1 - The characteristics, inherent risks, behaviour and correlation of asset classes. Part 1 - Cash investments and fixed interest securities.

Question 1

How are the values cash and fixed interest securities vulnerable?

Answer 1

The are eroded by inflation

Question 2

Which type of investment is generally considered a loser in an economic downturn?

Answer 2

Equities

Question 3

In periods of declining interest rates, which types of investments are most attractive?

Answer 3

Fixed interest bonds and equities

Question 4

What are the different types of risks to investment capital and income?

Answer 4

Shortfall
Systematic and Non-systematic
Currency
Interest Rate
Liquidity
Counterparty
Regulatory
Income
Inflation

Question 5

Why is it important for an investor to have an element of cash within their portfolio?

Answer 5

So its easily accessible in the event of an emergency

Question 6

What are the key characteristics of cash investments?

Answer 6

Receive regular interest payments
The capital is not exposed to investment risk
There is no potential for capital growth
Is is called a liquid asset

Question 7

What should an investor consider before entering into a fixed term cash deposit?

Answer 7

The penalty for withdrawal could outweigh the interest differential
A notice period/penalty would normally apply

Question 8

What are the wider risks for deposit based investments?

Answer 8

Default risk - credit worthiness of the institution
Inflation risk - real return after inflation is negative
Interest Rate risk - Returns may vary over time

Note - for currency deposits, exchange rate movements could affect the rate payable and also impact on the overall capital

Question 9

What elements does an investor need to consider regarding the FSCS for deposits?

Answer 9

The limits only apply to each investor
An investor with accounts across several providers cannot recover more than a person with all accounts in one place.
Joint account holders can each recover the maximum in respect of the same account
If accounts are held with subsiduaries, only the parent company is authorised and only for the first £85K

Question 10

Why was there a reinvestment risk for savers in 2009?

Answer 10

Many had invested some 3-5 years before when interest rates were higher and therefore could not secure the same rate on reinvestment. This was particularly exposing for retired savers or others who relied on income from savings.

Question 11

What are the common dangers of offshore accounts?

Answer 11

High rates are usually offered by hihg inflation countries with unstable currencies
Even strong currencies fluctuate, they may not rise enough to compensate for a low interest rate
There may not be the same supervisory structure as the UK and therefore institutional collapse may be more probable

Question 12

What are the features of structured deposits?

Answer 12

Based on the performance of an index - such as FTSE
Risk free way to invest in the rise of stock markets
Generally require a commitment of 5 years
100% capital protection

Question 13

What are the key features of an ISA?

Answer 13

Interest is paid tax free
£20K limit
Arranged on an individual basis
Withdrawals can be made at any time
Subject to provider rules, amounts can be replaced within  the same tax year

Question 14

What type of ISA transfers can be undertaken?

Answer 14

Some or all of savings from a previous tax year can be moved to a different ISA manager
Within the same tax year, all of the savings can be moved
ISA cash savers can move their money to another cash ISA or to stocks and shares/Innovative finance ISA
Stocks and shares ISA can be moved to a cash ISA
A help to buy ISA can be moved to a lifetime ISA

Question 15

What are classed as eligible investments for ISA?

Answer 15

Bank and building society accounts
Units and shares in a UK unit trust and OEIC’s, UCTIS
Stakeholder cash deposits
National savings direct ISA

Question 16

What are the minimum and maximum investment amounts in a National Savings Income Bond and Growth Bond and what term can they be over?

Answer 16

£500 minimum
£10,000 maximum
One or three years (two and five year terms are only availabe to customers renewing a maturing bond)

Question 17

What is the simplest way a client could access the money markets?

Answer 17

Through a collective investment scheme

Question 18

What makes use of the money markets attractive to banks, companies and governments?

Answer 18

The instruments are highly liquid and carry a relatively low risk

Question 19

What are the money market instruments?

