Applied Financial Advice and Management

International
Certificate in
Advanced Wealth
Management:
Applied Financial
Advice and
Management
Edition 1, April 2014
This learning manual relates to syllabus

version 1.0 and will cover examinations from
21 July 2014 to 30 August 2016
Welcome to the Chartered Institute for Securities & Investment’s International Certificate in Advanced
Wealth Management: Applied Financial Advice and Management study material.
This manual has been written to prepare you for the Chartered Institute for Securities & Investment’s
International Certificate in Advanced Wealth Management: Applied Financial Advice and Management
examination.
Published by:
Chartered Institute for Securities & Investment
© Chartered Institute for Securities & Investment 2015
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Author:
Kevin Rothwell, Chartered FCSI
Reviewer:
Andrew McGuirk
Mike Andrews
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responsibility for persons undertaking trading or investments in whatever form.
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result of industry change(s) that could affect their examination.
The questions contained in this manual are designed as an aid to revision of different areas of the syllabus
and to help you consolidate your learning chapter by chapter.
Learning manual version: 1.3 (April 2015)

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Cash and Money Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1
Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2
Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
3
Alternative Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
4
Collective Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
5
Financial Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
6
Portfolio Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
7
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
It is estimated that this manual will require approximately 140 hours of study time.
What next?
See the back of this book for details of CISI membership.
Need more support to pass your exam?

See our section on Accredited Training Providers.
Want to leave feedback?

Please email your comments to learningresources@cisi.org
1
Chapter One
Cash and Money Markets

1. Cash Deposits 3
2. Money Market Funds 13
This syllabus area will provide approximately 4 of the 80 examination questions

2
1. Cash Deposits
1
Learning Objective
1.1.1 Analyse the main characteristics, risk and returns of cash deposits: types of account; foreign
currency accounts; characteristics – capital security; interest options; returns – rates of interest;
interest rate comparisons; effect of charges and penalties; risks – default risk; deposit insurance;
credit risk assessment; inflation risk; interest rate risk; selection criteria – access; security;
liquidity; interest rates
1.1.2 Analyse the factors to take account of when selecting cash deposits: access; security; liquidity;
interest rates
The term cash deposits is used to refer to the deposits that are made with banks and other financial
institutions; in other words the current and savings accounts used every day by retail and commercial
customers.
The financial institutions that accept cash deposits are referred to as deposit takers to reflect the
fact that there is now a wide range of financial institutions that compete with the products that were
traditionally offered by banks. A deposit-taking institution is one that is licensed by a country’s regulator
to accept deposits and includes banks, savings institutions and securities firms.
1.1 Types of Accounts

Financial institutions offer a wide range of account types in which savers and investors can hold their
cash. The main types of accounts that are encountered are:
Types of Accounts
• These are typically used for everyday banking needs, such as receiving payments,
undertaking transactions and allow the holder to get at the money as and when
Current or needed.
checking • Most accounts offer a comprehensive range of services, including access to online
accounts banking and debit cards.
• Interest rates for current accounts are often low or even nil, but these accounts
provide customers with the benefit of easy access to available funds.
• These are typically used for surplus funds to earn a better rate of interest and may
Savings represent both short-term and long-term investments.
accounts • The rate of interest offered will typically vary depending on the amount deposited
and the period of notice that needs to be given before withdrawal is permitted.
3
The range of savings accounts available in any country will depend on competition and the description of
the account will also vary. The description of the account can be different from one country to another, so
a simple classification is ease of access which allows accounts to be broken down into three types:
Classification of Savings Accounts

Instant • These allow the holders to get at their money when they want, but may limit the
access number of times it can be accessed within a given period.
accounts • The rate of interest paid is often at a variable rate.
• These require that the holder gives a certain period of notice before withdrawing
all or part of the deposit.
• Typical notice periods are 30, 60 and 90 days.
Notice • A 90-day notice account requires that the depositor give 90 days’ advance
accounts warning before they can have their money back.
• Where the deposit taker allows this notice to be waived, it may apply a penalty to
compensate itself.
• They generally earn interest at variable rates, which are linked to base rate.
Fixed-term • These earn a set rate of interest over their entire life which may be fixed.
accounts • The deposits are tied up for a set period, which can range from months to years.
Opening an account is a relatively straightforward process and typically will require the investor to
provide proof of identity so that anti-money laundering obligations can be met.
1.1.1 Islamic Savings Accounts

• Islamic savings accounts differ from the types of accounts mentioned above and have been designed
to meet the needs of Muslims who need accounts that are Sharia’a-compliant. These accounts are,
however, not restricted to Muslims and offer an ethical alternative to traditional banking accounts.
• Sharia’a law as set down in the Qur’an and Sunnah forbids the earning or paying of interest and so
the traditional deposit and lending methods that are based on interest payments are unacceptable.
• Sharia’a law goes beyond forbidding interest and requires an element of shared risk. Money
invested in an Islamic savings account is invested in ethical activities, not lent out and earns a profit
rate rather than interest.
• Islamic accounts therefore differ in that interest is not paid but also that there is no certainty that the
investor will get their money back in full. They therefore carry investment risk.
1.1.2 Overseas Accounts

An investor may also open an account in another country, perhaps to facilitate payments on their
property there or because they are regular visitors. The rules for opening accounts for non-residents
may require additional information and documentation to be provided, such as a national identity
number and a declaration of fiscal residence. This is typically because countries will share information
on the interest earned by non-residents with the tax authorities of other states to prevent tax avoidance.
4
European Union (EU) Savings Directive
1
The European Union (EU) Savings Directive aims to counter cross-border tax evasion by collecting and
exchanging information about foreign resident individuals receiving savings income outside their
resident state. It requires deposit takers and other financial institutions to identify customers who are
residents of another country who receive interest and submit details that can be exchanged with the tax
authorities of that country.
As an alternative, international banks will open international accounts that provide access to a
comprehensive range of services, including online banking, international payments and money transfer
services in a range of major currencies. These are designed for individuals who regularly travel between
international locations.
1.1.3 Foreign Currency Deposits

Deposits can also be held with many deposit takers in a range of currencies either to take advantage of
higher rates or to speculate on currency movements.
An investor may choose to hold cash in foreign currency because the interest rates earned on that
currency are higher. There is the risk, however, that the currency depreciates and that the additional
income earned is more than outweighed by a loss in capital value when the deposit is converted back.
Alternatively, an investor may hold the foreign currency for speculative reasons, in the belief that the
currency is due to appreciate in value and that a capital gain can be made. This runs the risk, of course,
that the currency instead depreciates, generating a loss.
Banks offering foreign currency deposits may apply higher charges because of the greater administrative
costs involved and these may offset some of the additional returns that might otherwise be earned.
1.2 Characteristics of Cash Deposits

The main characteristics of cash deposits are:
• The return simply comprises interest income with no potential for capital growth.
• The amount invested is repaid in full at the end of the investment term.
The interest rate applied to the deposit is usually:
• A flat rate or an effective rate. An effective rate, also known as an annual equivalent rate (AER), is
where interest is compounded more frequently than once a year.
• Fixed or variable.
• Paid net or gross of tax.
• Dependent upon its term and/or notice required by the depositor.
• Subject to penalties on early withdrawal in the case of fixed-term deposits.
5
1.3 Returns
Whilst the interest earned on a cash deposit clearly represents the return, care needs to be taken when
comparing the returns from competing accounts.
Returns on competing accounts require close inspection as:
• dvertised rates do not always represent the true rate actually earned.
A
• Tax treatment may vary and the rates may be quoted net or gross of tax.
• There may be minimum or maximum investment amounts which may restrict the usefulness of an account.
• Attractive accounts may only be available for funds that are new to that savings institution and not
from existing accounts with the same firm.
• There may be penalty charges if withdrawals are made or early encashment is needed, which will
reduce returns.
• High quoted returns may only last for a limited period, to be replaced by lower rates. Many top-
of-the-table rates include temporary bonuses for three, six or 12 months, after which the accounts
often switch to uncompetitive rates and do not inform account holder. Therefore this needs to be
monitored.
It is important, therefore, to ensure that the rates that are being compared are calculated on the same
basis and take account of any charges, the impact of taxation and the impact of any extension rates.
1.3.1 Interest Rate Comparisons

Competition between deposit-taking institutions is intense and highly competitive as consumers have
recognised the commodity nature of savings accounts and are happy to switch funds to institutions
offering more competitive rates.
This has led to a situation where deposit-taking institutions advertise their interest rates in a way that
makes their accounts seem as competitive as possible. There are a myriad of different ways in which
banks and savings institutions publicise their rates, making comparisons between competing accounts
less than straightforward. Close examination of the actual terms is therefore essential.
The advertised rate is often referred to as the nominal rate and the annualised rate, allowing for the
frequency with which interest is paid, is referred to as the AER or effective rate. The AER or annual
percentage rate allows comparisons to be made between competing accounts.
The following example highlights this point.
Example – Effect of Interest Payment Frequency

Two deposit-taking institutions are advertising new accounts with market beating rates in order to
attract customer deposits. Both Bank A and Bank B are offering an instant access account with an
advertised rate of 3%. Interest on Bank A’s account is credited quarterly and the interest on Bank B’s
account is credited at the end of the first year.
6
Assuming a client has $25,000 to invest the effect of this differing payment frequency can be seen below:
1
Date Transactions Bank A Bank B
Day 1 Deposit 25,000.00 25,000.00
At end of Q1 Interest added 187.50 0.00
At end of year 1 Interest added 191.75 750.00
Resulting balance 25,758.48 25,750.00
The key point to remember is that given identical nominal interest rates, the more frequently interest is
compounded, the more advantageous it is to the investor.
There may be occasions when it is essential to be able to calculate the effective rate, so that a proper
comparison can be made, eg, where the rates quoted are not straightforward or there are other factors
to take into account.
Calculating an Annual Equivalent Rate (AER)

The effective annual rate can be calculated using the formula shown below:
AER = (1+r)n
The letter r in the formula simply refers to the nominal rate of interest and the letter n refers to the
number of periods in which interest will be paid. The AER for the account offered by Bank A in the above
example can be simply calculated using this formula by:
Firstly, working out the rate of interest being paid. In this example, it is 3% per annum but is paid
quarterly. You therefore need to divide the annual rate by the number of periods in which it is paid – ie,
3% divided by 4 = 0.75%.
The result is converted into a decimal to give 0.0075.
You then get the first step in the formula of (1 + 0.0075).
This is then multiplied to the power of 4, the number of periods – 1.0075 to the power of
4 = 1.030339.
This is then converted into a percentage figure by deducting 1 and multiplying by 100 to give 3.03%.
Although the difference in the rates of interest can appear small in percentage terms, it can add up to
reasonable amounts of money, particularly for larger deposits left over long periods.
7
1.3.2 Charges
Although there are no explicit charges for depositing funds in an account, charges can arise or implicit
costs may arise where a non-interest bearing account has to be operated in conjunction with an account
offering high rates of interest.
The overall rate earned can be greatly reduced if penalty charges are levied on withdrawal or other
charges, whether explicit or implicit, are incurred.
Higher rate deposits typically involve restrictions on access. Access in breach of these conditions usually
incurs a financial penalty which affects the overall rate of return achieved. If there is any chance of
incurring penalties, the prudent investor should compare accounts based on the appropriate post-
penalty return as well as the advertised return.
It is also important to remember that charges may not be explicit and instead an account offering a high
interest rate may require a minimum cash balance to be held, on which no interest is earned; or a fee for
the operation of an account may be charged.
1.3.3 Tax Treatment

As well as considering the effective annual rate on an account, it is also important to take tax into
consideration when comparing accounts.
• Interest rates can be quoted net or gross of the effect of taxation and it is important to compare like
with like.
• Deposits in some countries have tax withheld at source on the gross amount.
• Deposits in offshore accounts may not have tax deducted but the interest earned may still be liable
to income tax in the investor’s home country.
1.3.4 Extension Rates

Many accounts default to an extension rate once the initial agreed deposit period is over. This rate is
often considerably below the original rate offered and sometimes well below any market rate.
If the investor overlooks this change of rate and leaves money in the account, the overall rate of return
can fall significantly.
1.4 Risks
Although cash investments are relatively simple products, it does not follow that they are free of risks
as the bank collapses during the financial crisis of 2008 so clearly demonstrated. Some of the risks
presented by cash-based investments include:
• Deposit-taking institutions are of varying creditworthiness; default risk must be assessed.

• Inflation reduces returns and could mean the real return after tax is negative.
• Interest rates change and so the returns from cash deposits will vary.
• Currency fluctuations and different regulatory regimes where funds are invested offshore present
further risks.
8
As a result, when comparing available investment options it is important to consider the risks that exist,
1
as well as comparing the interest rates available.
1.4.1 Default Risk

The collapse of a number of banks and building societies during the financial crisis showed the risk that
one might go bust to be a very real one. The risk associated with a particular institution therefore needs
to be assessed carefully and to judge the level of risk it is important to consider:
• the creditworthiness of the bank or savings institution; and

• the extent to which any compensation scheme will protect the deposits made.
Assessing the creditworthiness of a bank or building society requires a judgement to be made about its
capital strength. This can be assessed by looking at its:
• Tier one capital ratio – this is the ratio that regulatory authorities use to judge the adequacy of a
bank’s capital position and is expressed as a percentage, so the higher the percentage the greater its
strength.
• Credit rating – these are issued by credit rating agencies, such as Standard & Poor’s, Fitch and
Moody’s, principally to assess the default risk associated with bonds issued by governments and
companies but they do give an indication of bank stability and their ability to repay debts.
• Credit Default Swap (CDS) rates – this is the cost of insuring a bank against default by using a CDS.
At the time of writing, most major international banks have CDS rates of around 100 to 150; anything
higher would indicate that the market considers there is a higher risk of default.
Credit Default Swaps (CDSs)

A CDS is an over-the-counter (OTC) derivative, whereby the seller of the swap agrees to compensate the
buyer in the event of a loan default in exchange for a series of cash payments. In the event of default,
the buyer receives compensation, usually reflecting the value of the loan and the seller takes on the
defaulted loan.
The extent of any compensation payable under bank deposit protection schemes should also be
considered.
Deposit insurance, as it is also known, is a measure implemented in many countries to protect bank
depositors, in full or in part, from losses caused by a bank’s inability to pay its debts when due.
• The purpose of deposit insurance varies, but typically involves promoting financial stability and
protecting small savers from loss in the case of a troubled or failing bank.
• For example, the Federal Deposit Insurance Corporation in the US provides insurance cover for all
deposit accounts, money market deposit accounts and certificates of deposit (CDs). The standard
insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.
• Across the EU, a Directive requires member states to have deposit guarantee schemes for the first
100% of deposits up to €100,000.
• The explicit rules of a deposit insurance system may provide for insurance for all customers of a bank
or only for retail customers and small businesses.
9
According to the International Association of Deposit Insurers, 112 countries have some form of
explicit deposit insurance, as of autumn 2013, with a further 41 studying or considering the
implementation of one.
It is important also to bear in mind that in the event of default of a deposit-taking institution, it will take
time to resolve the position and return deposits to investors. The timescale needed to be able to sort
matters out will depend upon the complexity involved and could take from one to six months to complete.
Although bank deposit protection schemes give some degree of protection, its availability should not
distract investors from assessing credit risk extremely carefully – higher than normal returns may mean
higher than normal risk.
1.4.2 Inflation Risk

Inflation risk refers to the impact that inflation has on the real value of money.
The purchasing power of interest earned on cash investments is undermined by rising prices. Long-term
investors in cash deposits face the real possibility that the final sum paid out including interest may buy
less than the original sum invested would have purchased.
In the 1970s and early 1980s, the rates of interest were often so much lower than the rates of inflation
that even shorter-term deposit holders who reinvested all the interest received experienced substantial
erosion of the real value of their deposits.
The table below shows the real returns for the G7 countries in 2012, once inflation is deducted from
long-term interest rates, based on 10 year benchmark government bonds. It is the gross return only and
takes no account of any liability to tax that an investor may incur.
Real Interest Rates
2012 US UK Japan Germany France Italy Canada

Long-term
1.8 1.9 0.9 1.6 2.5 5.5 1.9
interest rates
Inflation 2.1 2.8 0.0 2.1 2.2 3.3 1.5
Real Return –0.3 –1.0 0.9 –0.6 0.3 2.2 0.4
Source: based on data from UK Treasury
In recent years, the low rates of interest available on savings, due to government action to address the
risks of recession, mean that real returns have fallen to negative levels in a number of countries as the
following graph for the UK demonstrates.
10
1
5
3
% Real Rate
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
–1
–2
Advisers frequently need to factor in the effect of inflation on sums needed by clients to meet future
liabilities. Present and future value calculations can be used to estimate the impact of inflation or
estimate the amount that needs to be invested.
1.4.3 Interest Rate Risk

Investment in cash deposits carries interest rate risk, namely the return that is earned will vary
depending upon movements in interest rates.
This is obviously implicit with short-term accounts carrying variable interest rates that are dependent
upon movements in base rates.
Fixed-term deposits also carry risk, namely that the investor is locked in at a fixed rate for fixed-terms and
not able to take advantage of rising interest rates available in the market. They also carry reinvestment
risk. The original investment may be made at a time when interest rates are high but at maturity, rates
may have fallen and it may not be possible to secure the same level of interest.
1.5 Selection Factors

Cash deposits provide a low-risk way to generate an income or capital return, as appropriate, while
preserving the nominal value of the amount invested. They also provide a valuable role in times of
market uncertainty.
However, they have under-performed most other asset types over the medium to long-term and
moreover, in the long-term, the post-tax real return from cash has barely been positive.
One of the key reasons for holding money in the form of cash deposits is liquidity, which is the ease and
speed with which an investment can be turned into cash to meet spending needs.
11
• The ease and speed of access will clearly depend upon the terms of the account.
• Deposits held in instant access accounts are highly liquid as access can be gained to them
immediately, so that they can be used to meet spending needs as and when they arise.
• Other accounts will require notice of withdrawal to be given, such as seven day or 30-day notice
accounts, and so can be accessed reasonably quickly or sooner if early withdrawal penalties are
incurred.
• Most investors are likely to have a need for cash at short notice and so should plan to hold some
cash on deposit to meet possible needs and emergencies before considering other less liquid
investments.
The other main reasons for holding cash investments are as a savings vehicle and for the capital security
they provide.
Selection of a suitable home for a cash deposit needs to take into account whether the rate is
competitive, the account features and the risk associated with the deposit-taking institution. Some of
the key elements to consider in terms of account type and features are set out below.
Assessing Savings Account Features

• Minimum deposit
• Maximum deposit
• Whether subsequent deposits can be made
Deposit Size
• Restrictions on size of subsequent deposits
• Whether funds have to be newly introduced or whether existing funds can be
moved
• Whether funds can be withdrawn at any time
• Minimum and maximum withdrawals that are permitted
• The extent of any notice periods
Withdrawals
• Any penalties payable for withdrawals
• The number of withdrawals that can be made in any one period
• Penalties for breaking fixed-term deposits
• Whether interest is fixed or variable
• If interest rates are tiered, how much needs to be deposited to access attractive
rates
Interest
• Frequency of payment if an income stream is important
• Whether an attractive rate is dependent upon a bonus and the rate that the
account will fall to afterwards
• Whether other accounts have to be opened to be able to invest at the advertised
Access
rate
• Whether an account is postal only
• Whether an account is internet only
Operation
• Whether deposits can be made at a branch of the deposit-taker
• Service standards and reputation of the provider
Default risk should also be factored not just into the risks associated with a particular deposit-taking
institution but also into how many accounts an investor should hold with different institutions to
diversify funds amongst providers in order to reduce the impact of default.
12
2. Money Market Funds
1
Learning Objective
1.2.1 Analyse the key features, risks and returns of money market funds: types - types of funds;
constant and variable NAV; characteristics - structure and operation; charges and tax;
supervision; underlying investments; returns - rates of interest; risks - interest rate risk; credit
risk; liquidity risk; credit ratings; use of weighted average maturity and weighted average life
1.2.2 Analyse the factors to take account of when selecting money market funds: uses of money
market funds; selection criteria
Money market funds developed in the US in the 1970s at a time when there was a ceiling on the rates that
banks were legally allowed to pay. By pooling investors’ funds they were able to offer investors higher
market rates and were accessible to ordinary investors because of their low investment minimums.
Money market funds were introduced into Europe in the 1980s, starting in France where bank regulation
prohibited the payment of interest on bank deposit accounts. Their use expanded as the sector grew to
meet demand for cash management services from multinational companies and saw both Luxembourg
and Ireland join France to become the major European fund centres.
These funds are now used in many markets and attract both institutional and retail investors alike. The
amounts invested in money market funds are shown below.
Money Market Funds Globally
2013 Q1 (EUR billions)
US Europe Australia Brazil Canada Japan
2,027 1,012 277 44 22 15
Source: EFAMA
2.1 Types of Money Market Funds

Money market funds are mutual funds that invest in short-term money market instruments and which allow
investors to participate in a more diverse and high-quality portfolio than if they were to invest individually.
Although all money market funds should provide security of capital and liquidity, there is not as yet a
common global definition for these funds. It is useful, therefore, to be aware of the definitions used in
Europe, which help to highlight some of the major differences between the different types of funds available.
In Europe, guidelines were introduced in 2011 to provide standard definitions of money market funds;
these distinguish between two types – short-term money market funds and money market funds.
13
• A short-term money market fund must maintain a constant net asset value, which means that it
should have an unchanging NAV where income in the fund is accrued daily and can either be paid
out to the investor or used to purchase more units in the scheme.
• A money market fund, by contrast should have a fluctuating NAV.
Constant and Fluctuating NAVs

• Money market funds can be either constant NAV funds or variable NAV funds.
• NAV is made up of the value of the underlying portfolio, plus or minus cash balances, undistributed
income and accruals for charges and other expenses.
• Shares in CNAV funds are issued with an unchanging face value, such as $1,
Constant NAV €1, or £1 per share.
(CNAV) funds • These funds tend to hold assets until maturity and so use amortised cost
accounting to value their assets.
• The value of shares in VNAV funds change daily based on the value of the
Variable NAV underlying instruments.
(VNAV) funds • These funds tend to sell assets before maturity to realise capital gains and so
use mark-to-market accounting to value their assets.
Any fund in Europe which falls outside these two categories can no longer call itself a money market
fund. The intention is that investors will be certain that anything called a money market fund is
operating with the provision of security as its main objective.
Other titles often encountered with money market funds are treasury money market funds and prime
money market funds, which indicate the type of asset they invest in. Treasury funds invest exclusively in
government securities, whilst prime money market funds invest in non-government securities.
Within the different types of money market funds there can be either distribution or accumulation
shares. In a distributing money market fund, interest income is paid out to the investor on a pre-set
regular basis, whilst in an accumulating money market fund this interest income is added to the value
of the fund’s shares.
Traditional money market funds should be distinguished from enhanced cash or dynamic money
market funds, which typically seek higher yields through investment in longer-term or lower-quality
instruments and so expose the investor to additional risk. As the structure and investment strategy of
these funds differ it is important to understand the intended purpose of a money market fund and its
objectives before investing.
14
2.2 Characteristics
1
The main characteristics of money market funds are noted below.
Characteristics of Money Market Funds

• Money market funds in Europe are usually set up as UCITS (Undertakings for
Structure Collective Investment Schemes) funds and so are required to adhere to the rules
on permissible investments and spread of risk contained in the UCITS Directives.
Underlying • Money market funds invest in short-term, high-quality money market
investments instruments. See below for more detail.
NAV • Money market funds can be either CNAV funds or VNAV funds.
• The governance of a money market fund will depend on the jurisdiction in which
it is established, but as a minimum the responsibilities of management and
safeguarding of assets should be undertaken by independent and separate bodies.
• It should be expected to have a board of directors responsible for the
Governance
management of the fund, who are required to act in the best interests of the
shareholders and ensure compliance with regulatory obligations.
• The assets in money market funds should be held by a trustee, who is required to
provide regular oversight and monitoring for the fund.
Regulatory • Money market funds require authorisation from the regulator in the state in
Supervision which they are established, who will undertake ongoing supervision of the fund.
• Money market funds generally charge an annual management fee but not an
Charges
initial or a redemption fee.
• The tax implications of using a money market fund vary according to the
investor’s individual situation and may also depend on the domicile of the fund.
Tax
• Individuals can typically expect the interest income arising to be taxable in the
same way as other income.
• Many money market funds and especially those targeted at institutional
Credit ratings investors are expected to be AAA rated and must comply with the constraints of
that rating.
Money market funds invest in short-term, high-quality money market instruments. Typically these
instruments include short-term government securities, repos, time deposits, CDs, commercial paper (CP)
and floating rate notes (FRNs).
Money market instruments are investments with a life span of one year or less that can be sold at very
short notice, usually within a day. Their basic characteristics and the size of the players in the market
make for high levels of liquidity.
The dollar, euro and sterling money markets are particularly deep and liquid. The issuers all have high
creditworthiness meaning that the instruments can be extremely high-quality assets. The investors
are mainly banks, shuffling reserves around the world and speculating on the direction of interest and
exchange rates so there are high levels of trading.
15
The short maturity date of money market instruments and the high issuer quality means that money
market instruments carry low investment risk and as a result, they usually offer very low returns. The
returns will differ based on the level of creditworthiness of the issuer with treasury bills at the bottom of
the risk reward curve and one year CP at the top.
The key features of the main types of money market instrument are shown below.
Money Market Instruments

• Money market deposits are fixed-term deposits of up to one year with banks
and securities houses and are also known as time deposits.
• They are not negotiable and so cannot be liquidated before maturity. The
Cash instruments interest rate offered will be fixed by reference to a benchmark rate such as
such as deposits the London interbank offered rate (LIBOR) of the same term.
and repos • A repo is a sale and repurchase agreement and is similar to a secured loan.
Typically, a repo enables a holder of securities to obtain funding (raise cash)
against the securities as collateral and for a lender of cash to obtain high-quality
collateral against a loan. This puts vital liquidity into the markets.
• Treasury bills are issued at a discount to par, while being redeemed at their
nominal value.
• They are usually issued weekly via an auction and with terms of one, three
Treasury bills
and six months.
• Treasury bills are highly liquid and act as the benchmark risk-free interest
rate when assessing the returns potentially available on other asset types.
• CDs are negotiable bearer securities issued by commercial banks in
exchange for fixed-term deposits.
• With a fixed-term and a fixed rate of interest, set marginally below that for
an equivalent bank time deposit, the holder can either retain the CD until
CDs
maturity or realise the security in the money market whenever access to the
money is required. CDs can be issued with terms of up to five years.
• As they are a fixed-interest security, the price will fluctuate with the
competitiveness of the interest rate compared to the prevailing yields.
• CP is the term used to describe the unsecured negotiable bearer securities
that are issued by companies.
CP
• These securities are usually issued at a discount to par with a maturity of
between eight and 365 days.
FRNs • Money market funds can also invest in FRNs with relatively short maturities.
2.3 Returns
Money market instruments rarely feature in a private client’s investment portfolio, because they are
primarily used by the Treasury operations of central banks, international banks and multinational
companies and are traded in a highly sophisticated market. Instead, they need to be accessed through
specialist money market funds.
16
There is a range of money market funds available and they can offer some advantages over bank accounts.
1
• There is the obvious advantage that the pooling of funds with other investors gives the investor
access to assets they would not otherwise be able to invest in.
• Money market funds diversify risk across a range of highly rated issuers and so reduce the
concentration risk of holding funds with one bank.
• Credit risk is managed by diversification and most funds have AAA ratings.
• Assets are held by an independent custodian and so are protected in the event of the failure of the
fund manager.
With interest rates at low levels, however, the rates on offer on money market accounts may compare
unfavourably in some countries with what can be achieved in instant access or short notice accounts.
2.4 Risks
Although many money market funds are managed according to conservative guidelines, these funds
are not risk free. They are exposed to interest rate risk, credit risk and liquidity risk.
Risks
•
As money market funds hold fixed-income securities, they are susceptible to
movements in interest rates.
• A money market fund operates with a maximum weighted average maturity (WAM).
• The WAM provides a measure of the susceptibility of the fund to interest rate risk; the
higher the WAM, the greater the impact which a change in interest rates will have on
the fund.
• Money market funds may invest in all types of money market securities, from
deposits, and government securities to short-dated corporate debt.
• The return payable on the security is higher where the credit risk is greater.
• Most money market funds provide a breakdown of the credit rating of the underlying
securities in the fund, allowing you to see the credit quality of the portfolio.
• These funds also operate with a maximum weighted average life (WAL) which
provides a measure of credit risk. The higher the WAL, the greater the credit risk.
• A money market fund seeks to provide daily liquidity.
• In normal markets, the fund can liquidate, or sell, securities, but in a stressed market,
the fund may need to rely on the regular maturing of the securities in the portfolio.
• The natural liquidity of a fund can be assessed by looking at the amount of overnight
and one-week securities held by a fund. The greater the proportion in these short-
dated securities, the more liquid the fund.
A money market fund will invest in a range of instruments from many providers and they can offer high
security levels. They are still, however, exposed to risk as the credit crisis revealed when a major US
mutual fund broke the buck and enhanced cash funds both in the US and Europe had to seek financial
support from their parent groups and imposed redemption delays.
17
Breaking the Buck
• Investors in money market funds typically see them as a variation on a cash deposit and so there is
no expectation that the value of what was invested will fall.
• Breaking the buck is when the NAV of a money market fund falls below $1 – in other words, when
the value of what was invested falls below what was originally deposited.
• The term breaking the buck entered common usage during the financial crisis, when the money-
market world was rocked by the news that the Reserve Primary Fund in the US which had $64
billionn in assets had seen its NAV drop to 97 cents a share because of its holdings in Lehman
Brothers. Investors pulled more than $200 billion from prime money-market funds over the next two
days.
The experience of the financial crisis led regulators to tighten the rules surrounding eligible assets and
other criteria for money market funds particularly in the area of portfolio quality, maturity and liquidity.
Short-term money market funds in Europe and US funds (ones authorised under SEC rule 2a-7) have to
meet the following criteria in order to mitigate the interest rate risk, credit risk and liquidity risk to which
they are exposed.
Risk Mitigation Standards

Interest • The portfolio should have a maximum weighted average maturity (WAM) of 60
Rate Risk days.
• No single security to have a maturity date greater than 397 days.
• The portfolio should have a maximum weighted average life (WAL) of 120 days.
Credit Risk
• All securities held must meet minimum credit rating standards and the portfolio as
a whole must meet diversification standards.
• A minimum of 10% of the fund to be held in overnight deposits or securities.
Liquidity Risk
• Retain between 20–30% of funds in securities with maturities of less than one week.
These requirements reduce market risk from significant interest rate volatility and enable the provision
of same-day or next-day liquidity. You should also be able to see that these requirements mean that the
portfolios of money market funds have to meet very conservative standards.
The credit rating agencies provide ratings of money market funds and the below are the descriptions
that the main ratings agencies apply to those that are rated AAA.
• Standard & Poor’s: ‘Extremely strong capacity to maintain principal stability and limit exposure to
principal losses due to credit market and/or liquidity risks.’
• Moody’s Investors Service: ‘Very strong ability to meet the dual objectives of providing liquidity and
preserving capital.’
• Fitch Ratings: ‘Extremely strong capacity to achieve money market fund’s investment objective of
preserving principal and providing shareholder liquidity through limiting credit, market, and liquidity
risk.’
It is important to remember that just as a bond with an AAA rating may be downgraded or default, funds
with a triple-A rating are not guaranteed.
18
2.5 Selection Criteria
1
Money market funds can fulfil a number of roles within a client’s portfolio, including:
• short-term home for cash balances;

• as an alternative to bonds and equities;
• as part of the asset allocation strategy.
They also offer a potentially safe haven in times of market falls. When markets have had a long bull
market and economic prospects begin to worsen, an investor may want to take profits at the peak of
the market cycle and invest the funds raised in the money markets until better investment opportunities
arise. The same rationale can be used if the investor does not want to commit new cash at the top of the
market cycle. The nature of money market instruments means that they offer an alternative investment
that does not give exposure to any appreciable market risk.
To assess whether a money market fund is suitable for inclusion in a portfolio, the adviser needs to
consider a number of issues including:
• The relative rate of return compared to a money market account or other cash deposit.
• The charges that will be incurred and their effect on returns.
• Speed of access to the funds on withdrawal.
• The underlying assets that comprise the money market fund.
• How the creditworthiness of the underlying assets is assessed.
• The rate of return compared to other money market funds and how that is being generated.
• The experience of the fund management team.
Money market funds can have a core role to play in an investment portfolio. It needs to be remembered,
however, that they still carry some risks. The short-term nature of the money market instruments
provides some protection, but it should be noted that money market funds may invest in instruments
where the capital is at risk and so may not be suitable for some investors.
19
End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.
1. What are the advantages and disadvantages of instant access accounts as compared to fixed-term
accounts?
Answer reference: Section 1.1
2. Why would whether interest is paid net or gross of tax matter to an investor?
3. Account A pays 5% interest per annum payable quarterly and account B pays 5.25% interest per
annum but has an annual account charge of $15. If an investor has $10,000 to deposit how will the
return on the two accounts compare after one year?
4. An investor has a requirement for a sum of $50,000 to meet expected family expenditure in ten years’
time. What approximate amount needs to be invested today to generate the funds needed if an
average return of 5% and inflation of 2% is expected?
Answer reference: Section 1.3.1
5. An investor has a substantial amount of money that they intend to place in cash deposits. Why might
a strategy of spreading the funds around a number of banks be worthwhile?
6. Why should enhanced cash funds be distinguished from traditional money market funds?
7. A money market fund will invest in a range of short-term high-quality assets including treasury bills
and CP. How does the credit risk of the two types of instruments compare?
8. How does the use of a money market fund assist in mitigating default risk as compared to a bank deposit?
9. What benefit does a money market fund that has a WAM of less than 60 days have for an investor?
10. Why is it important to assess the underlying assets of a money market fund before recommending
one to a client?
20
Chapter Two
2
Bonds
1. Characteristics and Types of Bonds 25
2. Returns 47
3. Risks 56
4. Bond Analysis 61

24
Bonds
1. Characteristics and Types of Bonds

Bonds are known by various names such as fixed-interest securities, loan stock and debt.
2
1.1 Main Features of Bonds
Learning Objective
2.1.1 Understand the main purposes for issuing bonds and their key features: structures; where
issued; classifications
A fixed-interest security can be defined as a tradable negotiable instrument, issued by a borrower for a
fixed term, during which a regular and predetermined fixed rate of interest based upon a nominal value
is paid to the holder until it is redeemed and the principal is repaid.
Characteristics of Bonds
Negotiable • Bonds are negotiable instruments, in that ownership of the security can pass
instrument freely from one party to another. This makes bonds tradable.
• Bonds can be issued by a wide range of borrowers, including supranationals,
Borrower such as the World Bank, governments, government agencies, local government
and companies.
• Most bonds are issued with a predetermined fixed rate of interest, known as the
bond’s coupon.
Fixed rate of • This can be expressed either in nominal terms or, in the case of index-linked
interest bonds, in real terms, and is usually paid semi-annually.
• However, some bonds are issued with a variable, or floating, coupons while
others are issued without any coupon at all.
• Also known as the par value, most bonds have a nominal value of $100 or £100.
• In contrast to the nominal value of equity shares, a bond’s nominal value is of
practical significance, as it is the price at which the bond is usually issued and
redeemed, though some issues are made and/or redeemed either at a discount
Nominal value or at a premium to par.
• Bonds are also traded on the basis of nominal value rather than market value.
• In addition, the coupon is expressed as a percentage of the nominal value. So, a
bond with a nominal value of $100 and a 7% coupon paid semi-annually means
the holder will receive $3.50 every six months.
• The holder is the owner of the bond.
• Title to holdings is usually in registered form and the record of ownership is
Holder
held in a central securities depositary, with settlement of trades taking place by
book entry transfer.
25
• Most bonds have a fixed redemption date, upon which the bond matures and
the underlying principal, known as the maturity payment, is returned to the
holder by the issuer.
Redeemed • Others are dual-dated, in that they have two redemption dates, between which
the bond is redeemed by the issuer.
• Some bonds, however, are issued in irredeemable, or undated, form or
effectively become undated by virtue of the wording of their redemption terms.
• The principal amount of a bond is its nominal value and represents the maturity
Principal
payment made by the issuer to the holder of the bond at maturity.
Bonds are usually classified according to the issuer, their structure or defining characteristics and the
market into which they are issued.
Classification of Bonds
• Most bonds are issued by governments and supranational organisations
Issuer (known collectively as sovereign borrowers), companies and, to a lesser extent,
local government authorities.
• Bond structures can range from conventional, or straight, issues through to
ones that have other unique features.
• Examples of such bonds include index linked, convertible and zero coupon
bonds (ZCBs), FRNs and bonds with provisions for early repayment.
• Index-linked bonds are ones where the coupon payments and redemption
proceeds are adjusted for the impact of inflation. They are also referred to as
inflation protected securities.
• ZCBs are ones without coupon payments. They are issued at a discount to their
nominal value but are redeemed at par, thereby providing their entire return as
Structures
capital gain.
• Convertible bonds confer a right on the holder to convert into other bonds, or
if issued by a company, into its ordinary shares, on pre-specified terms and on
predetermined dates.
• FRNs are ones that have coupons that are adjusted periodically in line with a
benchmark rate such as LIBOR.
• Bonds with provisions for early redemption. A callable bond enables the issuer
to call for early repayment, whereas a bond with a put provision enables the
holder to call for early repayment.
• Bonds may be issued into the issuer’s own domestic bond market.
Where issued • They may also be issued internationally in one or across a range of bond, or
debt, markets.
26
Bonds
1.2 Government Bonds
Learning Objective
2
2.1.2 Analyse the main investment characteristics of the major government bond classes: issuers -
supranationals; sovereign governments; public authorities: local government/ municipalities;
types - conventional; dual dated; undated; floating rate; zero Coupon; inflation protected
Governments use the bond markets to raise finance in order to meet the excess of government
spending over taxation. In doing so, they issue a wide range of bonds offering differing maturity dates
and coupons which can be used in the construction of a bond portfolio for investors.
In this section, we consider some key features that are common to all government bonds and then look
in more detail at the type of government bonds issued in the US, the UK and Japan.
1.2.1 Features of Government Bonds

Government bonds are ones that are issued by a national government and which are denominated in
that country’s domestic currency. Bonds issued in foreign currencies are known as sovereign bonds,
although the term has now come to be used to refer to all government bonds.
Governments issue a range of different types of bonds in order to raise finance. The main types
encountered are conventional fixed-interest bonds with a range of maturity dates and index-linked or
inflation-protected bonds.
The responsibility for the issue of government bonds is undertaken by a government agency; for
example, by the Bureau of Public Debt in the US, by the Ministry of Finance in Japan and by the Debt
Management Office (DMO) in the UK.
They are issued into the primary market and are usually sold by auction. They are then subsequently
traded in the secondary market, either via a stock exchange or OTC by market participants.
Apart from governments, other issuers include:
• Supranational organisations such as the internatinal monetary fund (IMF), the World Bank,
the European Investment Bank (EIB) and the Asian Development Bank issue bonds – so-called
supranational bonds.
• Government-sponsored agencies issue bonds, known as agency bonds, for particular purposes.
These are common in the US where examples include the federal home loan banks (FHLBs), the
Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac).
• Local government and municipalities raise their financing through their government or by raising
funds through the issue of bonds.
• Sub-sovereign, provincial, state and local authorities issue bonds. In the US, state and local
government bonds are known as municipal bonds and municipalities in the US issue these bonds to
finance local borrowing. These bonds are often tax efficient – particularly for investors who reside in
that municipality.
27
1.2.2 US Government Bonds
Government bonds issued by the US government are known as Treasuries and there are four main
marketable types that are described below.
US Treasuries
• Treasury bills are a money market instrument used by governments to
finance their short-term borrowing needs.
• They have maturities of less than a year and are typically issued with
maturities of 28 days, 91 days and 182 days.
Treasury bills
• They are ZCBs, so pay no interest, and instead are issued at a discount to
their maturity value.
• Once issued, they trade in the secondary market and are priced on a yield to
maturity (YTM) basis.
• Treasury notes are conventional government bonds that have a fixed
coupon and redemption date.
Treasury notes
• They have maturity dates ranging from two to ten year’s and are commonly
issued with maturities of two, five and ten year’s.
• Treasury bonds are again conventional government bonds, but with longer
Treasury bonds
maturities of between ten and 30 year’s.
• These are index-linked bonds and are referred to as TIPS.
Treasury inflation- • The principal value of the bond is adjusted regularly based on movements
protected in the consumer prices index (CPI) to account for the impact of inflation.
securities (TIPS) • Interest is paid half yearly and, unlike the UK version, the coupon remains
constant but is paid on the changing principal value.
STRIPs are also traded based on the stripped elements of Treasury notes, bonds and TIPS. Each bond
is broken down into its underlying cash flows: that is, each individual interest payment, plus the single
maturity payment. Each is then traded as a separate zero coupon bond. A STRIP is an acronym for
separate trading of registered interest and principal securities.
1.2.3 UK Government Bonds

Gilt-edged securities, or gilts, are UK government securities principally issued to finance government
spending. Once issued, gilts are traded on a secondary market provided by the London Stock Exchange (LSE).
The UK government also issues short-term treasury bills with similar maturity dates and characteristics
as the US ones. The main types of longer-term instruments are conventional gilts and index-linked gilts.
28
Bonds
UK Gilts
• In the UK, conventional gilts are instruments that carry a fixed coupon and a
single repayment date, for example, Treasury 4% 2016.
2
• This type of bond represents the majority of UK government bonds in issue.
• Conventional gilts guarantee to pay the holder of the gilt a fixed-interest
payment every six months until the maturity date, at which point the holder
Conventional receives the final coupon payment and the return of the principal.
gilts • Conventional gilts are usually issued with coupon dates of 7 March and
September or 7 June and December to allow them to be stripped, which
converts them into a form of ZCB.
• Issues of conventional gilts are now termed Treasury gilts and older bonds will
have titles such as treasury stocks, conversion stock and exchequer stock. This
is simply a change in terminology and has no other significance.
• Index-linked bonds are ones where the interest payments and the redemption
amount are increased by the amount of inflation over the life of the bond.
• As with conventional gilts, investors receive two interest payments a year and
get a maturity payment based on the nominal or face value of their holding.
• However, these payments are adjusted to take account of what inflation has
Index-linked
done since the gilt was issued. The amount of inflation uplift is determined by
gilts
changes in the retail prices index (RPI).
• An example is 2½% Treasury Index-Linked Stock 2020. When this stock was
issued, it carried a coupon of 2½%, but the amount received is uplifted by the
amount of inflation at each interest payment. Similarly, the amount that will be
repaid in 2020 is adjusted.
Other types of UK government bonds include dual-dated bonds and irredeemable bonds.
Gilts are traditionally categorised by their remaining term to maturity:
• shorts – conventional-dated gilts with up to seven years remaining to redemption.

• mediums – conventional-dated gilts with between seven and 15 years remaining to maturity.
• longs – conventional-dated gilts with more than 15 years remaining to redemption;
• undated.
The above definition differs from that used by the Financial Times, which adopts five, rather than seven,
years as the cut-off point between shorts and mediums.
29
1.2.4 Japanese Government Bonds (JGBs)
The Japanese government bond market is one of the largest in the world and its bonds are usually
referred to as JGBs.
JGBs are classified into six categories:
• short-term jgbs;
• medium-term bonds;
• long-term bonds;
• super-long-term bonds;
• individual investor bonds;
• inflation-indexed bonds.
Short-term JGBs have maturities of six months and one year and are issued as ZCBs; in other words they
are issued at a discount, carry no interest and are repaid at their face value.
Medium, long and super-long JGBs are conventional bonds and so have fixed coupons that are paid
semi-annually and have set redemption dates. The individual investor bonds and 15-year super-long
JGBs pay floating-interest rates.
Inflation-indexed bonds operate in a similar way to TIPS: that is, the principal amount is inflation-
adjusted based on movements in the CPI and the coupon is fixed but payable on the inflation-adjusted
principal amount.
1.3 Corporate Bonds
Learning Objective
2.1.3 Analyse the main issuers of corporate debt and the main investment characteristics of secured
and unsecured debt: issuers and types of corporate bonds; security - seniority; fixed and
floating charges; impact of security; redemption provisions; types of secured debt - debentures
and secured debt; securitisation process and asset backed and mortgage backed securities;
types of unsecured debt - income bonds; subordinated bonds; high yield; convertible bonds
Corporate debt is simply money that is borrowed by a company that has to be repaid.
30
Bonds
1.3.1 Issuers and Types of Corporate Bonds

Generally, corporate debt requires servicing by making regular interest payments. Corporate debt can
be subdivided into money borrowed from banks via loans and overdrafts, and directly from investors in
the form of debt instruments or, as they are more commonly known, corporate bonds.
2
For a corporation, the power to borrow needs to be laid out in the articles of association and the
decision about taking on new debt is taken by the board of directors and may have to be agreed at an
annual general meeting (AGM) of a company’s shareholders.
Although many companies are reliant upon short-term bank borrowing and retained profits to finance
their operations, longer-term finance can be obtained for expansion by issuing bonds in the domestic
and/or international corporate bond market.
Advantages and Drawbacks of Debt Finance

• Debt finance can be less expensive than equity finance, ie, issuing shares, as the
interest costs on debt are usually tax deductible.
• The interest on debt has to be paid and is paid before dividends, so there is more
Advantages
certainty to the investor in corporate debt rather than corporate equity.
• Additionally, if the firm were to go into liquidation, the holders of debt finance will
be paid back before the shareholders receive anything.
• The lenders are often able to claim some or all of the assets of the firm in the event
of non-compliance with the terms of the loan, eg, a bank providing mortgage
Drawback
finance would technically can to seize property assets of a firm if there is any
default, and not necessarily an outright bankruptcy of the company.
Like other companies, financial institutions issue bonds to finance borrowing. These financial institutions
also arrange borrowing for themselves and others by creating special purpose vehicles (SPVs) to enable
money to be raised that does not appear within the accounts of that entity.
This type of finance is often described as off-balance sheet finance, because it does not appear in the
balance sheet that forms part of the company’s accounts.
31
The development of financial engineering techniques has resulted in a large variety of corporate bonds
being issued and traded. Some of the main types are described below.
Types of Corporate Bonds

• Medium-term notes are standard corporate bonds with maturities ranging
originally from nine months to ten years; today the term is also applied to
instruments with maturities as long as 30 years.
Medium-term • They differ from other debt instruments in that they are offered to investors
notes continually over a period of time by an agent of the issuer, instead of in a single
tranche of one, sizeable, underwritten issue.
• The market originated in the US to close the funding gap between CP and
long-term bonds.
• The key features of fixed-rate bonds have already been described above.
Fixed-rate
• Essentially, they have fixed coupons which are paid either half-yearly or
bonds
annually and predetermined redemption dates.
• FRNs are bonds that have variable rates of interest.
• The rate of interest will be linked to a benchmark rate such as LIBOR. This is the
FRNs rate of interest at which banks will lend to one another in London, and is often
used as a basis for financial instrument cash flows.
• An FRN will usually pay interest at LIBOR, plus a quoted margin or spread.
• A convertible bond is a conventional fixed-rate bond that carries the right to
convert into the shares of a company.
Convertible • The terms on which the bond can be converted will be determined at issue and
bonds the holder will have periodic opportunities to exercise their right to convert.
• If the option to convert is not exercised, the bond reverts to being a
conventional bond and is repaid on its maturity date.
• A ZCB is one that pays no interest and instead is issued at a discount to its par
ZCBs value and is eventually redeemed at the full par value.
• All of the return is provided in the form of capital growth rather than income.
1.3.2 Security and Debt Seniority

Apart from the type of bond and the issuer, other distinguishing features of bonds are the security and
redemption provisions that are attached to them.
Bond Security
When a company is seeking to raise new funds by way of a bond issue, it will often have to offer security
to provide the investor with some guarantee for the repayment of the bond.
In this context, security usually means some form of legal charge or pledge over the issuer’s assets (eg, its
property, buildings or trade assets) so that, if the issuer defaults, the bondholders have a claim on those
assets before other creditors and so can regard their borrowings as safer than if there were no security.
32
Bonds
In some cases, the security may also take the form of a third-party guarantee – for example, a guarantee
by a bank that, if the issuer defaults, the bank will repay the bondholders.
The greater the security offered, the lower the cost of borrowing should be.
2
Domestic corporate bonds are usually secured on the company’s assets by way of a fixed or a floating charge.
Fixed and Floating Charges

• A fixed charge is a legal charge, or mortgage, specifically placed upon one or a
Fixed charge
number of the company’s fixed, or permanent, assets.
• A floating charge, however, places a more general charge on those assets that
continually flow through the business and whose composition is constantly
changing, such as the issuing company’s stock-in-trade.
• It is important to note that a company may not be inhibited from disposing of
Floating charge
any specific assets if its borrowing is only subject to a floating charge.
• The floating charge may simply cover whatever the company has in its
possession at any time and, unless itemised in an addendum to a floating
charge, no sale or disposition is excluded.
In liquidations fixed charges have priority over floating charges.
The type of security provided is incorporated into a legal deed, and the company’s compliance with it is
overseen by an independent trustee appointed by the company. If any of these terms are breached, the
trustee has the right to appoint a receiver to realise the assets subject to the charge.
Redemption Provisions
In some cases, a corporate bond will have a call provision, which gives the issuer the option to buy back
all or part of the issue before maturity.
This is attractive to the issuer as it gives it the option to refinance the bond (ie, replace it with one at a
lower rate of interest) when interest rates are lower than the rate currently being paid on the bond. This
is a disadvantage, however, to the investor, who will probably demand a higher yield as compensation.
Call provisions can take various forms. There may be a requirement, for example, for the issuer to
redeem a specified amount at regular intervals. This is known as a sinking fund requirement.
You may also see bonds with put provisions; these give the bondholder the right to require the issuer
to redeem early, on a set date or between specific dates. This makes the bond attractive to borrowers
and may increase the chances of selling a bond issue in the first instance; it does, however, increase the
issuer’s risk that it will have to refinance the bond at an inconvenient time.
33
Debt Seniority
When there are multiple forms of debt, the issuer will have to establish an order of priority as to which
debt will be serviced and the so-called seniority within the entity’s capital structure in the event of
financial difficulties leading to a restructuring or liquidation. In broad terms, the seniority of debt falls
into three main headings:
• senior;
• subordinated;
• mezzanine and payment in kind (PIK).
Debt Seniority
• Senior debt is a class of corporate debt that has priority with respect to interest
and principal over other classes of debt and over all classes of equity by the
same issuer.
• Senior debt is often secured by collateral on which the lender has put in place
a first lien or charge. Usually this covers all the assets of a corporation and is
often used for revolving credit lines. Senior debt has priority for repayment in a
debt restructuring or winding-up of a company.
Senior debt • However, in various jurisdictions and under exceptional circumstances, there
can be special dispensations which may subordinate the claims of holders of
senior debt.
• For example, in US Chapter 11 bankruptcies new lenders can come in to fund
the continuing operation of companies and be granted status as super-senior
to other (even senior-secured) lenders.
• This so-called debtor in possession status also applies in other jurisdictions
such as France.
• Subordinated debt or bonds have accepted that their claim to the issuer’s
assets ranks below that of the senior debt holders in the event of a liquidation.
Subordinated • As a result of accepting a greater risk than the senior debt holders, the
subordinated borrowing will be entitled to a greater rate of interest than that
available on the senior debt.
• The mezzanine level of debt, if it exists at all, will be even more risky than the
subordinated debt.
• It will rank below other forms of debt, but above the equity in liquidation.
• As the most risky debt, the mezzanine debt will offer a greater rate of interest
Mezzanine
than subordinated and senior levels of debt.
and PIK
• Mezzanine borrowing can be raised in a variety of ways – one example is the
issue of PIK notes. PIK notes are simply ZCBs that are issued at a substantial
discount to their face value. When they are repaid, the difference between the
redemption value and the purchase cost will provide the investor’s return.
It should be noted that each of the three main categories can themselves contain sub-categories, such
as senior secured, senior unsecured, senior subordinated and junior subordinated.
34
Bonds
1.3.3 Secured Debt

Secured debt is a bond that is backed by collateral of some sort, such as a company’s assets. In the event
of default, the assets can be realised to repay the bondholders. Secured bonds can also be backed by a
revenue stream that comes from mortgages or the project that the bond was used to finance.
2
Debentures
The term debenture is used differently from country to country and so it is important to understand the
context in which it is being used.
In the UK, a debenture refers to a bond that is secured on specific assets. A debenture is a legal
document that is used to take a charge over specific assets. It will appoint a trustee who is responsible
for safeguarding the interests of the bond holders and taking action to enforce the charge if conditions
are breached. The term loan stock is used to describe a bond which is unsecured.
In the US, a debenture is a type of debt instrument that is not secured by physical asset or collateral.
Debentures are backed only by the general creditworthiness and reputation of the issuer. Secured
bonds are often referred to as mortgage bonds.
Securitisation and Asset-Backed Securities

Securitisation involves packaging the rights to the future revenue stream from a collection of assets into
a bond issue.
There is a large group of bonds that trade under the overall heading of asset-backed securities (ABSs).
These are bundled securities, so called because they are marketable securities that result from the
bundling or packaging together of a set of non-marketable assets.
The assets in this pool or bundle range from mortgages and credit card debt to accounts receivable. The
largest market is for mortgage-backed securities (MBS), whose cash flows are backed by the principal
and interest payments of a set of mortgages. These have become known worldwide as a result of the
sub-prime collapse in the US.
A significant advantage of ABSs is that they bring together a pool of financial assets that otherwise
could not easily be traded in their existing form. By pooling together a large portfolio of these illiquid
assets they can be converted into instruments that may be offered and sold freely in the capital markets.
1.3.4 Unsecured Debt

Bondholders face the risk that the issuer of the bond may default on their obligation to pay interest and
the principal amount at redemption. This so-called credit risk – the probability of an issuer defaulting
on their payment obligations and the extent of the resulting loss – can be assessed by reference to the
independent credit ratings given to most bond issues. Unsecured debt by its nature will have a lower
credit rating than more highly rated debt that offers greater security in the event of liquidation.
35
Types of Unsecured Debt
• Bonds that have a non-investment grade rating from a credit rating agency are
usually referred to as high-yield bonds to reflect the higher yields demanded
by investors because of their greater risk of default.
High yield
• There is no inherent obstacle for capital markets to issue and raise money by
bonds
using high-yielding debt instruments, as the market should know how to price
in the additional risk in setting the terms of the issue, including the amount of
the coupon.
• Subordinated debt is not secured and the lenders have agreed that, if the
company fails, they will only be reimbursed when other creditors have been
Subordinated paid back, and then only if there is enough money left over.
bonds • Interest payments on subordinated borrowings will be higher than those on
equivalent unsecured borrowings that are not subordinated. This is simply
because of the additional default risk faced by subordinated lenders.
• Typically, a convertible bond will pay a lower coupon, though this is
compensated by the option to convert into shares at the conversion date.
Convertible
• Convertibles are often subordinated, meaning that all senior creditors must
bonds
be settled in full before any payment can be made to holders in the event of
insolvency.
• Income bonds are the most junior of all bonds.
• Their payments are made only after the issuer earns a certain amount of
income. The issuer is not bound to make interest payments on a timely or
Income bonds
regular basis if the minimum income amount is not earned.
• The investor is aware of the risks involved and may be willing to invest in these
bonds if there is an attractive coupon rate or high YTM.
1.4 Eurobonds and Foreign Bonds
Learning Objective
2.1.4 Analyse the main investment characteristics, behaviours and risks of eurobonds and foreign
bonds: issuers – sovereign, supranational and corporate; types of eurobond – straight, FRN/
VRN, subordinated, asset backed, convertible
Bonds can be categorised geographically.
• A domestic bond is issued by a domestic issuer into the domestic market, for example, a UK company
issuing bonds, denominated in sterling, to UK investors.
• In contrast, a foreign bond is issued by an overseas entity into a domestic market and is denominated
in the domestic currency. Examples of a foreign bond are a German company issuing a sterling bond
to UK investors or a US dollar bond issued in the US by a non-US company.
• Eurobonds are large international bond issues often made by governments and multinational
companies.
36
Bonds
Essentially, eurobonds are international bond issues.
They are a way for an organisation to issue debt without being restricted to their own domestic market.
They are generally issued via a syndicate of international banks. Eurobonds are issued internationally,
2
outside any particular jurisdiction, and as such they are largely free of national regulation. For example, a
US dollar eurobond could be issued anywhere in the world, except for the US. As such, a better name for
it might be an international bond.
The investment banks who originate eurobond issues have been innovative in developing the structure
of a eurobond to accommodate the needs of issuers and investors. The basic types are as follows:
• Straight or plain vanilla bonds.

• Floating rate eurobonds – these are bonds where the coupon rate varies. The rate is adjusted in line
with published, market interest rates such as LIBOR or EURIBOR plus a margin.
• Subordinated eurobonds – as with subordinated notes in general, these are notes which have a
junior or inferior status within the capital structure hierarchy and have greater risk than a senior or
secured note.
• Asset-backed eurobonds – as the name implies, these are ones where a specific asset or item of
collateral has been pledged by the issuer as security for the bond.
• Convertible eurobonds – are ones where the issuer has granted certain rights to the holder to
convert the bond into equity of the issuer, according to the terms of the offering prospectus.
Most eurobonds are bought by major institutions looking for a sound long-term investment, delivering a
fixed rate of return. Eurobond prices in the secondary market tend to be less sensitive than a company’s
shares to changes in its commercial performance or business prospects. Instead, eurobond prices are
more sensitive to wider economic shifts, such as changes in interest rates and currency fluctuations.
1.5 Bond Issuance
Learning Objective
2.1.5 Understand the role, structure and characteristics of global corporate bond markets: how
bonds are issued and the main participants involved; market structure – decentralised
dealer markets; dealer provision of liquidity; bond pools of liquidity; market supervision and
regulation; trading conventions – clean and dirty pricing; day count conventions; settlement
Bond issuance varies depending upon whether the issuer is a government or a company. Governments
are some of the largest borrowers in the world and so have their own agencies that deal with issuing
bonds, whilst companies issue bonds infrequently and so require the specialist services of corporate
finance firms.
1.5.1 Government Bonds

The two main participants in the issue of government debt are the government’s issuing agency and
primary dealers.
37
Participants in Government Bond Issues
• As governments are regular borrowers in the capital markets, the responsibility for
Issuing the issue of government bonds is undertaken by a government agency.
agency • Examples include the Bureau of Public Debt in the US, the Ministry of Finance in
Japan and the DMO in the UK.
• A primary dealer is a firm which buys government securities directly from a
government with the intention of reselling them to others and so acts as a market
maker.
Primary • Primary dealers are required to participate in auctions of government bonds and
dealers subsequently, to make a two-way market in the bonds.
• They are referred to as primary dealers in the US and as market makers in the UK.
• Governments that use primary dealers include Canada, France, Italy, Spain, the
United Kingdom and the United States.
The most commonly used method of issuing government bonds is the auction method, where the
agency announces the auction, receives bids and allocates the bonds to those that bid highest, at the
price they bid.
When participating in an auction there are two bidding options – competitive and non-competitive.
• In competitive bids, primary dealers place bids for the bond and the successful bidders pay the price
at which they bid.
• With a non-competitive bid, a bidder agrees to accept the rate or yield determined at auction
and applicants receive the bonds they applied for at a weighted average of accepted prices in
the auction. This enables smaller investors to participate in the primary market for bonds, whilst
avoiding the necessity of determining an appropriate price.
One of the metrics which is used to judge the success of a government auction is the bid-to-cover ratio,
which is used to express the demand for a particular security during offerings and auctions.
• The higher the bid-to-cover ratio, the higher the demand. A ratio above 2.0 indicates a successful
auction comprised of aggressive bids.
• A low ratio is an indication of a disappointing auction, often marked by a wide spread in the yields bid.
It is a ratio that is closely followed by financial analysts in the sale of US Treasury bonds and is becoming
more of a focus in other government bond auctions as well.
1.5.2 Corporate Bonds

Corporate bond issuance has developed over the years from single capital raising issues to scheduled
programmes of regular issues and even issues based on demand by investors.
38
Bonds
Issue Methods
• Traditionally, borrowing money via a bond issue was only sensible when large
sums of money were being raised in a single capital-raising transaction. The sums
Single
2
had to be large enough to make the costs involved in issuance worthwhile.
capital
• The details of the bond would be established, including its coupon and maturity,
raising
and the bonds would be marketed to potential investors.
issues
• The investors would either be invited to bid for the bonds in an auction-type
process, or a tender method was adopted.
• To overcome the costs and regulatory registration involved in single issues, a
process known as shelf registration was introduced in the US that enabled a
single registration to be used for a number of bond issues over a period of up to
two years.
Scheduled • This has been heavily used in the medium-term note (MTN) market for bonds
programmes with generally two to ten years between issue and maturity.
• The process involves the bond issuer finding two or more dealers that are willing
to offer their services to market the bonds to their clients on a best-efforts basis.
The issuer will then issue bonds as and when the money is required, with coupon
rates and maturity in accordance with market demand.
• Shelf registration introduced flexibility to the bond market, allowing companies
to issue smaller batches of bonds, with the coupons and maturity varying
according to market demand at the time.
Reverse
• It also allowed for some MTNs to be issued in response to an enquiry from clients
enquiries
of the dealers that want a particular maturity and coupon.
• The issuer can decide whether to accept the terms and issue the bonds or not.
• These are called reverse inquiries in the US.
Many of the activities in originating bond issues are similar to those in equity issues, particularly if
the bonds are going to be listed and therefore need a prospectus. In such cases there will be a whole
origination team involving the issuer, its investment bank, reporting accountants, legal and PR advisers.
39
A typical new issue of bonds may contain any, or all of the following stages shown in the table below.
Bond Issuance
• The issuer of the bonds will need to decide that a bond issue is appropriate
and which investment banks it wants to assist in the issue.
• The final decision will be dependent upon an assessment of the qualities of
Pitching
the potential banks.
• A final decision is usually made on the basis of a pitch or presentation made
by the banks to the issuer.
• During the pitching stage, the banks will detail their views of how much
Indicative bid
finance the issuer is likely to raise, given the terms of the bond issue.
• Once the issuer has decided upon the banks to raise the finance on its behalf,
Mandate
it will announce the names of the banks that have been given the mandate to
announcement
arrange the issue on its behalf.
• This is given by one of the credit rating agencies and will be vital to the
amount of finance that can be raised.
• The details of the proposed terms and conditions of the bond will have to
Credit rating
be provided to the agency to get a credit rating, and there may be a need
for credit enhancements, such as insurance, to enable a higher rating to be
achieved.
• Once the bank running the issue has been appointed, it will arrange and run a
series of visits to the potential buyers of the bonds.
Roadshow
• This is commonly described as the roadshow, because it involves travelling
around a number of major financial centres to see the key investors.
• If the bond is to be listed, a prospectus will need to be submitted to the
Listing relevant listing authority and an application made for admission to trading on
a stock exchange.
• For larger bond issues there will be a number of banks acting for the issuer.
• The lead manager is the primary contact with the issuer and the other
Syndication co-managers will sell the bond into their particular client base, perhaps based
on geographical regions.
• The total of all the banks involved is the syndicate.
40
Bonds
1.6 Trading
Learning Objective
2
2.1.6 Understand the role, structure and characteristics of global corporate bond markets: market
structure – decentralised dealer markets; dealer provision of liquidity; bond pools of liquidity;
market supervision and regulation; Trading conventions – clean and dirty pricing; day count
conventions; settlement
The bond market is markedly different from the equity market.
• First, the characteristics of bonds in terms of redemption date and relative safety attract a specific
type of investor, particularly pension funds and insurance companies who tend to follow buy and
hold strategies. This limits the level of activity in the secondary market.
• Often investors will want to trade a certain category of bond rather than a given bond. For example,
they may want to trade a utility company’s bond that has ten years to maturity and is A-rated so
when they contact dealers, the investor will not only ask for a quote but also which bonds are
available for trade at the moment.
• Trading is much less concentrated and is spread over thousands of securities, making it more
difficult to identify a counterparty to trade with.
As a result, the market structure and how trading takes place differs markedly from the equity markets.
1.6.1 Market Structure

There is no central physical location or exchange for bond trading, as there is for publicly traded equities.
The bond market is instead more oriented towards OTC market trading, rather than on-exchange trading.
There are some exceptions to this. For example, some corporate bonds are listed on the New York Stock
Exchange (NYSE) and on the London Stock Exchange (LSE). The latter has also launched a retail bond
platform recognising the growing interest in this segment of the market.
OTC versus On-exchange Trading

As part of a report into bond market transparency, a European regulatory body cited information
from the Securities Industry and Financial Markets Association from their members that indicated that
around 50% of trading in government bonds was conducted over the telephone, rising to a figure
of 90% or more for corporate bonds. By contrast, order-driven trading, which dominates trading in
equities, accounts for only around 7%–12% of government and supranational bond trading and around
10% of investment grade corporate bond trading. There is some limited bond trading that takes place
on-exchange but it is a very small percentage of overall market activity.
Investors can trade marketable bonds among themselves in principal-to-principal deals and this can
be done at any time. However, most trading is done through the network of bond dealers, and more
specifically, the bond trading desks of major investment dealers. The dealers occupy the pivotal position
in a vast network of telephone and electronic platforms that connect the interested players.
41
Decentralised Dealer Market
Unlike the traditional centralised stock exchanges for dealing in equities, the method of dealing in
corporate bonds tends to be away from the major exchanges in what is commonly described as a
decentralised dealer market.
A decentralised dealer market structure is one that enables investors to buy and sell without a centralised
location. In a decentralised market, the technical infrastructure provides traders and investors with
access to various bid/ask prices and allows them to deal directly with other traders/dealers rather than
through a central exchange.
Bond dealers usually make a market for bonds. In essence this means that the dealer employs traders
who have detailed knowledge and expertise in a specific sector of the bond market and are prepared to
quote a price to buy or sell them.
As a result of the market structure, pre-trade and post-trade transparency is different in bond markets
compared with equity markets.
Pre- and Post-Trade Transparency

• While there is a considerable amount of pre-trade transparency in the bond
market, it is much more fragmented than in the equity market.
• For more liquid sovereign and corporate bonds, dealers advertise indicative prices
Pre-trade
at which they are willing to deal via brokers, data vendors or trading platforms.
transparency
• For other less liquid bonds, investors are able to phone round dealers to obtain
tradable quotes at which dealers are willing to deal, although the ability to obtain
tradable quotes will be heavily influenced by the liquidity of the bond in question.
• The key difference between the bond and equity market sectors is in relation to
post-trade transparency.
Post-trade • Because equity trading takes place across an exchange there is much greater
transparency post-trade information available that informs investors about actual trades.
• In contrast there is little post-trade information about executed transactions
available to bond market participants.
Bond Pools of Liquidity

The primary function and role of market makers in corporate bonds is to provide liquidity to the
marketplace and to act as a facilitator or agent in trades between the principals. Dealers are those that
have been appointed by the corporate issuer to act as distributors on their behalf in the issuance and
underwriting of bond issues. There is often a combination of such roles by large financial institutions.
Dealers provide liquidity for bond investors, thereby allowing investors to buy and sell bonds more
easily – business to consumer (B2C) and with a limited concession on the price. Dealers also buy and sell
amongst themselves – business to business (B2B) either directly or anonymously via bond brokers, an
exercise which is known as proprietary trading as the profit and loss for such trades are taken on to the
dealer’s books rather than those of its customers or clients.
42
Bonds
The primary incentive for trading bonds amongst dealers is to take a spread between the buying and
selling price. Dealers often have bond traders located in the major financial centres and are able to trade
bonds 24 hours a day (although not usually on weekends).
2
Most debt instruments are traded by investment banks making markets for specific issues. If an investor
wants to buy or sell a bond, they will need to make a request for quote (RFQ) from the issuing bank.
An investor looking to buy or sell a bond can come to a bank and obtain a price at which the dealer is
willing to sell or buy that bond. In buying or selling the bond the dealer is not really expressing a view on
the investment but rather his view on whether he is prepared to hold the resultant long or short position
to facilitate his client’s own investment decision. The dealer’s willingness to hold a short position will be
heavily influenced by the liquidity in the bond and his ability to close out the short position.
Liquidity will vary depending on the type of bond being traded. Outside of the major government bond
markets, there is limited turnover in bonds as many investors prefer to hold their bonds until maturity.
Research suggests that very few corporate bonds trade on a frequent basis.
The following table gives an indication of the relative liquidity of different types of bond and is based
on research published by the European Securities Markets Authority (ESMA). This is a high-level,
generalised description and any bonds within each group will display more or less liquidity.
Bond Liquidity
• Developed markets and supranational – highly liquid.
Government bonds
• Emerging markets – liquid.
Investment grade corporate bonds • Very liquid.
• High yield bonds – less liquid.

Non-investment grade bonds
• Emerging market corporate bonds – less liquid.
• Covered bonds – liquid.
• Asset backed bonds – less liquid.
Asset-backed bonds
• Mortgage backed bonds – depends on issuer.
• CDOs, CLOS and Synthetic CDOs – illiquid.
Supervision and Regulation

Since it is a decentralised dealer market, it is self-regulated by the International Capital Market
Association (ICMA).
In addition, as the huge majority of corporate bond dealers are based in London, the UK regulator plays
a key role in the regulation of the European bond market. Other regulators concerned with this market
include the AMF in France and the LSE.
All members of ICMA have to report their trades to this self-regulatory organisation, through a system
known as TRAX. TRAX captures most of the professional business in continental Europe and the UK and
it makes its information available to national regulators who can use it for monitoring and surveillance.
43
1.6.2 Trading Conventions
The bond market also has its own trading conventions that apply.
Price Quotations
Bonds are typically quoted per $100 nominal of stock so a quote for a US Treasury 3.5% bond 2020
might be:
Bid Ask
108.1563 108.2188
So, if an investor wishes to buy $100 nominal of stock, they will pay the ask price and it will cost 108.22.
Similarly, if they were to sell $100 nominal of stock then they will receive the bid price and they will
receive 108.16.
Although price quotations are by convention expressed in multiples of $100 nominal of stock, it does
not follow that this is the minimum amount that can be traded. In highly liquid government bond
markets, any nominal value can be bought or sold, but in the less liquid corporate bond market, bonds
often trade in multiples of $10,000, $50,000, $100,000 or any other amounts.
Clean and Dirty Prices

Interest entitlements on bonds accrue on a day-to-day basis from the day after the last interest payment
until the next coupon payment date. If a security is sold during this period, the seller typically has an
entitlement to any interest that has accumulated since the last coupon date.
• The market convention is that the buyer will normally compensate the seller for this accrued interest
at the time of settlement.
• The accrued interest due to the seller will be added to the buyer’s purchase cost and paid to the seller.
In most markets, the price quoted for a bond will exclude the accrued interest and is known as the clean
price. When the trade is settled, accrued interest is added on and is known as the dirty price. This is often
described as bonds are quoted clean, but settle dirty.
When a bond is sold, the accrued interest will need to be calculated and added to the clean price that
the buyer pays the seller. If the trade date, however, is after the record date, the coupon will be paid to
the seller and the accrued interest then subtracted from the clean price. The first of these is known as a
cum-interest transaction and the second is known as an ex-interest transaction.
To show how the accrued interest is calculated and dealt with, let’s assume:
• We have a holding of £100,000 nominal of a 5% Treasury gilt.

