Professional Documents
Culture Documents
Introduction
to Securities
& Investment
The Official Learning and Reference Manual
Published by:
Chartered Institute for Securities & Investment
Chartered Institute for Securities & Investment 2012
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Written BY:
Kevin Rothwell
REVIEWs BY:
Martin Mitchell
Jon Beckett
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Managing Director
Contents
Chapter 4: Equities 45
The workbook then moves on to examine some of the main asset classes in detail,
starting with equities. It begins with the features, benefits and risks of owning shares
or stocks, looks at corporate actions and some of the main world stock markets and
indices, and outlines the methods by which shares are traded and settled.
Chapter 5: Bonds 71
A review of bonds follows which includes looking at the key characteristics and types
of government and corporate bonds and the risks and returns associated with them.
Chapter 6: Derivatives 87
Next there is a brief review of derivatives to provide an understanding of the key
features of futures, options and swaps and the terminology associated with them.
Glossary 153
It is estimated that this workbook will require approximately 70 hours of study time.
1
The Financial Services Industry
1. Introduction 3
4. Financial Markets 5
5. Industry Participants 9
Chapter One
The investment chain through the The financial activities that make up the
investment chain, savers and borrowers are professional financial sector include:
brought together, bringing finance to business
and opportunities for savers to manage their
Equity markets the trading of quoted
shares.
finances over their lifetime. The efficiency of
this chain is critical to allocating capital to
Bond markets the trading of government,
supranational or corporate debt.
the most profitable investments, providing
a mechanism for saving, raising productivity
Foreign exchange the trading of
currencies.
and, in turn, improving competitiveness in
the global economy.
Derivatives the trading of options, swaps,
futures and forwards.
Risk in addition to the opportunities that
the investment chain provides for pooling
Fund management managing the
investment portfolios of collective investment
investment risks, the financial services
schemes, pension funds and insurance funds.
sector allows other risks to be managed
effectively and efficiently through the use
Insurance re-insurance, major corporate
insurance (including professional indemnity),
of insurance and increasingly through the
captive insurance and risk-sharing insurance.
use of sophisticated derivatives. These tools
help business cope with global uncertainties
Investment banking tailored banking
services provided to organisations;
as diverse as the changing value of
these services include activities such as
currencies, the incidence of major accidents
corporate finance, undertaking mergers and
or extreme weather conditions. They also
acquisitions, equity trading, fixed income
help households protect themselves against
trading and private equity.
everyday contingencies.
International banking cross-border
Payment systems payment and banking
banking transactions.
services operated by the financial services
sector provide the practical mechanisms The retail sector focuses on services provided
for money to be managed, transmitted to personal customers, including:
and received quickly and reliably. It is
an essential requirement for commercial Retail banking the traditional range of
activities to take place and for participation current (US: checking) accounts, savings
in international trade and investment. Access accounts, lending and credit cards.
to payment systems and banking services is Insurance the provision of a range of
a vital component of financial inclusion for life insurance and protection solutions for
individuals. areas such as medical insurance, critical
illness, motor, property, income protection and 2010 and falling back again in 2011 as fears
and mortgage protection. over the sovereign debt crisis hit confidence in
Pensions the provision of investment equity markets.
accounts specifically designed to capture
savings during a persons working life and The largest stock exchanges in the world are in
provide benefits on retirement. the US. The New York Stock Exchange (NYSE
Euronext) is the largest exchange in the world
Investment services a range of investment
and had a domestic market capitalisation of
products and vehicles ranging from execution-
over US$11.8 trillion at the end of 2011
only stockbroking to full wealth management
domestic market capitalisation is the value
services and private banking.
of shares listed on an exchange. (The NYSE
Financial planning and financial advice.
is part of the NYSE Euronext Group, which
also owns a number of European exchanges
70,000,000
60,000,000
50,000,000
40,000,000
$mn
30,000,000
20,000,000
10,000,000
0
End 2004
End 2000
End 2006
End 2008
End 2009
End 2005
End 2003
End 1994
End 2002
End 1990
End 1999
End 2007
End 1996
End 1998
End 2001
End 1995
End 1992
End 1997
End 1993
End 1991
End 2010
End 2011
value of the shares quoted in Europe is over selling financial instruments including shares,
US$10 trillion. bonds and derivatives. These systems can be
crossing networks or matching engines that
The same report shows that Asian exchanges
are operated by an investment firm or another
also have an important share of world trading.
market operator.
The Tokyo Stock Exchange (TSE) was the
worlds third-largest market and had a domestic We will look in more detail at equities and
market capitalisation of US$3.3 trillion just equity markets in Chapter 4.
ahead of the London Stock Exchange.
The economic growth of China and India is also 4.2 Bond Markets
reflected in the domestic market capitalisation
of their exchanges with the Shanghai and Hong Although less well known than equity markets,
Kong exchanges ranked sixth and seventh, with bond markets are larger both in size and value
a market capitalisation of US$2.3 trillion each. of trading. However, the volume of bond trading
The National Stock Exchange of India and the is lower, as most trades tend to be very large
Bombay Stock Exchange both have a domestic when compared to equity market trades.
market capitalisation of US$1 trillion. The amounts outstanding on the global bond
market (see graph, opposite) totalled a record
$95 trillion in 2010, up 5% on the previous
Largest Domestic Equity US$bn
year. Domestic bond markets accounted for
Markets by Capitalisation
70% of the total, and international bonds for
NYSE Euronext (US) 11,795 the remainder. The bonds traded range from
domestic bonds issued by companies and
NASDAQ OMX (US) 3,845 governments, to international bonds issued by
Tokyo Stock Exchange Group 3,325 companies, governments, and supranational
agencies such as the World Bank. The US
London Stock Exchange Group 3,266 has the largest bond market, but trading
in international bonds is predominantly
NYSE Euronext (Europe) 2,446
undertaken in European markets.
Shanghai Stock Exchange 2,357
The amount of government bonds outstanding
Hong Kong Exchanges 2,258 has increased significantly in recent years, and
this has resulted in growing concerns about the
TMX Group (Canada) 1,953 ability of some countries to continue to finance
and service their debt. This has been most
BM & FBOVESPA (Brazil) 1,255
notable with the downgrading of the US and
Australian Exchange 1,244 the European eurozone sovereign debt crisis.
The crisis was originally centred on Greece,
Deutsche Borse 1,184
whose government debt was downgraded by
SIX Swiss Exchange 1,184 the international credit rating agencies (see
Chapter 5, Section 2.3) to junk status. Other
countries with high budget deficits, such as
Source: World Federation of Exchanges data
Portugal, Ireland, Turkey, Italy and Spain, also
as at end 2011
saw downgrades. Worries about this spreading
to other eurozone countries has required
Rivals to traditional stock exchanges have also a comprehensive rescue package from the
arisen with the development of technology European Union (EU) and the International
and communication networks known as Monetary Fund (IMF) worth trillions of dollars
multilateral trading facilities (MTFs). aimed at attempting to restore financial
These are systems that bring together multiple stability across Europe.
parties that are interested in buying and
We will look in more detail at bonds in Chapter 5.
100,000
900,000
800,000
700,000
600,000
$m
500,000
400,000
300,000
200,000
100,000
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
International
Domestic
Main Countries for FX Trading 2010 and the US dollar, which have accounted for
most of the growth in this market since 2001.
The growth in the market came about as a
Other 33.9% UK 36.7% reaction to the 2000 stock market crash as
traders sought to hedge their position against
interest rate risk.
Cost pressures have driven down the charges Historically these banks have tended to operate
that a custodian can make for its traditional through a network of branches located on the
custody services and have resulted in high street, but increasingly they also provide
consolidation within the industry. The custody internet and telephone banking services.
business is now dominated by a small number
of global custodians who are often divisions
of major banks. Amongst the biggest global 5.5 Savings Institutions
custodians are the Bank of New York Mellon and As well as retail banks, most countries also
State Street. have savings institutions that started off by
Generally, they also offer other services to specialising in offering savings products to
their clients, such as stock lending, measuring retail customers, but now tend to offer a similar
the performance of the portfolios of which they range of services to banks.
have custody and maximising the return on any They are known by different names around
surplus cash. the world, such as cajas in Spanish-speaking
countries. In the UK, they are usually known
as building societies, recognising the reason
5.3 International Banking
they first came about: they were established in
International banking refers to banking the 19th century when small groups of people
activities that involve cross-border transactions would group together and pool their savings,
and its growth reflects the increasingly global allowing some members to build or buy houses.
nature of trade and the associated banking Building societies are jointly owned by the
activities. individuals that have deposited or borrowed
money from them the members. It is for this
Typical activities involved in this sector relate reason that such savings organisations are
to the financing of trade between parties in often described as mutual societies.
different countries. Trade finance involves the
bank acting as an intermediary between an Over the years, many savings institutions have
exporter who prefers an importer to pay in merged or been taken over by larger ones.
advance for goods before they are shipped, More recently, a number have transformed
whilst the importer wants documentary themselves into banks that are quoted on
evidence from the exporter that the goods stock exchanges a process known as
have been shipped before payment is made. demutualisation.
Traditionally, this involved the importers bank
providing a letter of credit to the exporter that
guaranteed payment upon presentation of
5.6 Insurance Companies
documentation that proved the goods had been As mentioned above, one of the key functions
shipped. More recently, this has developed of the financial services industry is to allow
to utilise the international payment systems risks to be managed effectively.
provided by the Society of Worldwide Interbank
Financial Telecommunication (SWIFT) to The insurance industry provides solutions for
facilitate the payment for goods and speed up much more than the standard areas, such as
the flow of trade. life cover and general insurance cover.
charging fees for their advice, and commissions include the Abu Dhabi Investment Authority
on transactions. and China Investment Corporation.
Also like fund managers, stockbrokers also SWFs are defined as special purpose investment
look after client assets and charge custody and funds or arrangements owned by a government.
portfolio management fees. Their key characteristics are:
Official and private commentators have Those who advise on the products of all the
expressed concerns about the transparency companies active in the area of the market
of SWFs, including their size, and their that they specialise in, who are known as
investment strategies, and that SWF whole of market advisers and who are
investments may be affected by political paid by way of commission on the products
objectives. they sell.
There are also concerns about how their Independent financial advisers, who also
investments might affect recipient countries, advise on the whole range of products on
leading to talk about protectionist restrictions offer in the market, and who offer their
on their investments, which could hamper the clients the option to pay for advice by fee
international flow of capital. rather than commission.
Think of an answer for each question and refer to the appropriate section for confirmation.
1. What are the main activities undertaken by the professional financial services sector?
6. What is protection planning and what scenarios can protection policies provide cover for?
7. What are the types of financial adviser and how does the range of products they advise on
differ?
1. Introduction 19
3. Central Banks 21
4. Inflation 25
Chapter Two
Firstly, we will look at how economic activity Know the factors which determine the level of
is determined in various economic and economic activity: state-controlled economies;
political systems, and then look at the role market economies; mixed economies; open
of governments and central banks in the economies
management of that economic activity.
Sometimes these economies are referred result in the inferior football player seeking an
to as planned economies, because alternative career.
the production and allocation of resources
is planned in advance rather than allowed 2.3 Mixed Economies
to respond to market forces. However, the
need for careful planning and control can A mixed economy combines a market economy
bring about excessive layers of bureaucracy, with some element of state control. The vast
and state control inevitably removes a great majority of economies are mixed to a lesser or
deal of individual choice. greater extent.
These factors have contributed to the reform of While most of us would agree that unsuccessful
the economies of the former Soviet states and companies should be allowed to fail, we
the introduction of a more mixed economy generally feel that the less able in society
(covered in more detail in Section 2.3). should be cushioned from the full force of the
market economy.
2.2 Market Economies In a mixed economy, the government will
provide a welfare system to support the
In a market economy, the forces of supply
unemployed, the infirm and the elderly, in
and demand determine how resources are
tandem with the market-driven aspects of the
allocated.
economy. Governments will also spend money
Businesses produce goods and services to meet running key areas such as defence, education,
the demand from consumers. The interaction public transport, health and police services.
of demand from consumers and supply from
Governments raise finance for this public
businesses in the market will result in the
expenditure by:
market-clearing price the price that reflects
the balance between what consumers will collecting taxes directly from wage-earners
willingly pay for goods and services, and what and companies;
suppliers will willingly accept for them. collecting indirect taxes (eg, sales tax and
If there is oversupply, the price will be low and taxes on petrol, cigarettes and alcohol); and
some producers will leave the market. If there raising money through borrowing in the
is undersupply, the price will be high, attracting capital markets.
new producers into the market.
2.4 Open Economies
There is a market not only for goods and
services, but also for productive assets, such In an open economy there are few barriers to
as capital goods (eg, machinery), labour and trade or controls over foreign exchange.
money. For the labour market, it is the wage
Although most western governments create
level that is effectively the price, and for the
barriers to protect their citizens against illegal
money market it is the interest rate.
drugs and other dangers, they generally have
People compete for jobs and companies policies to allow or encourage free trade.
compete for customers in a market economy.
From time to time, issues will arise where
Scarce resources, including skilled labour such
one country believes another is taking unfair
as a football player, or a financial asset such
advantage of trade policies and will take some
as a share in a successful company, will have a
form of retaliatory action, possibly including
high value. In a market economy, competition
the imposition of sanctions. When a country
means that inferior football players and shares
prevents other countries from trading freely
in unsuccessful companies will be much cheaper
with it in order to preserve its domestic market,
and, ultimately, competition could bring about
this is usually referred to as protectionism.
the collapse of the unsuccessful company, and
The World Trade Organisation (WTO) exists of government control or political interference.
to promote the growth of free trade between They usually have the following responsibilities:
economies. It is, therefore, sometimes called
upon to arbitrate when disputes arise. Acting as banker to the banking system by
accepting deposits from, and lending to,
commercial banks.
3. Central Banks Acting as banker to the government.
Managing the national debt.
Traditionally, the role of government has been Regulating the domestic banking system.
to manage the economy through taxation and Acting as lender of last resort to the banking
economic and monetary policy, and to ensure system in financial crises to prevent the
a fair society by the state provision of welfare systemic collapse of the banking system.
and benefits to those who meet certain criteria, Setting the official short-term rate of interest.
while leaving business relatively free to address Controlling the money supply.
the challenges and opportunities that arise. Issuing notes and coins.
Holding the nations gold and foreign currency
Governments can use a variety of policies when
reserves.
attempting to reduce the impact of fluctuations
Influencing the value of a nations currency
in economic activity. Collectively these
through activities such as intervention in the
measures are known as stabilisation policies
currency markets.
and are categorised under the broad headings
Providing a depositors protection scheme for
of fiscal policy and monetary policy. Fiscal
bank deposits.
policy involves making adjustments using
government spending and taxation, whilst
monetary policy involves making adjustments 3.2 Features of the Main
to interest rates and the money supply. Central Banks
Rather than following one or other type
Learning Objective 2.1.3
of policy, most governments now adopt a
pragmatic approach to controlling the level of Know the common features of the following:
economic activity through a combination of the Federal Reserve (US); the Reserve Bank
fiscal and monetary policy. In an increasingly of Australia; the Central Bank of Bahrain; the
integrated world, however, controlling the level Peoples Bank of China; the Central Bank of
of activity in an open economy in isolation Egypt; the Bank of England; the European
is difficult, as financial markets, rather than Central Bank; the Reserve Bank of India; the
individual governments and central banks, tend Bank of Japan; the Bank of Korea; the Money
to dictate economic policy. Authority of Singapore; the Central Bank of the
United Arab Emirates
Governments implement their economic policies
using their central bank, and a consideration of
Here is a brief review of the major central
their role in this implementation is noted below.
banks:
governed by a seven-strong board appointed setting UK monetary policy, in line with that
by the President of the United States. This of most other developed nations. The process
governing board, together with the presidents had previously been subject to the possibility of
of five of the 12 Federal Reserve Banks, makes political interference.
up the Federal Open Market Committee (FOMC).
The chairman of the FOMC, also appointed The MPCs primary focus is to ensure that
by the US President, takes responsibility for inflation is kept within a government-set range.
the committees decisions, which are directed This it does by setting the base rate, an
towards its statutory duty of promoting price officially published short-term interest rate and
stability and sustainable economic growth. the MPCs sole policy instrument.
The FOMC meets every six weeks or so to At its monthly meetings it must gauge all of
examine the latest economic data in order to those factors that can influence inflation over
gauge the health of the economy and determine both the short and medium term. These include
whether the economically sensitive Fed funds the level of the exchange rate, the rate at which
rate should be altered. Very occasionally it the economy is growing, how much consumers
meets in emergency session, if economic are borrowing and spending, wage inflation,
circumstances dictate. and any changes to government spending and
taxation plans. When setting the base rate,
As lender of last resort to the US banking however, it must also be mindful of the impact
system, the Fed has, in recent years, rescued a any changes will have on the sustainability of
number of US financial institutions and markets economic growth and employment in the UK
from collapse. In doing so it has prevented and the time lag between a change in rate
widespread panic, and prevented systemic and the effects it will have on the economy.
risk from spreading throughout the financial Depending on the sector of the economy, this
system. can be anything from a very short period of
time (eg, credit card spending when consumers
3.2.2 Europe are already stretched), to a year or more
(eg, businesses altering their investment and
Bank of England (BoE) expansion plans).
The UKs central bank, the Bank of England, In addition to its short-term interest-rate-
was founded in 1694, but it wasnt until setting role, the Bank of England also assumes
1997, when the Bank of Englands Monetary responsibility for all other traditional central
Policy Committee (MPC) was established, that bank activities, with the exception of supervising
the Bank gained operational independence in the banking system, managing the national
organising and promoting banking and Its role is to secure monetary stability and to
supervising the effectiveness of the banking operate the currency and credit system of India.
system; In carrying out this role, it is responsible for:
maintaining the governments reserves of
gold and foreign currencies; and formulating, implementing and monitoring
monetary policy;
acting as the bank for the UAE government
and for banks operating in the country. regulating and supervising the financial
system; and
acting as banker for central and state govern
3.2.4 Asia
ments, and for the banking system.
exchange policies conducive to the growth The banking system provides a mechanism by
of the economy. However, unlike many other which credit can be created. This means that
central banks, like the Fed or Bank of England, banks can increase the total money supply in
MAS does not regulate the monetary system the economy.
via interest rates to influence liquidity. Instead,
it does so via the foreign exchange markets. Example
4.2 The Impact of Inflation in base rate affect spending by companies and
their customers and, over time, the rate of
inflation.