Answer 19

Treasury bills
Commerical bills
Certificates of deposits
Others - repos, bills of exchange

Question 20

Who issues treasury bills and how is the rate of return evidenced?

Answer 20

Issued by the Government
The par/face value is less than the issue price, at maturity the Government pays the full par value, therefore the interest is the difference between the purchase price and the maturity value.

Question 21

What would a certificate of deposit be used for and can they be cashed in early?

Answer 21

Used by Banks and building societies to raise funds.
They cannot be cashed in early but can be traded on the money markets but the yield would be slightly lower than the agreed rate at the outset (usually linked to LIBOR)

Question 22

What are commercial bills and how do they operate?

Answer 22

Short term negotiable debt instruments
Issued at a discount to their maturity value
Unsecured, so only issued by companies with high credit ratings.
Yeilds higher than treasury bills due to the credit risk and reduced liquidity

Question 23

How do managers categorise funds on the money markets?

Answer 23

Short-term funds - weighted average of maturity of no more than 60 days, weighted average life of no more than 120 days

Standard funds - periods extended to six - twelve months

Question 24

What factors should be considered when deciding if money market funds are right for a client?

Answer 24

How the funds compare with other cash-based investments
What charges are made and how these impact returns
How long it will take to realise the assets if the client needs access
What assets are contained and the degree of risk exposure
How experienced the fund management team is

Question 25

What is the general description of a fixed interest security?

Answer 25

Issed by Governments, companies or other official bodies to raise money/finance The owner will receive regular fixed interest payments and usually repayment of capital at the end of the agreed period Cannot be cashed in early, but the investor can sell them on the stock market at any time

Question 26

Why are fixed interest securities also know as 'negotiable fixed interest, long term debt instruments'?

Answer 26

They are Negotiable - the lender can sell the entiltement to a thrid party, who can sell it on Fixed interest - the borrower is committed to pay for the duration of the loan Long term - run between 2 - 30 years Debt instrument - financial instruments representing debt

Question 27

What other names refer to fixed interest securities?

Answer 27

``` Bonds Loan Stock Debentures Loan Notes Gilts - issued by the government Corporate Bonds - issued by companies ```

Question 28

Why would a company use a bond to raise capital, as opposed to a Bank loan?

Answer 28

May not be able to lend for the required period Bond market offers a wider range of lenders Often cheapest method of borrowing money

Question 29

What are the three general characteristics of Bonds?

Answer 29

Coupon - fixed rate of interest Par Value - redemption value Redemption date - repaid after a fixed period

Question 30

What are the three key features the title of a bond will give?

Answer 30

Issuers name Coupon Maturity date Will also contain a nominal value of £100 (market value will differ) as the bond nears maturity it will approach the nominal value

Question 31

How are Bonds priced?

Answer 31

Traded by their nominal/par value for £100 Nominal or par value determind by - the price at the which the bond will be redeemed by the issuer at the redemption date, the amount of interest received.

Question 32

Why would the prices quoted within the FT and other newspapers, be different to the price an investor would pay?

Answer 32

They are mid-market prices | They are clean prices - ignoring interest accrued - which is calculated daily and added or subtracted to the clean price

Question 33

What does Cum dividend mean in relation to Bond interest?

Answer 33

The purchaser will receive all 6 months interest The buyer has to compensate the seller for the interest they did not receive The buyer will pay the clean price, plus the accrued interest

Question 34

What does the Ex dividend mean in relation to Bond interest?

Answer 34

Interest payments are made to the registered holder, seven days before due If the bond is purchased after than time, before the due date, it is bought ex - the full interest will be paid to the seller The clean price is adjusted to reflect this

Question 35

How are bonds issued in the Primary Market

Answer 35

Large investors put in bids at the price and quantity they want Successful bidders pay the bidded price The can submit non-competative bids up to £500K and the stock is issued at the average of the accepted price

Question 36

If a Bond was issued by an investment bank on behalf of organisations or companies - what is the issue process?

Answer 36

The issue is marketed to potential investors Potential investors place bids Final terms are agreed and issued, investors have 24 hours to make firm bids

Question 37

Why is the secondary market of bond trading brisk?

Answer 37

``` Holders constantly adjust their holdings to reflect What income they need Credit ratings of issuers Future interest rate trends Changes to expected inflation Conduct of government finances International tensions - social and political Attractiveness of other assets ```

Question 38

What are the four major bond markets?