• Interest is paid in equal half yearly instalments on 7 March and September.
• Interest payments are payable to the person who is the registered holder of the gilt 7 business days
before the coupon payment date.
• Settlement takes place at T+1.
44
Bonds
Example – Cum-Interest Transaction

An investor sells their holding of £100,000 nominal of 5% Treasury gilt on 6 April for settlement at T+1
on 7 April.
2
The interest due to the seller can be calculated as follows:
Accrued interest
(Days of accrual)
= Nominal value × Coupon for the period × ______________________
(Days in coupon period)
The nominal value is £100,000 and the coupon for the period is 2.5%.
The days of accrual will be from 8 March up to the day before settlement day, 6 April. There are 30 days
in the period.
Interest accrues from the day after the last payment date, 8 March up to the next payment date on 7
September. There are 184 days in the period.
So, the accrued interest due to the seller will be:
30
____ 30
____
Accrued interest = £100,000 × 2.5% × = £2,500 × = £407.61
184 184
Example – Ex-Interest Transaction

Let’s assume this time that the investor sells their holding after the record date but before the coupon is
paid. The seller will receive all of the coupon payment as their name will be on the register at the time of
the payment and so must compensate the buyer for the interest that they have lost.
The gilt will go ex-dividend seven days prior to the coupon payment date on 29 August. If the investor
sells their holding, say, on 1 September for T+1 settlement the purchaser will be entitled to:
• Accrued interest from the settlement day, the day they pay for the stock, up to the coupon payment
date of 7 September. There are six days in the period.
So, the accrued interest that the seller is due to pay the purchaser is:
6
____ 6
____
Accrued interest = £100,000 × 2.5% × = £2,500 × = £81.52
184 184
The accrued interest will be deducted from the proceeds of sale that is due to be paid to the seller. The
buyer will receive what is known as rebate interest which will reduce the total cost of the purchase by
the same amount.
45
Day Count Conventions
Conventions also vary between markets as to how to calculate the number of days in a coupon period.
A day count convention is a system used in bond and related markets to determine the number of days
between two coupon dates. It sets out how many days there are in any given month and in a year and is
used to calculate accrued interest.
Some of the more common conventions used are shown below.
Day Count Conventions

• This convention uses the actual number of days between two periods and divides
the result by the actual number of days in the year and so adjusts for leap years.
Actual/Actual • The example shown above takes the actual number of days that have accrued in
the period and in the coupon period. It is the day count convention used for UK
gilts and many corporate bonds.
• This convention assumes that there are 365 days in each year and so no change is
needed in leap years.
Actual/365
• It is used when pricing US government Treasury bonds and may be used for some
corporate bonds.
• This convention assumes there are just 360 days in a year and is calculated using
the actual number of days in the period.
Actual/360
• It is commonly used for CP, treasury bills and other short-term debt instruments
that have less than one year to maturity.
• This convention assumes that there are 30 days in every month, regardless of how
30/360 many there actually are and just 360 days in the year.
• It is sometimes used for eurobonds and is seen in US corporate and agency bonds.
Most government bond markets have standard conventions that are used. For corporate bonds, the
convention that is used will be set out in the prospectus accompanying the issue of the bond.
Settlement
Settlement is the process whereby a trade is concluded and securities and cash change hands.
Most government bonds are issued in registered form and are held and settled by book entry transfer
at a central securities depository (CSD). Eurobonds and some corporate bonds are issued in bearer form
and the bearer bonds are usually immobilised in an international CSD such as Euroclear or Clearstream.
When a bond trade takes place, it will usually settle on a standard settlement date unless different
arrangements are made. Government bonds settle on T+1 that is one business day after the trade date
and is a process often referred to as cash settlement. Corporate bonds will typically settle at T+3 that
is three business days after the trade. The settlement period may vary from market to market and in
Europe, for example, the standard settlement period changes to T+2 from October 2014.
46
Bonds
2. Returns
Learning Objective
2
2.2.1 Analyse the specific features of bonds from an investment perspective: coupons - coupon and
payment date; floating rate coupons; other types of coupon; redemption provisions - maturity
date; embedded put or call options; inflation protection - methods of index linking; impact on
coupons and maturity payments; return during a period of zero inflation; other characteristics -
convertible bonds; exchangeable bonds
2.1 Coupons
A coupon is the common term that is used for the rate of interest paid on the nominal value of a bond.
The name coupon derives from the way in which interest payments on bearer bonds used to be made.
With a bearer instrument, the issuer has no register of holders and instead ownership is evidenced by
holding the bearer certificate.
As the issuer has no record of ownership, a different process was required to be able to make interest
payments to holders. Each bearer bond certificate contained a separate sheet of coupons. When the
interest payment was due, a coupon would be detached by cutting it off and it would then be submitted
to the paying agent for the issuer who, in exchange, would issue a payment for the interest due.
The term coupon is now used to refer to all bond interest payments.
There are a range of possible options as to how a coupon on a bond is paid. Details of the rate, payment
dates and any variations will be set out in the bond’s prospectus when it is first issued.
Bond Prospectus and Final Terms

When a bond is first issued, a prospectus will be issued and the final terms of the bond will set out the terms
on which interest is payable. Set out below is an extract from the final terms for a 4.75% 2021 bond issued
by the LSE Group in 2012 which follows the standard format for new bond issues.
Provisions Relating to Interest (if any) Payable

14. Fixed Rate Note Provisions: Applicable
(i) Rate of Interest: 4.75% payable semi-annually in arrears

(ii) Interest Payment Date(s): 2 May and 2 November in each year, commencing on
2 May 2013 up to and including the maturity date
(iii) Fixed Coupon Amount(s) Not Applicable
(iv) Broken Amount(s): Not Applicable
(v) Fixed Day Count Fraction: Actual/Actual (ICMA)
(vi) Determination Date(s) 2 May and 2 November in each year
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15. Floating Rate Note Provisions: Not applicable
16. Zero Coupon Note Provisions: Not applicable
17. RPI-Linked Note Provisions: Not applicable
Whilst we don’t need to know about all of the terms mentioned above, you can see clearly that details of
the fixed coupon payment are set out.
Fixed Coupons
Conventional bonds carry fixed coupons which are at a set level for the entire life of the bond.
The coupon is payable on the nominal value of the bond and can be payable half yearly or annually. So,
for example, if an investor has a holding of £10,000 Treasury 4% gilt 2022 the coupon will be paid in two
equal half yearly instalments of £200.
A bond does not have to be issued at the beginning of a coupon period. If it is issued at some point
between two coupon dates, the first payment will be paid on either the:
• first coupon date and be equivalent to an amount less than the whole coupon. This is called a short
coupon; or
• second coupon date and be equivalent to an amount greater than the whole coupon. This is called
a long coupon.
Stepped Coupons
Stepped coupon bonds are a variation on the above where the coupon is fixed for a period of time and
then increases or decreases in steps by pre-specified amounts as the bond moves through its life cycle.
There are variations on the theme of these including:
• Step-up bonds where coupon rates rise after a fixed period or on the happening of a specified event.
For example, a five-year bond can have a coupon rate of 6% for the first two years and 6.5% for the
last three years.
• Step-down bonds are ones where the coupon rate falls after a certain period or on the happening of
an event. For example, a five year bond may have a coupon of 9% for the first two years and 8% for
the last three years.
• When there is only one change in coupon rate during the life of the bond, the issue is referred to as
a single step-up (step-down) bond. When there is more than one change, the issue is referred to as
a multiple step-up bond.
Step-up bonds clearly give an investor the scope for potential increases, so why would an issuer want to
agree to such terms? Typically, this is to make the fund raising easier and is often associated with a callable
option where if the issuer does not call the bond early, the coupon increases to compensate the investor.
Step-down bonds are less common and tend to be associated with a scenario where the issuer has to pay
a higher initial coupon than they would prefer, as they are expecting their financial position to improve
and so want to have the step-down kick in when that takes place, in order to reduce their funding costs.
48
Bonds
Floating Rate Coupons

FRNs have coupon payments that reset periodically according to a certain pattern known as the coupon
formula. They are also called variable-rate bonds or simply floaters.
2
The coupon formula ties the coupon rate to a certain benchmark or reference rate, such as LIBOR.
Usually the formula is:
Coupon rate = Reference rate + Quoted margin
The coupon formula for an issue may be as follows:
Coupon rate = Three-month LIBOR + 200 basis points
So, if three-month LIBOR for the coupon period is 1%, the rate for this coupon period will be set as 1% +
2% (200 basis points) = 3%.
When the bond is issued, the first coupon is calculated using the coupon formula on the issue date. A
calculation agent is appointed who determines the interest-rate that takes effect on each subsequent reset
date. The key point is that the rate of the next coupon is always known before the coupon period starts.
As mentioned above, the coupon formula will be made up of a reference rate and a quoted margin.
There are many variations on how this will be used and some examples are shown in the table below.
Reference Rate and Margin

• The reference rate will typically be a well-known rate such as LIBOR or EURIBOR.
Reference • However, it can be any reference rate such as swap rates, US Federal funds rate or CP rate.
rate • The reference rate can also be an index so that the coupon is linked to, for example,
the S&P 500 index.
• The spread over the reference rate can take a number of forms.
• Positive margin – usually the quoted margin is positive as LIBOR (or similar reference
rate) is the cost of borrowing for the most reliable international banks with very
high credit ratings.
• Negative margin – it is possible, however, for some issues to have a negative quote
Margin
margin so that the coupon rate will be less than reference rate.
• Maximum/minimum spread – the margin may also have a cap or a floor to restrict the
spread. A floater can have both a cap and a floor and this feature is referred to as a collar.
• Other possible variations on the structure include stepped spread floaters, leveraged
and deleveraged floaters, dual-indexed floaters and range floaters.
Zero Coupon Bonds (ZCBs)

ZCBs carry no coupon and simply redeem at face value at maturity. Such bonds are purchased at a
discount to the face value or redemption value.
STRIPS are an example of a ZCB. A conventional government bond is stripped into its individual coupon cash
flows and the maturity payment. Each then trades as a separate zero coupon instrument.
49
For example, the maturity payment due on 7 September 2020 on the UK gilt, 3¾ % Treasury gilt 2020 is
tradable as 3¾% Treasury Principal Strip 07Sep2020. It is priced at around £86.31 so an investor who
bought £10,000 nominal of the bond would pay £8,631 excluding dealing costs; they would receive no
coupons during the life of the bond, but on repayment receive all of their return as capital when they
receive the nominal value of £10,000.
Inflation-linked Coupons
Index-linked bonds or inflation-protected securities are ones where the coupon and redemption
proceeds are adjusted for the effects of inflation. How this affects coupon payments is considered later
in this chapter.
2.2 Redemption Provisions

The vast majority of bonds are redeemed in cash at maturity. This redemption may be either:
• At par value – where the bond is redeemed at the nominal value of the bond on the redemption date.
• At a premium – where it is redeemed at a specified premium above the nominal value of the bond
on the redemption date.
Initially all bonds were redeemable at a specific maturity date which determines when the principal
is due for repayment. However, as bonds have become more complex, there are now a number of
variations including:
• Irredeemable bonds.
• Double-dated bonds.
• Callable bonds where the issuer of the bond is able to redeem the bond at an earlier date.
• Puttable bonds which gives the holder the ability to sell the bond back to the issuer.
• Other variations exist where instead of obliging the issuer to repay cash at the maturity date of the
bond, the issuer may offer the holder the choice between normal cash redemption proceeds and
some other asset, such as an alternative bond of a later maturity or shares issued by a company.
2.2.1 Embedded Options

Embedded options are sometimes a part of a bond’s characteristics. An embedded option is a part of the
formal structure of the bond that gives either the bondholder or the issuer the right to take some action
against the other party.
There are several types of options that can be embedded. Some common types of bonds with embedded
options include callable bonds, puttable bonds, convertible bonds and exchangeable bonds.
Callable Bonds
A callable bond, which is also known as a redeemable bond, allows the issuer to retain the privilege of
redeeming the bond at some point before the bond reaches the date of maturity. If the bond contains
such an option, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds
from the bond holders at a defined call price.
50
Bonds
The call price will usually exceed the par or issue price. In certain cases, mainly in the high-yield debt
market, there can be a substantial call premium.
Thus, the issuer has an option, for which it pays in the form of a higher coupon rate. If interest rates in
2
the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a
cheaper level and so will be incentivised to call the bonds it originally issued.
With a callable bond, investors have the benefit of a higher coupon than they would have had with a
straight, non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called, and
they can only reinvest at the lower rate.
Puttable Bonds
A puttable bond or put bond is a combination of a straight bond and an embedded put option. The
holder of the puttable bond has the right, but not the obligation, to demand early repayment of the
principal. The put option is usually exercisable on specified dates.
This type of bond protects investors: if interest rates rise after the bond purchase, the future value of
coupon payments will become less valuable. Therefore, investors sell bonds back to the issuer and may
invest the proceeds elsewhere at a higher rate. Bondholders are ready to pay for such protection by
accepting a lower yield relative to that of a straight bond.
Of course, if an issuer has a severe liquidity crisis, it may be incapable of paying for the bonds when the
investors wish. The investors also cannot sell back the bond at any time, rather only on specified dates.
However, they will still be ahead of holders of non-puttable bonds, who may have no more right than timely
payment of interest and principal (which could perhaps be many years to get all their money back).
2.3 Inflation Protection

Inflation protected or index-linked bonds are ones where the interest payments and the maturity
payment are adjusted by the amount of inflation over the life of the bond. The amount of inflation uplift
is determined by changes in a published inflation index.
When a bond is first issued, the inflation index and a specific month’s index will be taken as the basis for
calculating inflation adjustments. The rate of inflation is usually not published for sometime after the
month to which it relates and so a methodology is needed so that the market is aware of the rate of the
next interest coupon payment.
The methodology used to calculate the inflation adjustment in the US, UK and Japan is based on the
method pioneered by the Canadian government, which is seen as representing current international
best practice.
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Indexation Methodology
Prior to this methodology being used, index-linked bonds used to have an eight-month indexation lag
– two months to allow for publication of the inflation index and six months so that the next dividend is
always known at the start of the relevant dividend period for accrued interest calculations.
In the UK, for example, there are still index-linked gilts in issue that use this method, as it was the first
country to issue index-linked bonds and these were issued before the three month lag indexation
method was adopted.
By doing away with the requirement to always know the next dividend payment six months in advance,
it has been possible to shorten the lag to three months for all new index-linked bonds.
The method of indexation for index-linked bonds with a three-month indexation lag uses an interpolated
inflation figure, which is converted into a daily adjustment ratio to be calculated known as the index
ratio. The semi-annual interest payments are calculated using the index ratio as follows:
Coupon
Interest payment = _______ × Index ratio
2
Index-Linked Coupon
Let’s assume that we have a holding of £100 nominal of 1¼% Index-linked Treasury gilt 2017. Half yearly
coupons are payable on 22 May and November and the index ratio at the time of the coupon payment
due in May 2013 was 1.28195. The interest payable would have been:
1.25%
Interest payment per £100 nominal = ______ × 1.28195 = 0.80129
2
The index ratio applied to interest payments measures inflation from approximately three months
before the bond is first issued to approximately three months before the interest payment date. The
exact length of lag depends on which day of the month the bond is issued on and which day of the
month the interest payment is due on. The index ratio changes every day and each day’s Index Ratio is
used in the calculation of the accrued interest for that day.
The maturity proceeds are calculated in the same way.
Index-Linked Maturity
2½% index-linked Treasury stock 2013 was first issued on 21 February 1985 and was repaid on 16 August
2013. The inflation index (RPI) at the time of issue was 89.2 and at repayment was 246.8 to give an index
ratio of 2.7667. So, the amount payable at maturity per £100 nominal of the bond was:
Maturity payment = £100 nominal x 2.7667 = 276.67
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Bonds
The pricing convention is however different. Index-linked stocks trade on what is known as a real-price
basis, which means with inflation stripped out; the inflation adjustment to the capital value and the
accrued interest is added afterwards to the inflation-adjusted dirty price.
2
Pricing Convention
The following table provides an example of how the inflation adjusted dirty price is made up and is
based on a UK index-linked gilt:
Real Index
Stock Dirty Price
Price Ratio
Inflation-Adjusted Inflation-Adjusted Inflation-Adjusted
Price Accrued Interest Dirty Price
1¼% Index-linked
112.52 1.29067 145.2261884 0.613770 145.839958
Treasury gilt 2017
The ‘inflation-adjusted dirty price’ is calculated as follows:
Inflation-adjusted dirty price = (Index ratio x real clean price) + (Index ratio x real accrued interest).
It should also be noted that there is no deflation floor, so the final redemption payment could be less
than the nominal value, if there is a general fall in the level of prices. The amount of capital that the
investor will get back on redemption will depend on what inflation does up until a point three months
before the stock is redeemed.
Inflation-protected securities used to only be issued by governments but companies are also now
issuing index-linked debt. The terms of such bonds will vary by issue.
Index-linked bonds are attractive in periods where a government’s control of inflation is uncertain, by
providing extra protection to the investor.
They are also attractive to long-term investors such as pension funds. They need to invest their funds
and know that the returns will maintain their real value after inflation, so that they can meet their
obligations to pay pensions.
2.4 Convertible and Exchangeable Bonds

Bonds may also be convertible or exchangeable into the shares of either the issuing company or another
company at an agreed-upon price. They are a hybrid security with debt and equity-like features.
53
2.4.1 Convertible Bonds
A convertible bond is one that gives the holder an option to convert the bond into the shares of the
issuing company.
Features of convertible bonds are:
• Typically, a convertible bond will pay a lower coupon, though this is compensated by the option to
convert into shares at the conversion date.
• Convertibles are often subordinated, meaning that all senior creditors must be settled in full before
any payment can be made to holders in the event of insolvency.
• Convertibles have some of the characteristics of bonds, responding to changes in interest rates, and
some of the characteristics of shares, responding to share price movements.
Convertible bonds are issued by companies and give the investor holding the bond two possible
choices:
• simply collect the interest payments and then the repayment of the bond on maturity; or
• convert the bond into a pre-defined number of shares in the issuing company, on a set date or dates,
or between a range of set dates, prior to the bond’s maturity.
The attractions to the investor are:
• If the company prospers, its share price will rise and, if it does so sufficiently, conversion may lead to
capital gains.
• If the company hits problems, the investor will retain the bond – interest will be earned and, as
bondholders, investors rank ahead of existing shareholders if the company went bust. (Of course, if
the company was seriously insolvent and the bond was unsecured, the bondholder might still not
be repaid, but this is a more remote possibility than that of a full loss as a shareholder.)
For the company, relatively cheap finance is acquired. Investors will pay a higher price for a bond that
is convertible because of the possibility of a capital gain. However, the prospect of dilution of current
shareholder interests, as convertible bondholders exercise their options, has to be borne in mind.
Given the terms on which the convertible loan stock can be converted into the issuing company’s
shares, a conversion premium or discount can be established.
Conversion Premium Formula

The conversion premium/discount is calculated as follows:
[ Market price of convertible

____________________________________________ stock
_________________________
(Conversion ratio × Market price of ordinary shares)
–1
] x 100
The conversion ratio in the formula refers to the number of ordinary shares that will be received in
exchange.
54
Bonds
The calculation and its use can be seen by looking at the following example.
Example
A company has issued an 8% convertible loan stock at $100 nominal. This can be converted into the
2
company’s shares at a rate of 18 shares for every $100 nominal of the loan stock.
If the loan stock is priced at $120 and the shares are priced at $5.75, the conversion premium or discount
can be calculated as follows:
[ 120
______________
(18 × 5.75)
–1
] x 100 = 15.9%
The result shows that the convertible is at a premium to the shares and so buying the convertible bond
is a more expensive route than buying the shares directly. However, the 8% coupon currently being paid
on the convertible bond may be sufficiently attractive, when compared to that being paid on the shares,
to justify the premium.
The fact that the bonds are at a premium also indicates that it would not be worth exercising the option to
convert into shares. This can be seen by simply comparing the respective values of the shares as follows:
Nominal Price Market Value
Convertible bond 100 $120 $120.00
Shares 18 $5.75 $103.50
When considering whether to convert into shares, an investor will also look at the effect that conversion
will have on the income received.
If the price of the convertible stands at a discount to the price of the ordinary shares, it is a less expensive
way of buying into the company’s ordinary shares or worth converting. Staying with the above example,
if the bond were priced at $110 and the shares was priced at $6.75 then it would be worth converting as
can be seen below.
Nominal Price Market
Convertible bond 100 $1.10 $110.00
Shares 18 $6.75 $121.50
The higher the premium, the more the convertible loan stock will behave like a conventional stock,
whereas the lower the premium, the nearer the loan stock will be to conversion and therefore the closer
its price movements will be to that of the company’s equity.
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2.4.2 Exchangeable Bonds
An exchangeable bond is a straight bond with an embedded option to exchange the bond for the stock
of a company other than the issuer (usually a subsidiary or company in which the issuer owns a stake) at
some future date and under prescribed conditions.
The key features of an exchangeable bond are:
• An exchangeable bond is different from a convertible bond as the convertible only gives the holder
the option to convert bonds directly into shares of the issuer.
• The pricing of an exchangeable bond is similar to that of convertible bond, splitting it into a
straight debt part and an embedded option part and valuing the two separately. So, the price of an
exchangeable bond = price of straight bond + price of option to exchange
• The price of an exchangeable bond is always higher than the price of a straight bond because the
option to exchange adds value to an investor.
• The yield on an exchangeable bond is lower than the yield on a straight bond.
3. Risks
Learning Objective
2.2.2 Analyse the risks associated with bonds and the role of credit rating agencies: general risks;
market risks; default risk
3.1 General Risks

The main risks associated with holding either government or corporate bonds are:
• Credit risk – the risk that interest payments and the repayment of the bond may not be made.
• Market or price risk. The risk that movements in interest rates have a significant impact on the
value of bond holdings.
• Unanticipated inflation risk – the risk of inflation rising unexpectedly and its effect on the real
value of the bond’s coupon payments and redemption payment.
• Liquidity risk – where bonds are not easily or regularly traded, and can therefore be difficult to
realise at short notice or can suffer wider than average dealing spreads.
• Exchange-rate risk – where bonds are denominated in a currency different to that of the investor’s
home currency and so are potentially subject to adverse exchange-rate movements.
There are a number of further risks attached to holding corporate bonds, notably:
• Early redemption risk – the risk that the issuer may invoke a call provision if the bond is callable.
• Seniority risk – the risk attached to the seniority with which corporate debt is ranked in the event
of the issuer’s liquidation.
Of these risks, market risk and credit risk are of principal concern to bond investors.
56
Bonds
3.2 Market Risk

Bond prices are determined by discounting future cash flows at the prevailing rate of interest to
calculate the NPV of the bond’s cash flow and thereby arrive at the current bond price.
2
As a result, one of the most important risks to a bondholder is the impact of changing interest rates.
This is the risk that an interest-rate movement may bring about an adverse movement in the value of an
investment. It is particularly acute when the investment is a fixed-interest bond and the interest-rate rises.
Because of the inverse relationship between bonds and interest rates, the value of the bond will fall.
Example
A bond issued with a 5% coupon will be less desirable as interest rates increase and further bonds are
issued with higher coupon rates – for example, with 6% coupons. In simple terms, the price of the bond
obtainable in the secondary market will have to decline so that the YTM for the 5% bond becomes equal
to the YTM for the 6% bond. The way in which the lower coupon bond remains competitive in its YTM is
by having a lower current price.
Interest-rate risk is largely removed if the bond is floating rate, since the coupon will be reset in line with
the higher market interest rate. FRNs can, however, be susceptible when there is a de-coupling between
rates and inflation.
Duration and modified duration (volatility) are the means of measuring this risk more precisely. Convexity
is a measure that is used to explain the sensitivity of a bond’s price to changes in the discount rate.
3.3 Default Risk

Credit risk refers to the general risk that counterparties may not honour their obligations. A subset of
credit risk is default risk, which occurs when a debtor has not met their legal obligations, which can be
either that it has not made a scheduled payment or has violated a loan covenant.
Investors in bonds face the risk of the issuer defaulting on their payment obligations. Credit risk can be
assessed by reference to the independent credit rating agencies, mainly Standard & Poor’s, Moody’s and
Fitch Ratings.
Government bonds are sometimes described as having no default risk, as government guarantees
mean there is little or no risk that the government will fail to pay the interest or repay the capital on the
bonds. Although government guarantees reduce the risk of holding government bonds, it is important
to remember that it is not eliminated altogether.
Typically, the government guarantees payment of interest and the redemption proceeds on
predetermined due dates. As governments can raise taxes, reduce spending, or simply print more
money to redeem the bond at maturity, they are often described as being risk-free.
57
Risk-free Government Bonds
It should be recognised, however, that government bonds are only theoretically risk-free and that the
guarantee is only as good as the government that is giving it.
Governments do occasionally default, as Argentina did in 2001 and as did Russia in 1998, which led to
the collapse of the US hedge fund Long-term Capital Management.
The recent Greek debt crisis emphasises the message that, while in the good times it is easy for
commentators to say that government debt is risk-free because they can simply print more money,
the reality is significantly different. Years of unrestrained spending left Greece badly exposed when the
global economic downturn struck and it had to seek a bail out from the IMF and the EU. Bond holders
had to accept a write down of the value of their outstanding holdings.
Investors in sovereign bonds have the additional risk that the issuer is unable to obtain foreign currency
to redeem the bonds.
The risk associated with government bonds is assessed by the ratings agencies, who regularly issue
reports on the creditworthiness of various governments. For example, the UK is rated AAA by Standard
& Poor’s, which is defined as the issuer having an extremely strong capacity to meet its financial
commitments. The US and Japan’s sovereign debt is rated AA which indicates it has a very strong
capacity to meet financial commitments.
Some other governments, however, have less financial strength, and this translates into a lower rating.
For example, Greece’s rating was downgraded to BB+ in April 2010, making it the first eurozone country
to have its debt downgraded to junk status. Investors demanded higher returns to compensate for the
increased risk and the two-year government bond yield surged to 15%, making it highly expensive for
the country to borrow from the debt market. Its five-year bond yields hit 10.6%, which was higher than
the yields on bonds issued by many emerging market economies.
Credit risk for other types of bonds needs to be carefully monitored, hence the reason why bonds will
have security, insurance and covenants and are carefully monitored by the ratings agencies.
58
Bonds
3.4 Other Risks

Inflation-protected or index-linked bonds carry certain additional risks over conventional bonds.
2
Risk Factors for Inflation-Protected Securities
• When a new bond is first issued, there is no assurance that an active
secondary market will develop.
Secondary
• Where a secondary market exists for a series of bonds, it is not possible to
market trading
predict how the bonds will trade in the secondary market.
• The bonds may be less liquid than conventional bond issues.
• The price in the secondary market is subject to changes in real yields and
fluctuations in the inflation index, which may result in trading gains or losses.
Price variability
• Real yields may vary depending on economic developments and the supply
and demand for each series of bonds.
• Coupon payments vary depending on changes in the relevant index ratio,
which incorporates inflation data.
Cash flow
• As a result, the amount of interest may rise or fall from one coupon payment
variability
date to the next and such variations may be material during periods of
significant changes in inflation.
• The calculation of the index ratio incorporates an approximate three-month
Indexing lag lag, which may have an impact on the trading price, particularly during
periods of significant changes in inflation.
• There is no deflation floor, so the maturity payment may be less than the
Maturity payment
nominal value of the bonds for some type of issues.
Tax • Consideration needs to be given as to how tax laws treat the inflation
considerations adjustment and whether they are treated as income or capital gain.
3.5 Credit Rating Agencies

A credit rating provides an estimate of the credit worthiness of an individual, corporation or even a country.
For corporate and sovereign issuers, an evaluation is made by credit rating agencies of a borrower’s
overall credit history and they provide a classification system, enabling a lender or investor to estimate
the probability of the issuer of a credit, such as a bond, being able to make repayment in accordance
with the terms of the borrowing, or more specifically the offering prospectus for a bond issue.
A major factor in the credit rating given to a bond is the level of security associated with it and its
ranking in the event of bankruptcy.
59
3.5.1 Ratings Agencies
When a bond is first issued, the issuer will provide details of its financial soundness and creditworthiness
in a document known as an offering document, prospectus or official statement. But as the bond may
not be due for redemption for many years, investors need a method of checking on a regular basis
whether the government or company remains capable of meeting its obligations.
The credit risk for bonds – the probability of an issuer defaulting on their payment obligations and the
extent of the resulting loss – can be assessed by reference to the independent credit ratings given to
many bond issues.
Rating agencies assign ratings to many bonds when they are issued and monitor developments during
the bond’s lifetime. The three most prominent credit rating agencies that provide these ratings are
Standard & Poor’s, Moody’s and Fitch Ratings.
Each of the agencies assigns its ratings based on in-depth analysis of the issuer’s financial condition and
management, economic and debt characteristics, and the specific revenue sources securing the bond.
The ratings used by the three main credit ratings agencies provide a guide for investors who are seeking
knowledge regarding risk and as a way of assisting in determining the appropriate prices at which
bonds of each category should trade in the secondary markets for such issues.
The credit rating agencies are paid by the debt issuer and offer different types of rating services:
public ratings; private ratings for internal or regulatory purposes; shadow ratings – again for private
consumption – and model-based ratings. Each kind involves differing degrees of evaluation.
Public ratings are available to the public through their ratings information desks, through published
reports and via the internet.
The types of securities provided with a credit rating depend on the demand for the bond and the
willingness of the issuer to pay for the credit rating. All types of instruments are therefore potentially
covered by a credit rating but just because some of an issuer’s bonds have a credit rating does not mean
that all are rated.
An inferior credit rating indicates a higher risk of defaulting on a loan, and investors will want to be
compensated for this additional risk by higher interest rates and other provisions, or they may simply be
unwilling to purchase the bonds being offered by the issuer.
The cutting of a credit rating makes it more expensive for governments to raise money with their
sovereign bond issues as it will require higher coupon payments to attract investors who perceive more
risk, for example, in an Irish government bond rather than a US Treasury.
3.5.2 Conflicts in the Rating Process

The role of credit rating agencies was criticised during the aftermath of the sub-prime crisis, particularly
on their rating of asset-backed bonds and other securitisation issues, especially as many were
downgraded suddenly from AAA status to non-investment grade.
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Bonds
The ratings agencies have an unusual relationship with the principal participants in bond markets.
On the one hand their ratings are used by buyers of bonds, such as pension funds and other asset
management companies and regarded as independent and objectively determined, and on the other
hand their instructions and appointment comes from the seller of the bonds. As was seen in cases
2
which have been the focus of testimony before the US Congress, there are at least grounds for believing
that the manner in which the agencies are commissioned by, and paid by, bond issuers, provides a
reasonable question as to the reliability and independence of the assessments made.
This led to calls for change. In April 2009, the European Commission (EC) introduced new regulations
for credit rating agencies which issue opinions on creditworthiness of companies, governments and
sophisticated financial structures. All credit rating agencies that would like their credit ratings to be
used in the EU have to apply for registration.
Registered credit rating agencies are subject to regulatory supervision and have to comply with rules
designed to ensure the following:
• ratings are not affected by conflicts of interest;

• credit rating agencies remain vigilant on the quality of the rating methodology and the ratings;
• they act in a transparent manner.
4. Bond Analysis
4.1 Bond Valuation Measures
Learning Objective
2.3.1 Analyse fixed income securities using the following valuation measures, and understand the
benefits and limitations of using them: flat yield; gross redemption yield (GRY) (using internal
rate of return [IRR]); net redemption yield (NRY); yield curves
The return from bonds comprises the income return and the capital return.
The income return represents the interest paid on a bond during its lifetime, and the capital return
represents the difference between the acquisition price of the bond and the amount received at
maturity.
4.1.1 Flat Yield

The simplest measure of the return from a bond is to calculate its running yield, also known as the flat
or interest yield. This expresses the coupon as a percentage of the market, or clean, price of the bond.
The formula for calculating the flat yield is:

Coupon
Flat yield = ________ x 100
Price
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So, for example, a bond with a 6% coupon that is due to be redeemed at par in five years and is currently
priced at 110 will have a running yield of:
6
________ x 100 = 5.45%
110
There are three key drawbacks in using the flat yield as a robust measure in assessing bond returns.
• Since it only measures the coupon flows and ignores the maturity payment it is giving an inaccurate
perspective on the actual returns from the bond if the price is above or below par.
• The calculation completely ignores the timing of any cash flows and, because there is no discounted
cash flow analysis, the time value of money is completely overlooked.
• With FRNs, the return in any one period will vary with interest rates. If the coupon is not a constant,
then using a flat yield basis for measuring returns becomes an arbitrary matter of selecting which
coupon amount, amongst many possible values, to use for the calculation.
4.1.2 Gross Redemption Yield (GRY)

The flat yield ignores the difference between the current market price and the redemption value.
We also need to take into account the gain or loss that an investor will make if a stock is held until
redemption to determine the return that the investor is actually receiving.
To remedy this, the gross redemption yield (GRY) or yield to maturity (YTM) is used.
Simply put, the GRY is a combination of the running yield plus the gain or loss that will occur if the bond
is held until it is redeemed to give an average annual compound return.
It can be seen that this then gives a more accurate indication of the return that the investor receives
and can be used to compare the yields from different bonds to identify which is offering the best return.
• In the example above, the GRY will be lower than the running yield as the market price is higher than
the bond’s par value and the bond will suffer a capital loss if held to maturity.
• If, however, the market price is below par, the GRY will be greater than the running yield, as a capital
gain will be made if the bond is held to maturity.
The table below shows rates on some UK gilts which demonstrate the difference between flat yields and
redemption yields for bonds with a market price above and below par.
Flat Yields versus GRYs
Stock Price Flat Yield Redemption Yield
Treasury 1.75% 2022 93.86 1.87% 2.52%
Treasury 4% 2022 112.56 3.56% 2.35%
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Bonds
Calculating the GRY requires a process of iteration but firstly, we will look at a simple formula for
calculating the GRY of a bond that is sometimes known as the Japanese GRY.
The Japanese method for calculating the GRY is to take the flat yield and then add the average annual
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capital gain (or deduct the average annual loss) to redemption, stated as a percentage of the current
market price. So, we can state the Japanese GRY as follows.
GRY=Flat yield +
( (Par-market price) ÷ _________________
___________________________ Number of years
Market price
to redemption
_________________________
) x 100
The main use of this method is to provide a quick and easy way of assessing the GRY that takes into
account all of the returns, income and capital.
Staying with the example above, we have a bond with a 6% coupon that will be repaid in exactly five
years’ time. Its current price is $110 and its flat yield is 5.45%.
So, we have:
GRY =
( )( 6
_____
110
+
(100 – 110) ÷ 5
___________________
110 ) × 100 = approx 3.63%
This method is not an absolutely accurate measure of return and is liable to overstate the effects of any
capital gain or loss and the inaccuracy increases the further away a bond is from maturity. It is, however,
a useful tool to quickly and easily assess a bond’s GRY.
Its drawback is that the calculation ignores the timing of the cash flows and the time value of money.
The way in which it is calculated in practice is more complex and the only way to get the answer is
through a process of iteration to calculate the bond’s internal rate of return (IRR) by using discounted
cash flow techniques.
The bond’s GRY is the IRR which produces an NPV of zero by applying a discount rate to the bond’s cash flows.
As the only accurate way to establish this IRR is through a lengthy process of trial and error, using a range
of discount rates, an approximate IRR is usually derived through a short-cut methodology known as
interpolation. Interpolation takes a lower discount rate that produces a positive NPV and a higher discount
rate that results in a negative NPV, and then finds the rate between them that produces a zero NPV.
To get an indication of which rates are suitable, we can use the flat yield and the Japanese GRY
assessments as a starting point.
• Since the bond is priced above par, we know that the GRY must be lower than the flat yield of 5.45%.
• As the Japanese GRY overstates the effect of any gain or loss to redemption the GRY must be higher
than 3.63%.
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So, the first step is to establish what rates to use that will produce a positive and negative NPV. We know that
the Japanese GRY is the more accurate of the two measures, so we can start with one slightly higher – let’s
say 3.7% – that should produce a positive NPV; and one we hope will produce a negative NPV – let’s say 4%.
Net Present Value (NPV) of Bonds Cash Flows

The table below shows the bond’s cash flows discounted at the rate of 3.7% and 4% using the present
value formula.
Cash Cash Discounted Discounted

Year
Inflows Outflows Cash Flow Cash Flow
Using 3.7% Using 4%
1 –110 –110 –110
1 6 5.79 5.77
2 6 5.58 5.55
3 6 5.38 5.33
4 6 5.19 5.13
5 6 5.00 4.93
5 100 83.39 82.19
NPV –110 130 0.33 –110
The calculations involved identifying the present value of each of the individual coupon cash flows
using the present value formula which is obviously time consuming. Instead, we can use the present
value of an annuity formula as a shortcut to find out the present value of the coupons.
1
Present value of an annuity = $ x ___ x
r [ 1
1 – _________
(1 + r)n ]
So, the present value of the coupon payments using the first discount rate of 3.7% is:
1
6 x _______ x
0.037 [ 1
1 – _______________5
(1 + 0.037) ] = 26.94
Then we calculate the present value of the maturity payment as 100 ÷ 1.0375 = 83.39. The total of these
discounted cash flows is 110.33 (26.94 + 83.39) minus the cash outflow of 110 gives a NPV of 0.33. This
could then be repeated for the discount rate of 4%.
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Bonds
So, we have a positive and a negative NPV using these discount rates which tells us that the actual GRY
rate should lie somewhere in between. Our next step is to find out precisely where in between this lies.
Calculating the GRY
2
We have found that the rate of 3.7% is too low and 4% is too high, so the GRY lies between these two points.
To identify the GRY we can use the following formula, where r1 and r2 represent the discount rates we
have used, to give us a closer approximation of the actual GRY:
So the GRY is:

Approximate IRR = r1 +
{ Positive NPV
(Positive NPV-Negative NPV) }
_______________________________________ x ( r 1 – r 2) = × 100
GRY = 3.7 +
{ 0.33
________________
(0.33 – 1.10)
x (4 – 3.7)
} × 100 = 3.7 +
[ ]0.33
_____ x 0.3
1.43
× 100 = 3.769%
We can then test the accuracy of the result by repeating the calculations above:
Present value of coupons = 6 ×

1
___________
0.03769 [ 1 – _____
0.33
_____
_____
1 + 0.037695
_____
_____
] = 26.885
The present value of the maturity payment is 100 ÷ 1.037695 = 83.11 so the total of these discounted
cash flows is 110 (26.89 + 83.11) minus the cash outflow of 110 gives a NPV of 0.00.
The tabular calculation below shows the minor rounding error in the calculation. If necessary we could
then repeat the iterations refining them for any minor rounding errors if greater precision is needed.
Year Cash Inflows Cash Outflows Discounted Cash Flow
Using 3.769%
1 –110 –110
1 6 5.782
2 6 5.572
3 6 5.370
4 6 5.175
5 6 4.987
5 100 83.112
NPV –110 130 –0.0032
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The GRY as a yield measure does however have its drawbacks. Firstly, it assumes that the bond will
be held to redemption. More fundamentally though, it assumes that the interest payment can be
reinvested at the same rate as the bond. This inability to reinvest coupons at the same rate of interest as
the GRY is known as reinvestment risk.
These limitations however do not invalidate its widespread use as a measure for comparing returns
between different bonds. It still represents the best assessment of the potential pre-tax returns from a
bond at any point in time and is the major return measure considered when appraising bonds.
4.1.3 Net Redemption Yield (NRY)

For a taxpayer, the GRY only tells part of the story. Any gain that is made if a bond is held until maturity
is often likely to be free of tax, whereas the half-yearly or annual interest received will be subject to
income tax in the investor’s hands.
Redemption yields are also quoted on a net-of-tax basis so that a direct comparison can be made of the
after-tax return to the investor.
This can be calculated by using the same Japanese GRY formula as above, but reducing the running
yield to the net yield after tax at the holder’s income tax rate. It is possible to get a quick approximation
of the NRY by adjusting the formula as below.
GRY =
Annual
_________ net coupon
_________
_________
Market price x 100
_________
___________
+
( (Par-market price
____________________ ÷_____
_____ No ____
of years
________to
Market price
redemption
__________________
)
The NRY allows investors to review the after tax yields to determine which will be most tax effective for
their particular tax position.
4.1.4 Gross Redemption Yields (GRYs) for Other Bonds

The GRY we considered above was for a conventional bond with an annual coupon. The calculation
method of GRY will vary where different features are in place as noted below.
GRY for other Types of Bonds

• The standard method of calculating GRY does not give a completely accurate
assessment of returns, since it ignores the compounding effect of interest rates
Bonds with
within any year.
half-yearly
• The market convention is to discount the half-yearly cash flows at a semi-annual
coupons
rate of return and then multiply the semi-annual rate by two to produce the GRY
of the bond.
• With callable bonds, the holder will not know whether the bond will be repaid
before its final maturity date.
Callable
• A yield to call is therefore also calculated to evaluate the return up to the call date.
bonds
An assessment then has to be made as to which to use, based on expectations of
whether the bond will be called.
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Bonds
• The difficulty with using the standard approach with FRNs is that we do not know
what the future coupons will be.
FRNs
• Instead, a practical approach is taken that assumes current rates will not change
in the future and so the GRY can be calculated using the latest reset rate.
2
• With an index-linked or inflation-protected bond, both coupon and redemption
Index-linked
proceeds, vary with inflation since the issue reference date.
bonds
• The normal GRY calculation has to be adjusted for assumed rates of inflation.
4.1.5 Yield Curve

Interest rates differ depending upon the term of the investment and, typically, a long-dated bond will
carry a higher GRY than a shorter one.
This relationship between yield and maturity is known as the term structure of interest rates and can be
illustrated diagrammatically by a redemption yield curve, or yield curve, as it is more commonly known.
The following diagram demonstrates a typical yield curve:
Return
Yield
Period to Redemption
Although yield curves can assume a range of different shapes, more often than not the yield curve is
described as being upward-sloping, in that it displays a positive slope. This is known as a normal yield
curve as it depicts the commonly observed relationship of long-term interest rates being higher than
short-term interest rates.
If the yield curve is said to be steep, it means the yields on short-dated stocks are relatively low when
compared to longer-dated stocks. This means that an investor can obtain significantly higher yields, and
therefore income, by buying a stock with a longer maturity than they can with a shorter one.
Alternatively, the yield curve may be described as flat, which means that the difference between short-
and long-term rates is relatively small. This means that the reward for buying longer-dated stocks is
relatively small and investors may choose to stay in the short end of the maturity range.
When yields on shorter-dated stocks are higher than those on longer-dated ones, the yield curve is said
to be inverted and is usually seen when the market expects interest rates to decline.
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4.2 Duration
Learning Objective
2.3.2 Analyse the factors that influence bond pricing: relationship between interest rates and bond
prices and how modified and Macaulay duration are used; yield to maturity; credit rating;
impact of interest rates; market liquidity
In order to assess how sensitive one bond is compared with another, a measure that incorporates the
coupon, the remaining life and the yield is used. Duration is a measure that reveals how sensitive a bond
is to changes in interest rates.
Importance of duration:
• Duration provides an estimate of the average sensitivity of a bond’s price to a change in a bond’s yield.
• It is an important measure for investors to consider, as bonds with higher durations (given equal credit,
inflation and reinvestment risk) may have greater price volatility than bonds with lower durations.
• It is also an important tool in structuring and managing a bond portfolio.
There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price
of bonds falls and vice versa. Bond yields in turn reflect the required rate of return (and credit risk
premium) which varies as interest rates move up and down.
The degree to which the price moves, however, is determined by a number of other factors.
Factors Influencing Price Movement

• The size of the coupon on the bond will affect the degree of price movement.
• The smaller the coupon, the more the bond’s price will move in response to
Coupon
interest-rate changes, so low-coupon bonds are more volatile than higher-
coupon bonds.
• The remaining life of a bond will also have an impact and is known as the pull to
Time to maturity.
maturity • The closer a bond is to maturity, the less effect a change in interest rates will have
as the price will move towards its par value.
• The sensitivity of a bond’s price will also be affected by its yield: the lower the
yield, the more sensitive it will be to any changes in interest rates.
Yield
• So, for example, an increase in yields from 2% to 3% will have a greater
proportionate effect than an increase from 5% to 6%.
Additional factors that may impact the degree a price moves include:
• The term structure and convexity of the yield curve.
Other
• Credit risk premium.
factors
• Any embedded options or early-redemption options (put/call).
• The prevailing premium or discount to par.
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Bonds
The most commonly used measures of duration are:
• macaulay duration;
• modified duration;
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• effective duration.
4.2.1 Macaulay Duration

This measure was developed in 1938 by Frederic Macaulay and measures the number of years required
to recover the true cost of a bond, considering the present value of all coupon and principal payments
received in the future.
Investment theory tells us that the price of a bond is the sum of all of its cash flows discounted at an
interest-rate that reflects the inherent investment risk. In addition, due to the time value of money, it
assumes that cash flows returned earlier are worth more than cash flows returned later.
The cash flows from a bond arise at different points in time and so have different sensitivities to rate
movements, so a bond may be thought of as an amalgamation of differently timed cash flows each with
its own sensitivity. As a result, the sensitivity of a bond to changes in rates must be a weighted average
of the sensitivities of the individual cash flows. This is a bond’s duration.
In its basic form, duration measures the weighted average of the present value of all future cash flows
from a bond. Taking a simple example of a five-year bond that pays annual coupons, the concept can be
seen diagrammatically as shown below.
Coupon 1 Coupon 2 Coupon 3 Coupon 4 Coupon 5

& Principal
Present value Actual cash flow Years
Duration
All of the components of a bond–price, coupon, maturity and interest rates are used in the calculation
of its duration. The formula for duration is the sum of the present values of the bond weighted for time
divided by the bond’s price.
∑ (t × PVt )
Macaulay duration = _________
Price
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Alternatively, if we remember that the price of a bond is the sum of the present value of its cash flows, it
can be expressed more understandably as:
∑ (NPV of the bond’s cash flows × Time to cash flow being received)
____________________________________________________________
(∑ NPV of the cash flows to be received)
On the face of it, the calculation can look quite challenging but if we use a straightforward example
we can see the stages that are involved in the calculation. Let’s assume that we want to calculate the
duration of a 5% coupon bond that has a GRY of 6% and a term of three years. To keep the calculation
simple, we will assume that the interest is paid annually.
Firstly, we need to know the price of the bond by calculating the present value of the future cash flows.
You will recall that present value is established by discounting the amount to be received by a rate of
interest which in our example is the GRY of 6%.
Year Cash Flow Discount Rate Formula Present Value
1 Interest 5.00 6% 5.00 ÷ 1.06 4.72
2 Interest 5.00 6% 5.00 ÷ 1.062 4.45
3 Interest 5.00 6% 5.00 ÷ 1.063 4.20
3 Redemption 100.00 6% 100.00 ÷ 1.063 83.96
Total 115.00 97.33
So, the sum of NPV of the cash flows will represent the current price of the bond.
Next, we need to multiply each discounted cash flow by the number of years before the cash flow is received.
Year Cash Flow Present Value No of Years Present Value x No of Years
1 5 4.72 1 4.72
2 5 4.45 2 8.90
3 5 4.20 3 12.60
3 100 83.96 3 251.88
Total 115 97.33 278.10
Finally, we can now use the formula above to calculate duration:
∑ (NPV of the
_______________ bond’
_________ s cash
_________ flows___________
_________ × Time) 278.10
or _________ = 2.86 years
∑ NPV of the bond’ s cash flows 97.33
It is the only type of duration measured in years. Macaulay duration is a relative measure that allows one
bond to be compared with another to determine which is the more volatile.
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Bonds
4.2.2 Modified Duration (MD)

As mentioned above, duration is a relative measure that allows one bond to be compared with another
to determine which is the more volatile. It does not, however, quantify how sensitive a bond is to
changes in interest rates. This is done by using modified duration (MD).
2
This measure expands or modifies Macaulay duration to measure the responsiveness of a bond’s price
to interest-rate changes. It is defined as the percentage change in price for a 100 basis point change in
interest rates. The formula assumes that the cash flows of the bond do not change as interest rates change.
The MD of a bond estimates how much a bond’s price will change if there is a change in interest rates
and so yields. The formula for calculating modified duration is:
Macaulay duration
____________________
(1 + GRY)
As with Macaulay duration, the higher the MD, the more sensitive a bond is to changes in its yield.
Using the results of the calculation above, we can therefore calculate what the effect of a 1% rise in
yields will be on the bond’s price. The MD of the bond is:
____2.86
________ = 2.70
(1 + 0.06)
So, for a 1% change in yields the price should change by 2.70%. We saw above that the price of the bond
is 97.33, so if yields rise by 1% the price of the bond should fall to:
97.33 – (97.33 × 0.0270) = 94.70
It should be noted, however, that this is only an approximation of the impact. It is more accurate to
consider duration as an average indicator, at one point in time, and one that indicates the sensitivity of
a bond’s price to a 100 BPs (1%) change in yield. The MD calculation produces a quite accurate result for
small changes in yield; however it becomes increasingly inaccurate for larger shifts.
4.2.3 Effective Duration

Effective duration further refines the MD calculation and is particularly useful when a portfolio contains
callable securities. It is also known as option adjusted duration.
Effective duration requires the use of a complex model for pricing bonds that adjusts the price of the
bond to reflect changes in the value of the bond’s embedded options, such as call options or a sinking
fund based on the probability that the option will be exercised. Effective duration incorporates a bond’s
yield, coupon, final maturity and call features into one number that again indicates how price sensitive
a bond is to changes in interest rates.
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4.2.4 Portfolio Duration and Market Risk
As we have seen, all of the components of a bond–price, coupon, maturity, and interest rates all
contribute to the calculation of duration. From these, we can draw some general principles.
Properties of Duration
• As maturity increases, duration increases and the bond’s price becomes more
sensitive to interest-rate changes.
Maturity • A decrease in maturity decreases duration and renders the bond less sensitive to
changes in market yield.
• Therefore, duration varies directly with maturity.
• As the bond coupon increases, its duration decreases and the bond becomes less
sensitive to interest-rate changes.
Coupons • Increases in coupon rates raise the present value of each periodic cash flow and
therefore the market price.
• This higher market price lowers the duration.
• As interest rates increase, duration decreases and the bond becomes less sensitive
to further rate changes.
• As interest rates increase, all of the NPVs of the future cash flows decline as their
Interest
discount factors increase, but the cash flows that are farthest away will show the
Rates
largest proportional decrease. So the early cash flows will have a greater weight
relative to later cash flows.
• As yields decline, the opposite will occur.
The implication of this is that duration allows bonds of different maturities and coupon rates to be
directly compared and allows a bond portfolio to be constructed based on weighted average duration
that provides the ability to determine changes in value based on forecast changes in interest rates.
Portfolio duration is important to bond portfolio managers. The duration of a portfolio is the weighted
average duration of all the bonds in the portfolio weighted by their values as shown in the example below.
Weighted Average Duration
Bond Market Value Portfolio Weight Duration Weighted Duration
A 10,000 0.1 3 0.3
B 20,000 0.2 6 1.2
C 30,000 0.3 5 1.5
D 40,000 0.4 7 2.8
Total 100,000 1.0 5.8
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Bonds
Understanding a portfolio’s weighted average duration means portfolio managers may be able to
modify interest-rate risk by changing the duration of the portfolio.
Portfolio duration strategies may include reducing duration by adding shorter maturities or higher-coupon
2
bonds when interest rates are expected to rise. Alternatively, they may increase duration by extending the
maturities, or including lower-coupon bonds to the portfolio when rates are expected to fall.
4.2.5 Convexity
One of the limitations of duration as a measure is that it assumes that for a certain change in interest
rates, an equal change in price will occur – in other words, it assumes a linear relationship.
As interest rates change, however, the price of a bond is unlikely to change in a linear fashion and
instead will change in a curved or convex pattern. This is because as the yield changes, so will the
duration and consequently the MD. It is this that gives rise to the concept of convexity. As the yield falls,
the duration will increase and so will the MD; as MD increases, the line will steepen.
For any given bond, a graph of the relationship between price and yield is convex. This means that the
graph forms a curve rather than a straight line as shown in the diagram below.
Relationship between Bond Price and Yield
Actual Relationship -
Price Convexity
Predicted Relationship -
Duration
Yield
The impact of convexity will be that the MD will tend to overstate the fall in a bond’s price and understate the
rise. However, for relatively small movements in the yield, MD is a good estimate; the problem of convexity
only becomes an issue with more substantial fluctuations in the yield.
Duration and convexity are important measurement tools for use in valuation and portfolio management
strategies. Used in conjunction with duration, convexity provides a more accurate approximation of the
percentage price change resulting from a specified change in a bond’s yield than using duration alone.
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4.3 Factors Influencing Bond Pricing
In most cases, the income from a bond remains the same through its life. However, during the life of the
bond, there are many factors especially inflation and the changes in the interest-rate environment that
can make the bond more or less attractive to investors. These factors lead to the price of bonds changing.
In very general terms, the factors that influence the prices of bonds can be sub-divided into:
• issuer-specific factors;
• macro-economic or market factors.
The characteristics of a particular issue and the quality of the issuer encompass the following:
• The issuer’s current credit rating, which itself will reflect the issuer’s specific prospects and highlight
the issuer’s default risk.
• The structure and seniority of the particular issue; for example, the bonds may be high or low priority
in the event of default by the issuer and may be structured in a way that gives the bonds particular
priority in relation to particular assets.
• These factors, combined with prevailing yields available on other benchmark bonds such as
government issues in the same currency with similar redemption dates, will determine the required
YTM and, therefore, the bond’s price.
• The more liquid bonds tend to be more expensive, encompassing a liquidity premium and having
lower bid/offer spreads.
The ease with which an issue can be sold in the market will affect the investor’s perception of the risk
of holding a bond. Smaller issues especially are subject to this risk. In certain markets, the volume of
trading tends to concentrate into the benchmark stocks, or the on-the-run stocks, especially in the
government bonds market, thereby rendering most other issues illiquid.
Other bonds become subject to seasoning as the initial liquidity dries up and the bonds are purchased
by investors who wish to hold them to maturity.
During periods of market volatility, investors will have a preference for the most liquid instruments and
may hoard the on-the-run bonds and so force their price to be out of normal alignment with similar
bonds which have a slightly different maturity date. This can result in a breakdown in complex strategies
designed to exploit the spreads or price differences across the yield spectrum.
Macro-economic and market factors affecting bond prices and yields include interest rates and a bond’s
sensitivity to maturity and coupon.
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Bonds
Macro Economic and Market Factors

• A major driver of bond prices is the prevailing interest-rate and expectations of
interest rates to come.
2
• Yields required by bond investors are a reflection of their interest-rate
expectations.
• For example, if interest rates are expected to rise, bond prices will fall to bring the
yields up to appropriate levels to reflect the interest-rate increases. The reason
for this is that investors will be prepared to pay less for a particular bond with a
Interest Rates fixed coupon rate than they were prepared to pay previously.
• If interest rates fall, then investors will be prepared to pay more for a fixed-rate
bond than previously, and bond prices will tend rise.
• The interest-rate itself is heavily impacted by inflationary expectations. Investors
will generally require a higher return if the expected rate of inflation rises.
Therefore, prices of fixed-rate bonds will tend to fall with rising expectations of
inflation.
• The reverse is true if inflation is expected to fall.
• Longer-dated bonds will be more sensitive to changes in interest rates and the
Sensitivity to required YTM than shorter-dated stocks.
Maturity • The reasoning behind this is simply that the longer-dated bond is more exposed
to the movements of the yield, since it has longer to go to maturity.
• If the yield is low, the present value of flows in the future is enhanced and the
bond is more sensitive to the changing GRY.
Sensitivity to • If yields are particularly high, the cash flows in the future are worth relatively little
Coupon and the sensitivity is diminished.
• Lower-coupon stocks demonstrate the greatest level of sensitivity to changes in
yield.
There is also a relationship between bond and equity markets that affects pricing.
The primary difference between the corporate bond market and the equity market relates to the nature
of the security being traded.
• A corporate bond usually has a specified income stream in the form of coupon payments which will
be paid to the holder of the bond, and a bondholder has a more senior claim against the assets of
the issuer in the case of a bankruptcy or restructuring.
• Investors in equities face fluctuating dividend payments and a greater risk in the event of insolvency.
This gives rise to the concept of the equity-risk premium. If the return on an equity is 6.5% and the
risk-free rate over the same period is 3%, the equity-risk premium will be 3.5% for this equity over that
period of time.
There is no universally agreed method to calculate the equity-risk premium, but one simple way is to
compare an equity market’s earnings yield to a sufficiently long-dated government bond. In the US, the
equity-risk premium can be computed as the difference between the earnings yield of the S&P 500 and
the yield on a 10-year US Treasury note.
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The reason behind this premium stems from the risk-return trade-off, in which a higher rate of return
is required to entice investors to take on riskier investments. The risk-free rate in the market is often
quoted as the rate on longer-term government bonds, which are considered risk free because of the low
chance that the government will default on its loans.
4.4 Credit Ratings
Learning Objective
2.3.3 Analyse sovereign, government and corporate credit ratings from an investment perspective:
country rating factors; debt instrument rating factors; use of credit enhancements; investment
and sub-investment grades; impact of grading changes
4.4.1 Country Rating Factors

The ratings agencies assess the creditworthiness of individual countries and assign ratings. Since the
credit crisis, a number of countries have had their credit ratings downgraded and changes to these are
closely watched by the market and have a direct impact on their cost of funding.
Governments have unique powers, such as the ability to raise taxes, set laws, and control the supply of
money, which generally make them more creditworthy than other issuers. As a result, there is a greater
proportion of sovereign ratings at the higher end of the scale compared with other sectors.
The rating agencies use a combination of several quantitative and qualitative variables (economic,
social and political) in order to assign a credit rating to a debtor or to a debt instrument.
When assessing the creditworthiness of sovereign issuers, the ratings agencies will take into account a
number of factors including both political and economic factors.
• Political factors – since the willingness of a government to pay is a crucial factor that distinguishes
sovereign debts from corporate debts, political factors play a key role in determining sovereign
ratings.
• Economic factors – the main economic variables considered are: per capita income; gross domestic
product (GDP) growth; inflation rate; economic development; ratio of foreign debt to GDP; real
exchange rate; and default history.
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Bonds
The relevance of the economic factors that are considered includes the following.
Economic Factors
2
An increase of the per capita income implies a larger potential tax base and a
Per capita income
greater ability for a country to repay debt.
An increasing rate of economic growth tends to decrease the relative debt
GDP growth
burden. Moreover, it may help in avoiding insolvency problems.
A low inflation rate reveals sustainable monetary and exchange rate policies. It
Inflation rate
can also be seen as a proxy of the quality of economic management.
Economic Developed countries are integrated within the world economy and are less
development inclined to default on their foreign debt in order to avoid sanctions from lenders.
A large current account deficit implies the dependence of a country on foreign
Current account
creditors. A persistent deficit affects the country’s sustainability.
Foreign debt/GDP This ratio is negatively related to default risk.
Real exchange
The real exchange rate assesses the trade competitiveness of the economy.
rate
Default history A country’s default history affects its reputation.
Ratio debt/GDP The higher this ratio is, the greater the occurrence of a liquidity crisis.
Ratio reserves/
The higher this ratio is the more reserves are available to service foreign debt.
imports
Ratio investment/ This ratio captures the future growth ability of a country and it is a decreasing
GDP function of default.
These provide a means of evaluating the governance of a country and affect a
Rule of law
country’s willingness to pay.
4.4.2 Debt Instrument Rating Factors

The financial obligation to which a rating refers is usually a bond or similar debt instrument rather than
the issuer as a whole.
The company wishing to raise money by issuing a bond relies on an independently verified credit
rating to inform potential investors regarding the relative ability of the company to meet its financial
commitments. The agencies themselves make it clear that they are not in the business of recommending
the purchase or sale of any security, but only address credit risk.
There are two types of issued credit ratings, dependent upon the length of time for which the financial
obligation is issued. There are long-term issue credit ratings and short-term issue credit ratings, each
with their own set of standards. The latter relate to obligations which were originally established with a
maturity of less than 365 days (and to short-term features of longer-term bonds).
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Ratings may be public or private. They provide opinions, not recommendations, and are derived from
both audited and unaudited information.
It is important to appreciate that credit ratings are tailored to particular sectors. Ratings should be
comparable across different sectors, but a rating may serve a very specific purpose in, say, the banking
or insurance sectors; for example, the likelihood of a bank running into serious financial difficulty
requiring support, and whether it would get external support in such an event. This obviously has no
equivalent outside the financial sector.
The credit rating for a particular instrument is not meant to be a recommendation to an investor to buy,
sell or hold onto the instrument. That is a decision for individual investors based on their appetite for
risk. The debt instruments with the lowest credit ratings will carry the highest levels of potential reward
but also the highest levels of potential risk.
4.4.3 Use of Credit Enhancements

Credit enhancement refers to a process where measures are taken to ensure bonds have the required
credit rating for investors by enhancing their security.
Issues such as ABSs are credit enhanced in some way to gain a higher credit rating. The simplest method
of achieving this is through some form of insurance scheme that will pay out should the pool of assets
be insufficient to service or repay the debt.
Examples of credit enhancement include:
• Over-collateralisation.
• Pool insurance.
• Senior/junior note classes – rights of junior note class are subordinated and do not receive payments
until certain agency rating requirements have been met, specifically satisfactory performance of the
collateral pool over a period or until senior note classes have been redeemed.
• Margin step up – bonds are usually structured with a call date and to make sure the issuer does not
pass on this, provision for the coupon to be stepped-up.
• Excess spread – the difference between the return on the underlying assets and the interest-rate
payable on bonds is used to cover expenses and losses. Any surplus is held as a reserve against
future losses.
• Substitution – this enables the issuer to utilise principal from redemptions to purchase new
collateral so lengthening the effective life of the bond.
4.4.4 Investment and Sub-Investment Grades

Although the three rating agencies use similar methods to rate issuers and individual bond issues, the
rating each gives often differs, though not usually significantly so. The scope of this analysis has recently
been widened to take account of the size of an issuer’s pension scheme deficit and, following the
collapse of Enron, the nature and extent of its off-balance sheet liabilities.
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Bonds
Bond issues subject to credit ratings can be divided into two distinct categories: those accorded an
investment grade rating and those categorised as non-investment grade or speculative. The latter are
also known as high-yield or junk bonds. Investment grade issues offer the greatest liquidity. The table
below shows the credit ratings available from the three companies.
2
Bond Credit Ratings
Standard
Credit Risk Moody’s Fitch Ratings
& Poor’s
Investment Grade
Highest Quality Aaa AAA AAA
High Quality Very Strong Aa AA AA
Upper Medium Grade Strong A A A
Medium Grade Baa BBB BBB
Non-Investment Grade
Somewhat
Lower Medium Grade Ba BB BB
Speculative
Low Grade Speculative B B B
Poor Quality May Default Caa CCC CCC
Most Speculative Ca CC CC
No interest being paid or
C D C
bankruptcy petition filed
In Default C D D
(Standard & Poor’s and Fitch Ratings modify their ratings by adding a plus or minus sign to show relative
standing within a category, whilst Moody’s do the same by the addition of a 1, 2 or 3.)
The highest grade corporate bonds are known as AAA or Aaa and these are bonds that the three
agencies have deemed the least likely to fail.
Bonds rated in the BBB category or higher are considered to be investment grade. Very few organisations,
with the exception of supranational agencies and some western governments, are awarded a triple-A
rating, though the bond issues of most large corporations boast an investment grade credit rating.
Securities with ratings in the BB category and below are considered high-yield or below investment
grade. While experience has shown that a diversified portfolio of high-yield bonds will have only a
modest risk of default, it is extremely important to remember that the higher interest-rate that they
carry is a warning of higher risk.
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4.4.5 Impact of Grading Changes
Ratings are regularly reviewed and are often revised in the light of changed economic conditions and/or
changes in the outlook for an industry or the issuer’s specific circumstances.
Rating agencies will signal they are considering a rating change by placing the security on credit watch
(S&P), under review (Moody’s) or on rating watch (Fitch Ratings).
Most revisions result in credit downgrades rather than upgrades. The price change resulting from a
credit downgrade is usually much greater than for an upgrade, given that the price of a bond can fall all
the way to zero, whereas there is a limit to how high a bond’s price can rise. A downgrade will also make
raising future finance more expensive for the bond issuer as investors will demand a higher return for
the higher risk.
As a result of taking on large amounts of additional debt to finance their acquisition of third generation
(3G) telecom licences in 2000, the bond issues of many large telecom companies suffered severe credit
downgrades and, as a consequence, experienced an indiscriminate marking down in the prices of their
bond issues.
More recently, ratings changes for eurozone countries saw the cost of borrowing rise over concerns that
they might follow the same route as Greece. Its rating was downgraded to BB+ in April 2010, making it the
first Eurozone country to have its debt downgraded to junk status, and in 2011 to CCC, branding it with the
lowest credit rating of any government in the world. Investors demanded higher returns to compensate
for the increased risk, making it highly expensive for the country to borrow from the debt market. The
downgrading of Greek debt to junk status led to an emergency package to support the Greek economy
and eventually to bondholders having to accept a write-down on the value of their bonds.
4.5 Bond Pricing
Learning Objective
2.3.4 Understand how bond prices are calculated and the main methods of quotation: differences in
yield, spread and price quotation methods; spread over government bond benchmark; spread
over/under LIBOR or other benchmark rate; spread over/under swap rates
As we saw earlier the price of a bond is the sum of the present values of the bond’s cash flows discounted
at an appropriate rate. That discount rate will vary from issuer to issuer.
In the corporate bond market, unlike the government bond markets where it is assumed that no
sovereign borrower will default, the determination of the likelihood that a corporate borrower may
default is a vital part in the pricing mechanism for corporate bonds.
The price of a corporate bond will be influenced by the prices (and inversely to the yields) on an
equivalent government bond. However, the corporate bond’s price will usually be subject to a discount
to represent the risk that the corporate may default compared with the risk-free default nature of the
government bond.
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Bonds
Credit rating agencies provide a rating system for corporate bonds. The highest-grade corporate bonds
are known as AAA or Aaa and these are bonds that these agencies have deemed the least likely to
fail. Companies such as General Electric (GE) have been given this status, although there is always the
possibility of a downgrade when the perceived riskiness of the borrower changes.
2
Lower-grade corporate bonds are perceived as more likely to default, where the borrower will have to
entice lenders with a higher coupon payment and higher YTM. Equally, there is also a chance they may be
upgraded in the near future and, therefore, may be considered as a potential good investment.
Financial analysts and investment professionals will pay close attention to spreads in the bond markets.
A spread is simply the difference between the yield available on one instrument and the yield available
elsewhere. It is usually expressed in BPs. A BP is equal to 0.01% which means that a 100 BP uplift or
premium is equal to 1%.
Spreads
• Spreads are commonly expressed as spreads over government bonds.
Spread
• For example, if a ten-year corporate bond is yielding 6% and the equivalent ten-
Over/Under
year gilt is yielding 4.2%, the spread over the government bond is 6% – 4.2% =
Government
1.8% or 180 basis points.
Bond
• This spread will vary, mainly as a result of the relative risk of the corporate bond
Benchmark
compared to the gilt, so for a more risky corporate issuer, the spread will be greater.
• Spreads are also calculated against other benchmarks, such as the published
interest rates represented by LIBOR.
• Because the government is less likely to default on its borrowings than the major
Spread Over/ banks (that provide the LIBOR rates), the spread of instruments versus LIBOR will
Under LIBOR generally be less than the spread against government bonds.
• In the earlier example, if the equivalent LIBOR rate was 4.5%, the spread over
LIBOR would be 6% – 4.5% = 1.5% or 150 BPs, compared to the 180 BP spread over
government bonds.
• There is a very active market in exchanging floating rates for fixed rates in the
so-called swaps market. Also CDSs, which are a form of insurance against the
risk of borrowers defaulting on their debt, are some of the most actively traded
instruments each day in the capital markets.
• The rates available on various swaps – both for corporate credits and also
sovereign credits – are also used as benchmarks against which to measure the
Spread Over/ yield available on any specific security.
Under Swap • The swap spread is the difference between the ten-year Treasury and the swap
Rates rate, which is the fixed rate on a LIBOR-based interest-rate swap.
• Under normal market conditions, the ten-year Treasury yield will be lower than
the swap rate, reflecting the credit quality of the US government versus that of the
participants in the interbank credit markets.
• In general terms, the swap spread is defined as the difference between the swap
rate and yield of (on-the-run) government bonds of equal maturity (on-the-run
means the most recent issuance of a US Treasury bond or UK gilt).
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The specific features of a bond can mean that pricing off a benchmark security/rate becomes more
difficult. For example, a ten-year corporate bond, with a put/call feature, is unlikely to price off the ten-
year gilt but rather a benchmark curve as the estimate of the maturity of the corporate bond is unlikely
to coincide with the specific maturity of the given gilt because of the put/call feature.
The term pricing off simply means the price/value of one thing – here a bond – being determined from
the price/value of something else – here another bond.
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Bonds
2
1. A bond has been issued with a nominal value of $1,000 repayable in six years’ time at a price of $880
and pays no interest. What type of bond is this and how might it be used in meeting the needs of a
client?
2. A US government bond has been issued that is repayable in exactly ten years’ time. If the bond is
stripped how many STRIP instruments will be created?
3. In what order will the following types of bonds typically be placed with the most secure first:
• Senior secured
• Senior unsecured
• Senior subordinated
• Junior subordinated
• Mezzanine
4. A financial institution has issued a ten-year bond that contains a call option exercisable in five years’.
What other feature might you expect to see attached to the bond?
5. A recent government bond auction is reported to have a bid-to-cover ratio of 2.1. What does this
indicate?
6. A 5% Treasury bond has a bid/offer quote of 103:105. If an investor were to sell $1,000 nominal
of stock what would the total consideration for the transaction be (ignoring brokerage charges)
assuming that there were 184 days in the coupon period and 92 days since the past coupon payment
date?
7. A convertible bond is priced at $120 and is convertible into the ordinary shares of the issuer at a
rate of 15 shares per $100 nominal. What price would the ordinary shares need to reach to make
conversion worthwhile?
8. If a bond is priced at 110, has a coupon of 5% and is due to be repaid in exactly five years’ time, what
is its approximate GRY using the Japanese calculation method?
9. A bond is currently priced at 110, has a duration of 9.5 and required yields are 5%. What would
happen to the price if interest rates were to rise by 1%?
10. If a bond’s credit rating changed from BBB to BB, how would you expect this to affect its price?
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84
Chapter Three
Equities
3
1. Characteristics and Types of Equities 87
2. Returns 108
3. Risks 117
4. Equity Analysis 118

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Equities
1. Characteristics and Types of Equities

Equities represent the risk capital of a company and in this section, we will look at the main types that are
encountered, their characteristics and how they are issued and subsequently traded.
1.1 Characteristics of Equities
3
Learning Objective
3.1.1 Analyse the investment characteristics of equities: types – ordinary and common shares;
preference or preferred shares; rights – dividends; voting; pre-emption
A company’s share capital can be broadly divided into two distinct classes of share:
• ordinary shares or common stock;

• preference shares or preferred stock.
1.1.1 Ordinary Shares

The ownership of a company is represented by the number of shares that an investor owns and these
are known as ordinary shares or common stock. Which term is used depends upon the convention in a
market but essentially they represent the primary risk capital of a company.
Risk Capital
This can be readily understood by considering that buying a company’s shares confers what is known
as an equity interest in the company, that is, a direct stake is taken in the company’s fortunes. If the
company does well the investor can expect to share in that success, but if it were to go bust, the investor
could potentially lose the total value of their investment. They are only entitled to receive what is left
over once all other claims on the company’s resources have been settled.
Over the longer term, ordinary shareholders have been handsomely rewarded for assuming this equity
risk, though in the short-term they have generally experienced a greater volatility in returns than any of
the other main asset types.
Nominal Value
Ordinary shares are usually referred to as ordinary £1 shares, ordinary 25p shares or some similar
variation, with the amount – £1 or 25p – representing what is known as their nominal value.
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Nominal Value of Shares
When a company is first created, individuals come together and subscribe funds to form the company.
They may subscribe equal amounts or different ones, but they will obviously have a share in the company.
This ownership or part share in the company is represented by the number of shares they have in the
business.
For example, imagine two individuals decide to create a company to undertake business and the initial
amount of capital that is subscribed by both is £100 but that investor A subscribes £60 and investor B
subscribes £40. At the outset of the business, investor A clearly owns 60% and investor B owns 40%. This
ownership is reflected in the number of shares that are allocated to them.
They could decide to set the nominal value of shares in the company at £1, in which case investor A will
have 60 ordinary £1 shares and investor B will have 40 ordinary £1 shares. Their respective shareholdings
determine the amount of the business that they own and how profits will be shared in the future.
The nominal value of the shares in this case is £1. At the outset of the company, it was worth £100; the
cash both subscribed. As the business progresses, the value of the business will hopefully grow and let’s
assume that very quickly it is worth £10,000. The shares remain as ordinary £1 shares but they own 60% or
40% of a business worth more than that. This is why they are referred to as having a nominal value of £1.
The nominal value is of no special significance except where a company wishes to issue further shares,
when it must do so at or above this price, and in the event of the company going into liquidation.
Shares of No Par Value

Some countries have ordinary shares that have no par value. The US is the most obvious example where
ordinary shares are instead referred to as common shares or common stock.
There is an international trend for countries that issue shares with a nominal value to move to a system
of no-par value as it is seen to provide companies with greater flexibility in structuring their share capital.
It is generally accepted that par value does not serve its original purpose of protecting creditors and
shareholders, and in fact may even be misleading because the par value does not necessarily give an
indication of the real value of the shares.
It is considered that retiring the concept of a nominal or par value creates an environment with greater
clarity and simplicity and is more desirable for the business community generally. Jurisdictions that have
adopted mandatory no-par value shares include Australia, Hong Kong, New Zealand and Singapore.
Partly Paid Shares

Under company law, a company’s shareholders have what is known as limited liability. This means that they
have no personal liability for the payment of the company’s debts and their liability extends only to the
extent of any outstanding payment on the nominal value of the company’s shares held if issued partly paid.
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Equities
Partly Paid Shares

Staying with the example above, let’s assume that instead of paying the full nominal value of each share
when the business is incorporated both investors only paid half. In that case, they would still own 60
ordinary £1 shares but they would be described as partly paid. In this example, they are 50p paid (£0.50)
reflecting that they only paid half of the amount due.
Should the business not go as planned and it has debts beyond what it owes, as an ordinary shareholder
3
they have a liability for payment of those debts. Under the legal concept of limited liability, however,
their liability to make further payments to the company is limited to the unpaid amount. Investor
A would have a liability to subscribe a further £30 – in other words, he committed to subscribe to
60 ordinary £1 shares but paid only half of that and so is liable to pay the remaining amount to the
liquidator of the company. Investor B would similarly be due to pay a further £20.
Redemption
Ordinary shares are typically irredeemable as there is no specified provision for their repurchase by the
company.
Company law usually prevents the redemption of ordinary shares except in the event of a winding up
of the company. A company may, however, issue redeemable shares that can be redeemed, or bought
back, by the company so long as conventional non-redeemable ordinary shares are also in issue.
Redeemable Shares
Publicly listed companies will on occasions issue redeemable shares. This is often done as a way to
return capital to the ordinary shareholders in a tax-efficient manner.
A company must always have conventional ordinary shares in issue and these cannot have redemption
provisions as they represent the equity capital of the company. If a company has been successful and
built up funds, there may come a point where it wants to return some of that capital to the ordinary
shareholders. It could do so by paying dividends or winding the company up and paying the funds to
the shareholders.
Paying this out as dividends may involve significant tax liabilities for some shareholders. An alternative
method is to issue redeemable shares to existing shareholders who will hold these in addition to their
existing shares.
• These redeemable shares will have fixed dates on which the shares can be surrendered to the
company in return for payment of a cash sum and a final date at which the nominal value of the
shares will be paid.
• The range of dates is intended to give shareholders flexibility over when they redeem their shares so
that they can time this to suit their personal tax position best.
• These shares are often referred to as B shares or even C shares to differentiate them from conventional
ordinary shares. They should not be confused with the non-voting shares referred to below.
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Other Types of Shares
Other types of shares include:
• Non-voting shares – often designated as either A or B shares, these rank equally alongside other
ordinary shares in all other respects.
• Deferred shares – in order to retain an element of control, a company’s original promoters may
have deferred, or founders’, shares that confer enhanced voting rights in exchange for their right to
a dividend being deferred for a set period.
For publicly listed companies that are quoted on a main market such as the LSE, it is rare to see non-
voting shares or deferred shares. They are more regularly encountered with unlisted companies or
smaller companies that only have a relatively small proportion of their shares listed on a stock exchange.
1.1.2 Preference Shares

In addition to ordinary shares, companies can also issue preference shares or preferred stock. Financial
institutions, such as banks, have been regular issuers of preference shares.
Preference shares rank ahead of ordinary shares for the payment of dividends and for capital repayment
in the event of the company going into liquidation. They are usually only entitled to a fixed rate of
dividend based on the nominal value of the shares, so a 6% preference £1 share would pay a net annual
dividend of 6p per share. The dividend is payable only if the company makes sufficient profits and the
board of directors declares payment of the dividend.
Types of Preference Shares

Most preference shares in issue are cumulative which means they are entitled to receive all dividend
arrears from prior years before the company can pay its ordinary shareholders a dividend. Normally,
they do not carry voting rights except when the dividend is in arrears.
Other types of preference shares include:
• Participating preference shares – in addition to the right to a fixed dividend, these shares are also
entitled to participate in the company’s profits if the ordinary share dividend exceeds a pre-specified
level.
• Redeemable preference shares – these are issued with a predetermined redemption price and
date. Some redeemable preference shares are issued as convertible preference shares.
• Convertible preference shares – these preference shares, as well as having a right to a fixed dividend,
can be converted by the preference shareholder into the company’s ordinary shares at a pre-specified
price or rate on pre-determined dates. If not converted, then the preference shares simply continue to
entitle the shareholder to the same fixed rate of dividend until the stated redemption date.
Convertible Preference Shares

Convertible preference shares are usually issued in the following circumstances:
• Takeovers – the bidding company in a takeover will issue convertible preference shares to the
target company’s shareholders, so as to defer the dilution of the bidder’s ordinary share capital or to
provide an enhanced income for accepting shareholders.
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Equities
• Company restructuring – companies undergoing a capital restructuring may issue convertible

preference shares to their creditors in exchange for waiving outstanding debts.
Convertible preference shares will have a specified conversion ratio which sets out how many
convertible shares can be converted into one ordinary share. As a result, a conversion premium or
discount can be calculated.
3
Formula
The conversion premium/discount is calculated as follows:
[ (Conversion
_________ ratio
_________ × market
_________ price of_________
__________________
Market price of ordinary shares
convertible
_________shares)
_________ – 1
] x 100
The conversion ratio in the formula refers to the number of convertible preference shares that have to
be converted into one ordinary share.
If it is at a discount the convertible is a less expensive way of buying into the ordinary shares than
buying these shares directly. This happens when the price of the convertible has lagged behind the rise
in the ordinary share price or offers a relatively less attractive rate of dividend. The opposite is true if the
convertible stands at a premium.
The calculation and its use can be seen by looking at the following example.
Example
A company has issued 7% cumulative redeemable preference shares at $1.10. They are currently priced
at $1.25 per share and can be converted into the company’s ordinary shares at the rate of five preference
shares for one ordinary share.
If the ordinary shares are priced at $6.00, the conversion premium or discount is calculated as follows:
[ (5 ×_________
______ 1.25)
6.00
–1
] x 100 = 4.2%
The result shows that the convertible shares are at a premium to the ordinary shares and so buying
the convertible preference shares is a more expensive route than buying the ordinary shares directly.
However, the fixed rate of dividend currently being paid on the preference shares may be sufficiently
attractive, when compared with that being paid on the ordinary shares, to justify the premium.
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The fact that the shares are at a premium also indicates that it would not be worth exercising the option
to convert into ordinary shares. This can be seen by simply comparing the respective values of the
shares as follows:
Shares No of Shares Price Market Value
Convertible Preference Shares 5 $1.25 $6.25
Ordinary Shares 1 $6.00 $6.00
When considering whether to convert the shares, an investor will also look at the effect that conversion
will have on the income received.
1.1.3 Characteristics
Some of the key characteristics of shares are considered below.
Bearer and Registered Shares

An investor’s share of a company is determined by the number of shares they own and these shares can
be either registered or bearer.
When a company is first created, individuals come together and subscribe funds to create the company
and in exchange receive shares in the company to reflect that ownership. Share ownership is usually
recorded in a register of shareholders, hence the name registered shares.
The alternative to registered share ownership is bearer.
Bearer
This involves issuing a certificate to represent the number of shares or nominal value of a bond that an
investor owns but the fundamental difference is that there is no name on the certificate. The company
therefore only keeps a record of the certificate issued and each has a unique number to identify it.
As there is no name on the certificate or register, transfer of ownership takes place simply by passing the
certificate on to another person. The person who holds the certificate – the bearer – is the owner.
In practice, bearer shares are held by a CSD to overcome the problems that would otherwise arise of lost
share certificates and the risk of them being used by criminals to launder money.
Bearer is the method often used for eurobond and other international bond issues.
Book Entry Transfer

A private company will typically issue a share certificate to each shareholder to show the number of
shares they hold. The share certificate records the number of shares they hold and their name but it is
the entry in the share register that is definitive proof of ownership.
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Equities
In the past, when a shareholder wanted to sell their shares to another person this involved completing
a transfer form and then sending the share certificate and the form to the company so that their
ownership could be cancelled and the new owner’s name entered on the share register.
This was inefficient and lead to delays and difficulties settling share transactions. As a result, today it is
normal for ownership of shares to be held electronically and for transfer of ownership to take place by
amending this electronic record. This process is known as book entry transfer.
3
All developed markets require shares to be held and settled in this way. The shares held in this way may
be referred to as immobilised or dematerialised.
• Immobilised – refers to where share certificates are still issued but they are held in a central vault
and not issued to shareholders, hence the term immobilised.
• Dematerialised – was a process that was developed later and involves dispensing with the
certificate altogether.
In most markets, there will be one organisation responsible for holding the electronic records and
settling trades, known as a central securities depository or CSD. For example, in the US this is undertaken
by the Depository Trust Corporation (DTC) and in the UK by Euroclear.
Shareholder Rights
Ordinary shareholders are entitled to a number of rights, which will be specified in the company’s
constitutional documents such as the Articles of Association.
Rights of Shareholders
Ordinary shareholders own the company but the day-to-day control of the company is undertaken by
the board of directors which is empowered to act on behalf of the company. A shareholder is a part
owner in that business and the board of directors are running it on their behalf. Although they have
authority to run it, the shareholders need a mechanism to ensure that they can be held accountable for
the actions they undertake on behalf of the owners and have a say in certain key issues affecting the
company. This is the reason why shareholders need certain legal rights.
The rights of ordinary shareholders include the following:
• Being notified in advance of all company meetings and attending and voting on resolutions put by
the directors at these meetings.
• Receiving a copy of the company’s annual and interim report and accounts.
• Sharing in the profits of the company through the payment of dividends.
• Subscribing for new ordinary shares issued to raise additional capital before they are offered to
outside investors.
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These are considered further below.
Shareholder Rights
• Shareholders need to hold the directors to account in their management of the
company and they do so through formal company meetings.
• Companies are required to hold AGMs and further extraordinary meetings when
Company
certain special proposals need the approval of the shareholders, the owners. (An
meetings
example would be a proposed takeover of the company.)
• Shareholders must be notified in advance of all company meetings and there are
formal notice periods that must be adhered to.
• The board of directors are required to present the annual report and accounts to
shareholders at the AGM.
• The purpose is to seek shareholder endorsement of their management of the
Reports and business during the period, which is achieved by asking shareholders to vote on a
Accounts resolution to accept the accounts.
• Whilst this may appear a formality, if the shareholders were to vote against
acceptance then this would leave the board with no option but to tender their
resignation.
• The directors present resolutions to the shareholders at company meetings and
ask them to vote in favour in order to obtain their approval.
• Shareholders are entitled to attend meetings and vote on the resolutions put by
Voting
the directors at these meetings.
• A shareholder typically has one vote per share and can attend and vote in person
or appoint a proxy to attend and vote on their behalf.
• Shareholders are the owners of the company and participate in the profits made
through the payment of dividends.
Sharing in • The board of directors is empowered to run the company and their powers include
profits determining whether there is sufficient profit to warrant payment of a dividend.
• It is for the directors to propose that a dividend be paid and up to the shareholders
to decide whether they agree with the proposal by voting on this at the AGM.
• Shareholders are the owners of the company and if the company wants to raise
Subscribing additional equity capital they must first seek shareholder approval.
for new • This is known as a pre-emption right as the company must seek approval from
ordinary shareholders to do so and must allow existing shareholders to subscribe additional
shares capital before they are offered to outside investors.
• Not all countries have pre-emption rights.
Ranking for Dividends

A dividend is a payment, or distribution, to shareholders out of the profits of the company.
Ordinary shareholders represent the owners of a company and so are entitled to participate in the
profits of a company. They typically participate in profits by payment of dividends from the profits the
company has made, although there are other ways in which they may do so. As a result, they can only do
so once all other obligations of the company have been met.
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Equities
Preference shareholders have a prior claim on payment of their dividend, hence the use of the term
preference in their title. Preference shares are typically entitled to a fixed dividend of a certain
percentage of the nominal value of the shares and this must be paid before any dividend can be
declared and paid to ordinary shareholders. Unless the preference shares are non-cumulative, any
arrears of dividends from a previous year is paid first, followed by that year’s dividend and then only if
there is sufficient profit remaining can an ordinary share dividend be declared.
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Ranking in Liquidation
Equity capital is the risk capital of a company and so is the last to be paid out in the event of liquidation
of a company.
On the liquidation of a company, a liquidator is appointed whose role is to realise its assets and then use
the proceeds to pay its debts and return any surplus to shareholders. The order in which these are paid
will vary from country to country but the key point to note is that preference and ordinary shareholders
are paid out only after all other claims are met.
As with dividend payments, preference shareholders have priority over ordinary shareholders.
Preference shareholders would receive back the nominal value of the shares held if sufficient funds
remain; ordinary shareholders are entitled to share the funds that remain, if any.
1.2 Depositary Receipts (DRs)
Learning Objective
3.1.2 Analyse the characteristics of depositary receipts; depositary receipts (DRs) – types; issue
process; rights to dividends and other events; depositary receipts; globally registered shares
Investor demand for international shares is growing and is driven by the increasing desire of individual
and institutional investors to diversify their portfolios globally, reduce risk, and invest globally in the
most efficient manner.
Investing overseas can, however, be an expensive process involving additional brokerage costs, custody
costs and foreign exchange (FX) conversions. Depositary receipts (DRs), depository interests and
globally registered shares help overcome some of these hurdles.
1.2.1 Depositary Receipts (DRs)

DRs provide a cost effective and simple way of investing in overseas companies without the higher costs
that are normally associated with owning foreign shares.
A DR is a negotiable instrument that represents an ownership interest in securities of a foreign issuer

typically trading outside its home market. The two common types that are encountered are:
• American depositary receipts (ADRs).

