Chapter 11: Other investment classes Flashcards
(24 cards)
Outline the purpose of collective investment schemes (CISs) from the perspective of both the investor and the management of the CIS
From the investor’s perspective:
* Diversification and lower portfolio risk
* Access to expertise
* Access to larger / unusual investments through indirect investment.
* Economies of scale (reducing investment expenses)
* Possible tax advantages
From the management of the CISs perspective:
* To follow the stated investment objective
* To create return for investors commensurate with the level of risk taken.
Discuss closed-ended schemes in the context of CISs
In a closed-ended scheme, once the initial tranche of money has been invested, the fund is closed to new money. After launch, the only way of investing in an investment trust is to buy units from a willing seller.
Discuss open-ended schemes in the context of CISs
In an open-ended scheme, managers can create or cancel units in the fund as new money is invested or disinvested.
Discuss investment trusts
Investment trusts are a form of closed-ended fund. They are public companies whose function is to manage shares and other investments. They have a capital structure exactly like other public companies, and can raise both loan and equity capital.
Despite the name, an investment trust is a company. A guide to what the share price might be expected to be is the net asset value per share which is the value of the company’s underlying assets divided by the number of shares.
The main parties involved are:
* board of directors
* investment managers
* shareholders
Discuss unit trusts
A unit-trust is an open-ended investment vehicle whereby investors can buy units in an underlying pool of assets from the trust manager.
Unit trusts are trusts in the legal sense. They have limited powers to borrow against their portfolio.
The unit price is calculated (usually daily) by the unit trust provider as market value of underlying assets / number of units.
In practice, complications to this calculation include:
* whether to use the bid or offer prices of the underlying assets
* how to allow for the expenses the unit trust incurs in buying and selling underlying assets
* how to adjust the unit price to apply any charges to investors
* how to round the answer
The main parties involved include:
* Management company
* Trustees
* Investors
Discuss the differences between closed-ended and open-ended CISs
- The marketability of the shares of closed-ended funds is often less than the marketability of their underlying assets
- Gearing of closed-ended funds can make their share price more volatile than that of the underlying equity
- It may be possible to buy assets at less than net asset value in a closed-ended fund.
- The increased volatility of closed-ended funds means that they should provide a higher expected return.
- Share prices in closed-ended funds are also more volatile than the prices of the underlying equities because the size of the discount can change.
- At any point in time there may be uncertainty as to the true level of net asset value per share of a closed-ended fund, especially if the investments are unquoted
- Closed-ended funds may be able to invest in a wider range of assets than unit trusts.
- They may be subject to tax at different rates.
List the advantages of collective investment vehicles compared to direct investment
- They are useful for obtaining specialist expertise
- They are an easy way of obtaining diversification
- Some of the costs of direct investment management are avoided
- Holdings are divisible - part of a holding in any particular trust can be sold
- There may be tax advantages
- There may be marketability advantages
- They can be used to track the return on a specific index.
List the disadvantages of collective investment vehicles compared to direct investment
- Loss of control - the investor has no control over the individual investments chosen by the managers
- Management charges are incurred
- There may be tax disadvantages such as withholding tax which cannot be reclaimed.
What are derivatives?
A derivative is a financial instrument whose value is dependent on - or derived from - the value of another underlying asset.
A derivative can be thought of as a contract between 2 parties to trade an underlying asset at a date in the future.
Derivatives can be used to control risk by either:
* reducing the risk (hedging) or
* Increasing the risk (speculation)
What is a forward contract?
A forward contract is a contract to buy or sell an asset on an agreed basis in the future.
Forward contracts are non-standardised, the details can be tailor-made and will be negotiated between the 2 trading parties.
Forward contracts are not exchange-traded but are traded over-the-counter (OTC). The counter is a notional one - in practice it involves telephone-based trading between 2 financial institutions or between a financial institution and a corporate client.
There is no exchange on which the contracts are traded, so the degree of credit risk relating to the transaction will depend upon the creditworthiness of the counterparty.
What is a futures contract?
Like a forward contract, a futures contract is a contract to buy or sell an asset on an agreed basis in the future. However, futures contracts are standardised contracts that can be traded on a recognised exchange.
A standardised contract is one where all of the details surrounding the asset to be traded, with the exception of the price at which the parties agree to trade, are pre-determined.
All that is left to be agreed by the individual buyers and sellers of the contract is the price at which the underlying asset will be traded on the delivery date.
Standardisation results in easy administration as well as a very liquid futures market.
The credit risk to each individual party under a futures contract is minimal as the clearing house intervenes to guarantee each side of the original bargain. To uphold this guarantee, each party makes a small good faith deposit with the clearing house, which is called initial margin.
Define a long and short position in relation to futures and forward contracts
Having a long position in an asset means having positive economic exposure to the asset. In futures and forward dealing, the long party is the one who has contracted to take delivery of the asset in the future.
