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PCIAM > Chapter 5 > Flashcards

Chapter 5 Flashcards

1
Q

What do we assume the par value of a bond is for exam purposes?

A

£100

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2
Q

What is the coupon on a bond?

A

This is the income from the bondH

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3
Q

How do we calculate the bond coupon?

A

It is given as an annual % of face value

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4
Q

What does it mean that a bond trades above par?

A

It means that the bond is trading above its par value

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5
Q

What does it mean that a bond trades at a premium?

A

It means that the bond is trading above its par value

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6
Q

What does it mean that a bond trades below par?

A

It means that the bond is trading below its par value

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7
Q

What does it mean that a bond trades at a discount?

A

It means that the bond is trading below its par value

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8
Q

What is the CGT treatment of bonds?

A

It does not have CGT.

The exemption from capital gains tax extends to options and other contracts to buy or sell gilts.

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9
Q

What can we say about the bond price if its coupon rate is higher than its yield?

A

We then know that it is trading at a premium

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10
Q

What can we say about the bond price if its coupon rate is lower than its yield?

A

We then know that it is trading at a discount

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11
Q

What is the budget deficit also known as?

A

Public sector net cash requirement (PSNCR)

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12
Q

How is the public sector net cash requirement funded?

A

It is funded through raising bonds (debt)

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13
Q

Who issues gilts?

A

The Debt Management Office (DMO)

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14
Q

Who is responsible for the DMO?

A

The treasury

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15
Q

What are the main sources of public sector net cash requirement funding?

A

Gilts, treasury bills, and NS&I products

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16
Q

For index linked gilts, what is the par value linked to?

A

The RPI

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17
Q

For index linked gilts, what measurement will it change to in 2030?

A

It will change to CPIH

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18
Q

When it comes to index linked gilts, how is the coupon payment calculated?

A

We take the par value, multiply it by the relevant RPI, and then use the normal coupon rate on the inflated par value. This will give us the coupon payment

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19
Q

If inflation is above the break even inflation rate what bonds are preferred?

A

Index linked bonds

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20
Q

If inflation is below the break even inflation rate, what bonds are preferred?

A

vanilla bonds

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21
Q

What does the UK MBA sell?

A

THey sell municipal bonds on the capital markets

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22
Q

What is the UK MBA?

A

The UKA MBA is the UK Municipal Bonds Agency and they raise debt to fund local activities

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23
Q

Who guarantees UK Municipal Bonds Agency Bonds?

A

No one

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24
Q

What are the three lending programmes of the UK MBA?

A
  1. Pooled loans of at least 1 million for maturities exceeding more than 1 year (not guaranteen by the local municipality)
  2. Stand alone loans to a single local authority for at least £250m, for maturities exceeding one year (guaranteed by municipality)
  3. Short-term pooled loans with maturity of less than 1 year (no guarantees)W
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25
Q

What is a bullet when it comes to government bonds?

A

This is when a bond has a specified redemption rate

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26
Q

What is special about double dated bonds?

A

These are bonds where the government can choose to redeem the gilts on any day between the first and final maturity date

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27
Q

What is the notice for redemption on double dated bonds?

A

At least 3 months

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28
Q

What are undated bonds?

A

These are bonds that are irredeemable or perpetual

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29
Q

What is a sinking fund provision?

A

This is a provision for the repayment of the capital outstanding (reduces default risk).

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30
Q

How does a sinking fund provision work?

A

It works in two different ways,

  1. A counterpart can be established where the issuer of the bonds puts down collateral each year in readiness for redemption
  2. The issuer may repay a set proportion of the bond at set intervals.
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31
Q

What is the formula for settlement price?

A

Settlement price = Clean price + accrued interest

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32
Q

What is the formula for the dirty price of a bond?

A

Settlement price = Clean price + accrued interest

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33
Q

What is the formula for the flat yield?

A

(Gross annual coupon/market clean price) * 100

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34
Q

What is the formula for the income yield?

A

(Gross annual coupon/market clean price) * 100

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35
Q

What is the formula for the running yield?

A

(Gross annual coupon/market clean price) * 100

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36
Q

What is the assumptions of the flat yield?

A

Ignored reinvestment of coupons, and ignores capital gains or loss

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37
Q

For whom is the flat yield useful for?

A

For an investor seeking income and not expecting to hold the bond until maturity

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38
Q

What is the main assumption of the gross redemption yield?

A

Coupons are reinvested at the yield of our calculations

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39
Q

What is the main assumption of the yield to maturity?

A

Coupons are reinvested at the yield of our calculations

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40
Q

What two parts do we add together to get the gross redemption yield?