• Global depositary receipts (GDRs).
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American Depositary Receipts (ADRs)
ADRs were introduced in 1927 and were originally designed to enable US investors to hold overseas
shares without the high dealing costs and settlement delays associated with overseas equity
transactions.
• An ADR is dollar-denominated and issued in bearer form, with a depository bank as the registered
shareholder.
• They confer the same shareholder rights as if the shares had been purchased directly.
• The depositary bank makes arrangements for issues such as the payment of dividends, also
denominated in US dollars, and voting via a proxy at shareholder meetings.
• The beneficial owner of the underlying shares may cancel the ADR at any time and become the
registered owner of the shares.
The US is a huge pool of potential investment and so ADRs enable non-US companies to attract US
investors to raise funds. ADRs are listed and freely traded on the NYSE, American Stock Exchange (AMEX)
and NASDAQ. An ADR market also exists on the LSE.
Each ADR has a particular number of underlying shares, or is represented by a fraction of an underlying
share.
Example
Volkswagen AG (the motor vehicle manufacturer) is listed in Frankfurt and has two classes of shares
listed – ordinary shares and preference shares. There are separate ADRs in existence for the ordinary
shares and preference shares. Each ADR represents 0.2 individual Volkswagen shares.
This gives investors a simple, reliable and cost-efficient way to invest in other markets and avoid
high dealing and settlement costs. Other well-known companies, such as BP, Royal Dutch Shell and
Vodafone, have issued ADRs.
Global Depositary Receipts (GDRs)

ADRs are not the only type of depositary receipts that may be issued. Those issued outside the US are
termed global depositary receipts (GDRs). These have been issued since 1990 and are traded on many
exchanges.
GDRs are increasingly issued by Asian and emerging market issuers. For example, more than 400 GDRs
from 37 countries are quoted and traded on a section of the LSE. GDRs are also listed and traded in
Luxembourg, Singapore and Dubai.
The rise of sophisticated international markets has driven a shift since 2001 toward GDRs as global
corporations increasingly seek to raise capital in the international markets. In some cases, GDRs
are created not to raise capital but to establish a presence in a new market in order to increase the
company’s visibility and pave the way for future offerings.
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Issue Process
Listing GDRs on a stock exchange involves using the formal listing process. The company will need to
appoint a sponsor, decide on whether a public offer or placing is most appropriate and meet the listing
requirements of that country.
The percentage of shares that may be converted into DRs will depend on local restrictions on foreign
ownership. Issues of depositary receipts can be either sponsored or unsponsored.
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Sponsored and Unsponsored Programmes
This is where DRs are issued by one depositary appointed by the company under a
Sponsored Deposit Agreement or service contract.
programmes Sponsored DRs give control of the facility to the company, provides flexibility on
which exchange the listing takes place and provides the ability to raise capital.
This is where DRs are issued by one or more depositories in response to market
Unsponsored
demand but without a formal agreement with the company.
programmes
This method is now little used by issuers due to the lack of control and costs.
As mentioned above, the issuer will appoint a depositary bank and enter into a deposit agreement
which defines the depositary’s role and allows it to issue the company’s DRs.
In certain circumstances, the custodian bank may issue depository receipts before the actual deposit of
the underlying shares. This is called a pre-release of the DR and so trading may take place in this pre-
release form. It must be fully collateralised with cash or other acceptable collateral and the underlying
shares must be delivered within a specified time period, usually three months.
Beneficial Ownership Rights

DRs carry most but not all ownership rights associated with the underlying shares.
• DRs provide for dividends to be converted and the net proceeds after deduction of any fees to be
paid out in the currency of the DR, which are typically US dollars.
• Good corporate governance requires that an issuer should give their DR holders the right to vote
in shareholder meetings. The depositary bank will obtain details of meetings and provide details
of voting arrangements to DR holders. They will then receive their voting instructions and provide
the custodian voting instructions and any necessary paperwork for the votes to be included in the
shareholders’ meeting.
• Because of the structure of DRs, it is not possible for rights issues to be taken up and instead the
depository bank will sell the rights and distribute proceeds to DR holders.
Transferability
Once the DRs are listed, they are traded and settled in the same way as other equities.
• The market price of a DR is equivalent to the ordinary share price times the DR ratio multiplied by
the applicable FX rate plus any transaction costs. The DR ratio is the number of underlying shares
that the DR represents.
• DRs are usually priced in dollars although it is possible for them to be established in other currencies.
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• DR certificates are not issued and instead a master certificate is issued to a custodian who is also
known as the common depositary.
• The DRs will typically be held in Europe at either Clearstream or Euroclear and in the US at the DTCC
depositary bank.
• As DRs are issued and cancelled, the number of DRs outstanding goes up and down automatically.
A brief summary of the role of the issuer, the depository bank and the custodian is shown below.
Role of Participants
• Provides notices of shareholder meetings
• Pays corporate distributions
• Meets ongoing listing obligations
• Issues DRs against deposit of local shares with the custodian
• Handles investor queries
• Converts and pay dividends
• Provides tax withholding documentation
• Registers shares in depositary account with issuer’s registrar
• Notifies details of corporate actions
• Remits dividends to depository
1.2.2 Depository Interests (DIs)

A depository interest (DI) is a way of holding foreign shares through an investor’s local CSD.
Example
A company can apply to CREST which is the UK central securities depository to have its shares treated as
an international security for depository interest purposes.
CREST will hold accounts at overseas CSDs such as the DTCC in the US, at Euroclear or at SIX for Swiss
securities. Securities are transferred into their account at the overseas CSD and held on behalf of the CREST
member, which means that once traded they can be settled in the same way as domestic securities.
A UK member of CREST will hold its UK securities at CREST in electronic form and the advantage of this
approach is that these international securities can then be held in the same account and settled in the
same way as the other securities they hold.
Some of their key characteristics are:
• The DI has the same ISIN as the international security.

• No separate listing is required.
• There is a 1:1 relationship between the DI and the underlying security.
• Economic rights are unaffected and dividends, interest and other benefits are passed on.
• CDI holders receive notices of meetings and other documents issued by the company.
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1.2.3 Globally Registered Shares

Historically shares have been listed on only one exchange; however, it is becoming increasingly common for
companies that are active in more than one market to list their shares on a number of exchanges. This multi-
listing is leading to the development of globally registered shares as a natural evolution of the DR concept.
This is particularly true of multinational companies whose revenue streams are received in multiple
currencies. However, significant costs can be involved, as the company will incur listing fees on each
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exchange and will have to deal with the complexities of disseminating shareholder information, managing
income distributions, rights issues and other corporate events across shareholders in multiple jurisdictions.
The table below shows a comparison of some of the key characteristics of DRs and globally registered shares.
DRs and Globally Registered Shares

• Shares are listed on a single exchange in a single currency, but DRs can be listed on
multiple exchanges in multiple currencies.
• DRs are generally not transferable across markets.
DRs • The listing requirements for a DR on a stock exchange are typically less stringent
than for a share.
• A DR does not necessarily require the co-operation of the underlying company.
• A DR increases the size of the potential investor community.
• They can be listed on multiple exchanges in multiple currencies.
• They can be transferred across markets.
Globally • The globally registered share has to meet the listing requirements of each exchange
registered on which it is listed.
shares • Its creation is driven by the issuing company.
• It increases the size of the potential investor community and extends the global
reach and global reputation of the issuing company.
1.3 New Issue Process
Learning Objective
3.1.3 Understand the role, structure and characteristics of equity markets: how new equity issues
are undertaken and the role of the participants; order driven and quote driven markets;
on-exchange and off-exchange trading; pre- and post-trading transparency; registration and
safe custody
Recognised stock exchanges, such as the NYSE in the US and the LSE in the UK, are marketplaces for
issuing securities and they facilitate the trading of those securities via the trading and market making
activities of their member firms.
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1.3.1 Primary and Secondary Markets
All stock exchanges provide both a primary and a secondary market.
Primary and Secondary Issues

• The primary market, or the new issues market, is where securities are issued for the
first time.
Primary
• The primary markets exist to enable issuers of securities, such as companies, to raise
market
capital and enable the surplus funds held by potential investors to be matched
with investment opportunities the issuers offer. It is a crucial source of funding.
• The secondary market is where existing securities are traded between investors.
Secondary • Secondary issues or secondary public offerings of shares are often referred to as
market follow-on offering as they refer to an issue of stock subsequent to the company’s
initial public offering.
1.3.2 Initial Public Offerings (IPOs)

The terminology often used is that companies float on the stock exchange when they first access the
primary market.
The process that the companies go through when they float is known as the initial public offering
(IPO). Companies can use a variety of ways to achieve flotation, such as offers for sale, offers for
subscription and placings.
IPO Methods
• Most common method used for an IPO.
Offer for
• Do not necessarily have to issue new shares so are used as a way for founders or
sale
private equity owners to realise part of their investment.
• Only new shares can be issued.
Offer for
• Company issues the prospectus as advised by a sponsor.
subscription
• Then can follow fixed price or tender route.
• Company markets the issue to a broker, issuing house or other financial institution.
• Firms then market to their clients – hence known as selective marketing.
Placing
• No access to the general public.
• Least expensive route but there are often limits on how much can be raised in this way.
To undertake an IPO, a company will appoint an investment bank to advise on the transaction. In
conjunction with a team of advisers, the investment bank will advise on the best method for the capital
raising and undertake due diligence on the company’s financial and legal position.
A listing on a stock exchange involves two applications.
• Companies seeking a listing have to meet stringent entry criteria. These criteria are known as the
listing rules and are administered by the country’s regulator in its capacity as the listing authority.
The listing authority will approve the prospectus and authorise the listing.
• It is then up to a stock exchange to approve them for trading on their exchange, a process known as
admitted to trading.
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Example
In the US, the Securities and Exchange Commission (SEC) requires companies seeking a listing on the US
exchanges to register certain details with the SEC first. Once listed, companies are then required to file
regular reports with the SEC, particularly in relation to their trading performance and financial situation.
In a similar way in the UK, responsibility for the approval of prospectuses and admission of companies
to trade on an exchange lies with the UK Listing Authority (UKLA) which is part of the Financial Conduct
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Authority (FCA). The LSE is then responsible for the admission to trading of companies to the market.
1.3.3 Underwriting
There are no guarantees that an IPO will succeed in selling all of the shares being offered, and, if markets
are going through periods of adversity and turmoil, it is common for an IPO to be withdrawn. New issues
may be sold on a best efforts basis by the manager of the IPO or can be underwritten by an investment
bank or the shares sold in an offering.
A large IPO is usually underwritten by a syndicate of investment banks led by one or more major
investment banks. Upon selling the shares, the underwriters keep a commission based on a percentage
of the value of the shares sold called the gross spread.
1.3.4 Continuing Obligations

When a company applies for a listing on a stock exchange, it must comply with a series of rules and once
listed comply with a series of ongoing obligations.
Among other things, these require a company to promptly make public all price-sensitive information
and issue the annual and interim report and accounts to shareholders within a set timeframe.
Price-sensitive information is information which would be expected to move the company’s share price
in a material way once in the public domain.
• This includes details of any significant change to a company’s current or forecast trading prospects,
dividend announcements, directors’ dealings and any notifiable interests in the company’s shares.
• A notifiable interest is where a shareholder or any parties connected to the shareholder has a certain
percentage interest (typically 3% or 5%) in the nominal value of the company’s voting share capital.
If that is the case, they must inform the company of their holding within two business days.
1.3.5 Dual Listings

Dual listing refers to the fact that many securities are listed on more than one exchange. This can be the
case where a company’s shares are listed and traded internationally both on the LSE and the NYSE, such
as in the case of BP, Vodafone and HSBC.
Dual listing can also refer to stocks trading on more than one exchange within the same jurisdiction. Many
stocks are traded on the New York and other regional exchanges. For example, the common stock of
General Motors is listed on the NYSE but it also enjoys a large amount of activity on regional exchanges.
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Although dual-listing theoretically should improve the liquidity of a stock, thereby benefiting investors,
most dual-listed securities trade chiefly on one exchange.
Dual listing can have other consequences. For example, a UK company with a US listing is obliged to
meet the requirements of the US Sarbanes-Oxley Act on the accuracy of financial statements and is
subject to the US Foreign Corrupt Practices Act.
1.4 Equity Markets
Learning Objective
3.1.3 Understand the role, structure and characteristics of equity markets: how new equity issues
are undertaken and the role of the participants; order driven and quote driven markets;
on-exchange and off-exchange trading; pre- and post-trading transparency; registration and
safe custody
3.1.4 Understand the conventions of equity markets: trading conventions - settlement conventions;
Delivery versus Payment; ex-dividend periods; regulatory considerations - best execution;
timely execution; allocation and aggregation; conflicts of interest
1.4.1 Market Structure

The trading systems provided by exchanges around the world can be classified broadly as either quote-
driven or order driven.
Quote-driven trading systems employ market makers to provide continuous two-way, or bid and offer,
prices during the trading day in particular securities regardless of market conditions. The bid price is the
price that the market maker will pay when you want to sell and the offer price is the price you pay when
you want to buy. Market makers make a profit, or turn, through this price spread. Although outdated
in many respects, many practitioners argue that quote-driven systems provide liquidity to the market
when trading would otherwise dry up. The NASDAQ and the LSE’s SEAQ trading systems are two of the
last remaining examples of quote-driven equity trading systems.
With order-driven systems, the investors indicate how many securities they want to buy or sell and at
what price. The system then simply brings together the buyers and sellers. Order-driven systems are
very common in the equity markets, where the NYSE, the Tokyo Stock Exchange and the LSE’s Stock
Exchange Electronic Trading Service (SETS) are all examples of order-driven equity markets.
On-Exchange and Over-the-Counter Trading (OTC)

Trading can be undertaken both on exchange and off exchange or OTC.
Exchange trading can take place on a regulated market such as Euronext, the LSE or the Frankfurt Stock
Exchange. Alternatively, it can take place through multilateral trading facilities (MTFs) – sometimes
referred to as alternative trading systems.
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MTFs are registered non-exchange trading venues, which bring together purchasers and sellers of securities.
Subscribers can post orders into the system and these will be communicated electronically via an electronic
communication network (ECN), for other subscribers to view. Matched orders will then proceed for execution.
There are two main types of MTF – open-order book-type venues and dark liquidity pools.
Types of MTF
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Open-order-book-type venues provide publicly displayed liquidity.
Open-
These handle predominantly small-ticket, high-volume trading with trades settled via
order book
a central counterparty.
venues
Examples include BATS Europe, Chi-X Europe and Turquoise.
Dark liquidity pools provide anonymous trading.
These execution venues do not display order details publicly, thereby preserving
anonymity of trading parties and minimising the degree to which their trading activity
can impact the market.
Dark pools These dark pool MTFs typically support large ticket size trades at lower trading
volume – and in many cases they will not employ a CCP structure, with the broker
standing as counterparty to the trade and a global settlement agent employed to
provide trade settlement.
Examples include Chi-Delta, Smartpool and LiquidNet.
Although many financial instruments are traded on-exchange, there are times when a complex and
highly structured instrument may be created specifically to meet the specialised investment needs of
an individual client. In this case, it will typically be traded off-exchange or over-the-counter (OTC). Some
derivatives products are widely traded OTC.
Pre- and Post-Trading Transparency

Transparency in the securities markets may be defined as the degree to which information regarding
quotations for securities, the prices of transactions, and the volume of those transactions is made
publicly available.
Pre and Post Trade Transparency

At its broadest level, this could include information accurately indicating the size and
price of prospective trading interest, such as firm quotations in representative size,
and resting limit orders, both at the best firm bid and ask quotations and away from
such quotations.
Pre-trade
Some markets, particularly those that have developed completely automated trading
transparency
markets that display the entire contents of the limit order book for a particular
security, permit total transparency.
Other markets permit lower levels of transparency, such as limiting the display of
quotations to the highest bid and lowest offer.
Post-trade This refers to the dissemination of trade price and volume of completed transactions
transparency from all markets trading that security.
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The level or degree of transparency is an essential determinant of an effective market and regulators
and exchanges work to ensure there is the greatest degree of transparency to permit the investor to
make an informed investment decision.
It is critical to note that pre-trade transparency alone is not sufficient for adequate levels of investor
protection. Even where firm price quotes exist, a substantial number of price-sensitive transactions may
take place between or outside of the spread. Although quotes may help investors decide where and
when to trade, transaction reports help investors determine whether the quotes are reliable, and help
them assess the quality of the markets and executed transactions.
Also, all market participants attempt to anticipate market trends. Without trade and volume information,
there are few warnings of impending market trends. Market participants cannot respond quickly to
selling or buying surges because they do not see them happening.
Maximum transparency requires the dissemination of transaction reports and quotations on a prompt,
real-time basis.
1.4.2 Trading Conventions

When an investment firm deals in or on behalf of a client it is acting either as principal or as an agent.
• Principal trading is when the firm buys or sells an instrument for a client against its own account.
Market makers are firms that maintain a firm bid and offer price in a given security, making
themselves available to buy or sell a specified list of securities at publicly quoted prices within a
specified quoted trade size. The bid price is the price at which the market maker is prepared to
purchase a security from another investor. The offer price is the price at which the market-maker is
prepared to sell that security to the counterparty.
• Agency trading is when a firm acts as an intermediary, or agent, on behalf of a client. Its role is to
find a counterparty with whom it can execute the client’s order.
All orders input to stock exchange order-matching systems must be firm and not indicative orders as,
once displayed, an order must be capable of immediate execution.
Some of the order types that can be used are shown below.
Order Types
• This specifies the number of shares to be bought or sold and is executed
immediately at the best possible price(s).
At best • Placing an order at best can be precarious when two-way trade in a particular
stock is thin, as prices can lose touch with reality, especially at the very beginning
and very end of the trading day.
• These require the investor to specify both the quantity of a particular security to be
traded and a minimum price at which to sell or a maximum price at which to buy.
Limit orders
• A limit order does not have to be executed immediately, and can remain displayed
on the trading system for a certain period of time, such as up to 90 calendar days.
Execute and • These orders are filled in whole or in part at, or better than, the stipulated price
eliminate with any unfilled portion of the order being automatically deleted from the system.
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• If the entire order cannot be filled immediately at a price no worse than that
Fill or kill
stipulated by the investor it is automatically deleted.
• These are a type of limit order which allow market participants to enter large
orders on to the order book with only a certain specified portion of the order – the
Iceberg
peak size – publicly visible.
orders
• The trading system automatically introduces new peaks on to the order book
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following the complete execution of the revealed peak.
Ex- and Cum-Div Trades

Trading inevitably takes place around the time when dividends are to be paid or corporate actions are
underway. As a result, trading conventions have developed to ensure that there is certainty as to whom
a dividend or corporate action benefit belong.
When a dividend payment or corporate action takes place, the issuer needs to identify holders of the
security in order to distribute the event to them. The issuer will therefore announce the event and state
that holders of the security who are registered on its books at close of business on a given day will
benefit. That date is the books closed date or record date.
If trading takes place close to the record date, the exchange sets an ex-date. In the UK for example, equities are
always quoted ex-dividend on a Wednesday and the books closed date or record date is the Friday.
• Trading that takes place before Wednesday is described as cum-dividend which is market shorthand
that the sale of shares is made with (cum) the benefit of the dividend.
• Trading on Wednesday onwards is described as ex-dividend as the sale of shares is made without
(ex) the dividend.
The same principle applies for rights issues and other corporate actions which will have their associated
record dates and ex-dates.
During the ex-dividend period, it is possible to arrange a special cum-trade. This is where, by special
arrangement between the buyer and seller, the buyer of the share during the ex-dividend period does
receive the next dividend. These trades can be done up to and including the day before the dividend
payment date, but not on or after the dividend payment date. In a similar manner to a special cum-trade, an
investor can also arrange a special ex-trade. This is only possible in the ten business days before the ex-date.
If the trade fails to settle in time or there is late registration of the purchaser for whatever reason, they will
still be entitled to the benefit as the trade took place before the books closed date. In such cases, the broker
acting for the purchaser should claim the entitlement from the seller and where necessary, instruct the
seller’s broker to take the desired action under a corporate action in order to protect the buyer’s position.
Settlement
Once a trade has been executed, details of the trade need to be reported to the CSD so that the trade
can settle.
Markets have standard conventions for when a trade is due to settle and the intended settlement date is
usually referred to as T+3 – which means that the trade will settle on trade date plus three business days.
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So, for example, if a security is traded on Monday it will settle three business days later on Thursday.
At that date, ownership of the security moves from seller to buyer and the latter will be on the share
register from that point.
Settlement conventions vary from market to market and some will settle on a much tighter timescale
such as T+1, T+2 or in some cases on trade date itself. For example, from October 2014 the standard
settlement period across Europe is to change to T+2; this means that a trade will be settled two business
days after it is executed so, for example, a trade executed on Monday would settle on Wednesday. As a
result, the dividend timetable which determines when a stock goes ex-dividend will also change.
Transfer of ownership takes place at the CSD in a process known as book entry transfer where electronic
transfer of title takes place. Nearly all markets operate a settlement system that uses a process known as
delivery versus payment (DvP) which involves the simultaneous exchange of securities and cash.
1.4.3 Regulatory Considerations

There are a series of regulatory rules and principles designed to ensure that when trades are undertaken
on behalf of investors, that their interests are protected.
Best Execution
The best execution rules require firms to execute orders on the terms that are most favourable to their
client. Broadly, they apply if a firm owes contractual or agency obligations to its client and are acting on
behalf of that client.
Specifically, they require that firms when executing orders take all reasonable steps to obtain the best
possible result for their clients when executing orders.
The requirements for best execution extend beyond just price and so speed of execution, the likelihood
of execution, the likelihood of settlement, the size and nature of the order, market impact and any other
implicit transaction costs may be given precedence over the immediate price and cost consideration.
For retail clients, best execution is judged by total consideration. Firms must take account of the total
consideration for the transaction; in other words the price of the financial instrument and the costs
relating to its execution, including all expenses directly related to it, such as execution venue fees,
clearing and settlement fees and any fees paid to third parties.
If a firm can execute the client’s order on more than one execution venue, the firm must take into account both
its own costs and the costs of the relevant venues in assessing which will give the best outcome.
Its own commissions should not allow it to discriminate unfairly between execution venues, and a firm
should not charge a different commission or spread to clients for execution in different venues if that
difference does not reflect actual differences in the cost to the firm of executing on those venues.
Timely Execution
Instructions to trade on behalf of a client should also be executed in a timely fashion and in such a way
that conflicts of interest are avoided.
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This requires firms to have procedures and arrangements which provide for the prompt, fair and
expeditious execution of client orders, relative to other orders or the trading interests of the firm.
A conflict of interest might arise as a result of front running. The practice of front running or pre-
positioning – dealing ahead of customer orders – has long been considered unacceptable, since it takes
advantage of knowledge of the order and its likely impact on the trading price. It is a form of market abuse.
3
Orders should be placed in the order in which they arrive so that they are placed in due turn. This is to
prevent the orders of one client being given preferential treatment over those of another.
Aggregation and Allocation

Firms must only aggregate their own-account deals with those of a client, or aggregate two or more
clients’ deals, if:
• This is unlikely to disadvantage any of the aggregated clients.

• The fact that aggregation may work to their disadvantage is disclosed to the clients.
• An order allocation policy has been established, which provides, in sufficiently precise terms, for the
fair allocation of transactions. This must cover how volume and price of orders will affect allocation;
it must also cover how partial allocations will be dealt with.
If an aggregated order is only partly executed, the firm must then allocate the various trades in order
with this allocation policy.
If firms have own-account deals in an aggregated order along with those of clients, it must not allocate
them in a way which is detrimental to the clients. In particular, it must allocate the client orders in
priority over its own, unless it can show that without the inclusion of its own order, less favourable terms
would have been obtained. In these circumstances, it may allocate the deals proportionately.
The firm’s order allocation policy must incorporate procedures preventing the reallocation of own-
account orders aggregated with client orders, in a way detrimental to a client.
Conflicts of Interests
The rules on conflicts of interest require that firms take all reasonable steps to identify conflicts of
interest between:
• the firm and its employees or agents and a client of the firm;
• one client of the firm and another.
Firms are expected to maintain and apply effective organisational and administrative arrangements
designed to prevent conflicts of interest from adversely affecting the interests of their clients.
Conflicts of interest rules apply where a firm owes a fiduciary duty to its clients and a conflict arises
between its own interests and those of the client. From an investment management perspective,
conflicts can arise in how a trade is executed, hence the rules on best execution, timely execution and
how they are aggregated and allocated.
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2. Returns
Learning Objective
3.2.2 Analyse the impact of mandatory and voluntary corporate actions on equity holdings: income
events – dividends; dividends with options; capital events – bonus issues; stock splits; reverse
stock splits; capital raising events – rights issues; open offers; placings
Some of the key benefits of holding shares are:
• dividends;
• capital gains;
• shareholder benefits;
• the right to subscribe for new shares;
• the right to vote.
The returns from holding equities are derived mainly from dividends and the prospects for capital growth.
2.1 Income Events
2.1.1 Dividends
Day-to-day management of a company is undertaken by the board of directors and their power to run
the company extends to whether a dividend can be paid. The board determines whether the company
is sufficiently profitable to pay a dividend and if so, how much. They present a resolution to the ordinary
shareholders requesting approval of the proposed dividend and the ordinary shareholders vote
whether to accept or reject the resolution.
Right to a Dividend
It should be noted that ordinary shareholders participate in profits by way of dividends but that they do
not have any right to a dividend; it is up to the board to propose payment of dividends.
The frequency with which companies pay dividends varies: some companies pay one dividend a year,
some pay two dividends a year and some pay four dividends.
• If more than one dividend is paid, the earlier dividends are called interim dividends and the last
dividend is called a final dividend.
• The interim dividend is paid after the results for the first six months of a company’s financial year
have been announced.
• Before declaring an interim dividend, the directors must satisfy themselves that the financial position
of the company warrants the payment of such a dividend out of profits available for distribution.
• The final dividend is paid after the AGM has approved the accounts and the dividend for the full
financial year.
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The board has to operate within a set of rules that limit its ability to pay dividends.
To ensure that the assets of a company are not depleted at the expense of the creditors, company law
restricts the type of profit which can be distributed to shareholders.
Companies can pay dividends out of current year’s profits and out of reserves.
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Profits and Reserves
• Profits and losses can be divided into two types: realised and unrealised.
• Realised profit is one which has arisen from a real transaction. For example, if a
company sells an asset it will make, or realise, a profit or a loss on the transaction.
• Unrealised profit is one which arises simply because the asset has increased in value
Profits
but has not been sold. For example a company may buy a building for 1 million and
in three years the building may be worth 1.6 million. The company may recognise the
increase in value in its accounts, but the profit of 0.6 million is unrealised; it has not
arisen from a sale. An unrealised profit is sometimes referred to as a book profit.
• Reserves are undistributed profits that have not been distributed to shareholders.
• Net realised profits can be distributed as a dividend but unrealised profits cannot be
distributed.
• This means that revenue reserves can be paid out to shareholders. So, for example,
Reserves
if a company has made insufficient profit to cover a dividend they can still pay a
dividend using their reserves or previous year’s profit.
• Once reserves have been capitalised, such as when a bonus issue takes place, they
can no longer be distributed.
Dividends are paid to shareholders whose names appears on the share register. Because shares are
continually changing hands the share register is inevitably behind the actual trading of the shares and so
there is a defined process and a well-established timetable in place for the payment of dividends so that
investors, both buyers and sellers, know exactly what their entitlements are and nothing is left to chance.
Stock exchanges publish dividend procedures annually to document the defined process that companies
need to follow. There are three key dates in the payment of dividends for registered securities:
• ex-dividend date;
• record date;
• payment date.
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Dividend Dates
• The amount of the dividend is announced several days before the ex-dividend day.
• On the ex-dividend day, the share trades without the right to the next dividend
Ex-dividend
payment; they are said to be ex-dividend.
date
• Prior to the ex-date the shares are said to be trading cum-dividend.
• In theory, on the ex-date the share price should fall by the amount of the dividend.
• The record date is the day on which the company closes its share register for the
purpose of the payment of dividends and is sometimes known by its alternative
Record date name of books closed date.
• In other words, the company will pay the dividend to those persons recorded as
shareholders on the register of shareholders on the record day.
Payment • The dividend payment day is the day on which the shareholder will receive the
date dividend, either by cheque or bank transfer.
2.1.2 Dividends with Options

Instead of paying a cash dividend, a company may choose to provide options as to how it is paid. Some
of the main types encountered are:
• scrip or stock dividends.

• dividend reinvestment plans.
Instead of distributing dividends to shareholders as a cash payment, a company may choose to pay the
dividend instead in the form of new shares in the company. Such a dividend is called a scrip or stock
dividend and is offered as an alternative to receiving the cash dividend.
Example
A company has a share price of $2.00 and pays a dividend of $0.08 per share. If the company were to offer a
scrip dividend to its shareholders it might offer shareholders one new share for every 25 shares that they hold.
The formula for the scrip issue of 1:25 (one new share for each 25 shares held) is calculated as:
Share price
__________________ 2.00
= ____ = 25
Dividend per share 0.08
So, if an investor holds 10,000 shares he may take a cash dividend of $800 (10,000 x 0.08) or he may take
400 new shares (10,000 ÷ 25) which at $2.00 per share are also worth £800.
The price of $2.00 is calculated by a formula that is usually based on the average closing mid-market
price in the week that the shares are marked ex-dividend.
The advantage of a scrip dividend for the shareholder is that he acquires new shares without incurring
dealing costs. The advantage for the company is one of cash flow; the cash which would have been used
to pay the dividend is retained within the company.
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A scrip dividend is offered as an alternative to the cash dividend and, therefore, the company must ask
shareholders if they wish to take it up. This involves notifying shareholders of the option and asking
them to make an election within a deadline if they want to take up the scrip dividend offer. If action is
not taken the shareholder will receive a cash dividend.
A dividend reinvestment plan (DRIP) is a variation on this theme. Under a DRIP, however, the company
makes a cash payment to all shareholders and offers a scheme whereby shareholders can instead ask
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the company to use the cash to buy shares on their behalf in the market.
DRIPs therefore differ from scrip issues:
• With a scrip dividend new shares are issued by the company and the cash which would otherwise
be used for the dividend is retained within the company. With a DRIP, the company pays the full
amount of the cash dividend.
• With a scrip issue, the company issues newly created shares to those investors electing to receive
their dividend in this way. With a DRIP, the company uses the cash dividend to buy the shares in the
market and passes on the benefit of low commission rates it can negotiate for a large bulk purchase.
• It can take up to three weeks for the shares to be added to a portfolio in the case of a DRIP and one
week in the case of a scrip dividend.
• A scrip dividend dilutes existing holdings as new shares are issued. A DRIP does not as the shares
required are purchased in the market.
2.2 Capital Events
2.2.1 Bonus Issues

From time to time, companies may decide to issue further shares to existing shareholders without
raising further capital as a means to make their shares more marketable.
Once a company’s share price starts trading above a certain price level, its marketability starts to suffer,
as investors shy away from the shares as they consider them to be too expensive. So, a reduction in a
company’s share price as a result of a bonus issue usually has the effect of increasing the marketability of
its shares and often raises expectations of higher future dividends. This in turn usually results in the share
price settling above its new theoretical level and the company’s market capitalisation increasing slightly.
The issue of new shares to existing shareholders without requiring any payment from them is usually
known as a bonus issue. It can also be referred to as a capitalisation issue or scrip issue and the names
are interchangeable. (Note: do not confuse the term a scrip issue with a scrip dividend; they are
completely different actions.)
Under a bonus issue, a company will issue new shares to existing shareholders in proportion to their
existing shareholding.
• A bonus issue involves the company issuing further units of a security to existing holders, based on
the holdings of each member on record date.
• This involves the company converting reserves into the form of share capital. These reserves may
have arisen from the accumulation of undistributed past profit or from issuing new shares in the
past at a premium to their nominal value.
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• These shares rank pari passu (ie, the same in all respects) with those already in issue and are
distributed to the company’s ordinary shareholders in proportion to their existing shareholdings
free of charge.
Example
If a company’s shares were trading at £16 it might announce a 3:5 bonus issue to reduce the price and
improve marketability. What will be the theoretical effect on the post-bonus issue share price?
Let’s assume that an investor holds 1,000 shares which are valued at £16,000. Under the terms of the issue
they will receive an additional 600 shares and the effect on the share price is shown in the table below.
Shares No of Shares Price Value
Before the Bonus Issue 1,000 £16.00 £16,000
Bonus Issue 600 - -
After the Bonus Issue 1,600 £10.00 £16,000
The theoretical ex-bonus share price is simply calculated by dividing the value of the shares by the
increased number of shares that the investor now holds – in other words, £16,000 ÷ 1,600.
The value of the shares has not changed as no new money has been raised by the company; instead
the share price reduces and is hopefully more attractive at that lower level. (Note: it is referred to as
the theoretical post-bonus issue price as, in practice, investor perception and the effect of demand and
supply will determine what really happens.)
2.2.2 Stock Splits

An alternative to a bonus issue as a way of reducing a share price is to have a stock split
How a stock split works depends upon whether a company’s shares have a nominal value or are of no par value.
In the UK, for example, shares have a nominal value and a stock split is where each existing share is split
into a greater number of shares with a lower nominal value. It is also sometimes known as a subdivision.
Subdivision
A company with shares having a nominal value of £1 and a £10 market price have a share split whereby
each ordinary £1 share is divided into four shares, each with a nominal value of 25p (£0.25). In theory,
the market price of each new share should adjust to be £2.50 (£10/4).
It might appear as though there is little difference between a bonus issue and a stock split, but a bonus
issue does not affect the nominal value of the company’s shares.
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Where shares have no par value, such as in the US, there is no difference between a bonus issue and a
stock split.
For example, a US company might determine that its share price is too high and is deterring investors
and wants to reduce the share price to increase its marketability. So, if a company had a market
capitalisation of $2 billion and 20 million shares in issue, it might announce a 2:1 stock split whereby the
stock holder receives two shares for every share held. The value of the company does not change as a
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result of the stock split, so it is still valued at $2 billion, but as there are now 40 million shares in issue as
the share prices reduce from $100 per share to $50 per share.
2.2.3 Reverse Stock Splits

A consolidation is the reverse of a split: shares are combined or consolidated. A consolidation issue
is also known as a reverse split. This is where a company decides to decrease the number of issued
securities, for example, by:
• consolidating every four shares currently existing into one share of four times the nominal amount; or
• where shares are of no par value, replacing existing shares with a lower number of shares.
Example
For example, if a UK company has 1 million shares in issue each with a nominal value of 50p, it can simply
increase the nominal value per share to £1 and reduce the number of shares in issue to 500,000.
Assuming an investor holds 1,000 ordinary 50p shares which were priced at £1 per share, the theoretical
effect on the share price can be seen in the following table:
Before the consolidation 1,000 ordinary 50p shares £1.00 £1,000
After the consolidation 500 ordinary £1 shares £2.00 £1,000
A company may undertake a reverse stock split if the share price has fallen to a low level and they wish
to make their shares more marketable.
It may also be done when the company wants to raise more equity capital from existing shareholders.
Under company law, new shares cannot be issued at less than their nominal value and so this can present
a problem when companies need to raise new capital. A rights issue will be priced at a discount to the
current share price, in order to make it attractive to existing shareholders to subscribe new capital. If the
share price is too low, this may make it impractical as a sufficient discount cannot be priced in.
A company may therefore need to announce a consolidation in conjunction with the rights issue. The
consolidation issue will raise the market price of each share, so that it can then have a rights issue to
raise additional capital, which it will price at a discount to that figure.
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2.3 Capital Raising Events
Once a company has a stock market listing, it can use that to raise additional funds through a capital
raising event such as a rights issue, an open offer or a placing.
2.3.1 Rights Issues

When a company wishes to raise further equity capital, whether to finance expansion, develop a new
product or replace existing borrowings, it can make a rights issue to its existing ordinary shareholders.
A rights issue is where a company gives existing investors the right to subscribe for additional new
shares at a discount to the market price at the time of announcement.
• The rights issue is accompanied by a prospectus, which outlines the purpose of the capital-raising
exercise, but does not require an advertisement of the issue to be placed in the national press.
• New shares are offered in proportion to each shareholder’s existing shareholding, at a price
discounted to that prevailing in the market to ensure that the issue will be fully subscribed and often
to avoid the cost of underwriting the shares.
• The number of new shares issued and the price of these shares will be determined by the amount
of capital to be raised. This price, however, must be above the nominal value of the shares already
in issue.
A key difference between a rights issue and other capital raising events is that the rights represent a
security in their own right, which is renounceable or transferable. In some markets, they are referred to
as tradable rights which is a better description of their characteristics.
The choices open to shareholders under a rights issue are:
• Take up the rights in full by purchasing all of the shares offered.

• Sell the rights.
• Sell sufficient of the rights to take up the balance (an approach sometimes known as tail-swallowing).
• Take no action and allow the rights to lapse, which means that the company will sell the rights for
the investor and distribute any proceeds to the investor. For the smaller shareholder not wishing to
increase their shareholding in the company, this is often the most economical way to proceed.
We will use a UK example to consider what takes place during a rights issue, the effect on the share price
and the options available to shareholders.
Rights Issue Terms

ABC Holdings has 1 million shares in issue, currently trading at £4.00 each. To raise finance for expansion,
it decides to offer its existing shareholders the right to buy one new share for every five previously held.
This is described as a 1 for 5 rights issue. The price of the rights share is set at a discount to the prevailing
market price, at only £3.50.
The new shares issued will rank equally, or pari passu, with the original shares. As a result, the share price
will be adjusted once the shares are traded ex-rights to take account of the additional capital that the
company will have and the greater number of shares in issue.
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The price to which the share price will fall as a result of the rights issue is called the theoretical ex-rights price.
Theoretical Ex-Rights Price

To see how this is calculated let’s assume that a company has 1 million shares in issue and announces a
1:5 rights issue to raise additional capital at a price of £3.50 per share:
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Before the rights 1,000,000 £4.00 4,000,000
Rights 200,000 £3.50 700,000
After the rights 1,200,000 £3.92 £4,700,000
The table above shows the initial number of shares in issue of 1,000,000 which at the current price of
£4 are valued at £4 million. Under the terms of the rights issue, investors can subscribe for one new
share for every five existing shares held, so the total number of shares will increase by 200,000 and the
company will receive an additional £700,000 of capital.
The company is now theoretically worth £4.7 million, but has more shares in issue. To work out the
theoretical ex-rights price, therefore, we need to divide its value by the increased number of shares in
issue. The theoretical ex-rights price will therefore be £3.92, which is £4,700,000 divided by 1,200,000
shares. This is the theoretical price that the shares trade at once they are ex-rights, but the actual price
will be determined by demand and supply and investor sentiment towards the issue.
During the period of the rights issue, the rights are known as nil-paid rights and are separately tradable
and will have some value. This is known as the rights premium and the theoretical rights premium can
be calculated using the above information.
Theoretical Rights Premium

If the theoretical ex-rights price is £3.92 and each right gives an investor the right to subscribe for one
additional share at £3.50, the theoretical rights premium is the difference between the two: £0.42 per
right. Again, the actual price will be determined by demand and supply.
Each shareholder is given choices as to how to proceed following a rights issue. For an individual
holding 1,000 shares in ABC Holdings, they could:
• Take up the rights by paying the £3.50 and increasing their holding in ABC Holdings to 1,200 shares.
• Sell the rights on to another investor. The rights entitlement is transferable (often described as
renounceable) and will have a value, because it enables the purchase of a share at the discounted
price of £3.50.
• As an alternative, the investor could, of course, sell just part of the rights and, with the cash raised,
take up the remainder.
• Do nothing. If the investor chooses this option, the company’s advisers will sell the rights at the best
available price and pass on the proceeds (after charges) to the shareholder.
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2.3.2 Open Offers
An open offer is a method of raising new capital that is similar to a rights issue. It is another type of
secondary market offering whereby a company seeks to raise new capital.
An open offer invites shareholders to buy new shares at a price below the current market price but,
unlike a rights issue, it cannot be sold and so, if the shareholder decides not to take up the entitlement,
it lapses.
Open offers are made at a discount and as this leads to a dilution in value for the non-accepting
shareholder, the listing rules in some countries limit the discount to a maximum of 10%.
For normal open offers holders cannot apply for more than their entitlement. The issue, however, can
be structured so that holders may be allowed to apply for more than their pro rata entitlement, with the
possibility of being scaled back in the event of the offer being over subscribed.
It can also be structured as an open offer with compensation where any shares not taken up are sold in
the market and proceeds distributed.
2.3.3 Placing
In a placing, a company simply markets the issue directly to a broker, an issuing house or other financial
institution, which in turn places the shares to selected clients.
A placing is the least expensive subsequent capital-raising method as the prospectus accompanying the
issue is less detailed than that required for the other two methods as only a limited number of potential
shareholders need be dealt with.
Its drawback is that existing shareholder’s ownership can be diluted and so in many markets there are
restrictions on when it can be issued, the amount that can be raised and the amount of discount on the
existing share price that is permitted.
2.3.4 The Impact of Corporate Actions

When a company announces a corporate action, it will describe the rationale for the event in its
communication of the event and in the corporate action documentation.
If a company is raising capital, its rationale will be examined closely. Essentially, investors are being
asked to invest further funds and will therefore analyse whether committing further funds is warranted,
given the company’s prospects. If a company wishes to raise additional capital, therefore, it will need to
provide a compelling case that investors are prepared to back.
Apart from the rationale for a corporate action and the investor’s reaction to the proposal, a further key
consideration is whether the issue will be earnings dilutive.
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Analysts look at earnings per share (EPS) and other key ratios to determine the performance of a
company and establish trends. EPS are one of the key measures of the profitability of a company and
the quality of a company’s earnings and its ability to grow them in a consistent manner are probably the
most important factors affecting the share price.
Any corporate action that will affect reported earnings is therefore analysed quite closely.
3
A capital-raising event will raise further capital for the company but analysts will want to know whether
the revenue that the additional capital will generate will add positively to the company’s earnings
stream or negatively. If it will reduce average earnings as measured by EPS, this negative effect is
described as being earnings dilutive. The market’s view on whether to support the corporate action will
be determined by the results of this analysis.
3. Risks
Learning Objective
3.2.1 Analyse the sources of return and the risks associated with equities, including: liquidation;
impact of market volatility
As recent years have shown, shares are relatively high risk. The main risks associated with holding shares
can be classified under three headings:
• price risk;
• liquidity risk;
• issuer risk.
Price risk is the risk that share prices in general may fall, and even though the company involved may
maintain dividend payments, investors could face a loss of capital. As well as general collapses in prices,
any single company can experience dramatic falls in its share price when it discloses bad news, such
as the loss of a major contract. Price risk varies between companies. Volatile shares such as technology
companies tend to exhibit more price risk than more defensive shares such as utility companies and
general retailers.
Liquidity risk is the risk that shares may be difficult to sell at a reasonable price. This typically occurs
when share prices in general are falling and the spread between bid and offer prices widens. Shares
in smaller companies tend to have a greater liquidity risk than shares in larger companies; smaller
companies also tend to have a wider price spread than larger, more actively traded companies.
Issuer risk is the risk that the issuing company collapses and the ordinary shares become worthless. This
may be very unlikely for larger, well-established companies, but it remains a real risk and can become
of increasing concern in times of economic uncertainty, such as the one we are experiencing at the
moment. The risk for smaller companies can clearly be more substantial.
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4. Equity Analysis
4.1 Framework for Financial Statements
Learning Objective
3.3.1 Apply an understanding of legal requirements to prepare accounts and of the framework
for financial statements: responsibility for preparation and required information in accounts;
objectives and qualitative characteristics of financial statements; international financial
reporting standards; auditors reports
The directors of a company are legally required to prepare financial statements and make other
disclosures within an annual report and accounts.
• Financial statements summarise all transactions entered into by a company during its accounting
period.
• These set out the results of the company’s activities during its most recent accounting period and
its financial position as at the end of the period. An accounting period typically spans a 12-month
time-frame.
• These statements must be presented at the company’s AGM and filed with the appropriate
government agency.
4.1.1 Framework for Financial Statements

The format of financial statements and disclosures is based on standards issued by international and
local ASBs.
The International Accounting Standards Board (IASB) has issued guidance on financial statements in a
document known as the Framework for the Preparation and Presentation of Financial Statements.
The framework describes the basic concepts by which financial statements are prepared and it:
• defines the objectives of financial statements;

• identifies the qualitative characteristics that make information in financial statements useful; and
• defines the basic elements of financial statements and the concepts for recognising and measuring
them.
Objectives of Financial Statements

The management of a business has the primary responsibility for preparing and presenting its
financial statements and the objective of these is to provide information about the financial position,
performance and changes in financial position of a business that is useful to a wide range of users in
making economic decisions.
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Objectives of Financial Statements

• Financial position is affected by the economic resources it controls, its financial
structure, its liquidity and solvency, and its capacity to adapt to changes in the
Financial
environment in which it operates.
position
• This information is contained in the balance sheet which is now known as the
statement of financial position.
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• Performance is the ability of an entity to earn a profit on the resources that have
been invested in it.
Performance
• Information about this is provided in the income statement and in a further
financial statement, the statement showing changes in equity.
• This is information about the investing, financing and operating activities that a
Changes business has undertaken during the reporting period and is contained in the cash
in financial flow statement.
position • This information helps in assessing how well the entity is able to generate cash
and cash equivalents and how it uses those cash flows.
• Notes and supplementary schedules should be used to:
Notes to the explain items in the balance sheet and income statement;
accounts disclose the risks and uncertainties affecting the business;
explain any resources and obligations not recognised in the balance sheet.
The framework also sets out the underlying assumptions of financial statements:
• Accrual basis – the effects of transactions and other events are recognised when they occur,
rather than when cash or its equivalent is received or paid, and they are reported in the financial
statements of the periods to which they relate.
• Going concern – the financial statements presume that an entity will continue in operation indefinitely
or, if that presumption is not valid, disclosure and a different basis of reporting are required.
Accruals
The accruals concept requires revenue and the associated costs to be shown in the period they are
earned or incurred, not in the period they are received.
For example, a company has a financial year end of 30 June. It invoices $5,000 for work undertaken in early
June but the invoice is not paid until July, in other words in the next financial year. The revenue from this
work is accounted for in the current year even though the money is not received until the next one.
Qualitative Characteristics of Financial Statements

The framework addresses general purpose financial statements that a business prepares and presents at
least annually to meet the common information needs of a wide range of external users.
The principal classes of users are present and potential investors, employees, lenders, suppliers and
other trade creditors, customers, governments and their agencies and the general public. All of these
categories of users rely on financial statements to help them in decision making.
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As investors are providers of risk capital, financial statements that meet their needs will also meet most
of the general financial information needs of other users.
The framework provides that information should be presented in a way that is readily understandable
by users who have a reasonable knowledge of business and economic activities and accounting and
who are willing to study the information with reasonable diligence.
The principles that should be followed in presentation of the financial statements should address:
• relevance of the information;

• reliability of the information;
• comparability with earlier periods.
Qualitative Characteristics
• Relevant information enables users to make economic decisions and the financial
statements can do that both by helping them evaluate past, present and future
events and by confirming or correcting past evaluations they have made.
• To be relevant, information should also be material and timely. Information is
Relevance
material if its omission or mis-statement could influence the economic decisions
of users.
• To be useful, information must be provided to users within the time period in
which it is most likely to bear on their decisions.
• Information in financial statements is reliable if it is free from material error and
bias and can be depended upon by users to represent events and transactions
faithfully.
• Financial statements, however, have to use estimates, and the uncertainty
Reliability surrounding these is dealt with by disclosure and by exercising prudence.
• Prudence is the inclusion of a degree of caution in the exercise of the judgements
needed in making the estimates required under conditions of uncertainty, such
that assets or income are not overstated and liabilities or expenses are not
understated.
• Users must also be able to compare the financial statements of a business over
time so that they can identify trends in its financial position and performance.
Comparability
• They will also want to be able to compare the financial statements of different
businesses so disclosure of accounting policies is important for comparability.
Elements of Financial Statements

Financial statements portray the financial effects of transactions and other events by grouping them
into broad classes according to their economic characteristics. These broad classes are termed the
elements of financial statements.
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The elements directly related to financial position are contained in the statement of financial position
and are:
• Assets – a resource controlled by the business and from which future economic benefits are
expected to flow.
• Liabilities – a present obligation of the entity, the settlement of which is expected to result in an
outflow from the business.
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• Equity – the residual interest in the assets of the business after deducting all its liabilities.
The elements directly related to performance (income statement) are:
• Income – increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity. It includes both
revenue and gains. It excludes contributions from equity participants.
• Expenses – decreases in economic benefits during the accounting period in the form of outflows,
depletion of assets or liabilities that result in decreases in equity. It includes losses as well as those expenses
that arise in the ordinary course of business. Again it excludes distributions to equity participants.
The cash flow statement reflects both income statement elements and some changes in balance sheet
elements.
Having defined what the content of financial statements should be, the framework defines when they
should be recognised in the financial statements. Recognition is the process of incorporating in the
balance sheet or income statement an item that meets the definition of an element and satisfies the
following criteria for recognition:
• it is probable that any future economic benefit associated with the item will flow to or from the
business; and
• the item’s cost or value can be measured with reliability.
Measurement involves assigning monetary amounts at which the elements of the financial statements
are to be recognised and reported. The framework acknowledges that a variety of measurement bases
are used today to different degrees and in varying combinations in financial statements, including:
• historical cost;
• current cost;
• net realisable (settlement) value;
• present value (discounted).
Historical cost is the measurement basis most commonly used today, but it is usually combined with
other measurement bases. The framework does not include concepts or principles for selecting which
measurement basis should be used for particular elements of financial statements or in particular
circumstances. Individual standards and interpretations do provide this guidance.
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4.1.2 Accounting Standards
The form and content of company financial statements and their respective disclosures are prescribed
by company law and mandatory accounting standards set by the ASB.
The ASB’s objectives include establishing and improving standards of financial accounting and
reporting, issuing new accounting standards as business practices evolve and addressing urgent
accounting issues. These objectives are designed to support investor, market and public confidence in
the financial and governance stewardship of listed entities.
The IASB aims to harmonise the way that accounts are presented, regardless of international boundaries.
international accounting standards (IAS) comprises international financial reporting standards (IFRS),
which are issued by the IASB, together with an earlier set of IASs were set by an earlier organisation from
1973 onwards.
All companies listed on EU stock exchanges are required to prepare their financial statements in
conformity with these international accounting standards. IAS 1 ‘Presentation of Financial Statements’
sets out the overall framework for presenting financial statements.
4.1.3 Auditors’ Report

Companies whose accounts are subject to a statutory independent audit must appoint, or reappoint,
an auditor at the company’s AGM to carry out an independent assessment of the company’s accounts
prepared by the directors.
Audit Report
The audit report must:
• Identify to whom the report is addressed.

• Identify the financial statements being audited.
• Contain a section covering the responsibilities of the:
auditor – to express an opinion;
directors – to prepare the accounts and accept responsibility for their truth, fairness and
compliance with the Companies Act;
• Indicate the basis of the auditor’s opinion, ie, the adherence to auditing standards, description of
the audit process such as audit testing done and consideration of the appropriateness of accounting
policies used.
• State that the auditor has planned and performed the audit in such a way as to obtain reasonable
assurance that the financial statements are free from material error or mis-statement, however,
arising.
• Contain an audit opinion on the statement of financial position at the period end and the profit or
loss and cash flows for the period.
The audit report gives an opinion on whether or not the accounts give a true and fair view of the
company’s activities and financial position and whether they have been prepared in accordance with
the law and mandatory accounting standards. If so, then an unqualified audit report is issued. If not, the
auditor must modify the report.
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Equities
These modified reports fall into two categories:
• Limitation of scope of the audit – if there has been a limitation on the scope of the auditor’s work
that prevents him from obtaining sufficient evidence to give an unqualified opinion.
• Adverse opinion – if the auditor disagrees with an accounting treatment or a view made in the
statements, which the directors refuse to amend.
3
The importance of the qualification also falls into two categories:
• Material.
The auditor disagrees with the treatment adopted by the directors or an uncertainty that limits
the scope of the audit opinion. The effect of the disagreement or limit in scope is not so material
to require an adverse or disclaimer of opinion.
The reader’s view of the accounts in specifically stated parts will be altered by this limitation or
disagreement.
• Fundamental.
The limitation or disagreement is so material as to render the whole set of accounts meaningless.
As a result, there are four possible styles of qualification, each of which will attract a slightly different
wording in the auditor’s report. The table below shows the form of wording that will be used when the
auditor is stating his opinion.
Auditors Report
Limitation of Scope Disagreement
Material Give a true and fair view except for Give a true and fair view except for
Unable to express an opinion Do not give a true and fair view
Fundamental
(disclaimer of opinion) (adverse opinion)
In all cases, the auditor will state what he is uncertain about or disagrees with.
4.2 Structure of Financial Statements
Learning Objective
3.3.2 Understand the purpose, structure and content of financial statements produced under IFRS
A simplified set of financial statements that would be produced under IFRS is shown as an appendix at
the end of this chapter and reference should be made to it when reviewing the sections below which
outline the purpose and content of each statement.
4.2.1 Statement of Financial Position

The statement of financial position provides a snapshot of a company’s financial position as at its
accounting year end by summarising the assets it owns and how these are financed.
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Its three main components are assets, liabilities and shareholders’ funds each of which is considered
further below.
Accounting Equations
As you can see from the example in the appendix, the construction of the statement of financial position
is underpinned by the accounting equation:
Assets = Liabilities + Equity
In other words, the balance sheet balances. Other versions on this equation are:
• Net assets (total assets less liabilities) = Shareholders funds

• Assets – Liabilities = Share capital + Reserves
• Assets = Liabilities + Share capital + Reserves
Assets
An asset is anything that is owned and controlled by the company and confers the right to future
economic benefits. Assets are categorised as either non-current assets or current assets.
Non-current assets are alternatively called fixed assets or long-lived assets. They are those assets
used within the business to generate revenue on a continuing basis rather than being purchased for
immediate resale. They therefore represent capital expenditure made by the company. Fixed assets are
categorised as either:
• tangible;
• intangible;
• investments.
Types of Fixed Assets

• Those that have physical substance, such as land and buildings and plant and
machinery that are used within the business over a number of years with a view to
deriving some benefit from their use.
Tangible
• Alternatively referred to as property, plant and equipment. Examples include;
freehold land and buildings; leasehold land and buildings; plant and machinery;
motor vehicles; fixtures and fittings.
• Those assets that although without physical substance, can be separately
identified and are capable of being realised.
• They frequently represent intellectual property rights of the company that enable
Intangible
it to operate and generate profits in a way that competitors cannot.
• Examples include; development expenditure; patents, licences and trademarks;
publishing rights and titles; goodwill; and brands.
• Fixed-asset investments are typically long-term investments held in other
Investments
companies.
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For tangible fixed assets with a limited economic life, an annual depreciation charge is made to the
income statement to write off the asset over the asset’s remaining useful economic life by employing an
appropriate depreciation method.
Depreciation
The two most common depreciation methods comprise:
3
• The straight line method – this is the simpler of the two methods, as it simply spreads the
depreciable amount equally over the useful economic life of the asset.
• The reducing balance method – this produces a depreciation percentage rate which, rather than
being applied to the depreciable amount, is instead applied to the net book value (NBV) of the asset.
This results in a higher depreciation charge than the straight line method in the early years of the
asset’s life and a lower charge in the later years.
The total amount written off over the asset’s useful economic life will be the same in both cases.
Assuming a machine was purchased for $24,500, has an estimated useful economic life of six years and
an estimated disposal value after six years of $1,000, depreciation is calculated as follows:
Straight line depreciation:
(Cost - Disposal Value)

______________________________________________________ ($24,500 – $1,000)
= ________________________ =$3,916.67 pa
Remaining Useful Economic Life (Years) 6
The depreciation charge will be the same in years one to six.
Reducing balance depreciation:
______________________ ________
√ √
n 6
1– Expected Residual Value = 1 –
_________________________________ $1,000 = 41.32%
___________
Original Cost $24,500
The results can be seen in the table below:
Straight Line Method Reducing Balance Method
Year Depreciation charge (£) NBV (£) Depreciation charge (£) NBV (£)
1 3,916.67 20,583.33 10,123.40 14,376.60
2 3,916.67 16,666.66 5,940.41 8,436.19
3 3,916.67 12,749.99 3,485.83 4,950.35
4 3,916.67 8,833.32 2,045.48 2,904.87
5 3,916.67 4,916.65 1,200.29 1,704.58
6 3,916.67 998.98 704.33 1,000.25
Total 23,500.02 – 23,499.75 –
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Note: the minor differences between the numbers resulting from the two methods are due to rounding
up the straight line depreciation charge and rounding down the reducing balance percentage rate.
Current assets are those assets purchased with the intention of resale or conversion into cash, usually
within a 12-month period. Current assets are categorised into the following:
• Inventory – goods held available for sale.

• Accounts receivable – amounts owed to the company, perhaps as a result of selling goods on
credit (often referred to as trade receivables).
• Investments – shares held in the short-term with the intention of reselling, eg, short-term
speculative investments.
• Cash – either held physically or by a financial institution such as a bank.
They are therefore also known as revenue items. Current assets are listed in the statement of financial position
in descending order of liquidity and typically appear at the lower of cost or net realisable value (NRV).
Liabilities
There are three broad categories of liabilities:
• Creditors or payables – these are known amounts owed by the company, eg, invoices received and
bank overdrafts.
• Accruals – these are liabilities for which the timing of payment is generally known but the amount
to be paid is uncertain. Accruals normally arise from routine transactions of the business, either of
an operating or financing nature.
• Provisions – these are either an amount to account for the reduction in the value of an asset (eg,
depreciation) or an estimate of a known but not exactly quantified liability arising from something
outside of the normal trading activities of a company.
Liabilities are categorised according to whether they are to fall due within one year or more than one year.
Liabilities
• Current liabilities should fully reflect all liabilities payable within 12 months of
Current the period end.
liabilities • They include bank overdrafts and taxation payable within one year, as well as
amounts owed to suppliers, known as trade payables.
• This comprises borrowing that is not repayable within the next 12 months.
Non-current
• It will typically include such items as long-term bank loans and bonds issued by
liabilities or
the company.
long-term
• It also includes any other known liabilities, such as trade payables that do not
liabilities
require settlement within the year.
A proposed dividend is not shown as a liability in the statement of financial position at the year end
although it will be disclosed elsewhere within the report and accounts. IASs instead requires that
proposed dividends are treated as an event arising after the statement of financial position date; they
are not liabilities until approved by shareholders at a general meeting.
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Shareholders’ Funds
The items shown on the statement of financial position under equity or shareholders funds can be
categorised as:
• share capital;
• capital reserves;
• retained earnings.
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Shareholders’ Funds
• When a company is created, the memorandum of association must state the amount
of the share capital with which the company proposes to be registered and the
Share division of that share capital into shares of a fixed amount.
capital • This capital amount is known as the authorised share capital and acts as a ceiling on
the amount of shares that can be issued, although it can be increased subsequently
by the passing of an ordinary resolution at a company meeting.
• Capital reserves include the revaluation reserve, share premium reserve and capital
redemption reserve.
• The revaluation reserve arises from the upward revaluation of fixed assets, both
tangible and intangible.
• The share premium reserve arises from issuing shares at a price above their nominal
Capital value.
reserves • The capital redemption reserve is created when a company redeems, or buys back, its
shares and makes a transfer from its revenue reserves to its capital reserves equal to
the nominal value of the shares redeemed.
• Capital reserves are not distributable to the company’s shareholders as apart from
forming part of the company’s capital base, they represent unrealised profits, though
they can be converted into a bonus issue of shares.
• Retained earnings are a revenue reserve and represents the accumulation of the
Retained company’s distributable profits that have not been distributed to the company’s
earnings shareholders as dividends, or transferred to a capital reserve, but have been retained
in the business.
4.2.2 Income Statement

The income statement summarises the company’s revenue transactions over the accounting period to
produce a profit or a loss. As a result, the income statement is often referred to as the profit and loss
account. However, being constructed on an accruals basis, rather than a cash basis, profit must not be
confused with the company’s cash position.
The two specific functions of this financial statement are to:
• detail how the company’s reported profit was arrived at; and
• state how much profit has been earned and how it has been distributed. The amount of profit
earned over the accounting period will impact the company’s ability to pay dividends and its ability
to finance the growth of the business from internal resources.
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In addition to the income statement, the accounts will also include:
• A statement of other comprehensive income which includes items such as revaluation gains and
losses, and actuarial gains and losses as well as the usual income statement items.
• A statement of changes in equity for the year into which is added the net income for the year and
from which is deducted dividends paid.
Revenue Recognition
Revenue is calculated on an accruals basis and represents sales generated over the accounting period,
regardless of whether cash has been received. Revenue is recognised in the income statement when it
meets the following criteria:
• It is probable that any future economic benefit associated with the item of revenue will flow to the
company.
• The amount of revenue can be measured with reliability.
Accounting for Costs

The cost of sales is arrived at by adding purchases of stock made during the accounting period, to the
opening stock for the period and deducting from this the value of the stock that remains in the business
at the end of the accounting period. Again this is done by applying accruals rather than cash accounting.
• Provisions should be disclosed in the notes to the financial statements and recognised as a liability
where payment is probable and the amount can be estimated reliably.
• Exceptional items are reported separately to remove the distorting influence of any large one-off
items on reported profit, so that users of the accounts may establish trends in profitability between
successive accounting periods and derive a true and fair view of the company’s results.
Calculating Profit
As you will see from the sample accounts, several levels of profit are disclosed:
• Gross profit – is calculated by deducting the cost of goods sold from revenue.
• Operating profit – is stated after deducting distribution costs and administration expenses.
Administration expenses usually include depreciation charges.
• Profit before and after taxation.
Net income is the company’s total earnings or profit. It is calculated by taking the total revenues
adjusted for the cost of business, interest, taxes, depreciation and other expenses.
Net income is the profit that is attributable to the shareholders of the company and is stated before the
deduction of any dividends, because dividends are an appropriation of profit and are at the discretion
of the company directors.
Net income is added to the retained earnings in the balance sheet and disclosed within the statement of
changes in equity. It is also within this statement that the dividends paid during the year are deducted
from the retained earnings. As we will see later, dividends paid are also disclosed in the cash flow
statement.
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4.2.3 Cash Flow Statement

Cash flow statements seek to identify how a company’s cash has been generated over the accounting
period and how it has been expended. It differentiates between the profit shown in the income
statement and the actual cash generated by the business.
Profit versus Cash
3
Not all income statement items result in an immediate cash flow or even any cash flow at all. For example:
• Depreciation – a cash flow occurs when the asset is purchased and when it is sold but not when it
is depreciated.
• Accrued expenses/purchases on credit – cash flows in relation to these items are when these
amounts are actually paid, which is after they have been charged against profits.
• Sales on credit/prepaid expenses – cash flows are when these debts are settled which, again,
differs from when they are taken into the income statement.
Since cash is such an important figure in determining the continuing existence of a company, we need
a statement showing how the company’s financial resources have been generated and have been used
in order to highlight the liquidity position and trends of the company.
They are constructed by:
• Removing accruals, or amounts payable and receivable, from the income statement, so that these
amounts may be accounted for on a cash paid and received basis.
• Adjusting for balance sheet items such as an increase in the value of a company’s stock or debtors or
a decrease in creditors, all of which increase reported profit but do not impact cash.
• Adding back non-cash items, such as depreciation charges, amortisation and book losses from the
sale of fixed assets, whilst deducting book profits from fixed asset disposals recorded in the income
statement, which impact recorded profit but not the company’s cash position.
• Bringing in changes in balance sheet items that impact the company’s cash position, such as finance
raised and repaid over the accounting period and fixed assets bought and sold.
As not all of the effects of accruals accounting can be stripped out from a company’s operating profit,
the cash flow statement is a bit of a misnomer in that it contains a mixture of accruals, cash and credit,
or fund, flows.
Analysis of the cash flow statement shows that it is important that a company generates positive cash
flow at the operating level or it will become reliant upon fixed asset sales and borrowing facilities to
finance its day-to-day operations.
A company’s survival and future prosperity are also dependent upon it replacing its fixed assets to
remain competitive. However, these assets must be financed with capital of a similar duration to the
economic life and payback pattern of the asset; otherwise the company will have insufficient funds to
finance its operating activities. The cash flow statement will also identify this.
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4.2.4 Consolidated Company Report and Accounts
Many listed companies have both subsidiaries and investments in other companies. How they are
treated for accounting purposes is shown below.
Consolidated Company Reports

• If company A has less than a 20% holding in the voting share capital of company
B and does not exercise any significant influence over the operating policies of
company B, this investment is recognised in company A’s statement of financial
Investments
position at either its cost or its current market value.
• Any dividends received are taken to the income statement in arriving at profit on
ordinary activities before taxation.
• If a company has between a 20% to 50% shareholding or exercises a significant
influence over the management of the other company it is known as an associate
company.
Associates
• The equity method of accounting requires that it shows a percentage of the
operating profit in its income statement and a percentage of the value of its assets
in its consolidated statement of financial position.
• When a company controls another company, it is known as a parent company with
a subsidiary.
• The most common way that control of a subsidiary is achieved is through the
Subsidiaries ownership of sufficient shares in the subsidiary to determine the composition of
the board of the subsidiary and so exercise control.
• This gives rise to the common presumption that owning more than 50% of the
shares is enough to create a subsidiary.
• To account for its control, a parent company is required to present group
accounts that amalgamate the assets and liabilities of the parent with those of its
subsidiary companies.
• In instances where the parent has greater than 50% but less than 100% of the
Group
shares of the subsidiary, the remaining shares are owned by persons other than
accounts
the parent and are known as the ‘minority interests’.
• The percentage of the net income that is owned by the minority shareholders
are shown as a deduction at the foot of the group income statement. A similar
adjustment is also made at the base of the group statement of financial position.
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4.3 Securities Analysis
Learning Objective
3.3.3 Analyse equities using the following profitability, liquidity and gearing ratios: return on capital
employed (ROCE); Asset turnover; Net profit margin; Gross profit margin; Equity multiplier;
working capital (current) ratio; Liquidity ratio (acid test); Z score analysis; financial gearing;
3
Interest cover
The financial statements and associated explanatory notes issued by a company contain a significant
amount of data that needs to be turned into meaningful numbers. These can then be used for assessing
the profitability of a company, the risks attached to those earnings, its ability to meet its liabilities as
they fall due and to identify trends.
The range of yields and ratios that can be used in making assessments can be grouped under four headings.
Ratios and Yields

Measures to assess the trading or operating performance of the company, ie, levels
Profitability
of trading profits generated and the effectiveness of the use of trading assets.
Measures to assess the trading risk of the company. This is the risk that, as a result
Liquidity of trading activities, the company may be unable to pay its suppliers as the debts
fall due and cease to exist.
Measures to assess the risks to the providers of finance due to the company’s level of
Gearing
borrowing.
Investors’ Measures to assess the returns to providers of finance, who may be either
ratios shareholders or lenders.
4.3.1 Profitability Ratios

Profitability ratios are used to assess the effectiveness of a company’s management in employing
the company’s assets to generate profit and shareholder value. There are a wide range of ratios that
are used but we will consider just some of the main ones – return on capital employed (ROCE); asset
turnover; profit margins; and the equity multiplier.
Return on Capital Employed (ROCE)

Firstly, we will look at return on capital employed (ROCE). ROCE is a key measure of a company’s
profitability and looks at the returns that have been generated from the total capital employed in a
company – that is debt as well as equity.
It expresses the income generated by the company’s activities as a percentage of its total capital.
This percentage result can then be used to compare the returns generated to the cost of borrowing,
establish trends across accounting periods and make comparisons with other companies.
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ROCE Formula
ROCE is calculated as follows:
Profit before Interest and Tax

ROCE = _________________________ × 100 = x%
Capital Employed
This profit figure can be viewed as operating profit plus interest receivable and income from other
investments, ie, the profits that management has generated from the resources it has available. It is
specifically before interest payable since that will clearly be dependent on the financing of the business;
the larger the loans, the larger the interest payable.
Capital Employed
The component parts of capital employed are shown below in an expanded version of the formula:

___________________________________________________
ROCE = (Total Assets - Current Liabilities + Short-term Borrowing) × 100 = x%
Capital employed is total assets less current liabilities (but excluding borrowings in current liabilities,
such as overdrafts and finance lease obligations). Alternatively, capital employed can be calculated from
the financing side of the statement of financial position as:
Shareholders’ funds + Non-current liabilities + Borrowings in current liabilities
It should be noted that the result can be distorted in the following circumstances:
• The raising of new finance at the end of the accounting period, as this will increase the capital
employed but will not affect the profit figure used in the equation.
• The revaluation of fixed assets during the accounting period, as this will increase the amount of
capital employed while also reducing the reported profit by increasing the depreciation charge.
• The acquisition of a subsidiary at the end of the accounting period, as the capital employed will
increase but there will not be any post-acquisition profits from the subsidiary to bring into the
consolidated profit and loss account.
Asset Turnover and Profit Margin

Having established the ROCE, we now need to consider what may have caused any change from one
year to the next. This is caused by one of two factors.
• changes in profit margin;

• changes in turnover volumes.
This can be undertaken by breaking the ROCE down further into two secondary ratios: asset turnover
and profit margin.
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Asset Turnover & Profit Margin

• Asset turnover looks at the relationship between sales and the capital employed in a
business.
• It describes how efficiently a company is generating sales by looking at how hard a
company’s assets are working.
Asset
• The formula for calculating it is:
turnover
3
Sales
Asset Turnover = ___________________
Capital Employed
• Sales refers to revenue or turnover.
• Profit margin looks at how much profit is being made for each dollar’s worth of sales.
• Clearly the higher the profit margin the better.
• The formula for calculating it is:
Profit
margin Profit before Interest and Tax
_______________________________
Profit Margin =
Capital Employed
• Sales refers to revenue or turnover.
The relationship between ROCE and each of these can be shown as follows.

_______________________________
ROCE =
Capital Employed

_______________________________ Sales
Profit Margin = Asset Turnover = ___________________
Sales Capital Employed
ROCE and Profit Margin and Asset Turnover
You can see that if we multiply the profit margin by the asset turnover, we will get back to the ROCE
since the revenue figures will cancel.
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Example
Assume ABC Ltd has sales of $5m, a trading profit of $1.5m and the following items on its balance sheet:
• Share capital $1.0m

• Reserves $5.0m
• Loans $1.0m
• Overdraft $0.5m
So its ROCE, profit margin and asset turnover can be calculated as follows:
ROCE:

_______________________________ $1.5m
or ___________________________________ × 100 = 20%
Capital Employed ($1.0m + $5.0m + $1.0m + $0.5m)
Profit Margin:

_______________________________ $1.5m
or _______ × 100 = 30%
Sales $5m
Asset Turnover:
Sales
____________________ $5m
= _______ = 0.66 times
Capital Employed $7.5m
Profit margin and asset turnover can therefore be used in conjunction with ROCE to gain a more
comprehensive picture of how a company is performing. The results of the calculations will need
interpreting to determine whether they represent a positive picture which will depend upon the returns
being achieved by comparative firms operating in the same or similar industries.
Asset turnover measures how efficiently the company’s assets have been utilised over the accounting
period, while the company’s profit margin measures how effective its price and cost management has
been in the face of industry competition. High or improving profit margins may, of course, attract other
firms into the industry, depending on the existence of industry barriers to entry, thereby driving down
margins in the long run.
The asset turnover ratio tends to be inversely related to the net profit margin ie, the higher the net profit
margin, the lower the asset turnover. The result is that investors can compare companies using different
models (low-profit, high-volume versus high-profit, low-volume) and determine which one is the more
attractive business.
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Gross, Operating and Net Profit Margin

Various profit margins can be looked at to analyse the profitability of a company in order to determine if
it is both liquid and being run efficiently.
Gross Profit Margin & Operating Profit Margin

• The gross profit margin shows the profit a company makes after paying for the cost
3
of goods sold.
• It shows how efficient the management is in using its labour and raw materials in the
process of production.
• The formula for gross profit margin is:
Gross
Profit Gross Profit
____________
Gross Profit Margin (%) = × 100
Margin Revenues
• Firms that have a high gross profit margin are more liquid and so have more cash
flow to spend on research & development expenses, marketing and investing.
• Gross profit margins need to be compared with industry standards to provide
context and should be analysed over a number of accounting periods.
• The operating profit margin shows how efficiently management is using business
operations to generate profit.
• It is calculated using the formula:
Operating Operating Profit

__________________
Profit Operating Profit Margin (%) = × 100
Revenues
Margin
• The higher the margin the better, as this shows that the company can keep its costs
under control and can mean that sales are increasing faster than costs and the firm is
in a relatively liquid position.
The difference between gross and operating profit margin is that the gross profit margin accounts for
just the cost of goods sold, whereas the operating profit margin accounts for the cost of goods sold and
administration/selling expenses.
The net profit margin analyses profitability further, by taking into account interest and taxation. Again it
needs to be compared to industry standards to provide context.
Formula – Net Profit Margin

The formula for calculating it is:
Net Income
Net Profit Margin (%) = _______________ × 100
Revenues
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With the net profit margin ratio all costs are included to find the final benefit of the income of a business
and so measures how successful a company has been at the business of making a profit on each sale.
• It is one of the most essential financial ratios as it includes all the factors that influence profitability
whether under management control or not.
• The higher the ratio, the more effective a company is at cost control.
• Compared with an industry average, it tells investors how well the management and operations of a
company are performing against its competitors.
• Compared with different industries, it tells investors which industries are relatively more profitable
than others.
Equity Multiplier
The equity multiplier is a financial leverage ratio that evaluates a company’s use of debt to purchase assets.
Formula – Equity Multiplier

The formula for equity multiplier is total assets divided by shareholders funds:
Total Assets
Equity Multiplier = _______________________
Shareholder Funds
It is possible for a company with terrible sales and margins to take on excessive debt and artificially
increase its return on equity. The equity multiplier allows the investor to see what portion of the return
on equity is the result of debt.
The equity multiplier is a component part of the DuPont system of financial analysis which was created
in 1919 and is still used around the world today. It uses the net profit margin, asset turnover and the
equity multiplier to determine return on equity.
Formula – Return on Equity

The formula for equity multiplier is total assets divided by shareholders funds:
Return on Equity = Net Profit Margin × Asset Turnover× Equity Multiplier
If return on equity is unsatisfactory, the Du Pont identity helps locate the part of the business that is
underperforming, by showing that return on equity is affected by three things:
• Operating efficiency – as measured by profit margin.