Learning Objective 2.1.5
Understand the meaning of inflation: measure Changes in base rate can take up to two years
ment; impact; control to have their full impact on inflation, so the
central bank has to look ahead when deciding
on the appropriate monetary policy. If inflation
Inflation is a persistent increase in the general
looks set to rise above target, then the central
level of prices. There are a number of reasons
bank raises rates to slow spending and reduce
for prices to increase, such as excess demand
inflation. Similarly, if inflation looks set to fall
in the economy, scarcity of resources and
below its target level, it reduces bank rates to
key workers or rapidly increasing government
boost spending and inflation.
spending. Most western governments seek to
control inflation at a level of about 23% per As well as experiencing inflation, economies
annum without letting it get too high (or too can also face the problems presented by
low). deflation. Deflation is defined as a general
fall in price levels. Although not experienced
High levels of inflation can cause problems:
as a worldwide phenomenon since the 1930s,
Businesses have to continually update prices deflation has been in evidence over the past
to keep pace with inflation. ten years in countries such as Japan.
Employees find the real value of their salaries
Deflation typically results from negative
eroded.
demand shocks, such as the bursting of the
Those on fixed levels of income, such as
1990s technology bubble, and from excess
pensioners, will suffer as the price increases
capacity and production. It creates a vicious
are not matched by increases in income.
circle of reduced spending and a reluctance to
Exports may become less competitive.
borrow as the real burden of debt increases in
The real value of future pensions and invest
an environment of falling prices.
ment income becomes difficult to assess
which might act as a disincentive to save. It should be noted that falling prices are
not necessarily a destructive force per se
There are, however, some positive aspects to
and, indeed, can be beneficial if they are
high levels of inflation:
as a result of positive supply shocks, such
Rising house prices contribute to a feel as rising productivity growth and greater
good factor (although this might contribute price competition caused by the globalisation
to further inflation as house owners become of the world economy and increased price
more eager to borrow and spend and lead to transparency.
unsustainable rises in prices and a subsequent
crash, as has been seen recently). 4.3 Key Economic Indicators
Borrowers benefit, because the value of
borrowers debt falls in real terms ie, after
Learning Objective 2.1.5
adjusting for the effect of inflation.
Understand the meaning of inflation: measure
Inflation also erodes the real value of a
ment; impact; control
countrys national debt and so can benefit an
economy in difficult times.
As well as being essential to the management
Central banks use interest rates to control of the economy, key economic indicators can
inflation. They set an interest rate at which provide investors with a guide to the health
they will lend to financial institutions, and this of the economy and aid long-term investment
influences the rates that are available to savers decisions. Below we look at some of the main
and borrowers. The result is that movements indicators.
16
14
CPI Inflation %
12
10
0
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Source: Office for National Statistics (ONS)
firms employing these resources. This gives the growth and productivity of the labour
rise to what is known as the circular flow of force;
income. the rate at which an economy efficiently
channels its domestic savings and capital
Payment for inputs attracted from overseas into new and innova
to production
process
tive technology and replaces obsolescent
capital equipment;
the extent to which an economys infra
Direct
taxation
structure is maintained and developed to
Direct
Consumers Government taxation Firms cope with growing transport, communication
Transfer
payments and energy needs.
Indirect Government
taxation spending
In a mature economy, the labour force typically
grows at about 1% per annum, though in
Income spent on countries such as the US, where immigrant
domestic production labour is increasingly employed, the annual
growth rate has been in excess of this. Long-
Imports Exports
Overseas term productivity growth is dependent on
economies Investment
Savings factors such as education and training and the
Financial markets utilisation of labour-saving new technology.
and institutions Moreover, productivity gains are more difficult
to extract in a post-industrialised economy than
This economic activity can be measured in one one with a large manufacturing base. Since the
of three ways: early 1970s, both the UK and US economies
have been transformed into post-industrial
by the total income paid by firms to individuals; economies. Long-term productivity growth in
by individuals total expenditure on firms each country has averaged about 1.25% and
output; or 1.75% per annum, respectively.
by the value of total output generated by firms.
Given these factors, the UKs long-term trend
rate of economic growth has averaged a little
Gross Domestic Product (GDP)
over 2% per annum, while that of the US has
GDP is the most commonly used measure averaged nearly 3%. In developing economies,
of a countrys output. It measures economic however, economic growth rates approaching
activity on an expenditure basis and is typically 10% per annum are not uncommon.
calculated quarterly as follows:
The fact that actual growth fluctuates and
deviates from trend growth in the short term
Gross Domestic Product
gives rise to the economic cycle, or business
consumer spending
cycle.
plus government spending
plus investment
GDP Growth
plus exports Economic Peak
less imports Expansion
equals GDP Trend
Growth
0
Economic Growth
Deceleration
Acceleration
Economic
Recession
Recovery
Trough
There are many sources from which economic Contraction
Boom
Balance of Payments
The balance of payments is a summary of
all the transactions between a country and These are usually divided into categories
the rest of the world. If the country imports such as foreign direct investment where an
more than it exports, there is a balance of overseas firm acquires a new plant or an
payments deficit. If the country exports existing business, portfolio investment which
more than it imports, there is a balance of includes trading in stocks and bonds, and other
payments surplus. investments, which include transactions in
currency and bank deposits.
The main components of the balance of
payments are the trade balance, the current For the balance of payments to balance, the
account and the capital account. current account must equal the capital account
plus or minus a balancing item used to rectify
The trade balance comprises a visible trade
the many errors in compiling the balance of
balance the difference between the value of
payments plus or minus any change in central
imported and exported goods, such as those
bank foreign currency reserves.
arising from the trade of raw materials and
manufactured goods and an invisible trade A current account deficit resulting from a
balance the difference between the value of country being a net importer of overseas goods
imported and exported services, arising from and services must be met by a net inflow of
services, such as banking, financial services capital from overseas, taking account of any
and tourism. If a country has a trade deficit in measurement errors and any central bank
one of these areas or overall, this means that intervention in the foreign currency market.
it imports more than it exports, and, if it has a
trade surplus, it exports more than it imports. Having the right exchange rate is critical to
the level of international trade undertaken, to
The current account is used to calculate international competitiveness and therefore
the total value of goods and services that to a countrys economic position. This can be
flow into and out of a country. The current understood by looking at what happens if a
account comprises the trade balance figures countrys exchange rate alters.
for the visibles and invisibles. To these figures
are added other receipts such as dividends If the value of its currency rises, then exports
from overseas assets and remittances from will be less competitive, unless producers
nationals working abroad. reduce their prices, and imports will be cheaper
and therefore more competitive. The result will
The capital account records international be either to reduce a trade surplus or worsen a
capital transactions related to investment in trade deficit.
business, real estate, bonds and stocks. This
includes transactions relating to the ownership If its value falls against other currencies then
of fixed assets and the purchase and sale the reverse happens: exports will be cheaper
of domestic and foreign investment assets. in foreign market and so more competitive, and
Level of Unemployment
The extent to which those seeking employment
cannot find work is an important indicator of
the health of the economy. There is always
likely to be some unemployment in an economy
some people might lack the right skills and/or
live in employment black spots. Higher levels
of unemployment indicate low demand in the
economy for goods and services produced and
sold to consumers and, therefore, low demand
for people to provide them.
Think of an answer for each question and refer to the appropriate section for confirmation.
1. What are the key differences between state-controlled and market economies?
6. What are the principal differences between the RPI, the RPIX and the CPI?
1. Introduction 35
2. Asset Classes 35
3. Foreign Exchange 42
Chapter Three
2.1.1 Cash Deposits The interest rate paid on deposits will also vary
with the amount of money deposited and the
time for which the money is tied up.
Learning Objective 3.1.1
Know the characteristics of fixed term and Large deposits are more economical for a
instant access deposit accounts bank to process and will earn a better rate.
Fixed-term accounts involve the investor
Learning Objective 3.1.2 tying up their money for a fixed period of time
Understand the distinction between gross and such as one, two or three years, or where a
net interest payments fixed period of notice has to be given such
as 30 days, 60 days or 90 days. In exchange
Learning Objective 3.1.3 for tying up their funds for these periods, the
Be able to calculate the net interest due given investor will demand a higher rate of interest
the gross interest rate, the deposited sum, the than would be available on accounts that
period and tax rate permit immediate access.
Instant access deposit accounts typically earn
Learning Objective 3.1.4 the lowest rates of interest of the various
Know the advantages and disadvantages of deposit accounts available.
investing in cash Current (US: checking) accounts will generate
an even lower rate, and sometimes pay no
interest at all.
Cash deposits comprise accounts held with
banks or other savings institutions, such as Generally, interest received by an individual
building societies. They are held by a wide is subject to income tax. In many countries,
variety of depositors from retail investors, tax is deducted at source that is, by the
through to companies, governments and deposit-taker before paying the interest to
financial institutions. the depositor. In the UK, for example, tax
is deducted at a flat 20% (regardless of
The main characteristics of cash deposits are:
the depositors tax rate) before payment of
The return simply comprises interest income interest. The headline rate of interest quoted
with no potential for capital growth. by deposit-takers, before deduction of tax, is
The amount invested (the capital) is repaid referred to as gross interest, and the rate of
in full at the end of the investment term. interest after tax is deducted is referred to as
net interest.
For this exam, it is necessary to be able to investment can be turned into cash to meet
calculate the net interest due, so study the spending needs. Most investors are likely to
example and then practice this using the two have a need for cash at short notice and so
exercises. The answers to the exercises are at should plan to hold some cash on deposit to
the end of this chapter. meet possible needs and emergencies before
considering other less liquid investments.
Example The other main reasons for holding cash
investments are as a savings vehicle and
Mrs Jones is entitled to 5% gross interest on for the interest return that can be earned on
200 deposited in XYZ Bank for a year, and them.
tax at 20% is deducted before payment of the
interest. Investing in cash does have some serious
drawbacks, however, including:
She will earn 200 x 5% = 10 interest on her
bank deposit before the deduction of any tax. Banks and savings institutions are of varying
She will receive 8 from XYZ Bank. XYZ Bank creditworthiness and the risk that they may
will subsequently pay the 2 of tax on behalf of default needs to be assessed and taken into
Mrs Jones to the tax authorities. account.
Inflation reduces the real return that is being
This can be summarised as follows: earned on cash deposits and often the after-
tax return can be negative.
Gross interest earned: 200 x 5% = 10.
Interest rates vary, and so the returns from
Tax deducted by XYZ Bank: 20% x 10 = 2. cash-based deposits will also vary.
Net interest received by Mrs Jones: 10 x 80%
Although banks and savings institutions are
= 8.
licensed, monitored and regulated, it is still
possible that such institutions might fail, as
has been seen recently in the aftermath of the
Exercise 1 financial crisis. Deposits are therefore usually
also protected by a government-sponsored
Mr Evans pays tax at 20%, and all of the tax
compensation scheme. This will repay any
is deducted at source. He has had 3,000 on
deposited money lost, typically up to a set
deposit at XYZ Bank for a year, earning 4%
maximum, due to the collapse of a bank or
gross interest. How much interest does Mr
savings institution: the sum generally is fixed
Evans receive, and how much tax is deducted?
so as to be of meaningful protection to most
retail investors, although it would be of less
help to very substantial depositors.
Exercise 2
Where cash is deposited overseas, depositors
Alan pays tax in his country at 20%. Alan has should also consider the following:
10,000 on deposit at XYZ Bank earning 3%
gross interest. What is the net rate of interest The costs of currency conversion and the
he is earning? potential exchange rate risks if the deposit
is not made in the investors home currency.
The creditworthiness of the banking system
and the chosen deposit-taking institution
Advantages and Disadvantages
and whether a depositors protection scheme
There are a number of advantages to investing exists.
in cash: The tax treatment of interest applied to the
deposit.
One of the key reasons for holding money
Whether the deposit will be subject to any
in the form of cash deposits is liquidity.
exchange controls that may restrict access to
Liquidity is the ease and speed with which an
the money and its ultimate repatriation.
2.1.2 Money Markets price of less than $100 per $100 nominal
and commonly redeemed after three months.
Learning Objective 3.2.1 For example, a Treasury bill might be issued
for $998 and mature at $1,000 three months
Know the difference between a capital market
instrument and a money market instrument later. The investors return is the difference
between the $998 they paid, and the $1,000
Learning Objective 3 2.2 they receive on the Treasury bills maturity.
Know the definition and features of the Certificates of deposit (CDs) these
following: Treasury bill; commercial paper; are issued by banks in return for deposited
certificate of deposit money: think of them as tradeable deposit
accounts, as they can be bought and sold in
Learning Objective 3.2.3 the same way as shares. For example, ABC
Know the advantages and disadvantages of Bank might issue a CD to represent a deposit
investing in money market instruments of $1 million from a customer, redeemable
in six months. The CD might specify that
The money markets are the wholesale ABC Bank will pay the $1 million back, plus
or institutional markets for cash and are interest of, say, 2.5% of $1 million. If the
characterised by the issue, trading and customer needs the money back before six
redemption of short-dated negotiable months has elapsed, they can sell the CD to
securities. These can have a maturity of up another investor in the money market.
to one year, although three-month maturity is Commercial paper (CP) this is the
more typical. corporate equivalent of a Treasury bill.
Commercial paper is issued by large
By contrast, the capital markets are the long- companies to meet their short-term
term providers of finance for companies, either borrowing needs. A companys ability to issue
through investment in bonds or shares. commercial paper is typically agreed with
banks in advance. For example, a company
Owing to the short-term nature of the money
might agree with its bank to a programme of
markets, most instruments are issued at a
$10 million worth of commercial paper. This
discount to their face value to save on the
would enable the company to issue various
administration associated with registration and
forms of commercial paper with different
the payment of interest. Although accessible
maturities (eg, one month, three months
to retail investors indirectly through collective
and six months), and possibly different
investment (mutual) funds, direct investment
currencies, to the bank. As with Treasury
in money market instruments is often subject
bills, commercial paper is zero coupon and
to a relatively high minimum subscription
issued at a discount to its par value.
and therefore tends to be more suitable for
institutional investors. These money market instruments are all bearer
instruments where the issuer does not maintain
Examples of the main types of money market
a register of ownership. Ownership is simply
instruments are:
evidenced by holding the instruments.
Treasury bills these are usually issued Settlement of money market instruments is
weekly by or on behalf of governments and typically achieved through the same settlement
the money is used to meet the governments system that is used for equities and bonds, and
short-term borrowing needs. Treasury bills is commonly settled on the day of the trade or
are non-interest-bearing instruments and so the following business day.
are sometimes referred to as zero coupon
instruments (see Chapter 5, Section 4.2.5). As mentioned earlier, the money market is
a highly professional market that is used by
Instead of interest being paid out on them,
banks and companies to manage their liquidity
they are issued at a discount to par ie, a
needs. It is not accessible by private investors,
who instead need to utilise either money As seen, money market deposit accounts can
market accounts offered by banks, or money be used as a temporary home for idle cash
market funds. balances rather than using a standard retail
deposit account. For the retail investor these
A money market account is perhaps better
accounts can at times offer higher returns than
described as a money market deposit account.
can be achieved on standard deposits, and are
It is essentially a savings account that typically
offered by most retail banks.
requires a substantial minimum balance and
notice period. As it is a form of bank account, The disadvantage is that the higher returns
the depositor generally has the safety net of can usually only be achieved with relatively
some form of depositor protection scheme. large investments. As an alternative, a money
market fund can produce greater returns due to
In contrast, a money market fund is actually
the pooled nature of this collective investment
a money market mutual fund, a collective
vehicle which can access better rates than
investment scheme which pools investors
smaller deposits.
money to invest in short-term debt instruments
such as Treasury bills and commercial paper. Money markets also offer a potentially safe
There is a range of money market funds haven in times of market falls. When markets
available and they can offer two major have had a long bull period and economic
advantages over money market accounts. prospects begin to worsen, an investor may
There is the obvious advantage that the pooling want to take profits at the peak of the market
of funds with other investors gives the investor cycle and invest the funds raised in the money
access to assets they would not otherwise be markets until better investment opportunities
able to invest in. The returns on money market arise.
funds tend to also be greater than a simple
money market account offered by a bank, The same rationale can be used where the
mainly because the investor is taking a greater investor does not want to commit new cash
risk since such funds are not covered by the at the top of the market cycle. The nature of
depositor protection scheme. money market instruments means that they
offer an alternative investment that gives
limited exposure to any appreciable market
Advantages and Disadvantages
risk.
Cash deposits instruments provide a low-risk
way to generate an income or capital return, Within a clients normal portfolio of investments,
as appropriate, while preserving the nominal a proportion of the investments will be held as
value of the amount invested. They also play cash. Money market investments can therefore
a valuable role in times of market uncertainty. be the vehicle for holding such asset allocations
However, they are unsuitable for anything other and are in competition with other short-term
than the short term as, historically, they have deposit accounts.
underperformed most other asset types over
Money market funds, therefore, can have a core
the medium to long term. Moreover, in the
role to play in an investment portfolio. It does
long term, the return from cash deposits has
need to be remembered, however, that they
often been barely positive after the effects of
still carry some risks and the level of risk varies
inflation and taxation are taken into account.
between one type of instrument and another.
So, money market investments can be used The short-term nature of the money market
instead to fulfil a number of roles within a instruments provides some protection, but
clients portfolio, including: short-term interest rates fluctuate frequently,
which will result in some price volatility.
as a short-term home for cash balances;
as an alternative to bonds and equities
(particularly in uncertain times).
Bonds are essentially IOUs; the issuer of the Equities, or shares or stocks, are another
bond receives money from the initial buyer of major asset class.
the bond and undertakes to pay the holder of
the bond regular interest, and then return the Holding shares in a company is the same as
money (the capital) at a particular future date. having an ownership stake in that company.
