Chapter 2 - Understand the behaviour, performance, risk profile and correlation of key investment types Flashcards by Joshua Macdonald

Risks associated with Savings Accounts

No investment risk
Exposed to default risk
No capital growth other than interest that accumulates which is variable or flexible

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Annual Equivalent Rate (AER) example

AER = (1 + R/N)N -1
R = Rate of Interest
N = Number of periods interest is paid

Example:
Investment A offer 1% compounded quarterly. Investment B also offers 1% compounded six-monthly(bi-annual). Which is better?

Investment A
(1 + 0.0025%)4P – 1 x 100 = 1.00375% (1.0038%)

Investment B
(1 + 0.0050)2P – 1 x 100 = 1.0025% (1.003%)

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What is Credit Risk?

Credit Risk is the risk of a bank of building society defaulting.

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What is Tier One Capital Ratio?

The ratio that regulatory authorities use to judge the adequacy of the bank’s capital position.

The higher the percentage the greater the strength of the bank

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Are Deposits in Gibraltar covered? (FSCS)

Yes

European Economic Area (EEA), Channel Islands and Isle of Man are not covered by FSCS

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What are Money Market Instruments?

They allow governments, banks and companies short term funds at low interest rates.

These include:
Time Deposits
Treasury Bills
Certificates of deposit
Commercial paper
Bankers acceptances
Bills of exchange

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What are Treasury Bills?

Treasury Bills are issued by governments to finance their short-term cash needs.

Maturities of one, three or six months.

Minimum - £500,000

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What are Certificates of Deposit?

Certificates of deposit (CD) are receipts from banks for deposits placed with them.

Deposits are fixed rate linked with Sterling Overnight Interest Average (SONIA) previously it was London Inter-bank Offered Rate (LIBOR)

Maturities of one to three months and interest is paid on maturity.

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What are Commercial Paper?

Commercial Paper is short-term money market funding issued by companies to fund their day-to-day cash flows - similar to treasury bills.

Maturities between 30 and 90 days

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What are the two types of Money Market Funds?

Short-term money market fund
They are invested in short term debt and have a weighted average maturity of no more than 60 days and an average life of no more than 120 days.

Standard money market funds
Aim to achieve slightly higher returns investing in assets with extended maturity periods of size and twelve months.

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What is a Bond?

Debt investments are financial instruments that give a right to interest, and the repayment of capital on loans made to governments and companies.

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Alternative names of bonds?

Fixed interest or fixed-income securities or debt securities.

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What is a Gilt?

In the UK government sector, bonds are known as Gilts.

In the international sector they are Eurobonds.

In the Corporate sector they are called Debentures, loan stock or loan notes.

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Three key features of a Bond?

Issuers name - Identifies who is liable for the interest payments and repayment of principal

The Coupon - Interest rate payable and if it is fixed for the life of the stock - Most bonds pay twice a year.

Maturity Date - Identifies the year in which the issuer will repay the nominal value of the bond to the investor.

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What are Conventional Gilts?

Fixed coupon
Single repayment date
Interest paid every six months
Issued 7 March September or 7 June December
Now called Treasury Gilts

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What are Index-Linked Gilts?

Index-linked gilts are those where the interest payments and the redemption amount are increased by the amount of inflation over the life of the bond

Interest paid every six months
RPI (CPIH) linked

Gilt STRIPS

STRIPS is the acronym for “Separate Trading of Registered Interest and Principal Securities”

A stripped gilt is one that is separated into its individual coupon payments and its redemption payment

What is the difference between a Floating Charge and Fixed Charge?

Fixed Charge is a legal charge specifically placed on one or a number of companies fixed or permanent assets

Floating Charges places a more general charge on those assets that continually flow through the business.

What is a Eurobond?

Eurobonds give issuers the ability to tap potential lenders internationally, rather than just domestically and make bond issued at short notice.

What is a Foreign Bond?

Foreign Bonds are debt instruments that are issued by foreign borrowers in domestic bond market of another country.

What are Convertible Bonds?

They give the investor the right to convert the bond into a pre-defined number of ordinary shares in the issuing company, on a set date or dates between a range of set dates, prior to the bonds maturity.

Convertible Premium Discount Calculation

Convertible Bond - Nominal 100 - Price £1.10 - Market Value £110
Ordinary Shares - Nominal 25 - Price £4.00 - Market Value £100

Market Price of convertible stock / conversion ratio
x market price of ordinary shares - 1 x 100

(£110 / 25 x £4.00 - 1) x100 = 10%

How to calculate the Interest Yield?

Coupon / clean price x 100

Interest Rate of Coupon - 2%
Clean price (price paid) - £106.39

2 / 106.39 x 100 = 1.88%

Investor has a holding of £1,000 “6% Treasury Stock 2028” which is priced at £107.38. What is the interest yield?

6 / 107.38 x 100 = 5.587% (5.59%)

What are interest yields also called?

Running yield Income yield Flat yield

How to calculate the Redemption Yield?

Step 1 - Calculate the interest yield Step 2 - Work out if there is a gain or a loss (value above or below par) Step 3 - Divide this by the number of years to maturity. Step 4 - Interest yield - the above value = Redemption value

Katherine bought £1,000 nominal of gilt carrying an 8% coupon that is to be repaid in 4 years time. Current price is £124.27 (£1,242.70). What is the redemption yield?

Interest yield 8% / 124.27 x 100 = 6.44% Redemption Yield 1,000 - 1242.70 = -242.70 / 4 = -60.675 -60.675 / 1242.70 x 100 = -4.88% Interest Yield - Redemption Yield 6.44 - -4.88 = 1.56%

What is normal yield curve?

Starts off lower but gradually grows over time, more for long term investments.

What is a flat yield curve?

Tends to appear when markets are stagnating and potentially sloping into an inverted curve.

What are the main risks associated with holding government or corporate bonds?

Credit Risk - risk that the interest payments and the repayment of capital might not be made Market/price risk - movements in interest rates have a significant impact on value of bond holdings Inflation risk - risk of inflation to rise unexpectedly, will impact real value of coupon and redemption figures. Liquidity risk - Unable to move/trade should the client require the funds urgently. Exchange rate risk - where bonds are in different currency, adverse exchange rate movements can affect this.

What is the difference between Ordinary and Preference shares?

Ordinary Higher risk - last to be paid in the event of liquidation Have the rights to share profits of company Right to attend and vote at company meetings Preference Less risky Fixed dividend each year aslong as company has sufficient profits, paid before ordinary shareholders No right to attend or vote at company meetings

What are the different types of ordinary shares?

A Shares - Participate in profits and dividends but are non-voting shares B Shares - Usually redeemable shares issued as part of a capital return Deferred shares - Issued by founders of the company and only pay a dividend after a certain period or once all other dividends are paid.

What Basic rights does a Shareholder have?

Receive annual accounts and be notified of annual general meetings Able to attend company meetings and vote Receive a share in the profits of the company Right to a surplus on winding up once liabilities are paid

What Statutory rights does a shareholder have?

Companies hold annual general meetings at least once a year Shareholders with more than 10% voting rights can call extraordinary meetings Shareholders with 5% of more can propose resolutions. Any shareholder can petition the court on the grounds that affairs of the company have been conducted in a manner unfairly.

What is The Primary Market?

Where bonds are issued for the first time.

What is the Secondary Market?

A market that can trade bonds that have already been released.

What are Rights Issues?

Companies may come back to the stock market at any time to raise share capital.

What is Bonus Issues?

This involves the company issuing further shares to existing shareholders WITHOUT raising new funds.

What are Share Splits?

When businesses split current shares into more shares (more shares but same cost)