Answer 38

Government Corporate Sterling loans to foreign borrowers Eurobonds - named according to the country in which they are issued (in a different currency) - i.e. Eurosterling bond/eurodollar bond

Question 39

What are the risks associated with bonds?

Answer 39

Interest rate risk - lower means greater value, higher interest rates means a falling value, therefore longer term bonds fluctuate more rapidly Liquidity risk - can be difficult to sell readily at an acceptable price Inflation risk - effect of erosion, however index linked bonds provide better protection as adjusted for inflation Currency risk - movements in exchange rates Default risk - issuer may not be able to meet their obligation to pay

Question 40

What are the two categories of credit ratings for Bonds?

Answer 40

Investment grade - ratings of BBB- or higher (or Baa3) relatively low risk of default Non investment grade - ratings of below BBB-(or Baa3) considered to have a significantly higher risk of default. (also known as junk bonds/high yield bonds)

Question 41

What are the two factors affecting the volatility of bonds?

Answer 41

The lower the coupon the more volatile the bond | The longer the period to redemption, the more volitile the bond

Question 42

What is the purpose of a yield curve?

Answer 42

Means of comparing yields on different bonds as well as giving an indication of the markets expectations in future

Question 43

Why would a yield curve be inverted?

Answer 43

Investor expectations that interest rates will rise in the short term, and lower in future Factors impacting supply and demand that reduce the yield on longer dated bonds

Question 44

What are the three categories given to gilts by the DMO?

Answer 44

shorts - less than seven (five by the financial press) Mediums - seven and 15 years (five and fifteen) Longs - Over fifteen years (same in press)

Question 45

How are investors protected by using Index Linked Guilts?

Answer 45

Interest payments revised in line with RPI Capital repayment on redemption reflects changes in RPI Note - if RPI falls, then both of the above will fall

Question 46

If a guilt is stripped, can the interest element be traded seperately to the redemption payment?

Answer 46

Yes it can

Question 47

What are the two types of corporate bond and what other restrictions might be in place for those issuing the bond?

Answer 47

secured or unsecured An upper limit of borrowing the company might need to stay within certain financial ratios

Question 48

What is the definition of a Debenture?

Answer 48

A written acknowledgement of a debt

Question 49

What would a trust deed for a debenture include?

Answer 49

Terms of issue - interest rate, payment dates and redemption date Assets backing the debenture Powers of the trustee Any conditions imposed on the borrower

Question 50

What are the two ways a debenture can be secured?

Answer 50

Fixed charge over a specified asset | Floating charge - a general charge over any of the assets of a company that are not otherwise secured elsewhere

Question 51

Which would you prefer as a lender - a fixed or a floating charge and why?

Answer 51

Fixed - as the assets cannot be sold without authorisation of the debenture holder. Assets can be sold with a floating debenture and has lower priority for payment if the company is wound up.

Question 52

What is a convertible bond and its characteristics?

Answer 52

Unsecured loan stock that can be converted into ordinary shares of the issuing company. Interest is payable until the option is exercised, they carry a lower coupon due to the potential gain on conversion to shares Conversions rights vary - specified dates, periods and number of conversions Nuber of shares may differ between issues, or fixed or reducing If not converted, the Bond will revert to a conventional bond on end, but a company retains the right to redeem any outstanding stock

Question 53

What is a floating rate note?

Answer 53

Securities issued by companies that are linked to a money market rate, such as LIBOR