So a shareholder in, say, the global bank ABC
Although bonds rarely generate as much is a part-owner of ABC. Income will be in the
comment as shares, they are the larger market form of regular dividends paid, plus a potential
of the two in terms of global investment capital gain if the company does well and the
value. Bonds are roughly equally split between share price rises.
government and corporate bonds.
Shares in ABC are, however, riskier than bonds,
Government bonds are issued by national for the following reasons:
governments (eg, Japan, the US, Italy,
Germany, and the UK). At the extreme end of the spectrum,
there is always the risk that the
Supranational bonds are issued by
agencies, such as the European Investment company could go into liquidation (but,
of course, in this case the holder of a
Bank and the World Bank.
bond issued by ABC may also be likely to
Corporate bonds are issued by companies,
lose out).
such as the large banks and other large listed
companies. More likely is the chance that the shares
may go down in value, instead of up as the
Bonds are generally less risky than shares, investor hopes.
provided their issuers remain solvent. In addition, there is the risk that ABC will
Investments such as government bonds have have a poor trading year: if it makes little or
until recently been regarded as being of no profit, it may be unable to pay a dividend
particularly low risk, as it has been regarded or may pay a lower one than in previous
as unlikely that a government will default, ie, years. This is a serious risk for an investor
fail to pay the interest or repay the capital on relying on dividend income.
the bond (although it has happened, usually
when a country undergoes a turbulent regime The major reason an investor would prefer
change or serious economic problems such as equities over bonds is the potentially greater
are currently being seen in Greece and some benefits that can arise from owning shares,
other Eurozone countries). namely dividends, and the prospect of capital
growth.
Corporate bonds, however, can face more real
default risks, namely that the company could Traditionally, equity investments have
go bust. outperformed bonds and cash over the
longer term, that is a period of ten years
Both carry interest rate risk, which means that or more.
the price of the bond could fall substantially if
interest rates rise sharply.
to encash holdings, property funds brought in financial instruments and speculation in the
measures to stem outflows and, in some cases, currency markets.
imposed 12-month moratoria on encashments.
Trading in currencies became 24-hour, as it
However, property can be subject to prolonged could take place in the various time zones
downturns, and its lack of liquidity, significant of Asia, Europe and America. London, being
maintenance costs, high transaction costs on placed between the Asian and American time
transfer and the risk of having commercial zones, was well placed to take advantage of
property with no tenant (and, therefore, no this and has grown to become the worlds
rental income) really makes only commercial largest forex market. Other large centres
property suitable as an investment for long- include the US, Japan and Singapore.
term investing institutions, such as pension
funds. The availability of indirect investment Trading of foreign currencies is always done
media, however, makes property a more in pairs. These are currency pairs where one
accessible asset class to those running smaller currency is bought and the other is sold and
diversified portfolios. the prices at which these take place make up
the exchange rate. When the exchange rate
is being quoted, the name of the currency is
3. Foreign Exchange abbreviated to a three digit reference; so, for
example, sterling is abbreviated to GBP ,which
you can think of as an abbreviation for Great
Learning Objective 3.4.1
Britain pounds.
Know the basic structure of the foreign
exchange market including: currency quotes; The most commonly quoted currency pairs are:
settlement
US dollar and the Japanese yen (USD/JPY).
Euro and US dollar (EUR/USD).
The foreign exchange market, which is also US dollar and Swiss franc (USD/CHF).
known as the forex market or just the FX British pound and US dollar (GBP/USD).
market, refers to the trading of one currency
for another. It is by far the largest market in When currencies are quoted, the first currency
the world. is the base currency and the second is the
counter or quote currency. The base currency
Historically, currencies were backed by gold is always equal to one unit of that currency,
(as money had intrinsic value); this prevented in other words, one pound, one dollar or one
the value of money from being debased and euro. For example, at the time of writing, the
inflation being triggered. This gold standard EUR:USD exchange rate is 1:1.3141, which
was replaced after the Second World War by means that e1 is worth $1.3141. When the
the Bretton Woods Agreement. This agreement exchange rate is going up, it means that the
aimed to prevent speculation in currency value of the base currency is rising relative
markets by fixing all currencies against the to the other currency and is referred to as
US dollar and making the dollar convertible to the currency strengthening, and, where the
gold at a fixed rate of $35 per ounce. Under opposite is the case, that the currency is
this system, countries were prohibited from weakening.
devaluing their currencies by more than 10%,
which they might have been tempted to do to When currency pairs are quoted, a market
improve their trade position. maker or foreign exchange trader will quote
a bid and an ask price. Staying with the
The growth of international trade, and example of the EUR:USD the current quote
increasing pressure for the movement of is 1.3140/42 the euro is not mentioned, as
capital, eventually destabilised this agreement, standard convention is that the base currency
and it was finally abandoned in the 1970s. is always one unit. If you want to buy e100,000
Currencies were allowed to float freely against then you will need to pay the higher of the two
one another, leading to the development of new prices and deliver $131,420; if you want to sell
e100,000 then you get the lower of the two Forward transactions in this type of
prices and receive $131,400. transaction, money does not actually change
hands until some agreed future date. A buyer
The forex market is an over-the-counter (OTC) and seller agree on an exchange rate for any
market, ie, one where brokers and dealers date in the future, for a fixed sum of money,
negotiate directly with one another. The main and the transaction occurs on that date,
participants are large international banks which regardless of what the market rates are then.
continually provide the market with both bid The duration of the trade can be a few days,
(buy) and ask (sell) prices. Central banks are months or years.
also major participants in foreign exchange
Futures foreign currency futures are
markets, which they use to try to control
standardised versions of forward transactions
money supply, inflation, and interest rates.
that are traded on derivatives exchanges
There are several types of transaction in standard sizes and maturity dates. The
undertaken in the foreign exchange market, average contract length is roughly three
particularly: months.
Swaps a common type of forward trans
Spot transactions the spot rate is the action is the currency swap. In a currency
rate quoted by a bank for the exchange of swap, two parties exchange currencies for a
one currency for another with immediate certain length of time and agree to reverse
effect. the transaction at a later date. These are not
However, it is worth noting that, in many exchange-traded contracts and, instead, are
cases, spot trades are settled that is, the negotiated individually between the parties
currencies actually change hands and arrive to a swap. They are a type of OTC derivative
in recipients bank accounts two business (see Chapter 6).
days after the transaction date.
Answers to Exercises
Exercise 1
Interest earned = 3,000 x 4% = 120
Exercise 2
Gross rate of interest = 3%
Net amount due = Gross amount (3%) less tax (3% x 20% = 0.6%) = 2.4%
Think of an answer for each question and refer to the appropriate section for confirmation.
1. How much net interest will be paid on a cash deposit of 10,000 deposited for six months at
2.5% pa, if the tax rate is 20%?
3. Corporate Actions 53
5. Depositary Receipts 58
8. Settlement Systems 65
Chapter Four
Equities
In general terms, the capital of a company is The alternative to holding shares in registered
made up of a combination of borrowing and the form is to hold bearer shares. The person who
money invested by its owners. The long-term holds, or is the bearer of, the shares is the
borrowings, or debt, of a company are usually owner. Ownership passes by transfer of the
referred to as bonds, and the money invested share certificate to the new owner.
by its owners as shares, stocks or equity.
were fortunate enough to own 20% of the share, that is one-half of the amount due. The
telecoms giant Vodafones ordinary shares, he shares would then be termed partly paid, but
would own one-fifth of Vodafone. the shareholder has an obligation to pay the
remaining amount when called upon to do so by
The terminology used varies from market to
the company.
market, so that equity capital may be known
as ordinary shares, common shares or common
stock. Whatever terminology is used, they all 1.2 Preference Shares
share the same characteristics: namely, they
Some companies have preference shares as
carry the full risk and reward of investing in a
well as ordinary shares. The companys internal
company. If a company does well, its ordinary
rules (its Articles of Association) set out how
shareholders will do well.
the preference shares differ from ordinary
As the ultimate owners of the company, it shares.
is the ordinary shareholders who vote yes
Preference shares are a hybrid security with
or no to each resolution put forward by the
elements of both debt and equity. Although they
company directors at company meetings. For
are technically a form of equity investment, they
example, an offer to take over a company may
also have characteristics of debt, particularly
be made and the directors may propose that
that they pay a fixed income. Preference shares
it is accepted but this will be subject to a vote
have legal priority (known as seniority) over
by shareholders. If the shareholders vote no,
ordinary shareholders in respect of earnings
then the directors will have to think again.
and, in the event of bankruptcy, in respect of
Ordinary shareholders share in the profits of assets.
the company by receiving dividends declared
Normally, preference shares:
by the company, which tend to be paid half-
yearly or even quarterly. The company directors are non-voting, except in certain
will propose a dividend, and the proposed circumstances such as when their dividends
dividend will need to be ratified by the ordinary have not been paid;
shareholders before it is formally declared as pay a fixed dividend each year, the amount
payable. being set when they are first issued;
rank ahead of ordinary shares in terms of
However, if the company does badly, it is also
being paid back if the company is wound up,
the ordinary shareholders that will suffer. If
up to a limited amount to be repaid.
the company closes down, often described as
the company being wound up, the ordinary Preference shares may be cumulative, non-
shareholders are paid after everybody else. cumulative and/or participating.
If there is nothing left, then the ordinary
shareholders get nothing. If there is money If dividends cannot be paid in a particular
left, it all belongs to the ordinary shareholders. year, perhaps because the company has
insufficient profits, ordinary preference shares
Some ordinary shares may be referred to as would get no dividend. However, if they were
partly paid or contributing shares. This cumulative preference shares then the
means that only part of their nominal value has dividend entitlement accumulates. Assuming
been paid up. For example, if a new company sufficient profits, the cumulative preference
was established with an initial capital of 100, shares will have the arrears of dividend paid
this capital may be made up of 100 ordinary in the subsequent year. If the shares were
1 shares. If the shareholders to whom these non-cumulative, the dividend from the first
shares are allocated have paid 1 per share year would be lost.
in full, then the shares are termed fully paid.
Alternatively, the shareholders may contribute Participating preference shares entitle the
only half of the initial capital, say 50 in total, holder to a basic dividend of, say, 3% a year,
which would require a payment of 50p per but the directors can award a bigger dividend in
a year where the profits exceed a certain level. 1.3 Benefits of Owning
In other words, the preference shareholder can
Shares
participate in bumper profits.
Holding shares in a company is having an
Preference shares may also be convertible or
ownership stake in that company. Ownership
redeemable. Convertible preference shares
carries certain benefits and rights and ordinary
carry an option to convert into the ordinary
shareholders expect to be the major beneficiaries
shares of the company at set intervals and on
of a companys success. This reward or return
pre-set terms.
can take one of the following forms.
Redeemable shares, as the name implies,
have a date at which they may be redeemed; 1.3.1 Dividends
that is, the nominal value of the shares will be
paid back to the preference shareholder and A dividend is the return that an investor gets
the shares cancelled. for providing the risk capital for a business.
Companies pay dividends out of their profits,
which form part of their distributable reserves.
Example These are the post-tax profits made over the
life of a company, in excess of dividends paid.
Banks and other financial institutions are regular
issuers of preference shares. So, for example,
an investor may have the following holding of a Example
preference share issued by Standard Chartered
ABC plc was formed some years ago. Over the
1,000 Standard Chartered 7% non-
companys life it has made 20 million in profits
cumulative irredeemable preference shares.
and paid dividends of 13 million. Distributable
This means: reserves at the beginning of the year are,
therefore, 7 million.
The investor will receive a fixed dividend of
7% each year which is payable in two equal This year ABC plc makes post-tax profits of
half-yearly instalments on 1 April and 1 3 million and decides to pay a dividend of 1
November. million. At the end of the year distributable
The amount of the dividend is calculated reserves are:
by multiplying the amount of shares held Millions
(1,000) by the interest rate of 7% which
gives a total annual dividend of 73.75 which Opening balance 7
will be paid in two instalments. Profit after tax for year 3
The dividend will be paid provided the
10
company makes sufficient profits and has to
be paid before any dividend can be paid to
ordinary shareholders. Dividend (1)
The term non-cumulative means that if the Closing balance 9
company does not make sufficient profits
to pay the dividend, then it is lost and the Note, despite only making 3 million in the
arrears are not carried forward. current year, it would be perfectly legal for
The term irredeemable means that there ABC plc to pay dividends of more than 3 million
is no fixed date for the shares to be repaid because it can use the undistributed profits
and the capital would only be repaid in the from previous years. This would be described as
event of the company being wound up. The a naked or uncovered dividend, because the
amount the investor would receive is the current years profits were insufficient to fully
nominal value of the shares, in other words cover the dividend. Companies occasionally do
1,000, and they would be paid out before this, but it is obviously not possible to maintain
(in preference to) the ordinary shareholders. this long-term.
Companies seek, where possible, to pay In contrast, some companies might have
steadily growing dividends. A fall in dividend dividend yields that are relatively low. This is
payments can lead to a negative reaction generally for the following reasons:
amongst shareholders and a general fall in the
willingness to hold the companys shares, or to the share price is high, because the company
provide additional capital. is viewed by investors as having high growth
prospects; or
Potential shareholders will compare the a large proportion of the profit being
dividend paid on a companys shares with generated by the company is being ploughed
alternative investments. These would include back into the business, rather than being paid
other shares, bonds and bank deposits. This out as dividends.
involves calculating the dividend yield.
The dividend per share is 1 million/20 million 1.3.3 Pre-Emptive Rights: Right to
shares, ie, 0.05. So 0.05/2.50 (the share price) Subscribe for New Shares
is again 2%.
If a company were able to issue new shares
to anyone, then existing shareholders could
Some companies have a higher than average lose control of the company, or at least
dividend yield, which may be because: see their share of ownership diluted. As a
result, in most markets apart from the US,
The company is mature and continues to
existing shareholders in companies are given
generate healthy levels of cash, but has
pre-emptive rights to subscribe for new
limited growth potential, perhaps because
shares. What this means is that, unless the
the government regulates its selling prices,
shareholders agree to permit the company to
and so there is no great investor appetite
issue shares to others, they will be given the
for its shares. Examples are utilities, such as
option to subscribe for any new share offering
water or electricity companies.
before it is offered to the wider public, and in
The company has a low share price for
many cases they receive some compensation if
some other reason, perhaps because it is,
they decide not to do so.
or is expected to be, relatively unsuccessful;
its comparatively high current dividend is, Pre-emptive rights are illustrated in the
therefore, not expected to be sustained and following example.
its share price is not expected to rise.
Before the issue Shares are relatively high-risk, but they have
Mr B = 20,000 (20%) the potential for relatively high returns when
Other shareholders = 80,000 (80%) a company is successful. The main risks
Total = 100,000 (100%) associated with holding shares can be classified
under four headings.
New issue
Mr B = 10,000
2.1 Price Risk
Other shareholders = 40,000
Total = 50,000 Price risk is the risk that share prices in general
might fall. Even though the company involved
After the issue
might maintain dividend payments, investors
Mr B = 30,000 (20%) could face a loss of capital.
Other shareholders = 120,000 (80%)
Total = 150,000 (100%) Market-wide falls in equity prices occur,
unfortunately, on a fairly frequent basis. For
example, worldwide equities fell by nearly 20%
on 19 October 1987, with some shares falling
A rights issue is one method by which a company by even more than this. That day is generally
can raise additional capital, complying with referred to as Black Monday and the Dow Jones
pre-emptive rights, with existing shareholders index fell by 22.3%, wiping US$500 billion off
having the right to subscribe for new shares share prices.
(see Section 3.1).
Dow Jones (Jul 1987Jan 1988)
2700
Ordinary shareholders have the right to vote
2600
on matters presented to them at company
meetings. This would include the right to vote 2500
on proposed dividends and other matters, 2400
such as the appointment, or reappointment, of 2300
directors.
2200
1900
The votes are cast in one of two ways:
1800
The individual shareholder can attend the
1700
company meeting and vote.
Aug Sep Oct Nov Dec Jan
Markets in every country around the world Price risk varies between companies: volatile
followed suit and collapsed in the same shares such as shares in investment banks
fashion. Central banks intervened to prevent tend to exhibit more price risk than defensive
a depression and a banking crisis and, shares, such as utility companies and general
remarkably, the markets recovered much of retailers.
their losses quite quickly from the worst ever
one-day crash.
2.2 Liquidity Risk
5000 Liquidity risk is the risk that shares may be
difficult to sell at a reasonable price. This
4000
typically occurs in respect of shares in thinly
3000 traded companies smaller companies, or
those in which there is not much trading
2000
activity. It can also happen, to a lesser degree,
1000 where share prices in general are falling, in
0 which case the spread between the bid price
(the price at which dealers will buy shares) and
1970 1980 1990 2000
the offer price (the price at which dealers will
sell shares) may widen.
After the 1987 crash, global markets resumed
Shares in smaller companies tend to have
the bull market trend driven by computer
a greater liquidity risk than shares in larger
technology. The arrival of the internet age
companies smaller companies also tend to
sparked suggestions that a new economy was
have a wider price spread than larger, more
in development and led to a surge in internet
actively traded companies.
stocks. Many of these stocks were quoted on
the NASDAQ exchange, which went from 600 to
5000 by the year 2000. This led the chairman 2.3 Issuer Risk
of the Federal Reserve to describe investor
behaviour as irrational exuberance. This is the risk that the issuer collapses and the
ordinary shares become worthless.
By early 2000, reality started to settle in and
the dot.com bubble was firmly popped with the In general, it is very unlikely that larger, well-
NASDAQ crashing to 2000. Economies went into established companies would collapse, and the
recession and heralded a decline in world stock risk could be seen, therefore, as insignificant.
markets, which continued in many until 2003. Events such as the collapse of Enron and
This was followed by general increases in equity Lehman Brothers, however, show that the
prices until falls were again seen across world risk is a real and present one and cannot be
stock markets in 2008 in the credit crunch. At ignored.
the time of writing, more recent falls have been
Shares in new companies, which have not
attributed to the crisis in the Eurozone that
yet managed to report profits, may have a
has seen Ireland, Portugal, Greece and Italy
substantial issuer risk.
requiring international assistance.
All of this clearly demonstrates the risks 2.4 Foreign Exchange Risk
associated with equity investment from general
price collapses. In addition to these market- This is the risk that currency price movements
wide movements, any single company can will have a negative effect on the value of an
experience dramatic falls in its share price investment.
when it discloses bad news, such as the loss of
a major contract.