• Asset use efficiency – as measured by total asset turnover.
• Financial leverage – as measured by the equity multiplier.
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4.3.2 Liquidity Ratios

A company’s survival is dependent upon both its profitability and its ability to generate sufficient cash
to support its day-to-day operations. This ability to pay its liabilities as they become due is known as
liquidity and can be assessed by using the current ratio and the liquidity ratio.
Current Ratio & Liquidity Ratio
3
The working capital ratio is more commonly referred to as the current ratio.
The current ratio is simply calculated by dividing a company’s current assets by its current
liabilities as follows:
Current Assets
Current Ratio = _______________________
Current Current Liabilities
ratio
Although a company will want to hold sufficient stock to meet anticipated demand, it
must also ensure that it doesn’t tie up so many resources as to compromise its profitability
or its ability to meet its liabilities.
The higher the result, therefore, the more readily a company should be able to meet its
liabilities that are becoming due and still fund its ongoing operations.
The liquidity ratio is also known as the quick ratio or the acid test.
It excludes stock from the calculation of current assets, as stock is potentially not liquid, in
order to give a tighter measure of a company’s ability to meet a sudden cash call.
Its formula is:
Liquidity Current Assets – Stock
ratio Liquidity Ratio = _____________________________
Current Liabilities
For most industries a ratio of more than one will indicate that a company has sufficient
short-term assets to cover its short-term liabilities. If it is less than one it may indicate the
need to raise new finance.
4.3.3 Gearing Ratios

Gearing or debt ratios are used to determine the overall financial risk that a company and its shareholders
face. In general, the greater the amount of debt that a company has, the greater the risk of bankruptcy.
Financial Gearing
Investors prefer consistent earnings growth, or high quality earnings streams, to volatile and
unpredictable earnings. The quality of this earnings stream is dependent upon whether the company’s
business is closely tied to the fortunes of the economic cycle. It also depends on the level of a company’s
financial gearing, or capital structure.
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A company’s financial gearing (alternatively termed leverage) describes its capital structure, or the ratio
of debt to equity capital it employs. Financial gearing is also known as the debt to equity ratio and is
calculated as follows:
Debt to Equity Ratio
(Interest-bearing Debt + Preference Shares)

Debt to Equity Ratio = _______________________________________________________ × 100
Ordinary Shareholders Equity
Preference shares are included in the debt part of the calculation as preference share dividends take
priority over the payment of equity dividends.
A company’s financial gearing can also be expressed in net terms by taking into account any cash held
by the company, as this may potentially be available to repay some of the company’s debt.
Debt finance can enhance a company’s earnings growth as it is a more tax-efficient and generally
less expensive means of financing than equity capital. If it is excessive, however, it can also lead to an
extremely volatile earnings stream, given that debt interest must be paid regardless of the company’s
profitability.
Interest Cover
Shareholders and prospective lenders to the company will also be interested in the company’s ability to
service, or pay the interest on, its interest-bearing debt.
Interest Cover
The effect of a company’s financial gearing policy on the profit and loss account is reflected in its
interest cover which is calculated as follows:
Interest Cover = _____________________________________ × 100
Interest Payable
The higher interest cover that a company has, the greater the safety margin for its ordinary shareholders
and the more scope it will have to raise additional loan finance without dramatically impacting its ability
to service the required interest payments or compromise the quality of its earnings stream. An interest
cover of 1.5 or less indicates that its ability to meet interest expenses may be questionable.
This ratio, however, requires careful interpretation as it is susceptible to changes in the company’s
capital structure and general interest rate movements, unless fixed-rate finance or interest-rate hedging
is employed.
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4.3.4 Investor Ratios
Learning Objective
3.3.4 Analyse equities using the following investor ratios: earnings per share (EPS); earnings before
interest, tax, depreciation, and amortisation (EBITDA); earnings before interest and tax (EBIT);
historic and prospective price earnings ratios (PERs); dividend yields and Dividend cover; price
3
to book ratio (P/B)
In the following section we will consider some of the ratios that are used to assess potential investments.
Earnings per Share (EPS)

EPS is a measure of the profitability of a company that is expressed in an amount per share in order that
meaningful comparisons can be made from year to year and with other companies.
The quality of a company’s earnings stream and its ability to grow its EPS in a consistent manner are
probably the most important factors affecting the price of a company’s shares, not least because
earnings provide the ability to finance future operations and the means to pay dividends to shareholders.
There are three principal measures we need to consider:
• EPS;
• Earnings before interest and tax (EBIT);
• Earnings before interest, tax, depreciation and amortisation (EBITDA).
Earnings per Share

The EPS ratio measures the profit available to ordinary shareholders and is taken as
the profit after all other expenses and payments have been made by the company.
It is calculated as follows:
EPS (Net Income-Preference Dividends)
EPS = _____________________________________________
Number of Ordinary Shares in Issue
The resulting figure is known as basic EPS.

Earnings per share can also be calculated before the impact of interest payments and
EBIT taxation.
EBIT is, therefore, operating income or operating profit.
Earnings can charges through an EPS measure known as EBITDA.
EBITDA EBITDA provides a way for company earnings to be compared internationally, as the
earnings picture not clouded by differences in accounting standards worldwide.
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Price Earnings Ratio (PER)
The PER measures how highly investors value a company in its ability to grow its income stream.
It is calculated by dividing the market price by the EPS as follows:
Share Price
PER = _______________
EPS
A company with a high PER relative to its sector average reflects investors’ expectations that the
company will achieve above-average growth. By contrast, a low PER indicates that investors expect the
company to achieve below average growth in its future earnings.
Although PERs differ significantly between markets and industries, there can be several reasons why a
company has a higher PER than its industry peers, apart from its shares simply being overpriced. These
may include:
• a greater perceived ability to grow its eps more rapidly than its competitors;
• producing higher quality or more reliable earnings than its peers;
• being a potential takeover target;
• experiencing a temporary fall in profits.
One way of establishing whether a company’s PER is justified is to divide it by a realistic estimate of the
company’s average earnings growth rate for the next five years. A number of less than one indicates that
the shares are potentially attractive. This is sometimes referred to as the ‘PEG’ ratio – price earnings to
growth rate.
Dividend Yields and Cover

Dividend yields give investors an indication of the expected return on a share so that it can be compared
to other shares and other investments.
Dividend Yield
Dividend yields are calculated by dividing the net dividend by the share price as follows:
Net Dividend per Share

Dividend Yield = ______________________________ × 100 = x%
Share price
A low dividend yield may imply the potential for high dividend growth, whereas the opposite may be
true of a high dividend yield – although this may not always be the case.
As well as looking at the dividend yield, investors will also consider the ability of the company to
continue paying such a level of dividend. They do this by calculating dividend cover which looks at how
many times a company could have paid out its dividend based on the profit for the year.
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Dividend Cover
EPS
Dividend Cover = _____________________________________
Net Dividend per Share
The higher the dividend cover, the less likely it is that a company will have to reduce dividends if profits fall.
3
Price to Book Ratio (P/B)
The price to book (P/B) ratio measures the relationship between the company’s share price and the NAV
per share attributable to its ordinary shareholders.
The P/B ratio divides the share price by the NAV per share and is expressed as a multiple to indicate how
much shareholders are paying for the net assets of a company. The formula is:
Share Price
P/B Ratio = ___________________
NAV per Share
If the ratio shows that the share price is lower than its book value, it can indicate that it is undervalued
or simply that the market perceives that it will remain a stagnant investment. If the share price is higher
than its book value, this suggests that investors view it as a company which has above-average growth
potential.
4.4 Investment Valuation
Learning Objective
3.3.5 Apply the principles of the following investment valuation methods to the process of equity
analysis: dividend valuation models; earnings and asset valuation models; shareholder
valuation models
Some of the ways in which equities can be valued include:
• dividend flows;
• earnings growth;
• NAV;
• Shareholder value added.
Dividend Valuation Model

The dividend valuation model applies a theoretical price to a company’s shares, by discounting the
company’s expected flow of future dividends into infinity.
In other words, it uses the formula to calculate the present value of a perpetuity and instead uses it to
calculate the value of a share. The required rate for the formula is derived by adjusting the risk-free rate
given by a treasury bill or stock for the relative risk of the investment.
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Example
ABC plc is expected to pay a dividend of $0.10 next year. Assuming the required return to equity holders
is 11% and the dividend is expected to continue at this level, the share price should be:
Next Year’s Dividend 0.10

Share price = __________________________________________ = ______ = $0.91
Required Return to Equity Holders 0.11
This, however, takes no account of the potential for rising dividends. This gives rise to Gordon’s growth
model, which assumes that future dividends will grow at a constant rate.
Gordon’s Growth Model

The formula for calculating it is:
Dividend in One Year’s Time

Share price = _____________________________________________________________________________
Required Return to Equity Holders-Growth Rate of Dividends
Continuing with the example above, if ABC plc’s dividends are expected to grow at a constant rate of
5%, the share price should be:
0.10
Share price = _____________ = $1.67
0.11 – 0.05
Earnings Models
As we saw earlier, a PER provides an indication of how highly rated a company is in its ability to grow its
earnings stream.
Very simply, a PER, therefore, indicates the number of years that it would take at the current EPS to repay
the share price ignoring the time value of money. It, therefore, can simply be turned around to provide
an indication of the value of an equity.
Example
XYZ plc is operating in a sector where the average prospective PER is currently eight times.
If XYZ’s earnings per share are expected to be $0.30, the implied value of an XYZ plc share is:
PER x expected EPS = 8 x 0.30 = $2.40
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Asset Valuation Models

NAV represents the net asset value per share attributable to ordinary shareholders and is calculated as
follows:
(Total Assets – Liabilities – Preference shares)
NAV = _________________________________________________________
Number of Shares in Issue
3
As a measure of the value of a share, it does not take account of the fact that the ordinary shares of a
company normally are expected to trade at premium to their NAV.
An example of this is the internally generated goodwill attributable to the company’s management,
market positioning and reputation that is not capitalised in the company’s balance sheet under the
historic cost convention. The latter underpins the preparation of financial statements.
However, the NAV per share is useful for assessing the following:
• The minimum price at which a company’s shares should theoretically trade.

• The underlying value of a property company.
• The underlying value of an investment trust; a plc that invests in other company and government
securities.
NAV per share is not useful for assessing the value of service or people-oriented businesses that are
driven by intellectual, rather than physical, capital because the former cannot be capitalised in the
balance sheet.
Shareholder Valuation Models

The approach taken by shareholder value models is to establish whether a company has the ability to
add value for its ordinary shareholders by earning returns on its assets in excess of the cost of financing
these assets.
Economic value added (EVA) is the most popular of these shareholder value approaches.
The EVA for any single accounting period is calculated by adjusting the operating profit in the
company’s income statement, mainly by adding back non-cash items, and subtracting from this the
company’s weighted average cost of capital (WACC) multiplied by an adjusted net assets figure from the
company’s balance sheet, termed invested capital.
If the result is positive, then value is being added. If negative, however, value is being destroyed.
It should be noted that EVA:
• is based on accounting profits and accounting measures of capital employed;

• only measures value creation or destruction over one accounting period; and
• in isolation cannot establish whether a company’s shares are overvalued or undervalued.
In order to determine whether a company’s shares are correctly valued, the concept of market value
added (MVA) needs to be employed.
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A company’s MVA is the market’s assessment of the present value of the company’s future annual EVAs.
Quite simply, if the present value of the company’s future annual EVAs discounted at the company’s
WACC is greater than that implied by the MVA, this implies that the company’s shares are undervalued
and vice versa if less than the MVA.
Like EVA, MVA also relies on accounting values to establish the invested capital figure and in addition
requires analysts to forecast EVAs several years into the future to determine whether the resultant MVA
is reasonable.
4.5 Financial Analysis
Learning Objective
3.3.6 Understand the main challenges and limitations of performing financial analysis
Ratios are a convenient way of summarising and presenting information. In general they are easy to
understand and they help to focus attention on the important aspects of business performance and risk.
A ratio is, however, meaningless in isolation. In order to be useful a ratio must have something it can be
compared against such as:
• prior year figures;

• competitors’ figures;
• budget figures.
Ratios can be used to highlight trends over a number of years, which may not be so apparent from the
figures themselves. These trends can then be used by to assess how the company is performing and to
identify:
• Whether the trends are moving upwards or downwards in terms of returns being achieved or the
risks faced.
• Large changes in the ratios from one year to the next or large variances of the ratio against
competitors or budgets.
Whilst ratio analysis does have its limitations, it does prompt further investigation and allows investors
or potential investors to ask questions.
• As financial statements contain historic data, ratios are not predictive. Past performance may give
no indication of future performance, particularly for research and development companies which
may, for example, make a major discovery in medicine or technology.
• Despite accounting regulations, accounting data can be window-dressed.
• Ratios do not provide all the answers and are of limited value in isolation, but do prompt further
investigation.
• Different companies within the same industry may be at different stages of building their business.
For example, a new technology company may have very high levels of debt and limited cash flow. It
may have ratios which are poor compared with more established companies in the same industry.
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Equities
However, because of a culture of innovation and enterprise, it may actually perform better and
ultimately give a higher return on investment.
• Industry averages can also be misleading as they may be based on different accounting policies. This
can be a problem when comparing industries in different countries that have different accounting
standards.
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1. A company has gone bust leaving unpaid debts. In what circumstance might an ordinary shareholder
have a liability for part payment of these debts and to what extent?
2. A company has issued 5% cumulative redeemable preference shares at $1.00. They are currently
priced at $1.75 per share and can be converted into the company’s ordinary shares at the rate of
six preference shares for one ordinary share. You are monitoring the price of the ordinary shares
to identify conversion opportunities. What price would the ordinary shares need to be in order for
conversion to be worth considering?
3. A client has asked you to explain what their rights as a shareholder are to payment of dividends. How
would you explain what the correct position is?
4. A client has placed an order with their broker to buy 10,000 ABC shares at no more than $10 per share
and with a fill or kill condition. 9,000 shares are available on the order book at a price of $10 and a
further 1,000 shares at a price of $10.10. How would the order be executed?
5. A company has declared an interim dividend of $0.10 per share with a scrip dividend option based
on an average closing market price of $9.50. If an investor has elected to take scrip dividends on their
holding of 1,000 shares, how many shares would they receive?
6. A UK company has announced a 1:3 bonus issue. What would the theoretical ex-bonus price be if the
share price before the bonus issue was £6.80?
7. A UK company has announced a 1:4 rights issue at £1.50 when the shares are priced at £6. If an
investor holds 10,000 shares and wants to sell the rights, what amount could they be sold for
assuming they are sold at the theoretical ex-rights premium?
8. Explain what the accruals concept is and provide examples.
9. A company has the following:
Total assets of $100m
Current liabilities of $35m
Short-term borrowings of $5m
Profit before interest and tax of $8m
What is its ROCE?
10. A company paid a dividend last year of $0.05 per share. It will increase by 5% this year and in
forthcoming years. Using Gordon’s Growth Model what would you expect its share price to be if the
required return to equity holders is 7%?
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Sample Financial Statements

A simplified set of financial statements as produced under IFRS is shown below. Although not shown in
the example, the format requires the previous year’s comparative balance sheet numbers to be set out
alongside those of the current year and for a numerical reference to be inserted in the notes column to
support explanatory notes to the various balance sheet items.
3
Statement of Financial Position
The top half of the statement which records the total net assets owned by the company is shown below.
ABC plc
Consolidated Statement of Financial Position
As at 31 December
Notes 2013 ( €m) 2012 (€m)
Assets
Non-current assets
Property, plant and equipment 8,900
Intangible assets 1,800
Investments in associates 300
Assets available for sale 300
11,300
Current Assets
Inventories 3,600
Trade and other receivables 2,600
Investments held for trading 120
Cash 860
7,180
Total Assets 18,480
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The bottom half of the statement which reflects shareholders’ funds and liabilities is shown below.
As at 31 December
Notes 2013 (€m) 2012 (€m)
Equity
Capital and reserves
Share capital – 50p ordinary shares 5,000
Share capital – preference shares 100
Share premium account 120
Revaluation reserve 100
Capital redemption reserve 80
Retained earnings 6,880
Total Equity 12,280
Liabilities
Non-Current Liabilities
Bank loans 2,000
2,000
Current Liabilities
Trade and other payables 4,200
4,200
Total Liabilities 6,200
Total Equity and Liabilities 18,480
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Income Statement
An example income statement for ABC plc is shown below. As with the statement of financial position,
comparative numbers and explanatory notes must be provided.
ABC plc
Income Statement
3
As at 31 December
Notes 2013 (€m) 2012 (€m)
Continuing Operations
Revenue 9,500
Cost of sales (7,000)
Gross Profit 2,500
Distribution costs (110)
Administrative expenses (30)
Other income –
Operating Profit 2,360
Exceptional loss (260)
2,100
Income from fixed asset investments 30
Interest receivable 90
Interest payable (230)
Profit before Taxation 1,990
Taxation (555)
Net Income 1,435
Earnings per share (pence) 14.3p
The next example shows the Statement of Comprehensive Income for ABC plc. As before, comparative
numbers and explanatory notes must be provided.
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The statement of comprehensive income records items such as FX translation differences, gains or losses
on revaluation of property and actuarial gains or losses on pension scheme plans. To this is added the
net income from the income statement to generate a total comprehensive income for the financial year.
ABC plc
Statement of Comprehensive Income
As at 31 December
Notes 2013 £m 2012 £m
Other Comprehensive Income
Exchange differences on translating foreign operations 100
Available-for-sale financial assets –
Cash flow hedges –
Gains on property revaluation
Actuarial gains (losses) on defined benefit pension plans (75)
Taxation on components of other comprehensive income (25)
Other Comprehensive Income for the Year 0
Net Income 1,435
Total Comprehensive Income 1,435
Earnings per share (pence) 14.3p
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Statement of Changes in Equity

The net income is then taken to the statement of changes in equity for the year and shown as retained
earnings as shown in the following example.
ABC plc
Statement of Changes in Equity for the Year Ended 31 December 2013
3
Pref Share Capital
Ord Share Revaluation Retained
Share Premium Redemption Total
Capital Reserve Earnings
Capital Account Reserve
As at 1 January
4,470 100 0 0 80 5,880 10,530
2013
Gain on
100 100
revaluation
Issue of shares 530 120 650
Net income for
1,435 1,435
the year
Preference
–5 –5
dividends paid
Ordinary
–430 –430
dividends paid
As at 31
December 5,000 100 120 100 80 6,880 12,280
2013
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Cash Flow Statement
The statement of cash flows for ABC plc, based on the IAS 7 format, is shown below. Although not
shown, explanatory notes to the cash flow statement and comparatives are also required.
ABC plc
Consolidated Statement of Cash Flows
As at 31 December
Notes 2013 (€m) 2012 (€m)
Operating Activities
Cash receipts from customers 4,528
Cash paid to suppliers and employees (2,001)
Cash generated from operations 2,527
Tax paid (440)
Interest paid (150)
Net cash from operating activities 4,464
Investing Activities
Interest received 80
Dividends received 40
Purchase of fixed assets (1,890)
Proceeds on sale of investments 120
Net cash used in investing activities (1,650)
Financing Activities
Dividends paid (435)
Repayments of borrowings (200)
Proceeds on issue of shares 650
Net cash generated from financing activities 15
Net increase in cash and cash equivalents 2,829
Cash and cash equivalents at the beginning of the year 425
Cash and Cash Equivalents at the End of the Year 3,254
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Chapter Four
Alternative Investments
1. Foreign Exchange (FX) 155
4
2. Property 162
3. Derivatives 174

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1. Foreign Exchange (FX)
Learning Objective
4.1.1 Analyse the characteristics, risks and return of foreign exchange (FX) from an investment
perspective: basic structure and operation of the foreign exchange market; FX quotes - quoting
conventions; currency pairs; determinants of spot foreign exchange prices
4
1.1 Structure of the Foreign Exchange (FX) Market
The foreign exchange market, which is also known as the forex market or just the FX market, refers to
the trading of one currency for another. It is by far the largest market in the world with average daily
turnover in excess of US$4 trillion.
The FX market exists to serve a variety of needs from companies and institutions purchasing overseas
assets denominated in currencies different to their own, to satisfying the foreign currency needs of
business travellers and holidaymakers.
The increasing globalisation of financial markets has seen explosive growth in the movement of
international capital. Over $4 trillion a day flows through world FX centres, with over a third of this
turnover passing through London alone. Despite the introduction of the euro, the world’s most heavily
traded currency remains the US dollar, the world’s reserve currency.
The FX market does not have a centralised marketplace. Instead, it comprises an international network
of major banks each making a market in a range of currencies in a truly internationalised 24-hour market.
Each bank advertises its latest prices, or rates of exchange, through commercial quote vendors and
conducts deals through electronic broking systems.
Historically, currencies were backed by gold (as money had intrinsic value); this prevented the value
of money from being debased and inflation being triggered. This gold standard was replaced after the
Second World War by the Bretton Woods Agreement. This agreement aimed to prevent speculation
in currency markets by fixing all currencies against the US dollar and making the dollar convertible
to gold at a fixed rate of $35 per ounce. Under this system, countries were prohibited from devaluing
their currencies by more than 10%, which they might have been tempted to do to improve their trade
position.
The growth of international trade, and increasing pressure for the movement of capital, eventually
destabilised this agreement, and it was finally abandoned in the 1970s. Currencies were allowed to float
freely against one another, leading to the development of new financial instruments and speculation in
the currency markets.
Trading in currencies became 24-hour, as it could take place in the various time zones of Asia, Europe
and America. London, being placed between the Asian and American time zones, is the world’s largest
FX market followed by the US, Singapore and Japan.
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The FX system has some elements of management of rates by central banks and governments, but is
largely a system which is described as free-floating.
• Pure free float would be where no government intervention takes place and only market forces
determine rates.
• The present-day system is largely based upon the activities of the large banks and other institutions
which are conducting transactions between themselves in the FX market.
• Central banks can issue policy statements and from time to time may intervene directly into the
market to buy or sell their currency or another currency from their reserves.
• Central banks will attempt to guide the markets with respect to determining factors such as interest
rates, trade policies and other capital market incentives.
1.2 Foreign Exchange (FX) Quotes

Trading of foreign currencies is always done in pairs such as the euro and the dollar. These are currency
pairs where one currency is bought and the other is sold and the prices at which these take place make
up the exchange rate.
When an exchange rate is quoted, the name of the currency is abbreviated to a three digit reference
based on standardised currency codes published by the International Organisation for Standardisation
(ISO 4217 currency codes).
Currency Codes
Currency codes are composed of a country’s two character international country code plus a third
character denoting the currency unit. For example:
USD – United States dollar.
GBP – Great British pounds.
When an exchange rate is quoted it involves two currencies that are referred to as a currency pair. There
are four major currency pairs which are the most liquid and commonly traded currency pairs in the
market:
• EUR/USD – Euro and US dollar – is the most commonly traded currency pair.
• GBP/USD – British pound and US dollar.
• USD/JPY – US dollar and Japanese yen.
• USD/CHF – US dollar and Swiss franc.
When currencies are quoted, the first currency is the base currency and the second is the quote
currency. The base currency is always equal to one unit of that currency, in other words, one dollar, one
pound or one euro.
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Currency Quote
Let’s assume that the EUR/USD exchange rate is quoted as 1.3515.
The euro is the base currency and the US dollar is the quote currency.
The euro is not mentioned as standard convention is that the base currency is always one unit.
So €1 equals $1.3515.
When currency pairs are quoted, a market maker or FX trader will quote a bid and an ask price. The bid
and ask prices are 1.3513:1.3517.
4
The prices are quoted from the perspective of the market maker.
If you want to buy €100,000 you will need to pay the higher of the two prices and deliver $135,170.
If you want to sell €100,000 you get the lower of the two prices and receive $135,130.
In the spot market, the base currency is usually the US dollar. The main exceptions are the British pound
and the euro.
When the exchange rate is going up, it means that the value of the base currency is rising relative to the
other currency and is referred to as the currency strengthening, and, where the opposite is the case, that
the currency is weakening.
Currencies are traded in fixed contract sizes, specifically called lot sizes, or multiples thereof. The
standard lot size is 100,000 units of the base currency. Retail brokerage firms also offer 10,000 units or
mini lots. Leverage is widely employed in FX trading and it is not uncommon for brokerage accounts
to offer leverage of up to 200:1, which can be quite dangerous for the retail investor, considering the
volatility of many currency pairs.
1.3 Determinants of Spot Rates

The spot rate is the rate quoted by a bank for the exchange of one currency for another immediately.
Deals struck in the spot market are for delivery and settlement two business days after the date of the
transaction, that is, on a T+2 basis.
Rolling Over Positions

Rolling over is the process of extending the settlement date of an open position in the FX market. In
most currency trades, a trader is required to take delivery of the currency two days after the transaction
date. However, by rolling over the position – simultaneously closing the existing position at the daily
close rate and re-entering at the new opening rate the next trading day – the trader artificially extends
the settlement period by one day.
The value of a currency could be described as a country’s share price, as its value tends to reflect most
aspects of a country’s fortunes. This makes currencies probably the most unpredictable of all the asset
classes and exchange rates one of the most difficult macroeconomic variables to forecast.
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A whole series of factors can influence the exchange rate and in fast moving markets it is not always
evident what is influencing the change.
Foreign exchange rates do, however, have strong relationships with a country’s economic fundamentals.
These include: GDP; rate of inflation; interest rates; employment levels; and the balance of payments.
If an economy has positive economic fundamentals, such as a relatively high rate of annual GDP growth,
low inflation and stable monetary policy this will prove more attractive to foreign investors than those
economies which are stagnating and where there is a much more uncertain economic outlook.
Impact of Economic Data

The performance of a national economy is generally measured by changes in its GDP.
GDP If the economy of one country is performing well relative to that of another country, the
country with the stronger economic performance will usually have a stronger currency.
Higher levels of inflation will erode the domestic value of a currency, because it takes
more domestic currency to buy foreign goods.
Inflation
Higher levels of inflation also reduce the real level of interest rates. Foreign investors
will have less incentive to invest in a country with high inflation.
If the central bank implements a tight monetary policy by raising interest rates then,
all things being equal, this policy will attract more foreign investment.
Interest rates
If monetary policy is loose, foreign investors may abandon the currency in favour of
higher-yielding currencies.
The level of employment in a nation also influences the value of a currency. When
Employment employment levels are high, consumer and general household consumption will be
strong and the economy will benefit.
A country’s balance of payments helps determine the value of a currency. The larger
the positive balance of payments, the stronger the currency value relative to other
Balance of world currencies.
payments A major component of the balance of payments equation is the current account
balance. In general, when the current account balance is positive and the trend is
positive, the domestic currency will be strong.
Other factors that influence the exchange rate are:
• International trade – there are considerable imbalances in the global trade of goods and services with
many nations running large deficits and having to attract capital flows from the large surplus nations.
• Economic and political problems – during times of economic and political stress, safe haven
currencies such as the US dollar, Swiss franc and Japanese yen experience increased demand as
investors seek safer homes for their money.
• Debt/GDP ratios – global capital flows for the purchase of government debt to finance government
deficits are increasingly affecting global exchange rates. Countries where debt/GDP is relatively
high will, on the whole, attract less capital for their respective bond markets and the currencies will
under-perform those countries with lower debt/GDP ratios.
• FX carry trade – one of the principal driving factors for speculative capital flows is to exploit interest
rate differentials between countries. In essence, large institutional investors will borrow funds in
a currency where there is a relatively low borrowing rate and will invest those funds in another
currency where there is a higher rate of interest available for short-term deposits.
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The above list is by no means exhaustive and other factors can influence the value of a currency.
Although currencies very rarely go into terminal decline, they can under and overshoot their long-
term fundamental values often for significant periods of time for a variety of economic and political
reasons and in response to fickle changes in market sentiment. Currency forecasting can, therefore, be
extremely hazardous.
1.4 Forward Rates
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Learning Objective
4.1.2 Calculate forward exchange rates using: premiums and discounts; interest rate parity
A forward exchange contract is an agreement between two parties to either buy or sell foreign currency
at a fixed exchange rate for settlement at a future date. The forward exchange rate is the exchange rate
set today even though the transaction will not settle until some agreed point in the future, such as in
three months’ time.
An FX forward allows companies or individuals entering into forward transactions to know how much an
overseas currency will cost or generate in advance. This will enable them to plan and budget more accurately.
Outright Forwards
An outright forward is an agreement between two counterparties to exchange currencies at a fixed rate
on a future date other than spot delivery.
The future date is usually expressed in weeks or months up to one year; for example – one week; two
weeks; three weeks; one month; two months; three months; four months... 12 months. For the major
currencies terms of up to five years are possible.
The term of an outright deal is measured starting with the spot value date.
Trade Spot Value Outright Value

Date Date (T+2) Date
If the theoretical value date of an outright is a non-business day, the value date is deferred to the next
working day.
The relationship between the spot and forward exchange rates for two currencies is determined by
their respective nominal interest rates over the term being considered. The relationship is purely
mathematical and has nothing to do with market expectations.
The idea behind this relationship is embodied in the principle of interest rate parity and is best illustrated
by an example.
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Example
Let’s assume that the EUR/USD spot rate is 1.35 and that the six-month deposit rates in the euro deposit
market are 3% for the euro and 2% for the US dollar. The rates are annual ones and for simplicity, we will
assume that for six months the rate would be exactly half.
With this information, we can use the interest rate parity formula to calculate the forward rate:
Forward rate = Spot rate ×

[ (1+ quote currency interest rate)
___________________________________
(1+ base currency interest rate) ]
So the forward rate = 1.35 ×
[ (1 + 0.01)
___________
(1 + 0.015) ] = 1.3433
This can be validated by going back to the principle of interest rate parity which is that the forward rate
should take account of the interest rate differential between the two currencies.
So, if €1 equals $1.35 today and both are invested at their respective rates, in six months’ time they will
be worth:
Spot Rate Interest Rate End Period
EUR 1 1.5% 1.015
USD 1.35 1% 1.3635
So, the forward rate is 1.3635 ÷ 1.015 = 1.3433. The forward rate is lower than the spot rate due to
interest rates being lower for the US dollar than for the euro.
If this relationship did not exist, an arbitrage opportunity would arise between the spot and forward
rates. Therefore, in order to prevent these arbitrage opportunities arising, the spot and forward
exchange rates must be linked by the interest rate parity principle or by arbitrage pricing.
Market convention is for the spot rate to be quoted with a premium or discount, rather than for the
forward rate to be quoted.
Premiums and Discounts

If interest rates are higher in the base currency than the quote currency, a premium
between the spot and forward exchange rate is said to arise.
Premiums
Premiums are deducted from the spot exchange rate to derive the forward
exchange rate.
If interest rates are lower in the base currency than the quote currency, a discount
Discounts arises.
Discounts are added to the spot rate.
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1.5 FX Futures, Options and Swaps
Learning Objective
4.1.3 Understand the characteristics and pricing of FX futures, options and swaps
In both the spot and forwards market, the intention of both parties is to deliver the currencies involved.
Currencies can, however, also be traded in the derivatives markets.
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• FX futures and options share the same characteristics of futures and options that are considered
later in this chapter and can be traded on exchange and OTC.
• An FX swap is a type of OTC derivative – swaps are also considered later in this chapter.
In the FX swap market, one currency is swapped for another for a period of time, and then swapped
back. The opening leg of the transaction will typically be a spot transaction and the closing one an
outright forward.
Dealers often find it useful to shift temporarily into or out of one currency in exchange for a second
currency without incurring the exchange rate risk of holding an open position or exposure in the
currency that is temporarily held.
They are widely used by traders and other market participants for managing liquidity and shifting
delivery dates, for hedging, speculation and taking positions on interest rates.
The cost of an FX swap is quoted in swap points and is determined by the interest rate differential
between the two swapped currencies. The counterparty that holds the currency that pays the higher
interest rate for the period of the swap will pay the points, neutralizing the interest rate differential and
equalizing the return on the two currencies; and the counterparty that holds the currency that pays the
lower interest rate will earn or receive the points.
1.6 Uses of FX
Learning Objective
4.1.4 Apply an understanding of how FX transactions are used for: foreign currency cash
management; speculation
Foreign currency can be regarded as an asset in its own right and is a factor that has to be considered
with a globally diversified portfolio.
The FX market is the largest and most liquid in the world and has historically displayed low correlations
with other traditional asset classes. The characteristics of the FX market may lead to market inefficiencies
and profit opportunities arising that are unobtainable in traditional markets. As such, a professionally
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managed basket of currencies may provide positive returns over time, while potentially providing
valuable diversification benefits.
There are many benefits to investing in overseas assets, particularly overseas equities, owing to the
positive diversification effects that can result.
Currency risk can, however, either augment or detract from the return generated by the asset. Foreign
currency risk can be reduced, though not completely eliminated, by employing the following hedging
instruments or strategies:
• forward contracts;
• back-to-back loans;
• foreign currency options;
• foreign currency futures;
• currency swaps.
Exchange rate forecasting is an inexact science despite the existence of parity relationships and
advances in forecasting techniques. Although overseas currency hedging should be considered when
investing, like any other form of hedging the result is usually imperfect.
Depending on the method adopted, hedging strategies can also be costly to devise, time consuming
and sometimes inflexible. Indeed, research suggests that, on balance, hedging should be used when
investing in overseas bonds but generally avoided when investing in a diversified portfolio of overseas
equities denominated in a variety of currencies.
2. Property
Learning Objective
4.2.1 Understand the characteristics of the main types of direct and indirect property investments:
sectors – residential; buy-to-let; commercial; types – freehold; lease structures; operation
– conveyancing; costs; valuation finance and gearing; investment funds – range of indirect
investment vehicles available
Property has an instinctive appeal to many investors and its tangible character means many people
have views on the state of the property market and property prices.
2.1 Characteristics of Property

Over the last few decades, investment in property has proliferated as people saw the value of properties
rise this led to greater interest in this asset class.
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Property as an asset class is unique in its distinguishing features:
• Given that each individual property is unique in terms of location, structure and design, the property
market can be segmented into an infinite number of individual markets.
• Valuation is subjective as property is not traded in a centralised market place and continuous and
reliable price data is not available.
• It is subject to complex legal considerations and high transaction costs upon transfer.
• It is highly illiquid as a result of not being instantly tradable.
• It is not divisible. Since property can only be purchased in discrete units, diversification is made
difficult.
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• The supply of land is finite and its availability can be further restricted by legislation and local
planning regulations. Therefore, price is predominantly determined by changes in demand.
2.1.1 Property Sectors

Property has a role to play in a well diversified portfolio and an investment manager needs to consider
whether exposure to the residential or commercial sector is appropriate for the portfolio they are
managing.
These two markets do not move in parallel and appeal to different categories of investor. It is therefore
important to understand the differences between the two.
Residential Property
The residential property market is, of course, dominated by the owner-occupier, and their house is still
often the main asset that a private investor has.
Investing in residential property beyond the individual’s own home usually involves buying a second
holiday home or investing in buy-to-let property; that is the private rented sector.
Strong capital performance since the 1990s led to significant growth in the buy-to-let market and
although that situation changed with the onset of recession and the decline in house prices, the sector
has since seen improving conditions.
• A period of low interest rates has seen investors seeking income and the higher returns available
from rented properties seem attractive.
• The loan-to-value (LTV) ratios set by most banks for mortgage lending mean that first-time buyers
are finding it difficult to enter the property market and so are thereby increasing the demand for
rental properties.
Investing in a residential property is not the same as buying a family home as other factors need to be
considered:
• Rental yields on residential property vary widely, depending upon the property’s age, size, location
and tenants.
• The costs of renting out property where management agents are used can be 10–15% of rents.
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• The expected levels of rental income and therefore the yield, needs to take account of management
fees, insurance and maintenance costs. An allowance for voids – periods when the property is empty
– also needs to be factored in to expected return.
• Long rental agreements are usually avoided as they may give tenants rights and depress property prices.
• Capital returns may differ from the return on a family home as the property value will also have to
reflect the expected yield that investors are seeking.
Commercial Property
Commercial property is divided into three main sectors: retail, offices and industrial. The types of
underlying property contained in each sector are shown below.
Commercial Property Sectors

The retail sector includes shopping centres, retail warehouses, standard shops,
Retail
supermarkets and department stores.
Offices The offices sector includes standard offices and business parks.
The industrial sector includes standard industrial estates and distribution warehousing,
Industrial
or logistics facilities.
The geographical distribution of commercial property in a country will often be driven by different
factors which can influence a property’s price and its rental. Academic research has shown that
commercial property is found to be concentrated in a few preferred geographic clusters and that these
vary by property sector.
• Retail property tends to be more evenly distributed across regions than offices or industrial.
Shopping centres, retail warehouses, department stores, supermarkets and standard shops are
found in most towns of any size throughout the country and, with the exception of standard shops,
come in large lot sizes. Although widely spread, it tends to be clustered in areas with above average
employment and above average spending power.
• The office market tends to be heavily skewed towards important cities and financial centres. Office
investment is concentrated in clusters with a significant number of large, high values offices in the
financial services industry such as in London.
• Industrial property also tends to be concentrated in prosperous areas that have access to distribution
networks, appropriate infrastructure and experienced technical skills.
Commercial property differs from the buy-to-let market and some of the main differences are:
• The tenant will usually be responsible for repairs and will have to maintain the property.
• A significant component of the return from commercial property comes from income, so the lease
will usually be for a long period of time and contain clauses for the rent to be reviewed periodically.
Full Repairing and Insuring Leases

• The majority of leases of commercial property use a full repairing and insuring lease.
• This imposes repair and insurance obligations on the tenant so that landlords can ensure they have
as good an investment as possible by passing on as many costs as possible to the tenant.
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• The repairing obligation is likely to stipulate that the tenant must repair and maintain the property
in the condition at the start of the lease and importantly to hand it back in that condition at the end
of the lease.
• In the majority of cases, the landlord insures the property with the tenant repaying the premium to
the landlord. The landlord will usually insist on insuring the property as they are then in control and
can ensure that the property is properly insured at all times.
When a commercial property is rented out, a rent review period is agreed between the landlord and
the tenant and set out in the terms of the lease. Typically, commercial rents may be reviewed every five
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years and the revised rent is based on what rents can be achieved in the open market for comparable
properties. Leases often provide for upwards-only reviews where the new rent cannot be lower than the
rent that the tenant is currently paying.
Differences between Residential and Commercial Property

Some of the key differences between residential and commercial property are shown in the table below.
Residential Property Commercial Property
Size of investment required means direct

Range of investment opportunities
Direct investment in commercial property
including second homes, holiday homes
investment is limited to property companies and
and buy to let
institutional investors
Long-term contracts with periods
Tenancies Typically short renewable leases
commonly in excess of ten years
Repairs Landlord is responsible Tenant is usually responsible
Significant component is income return
Returns Largely linked to increase in house prices
from rental income
The commercial and residential property markets are very different and often move in different directions.
2.1.2 Types of Property

Private international law draws a distinction between movable and immovable property in most
countries. Immovable property is usually defined as land and things attached to or growing on the land.
Immovable property is called by different names around the world – real estate; real property;
immobilier – and it is important to distinguish how the term is being used in respect of ownership
when it is encountered. The following table sets out in simplified terms the two main types that are
encountered although the precise term and its meaning used may change from country to country.
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Freehold and Leasehold Property
A freehold interest in a property means that the owner has outright ownership of land
or property for an unlimited period.
Freehold The freeholder of a property has the right to use or dispose of the property as they wish,
albeit subject to legislation, local planning laws and any covenants that specifically
apply to the property.
A leasehold interest is, on the other hand, a temporary right to occupy land or property.
A lease will be for a fixed term and can last for either a short period or many, many years.
A person who owns the freehold interest in a property may grant a lease on it to another
person and by doing so creates a lesser interest in the property known as a leasehold
Leasehold interest.
The leaseholder, or tenant, to whom this interest is conferred, has the right to use the
property for a specific period, subject to the terms of the lease and the payment of rent.
Unless prevented from doing so under the terms of the lease, the leaseholder can also
create a sub-lease and act as the head lessee to a sub-tenant.
2.1.3 Property Transactions

Property Valuation
With the exception of auctions, there is obviously no formal public market in commercial or residential
property and transactions are agreed between buyers and sellers, often using the services of specialised
agents.
This lack of a formal exchange means that valuers are used to estimate the likely selling price of a
commercial property. This process combines financial information about the property with market data
to come to a balanced, evidence-supported assessment of its value.
Property Finance and Gearing

The property market is dependent on the availability of finance from banks and other providers.
Appropriate gearing allows property investors and developers access to larger opportunities and thus
the chance to leverage higher returns.
Finance and funding underlies much of the activity which goes on in the property market, with deals
ranging from relatively simple residential mortgages to highly complex structured deals which may
involve several tiers of finance from a variety of sources.
Property Transaction Costs

Sales and purchases of property are both time consuming and expensive. The costs of buying a property
are significant when compared with other assets and in the UK, for example, average around 1.75% for
agents’ fees and legal costs. In addition, property taxes may be applied such as stamp duty land tax (SDLT).
Transfer of Property
Transfer of property rights is governed by the lex situs principle in most countries. This simply means, for
example, that when property is situated in England, English domestic law is applicable. The reasoning
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for this is that the property is under the close control of the authorities of the country where the property
is situated.
Conveyancing is the legal term that describes the transfer of ownership of property. Property law
requires this to be formally documented and then the change of ownership recorded in the records of a
government land records agency.
In many countries, title is recorded electronically, which can provide conclusive evidence of title to
property and make transfer of ownership relatively straightforward. Other countries still have a deeds
system where title is proved by a set of legal documents that trace the legal history of ownership of the
4
property. Transfer of ownership is then more difficult, as complex due diligence needs to be undertaken
to prove that a valid title is held.
2.2 Risks and Returns
Learning Objective
4.2.2 Analyse the sources of risk and return associated with investing in property and property funds;
factors affecting returns – capital growth; yield; location and quality; occupancy rate; tenant
creditworthiness; term and structure of lease; risks – liquidity; volatility; sector risk
4.2.3 Analyse property and property funds from an investment perspective; cash flow and average
yield; capitalisation rate; rental value and review; reversionary value; investment performance
measurement; role of Investment Property Databank (IPD).
2.2.1 Returns
As an asset class, property has at times provided positive real long-term returns allied to low volatility
and a reliable stream of income.
• It is an asset-backed investment and can therefore provide some long-term protection against
inflation.
• Tenants of commercial property have to pay their rent even when they make a loss, giving it some of
the characteristics of bonds although if a property becomes vacant and tenants cannot be found, the
asset can become a drain on resources.
• Commercial property values follow business profitability only in very general terms, and the property
cycle can be different from the business profit cycle.
• In areas where businesses flourish and people live, demand for property rises and with it rents and
land values.
Commercial Property
Commercial property as an asset class offers a number of portfolio benefits including stable cash flows,
performance, low volatility and diversification.
A significant part of the return from commercial property comes as rental income, so the length of leases
and the income yield are important factors.
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• Although the length of new leases has been shortening in recent years, the average is over ten years
for retail property, more than seven years for offices and slightly less than seven years for industrials.
• On average, commercial property leases provide a contracted income stream of around seven years
based on the period to the expiry of the lease, but ignoring break options.
• The income yield from commercial property is relatively high and has been one of its attractions.
Equally important is the quality of the tenant. In the commercial property market, it is the quality of
the tenant’s covenant and the tenant’s ongoing ability to pay the rent that are the most important
considerations upon acquisition. A tenant that is regarded as institutional can provide an attractive,
long-term income stream that can be used to service debt, to provide an income to the investor, or a
combination of the two.
Capital growth has, however, fluctuated considerably. For example, property outperformed UK bonds
and UK equities between 2000 and the end of 2006 but the commercial property market then fell sharply
in 2007. In 2008, property rebounded and outperformed equities but not gilts. 2009 saw equities once
again rebound and returns outstripped other asset classes, demonstrating the point that returns from
different asset classes vary with economic conditions and emphasising the importance of diversification
and asset allocation.
Commercial property’s volatility has tended to be lower than that of other asset classes and offers
diversification benefits as the real estate market does not follow the same pattern as the two other main
asset classes, equities and bonds. In contrast, the performance of equities and gilts is strongly correlated.
Residential Property
A significant part of the return from residential property also comes as rental income but there is a wide
divergence in the levels of income that can be obtained from letting residential property.
• The residential investment property market tends to focus on flats and small houses: as a general
rule the larger the property, the lower the rental yield.
• The returns from more expensive properties are generally lower than the returns from cheaper
properties. This is because there is an upper limit on what most tenants can afford to pay as rent.
• Some of the highest yields are available from student lets, but this category of tenant may involve
the most work for the landlords or their agents.
Rental levels are important for many private investors, as a large portion of the rent is often consumed
by mortgage interest. The actual return, however, is highly dependent on costs, maintenance outlays
and void periods.
• An agent’s management fees can account for around 10–15% of rents.

• Maintenance costs can fluctuate widely and, on occasions, can absorb all of the rental income and
more, especially with older property.
• Void periods when the property is empty can significantly reduce the actual return achieved.
Capital growth will depend on the state of the housing market as well as other factors.
• The residential housing market is also cyclical and highly dependent on consumer incomes and
confidence.
• Where the property is situated can make substantial differences to values and prospects for growth.
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• The age and condition of the property will also clearly affect the value of a property and its prospects
for growth.
• Where the property is being sold as an investment property, its value will be highly influenced by
the general level of returns elsewhere in the market, the availability of tenants, the types of tenant
the property is suitable for and the tenure of the property.
Diversification in the residential property market is challenging. Cost presents the most obvious
practical issue of the scale of diversification that is possible. Where investment can be spread over a
series of properties, then buying ones in different locations can reduce the risk of concentration but can
increase management costs.
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2.2.2 Risks
An exposure to property can provide diversification benefits owing to its low correlation with both
traditional and alternative asset classes. However, property can be subject to prolonged downturns
and, if invested in directly, its lack of liquidity and high transaction costs on transfer only really make it
suitable as an investment medium for the long-term.
Risks associated with property investment include:
• property risk;
• location of the property;
• the effect of the use of the property on its value;
• the credit quality of the tenants;
• the length of the lease;
• market risk;
• effect of changes in interest rates on valuations;
• performance of individual property sectors;
• prospects for rental income growth;
• investment vehicle risk;
• liquidity of indirect investment vehicles;
• diversification of the underlying portfolios;
• level of gearing.
Although property has a place in a well diversified portfolio, from an investment perspective its volatility
and lack of liquidity should not be forgotten.
Volatility or Sector Risk

The recent financial crisis saw the values of both residential and commercial property fall significantly and
they have yet to fully recover. Investors were unable to readily sell their properties, and property funds
imposed redemption moratoriums so that investors had to wait up to 12 months to realise their holdings, as
fund managers tried to restrict the damage that flooding the market with forced sales would have caused.
This does not, however, negate the argument supporting the inclusion of property within a properly
diversified portfolio. The declines in 2008–09 need to be seen in the context of the long-term growth
seen in real property value over the long-term.
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It is important to remember though that property is an asset whose price is subject to the laws of supply
and demand and is affected by the economic cycle just as other assets are. When supply and demand
get out of balance price bubbles can arise and when they burst, investors can be left nursing significant
losses but equally buying opportunities can arise until equilibrium is restored.
The value of residential properties is inextricably linked to affordability, and the adviser should remain
keenly aware of published statistics that show this.
Commercial property is particularly exposed to interest-rate risk. Commercial and residential properties
are valued on their income-producing capabilities and so rises in interest rates will depress prices in
order to force up yields.
Liquidity
One of the main risks of direct property investment is its lack of liquidity. The main reasons for this are:
• Property is relatively expensive to buy and sell with agent fees, legal fees and land taxes payable.
• Property often takes some time to sell. Even in a good market, the period between putting a
property on the market and receiving the cash can be several months. In poor markets, it can take
years to make a disposal.
During the credit crisis, the illiquid nature of property investment led a number of property funds to
close their funds to redemptions, owing to the inability of the companies to sell the properties fast
enough to return money to investors.
2.2.3 Property Analysis

Like other assets, property can be evaluated using a number of measures.
Average Yield
The return on an investment in property is measured by an initial yield. The initial yield is calculated as
follows:
Annual rental income
Initial yield = ______________________ × 100
Price of the property
The annual rental income is the yearly rent a property earns when leased.
Rental Yields
An investor purchases an investment property for $25m, which is leased at an annual rent of $1.5m.
The initial yield is calculated as follows:
1.5m
Initial yield = -------------- × 100 = 6%
25m
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Rental Reviews
The initial yield is used by property investors to compare property investment opportunities. However,
it is inaccurate as a measure for comparison with other investments, because it does not allow for the
rental growth that a lease provides through rent reviews.
Some leases include break clauses that can significantly impact on the investment value of a property as
they can give the landlord and the tenant the option to end the lease before its expiry date.
• The standard convention is to assume that a tenant’s break option will be exercised and that it will
negatively impact as the income from the property can change or even disappear at this point.
4
• On the other hand, landlords’ break options can have a positive impact, as they give the opportunity
to relet at a higher rent, find a better tenant or refurbish the property.
Capitalisation Rate
The capitalisation rate is used to evaluate the value of a property based on the rental income it will
produce.
Whilst a variety of factors will be considered when evaluating a property, investors need a method to
compare different properties that cost different amounts and generate different levels of income. The
capitalisation rate enables investors to do this and to also compare the return against other types of assets.
The capitalisation rate is determined by dividing the net income generated by the property by its asking
price to determine what yield it is producing.
Capitalisation Rate
Staying with the example above, an investor is looking to buy an investment property for $25m, which
is leased at an annual rent of $1.5m. Let’s assume that management costs account for 10% of the annual
rental. The capitalisation rate is:
1.5m – 150k
-------------------------------- × 100 = 5.4%
25m
The capitalisation rate can be further refined to account for costs of purchase such as legal and any
agent charges.
The capitalisation rate can also be used to determine what the current value of the property should be
by using an expected return on the property. The price of the asset can be determined by dividing the
annual net income generated by the property by its expected return.
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Capitalisation Rate
An investor is evaluating two properties and wants to determine what would be an appropriate price to
pay given that they expect rental properties to produce a return of 5%. Property A generates an annual
net income of $100k and property B generates an annual net income of $75k.
$100k
Value of property A = = $2,000,000
0.05
$75k
Value of property B = = $1,500,000
0.05
As property valuations are a subjective opinion of an estate agent or valuer, one advantage of the
capitalisation rate is that it provides a separate evaluation of the property’s value to compare against
the market appraisal.
The capitalisation rate also allows a comparison to be made with other assets. The expected return of
5% in our example above can be evaluated against comparable returns from cash, bonds and equities.
Reversionary Value
The reversionary value of a property is its value at the end of a period such as the end of a lease. For
example, a landlord may estimate the reversionary value of their property once a lease expires in ten years’
time as $100k; in other words, they expect that the property can be sold for that amount in the future.
Investment Performance Measurement

Commercial property investors need a standard benchmark to measure the returns they achieve on
their real estate and compare its performance. This is provided by an independent research company,
IPD (Investment Property Databank), which produces objective, reliable property benchmarks and
indices for around 20 countries.
2.2.4 Investment Funds
Learning Objective
4.2.1 Understand the characteristics of the main types of property: sectors – residential; buy-to-let;
commercial; types – freehold; lease structures; operation – conveyancing; costs; valuation finance
and gearing; investment funds – range of indirect investment vehicles available
The availability of indirect investment makes property a more accessible asset class to those portfolio
managers running smaller diversified portfolios.
Some of the ways in which indirect exposure to property can be obtained are shown in the following
table.
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Property Investment Vehicles

• The shares of property developers can be a useful way of gaining exposure to the
fortunes of the property market.
Property • However, they are often difficult to value and tend to mirror the fortunes of the
companies equity market rather than the property market.
• Listed property company shares can also be less tax efficient as the company will
be taxable on its profits and the investor taxable again on dividend distributions.
• Real estate investment trusts (REITs) are now widely available for both local and
global residential and commercial property investment.
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REITS
• They are usually required to distribute 90% of taxable profits so that they are not
liable to corporation tax and instead the income is taxable in the investor’s hands.
• There are a range of mutual funds that invest in properties including unit trusts
and SICAVs.
Mutual • Authorised funds will often have to abide by rules on diversification of assets and
funds minimum cash balances that have to be held to meet investor redemptions.
• Unauthorised funds may have more flexibility but cannot be marketed to the
general public and are only suitable for sophisticated investors.
• Life insurance companies have unit-linked life and/or pension funds that invest
Life directly in property.
assurance • They are typically part of a range on offer to investors in occupational or personal
bonds pension schemes and their longer-term nature usually allows them to operate
with less cash reserves than authorised mutual funds.
Limited • Limited partnerships are popular with specialised investors as they are tax
partnerships transparent and can be leveraged.
• Commercial property syndicates allow investors to pool their assets to buy one or
more properties.
• The advantage of investing this way is that individuals can gain direct exposure to
Syndicates a higher-priced commercial property than they could buy on their own.
• In comparison to funds, syndicates are typically used by wealthy individuals or
sophisticated investors with large amounts of money to invest.
• Many private banks offer property investment syndicates to clients.
• Real estate derivatives are financial instruments which give investors a return that
reflects the performance of the direct property market.
Derivatives
• They are a relatively new area but include property income certificates, structured
products based on an IPD index and IPD index swaps.
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3. Derivatives
3.1 Characteristics of Derivatives
Learning Objective
4.3.1 Understand the core concepts, terminology, characteristics and uses of: futures; options; swaps
Mention derivatives and people tend to think of high-risk instruments that are impenetrably complex.
Derivatives can be high-risk; after all, it was trading in derivatives that contributed to the collapse of
Lehman Brothers and massive monetary losses at many other organisations during the credit crisis.
However, it is not necessarily true that these instruments are inherently dangerous. In fact, many of
these derivatives are not particularly complex either.
They are chiefly designed to be used to reduce the risk faced by organisations and individuals; an
approach technically referred to as hedging.
Uses of Derivatives
Derivatives are not a new concept – they have been around for hundreds of years.
Their origins can be traced back to agricultural markets where farmers needed a mechanism to guard
against price fluctuations caused by gluts of produce and drought. So, in order to fix the price of
agricultural produce in advance of harvest time, farmers and merchants entered into forward contracts.
These set the price at which a stated amount of a commodity would be delivered between a farmer and
a merchant (termed the counterparties) at a pre-specified future time.
A forward is, therefore, a derivatives contract that creates a legally binding obligation between two
parties for one to buy and the other to sell a pre-specified amount of an asset at a pre-specified price
on a pre-specified future date. As individually negotiated contracts, forwards are not traded on a
derivatives exchange.
These early derivative contracts introduced an element of certainty into commerce and gained immense
popularity; they led to the opening of the world’s first derivatives exchange in 1848, the Chicago Board
of Trade (CBOT).
The exchange soon developed a futures contract that enabled standardised qualities and quantities of grain
to be traded for a fixed future price on a stated delivery date. Unlike the forward contracts that preceded it,
the futures contract could itself be traded. These futures contracts were subsequently extended to a wide
variety of commodities and offered by an ever-increasing number of derivatives exchanges.
It wasn’t until 1972 that the Chicago Mercantile Exchange (CME) introduced the world’s first financial
futures contract when they launched currency futures with the creation of the International Monetary
Market (IMM) – the first futures market for financial instruments.
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It wasn’t until 1975 that CBOT introduced the world’s first financial futures contract. This set the scene
for the exponential growth in product innovation and the volume of futures trading that soon followed.
Types of Derivatives
The essential difference between forwards, futures and options is shown below.
Types of Derivatives
A forward contract is an OTC transaction in which delivery of the commodity/asset is
deferred until a date in the future that is specified in the contract.
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Although the delivery is made in the future, the price is determined on the initial trade date.
A future is a contract between two parties to make or take delivery of a specific quantity
and quality of a specified asset on a fixed future date at a price agreed today.
The contract is standardised and traded on an exchange.
An option is a contract that allows the holder to choose whether to buy or sell an asset at a
price that is agreed today in return for payment of a premium.
The contract is standardised and traded on an exchange.
The Role of Derivatives in a Portfolio

Derivatives are used for both hedging and speculation.
They have a major role to play in the investment management of many large portfolios and investment
funds, and are used for hedging, anticipating future cash flows, asset allocation change and arbitrage.
Hedging is a technique employed by portfolio managers to reduce the impact of adverse price
movements, for example by selling sufficient futures contracts.
Closely linked to this idea, if a portfolio manager expects to receive a large inflow of cash to be invested
in a particular asset, futures can be used to fix the price at which it will be bought and offset the risk that
prices will have risen by the time the cash flow is received.
Changes to the asset allocation of a fund, whether to take advantage of anticipated short-term
directional market movements or to implement a change in strategy, can be made more swiftly and less
expensively using futures than by adjusting the underlying portfolio.
Arbitrage is the process of deriving a risk-free profit from simultaneously buying and selling the
same asset in two different markets, where a price difference between the two exists. If the price of a
derivative and its underlying asset are mismatched, the portfolio manager may be able to profit from
this pricing anomaly.
Derivatives can also be used to gain exposure to illiquid assets such as a property derivative based on
a commercial property index. Derivatives are also used for speculation. Since only initial margin, and
not the full notional value of the contract, is payable by the counterparties at the point of opening their
respective positions, futures provide an ideal means by which to speculate on both rising and falling
asset prices in a range of markets.
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3.2 Futures, Options and Swaps
Learning Objective
4.3.2 Apply an understanding of how derivatives strategies are used within portfolio management
for the purposes of: hedging; immunization; speculation; rebalancing
3.2.1 Futures
A future is a legal agreement between a buyer and a seller to make or take delivery of a specific quantity
and quality of a specified asset on a fixed future date at a price agreed today.
• The buyer agrees to pay a pre-specified amount for the delivery of a particular quantity of an asset
at a future date.
• The seller agrees to deliver the asset at the future date, in exchange for the pre-specified amount of
money.
Key Characteristics
Futures are often described as futures contracts because they are traded on organised exchanges such
as Liffe in London, the CME Group in the US, or the Eurex Exchange in Germany.
The terms of each contract are standardised in a legal document called the contract specification. This
is because it would not be financially viable for an exchange precisely to satisfy every single trader’s
requirements regarding particular underlying assets. The aim of the contract specifications is to allow
participants to take positions on general price movements in any given market.
The price is agreed between buyer and seller. In fact, it is the sole element of the futures contract that is
open to negotiation. However, the exchange does specify the minimum permitted movement in price
and the method of quotation.
Standardisation
CBOT, now part of the CME Group, trades wheat futures, where the contract is based on a set of specific
grades of wheat and the specific quantity is 5,000 bushels; in other words each individual contract
represents 5,000 bushels of wheat.
The specified asset is obviously wheat, but of what quality? The contract specification goes to great
lengths to detail precisely what is acceptable under the terms of each contract. For example, the CBOT’s
wheat future specifies that the grain must be a specific deliverable grade, a list of which is set out
by the exchange. It also specifies what form of delivery is acceptable by listing the names of storage/
warehouses to which delivery must be made.
For a wheat future contract the quote is on a per bushel basis and the minimum movement is 0.25 of a
cent ($0.0025) per bushel (known as the tick size) and, because each contract represents 5,000 bushels,
the value of the minimum price movement per contract (the tick value) is $12.50 per contract.
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The fixed future date is also laid down by the exchange. Although it is a set day within the month, the
fixed future date is often referred to as the contract month, and for the CBOT wheat future there are
delivery months in March, May, July, September and December each year.
For all futures contracts, the contract specification standardises the futures product and, as long as
the contracts have a common underlying asset and a common delivery date, the contract is said to be
fungible; in other words it is identical to, and substitutable with, others traded on the same exchange.
Fungibility
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Futures contracts and options are fungible since they are highly standardised contracts. To be
interchangeable, they need to be for the same underlying asset and delivery date. For example:
All March long gilt futures on NYSE Liffe London are fungible.
A March long gilt future on NYSE Liffe London is not fungible with a June Long Gilt future on the same
exchange, because the delivery dates are different.
Forwards and swaps are not fungible since they are customised contracts.
The consequences of standardisation and fungibility are:
• Traders know what they are trading.

• Traders know what their delivery obligations are; buyers know the cost of the asset they have
bought, and sellers know the amount they will receive and the quality of the asset they have sold.
• Contracts are easy to trade because activity is concentrated in a single contract.
• It is possible to trade large volumes.
• The concentration of activity provides liquidity and therefore efficiency to the market.
Futures positions are opened by going long (buying) or short (selling).
• By opening either a long or short futures position, the trader becomes exposed to changes in the
futures price and the position will incur profits or losses as a result of the movement in price.
• Holding the contract to expiry will oblige the trader to meet the delivery obligations. If the price of
the asset rises, the futures buyer will have made a profit. The trader will take delivery at the lower
price and be able to sell the asset in the cash market at the higher price.
• Conversely, if the price is lower than the agreed price, the trader’s counterparty (the futures seller)
will make a profit.
The fungible nature of contracts means that a trader can remove any delivery obligations by taking an
equal and opposite position. The trader is described as having closed out his position.
Closing Out
For example, a trader who has bought a future and is required to buy a specified quantity of the
underlying asset can simply sell a fungible future. The result is that they have agreed to both buy and
sell the same item at the same future date.
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Terminology
Futures have their own specialised terminology and some of the key terms that are regularly
encountered are shown below.
Terminology
Futures An exchange-traded contract that is a firm agreement to make/take delivery of a
contract standard quantity of a specified asset on a fixed future date at a price agreed today.
Contract The contract specification standardises the futures product in terms of quantity per
specification contract, acceptable quality and delivery date.
The smallest permitted variation between prices quoted to buy and sell on derivatives
exchanges.
Tick size
For example, the tick for gold is 10 cents so prices of $1,280.00, $1,280.10, $1,280.20
can be quoted but not $1,280.13.
Tick value The profit or loss that arises when prices move by one tick.
The settlement of a contract by delivery of the asset by the seller to the exchange
Delivery clearing house. The long position holder takes delivery from the clearing house against
payment.
Contracts for Difference (CFDs)

Some futures contracts are based on tangible goods such as grain and oil. If the contract is carried
through to expiry there will be an exchange of the underlying for the pre-agreed cash sum. These
contracts are described as being physically deliverable.
However, many people trade in futures contracts where the underlying is intangible such as a stock
market index. At the end of the contract, physical delivery of the underlying is either impossible or
impractical. Contracts where the underlying is intangible are known as contracts for differences
(CFDs) and are cash settled.
Example
An investor buys a FTSE 100 future at an agreed price of 6500 points and at expiry the index stands at
6515 points. The investor has made a profit, not by buying or selling a tangible asset such as grain or a
bond, but by receiving a set amount of cash for each point gained.
The amount of money for each point is specified in the futures contract. In the case of the FTSE 100
future traded on LIFE in London, that amount is £10, so the seller of the future simply pays the buyer 115
points multiplied by £10, in other words £1,150.
Futures Pricing
Whilst it is tempting to think that the futures price is the market’s perception of what the price of the
underlying asset will be at the time of delivery, this is not always the case.
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Although prices in both markets are set by the interaction of buyers and sellers, there is a mathematical
relationship that binds them together – fair value of the future = cash price + cost of carry.
Fair Value of a Future

The cost of carry can be understood by comparing buying an asset today in the cash market or a future
for delivery in three months’ time:
• By buying the asset today, the investor is forgoing the interest which could be earned on the funds
for the coming three months.
• There may be costs associated with storing the asset until it is needed, as in the case of a commodity.
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• The result is that anyone wanting delivery of the asset in three months’ time will be willing to pay a
higher price because they are earning interest on their funds in the meantime and not incurring any
storage costs.
• Similarly, the person holding the asset will require a higher price for future delivery to compensate
for the costs involved.
These are referred to as costs of carry. The main components of costs of carry are:
• finance costs (interest) over the period;

• storage costs;
• insurance.
Knowing what the cash price of an asset is, and knowing how much it will cost to carry the asset up to
the moment of delivery, it is possible to calculate a futures price that will be fair to both the buyer and
seller of the contract.
• This is known as the fair value of the future.

• If the differential between the cash price and futures price is less than the cost of carry, the investor
is better off buying the future rather than buying the asset and holding it.
• If the differential is greater than the cost of carry, an investor is better off buying the asset and
holding it.
• It is only when the differential exactly reflects the cost of carry that the buyer is indifferent as to
whether to buy in the cash market or the futures market.
Contango and Backwardation

When the futures price is higher than that of the underlying asset, the market is said
to be in contango.
Contango
This is usual for a financial future and is the normal situation as there is a net cost of
carry.
However, when the futures price is lower than that of the underlying asset, the
market is in backwardation.
Backwardation Backwardation is common within commodities markets when there is a very steep
premium for material available for immediate delivery, indicating a perception of a
current shortage in the underlying commodity.
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Basis
Basis measures the difference between cash and futures prices.
• Basis is negative in contango markets. In contango markets the futures price is greater than the cash
price, so the basis will be a negative number.
• Basis is positive in backwardation markets. In backwardation markets, the futures price is less than
the cash price, so the basis will be a positive number.
Because of convergence, in both types of market the basis must narrow to zero as the contract moves
towards expiry. As the cost of carry determines the differential between cash and futures prices and is
the cost associated with holding the asset from now until expiry, it follows that as the point of expiry
approaches, the costs of carry diminish and the differential must narrow. At expiry, the cost of carry is
zero, so the cash and futures prices must converge over the life of the future until they meet at expiry.
In a perfect market, basis should reflect the cost of carry and the future would always trade at its fair
value. However, as markets are not perfect, the actual difference between two prices will be influenced
by short-term supply-and-demand pressures. It is unlikely that the future will be trading exactly at its fair
value at any moment in time.
Basis can change as a result of changes:
• in supply-and-demand;
• to the cost of carry, eg, interest rates, insurance costs, dividend yields;
• in time remaining to expiry (convergence).
Movements in basis can adversely impact hedging strategies and correctly anticipating the changes in
basis can provide trading opportunities.
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Risk/Reward Profile of Futures

There are three ways futures can be used.
Using Futures
Speculators seek to make a profit from price movements by buying or selling futures
contracts. Speculative investments involve a high degree of risk and usually have short
holding periods.
If an investor feels the price of the underlying is going to go up, he can speculate by
buying the underlying asset itself or, alternatively, by buying futures contracts on that
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Speculation
underlying.
Futures are often seen to be more attractive than the underlying asset itself because
they are highly geared. Put simply, this means that a small expenditure/initial
investment gives the holder a big exposure to a market, ie, the potential for large
profits or losses.
People who want to guard themselves against adverse price movement hedge using
futures.
A hedger seeks to protect a position, or anticipated position, in the spot market
by taking an opposite position in the futures market. A perfect hedge is a risk-free
position.
Hedging For example, a fund manager can remove his exposure to a stock market fall that will
affect the portfolio of shares he manages. He does this by taking a temporary short
position in futures in an equity index. It will deliver profits to offset the impact a fall in
the stock market would have.
Fund managers often use these hedging strategies as temporary shields against
market movements.
An arbitrageur observes that the same underlying asset or financial instrument is
selling at two different prices in two different markets.
He undertakes a transaction whereby he simultaneously buys the asset or instrument
Arbitrage at the lower price in one market and simultaneously sells it at the higher price in the
other market.
Arbitrage gives him a risk-free profit that will be realised when the prices in the two
markets come back into line and the arbitrageur closes out the position.
As we saw above, the buyer of the future is described as going long. In other words, the buyer is agreeing
to take delivery of the underlying asset and hopes that the price of the underlying asset will rise.
As the following diagram shows, the long futures position makes money in a rising market and loses
money in a falling market.
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Long Futures Position
500
400
Profit
300
200
100 Profit
0
30 40 50 60 70 80 90 100 110 120
100
Underlying price
200 Loss
300
Loss
400
500 Prices fall Prices rise
The seller of the future is taking a short position. In other words, the seller is undertaking to make
delivery of the underlying asset and hopes that the price of the underlying asset will fall.
As the diagram below shows, the short futures position hopes to make money in a falling market and
loses money in a rising market.
Short Futures Position
500
400
Profit
300
200
Profit
100
Underlying price
0
30 40 50 60 70 80 90 100 110 120
100
200
300 Loss
Loss
400
500 Prices fall Prices rise
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As you can see, the long and short positions are mirror images of each other, so that if the long position
gains, the short position loses. For this reason, futures contracts are often referred to as a zero sum game.
Given that futures are highly geared instruments, if the market moves against the speculator, losses can
mount up very quickly. Indeed, following several high profile disasters involving derivatives, most non-
practitioners tend to think of futures solely as speculative instruments, used in the pursuit of making
quick profits, despite evidence to the contrary.
Whatever the perception, speculation per se should not be discouraged as, apart from adding to market
liquidity, without speculators those wishing to use futures to hedge risk would be unable to do so.
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3.2.2 Options
An option gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an
underlying asset at a pre-agreed exercise price, on or before a pre-specified future date or between two
specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer.
The two main types of options are:
• A call option gives the right to buy a specified quantity of an asset at a pre-agreed price.
• A put option gives the right to sell a specified quantity of an asset at a pre-agreed price.
The two parties to an options contract are the holder (or buyer of the option) and the writer. The writer
confers the right, rather than the obligation, to the holder to either buy or sell an asset at a pre-specified
price in exchange for the holder paying a premium for this right. This premium represents a fraction of
the cost of the asset or the notional value of the contract. Options, therefore, differ from futures in that
a right is conferred in exchange for the payment of a premium.
As the holder is in possession of a right, rather than an obligation, the holder does not have to exercise
this right if the transaction ultimately proves not to work in their favour. The option can simply be
abandoned with the loss of the premium paid. The writer, however, is obliged to satisfy this right if
taken up, or exercised, against them by the holder.
Potentially the writer has an obligation to deliver the asset to the holder of a call option at the exercise
price if the option is exercised. Alternatively, the writer could be required to take delivery from the
holder of a put option if exercised. All the holder can lose is the premium paid. As a result, only the writer
is required to make initial and variation margin payments to the clearing house.
Most exchange-traded financial options are cash settled rather than physically settled. Therefore, if
exercised, the cash difference between the exercise price of the option and that of the underlying asset,
rather than the asset itself, passes from the writer to the holder.
Call Options
With a call option, the buyer pays a premium for the right to buy the underlying asset on or before
expiry if they wish. The more the price of the underlying asset rises, the more profit the buyer will make.
The buyer (or holder) of a call option take a long call position, while the writer of the same option takes
the opposite short call position.
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Assume an investor buys a call option on ABC shares at a premium of 10 and an exercise price of 100
which is exercisable in three months’ time.
Call Option
ABC shares
20
Profit
Break even - 110

10 All the money
(Exercise price + premium)
0 Underlying share price

70 80 90 100 110 120 130
-10
Loss
-20
Option abandoned Option exercised
The diagram shows:
• Out-of-the-money – If the underlying share price is below 100, the holder will abandon the option
and lose the premium of 10.
• In-the-money – If the underlying share price is above 100, the holder will exercise the option.
• At-the-money – the underlying share price is the same as the exercise price.
• Break-even – If at expiry the underlying share price is 110, the holder will break even as it costs 100
to buy shares plus the premium of 10.
What happens at expiry depends on the price of the underlying shares on the expiry day.
• If the share price is below exercise price, the option is worthless and the holder will abandon the
option.
• If the prevailing share price is above the exercise price, the holder has the right to buy the shares at a
lower price than in the cash market. He will, therefore, exercise the option, paying the exercise price
for the share and then may sell it in the market for the higher price.
• Even if the market price is not above the breakeven price the option is worth exercising as the
holder will make a profit of say 1 per contract which can then be used to offset the up-front cost of
the premium.
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Risk Reward Profile

• The higher the price of the underlying shares, the more profit the buyer will make
and vice versa.
Holder • The maximum profit is unlimited.
• The maximum loss for the buyer is limited to the premium paid, as they can simply
abandon the option.
• The writer of the option clearly has a different perspective on the transaction.
• In return for writing the option, the seller of the option receives the premium and
is hoping that the underlying share price will not rise and so the holder will not
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exercise the option but instead abandon it, leaving the writer with the premium.
Writer • The higher the price of the underlying asset, the more loss the writer of the option
will make.
• The maximum profit is the premium.
• The maximum loss for the writer is unlimited as the price of the underlying asset can
theoretically rise to any level.
Put Options
With a put option, the buyer pays a premium for the right to sell the underlying asset on expiry if they
wish. The more the price of the underlying asset falls, the more profit the buyer will make.
Buyers of a put option take a long put position, while the writer of the same option takes the opposite
short put position.
Assume an investor buys a put option on ABC shares for a premium of 60 which can be exercised at 200.
The position would instead look as shown below.
Put Option
ABC shares
120
Profit Break even - 140
(Exercise price + premium)
60
At the money
0 Underlying
20 80 140 200 260 320 330 share price
-60
Loss
-120
Option exercised Option abandoned
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The diagram shows:
• Out-of-the-money – if the underlying share price is above 200, then the holder will abandon the option.
• In-the-money – if the underlying share price is less than 140, the holder can exercise the option to
sell at 200.
• At-the-money – the underlying share price is the same as the exercise price.
• Break-even – if at expiry, the underlying share price is 140, the holder could buy the shares in the
open market and exercise option to sell at 200. Profit of 60 is offset by premium of 60.
So, at expiry:
• If the share price is above the exercise price, the holder will abandon the option. The option is worthless.
• If the share price is below the exercise price, the holder can buy the share in the cash market at the lower
price then exercise the option at the strike price, thus selling the share at the higher price to make a profit.
Risk Reward Profile

• The potential risks and rewards for the long put position are:
the maximum profit is the strike price less the premium paid;
Holder
the maximum loss for the buyer is limited to the premium paid as they can
simply abandon the option.
• The seller of the put option will receive the premium but takes on the obligation to
buy the underlying asset at the exercise price at expiry.
• From the perspective of the writer, therefore, they are hoping that the share price
will not fall as expected and so the buyer will abandon the option, leaving them with
Writer
the premium.
• As a result, potential risks and rewards for the short put position are:
the maximum profit is the premium;
the maximum loss for the writer is the strike price less the premium.
Exercise Style
The exercise style of an option describes how it may be exercised. The three most popular exercise styles
are European, American and Bermudan.
Exercise Styles
• With a European option, the holder can exercise the option only on the expiry
European
date. With a three-month option, for example, he can choose only at the end of
option
three months whether or not to exercise.
• An American option, however, allows the holder to choose to exercise at any time
American
between the purchase of the option and expiry. The premium is normally higher
option
for American options, if all other specifications of the option are the same.
• Bermudan options lie between European and American. A Bermudan option can
Bermudan
be exercised on any of various specified dates between original purchase of the
option
option and expiry.
European and American options are both available everywhere; the terms are technical, not geographical.
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Intrinsic and Time Value

The premium for an option is made up of its intrinsic value and its time value:
• Intrinsic value – this is simply the value of the option if it were to be exercised now.
• Time value – an option with a long time to expiry will have a greater amount of time value
incorporated into its price, so that the longer the period, the greater will be the time value.
Example
A call option with the right to buy at 90 is trading at 30 when the underlying is trading at 100. The
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intrinsic value is 10 and the time value is the remaining 20.
From this example you can see that = Intrinsic value + Time value = Premium.
In practice, the option premium will be affected by many factors including:
• Underlying asset price – the higher the asset price, the more valuable are call options and the less
valuable are put options.
• Exercise price – the higher the exercise price, the less valuable are call options and the more
valuable are put options.
• Time to maturity – the longer the term of the option, the greater the chance of the option expiring
in-the-money; therefore, the higher the time value and the higher the premium.
• Volatility of the underlying asset price – the more volatile the price of the underlying asset, the
greater the chance of the option expiring in-the-money; therefore, the higher the premium.
There are two other factors that will affect the option premium: the income yield on the underlying
asset and short-term interest rates. It should be noted that their effects on option prices are fairly minor
in relation to the other factors.
3.2.3 Swaps
So far the focus has been on exchange-traded derivatives (ETDs) rather than the over-the-counter (OTC)
or off-exchange derivatives. The OTC derivatives market is by far the larger in terms of notional value of
contracts traded.
As seen earlier, exchange-traded futures and options are standardised contracts. By contrast, in the OTC
market, the terms of each contract are agreed individually between the parties to each transaction. OTC
derivatives are heavily used for risk management, speculation and arbitrage principally because they
are not standardised but constructed around the unique needs of users.
Interest Rate Swaps (IRSs)

An interest rate swap (IRS) is an agreement between two parties to periodically exchange a series of
interest payments in the same currency to collectively reduce the cost of borrowing.
Being cash-settled CFDs, at no stage in the transaction is the notional loan principal, upon which the
swap is based, exchanged. IRSs can be used for both new and existing borrowing for terms up to about
25 years.
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Interest rate swaps take two forms:
• Fixed rate into floating rate. This is commonly known as a coupon or vanilla swap.
• One type of floating rate into another type of floating rate. This is termed a basis swap.
The two exchanges of cash flow are known as the legs of the swap, and the amounts to be exchanged
are calculated by reference to a notional amount. Its role is to enable the calculation of the interest
payments to be made and so the notional amount never changes hands.
Typically, one party will pay an amount based on a fixed rate to the other party, who will pay back an
amount of interest that is variable and usually based on a benchmark such as London Interbank Offered
Rate (LIBOR). The variable rate will usually be set as LIBOR plus, say, 0.5% and will be reset quarterly.
Currency Swaps
Currency swaps are simply interest rate swaps made in two different currencies that require an exchange
of the loan principal at the beginning and at the end of the swap period.
The exchange rate at which the loan principal is swapped is agreed at the outset. As a result of this
exchanging of principal, the credit risks between the parties are higher than for a single currency
interest rate swap.
Currency swaps are mainly used as a hedging, or risk management, tool rather than for speculation and
arbitrage.
Equity Swaps
Volatility or equity swaps are an agreement between two parties, an institutional investor and a bank for
instance, to exchange a series of periodic payments between one another based on a notional principal
amount.
One set of payments is linked to the total return on an equity index, the other usually to a fixed or
floating rate of interest, though this can be the return on another equity index.
The advantages to a portfolio manager being in receipt of the cash flows from the equity exposure
include:
• Gaining equity exposure without the costs associated with buying and holding equities.
• Facilitating index tracking.
• Facilitating access to illiquid markets that may be inaccessible to foreigners.
• Permitting a longer-term exposure than would be possible using exchange-traded derivatives.
However, if the return on the equity index is negative in any period, the portfolio manager will be
required to make both an interest payment and an additional payment in respect of this negative return.
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1. Explain what is meant by rolling over a position in the foreign exchange market.
2. If the three-month rate of interest is lower in the Eurozone than in the US would the EUR/USD forward
rate be higher or lower than the spot rate?
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3. If the GBP/USD spot exchange rate is $1.5500, and the six-month interest rate for the UK is 3% and for
the US is 2%, what will the six-month forward exchange rate be?
4. How do tenancies of residential and commercial property differ?
5. How would you expect a tenant’s break clause to impact the investment value of a property?
6. An investor has a buy-to-let property valued at $100,000 that has a monthly rental of $300 and is
usually let for ten months per year. Management agents are used, and expenses normally account for
10% of rental income. What is the yield on the investment?
7. An investor buys a January $5 call option at $0.25. At the expiry, the stock is at $4.75. How much will
the investor lose per share?
8. If you were to sell a 240 put option for 17, what would be your maximum profit?
9. What is the difference between intrinsic value and time value?
10. What type of swap allows an investor to exchange the returns on an equity-based investment for the
return on another equity-based investment?
189
190
Chapter Five
Collective Investments
1. Open-Ended Funds 193
2. Exchange-Traded Funds (ETFs) 206
5
3. Closed-Ended Funds 211
4. Life Assurance Based Investments 221
5. Alternative Investment Funds 223
6. Fund Evaluation 232

192
Collective investments are pooled investment schemes that enable private investors and wealth
managers to access professional management of an investment portfolio. There are a variety of different
structures available and the main types are considered below. Whatever structure is used, the underlying
concept is that the investor buys a proportionate share in the risks and rewards of a collectively owned
pool of managed assets. The instrument the investor buys into will have three common characteristics:
• A pooling of resources to achieve sufficient size for portfolio diversification, reduced costs and cost-
efficient trading.
• A formal legal and governance structure for operation of the fund and for investor protection.
• Professional portfolio management to execute a defined investment strategy.
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1. Open-Ended Funds
Learning Objective
5.1.1 Analyse the key features, risks and returns of open-ended funds: types; characteristics; pricing;
dealing
5.1.2 Analyse the factors to take account of when selecting open-ended funds: fund size; risk rating;
total expense ratio; portfolio turnover; liquidity; counterparty risk
1.1 Characteristics
Open-ended funds are collective investment schemes such as mutual funds that are able to expand or
contract their share capital in response to customer demand.
1.1.1 Types of Open-Ended Funds

Open-ended funds are widely found across the globe and are known by different names in different
markets. Despite the different names, they share common characteristics and so are known generically
as collective investment schemes (CISs).
Definition of a Collective Investment Scheme (CISs)

The International Organisation of Securities Commissioners (IOSCO) definition of a CIS which is used by
many international organisations is an instrument that:
a. invests in transferable securities;

b. is publicly marketed; and
c. is open-ended.
An open-ended CIS is one in which in which NAV is calculated periodically and investors may buy or
redeem shares at NAV, net of certain charges, at regular intervals.
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More commonly encountered terms for open-ended funds are shown below.
Open-Ended Funds
US • In the US, the term mutual fund is used.
• In continental Europe, the corporate version is known as a SICAV.