A

We take the flat yield and add on the redemption yield

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41
Q

What is the formula for the gross redemption yield?

A

Income yield = (Coupon payment / “current trading price”) * 100

Gain at redemption = nominal value - market value

annualised gain = ((“gain at redemption”)/”Years to maturity”)/(“current trading price”)) * 100

Gross redemption yield = Income yield + annualised gain

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42
Q

What’s more tax efficient, a low coupon bond issued at a discount or a high coupon bond issued at a premium?

A

The former

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43
Q

When calculating the net redemption yield, what element do we apply tax to?

A

We apply this to the flat yield by multiplying it by 0.8

(20% income tax taken at source)

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44
Q

What are the three main theories explaining the yield curve?

A

THe liquidity preference theory, pure expectations theory, and market segmentation theory (or preferred habitat)

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45
Q

What does the liquidity preference theory explain?

A

It explain the upward sloping yield curve.

Investors expect a premium for longer-dated investments due to increased risk

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46
Q

What does the pure expectations theory explain?

A

It explains that long-term yields are the geometric average of expected short term rates.

This curve reflects market expectations of interest (this is hwere the inverted yield curve comes from)

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47
Q

What does the Market segmentation theory explain?

A

THat the yield curve is affected by suypply and demand forces in particular segments

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48
Q

What can quantitative easing lead to?

A

Hyperinflation

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49
Q

What makes a government bond tax efficient?

A

When it has a low coupon and has more gain to maturity

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50
Q

What is anomaly switching with bonds?

A

This is switching between two bonds with similar characteristics, where there is a mispricing creating arbitrage.

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51
Q

What is policy switching with bonds?

A

Switching between two bonds with dissimilar characteristics where we expect something in the market is going to change the orice of one bond relative to another.

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52
Q

What is the relationship between bond prices and yields?

A

Inverse

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53
Q

What does the “Pull to redemption” refer to?

A

It talks about how bonds converge at the par value as it moves towards redemption.

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54
Q

What is the characteristic of a bond with a high sensitivity?

A

Bonds with low coupon

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55
Q

What is the characteristic of a bond with a low sensitivity?

A

A high coupon bond

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56
Q

Which bond has the highest duration sensitivity?

A

Zero Coupon Bonds

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57
Q

What is the Macaulay duration?

A

It is the weighted average of the timing of the bonds cash flow using the present values of those cash flows as weights.

Said differently, it is the point in the where price risk and reinvestment risk balance

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58
Q

What is the modified duration?

A

It is the approximate percentage change in a bonds price for a 1% change in yield

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59
Q

What is the macauley duration of a zero coupon bond?

A

It is the same as its maturity

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60
Q

Is the relationship between yield and price linear or convex?

A

It is convex

61
Q

What do we mean that modified duration can overstate or understate the value of a bond?

A

As the relationship between price and interest rate is convex, it means that the modified duration understates the increase in bond price when the yields fall and overestimates the decline in price when yield rises.

This is because an assumption of the modified duration is that the relationship between price and interest rates is linear.

62
Q

What are the three broad passive management strategies for bonds?

A

Duration matching, cash flow matching and combination matching/horizon matching

63
Q

What is duration matching?

A

This is a passive bond strategy where we invest in bond portfolios to meet future long-term liabilities.

64
Q

What are the risks with duration matching?

A

Price risk and reinvestment risk

65
Q

What is the duration when referring to duration matching?

A

Macauley duration

66
Q

What is the difference between a bullet and a barbell strategy?

A

A bullet strategy is to use bonds that have close to exactly the duration we need, and barbell is when we use the average of the durations of the bonds

67
Q

What is a duration gap?

A

Duration gap = macauley duration - investment horizon

68
Q

What does it mesn when the duration gap is zero?

A

This means that the coupon reinvestment risk offsets the price risk

69
Q

What does it mean when the duration gap is negative?

A

This means that the coupon reinvestment risk dominates price risk

70
Q

What does it mean when the duration gap is positive?

A

This means that price risk dominates doupon reinvestment risk

71
Q

What are the assumptions of cash flow matching?

A

It is that we do not reinvest coupons and we use them to meet liabilities

72
Q

What is combination matching?

A

This is a mixture of duration matching and cash flow matching. We cash flow match the next four quarters (the short term) and immunise the remainding investment horizon.

The portfolio get rebalanced every 4 quarters.

73
Q

What dos a parallel shift in the YC mean?

A

This means that the yield curve will either steepen or flatten

74
Q

What is a warrant?

A

A warrat gives the holders the right to buy new shares in a company at a pre-agred price at a fixed date in the future.

75
Q

What is a eurobond?

A

This is a bond denominated in a currency other than the market it is issued

76
Q

What is a foreign bond?