Know the definition of a corporate action and Know the different methods of quoting
the difference between mandatory, voluntary securities ratios
and mandatory with options
Learning Objective 4.1.5
Understand the following terms: bonus/scrip/
A corporate action occurs when a company capitalisation issues; rights issues/open offers;
does something that affects its share capital stock splits/reverse stock splits; dividend
or its bonds. For example, most companies pay payments; takeover/merger
dividends to their shareholders twice a year.
already holds. The terms of the bonus issue on what that means for the prospects for the
may be expressed as 1:4, which means that company. If it is to finance expansion, and the
the investor will receive one new share for strategy makes sense to the investors, then
each existing four shares held. This is the the share price could subsequently recover. If
standard approach used in European and Asian the money is to be used for a strategy that the
markets and can be simply remembered by market does not think highly of, the response
always expressing the terms as the investor might be the opposite.
will receive X new shares for each Y existing
shares. Example
The approach differs in the US. The first ABC plc has 100 million shares in issue,
number in the securities ratio indicates the final currently trading at 4.00 each. To raise finance
holding after the event; the second number is for expansion, it decides to offer its existing
the original number of shares held. The above shareholders the right to buy one new share
example expressed in US terms would be 5:4. for every five previously held. This would be
So, for example, if a US company announced a described as a one for five rights issue.
5:4 bonus issue and the investor held 10,000
shares, then the investor would end up with The price of the rights would be set at a discount
12,500 shares. to the prevailing market price, at say 3.40.
As an example of a rights issue, the company The share price of the investors existing
might offer shareholders the right that for shares will also adjust to reflect the additional
every four shares owned, they can buy one shares that are being issued. So if the investor
more at a specified price that is at a discount to originally had five shares priced at 4 each,
the current market price. worth 20, and can acquire one new share at
3.40. On taking the rights up, the investor will
The initial response to the announcement of a have six shares worth 23.40 or 3.90 each.
rights issue is nearly always for the share price The share price will therefore change to reflect
to fall until the market has time to reflect on the effect of the rights issue.
reasons for the rights issue and take a view
Primary markets exist to raise capital and Each ADR has a particular number of underlying
enable surplus funds to be matched with shares, or is represented by a fraction of an
investment opportunities, while secondary underlying share. For example, Volkswagen AG
markets allow the primary market to function (the motor vehicle manufacturer) is listed in
efficiently by facilitating two-way trade in Frankfurt and has two classes of shares listed
issued securities. ordinary shares and preference shares. There
are separate ADRs in existence for the ordinary
A stock exchange is an organised marketplace shares and preference shares. Each ADR
for issuing and trading securities by members represents 0.2 individual Volkswagen shares.
of that exchange. Each exchange has its own ADRs give investors a simple, reliable and cost-
rules and regulations for companies seeking efficient way to invest in other markets and
a listing and continuing obligations for those avoid high dealing and settlement costs. Other
already listed. All stock exchanges provide both well-known companies, such as BP, Nokia,
a primary and a secondary market. Royal Dutch and Vodafone, have issued ADRs.
The LSEs main trading system is SETS (Stock Xetra is Deutsche Brses electronic trading
Exchange Trading Service), an automated system for the cash market and matches buy
system that operates on an order-driven basis. and sell orders from licensed traders in a
This means that, when a buy and sell price central, fully electronic order book.
match, an order is executed automatically.
In May 2011, floor trading at the Frankfurt
For securities that trade less regularly, market stock exchange migrated to Xetra technology.
makers are involved to keep the shares liquid. The new Xetra Specialist model combines
These market makers are required to provide the advantages of fully electronic trading
bid and ask prices for the shares of the especially in the speed of order execution
particular companies, ensuring that there is with the benefits of trading through specialists
always a market for the stock. who ensure that equities remain liquid and
continually tradeable. The machine fixes the
The LSE is also the majority shareholder in
price; the specialists supervise it; investors
MTS, the electronic exchange that dominates
benefit from faster order-processing.
trading in the European government bond
market. The MTS market model uses a common Deutsche Brse also owns the international
trading platform, while corporate governance central securities depository Clearstream,
and market supervision are based on the which provides integrated banking, custody
respective national regulatory regimes. and settlement services for the trading of
fixed-interest securities and shares.
Stocks and bonds are traded through the fully There are three types of securities currently
computerised OASIS system, which provides traded on EGX: equities, fixed income and
an electronic, transparent order system in closed-ended mutual funds.
which orders trade in price/time priority during
All trading is conducted through member firms,
continuous trading.
which carry out transactions as agents; that
ASE has more than 20 indices and in 2003 is, they arrange to buy or sell in return for an
introduced the FTSE Med 100 Index, a joint agreed-upon commission fee from investors.
index involving ASE, the Tel Aviv Stock Orders are input to the EFA system, which is an
Exchange and the Cyprus Exchange. electronic order system.
derivatives. It utilises a trading platform The open outcry system has been phased out
provided by NASDAQ OMX. Although it is by Indian exchanges. Since July 2004, the
now part of the DFM Group, the two markets Securities and Exchange Board of India (SEBI),
continue to operate independently because of the Indian securities regulator, has required
their different regulatory regimes. all institutional trades on the stock exchanges
to be executed electronically. All Indian stock
markets now offer screen-based electronic
6.4 Asia trading.
6.4.1 Tokyo Stock Exchange (TSE) NSE also provides a formal trading platform
for trading of a wide range of debt securities,
The TSE is one of five exchanges in Japan but
including government securities.
is, undoubtedly, one of the more important
world exchanges.
6.4.4 Shanghai Stock Exchange
The TSE uses an electronic, continuous (SSE)
auction system of trading. This means that
brokers place orders online and, when a buy The SSE is the largest exchange in China. It
and sell price match, the trade is executed was reopened in 1990, and in 2006 hosted the
automatically. Deals are made directly between worlds largest ever initial public offer (IPO), by
buyer and seller, rather than through a market the Industrial and Commercial Bank of China,
maker. The TSE uses price controls so that the which was valued at US$21.9 billion (CNY176.75
price of a stock cannot rise above, or fall below, billion).
a certain point throughout the day. These
The exchange trades stocks, bonds, and funds.
controls are used to prevent dramatic swings in
Bonds traded include Treasury bonds, corporate
prices that may lead to market uncertainty or
bonds, and convertible corporate bonds. There
stock crashes. If a major swing in price occurs,
are two types of shares traded: A shares,
the exchange can stop trading on that stock for
which are priced in the local renminbi yuan
a specified period of time.
currency, and B shares, which are quoted in
US dollars.
6.4.2 Hong Kong Stock Exchange
(HKSE) The SSE has a modern trading system where
orders are matched automatically by a
The HKSE ranks as one of the larger stock computer system, according to the principle of
exchanges in the world as measured by market price and time priority. Orders can be sent to
capitalisation. The Hang Seng Index, which the SSEs main framework through terminals,
consists of the largest companies traded on either on the floor or from member firms.
the exchange, is a key indicator of investing
conditions in the region. The SSE owns a 3,600-square-metre trading
floor, the largest in the Asia-Pacific area.
The Hong Kong stock market also is perceived
to offer a stable method for international
6.4.5 Singapore Exchange Limited
investors to participate in the industrial
evolution of China.
(SGX)
The SGX is the stock exchange in Singapore.
6.4.3 Indian Stock Exchanges It was formed in 1999 following the merger of
the Stock Exchange of Singapore (SES) and the
The Indian stock market supports 23 stock Singapore International Monetary Exchange
exchanges. The National Stock Exchange (NSE) (SIMEX). It is the first demutualised and
and the Stock Exchange Mumbai (formerly integrated securities and derivatives exchange
the Bombay Stock Exchange) account for in Asia.
the majority share of Indias exchange-traded
turnover.
Shares are mainly traded in board lots of 1,000 merged, in 1987, to form ASX. It merged
shares, although the trading of odd lots is also with the Sydney Futures Exchange (SFX), the
allowed. Workstations installed at brokers primary derivatives exchange in Australia, in
offices are linked directly to the exchanges 2006.
computer system. Orders are routed to the
central trade-matching engine, known as the The ASX has over 2,000 companies listed on
Central Limit Order Book. The system maintains its exchange. Trading is all-electronic and the
an order book for every traded stock and major market index is the S&P/ASX 200, made
matches buy and sell orders. Each order in the up of the top 200 shares in the ASX.
order book has a limit price. This is the highest
(for a buy order) or lowest (for a sell order)
price at which the order can be executed.
7. Stock Market
Orders in the system are held according to Indices
price, then time priority.
Its order-routing system was automated in Stock market indices were originally designed
1983 and member firms began transmitting to provide an impressionistic mood of the
orders electronically to the trading floor from market and, as such, were not constructed in a
1988. The trading system was fully automated particularly scientific manner. In recent years,
in 1997 when the exchange began to operate however, index construction has become more
without the trading floor. of a science, as performance measurement has
come under increased scrutiny and the growth
6.5 Australia of index-related products has necessitated
the need for more representative measures of
market movements, with greater transparency
6.5.1 Australian Securities surrounding their construction.
Exchange (ASX)
Most stock market indices have the following
The ASX is one of the worlds top ten listed four uses:
exchange groups measured by its market
capitalisation. To act as a market barometer. Most equity
indices provide a comprehensive record of
It began as six separate state-based exchanges, historic price movements, thereby facilitating
established as early as 1871, and eventually the assessment of trends. Plotted graphically,
these price movements may be of particular and the share price movement of one can have
interest to technical analysts and momentum a disproportionate effect on the index.
investors by assisting in identifying the right
point to buy or sell securities, an approach Following on from these earlier indices, broader-
referred to as market timing. based indices were calculated based on a
greater range of shares and which also took into
To assist in performance measurement. Most
account the relative market capitalisation of
equity indices can be used as performance
each stock in the index to give a more accurate
benchmarks against which portfolio
indication of how the market was moving. This
performance can be judged.
development process is ongoing, and most
To act as the basis for index tracker funds,
market capitalisation-weighted indices have
exchange-traded funds (ETFs), index
a further refinement in that they now take
derivatives and other index-related products.
account of the free-float capitalisation of their
To support portfolio management research
constituents. This float-adjusted calculation
and asset allocation decisions.
aims to exclude shareholdings held by large
As well as considering which market they are investors and governments that are not readily
tracking, it is important to also understand how available for trading.
the index has been calculated. Early indices,
There are now over 3,000 equity indices
such as the Dow Jones Industrial Average
worldwide, some of which track the fortunes of
(DJIA), are price-weighted so that it is only
a single market while others cover a particular
the price of each stock within the index that
region, sector or a range of markets. Some of
is considered when calculating the index. This
the main indices that are regularly quoted in
means that no account is taken of the relative
the financial press are as shown below.
size of a company contained within an index
Country Name
DJIA (Dow Jones Industrial Average): providing a narrow view of the US stock
market (30 stocks)
US
S&P 500 (Standard & Poors): providing a wider view of the US stock market
Settlement occurs on a T+3 settlement cycle. instruments. The Federal Reserve Bank is still
the depository for most US Government bonds
The ADX and the DFM use the Equator system
and securities.
and settlement takes place at T+2. The CSD
division does not operate on a DvP basis. When Transfer of securities held by DTC is by book
trading on either market, the broker has to entry, although shareholders have the right
set up a settlement account for the customer to request a physical certificate in many
in a bank that is used solely for settlement cases. However, about 85% of all shares are
purposes. It has to then ensure that it has the immobilised at DTC and efforts are under way
funds prior to placing any buy orders, and in in the US to eliminate the requirement to issue
the event of any default by the customer it can physical certificates at the state level.
apply to the market authorities for any disputed
shares to be sold. Equities settle at T+3, whilst US government
fixed income stocks settle at T+1. Corporate,
municipal and other fixed income trades settle
8.14 United Kingdom and at T+3.
Ireland
CREST is the central securities depository for
UK and Irish equities. Settlement of equity
trades takes place on T+3 and on T+1 for bonds.
Think of an answer for each question and refer to the appropriate section for confirmation.
3. When a shareholder appoints someone to vote on his behalf at a company meeting, what it is
referred to as?
4. What are the constitutional documents of a company more commonly known as?
6. Under what type of corporate action would an investor receive additional shares without
making any payment?
1. Introduction 73
2. Characteristics of Bonds 73
3. Government Bonds 77
4. Corporate Bonds 80
5. Asset-Backed Securities 82
6. International Bonds 83
7. Yields 84
Bonds
1. Introduction 2. Characteristics of
Although bonds do not often generate as much Bonds
media attention as shares, they are the larger
market of the two in terms of global investment
2.1 Definition of a Bond
value. As we saw in Chapter 1, the value of
outstanding debt globally totalled $95 trillion at
the end of 2010 compared to an equity market Learning Objective 5.1.1
capitalisation of over $56 trillion. Know the definition and features of government
bonds
Bonds are roughly equally split between
government and corporate bonds. Govern
A bond is, very simply, a loan.
ment bonds are issued by national governments
and by supranational agencies such as the A company that needs to raise money to
European Investment Bank and the World Bank. finance an investment could borrow money
Corporate bonds are issued by companies, such from its bank or, alternatively, it could issue a
as the large banks and other large corporate bond to raise the funds they need.
listed companies.
With a bond, an investor lends in return for the 2. Stock the name given to identify the
promise to have the loan repaid on a fixed date stock and the borrower, which in this case
and (usually) a series of interest payments. is the US government. As will be seen later,
the term Treasury bond represents US
Issuer government bonds issued with relatively
long periods to maturity; however, the term
Company A 7%
Face value, is also used to describe bonds issued by
nominal, par will pay: 7% many other countries.
or principal
10,000 3. Coupon this is the amount of interest rate
7%
paid per year, expressed as a percentage of
Maturity or 2018 7% the face value of the bond. The bond issuer
redemption
7% will pay the coupon to the bondholder. The
7%
Coupon rate is quoted gross and will normally be
paid in two separate and equal half-yearly
interest payments. The annual amount of
Bonds are commonly referred to as loan stock, interest paid is calculated by multiplying
debt and (in the case of those which pay fixed the nominal amount of stock held by the
income) fixed interest securities. coupon; that is, in this case, $10,000 times
7.5%.
The feature that distinguishes a bond from most
4. 2024 this is the year in which the stock
loans is that a bond is tradeable. Investors can
will be repaid. Repayment will take place
buy and sell bonds without the need to refer to
at the same time as the final interest
the original borrower.
payment is made. The amount repaid will
Although there are a wide variety of fixed be the nominal amount of stock held, that is
interest securities in issue, they all share $10,000. As well as the redemption date it
similar characteristics. These can be described is also known as the maturity date, which in
by looking at an example of a US government this case is 15 November 2024.
bond. 5. Price this stock can be freely traded at any
time on the NYSE and, as mentioned above,
Nominal $10,000 it is quoted at $146.80. The convention
Stock Treasury bond in the bond markets is to quote stock per
$100 nominal of stock. In this example,
Coupon 7.5%
the price quoted is $146.80 and so each
Redemption date 2024
$100 nominal of stock purchased will cost
Price $146.80 $146.80 before any brokerage costs.
Value $14,680 6. Value the value of the stock is calculated
by multiplying the nominal amount of stock
Lets assume that an investor has purchased a by the current price. Comparing the nominal
holding of $10,000 7.5% Treasury bond 2024 as value of the stock of $10,000 to the current
shown in the table above. market value of $14,680 ($10,000/$100
x $146.80) in other words, ignoring the
Each of the terms in the table are explained coupon the investor will make a loss of
here: $4,680 if the stock is held until redemption.
1. Nominal this is the amount of stock
purchased and should not be confused with
the amount invested or the cost of purchase.
This is the amount on which interest will be
paid and the amount that will eventually be
repaid. It is also known as the par or face
value of the bond.
Investment Grade
Highest quality Aaa AAA AAA
High quality Very Strong Aa AA AA
Upper medium Strong A A A
grade
Medium grade Baa BBB BBB
Non-Investment Grade
Lower medium Somewhat Ba BB BB
grade speculative
Low grade Speculative B B B
Poor quality May default Caa CCC CCC
Most speculative C CC CC
No interest being paid or bankruptcy C D C
petition filed
In default C D D
Treasury bonds again conventional gover- of the government by the Debt Management
nment bonds but with maturities of more Office (DMO).
than ten years from their issue date, most
commonly issued with maturities of 30 years. Conventional government bonds are instru
ments that carry a fixed coupon and a single
Treasury inflation-protected securities
repayment date, such as 5% Treasury Gilt
these are index-linked bonds and are referred
2018. This type of bond represents the majority
to as TIPS. The principal value of the bond
of government bonds in issue.
is adjusted regularly based on movements
in the consumer prices index to account for The other main type of bond issued by the
the impact of inflation. Interest payments are UK government is index-linked bonds. Index-
paid half-yearly and, unlike the UK version, linked bonds are bonds where the coupon and
the coupon remains constant but is paid on the redemption amount are increased by the
the changing principal value. amount of inflation over the life of the bond;
they are similar to the US TIPS.
STRIPS (Separate Trading of Registered
Interest and Principal of Securities) are also As well as categorising government bonds by
traded based on the stripped elements of type, another common division is by how many
Treasury notes, bonds and TIPS. Each bond is years remain until redemption. UK government
broken down into its underlying cash flows stocks are classified into the following:
that is, each individual interest payment plus
the single redemption payment. Each is then 0seven years remaining: short-dated
traded as a separate zero coupon bond. Seven15 years remaining: medium-dated
15 years and over remaining: long-dated
US Treasuries are traded for settlement the
next day. They have been issued in book entry In 2005, the Debt Management Office issued
form since 1986 that is, entry on the bond new gilts with redemption dates 50 years later
register and transfers can only take place for the first time. Although these are classified
electronically and no physical bond certificates within the banding of 15 years and over, they
are issued. Interest is paid on a semi-annual are often referred to as ultra-long gilts.
basis.
Gilts are traded for settlement the next day.
In addition to government bonds, federal Settlement takes place electronically and
agencies and municipal authorities also issue transfers take place by book entry. Interest is
bonds. Some of the biggest issuers of bonds paid on a semi-annual basis.
are Fannie Mae and Freddie Mac, which issue
bonds to support house purchase activity.