• There are a variety of other structures in use, some of them being neither trust nor
Europe
corporate, but purely based on contractual arrangements such as Fonds Commun
de Placement (FCPs).
• In the UK they take the legal form of unit trusts or open-ended investment
UK
companies (OEICs).
An investor is likely to come across a range of different types of investment fund, as many are now
established in one country and then marketed internationally.
Despite the different names that are used, there are three basic legal structures that are used for CIS –
corporate, trust and contractual forms.
Legal Structure of CISs

• In the corporate form, the CIS is established as a separate corporate entity in
which the assets are owned by the investment company and the investors are the
shareholders of the investment company.
• The investment company will have variable capital – in other words, its capital
Corporate
base can expand or contract in accordance with demand. For this reason, it is
form
known as an investment company with variable capital (ICVC).
• While the law in the United States recognises other forms of CIS, the vast majority
are open-ended mutual funds organised in corporate form. A SICAV and an OEIC
are also organised in the same way.
• A trust is an Anglo-Saxon law concept in which an identified group of assets
is constituted and managed by trustees for the benefit of another party (the
beneficiary).
Trust • A trust is created by a legal deed between the manager of the trust and the trustee.
form The investor is a beneficiary of the trust and owns units of the trust.
• The trust form is found in the UK as a unit trust and in Singapore and New Zealand.
In Canada, most CISs initially were organised in corporate form but now most are
organised as trusts.
• In the contractual form, a legal contract is used to create the fund by the
investment management company.
• The investor enters into a contract with an investment management company,
Contract which agrees to purchase a portfolio of securities and manage those securities on
form behalf of the final investor.
• The investor owns a proportional share of the portfolio and their holdings are
represented by units.
• Denmark, Germany, Portugal, Sweden and Switzerland have the contractual form.
194
The laws of some countries allow for only one legal form for collective investments, while others
allow for more than one. Luxembourg which is the largest centre for fund domicile outside of the US
recognises both corporate and contractual forms – a SICAV is the corporate form and the FCP is the
contractual one.
A further common characteristic of the different types of funds is their arrangements for corporate
governance and investor protection. There are essentially two models; one used in the US and the other
used in continental Europe.
US Mutual Fund Structure

A US mutual fund is structured as an investment company with a board of directors who have
responsibility for oversight of the fund and who carry significant legal liability for performance of their
5
function.
The function of the board of directors is to represent the interests of the shareholders – in other
words, the investors – and to supervise the other parties involved. Committees on audit, pricing, legal
compliance and nominations are usually organised to supervise the activities undertaken. A significant
number of directors must be independent; legislation requires that at least 40% are independent but in
practice most funds have an overwhelming majority of independent directors.
Role of Parties to a Mutual Fund

• A fund manager is appointed to manage the investment portfolio and the board of
directors monitors their actions in fulfilling their investment mandate.
• Directors are expected to monitor investment performance in the light of the
Fund
fund’s objectives and assess performance against agreed benchmarks.
manager
• The board is responsible for monitoring compliance with rules concerning pricing,
valuation, portfolio diversification and liquidity as well as limits on activities such
as investments in illiquid securities or derivatives and the use of credit.
• An investment adviser is appointed to assume responsibility for conduct of the
Investment mutual fund on a day-to-day basis.
adviser • The investment adviser will be an affiliate company but is appointed under a
formal contract that the board must review annually.
• The board also selects and appoints a custodian who has responsibility for
safekeeping of the fund’s assets and so assets are segregated from the other
Custodian parties to provide investor protection.
• They will provide reports to the board on portfolio activity to enable them to
undertake their monitoring function.
• The board will also appoint auditors and receive reports from them in exercise of
Auditors
their oversight function.
The structure therefore contains the two key elements of corporate governance and investor protection
found in all CISs, supervision of the activities of investment management firms and appointment of a
separate custodian to safeguard assets.
195
Continental European Structure
There is a great similarity in the governance and investor protection structures found in Europe as a
result of the UCITS Directive.
Undertakings for Collective Investment in Transferable Securities (UCITS) Directive

UCITS stands for Undertakings for Collective Investment in Transferable Securities and refers to a
series of EU regulations that are designed to facilitate the promotion of funds to retail investors across
Europe. A UCITS fund, therefore, complies with the requirements of these directives, no matter in which
EU country it is established.
The main type of structure found in Europe is an investment company with variable capital. Segregation
of duties between managing the fund and oversight are again seen.
• When an ICVC is set up it is a requirement that an authorised corporate director (ACD) and a
depositary are appointed.
• The ACD is responsible for the day-to-day management of the fund, including managing the
investments, valuing and pricing the fund and dealing with investors.
• The investments are held by an independent depositary, responsible for looking after the
investments on behalf of the OEIC shareholders and overseeing the activities of the ACD.
Another main structure that is encountered is a unit trust. A unit trust scheme is formed on the basis of
a legal trust with both a trustee and a fund manager responsible for its operation.
• The role of the unit trust manager is to decide, within the rules of the trust and the various
regulations, which investments are included within the unit trust and then market the fund to
potential investors.
• The manager also provides a market for the units by dealing with investors who want to buy or sell
units. It also carries out the daily pricing of units, based on the NAV of the underlying portfolio.
• The trustee must be approved and registered as a trust company by the competent authorities and
be an independent organisation from the investment manager.
• The trustee is responsible for safeguarding the assets of the trust and monitoring the activities of
the manager.
UCITS
European funds are often established as UCITS funds as this allows an investment fund to be sold
throughout the EU, subject to regulation by its home country regulator.
The fund could be structured in corporate, trust or contract form and whichever legal structure is used,
it will have to follow rules on the range of assets that can be invested in, diversification and other factors
designed to provide investor protection.
While UCITS regulations are not directly applicable outside the EU, other jurisdictions, such as
Switzerland and Hong Kong, recognise UCITS when funds are applying for registration to sell into those
countries. In many countries, UCITS is seen as a brand, signifying the quality of how a fund is managed,
administered and supervised by regulators.
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Evaluation of Fund Structures

The governance and investor protection arrangements in place for most funds are designed to ensure
investor protection and the absence of any major scandals concerning investment funds probably
points to their robustness.
It is important to remember, however, that oversight will be divided depending on the structure amongst:
• the directors of the investment management company;

• the depositary, trustee or custodian;
• independent auditors;
• supervisory authorities.
Wealth and investment managers, however, cannot take such arrangements for granted and when
5
evaluating a fund it essential to include consideration of the legal structure and the effectiveness of
the governance and investor protection arrangements. This is even more the case for non-mainstream
funds which may invest in illiquid or exotic assets and where the risks of mispricing are greater.
1.1.2 Characteristics of Open-Ended Funds

In the following sections, we consider some of the key characteristics of open-ended funds.
Share Capital
An open-ended fund is one where the capital can expand or contract in response to investor demand.
The fund manager is responsible for arranging for the issue and the cancellation of shares for the fund
and is permitted to sell and redeem them for its own account. The way in which this should operate is
best seen by looking at the creation and cancellation process.
Creation and Cancellation Process

Investors place orders to buy or redeem shares with the fund manager responsible for management of
the fund. The fund manager then gives instructions to the depositary or trustees to create new shares or
cancel existing shares depending upon the deals placed by the investors.
The depositary or trustee will only issue new shares on receipt of payment for those shares and where
shares are cancelled, will only pay funds to the fund manager on receiving evidence of transfer of legal
title to the shares.
The authorised fund manager can also hold onto units to meet potential demand and when it does so,
it will hold these shares in the manager’s box (known as running a box). This means that a fund can,
for example, accept instructions from investors to sell and then take those shares and use them to meet
demand from other investors and so, potentially, make a profit in the process.
This gives rise to a potential conflict of interest between those of the fund manager on one side and its
investors on the other. As a result, regulations will prescribe a series of conditions that must be met to
prevent the fund manager from manipulating orders and making hidden profits. They also require the
depositary or trustee to carefully supervise the process.
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Types of Shares
An open-ended fund can have more than one type of share in issue which are known as share classes or
in the US as multi-class funds. Each class of share is invested in the same pool of underlying investments
but each may carry different income distribution rights or charges.
The main types of income distribution rights are:
• Income or distribution shares where the investor receives regular income distributions from the fund.
• Accumulation shares where instead of receiving the income distribution, it is reinvested within the
fund.
Funds will also have a variety of other share classes, each of which carry different fee charges.
Institutional investment in funds is clearly going to be significantly larger than any retail investment. As
a result, most funds have different share classes for retail and institutional investors.
Institutional share classes will usually carry lower charges than a comparable retail fund. Institutional
share classes are also used to restrict access to certain types of investment strategy to investors who can
qualify as institutional or professional investors.
Net Asset Value (NAV)

A key feature of open-ended funds is that a fund’s NAV is calculated periodically and investors may buy
or redeem shares at NAV, net of certain charges, at regular intervals.
The NAV of a fund represents the value of the fund’s underlying investment portfolio, less its liabilities.
Its liabilities represent accruals for money owed to lending banks, fees owed to investment managers
and service providers and other liabilities.
Net Asset Value

At a summarised level, the NAV of a fund is calculated as follows.
Value of underlying investments
Cash balances held for investment or as part of the fund’s asset allocation
Dividends and interest received on the investment portfolio that have yet to
be distributed to shareholders
Accrual of known expenses and charges
The portfolio’s assets are generally valued by objective criteria established at the outset of the fund.
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• If assets are traded on exchange, the most common method of valuation is to use the market value
of the assets in the portfolio.
• If value of OTC derivatives may be provided by the counterparty to the derivative which may be
trading similar derivatives with other parties.
• Where there is no objective method of calculating the value of an asset, the fund manager’s own
valuation is used, subject to agreeing the approach with the fund’s directors, trustees or depositary.
The NAV is used to calculate the price at which investors buy or sell shares in the fund. As a simple example,
if a fund has a NAV of £100 million and there are 10 million shares in issue, then the shares are valued at
$10 each. Charges may then be applied to that price when an investor deals.
The NAV is calculated on a regular basis and for mainstream funds this is usually daily. This is referred to as
the valuation point and the frequency of valuations will be found in the scheme’s prospectus.
5
1.1.3 Fund Pricing
The prices at which open-ended funds are bought and sold are based on the value of the fund’s
underlying investments.
The fund has the flexibility to quote prices which can be either single-priced or dual-priced, although this
decision must be taken at the outset and the manager cannot switch between the two as and when it suits.
Traditionally, unit trusts used dual pricing and ICVCs have used single pricing. All funds now have a
choice of which pricing methodology they use; whichever is chosen must be disclosed in the prospectus.
Single pricing refers to the use of the mid-market prices of the underlying assets to produce a single
price, while dual pricing involves using the market’s bid and offer prices of the underlying assets to
produce separate prices for buying and selling of shares/units in the fund.
Dual Pricing
Where a fund is dual priced, the underlying investments are valued using the bid and offer prices for
that investment from the market in which they are quoted.
As well as taking a price that more accurately reflects what the investment might be bought or sold for,
the NAV will also take into account dealing charges and any initial charges that the fund will make for
investing in it.
Example
A fund that uses dual pricing might quote prices of £1.97–£2.03. This means that the fund manager is
willing to sell (create) new units at £2.03p each and is willing to buy back and cancel old units for £1.97p.
This spread of buying and selling prices is also referred to as two-way pricing. The difference between the
buying and selling prices is designed to cover dealing expenses and any initial charge imposed by the fund.
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Single Pricing
If a fund is single-priced, its underlying investments will be valued based on their mid-market prices.
Example
If the NAV of each share in an OEIC was £1.00, the OEIC would both sell (create) new shares at £1.00 each,
and buy back and cancel old shares at £1.00. Since there is no spread between the buying and selling
prices, this is described as being single priced.
Any initial charges are not included in the single price and instead are added on separately.
This method of pricing does not provide the ability to recoup dealing expenses and commissions within
the spread. Such charges can be recouped either by applying a separate charge, known as a dilution
levy, on purchases or redemptions or by swinging the daily price to a dual priced basis depending on
the ratio of buyers and sellers on any day.
1.1.4 Dealing
Regardless of whether the dual pricing or single pricing method is used, funds may be priced for dealing
on either a forward or historic basis.
Forward and Historic Pricing

• Forward pricing refers to the pricing method whereby the subscription and
redemption of units of an investment fund are effected at the NAV that is next
Forward
computed after receipt of the subscription or redemption request.
pricing
• In other words, the price of the shares is unknown to the investor at the time of
placing the request.
Historic • In contrast, historical pricing is the pricing method whereby investors subscribe or
pricing redeem shares based on the last calculated NAV of the investment fund.
Historic pricing has the potential for abusive trading practices to be used to exploit timing differences.
For example, in a rising market, investors could subscribe to fund units based upon the previous day’s
lower price, redeem their shares in a few days, and be assured of riskless profits, while at the same time
diluting the remaining unit holders’ holdings.
As a result, forward pricing is now the method used by the vast majority of funds.
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Forward Pricing
Forward pricing means that orders to buy or sell from investors will be dealt at the prices determined at
the next valuation point. Many European funds have a 3pm valuation point and as the diagram below
shows, orders received after 3pm on Monday are not executed until the following day using the price
established at the valuation point on Tuesday.
Fund is Fund is
Fund Trading
valued valued
Monday Tuesday
3.00pm 3.00pm
Investor Investor Investor

Orders Orders Orders
5
Executed Received Executed
If an investor places an order to buy or sell units in a fund, there will be a defined process that needs to
be followed.
If the investor is buying, they will place the order with the fund and assuming it is forward priced, it will be
executed at the next valuation point. At that point the price of the funds will be known and a contract note will
be issued showing the number of units or shares purchased, the price, charges and the total consideration.
• Payment for the purchase is typically due no later than four business days after the deal is executed.
• Where the investor is selling or redeeming their shares, they will need to transfer the units or
shares back to the fund manager. The fund manager will send the proceeds to the investor usually
no later than the fourth business day following receipt of all the duly executed instruments and
authorisations to enable the transfer of title to take place.

Some of the factors that should be considered when analysing open-ended funds are considered below.
1.2.1 Investment Strategy

A fund’s investment mandate is a statement of its aims, the limits within which it is supposed to invest,
and the investment policy it should follow.
A fund mandate will typically define the following:
• The aim of the fund (eg, to generate dividend income or long-term growth).
• The type of strategy it will follow (which will tend to follow from the above).
• What regions it will invest in (UK, Europe, emerging markets, etc).
• What sectors it will invest in.
• What types of securities it will invest in (equities, bonds, derivatives, etc).
• Whether the fund will short sell and whether it will be hedged.
• Whether it will be geared and to what extent.
• A benchmark index that the fund aims to beat (or match if it is a tracker fund).
• The maximum error in tracking the benchmark.
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Fund mandates are set by the fund management company, but publicised so that investors can choose
a fund that suits their requirements.
The asset allocation of the fund will be decided by the management team and there is often scope for
a fair degree of discretion. However, if the mandate or trust deed for the fund is very specific then there
will be fewer degrees of freedom for the class of assets and individual securities that the manager can
select for the fund.
One important risk for investors in certain high-profile funds relates to the possible loss of a key
manager. Firms which rely heavily on the input of a star manager can find themselves subject to large-
scale redemptions if the manager leaves. This can lead to loss of capital, the possible recall of any
borrowed funds and reputational damage.
1.2.2 Fund Size

Funds usually choose an index to be their performance benchmark. The index will match the region or
sector the fund invests in.
The use of indices as benchmarks is one of the reasons why so many different indices exist: they need to
match the variety of funds. Even so, some funds and portfolios are better served by using a composite
of several indices.
One danger this brings is that it tempts managers to track their benchmark index and avoid the risk
of under-performing, rather than genuinely trying to beat it: supposedly actively managed funds thus
become closet trackers.
• As an actively managed fund becomes larger, so its performance may suffer. The portfolio manager
has less time to conduct in-depth research and monitor each of the fund’s holdings and may move
the market against the fund if they trade a sizeable amount of stock.
• By contrast, size works in favour of passively managed funds, especially those that employ full
replication, as large funds can spread their costs over a wider base.
Another factor to be aware of is survivorship bias. This is the tendency for failed companies to be
excluded from performance studies because they no longer exist. It often causes the results of studies
to skew higher because only companies which were successful enough to survive until the end of the
period are included.
For example, a fund company’s roster of funds today will include only those that are successful now.
Many losing funds are closed and merged into other funds to hide poor performance.
1.2.3 Risk Rating

Like all investments, open-ended funds are subject to a series of risks.
Fund regulations require that a detailed prospectus is prepared for every fund and that within this is
described the particular risks that the fund is exposed to. Many funds will also produce a simplified
prospectus, which will be written in a more user-friendly style and which will explain the types of risk an
investor may face and the ways in which the fund attempts to mitigate these risks.
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Some of the types of risk that most open-ended funds encounter are shown below.
Fund Specific Risks

• Generally speaking, funds that invest in smaller companies and shares in
emerging markets are traded less frequently than larger ones and so are subject
Liquidity risk to greater liquidity risk.
• This means that there may be difficulty in both buying and selling shares so
individual share prices may be subject to short-term price swings.
• There is always a credit risk associated with investing in bonds.
• With investments in lower-grade corporate bonds there is a higher risk that the
Credit risk issuer will not meet its debt obligations.
• The higher the credit risk, the greater the likelihood of a failure to pay interest or
5
capital when due.
• Investments made overseas may be affected by movements in exchange rates
Currency risk
which may cause the value of the underlying investment to rise and fall.
• Due to the concentrated nature of many open-ended portfolios, short-term
Concentration
volatility in the price could have a relatively high impact on the fund’s value and
risk
its performance.
In order to help investors make an assessment of the level of risks associated with a fund, new rules have
been brought in that a require a fund to report a synthetic risk-reward indicator in its fund literature.
Synthetic Risk-Reward Indicator
Lower risk Higher risk
Typically lower rewards Typically higher rewards
1 2 3 4 5 6 7
There should also be a narrative explanation of the indicator and its main limitations.
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1.2.4 Total Expense Ratio (TER)
Open-ended funds will clearly make charges for undertaking the management of the fund and the types
of charges that arise include those shown below.
Fund Charges
• Investment funds may impose an initial charge for investing in a fund and it is
normally expressed as a percentage of the amount invested.
• The range of charges varies widely from fund to fund and depending upon
whether the investor deals direct with a fund or uses a fund supermarket or fund
Initial
platform.
charges
• Because of investor dissatisfaction with the high level of initial charges, a number
of fund groups have dispensed with these and instead moved to a basis of
charging exit fees if the investor disposes of their holding within a specified
period of time.
• A fund will incur costs and expenses for the running of the fund such as dealing
commissions, audit fees and custody fees.
Ongoing
• The fund management group will also make a charge for the management
charges
of the fund and this is usually expressed as a percentage of the funds under
management.
• Performance fees may also be charged in certain funds over and above the annual
fee providing that specified levels of growth over a benchmark have been achieved.
Performance
• Charges vary from fund to fund but the charging structure must be detailed in
charges
the fund’s prospectus. There are also various other charges made by a fund and
the combined effect of these is disclosed in the total expense ratio.
Increased competition and price transparency in the UK investment funds market has led to initial
charges in particular falling quite considerably, in some cases to zero, though annual management
charges have yet to feel the full force of competition.
Other charges levied against a fund’s assets that are not as transparent as initial and management
charges are collectively known as the fund’s total expense ratio (TER). The TER typically comprises
brokers’ commission and auditors’ and custodian fees.
The TER is a measure of the total annual charges for a fund.
• The costs included in the TER are all the annual operating costs, principally the annual management
charge but also administration fees, and trustee and audit fees.
• The total cost of running the fund is divided by the fund’s total assets and the TER is then expressed
as a percentage.
• The size of the TER is very important to investors because these costs come out of the fund, and
affect the value of an investment in a fund.
• High charges therefore put a fund’s potential performance at an immediate disadvantage.
Active funds generally have higher initial and annual management charges and TERs than passive
funds, whilst open-ended funds generally have higher charges than closed-ended funds.
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1.2.5 Portfolio Turnover

Portfolio turnover measures how frequently the assets within a portfolio are bought and sold by the
fund manager.
It is calculated by taking either the total amount of securities purchased or the total amount of securities
sold, whichever is the lower, and then dividing this by the fund’s average monthly NAV. The result is
usually reported over a 12-month time period.
Portfolio turnover is relevant as it indicates the amount of trading that the fund undertakes and therefore
provides an indication of the brokerage costs that it will have incurred. Brokerage costs are not included
in the TER but can represent a significant expense that can impact fund performance.
5
A fund with a high turnover rate will incur more transaction costs than a fund with a lower one. Unless
the superior asset selection renders benefits that offset the added transaction costs they cause, a less
active trading posture may generate higher fund returns.
1.2.6 Liquidity
A further factor to be aware of is the impact of liquidity and price volatility. With open-ended funds it is
also important to be aware of the impact of dual pricing and single pricing.
Unit trusts will typically use dual pricing and may move their pricing to an offer or bid basis.
Dual Pricing
• A fund may switch to an offer basis if the market is moving upwards or the fund is
attracting investors.
• In these circumstances, managers can move the spread to the top of the range.
Offer
• This effectively means that the offer price being paid will be the creation price plus
basis
initial charges and so increases the price for buyers.
• However, it also increases the price for sellers of units who will get a price of around
5–7% below the creation price and considerably higher than normal.
• When the market is moving downwards or more money is leaving the fund than is
coming in the fund may switch to a bid basis.
• In these circumstances, managers can move the spread to the bottom of the range.
Bid
• This effectively means that the buying price being paid will be the cancellation price
basis
and reduces the price for sellers.
• However, it also reduces the price for buyers of units who will get a price of around
5–7% above the cancellation price and considerably lower than normal.
ICVCs will typically be single priced and so need a mechanism to ensure the fund is not disadvantaged
by large inflows and outflows. It can do this in a number of ways:
• Applying a dilution levy to all deals above a certain size to make an allowance for the costs of dealing
in the underlying fund.
• Switching to a so-called swinging price basis when there are large flows. This effectively means
switching to a dual price basis for a temporary period.
• Offering in specie settlement for very large deals. This involves the fund returning a portion of the
underlying assets to the investor leaving them to realise the investments in the market.
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Whilst open-ended funds are typically valued and dealt daily, it is important to be aware that this can
break down in the event of severe market falls. This was seen with property funds during the credit crisis
when the number of redemptions was such that funds could not sell property quickly enough to raise
the funds needed to meet the amounts due to selling investors. Many imposed moratoriums of up to 12
months during which the investor was unable to realise their investment.
1.2.7 Counterparty Risk

Counterparty risk refers to the risk that a counterparty to a transaction will fail to perform their
obligations under the contract which could cause a trade to fail or an OTC derivative to become
worthless, negating a hedging strategy.
2. Exchange-Traded Funds
Learning Objective
5.2.1 Analyse the key features, risks and returns of exchange traded funds: types; characteristics;
pricing; dealing
5.2.2 Analyse the factors to take account of when selecting funds: replication methodology;
counterparty risk; liquidity; costs
Exchange-traded products (ETPs) are open-ended investments that are listed on an exchange and
traded and settled like shares. The main types are:
• exchange-traded funds (ETFs);

• exchange-traded commodities (ETCs) (considered in section 5.2.3);
• exchange-traded notes (ETNs).
They are passive investments aiming to replicate the performance of a given market, generally by
tracking an underlying benchmark index.
2.1 Exchange-Traded Funds (ETFs)

ETFs are a type of open-ended investment fund that are listed and traded on a stock exchange. They typically
track the performance of an index and trade very close to their NAV.
2.1.1 Characteristics of Exchange-Traded Funds (ETFs)

Some of their distinguishing features include:
• They track the performance of a wide variety of fixed-income and equity indices as well as a range of
sector and theme-specific indices and industry baskets. Some also now track actively managed indices.
• Some ETFs are more liquid, or more easily tradable, than others depending upon the index they are
tracking.
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• The details of the fund’s holdings are transparent so that their NAV can be readily calculated.
• They have continuous real-time pricing so that investors can trade at any time. They will generally
have low bid-offer spreads depending upon the market, index or sector being tracked.
• They have low expense ratios and no initial or exit charges are applied. Instead, the investor pays
normal dealing commissions to his stockbroker.
ETFs can be used by retail and institutional investors for a wide range of investment strategies, including
the construction of core-satellite portfolios, asset allocation and hedging.
In Europe, they are usually structured as UCITS III compliant funds. A UCITS fund is an open-ended fund
that can be sold cross-border in Europe and is the structure used by the large fund groups who want to
sell their funds in multiple countries.
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2.1.2 Reverse Exchange-Traded Funds (ETFs)
ETFs can also be constructed as reverse ETFs or inverse funds. This means that they are constructed so
that the ETF has either outright short positions in the underlying instruments or derivatives that provide
a synthetic short position for that sector.
Accordingly an investor who buys or takes a long position in such an inverse fund is effectively short the
sector or index and will benefit from a downward movement in that particular sector or index. This feature
makes it easier for many investors to take a short position than having to borrow stock from a brokerage.
2.1.3 Leveraged Exchange-Traded Funds (ETFs)

Leveraged ETFs are a specialized type of ETF that attempt to achieve returns that are more sensitive to
market movements than non-leveraged ETFs.
To accomplish their objectives they pursue a range of investment strategies through the use of swaps,
futures contracts, and other derivative instruments. An important characteristic of these index-tracking
leveraged funds is that they seek to achieve their stated objectives on a daily basis, and their performance
over longer periods of time can differ significantly from the multiple or inverse multiple of the index
performance over those longer periods of time. This effect can be magnified in volatile markets.
Leveraged index ETFs are often marketed as bull or bear funds.
• A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more
pronounced than an index such as the FTSE 100 or the S&P 500.
• A leveraged inverse (bear) ETF fund will attempt to achieve returns that are -2x or -3x the daily index
return, meaning that it will gain double or triple the loss of the market.
• Leveraged ETFs require the use of financial engineering techniques, including the use of equity
swaps, derivatives and rebalancing to achieve the desired return.
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2.2 Exchange-Traded Notes (ETNs)
An exchange-traded note (ETN) is a senior, unsecured, unsubordinated debt security issued by an
underwriting bank. Funds established in this way are not UCITS 111 compliant.
When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index,
minus fees upon maturity. As a result, the ETN has an additional risk compared to an ETF – upon any
reduction of credit ratings or if the underwriting bank goes bankrupt, the value of the ETN will be eroded.
There are two types of ETNs; namely collateralised and uncollateralised notes. Collateralised ETNs are
hedged partly or fully against counterparty risk whereas uncollateralised ETNs are fully exposed to
counterparty risk.
Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but
they do share several characteristics of the latter.
• Similar to equities, they are traded on an exchange and can be shorted.

• Similar to index funds, they are linked to the return of a benchmark index.
• But as debt securities, ETNs don’t actually own anything they are tracking.
ETNs may be liquidated before their maturity by trading them on the exchange or by redeeming a
large block of securities directly to the issuing bank. The redemption is typically on a weekly basis and a
redemption charge may apply, subject to the procedures described in the relevant prospectus.
Since ETNs are unsecured, unsubordinated debts, they are not rated, but are backed by the credit
of underwriting banks. Like other debt securities, ETNs do not have voting rights. Unlike other debt
securities, interest is not paid during the term of most ETNs.

The factors that would be considered for ETFs are the same as we have already looked at for open-ended
funds, but with some additional considerations which are reviewed below.
2.3.1 Physical or Synthetic Replication

ETFs usually track equity or fixed-income market indices and in order to achieve their investment
objectives, ETF providers can either use physical or synthetic replication. The risks of the latter have
been the subject of intense regulatory scrutiny by regulators around the world.
Physical replication can be achieved either through full replication or by sampling.
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Physical Replication Methods

Full • This is an approach whereby the fund attempts to mirror the index by holding
replication shares in exactly the same proportions as in the index itself.
• This involves choosing investments that are representative of the index.
• The expectation is that overall the tracking error or departure from the index
will be relatively low.
Stratified
• The amount of trading of shares required should be lower than for full replication,
sampling
since the fund will not need to track every single constituent of an index.
• This should reduce transaction costs and therefore will help to avoid such costs
eroding overall performance.
• This is a computer-based modelling technique, which aims to approximate to the
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index through a complex statistical analysis based on past performance.
• The optimised sampling approach is more common for indices with a large
Optimisation
number of components, in which case the provider would only buy a basket of
selected component stocks, reflecting the same risk-return characteristics of the
underlying index.
The alternative is to use synthetic replication. This involves the ETF providers entering into a swap
agreement with single or multiple counterparties. The provider agrees to pay the return of a pre-defined
basket of securities to the swap provider in exchange for the index return.
The ETF will enter into a swap agreement with a single counterparty or as is more likely these days,
multiple counterparties.
The first type of swap used was an unfunded swap. This is where the ETF purchases a basket of securities
and undertakes to swap the return on that basket. The constituents of the basket do not necessarily
have to correspond with the index that is being tracked.
Since 2009, funded swaps have been more common where the ETF provider transfers the cash instead
and receives collateral as security for the money transferred. The collateral will typically be greater than
the value of the cash transferred and will consist of high quality sovereign government bonds and
equities that can be readily realised.
In both cases, the counterparty undertakes to deliver the performance of the index the ETF is tracking.
Synthetic replication generally reduces costs and tracking error, but increases counterparty risk. For
markets not easily accessible, swap structures do have an advantage over physical replication.
The main advantage of physical replication is its simplicity. This, however, comes at the cost of greater
tracking error and higher TER. The main advantage of synthetic replication tends to be lower tracking
error and lower costs, but with the downside of counterparty risk.
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2.3.2 Collateral and Counterparty Risk
As well as being aware of the different types of ETFs available, it is also important to be aware of the risks
that arise from stock lending and the use of swap counterparties.
Many ETFs and traditional index funds will utilise stock lending to generate fee income. This involves the
fund lending its securities to other market counterparties in exchange for fees which can help reduce
the operating expenses of the fund. This introduces the following risks:
• Counterparty risk – this is the risk that the party to whom the securities have been lent fails to
return the securities when demanded.
• Collateral risk – this is the risk that the collateral taken as security for stock that is loaned out is
insufficient if it has to be realised to replace the securities loaned.
Stock lending is a specialised function and there are established techniques for managing the risks
associated with lending including:
• enforceable legal agreements;

• the taking of collateral greater in value than the securities lent; and
• the regular mark-to-market of the securities lent so that additional collateral can be called.
As for swaps, most funds in Europe are structured as UCITS funds and so have to meet certain concentration
and diversification requirements, which include the requirement that a fund cannot invest more than 20%
of its NAV in instruments issued by the same body. The maximum exposure to any swap counterparty is
limited to 10% of the fund’s NAV so that an ETF will have to have multiple counterparties and will look to
hedge its exposure by requiring collateral to be posted with an independent custodian. Most providers
disclose the composition of the collateral taken daily on their websites.
2011 saw a number of concerns about the risks that ETFs pose in this area. This has led to the
introduction of a new regulatory framework for ETFs and other UCITS investment funds that have similar
investment objectives to increase disclosure on areas such as collateral and the counterparty risks that
can arise from securities lending practices.
The framework requires all investment funds to disclose the following items.
Disclosure Requirements
Index-tracking • Details of the tracking methodology to be used and the size of the tracking
UCIT funds error.
• A common identifier is to be used to identify whether a fund is an ETF and
ETFs to recognise that ETFs have unique characteristics that are different from
traditional open-ended funds.
Leveraged ETFs • How leverage is achieved and the costs associated with the strategy.
Actively • Make clear it is not an index tracker and explain how outperformance will be
managed funds achieved.
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• Participation in securities lending and a detailed description of the risks,

conflicts of interest, and impact on performance.
Collateral and
• Its collateral management policy and the extent to which it is able to recall any
counterparty
securities lent or to terminate lending agreements at any time.
risk
• Details of fees arising from securities lending and fee-sharing arrangements
with lending agents.
2.3.3 Charges
Many ETPs are managed by large financial intermediaries, including Barclays and JP Morgan Chase and
the fees and charges are very competitive and often considerably lower than those applied to more
traditional managed funds.
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Also no stamp duty is applied to purchases of ETPs as they are typically domiciled offshore.
Their tax treatment will typically mirror that of other open-ended investment funds. It is important to
establish, however, how the fund is treated in the investor’s tax residence to be sure of this.
3. Closed-Ended Funds
Learning Objective
5.3.1 Analyse the key features, risks and returns of closed ended funds: types; characteristics; pricing;
dealing; specialist funds - private equity; infrastructure; project finance; forestry
5.3.2 Analyse the factors to take account of when selecting closed ended funds: discounts and
premiums; gearing; liquidity; fund size; total expense ratio; portfolio turnover; counterparty risk
A closed-ended investment company is another form of investment fund.
When they are first established, a set number of shares are issued to the investing public, and these
are subsequently traded on a stock market. Investors wanting to subsequently buy shares do so on the
stock market from investors who are willing to sell.
The capital of the fund is therefore fixed, and does not expand or contract in the way that an open-
ended fund does. For this reason, they are referred to as closed-ended funds in order to differentiate
them from mutual funds, SICAVs, unit trusts and OEICs.
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3.1 Characteristics of Closed-Ended Funds
3.1.1 Types of Closed-Ended Funds

Closed-ended funds are found in many countries and the main types that are encountered are shown below.
Types of Closed-Ended Fund

• Closed-ended funds are known legally as closed end companies. They can have
different investment objectives, strategies, and investment portfolios. They also can
US
be subject to different risks as they are permitted to invest in a greater amount of
illiquid securities than are mutual funds.
• Investment trusts are a form of closed-ended investment fund and were the first type
of collective investment vehicle introduced in the UK in 1868.
UK
• Other types of closed-ended fund are venture capital trusts and investment
companies.
Globally • REITs are a specialised form of closed-ended fund that invests in property.
US Funds
In the US, there are two main types of closed-ended funds—bond and equity. Bond funds are the most
common type of closed-ended fund, accounting for 65% of the total number of funds.
The largest category of closed-ended fund is municipal bond funds that invest in the bonds issued
by states, local governments and agencies and which are tax-exempt for federal tax purposes. Many
municipal bond funds use leverage to enhance their return potential. Other types of closed-ended
funds include US bond funds, diversified US equity funds, sector and speciality funds and global funds.
They pursue objectives similar to growth or income mutual funds.
Closed end funds make regular income distributions as well as distributing realised capital gains so that
the funds do not pay tax at fund level and instead are said to pass through to be taxed in the hands of
shareholders. Investors can elect to become part of an automatic reinvestment plan so that funds can
be reinvested.
UK Funds
Investment trusts are a form of closed-ended investment fund and were the first type of collective
investment vehicle introduced in the UK in 1868.
Despite its name, an investment trust is actually a company, not a trust. Investors’ interests are protected
by an independent board of directors, the continuing obligation requirements of a stock market listing
and the Companies Acts.
Many of the original investment trusts that were first launched are still in existence and today often
resemble global equity funds. Most funds now, however, are specialist funds that are structured as
venture capital trusts or investment companies that invest in areas such as infrastructure, private equity
and venture capital.
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Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) are a type of closed-ended fund that pools investors’ funds to
invest in commercial and, possibly, residential property.
REITs can provide investors with tax-efficient and diversified exposure to rental properties as they are
tax-transparent property investment vehicles.
Provided they distribute at least 90% of their taxable income to investors, they are exempt from capital
gains tax (CGT) and from corporation tax. Instead, investors pay tax on the dividends and capital growth
at their own marginal tax rates, thus avoiding the double taxation that would otherwise affect investors
in property companies.
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In the following sections, we consider some of the key characteristics of closed-ended funds.
Share Capital
Closed-ended funds generally issue a fixed number of common shares that are listed on a stock
exchange via an IPO.
Once issued, a closed-ended fund’s common shares typically are not purchased or redeemed directly by
the fund, but instead are bought and sold in the open market.
To increase their share capital, the investment company needs to go through a capital-raising exercise.
This could be either a rights issue which is an offering of new shares to current investors at a subscription
price that is typically lower than the current share price and/or NAV. In the UK, it is more commonly
achieved by an issue of new shares that are convertible into the ordinary shares of the company.
Share Classes
As a listed company, a closed-ended fund can issue different classes of shares.
In the US, a closed-ended fund can issue one class of preferred shares in addition to common shares.
• Preferred shares differ from common shares in that preferred shareholders are paid dividends but
do not share in the gains and losses of the fund.
• Issuing preferred shares allows a closed-ended fund to raise additional capital which it can use to
buy more securities for its portfolio. This is a type of gearing or leveraging intended to allow the
fund to produce higher returns for its common shareholders.
In the UK, investment companies can be categorised into two main types, conventional and split capital trusts.
• Conventional investment companies issue a single class of ordinary shares which have the same
characteristics as other listed shares.
• Split capital investment trusts can issue different classes of share that appeal to different types of
investor. These trusts generally have a fixed wind-up date, five to ten years after launch. They are
known as split capital trusts, because of the differing capital entitlements.
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Split Capital Trusts – Types of Shares
• These are entitled to all the income generated by the assets, but a fixed amount
Income shares
(typically £1) per share when the trust is wound up.
Zero dividend • These pay no income but provide a fixed rate of capital growth until the trust is
preference wound up.
shares • Zeros have first call on the trust’s assets after any borrowing has been repaid.
• These receive no income but are entitled to all the capital in the trust, once any
loans have been repaid and the income and preference shareholders have been
Capital shares
paid out.
• Capital shares therefore carry the highest investment risk.
Each class of share will appeal to a different type of investor, but all rely to a greater or lesser extent on
the performance of the underlying investments.
Net Asset Value (NAV)

The NAV of a closed-ended fund is calculated by subtracting the fund’s liabilities (eg, fund expenses)
from the current market value of its assets and dividing by the total number of shares outstanding.
The NAV of a closed-ended fund is therefore calculated in the same way as mutual funds. As a closed-
ended fund is listed on the stock market, the results of the NAV calculation are reported to the stock
exchange and end investors so that all potential market users are aware of the NAV calculation.
Many closed-ended funds calculate the value of their portfolios every business day, while others calculate
their portfolio values weekly or on some other basis. The frequency of valuation will often be dependent
on the nature of the underlying assets held in the portfolio. A bond or equity fund is likely to be valued
daily, whereas a venture capital fund that invests in illiquid assets may be valued far less frequently.
Gearing
Closed-ended funds have the ability to employ gearing or leverage as part of their investment strategy.
As companies, they are allowed to borrow money on a long-term basis by taking out bank loans or
issuing bonds. This can enable them to invest the borrowed money in more stocks and shares and add a
level of gearing to the portfolio to potentially enhance shareholder returns.
Pricing and Dealing

Closed-ended funds are usually quoted and traded on a stock exchange such as the NYSE or LSE.
Although the funds value their portfolios regularly and publish the underlying NAV per share, they do
not necessarily trade at their NAV. The price they trade at will instead be determined by demand and
supply as with any other share.
• When the investment trust share price is above the NAV, it is said to be trading at a premium.
• When the investment trust share price is below the NAV, it is said to be trading at a discount.
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In that way, they trade and settle in the same way as other equities. A major difference from open-ended
funds is that there is no initial commission payable and instead the investor will pay brokerage charges
to buy or sell the shares.
3.2 Specialist Funds

Closed-ended funds can also be set up to invest in areas such as private equity, property or infrastructure.
Typically these are long-term investment strategies and so the closed-ended nature of the structure is
more appropriate to their needs. This can have advantages for a fund in that it does not need to realise
assets at possibly distressed prices to meet investor redemptions.
It may require investors to commit their money for long periods of time so that the planned investments
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have time to deliver their expected returns.
Closed-ended companies may not be traded on a stock market and so periodic redemptions may be
made available to offer investors a way to realise all or part of their investment.
Private Equity
Private equity investment is usually structured as a limited partnership arrangement and looks to target
institutional investors and only the wealthiest private investors.
Access to private equity is possible, however, for ordinary investors through listed closed-ended funds.
Private equity firms invest in other businesses and then try to maximise their returns by exiting the
company at a profit. Investment funds specialising in private equity were hit hard during the financial
crisis and subsequently, as generating returns during a period of recession, low growth and scarce credit
presented a challenging environment. Signs of economic recovery mean that these types of funds have
been outperforming traditional sectors.
There are a number of factors that should be analysed when considering including private equity funds
within a client’s portfolio:
• Private equity funds are a specialist and widely varied sector. Analysis of the fund needs to take place as
some hold direct investments in companies and others do so indirectly through investment in other funds.
• Private equity funds make money by investing in businesses that need access to growth capital or
that need overhauling. The types and spread of investments they hold need to be analysed along
with any commitments they may have to provide further capital.
• They will often use high levels of debt and so are exposed to interest rate rises and credit squeezes.
• Funds will look to take their profit by a trade sale or flotation and so their planned exit route needs evaluation.
• Private equity is highly correlated with the economic cycle and realising a profit can be problematic.
Given the timescales needed for such investments to work, the sale can occur at a time when there
is little market interest in a sale or floatation.
• In stable economic environments the drivers of outperformance and the ability to exit investments
are in place. In such scenarios, discounts can be expected to narrow whilst once the economic
environment deteriorates, discounts will widen.
• The size of fund also varies widely and the market capitalisation of the fund needs to be judged in
terms of the level of liquidity that is present and whether this would present any issues when buying
or trying to realise the investment.
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Infrastructure
Listed infrastructure funds invest mainly in private finance initiatives and public-private partnerships
which are set up to allow private investors to invest in infrastructure projects such as roads and hospitals.
Their attraction is that they offer higher yields than corporate bond funds along with relatively low
volatility. There are two main types of infrastructure fund – direct funds and equity funds.
Types of Infrastructure Fund

• These invest directly in infrastructure projects such as the building of schools or
hospitals.
Direct
• They may target a single country or be international in nature.
funds
• They may also target mature opportunities that are lower risk or projects at the more
capital-intensive stage.
• These invest indirectly by targeting infrastructure companies rather than direct
Equity investment.
funds • They will be more closely correlated with the equity market but are often defensive in
nature and offer a steady and consistent yield.
There are a number of factors that should be analysed when considering including infrastructure funds
within a client’s portfolio:
• An assessment needs to be made as to whether to use a direct or indirect fund and the relative risks
of each approach.
• The spread of investments held by the fund needs to be assessed.
The lowest-risk projects are usually government-backed social infrastructure. These typically
have long-term contracts that provide for revenues to rise in line with inflation; consequently
investors have a high degree of certainty about future earnings.
Next come utilities such as energy and water, which have fairly stable user demand and are normally
allowed to set prices at a level that guarantees them a predetermined long-term return on investment.
Lastly, projects such as transport and communications facilities may see demand rise and fall
depending on the state of the economy, so their earnings will be more volatile.
• If a fund exploits international opportunities the risks associated with each country invested in need
to be considered.
• Low interest rates make the returns on infrastructure funds attractive which drives up the price and
in turn often leads to the fund trading at a premium to NAV. Advisers should be aware of the price
they may be paying for an attractive return.
Project Finance
Project finance is closely related to infrastructure projects and involves the raising of the finance for a project.
Definition of Project Finance

Project finance is defined by the International Project Finance Association (IPFA) as:
The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse
or limited recourse financial structure where project debt and equity used to finance the project are paid back
from the cash flow generated by the project.
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So, project finance is about the raising of long-term funds to finance a project. Traditionally, project
financing has been most commonly used in mining, transportation and telecoms businesses as well as
for sports and entertainment venues.
The finance will usually be raised by creating a special purpose vehicle (SPV) to borrow the funds based
on the projected cash flow of the project, rather than the balance sheet of its sponsors. The financing
is usually secured on the project’s assets which include the revenue-producing contract so that lenders
are able to assume control of the project if the project company gets into difficulties.
Project finance is often more complicated than alternative financing methods. A complex project
finance structure may incorporate corporate finance, securitisation, derivatives, insurance provisions or
other types of collateral enhancement to mitigate risk.
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Forestry
Investment funds are available that invest in timber and forestry assets. Forestry has long been included
in the portfolios of institutional investors and the very wealthy but the availability of investment funds
now makes this more accessible to ordinary investors.
There are three main routes to investment in forestry funds – private forestry funds, listed forestry funds
and SPVs.
Forestry Funds
• These make up the bulk of the market and are usually structured as either a
commercial property syndicate or an unregulated fund.
Private
• They rely on the experience of the forestry manager and may invest locally or
forestry
internationally and in different types of forestry asset.
funds
• They are generally illiquid assets that can be difficult to exit at other than the
predetermined end date set by the fund manager.
• There are a number of international forestry funds listed on various stock exchanges
Listed each with varying investment strategies and geographical focus.
forestry • Whilst a listing will mean these funds have greater liquidity, the funds are likely to
funds trade at a discount and can be affected by general adverse news about the industry.
They are thinly traded and so liquidity can quickly dry up.
• Asset management companies will source an investable project, asset or company
that requires funding, and then form an SPV as a conduit to raise the required
SPVs capital to make the investment.
• These are suitable only for experienced Investors capable of bearing the associated
risks.
Some of the characteristics of investing in forestry include:
• They offer an element of diversification away from traditional asset classes.

• Timber only needs to be harvested when the market is growing and demand is high meaning that it
can provide a hedge against inflation.
Given the illiquid nature of forestry investment it is important to give careful consideration as to
whether an investor is capable of bearing the economic risk of holding the fund in the long term.
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In this section, we look at some of the factors that should be considered when selecting closed-ended
funds for inclusion in a client’s portfolio.
Discounts and Premiums

Closed-ended company shares generally trade at a discount to their NAV.
Many funds have control policies in place that attempt to limit the extent of the discount. Some will state
a specific discount target level which, if breached, will prompt them to take action. The most common
type is a share buyback but others include tender offers, restructuring and continuation resolutions.
Discount Control Mechanisms

• This is the most common measure and involves the company buying back its own
shares and cancelling them. This bolsters the fund’s NAV per share, but it means
the fund’s costs as a proportion of total assets increase.
Share
• Share buybacks can be effective for large funds but less practical for smaller
buybacks
funds with fewer assets under management. Similarly, they are less useful for
funds which invest in illiquid asset classes as the fund may not be able to raise
sufficient cash to execute the share buyback upon breach of any target.
• This involves the fund offering to acquire shares for cash usually at or close to the
fund’s NAV.
Tender offers
• There may be limits on the amount that can be tendered and the costs may be
factored into the tender price to reduce the impact on remaining shareholders.
• This option may be used when the board thinks a buyback or tender offer may
not produce the desired results.
Restructuring
• It may involve converting the fund into an open-ended fund or a change in its
investment strategy to try and unlock value for shareholders.
• To keep discounts from growing too wide, some funds promise to hold
continuation resolutions on the fund’s future in the event of the discount
Continuation
breaching a pre-specified trigger.
resolutions
• This would require shareholders to vote in favour of winding up the company so
that all assets are realised and cash distributed to shareholders.
The extent of discounts is widely quoted as an incentive to buy closed-ended fund shares because of
the investment opportunity it represents. It is important to remember, however, that in volatile markets
discounts can widen significantly and be value destroying for existing investors.
Gearing or Leverage
The use of leverage allows a closed-ended fund to raise additional capital through borrowing money
which it can use to buy more securities for its portfolio.
Leverage can allow a fund to achieve higher long-term returns, but also increases the likelihood of share
price volatility and market risk.
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• In the US, there are regulatory limits on the use of leverage. For each $1.00 of debt issued, the fund
must have $3.00 of assets immediately after issuance and at the time of dividend declarations.
Similarly, for each $1.00 of preferred stock issued, the fund must have $2.00 of assets at issuance and
dividend declaration dates.
• In the UK, it is up to the board of directors to determine whether their investment trust will use any
gearing and the extent to which they will gear up.
The types of gearing or leverage used by closed-ended funds can be classified as either structural
leverage or portfolio leverage.
Types of Leverage
• Structural leverage is the most common type and affects the closed-ended fund’s
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capital structure by increasing the fund’s portfolio assets.
Structural • Types include borrowing and issuing debt and preferred stock.
leverage • In the US, the issuance of preferred stock accounts for the majority of closed-ended
fund structural leverage.
• In the UK, the issue of bonds is now used more than preference stock.
• Portfolio leverage is leverage that results from certain types of portfolio investments.
Portfolio
• The types of investment that might produce portfolio leverage include certain types
leverage
of derivatives, reverse repurchase agreements and tender option bonds.
Leverage can magnify shareholder gains but also magnify losses too.
• If a fund borrows money in the expectation that the market will rise and it does, the return to
shareholders will be even greater.
• If markets fall and the performance of the portfolio is poor, the losses made are magnified due to the
cost of borrowing.
Leverage
A closed-ended fund has shareholders funds of $87 million and borrowings of $13 million giving a total
portfolio of $100 million. What would be the effect of a 10% fall or rise in the market, assuming the 10%
movement in the market translated directly into the same change in its investment portfolio?
A 10% rise in the market:
• The value of the portfolio would rise by $10 million to $110 million.
• The borrowings would remain unchanged so the value of the shareholders funds would have risen
from $87 million to $97 million, the full amount of the rise.
• So instead of the value of the portfolio rising by the same as the market, the gearing has magnified the gain.
• Without the gearing the portfolio would have risen by $8.7 million, but with gearing the rise is $10
million which is 15% more. This 15% is directly as a result of gearing.
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A 10% fall in the market:
• The value of the portfolio would fall by $10 million to $90 million.
• The borrowing has remained the same. The shareholders fund will now have declined in value from
$87 million to $77 million.
• So instead of the portfolio falling by 10% in line with the market, the gearing has magnified the loss.
• Without the gearing the portfolio would have fallen by $8.7 million but with gearing the loss is $10
million, which is 15% more.
When looking at a fund’s leverage, it is important to understand the true extent of a fund’s borrowing so
funds will often quote net and gross figures.
• The gross figure represents the actual amount of borrowing, whilst the net amount sets off any cash
held by the fund.
• If the fund’s borrowing is long dated, however, there may be penalty costs involved in repaying
early so analysis of its debt structure is needed.
The use of leverage presents risks for shareholders over and above what would be seen with an open-
ended fund. The NAV and the returns earned will be more volatile and if short-term interest rates rise, the
cost of leverage will increase most likely reducing the returns earned by the fund’s shareholders.
As gearing can work to the advantage or to the detriment of the investor, this makes closed-ended
funds a more risky proposition than open-ended funds.
Liquidity
As they are closed-ended, the fund manager can take a longer-term view when implementing their
investment policy than the manager of an open-ended fund that must maintain an element of liquidity
to meet potential redemptions.
This can be particularly advantageous for specialist funds that need to take a long view in order for
strategies to pay off such as with infrastructure projects. In these types of investment scenario, a closed-
ended fund provides a structure that better suits the intended project.
Trading in closed-ended funds raises the potential issue of liquidity and whether there will be sufficient buyers
and sellers to enable the shares to be readily traded. This issue becomes more acute with smaller and more
specialist trusts such as ones that target specialist investment strategies such as infrastructure or woodlands.
Wealth managers should take into account the liquidity of the stock. With open-ended funds, the
manager operates trading and will redeem shares at their NAV at regular valuation points. With closed-
ended funds, liquidity will be variable as with all other shares and liquidity can dry up in volatile markets.
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Fund Size
The size of a closed-ended fund can vary from large global bond or equity funds to relatively small
specialised funds investing in private equity or venture capital. Few funds are of such a size that it would
detract from performance and the main consideration when assessing fund size is the liquidity available
in the market for trading.
Total Expense Ratio (TER) and Portfolio Turnover

Closed-ended funds calculate and publish TER and portfolio turnover figures in the same ways as open-
ended funds. Traditionally, closed-ended funds have lower charges and TER than open-ended funds as
there is no need to pay commission to investment advisers.
Counterparty Risk
5
All funds are exposed to some counterparty risk depending upon what services are outsourced or what
instruments they invest in. The considerations for closed-ended funds are no different.
4. Life Assurance Based Investments
Learning Objective
5.4.1 Analyse the key features, risks and returns of life assurance based investments: insurance vs
assurance; types: insurance policies; insurance bonds; unit-linked insurance products
5.4.2 Analyse the relative merits and limitations of investing in life assurance based investments
compared with other forms of direct and indirect investment; taxation of insurance-based
investments; uses in investment, financial protection, retirement and pension planning
Life assurance policies can be thought of as an insurance policy wrapper within which are held some
form of investment.
Some of the basic principles of life assurance policies are noted below.
Basic Principles of Life Assurance

The person who proposes to enter into a contract of insurance with a life insurance company
Proposer
to insure themselves or another person on whose life he or she has an 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 same
Life
person, this is not necessarily the case.
assured
A policy on the life of one person, 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 A single life policy pays out on your death or if some other insurable event occurs, such as
life if you are diagnosed with terminal illness and have critical illness cover.
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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 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
Joint life
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. Because the levels of cover are effectively doubled when compared to one joint life
policy, the costs of two single life ones will generally be a little higher, but are unlikely to be
twice as high. Using two single life policies to provide cover usually, therefore, represents
good value for money.
If you want to buy a life insurance policy on someone else’s life, you must have an interest
Insurable
in that person remaining alive, or expect financial loss from that person’s death. This is
interest
called an insurable interest.
Life assurance based investments typically follow one of three structures – non-profit, with profits and
unit linked.
Types of Life Assurance Policies

Non- • A non-profit policy is one that is for a guaranteed sum only, where the insured sum is
profit chosen at the outset and is fixed.
• With profits pay a guaranteed amount plus any profits made during the period
between the policy being taken out and death.
• With-profits policies are typically used to build up a sum of money to buy an annuity
or pension on retirement, to pay off the capital of a mortgage, or in the case of whole-
With
of-life assurance to insure against an event such as death.
profits
• One advantage of with-profits schemes is that profits are locked in each year. If an
investor bought shares or bonds directly, or within a unit trust or investment trust, the
value of the investments could fall just as they are needed because of general declines
in the stock market. With-profits schemes avoid this risk by smoothing the returns.
• Unit-linked policies are ones where the return will be directly related to the
Unit investment performance of the funds contained within the policy
linked • These may be units in the insurance company’s fund or externally managed
investment funds.
There is a wide range of variations on the basic life policy that are driven by mortality risk, investment
and expenses and premium options – all of which impact on the structure of the policy itself. Mortality
risk deals with the expected life of the person insured, whether any additional charges might be
imposed, and the level of risk borne by the life company, which can affect the cost of the cover provided.
The reason for such policies being taken out is not normally just for the insured sum itself. Usually they
are bought as part of a protection planning exercise to provide a lump sum in the event of death, which
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may be used to pay off a mortgage or to provide funds to assist with the payment of inheritance tax
(IHT). They can serve two purposes, therefore: both protection and investment.
5. Alternative Investment Funds
5.1 Hedge Funds
Learning Objective
5.5.1 Understand the key features of Hedge Funds: types of hedge funds; investment strategies; use
5
of short and long positions
Hedge funds are actively managed funds that seek to provide positive absolute returns, regardless of
overall market movements. The concept of profiting regardless of directional market movements is core
to the hedge fund concept.
5.1.1 Types of Hedge Funds

The term hedge fund is a bit of a misnomer. Whilst the first hedge fund was indeed a hedged fund not
all hedge funds hedge market risk, use short positions or leverage. There are, however, a wide range of
complex hedge fund structures, many of which place a greater emphasis on producing highly geared
returns than the control of market risk.
Hedge funds are usually categorised by the type of investment strategy that they follow. However, classifying
hedge funds is notoriously difficult as there are many interpretations of strategy which change over time.
The chart below shows a basic classification of hedge funds based on the type of strategy followed.
Types of Hedge Funds
Hedge Funds
Relative Value Event Driven Directional
 Commodities  Merger Arbitrage  Equity Long/ Short

Arbitrage  Distressed Securities  Discretionary Trading
 Fixed Income
Arbitrage
 Systematic Trading
 Equity Market Neutral  Emerging Markets
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Different strategies have different risk-return relationships as well as differing sources of returns, which
allow the investor to capture diversification benefits by investing across strategies.
The characteristics of the main types of strategy are shown below.
Hedge Fund Strategies

• Strategies in this category are typically ones that have very little or no directional
market exposure to the underlying equity or bond market.
• As these have little or no directional market exposure they are often referred to as
Relative adopting market neutral strategies.
value funds • These funds rely on arbitrage to produce returns and leverage will typically be
high.
• Although these strategies usually have limited volatility, they can still suffer when
market liquidity dries up.
• These funds use strategies where the underlying investment opportunity and
risk are associated with the price movements arising from anticipated corporate
events to achieve their returns.
Event driven • The approach tends to be uncorrelated with investment markets, but usually
funds performs best in strong market conditions, when there is greater corporate
activity.
• As with relative value funds, event driven funds generally fall into the lower
volatility range of hedge funds and leverage will typically be low to medium.
• Directional funds represent the majority of hedge funds and so encompass a wide
range of strategies.
• Long/short funds invest in equity and/or bond instruments, and combine long
investments with short sales of individual securities and derivatives to reduce
market exposure.
Directional • Long/short funds can operate with a bias towards either the long or short side or
funds a balance between the two. This is the most popular strategy.
• Trading strategy funds trade in currencies, bonds, equities and commodities. In
each asset class they may use the same long/short approach as equity hedge
funds. These are hedge funds that most closely match the public perception of a
hedge fund. In reality they now represent a relatively small part of the hedge fund
universe.
Many hedge funds start out in one single sub-strategy. The investment returns, volatility, and levels of
risk of a single hedge fund can vary enormously, depending on the particular strategies that are used.
As a hedge fund grows, it often ventures into different strategies. These separate sub-strategies can be
offered either as separate funds or in one fund under the banner of multi-strategy.
Funds of Hedge Funds

Hedge funds were traditionally limited to institutional investors and very wealthy individuals, but the
availability of funds of hedge funds has opened the market to a wider investment audience.
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As the name implies, a fund of hedge funds is a pooled fund of underlying hedge funds that are blended
together to meet a range of investor risk and return objectives. This blending of funds and strategies aims
to deliver a more consistent return than an individual fund by diversifying across a range of funds and
strategies. Others, however, can be highly concentrated into a few funds, strategies or regions.
A fund of hedge funds is intended to spread the risk over several funds, but has the disadvantage
that they are expensive. The underlying fund may have an annual charge as high as 2% per year, with
a typical performance bonus of 20%. On top of this there may be a fee of up to 2% to the manager
selecting the range of hedge funds.
Funds of hedge funds used to be the vehicle of choice for most new institutional investors but lacklustre
returns, unexpected illiquidity and the Madoff fraud saw many close, merge or change to new services
such as managed accounts.
5
Managed Accounts
Managed accounts are a platform concept that separates the functions within a hedge fund into its
constituent parts.
• The platform takes overall governing and operational control.

• The hedge fund manager is appointed to trade the portfolio within the risk and operational controls
set by the platform.
• This allows clients to segregate their investments in vehicles separate from the hedge fund meaning
investors retain control over their assets.
Managed accounts gained popularity after the 2008 financial crisis and offer investors similar returns
to a manager’s main hedge fund offering. However, they differ from direct investments in several key
respects by offering improved liquidity, transparency and investor control and usually with the ability to
redeem much more frequently than the main fund.
For all of their variety, there are some common features within hedge funds.
Characteristics of Hedge Funds

• Most hedge funds are set up either as private partnerships in the US or as
unauthorised CISs in offshore financial centres.
• An investment bank, known as a prime broker, typically provides the fund with
Structure
trading and credit facilities as well as administrative support, while the fund
management is usually conducted in a major financial centre such as New York
or London.
High • The minimum initial investment into a hedge fund ranges somewhere between
investment US$100,000 and US$1 million. Most hedge funds also impose a limit on the size to
entry levels which they can grow so as to keep the fund nimble.
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• Hedge funds have complete investment flexibility in terms of where, how and in
what assets they decide to invest.
Investment
• In addition to being able to take long and short positions in securities, hedge
flexibility
funds also take positions in commodities, currencies and mortgage-backed
securities.
• Hedge funds borrow and employ derivatives to potentially enhance returns
Gearing
through gearing.
• Despite the greater concentration of their portfolio holdings, hedge funds, when
Low
combined with conventional portfolios, usually provide additional diversification
correlation
owing to their low correlation with world equity and bond market movements.
to world
• However, the extent to which the inclusion of a hedge fund diversifies the risk
securities
of a portfolio containing traditional assets is wholly dependent upon the hedge
markets
fund’s chosen investment strategy.
• Hedge funds typically levy an annual management fee of 2% in addition to a
Performance performance-related fee of about 20% if an absolute performance target in
related fees excess of the risk-free rate of return is met or exceeded and previous losses have
been made good.
• Hedge fund managers are further incentivised by being expected to invest some
Manager
of their own wealth into the fund. This reinforces the alignment of manager and
investment
investor interests.
• Many hedge funds impose an initial lock-in period of between one and three
years before investors may deal in the hedge fund’s shares.
Dealing
• Any dealing that subsequently takes place is usually only permitted at the end of
each month or quarter.
• Hedge funds are usually domiciled in an offshore financial centre such as the
Regulation Cayman Islands or Dublin and are usually subject to a light-touch regulatory
regime.
5.1.3 Selection Factors

Hedge funds are largely unregulated and are able to undertake a wider range of deals than would be
allowed for a regulated product. As a result, hedge funds can have a higher level of risk than traditional
assets, but they also have the potential for higher returns.
Hedge funds are often included in customised benchmarks for private clients and so the risks associated
with hedge funds and the factors that should be taken into account when selecting them need to be
understood.
Specific risks include:
• illiquid investments;
• currency risk;
• gearing is used widely;
• infrequent dealing points;
• settlement is OTC;
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• lack of visibility on portfolios;

• fraud;
• lack of independent trustee boards.
The risks can be high because:
• Hedge funds can take larger positions in securities than open-ended funds which are subject to
limits on the percentage of the fund’s NAV that can be invested with any one issuer. This means that
they may be less diversified than normal funds and so, if one of their investments goes badly wrong,
the impact on the fund could be proportionately higher.
• They can also invest in strategies and derivatives that normal funds cannot use or at least, not to
any great extent. This can mean that as well as offering theoretically greater potential for profits,
and/or resilience to market turbulence, they could also incur greater risk of loss and more volatile
5
performance.
• Because they are not subject to such close supervision, they may be more vulnerable to corrupt or
incompetent operators – increasing investors’ risk of loss through mismanagement or theft of their
assets.
On the other hand, because some of them use strategies enabling them to produce positive returns
in falling markets, they can, if properly used, provide a valuable measure of protection to a portfolio in
volatile times.
Their performance can be largely uncorrelated to other asset classes for long periods of time. However,
when a major event or shock occurs in the financial markets the correlation returns to other asset classes
and can increase markedly – a factor known as correlation compression.
Due diligence is the single most important aspect of the investment process for an investor investing in
a hedge funds. Some of the factors that should be considered when analysing hedge funds are shown
below.
Hedge Fund Due Diligence

• Due diligence includes a thorough analysis of the fund, including investment
strategy, investor base, manager competence, operational infrastructure, financial
Fund
and legal documentation.
structure
• Fund size needs to be assessed as most funds have capacity constraints that mean
that growth beyond a certain size translates into performance deterioration.
• Any portfolio construction is a trade-off between expected return and risk, but
there is no accepted consensus as to how a hedge fund portfolio should be
constructed
Investment
• It is important therefore to determine the sources of risk and return in each strategy.
strategy
• This involves dissecting the strategies into their component parts to determine
how the fund has the potential to make profits and what risks are being taken in
order to achieve the returns.
227
• There is a need to be able to assess the fund manager’s understanding of the sector
in which they are operating and how they are able to adapt to change and employ
comprehensive risk management to deal with the dynamic nature of markets and
strategies.
Fund
• There is a need to be able to assess their experience of portfolio management and
manager
risk management and their experience of different market conditions.
• How much of the fund manager’s own money is invested in the fund. The argument
is that interests between manager and investor are aligned when both have their
funds invested together.
• Style drift is the risk that hedge fund managers drift away from their areas of
expertise, where they have an edge, into fields where they have a competitive
Style drift disadvantage.
• Short-term opportunistic style drift may be acceptable but a continuous departure
from a manager’s area of expertise will force reassessment of their area of expertise.
5.2 Other Investment Funds
Learning Objective
5.5.2 Analyse the factors to take account of when investing in Hedge Funds compared with other
forms of direct and indirect investment; sources of risk and return; due diligence
5.5.3 Analyse the key features, relative merits and limitations of investing in the following alternative
investment funds compared with other forms of direct and indirect investment: absolute
return funds; structured products; commodities and commodity funds
5.2.1 Absolute Return Funds

One of the most popular types of funds to be launched in recent years has been the absolute return fund.
The goal of an absolute return fund is to generate positive returns in any market condition; if the stock
markets are rising or falling the absolute return fund, in theory, should be able to make money for
investors. The concept is the same as a hedge fund but they can be established as an authorised fund
for sale to the general public
Absolute return funds have been able to set up as a result of UCITS 111 which permitted a wider range
of investments to be utilised in an investment fund. Under UCITS 111:
• Funds may invest in asset classes other than the usual equities and bonds.
• Funds can hold an unlimited percentage of cash; in traditional funds there is usually a limit on the
amount that can be held and even the time that it can be held for.
• It allows absolute return funds to use derivatives to control risk.
• Funds can take advantage of stocks or shares deemed to be overvalued by short selling.
• Funds are allowed access to a wider range of investment opportunities than they were able to under
the original rules.
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They cannot, however, borrow to increase leverage as a hedge fund would. Instead, the only way to
increase gearing is to use a synthetic instrument or derivative to gain greater access to the market.
5.2.2 Structured Products

Structured products are an investment product based on derivatives which generally feature protection
of capital if held to maturity but with a degree of participation in the return from a higher-performing,
but riskier, underlying asset.
They are created to meet the specific needs of high net worth individuals (HNWIs) and general retail
investors that cannot be met by standardised financial instruments that are available in the markets.
These products are created by combining underlying assets such as shares, bonds, indices, currencies
5
and commodities with derivatives. This combination can create structures that have significant risk/
return and cost-saving advantages compared to what might otherwise be obtainable in the market.
Types of Structured Products

• These investments generally offer a return at maturity linked to an underlying
asset such as a broad-based equity index or a qualified basket of stocks.
• Investors typically give up a portion of the equity appreciation in exchange for
Principal
principal protection.
protected
• A principal-protected investment may be appropriate for investors unwilling to
investments
risk their principal or who have long-term financial obligations.
• Maturities often range from five to seven years and clients should intend to hold
the investments to maturity.
• Buffer zone investments have limited downside protection.
• In exchange for risking their principal, the investor will have greater upside
potential relative to a fully principal protected investment.
Buffer zone • A buffer zone investment may be appropriate for an investor who is comfortable
investments with taking some downside risk but would like a buffer to mitigate or moderate
losses.
• In general, buffer zone investments can be structured to have a shorter maturity
than principal protected investments, often between two and four years.
• Return enhanced investments are leveraged products for a moderately bullish
market.
• In exchange for accepting full downside exposure in the underlying, a return-
Return
enhanced investment offers double or triple the equity returns up to a pre-
enhanced
specified maximum.
investments
• If an investor believes that market returns are likely to be flat to slightly up over
the near-term, a return-enhanced investment may be an ideal investment vehicle.
• Return-enhanced investments tend to have maturities of one to three years.
• Income-based investments offer varying degrees of principal protection and are
Income
primarily focused on generating one or more payments during the term of the
investments
investment.
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Strategic
• These are designed for an investor who may wish to have exposure to a fairly
asset
inaccessible index or to a complicated and expensive trading strategy.
investments
Hybrid • These innovative investments enable investors to take investment views
investments simultaneously across several asset classes.
Structured products have offered a range of benefits to investors and generally have been used either
to provide access to stock market growth with capital protection or exposure to an asset, such as gold
or currencies, that would not otherwise be achievable from direct investment. Their advantages include:
• potential protection of initial capital investment;

• enhanced returns and reduced volatility;
• access to different asset classes;
• reduced risk.
They do have drawbacks, however, including:
• Principal protection will depend upon the creditworthiness of the counterparty providing the
protection guarantee.
• The fees payable for these products will be higher than for many simpler products or via holding the
assets directly.
• They have to be held to maturity to secure any gains unless they are a listed investment note.
Structured products rarely trade after issuance and someone who wants or needs to sell a structured
product before maturity should expect to sell it at a significant discount.
• There is no daily pricing and they are priced on a matrix, not NAV. Matrix pricing is essentially a best-
guess approach and the lack of pricing transparency can make it very hard for present valuation
purposes.
• The complexity of the return calculations means it can be difficult to understand how the structured
product will perform relative to simply owning the underlying asset.
5.2.3 Commodities and Commodity Funds

The physical trading of commodities concerns itself with procuring, transporting and consuming real
commodities by the shipload on a global basis. This trade is dominated by major international trading
houses, governments, and the major producers and consumers.
There are a number of different commodity markets, which are differentiated by the commodity that is
traded. Some of the main ones are:
• agricultural markets;
• base and precious metals;
• energy markets;
• power markets;
• plastics markets;
• emissions markets;
• freight and shipping markets.
230
The derivatives markets exist in parallel and serve to provide a price-fixing mechanism and somewhere
that the physical markets can hedge market price risk.
Some of the features of the base and precious metals markets and energy markets are shown below.
Characteristics of Commodity Markets

• There are numerous metals produced worldwide and subsequently refined for use in
a large variety of products and processes.
• As with all other commodity prices, metal prices are influenced by supply and demand.
• The factors influencing supply include the availability of raw materials and the costs
of extraction and production.
Base and
• Demand comes from underlying users of the commodity, for example, the growing
Precious
5
demand for metals in rapidly industrialising economies, including China and India.
Metals
• It also originates from investors such as hedge funds which may buy metal futures in
anticipation of excess demand, or incorporate commodities into specific funds.
• Producers use the market for hedging their production.
• Traditionally, the price of precious metals such as gold will rise in times of crisis –
gold is seen as a safe haven.
• The energy market includes the market for oil (and other oil-based products like
petroleum), natural gas and coal.
• Supply of these commodities is finite, and countries with surplus oil and gas reserves
are able to export to those countries with insufficient oil and gas to meet their
requirements. Prices could be raised by producers restricting supply, for example, by
the activities of the major oil producers in the Organisation of Petroleum Exporting
Energy
Countries (OPEC).
Markets
• Demand for oil and gas is ultimately driven by levels of consumption, which in turn
is driven by energy needs, for example from manufacturing industry and transport.
• Prices can react sharply to political crises, particularly in major oil-producing regions
of the world such as the Middle East. Furthermore, since the level of demand is
directly determined by the consuming economies’ growth, economic forecasts and
economic data also have an impact on energy prices.
Exchange-Traded Commodities (ETCs)

ETCs are investment vehicles that track the performance of an underlying commodity index, including
total return indices based on a single commodity. They are similar to ETFs and are traded and settled
in the same way as shares enabling investors to gain exposure to commodities, on-exchange, during
market hours.
Most ETCs implement a futures trading strategy, which may produce quite different results from owning
the underlying commodity. In the case of many commodity funds, they simply roll so-called front-
month futures contracts from month to month. This does give exposure to the commodity, but subjects
the investor to risks involved in different prices along the term structure of futures contracts, which may
include additional costs as the expiring contracts have to be rolled forwards.
In addition to investment vehicles which track commodities there are also exchange-traded currencies
(ETCs) which provide exposure to FX spot rate changes and local institutional interest rates.
231
ETCs are not UCITS 111 compliant but will be fully collateralised, meaning that counterparty risk is
hedged out.
6. Fund Evaluation
Learning Objective
5.6.1 Understand the range of research available for mutual funds and their relative merits and
limitations in the fund selection process
Investment funds are usually promoted on the basis of their past performance and level of charges. One
of the most frequently asked questions in the investment world is is past performance a reliable guide to
future performance?
Another way of phrasing this question would be to ask what is the probability of this year’s above-
average performing fund still being an above average performer next year. One of the greatest myths
perpetuated by many product providers is, the better a fund’s past performance and the higher its level
of charges, the greater its chances of outperforming the peer group in the future.
Although past performance provides prima facie evidence of a portfolio manager’s skill and investment
style, as well as evidence of the risks taken to generate this performance, against this must be weighed
the possibility of:
• Chance – that good performance could be the result of luck not skill.
• Change – even if good performance is attributable to skill, very few portfolio managers manage the same
portfolio for any considerable length of time. Moreover, manager skill, especially an ability to exploit a
particular investment style or rotate between styles, is rarely consistent in changing market conditions.
Unsurprisingly, therefore, this leads to a significant amount of research being undertaken. There are
a number of independent ratings agencies that provide ratings for investment funds, most of whom
provide this data free of charge to financial advisers. The majority of these ratings are based on risk-
adjusted past performance, though some place considerable weight on qualitative factors, such as how
a portfolio manager runs their fund. However, even the evaluation of qualitative factors only provides an
indication of how a certain portfolio manager is likely to perform when adopting a particular investment
style under specified market conditions.
A simple conclusion can be reached: past performance should never be used as the sole basis on which
to judge the suitability of a fund or, indeed, be relied upon as a guide to future performance. Moreover,
it goes without saying that funds that impose high charges will put the investor at an immediate
disadvantage and prove to be a significant drag on subsequent fund performance.
Although there is no failsafe way of ensuring that a particular fund will consistently achieve above average
performance, the following factors improve the chances of selecting an above-average performing fund.
232
6.1 Fund Prospectus

Investment funds are required to produce and keep up to date a series of documents that provide
comprehensive information to investors and their advisers that allow them to make an informed
decision before investing in a fund.
Fund Prospectus
The prospectus has to be kept up to date and made available to current and potential investors.
The document sets out details of the investment objective of the fund and the strategies it uses along
with details of the fund manager and the trustee or depositary. It will also set out the different share
classes, its charges, the process used for valuation and pricing, how investor dealing takes place and
how income will be distributed or reinvested.
5
Simplified Prospectus
A fund’s prospectus is a long and very detailed document that is not easy for the average investor to
read or understand. As a result, European funds produce a simpler summary of the key information in a
simplified prospectus.
These have to follow a prescribed format whereby the objectives of the fund, its risks and the key
information needed by investors have to be set out in a simple to understand and easy to read format.
Key Investor Information Document (KIID)

More recently, shortcomings with the simplified prospectus have been addressed and UCITS funds now
have to produce a key investor information document (KIID).
The KIID must be clearly identifiable as such and has to follow a required format so that there is clear
consistency across the whole range of UCITS funds in all Member States. A KIID must be produced for
each sub-fund and the key elements that have to be included in the KIID are shown below.
Key Investor Information Document

