Day 2 Topics

Question 1

Rational Investor - Required Rate of Return

Answer 1

want to receive at least the risk free rate, real return and risk premium

Question 2

Future Value - Compounding

Answer 2

FV = PV(1+r)^n

Question 3

Present Value - Discounting

Answer 3

PV = FV/(1+r)^n

Question 4

Annuity Discount Factor

Answer 4

1/r x (1-(1/(1+r)^n))

Question 5

Annuity Discount Factor with growing annuities

Answer 5

A/(r-g) x (1-(1+g)^n/(1+r))

Question 6

Compound Interest Rate

Answer 6

r = (FV/PV)^1/n - 1

Question 7

Compound periods

Answer 7

n = (logFV - logPV)/log(1+r)

Question 8

Periodic (Non-annual) Compounding

Answer 8

1. Calculate the periodic rate = (1+r) = (1+R)^1/n
2. use the annuity discount factor 1/r x (1-(1/(1+r)^n))

Question 9

Discounting perpetuities and perpetuities that grow

Answer 9

PV = payment/r
PV = payment/(r-g)

Question 10

Continuous Compounding

Answer 10

FV = Pe^rt

P = principal sum
e = 2.718
r = rate per period
t = time in years

Question 11

Interest Rate Expressions - APR Formula

Answer 11

APR = (r+f/principal)/y x 365

r = interest paid over the life of the loan
f = any fees
y = number of days in the loan term

Measures the cost of borrowing
Only applicable over 1 year

Question 12

Interest Rate Expressions – Annual Equivalent Rate (AER)

Answer 12

AER = (1+r)^12/n - 1

r is the rate of interest for each time period
n is the number of months in the tine period

used for savings or deposits

Question 13

AER - Continuous compounding

Answer 13

AER = e^rt - 1

e = 2.718
r = rate per period
t = time in years

Question 14

Real Return

Answer 14

(1+r nominal)/(1+r inflation) - 1

Question 15

Advantages and Disadvantages NPV

Answer 15

Adv:

 Time Value of Money
 Monetary profit
 Assumes reinvestment
 Works for in and outflows
of cash
 Shows total return
 All risks factored into
discount rate
 Good measure of
profitability

Dis:

 Certainty of future
cashflows?
 True cost of capital?
 Sunk costs are ignored
 Comparison of different
periods or amounts
 Accuracy of discount rate
used?
 Incorrect initial outlay
 No allowance for nonquantitative
factors

Question 16

Uses and Limitations of
IRR

Answer 16

 Useful for comparing
projects – choose the
one with the higher IRR
 But should choose
investment with higher
NPV at the relevant cost
of capital
 Negative cashflows
results in multiple IRRs
 Assumes all cashflows
are re-invested at the IRR

Question 17

Geometric Annualisation

Answer 17

(1+ra)^n = (1+r1)(1+r2)(1+r3)…(1+ri)

i.e. ra = [(1+r1)(1+r2)(1+r3)…(1+ri)]^1/n – 1

Question 18

CAGR

Answer 18

Measures the annual growth rate of an investment over a specified period

CAGR = (Ve/Vs)^1/t - 1

Ve = end value
Vs = start value
t = time in years

Question 19

Value of a share = Dividend Valuation Model/Gordons Growth Model

Answer 19

next dividend/(required return - dividend growth)

Question 20

Efficient Market Hypothesis

Answer 20

 EMH states that if markets are efficient share prices fully reflect all information and so trade at their
fair value.

Weak Form =
* All historical information
is reflected in the share
price.
* Excess returns cannot be
generated via technical
analysis but can through
fundamental analysis.

Semi-strong form =

• All historical and public
  information is reflected in
  the share price.
• Excess returns cannot be
  generated via technical
  analysis or fundamental
  analysis but can via
  having access to private
  information.

Strong form =

• All historical, public and
  private information is
  reflected in the share
  price.
• It is impossible to
  generate excess returns.
• The only way to achieve
  higher returns is to take
  on more risk.

Question 21

Cognitive biases

Answer 21

Loss aversion - hold on to losses too long and sell gains too quickly
Overconfidence bias - overtrading, too much belief in own ability
Anchoring bias: Individuals rely too heavily on an initial reference point when making decisions, even if it’s irrelevant to the current situation.
Herd behavior: Investors follow the crowd rather than making independent decisions, which can contribute to market bubbles or crashes.

Question 22

Pros and cons of algorithmic trading

Answer 22

adv:

 ‘Slice and dice’ trades
 Decreased transparency
 Dark pools reduce fees

Dis:

 Decreased transparency
 ‘Contrarian’ trades could
be construed as market
manipulation
 Flash crashes
 Prices on exchanges may
not be a true
representation
 HF traders may ‘front run’
trades

Question 23

Dark Pools

Answer 23

 Dark pools refer to a non displayed or hidden nature of the buy and sell orders that reside within a crossing platform. The biggest sources of dark liquidity are within investment banks and major brokers

 Types:

 Broker-dealer owned e.g. JP Morgan
 Agency broker or exchange-owned e.g. CBOE Global Markets
 Electronic market makers e.g. Getco and Knight

 Advantages:

 Effect of large deals reduced
 May be cheaper
 No indication of market strategy

 Disadvantages:

 Price on exchange may not be representative
 Lack of transparency
 Front running by HF traders

Question 24

Types of Shares

Answer 24

deferred ord shares
= div not paid unless specific
condition has been met

golden shares = special voting rights
want someone to have a controlling vote

A or NV shares - not as many rights
no voting rights

redeemable shares - company
can redeem them back. can only
offer if other shares have been
offered

cumulative shares - if no div then they must get
a div before ord shares next time