3.3 Germany
Municipal bonds are issued by states, cities,
The main types of German government bonds
counties and other government entities to raise
are Bunds, Schatz and Bobls. Bunds are
money to build schools, highways, hospitals
longer-term instruments; Schatz are issued
and sewer systems, as well as many other
with two-year maturities: Bobls are issued with
projects. Interest is usually paid semi-annually,
five-year maturities.
and many are exempt from both federal and
state taxes. Bunds are issued with maturities of between eight
and 30 years, but the most common maturity is
ten years. The Bund market is large and liquid
3.2 United Kingdom
and the yield on Bunds sets the benchmark for
UK government bonds are known as gilts. other European government bonds.
When physical certificates were issued,
Domestic trades settle two business days after
historically they used to have a gold or gilt edge
trade date, whilst international settlement
to them, hence they are known as gilts or gilt-
follows the practice in the eurobond market and
edged stock. The bonds are issued on behalf
takes place on T+3, that is three business days
later. All settlement takes place electronically Not all bonds are listed and most trading
by book entry. Interest on Bunds is paid on an takes place in the OTC market. Settlement
annual basis. varies depending upon the type of trade but is
typically T+3. Stock traded on the Tokyo Stock
Exchange settles three days after trade date.
3.4 France
French government debt is made up of longer- 3.6 Primary Market Issuance
term instruments known as OATS and shorter-
dated stocks known as BTANs, which have Government bonds are usually issued through
maturities up to five years. agencies that are part of that countrys Treasury
department.
Trading in OATS in both the domestic and
international market is for T+3, that is three
business days later. Trading in BTANs, however,
Example
is for T+1 in domestic markets, and T+3 for In the UK, when a new gilt is issued, the
international settlement. All settlement takes process is handled by the Debt Management
place electronically by book entry. Office (DMO), which is the agency acting on
behalf of the Treasury.
Interest on OATS is paid on an annual basis.
Issues are typically made in the form of an
3.5 Japan auction, where large investors (such as banks,
pension funds and insurance companies) submit
The Japanese government bond market is one competitive bids. Often they will each bid for
of the largest in the world and its bonds are several million pounds worth of an issue.
usually referred to as JGBs.
Issue amounts are normally between 0.5
JGBs are classified into six categories: billion and 2 billion. The DMO accepts bids
from those prepared to pay the highest price.
short-term bonds;
medium-term bonds; Smaller investors are able to submit non-
long-term bonds; competitive bids. Advertisements in the
super-long-term bonds; Financial Times and other newspapers will
individual investor bonds; include details of the offer and an application
inflation-indexed bonds. form.
Short-term JGBs have maturities of six months Non-competitive bids can be submitted for
and one year and are issued as zero coupon up to 500,000, and the applicant will pay
bonds; in other words they are issued at a the average of the prices paid by competitive
discount, carry no interest and are repaid at bidders.
their face value.
Medium, long and super-long JGBs are The issuer for the government bonds described
conventional bonds and so have fixed coupons above are as follows:
that are paid semi-annually and have set
redemption dates. The individual investor US: Bureau of the Public Debt.
bonds and 15-year super-long JGBs pay floating UK: Debt Management Office.
interest rates. Germany: Finanzagentur GmbH.
France: Agence France Trsor.
Inflation-indexed bonds operate in a similar Japan: Ministry of Finance.
way to TIPS, that is, the principal amount is
inflation-adjusted based on movements in the
consumer price index and the coupon is fixed
but payable on the inflation-adjusted principal
amount.
4. Corporate Bonds The greater the security offered, the lower the
cost of borrowing should be.
4.1 Features of Corporate Call provisions can take various forms. There
may be a requirement for the issuer to redeem
Bonds
a specified amount at regular intervals. This is
There are a wide variety of corporate bonds known as a sinking fund requirement.
and they can often be differentiated by looking
Some bonds are issued with put provisions;
at some of their key features, such as:
these give the bondholder the right to require
security; and the issuer to redeem early, on a set date or
redemption provisions. between specific dates. This makes the bond
attractive to investors and may increase the
chances of selling a bond issue in the first
4.1.1 Bond Security
instance; it does, however, increase the issuers
When a company is seeking to raise new funds risk that it will have to refinance the bond at an
by way of a bond issue, it will often have to inconvenient time.
offer security to provide the investor with
some guarantee for the repayment of the bond.
4.2 Types of Corporate Debt
In this context, security usually means some
form of charge over the issuers assets (eg, its There is a large variety of corporate debt being
property or trade assets) so that, if the issuer issued and traded. Some of the main types are
defaults, the bondholders have a claim on described below.
those assets before other creditors (and so can
regard their borrowings as safer than if there
4.2.1 Medium-Term Notes (MTNs)
were no security). In some cases, the security
takes the form of a third-party guarantee Medium-term notes are standard corporate
for example, a guarantee by a bank that, if bonds with maturities ranging usually from
the issuer defaults, the bank will repay the nine months to five years, though the term
bondholders.
is also applied to instruments with maturities If the company hits problems, the investor will
as long as 30 years. Where MTNs differ from retain the bond interest will be earned and,
other debt instruments is that they are offered as bondholder, the investor would rank ahead
to investors continually over a period of time of existing shareholders if the company goes
by an agent of the issuer, instead of in a single out of business. (Of course, if the company
tranche of one sizeable underwritten issue. was seriously insolvent and the bond was
unsecured, the bondholder might still not be
The market originated in the US to close the repaid, but this is a more remote possibility
funding gap between commercial paper and than that of a full loss as a shareholder.)
long-term bonds.
For the company, relatively cheap finance is
acquired. Investors will pay a higher price
4.2.2 Fixed Rate Bonds
for a bond that is convertible because of the
The key features of fixed rate bonds have possibility of a capital gain. However, the
already been described above. Essentially, prospect of dilution of current shareholder
they have fixed coupons which are paid either interests, as convertible bondholders exercise
half-yearly or annually, and pre-determined their options, has to be borne in mind.
redemption dates.
4.2.5 Zero Coupon Bonds
4.2.3 Floating Rate Notes (FRNs)
A zero coupon bond (ZCB) is one that pays no
Floating rate notes are usually referred to as interest. As seen, coupon is an alternative
FRNs and are bonds that have variable rates of term for the interest payment on a bond. The
interest. example below illustrates why a zero coupon
bond may be attractive.
The rate of interest will be linked to a benchmark
rate such as the London InterBank Offered Rate
Example
(LIBOR). This is the rate of interest at which
banks will lend to one another in London, and Imagine that the issuer of a bond (Example plc)
is often used as a basis for financial instrument offered you the opportunity to purchase a bond
cash flows. with the following features:
An FRN will usually pay interest at LIBOR plus a 100 nominal value.
quoted margin or spread. Issued today.
Redeems at its par value (that is 100
4.2.4 Convertible Bonds nominal value) in five years.
Pays no interest.
Convertible bonds are issued by companies.
They give the investor holding the bond two Would you be interested in purchasing the
possible choices: bond?
to simply collect the interest payments and It is tempting to say no who would want to
then the repayment of the bond on maturity; or buy a bond that pays no interest?
to convert the bond into a pre-defined number
However, there is no requirement to pay the
of ordinary shares in the issuing company, on
par value a logical investor would presumably
a set date or dates, or between a range of set
happily pay something less than the par value,
dates, prior to the bonds maturity.
for example 60. The difference between the
The attractions to the investor are: price paid of 60 and the par value of 100
recouped after five years would provide the
If the company prospers, its share price will investor with their return of 40 over five years.
rise and, if it does so sufficiently, conversion
may lead to capital gains.
As the example illustrates, these zero coupon returns grew, and banks started to issue
bonds are issued at a discount to their mortgage bonds backed by sub-prime loans.
par value and they repay, or redeem, at par
The way in which securitisation operates can be
value. All of the return is provided in the form
seen by looking at mortgage-backed bonds as
of capital growth rather than income and, as
an example in the following simplistic diagram:
a result, it may be treated differently for tax
purposes.
Pool of
Mortgages Bank
SPV
(Bond Issuer)
Learning Objective 5.2.1
Issue Proceeds from
Know the definitions and features of the
Securities Sale of Notes
following types of bond: asset-backed securities
Investors
that may have come from deposits that can The result saw bond prices collapse and banks
be withdrawn at short notice. take huge losses as the downturn in the
property market hit their own mortgage book
From the investors point of view, mortgage-
and because of the guarantees provided to the
backed bonds offer the following benefits:
SPVs. The bonds had been sold to investors
It is a marketable asset-backed instrument worldwide, who saw sharp falls in the value of
to invest in. their holdings, including many that were judged
Original mortgages will provide good security as safe by the ratings agencies.
if well diversified and equivalent in terms of
quality, terms and conditions.
Credit enhancements make the securitised 6. International
bonds a better credit risk. Bonds
A significant advantage of asset-backed
securities is that they bring together a pool of Learning Objective 5.2.1
financial assets that otherwise could not easily Know the definitions and features of the
be traded in their existing form. The pooling following types of bond: domestic; foreign;
together of a large portfolio of these illiquid eurobond
assets converts them into instruments that
may be offered and sold freely in the capital
In this section we will consider the main types
markets.
of international bonds that are issued.
Their drawback was brought vividly to light in
the sub-prime crisis. In normal circumstances, 6.1 Foreign Bonds
a pool of mortgages with high credit quality
will provide a diversified spread of risk for Bonds can be categorised geographically. A
bond investors. What happened in the sub- domestic bond is issued by a domestic
prime crisis is that poor quality (or sub-prime) issuer into the domestic market, for example,
mortgages were added to the mortgage pool a UK company issuing bonds, denominated in
which left them vulnerable to the downturn in sterling, to UK investors.
the US property market.
Staying with the example of the US Treasury The yield curve, as shown in the diagram
stock used above, it was purchased for $146.80 above, is a way of illustrating the different
but will only repay $100 when it is repaid in rates of interest that can be obtained in the
2024. So if an investor holds the bond until market, for similar debt instruments with
repayment, they will receive an attractive different maturity dates. Although yield curves
return each year but will make a capital loss, can assume a range of different shapes, in
and so a measure is needed to take this into normal market circumstances the yield curve
account. is described as being positive, ie, it slopes
upward, as in the diagram.
The redemption yield is a measure that
incorporates both the income and capital return The rationale for this is that the longer an
assuming the investor holds the bond until its investor is going to tie up capital, the higher
maturity into one figure. the rate of interest they will demand to
compensate themselves for the greater risk,
and opportunity cost, on the capital they have
invested.
Think of an answer for each question and refer to the appropriate section for confirmation.
5. You have a holding of 1,000 Treasury 5% stock 2028 which is priced at 104. What is its
flat yield?
1. Overview of Derivatives 89
2. Futures 90
3. Options 92
4. Swaps 93
5. Derivatives Markets 94
Chapter Six
Derivatives
on a stated delivery date. Unlike the forward quality will be based on the oil field from
contracts that preceded it, the futures which it originates (eg, Brent crude from
contract could itself be traded. These futures the Brent oil field in the North Sea), the
contracts have subsequently been extended to quantity is 1,000 barrels, the date is three
a wide variety of commodities and are offered months ahead and the location might be the
by an ever-increasing number of derivatives port of Rotterdam in the Netherlands.
exchanges.
It was not until 1975 that CBOT introduced the 2.3 Futures Terminology
worlds first financial futures contract. This
Derivatives markets have specialised
set the scene for the exponential growth in
terminology that is important to understand.
product innovation and the volume of futures
trading that followed. Staying with the example above, the electricity
company is the buyer of the contract, agreeing
to purchase 1,000 barrels of crude oil at
2.2 Definition of a Future
US$100 per barrel for delivery in three months.
Derivatives provide a mechanism by which the The buyer is said to go long of the contract,
price of assets or commodities can be traded in whilst the seller (the oil company in the above
the future at a price agreed today, without the example) is described as going short. Entering
full value of this transaction being exchanged into the transaction is known as opening the
or settled at the outset. trade and the eventual delivery of the crude oil
will close-out the trade.
A future is a legally binding agreement between
a buyer and a seller. The buyer agrees to pay a The definitions of these key terms that the
pre-specified amount for the delivery of a futures market uses are as follows:
particular pre-specified quantity of an asset at
a pre-specified future date. The seller agrees to Long the term used for the position taken
deliver the asset at the future date, in exchange by the buyer of the future. The person who is
for the pre-specified amount of money. long the contract is committed to buying the
underlying asset at the pre-agreed price on
the specified future date.
Example Short the position taken by the seller of the
A buyer might agree with a seller to pay $100 future. The seller is committed to delivering
per barrel for 1,000 barrels of crude oil in three the underlying asset in exchange for the pre-
months time. The buyer might be an electricity- agreed price on the specified future date.
generating company wanting to fix the price it Open the initial trade. A market participant
will have to pay for the oil to use in its oil-fired opens a trade when it first enters into a future.
power stations, and the seller might be an oil It could be buying a future (opening a long
company wanting to fix the sales price of some position) or selling a future (opening a short
of its future oil production. position).
Close the physical assets underlying most
futures that are opened do not end up
A futures contract has two distinct features: being delivered: they are closed-out instead.
For example, an opening buyer will almost
It is exchange-traded for example, on the invariably avoid delivery by making a closing
derivatives exchanges like NYSE Liffe or the sale before the delivery date. If the buyer
IntercontinentalExchange (ICE). does not close-out, he will pay the agreed sum
It is dealt on standardised terms and receive the underlying asset. This might
the exchange specifies the quality of the be something the buyer is keen to avoid,
underlying asset, the quantity underlying for example because the buyer is actually a
each contract, the future date and the financial institution simply speculating on the
delivery location only the price is open to price of the underlying asset using futures.
negotiation. In the above example, the oil
Learning Objective 6.3.1 The buyers of options are the owners of those
Know the definition and function of an option options. They are also referred to as holders.
Options did not really start to flourish until The following example of an options contract is
two US academics produced an option pricing intended to assist understanding of the way in
model in 1973 that allowed them to be readily which option contracts might be used.
priced. This paved the way for the creation of
standardised options contracts and the opening Example
of the Chicago Board Options Exchange
(CBOE) in the same year. This in turn led to Suppose shares in Jersey Inc are trading at
an explosion in product innovation and the $3.24 and an investor buys a $3.50 call for
creation of other options exchanges, such as three months. The investor, Frank, has the
NYSE Liffe. right to buy Jersey shares from the writer of
the option (another investor Steve) at $3.50
Options can also be traded off-exchange, or OTC, if he chooses, at any stage over the next three
where the contract specification determined by months.
the parties is bespoke.
If Jersey shares are below $3.50 three months
later, Frank will abandon the option.
3.2 Definition of an Option
If they rise to, say, $6.00 Frank will contact
An option gives a buyer the right, but not the
Steve and either:
obligation, to buy or sell a specified quantity of
an underlying asset at a pre-agreed exercise exercise the option (buy the share at $3.50
price, on or before a pre-specified future date and keep it, or sell it at $6.00); or
or between two specified dates. The seller, persuade Steve to give him $6.00 $3.50 =
in exchange for the payment of a premium, $2.50 to settle the transaction.
grants the option to the buyer.
If Frank paid a premium of 42 cents to Steve,
what is Franks maximum loss and what level
3.3 Options Terminology does Jersey plc have to reach for Frank to make
a profit?
There are two classes of options:
The most Frank can lose is 42 cents, the
A call option is where the buyer has the
premium he has paid. If the Jersey plc shares
right to buy the asset at the exercise price, if
rise above $3.50 + 42 cents, or $3.92, then
they choose to. The seller is obliged to deliver
Frank makes a profit. If the shares rose to
if the buyer exercises the option.
$3.51 then Frank would exercise his right to buy
A put option is where the buyer has the right
better to make a cent and cut his losses to 41
to sell the underlying asset at the exercise
cents than lose the whole 42 cents.
price. The seller of the put option is obliged
CME Group
5.1 Over-the-Counter (OTC)
The main derivatives exchange in the US is
and Exchange-Traded
the CME Group, which was formed out of the
Derivatives (ETD) merger in 2006 of the Chicago Board of Trade
and the Chicago Mercantile Exchange. It is the
As we saw earlier, there are two distinct groups
worlds largest and most diverse derivatives
of derivatives, differentiated by how they
exchange and consists of four distinct markets:
are traded. These are OTC derivatives and
exchange-traded derivatives. CME;
OTC derivatives are ones that are negotiated CBOT;
and traded privately between parties without NYMEX;
the use of an exchange. Interest rate swaps COMEX.
are just one of a number of products that are The Chicago Mercantile Exchange (CME) trades
traded in this way. interest rates, equities and currencies as well
The OTC market is the larger of the two as commodities, and has the largest number
in terms of value of contracts traded daily. of outstanding open contracts of any exchange
Trading takes place predominantly in Europe in the world. It trades by a mixture of open
and, particularly, in the UK. outcry and electronic trading. Its Globex
trading system was the first global electronic
Exchange-traded derivatives are ones that trading platform and has traded over one billion
have standardised features and can therefore transactions.
be traded on an organised exchange, such
as single stock or index derivatives. The role The Chicago Board of Trade (CBOT) exchange
of the exchange is to provide a marketplace is the worlds oldest futures and options
for trading to take place but also to provide exchange. As seen earlier, it was established in
some sort of guarantee that the trade will 1848 to provide a market for futures contracts
eventually be settled. It does this by placing for agricultural products. Trading still takes
an intermediary (the central counterparty or place by open outcry in a pit which allows
CCP) between the parties to each trade and by hundreds of traders to deal with each other
requiring participants to post a margin, which during the trading day by a mixture of hand
is a proportion of the value of the trade, for all signals and shouting.
transactions that are entered into. The New York Mercantile Exchange (NYMEX)
specialises in energy derivatives and
5.2 Derivatives Exchanges particularly oil and gas contracts.
emissions futures contract, in conjunction Eurex was created by Deutsche Brse AG and
with the European Climate Exchange. the Swiss Exchange. Trading is on the fully
computerised Eurex platform and its members
ICEs other markets are centred in North
are linked to the Eurex system via a dedicated
America and include trading of agricultural,
wide-area communications network (WAN).
currency and stock index futures and options.