• The first section requires a clear description of the fund’s objectives and
Objective investment policy.
and • The types of assets that will be invested in and whether any particular market or
investment sector is targeted.
policy • The types of shares and when dealing takes place.
• Whether any income arising from the fund is distributed or reinvested.
• The second section has to contain a synthetic risk reward indicator to evaluate the
Risk and
level of risk that investment in the particular fund represents.
reward
• There should also be a narrative explanation of the indicator and its main
profile
limitations.
233
• The third section concerns charges for the fund which have to be presented in a
prescribed format.
Charges for
• It should contain details of any entry or exit charge and the amount of ongoing
this fund
charges, each of which should be clearly distinguished.
• Performance fees have to be disclosed separately.
Practical • This contains details of the trustee or depositary and other items such as how to
information obtain further information.
6.2 Independent Fund Ratings

There are a number of independent ratings agencies that provide ratings for investment funds, most of
whom provide this data free of charge to financial advisers.
Some of the main ratings agencies and the differing approaches they adopt are considered below.
• Lipper. A fund-rating system that provides a simple, clear description of a fund’s success in meeting
certain investment objectives, such as preserving capital, lowering expenses or building wealth.
• Standard & Poor’s. A quantitative screening approach to identify the range of funds which it will rate.
It assesses historical performance to identify the top 20% of funds for further detailed quantitative
and qualitative analysis.
• Morningstar OBSR. A qualitative rating system which gives an assessment of a fund’s investment
merits. Its approach uses a combination of past performance and predictions of future performance.
Funds are then allocated a Morningstar qualitative rating against a peer group of pan-European and
Asian funds.
The majority of these ratings are based on risk-adjusted past performance, though some place
considerable weight on qualitative factors, such as how a portfolio manager runs their fund. However,
even the evaluation of qualitative factors only provides an indication of how a certain portfolio manager
is likely to perform when adopting a particular investment style under specified market conditions.
Although none of these ratings agencies claim to have predictive power, they seek to provide a valuable
tool for financial advisers to filter out those funds that consistently under-perform. Indeed, research
tends to suggest that funds awarded a top rating by one of these ratings agencies improves upon the
50:50 chance of that fund being an above-average performer in the future.
6.3 Fund Fact Sheets

With so many funds available, the ratings agencies provide a valuable way of filtering them down to a
manageable number that an adviser can review to ascertain whether they are suitable for inclusion in a
portfolio.
Once the universe of possible funds has been filtered down to a more manageable level, it is necessary
to drill down into the detail of these particular funds and this can be achieved using the readily available
fund fact sheets. The typical content of a fund fact sheet includes:
• investment objective;
• fund profile and its asset allocation;
234
• portfolio composition;
• portfolio turnover;
• fund performance;
• risk measures.
The risk measures section assesses the fund using a variety of industry-standard measures, with a history
of at least three years. These measures assess a fund’s volatility as well as looking at its risk against a
given benchmark and typically include:
• Standard deviation – this measures the dispersion of the fund’s returns over a period of years.
Funds with a higher standard deviation are generally considered to be riskier.
• R-squared – this measures the degree to which the fund’s performance can be attributed to the
index against which it is benchmarked. For example, if a fund is benchmarked against the S&P
5
500 and has an R-squared of 80%, this would indicate that 80% of its returns can be attributed to
movements in the index itself.
• Information ratio – this is a measure of the risk-adjusted return achieved by a fund. A high
information ratio indicates that when the fund takes on higher risks (so that its standard deviation
rises), it increases the amount by which its returns exceed those of the benchmark index. It is
therefore a sign of a successful fund manager.
• Sharpe ratio – this is simpler and measures the fund’s return over and above the risk-free rate. The
higher the Sharpe ratio, the better the risk-adjusted performance of the portfolio and the greater
the implied level of active management skill. But the Sharpe ratio makes no allowance for the extra
risk incurred in achieving those higher returns.
6.4 Fund Manager Ratings

As well as assessing the fund itself, many believe it is important to consider individual fund manager
ratings as well. Fund managers regularly switch funds and jobs, so the top-performing funds are not
necessarily being run by the managers who were responsible for their high performance levels.
One organisation that evaluates fund manager’s performance is Citywire, which covers fund managers
from across Europe. They produce fund manager ratings to identify the individual managers who have
the best risk-adjusted personal performance track records over three years. Its rating approach uses a
version of the information ratio to identify which fund managers are adding value to their funds in terms
of outperformance against their benchmark.
6.5 Fund Group Publications

Many fund management groups now exploit the internet to provide greater levels of detail about
the funds they are managing and prospects for different market sectors. They now regularly schedule
web-based presentations about new funds and markets or arrange online conferences where a fund
manager is questioned about his or her investment strategy and plans.
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1. Why is it important to evaluate a fund’s structure and in what cases may detailed evaluation be
required?
2. Why is the TER of a fund an important factor to evaluate when assessing a fund?
3. How do ETNs differ from ETFs?
Answer reference: Section 2
4. What factors should you assess when considering the counterparty risk of a synthetically replicated
ETF?
5. What are infrastructure funds and what is their attraction to a private investor?
6. What is structural leverage and how does it impact investor returns?
7. What is a market neutral strategy?
8. What is correlation compression and when might it impact hedge fund performance?
9. You are evaluating the terms of a principal protected structured product. What is the primary risk
associated with this type of product?
10. An actively managed investment fund is benchmarked against the FTSE All Share Index and has an
R-squared ratio of 75%. What would this imply?
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Chapter Six
Financial Advice
1. The Investment Advice Process 239
2. International Planning Considerations 266
3. Trusts and Foundations 273
6
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Financial Advice
1. The Investment Advice Process

The investment advice process can be divided into five distinct stages:
• determining the client’s requirements;

• formulating the strategy to meet the client’s objectives;
• implementing the strategy by selecting suitable products or constructing an investment portfolio;
• revisiting the recommended investments to ensure they continue to meet the client’s needs;
• periodically revisiting the client’s objectives and revising the strategy and products held, if needed.
In this and the next chapter, we will look at the key elements of the investment advice process, the
additional considerations that are needed for international planning and the factors that should be
taken into account in portfolio construction.
1.1 Structured Advice Process
6
Learning Objective
6.1.1 Apply fundamental principles of financial planning to wealth management scenarios:
structured advice process; gathering client information; risk assessment
Adopting a structured and disciplined approach to investment advice is essential in these days of
increasing professionalism and regulatory scrutiny.
1.1.1 Structured Advice Process

Trust is at a premium today in the financial services industry and being able to show clients that a firm
has a rigorous process to understand their needs and control risks can go a long way to building trust
and having a long-term profitable relationship with a client.
Having a structured investment advice process helps a wealth management firm to bring consistency to
their advice process. Consistency means that each client should get the same service and outcome no
matter which adviser they see. Inconsistency leads to regulatory and reputational risk, while consistency
leads to trust and solid, long-term and profitable client relationships.
Many firms now adopt a statement of principles as a way of embedding their values into the investment
process. This sets out the firm’s beliefs and approach to investment management and covers areas such as:
• How a structured financial planning process aims to provide clear and suitable advice based on the
client’s circumstances.
• The investment philosophy used and how risk is assessed, assets allocated and portfolios reviewed.
• How these are used to prepare an investment plan that takes account of the client’s unique
circumstances.
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1.1.2 Client Information
Individuals have varying objectives and expectations and before advising the client an adviser must be
aware of these various needs, preferences, expectations and the financial situation of the client.
The adviser must know the client before being able to provide appropriate advice. Indeed, regulators
make this an essential requirement in many countries – the know your customer (KYC) process.
Gathering all of the information needed to be able to properly advise a client is often a time-consuming
affair and clients often do not appreciate why so much information is needed or why so much time
needs to be spent. This requires the adviser to build rapport with the client so that they will feel
confident about expressing their personal needs and concerns, in order to establish all of the facts that
are needed for the adviser to be able to make a suitable recommendation.
The fact-find process will need to go beyond just hard facts and elicit views and opinions from the client
which will allow the adviser to assess the level of risk they are comfortable with and the extent to which
family values such as ethical or religious beliefs will affect investment decisions.
The fact find is crucial to the investment advice process and so many firms use electronic ways of
collecting client information and risk attitude to improve the quality and consistency of the firm’s advice
process.
The role of the adviser in all this is to build a relationship with a client that allows them, in a structured
way, to identify the information needed to provide suitable advice and guide the client through the
choices that face them.
Below, we will consider some of the key client information that an adviser needs to establish.
It is necessary to establish and capture extensive amounts of data about a client. It is a time-consuming
process and so it is important to understand why certain types of personal and financial details are
needed so that the correct amount of information is obtained and the reason for its need can be
explained to clients.
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Financial Advice
The following table provides some examples of why information about the client’s personal and
financial position is needed for investment planning purposes.
Personal and Financial Details

Information
Why Needed
Needed
• Details of the client’s name and address will need to be verified to comply with
anti-money laundering requirements.
Personal details • The client’s stage of life they have reached may have implications for any asset
allocation strategy. It will also give an indication of their potential viewpoint
on long-term investments.
• The client’s health may influence the investment strategy and allocations to
cash, bonds and equities.
• If they are in good health, it may indicate a need to generate a growing level
Health status
6
of income for many years. If they are in poor health, it may drive an investment
strategy to produce a more immediate income.
• A client’s health may also influence their attitude to risk.
Details of • This may equally impact the client’s investment objectives and attitude to risk.
family and • It may also indicate a need to fund immediate or future spending on areas such
dependants as schooling or weddings.
• Existing income will impact the level of income that needs to be generated
Details of their
from a portfolio and the level of risk that the client is able to tolerate.
occupation,
• The client’s occupation or business will give a good indication of their
earnings and
experience in business matters which may be relevant when judging the
other income
suitability of a particular type of investment that carries greater risk and where
sources
the firm is required to assess the client’s experience before recommending it.
Estimates of
• This will be needed in conjunction with their income, where it is necessary to
their present
look at budgeting, planning to meet certain liabilities or generating a specific
and anticipated
income return.
outgoings
• Full details of the client’s assets and liabilities are clearly needed.
Assets and
• In addition, details will be needed of where assets are held, their tax treatment,
liabilities
acquisition costs and details of any early encashment penalties.
• The pension arrangements the client has made will need to be closely linked to
Any pension
the investment strategy that is adopted both for retirement and other financial
arrangements
objectives.
Potential
• This will be relevant if the amounts due to be inherited might influence the
inheritances
investment strategy adopted.
and any estate
• The adviser should also check whether the client has left any specific gifts of
planning
shares in their will and, if so, whether this would prevent any sale of such a
arrangements,
holding.
such as a will
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1.1.3 Risk Profile
Investment always involves a trade-off between risk and return. However, different people are prepared
to tolerate different levels of investment risk and investment risk means different things to different
investors. Variations in attitude arise because of individual differences in circumstances, experiences
and psychological make-up as we shall see in Section 1.2 on behavioural finance.
A client’s risk profile is made up of three components:
• Risk tolerance – this is the client’s willingness to accept a certain level of fluctuation in the value of
their investments without feeling an immediate need to sell.
• Attitude to risk – this represents their personal opinion on the risks associated with making an
investment based on their prior knowledge and experience.
• Risk capacity – this is the client’s ability to absorb any financial losses that might arise from making
a particular investment.
Taken together, these three elements should allow a risk classification or profile to be determined that
can be agreed with the client.
The risk assessment process usually starts with investigation of attitudes; consideration of risk capacity
usually follows later since it requires knowledge of the client’s objectives and the particular investments
that are being considered.
Risk Attitudes
Risk attitudes help to identify the degree of uncertainty that an investor can handle in regard to a
negative change in the value of his or her portfolio.
These attitudes may be influenced by both objective and subjective factors.
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Objective and Subjective Factors

• The timescale over which a client may be able to invest will determine both what
products are suitable and what risk can be adopted.
• Family commitments are likely to have a significant impact on a client’s risk profile as
they will want to meet their obligations which may make higher-risk investments less
suitable.
Objective • Wealth will clearly be an important influence on the risk that can be assumed. A
factors client with few assets can little afford to lose them, while ones whose immediate
financial priorities are covered may be able to accept greater risk.
• Stage of life is equally important as it will impact the level of risk that can be adopted
and the time horizon over which they consider investments.
• The age of the client will often be used in conjunction with the above factors to
determine acceptable levels of risk.
• Investors who are more knowledgeable about financial matters are more willing to
6
accept investment risk.
• Some individuals have a psychological make-up that enables them to take risks
more freely than others, and see such risks as an opportunity.
Subjective • A client’s preferred investment choice such as a client’s normal preferences for the
factors relative safety of a bank account versus the potential risk of stocks and shares.
• A client’s approach to bad decisions. Some clients can take the view that they
assessed the opportunity fully and therefore any loss is just a cost of investing.
Others regret their wrong decisions and therefore avoid similar scenarios in the
future.
Establishing objective factors is clearly a preferable and more accurate way to help define a client’s risk
tolerance, but subjective factors clearly have a part to play.
Subjective factors enable an adviser to try and establish a client’s attitude to taking risks. A client’s
attitudes and experiences must also play a large part in the decision-making process. A client may well
be able financially to invest in higher-risk products and these may well suit their needs, but if they are
cautious by nature, they may well find the uncertainties of holding volatile investments unsettling, and
both the adviser and the client may have to accept that lower-risk investments and returns must be
selected. This subject is investigated further in Section 1.2 on behavioural finance.
Risk Capacity
Risk capacity is the client’s ability to absorb any losses that may arise from making a particular
investment.
Risk tolerance and risk perception are partly subjective, but risk capacity is largely a matter of fact. While
subjective factors largely determine risk perception and attitude, the key question in assessing risk
capacity is more what the consequences will be for the client if losses are incurred.
In some cases, risk capacity will play the most important role in determining the client’s overall risk
profile. The client’s capacity for risk will also be affected by the level of investment being considered.
If the amount at risk represents a significant portion of the overall portfolio, risk capacity may be
diminished. Risk capacity will be greater when the amount at risk is a small fraction of available capital.
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Risk Profiling Tools
There are a number of approaches that can be taken to establish the client’s risk profile.
Risk Profiling Tools

• A much-used approach to establishing a client’s risk profile is to describe
different types of investment attitudes to find out which is closest to the
Risk client’s view.
descriptions • This has the advantage of simplicity.
• Its drawback is that statements such as medium risk or on a scale of one
to ten mean different things to different people.
• The aim of psychometric risk profiling is to assess the client’s psychological
risk tolerance or preference, rather than their objective financial capacity to
take risks.
• It uses a questionnaire to generate a risk score that can be compared to
other clients.
• Its advantage is that it allows clients to consider their attitude to investment
Psychometric
decisions very carefully and to articulate them to the adviser, who can ask
risk profiling
further questions and discuss the relationship of risk to the behaviour of
different asset classes.
• It is important to remember though that the psychological profile is only
one of the inputs into the investment decision-making process. But it is a
good starting point to a discussion that could include the impact of the
profile on potential outcomes for the client’s different goals.
• The stochastic model forecasts a range of possible returns from different
portfolios of investments. It helps clients choose the appropriate portfolio
by showing the range of possible outcomes from each portfolio and the
probability of achieving them.
Stochastic • Its advantage is that it helps to explain investment risk to the client,
modelling compare alternative strategies and recommend a portfolio of suitable
investments.
• It is important to understand that the model is making predictions about
the future and is therefore reliant on its assumptions. A further drawback is
that some clients may think these projections are set in stone.
Tools can usefully aid discussions with clients by helping to provide structure and promote consistency.
But they often have limitations which mean there are circumstances in which they may produce flawed
results. Where firms rely on tools they need to ensure they are actively mitigating any limitations
through ensuring suitability and the KYC process.
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Financial Advice
1.2 Behavioural Finance
Learning Objective
6.1.2 Understand the key principles of behavioural finance and its impact on attitude to risk
Traditional finance theory assumes that people make rational investment decisions as they choose
between different asset classes in the light of prospective risk and return and think rationally about their
overall objectives.
In practice, however, emotion and psychology influence our decisions causing us to act in unpredictable
or irrational ways. Behavioural finance tries to combine what psychologists call cognitive behaviour
with conventional financial theory to better understand how we make decisions.
6
An understanding of the concepts of behavioural finance is important for wealth managers as they can
help us understand clients needs’ better and design and deliver services that take into account how we
act in practice.
For the wealth manager, financial theory and behavioural finance are areas that it is important to
understand. Modern portfolio theories are a key skill to deploy in portfolio construction, whilst
behavioural finance enables us to understand clients and how they make decisions better.
1.2.1 Background to Behavioural Finance

Advocates of behavioural finance assert that the standard finance model of rational behaviour does not
explain well how most people undertake financial decision making.
Modern financial theories such as CAPM and the efficient markets hypothesis assume for the most part
that people act rationally. As time went on, experts in economics and finance started to find evidence
of anomalies and behaviours that could not be explained by the theories available. These anomalies
prompted academics to look to cognitive psychology to account for the irrational and illogical
behaviours that modern finance had failed to explain.
Behavioural finance does not attempt to reject the rational behaviour of traditional economics as faulty;
rather, it suggests that the boundaries within which it applies are more specific than realised. Instead
it highlights the cognitive fallacies and biases in the way we think which preclude us from acting in a
logical and rational manner.
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Although behavioural finance has been gaining support in recent years, it is not without its critics.
Whatever the merits or otherwise of the competing arguments, for wealth managers it provides a
source of intelligence on the decision-making process of investors and helps to explain a variety of
investment related issues such as:
• seemingly chaotic stock prices;

• excessive share price volatility and bubbles in prices;
• follow-the-leader or herding behaviour;
• selling winning investments too early and selling losing investments too late;
• asset prices appearing to over or under react to new market information;
• misestimation of risk;
• asymmetric attitude to risk and loss;
• belief in the value of time diversification (that risk diminishes with time);
• mistaking ‘good’ companies for ‘good’ investments;
• individual investors holding poorly diversified portfolios;
• preferences for shares of companies often reported in the news.
1.2.2 Decision-Making
Behavioural finance suggests that very often our decision-making process is not a strictly rational one
where all relevant information is collected and objectively evaluated. Rather, we will often take mental
shortcuts or use our intuitions and gut feelings in the process.
Heuristics and Bounded Rationality

Heuristics refers to the rules of thumb, educated guesses or gut feelings which humans use to make
decisions in complex, uncertain environments.
Limited time and cognitive capacity mean people have problems inferring relevant facts when making
decisions, even when they may have all the relevant information. Behavioural finance refers to this as
bounded rationality.
Some key decision attributes have been identified including:
• Individual’s preferences tend to be multidimensional, open to change, and often formed only
during the decision process itself.
• Individuals appear to be adaptive. The nature of the decision and the environment in which the
decision is made contribute to the selection of a decision process or technique.
• Individuals seek satisfactory, rather than optimal, solutions.
Some results of research into decision-making from behavioural finance are detailed below.
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Financial Advice
Key Concepts
• Individuals may not take into account all relevant information.
Use of information • This may help to explain why investors rely on past performance and fail to
take full account of risk and expected return
• Evidence shows that, once people have made asset allocation decisions,
they tend to leave them unchanged. The status quo then becomes
Investment inertia people’s default position.
• Status quo bias is the tendency for people to stick with their prior choices,
especially in circumstances of too much complexity.
• When faced with having to make decisions under conditions of uncertainty
and inadequate information, an individual will tend to see patterns and
similarities to previous contexts where perhaps none exists.
Representativeness • This is used to explain a behaviour known as herding.
• Herding occurs when investors will tend to follow each other, somewhat
6
irrationally, and be led by an ebullient and upward-trending market into
speculative bubbles.
• Overconfidence leads many investors to overestimate their predictive
ability.
Overconfidence • People can be slow to revise their previous assessment of a company’s
likely future performance, even when there is notable evidence that their
existing assessment is incorrect.
• People tend to base their decisions on reference points that are often
arbitrarily chosen.
• People are concerned not only with what they have but with how it
Anchoring
compares to what they used to have and with what they might have had.
• For example, whether people choose to sell shares is influenced by what
they paid for them.
• This is the belief that there are discernible sequences or patterns observable
Gambler’s fallacy in repeated independent trials of some random process, such as the
repeated spinning of a roulette wheel.
• This is the notion that if something readily comes to mind when asked
to consider a question or make a judgment, then what has come to mind
Availability must be relevant and important.
• This means that investors tend to overweight more memorable facts and
evidence.
Research finds that individuals tend to rely more heavily on heuristics as decisions become more
complex, or when time is short, or emotions run high. People also tend to reduce the portion of
information considered when they are under stress.
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From these, a number of useful conclusions can be sought that can help when explaining investment
choices and risk:
• Offering more choice to consumers is not always helpful as it can increase procrastination, reduce
satisfaction, and incline people to invest less or invest in low risk/return funds and drive individuals
to simple options.
• Behavioural economists refer to the concept of choice overload to describe the situation where
complex investment menus may discourage participation.
• Well-designed and managed investment solutions may be a better option for most people than too
much choice.
• Wealth managers need to counsel their clients to avoid the risk of herd behaviour by using examples
of previous asset price bubbles.
• When dealing with overconfidence, wealth managers need to exercise even greater care in
establishing a client’s risk profile with careful framing of questions and explanations of the risk of loss.
• Anchoring shows that people are very much influenced by the manner in which a question is posed
or any background information and context is provided. Questions and information need to take
account of the cognitive ability of the client and any tendency to overconfidence or risk aversion.
1.2.3 Prospect Theory

Traditional financial theory suggests that we aim to maximise our investment decisions by making an
overall evaluation of whether an investment choice is desirable.
According to prospect theory, however, people value gains and losses differently and so will base
decisions on perceived gains rather than perceived losses. So, if a person is given two equal choices, one
expressed in terms of possible gains and the other in possible losses, they will choose the former – even
when they achieve the same economic end result.
Some of the key concepts addressed by prospect theory are shown below.
Prospect Theory
• Research in behavioural finance finds that investors are inconsistent in their
Loss
attitude to risk. Individuals play safe when protecting gains but are reluctant to
aversion
realise losses.
• This arises from the desire to avoid feeling the pain of regret resulting from a poor
investment decision.
• Regret aversion can encourage investors to hold poorly performing shares,
Regret since avoiding their sale also avoids having to acknowledge the fact that a poor
aversion investment decision has been made.
• The wish to avoid regret can also bias new investment decisions, as people will
often be less willing to invest new sums in investments or markets that have
performed poorly in the recent past.
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Financial Advice
• Behavioural finance has challenged the standard economic assumption that

individuals treat types of income and wealth equally.
Mental
• It could mean for example, that individuals prefer to invest their own pension
accounting
contribution as safely as possible, while there may be more appetite to seek higher
returns with the employer contribution.
• According to portfolio theory, the correct procedure to adopt for success as an
investor is to become an information trader, as being in possession of high-
quality information is the key to a profitable investment strategy.
Information
• Since noise is the opposite of information, people who trade on noise make
and noise
trading decisions without the use of fundamental data, relying instead on trends,
traders
sentiment, anomalies and momentum.
• Since noise traders, by definition, do not trade on fundamentals, they are allegedly
more likely to buy high and sell low.
Research suggests that is it is easier for an individual to forgo a gain than to accept a loss. This has
6
implications for investment behaviour and investment decisions:
• Investors will be risk averse for a realised gain and will act to lock in this gain prematurely, a so-called
disposition effect.
• When it comes to losses, a break even effect operates. Recognising they face a certain loss, many
investors take on additional risk in an attempt to recover their investment and break even. This is
particularly so in falling stock markets, where losses are perceived as temporary and another bet will
enable the losses to be recovered.
It is also important to recognise that certain groups of people may have higher levels of loss aversion due to a:
• lack of financial capacity to bear a loss;

• lack of financial capability to understand the meaning of investment loss;
• psychological reluctance or unwillingness to bear a loss.
Loss aversion with loss avoidance behaviour is a potential problem as it may lead investors to apply loss
aversion strategies that are inappropriate or stop investing altogether. A wealth manager should focus
on communication strategies in order to help clients better understand this area.
1.3 Investment Objectives

Learning Objective
6.1.3 Advise on investment objectives; constraints, investment strategy and suitability criteria
1.3.1 Objectives
Given the wide range of available investment opportunities that might be suitable for a client, an
adviser needs to start with understanding what the client’s investment or financial objectives are.
This requires the client to consider what they are trying to achieve. The answer will determine the
overall investment strategy that will be driving the investment planning process.
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Typical financial objectives include:
• maximising future growth;

• protecting the real value of capital;
• generating an essential level of income;
• protecting against future events.
It is also important to remember that a client may have more than one financial objective, such as
funding school fees, while at the same time maximising the growth of their investments to provide the
funds needed in retirement.
Having determined the client’s overall financial objectives, the adviser also needs to know how this will
affect the choice of investments. Investment objectives are often categorised into:
• Income – the investor seeks a higher level of current income at the expense of potential future
growth of capital.
• Income and growth – the investor needs a certain amount of current income but also invests to
achieve potential future growth in income and capital.
• Growth – the investor does not seek income and their primary objective is capital appreciation.
• Outright growth – the investor is seeking maximum return through a broad range of investment
strategies which generally involve a high level of risk.
1.3.2 Investment Strategy and Constraints

Once the client’s investment objectives have been agreed, the adviser needs to look at developing an
investment strategy that can be used to achieve these objectives. In developing an investment strategy,
the adviser will need to take account of the following constraints:
• risk profile;
• liquidity requirements;
• time horizons;
• tax status;
• investment preferences.
We will look at each of these below.
1.3.3 Risk Profile

As we saw earlier, a client’s risk profile is made up of a combination of attitudes and risk capacity – that
is the client’s ability to absorb any financial losses that might arise from making a particular investment.
These allow a risk classification or profile to be determined that can be agreed with the client.
Volatility in the prices of investments or the overall value of an investment portfolio is inevitable. At a
personal level this translates into the risk that prices may be depressed at the time when an investor
needs funds and will mean that they will not achieve their investment goals.
A client needs to have a very clear understanding of their tolerance to risk, as it is essential to choosing
the right investment objectives. Risk tolerance is a very personal subject and is very dependent upon
the emotional make-up of a person. It is also objective as well, in that age will affect how much risk
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Financial Advice
a client can assume. As you get older, there is less time to recover from poor investment decisions or
market falls and so appetite to take risk may change.
Although risk is an emotive subject, establishing a client’s tolerance towards risk need not be subjective.
Indeed, an objective measure of a client’s risk tolerance is provided by the risks that will need to be taken
if the client’s stated investment objective is to be met. If the client believes these risks are too great, then
the client’s objective will need to be revised.
1.3.4 Liquidity and Time Horizons

It is also essential to understand a client’s liquidity requirements and the time horizons over which they
can invest as these will also have a clear impact on the selection and construction of any investments.
Liquidity and Time Horizons

• Liquidity refers to the amount of funds a client might need both in the short and
6
long-term.
• When constructing an investment portfolio, it is essential that an emergency cash
reserve is put to one side which the client can access without having to disturb
longer-term investments.
• If there are known liabilities that may arise in future years, consideration should also
Liquidity be given as to how funds will be realised at that time.
• Consideration needs to be given as to whether it is sensible to plan on realising
profits from equities as market conditions may be such as to require losses to be
established unnecessarily.
• Instead, conservative standards suggest investing an appropriate amount in bonds
that are due to mature near the time needed so that there is certainty of the
availability of funds.
• Time horizon refers to the period over which a client can consider investing their funds.
• Definitions of time horizons vary, but short-term is usually considered to be from one
to four years, while medium term refers to a period from five to ten years and long-
term is considered to be for a period of ten years or more.
Time • Time horizon is very relevant when selecting the types of investment that may be
horizon suitable for a client.
• It is generally stated that an investor should only invest in equities if they can do
so for a minimum period of five years. This is to make the point that growth from
equities comes about from long-term investment and the need to have the time
perspective that can allow an investor to ride out periods of market volatility.
The lower the client’s liquidity requirements and the longer their timescale, the greater will be the
choice of assets available to meet the client’s investment objective.
The need for high liquidity allied to a short timescale, demands that the client should invest in lower-risk
assets such as cash and short-dated bonds, which offer a potentially lower return than equities; if the
opposite is true, the portfolio can be more proportionately weighted towards equities.
Whatever their requirements, it is important, however, that the client maintains sufficient liquidity to
meet both known commitments and possible contingencies.
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1.3.5 Tax Status
Establishing the client’s tax position is essential so that their investments can be organised in such a way
that the returns attract the least tax possible.
This requires the investment manager to be aware of what taxes may affect the investor, such as taxes
on any income arising or on any capital gains, how these are calculated and what allowances may be
available.
An adviser will also need to establish the client’s residence and domicile status as these may impact how
any investments are structured and taxed.
1.3.6 Investment Preferences

Some investors prefer to either exclude certain areas of the investment spectrum from their portfolios or
concentrate solely on a particular investment theme, such as socially responsible or ethical investment,
or require the portfolio to be constructed in accordance with Islamic principles.
These are covered in more detail later in this chapter.
1.4 Analysis
Learning Objective
6.1.4 Analyse a client’s financial position; asset and cash flow projections
Once the fact-find and discussions with the client have been undertaken the next stage is to collate all
of the data that has been collected, analyse the client’s financial position and prioritise the areas where
action is needed.
This involves turning the data into a comprehensible form that allows it to be readily analysed. This can
be broken down into a number of areas such as:
• net assets statement;

• cash flow statement;
• the tax position;
• lifetime cash flow projections.
1.4.1 Net Assets Statement

The net assets statement is simply a personal balance sheet that shows the client’s assets and liabilities
and their net worth.
It is useful to have a structured approach to preparing a balance sheet as ordering the assets and
liabilities in groups will aid the analysis of the client’s position and makes it clearer and easier to identify
any issues that need to be investigated further.
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A simplified balance sheet format is shown below.
Simplified Net Assets Statement

Assets
Cash Assets Current Accounts £
Savings Accounts £
Total £
Property Address £
Property Funds £
Total £
Bonds Government Bonds £
Corporate Bonds £
Bond Funds £
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Total £
Equities Direct Equities £

Equity Funds £
Total £
Alternative Assets Hedge Funds £

Absolute Return Funds £
Structured Products £
Total £
Other Assets Insurance Bonds £

Pension Funds £
Other Assets £
Total £
Total Assets £
Liabilities
Property Mortgage – Address £
Mortgage – Address £
Total £
Other Liabilities Credit Cards £
Loans £
Total £
Total Liabilities £
Net Worth £
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As most clients’ assets are complex, it would make sense to have separate statements of each asset
class that show the detail of what the client’s position is so that the above example becomes a summary
statement. By presenting the statement in this way, the client’s assets and liabilities can be clearly seen.
An asset allocation summary should also be produced showing the percentage of assets allocated to
different asset classes.
• Each asset class can then be further broken down into allocations to areas such as large cap shares
sub-sectors or by sector.
• Some investments, such as investment bonds, fall into more than one asset class. The usual approach
is to apportion the fund between the asset classes, depending on the most recent distribution of the
fund.
• A similar approach can be adopted for pension funds where the client can have control over how
the funds are invested and allocated between asset classes.
Presenting the client’s assets in this way allows an analysis of their current position to be undertaken
and then compared against their investment objectives and risk profile. The analysis should look to
identify a range of issues including:
• any mismatch between the client’s risk profile and the overall portfolio;
• whether the assets are appropriate for the client’s objectives;
• any over-allocation to one asset class or market;
• whether there are too many products with one provider;
• an assessment of the probability of the client meeting their investment targets.
The structure of the portfolio and the past performance of investments and funds can then be
investigated to identify:
• asset class, sector and market percentage breakdown;

• large exposures to single investments;
• past performance of individual investments and mutual funds;
• volatility of the individual investments held compared to the client’s risk profile;
• the draw down for the portfolio compared to the client’s risk profile – that is the maximum
percentage loss in value over the period of ownership.
The results of this analysis should generate a series of issues that need to be addressed for an optimal
investment solution that meets the client’s needs.
1.4.2 Cash Flow Statement

A cash flow statement will show the client’s income and expenditure.
The content of the statement will be determined by factors such as the complexity of the client’s income
sources and the extent to which income is an important factor in the evaluation of an investment strategy.
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A simplified format of the cash flow statement based on the summary balance sheet used previously is
shown below.
Simple Cash Flow Statement
Income Monthly Annually

Cash Assets Current Accounts £ £
Savings Accounts £ £
Total £ £
Property Address £ £
Property Funds £ £
Total £ £
Bonds Government Bonds £ £
Corporate Bonds £ £
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Bond Funds £ £
Total £ £
Equities Direct Equities £ £
Equity Funds £ £
Total £ £
Alternative Assets Hedge Funds £ £
Absolute Return Funds £ £
Structured Products £ £
Total £ £
Other Assets Insurance Bonds £ £
Pension Funds £ £
Other Assets £ £
Total £ £
Total Income £ £
Outgoings Monthly Annually
Property Mortgage £ £
Maintenance £ £
Total £ £
Other Liabilities Household Expenses £ £
Holidays and Discretionary Spending £ £
Total £ £
Total Outgoings £ £
Net Income £ £
Sources of income should be shown after tax.
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As each individual’s income and expenses vary widely according to circumstances, the actual headings
used could be very different depending on the client. The summary could also show how much
expenditure is fixed and how much is discretionary.
The reason for preparing a cash flow statement will vary by client but could include:
• Quantifying the income that needs to be generated from investments to meet the client’s income
requirement.
• Identifying where there is a surplus of income over expenditure and the opportunities to plan the
investment of these funds.
• Current cash flow can also be used as a basis of estimating future income and expenditure in
retirement and what would happen if the client became seriously ill and was unable to work.
1.4.3 Tax Position

Tax can have a major impact on both income and the taxation of capital gains and consequently on the
selection of investments that are appropriate for a client. A separate summary of the client’s tax position
can therefore be beneficial.
An understanding of how a client’s income is taxed is essential. Tax calculations will point to whether
income-generating assets or capital growth is the more appropriate and tax efficient approach.
If a client is liable to CGT, details of the acquisition costs are needed to identify any liability to tax that
may arise on disposal of their current assets and whether timing of such disposals is needed.
1.4.4 Lifetime Cash Flow Projection

A lifetime cash flow projection is one that can be prepared once the analysis of the client’s circumstances
have been completed and will incorporate cash flows based on existing assets and investment
recommendations.
It shows longer-term cash flow movements in order to identify where clients will have surplus or deficits
and is useful to identify precisely what actions are needed. These are best presented as a combination
of figures and graphics and can be a powerful tool as it allows the client to see what will take place in
graphic form.
Projections can also take into account expected returns from investments but these should be viewed
very cautiously. Predicting future returns is notoriously inaccurate, so why would a structured advice
process relay on an imponderable? Far better, is to show clients what it is realistic to expect and then
discuss the potential for a better outcome if the investment solutions selected perform as hoped.
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1.5 Other Client Types
Learning Objective
6.1.5 Understand the main considerations that should be taken into account when developing
investment strategies for: trusts and charities; ethical and socially responsible investment;
Sharia’a and other faith based values
In the previous sections, we looked at the factors that should be considered when undertaking a
structured investment advice process for wealthy individuals. Wealth managers also need to take
account of additional factors when dealing with trusts and charities and they need to take account of
the ethical and religious beliefs of clients.
1.5.1 Trusts and Charities
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Trusts and charities may have funds available to invest and advisers need to be aware of additional
factors that need to be taken into account when providing investment advice.
Trustees of trusts and charities have a fiduciary responsibility for the funds they are managing. In order
to carry out their obligations, the trustees have a range of powers and duties that are conferred either
by the trust deed or by statute. From an investment perspective, these include a duty to invest and the
power to appoint investment managers.
In the UK, for example, trustees have a duty to invest and have regard to the need for diversification and
suitability of investments to the trust. These are referred to as standard investment criteria.
• The requirement to diversify the trust fund means that, where appropriate, the trustees should use a
spread of investments. The degree of diversification that is desirable will depend on the size of trust assets.
• Suitability includes considerations as to the size and risk of the investments and the need to produce an
appropriate balance between income and capital growth to meet the needs of the trust. It also includes
any relevant ethical considerations as to the kind of investment which is appropriate for the trust.
Suitability depends on a range of factors including:
• nature and terms of the trust;

• the investment requirements of the trustees and beneficiaries;
• amount available to invest;
• investment term;
• investment skills and knowledge of the trustees;
• underlying taxation of the investment;
• tax position and risk profile of the trustees and beneficiaries;
• administration costs involved.
Trustees are required to review the trust investments on a regular basis in light of the standard
investment criteria and consider whether or not they should be varied. To do this, the trustees are
required to obtain and consider proper advice.
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Trustees have power to appoint investment managers. Trustees have a duty of care when exercising
their powers of investment and so trustees will be expected to satisfy themselves that the intended
adviser is properly qualified.
If the trustee breaches their duties they will be personally liable for breach of trust. Beneficiaries can
sue for such a breach of trust so long as the trustee lives or against his estate if he has died. A trustee’s
liability is joint and several which means that the beneficiaries can claim against one or all of the trustees
and can execute judgements against one or all.
1.5.2 Ethical and Socially Responsible Investment (SRI)

Many clients today expect their personal beliefs about ethical behaviour and climate concerns to be
reflected in how and where they invest.
Ethical funds were launched in the 1980s but to a muted response. After a slow start, however, the
popularity of ethical investing soon gathered pace as public awareness of environmental issues grew
and governments began to respond with a combination of environmental legislation and taxes.
Growth of Ethical Funds

The growing popularity of ethical funds can be seen by looking at the market statistics produced by
a UK organisation, Ethical Investment Research Services which researches around 3,500 companies in
more than 45 countries. Its research shows that funds under management in UK-based CISs grew from
£199 million in 1989 to over £12 billion by the middle of 2013.
The growing interest in actively encouraging corporate social responsibility is central to what has
become known as socially responsible investment (SRI); the phrase is designed to describe the inclusion
of social and environmental criteria in investment fund and stock selection. Indeed, SRI funds have
been at the forefront of an industry-wide move to include the analysis of the non-financial aspects of
corporate performance, business risk and value creation into the investment process.
There are two principal SRI approaches: ethical investing and sustainability investing, both of which are
considered below.
Ethical Funds
Ethical funds, occasionally referred to as dark-green funds, are constructed to avoid those areas
of investment that are considered to have significant adverse effects on people, animals or the
environment. This they do by screening potential investments against negative, or avoidance, criteria.
As a screening exercise combined with conventional portfolio management techniques, the strong
ethical beliefs that underpin these funds typically results in a concentration of smaller company
holdings and volatile performance, though much depends on the criteria applied by individual funds.
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Sustainability Funds
Sustainability funds are those that focus on the concept of sustainable development, concentrating on those
companies that tackle or pre-empt environmental issues head-on. Unlike ethical investing funds, sustainability
funds, sometimes known as light-green funds, are flexible in their approach to selecting investments.
Sustainability investors focus on those risks which most mainstream investors ignore. For instance,
while most scientists and governments agree that the world’s carbon dioxide absorption capacity is fast
reaching critical levels, this risk appears not to have been factored into the share valuations of fossil fuel
businesses. Factors such as these are critical in selecting stocks for sustainability funds.
Sustainability fund managers can implement this approach in two ways, positive sector selection and
best of sector.
Sustainability Approaches
• Positive sector selection is selecting those companies that operate in sectors
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likely to benefit from the global shift to more socially and environmentally
Positive sector
sustainable forms of economic activity, such as renewable energy sources.
selection
• This approach is known as investing in industries of the future and gives a
strong bias towards growth-oriented sectors.
• Companies are often selected for the environmental leadership they
demonstrate in their sector, regardless of whether they fail the negative criteria
Choosing the applied by ethical investing funds.
best of sector • For instance, an oil company which is repositioning itself as an energy business
focusing on renewable energy opportunities will probably be considered for
inclusion in a sustainability fund but will be excluded from an ethical fund.
With the growing trend among institutional investors of encouraging companies to focus on their
social responsibilities, sustainability-investing research teams enter into constructive dialogue with
companies to encourage the adoption of social and environmental policies and practices so that they
may be considered for inclusion in a sustainability investment portfolio.
Integrating social and environmental analysis into the stock selection process is necessarily more
research intensive than that employed by ethical investing funds and dictates the need for a substantial
research capability. Moreover, in addition to adopting this more pragmatic approach to stock selection,
this can result in the construction of a better-diversified portfolio with the potential to generate an
acceptable level of investment return.
Typically, financial, environmental and social criteria are given equal prominence in company
performance ratings by sustainability-investing research teams. This is known as the triple bottom line.
A common misconception with ethical and SRI is that it will involve accepting poorer investment returns
compared with mainstream investments.
Ethical Investment Research Services has undertaken research which shows that ethical investing need
not necessarily involve accepting lower performance. Several of their studies undertaken over the last
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decade have indicated that investing according to ethical criteria may make little difference to overall
financial performance, depending on the ethical policy applied.
There are a range of indices that can be used to track performance, such as the FTSE4Good indices
which cover most sizeable companies around the world and set three global benchmarks against which
companies are judged for inclusion.
1.5.3 Islamic Finance

Islamic finance refers to a system of banking or banking activity that is consistent with the principles of
Islamic Sharia’a law and its practical application through the development of Islamic economics.
Sharia’a prohibits the payment of fees for the renting of money (Riba, usury) for specific terms, as well
as investing in businesses that provide goods or services considered contrary to its principles (Haraam,
forbidden).
The over-arching principle of Islamic finance is that all forms of interest are forbidden. The Islamic
financial model works on the basis of risk sharing. The customer and the bank share the risk of any
investment on agreed terms, and divide any profits between them.
The main categories within Islamic finance are:
• Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back
over a specific period.
• Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end
of the contract.
• Mudaraba offers specialist investment by a financial expert in which the bank and the customer
share any profits. Customers risk losing their money if the investment is unsuccessful, although the
bank will not charge a handling fee unless it turns a profit.
• Murabaha is a form of credit which enables customers to make a purchase without having to
take out an interest-bearing loan. The bank buys an item and then sells it on to the customer on a
deferred basis.
• Musharaka is an investment partnership in which profit-sharing terms are agreed in advance, and
losses are pegged to the amount invested.
1.5.4 Faith-Based Values

A branch of SRI, faith-based investing, has been around for a long time.
In the 1800s, the Quakers, who were anti-slavery and anti-war, avoided investing in weapons production.
Today, faith-based investing is often a combination of SRI plus the screening out of several other things
germane to a particular religion.
Each group decides both what their financial goals are and their strategies to achieve those goals. They
also look at their social and religious teachings and that leads them to be willing to hold certain things
in their portfolios.
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1.6 Investment Management Solutions
Learning Objective
6.1.6 Understand the use and importance of investor policy statements (IPSs) and the range of
investment solutions available for wealth management clients: investment policy statements;
investment solutions - wraps and other platforms; multi asset funds and target date funds;
discretionary portfolio management
After determining a client’s objectives and risk profile and after analysing the client’s current financial
position and any constraints, the final stage of the investment advice process is the development of
solutions that are suitable for the needs of the client.
1.6.1 The Investment Policy Statement (IPS)
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An investment policy statement (IPS) can be thought as a summary of a client’s investment objectives
that captures their required returns, risk profile and any constraints that the investment manager will
operate under. It sets these out along with the investment strategy that will be used to achieve the
client’s goals.
An IPS should be unique to the client but the following table shows some of the essential factors that
should be detailed.
Investment Policy Statement

• The investment objectives should be set out using a standard wording that
has been explained and agreed with the client such as capital growth, wealth
preservation or income.
Investment
• This should spell out the goals of the client that are relevant to managing their
objectives
investments, such as to generate a steady level of growth until retirement.
• It should also detail any specific returns that need to be met such as a certain
level of after tax income.
• The client’s agreed risk profile should be set out.
Risk profile
• It should also expand on their attitudes to risk and their capacity for risk taking.
• Views on volatility and drawdown.
• Any requirements for maintaining a certain level of liquidity.
Liquidity • Any need to invest surplus funds or generate funds to top up the client’s
requirements emergency cash reserve.
• Details of known future liabilities that have to be met from the portfolio.
• Factors that will affect the time horizon over which the client is investing such as
Time horizon
date of retirement.
• Tax position of the client and its impact on investment selection.
Tax position • Use of any tax wrappers or accounts.
• Any considerations that should be applied to establishing taxable capital gains.
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Investment • The investment solution to be adopted to meet the client’s objectives such as
strategy multi-manager funds or discretionary investment management.
• Should set out all permissible asset classes in which the portfolio may be invested.
Asset • A target asset allocation can be set out with the proviso that this may change
allocation depending on market factors.
• Any constraints on the investment manager’s ability to adjust asset allocations.
• Any ethical or other constraints that should be followed in construction and
management of the investments.
Constraints
• Any restrictions on the inclusion of particular stocks within a portfolio or
restrictions on the sale of any holdings.
Benchmark • The benchmark against which the portfolio performance will be judged.
Any other • Any other factors that may influence investment selection and management
factors including items such as inheritances.
1.6.2 Investment Solutions

Whilst the investment policy statement sets out the client’s risk and return objectives, it is still necessary to
select an investment proposition that is appropriate, suitable and capable of achieving the client’s goals.
There are a range of potential investment solutions to choose from that can cater for different types of
client including:
• A preferred fund panel for clients who want execution-only services.

• A portfolio of low-cost mutual funds for clients with modest asset levels who require a low-cost
ongoing service.
• A model portfolio service for clients with a higher level of assets and investment experience, where
the additional costs are appropriate.
• Discretionary fund management for clients who require bespoke investment management solutions.
There are other solutions but as a generalisation they all fall essentially within two types of structure:
• Investment funds – where the client invests directly in mutual funds or managed solutions such as
multi-asset and fund of funds.
• Discretionary management – where a portfolio is managed on behalf of the client by a
discretionary investment manager on a model portfolio basis or as a bespoke service.
Within these two categorisations there are a wide variety of different services and products and it is
important to differentiate in order to be able to identify the right solution for a client.
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1.6.3 Investment Funds

The essential characteristic of this type of investment service is the use of investment funds to achieve a
diversified portfolio of assets. They may use mutual funds or any of the other types of investment fund
such as closed-ended funds, absolute-return funds or hedge funds.
In analysing such services, differentiating factors that should be analysed include whether:
• The approach is return focused or risk targeted.

• It involves management of a portfolio or the use of a multi-manager type solution.
• It uses only traditional asset classes or also includes alternative assets.
• The level of asset and geographic diversification and whether the investment approach is active
management, passive management or a blend of the two.
Return Focused and Risk Targeted Funds

Many investment firms run model portfolios of investment funds that are targeted at different
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investment objectives such as growth, balanced or income. These are regularly monitored and adjusted
depending on market movements and fund manager changes. The approach is return focused and aims
to meet or exceed a benchmark target.
Risk targeted funds are now becoming increasingly common. The concept is to maximise returns but
only by taking on a certain level of risk within pre-defined volatility bands. Once a client’s risk profile
has been agreed a model portfolio is selected that is designed to provide and maintain a suitable
combination of asset classes and funds that deviate little from the agreed risk parameters. The fund’s
aim is to ensure the asset mix within the fund continues to meets the risk profile and does not simply
aspire to beat a sector average performance.
Both approaches often take subtly different paths to achieving their goals and it is important to
understand the investment style and risk management controls used in order to analyse which
approach is suitable for a client.
As a generalisation, the constraints imposed on risk targeted funds can make it difficult for the fund to
outperform its benchmark and so significant outperformance should not be expected.
Model Portfolios and Multi-Manager Funds

An investment firm may construct and manage model portfolios of funds itself or outsource the
investment activity by using a multi-manager solution.
The term multi-manager encompasses a wide range of funds that have different investment objectives
and different methods of achieving them. Within this approach, there are two main approaches:
• Fund of funds – assets are invested in other collective funds to utilise the expertise of specialist
managers in each asset class.
• Manager of manager – assets are managed by specialist managers in each asset class on a
segregated basis, as mandated by the multi-manager fund manager.
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In analysing such funds, it is important to understand whether they are fettered or unfettered, the types
of assets they will invest in and whether they are return focused or risk targeted.
A fund of funds approach can be either fettered which means that it only invests in funds managed by
the same group or unfettered where it may invest in any fund and fund management group it chooses.
Advocates of unfettered funds argue that they achieve a much wider degree of diversification and therefore
potential return, while fettered funds claim lower costs, reduced elements of double charging and a deeper
understanding of the funds they are investing in. There are very good funds in both categories.
When analysing multi-manager funds it is also important to understand the composition of the underlying
portfolio. Many funds will invest only in traditional assets, whilst others will adopt a more multi-asset
approach, investing in commodities and hedge funds for example. It is important that advisers understand
the component parts of each fund as these could expose investors to different types of risk. The investment
style adopted may see active-only funds used, passive-only funds used or a blend of the two.
Equally, it is important to know whether the fund is return focused and if so what benchmark it uses or
risk targeted and the extent to which this will impact on returns.
1.6.4 Discretionary Investment Management

Discretionary investment management services vary widely and range from managed portfolios at the lower
value end of the market to bespoke portfolios that are tailored to the individual client at the other end.
Model or managed portfolios are standardised portfolios designed around a range of investment
objectives and risk approaches that can be matched to a client’s own objectives and risk profile. They
will typically be constructed of a mix of direct holdings and investment funds and are managed centrally
in line with the portfolio’s investment objective. They are designed to appeal to a wider audience but
will usually come without the range of services found in bespoke investment management.
Bespoke portfolio management is the traditional service offered by private banks, wealth managers,
stockbrokers and private client investment managers. This involves constructing and managing a
portfolio around the specific needs of a client and can be managed on a discretionary or advisory basis.
• Discretionary management is where the client gives discretion to the investment firm to manage
their investments on their behalf. The investment manager manages the portfolio and makes
changes to the portfolio, without referring to the client, but within the constraints of the client’s
investment objectives and the investment strategy that has been agreed with them.
• Advisory management is a service offered by investment managers which recognises that some
clients do not want to give up the decision making and want to remain actively involved in the
management of the portfolio. An investment manager will consider what changes might be made
to their portfolio and will discuss why those changes are needed with the client who will then
decide whether to accept the advice or not.
Bespoke portfolio management will utilises a range of asset types from traditional asset classes to
alternatives. The minimum portfolio size for a bespoke service is quite high and is often banded so that
the wealthiest investors receive the highest service levels.
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Some of the characteristics of bespoke investment management are:
• The investment mandate is agreed with the client with scope for increasing levels of customisation
for higher amounts.
• An investment manager will be appointed to manage the portfolio and the client will often have
direct access to the investment manager as well as their relationship manager.
• Both traditional and alternative asset classes will be used and existing assets can be incorporated
into the portfolio and large holdings managed separately.
• Charges will usually be by negotiation and dependent on the level of service provided.
• Reporting will be sophisticated and detailed with performance reporting and analysis.
1.6.5 Wraps and Platforms

Fund Supermarkets
Fund supermarkets are internet-based one-stop shops for retail investment funds. Originating in the US
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in 1992, they have proved extremely popular elsewhere since their inception. Most fund supermarkets
enable both retail investors dealing directly, and financial advisers, to deal in a wide range of investment
funds, managed by different product providers from one source with the supermarket facilitating the
placing of deals and looking after all of the associated administration.
However, some supermarkets only cater exclusively for either financial advisers or retail investors dealing
directly. Many have also begun to emulate their US counterparts in adding a range of product wrappers
within which these funds may be held, as well as the provision of interactive research and trading tools.
Fund supermarkets provide the following benefits:
• For investors – supplying them with consolidated records and statements of their investment fund
holdings.
• For financial advisers – reducing the time spent negotiating discounts on charges with product
providers, placing deals and the subsequent administration so that they may spend more time advising
clients. They still receive the same level of commission payments from product providers dealing
through fund supermarkets as they do by dealing directly with the individual product providers.
• For product providers – simplifying both their dealing administration and record-keeping, as all
records are held by the supermarket.
Wrap Platforms
A wrap is similar to a fund supermarket in many ways but is designed for the use of advisers. They are
online services used by intermediaries to view and administer their clients’ investment portfolios.
Where fund supermarkets tend to offer wide ranges of mutual funds, wraps often offer greater access to
other products too, such as pension plans and insurance bonds. Wrap accounts enable advisers to take a
holistic view of the various assets that a client has in a variety of accounts. Advisers also benefit from using
wrap accounts to simplify and bring some level of automation to their back office, using internet technology.
They also offer a range of tools which allow advisers to see and analyse a client’s overall portfolio and
to choose products for them. As well as providing facilities for investments to be bought and sold,
platforms generally arrange custody for clients’ assets.
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2. International Planning Considerations
2.1 Domicile
Learning Objective
6.2.1 Understand the concept of domicile and its impact on international wealth management:
types of domicile; impact of domicile on tax; succession issues
Domicile is the country that a person treats as their permanent home, or lives in and has a substantial
connection with.
Every person must have a domicile, and it is not possible at any time to have more than one domicile.
There are three types of domicile: domicile of origin, domicile of choice and domicile of dependency.
Types of Domicile
• This is the domicile that every person acquires at birth.
• A child born during the lifetime of his father has his domicile of origin in the
country in which the father is domiciled at the time of the birth.
• If a child is born after his father’s death then it has a domicile of origin in the
country where his mother is domiciled at the time of the birth.
• A domicile of choice is acquired by a person residing in a country with the intention
of continuing to do so permanently or indefinitely.
• Any circumstances throwing light on the question may be considered in
determining whether a domicile of choice has been acquired.
• If a person abandons his domicile of choice in a particular country but does not
acquire a new domicile elsewhere, his domicile of origin will revive and continue
to govern his legal position until he acquires a new domicile of choice or of
dependency.
• A domicile of dependency arises in respect of children, married women and
mentally disordered persons.
• Their domicile will generally be the same as, and will change (if at all) in
accordance with, the domicile of the person on whom they are deemed to be
legally dependent.
• So, a legitimate child’s domicile during his minority will depend on the domicile of
his father during the father’s lifetime and (in general) on that of his mother after
his father’s death.
• An illegitimate child’s domicile during his minority will (usually) depend on his
mother’s domicile.
• The domicile of a married woman is the same as, and changes with, that of her
husband in some countries.
The concept of domicile is of considerable importance in a number of areas of law. It is the link between a
person and the legal system or rules that apply to matrimonial, legitimacy, succession and taxation issues.
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Domicile as a connecting factor that links a person to a legal system commands support in the law
of a number of countries, primarily those where the common law prevails. There are, however, other
connecting factors that command considerable support in many countries. Of these the most important
are nationality and habitual residence.
Nationality and Habitual Residence

• Nationality represents a person’s political status, whereby he or she owes
allegiance to some particular country. Apart from cases of naturalisation, it
depends essentially on the place of birth of that person or on his or her parentage.
Nationality
• Its advantage is that a person’s nationality is normally an easy matter to determine
but can present difficulties in countries such as the US where state law applies or
in cases of dual nationality.
• Habitual residence is becoming increasingly recognised, as it is an easier concept to
establish since it treats both sexes in exactly the same manner.
Habitual
• Its drawback, however, is that it may be difficult to determine where a person has
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residence
his habitual residence if he is constantly on the move and has no real or continuing
connection with any of the countries through which he passes.
Accordingly, the link that connects a person to a particular system of law may be his or her domicile, his
or her habitual residence or his or her nationality.
Domicile and its related concepts are important as they help to determine:
• who has a right to inherit assets on death;

• the form of any will or testamentary dispositions that are permitted;
• who inherits, for example, if there is no will, as some countries such as France have very rigid rules
on who can inherit;
• how much IHT is payable and where.
Impact of Domicile on Tax

Many countries have IHT laws that are designed to make it difficult for an individual to move abroad and
avoid paying IHT.
• If it cannot be successfully proved that the person has changed their domicile, the tax authorities
may claim that the person is deemed to be domiciled in that country and is liable to tax on their
worldwide assets.
• If, on the other hand, a person dies domiciled outside that country, IHT will only be chargeable on
death on such assets as are in that country.
• It follows that if a person is likely to be domiciled outside a country, they should try to ensure that
their assets in that country do not exceed the threshold at which IHT is payable.
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Changing domicile, however, is not a straightforward matter. To establish a domicile of choice an
individual must sever most or all ties with his domicile of origin and settle in the territory in which he
wishes to establish a domicile, with a clear intention of making his home there on a permanent basis.
It is up to the individual to prove that this has occurred and until this is proved, it is assumed that the
domicile of origin is retained.
There are a number of factors to which an individual can point to show that an individual has established
a domicile of choice, but there are two overriding requirements:
• A genuine wish to adopt the new territory as his only or his main home either permanently, or at
least indefinitely, with no intention of establishing his main home elsewhere.
• A physical presence in that territory.
If the first condition is established, then a long period of residence is not necessary to establish the new
domicile of choice. Conversely if it is absent, a period of continuous residence, for however long, will not
be sufficient.
Domicile and Succession

If a client holds assets in multiple countries, it is important that they take specialist legal advice from
lawyers in that territory.
This is especially the case if they own land abroad as succession to immovable property such as land is
governed by the law of the country or state where the land is situated. This law may contain strict provisions
as to whether a person is obliged under his or her will to leave the land to particular blood relatives.
A client should look to have one will that deals with their worldwide assets other than property in other
countries where they own land and have made separate wills. The main advantages of separate wills are:
• Each can be dealt with independently in the jurisdiction concerned.

• A will of immovable property can take account of the local law.
• Each will can be drafted to take account of local tax laws and may avoid unnecessary taxation
resulting from a single will, which may be tax-effective in one country but not in an other.
• Each can be drafted to include administrative powers and provisions which are appropriate to the
territory concerned and which can be readily interpreted according to the local law.
• Each can clearly define the responsibilities of each set of executors, for example, in relation to
payment of particular taxes and expenses.
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2.2 Tax Residency
Learning Objective
6.2.2 Understand the concept of residency and its impact on taxation issues in international wealth
management: meaning of residency; worldwide versus territorial tax systems; impact on
liability to tax; double taxation treaties and withholding taxes
Each country has its own rules which determine an individual’s liability to tax on income, gains and on
assets liable to IHT or a wealth tax.
So, when a transaction takes place which may be subject to tax in more than one country, care is needed
to establish which country’s tax systems are involved, the status of the client, the type of income or
asset involved and the nature of the transaction. Optimal tax planning may involve consideration of the
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impact of different countries’ tax systems and their interaction if double taxation is to be avoided.
Worldwide and Territorial Tax Systems

Most countries’ tax systems can be loosely categorised as either a worldwide or territorial-based system
of taxation.
• Under a worldwide system of taxation, residents of that country are taxed on their worldwide
income and capital gains irrespective of where the income or gains arise. For example, the US has a
worldwide-based system of taxation as has the UK, Australia, Germany, Italy and Japan.
• Under a territorial system of taxation, residents are taxed only on income and capital gains arising in
that country and income and gains arising outside of that country are not liable to tax.
• Some countries that adopt the territorial system, however, extend the tax base of residents to include
overseas income and gains but only if such income or gain is remitted to the country of residence.
Whilst there are variations on the above three systems, most countries’ tax systems fall into one of these types.
Residency
Irrespective of the type of tax system in place, it is usual for taxes to be levied on the residents of that
particular country.
Definitions of residency vary from state to state. For individuals, physical residency is the most important
factor but other factors such as property ownership or the availability of accommodation can also be
taken into account.
Many countries assess physical residency by the number of days that an individual spends in the country
and the regularity of their visits. For example, in the UK there is a statutory residence test to determine
whether an individual is resident and so liable to UK taxes.
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Example
Non-UK Resident
You are not resident in the UK for a tax year if:
• you were resident in the uk in one or more of the previous three tax years and you are present in the uk
for fewer than 16 days in the current tax year; or
• you were not resident in the uk in all of the previous three tax years and you are present in the uk for
fewer than 46 days in the current tax year; or
• you carry out what is effectively full-time work overseas.
UK Resident
You will be resident in the UK for the tax year if:
• you are present in the uk for 183 days or more in a tax year; or
• you have a uk home for a period of 91 consecutive days or more (of which at least 30 days must fall
in the tax year), you spend at least 30 days in that home in the relevant tax year, and during this 91
day period you have no overseas home, or have one or more homes overseas and are present in
each of these overseas homes for less than 30 days during the tax year in question; or
• you carry out what is effectively full time work in the uk.
The complexity of the rules surrounding residency mean that individuals who are not resident in a
country for a complete tax year, need to exercise particular care in understanding the rules and ensuring
their visits do not exceed the maximum time permitted.
Some countries, such as the US, adopt a citizenship test to determine liability to tax. The US extends its
tax system to tax the income and gains of its citizens wherever they are resident. So, whilst a US citizen
may no longer be resident in the US, they remain in principle liable to US taxes on their worldwide
income and capital gains.
Double Taxation Treaties and Withholding Taxes

Double taxation treaties are conventions between two countries that aim to eliminate the double
taxation of income or gains arising in one territory and paid to residents of another territory.
They work by dividing the tax rights each country claims by its domestic laws over the same income and
gains. They detail who will be treated as a resident of that country and that for overseas persons they
will be liable only for local source income.
Simply put, double taxation treaties set out how and who will tax income and gains.
Double taxation treaties between countries are usually based on the OECD model tax convention. The
first OECD model tax convention was issued in 1958 and since then the tax treaty network has expanded
all over the world. There are now over 1,300 double taxation conventions in existence world-wide and
the UK has one of the largest networks with more than 100.
The treaties detail how different types of income are dealt with.
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Double Tax Treaties

• Many countries levy a withholding tax on dividend distributions, but there are some
very notable exceptions where profits have been subject to primary tax, such as
Australia, Singapore, and the UK.
Dividends • Also, capital distributions may not attract withholding tax, as for example liquidation
distributions in the US.
• Article 10 of the Convention generally limits the withholding tax that may be
charged providing that the recipient is beneficially entitled to the dividends.
• Interest payments to non-residents may also attract a local withholding tax, which is
generally reduced according to treaties to 10% under the model treaty, but often to nil.
Interest
• Again, the requirement for the recipient to be the beneficial owner is relevant
sometimes.
If withholding tax is deducted on an overseas dividend before payment, the client is able to offset the
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withholding tax against their domestic liabilities.
If the client is not liable to tax, a tax reclaim in the country that imposed the withholding tax is needed,
which will require proof of beneficial ownership. They may also require submission of a form that has to
be certified by the tax authorities of the country in which they are resident to confirm their eligibility for
tax relief.
2.3 Tax Transparency
Learning Objective
6.2.3 Understand how the increase in international tax transparency policies impact on international
wealth management: tax avoidance versus tax evasion; tax information sharing; EU savings
directive; US QI; FATCA
Since the financial crisis, the subject of tax avoidance has become a major issue in many countries. At a time
of austerity and cuts in public services, the extent to which wealthy individuals and multi-national companies
have avoided taxes has been widely condemned and is leading to new definitions of what is acceptable.
Tax Avoidance Versus Tax Evasion

• Tax avoidance is generally the legal exploitation of the tax regime to one’s own
Tax advantage, to attempt to reduce the amount of tax that is payable by means that
avoidance are within the law, whilst making a full disclosure of the material information to the
tax authorities.
• By contrast tax evasion is the general term for efforts by individuals, companies,
trusts and other entities to evade the payment of taxes by illegal means.
Tax • Tax evasion usually entails taxpayers deliberately misrepresenting or concealing the
evasion true state of affairs to the tax authorities to reduce their tax liability, and includes, in
particular, dishonest tax reporting (such as under-declaring income, profits or gains;
or overstating deductions).
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Whilst the difference between tax avoidance and tax evasion used to be simply expressed as the first is
legal and the second is illegal, public perceptions of what is acceptable tax avoidance are leading this to
be more carefully defined.
The term tax mitigation is now being used to refer to acceptable tax planning. It refers to ways
of minimising tax liabilities in ways that are expressly endorsed by tax legislation. By contrast, tax
avoidance flouts the spirit of the law and is therefore thought by some to be unacceptable, albeit not
criminal in the way that evasion is.
International co-operation is increasingly being used to improve exchange of information between

countries in order to counter international tax avoidance and evasion.
• The process starts with the taxpayer providing information regarding his or her identity to the bank
or financial institution with which they have assets.
• These financial institutions are then required to report the identity of the non-resident taxpayer as
well as payments made to them to the tax authorities.
• Once the information has been received by the source country’s tax authorities it is consolidated
and bundled according to the country of residence of the taxpayer.
• The information is then transmitted from the source country to the residence country.
• The tax authorities in the residence country then match the details with their domestic records and,
based on the results, may take compliance action against the individual involved.
Tax Information Sharing

• It aims to counter cross-border tax evasion by collecting and exchanging information
about foreign resident individuals receiving savings income outside their resident state.
EU • The scheme requires banks, registrars, custodians and other financial institutions that
Savings make interest payments to establish the tax identification number of the beneficial owner.
Directive • The paying agent will then report that information and information about the savings
income payment to its own tax authority, who will pass it on to the tax authority of
the country or territory in which the individual is resident.
• Regulations were introduced in the US in 2001 to clamp down on US citizens
that attempted to evade tax by holding securities outside of the US and then not
declaring the income.
• The effect of these regulations is that non-US investors holding US stocks are required
to prove that they are not US citizens, by lodging proof of their domicile with their
custodians. The custodian is then obliged to report this to the US IRS.
US QI
• Custodians have had to apply for qualified intermediary (QI) status so that they can
Scheme
undertake this service on behalf of their customers. As a QI, the custodian is required
to determine the eligibility of its account holders to receive income with a reduced
rate of withholding tax deducted.
• The custodian is required to obtain from its customer a form W-8BEN under which the
customer states that he is the beneficial owner and is not a US person and certifies his
qualification for the benefits of the double tax treaty.
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• The Foreign Account Tax Compliance Act (FATCA) aims to combat tax evasion by US
tax residents using foreign accounts.
• It includes provisions on withholding taxes and requires financial institutions outside
FATCA
the US to pass information about their US customers to the US tax authorities, the IRS.
• Failure to meet these new reporting obligations would result in a 30% withholding
tax on the financial institutions.
3. Trusts and Foundations
3.1 Trusts
Learning Objective
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6.3.1 Understand the fundamentals of trusts and their use in international wealth management:
types of trusts – definition; fixed interest; discretionary trusts; other types of trusts;
establishing a trust – certainties; role of parties; uses of trusts – main uses; types of assets held;
sham trusts; private trust companies
Trusts are widely used in international wealth management to preserve wealth and to control the
distribution of assets on an individual’s death.
3.1.1 Types of Trusts

Trusts are based on an English law concept and developed from the early Middle Ages onwards, as a
way of preserving wealth and passing on assets on death in a controlled way. More recently their use
has expanded internationally and they tend to be a feature of countries that have common law systems.
Common Law and Civil Law

The terms common law system and civil law system are used to distinguish the two main approaches to law.
A common law system is the type that originated in the UK and is today found in many countries such
as the United States and Australia. It is a law system that can be developed on a case-by-case basis as
courts make decisions on cases brought before them.
Civil law refers to a jurisdiction that has adopted the continental European system of law that is derived
from ancient Roman law and is based on a codified set of laws.
Trusts are not exclusively found, however, in common law jurisdictions. Their inherent flexibility has led
civil law countries such as Japan, South Africa and Switzerland to introduce trusts into their legal systems.
A trust is the legal means by which one person gives property to another person to look after on behalf
of yet another individual or a set of individuals.
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Definition of a Trust
The formal definitions of a trust contained in legal textbook can be quite difficult to follow but the Hague
Convention on the Law Applicable to Trusts and on their Recognition has the following straightforward definition:
For the purposes of this Convention, the term trust refers to the legal relationships created – inter vivos or on
death – by a person, the settlor, when assets have been placed under the control of a trustee for the benefit of
a beneficiary or for a specified purpose.
A trust, therefore, is essentially a legal vehicle into which assets are transferred and which is then
managed by the trustees, who have a responsibility to hold and apply the assets for the benefit of the
named beneficiaries.
The central idea behind trust law hinges on separate ownership of property.
• Legal title to assets is vested in the name of the trustee or in the name of another person acting on
their behalf. The beneficiaries are described as having beneficial ownership.
• The assets of a trust constitute a separate fund and are not part of the trustee’s own estate.
• The trustee has the duty to manage the assets on behalf of the intended beneficiaries in accordance
with the terms of the trust and any special duties imposed by law.
A trust is created by a legal document which will contain provisions detailing its terms, the duties and
powers of the trustees and the beneficiaries who will benefit under the trust. One of the great advantages
of a trust is its flexibility and it is possible to create a wide range of trusts with different characteristics.
There are a variety of types of trust but generally they can be distinguished by two important
characteristics, namely whether they are fixed trusts or discretionary trusts.
• Fixed trusts – the main distinguishing characteristic of a fixed trust is that the trust deed will set out
precisely who will benefit from the trust and at what stage in the future.
• Discretionary trusts – these differ in that a class of beneficiaries is specified in the trust deed but the
trustees are given the power to determine which beneficiaries of that class will benefit and when.
The characteristics of some of the common types of trust that are encountered are shown below.
Types of Trust
Discretionary Trust
• This is the most flexible form of trust and by far the most popular in international tax planning and
wealth protection.
• The use of a discretionary trust will normally allow the trustees to appoint additional beneficiaries or
to remove existing beneficiaries, and will usually also allow the trustees to distribute the income and
capital of the trust between the beneficiaries as they see fit.
• The settlor will often write a letter of wishes which sets out what he would like to happen to the trust
fund in the future. This letter is not legally binding, but in practice the trustee always follows it.
• Alternatively, the settlor can designate someone else to give a letter of wishes in the future if necessary.
• It is also possible to name in the trust deed a person called a protector.
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Bare Trust
• A bare trust is one where the beneficiary has an immediate and absolute right to both the capital
and income held in the trust.
• They are sometimes known as simple trusts.
• The assets are held by the trustee but the trustee has no discretion over what income or capital to
pass on to the beneficiary or beneficiaries.
• Bare trusts are commonly used to transfer assets to minors. Trustees hold the assets on trust until the
beneficiary becomes of legal age; at this point, beneficiaries can demand that the trustees transfer the
trust fund to them.
Interest in Possession Trust
• An interest in possession trust, which is also known as a life interest trust, can provide a person with
a right to enjoyment of assets during their lifetime, with no absolute right to the capital or the assets.
• Instead, the trust can provide that this capital passes on to someone else after that person’s death.
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Protective Trusts
• A protective trust has been used for many years as a way for assets to be passed on to a beneficiary
who is a spendthrift and might waste money if it was left directly to them.
• The trust will be an interest in possession trust designed to benefit the individual until what is
known as a divesting event occurs. This might be the case if the individual is declared bankrupt or
tries to sell their interest in the trust to raise money.
• On occurrence of a divesting event, the trust converts into a discretionary trust for a named class of
beneficiaries usually including the original beneficiary.
Asset Protection Trusts
• An asset protection trust is a vehicle for holding an individual’s assets to shield them from creditors.
• Their use has increased in use in recent years with the rapid increase, primarily in the USA, of
litigation against professional firms and the medical profession.
• As a result, many individuals have elected to create trusts in neutral tax jurisdictions in which to place
part of their assets, in the hope that they will be safe from any future claims.
Charitable Trusts
• A charitable trust is a type of trust set up for a cause or purpose that will benefit a large group of
people or society in general, not specific individuals.
• Such a trust is considered to be for the benefit of the public and so qualifies for tax reliefs that private
trusts don’t get.
Non-Charitable Purpose Trusts
• These are a type of trust that can be created in certain jurisdictions that have no named beneficiaries
and can exist indefinitely. Instead, they must have a protector or enforcer whose role is to ensure the
trustee fulfils the purpose of the trust.
• They can be used for the preservation of wealth, succession planning and asset protection.
• Non-charitable purpose trusts are often established to hold shares in private trust companies. Using
this structure ensures privacy and allows for rapid commercial decisions to be made.
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• They are also used to hold shares in the family business for succession planning purposes. Upon the
death of the older generation, the trust allows the shares to continue to be held for purposes relating
to the family business, ensuring that shares are not split up amongst multiple beneficiaries and sold.
This is useful in ensuring continuity in the business in years to come.
3.1.2 Establishing a Trust

Whilst strictly there is no need to evidence a trust in writing, the complexities involved in creating a
trust and the legal and tax issues that need to be considered are such that specialist advice needs to be
sought when a trust is created.
Proper formalities should be observed in the creation of a trust in order to rebut any attack on their
validity at a later date.
A trust is usually created by the execution of a formal trust deed by the settlor and the trustees. The trust
deed will set out the terms of the trust, the duties and powers of the trustees and the beneficiaries who
are to benefit.
A trust document by itself will not, however, constitute an effective trust unless the trust property is
transferred to the trustees in a proper manner. The trust deed may be used to formally transfer assets to
the trustees but depending on the type of asset involved different formalities may apply.
Three Certainties
To be valid a trust usually needs to meet the test of the three certainties in order to ensure it is properly
controlled and enforced.
Three Certainties
Certainty of words or intention
• The key test is whether the requisite intention is present to show whether the creator of the trust
wanted someone to be under a duty to hold property for the benefit of another person.
• If there is an absence of certainty of intent to create a trust, there will be no valid declaration of a trust.
Certainty of subject matter
• Trusts can be declared over all kinds of property, including intangible property, but the subject
matter must be clearly defined in the trust instrument.
• As well as the property being defined, the property must be able to be identified; if it cannot be
identified the trust will be void for uncertainty.
Certainty of objects
• The objects of a trust refer to the intended beneficiaries;

• For fixed trusts, it must be possible to identify exactly who all of the beneficiaries are, in order for the
trustees to distribute the property correctly. It is not necessary to draw up a complete list when the
trust is created but only when property is to be distributed or a specified condition met;
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• For discretionary trusts, it is important to have certainty of objects so the trustees know who to
consider when deciding how to distribute the trust property. This means that the trustees must be
able to show whether a potential beneficiary will fit within the description of the objects.
Role of the Parties

The parties involved in a trust are shown in the diagram below.
Parties to a Trust
Appoints Settlor
Trust Protector
Creates
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Trust Deed
Outlines rights Transfer Names or

and duties defines
Legal Beneficial
Trustees Trust Property Beneficiaries
Ownership Ownership
Act in best interests of
The role of the parties includes:
• Settlor – the individual who decides to set up the trust and who arranges for a portion of his assets
(the initial settled funds) to be transferred to the trustees.
• Trustees – the individuals appointed by the settlor to act as trustees. It is normal to appoint
professional trustees or a corporation that is authorised to act as a trustee. A corporation allows for
continuity, as it avoids the necessity of appointing a new trustee if any one individual dies.
• Beneficiaries – the trust deed will identify who the initial beneficiaries are or specify a class from
which the beneficiaries may be drawn. Beneficiaries may include the settlor, the spouse, children,
grandchildren, any future children not yet born, or any other parties the settlor may propose.
• Trust Protector – an individual whose role is to ensure the trustees act in accordance with the settlor’s
wishes. They will typically have the power to appoint or remove trustees and to nominate further
beneficiaries. The use of a protector is optional but is generally recommended especially for offshore
trusts when it may be a single individual or a council of four individuals who act by a majority.
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3.1.3 Uses of Trusts
A properly structured trust is a flexible vehicle for international financial planning for wealthy private clients.
They are particularly useful in regulating the succession to family wealth, and to protect assets from a
wide variety of contingent risks. For residents of some countries trusts may provide a structure through
which inheritance and income taxes can be minimised. Some of their main uses are considered below.
Preservation of Wealth
A trust involves vesting the legal title of assets in the name of the trustees which can prevent the
ownership of the assets such as a family business being diluted by successive generations, whilst
allowing individuals to continue to benefit from the assets.
As the legal title to the assets remains with the trustee, this prevents the dilution of ownership that
would occur if the assets were distributed from the original owner to second and third generations.
Asset Protection
An asset protection trust can be used to protect the assets of an individual from claims by potential
future creditors.
If an individual transfers part of his assets to a trust, these assets cease to be part of his estate and as
such any future claims by creditors will not normally be enforceable against the trustees. However, it is
important to note that if the settlor creates the trust with the intent to avoid creditors, it is likely that the
trust can be set aside.
Forced Heirship
Certain countries have laws which determine how an individual’s estate should be distributed on their
death, known as forced heirship laws.
By divesting assets during the lifetime of the settlor, the trust will not form part of his estate upon his
death. If some of the assets of an individual are held outside that country, it may be possible to use a trust
to distribute those assets in a manner which would not be possible under the forced heirship laws.
Private Trust Companies

Private trust companies can be created and used by wealthy clients as a way of managing large family
businesses that professional trustees might find difficult. A private trust foundation can also be used to
achieve the same purpose.
A trust involves the transfer of ownership to the trustees and this can present issues for both the settlor
and the trustees. The settlor may be reluctant to hand over control as they are concerned that the
trustees will not necessarily understand the nature of the business owned by the trust. The trustees, for
their part, may be concerned that should something go wrong with the business, they could be sued by
the beneficiaries for failing to diversify the trust’s assets and so reduce risk.
In this arrangement, instead of the family business being owned by a trust, additional layers are created
in the structure.
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• A trust will hold the family business as its asset.