Question 25

Rights of shareholders

Answer 25

Basic rights: receive annual accounts notified of AGMs right to vote and share in profits share of surplus on wind-up Statutory rights: Companies must hold meetings once per year S/H > 10% can call EGMS S/H > 5% can propose resolutions S/H can petition courts Pre-emptive Rights: New shares offered to existing S/H before anyone else

Question 26

Corporate Actions

Answer 26

Bonus issue Share split Reverse split Rights issue Share buyback Dividends

Question 27

Adv/Dis of property investment

Answer 27

Adv: Attractive absolute returns over time historically Diversification Low correlation with other asset classes Performs well in inflationary environments Dis: liquidity risks can be costly (large upfront investment) Costs associated with renting risk of a vacant period

Question 28

REITs vs PAIFs

Answer 28

Close ended vs Open ended premium or discount to NAV vs Trade at NAV Priced continuously throughout the day vs Single pricing point each day Trades on LSE vs Directly with the fund manager Exempt from corporation tax on income and capital gains as long as 90% of property income (not gains) is distributed to shareholders. vs Exempt from corporation tax if HMRC are notified they want the PAIF regime to apply Must not be controlled by 5 or fewer participants and corporate shareholders can't hold >10% or tax charge applies vs No body corporate can hold more than 10% of the Fund’s NAV. Special tax charges to the PAIF will apply otherwise.

Question 29

Disadvantages of Property Funds

Answer 29

Volatility and liquidity Interest Rate and Inflation Market risk - asset price bubbles Gearing Valuation - hard to get accurate valuation of property Exchange rate Local risk

Question 30

Infrastructure

Answer 30

Large physical assets providing essential services/facilities e.g. bridges and hospitals Long duration uncorrelated returns stable and predictable cash flows high barriers to entry indivisibility

Question 31

Infrastructure Funds

Answer 31

Investment trust = direct investment Infrastructure equity fund = invest in shares and securities of infrastructure companies

Question 32

Private Equity

Answer 32

venture capital - equity in startups and early stage companies Distressed companies - financial trouble or declining performance Leveraged buyouts - buy into a company by taking on a high level of debt Mezzanine finance - a hybrid form of financing that blends debt and equity

Question 33

PE Partnerships

Answer 33

General partners: Limited number unlimited liability industry or entrepreneurial experience put up small proportion of capital Limited partners: unlimited number limited liability institutional and other investors provide bulk of capital

Question 34

PE Due diligence

Answer 34

visits to company discussions with employees and suppliers lawyers, accountants and consultants examine company startups - examine feasibility and management established firms - understand the business distressed companies - meet with lenders to renegotiate debt MBOs - succession issues LBOs - cashflow forecasts and ability to repay debt

Question 35

Hedge Funds features

Answer 35

frequently domiciled in offshore tax havens charge an AMC and performance fee performance fee only charged if exceeded high water mark provision (next highest month end NAV) Minimum lock in periods and may charge exit fees Complex strategies using derivatives and gearing typically outperform in bear markets

Question 36

Hedge fund strategies

Answer 36

Non- directional designed to gain a return regardless of market: fixed income arbitrage market neutral - long and short stocks highly correlated convertible arbitrage - buy the bond short the stock statistical arbitrage - mean reversion, stock will revert back to mean Volatility arbitrage - buy a call option and offset with short position in underlying Merger arbitrage - buy target company sell predator distressed companies - undervalued Directional designed to make money if market goes up or down: Long/short short only emerging markets private placements - invest directly in privately issued securities Global macro - global trends, large scale bets to beat market Systematic strategies - program that gives signals to buy and sell

Question 37

funds of hedge funds

Answer 37

Advantages  Diversification  Easy access to hedge funds for retail investors  May enable access to closed funds Disadvantages  Double layer of fees  Less visibility of underlying funds  Low possibility of interaction between the investor and HF manager  Diversification of HF strategies may be counterproductive e.g. opposing strategies cancelling each other out

Question 38

Venture Capital Trusts

Answer 38

Investing in a venture capital trust is investing in a company that invests in early stage and small businesses with high growth potential. They are a company not a trust They are close ended and exchange traded e.g. traded on the LSE. They can trade at a discount or premium to NAV They are priced according to supply and demand One such advantage is it is a more liquid option of investing in the underlying companies as these smaller companies are often very illiquid Another advantage is that as the companies are early stage with high growth potential if these businesses succeed then they will generate high returns. Another advantage is that it gives you access to invest in private companies that you would not otherwise have access to Another advantage is that there is no CGT on gains with no minimum holding period There is also income tax relief on 30% up to 200k investment, per tax year and no carry back facility, have to hold for 5 years, this is only available for newly issued shares, this is a tax deductor Another advantage is that there is no tax on dividends received Tax benefits only available for individuals over 18 Diversification benefits Downside: High risk Potential loss of capital Inexperienced management No loss relief for CGT Lack of track record

Question 39

EIS

Answer 39

The EIS is a government scheme to try encourage investment in small and early stage businesses Direct investment in a small unquoted business The criteria to qualify are under 250 employees, no more than £15 gross assets and annual limit that can be raised of £5m Tax benefits Income tax relief of up to 30% of £1m and an extra £1m in knowledge intensive companies Carry back facility to previous tax year Must hold for over 3 years Tax reducer Business relief - IHT free if held for over 2 years CGT relief if held for over 3 years CGT loss relief, can claim against gains or income less the income tax relief CGT deferral relief any gain can be deferred if reinvested in a EIS - charge will come into effect when disposed of unless is then reinvested again in to an EIS. 1 year before the gain and 3 years after Very high risk as small unlisted companies Illiquid May lose all capital invested