This enables members from across Europe
and the US to access Eurex from outside of
NYSE Liffe US Switzerland and Germany.
The other major derivatives exchange in the
US is NYSE Liffe. It is part of the NYSE London Metal Exchange (LME)
Euronext group and uses the market-leading
The LME trades derivatives on non-precious,
Liffe CONNECT system developed for the
non-ferrous metals, such as copper, aluminium
London market (see below) to trade a broad
and zinc. Trading is predominantly by open
range of products including precious metal
outcry on the floor of the exchange.
futures and options, stock index futures
and a comprehensive suite of US interest
rate derivatives, including eurodollar and US 5.2.3 Asia
Treasury futures.
Korea Exchange (KRX)
5.2.2 Europe In South Korea, derivatives trading takes
place on the KRX, which was created through
The main derivatives exchanges in Europe the integration of the three existing Korean
are NYSE Liffe, Eurex and the London Metal spot and futures exchanges: the Korea Stock
Exchange, and ICE Futures Europe, which was Exchange, the Korea Futures Exchange and
considered earlier. KOSDAQ.
The UAE has two main derivative markets: the 5.3 Investing in Derivatives
Dubai Mercantile Exchange, which trades oil
Markets
contracts, and an equity derivatives market,
where futures on UAE listed stocks can be
traded on the NASDAQ Dubai Borse. Learning Objective 6.5.2
Know the advantages and disadvantages of
NASDAQ Dubai investing in the derivatives and commodity
markets
NASDAQ Dubai was formerly known as the
Dubai International Financial Exchange, or
DIFX, and was established in 2005. As part of Having looked at various types of derivatives
its growth, it has expanded into derivatives and their main uses, we can summarise some
trading with the opening of equity derivatives of the main advantages and disadvantages of
trading in 2008. investing in derivatives.
Think of an answer for each question and refer to the appropriate section for confirmation.
4. What is an investor who enters into a contract for the delivery of an asset in three months time
known as?
6. What type of option gives the holder the right to sell an asset?
7. What is the price paid for an option known as and who is it paid to?
11. What are the main types of contract traded on NYSE Liffe and Eurex?
Chapter Seven
C I T
U ROVEDS
APP
Investment Funds
The other main rationale for investing the funds objectives. In this section we will
collectively is to access the investing skills look at the difference between active and
of the fund manager. Fund managers follow passive management.
their chosen markets closely and will carefully
consider what to buy and whether to keep or
1.2.1 Passive Management
sell their chosen investments. Few investors
have the skill, time or inclination to do this as Passive management is seen in those types
effectively themselves. of investment funds that are often described
as index-tracker funds. Index-tracking, or
However, fund managers do not manage
indexation, involves constructing a portfolio
portfolios for nothing. They might charge
in such a way that it will track, or mimic, the
investors fees to become involved in their
performance of a recognised index.
collective investments (entry fees or initial
charges) or to leave the collective investment Indexation is undertaken on the assumption
(exit charges), plus annual management fees. that securities markets are efficiently
These fees are needed to cover the fund priced and cannot therefore be consistently
managers salaries, technology, research, their outperformed. Consequently, no attempt is
dealing, settlement and risk management made to forecast future events or outperform
systems, and to provide a profit. the broader market.
2.1.3 Fees and Expenses purchase, and is payable to the mutual fund
and not the broker.
Operating a mutual fund involves costs such Deferred sales charge this is a fee that
as shareholder transaction costs, investment is paid when shares are sold and is known as
advisory fees, and marketing and distribution a back-end load. This typically goes to the
expenses. Mutual funds pass along these broker that sold the shares, and the amount
costs to investors by imposing charges. SEC payable decreases the longer the investor
rules require mutual funds to disclose both holds the shares, until a point is reached
shareholder fees and operating expenses in a when the investor has held the shares for
fee table near the front of a funds prospectus. long enough that nothing is payable.
Redemption fee another type of fee that
Operating expenses refers to the costs
is paid when an investor sells their shares,
involved in running the fund and are typically
but which is payable to the fund and not the
paid out of fund assets. Included within these
broker.
costs are:
Exchange fee this is a fee that some funds
Management fees the costs of the invest impose when an investor wants to switch to
ment adviser who manages the portfolio. another fund within the same group or family
Distribution and service fees these are of funds.
fees paid to cover the costs of marketing
Where a fund charges a front-end sales load,
and selling fund shares including fees to
the amount payable will be lower for larger
brokers and others and the costs involved
investments. The amount that needs to be
in responding to investor enquiries and
invested needs to exceed what are commonly
providing information to investors.
referred to as breakpoints. It is up to each
Other expenses under this heading are
fund to determine how they will calculate
all other charges incurred by the fund such
whether an investor is entitled to receive a
as custody charges, legal and accounting
breakpoint, and regulatory requirements forbid
expenses and other administrative expenses.
advisers selling shares of an amount that is just
As well as disclosing these costs, mutual funds below the funds sales load breakpoint simply
are also required to state the total annual fund to earn a higher commission.
operating expenses as a percentage of the
Some funds are described as no-load, which
funds average net assets. This is known as
means that the fund does not charge any type
the expense ratio, and helps investors make
of sales load. They may, however, charge fees
comparisons between funds.
that are not sales loads, such as purchase fees,
As well as the costs that are involved in running redemption fees, exchange fees and account
a mutual fund, a fund may also impose charges fees. No-load funds will also have operating
when an investor buys, sells or switches mutual expenses.
fund shares. The types of charges that are
levied include: 2.1.4 Classes of Shares
Sales charge on purchases this is the Many mutual funds have more than one class
amount payable when shares are bought of shares. Whilst the underlying investment
and is sometimes referred to as a front-end portfolio remains the same for all of the
load; it is paid to the broker that sells the different classes, each will have different
funds shares. It is deducted from the amount distribution arrangements and fees.
to be invested so, for example, if you invest
$1,000 and there is a 5% front-end load Some of the most common mutual fund share
then only $950 would be actually invested in classes offered to individual investors are:
the fund. Regulations restrict the maximum
front-end charge to 8.5%.
Class A shares these typically impose
a front-end load but have lower annual
Purchase fee this is a fee that funds
expenses.
sometimes charge to defray the costs of the
Class B shares these do not impose a front- The main type of open-ended fund that is
end load and instead may impose a deferred encountered is a Socit dInvestissement
sales load along with operating expenses. Capital Variable (investment company with
Class C shares these have operating variable capital) or SICAV in other words, an
expenses and a front-end load or back- open-ended investment company. Some of the
end load but this will be lower than for the main characteristics of SICAVs include:
other classes. They will typically have higher
annual operating expenses than the other They are open-ended, so new shares can be
share classes. created or shares can be cancelled to meet
investor demand.
Dealings are undertaken directly with the
2.1.5 Other Characteristics fund management group or through their
network of agents.
The tax treatment of a US fund varies depending
They are typically valued each day and the
upon its type.
price at which shares are bought or sold is
For example, some funds are classed as tax- directly linked to the net asset value of the
exempt funds, such as a municipal bond underlying portfolio.
fund where all of the dividends are exempt They are single-priced, which means that
from federal and sometimes state income tax, the same price is used when buying or selling
although tax is due on any capital gains. and any charges for purchases is added on
afterwards.
For other mutual funds, income tax is payable They are usually structured as an umbrella
on any dividends and gains made when the fund, which means that each fund will
shares are sold. In addition, investors may have multiple other funds sitting under one
also have to pay taxes each year on the funds legal entity. This often means that switches
capital gains. This is because US law requires from one fund to another can be made at a
mutual funds to distribute capital gains to reduced charge or without any charge at all.
shareholders if they sell securities for a profit Their legal structure is a company which is
that cannot be offset by a loss. domiciled in Luxembourg and, although some
The tax treatment of mutual funds for non- of the key aspects of the administration of
US residents means that, in practice, funds the fund must also be conducted there, the
domiciled in Europe or elsewhere are more investment management is often undertaken
likely to be suitable. in London or another European capital.
2.2.1 SICAVs and FCPs As FCPs have no legal personality, they have to
be administered by a management company,
As mentioned earlier, Luxembourg is one of the
but otherwise the administration is very similar
main centres for funds that are to be distributed
to that described above for SICAVs.
to investors across European borders and
globally. The main US fund groups along with
their European counterparts manage huge
fund ranges from Luxembourg, which are then
distributed and sold not just across Europe but
in the Middle East and Asia as well.
it has directors and shareholders. However, like When the share price is above the net asset
a unit trust, an investment trust will invest in a value, it is said to be trading at a premium.
range of investments, allowing its shareholders
to diversify and lessen their risk. When the share price is below the net asset
value, it is said to be trading at a discount.
Some investment trust companies have more
than one type of share. For example, an Example
investment trust might issue both ordinary
shares and preference shares. Such investment ABC Investment Trust shares are trading at
trusts are commonly referred to as split 2.30. The net asset value per share is 2.00.
capital investment trusts. ABC Investment Trust shares are trading at
a premium. The premium is 15% of the
In contrast with OEICs and unit trusts, underlying net asset value.
investment trust companies are allowed to
borrow money on a long-term basis by taking
out bank loans and/or issuing bonds. This can
enable them to invest the borrowed money in Example
more stocks and shares a process known as
XYZ Investment Trust shares are trading at
gearing or leverage.
95p. The net asset value per share is 1.00.
Also, some investment trusts have a fixed date XYZ Investment Trust shares are trading at a
for their winding-up. discount. The discount is 5% of the underlying
net asset value.
This type of investment trust also removes There is a spread between the price at which
a further risk from holding direct property, investors buy the shares and the price at
namely liquidity risk or the risk that the which they can sell them. This is usually very
investment will not be able to be readily small, for example just 0.1% or 0.2% for,
realised. REITs are closed-ended funds and are say, an ETF tracking the FTSE 100.
quoted on stock exchanges and shares in REITs An annual management charge is deducted
are bought and sold in the same way as other from the fund. Typically, this is 0.5% or less.
investment trusts. The investors pay stockbrokers commission
when they buy and sell. But, unlike other
UK shares, there is no stamp duty to pay on
purchases.
Learning Objective 7.6.1 Many hedge funds have high initial investment
Know the basic characteristics of hedge levels, meaning that access is effectively
funds: risk and risk types; cost and liquidity; restricted to wealthy investors and institutions.
investment strategies However, investors can also gain access to
hedge funds through funds of hedge funds.
Hedge funds are reputed to be high-risk. The common aspects of hedge funds are the
However, in many cases, this perception following:
stands at odds with reality. In their original
Structure most hedge funds are established
incarnation, hedge funds sought to eliminate
as unauthorised and therefore unregulated
or reduce market risk. That said, there are
collective investment schemes, meaning that
now many different styles of hedge fund
they cannot be generally marketed to private
some risk-averse, and some employing highly
individuals because they are considered too
risky strategies. It is, therefore, not wise to
risky for the less financially sophisticated
generalise about them.
investor.
The most obvious market risk is the risk that is High investment entry levels most
faced by an investor in shares as the broad hedge funds require minimum investments in
market moves down, the investors shares excess of 50,000; some exceed 1 million.
also fall in value. Traditional absolute return Investment flexibility because of the
hedge funds attempt to profit regardless of lack of regulation, hedge funds are able to
the general movements of the market by invest in whatever assets they wish (subject
carefully selecting a combination of asset to compliance with the restrictions in their
classes, including derivatives, and by holding constitutional documents and prospectus).
both long and short positions (a short position In addition to being able to take long and
may involve the selling of shares which the fund short positions in securities like shares and
does not at that time own in the hope of buying bonds, some take positions in commodities
them back more cheaply if the market falls). and currencies. Their investment style is
generally aimed at producing absolute
However, innovation has resulted in a wide returns positive returns regardless of the
range of complex hedge fund strategies, some general direction of market movements.
of which place a greater emphasis on producing Gearing many hedge funds can borrow
funds and use derivatives to potentially
enhance returns.
Liquidity to maximise the hedge fund
managers investment freedom, hedge funds
usually impose an initial lock-in period
of between one and three months before
investors can sell their investments on.
Cost hedge funds typically levy
performance-related fees which the investor
pays if certain performance levels are
achieved, otherwise paying a fee comparable
to that charged by other growth funds.
Performance fees can be substantial, with
20% or more of the net new highs (also
called the high water mark) being common.
Think of an answer for each question and refer to the appropriate section for confirmation.
2. What is an investment management approach that seeks to produce returns in line with an
index known as?
5. In which type of collective investment vehicle would you be most likely to expect to see a fund
manager quote bid and offer prices?
6. How does the trading and settlement of an authorised unit trust differ from an ETF?
7. What are some of the principal ways in which investment trusts differ from authorised unit
trusts and OEICs?
1. Introduction 119
Chapter Eight
9. Customers: relationships of trust a of a firm meets the spirit, as well as the letter,
firm must take reasonable care to ensure of the regulations. Breach of the regulations
the suitability of its advice and discretionary can lead to disciplinary action against the
decisions for any customer who is entitled to individual, with penalties ranging from public
rely upon its judgment. censure to fines, and ultimately being barred
10. Clients assets a firm must arrange from working in the financial services industry.
adequate protection for clients assets when
it is responsible for them.
1.2.3 FSA Training and
11. Relations with regulators a firm must
Competency Standards
deal with its regulators in an open and
co-operative way, and must appropriately Regulating the firm, and its key individuals,
disclose to the FSA anything relating to the is essential to ensuring that firms act in an
firm of which the FSA would reasonably appropriate manner, and, equally, ensuring
expect notice. that each firm has well-trained and competent
staff is a vital component in the quality of
1.2.2 FSA Statements of Principle the investment and financial advice given to
customers. As a result, the UK regulator (the
for Approved Persons
FSA) sets the following standards:
The approach taken to regulating firms in the
UK recognises that a firm is typically a collection It is the responsibility of the firm to ensure
of individuals. Some of these individuals are that staff members are appropriately qualified
considered key to the firm and its capacity for their role.
to meet its regulatory requirements and are There is an obligation on firms to ensure that
termed controlled functions in recognition their employees continue to be competent.
of the control that the regulator exercises over It is the firms responsibility to have a
them. sound training programme in place to ensure
that its employees remain up-to-date with
Broadly, controlled functions are those involved developments in the marketplace.
in dealing with customers or their investments,
and key managers in the firm including finance,
compliance and risk. 2. Money Laundering
The regulator details seven principles that such Money laundering is the process of turning
people must observe as they carry out their money that is derived from criminal activities
duties: dirty money into money which appears to
have been legitimately acquired and which can
1. Act with integrity. therefore be more easily invested and spent
2. Act with due skill, care and diligence. clean money.
3. Observe proper standards of market
conduct. Money laundering can take many forms,
4. Deal with regulators in an open and including:
co-operative way.
5. Take reasonable steps to ensure that the
turning money acquired through criminal
activity into clean money;
business of the firm is organised so that it
can be effectively controlled.
handling the proceeds of crimes such as
theft, fraud and tax evasion;
6. Exercise due skill, care and diligence in
managing the business of the firm.
handling stolen goods;
7. Take reasonable care to ensure the firm
being directly involved with, or facilitating,
the laundering of any criminal or terrorist
complies with the relevant requirements
property;
and standards of the regulatory regime.
criminals investing the proceeds of their crimes
By targeting these key individuals, the regulator in the whole range of financial products.
aims to ensure that the culture and operation
Examples include:
Insider trading takes place when an insider In all three cases the behaviour is judged
acquires, or disposes of, price-affected on the basis of what a regular user of the
securities while in possession of unpublished market would view as a failure to observe the
price-sensitive information. It also occurs if standards of behaviour normally expected in
they encourage another person to deal in the market.
price-affected securities, or to disclose the
information to another person (other than in An example of prohibited market abuse was
the proper performance of employment). the spreading of false rumours in March 2008
about certain companies listed on the LSE.
The instruments covered by the insider It was suspected that those spreading the
trading rules are usually broadly described as rumours were holding short positions in the
securities, which include: companies in other words, they had sold
shares which they did not own, in the hope of
shares;
buying them back at a lower price in the future.
bonds (issued by a company or a public
The spreading of false rumours was designed
sector body);
to push down the price.
warrants;
depositary receipts; Market abuse does not have the same
options (to acquire or dispose of securities); restrictions on the instruments covered as the
futures (to acquire or dispose of securities); insider trading regime. Broadly, market abuse
contracts for difference (based on securities, covers financial instruments that are traded
interest rates or share indices). on exchanges, which includes not only shares
and bonds and related derivatives, but also
Note that the definition of securities does
commodity derivatives.
not embrace commodities and derivatives on
commodities (such as options and futures
Suppliers Payments for goods and So what may start out as a well-intentioned
services (invoices) but inadequately thought-out action may have
consequences which extend far beyond your
Community Taxes and excise duties,
immediate area.
licence fees
Research1 shows more business leaders now So what makes the difference? A pilot study
understand that the way they do business is to the Cranfield/IBE report investigated the
an important aspect of fulfilling their financial distinguishing features, if any, of the operations
obligations to their stockholders, as well as of companies with explicit ethics policies
other stakeholders. They are responding to compared with those with a less robust policy.
accusations of poor behavioural standards in
various ways. Employee Retention
Firstly, more companies are putting in place One non-financial indicator is the retention
corporate responsibility policies or ethics of high-quality staff, recognised as vital to a
policies, the principal feature of which is a profitable and sustainable organisation. The
code of ethics/conduct/behaviour to guide their attraction and retention of high quality staff
staff. Companies now accept that an ethics would be expected to be reflected in higher
policy is one of the essential ingredients of productivity and, ultimately, profitability. This
good corporate governance. is well explained in Putting the Service-Profit
Chain to Work 4 in which the authors describe Standard and Poors and Barclays Bank data,
the links in the service-profit chain. They has indicated that companies with an explicit
argue that profit and growth are stimulated ethics policy generally have a higher rating
by customer loyalty; loyalty is a direct result than those without one. This in turn generated
of customer satisfaction; satisfaction is largely a significantly lower cost of capital.6
influenced by the value of services provided
to customers; value is created by satisfied, What is apparent from these research projects,
loyal and productive employees; and employee and others in the US, is that the leadership of
satisfaction, in turn, results from high-quality consistently well managed companies accepts
support services and policies that enable that having a corporate responsibility/ethics
employees to deliver results to customers. policy is an important part of their corporate
governance agenda.