• A private trust company is created to act as trustee of the family trust.
• The private trust company is a limited company and the board of the company can be selected
to ensure that there are suitably qualified advisers appointed who understand the nature of the
business along with the settlor.
• Whilst the settlor can own the shares in the private trust company directly it is probably be
undesirable to have any direct link with its ownership, whether for tax, disclosure or for a variety of
other reasons. Instead, a non-charitable purpose trust is created which holds the shares in a private
trust company as its sole asset.
Private trust companies and private trust foundations are used for owning and administering the assets
of wealthy families and are favoured because they enable the board of directors to be suitably qualified
and address the concerns of the trustees over their potential liability.
To avoid the possibility of the structure being attacked as a sham, there must be evidence that the
settlor and the trustee (the private trust company) intended to set up and operate a proper trust
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structure. The appointment of a licensed administrator to carry out the general administration of the
private trust company and the underlying trusts is used to help avoid such sham attack.
Other Uses
Trusts can play a key role in estate and financial planning for wealthy clients. Other uses include:
• Tax – The major tax benefit in using a trust is that the assets held by a trust belong to the trustees
and not to the settlor. By taking the assets out of the settlor’s estate, they would normally cease to
be taxable on the settlor. This can often be very useful for IHT and for deferring capital gains. The
tax benefits will depend on the tax position of the settlor and beneficiaries, and where they reside.
• Anonymity – trusts in many jurisdictions are not required to file information with the authorities,
either on creation or on an annual basis. It is also possible to create a trust through a declaration of
trust without identifying the settlor in the document itself.
• Commercial trusts – in many international centres there has recently been a growth in the use of
trusts for commercial purposes. uses include: employee incentive schemes, unit trusts and the issue
of a number of debt instruments.
Sham Trusts
It is becoming increasingly common for trusts to come under attack and for the validity of a trust to
be questioned on the basis that the instrument creating it is a sham document or fails to fulfil the
requirements for the creation of a valid trust.
From a wealth management perspective, this refers to where trusts are challenged because they are
aggressive tax avoidance devices, where creditors seek to overturn the validity of the trust in order to
get at the underlying assets or in divorce actions.
If the validity of a trust can be challenged, a court may set aside the trust and open the assets to
the claims of creditors. In some countries, where the validity cannot be challenged rules have been
introduced to allow a look through of the transaction where it is deemed to have been undertaken to
avoid, for example, payment of fees so that the effect of the creation of trust is ignored.
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To reduce the chances of attack on the validity of a trust, trustees should understand the importance of
acting independently.
• Evidence of a sham can be demonstrated where control of the trust property is vested in the settlor
and the trustees exercise no independent discretion or take any actions consistent with the terms
of the trust.
• Trustees should keep detailed minutes showing their proper independent consideration of trust
matters, the exercise of any discretion and that they were not subject to any improper influences of
the settlor.
• If trustees are asked by a settlor to be involved in a transaction which is being led by the settlor and
perhaps principally for his benefit, it is essential that the trustees demonstrate their independent
evaluation of the transaction and their consideration of the interests of other beneficiaries who may
be affected.
If the court finds a trust to be a sham, then the trust will be regarded as void and it is likely that the trust
property will be found to be held on a resulting bare trust for the settlor, which will leave the settlor with
an absolute beneficial interest in the trust property, which is capable of being taxed, inherited or claimed.
The trustees might then find themselves subject to tax penalties and subject to an investigation by the
financial services regulator into their conduct as trustees.
3.2 Foundations
Learning Objective
6.3.2 Understand the fundamentals of foundations and their use in international wealth
management: types of foundations – private; corporate; charitable; special purpose;
establishing a foundation – charter; role of founder, foundation council and other parties;
uses of foundations – types of assets held; restrictions on commercial activities; international
business companies
Foundations are similar to trusts and originated in civil law jurisdictions, but are also now available in
some common law jurisdictions as an alternative to a trust.
A foundation is an incorporated entity with separate legal personality but, unlike a company, it does not
have shareholders. Instead, it holds assets in its own name on behalf of beneficiaries or for particular
purposes and it operates in accordance with a constitution comprising of a charter and a set of rules.
Once established, a foundation will act through its council which will govern the foundation in
accordance with the terms of the foundation’s constitution. The council members perform much the
same role as trustees.
3.2.1 Types of Offshore Foundation

Foundations have long been favoured by wealthy individuals and families as a vehicle for accomplishing
their wealth and succession management strategies, corporate control and charitable objectives.
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Broadly speaking they fall into the following categories:
• private – for succession management and wealth management purposes;

• corporate – for continuity of control, pension and employee benefit schemes;
• charitable – for the benefit of charitable organisations;
• special purpose – donations serving a specific philanthropic purpose.
Whilst the above types offer specific objectives, foundations can be established to embrace all purposes
and objectives. The purposes are contained within the foundation charter and by-laws.
3.2.2 Establishing a Foundation

A foundation is established by executing a foundation charter, transferring funds and registering
the foundation at a public registry. Once the foundation charter is registered, it is incorporated as a
corporate body. The process is not dissimilar to setting up a company.
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The founder is the person who gifts assets to the foundation, which will be established for a specific
purpose that is set out in its charter and articles
Foundation Charter
The foundation charter contains details of the founder, the foundation council and its initial capital. It
will also set out the objectives and goals of the foundation which must be possible, reasonable, moral,
and legal and the manner in which the beneficiaries (which may include the founder) are selected.
A foundation may usually have a second document called its regulations which is a private document
generally drafted by the founder detailing beneficiaries, assets of the foundation and any instructions as
to how they are to be administered and distributed. Alternatively, a letter of wishes may be written by
the founder or protector with much of the same information.
The founder appoints a foundation council to oversee and manage the foundation’s assets in
accordance with the charter and the regulations or letter of wishes. From time to time the foundation
council as directed will distribute the assets, or a proportion thereof to the beneficiaries. The council
therefore has a mix of some duties of a trustee and some duties of a company director.
Private foundations may usually have a supervisory person, usually referred to as a protector or
guardian of the foundation. It is common for the protector to have a supervisory role over the
foundation council.
Unlike a corporation which issues shares to owners, a private interest foundation has no shareholders
and has no owners; instead it has beneficiaries. The beneficiaries may be named by the founder in the
regulations or letter of wishes or may be selected by the council or the protector.
Beneficiaries typically have very limited rights regarding knowledge of the foundation activities or even
of the fact that they are beneficiaries in many cases. The beneficiaries are not the beneficial owners of
the foundation.
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3.2.3 Uses of Foundations
As with trusts, foundations can have multiple uses for private, charitable and corporate purposes and
can be incorporated into a variety of potential structures tailored to best suit a particular client’s needs.
Uses of Foundations
• Foundations may be particularly attractive as a simple alternative to trusts for clients
especially from civil law jurisdictions for whom the concept of a trust may be unfamiliar.
• They can be used to achieve much the same ends as a private trust and are highly
flexible in respect of how long they last, how the founder may remain involved in
the administration and how much information the beneficiaries are entitled to.
Private • As with trusts, providing that they are appropriately drafted, the foundation may
also be a suitable vehicle for asset protection as it divorces the ownership of the
assets from the founder.
• It can also be used as part of a larger wealth management structure, holding various
companies or assets or can hold more high-risk, less income producing assets which
may not be appropriate to be held by all trusts.
• The term foundation has positive connotations for philanthropic clients.
Charitable • Its purposes do not have to be exclusively charitable and so can be more flexible
than the traditional charitable trust.
Unlike a company, a foundation cannot carry out commercial activities except those necessary for, or
incidental to, its purpose. It can, however, have a shareholding in an international business company
that is set up in an offshore centre to undertake commercial activities.
3.3 Trusts and Foundations Compared

Learning Objective
6.3.3 Understand the essential differences between trusts and foundations and be able to
distinguish them for other legal concepts
Trusts have been used in common law countries for many hundreds of years to help mitigate tax
liabilities and to assist with the flow of family wealth across the generations.
Historically, clients from civil law countries have been more familiar with the concept of the foundation.
Both types of jurisdiction now recognise the advantages of each and many countries have made both
options available.
Trusts and foundations are used for a wide variety of reasons which are very similar including:
• asset protection;
• circumvention of forced heirship laws;
• confidentiality;
• continuity on death;
• favourable tax treatment;
• philanthropy;
• preservation of wealth and selective distribution of assets.
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Financial Advice
Similarities and Differences between Trusts and Foundations

• One has a settlor who may have reserved powers and the other has a founder who
may have rights reserved to him over the management of the foundation.
• One has a trustee and the other a council and officers.
• One is governed by the provisions of a trust deed and the other by a charter and
Similarities
articles or regulations.
• The ownership of the assets in a trust is vested in the trustee, whilst a foundation
owns the assets directly.
• Both have beneficiaries.
• An important distinction between a trust and a foundation is that a trust is not a
legal entity, while a foundation is a registered legal entity.
• A trust is a legal relationship between the settlor, the trustee and the
beneficiaries. The trust itself is not a legal entity. The trustees are the legal, but not
Differences
beneficial, owners of the assets.
6
• A foundation constitutes a legal entity in its own right.
• Another key difference is that a trust can be used for commercial purposes, but a
foundation, except under limited circumstances, cannot.
When considering whether to use a trust or a foundation it is important to take account of the effect of
the tax treatment on all parties concerned.
• In common law jurisdictions there should be certainty as to the tax treatment of the settlor and
beneficiaries of any trust and in civil law jurisdictions there should be certainty of tax treatment in
respect of foundations.
• Careful consideration and advice needs to be taken when using a trust in a civil law jurisdiction and
a foundation in a common law jurisdiction.
• If there is no agreed position on the tax effects, the tax authorities are likely to treat the trust or
foundation in a way that most suits the tax authority.
3.4 Money Laundering
Learning Objective
6.3.4 Understand how offshore trusts are used for money laundering and steps that should be taken
to counter threats
Wealth management involves the provision of banking and investment services to wealthy individuals
that include bespoke product features that are tailored to a client’s particular needs.
Money launderers are attracted by this availability of complex products and services especially if they
operate internationally and in an environment that is familiar with high-value transactions.
283
Some of the factors that contribute to the increased vulnerability of wealth management to money
laundering include:
• Wealthy clients often require confidentiality and are reluctant or unwilling to provide adequate
documents, details and explanations.
• Clients often have many accounts in more than one jurisdiction, making it more difficult to
accurately assess the true purpose and business rationale for individual transactions accurately.
• Offshore trusts and company structures are used to maintain an element of secrecy about beneficial
ownership of funds.
• There is a culture of secrecy in certain jurisdictions, supported by local legislation, in which wealth
management is available.
• The transmission of funds and other assets by private clients often involve high value transactions,
requiring rapid transfers to be made across accounts in different countries and regions of the world.
The level of customer due diligence that needs to be undertaken is higher than will be encountered for
other types of financial services. In addition to the standard identification requirements, an investment
firm must endeavour to understand the nature of the client’s business and consider whether it is
consistent and reasonable, including:
• The origins of the client’s wealth.

• Where possible and appropriate, documentary evidence relating to the economic activity that gave
rise to the wealth
• The client’s business and legitimate business structures.
• The nature and level of business to be expected over the account including the type of transactions
and the use made by the client of products and services.
• Where corporate and trust structures are being used the reason why complex structures are being
used and the ultimate beneficial owner, settlor and beneficiaries.
In view of the nature of wealth management services generally, additional controls and procedures
should be applied both to the acceptance and ongoing maintenance of wealth management
relationships. These additional controls should include:
• A review process when considering the further development of the business relationship with, say,
the introduction of new funds or assets.
• Requiring that the information held relating to wealth management clients be reviewed and
updated on a periodic basis or when a material change occurs.
• Wealth management firms should consider reviewing their business with higher risk clients on at
least an annual basis.
• In view of the risk associated with wealth management activities, there should be a heightened
ongoing review of account activity and the use made of the firm’s other products.
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Financial Advice
1. How would you explain to a client why a structured investment process is of benefit to them?
2. What three components need to be established in order to determine a client’s risk profile and in
what order should they be established?
3. How does risk tolerance differ from attitude to risk?
4. Why is the concept of anchoring important to understand when trying to establish a client’s goals
and risk profile?
6
5. What is the breakeven effect and what is its relevance for investment decisions?
6. Identify five factors that should be established from an analysis of a client’s assets?
7. Explain the purpose of an investment policy statement.
8. A client has received an overseas dividend with withholding tax deducted. How is this tax dealt with?
9. What are the three certainties and what is their purpose?
10. What is the relevance of a sham trust from a wealth management perspective?
285
286
Chapter Seven
Portfolio Management
1. Risk and Return 289
2. Asset Allocation 299
3. Investment Management 318
4. Evaluating Investment Performance 348
7
288
1. Risk and Return
Learning Objective
7.1.1 Understand the sources of return sought by investors and how these can be compromised by
various risks: returns – types of investment return and related investment objectives; risks –
market, credit, liquidity, concentration and systemic
1.1 Investment Returns

As part of the financial planning process, a client’s investment objectives and attitude to risk will have
been established. Within that, several types of return can be distinguished.
Types of Investment Return

• The desired return is the amount of return the investor hopes to receive based
The investor’s
on that which past evidence suggests is possible.
7
desired return
• Alternatively, it may be the amount of return needed to meet a future liability.
• The required return is the amount of return the investor needs to achieve in
order to invest.
The investor’s • This is taken from the CAPM, and uses the risk-free rate, the beta of the security
required return to the market and the market return.
• It is the return required in order to hold a security with the level of risk as
specified by its beta.
• The amount of return the investor expects to receive based on analysis of a
prospective investment.
The investor’s
• In security appraisal, the expected return is compared to the required return in
expected return
order to determine whether a particular security is overvalued or undervalued
relative to the securities market line (SML).
The investor’s
• The amount of return the investor actually receives.
realised return
As you will see from the above, the first three types of investment return are on an expected, or forward-
looking, basis. Expected investment returns can also be thought of as being classed from low to high so
that the greater the expected return, the greater the risk.
Potential return and risk are generally positively correlated:
• High-risk investments generally have potential for a higher reward, plus a greater possibility of loss.
• Low-risk investments generally have a lower reward, with a lower possibility of loss.
After the event, however, some investors will have endured more or less risk than expected for a given
return, but this could not have been known beforehand.
289
An understanding of what is achievable from returns is crucial to being able to set an investment
objective and meet it within a risk constraint. It is because clients have investment objectives which
often require investment in something more than a risk-free asset that an investment strategy that
balances asset allocation with the level of risk the client can bear is needed.
The trade-off between risk and return is central to setting an investment objective. Two approaches that
can be used are:
• Determine the required level of return and calculate how much risk is acceptable to achieve that return.
• Determine an acceptable level of risk and then estimate what level of return might be expected.
If the return objective is too ambitious the investments selected are likely to have higher volatility which
will increase the spread of investment returns, expose the investor to higher losses in market downturns
and impact the portfolio value that is being targeted.
It is usual for an investment objective to adopt one of the following approaches:
• target replacement income objective;

• benchmark-driven return objective;
• best-efforts basis;
• liability-driven return objective.
Investment Objectives
• This expresses the desired return in terms of an amount of income that the
Target-
client may need in the future, usually in retirement.
replacement
• Alternatively, it may be expressed as an amount of money that will be
income objective
needed to generate the required income.
• This expresses the return relative to an appropriate benchmark, such as
Benchmark-driven interest rates, inflation or an index.
return objective • The objective is to generate positive absolute returns in excess of the
selected benchmark.
• This involves the investment manager allocating assets with a view to
Best-efforts basis maximising returns for an acceptable level of risk, but not defining what the
return should be.
Liability-driven • This involves the investment manager allocating assets to meet a specific
return objective end target.
1.2 Risk
Risk arises from the uncertainty of outcomes.
The result of each investment decision is uncertain in the same way that any future event is. We invest
expecting to make a profit but a loss may arise if the opportunity has been miscalculated or the expected
return does not materialise. Equally, an external event may lead to a market crash. All of this contributes
to the potential for profit and the uneasiness all investors feel about their investment decisions. This is
our general notion of risk.
290
There are a number of types of risk faced by investors that are difficult to avoid, and the main categories
are summarised below.
Types of Risk
• This is the risk that the overall market in general, or the relevant part of the capital
Market or markets for investors wanting exposure to specific sectors, will rise or fall, as
systematic economic conditions and other market factors change.
risk • This may affect returns over a period of time or it may have a more immediate
impact if an investor buys at the top of the market or sells at the bottom.
• Inflation will erode returns and purchasing power and, even if the investor has
Inflation
taken account of inflation in his or her analysis, the actual and expected inflation
risk
may be different from that assumed in calculating expected returns.
Interest
• Changes in interest rates will affect prices; this is a sub-category of market risk.
rate risk
• Any investor who purchases securities which are denominated in a foreign
currency may suffer (or benefit) from changes in the exchange rates between their
Exchange
base currency and the other currency.
7
rate risk
• In addition, one has to consider the risk that the investor’s home currency may fall
against other currencies, thereby diminishing its purchasing power for global assets.
• An investor may find that a company in which they have invested becomes
Default
insolvent due to a harsh operating environment, high levels of borrowing, poor
risk
management or other financial miscalculations.
• The assumption usually made is that large capital markets such as the LSE provide
liquidity for investors to sell a security with a narrow spread between the ask and
Liquidity the bid prices easily.
risk • During stressful periods this liquidity can diminish and it can become much harder
to readily sell a security. In extreme cases, the price quoted by the market-makers
or investment bank may be for a relatively small amount of shares.
Other types of risk that need to be considered include:
• Investment horizon – time horizon will influence the level of risk that can be taken in order to
achieve objectives. An investor with a long-term time horizon may be able to tolerate a higher risk,
as any poor returns in one year will be cancelled by high returns in subsequent years before the fund
is required to deliver its required outcome.
• Counterparty risk – is the risk that the party to a transaction will fail to meet their obligations.
Exchanges have established procedures to mitigate this type of risk but it is still present in OTC
markets and with certain investment products such as structured products and ETFs that use
synthetic replication.
• Systemic risk – is the risk of collapse or vulnerability of the entire financial system or entire market, as
opposed to risk associated with any one individual entity, group or component of the financial system.
The most general kind of risk is market or systematic risk which is primarily influenced by macro-
economic conditions and the state of the financial system. To a large extent this risk cannot be avoided
but for the typical investor there are some precautionary measures which will help to alleviate one’s
exposure to non-systematic risk.
291
Systematic and Diversifiable Risk
• The risk that can be diversified away is that relating to specific or particular
investments.
Diversifiable • This kind of risk is called non-systematic or specific risk.
risk • For example, a company might lose a major customer, or it might suffer a loss
in its share of sales in its particular market. Such events can adversely affect the
share price of that particular company.
• Systematic risk cannot be diversified away by holding a range of investments in
that particular market.
Systematic • This kind of risk is also called non-diversifiable risk or market risk.
risk • For example, during a global recession if all share prices are falling and returns
declining, a wide and diversified portfolio of shares is very likely to fall in line with
the wider market. The risk of this happening affects the whole system – the market.
By spreading investments made in a portfolio over several different securities, from different asset
classes, it is possible to get more or less the same returns that any one of them can offer, but with a much
lower risk since, though one may become worthless, it is unlikely that they will all do so simultaneously.
Diversification reduces risk without necessarily reducing returns.
An investor with limited funds to invest can achieve a high degree of diversification by investing in
collective funds such as mutual funds. This can reduce non-systematic risk to low levels. However,
systematic risk cannot be eliminated.
1.3 Volatility of Returns
Learning Objective
7.1.2 Analyse the effects of volatility and correlation on investments and asset classes: volatility of
returns: data distribution; standard deviation; positive, negative, zero and cross-correlation
Determining the risk of an investment requires an assessment of the variability of returns using the
standard deviation of returns. This involves calculating the variance of returns and from that the
standard deviation.
Calculating Standard Deviation

Let us assume that the following numbers represent the returns from an investment fund over the past
ten years:
Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Return 13 11 2 6 5 8 7 9 7 6
Variance measures the spread of data to determine the dispersion of data around the arithmetic mean
as shown in the following table.
292
• The arithmetic mean = (13% + 11% + 2% + 6% + 5% + 8% + 7% + 9% + 7% + 6%) ÷ 10 = 7.4%.

• Variance takes the difference between the return in each year from the arithmetic mean and then
squares it. Row 2 shows the difference in the return each year from the arithmetic mean and row 3
shows this difference squared.
• These are then totalled and the average of them represents the variance.
Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Total
1 Return 13 11 2 6 5 8 7 9 7 6
Difference from
the arithmetic
2 5.6 3.6 –5.4 –1.4 –2.4 0.6 –0.4 1.6 –0.4 –1.4
mean
(x – x)
Difference
3 squared 31.36 12.96 29.16 1.96 5.76 0.36 0.16 2.56 0.16 1.96 86.40
(x – x)2
Average
4 8.64
7
(86.40 ÷ 10)
Variance is useful in that it provides a measure of dispersion and is used to calculate the beta of a
stock, but it results in a value in different units than the original. It is obviously much easier to measure
dispersion when it is expressed in the same units, and this is known as standard deviation.
Standard deviation is the square root of the variance. The formula for calculating population standard
variance is:
________
√
∑ (x – x)2
________
Population standard variance = σ =
n
So, the standard deviation of the returns from the investment fund is the square root of the average of
8.634, which is 2.94.
Where only a sample set of data is being used, the formula is adjusted as sampling error may arise by
reducing the number of observations by one. ________
√
∑ (x – x)2
________
Sample standard variance = σ =
n–1
In effect, by taking the square root of the variance, the standard deviation represents the average
amount by which the values in the distribution deviate from the mean.
One thing which can be said at this stage is that, other things being equal, the higher the standard
deviation of the returns, the greater the risk. However, that statement has to be seen in the context
of the normal distribution of returns which lies at the foundation of so much financial theory and
293
which provides the framework for assessing the probability of different outcomes when the mean and
variability of historical returns have been calculated.
With sufficiently large data, the pattern of deviations from the mean will be spread symmetrically on
either side and, if the class intervals are small enough, the resultant frequency distribution curve may
look like the cross-section of a bell, in other words a bell-shaped curve as shown in the diagram below.
Normal Distribution Curve

Normal Distribution Curve
-4 -3 -2 -1 0 1 2 3 4
68% of values fall within ± one standard derivation from the mean
95% of values fall within ± two standard derivations from the mean
97.7% of values fall within ± three standard derivations from the mean
For a series of returns on financial assets, if we make the assumption that they are normally distributed
(which is not in fact the case as we will see later) then it becomes possible to estimate the probability of
their occurrence. Statistical analysis shows that in a normal frequency distribution curve:
• Approximately two-thirds or 68% of observations will be within one standard deviation either side
of the mean.
• Approximately 95% of all observations will be within two standard deviations either side of the
mean.
• Approximately 99.75% of all observations will be within three standard deviations of the mean.
Applying this to the investment fund returns above, we saw that the mean or average return was 7.4%
and the standard deviation was 2.94%. This would imply that if we can expect the returns to be normally
distributed that:
• There is a 68% probability that the annual returns will lie within ±1 standard deviation of the mean.
In other words, for two-thirds of the time the likely or expected return should lie between 4.46%
(7.4% – 2.94%) and 10.34% (7.4% + 2.94%).
294
• There is a 95% probability that the annual returns will lie within ±2 standard deviations of the mean.
In other words, for two-thirds of the time the likely or expected return should lie between 1.52%
(7.4% – 5.88%) and 13.28% (7.4% + 5.88%).
• There is a 99.7% probability that the return will fall within ±3 standard deviations of the mean.
Another way of saying that is that only 0.3% of returns will lie outside the so-called six sigma interval.
Data, however, does not always conform to a normal pattern and is then referred to as skewed.
If the peak of the curve is to the left of centre it is said to be positively skewed and if to the right,
negatively skewed. Most long-run distributions of equity returns are positively skewed. That is, equity
markets produce more extreme positive and negative returns than should statistically be the case – a
phenomenon known as kurtosis – but these extreme positive values far outweigh the negative ones.
1.4 Correlation and Covariance

Diversification is achieved by combining securities whose returns ideally move in the opposite direction
to one another, or if in the same direction, at least not to the same degree.
The correlation coefficient measures the strength of the relationship between two variables, such as shares.
7
• A positive correlation describes a relationship where an increase in the price of one share is
associated with an increase in another.
• A negative correlation is a relationship where an increase in one share price is associated with a
decrease in another.
• A perfect correlation is where a change in the price of one share is exactly matched by a change
in another. If both increase together they have a perfect positive correlation and the correlation
coefficient is +1. If one decreases as the other increases they are said to have a perfect negative
correlation and the correlation coefficient is –1.
• If there is no predictable common movement between security returns, there is said to be zero or
imperfect correlation.
Diversification and risk reduction is achieved by combining assets whose returns have not moved in
perfect step, or are not perfectly positively correlated, with one another.
Only when security returns are perfectly negatively correlated, in that they move in the opposite
direction to one another at all times and in the same proportion, can they be combined to produce a
risk-free return providing diversification and risk reduction. If there is zero or imperfect correlation, there
are still diversification benefits from combining securities. In fact, a perfectly positive correlation, when
security returns move in the same direction and in perfect step with each other, is the only instance
when diversification benefits cannot be achieved.
It should be noted, however, that correlations can arise from pure chance and so the past correlation
coefficients of investment returns are rarely a perfect guide to the future.
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The formula for calculating the correlation coefficient is shown below.
Formula – Pearson’s Correlation Coefficient

(n(∑xy) – (∑x) x (∑y)
r = __________________________________________________
√[n∑ x2 – (∑ x)2] x [n ∑ y2 – (∑ y)2]
This can be more readily followed by using an example
Example
To calculate the correlation coefficient let’s assume that we have the following data on the returns from
two assets and see how this is then used in the calculation.
Period Asset A Asset B

1 2.0% 3.0%
2 3.0% 5.0%
3 1.0% 2.0%
4 12.0% 8.0%
5 7.0% 4.0%
The first step is to add some additional columns to the data table to enable us to calculate xy, x2 and y2.
Period Asset A Asset B xy X2 Y2

1 2.0% 3.0% 2.0 * 3.0 = 6 2.02 = 4 3.02 = 9
2 3.0% 5.0% 3.0 * 5.0 = 15 3.02 = 9 5.02 =25
3 1.0% 2.0% 1.0 * 2.0 = 2 1.02 = 1 2.02 = 4
4 12.0% 8.0% 12.0 * 8.0 = 96 12.02 = 144 8.02 = 64
5 7.0% 4.0% 7.0 * 4.0 = 28 7.02 = 49 4.02 = 16
Next we can find the sum of those.
Period Asset A Asset B xy X2 Y2

1 2.0% 3.0% 6 4 9
2 3.0% 5.0% 15 9 25
3 –1.0% –2.0% 2 1 4
4 12.0% 8.0% 96 144 64
5 7.0% 4.0% 28 49 16
∑ 25 22 147 207 118
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Now we have those, we can put the numbers into the formula.
_____________5__*___147
______–___(25
_____*__22)
________________ = _____________735
______–___550
_________________ =
√[5 * 207 – (25 )] * [5 * 118 – (22 )] √(1035 – 625) * (590 – 484)
2 2
__________ = ____185
______185 _______ = ______185
__________ = 0.887415
√410 * 106 √43460 √208.4706
In the table above, the returns on the assets over that period show there is a strong tendency of the
returns to move together in a close association.
• This has resulted in a coefficient of correlation between the returns for A and B of 0.89 which
indicates a strongly positive correlation.
• There is strong correlation because there is a close degree of comovement in the returns and the
relationship is one of positive correlation because not only are the magnitudes of the changes in
returns similar but the sign of the changes track each other.
7
• In other words when A is going up so is B, and when A is going down so is B.
Covariance also indicates how two variables are related.
• A positive covariance means the variables are positively related.

• A negative covariance means the variables are inversely related.
The difference between the two is that covariance tells you whether two assets are positively or
negatively correlated, whilst correlation additionally tells you the degree to which they move together.
The covariance between two shares is calculated by multiplying the standard deviation of the first share
by the standard deviation of the second share and then by the correlation coefficient. Both correlation
and covariance are time consuming to calculate but it is useful to be aware of how they are related.
Relationship between Correlation and Covariance

Covariance (A,B)
Correlation (A,B) = _________________________________________________________________________
Standard deviation (A) * Standard deviation (B)
As a result: Covariance (A,B) = Correlation (A,B) * Standard deviation (A) * Standard deviation (B)
It is therefore possible to calculate either provided that other terms are provided by remembering the
relationship and substituting the terms provided.
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Example
1. The covariance between two numbers is 30 and their standard deviations are 5 and 15.
What is their correlation?
30
Correlation = ___________ = 0.40
(5 * 15)
2. The correlation between two numbers is 0.40 and their standard deviations are 5 and 15.
What is their covariance?
Covariance = 0.40 * 5 * 15 = 30
1.5 Diversification
A portfolio that includes a collection of securities from different asset classes will be less exposed to any
loss arising from one of the securities.
Diversification can be achieved in a number of ways including:
• By holding a combination of different kinds of asset within a portfolio spread across cash, bonds,
equities, property and other assets.
• By holding a variety of investments within each particular asset class.
• Using a spread of holdings across different sectors of the market.
• By spreading investments across different geographical markets
The actual portfolio that is constructed will need to reflect a balance between the different levels of risk
of each type of investment that is commensurate with the client’s needs and attitude to risk.
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2. Asset Allocation
Asset allocation is about blending various types of asset classes to produce a portfolio that possesses a
more favourable risk-reward profile than any of its component elements. It is based on the main principles
of portfolio construction contained in modern portfolio theory (MPT) and the CAPM.
2.1 Portfolio Construction
Learning Objective
7.2.1 Understand the main principles of portfolio construction theory and the need for
diversification: modern portfolio theory (MPT); capital asset pricing model (CAPM); efficient
markets hypothesis (EMH)
2.1.1 Modern Portfolio Theory (MPT)
7
MPT originated with an article entitled Portfolio Selection by Harry Markowitz which appeared in 1952
in the Journal of Finance.
The principles that were proposed in this highly influential paper now seem to be unremarkable, but at
the time the emphasis on diversification, and the mathematical model that enabled a portfolio manager
to assemble positions which provided the best level of expected return for a given risk tolerance, helped
to usher in a period of great innovation in investment theory.
Prior to MPT, the received wisdom on the manner of combining securities in a portfolio was to screen
securities that offered the most attractive opportunities for gain with the least risk and then add these
together in a portfolio. Bringing individual securities together in such a fashion often led to exposing the
portfolio to too many securities from the same sector, where the correlations between the returns amongst
the securities selected was imprudently high. In other words, the portfolio would lack the benefits of
diversification.
Markowitz’s major contribution was to outline a framework for deriving the benefits of diversification
for a portfolio manager. He focused attention on the manner in which the overall volatility of a portfolio
(which is considered to be the suitable proxy for its degree of risk) is calculated from the covariance
matrix of the returns of its constituents.
MPT provided the asset manager with a systematic procedure for evaluating different combinations
of securities and selecting those combinations which provided the optimal reward for a given level of
risk. The optimal allocations will be a trade-off between the risks the client is willing to tolerate and the
anticipated returns.
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Modern Portfolio Theory
MPT states that by combining securities into a diversified portfolio the overall risk will be less than the risk
inherent in holding any one individual stock and so reduce the combined variability of their future returns.
MPT states the risk for individual stocks consists of:
• Systematic risk – these are market risks that cannot be diversified away.
• Unsystematic risk – this is the risk associated with a specific stock and can be diversified away by
increasing the number of stocks in a portfolio.
Risk
Risk eliminated by diversification
Total risk of stock
Risk that cannot be diversified
0
Number of Stocks held in a Portfolio
So a well diversified portfolio will reduce the risk that its actual returns will be lower than expected.
The process advocated by Markowitz enabled a fund manager to calculate the correlated portfolio
volatility and the expected returns for numerous combination scenarios. From the range of possible
portfolio combinations there are a series of combinations that will optimally balance the risk and reward.
The optimal combinations that maximise the reward for the different possible levels of risk lie on what
Markowitz termed the efficient frontier.
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Efficient Frontier
Number of Stocks held in a Portfolio
Return % A portfolio above the curve is Efficient Frontier

impossible
High risk,
High return
Medium risk,
Medium return
Low risk,
Low return
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Portfolios below the Efficient Frontier are not efficient because for the same risk
one could achieve a greater return
Risk % (Standard Deviation)
The efficient frontier shows that it is possible for different portfolios to have different levels of risk and
return. Each investor decides how much risk they can tolerate and diversifies their portfolio accordingly.
The optimal risk portfolio is usually determined to be somewhere in the middle of the curve because
as you go up the curve, you take on proportionately higher risk for lower incremental returns. Equally,
positioning a portfolio at the low end of the curve is pointless as you can achieve a similar return by
investing in risk-free assets.
So a fundamental part of MPT is that constructing a portfolio with multiple securities, and guided by
correlations between those securities, will lead to greater diversification, which will in turn reduce the
risk of holding that portfolio.
Although since its origins in the early 1950s this basic portfolio selection model has been developed
into more sophisticated models, such as the CAPM in the mid-1960s and arbitrage pricing theory (APT)
in the late 1970s, it remains the backbone of finance theory and practice.
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2.1.2 Capital Asset Pricing Model (CAPM)
One of the consequences of Markowitz’s work on Modern Portfolio Theory is the realisation that through
using quantitative techniques in portfolio construction, diversification reduces risk.
A diversified investor will have eliminated, through diversification, the unsystematic risk inherent in the
individual securities in his portfolio and face just systematic risk. For this diversified investor a return
should be sought which is commensurate with the level of systematic risk only.
The capital asset pricing model (CAPM) says that the expected return on a security or portfolio equals
the rate on a risk-free security plus a risk premium and that if the expected return does not meet or beat
this required return, then the investment should not be undertaken.
CAPM is used to predict the expected or required returns to a security by using its systematic risks, in
other words, its beta. Systematic risk is assessed by measuring beta, which is the sensitivity of a stock’s
returns to the return on a market portfolio and so provides a measure of a stock’s risk relative to the
market as a whole.
Beta is calculated by constructing a scattergram of returns achieved by the stock against the market as a
whole. By using regression analysis, a line of best fit is then drawn and the gradient of the line represents
the stock’s beta:
• If the stock’s beta is 1, the stock has the same volatility as the market as a whole.
• If it has a beta of greater than 1, the stock is more volatile than the market as a whole.
• If a stock has a beta of 1.5, it has 50% greater volatility than the market portfolio.
• If it has a beta of less than 1, the stock is less volatile than the market as a whole, so a stock with a
beta of 0.7 has 30% less volatility.
We can use a stock’s beta in conjunction with the rate of return on a risk-free asset and the expected
return from the market to calculate the return we should expect from a stock.
Using CAPM to Calculate Expected Return

The CAPM formula is usually expressed as:
Return = rf+ β x (rm– rf )
Where:
rm = the return expected from the market portfolio.
rf = the return offered by a risk-free security.
β = the risk of the investment opportunity relative to that of the market portfolio (systematic risk
only).
This can be expressed more clearly as:
Expected return = Risk-Free Rate + Beta * (Market Rate – Risk Free Rate)
That is, the investor can expect to achieve the risk-free return (rf ) plus a proportion of the market risk
premium (rm – rf ) based on the levels of relative risk (β) he is willing to face.
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We can use the CAPM formula to calculate the return we should expect from a stock. For example, if
the current risk-free rate is 5% and the expected return from the market is 10%, what return should we
expect from a security that has a beta of 1.5?
The beta of the individual stock tells us that it carries more risk than the market as a whole and the CAPM
formula tells us that we should expect a return of:
Expected return = 5% + (10% – 5%) x 1.5 = 12.5%
The CAPM, by providing a precise prediction of the relationship between a security’s risk and return,
therefore provides a benchmark rate of return for evaluating investments against their forecasted return.
It also enables what is termed the security market line (SML) to be presented graphically. If a graph is
plotted depicting the expected return from a security against its beta, the relationship is revealed as a
straight line.
CAPM Security Market Line (SML)
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Expected
Return
Expected Return to the Market
Portfolio
e
ket Lin
Mar
rity
Secu
Risk-
Free
Rate
Beta = 1 Beta
The SML shows that the higher the risk of an asset, the higher the expected return. The market risk
premium is the return an investor would expect over and above the risk-free rate (such as the return on
a treasury bill or government bond) as a reward for taking on the additional market risk.
The CAPM is a tool which enables portfolios to be constructed once a client’s risk tolerance has been
determined.
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• An individual seeking a high return will need to take on high risk in order to have the chance of a
higher return.
• To achieve a higher return we need to construct a portfolio with a high β. A portfolio with a β greater
than 1 can be expected to give a return greater than that of the market, but at a correspondingly
enhanced level of risk.
• An investor with a long time horizon, who is not overly risk-averse, might seek out adventurous
investments and be willing to take additional risks in the promise of higher returns.
• A more risk-averse individual, such as someone reaching retirement, is liable to be seeking a more
secure and less risky portfolio and will, therefore, prefer a portfolio with a β less than 1.
• As the proportion of risk-free investments is increased in the portfolio, and the proportion of riskier
assets reduced, the portfolio β reduces towards 0.
The CAPM does however have its limitations.
CAPM Assumptions and Limitations

• All market participants borrow and lend at the same risk-free rate.
• All market participants are well diversified investors and specific risk has been
diversified away.
Assumptions • There are no tax or transaction costs to consider.
• All investors want to achieve a maximum return for minimum risk.
• Market participants have the same expectations about the returns and standard
deviations of all assets.
• Some of the CAPM’s assumptions appear to be inapplicable in modern capital
markets but it also has certain specific limitations:
The required rate of return derived from the model is only valid as long as the
inputs (market return, risk free rate and beta) are valid. As a result of changing
economic and fiscal circumstances we can expect that one or more of these
factors will change over a year.
The model assumes that the overall portfolio held is diversified and equates
to the market as a whole.
To calculate a β factor for an investment we are relying on historical data and
the observed co-movements in the returns of different assets and the market
Limitations
in general. Several studies have shown that the results of analysing historical
data over many different time periods reveal that β is, itself, subject to large
fluctuations. Therefore, when applying the results of historical analysis and
determining a β value there is good reason to be sceptical that the future beta
of a portfolio will resemble the past β of a portfolio.
An investment portfolio is said to be positioned on the efficient frontier if it is
expected to produce returns greater than other portfolios with different asset
mixes of the same or lesser risk. In practice, investments are often not able to
locate on the outer edge of this theoretical position and are instead located
within, rather than on, the efficient frontier.
2.1.3 Efficient Markets Hypothesis (EMH)

The efficient markets hypothesis (EMH) states that it is impossible to beat the market as prices already
incorporate and reflect all relevant information. It is a highly controversial and often disputed theory.
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Behind the EMH lie a number of key assumptions that underpin most finance theory models. Aside from
investors being rational and risk averse, they are also assumed to possess a limitless capacity to source
and process freely available information accurately.
Under the EMH, market efficiency can be analysed at three levels, each of which have different
implications for how markets work.
Efficient Markets Hypothesis

• A weak form price-efficient market is one in which security prices fully reflect
past share price and trading volume data.
Weak form • As a consequence, successive future share prices should move independently of
this past data in a random fashion, thereby nullifying any perceived informational
advantage from adopting technical analysis to analyse trends.
• A semi-strong efficient market is one in which share prices reflect all publicly
available information and react instantaneously to the release of new information.
Semi-strong
• As a consequence, no excess return can be earned by trading on that information
form
and neither fundamental nor technical analysis will be able to reliably produce
excess returns reliably.
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• A strong form efficient market is one in which share prices reflect all available
information and no-one can earn excess returns.
Strong form
• Insider dealing laws should make strong form efficiency impossible except where
they are universally ignored.
Generally speaking, most established Western equity markets are relatively price efficient. Although
testing for strong-form efficiency is impossible, as inside information would be required, the most
conclusive evidence supporting the semi-strong efficient form of the EMH is that very few active
portfolio managers produce excess returns consistently.
However, pricing anomalies and trends do occasionally arise as a result of markets and individual
securities under and overshooting their fundamental values. As a consequence, some active managers
do outperform their respective benchmarks and often do so in quite a spectacular fashion.
The limitations of the theory can, therefore, be seen to include the following:
• Investors do not always invest in a rational fashion, thereby providing others with pricing anomalies
to exploit.
• Investors frequently use past share price data, especially recent highs and lows and the price they
may have paid for a share, as anchors against which to judge the attractiveness of a particular share
price, which in turn influences their decision making.
• The inability for all market participants to absorb and interpret information correctly, given varying
abilities and the way in which the information is presented.
• Stock market bubbles develop and eventually burst which is a phenomenon which stands at odds
with the EMH.
• Investors frequently deal in securities for reasons completely unrelated to investment considerations,
such as to raise cash or in following a trend.
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2.2 Strategic and Tactical Asset Allocation
Learning Objective
7.2.2 Analyse the key approaches to investment allocation for bond, equity and balanced portfolios
including an appreciation of their limitations: strategic asset allocation – factors influencing
strategic allocation decisions; selection of benchmark; model portfolios; tactical asset
allocation – impact of market timing decisions on asset allocation
The fundamental challenge for any asset allocation strategy is to reach decisions about the inevitable
and inherent risks in holding different asset classes and the potential returns that will result from the
assets selected. As with all complex decisions involving judgments about risk and reward, there is no
single procedure or strategy that provides the single best solution.
A structured asset allocation process can, however, be seen as a series of stages:
• Evaluation of the client’s needs and attitude to risk.

• Assumptions about the future expected returns, risk and correlation between asset classes.
• Selecting the combination of assets that best match the investor’s objectives and risk profile to give
the minimum risk for the expected level of return.
• Establishing a long-term or strategic asset allocation policy which reflects the optimal mix of assets.
• Implementing tactical asset allocation decisions against the broad guidelines of the strategic asset
allocation policy.
• Undertaking periodic rebalancing of the portfolio to bring it back into line with the strategic
allocation framework, taking into account tax and transactions costs.
• From time to time, reviewing the strategic asset allocation policy to ensure its continued suitability
for the investor’s objectives and risk profile.
2.2.1 Strategic Asset Allocation (SAA)

At the strategic asset allocation stage, the portfolio manager decides what proportion of the total
portfolio to invest in broad asset categories such as shares, bonds, property and other alternative
investments.
This involves a series of stages:
• The first is considering the big picture by assessing the prospects for each of the main asset classes
within each of the world’s major investment regions against the backdrop of the world economic,
political and social environment.
• Once asset allocation has been decided upon, the next step is to consider the prospects for those
sectors within the various asset classes. Sector selection decisions in equity markets are usually
made with reference to the weighting each sector assumes within the index against which the
performance in that market is to be assessed.
• The final stage of the process is deciding upon which specific stocks should be selected within the
favoured sectors. A combination of fundamental and technical analysis will typically be used in
arriving at the final decision.
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The percentage of a portfolio invested in different asset classes will be varied to fit with the objectives
and level of risk an investor chooses and so will take account of their time horizon, the acceptable
level of loss they can bear financially and their need for income. Discretionary fund management firms
operate a range of model portfolios that are designed to meet the needs of differing investors.
Within larger portfolio management organisations, asset allocation and top-down strategy is usually
determined on a monthly basis by an asset-allocation committee. The committee draws upon forecasts
of risk and return for each asset class and correlations between these returns. It is at this stage of the
top-down process that quantitative models are often used, in conjunction with more conventional
fundamental analysis, to assist in determining which geographical areas and asset classes are most
likely to produce the most attractive risk-adjusted returns, taking full account of the client’s mandate.
Most asset allocation decisions, whether for institutional or retail portfolios, are made with reference
to the peer group median asset allocation. This is known as asset allocation by consensus and is
undertaken to minimise the risk of underperforming the peer group.
When deciding if and to what extent certain markets and asset classes should be over or under
weighted, most portfolio managers set tracking error, or standard deviation of return, parameters
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against peer group median asset allocations.
The investment strategy adopted will need to determine whether the asset allocation policy is achieved
using passive or active investment management which is considered later.
2.2.2 Tactical Asset Allocation (TAA)

Tactical asset allocation is about making short-term changes to portfolio’s asset allocation. It is based
on the assumption that relative returns among asset classes will diverge temporarily from equilibrium
levels, allowing the opportunity for excess returns.
It is a dynamic strategy that actively adjusts a portfolio’s strategic asset allocation based on short-term
market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances in
values among different assets classes. It attempts to add value to the long-term asset allocation policy
by overweighting those asset classes or sub-asset classes that are expected to outperform on a relative
basis and underweighting those expected to underperform.
Market timing is an example of tactical asset allocation. It could involve the proportions of capital
invested in any one asset class being set as a band, say, 10–20%. At any time more capital can be
allocated to one class to take it to the top of its range while another is reduced to the bottom of its
range. These tactical moves away from the mid-points of the permitted range for each asset class may
be implemented on a short-term basis.
The following table shows some simple examples of how a fund manager may make short-term and
tactical adjustments to a portfolio to take advantage of expectations about the near-term outlook for
the overall market and specific asset classes.
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Tactical Strategies
Market Outlook
Bullish Bearish
Reduce exposure to longer duration
Increase exposure to longer duration
Fixed Income bonds and shorten the duration of the
bonds.
portfolio.
Reduce exposure to higher beta stocks
Equities More exposure to higher beta stocks.
and moving to more defensive holdings.
If markets are expected to turn bearish,
Where markets are buoyant this could
Tactical this could turn to a risk off position
involve adding exposure to emerging
strategies involving eliminating the holdings
markets.
altogether.
Derivatives Buy call options or go long stock futures. Buy put options or go short stock futures.
Implementing tactical asset allocation strategies is complex and depends on the correct interpretation
of financial and economic signals to predict performance and assign relative short-term asset-class
weightings. Some examples are shown below.
Tactical Asset Allocation Signals

• This involves comparing earnings yields to nominal bond yields to determine
the relative attractiveness of equities over bonds.
‘Fed
• The underlying notion is that stocks and bonds compete for the same
model”’signals
investment funds and the higher returning asset class should be overweighted
in the portfolio.
• This involves attempting to time the business cycle by taking advantage of
variations in market risk premiums and firms’ earnings.
Macroeconomic
• This involves interpreting signals such as the term spread, the credit spread,
signals
unexpected inflation and industrial production. Business-cycle variables are
typically implemented over intermediate time horizons.
• This involves using fundamental valuation metrics, such as dividend yield,
Fundamental
book/market ratio, and P/E ratio, to determine the relative valuation of one
signals
share to another and take advantage of pricing anomalies.
• These attempt to follow the short-term momentum in markets. Typical
momentum signals include technical indicators, earnings growth, and
Momentum
changes in trading volumes.
signals
• When appropriately combined with fundamental or business-cycle signals,
they can produce complementary strategies.
• These attempt to add value through a contrarian strategy that looks for
Sentiment
extreme levels of sentiment, such as consumer confidence and margin
signals
borrowing, to identify deviations from equilibrium returns.
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2.3 Economics
The state of the economy has a direct impact on the construction and management of investment
portfolios and keeping abreast of developments is a key requirement for wealth managers.
2.3.1 Economic and Financial Cycles
Learning Objective
7.2.3 Understand the impact of economic, financial and stock market cycles on the investment
process: trade cycles; business cycles; asset price bubbles; economic shocks; difficulty in
forecasting national and international trends
At a national level, the amount of economic activity that takes place is measured by the National Income
Accounts on either an income, expenditure or output basis and stated in terms of GDP or GNI.
GDP measures the total market value of all final goods and services produced domestically typically
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during a calendar year. Market value is the value of output at current prices inclusive of indirect taxes,
such as VAT, while final output is defined as that purchased by the end user of a product or service.
Gross Domestic Product (GDP)

The most common method of calculating GDP is the expenditure method. GDP is calculated using the
following formula:
GDP = Consumption + Investment + Government Spending + (Exports – Imports)
The formula is often abbreviated to GDP = C + I + G + (X–M) and each component is defined as follows:
• Consumption – represents personal expenditure of households on goods and services such as

food, rent and services.
• Investment – represents expenditure by businesses and individuals for capital investment.
• Government spending – is the sum of government spending on goods and public sector jobs.
• Exports – captures the amount of goods produced for export to other countries.
• Imports – subtracts the value of goods and services imported from other countries.
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The table below looks at the factors that influence each of the components of GDP and their influence.
Components of GDP
• Consumption is driven by factors such as: – the level of national income;
consumer confidence; changes in the level of consumers’ wealth; expectations
of future income; availability and cost of credit.
• What proportion of consumers’ disposable income is spent, rather than saved,
on goods and services has a major economic impact.
• If consumers decide to start saving more and spending less, as a result of
declining confidence for instance this will impact adversely on the demand for
Consumption
firms’ output.
• This will then lead to a reduction in the demand by firms for labour and other
resources.
• This in itself then results in a further decline in the demand for firms’ output.
• This spiralling deficiency in demand may eventually require an element
of government intervention to restore the economy to its potential or full
employment level of output.
• Business investment is the amount firms spend on capital equipment and
stocks built up in anticipation of consumer demand.
• Investment is determined by the firms’ ability to invest, business confidence,
expectations of future returns, the rate of technological innovation and the
Investment
rate at which the capital assets are depreciating.
• A change in any one of these variables will result in a shift in investment
and therefore to a greater or lesser amount of business investment being
undertaken at each level of the interest rate.
• An increase in government spending and/or a reduction in the level or rate of
Government
taxation can be used to stimulate the level of demand in an economy in the
spending
short-term.
• Net trade represents the difference between the value of goods and services
exported (x) and those imported (m).
Net trade • Exports are directly affected by the level of national income within the
overseas economies to which the goods are exported, whilst imports often
depend on the level of domestic national income.
Although there are many sources from which economic growth can emanate, in the long run the rate of
sustainable or trend rate of growth ultimately depends on:
• The growth and productivity of the labour force.

• The rate at which an economy efficiently channels its domestic savings and capital attracted from
overseas into new and innovative technology and replaces obsolescent capital equipment.
• The extent to which an economy’s infrastructure is maintained and developed to cope with growing
transport, communication and energy needs.
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This trend rate of growth also defines an economy’s potential output level or full employment level of
output.
• An economy’s potential output level is the sustainable level of output an economy can produce
when all of its resources are productively employed.
• When an economy is growing in excess of its trend growth rate, actual output will exceed potential
output, often with inflationary consequences.
• When a country’s output contracts – that is, when its economic growth rate turns negative for at
least two consecutive calendar quarters – the economy is said to be in recession, or entering a
deflationary period, resulting in spare capacity and unemployment.
The fact that actual growth fluctuates and deviates from trend growth in the short-term gives rise to the
economic cycle, or business cycle.
Economic Cycle
GDP Growth
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Trend Growth
Expansion
Economic
Contraction Trough
Deceleration
Acceleration
Recession
Recovery
Boom
Time
Economic cycles describe the course an economy conventionally takes, usually over a seven to ten-
year period, as economic growth oscillates in a cyclical fashion. The length of a cycle is measured either
between successive economic peaks or between successive economic troughs.
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Phases of the Economic Cycle
• In the acceleration or expansion phase there is above average output growth and
Acceleration
businesses experience record sales and profits.
• As expansion continues, a strong customer demand justifies raising prices for
many products.
• As prices and inflation continue to rise, the economy begins to overheat and
Boom interest rates are increased by the central bank to dampen demand and stop
expansion.
• The period of boom occurs when the economy is growing at its fastest during the
overall cycle.
• As the economy starts to slow down, output growth slows – but inflation remains
high – so the central bank is reluctant to cut interest rates.
Deceleration
• Sales start to drop as consumers become more cautious and spend less.
Unemployment rises and some firms go out of business.
• If the slowdown becomes severe enough it will result in recession.
• Output growth is sluggish and company profits weak; inflation and interest rates
Recession are falling.
• The economy will eventually reach its trough. If the trough is deep it is called a
depression, typified by high levels of business failure and unemployment.
• The recovery phase is where the economy moves out of recession and people start
to spend more as they become more optimistic and confident about the future.
Recovery
• Output growth accelerates as providers increase production and company profits
rise, while inflation and interest rates remain low.
Although cycles typically assume a recovery, acceleration, boom, overheating, deceleration and
recession pattern, in practice it is difficult to identify exactly when one stage ends and another begins
and, indeed, to quantify the duration of each stage.
Where an economy is positioned in the economic cycle also has an effect on the structure of portfolios,
such as to whether they are growth or defensively orientated or where they are focused domestically or
internationally.
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2.3.2 Key Economic Indicators
Learning Objective
7.2.4 Understand key economic and business indicators from an investment perspective: gross
domestic product; interest rates; consumer price & inflation indices; unemployment rate; stock
market and foreign exchange indices; money supply changes; leading, lagging and coincident
indicators; pro cyclic, counter cyclic and acyclic indicators
When considering the latest release of economic data, it is important to know whether it is a:
• leading indicator;
• lagging indicator;
• coincident indicator.
Leading, Lagging and Coincident Indicators

• Leading indicators usually change before the economy as a whole changes and
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Leading so they are useful short-term predicators of the economy.
indicators • Stock markets are a leading indicator as markets usually begins to fall before the
economy and usually rise before the economy recovers from a recession.
• Lagging indicators are those that usually change after the economy as a whole
does. They can be used to confirm what has happened in an economy and can be
used to establish a trend.
Lagging
• A consumer confidence index is a lagging indicator because most people don’t
indicators
really feel the economy has changed until after it actually has and they have felt
the impact. Unemployment is also one as it takes time before companies lay off
staff or start hiring again.
• Coincident indicators are indicators that change at more or less the same time as
Coincident the economy. They are useful as they provide information about the current state
indicators of the economy.
• Examples include industrial production and sales figures.
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Interpreting economic data is both complex and the subject of intense debate by economists and
market analysts. Some of the key economic indicators that are encountered are shown below.
Key Economic Indicators

• The balance of payments provides us with important information concerning the
Balance of trading position of a country in the international economy.
payments • It tells us how much consumers are spending on imported goods and how
successful firms have been in exporting to other countries and markets.
Gross • GDP reflects the amount of economic activity that is taking place in the economy.
domestic • It is vitally important as it provides an indication of where an economy is in the
product economic and business cycle.
• The CPI measures the change in prices for retail goods and services and so tells
us how prices are changing in an economy and so whether inflation poses a risk.
CPI • Inflation is a major consideration for investors. Rising prices reduce the real value
of future interest and dividend payments, together with the real value of the
original investment.
• Measure the change in prices of goods produced by manufacturers and provide
an indication of the price of goods when they first leave the factory.
Producer
• It is monitored as an indicator of how consumer prices might change. The reason
price indices
is that increased prices in manufacturing typically lead to higher retail prices for
consumers.
• Growth in average earnings suggests that a wealthier consumer could lead to
Average increased demand and consumption.
earnings • It is watched as uncontrolled growth in average earnings can raise concerns about
inflation, as too much money may be chasing too few goods and lead to rising prices.
• This is a key indicator of the state of the economy as higher retail sales volume
Retail sales
shows stronger consumer demand, higher retail output, and economic growth.
• Changes by the central bank to their official interest rates affect demand for
Money and consumer loans, mortgages, bonds, and the exchange rate. Increases in rates or
interest rates even expectations of increases tend to cause the exchange rate to appreciate,
while rate decreases cause the currency to depreciate.
• A lower unemployment rate translates into more income-earning workers and
greater consumption. Increased expenditure accelerates economic growth, but
Employment can also heighten inflationary pressures.
• On the other hand, a rising unemployment rate is likely to be accompanied by
slowing economic growth or even recession.
• Confidence and sentiment reports are closely watched indicators of what is
happening in the economy.
Confidence • Rising consumer confidence generally precedes increased consumer spending
indicators which drives both economic growth and inflation. Falling consumer confidence
is an indicator that households will reduce spending leading to lower economic
growth and reduced pressure on inflation.
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2.3.3 Long-Term Global Trends
Learning Objective
7.2.5 Analyse the impact of economic trends and indicators on asset classes and sector allocation
As well as economic growth trends there are other key trends that a wealth manager should remain
abreast of as they may affect investment opportunities.
Globalisation and International Trade

The world economy is now highly interconnected so that changes in one country are felt in other
countries around the world. International trade and the free movement of technology are creating a
global economy in which consumers can buy goods from anywhere in the world.
International trade is a major driver of economic performance in countries and impacts on how assets
are allocated geographically as investment managers try to target those countries that can benefit most.
Capital and technology from the developed world is enhancing the growth of emerging economies and
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international trade creates opportunities for them to sell their products across the world. This creates
efficiencies for their industries and makes them raise their quality to global standards but places
pressure on traditional industries in developed countries.
In an open economy, where international trade accounts for a significant share of GDP, having the right
exchange rate is imperative to its international competitiveness.
An exchange rate is the price of one currency in terms of another. The overall effect of a change in the
exchange rate on the trade balance, assuming that demand is price elastic and all other factors such as
productivity are held constant, is as follows:
• A rise in the nominal value of a currency will reduce a trade surplus or worsen a trade deficit as
exports will be less competitive, unless exporters reduce their prices; whereas imports will be more
competitive, unless exporters to that country raise their prices.
• A fall in the nominal value of a currency will increase a trade surplus or reduce a trade deficit as
exports will be more competitive, unless exporters raise their prices; whereas imports will be less
competitive, unless exporters to that country reduce their prices.
By taking account of whether exporters and importers alter their prices when faced with a change in the
nominal exchange rate, we can establish whether a country’s overall international competitiveness has
improved or declined.
Real Exchange Rates

One way of establishing international competitiveness is by calculating the real exchange rate. For
example, the UK’s real exchange rate relative to that of the US can be formally stated as:
UK Price Level USD

Real exchange rate = _______________ × _____
US Price Level UK
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A rising real exchange rate signifies a reduction in international competitiveness. So, if UK inflation
is rising at a faster rate than in the US without a compensating weakening of the nominal exchange
rate, the UK’s international competitiveness declines. The precise effect on the trade balance and the
revenues of importing and exporting firms will of course also depend on factors such as the price
elasticity of these internationally traded goods and services, any productivity improvements in those
industries and the speed with which consumers substitute goods and services when faced with a
change in price.
As consumers are typically slow to change their spending patterns when faced with changing prices,
the impact of a change in the real exchange rate on the trade balance is never instantaneous. In fact,
a weakening of the nominal exchange rate will immediately raise import prices while reducing export
prices, thereby worsening the trade balance. However, once consumers adjust to these new relative
prices, the trade balance will improve. The trade balance, therefore, tends to experience a J-curve effect.
Direct investment by multinational companies in overseas markets has been a powerful driver of
globalisation. This means that investors can take advantage of globalisation by investing in foreign
markets through the shares of multinational companies with large overseas operations as well as
through emerging market funds.
International Events
International political developments can jolt economies, sending shock waves through investment
markets. Wars or fear of conflicts can lead to major changes of sentiment among investors and traders
and the risk of sovereign default can also have seismic effects on economies and markets.
International relations have become increasingly important as economies and markets have become
more globally integrated and interdependent. Financial markets and equity markets in particular, have
become more correlated so investors must be aware of international developments when allocating
assets.
Financial Bubbles
Financial bubbles happen when investors lose sight of fundamental values and buy shares or other
assets simply because they expect prices will continue to rise. Crashes occur when investors sell shares
because they think prices will continue to fall, or if they are forced sellers due to regulations or losses.
These speculative episodes are a recurring theme of financial history. They generally occur when excess
liquidity allows investors to magnify the financial repercussions of real changes, like technological
breakthroughs generating bubbles, or political unrest generating crashes.
Demographics
Around the world people are living longer and birth rates are declining, leading to ageing populations
with fewer workers and more people in retirement. This can have major long-term effects on investment
markets and opportunities.
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Many countries face a significant ageing of their population and its workforce. This creates both
opportunities and challenges:
• Many countries have to increase the age at which a state pension is paid because of the rising costs
of funding. This increases the opportunities for private sector provision of pension schemes.
• For some segments of the population, this increased longevity is leading to higher average wealth
holdings, as working households increase their savings in order to fund a longer retirement. This
offers the opportunity for greater wealth management services.
Ageing western populations are having a significant impact on equity markets as baby-boomers move
through the peak years of their lives for investment. This effect is particularly visible in the USA, where
investors now hold more in mutual funds than on deposit. The ageing of the West should also boost
particular sectors catering for a more elderly population – like financial services, tourism and leisure, and
health-care products and services.
Technological Change
The development and widespread use of new technology has radically altered the way in which industry
operates over the last twenty years.
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Development of new products has been enabled and improved techniques allow goods and services
to be produced more efficiently. New sectors and industries have been created that offer investors the
potential of high growth, but which can often be quite risky investment opportunities.
Technological change emerges from the systematic application of science and technology to the
production of goods and services.
A country’s capacity for technological change is often measured by the proportion of national output
devoted to research and development. In practice, the key to national economic performance is its
ability to adopt cutting-edge technology, which in turn hinges on the overall education and skills of the
workforce.
Technological change creates new fast-growing industries and transforms existing ones, providing the
scope and a spur for major cost savings.
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3. Investment Management
3.1 Investment Strategies
Learning Objective
7.3.1 Analyse the main cash, bond and equity portfolio management strategies and their short
and longer term implications for investors: cash management; active and passive equity
management strategies; active and passive bond strategies; alternative investment exposure;
core- satellite asset allocation
3.1.1 Cash Management

Managing the cash element of a client’s assets is fundamental to sound wealth management as having
sufficient funds for predictable expenses and emergency expenditure is essential to a financial plan.
A cash management strategy needs to address a number of key factors:
• It needs to analyse the cash requirements of the client in conjunction with expected inflows and
outflows, by developing cash flow projections that drill down to a level that is appropriate to the
client’s circumstances and needs.
• The client’s circumstances must be analysed to identify the types of accounts that will be needed
to provide an emergency liquidity reserve and whether accounts are needed to provide a source
of short-term and long-term funds or whether accounts are needed to capture surplus income and
channel this for investment.
• Accounts then need to be selected that meet these needs and which are suitable in terms of
security, liquidity and return.
These need to be brought together into a cash management plan that reflects the client’s financial
position and stage in life. It will be differentiated by whether it is designed to meet the funding needs of
the client or manage surplus funds.
Managing Funding Needs

Meeting the funding needs of the client is most often encountered where the client is retired, when
a sound cash management plan will need to recognise that retirement often signals the move from a
reliance on regular earnings to reliance on earnings from savings and investments.
A cash management plan will therefore need to provide an emergency liquidity reserve, take account
of predicted cash requirements and incorporate how the cash reserve the client needs will be
supplemented in both the short and long-term. This is shown diagrammatically next.
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Managing Funding Needs
Cash Management Plan Longer-Term Assets:

• Living expenses • Bonds
Client • Known cash Funding • Structured products
requirements • Equities
• Emergency reserve • Other assets
Managing the funding needs of clients involves ensuring that they have an adequate emergency
liquidity reserve and developing a strategy to deliver a reliable supply of funds to top up that emergency
reserve and provide both the short-term and long-term funding that has been identified as part of the
ongoing cash management programme.
The function of an emergency liquidity reserve is to provide a readily available source of funds to meet
unexpected events. It needs to meet two criteria therefore: a suitable amount and availability.
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• Assessing what is a suitable amount will usually revolve around home, health and job and can
be quantified by using these as discussion points with the client. What amount is appropriate is,
however, subjective and it is important therefore that it is both realistic and passes the client’s test
of being sufficient to provide them with a sense of security.
• Having decided on a suitable amount, it is important to find a suitable home for the funds. This
could include cash accounts, money market funds or even short-dated bonds.
Longer-term funding involves the client using the funds they have built up to finance the lifestyle they
wish to follow in retirement. Their income may be insufficient and it will be necessary to develop a
strategy to access capital by a structured withdrawal of funds from the long-term portfolio to meet both
their short-term and long-term needs. This is shown diagrammatically below.
Managing Short and Long-term Funding Needs
Client
Current
Account
Shorter-Term Assets:
Longer-Term Assets:
Instant Access • Term accounts
Surplus Funds • Investment
Funds • Bonds
portfolio
• Structured products
• Other assets
• Other assets
Emergency
Reserve
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There is a wide range of assets that can be used to finance the short-term funding needs of the client
and this wide variety of choices enables investments to be tailored to an individual’s financial objectives,
their income needs and their tolerance for risk. These can be structured so that there is a regular flow of
products maturing to top up the client’s cash reserve or emergency reserve.
It should also be remembered that the client’s attitude to risk for this part of their assets may be
different than for their longer term investments. A client may have an adventurous attitude to risk for
their long-term portfolio but a cautious attitude for shorter-term assets. Establishing this is obviously
key to selecting a suitable solution.
Managing Surplus Funds

Depending upon a client’s stage in life, they may not have a need for funds and instead may have surplus
income and other funds that instead need to be channelled effectively into longer-term investments.
Cash Management Plan Longer-Term Assets:

• Bonds
Client • Expenses • Surplus Investment • Structured products
• Cash needs funds
• Equities
• Reserve
• Other assets
After setting aside funds for living expenses and an emergency reserve, surplus funds should be directed
into an investment reservoir, prior to being invested into longer-term investments. The investment
reservoir is simply an account that can be used primarily as a matter of logistical convenience to transfer
surplus funds efficiently from the client to the long-term investment portfolio.
An investment reservoir allows surplus funds to be invested in accordance with the investment plan and
without delay, but also without decisions having to be made too frequently or over amounts that are
too small. This is shown diagrammatically below.
Income
Current Account
Investment Reservoir: Longer-Term Assets:

Instant Access Surplus Funds • Instant access accounts • Investment portfolio
Funds
• Money market funds • Other assets
Emergency
Reserve
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The diagram shows that the principle of an investment reservoir is to move the cash through the system
and into the investment reservoir and then out for investment as quickly and automatically as possible.
The accounts used for the investment reservoir therefore need to enable ready access to the funds and
where possible there should be an automatic sweep of surplus funds above an agreed amount.
As the purpose of the investment reservoir is to get funds invested, the wealth manager should place a
trigger point to avoid funds sitting in the account for too long. This trigger point could be say quarterly if
the cash flow is large or it could be value driven if the surplus cash flow is small, say when it reaches $20K.
3.1.2 Active Equity Selection Strategies

Stock selection, or stock picking, is important whenever the fund managers are prepared to accept the
overall consensus for the market as a whole, but believe that certain individual securities are mis-priced.
• An overpriced security is one that has an expected return that is less than should be expected on a
risk-adjusted basis.
• An underpriced security has an expected return that is more than would be expected on a risk-
adjusted basis.
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Active stock selection can involve the application of various fundamental, technical or quantitative
techniques. In terms of the CAPM, which is a methodology for valuing securities in reference to the
overall market or SML, a security is said to be mispriced if it has a non-zero alpha value. Such a security
has a return above what might otherwise be expected and is therefore undervalued.
The objective of a stock picker is to pick portfolios of securities with positive alpha. In terms of active
stock selection the manager will try to construct portfolios of securities that will have a more than
proportionate weighting of the underpriced or positive alpha securities, and correspondingly less than
proportionate weighting of the overpriced securities, which are exhibiting negative alpha.
Bottom-up methods are usually dependent on the style or approach of the individual fund manager or
team of managers. A fund management style is an approach to stock selection and management, based
on a limited set of principles and methods. The most widely recognised pure styles are:
• Value. This is the oldest style and is based on the premise that deep and rigorous analysis can
identify businesses whose value is greater than the price placed on them by the market. By buying
and holding such shares, often for long periods, a higher return can be achieved than the market
average. Managers of equity income or income and growth funds often adopt this style, since out
of fashion stocks often have high dividend yields.
• Growth at a reasonable price (GARP) is based on finding companies with long-term sustainable
advantages, in terms of their business franchise, quality of management, technology or other
specific factors. Proponents argue that it is worth paying a premium price for a business with
premium quality characteristics. The style is used mainly by active growth managers.
• Momentum is an investment strategy that aims to capitalise on the continuance of existing trends
in the market. The momentum investor believes that large increases in the price of a security will
be followed by additional gains and vice versa for declining values. This is the strategy most widely
adopted by middle-of-the-road fund managers.
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• Contrarianism. The concept behind contrarian investing is that high returns can be achieved by
going against the trend. Correctly judging the point where a trend has reached an extreme of
optimism or pessimism is difficult and risky. This style is found most often in hedge fund managers.
Other investment styles include the following.
Quantitative Funds
A quantitative (quant) fund is an actively managed fund where the stock-selection process is driven by
computer models. A pure quant fund relies solely on computer models to make this stock selection.
In a quant fund there is no place for manager’s judgement based on fundamental analysis. Instead, the
fund manager uses predetermined or preset models to undertake this stock selection process. Such
models sometimes rely on ideas such as portfolio theory, the CAPM, the dividend valuation model and
options pricing techniques – ie, fundamental evaluation tools – in order to determine which stocks to
hold and in what proportions. Sometimes the models are more based on the identification of patterns
as discussed in conjunction with technical analysis.
Typical strategies of quant funds are:
• growth;
• value;
• statistical arbitrage;
• correlation;
• long/short equity;
• dispersion.
It used to be observed that quant funds tend to perform better in market downturns, whereas more
fundamental funds perform better in upswings. Quant funds, based on correlations and exploiting
convergence or mean reversion strategies assume that the historical statistical relationships between
stocks will continue into the future, which clearly may not hold true. Their experience in the recent
market downturns is leading many to question whether this still holds.
Income Investing
Income investing aims to identify companies that provide a steady stream of income.
Income investing may focus on mature companies that have reached a certain size and are no longer
able to sustain high levels of growth. Instead of retaining earnings to invest for future growth, mature
firms tend to pay out retained earnings as dividends as a way to provide a return to their shareholders.
High dividend levels are prominent in certain industries such as utility companies.
The driving principle behind this strategy is to identify good companies with sustainable high dividend
yields to receive a steady and predictable stream of income over the long-term.
Because high yields are only worth something if they are sustainable, income investors will also analyse
the fundamentals of a company to ensure that the business model of the company can sustain a rising
dividend policy.
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Absolute Return
An absolute return strategy seeks to make positive returns in all market conditions, by employing a
wide range of techniques, including short selling, futures options, derivatives, arbitrage, leverage and
unconventional assets.
Alfred Winslow Jones is credited with forming the first absolute return fund in New York in 1949. In
recent years, the use of an absolute return approach has grown dramatically with the growth of hedge
funds and the launch of numerous open-ended funds following the same strategy.
Combined Approach
In practice, successful managers usually develop their own personal styles over a period of years, usually
based on one or other of the major styles outlined above.
Many houses use a combined approach, with fundamental analysis and quantitative analysis dictating
the markets and stocks which they wish to buy, and technical analysis being used to determine the
timing of entry into the market place.
As already noted, increasing numbers of fund managers are becoming familiar with technical analysis
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since if sufficient numbers believe in technical analysis, the markets will have a tendency to move in line
with the anticipations of technically focused traders.
When evaluating the style that is being followed it is also important to understand whether the fund
manager is operating within the restrictions imposed by a house style or is free to follow their own
convictions. Centralised versus decentralised refers to this approach:
• Centralised approach – a firm decides that it will have an agreed investment policy that all of its
investment managers will follow.
• Decentralised approach – a firm will give discretion to its investment managers to operate freely
or within general constraints.
The approach adopted can often be important in the analysis of a fund. Large fund groups often have the
organisational infrastructure that can support extensive research and are likely to have several people
involved in the management of a fund, so that the departure of one individual will not necessarily have
a great impact on performance.
By contrast, a smaller fund can allow a talented fund manager to demonstrate his or her skills and deliver
exceptional returns without the bureaucracy and constraints that may exist in a larger organisation.
Many boutique fund management operations have been set up to exploit this very edge. However,
these types of fund can present a risk through their dependence on one key individual. The potential
for superior investment returns needs to be balanced against the absence of organisational support and
the potential impact that can have on the consistency of returns.
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3.1.3 Passive Equity Management
Buy and hold
A buy and hold strategy involves buying a portfolio of securities and holding them for a long period of
time, with only minor and infrequent adjustments to the portfolio over time.
Under this strategy, investments bought now are held indefinitely, or if they have fixed maturities, held
until maturity and then replaced with similar ones.
Indexation
There is a variant to the buy and hold strategy that eliminates the diversifiable risk and effectively
replicates the performance of a market index; this is known as index matching or indexation.
There are several different ways of approaching indexation but the most fundamental one is to decide
on the appropriate index for the client as there are many different market indices available.
The duplication of an index by holding all of its constituents is known as complete indexation.
• The requirement is to match exactly the underlying components of the relevant index and as such it
can often be complex and expensive.
• For example, the S&P500 Index contains several hundred securities, weighted according to their
relative market proportions.
• To construct a portfolio of all these securities with the same proportions as the index will involve
extremely high commissions and dealing costs.
Although the large world indices are relatively stable in terms of their constituents there is a need from
time to time to make changes and modify the components. The components of an index are periodically
adjusted in the light of changes of ownership of certain companies, the removal of stocks whose market
capitalisation falls below a certain threshold level and their substitution with another company which
has grown in stature and market capitalisation to qualify for entry to the index.
If a fund manager is replicating such an index, where modifications are being made from time to time,
all of the changes and re-balancing will need to be made to the replica and this would involve dealing
costs and commissions as well as dealing spreads.
A bond index fund will be more complex and expensive to replicate. With the passage of time
the average maturity of a bond index will decline and to replace those bonds which are reaching
redemption with suitable alternatives and preserve the duration characteristics of the bond fund is a
particularly challenging undertaking.
In general terms duplication or complete indexation is often not practical, and therefore alternative
strategies designed to emulate the index’s performance are used.
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Indexation Methods
• As in statistical theory, the use of stratified sampling involves the selection of a
sample of securities from the total population comprising the index.
• The sample should be stratified so that it is representative of the primary
characteristics of the whole population, eg, the total population of the index
constituents can be divided into sectors in the case of equities and into different
maturities in the case of bonds.
Stratified
• A cross-section of securities is then selected from each sector with the intention
sampling
that the sample exhibits the highest correlation to the sector’s overall return
and likewise that there is a strongly correlated fit between the returns from the
sample and those from the entire population of the assets in the index.
• This procedure limits the initial transaction costs and subsequent rebalancing
costs, but increases the risk of tracking errors – the difference between the fund’s
return and the return on the market index.
• Factor matching involves the construction of an index fund using securities
selected on the basis of specifically chosen factors or risk characteristics.
• If the first risk factor required is that the sample matches the level of systematic
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risk, the selected portfolio will need to be chosen to have the same level of beta
Factor as the market.
matching • Other factors may be sector breakdown, dividend pattern, firm size, financial
structure and gearing ratio.
• The selected index fund will be a subset of the available securities within the
whole index that matched the market in terms of the required factors and have
the highest overall correlation with the market.
• Co-mingling involves the use of mutual funds rather than the explicit formation
of an index fund.
Co-mingling • Co-mingling may be especially suitable for clients with relatively small portfolios
and may provide an acceptable compromise between the transaction costs of
complete indexation and the tracking error of stratified sampling.
Tracking Error
The desire to replicate the performance of an index with a subset or sample is prone to tracking errors.
• In other words, when the index is changed in some fashion, for example to remove certain securities,
which may have been taken over or which have fallen below the market capitalisation threshold and
to include some new entrants, the replication format used may no longer be suitable.
• If the sample was based upon stratification and reflection of the sector composition of the index,
the removal of one or two key securities from a sector could have quite a pronounced effect on the
sample which was set up to emulate the previous composition of the index by sector.
• The replication may need to be quite significant in terms of changing the constituents of the sample
or replica to reflect again the stratification of the whole index.
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Another problem arises when the constituents of an index are changed.
• When the announcement of a change is made, the price of the security being deleted tends to fall,
while the price of the security being added tends to rise.
• Fund managers are then forced to take a loss on some of their holdings as they sell them from their
portfolio and have to pay over the odds for the additions, where the prices will fall back over time
after the index has settled down again.
• These effects can cause major tracking errors between index funds and the index itself.
Apart from the transaction costs involved in setting up and rebalancing, there are other problems
associated with running an index fund. The most important of these concerns income payments on the
securities. The total return on an index may include not only capital gains but also income in the form of
dividend or coupon payments. In order to match the performance of the index in terms of income, the
index fund will need to have the same pattern of income payments as the index. It will also have to make
the same reinvestment assumptions.
In addition, the index may assume that gross income payments are reinvested without cost back into
the index on the day each security becomes ex-div. In practice, however, this assumption can be wrong
for the following reasons:
• The dividend or coupon payment is not made until an average of six weeks after the ex-div date.
• The payment is received net of tax.
• There are dealing costs of reinvesting income payments.
• The income payments on different securities may be fairly small and it may not be worthwhile
investing such small sums on the days they are received.
Unless complete indexation was undertaken, it is unlikely that an index fund will exactly replicate
the income pattern of the index. So, over the longer term there is an expectation that the fund will
underperform the index, ie, suffer a tracking error.
Despite these issues, indexation is a popular form of fund management. It attempts to avoid, as far as
possible, decisions about selection and timing of investment, yet it is not purely passive. At the very
least, the choice of index and the reinvestment of income involve active intervention.
3.1.4 Active Bond Selection Strategies

As with an equities portfolio, a bond portfolio will be actively managed whenever there are mispriced
bonds available.
Active bond portfolio management operates around the activities of security selection and market
timing. However, there is a difference between active share selection and active bond selection. Most
equity managers engage in security selection, whereas most bond managers engage in market timing.
• A bond picker will construct a portfolio of bonds that, in comparison with the market portfolio,
has less than proportionate weightings in the overpriced bonds and more than proportionate
weightings in the underpriced bonds.
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• A market timer engages in active management when he does not accept the consensus market
portfolio and is either more bullish or more bearish than the market. Expectations of interest-rate
changes are therefore a crucial input into successful market timing.
Duration Switching
Market timing involves adjusting the relative duration of the bond portfolio over time.
• Market timing with bonds is sometimes called duration switching.

