return of an asset class? (2)

Answer 23

• get sample of returns using historic data
• adjust the mean and standard deviation based on factors for the future

Question 24

How do you use models to get the expected return of an asset class?

Answer 24

• Use models like CAPM
• Get data for factors
• Risk free rate, beta, return of market

Question 25

How are the best and worst days of market returns distributed and how does this affect market timing? (2)

Answer 25

- The worst and best return days are clustered - Makes timing challenging

Question 26

What expertise is needed to understand potential market downturns (4)

Answer 26

- Financial - Economic - Unprecedented (i.e. Covid) - Political

Question 27

Why is it hard to have the expertise needed to predict the market

Answer 27

Need to know a lot about different things

Question 28

What are the steps needed in timing the market (active management)?

Answer 28

- Identify signal - Develop conviction to act - Sizing how much to invest - Monitor and reverse if needed

Question 29

What does the performance of hedge funds suggest about active management performance?

Answer 29

Suggests marketing timing (active management) is difficult.

Question 30

The scientist first invites Bob to put £1 on the result of a heads or tails coin flip, offering £3 if Bob chooses correctly. Bob declines the bet. What behavioural bias might have led Bob to act the way he had? (3)

Answer 30

- loss aversion - fear of loss is greater than happiness from gain - Even with positive expected value

Question 31

Bill is willing to pay £1 for the chance to win £1.50 (£0.50 profit) on correctly calling heads or tails because he recently lost £5 in the casino and it is important that he breaks even on his gambling for the day. What behavioural bias might have led Bill to act the way he had?

Answer 31

- Mental accounting - Gambling account is down for the day - Negative expected value (0.5 x 1.50 = 0.75)

Question 32

A scientist does not ask Jane to wager money but instead offers her a choice of taking £0.50 or winning £1.00 if the next coin flip comes up heads. Jane takes the £0.50. What behavioural bias might have led Jane to act the way she had?

Answer 32

- Acted rationally - Should be indifferent between both outcomes

Question 33

What are the main benefits of holding adding commodities into portfolio? (3)

Answer 33

- diversification - Inflation link - Safety of precious metal

Question 34

What are the disadvantages of holding commodities in portfolio?

Answer 34

- Commodity returns are speculative - Does not generate value

Question 35

How can you invest in commodities?

Answer 35

- Direct equity (invest in companies) - Collective vehicles - Derivatives

Question 36

What are the three further investment risks taken over and above Treasury Bills should the client instead select a money market fund as the risk-free rate for the portfolio.

Answer 36

- Foreign currencies - Overseas governments may default - May pay interest (reinvestment risk)

Question 37

Concisely explain the real-world constraints and interactions that mean the theoretically efficient portfolio may not be held (3)

Answer 37

- Rebalancing decisions - Liquidity / availability - Ethics / RI

Question 38

How are index-linked gilts taxed when sold? (2)

Answer 38

- Tax free in line with gilt taxation - There is capital gains tax

Question 39

How are index-linked bonds taxed when sold?

Answer 39

- Profit made is taxed as income not capital gains

Question 40

Why are modern markets hard to beat? (3)

Answer 40

- A lot of investors and professionals - They are driven by making profit - Mispricing doesn't stay big for long

Question 41

What is the speed of information incorporated into security prices in EMH

Answer 41

Information is rapidly analysed and incorporated into security price

Question 42

How do real prices compare to theoretical prices? (3)

Answer 42

- Can be slightly different - Due to factors such as transaction costs, differences in information, etc - Overall unlikely to be wildly different

Question 43

Why is it hard to beat the market even for a smart investor?

Answer 43

- Market reflects the wisdom of all market participants - Investor would need an advantage to beat them consistently - Hard to get this advantage unless have insider info (illegal)

Question 44

Give three behavioural finance concepts that might give a fund comparative advantage in active asset allocation

Answer 44

- Myopia (Present Bias) - Herding - Loss aversion

Question 45

What is myopia (present bias)?

Answer 45

This is short-termism / lack of long-term thinking

Question 46

How can you use myopia (present bias) to get an advantage and beat the market? (4)

Answer 46

- Market participants may be forced to think short-term - This could be due to economics of their businesses - Take a long term approach - Allocate investments based on data that looks further into the future

Question 47

What is herding/conformity?

Answer 47

When investors/market participants follow each other

Question 48

Why is herding bad in investments?

Answer 48

- Markets reacts slower - Decision based on following the crowd - Important fundamentals might be ignored

Question 49

How can you use herding to your advantage in active management?

Answer 49

- Take opposing view if signal from analysis and conviction is strong - Use speed, when see that herding/momentum is forming - Get in at the start of momentum

Question 50

What is loss bias?

Answer 50

Irrational fear of loss even with positive expected outcome

Question 51

Why is loss aversion bad?

Answer 51

- ignores positive expected outcome - essentially loss because of fear

Question 52

How to use loss bias to your advantage in active management? (3)

Answer 52

- happens when market drops - take position when market participants are in "fear" - Use as signal of undervaluation

Question 53

Explain the purpose of the subjective scaling sometimes used within the risk tolerance calculation. (2)

Answer 53

- used as penalty taken off expected return - reduces significance of penalty

Question 54

Give 3 merits of using risk aversion scores in portfolio selection

Answer 54

- easy to calculate and explain - Helps to start conversation with client - Combines objective investment risk with subjective psychological risk

Question 55

Give 3 drawbacks of using risk aversion scores in portfolio selection

Answer 55

- Does not include risk need or risk capacity - Scaling (if added) is subjective - Relies on client's response

Question 56

What is the meaning of 'certainty equivalent'

Answer 56

if portfolio's certainty equivalent return > risk-free alternative then portfolio is desirable

Question 57

How does certainty equivalent help clients?

Answer 57

- helps understand riskiness between portfolios - helps understand riskiness between portfolio and risk free asset

Question 58

How can risk aversion scores help DC pension funds? (3)

Answer 58

- Know how much risk to take - Help members pick suitable default structure - Helps achieve right risk at different time/age