Unit 2 - 2. Asset Classes Flashcards
Equities (ordinary shares)
Unit 2 - 2. Asset Classes
Shares come in ordinary or preference
Every company has ordinary shares in issue, performance of ordinary shares is closely tied to the performance of the business. Shares usually come with voting rights (can vote by proxy).
Shares can come in different share classes.
Different share classes have different voting rights and potentially different places in the capital structure.
Shareholders may receive a dividend if the company is profitable.
Types of preference shares
Unit 2 - 2. Asset Classes
Cumulative - not only paid this years dividend before ordinary shareholders dividend is paid, but also any unpaid dividends from previous years.
Participating - participating shareholders are entitled to more money if there are additional funds available after all other preferred shareholders are paid, as if they are also common shareholders.
Redeemable - preference shares that enable the company to buy back the shares from the shareholder at an agreed price in the future
Convertible - preference shareholder has the right, but not the obligation, to convert preference shares into specified number of ordinary shares
Zero coupon - preference shares which pay no dividend
Debt Instruments (nominal value, redemption date, bond coupon, FRN, index linked)
Unit 2 - 2. Asset Classes
A bond is an IOU issued by an organization, in return for money lent to it.
Nominal value = amount the borrower will pay back to the holder of the bond at maturity.
Redemption date = date at which bond is paid back
Bond’s coupon = interest rate paid on bond
floating rate = bond linked to a floating rate such as libor (FRN)
index-linked = returns are linked to an index
Debt instruments: yields and modified duration
Unit 2 - 2. Asset Classes
Flat yield = (annual coupon/price)x100 (only coupon return, not capital gain/loss)
GRY/YTM = yield to maturity (both coupon and capital gain/loss return)
NRY = GRY after-tax cash flows
Modified duration = approx % change in the price of a bond brought about by a 1% change in the interest rate.
Debt instruments: Convertibles
Unit 2 - 2. Asset Classes
Convertible bonds give the holder the right, but not the obligation, to convert the bond into a predetermined number of ordinary shares of the issuer. Holder will convert, if at maturity, value of shares exceed the redemption value of the bond.
conversion ratio = nominal value / conversion price of shares (number of shares that each £100 of nominal value of the bonds can convert into)
conversion premium = A conversion premium is an amount by which the price of a convertible security exceeds the current market value of the common stock into which it may be converted.
Debt instruments: Accrued interest
Unit 2 - 2. Asset Classes
Accrued interest is the interest that has been earned, but not paid, and is calculated by:
accrued interest = coupon payment x (number of days since last payment/ number of days between payments)
clean price = flat price (d not include accrued interest)
dirty price = clean price plus accrued interest
common day count conventions (act = actual)
- ACT/360
- 30/360
- ACT/365
- ACT/ACT
Debt instruments: spreads and pricing benchmarks
Unit 2 - 2. Asset Classes
spread is simply the difference between the yields on two debt instruments.
Usually expressed in basis points (1/100 of 1%)
Benchmarks
- government bond yields (closest in maturity government bond for same gov)
- swap rates (floating rates for fixed rates)
Debt instruments: Yield curves and negative rates
Unit 2 - 2. Asset Classes
Shows the yields available to investors in government bonds over different time horizons. Visual representation of the term structure of interest rates.
Normal yield curve is upward sloping, time-preference of money.
Invert yield curve, downward sloping, long term rates are lower than short term rates. Expectations of reduction in interest rates at some stage in the future.
Negative rates = used by central banks to induce more spending
Debt instruments: Inflation and PV of a bond
Unit 2 - 2. Asset Classes
Real yield curves can be seen from inflation protected debt instruments. Comparing real and nominal yield curves, the term structure of expectations for future inflation can be derived.
PV = payment (coupon or face value) / discount rate (to power of years)
Government Debt (and inflation protected securities)
Unit 2 - 2. Asset Classes
Bonds issued by governments, can be considered the risk-free rate
Usually interest payments are semi-annually, ex-dividend is days before coupon when new buyers are not entitled, cum dividend is rest of the time.
Inflation protected securities - coupon payments and principal are adjusted in line with published index of price inflation. (CPI or RPI)
real interest rate = [(1 + nominal rate) / (1 + inflation rate)] - 1
CPI - EU wide formula, most used
RPI - UK measure, discredited
PPI - measures inflation further up the supply chain at the wholesale level
Government Debt (STRIPS and international gov bonds)
Unit 2 - 2. Asset Classes
STRIPS = separate trading of registered interest and principal of securities
Stripping a bond involves trading the interest and principal separately. Each strip forms the equivalent of a ZCB (zero coupon bond).
Advantage of STRIPS is that investors can precisely match their liabilities, removing any reinvestment risk.
International bonds
- USA (treasury bonds, notes, bills)
- UK (gilts)
- France (OAT)
- Germany (Bund, Bobl, Schatz)
- Japan (JGB)
Emerging/frontier government bonds are more risky.
Corporate Debt (secured debt and unsecured)
Unit 2 - 2. Asset Classes
Money borrowed a company that has to be repaid.
Lessen risk of the debt by offering assets of the company as a guarantee.
- fixed charge (debt carries fixed charge over a particular asset)
- floating charge (secured against group of assets)
bonds issued with fixed charge as generally referred to as debentures.
When corporation issues secured debt, will appoint trustee.
Unsecured debt is not secured against any of the company’s assets, so the holder has no special protection against default.
Examples
- subordinated bond (lowest debt level)
- guaranteed bond (guarantee provided by someone other than issuer, eg parent company)
- convertible bond
Corporate Debt (MBS and ABS)
Unit 2 - 2. Asset Classes
ABS - asset backed security
bonds backed by a particular pool of assets
securitization of assets to create the ABS product.
MBS - mortgage backed security (example of ABS)
created from mortgage loans pooled together.
sub divided into tranches
ABSs often utilise a special purpose vehicle (SPV) to lessen the default risk that investors face. SPV is often a trust
- SPV is separate entity from the originator of the assets
- SPV is a stand alone entity so if originator suffers bankruptcy, SPV remains intact.
Corporate Debt (Tiers of debt and credit ratings)
Unit 2 - 2. Asset Classes
Tiers (seniority of debt relative to others)
1- Senior debt
2- Subordinated debt
3- Mezzanine debt
Credit Ratings
Independent credit rating agencies gives probability of default
split into many grades Investment grade (BBB above) Non-investment grade (high yield/junk bonds)
Cash Assets (definition, deposits, T-Bills, CP, Repo)
Unit 2 - 2. Asset Classes
Money market instruments such as cash deposits and short term investments with less than one year till maturity.
Cash deposits = accounts held with banks or other savings institutions.
T-Bills = Short term loan instruments issued and guaranteed by the government with maturity dates from 1 to 12 months, pay no coupon.
CP = unsecured short term promissory note issued primarily by corporations (can be by municipal or sovereign issue). Often run through a CP programme by a company.
Repo = repurchase agreement, seller of an asset agrees to buy back that asset at a specified future time and price. It is a means of borrowing using an asset as a security.