A

A foreign bond is a bond that is denominated in the home currency of the market which it is issued but issued by overseas country

77
Q

What does a callable bond give the issues the right to?

A

It gives the issuer the option to repurchase the bond before redemption

78
Q

Why is callable bonds riskier for the holder?

A

It is riskier for the holder due to the issuer having the ability to redeem it before the redemption date exposing them to possible reinvestment risk.

79
Q

When would an issuer redeem a callable bond?

A

When yields are low

80
Q

What is a puttable bond?

A

A puttable bond gives the investor the option to sell back the bond before the redemption

81
Q

What is the price of the puttable option consisting of?

A

Price = nonputtable bond prices + put option

82
Q

What is the price of callable option consisting of?

A

Price = Non-callable bond price - call option

83
Q

When would an investor normally excersise a bond put option?

A

When interest option is high

84
Q

What is a floating rate bond?

A

This is a bond where the coupon floats in line with a benchmark interest rate

85
Q

What is a stepped bond?

A

This is a bond where the coupon rises at preset intervals over the life of the bond

86
Q

What is the capital cover ratio?

A

Capital cover = “Total Assets” / “cumulative value of securities”

87
Q

What is the capital priority percentage?

A

This is the percentage of the assets that would be used to repay each element of a company’s debt

88
Q

What is the formula for the capital priority percentage?

A

Capital priority percentage = “Cumulative value of securities” / “Total assets”

89
Q

What is the interest cover formula?

A

Interest cover = “Post-tax profits before servicing finance” / “Cumulative post-tax interest or dividend cost”

“post-tax profits before servicing finance” = EBIT

90
Q

What does the interest cover measure?

A

How many times interest can be paid out of profits

91
Q

What is a debenture?

A

A debenture is a type of bond or other debt instrument that is unsecured by collateral. Since debentures have no collateral backing, they must rely on the creditworthiness and reputation of the issuer for support

92
Q

What is the difference between debenture and loan stock?

A

Debenture are secured debt whilst loan stock can be secured, unsecured, convertible or non-convertible (but is most often unsecured)

93
Q

Who issues PIBS?

A

A PIBS (Permanent Interest Bearing Shares) are issued by building societies

94
Q

What is a CoCo?

A

CoCos are a type of hybrid debt which will convert into equity if a pre-specified trigger event occurs (solvency measure)

95
Q

What is special about ‘A’ shares?

A

These are non-voting ordinary shares

96
Q

What are deferred shares?

A

These are also referred to as “founders shares” and are not entitled to receive dividend until a specified time has passef or ordinary shares have received specified dividendW

97
Q

What is a golden share?

A

THis is a share with a special voting power such as a power of veto

98
Q

When it comes to dividends, what is assumed about preferred shares?

A

That they are cumulative preference shares unless stated otherwise

99
Q

What % of shareholder votes is needed to call an EGM?

A

10%

100
Q

What % does a shareholder votes does an individual need to control to propose a resolution?

A

5%

101
Q

What are two other words for bonus issues?

A

Scrip issue and capitalisation issues

102
Q

What is a scrip issue?

A

This is when a company issues shares for no consideration to existing shareholders

103
Q

What is the purpose of a capitalisation issue?

A

This is to reduce the share price and increase liquidity

104
Q

What is the purpose of a Scrip issue?

A

This is to reduce the share price and increase liquidity

105
Q

What is the purpose of a Bonus issue?

A

This is to reduce the share price and increase liquidity

106
Q

What are “pre-emption rights”?

A

Pre-emption rights are the rights that existing shareholders have, and they state that existing shareholdes must be offered ordinary shares, warrants, or convertible instruments before they are offered to anyone else

107
Q

What is the dividend yield formula?

A

Return = Dividend / Price

108
Q

What is the gordon growth model formula?

A

Price(t=0) = (D(t=1))/(r-g)

109
Q

How do we derive the assumed growth rate of dividends in the GGM model?

A

Retention rate * Return on equity = Assumed growth rate of dividends

110
Q

What is the dividend payout rate formula?

A

Dividend payout rate = dividend / PAT

Where PAT is Profit after tax

111
Q

What is the determinant of the PE ratio?

A

Growth rates and risk

112
Q

What are the determinants of Price to book value?

A

Growth rates & risk and return on equity capital

113
Q

What are the determinants of dividend yield?

A

Growth rates and risk

114
Q

What are the 4 issues with the PE ratio?

A
  • Useless for lossmaking companies
  • EPS is an accounting number
  • May need to use an adjusted (normalised) EPS figure
  • Can be used for market timing
115
Q

What are the 4 issues of the price to book ratio?