Customer Retention
A second non-financial indicator is customer
4.4 Assessing Dilemmas
retention; it too, is recognised as a significant Many firms and individuals maintain the highest
factor in the long-term viability of a company. A standards without feeling the need for a
research paper in 20025 showed that corporate plethora of formal policies and procedures
ethical character makes a difference to the documenting conformity with accepted ethical
way that customers (and other stakeholders) standards. Nevertheless, it cannot be assumed
identify with the company (brand awareness). that ethical awareness will be absorbed through
a sort of process of osmosis. Accordingly, if we
Besides maintaining good staff and customers,
are achieve the highest standards of ethical
how providers of finance and insurance rate an
behaviour in our industry, and in industry more
organisation is a major factor in determining
generally, it is sensible to consider how we can
the cost of each. What ratings agencies have
create a sense of ethical awareness.
developed, with varying degrees of success,
are measures of risk the lower the risk, If we accept that ethics is about both thinking
the lower the capital cost. One study, using and doing the right thing, then we should seek
first of all to instil the type of thinking which
Note References causes us, as a matter of habit, to reflect upon
what we are considering doing, or what we may
1. Webley, S. and Werner, A., Employee Views
be asked to do, before we carry it out.
of Ethics at Work, Institute of Business Ethics,
2009. There will often be situations, particularly
2. Webley, S. and More, E., Does Business at work, where we are faced with a decision
Ethics Pay? Ethics and Financial Performance, where it is not immediately obvious whether
Institute of Business Ethics, 2003. what we are being asked to do is actually right.
3. Ugoji, K., Dando, N. and Moir, L., Does
Business Ethics Pay? Revisited: The Value of A simple checklist will help to decide. Is it:
Ethics Training, Institute of Business Ethics,
Open, Honest, Transparent, Fair?
2007.
4. Putting the Service Profit Chain to Work, Open is everyone whom your action or
HBR, July/August 2008. decision affects fully aware of it, or will they
5. Chun, R., An Alternative Approach to be made aware of it?
Appraising Corporate Social Performance: Honest does it comply with applicable law
Stakeholder Emotion, Manchester Business or regulation?
School. Submitted to Academy of Management Transparent is it clear to all parties
Conference, Denver, Colorado, 2002. involved what is happening /will happen?
6. Webley, S. and Hamilton, K., How Does Fair is the transaction or decision fair to
Business Ethics Pay? in Appendix 3 of Does everyone involved in it or affected by it?
Business Ethics Pay? Revisited, 2007, op.cit.
A simple and often quoted test is whether is considered that more specific guidance of
you would be happy to appear in the media standards of professional practice would be
in connection with, or in justification of, the beneficial, such standards might be set out
transaction or decision. in an appropriately entitled document, or in
regulatory standards.
Professional Colleagues/
Body Society Client Employer Profession Self Others
Association Employer
Consequently, while regulatory standards may behaviour of industry participants that, while
draw on professional codes of conduct, they not being breaches of actual regulation, were
will not simply mirror them. However, the considered to be inappropriate or damaging to
overarching connection between all three of the industry.
these areas is an explicit requirement for the
highest standards of personal and professional It is worth noting that the key verb in both sets
ethics. of principles is the word must, a command
verb indicating that the subject has no
One of the paradoxical outcomes of the discretion in what decision they make, because
financial crisis is that rule-based compliance the Principle determines the correct course of
is being strengthened, as it is judged that action.
reliance upon principles-based decision-making
is deemed to have failed. However, while this Events since 2001 have caused the FSA to
may be a natural reaction, the strengthening revise its belief in the adequacy of the approach
of regulation, far from being an indication of that combines regulation with principles, since
the failure or weakness of an ethically based it is felt that this results in an overly black
approach, should in fact be seen as clarion call and white approach, ie, if an action is not
for the strengthening of ethical standards. specifically prevented by the regulations or
Principles then it is acceptable to follow that
These are the principal features of what we course of action. Such an approach is popular
can describe as the ethics versus compliance in a number of countries, but is now felt to fall
approach: short of what is required in order to produce
properly balanced decisions and policies.
Ethics Compliance
Consequently, the FSA consulted with a number
Prevention Detection of professional bodies including the CISI, as well
Principles-based Law/rules-based as consulting the financial adviser community,
Values-driven Fear-driven as a result of which the FSA has proposed a
Implicit Explicit code of conduct for financial advisers.
Spirit of the law Letter of the law
Discretionary Mandatory 4.5.2 CISI Code of Conduct
To act honestly and fairly at all times when dealing with clients, customers
and counterparties and to be a good steward of their interests, taking into
1. account the nature of the business relationship with each of them, the Client
nature of the service to be provided to them and the individual mandates
given by them.
To be alert to and manage fairly and effectively and to the best of your
5. Client
ability any relevant conflict of interest.
To decline to act in any matter about which you are not competent unless
7. you have access to such advice and assistance as will enable you to carry Client
out the work in a professional manner.
society at large. Where these duties are set out must understand the obligation upon us to act
in law, or in regulation, the professional must with integrity in all aspects of our work and our
always comply with the requirements in an professional relationships.
open and transparent manner.
Accordingly, it is appropriate at this stage to
Membership of the Chartered Institute for examine the Code of Conduct and to remind
Securities & Investment requires members ourselves of the stakeholders in each of the
to meet the standards set out within the individual principles.
Institutes Principles. These Principles impose
an obligation on members to act in a way The code of conduct is intended to provide
beyond mere compliance. direction to members of the CISI.
They set out clearly the expectations upon At the corporate and institutional level this
members of the industry to act in a way means operating in accordance with the rules
beyond mere compliance. In other words, we of market conduct, dealing fairly (honestly)
Think of an answer for each question and refer to the appropriate section for confirmation.
1. Pensions 137
2. Loans 139
3. Mortgages 142
Chapter Nine
provided out of a governments current year such occupational schemes to new employees
income, with no investment for future needs. because of rising life expectancies and volatile
investment returns, and the implications these
This is a problem in many countries with an
factors have on the funding requirement for
increasing number of people living longer in
defined benefit schemes.
retirement and so presenting serious funding
issues for governments. In the UK, for example, Instead, occupational pension schemes are
dependency ratios (the proportion of working now typically provided to new employees on a
people to retired people) are forecast to fall defined contribution basis where the size
from 4:1 in 2002 to 3:1 by 2030 and 2.5:1 by of the pension is driven by the contributions
2050. This means that by 2050 either each paid and the investment performance of the
worker will have to support almost twice as fund. Under this type of scheme, an investment
many retired people, or support per head will fund is built up and the amount of pension
need to fall substantially, or some combination that will be received at retirement will be
of these changes. determined by the value of the fund and the
amount of pension it can generate.
Authorised overdrafts, agreed with the bank in Generally, the interest rate charged on credit
advance, are charged interest at a lower rate. cards is relatively high compared to other forms
Some banks allow small overdrafts without of borrowing, including overdrafts. However, if
charging fees to avoid infuriating a customer a credit card customer pays the full balance
who might be overdrawn by a relatively low each month, he is borrowing interest-free. It is
amount. also common for credit card companies to offer
0% interest to new customers for balances
Overdrafts are a convenient but expensive way
transferred from other cards and for new
of borrowing money, and borrowers should
purchases for a set period, often six months.
try to restrict their use to temporary periods,
and avoid unauthorised overdrafts as far as
possible. 2.3 Loans
Loans can be subdivided into two groups:
2.2 Credit Card Borrowing secured or unsecured.
Customers in the UK and US are very attached Unsecured loans are typically used to purchase
to their flexible friends a typical pet name items such as a new kitchen. Another example
for credit cards from savings institutions like is a student loan to be repaid after university.
banks and building societies, and other cards The lender will check the creditworthiness of
from retail stores, known as store cards. In the borrower assessing whether he can afford
other countries including much of Europe, the to repay the loan and interest over the agreed
use is much less widespread. term of, say, 48 months from his income given
his existing outgoings.
A wide variety of retail goods such as food,
electrical goods, petrol and cinema tickets can The unsecured loan is not linked to the item
be paid for using a credit card. The retailer is that is purchased with the loan (in contrast to
paid by the credit card company for the goods mortgages which are covered in Section 3), so
sold; the credit card company charges the if the borrower defaults it can be difficult for
retailer a small fee, but it enables the store the lender to enforce repayment. The usual
to sell goods to customers using their credit mechanism for the unsecured lender to enforce
cards. repayment is to start legal proceedings to get
the money back.
Customers are typically sent a monthly
statement by the credit card company.
Customers can then choose to pay all the
Example
money owed to the credit card company, or just Jerry borrows 10,000, unsecured over a
a percentage of the total sum owed. Interest is 36-month period, to buy a new kitchen. After
charged on the balance owed by the customer. three months, Jerry loses his job and is unable to
continue to meet the repayments and interest.
Because the loan is unsecured, the lender is not
able to take the kitchen to recoup the money.
The lender can simply negotiate with Jerry to
reschedule the repayments, or commence legal
proceedings to reclaim the money owed.
Example
The Moneybags Credit Card Company might
quote their interest rate at 12% per annum,
charged on a quarterly basis.
As seen in the previous section, the costs At the end of the fourth quarter, interest will
of borrowing vary depending on the form of be charged at 3% on the amount outstanding
borrowing, how long the money is required for, (including the first, second and third quarters
the security offered and the amount borrowed. interest). 109.27 x 3% = 3.28 will be added
to make the outstanding balance 112.55.
Mortgages, secured on a house, are much
cheaper than credit cards and agreed In total the interest incurred on the 100 was
overdrafts. 12.55 over the year. This is an effective annual
rate of 12.55/100 x 100 = 12.55%.
Unauthorised overdrafts are incredibly
expensive and can be thought of as a fine that
the bank charges for not keeping them fully There is a shortcut method to arrive at the
informed of spending excesses. effective annual rate seen above. It is simply to
take the quoted rate, divide by the appropriate
Whether a mortgage is to buy a house or month, he is guaranteed to pay off the loan
flat to live in, or to buy-to-let, the factors over the term of the mortgage. The main risks
considered by the lender are much the same. attached to a repayment mortgage from the
The mortgage lender, such as a building society borrowers perspective are:
or bank, will consider each application for a
loan in terms of the credit risk the risk of not The cost of servicing the loan could increase,
being repaid the principal sum loaned and the since most repayment mortgages charge
interest due. interest at the lenders standard variable rate
of interest. This rate of interest will increase if
Applicants are assessed in terms of: interest rates go up.
The borrower runs the risk of having the
income and security of employment; property repossessed if he fails to meet the
existing outgoings utility bills, other repayments remember, the mortgage loan
household expenses, school fees etc; and is secured on the underlying property.
the size of the loan in relation to the value of
the property being purchased. An interest-only mortgage requires the
borrower to make interest payments to the
A second mortgage is sometimes taken out on lender throughout the period of the loan. At
a single property. If the borrower defaults on the same time, the borrower generally puts
his borrowings, the first mortgage ranks ahead money aside each month into some form of
of the second one in terms of being repaid out investment.
of the proceeds of the property sale.
The borrowers aim is for the investment
to grow through regular contributions and
3.2 Types of Mortgage investment returns (such as dividends, interest
The most straightforward form of mortgage is and capital growth) so that at the end of
a repayment mortgage. This is simply where the mortgage the accumulated investment is
the borrower will make monthly payments sufficient to pay back the capital borrowed, and
to the lender, with each monthly payment perhaps offer some additional cash.
comprising both interest and capital.
Example
Example
Ms Ward borrows 100,000 from XYZ Bank to
Mr Mullergee borrows 100,000 from XYZ Bank finance the purchase of a flat on an interest-
to finance the purchase of a flat on a repayment only basis over 25 years. Each month she is
basis over 25 years. Each month he is required required to pay 420 interest to XYZ Bank. At
to pay 600 to XYZ Bank. In the above example, the same time, Ms Ward pays 180 each month
Mr Mullergee will pay a total of 180,000 (600 into an investment fund run by an insurance
x 12 months x 25 years) to XYZ Bank, including company. At the end of the 25-year period, Ms
80,000 interest over and above the capital Ward hopes that the investment in the fund will
borrowed of 100,000. Each payment he makes have grown sufficiently to repay the 100,000
will be partly allocated to interest and partly loan from XYZ Bank and offer an additional
allocated to capital. In the early years the lump sum.
payments are predominantly interest. Towards
the middle of the term the capital begins to
The main risks attached to an interest-only
reduce significantly; at the end of the mortgage
mortgage from the borrowers perspective are:
term the payments are predominantly capital.
Borrowers with interest-only mortgages still
face the risk that interest rates may increase
The key advantage of a repayment mortgage
and their property is at risk if they fail to keep
over other forms of mortgage is that, as long
up the payments to the lender.
as the borrower meets the repayments each
The investment might not grow sufficiently based on the lenders standard variable rate,
to pay the amount owing on the mortgage. but with a cap at 7%. If prevailing rates fall to
In the example above, there is nothing 5%, the borrower pays at that rate; but if rates
guaranteeing that, at the end of the 25-year rise to 8% the rate paid cannot rise above the
term, the investment in the fund will be cap, and is only 7%.
worth 100,000 indeed, it might be worth
considerably less. Lending institutions often attract borrowers
by offering discounted rate mortgages. A
6% loan might be discounted to 5% for the
3.3 Payment Terms first three years. Such deals might attract
switchers borrowers who shop around and
There are four main methods by which the
remortgage at a better rate; they may also be
interest on a mortgage may be charged:
useful for first-time buyers as they make the
variable rate; transition to home ownership with a relatively
fixed rate; low but growing level of income.
capped rate; and
discounted rate. 3.4 Islamic Finance
In a standard variable rate mortgage the
borrower pays interest at a rate that varies Learning Objective 9.3.3
with prevailing interest rates. The lenders Know the prohibition on interest under Islamic
standard variable rates will reflect increases or finance and the types of mortgage contracts
decreases in base rates. Once he has entered
into a variable rate mortgage, the borrower will
Islamic law, the Shariaa, bans the payment or
benefit from rates falling and remaining low,
receipt of interest and, as a result, rules out the
but will suffer the additional costs when rates
use of traditional western loans and mortgages
increase. The interest rate charged may also
for buying property.
track the movement in the official base rate,
when it is known as a tracker mortgage. Financial institutions have, however, been
keen to develop mortgage schemes that avoid
In a fixed rate mortgage the borrowers
interest payments and can therefore be used
interest rate is set for an initial period, usually
by Muslims.
the first three or five years. If interest rates
rise, the borrower is protected from the higher Shariaa-compliant mortgages come in two
rates throughout this period, continuing to pay forms: the ijara and the murabaha. Both are
the lower, fixed, rate of interest. However, if carefully structured deals that avoid the use of
rates fall and perhaps stay low, the fixed rate interest payments, but still allow the financial
loan can only be cancelled if a redemption institution to make a profit.
penalty is paid. The penalty is calculated to
recoup the loss suffered by the lender as a Under the ijara system, the bank rather than
result of the cancellation of the fixed rate loan. the borrower buys the property. The customer
It is common for fixed rate borrowers to be rents the home from the bank for 25 years
required to remain with the lender and pay and the payments made during that time add
interest at the lenders standard variable rate up to the original price plus the banks profit.
for a couple of years after the fixed rate deal Rent reviews are undertaken periodically, say
ends commonly referred to as a lock in six-monthly. Once the final payment is made,
period. ownership of the property is transferred to the
customer. Since no interest is being paid, the
Capped mortgages protect borrowers from arrangement complies with Islamic law.
rates rising above a particular rate the
capped rate. For example, a mortgage might With the murabaha system, the bank also
be taken out at 6%, with the interest rate buys the property but then sells it on to the
KEY TERMS
The person who proposes to enter into a contract of insurance with a life
Proposer insurance company to insure himself or another person on whose life he has
insurable interest.
The person on whose life the contract depends is called the life assured.
Although the person who owns the policy and the life assured are frequently the
Lives
same person, this is not necessarily the case. A policy on the life of one person,
Assured
but effected and owned by someone else, is called a life of another policy. A
policy effected by the life assured is called an own life policy.
Single Life A single life policy pays out on one individuals death.
Where cover is required for two people, this can typically be arranged in one of
two ways, through a joint life policy or two single life policies.
A joint life policy can be arranged so that the benefits would be paid out following
the death of either the first, or, if required for a specific reason, the second life
assured. The majority of policies are arranged ultimately to protect financial
Joint Life dependants, with the sum assured or benefits being paid on the first death.
With two separate single life policies, each person is covered separately. If both
lives assured were to die at the same time, as the result of a car accident for
example, the full benefits would be payable on each of the policies. If one of
the lives assured died, benefits would be paid for that policy, with the surviving
partner having continuing cover on their life.
To buy a life insurance policy on someone elses life, the proposer must have an
Insurable
interest in that person remaining alive, or expect financial loss from that persons
Interest
death. This is called an insurable interest.