Having a short position in an asset means having a negative economic exposure to the asset. In futures and forward dealing, the short party is the one who has contracted to deliver the assest in the future.
What is an option?
An option is the right, but not the obligation, to buy or sell an asset.
Options are contracts agreed between investors to trade in an underlying security at a given date at a set price. The difference between options and futures is that the holder of the option is not obliged to trade. The writer, however, is obliged to trade if the holder of the option wants to.
When someone writes an option, they collect a premium for giving the holder the right to exercise the option.
What is a call and a put option?
A call option is the right, but not the obligation, to buy a specified asset for a specified price on a set dat or dates in the future.
A put option is the right, but not the obligation, to sell a specified asset for a specified price on a set date or dates in the future.
What are some other characteristics of options?
The exercise price is the price at which an underlying security can be sold to or purchased from the writer or issuer of an option. This is also known as the strike price.
The option premium or option price is the price that the holder pays to the option writer for the right to exercise the option.
Traded options are option contracts with standardised features actively traded on organised exchanges.
A European option is an option that can only be exercised at expiry
An American option is an option that can be exercised on any date before its expiry.
What are warrants?
A warrant is an option issued by a company over its own shares. The holder has the right to purchase shares at a specified price at specified times in the future from the company.
Outline the main uses of derivatives
Futures contracts can be used to set a price in advance.
While financial institutions can trade in futures, it needs to be sure of being able to sell long positions before delivery - an insurance company doesn’t want several tons of sugar arriving on its doorstep.
Investors trading in futures rarely want to actually receive delivery of the underlying asset.
Options also give financial institutions the opportunity to alter the structure of their portfolios without needing to trade in the underlying assets. This is because an option gives the buyer / seller economic exposure to the underlying asset without having to actually buy or sell that asset.
Derivative transactions are not cheap and the cost of the derivative and any collateral the counterparty may require need to be included in the calculations.
Outline 3 main reasons for investing overseas
- To match liabilities in the foreign currency
- To increase the expected returns
- To reduce risk by increasing the level of diversification
What are the problems with overseas investment?
- A different market performance to the home market and the associated mismatching risk
- Currency fluctuation risk
- Increased expertise needed to assess the market
- Additional administration functions: custodian, dividend tracking and collection
- different tax treatment
- different accounting practices
- less information may be available than in the home market
- language problems - although many of the larger overseas companies publish accounts in English
- time delays - timing differences have presented difficulties in the past, but advances in communications have made this much less of a problem
- poorer market regulation in some countries - although some large companies are listed in more than one major financial centre
- risk of adverse political developments
- liquidity - many less developed markets are not very liquid
- restrictions on the ownership of certain shares.
Outline 3 different ways of indirectly investing in overseas assets
- Investment in multinational companies based in the home market.
- Investment in collective investment vehicles specialising in overseas investment
- Investment in derivatives based on overseas assets
Advantages of 1. include:
* It is easy to deal in the familiar home market
* The companies will have expertise and tend to conduct their business in the most profitable areas overseas, including areas where direct investment may be difficult
Disadvantages of 1. include:
* Such a company’s earnings will be diluted by domestic earnings
* The investor will have no choice in where the company transacts its business
List the factors to consider before investing in emerging markets
- Current market valuation
- Possibility of high economic growth rate
- Currency stability and strength
- Level of marketability
- Degree of political stability
- Market regulation
- Restrictions on foreign investment
- Range of companies available
- Communication problems
- Availability and quality of information
Discuss attractions of investment in emerging markets
With the prospects of high growth rates, and possible market inefficiencies, opportunities exist for profitable investment, but with a correspondingly higher level of risk
The pricing of the currencies and the stock markets of developing economies is less efficient than that of the world’s largest markets. This means that there may be significant anomalies from time to time, giving investors the opportunity to buy cheaply (or to make expensive mistakes)
Some of the developing economies will grow at rates that are just not attainable by the large developed economies.
The economies and markets of many smaller countries are less interdependent than those of the major economic powers. Therefore investment in emerging markets may provide a good method of diversification.
Discuss the drawbacks of investment in emerging markets
The markets of small economies can be significantly affected by large flows of money, leading to stock markets and currencies of developing countries being potentially very volatile.
Stocks issued in emerging markets may be less marketable and this will be of concern to many investors.
The governments of some emerging markets lack stability, and this can increase the volatility of investment returns.
Because emerging markets are newer and generally smaller, there are more question marks against the efficiency of the processes for regulating the markets. Where markets are poorly regulated, foreign investors might lose out through insider trading by local investors and fraud.
Some of the emerging markets have tight controls on ownership by foreigners.
It is much more difficult for the investor to get enough good quality information to substantiate a view that investment is worthwhile. Specialist local expertise is therefore especially important. There may be greater communication issues, for example, language barriers, time zones and how information is presented.