A
  • Cant be used for loss-making companies
  • May need to adjust for accounting differences between companies – e.g. intangibles
  • May be better at highlighting liquidation risk
  • Viewed as a better discriminator of value
116
Q

What are the issue of the dividend yield?

A

High dividend yield may indicate may not be maintained
* Average dividend yield for FTSE = 3.5% - 4%

117
Q

Would a value investor look for a low or high PE ratio?

A

Low PE ratio

118
Q

Would a growth investor look for a low or high PE ratio?

A

High PE ratio

119
Q

Would a value investor look for a low or high price to book value?

A

A low price to book value

120
Q

Would a value investor look for a high dividend yield or a low dividend yield?

A

High dividend yield

121
Q

Would a growth investor look for a high dividend yield or a low dividend yield?

A

Low dividend yield

122
Q

What is the Yield gap?

A

This is the difference between the dividend yield on ordinary shares and the redemption yield on the relevant government bonds or bond index

123
Q

What is the difference between tactical and strategic asset allocation?

A

Tactical asset allocation is about the active management and aims to use short term exploitations of market opportunities whilst the strategic asset allocation is about the asset allocation of the portfolio longer term.

124
Q

What is the maximum gain and loss of a long future?

A

Gain is unlimited and max loss is limited to the price of the future

125
Q

What is the maximum gain and loss of a short future?

A

Maximum gain is limited to the price of the future whilst the maximum loss is unlimited

126
Q

What taxes are applicable to futures?

A

Capital gains

127
Q

What does it mean to “Close out” a future position?

A

This means to take an opposite position in a future contract to the one we already hold

128
Q

What do we refer to when talking about margin?

A

Margin is when we have used a trading house to be in the middle of the trade to act as guarantor for both parties in the futures contract.

129
Q

What is a variation margin?

A

THis is a margin that comes in addition to the normal margin, and it is payable if the futures contract loses money. It is calculated at the close of the business each day and is payable by the futures trader

130
Q

What is spot month margin?

A

This is extra margin charged to cover additional risk for contracts in certain months (often
delivery months)

131
Q

What is intraday margin?

A
  • Required in times of high volatility in the price of a contract during a trading day
  • If the amount of initial margin originally called for is consideredinadequate by the clearing house to cover the additional risk, extra margin is called
132
Q

What is a maintenance margin?

A

THis is an alternative system for calculating margin. A higher initial margin payment is made and then no variation margin is payable unless the balance on the margin account falls below the maintenance margin level

133
Q

What is the formula for the fair value of a future?

A

Fair value of future = Spot price of underlying + Net cost of carry

Where Spot price of the underlying is What it would cost to buy the
asset today (cash price) and the net cost of carry is What is would cost to hold the asset until the delivery date (storage, insurance) Less any benefits of carry such as cash flows from holding the asset (dividends)

134
Q

For futures, what does convergence mean?

A

This means that the fair value of the future is moving towards the spot price

135
Q

What is contango?

A

This is when the futures price is larges than the spot price

136
Q

What is backwardation?

A

This is when the spot price is larger than the futures price

137
Q

What is the tick value for a FTSE 100 index future?

A

£5

138
Q

What is the smallest tick size for the FTSE 100 index future?

A

0.5

139
Q

What is a contract for difference (CFD)?

A

A contract for differences (CFD) is a financial contract that pays the differences in the settlement price between the open and closing trades. CFDs essentially allow investors to trade the direction of securities over the very short-term and are especially popular in FX and commodities products.

140
Q

What makes CFD different from exchange traded products?

A
  • OTC product traded by CFD brokers or market makers
  • For long CFDs over shares, the buyer is also entitled to any dividendpaid by the underlying company on which the CFD is based, during the life of the contract
  • No fixed expiry date required
141
Q

What is the difference between spread betting and CFDs?

A
  • Spread bets constitute gambling, so winnings are free from CGT
  • They are available over a much more diverse and varied subject matter
  • Less flexible than their CFD counterparts (for example, they have set expiry dates, whereas a CFD can be closed at any time
142
Q

What are the three different expiry styles for options?

A
  • European: Exercised on expiry only
  • American: Exercised on any business day up to and including expiry
  • Bermudan: Exercised on set business days up to and including expiry
143
Q

What is the intrinsic value of an option?

A

Difference between the strike and the price of the underlying

144
Q

What is the formula for the premium of an option?

A

premium = intrinsic value + time value

145
Q

What is the formula for the time value for options?

A

Premium minus intrinsic value

146
Q

What is the formula for a warrant premium?

A
  • Warrant premium = Intrinsic value + Time value
147
Q
A
148
Q
A

PCIAM (7 decks)

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