In a non-profit policy the insured sum is annual bonuses, which are declared each
chosen at the outset and is fixed. For example, year by the insurance company, and which
500,000 payable on death. can vary. If the underlying performance of
the investments in the fund is better than
With-profits funds are used to build up a expected, this is a good year, and a part
sum of money to buy an annuity or pension of the surplus will be held back to enable
on retirement, to pay off the capital of a the insurance company to award an annual
mortgage, or to insure against an event such as bonus in a bad year. In this way, the returns
death. One advantage of with-profits schemes smooth out the peaks and troughs that may
is that profits are locked in each year. If an be occurring in the underlying stock market;
investor bought shares or bonds directly, or
a terminal bonus at the end of the period.
within a unit trust or investment trust, the
This could be substantial, for example 20% of
value of the investments could fall just as they
the sum insured, but is not declared until the
are needed because of general declines in
end of the policy term.
the stock market. With-profits schemes avoid
this risk by smoothing the returns. A typical The final kind of policy is a unit-linked
scheme might pay out: or unitised scheme. Each month, premiums
are used to purchase units in an investment
the sum assured or guaranteed sum, which fund. Some units are then used to purchase
is usually an amount a little less than the term insurance and the rest remain invested
premiums paid over the term; in the investment fund run by the insurance
company. Where it is held to fund a mortgage, for a surviving partner or to provide funds to pay
the insurance company will review the policies any tax that might become payable on death.
every five or ten years, making the investor
aware of any potential shortfall and perhaps When taking out life cover, the individual selects
suggesting an increase in the premiums to the amount that they wish to be paid out if the
boost the life cover or the guaranteed sum. event happens and the period that they want
the cover to run for. If, during the period when
The reason for such policies being taken out the cover is in place, they die, then a lump
is not normally just for the insured sum itself. sum will be paid out that equals the amount
Usually they are bought as part of a protection of life cover selected. With some policies, if
planning exercise to provide a lump sum in an individual is diagnosed as suffering from
the event of death to pay off the principal in a a terminal illness which is expected to cause
mortgage or to provide funds to assist with the death within 12 months of the diagnosis, then
payment of any tax that might become payable the lump sum is payable at that point.
on death. They can serve two purposes,
therefore, both protection and investment. The amount of the premiums paid for term
assurance will depend on:
Purchasing a life assurance policy is the same
as entering into any other contract. When a the amount insured;
person completes a proposal form and submits age, sex and family history;
it to an insurance company, that constitutes other risk factors, including state of health (for
a part of the formal process of entering into example, whether the individual is a smoker or
a contract. The principle of utmost good faith non-smoker), his occupation and whether
applies to insurance contracts. This places an he participates in dangerous sports such as
obligation on the person seeking insurance to hang-gliding; and
disclose any material facts that may affect how the term over which cover is required.
the insurance company may judge the risk of When selecting the amount of cover, an
the contract they are entering into. Failure to individual is able to choose three types of
disclose a material fact gives the insurance cover, namely level, increasing or decreasing
company the right to avoid paying out in the cover.
event of a claim.
Level cover, as the name suggests, means that
There are a wide range of variations on the the amount to be paid out if the event happens
basic life policy that are driven by mortality remains the same throughout the period in
risk, investment and expenses and premium which the policy is in force. As a result, the
options all of which impact on the structure of premiums are fixed at the outset and do not
the policy itself. change during the period of the policy.
Term assurance has a variety of uses, such as As you would expect, with decreasing cover
ensuring there are funds available to repay a the amount that is originally chosen as the
mortgage in case someone dies or providing a sum to be paid out decreases each year. The
lump sum that can be used to generate income amount by which it decreases is agreed at the
The critical illnesses that will be covered will to a percentage of annual earnings. Payments
be closely defined. will differ or cease on return to work.
Some significant illnesses may be excluded. The cover pays out a regular monthly benefit
Illness resulting from certain activities, such if the individual becomes unable to work for
as war or civil unrest, will not be covered. longer than a deferred period, which is the
time they must wait from when they first
Critical illness cover is available to those aged become unable to work until benefits start
between 18 and 64 years of age and must end under the cover.
before an individuals 70th birthday. It will pay
The benefit starts once the deferred period
out a lump sum if an individual is diagnosed
finishes. The longer the deferred period
with a critical illness and will normally be tax-
chosen, the lower the premiums will be; the
free. The cover will then cease.
options available will be periods such as four,
There will be conditions attached to the cover eight, 13, 26, 52 and 104 weeks.
that determine whether any payment will be
Once a claim is made, the insurance company
made. A standard condition applying to all
may extend the deferred period or even decline
illnesses covered is that the insured person
the claim. The claim will not be met if incapacity
must survive for 28 days after the diagnosis of
arises as a result of specific situations including
a critical illness to claim the benefit, and the
unreasonable failure to follow medical advice,
illness must be expected to cause death within
alcohol or solvent abuse, intentional self-
12 months.
inflicted injury and so on.
Critical illness cover can usually be taken out
on a level, decreasing or increasing cover basis 4.3.3 Mortgage Payment
and can often be combined with other cover Protection Cover
such as life cover.
Mortgage payment protection is designed to
ensure that the payments that are due for a
4.3.2 Income Protection Cover mortgage continue to be paid if the borrower is
Income protection insurance is designed to pay unable to work because of accident, sickness or
out an income benefit when a person is unable unemployment.
to work for a prolonged period due to sickness
They tend to be available from the lending
or incapacity. Since this may be paid for a
institution, as well as insurance companies,
significant period of time, the premiums are
although costs need to be carefully compared.
relatively expensive. Their use and value can
They are designed to cover short-term problems,
be readily appreciated by considering how a
such as covering the costs if an individual loses
family would continue to pay its bills if the main
their job and until they find alternative work,
income-earner were to fall ill. Some of the key
rather than long-term benefits.
features of such policies include:
The same basic features as reviewed above
They run for a set term and an individual
under income protection cover will apply, along
must be aged between 18 and 59 when the
with the following further considerations:
cover starts and it will stop when they reach
65. The protection provided will be on a level
The circumstances under which a benefit will basis, so regular reviews are needed so
be payable are clearly defined. The illness or that the cover reflects the payments due as
injury that an individual may suffer is referred mortgage interest rates change.
to as incapacity, and the insurance policy will The amount of benefit payable can be reduced
define what constitutes this in relation their to take account of income from other sources
occupation. and there may be limits on the maximum
They provide a regular income after a certain amounts that will be paid. As a result, the
waiting period but there will be maximum amount of benefit paid may not cover the
limits on the amount of benefits paid related mortgage payments.
4.3.4 Accident and Sickness Cover The costs that will be covered are usually
closely defined.
Personal accident policies are generally taken There will be limits on what will be paid out
out for annual periods and can provide for per claim, or even over a period such as a
income or lump sum payments in the event year.
of an accident. Although they are relatively Standard care that can be dealt with by a
inexpensive, care needs to be taken to look in persons local doctor may not be included.
detail at the exclusions and limits that apply.
These may include: Again, there will be exclusions such as for pre-
existing conditions.
The amount of cover may be the lower of a
set amount or a maximum percentage of the
individuals gross monthly salary.
4.3.7 Long-Term Care
The waiting period between when an The purpose of long-term care cover is to
individual becomes unable to work and when provide the funds that will be needed in later
benefits start may be 30 or 60 days. life to meet the cost of care. Simply considering
the cost of nursing home care explains the need
The insurance company will assess eligibility at
for such a policy, but its value to an individual
the time of the claim and may refuse a claim as
will depend on the amount of state funding for
a result of pre-existing medical conditions even
care costs that will be available.
if they have been disclosed.
Premiums will be expensive, reflecting the cost
4.3.5 Household Cover of care, and the benefit will normally be paid
as an income that can be used to cover the
House and contents insurance are well expenditure.
established products and are well understood
by consumers, so these will only be covered
briefly. 4.4 Business Insurance
Protection
Key considerations include:
Is the cover enough to pay for the complete Learning Objective 9.5.2
rebuild of a home? Know the main product features of the following:
To what extent are external features of a business insurance protection
house covered, such as walls, gates, drives
and pathways?
Business insurance protection can take many
What cover is there in case a neighbour sues
forms. Some examples of its use are to:
you for your tree falling on their property or a
similar accident? provide indemnity cover for claims against
What is the extent of cover for personal the business for faulty work or goods;
possessions? protect loans that have been taken out and
Is legal cover included? secured against an individuals assets;
provide an income if the owner is unable to
4.3.6 Medical Insurance work and the business ceases;
provide payments in the event of a key
Private medical insurance is obviously intended member of a business dying to cover any
to cover the cost of medical and hospital impact on its profits;
expenses. It may be taken out by individuals, or provide money in the event of death of a
provided as part of an individuals employment. major shareholder or partner so that the
remaining shareholders can buy out his share
Some of the key features of such policies
and his estate can distribute the funds to his
include:
family.
Think of an answer for each question and refer to the appropriate section for confirmation.
1. What is the difference between a defined benefit pension scheme and a defined contribution
pension scheme?
2. When can a lender repossess the specific property which was purchased with a loan?
3. How can the interest rates on different types of loans or accounts be readily compared?
4. Firm A charges interest annually at 6% pa on loans and Firm B charges interest quarterly at
6% pa. Which is the more expensive?
5. Your firm offers fixed rate loans at 6% pa charged quarterly. Ignoring charges, what is the
APR on the loan?
7. What are the main differences between the different ways in which interest is calculated on
mortgages?
8. What are the key differences between non-profit, with-profits and unit-linked policies?
9. What are the main factors that will influence the premium for a term assurance policy?
10. What are the main differences between critical illness cover, income protection cover and
accident and sickness cover?
Glossary
Glossary
Bank of England
Capitalisation Issue
The UKs central bank. Implements economic
See Bonus Issue.
policy decided by the Treasury and determines
interest rates.
Certificated
Coupon
Ownership (of shares) designated by certificate.
Amount of interest paid on a bond.
CREST
Clean Price
Electronic settlement system used to settle
The quoted price of a bond. The clean price
transactions for UK and Irish shares plus some
excludes accrued interest or interest to be
other international shares.
deducted, as appropriate.
Data Protection
Closed-Ended
Legislation regulating the use of client data.
Organisations such as companies which are a
fixed size as determined by their share capital.
Debt Management Office (DMO)
Commonly used to distinguish investment trusts
(closed-ended) from unit trusts and OEICs UK agency responsible for issuing gilts on behalf
(open-ended). of the Treasury.
Fund Manager
Initial Public Offering (IPO)
Firm that invests money on behalf of customers.
A new issue of ordinary shares whether made
by an offer for sale, an offer for subscription or
Future a placing. Also known as a new issue.
An agreement to buy or sell an item at a future
date, at a price agreed today. Differs from a Insider Dealing/Trading
forward in that it is a standardised amount and
Criminal offence by people with unpublished
therefore the contract can be traded on an
price-sensitive information who deal, advise
exchange.
others to deal or pass the information on.
Gilt-Edged Security
Integration
UK government bond.
Third stage of money laundering.
Monetary Policy
Loan Stock
The setting of short-term interest rates by
A corporate bond issued in the domestic bond
a central bank in order to manage domestic
market without any underlying collateral, or
demand and achieve price stability in the
security.
economy.
Yield Curve
Takeover
The depiction of the relationship between the
When one company buys more than 50% of the yields and the maturity of bonds of the same
shares of another. type.
Abbreviations
Multiple Choice Questions
The following questions have been compiled to reflect as closely as possible the standard you will
experience in your examination. Please note, however, they are not the CISI examination questions
themselves.
Tick one answer for each question. When you have completed all questions, refer to the end of this
section for the answers.
1. Which of the following is NOT a fiscal policy tool that a government would use to manage the
economy?
2. Holding assets in safe-keeping is one of the principal activities of which of the following?
A. Custodian bank
B. International bank
C. Investment bank
D. Retail bank
4. Which ONE of the following statements concerning call and put options is TRUE?
5. In which type of FX transaction would you agree the exchange rate to be used today with the
counterparty for a particular date, but not exchange currencies until a later time agreed
between the parties?
A. Forward
B. Future
C. Spot
D. Swap
A. Cash
B. Bonds
C. Derivatives
D. Equities
7. If there is expected to be a period of declining interest rates, which mortgage payment terms
are likely to be LEAST favourable?
A. Capped rate
B. Discounted rate
C. Fixed rate
D. Variable rate
8. In the event of a company going into liquidation, who would normally have the lowest priority
for payment?
A. Banks
B. Bond holders
C. Ordinary shareholders
D. Preference shareholders
11. Which of the following is hoping for the price of an asset to fall?
12. Which of the following types of US government securities is a zero coupon instrument?
A. Conventional bond
B. Dual dated stock
C. Index linked stock
D. Treasury bill
13. If a trader deliberately gives the misleading impression that demand for a particular share is
greater than it really is, this type of behaviour is likely to be classed as:
A. Front running
B. Product churning
C. Money laundering
D. Market abuse
14. If a credit card company quotes its interest rate as 20% pa, charged half-yearly, what is the
effective annual rate?
A. 20%
B. 21%
C. 22%
D. 23%
15. A policy that only pays out if death occurs during the term of the policy is:
A. An endowment plan
B. Term assurance
C. An income replacement plan
D. Whole-of-life assurance
16. The equity markets of which ONE of the following countries are represented by an index
called the SSE Composite?
A. Korea
B. Japan
C. China
D. India
A. Supranational bonds
B. Commercial paper
C. Structured products
D. Certificates of deposit
A. By application to CREST
B. Direct from the trust manager
C. Through an ACD
D. On the stock market
19. Which world stock market still operates partly on an open outcry basis?
A. LSE
B. Euronext Paris
C. NASDAQ
D. NYSE
20. An airline establishes an agreement via an exchange-traded instrument with an oil company
to pay a specific price in three months time for a specific quantity of fuel at that time. This
type of agreement is normally called:
A. An option
B. A future
C. A swap
D. A warrant
21. An investor holds 1,000 nominal value of a 7% UK government bond trading at 97. What is
the next gross interest payment that the investor can normally expect to receive?
A. 28.00
B. 33.95
C. 35.00
D. 36.05
22. Which one of the following types of financial instrument is normally covered by the insider
trading rules?
A. Conventional
B. STRIP
C. Index-linked
D. Ultra-long
24. You have a holding of 10,000 5% Treasury Stock 2014 which is currently priced at 112 and
on which you receive half yearly interest of 250. What is its flat yield?
A. 4.44%
B. 4.46%
C. 4.48%
D. 4.50%
A. Covered warrant
B. Future
C. Option
D. Swap
26. A fund that aims to mimic the performance of an index deploys which type of investment
style?
A. Contrarian
B. Growth
C. Passive
D. Thematic
A. Commercial paper
B. Commercial property
C. Money market account
D. Money market fund
29. Which one of the following events is the best example of a mandatory corporate action with
options?
A. Scrip issue
B. Takeover bid
C. Dividend payment
D. Rights issue
30. Which of the following products is most likely to track the performance of an index?
A. ETF
B. Investment trust
C. SICAV
D. Unit trust
31. A private equity fund is likely to use which of the following types of structure?
A. OEIC
B. Investment trust
C. Limited partnership
D. Trust
32. On what day would a share price normally be expected to fall by the amount of the dividend?
A. Record day
B. Ex-dividend day
C. Dividend payday
D. Dividend declaration date
33. A company has in issue 20 million ordinary shares of 50p nominal, originally issued at a price
of 2 and currently trading at 4. It has a 1:2 capitalisation issue. How much cash will the
company receive as a result of this issue?
A. Nil
B. 10 million
C. 20 million
D. 40 million
34. Which type of advisers are obliged to offer their clients the option of fees in lieu of
commission?
A. Tied advisers
B. Multi-tied advisers
C. Whole of market advisers
D. Independent financial advisers
35. Which one of the following activities is MOST likely to fall into the professional sector rather
than the retail sector?
36. One of the key objectives of the European Central Bank is to keep inflation (as defined by the
HICP) close to, but below, what threshold rate?
A. 2%
B. 3%
C. 4%
D. 5%
37. An investment fund which can be sold throughout the EU, subject to regulation by its home
country regulator, is known as?
38. All of the following are true of the differences between money market and capital market
instruments EXCEPT?
A. Capital market instruments are traded and settled via exchanges, and money market
instruments are not
B. Money market instruments are usually held for a shorter term than capital market
instruments
C. Money market instruments are all bearer instruments, whereas capital market instruments
are more usually certificated and registered
D. The money markets have a high minimum subscription level and are not suitable for
private investors to invest in directly
39. Where an annual general meeting includes a proposal to change the companys constitution,
what MINIMUM proportion of votes is normally required to carry it through?
A. 51%
B. 67%
C. 75%
D. 90%
40. The key difference between the primary market and the secondary market is that:
A. The primary market relates to equities and the secondary market relates to bonds
B. The primary market covers regulated and protected activities and the secondary market
covers unregulated and unprotected activities
C. The primary market is where new shares are first marketed and the secondary market is
where existing shares are subsequently traded
D. The primary market involves domestic trading and the secondary market involves overseas
trading
41. A bond with a coupon of 5%, redeemable in 2012, is currently trading at 80 per 100
nominal. What would be the impact on the flat yield if the price increases by 5?
42. What term is used to describe a situation where a trader has committed to buy, and is
currently holding, a future which has two weeks until the specified future date?
A. Call
B. Put
C. Long
D. Short
43. A money launderer is actively switching funds between products. At what stage of money
laundering would you expect to see this?
A. Investment
B. Integration
C. Layering
D. Placement
44. 70% of a funds assets are indexed to the FTSE 100 index and the balance is actively
managed. This type of investment approach is normally known as:
45. Which one of the following types of investment vehicle is MOST likely to be highly geared?
A. Hedge funds
B. Real estate investment trusts
C. Unit trusts
D. Open-ended investment companies
46. A retail investor has placed 10,000 on deposit at a rate of 2.5% net. What would the gross
amount of interest be, assuming that 20% tax has been deducted at source?
A. 62.50
B. 200.00
C. 250.00
D. 312.50
48. Where a client uses an ijara arrangement to borrow money to acquire a property, what
proportion of the property will the bank normally buy at outset?
A. None
B. A variable amount between 10% and 25%
C. 50%
D. 100%
49. Which one of the following types of life assurance policy has a significant investment element?
A. Level term
B. Increasing term
C. Family income benefit
D. Whole-of-life
Syllabus Learning Map
Life Assurance
9.4
On completion, the candidate should:
9.4.1 Understand the basic principles of life assurance Section 4
Know the main types of life policy:
9.4.2 term assurance Section 4
whole of life
Protection Insurance
9.5
On completion, the candidate should:
Know the main areas in need of protection family and personal,
9.5.1 Section 4.2
mortgage, long term care, business protection
Know the main product features of the following:
critical illness insurance
income protection
mortgage payment protection
Section 4.3
9.5.2 accident and sickness cover
household cover
medical insurance
long-term care insurance
business insurance protection Section 4.4
Examination Specification
Each examination paper is constructed from a specification that determines the weightings that will be
given to each element. The specification is given below.
It is important to note that the numbers quoted may vary slightly from examination to examination as
there is some flexibility to ensure that each examination has a consistent level of difficulty. However,
the number of questions tested in each element should not change by more than plus or minus 2.
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