• If the fund manager is expecting a bull market, because he is expecting a fall in the general level
of interest rates they will want to increase the duration of the portfolio by replacing low-duration
bonds with high-duration bonds.
• If the fund manager is expecting a bear market because he is expecting a rise in the level of interest
rates, he will want to reduce the duration of his portfolio.
Active bond portfolio management is generally not as profitable as active share portfolio management.
There are several reasons for this.
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• There are more shares traded than bonds.
• The most liquid bonds are government bonds that have only certain maturities.
• The volatility of bond prices is generally much lower than that of shares, so fewer opportunities for
substantial mis-pricing of bonds exists.
Riding the Yield Curve

‘Riding the yield curve’ is a bond strategy that can be used when the yield curve is upward sloping.
When there is a normal yield curve, an investment manager can buy bonds with maturities in excess of
his investment horizon or the time period over which he invests.
• He proceeds to hold the bonds until the end of this investment period and then sells them.
• If the yield curve has not shifted during that period, the investment manager will have generated
higher returns than if he had bought bonds with the same maturity as his investment horizon.
• This is because as the time to maturity declines, the YTM falls and the price of the bond rises, thereby
generating a capital gain (hence, the term yield curve ride).
• These gains will be higher than those available if bonds with the same maturity as the investment
horizon are used, because the maturity value of the latter bonds is fixed.
The following example shows how an opportunity to ride the yield curve might be taken if the term
structure of interest rates is upward sloping, meaning that longer-dated instruments are yielding more
than shorter-dated instruments.
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Example
To keep the example simple we shall assume that the two instruments are zero coupon Treasury notes
with one and two years remaining to maturity. The current yield curve reveals that a one-year note will
have a YTM of 8% whereas a two-year note will have a YTM of 9%. Since there are no coupons all of this
is in the current price of the bond.
Zero Coupon Time to YTM as per the

Formula Price of Bond
Treasury Bond Maturity Yield Curve
A 1 8.00% 100/108^1 92.59
B 2 9.00% 100/109^2 84.17
If the fund manager buys the one-year zero coupon bond and holds it for one year until redemption, the
return will be exactly as provided for by the yield curve – 8%.
100 – 92.59
r = _________________ = 8%
92.59
Since this is a zero coupon held to maturity, the reinvestment risk is zero.
The alternative scenario is to buy the two-year note and hold it for one year and sell it then as a zero
coupon with one year remaining. The return available then is as follows:
92.59 – 84.17
r = ____________________ = 10%
84.17
The return can again be determined from the holding period return calculation, though an assumption
is required regarding the selling price in one year. The risk this time is not zero as the fund manager is
exposed to movements in the yield curve.
So the yield curve ride is a strategy by which bond managers take on some risk in order to enhance returns.
Bond Switching
There are two main classes of bond switches, anomaly switches and policy switches.
An anomaly switch is a switch between two bonds with very similar characteristics, but whose prices or
yields are out of line with each other.
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Anomaly Switching
• This involves switching between two bonds that are similar in terms of maturity,
coupon and quality rating and every other characteristic, but which differ in terms
of price and yield.
• Since two similar bonds should trade at the same price and yield, this circumstance
results in an arbitrage opportunity between the expensive bond being sold and
the cheap bond being purchased.
Substitution
• If the coupon and maturity of the two bonds are similar, a substitution swap
switching
involves a one-for-one exchange of bonds.
• However, if there are substantial differences in coupon or maturity, the duration of
the two bonds will differ. This will lead to different responses if the general level of
interest rates changes during the life of the switch. It will therefore be necessary
to weight the switch in such a way that it is hedged from changes in the level of
interest rates.
• A pure yield pickup switch involves the sale of a bond that has a given YTM and the
Pure yield purchase of a similar bond with a greater YTM.
pickup • With this switch, there is no expectation of any yield or price correction, so no
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switch reverse transaction will need to take place at a later date, which may be the case
with a substitution switch.
A policy switch is a switch between two dissimilar bonds, which is designed to take advantage of an
anticipated change in interest rates; the yield curve; possible changes in the bond credit rating from the
major ratings agencies; or sector relationships.
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Policy Switches
• Expectations about the future direction of interest rates and market timing in
general is one of the primary factors that will encourage fund managers to switch
Changes in
between different bonds.
interest rates
• Switching from low-duration to high-duration bonds if interest rates are expected
to fall is an example of a policy switch.
• Normally, the yield curve is a smooth relationship between yield and maturity.
• Occasionally, however, this will not be the case and a policy switch could involve
the purchase of a high-yield bond and the sale of a low-yield bond.
• Another example of a policy switch resulting from changes in the structure of the
Changes in
yield curve is the bridge swap.
the structure
• As a result of an abnormal distortion in the yield curve, perhaps due to very high
of the yield
demand for bonds of a specific maturity there may be exploitable opportunities
curve
between different sections of the yield curve.
• As an example, suppose that eight- and ten-year bonds are selling at lower yields
and higher prices than the nine-year bond. A bridge swap involves selling the
eight and ten-year bonds and buying nine-year bonds.
• A bond whose credit rating is expected to fall will fall in price. To prevent a capital
Changes in loss, it can be switched for a bond whose quality rating is expected to rise or
bond credit remain unchanged.
ratings • This is an uncertain process and often there may be no advance warning of the
rerating by the major rating agencies.
Changes • A change in sector relationships is a change in taxes between two sectors: one
in sector sector may have withholding taxes on coupon payments eg, domestic bonds
relationships whereas another, eg, Eurobonds may not.
Policy switches are expected to lead to a change in the relative prices and yields of the two bonds and
involve greater expected returns, but also greater potential risks, than anomaly switches.
3.1.5 Passive Bond Management

Passive bond strategies are employed either when the market is believed to be efficient, in which case a
buy-and-hold strategy is used, or when a bond portfolio is constructed around meeting a future liability
fixed in nominal terms.
There are three types of passive bond selection strategy for the management of the bond element of
the portfolios that we will consider.
• Cash flow matching.

• Duration matching or immunisation.
• Horizon matching or combination matching.
Cash Flow Matching

Cash flow matching is a straightforward approach to bond management. The approach is simply to
purchase bonds whose redemption proceeds will meet a liability of the fund as they fall due.
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If there is a single liability, then clearly just one bond can be purchased with a maturity date close to
when the expected liability is due.
If there are several liabilities, then a range of bonds can be used with the coupons and maturity payments
being spread across the liabilities. This concept is shown in a simplified form in the diagram below.
Cash Flow Matching
Liability 1 Liability 2 Liability 3 Liability 4

Coupon and
Bond 1 Coupon Coupon Coupon
Maturity Payment
Coupon and
Bond 2 Coupon Coupon
Maturity Payment
Coupon and
Bond 3 Coupon
Maturity Payment
Coupon and
Bond 4
Maturity Payment
7
The strategy involves:
• Starting with the final liability, a bond is purchased whose final coupon and maturity payment will
meet the liability.
• Turning next to the penultimate liability, this may be satisfied in part by the coupon flows arising
from bond 1 and any remaining liability is matched against the final coupon and maturity payment
of a second bond.
• This process is continued for each liability, ensuring that bonds are purchased whose final coupon
and redemption values extinguish the net liabilities of the fund as and when they occur.
The following example shows how this might work in practice using some simple assumptions.
Example
Let’s assume that a client has liabilities of $10,000 that are due annually over the next four years and that
the following bonds are available.
• Bond 1 – 3% coupon; repayable in 4 years’ time; priced at 105.

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The table below shows the nominal amount of each stock that will need to be bought to meet the
expected liabilities.
Nominal Coupon Price Cost
Bond 1 9,700 3% 105 10,185
Bond 2 9,400 4% 109 10,246
Bond 3 9,200 2% 102 9,384
Bond 4 9,000 2% 100 9,000
Total 38,815
We can now look at the cash flows that will result from the bonds and see that they approximately meet
the client’s anticipated liabilities. (In each case, we will assume that the coupon is paid annually).
Liability 1 Liability 2 Liability 3 Liability 4
Bond 1 Coupon 291 Coupon 291 Coupon 291 Coupon 291
Maturity 9,700
Bond 2 Coupon 376 Coupon 376 Coupon 376
Maturity 9,400
Bond 3 Coupon 184 Coupon 184
Maturity 9,200
Bond 4 Coupon 180
Maturity 9,000
Total 10,031 10,051 10,067 9,991
The approach outlined is a simple buy and hold strategy and as such does not require a regular
rebalancing. In practice, it is unlikely that bonds exist with exactly appropriate maturity dates and
coupons but, intuitively, it is a straightforward concept to understand and to be able to explain to
clients.
An alternative approach to the above would be to buy zero coupon bonds such as STRIPS that match
the expected liability. The returns on STRIPS will, however, be lower than might be available on highly
rated corporate bonds.
Duration Matching or Immunisation

Immunisation is an investment management technique employed by those bond portfolio managers
with a known future liability to meet. An immunised bond portfolio is one that is insulated from the
effect of future interest rate changes.
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The ongoing fluctuation of interest rates poses a particular problem for fund managers with a portfolio
of bonds because of reinvestment risk. By using an approach based upon bond duration, it is possible
to maintain a steady return over a specific time horizon, irrespective of any changes in the interest rate.
Duration-based immunisation involves constructing a bond portfolio with the same initial value as the
present value of the liability it is designed to meet and the same duration as this liability.
A portfolio that contains bonds that are closely aligned in this way is known as a bullet portfolio.
Alternatively, a barbell strategy or ladder of bonds can be adopted.
Duration Matching
• Let’s assume a client has a liability due in ten year’s time but that there are no bonds
that exactly match the timescale.
• There are however bonds with nine-year and 11-year durations (note – durations not
maturity).
Bullet • A portfolio containing the two bonds could be constructed with half invested in
portfolio each. The portfolio would then have a duration that matched the liability – 0.500*9 +
0.500*11 = 10 years.
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• In practical terms, one bond would repay earlier than needed and the other would
need to be sold although it would be very short dated and so should realise close to
its par value.
• Again let’s assume the client has a liability due in ten year’s time.
• Using a barbell strategy, let’s assume we can identify two bonds, one with a four-year
duration and the other with a 15-year duration.
Barbell • By changing the proportions invested in each we can construct a portfolio that has a
portfolio duration that matches the liability by investing 45.5% in the first and the balance in
the latter – 0.455*4 + 0.545*15 = 10 years.
• In practical terms, the portfolio could not remain static and will obviously need
regular rebalancing.
• Instead of just two bonds, we could construct a portfolio containing a greater number
of bonds with a range of durations.
• The percentages invested in each would need to be adjusted to meet the liability.
Ladder • For example, let’s say for example that the durations and percentages invested were
portfolio (1 year*0.10) + (5 years*0.15) + (10 years*0.20) + (15 years*0.25) + (20 years*0.30)
• Then the overall duration of the portfolio will equal 10 years.
• As the earlier bonds repaid, the proceeds could be reinvested and the spread of
bonds maintained or concentrated as desired.
Barbell and ladder portfolios necessarily require more frequent rebalancing than bullet portfolios.
The primary factor which can introduce risk into the approach to immunisation will be caused by non-
parallel shifts in the yield curve – that is where there is a shift in the yield curve in which yields do not
change by the same number of BPs for every maturity. If this happens matching the duration of the
investment to the liability horizon no longer guarantees immunisation.
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Horizon Matching
Horizon matching or combination matching is a mixture of the above two approaches to managing bonds.
It is possible to construct a portfolio where, for example, the cash flow matches the liabilities for the
next four quarters but is then immunised for the remaining investment horizon. At the end of the four
quarters, the portfolio is rebalanced to cash flow match over the subsequent four quarters and is again
immunised for the remaining period.
3.1.6 Core Satellite Management

Having considered both active and passive management, it should be noted that active and passive
investment strategies are not mutually exclusive.
Index trackers and actively managed funds can be combined in what is known as core-satellite
management. This is achieved by indexing, say, 70% to 80% of the portfolio’s value so as to minimise the
risk of underperformance, and then fine-tuning this by investing the remainder in a number of specialist
actively managed funds or individual securities. These are known as the satellites.
This concept is illustrated in the diagram below.
Smaller Cap
Funds
Property
Funds
Commodity Passive Funds -

Funds • Global bond tracker
• Global equity tracker
Country
Funds
Specialist
Funds
The core can also be run on an enhanced index basis, whereby specialist investment management
techniques are employed to add value. These include stock lending and anticipating the entry and exit
of constituents from the index being tracked.
In addition, indexation and active management can be combined within index tilts. Rather than
hold each index constituent in strict accordance with its index weighting, each is instead marginally
overweighted or underweighted relative to the index based on their perceived prospects.
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3.1.7 Alternative Investments

Alternative investments can have a role to play in the portfolios of clients subject to their inclusion being
appropriate for the level of risk that the client is prepared to accept. Indeed, private client indices run
by the Wealth Management Association (WMA), formerly the Association of Private Client Investment
Managers (APCIMs), in the UK contain an allocation to hedge funds, although only a small percentage.
Property and commodities are not truly alternative investments, but as they have not been considered
so far, it is relevant to state that they warrant inclusion with an asset allocation strategy. Property usually
forms a percentage of most asset allocations and commodity exposure is often achieved through
holding natural resources shares.
The question of what constitutes an alternative investment is usually thought to refer to hedge funds
but it would be better to see this as any fund that deploys an investment strategy that produces returns
that are uncorrelated or only mildly correlated with traditional bond and equity portfolios.
One of the major advantages of holding alternative investments is the additional diversification benefits
that such exposure can bring, given their low levels of correlation with core bond and equity holdings.
Such funds will offer exposure to absolute return strategies, specialist commodity strategies, currencies
7
and derivatives. It’s important to remember, however, that this diversification often comes with high
levels of volatility.
3.2 Performance Benchmarks
Learning Objective
7.3.2 Understand the purpose and concept of benchmarking, the range of weighting methods used
in index construction, and the range of published indices available
7.3.3 Understand the main factors influencing the selection or construction of appropriate
benchmarks for wealth management clients
7.3.4 Apply an investment strategy for a wealth management client from the perspective of:
investment objectives; risk appetite; tax situation; total expense ratio (TER) and level of
portfolio turnover (PTR); suitability requirements; benchmarking; liquidity and timing factors
where asset accumulation and decumulation are relevant features
It is important that investors and other interested parties are able to monitor the performance of a fund
in order to assess the results that the investment manager has produced. This requires selection of a
suitable benchmark and analysis of the performance of the fund.
3.2.1 Benchmarking
If the performance of an investment fund or investment manager is to be assessed, the first issue to
address is how to measure that performance.
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Investment performance is usually monitored by comparing it to a relevant benchmark. To be useful,
a benchmark should align with the style and risk adopted by the investment manager and should be:
• Specified in advance.
• Appropriate to the manager’s investment approach and style.
• Measurable so that its value can be calculated on a frequent basis.
• Unambiguous in its construction.
• Reflective of the manager’s current investment opinions and knowledge and experience of the
securities included within the benchmark.
• Accepted by the investment manager who will be accountable for deviations in construction of the
portfolio due to active management.
• Investable so that it is possible to replicate the benchmark.
The ways in which portfolio performance is assessed can be grouped into three main categories.
Benchmarks
• An index comparison provides a clear indication of whether the portfolio’s
Comparison returns exceed that of the bond or stock market index that is being used as
with a relevant the benchmark return.
bond or stock • As well as the main stock market indices that are generally seen, many
market index sub-indices have been created over the years which allow a more precise
comparison to be made.
Comparison with • Investment returns can also be measured against the performance of other
similar funds or a fund managers or portfolios which have similar investment objectives and
relevant universe constraints.
comparison • A group of similar portfolios is referred to as an investment universe.
• Customised benchmarks are often developed for funds with unique
Comparison investment objectives or constraints.
with a custom • If a portfolio spans several asset classes a composite index may need to be
benchmark constructed by selecting several relevant indices and then multiplying each
asset class weighting to arrive at a composite return.
3.2.2 Indices and Weighting Methods

If an index is to be used as a benchmark, it is important to understand how it is constructed.
There are three main calculation methods used in the construction of a market index – price weighted,
market-value weighted and equal weighted.
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Index Calculation
• These are constructed on the assumption that an equal number of shares are held
in each of the underlying index constituents.
• The index is calculated by summing the total of each constituent’s share price and
comparing this total to that of the base period.
Price
• However, as these equal holdings are weighted according to each constituent’s
Weighted
share price, those constituents with a high share price, relative to that of other
constituents, have a greater influence on the index value.
• Although such indices are difficult to justify and interpret, the most famous of
these is the Dow Jones Industrial Average (DJIA).
Market • In these indices, larger companies account for proportionately more of the index
Value as they are weighted according to each company’s market capitalisation.
Weighted • The FTSE 100 is constructed on a market capitalisation weighted basis.
• In certain markets, the largest companies can comprise a disproportionately
large weighting in the index and, therefore, an index constructed on a market
Equal Value
capitalisation basis can give a misleading impression.
Weighted
• An equal-weighted index assumes that equal amounts are invested in each share
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in the index. The Nikkei 225 is an example of an equal-weighted index.
Most of the major indices used in performance measurement are market value weighted indices such
as: the S&P 500 and other S&P indices; the Morgan Stanley Capital International index, and the FTSE 100
and FTSE All Share indices.
Under market-capitalisation weighted indices, the total market capitalisation of a company is included,
irrespective of who is actually holding the shares and whether they are freely available for trading.
Market-capitalisation weighted indices are usually adjusted for available shares or their free float.
The free-float methodology includes only that proportion of a company’s issued shares that are
available for trading in the market. It generally excludes promoters’ holdings, government holdings,
strategic holdings and other locked-in shares, such as family or founder shareholdings, which will not
come to the market in the normal course of trading. Their introduction was driven by investors who
wanted to remove the distortion that unavailable to trade holdings brought to global indices and the
impact that had on resulting asset allocation decisions.
The free-float method is seen as a better way of calculating market capitalisation, because it provides
a more accurate reflection of market movements. When using a free-float methodology, the resulting
market capitalisation is smaller than what would result from a full-market capitalisation method. This is
useful for performance measurement, as it provides a benchmark more closely related to what money
managers can actually buy.
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The table below shows some of the world’s leading indices, their basis of construction and some of their uses.
World Indices and their Basis of Construction

• The DJIA was introduced over 100 years ago in 1896 and was the first convenient
benchmark for comparing individual stocks to the performance of the market or
Dow Jones for comparing the market with other indicators of economic conditions.
Industrial • It is the best-known index in the world and its 30 stocks account for close to 25%
Average of the total US equity market. It was obviously designed in pre-computer days and
as mentioned earlier it is based on a simple price-weighted arithmetic calculation,
making it less suitable for index products.
• The S&P 500 is regarded as the best indicator of the US equity markets. It
focuses on the large-cap segment of the US market and provides coverage of
S&P 500 approximately 75% of US equities that trade on NYSE and NASDAQ.
Index • It is a market-capitalisation weighted index that requires a free float of at least
50% and a minimum market capitalisation of US$4 billion. It is widely used as the
basis for index products.
• The FTSE 100 is a market-capitalisation weighted index representing the
performance of the 100 largest UK-domiciled blue chip companies.
• It is free-float weighted to ensure that a true investable opportunity is represented
within the index and screened for liquidity to ensure that the index is tradable.
FTSE 100 Capital and total return versions are available. It is reviewed and its components
rebalanced every quarter in March, June, September and December.
• The index represents approximately 80% of the UK’s market capitalisation and
is used as the basis for investment products, such as funds, derivatives and
exchange-traded funds.
• The FTSE All-Share measures the performance of companies listed on the LSE’s
main market. It covers close to 700 companies representing approximately 98% of
FTSE All the UK’s market capitalisation.
Share Index • It is a market-capitalisation weighted index and screened for size and liquidity.
• It is considered to be the best performance measure for the overall London equity
market and is the basis for a wide range of investment-tracking products.
• The Nikkei 225 or Nikkei Stock Average is Japan’s most widely watched index of
stock market activity and is the oldest and most-watched Asian index.
• As mentioned above, it is an equal-weighting index which is based on each
constituent having an equal-weighting based on a par value of 50 yen per share.
Nikkei 225
Because it is an equal weighting index it needs to be rebalanced periodically.
• The Nikkei 225 is designed to reflect the overall market, so there is no specific
weighting of industries. The 225 components of the Nikkei Stock Average are
among the most actively traded issues on the first section of the TSE.
• The MSCI World index is a free-float-adjusted market-capitalisation weighted index
that is designed to measure the equity market performance of developed markets.
MSCI World
• The index includes securities from 24 countries and is calculated on a capital
Index
or total return basis, in both dollars and other currencies. It is the common
benchmark index used for global funds.

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3.2.3 Single and Composite Benchmarks

There are various types of benchmarks in use but the primary types are shown in the following table.
Types of Benchmark
• These have an objective of aiming to exceed a minimum target return.
• For example, some absolute return funds have an objective to deliver positive
Absolute
returns over a rolling one, two or three-year period of a specified margin over a
benchmark rate such as LIBOR or Euribor.
• This uses peer group averages to determine the benchmark, by taking the
Manager performance of the median manager as the benchmark.
universes • As a result, it cannot be specified in advance and has been criticised as creating a
herd mentality, rather than a focus on the need of the portfolio.
• There are several broad market indices that can be used such as the MSCI World
Broad
Index, the S&P 500 and the FTSE All Share.
market
• They have the advantage that they are well recognised, easy to understand and readily
indices
measurable. Their drawback is that the manager’s investment style may be different.
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Style • These represent a proportion of the available securities within an asset category that can
indices be effectively grouped together, such as large-capitalisation stocks or small cap-stocks.
• This is a benchmark that is created by relating one or more systematic sources of
returns (factors or exposures) to returns of the benchmark.
Factor • The factors that make up the benchmark may be areas such as performance of the
models market, the sector or company size.
• Whilst they can help explain how performance is achieved, they are not easy to
understand, are not specified in advance and can be ambiguous and expensive to use.
• These compare a manager’s return to the returns of several style indices that best
Returns explain the manager’s return.
based • They are generally easy to use and measurable, but the mix of underlying styles may
not reflect the manager’s investment process.
Custom • These use a selection of securities that best reflects the investment manager’s
based approach to produce a composite or synthetic benchmark.
Customised benchmarks are often developed for funds with unique investment objectives or constraints.
If a portfolio spans several asset classes, a composite index may need to be constructed by selecting several
relevant indices and then multiplying each asset class by a weighting, to arrive at a composite return.
An example is the private investor indices produced by FTSE and the WMA. There are different private
investor indices, which each have different asset allocations and are composed of related indices, to
reflect the differing aims of investors.
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An example of the allocations and respective indices within the WMA indices are shown below.
Wealth Management Association Custom Benchmarks

Asset Conservative Income Growth Balanced Representative
Class Index Index Index Index Index
UK shares 21.5 37.5 45.0 40.0 FTSE All Share
FTSE World Ex-UK
International
11.0 17.5 37.5 30.0 index calculated in
shares
sterling
FTSE Gilts All Stocks
Bonds 50.0 32.5 7.5 17.5
index
Cash 5.0 5.0 2.5 5.0 7-Day LIBOR –1%
Commercial FTSE All UK Property
2.5 2.5 0.0 2.5
property index
FTSE/APCIMS Hedge
Hedge funds 10.0 5.0 7.5 5.0 (Investment Trust)
Index
Total 100% 100% 100% 100%
3.3 Investment Strategy
Learning Objective
7.3.4 Apply an investment strategy for a wealth management client from the perspective of:
investment objectives; risk appetite; tax situation; total expense ratio (TER) and level of
portfolio turnover (PTR); suitability requirements; benchmarking; liquidity and timing factors
where asset accumulation and decumulation are relevant features
Deciding on an investment strategy that is suitable for a client involves the use of all of the material
covered so far in this workbook and applying it to the unique needs of the client.
In general terms, the process that is involved can be broken down into a series of steps that include:
• Agreeing the client’s investment objectives.

• Investigating and agreeing the client’s attitudes to risk and risk capacity.
• Analysing the client’s financial situation and synthesizing this information to create understandable
summaries of the client’s financial position, asset allocation and cash flow.
• From this analysis, identifying the key areas that need action, recognising that many clients have
multiple objectives and may have different risk attitudes for each.
• Determining the best products, solutions or combinations of both that meet the client’s needs and
are suitable for their purposes.
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In determining investment products and solutions, an adviser could break this down into three stages:
• Determining a suitable home and allocation for cash assets and cash reserves.
• Identifying what funds should be invested in secure assets with little risk to capital.
• Then assessing what type of investment solution or service may be most appropriate.
The selection of suitable homes for cash assets will require an assessment of current rates and terms
for different accounts. A series of accounts that provide immediate access along with ones that require
notice will be needed to provide ready access to funds.
Before investigating investment solutions, secure investments should also be considered. In many
countries there are products or accounts that offer reasonable returns, allied with capital security.
Wealthy clients will often make the point that their capital was hard to build up, so some secure
investments are likely to have a place in most client’s assets. Examples might be guaranteed income or
growth products or structured products with capital protection.
When looking at investment solutions, a decision will need to be made as to whether indirect
investment through investment funds or a managed investment account is appropriate for the client.
Whilst the amount of investable funds will often determine what options are available, a client’s attitude
7
to risk and their risk capacity will have a significant bearing on the choices made.
3.3.1 Suitability
Regulatory standards require firms to ensure that the advice they provide is suitable for the client they
are advising.
Whilst regulatory standards may differ slightly from one country to another, there is a common principle
in all jurisdictions that a firm must apply reasonable care, skill and diligence in making recommendations
to its clients. Wealth management firms are required to provide best advice – meaning they have to
find out the client’s circumstances and needs before making a recommendation, and recommend only
suitable investments for the customer.
Examples of Regulatory Standards

A member or an associated person must have a reasonable basis to believe that a recommended
transaction or investment strategy involving a security or securities is suitable for the customer,
US
based on the information obtained through the reasonable diligence of the member or associated
person to ascertain the customer’s investment profile.
A firm must take reasonable care to ensure the suitability of its advice and discretionary decisions
UK
for any customer who is entitled to rely upon its judgement.
In terms of what is required to fulfil these obligations, it is useful to look at the detailed rules and guidance
that regulators provide as to how this standard is to be met. The UK regulator, for example, has the rules
shown in the following table for assessing suitability, which usefully summarise what is required.
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Assessing Suitability
A firm must take reasonable steps to ensure that a personal recommendation, or a decision to trade, is
suitable for its client.
When making the personal recommendation or managing his investments, the firm must obtain the
necessary information regarding the client’s:
a. knowledge and experience in the investment field relevant to the specific type of designated
investment or service;
b. financial situation; and
c. investment objectives;
so as to enable the firm to make the recommendation, or take the decision, which is suitable for him.
A firm must obtain from the client such information as is necessary for the firm to understand the
essential facts about him and have a reasonable basis for believing, giving due consideration to
the nature and extent of the service provided, that the specific transaction to be recommended,
or entered into in the course of managing:
a. meets his investment objectives;

b. is such that he is able financially to bear any related investment risks consistent with his investment
objectives; and
c. is such that he has the necessary experience and knowledge in order to understand the risks
involved in the transaction or in the management of his portfolio.
The information regarding the investment objectives of a client must include, where relevant,
information on the length of time for which he wishes to hold the investment, his preferences regarding
risk taking, his risk profile, and the purposes of the investment.
The information regarding the financial situation of a client must include, where relevant, information
on the source and extent of his regular income, his assets, including liquid assets, investments and real
property, and his regular financial commitments.
The information regarding a client’s knowledge and experience in the investment field includes, to
the extent appropriate to the nature of the client, the nature and extent of the service to be provided
and the type of product or transaction envisaged, including their complexity and the risks involved,
information on:
1. the types of service, transaction and designated investment with which the client is familiar;
2. the nature, volume and frequency of the client’s transactions in designated investments and the
period over which they have been carried out;
3. the level of education, profession or relevant former profession of the client.
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3.3.2 Suitable Advice

Assessing whether advice given is suitable involves:
• the client’s circumstances and needs at the time the recommendation was made;
• the features of the investment;
• what the firm knew (or should have known) at the time it makes the recommendation.
The firm then makes an objective assessment of the recommended investment’s suitability, in the light
of these factors.
So to provide best advice, wealth management firms need to ascertain information about the customer,
including but not limited to:
• Age, health, occupation and other relevant personal circumstances.

• Financial situation and needs, which may include questions about annual income and liquid net
worth.
• Other investments.
• Tax status such as domicile, residency and marginal tax rate.
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• Investment objectives which may include generating income, funding retirement, buying a home,
preserving wealth and/or market speculation.
• Investment experience.
• Investment time horizon such as the expected time available to achieve a particular financial goal.
• Liquidity needs, which are the client’s need to convert investments to cash without incurring
significant loss in value.
• Risk attitude and their capacity to bear losses.
Regulatory rules place an obligation on firms to seek as much information as possible from clients,
in order to ensure they can give suitable advice. However, clients are not obliged to provide the
information and many wealthy clients will often be reluctant to reveal all of their financial affairs to an
adviser. In this case, when some customer information is unavailable, despite a firm’s request for it, the
firm may narrow the range of recommendations it makes.
When considering whether a particular investment is suitable, it is necessary to look at the features of
the recommended investment including:
• its terms and conditions;

• its flexibility;
• the inherent risks including asset allocation and structural risks such as counterparty risk;
• the term or duration of the investment;
• the expected return;
• the charges applied by the product provider.
This involves going beyond a product’s description to analyse its underlying components and
characteristics.
Clear documentation directed at the client personally such as a reasons why letter or a suitability report
can be a useful method to demonstrate that the recommendation was suitable for the consumer.
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In preparing suitability reports, it is important to remember that they need to serve two purposes:
• meet regulatory standards that require them to be fair, clear and not misleading.
• be understandable to the client and provide a clear summary of their objectives, needs, priorities
and relevant existing investments, demonstrating how the adviser has taken account of these.
In particular, advisers should consider whether their suitability report:
• is tailored to the client and uses clear and plain language;

• explains the reasons for all recommendations and how they relate to the client’s objectives;
• provides a balanced view and highlights the risks associated with the recommendations;
• explains the costs, charges and potential penalties attached to the recommendations;
• identifies why the selected investments are suitable to meet the client’s needs and objectives.
3.4 Portfolio Management
Learning Objective
7.3.5 Understand the responsibilities of managing a client portfolio including: monitoring and
rebalancing the portfolio in light of market developments; developing recommendations
for ongoing investment purposes; reviewing and reporting on investment strategy and
performance; regular and periodic communication with the client; changes in client
circumstances; efficient administrative support
3.4.1 Portfolio Reviews

A client’s portfolio requires regular review to ensure that it continues to be suitable and meets the
investment objectives of the client and their risk tolerance.
Clearly, before advising any client an adviser must be aware of the various needs, preferences,
expectations and financial situation of the client. These circumstances are of course subject to change
over time. Sometimes these changes can be anticipated and sometimes they may be unexpected.
Changes in any of these factors may trigger the need for a client’s position to be reviewed. Examples of
these are shown next.
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Factors that might trigger the need for a client’s assets to be reviewed
• Changes in the client’s circumstances may require a need to liquidate a part of
the client’s holdings, in order to raise cash.
• To the extent that the current portfolio has an adequate allocation of cash
and short-term money market instruments available, this may not present any
immediate issues.
Client
• Alternatively, if part of a portfolio has to be liquidated this will alter the balance
circumstances
of the remaining assets and will require a re-balancing exercise to be performed
at some future point.
• The redemption of certain products may attract penalties and charges or if assets
have to be liquidated when markets are performing poorly, this could lead to
losses.
• Recent economic performance has demonstrated the need to keep a client’s
portfolio under regular review.
• Some clients may be faced with the loss of employment income leading to a
Financial reassessment of their priorities and the plans that have been made.
environment • Experience of economic uncertainty and market volatility may make some
7
clients more risk averse, leading to a reassessment of their risk profile and what
investments are suitable.
• On the other hand there are some clients who think more opportunistically and
see a drop in asset prices as an excellent buying opportunity.
• Financial innovation over recent times has been extraordinary.
Availability of
• New kinds of products, collective investment vehicles and other investment
new products
services means that the investment solutions that have been identified as being
and services
stable for clients need to be continually reassessed.
• There are pressures on fund managers from competitors and from poor
Competitive performance which have lead many fund managers to cut fees and charges.
environment • This may lead to the need to review the cost effectiveness of an investment
solution that has been selected for the client.
3.4.2 Client Reporting

A key element of an investment management service is the provision of current, reliable and useful
reporting on the state of a client’s portfolio.
Given the complex nature of the investment products available in markets and the fact that clients
may have exposure to different currencies, asset classes and instruments, the task of presenting this
information to a client presents a major challenge.
Sophisticated reporting software is now regularly used to generate investment reports for clients and is
often available in real time and accessible via the internet or distributed electronically.
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Reporting to clients usually falls into two main categories:
• Occasional reporting – eg, the issue of contract notes as and when trades are undertaken on behalf
of a client.
• Periodic reporting – regular reports on the valuation of the portfolio and supporting statements.
Contract Notes
When trades are undertaken for clients, details of the transaction need to be sent to the client in the
form of a contract note or written statement.
Contract Notes
After a broker has executed a deal, their reporting system will automatically generate and issue a
contract note. Some of the key details included on the contract note are:
• The name of the account for which the trade was undertaken.
• Details of the broker and whether the trade was executed by the broker as agent or principal.
• Date and time of the trade.
• Type of order (eg, market order; limit order) and the execution venue where the trade was executed.
• Details of the trade undertaken:
whether it was a sale or purchase;
name of the issuer and the number of shares or nominal value of stock traded;
the price paid, charges and the net consideration for the trade.
Contract notes need to be issued to the client as soon as possible and regulatory rules will usually spell
out the time scales that must be adhered to, such as no later than the business day following execution
of the trade.
Periodic Reporting
If a firm manages investment on behalf of a client, they must provide regular reports to the client on
their investment portfolio, how the portfolio has performed and the transactions that have taken place.
These are known as periodic reports.
The range of reports included in the periodic reporting pack to clients about their investment portfolios
include:
• investment valuations;
• performance reports;
• transaction reports;
• corporate action statements;
• capital cash statements;
• income statements.
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Content of Periodic Reports

• An investment firm will provide valuations of a client’s investment portfolio on a
regular basis.
• The key features that should be contained in the valuation include:
Investment
details of the client’s holdings;
valuations
the price and value of each investment and the basis of valuation, eg, whether
mid-prices and any exchange rates are used;
breakdown of the portfolio by asset class, market and sector.
• When managing an investment portfolio on behalf of a client it is necessary to
select a suitable benchmark against which the performance of the portfolio can
Performance
be judged.
reports
• The periodic report needs to provide details of the performance of the portfolio
and of the benchmark portfolio for comparison.
• A client needs to be advised of details of the trades that are undertaken within
Transaction their portfolio.
reports • This can be achieved by sending a contract note after the trade has been executed
or including a statement as part of the periodic report pack with the same details.
7
• Within the periodic report pack, there will usually be a statement detailing the
Corporate
corporate actions that have taken place during the period covered by the report.
action
• This will cover the terms of the corporate action and the impact on the client’s
statements
holding.
Cash and • The capital cash statement will show details of the cash transactions that
income have taken place in the portfolio, whilst the income statement will itemise the
statements dividends and interest received and any payments made.
Many firms will also issue a tax reporting pack at the same time or annually. The reporting pack will
typically contain CGT reports and tax certificates. The CGT reports will show each holding within the
portfolio, their base cost for CGT and the estimated gain or loss on sales. The tax certificate shows the
consolidated picture of the dividends and interest received in the portfolio and should be structured in
the same way as the income needs to be reported in the client’s tax return.
Regulatory rules will spell out the frequency with which reports must be issued. These usually require
periodic reports to be issued at least every six months but the client can request that they are provided
every three months instead.
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4. Evaluating investment performance
Performance evaluation attempts to explain why a portfolio produced a certain return. It does so by
breaking down the performance and attributing the results based on the decisions made by the fund
manager on asset allocation, sector choice and security selection.
This involves two elements:
• Performance measurement – calculating the performance of the fund based on changes in its
value over specified time periods.
• Performance attribution – assessing how the investment manager attained that performance by
undertaking analysis to identify the sources of the portfolio’s performance.
4.1 Performance Measurement
Learning Objective
7.4.1 Calculate the measures that can be used when evaluating investment performance: holding
period return; MWRR and TWRR; risk adjusted returns – sharpe ratio, treynor ratio, jensen ratio
and information ratio
To calculate the performance of a fund requires firstly what constitutes the portfolio’s return and then
how that return can be calculated in such a way that accounts for the distorting effect of external cash
flows into and out of the portfolio.
Three different methods used to measure portfolio performance include:
• Holding period return – sometimes referred to as total return;

• Money weighted rate of return (MWRR);
• Time weighted rate of return (TWRR).
Which method is used depends on whether we need to take account of the distorting effect of external
cash flows into and out of the portfolio.
4.1.1 Total Return

Total return is a measure of investment performance that includes the change in price of the asset, plus
any other income (including dividends, interest and capital gains distributions). It is assumed that all
income is reinvested over the period.
The calculation of total return is expressed as a percentage of the initial asset value. The formula for
calculating total return where there have been no external cash flows during the period is:
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Total Return
EMV–BMV
RTR = __________
BMV
where:
RTR = total return
EMV = end market value
BMV = beginning market value
As a result, calculating total return is straightforward.
Example
If an investor’s portfolio was valued at 250,000 at the beginning of the year and by the end, it was worth
262,500 and dividends of £5,000 had been received what is the total return on the portfolio?
7
(262,500+5,000)–250,000 17,500
RTR = ________________________ = ________ = 7%
250,000 250,000
So the total return is the growth, plus the dividends totalling 17,500 as a percentage of the starting
value. In percentage terms the total return was 7%.
Was that a good return? Total return alone cannot answer that question as it cannot make any allowance
for whether funds were added to the portfolio or withdrawn.
So, for example, a 7% return may seem attractive but what if 7,500 in cash had been added to the
portfolio on the last day of the year? That would reduce the return to just 4%. What would happen
if funds were regularly added and withdrawn during the year? Simply using total return would not
provide a usable rate of return and so we need to look at calculation methods that can adjust for this.
4.1.2 Money Weighted Rate of Return (MWRR)

The money weighted rate of return (MWRR) is used to measure the performance of a fund that has had
deposits and withdrawals during the period being measured. It is also referred to as the IRR of the fund.
349
(MWRR) Formula
The MWRR formula is the rate of return that solves the following:
MV1= (MV0 * (1 + r)m) + {Sum of (CFi * 1 + rLi)}
Where:
MV1 = end portfolio value
MV0 = beginning portfolio value
m = the number of days in the period
CFi = cash flows
L(i) = number of days the cash inflow is included in the portfolio or the number of days that a cash
outflow is absent
The MWRR therefore calculates the return on a portfolio as being equal to the sum of:
• the difference in the value of the portfolio at the end of the period and the value of the portfolio at
the start of the period, plus;
• any income or capital distributions made from the portfolio during that period.
The difference is then expressed as a percentage, the MWRR.
One of the main drawbacks of this method is that it cannot be solved algebraically. To calculate the
return is an iterative process; the return must be discovered through trial and error or interpolation to
find the required discount factor that causes the NPV of all the cash flows to be equal to zero. At this
point the discount factor will then provide the MWRR.
As a result, it is a more time-consuming calculation than other methods. Due to the trial and error nature
of the calculation, it is unlikely that you will see a problem in the exam that requires this method to be
used. Instead we need to consider a simpler way to calculate this which is shown below.
Example
In simple terms, the money weighted rate of return equals:
(Value
_________at
___the
______end
______of
____the
______period
__________–___Value
_________at
___the
______beginning
________________of
____the
_____period
___________±___cashflows)
____________
(Value at the start of the period ± cash flows adjusted for the number of months)
So the formula is:
(V1 – V0 ) ± Cf
MWR = __________ __n___
V0 + (Cf × 12 )
V0 = the value at the start of the period.

V1 = the value at the end of the period.
Cf = the cash flows.
n/12 = the number of months.
350
If cash is added to the portfolio it is a positive figure and will be subtracted from the returns in the
numerator. If it is a withdrawal it is a negative figure and has to be added back in to get the return. On
the bottom line of the equation this logic is reversed as the fund had use of any capital injected for the
balance of the year and lost the use of withdrawals for the remainder of the year.
Example
So, using this formula, let’s assume that a portfolio was worth 100,000 (V0) at the beginning of the
year and 110,000 (V1) at the end of December of that year. The transactions that took place during the
year were a cash injection of 5,000 at the end of March and a cash withdrawal of 7,000 at the end of
September to give a net cash outflow of 2,000.
The money weighted return can be seen to be:
110,000 – 100,000 + 2,000

MWR = __________________________________
[ _9___
100,000 + (5,000 × _12 _3___
) + (–7,000 × _12 ])
So, on the top line 2,000 has been deducted as there has been a net cash outflow and on the bottom
line, the cash injection is included for the nine months it was held and a proportion of the cash outflow
7
of 7,000 is subtracted as it was lost for the final three months of the year.
So, the money weighted return equals:
110,000 – 100,000 + 2,000 12,000

_______________________ = ________ = 0.11765 multiplied by 100 =11.77%
100,000 + 3,750 – 1,750 = 102,000
4.1.3 Time Weighted Rate of Return (TWRR)

The time weighted rate of return (TWRR) removes the impact of cash flows on the rate of return
calculation.
The TWRR is established by breaking the investment period into a series of sub-periods. A sub-period is
created whenever there is a movement of capital into or out of the fund. Immediately prior to this point,
a portfolio valuation must be obtained to ensure that the rate of return is not distorted by the size and
timing of the cash flow.
The TWRR is calculated by compounding the rate of return for each of these individual sub-periods,
applying an equal weight to each sub-period in the process. This is known as unitised fund performance.
TWRR Formula
The formula for TWRR is:
TWWR = {(1 + RSP1 )(1 + RSP2 ) … … (1 + RSPn)} – 1
where SPn equals the percentage return during a sub-period.
351
This can be seen in the following example.
Example
A portfolio is valued at 1,000 at the beginning of October and grows in value to 1,100 by 15 October. It
receives a cash inflow of 215 on 16 October and at 31 October is valued at 1,500.
Using TWRR, a percentage return is calculated for each separate period as follows:
(1,100 –1,000)
Sub – period 1: r = ______________ = 0.1 = 10%
1,000
The returns for each sub-period are then linked to produce the TWRR.
4.1.4 MWRR versus TWRR

The primary difference between these two calculation methods is that MWRR assumes that exactly the
same rate of return is earned during each sub-period, whilst TWRR on the other hand considers the
number of days invested when each potentially different sub-period return is calculated.
MWRR versus TWRR
MWRR TWRR
It is unaffected by external cash flow activity
It is appropriate where the and so correctly reflects the return that an
investment manager has control investor would have received if they invested
over the timing and size of cash at the start of the period.
Advantages
inflows and outflows. Most investment managers have little control
It only requires a valuation at the over the size and timings of cash flows and so
start and end of the period. using a rate of return that is not influenced by
them is more appropriate.
It can be distorted by the size and
Valuations are required on every day when
timing of external cash flows.
an external cash flow takes place meaning
If a manager has little or no
Disadvantages practically that daily valuations are required.
control over cash flows it is not
Daily valuations are administratively more
a suitable measure to evaluate
expensive and prone to errors.
portfolio performance.
In many cases, the differences between the MWRR and the TWRR will be relatively small but in certain
circumstances wide variations can occur. For example, the MWRR will change dramatically if a large cash
flow is received or paid near the beginning as opposed to near the end of the measurement period, whilst
the TWRR rectifies this by defining periods according to cash flows.
As a result, the TWRR is more widely used. The Global Investment Performance Standards (GIPs), require
the use of a TWRR to calculate returns.
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4.2 Performance Attribution
Learning Objective
7.4.2 Analyse portfolio performance in terms of: absolute and relative risk and return:
risk-reward ratios; contributions to return arising from asset allocation, currency movements,
stock selection and timing; effectiveness of hedging decisions
Investors will want to assess the returns achieved by a fund manager to determine which elements of
the strategy were responsible for results and why.
Performance attribution is a set of techniques that analysts use to explain why a portfolio’s performance
differed from the benchmark. This difference between the portfolio return and the benchmark return is
known as the active return.
4.2.1 Analysing Performance
7
The process is known as performance attribution and attributes the performance to:
• asset allocation;
• sector choice;
• security selection.
This can be best seen by looking at an example.
Example – Step 1
The first stage in the process is to determine the performance of the fund and of its external benchmarks.
We will assume that the investment fund we are analysing had a fund value of $10 million at the start of
the period we are considering and was valued at $10.5 million at the end.
The benchmark used for the fund assumed an asset allocation of 50% in equities and 50% in bonds. Over
the period equities produced a negative return of 10% and bonds a positive return of 5%.
The asset allocation of the fund, however, was 80% in bonds and 20% in equities.
Following this, the next step is to use the fund and benchmark statistics above to determine the absolute
outperformance or underperformance of the fund so that it can be compared to that of the benchmark.
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Example – Step 2
Fund Performance
For simplicity, we will assume that there were no cash inflows or outflows during the period. The
absolute performance of the fund can be calculated, therefore, by using the holding period return
formula to assess the absolute performance of the fund.
The holding period return formula is:
EMV – BMV
RTR = ___________
BMV
So, the absolute performance of the fund is:
$10.5m – $10m $0.5m

RTR = _______________ = ______ = 5%
250,000 $10m
Next, the benchmark performance can be calculated.
Example – Step 3
Benchmark Performance
The benchmark used for the fund assumed an asset allocation of 50% in equities and 50% in bonds.
Over the period equities produced a negative return of 10% and bonds a positive return of 5%. The
benchmark performance is therefore:
Value at Start of Value at End

Asset Allocation Return
the Period of the Period
Equities 50% $5m –10% $4.5m
Bonds 50% $5m +5% $5.25m
Total $10m $9.75m
The weighted average returns from the benchmarks are therefore:
R = (–10% * 0.5) + (5% * 0.5) = –2.5%
The next step is to calculate the absolute outperformance or underperformance of the fund relative to
the benchmark that is attributable to asset allocation.
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Example – Step 4
Performance Attributable to Asset Allocation

The performance that is attributable to asset allocation can therefore be seen to be:
Value at Start of Value at End

Asset Allocation Return
the Period of the Period
Equities 20% $2m –10% $1.8m
Bonds 80% $8m +5% $8.4m
Total $10m $10.2m
The fund has, therefore, outperformed the benchmark by $475k.
From this example, we can observe that the fund has delivered a positive return of 2% which exceeds
the returns available from adopting a purely passive approach of having a 50:50 allocation to the two
benchmarks.
7
The active approach taken by the investment manager has enabled them to outperform the benchmarks
by 4.5% as a result of the asset allocation decision.
Finally, the returns can be decomposed further by looking at the impact of stock selection. To determine
a portfolio manager’s stock selection skill, you need to subtract the fund value resulting from asset
allocation from the actual fund value at the end of the period.
Example – Step 5
Performance Attributable to Stock Selection

The fund value at the end of the period is $10.5m whilst the fund value attributable to asset allocation is
$10.2m. The outperformance attributable to stock selection is therefore $300k.
To decompose this further, we will need a breakdown of the fund’s value at the end of the period.
Let’s assume that the equities were valued at $1.8m and the bonds at $8.7m. The performance that is
attributable to stock selection can therefore seen to be:
Value at Start of End Value – Asset Value at End

Value Added
the Period Allocation of the Period
Equities $2m $1.8m $1.8m $0
Bonds $8m $8.4m $8.7m $300k
Total $10m $10.2m $10.5m $300k
Good stock selection within the bond segment of the portfolio has therefore added $300k to the fund’s
performance.
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4.2.2 Risk-Adjusted Returns
Risk adjusted returns refine the investment returns that we have seen so far by measuring how much
risk is involved in generating that return.
Sharpe Ratio
The Sharpe ratio measures the return over and above the risk-free interest rate from an undiversified
equity portfolio for each unit of risk assumed by the portfolio: risk being measured by the standard
deviation of the portfolio’s returns.
The ratio is expressed as follows.

RA – RF
Sharpe ratio = ______
σA
Where:
RA = average return on the account.
R F = average risk-free return.
𝝈A = standard deviation of account returns.
The higher the Sharpe ratio, the better the risk-adjusted performance of the portfolio and the greater
the implied level of active management skill. The Sharpe ratio provides an objective measure of the
relative performance of two similarly undiversified portfolios.
The ratio was first proposed by the Nobel Laureate, William F. Sharpe who is emeritus professor of
finance at Stanford University. The assumption behind the calculation, and the reason why the standard
deviation is used as the denominator to the equation, is that, since investors prefer a smooth ride to a
bumpy one, the higher the standard deviation, the lower the Sharpe ratio. Accordingly, high Sharpe
ratios are to be preferred and positive values are obviously better than negative values.
Treynor Ratio
The Treynor ratio is a measurement of the returns earned in excess of that which could have been
earned on a riskless investment such as a Treasury bill.
The Treynor ratio is sometimes called reward-to-volatility ratio, as it relates the excess return over
the risk-free rate to the additional risk taken as measured by the beta of the fund or portfolio. As the
portfolio’s return will have been generated only by the systematic risk it assumed, the Treynor ratio,
therefore, divides the portfolio’s return over and above the risk free interest rate by its CAPM beta.

RA – RF
Treynor ratio = ______
βA
Where:
R F = average risk free return.
𝜷A = standard deviation of account returns (the portfolio’s beta).
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The Treynor ratio takes a similar approach to the Sharpe ratio but is calculated for a well-diversified
equity portfolio and is used to compare performance with other portfolios.
Once again, the higher the ratio, the greater the implied level of active management skill.
Jensen Measure
The Jensen measure of risk-adjusted equity portfolio returns is employed to evaluate the performance
of a well-diversified portfolio against a CAPM benchmark with the same level of systematic risk as that
assumed by the portfolio.
Jensen measure = RA – {RF + βA * (RM – RF)}
Where:
R F = average risk-free return.
β A = standard deviation of account returns (the portfolio’s beta).
7
RM = average market return.
It can also be more simply expressed as Return on the Portfolio – Return predicted by CAPM.
The extent of any outperformance or underperformance is known as Jensen’s alpha.
The Jensen measure establishes whether the portfolio has performed in line with its CAPM benchmark
and, therefore, lies on the SML or whether it has outperformed or underperformed the benchmark and
is, therefore, positioned above or below the SML.
• A portfolio that generates a positive alpha will plot above the SML.
• A portfolio that generates a zero alpha will plot on the SML.
• A portfolio that generates a negative alpha will plot below the SML.
Information Ratio
The information ratio is often used to gauge the skill of a fund manager, as it measures the expected
active return of the manager’s portfolio divided by the amount of risk that the manager takes relative to
the benchmark.
So, the information ratio compares the excess return achieved by a fund over a benchmark portfolio to
the fund’s tracking error.
Its tracking error is calculated as the standard deviation of excess returns from the benchmark. The
tracking error gives us an estimate of the risks that the fund manager takes in deviating from the
benchmark.
357
RA – RB Expected value of excess returns

Information ratio = ______ or = _________________________________
𝝈A Standard deviation of excess returns
Where:
R B = benchmark return.
𝝈A-B = s tandard deviation of excess returns as measured by the difference between account and
benchmark returns.
A fund’s performance may deviate from the benchmark due to the investment manager’s decisions
concerning asset weighting. If the fund outperforms, the ratio will be positive and if it underperforms it
will be negative. A high information ratio is, therefore, a sign of a successful fund manager.
358
1. How does a benchmark-driven return objective differ from a best-efforts basis?

2. If an investment fund has an average return of 5% and a standard deviation of 2.5%, what range of
returns would you expect assuming returns are normally distributed?
3. If the covariance between two numbers is 18 and their standard deviations are four and nine. What is
their correlation?
4. Why is the optimal risk portfolio usually determined to be somewhere in the middle of the efficient
portfolio curve?
5. If a stock has a beta of 0.8, what does this imply for its volatility?
7
6. If the exchange rate between one country and a main trading partner strengthens or weakens, how
will this affect the balance of payments?
7. Why do dividend payments contribute to tracking error?
8. What type of investment management technique is immunisation?
9. A portfolio was valued at £100,000 at the beginning of the year and at the end was valued at
£103,500. If income was received in addition of £2,000, what was the total return?
10. Performance attribution breaks down the performance of a portfolio and attributes it to what factors?
359
360
Glossary & Abbreviations
362
Glossary
A glossary is provided below that provides an The risk arising from active management in excess
explanation of many of the terms used in this of the risk that would be incurred if the portfolio
learning manual, along with a number of others was passively managed (ie, the weighting
that may be needed for reference purposes. For differential versus the benchmark/index).
more expansive definitions, you should refer to
the workbook and your own further reading and Actuary
research. A professional skilled in evaluating and assessing
the potential impact of risks. Actuaries monitor and
Account advise on the solvency of life assurance companies
The individual account for a single client, or a and pension funds.
group of clients whose assets are held in a single
nominee account. Added Value
Performance in excess of a stated benchmark or
Accounting Reference Date index (see Alpha).
The closing date for a fund’s annual accounting
period. This date must be stated in the fund’s Additional Voluntary Contributions (AVCs)
prospectus (or scheme particulars). Employee contributions over and above any
compulsory contributions to a tax-approved
Accrued Income occupational pension scheme. Tax law often limits
Interest that has been earned but not yet paid. the total value of contributions that can be made.
Accumulation Shares/Units Agency Broker

A broker who is paid commission to secure the
Shares or units in a portfolio that automatically
best possible trade for his clients.
have income reinvested.
Aggregate Demand
Active Management
The total demand for goods and services within an
An investment approach employed to exploit economy.
pricing anomalies in those securities markets that
are believed to be subject to mispricing by utilising Aggregate Supply
fundamental and/or technical analysis to assist in The amount of output firms are prepared to supply
the forecasting of future events and the timing of in aggregate at each general price level in an
purchases and sales of securities. Also known as economy, assuming the price of inputs to the
Market Timing. production process are fixed, in order to meet
Active fund managers believe securities are mis- aggregate demand.
priced and can spot opportunities to outperform
the market through asset allocation and/or stock All Share Index
selection. See also Index Tracking and Passive
Properly the FTSE-All Share Index that summarises
Management.
the state of the UK equity markets. It covers some
900 of the major UK industrial, commercial and
Active Risk
financial companies.
The risk that arises from holding securities in an
actively managed portfolio in different proportions Allotment letter
from their weighting in a benchmark index. Also
Written confirmation from an issuing company to
known as Tracking Error.
the subscriber of the allotment of new shares.
363
Alpha Annuity
The return from a security or a portfolio in excess An investment that provides a series of pre-specified
of a risk-adjusted benchmark return. Also known periodic payments over a specific term or until the
as Jensen’s Alpha. occurrence of a pre-specified event, eg, death.
The out-performance of a portfolio against the A fixed annual allowance. Normally paid in the
benchmark attributable to the manager’s strategy. form of a pension.
Alternative Investment Market (AIM) Arbitrage

The London Stock Exchange’s (LSE) market for The process of deriving a risk-free profit by
smaller UK public limited companies (PLCs). AIM has simultaneously buying and selling the same asset in
less demanding admission requirements and places two related markets where a pricing anomaly exists.
less onerous continuing obligation requirements
upon those companies admitted to the market than Arbitrage Pricing Theory (APT)
those applying for a full list on the LSE. Complex mathematical theory suggesting there
are several factors that determine the rate of
Alternative Investments return on a security rather than just the movement
Investments outside the mainstream areas of of the overall market. The expected risk premium
bonds, equities, cash and property. They normally for each factor will be determined by the security’s
form a small proportion of portfolios. Examples are sensitivity to it.
hedge funds, venture capital, art and wine.
Arithmetic Mean
American Depository Receipt (ADR) A measure of central tendency established
An ADR represents a share, or a defined number of by summing the observed values in a data
shares, of a non-US company. A depository bank distribution and dividing this sum by the number
holds the shares and issues the depositary receipt. of observations. The arithmetic mean takes
ADRs may be listed in the US, UK and Luxembourg. account of every value in the distribution.
Amortisation Articles of Association

The depreciation charge applied in company The legal document which sets out the internal
accounts against capitalised intangible assets. constitution of a company. Included within the
Articles will be details of shareholder voting rights
Annual Equivalent Rate (AER) and company borrowing powers.
See Effective Rate.
Asset Allocation
Annual General Meeting (AGM) The distribution of investments across categories
The annual meeting of directors and ordinary of assets, such as equities, bonds and cash. Active
shareholders of a company. All companies are managers will change asset allocation to improve
obliged to hold an AGM at which the shareholders funds performance based on their forecast returns
receive the company’s report and accounts and have for each asset class.
the opportunity to vote on the appointment of the
company’s directors and auditors and the payment Asset-class
of a final dividend recommended by the directors. Category of assets, eg, equities, bonds, property
or cash.
Annual Management Charge
A charge imposed by the management firm on the Asset-Backed Securities (ABSs)
portfolio. For unit trusts and OEICs this is usually (ABSs) Same as Debentures. Bonds or notes backed
1-1.5 per cent of the NAV of the fund. Other clients by specific company assets. Similar to a mortgage.
negotiate the fee with the fund manager.
364
Association of Investment Companies (AIC) Bank of England

The trade association for closed-ended investment The UK’s central bank. Implements economic
trusts. policy decided by the Treasury and determines
interest rates.
At Best
An instruction to deal at the best price ruling in the Bargain
market at the time, ie, the highest price (selling) or Another name for a trade or transaction on the
lowest (buying). Stock Exchange.
At-The-Money Base Currency

When the market price of the underlying This is the first currency quoted in a currency pair
instrument is the same as the exercise price of the on the FX markets. Eg, if you are looking at a USD/
option/warrant. JPY quote then the base currency is the dollar.
Auction Base Rate

The normal process of selling government The minimum rate at which banks will lend money
securities. The Central Bank accepts bids down to to individuals. In the UK, this is set each month by
the lowest acceptable price (ie, highest yield). the Monetary Policy Committee (MPC) at the
Bank of England.
Authorisation
Required status for firms that want to provide Basis
financial services. The difference between the futures price and the
price of the underlying asset.
Authorised Corporate Director (ACD)
Fund manager for an Open-Ended Investment Basis Point (bp)
Company (OEIC). One hundredth of one percent, ie, there are one
hundred bp per 1%. Example 25bp = 0.25%.
Authorised Funds
Funds authorised by the UK regulator that can be Basis Point Value (BPV)
freely marketed to the public in the EU. The profit/loss on a fixed income portfolio from a
single basis point (BP) shift (up/down) in the yield
Backwardation curve. Directly related to the volatility (duration) of
This is when a future price is below the cash price. the portfolio.
It is a negative contango (common in commodity
markets but anomalous in financial futures). It is Bear
also used to refer to the anomalous situation when Someone who believes prices will fall in the future.
the best bid price for share is temporarily above (See Bull).
the best offer price.
Bear Market
Balance of Payments A decline in a securities market. The duration of
A summary of all the transactions between a the market move is less relevant.
country and the rest of the world. The difference
between a country’s imports and exports. Bearer Securities
Those whose ownership is evidenced by the
Balanced Funds mere possession of a certificate. Ownership can,
Funds invested in a range of asset classes (eg, therefore, pass from hand to hand without any
bonds, equities, cash and property) under the formalities. Although notionally no registration
discretion of the portfolio manager. of ownership, these are usually held electronically
365
in modern markets and physical paper does not Bond
transfer between buyer and seller. Security issued by a corporate or government, to
back borrowing. The issuer guarantees to repay
Benchmark the principal sum on redemption date plus interest
Target against which investment performance (coupons) during the life of the bond. Bonds may
is measured. It may be an index or the average be secured over assets of the firm, or unsecured.
performance of similar portfolios.
Bonus Issue
Beneficial Owner The free issue of new ordinary shares to a
The true owner of a security, regardless of the company’s ordinary shareholders in proportion
name in which it is registered. to their existing shareholdings through the
conversion, or capitalisation, of the company’s
Beneficiaries reserves. By proportionately reducing the market
The beneficial owners of trust property. value of each existing share, a bonus issue makes
the shares more marketable. Also known as a
Best Execution
Capitalisation Issue or Scrip Issue.
Secure the best possible deal, taking into account
all market conditions at the time of the transaction. Book Entry
Electronic settlement and record of ownership of
Beta
a security.
The covariance between the returns from a
security and those of the market relative to the Book Value
variance of returns from the market. A security Value at which a security is recorded on a balance
with a Beta of 1 would be expected to move in line sheet. Usually the purchase cost, less any depreciation.
with the index. Higher Beta stocks (or portfolios)
are expected to outperform in rising markets and Bottom Up
underperform falling markets. Lower Beta stocks Approach to investment management that gives
(or portfolios) are defensive. priority to stock selection rather than asset classes.
Bottom up managers rely on identifying and
Bid Price selecting securities to build an optimum portfolio.
The price at which securities (or units in collective
investment funds) are repurchased from the Bourse/Bolsa
investor. Stock exchange of European (or Latin American)
markets.
Bid-Offer Spread
Difference between the Bid (selling) and Offer Box
(buying) price. The stock of shares/units in a collective investment
scheme that are held by the manager acting as
Bloomberg principal.
Company that provides market and investment
information including real-time share prices. Broker Dealer
A stock exchange member firm that can act in a
Blue Chip Company dual capacity both as a broker acting on behalf of
Informal term for a large, well-known company clients and as a dealer dealing in securities on their
with long-standing history of profit growth, strong own account.
branding and consistent dividend payouts.
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Bull Capital Markets

Someone who believes prices will rise in the future The financial market for equity instruments and debt
(see Bear). instruments with a maturity greater than one year.
Bull Market Capitalisation

A rising securities market. The duration of the Total market value of share capital issued by a
market move is immaterial. company. Calculated by multiplying the number
of ordinary shares in free float by the price.
Business Cycle
See Economic Cycle. Capitalisation Issue
See Bonus Issue.
CAC 40
Index of the prices of major French company Cash Call
shares. A request for cash to be paid on partly paid
securities.
Call Option
An option that confers a right on the holder to buy Cash Memorandum Account
a specified amount of an asset at a pre-specified A record of a CREST member’s running total of a
price on or sometimes before a pre-specified date. day’s payment obligations to or from its payment
bank. CMAs are set to zero at the start of each day
Cancellation because at the end of each day net payments are
Units in open-ended funds are destroyed as cash is settled between payment banks.
taken out of the fund (Redemption).
Central Bank
Cancellation Rights Those public institutions that operate at the
Private customers may have the right to cancel the heart of a nation’s financial system. Central banks
purchase of an investment product and have their typically have responsibility for setting a nation’s
money returned by the firm. or a region’s short-term interest rate, controlling
the money supply, acting as banker and lender of
Capital last resort to the banking system and managing
The money injected into a business by the the national debt. They increasingly implement
shareholders and bondholders. their policies independently of government
control.
Capital Account
An account relating to the capital property of a Central Securities Depository (CSD)
portfolio (ie, excluding income). CSDs immobilise or dematerialise securities. CSDs
may also clear and settle trades and offer safe
Capital Asset Pricing Model (CAPM)
custody (eg, Euroclear and Clearstream). CREST
An economic model for valuing securities. It is
offers CSD facilities, settling trades in UK and
a mathematical model that enables investors to
overseas securities.
determine the expected return from a risky security.
The model uses Beta as the main measure of risk Certificated
Ownership designated by certificate.
Capital Gains Tax (CGT)
Tax payable by individuals on profit made on the Certificates of Deposit (CD)
disposal of certain assets. Certificates issued by a bank as evidence that
interest-bearing funds have been deposited with
it. CDs are traded within the money market.
367
Ceteris Paribus Clearstream (Cedel)
Other things being equal. In economics, the Clearstream was formed from the merger of Cedel
ceteris paribus caveat is used when considering and Deutsche Börse Clearing. Clearstream is an
the impact of a change in one factor or variable International Securities Depository (ISD).
on another variable, market or the economy as a
whole, holding all other factors constant. Closed-Ended
Organisations such as companies which are a fixed
Chargeable Accounting Period (CAP) size as determined by their share capital. Commonly
Usually the same period of time as a company’s used to distinguish investments trusts (closed-
accounting year. A company calculates its profits for ended) from unit trusts and OEICs (open-ended).
its CAP and then pays corporation tax on them. Large
companies (those paying the full rate of corporation Closing Out
tax) pay tax in four quarterly instalments. Companies The process of terminating an open position in a
that are not large, make one corporation tax payment derivatives contract by entering into an equal and
within nine months and one day following the end opposite transaction to that originally undertaken.
of the accounting period.
Collar (or Cylinder or Tunnel or Fence or Corridor)
Chartist The sale of a put (or call) option and purchase of a
Individual who studies charts of movements in call (or put) at different strikes – typically both out-
financial and economic indicators to predict how of-the-money and the purchase of a cap combined
security prices will move. with a sale of a floor.
Chinese Wall Collateral

Separation of different activities in an investment A form of security, guarantee or indemnity
bank, eg, investment management, corporate provided by way of security for the discharge of
finance and broking. Aims to prevent confidential any liability arising from a transaction.
information passing from one area to another.
Collateral Debt Obligations (CDOs)
Chop Stocks Sophisticated financial tools that repackage
Stocks purchased for pennies and sold for pound individual loans into a product that can be sold
or dollars values providing both brokers and stock on the secondary market. These packages consist
promoters massive profits. of auto loans, credit card debt, or corporate
debt. They are called collateralised because they
Class have some type of collateral behind them. A
Shares in a company/portfolio that have the same collateralised loan obligation (CLO) is an asset-
voting and dividend rights. backed security that is created by securitising
loans, usually commercial loans made by a bank.
Clean Price
The quoted price of a bond. The clean price Combinations
excludes accrued interest or interest to be A strategy requiring the simultaneous purchase or
deducted, as appropriate. sale of both a call and a put option on the same
underlying asset, sometimes with different exercise
Clearing prices but always with the same expiry dates.
Confirmation of trade details with the counterparty Combinations include straddles and strangles.
or the exchange.
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Combined Actuarial Performance Services (CAPS) Consultants

Independent performance measurement service Actuarial and insurance firms that advise trustees
widely used by pooled funds to compare the eg, choosing investment managers, meeting
performance of the portfolio manager. managers, asset allocation strategies.
Commercial Paper (CP) Consumer Prices Index (CPI)

Unsecured bearer securities issued at a discount to Measure of inflation used in many economies.
par by public limited companies with a full stock
exchange listing. Commercial paper does not pay Contango
coupons but is redeemed at par. When the futures price stands at a premium to the
price of the underlying asset.
Commission
Fee paid to a broker for buying or selling a security. Contingent Liability
Usually a percentage of the cost. Investors also pay Future possible losses, which cannot yet be
commission to IFAs. quantified.
Commodity Continuous Data

Items including sugar, wheat, oil and copper. Where numbers in a data series can assume any
Derivatives of commodities are traded on value.
exchanges (eg, oil futures on ICE Futures Europe).
Contract
Complement A standard unit of trading in derivatives.
A good is a complement for another if a rise in
the price of one results in a decrease in demand Contract for Difference (CFD)
for the other. Complementary goods are typically A contract designed to make a profit or avoid a
purchased in conjunction with one another. loss by reference to movements in the price of an
item. The underlying item cannot change hands.
Concentration
The number of different shareholdings in a Contract Note
portfolio. The fewer the securities held, the more A document sent to the investor on a purchase or
concentrated the portfolio is said to be. sale being made, detailing the price at which the
securities were bought or sold.
Concert Party
Investors buying securities in agreement between Contractual Settlement Date Accounting (CSDA)
themselves to suit some wider purpose (eg, to Investor receives cash on the standard settlement
evade disclosure rules in a takeover). date, irrespective of settlement of the securities
themselves.
Consideration
The monetary value of a deal excluding Convertible Bonds
commissions, stamp duty and VAT. Total Bonds issued with a right to convert into either
consideration will include the above. another of the issuer’s bonds or, if issued by a
company, the company’s equity, both on pre-
Constraints specified terms.
Limits or restrictions imposed on a portfolio
manager in relation to stocks, sectors or markets. Convertible Preference Shares
Preference shares issued with a right to convert into
the issuing company’s equity on pre-specified terms.
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Convexity Covered Warrants
The non-symmetrical relationship that exists A type of option issued by a third party, usually
between a bond’s price and its yield. The more a major securities house. Those issued on single
convex the bond, the greater the price rise for a stocks and share indices can be traded on the
fall in its yield and the smaller the price fall for a London Stock Exchange trading service. Covered
rise in its yield. Also see Modified Duration. warrants may be issued on baskets of shares,
debt securities, currencies, metals, and oil. They
Core/Satellite Portfolio are called covered, as the writer of the warrant (an
The partitioning of assets between a core portfolio investment bank) will often cover or hedge their
(lower risk/tracking funds) and more actively exposure under the covered warrant by buying
managed satellite funds. the underlying stock or taking out futures or
options on the derivatives exchange.
Corporate Actions
Actions involving issued securities other than Creation
trading. The decision may come from the issuer New units in open-ended funds are made to
(eg, distribution, redemption) or the holder (eg, accommodate cash inflows.
conversion or exercise of warrants).
Credit Creation
Corporate Bond Expansion of loans, which increases the money
Securities issued by a company (as opposed supply.
to government). Investors accept credit risk in
exchange for potentially greater returns. Credit Rating
Rating given to a company or institution by a
Corporate Governance credit-rating agency as an indication of the
The mechanism that seeks to ensure that likelihood of default on its bonds or other debt.
companies are run in the best long-term interests The highest (lowest risk) rating is AAA (triple A).
of their shareholders.
Credit Spread
Correlation Difference on the yield of a corporate bonds
The degree of co-movement between two compared with a government bonds of a similar
variables determined through regression analysis maturity. Credit spreads are higher for companies
and quantified by the correlation coefficient. with lower credit ratings to compensate investors
Correlation does not prove that a cause-and- for the higher risk.
effect or, indeed, a steady relationship, exists
between two variables, as correlations can arise CREST
from pure chance. Electronic settlement system used to settle
transactions for UK shares operated by Euroclear
Coupon UK and Ireland Ltd.
The predetermined rate of interest applying to a
bond over its term expressed as a percentage of Cross Elasticity of Demand (XED)
the bond’s nominal, or par, value. The coupon is The effect of a small percentage change in the
usually a fixed rate of interest. price of a complement or substitute good on a
complement or substitute.
Covariance
The correlation coefficient between two variables Currency Hedging/Currency Overlay
multiplied by their individual standard deviations. Reduction or elimination of exchange-rate risk
using futures, forwards or options.
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Currency Swap Defined Contribution (DC) Pension Scheme

An agreement whereby two counterparties agree Money purchase. Pension that depends on the
to swap interest and principal in two different contributions made and the investment return. UK
currencies. Personal pensions and US 401(k) programmes are
DC schemes.
Custody
Safe keeping of client assets. Firms are required Delivery versus Payment (DVP)
to be able to identify client assets separately This is the ideal method of settlement whereby
from firm’s assets. The firm may use nominee cash and securities are switched simultaneously
accounts to pool securities of different clients. A between client accounts, reducing settlement risk.
global custodian is responsible for this operation
on a worldwide basis. They may appoint local Demand Curve
custodians (depots or sub-custodians) in certain The depiction of the quantity of a particular good
countries. or service consumers will buy at a given price.
Plotted against price on the vertical axis and
Cyclical Stock quantity on the horizontal axis, a demand curve
Security that is sensitive to fluctuations in the slopes downwards from left to right.
economic or business cycle (eg, capital goods,
banks). Dematerialised (Form)
System where securities are held electronically
Dark Liquidity or Dark Pools of Liquidity without certificates.
By definition cannot be seen by any potential
market participant and its existence can only be Denomination
imputed ex post facto. Dark liquidity is generally The size in units of a currency of a security.
used to try to reduce market impact when trading
large orders. Depositary
Bank acting as custodian of the securities held by
Deadweight Loss the sub-funds of an OEIC.
A measure of the inefficient allocation of resources
that results from a monopoly restricting output Depository Trust Clearing Corporation (DTCC)
and raising price to maximise profit. US clearing and settlement organisation. Also acts
as custodian.
Debenture
A corporate bond issued in the domestic bond Depreciation
market and secured on the issuing company’s The charge applied in a company’s accounts
assets by way of a fixed or a floating charge. against its tangible fixed assets to reflect the
usage of these assets over the accounting period.
Debt/Equity Ratio
The ratio of long-term debt to equity in a company. Derivative
See also gearing. An instrument whose value is based on the price
of an underlying asset. Derivatives can be based
Defensive Stock on both financial and commodity assets.
Security that is less sensitive to movements in the
economic or business cycle, eg, utilities, tobacco. Devaluation
Fall in value of a currency in the global markets.
Defined Benefit (DB) Pension Scheme
Final salary pension where the pension paid is a
percentage of the employee’s final salary.
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Dilution Dividend
Effect on earnings per share (EPS) and book The distribution of a proportion of a company’s
value per share if all the convertible securities are distributable profit to its shareholders. UK
converted and all warrants and stock options were dividends are usually paid twice a year and are
exercised. Also the impact on a pooled fund of expressed in pence per share.
transaction costs due to investors’ buying/selling.
Dividend Cover
Dilution Levy
Company’s total earnings (profits) divided by the
Charge imposed on a large purchase or sale of
total paid in dividends. Used as an indication of the
units in an open-ended collective investment fund
company’s ability to maintain its dividend payout.
(eg, OEIC, SICAV etc).
Dividend Yield
Dirty Price
Most recent dividend as a percentage of current
The price paid for a fixed-income stock, including
share price.
accrued interest.
Domicile
Discount
A taxpayer only has one domicile. This is the
The difference in the spot and forward exchange
country s/he regards as the natural home. This is
rate that arises when interest rates in the quoted
not necessarily the same as residence or nationality.
currency are higher than those in the base currency.
Double Taxation Treaty
Discount Broker
An agreement between two countries allowing tax
Firm that charges low commission rates for
paid in one country to be offset against that due in
execution-only business.
the other on the same income.
Discount Rate
Dow Jones
The rate of interest used to establish the present
Major share index in the US, based on the share
value of a sum of money receivable in the future.
prices of 30 leading American companies.
Discounted Cash Flow (DCF) Yield
Dual Pricing
See Internal Rate of Return (IRR).
System in which a unit trust manager quotes two
prices at which investors can sell and buy.
Discrete Data
Where numbers in a data series are restricted to
Duration
specific values.
The weighted average time, expressed in years,
for the present value of a bond’s cash flows to be
Discretionary
received. Also known as Macaulay Duration.
The client delegates decision-making to a third
party, eg, discretionary portfolio management or
Earnings
discretionary stock lending (undertaken by the
Net profits of a company.
global custodian).
Earnings per Share (EPS)
Distribution Dates
The net (after tax) profits of a company divided by
The date when interest or dividends are distributed
the number of ordinary shares in issue. This is used
to investors. Also called Payment Date.
as the ‘E’ term in the P/E ratio to value shares.
Diversification
Earnings Yield
Investment strategy of spreading risk by investing
Company’s EPS divided by its current share price.
in a range of investments with uncorrelated returns.
The inverse of the P/E ratio.
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Earnings Before Interest, Tax, Depreciation and independently of past trends, in response to fresh
Amortisation (EBITDA) information, which itself is released at random.
Earnings (ie, profits) before Interest, Tax,
Depreciation and Amortisation. A measure of Electronic Communications Network (ECN)
the cash generating ability of a company. An alternative trading facility for shares.
Economic Cycle Eligible markets

The course an economy conventionally takes Markets in which an authorised fund is permitted
as economic growth fluctuates over time. Also to invest without limits. There is a 10 per cent cap
known as the Business Cycle. on investments in non-eligible markets.
Economic Growth Emerging Market

The growth of Gross Domestic Product (GDP) or A developing or newly industrialised country.
Gross National Product (GNP) expressed in real Low GDP per head. Can deliver high returns due
terms, usually over the course of a calendar year. to rapid pace of industrialisation, but can be risky
Often used as a barometer of an economy’s health. due to poor legal protection, currency, custody &
settlement risk, government corruption.
Economic Indicator
Statistic that gives an indication of current Endowment Policy
point of the economic cycle eg price inflation, A life assurance policy that pays out a sum assured
unemployment figures, wage rises. on the death of the life assured, or at the end of an
agreed term, whichever is the earlier. The money
Economies of Scale is traditionally invested in a range of securities,
The resulting reduction in a firm’s unit costs as the including equities. A traditional with-profits policy
firm’s productive capacity and output increases. may provide a higher payout by the addition of
Economies of scale are maximised and unit costs bonuses.
minimised at the minimum efficient scale (MES) on
a firm’s long-term average total cost (LTATC) curve. Enterprise Value (EV)
Beyond this point, diseconomies of scale set in. Value of a company’s total share and debt capital.
Effective Rate Equalisation

The annualised compound rate of interest applied The amount of distribution from a collective
to a cash deposit. Also known as the Annual investment scheme that represents the return of
Equivalent Rate (AER). initial capital to new investors.
Efficient Frontier Equilibrium

A convex curve used in modern portfolio theory that A condition that describes a market in perfect
represents those efficient portfolios that offer the balance, where demand is equal to supply.
maximum expected return for any given level of risk.
Equities
Efficient Markets Hypothesis (EMH) Ordinary shares, ie, the risk-taking part of a
The proposition that everything that is publicly company’s capital. Equity holders rank last in the
known about a particular stock or market should event of the winding-up of a company and for
be instantaneously reflected in its price. As a income distribution.
result of active portfolio managers and other
investment professionals exhaustively researching Equity Risk Premium
those securities traded in developed markets, the The extra return expected from investing in
EMH argues that share prices move randomly and equities rather than a risk less asset.
373
ETFs Ex-Dividend (XD)
ETFs are exchange-traded open-ended funds that The period during which the purchase of shares or
track an index. They are bought and sold on bonds (on which a dividend or coupon payment
a stock market throughout the day and settle has been declared) does not entitle the new
in dematerialised form. US ETFs include SPDRs, holder to this next dividend or interest payment.
Webs, Diamonds, Cubes and Opals.
Execution-Only
Ethical Investment Instructions to buy or sell, given directly to a
Strategy to invest only in companies that make broker or fund manager without receiving any
a positive contribution to an ethical issue (or advice.
avoid a negative contribution). Examples include
tobacco stocks, armaments manufacturers, alcohol Exempt Fund
producers, gaming companies. A fund that is exempt from tax. Investment is
restricted to non-taxpayers (eg, pension funds).
Eurobond
International bond issues denominated in Exercise an Option
a currency different from that of the financial To take up the right to buy or sell the underlying
centre(s) in which they are issued. Most Eurobonds asset in an option.
are issued in bearer form through bank syndicates.
Exercise Price
Euroclear The price at which the right conferred by an
Euroclear is the alternative European settlement option can be exercised by the holder against the
house with Clearstream. Euroclear settles writer.
international bonds, Gilts and shares. It is an
International Central Securities Depository (ICSD). Exit Charges
Managers can levy a charge on sale of shares/units
Euronext in a fund, rather than an initial charge.
European stock exchange network formed by
the merger of the Paris, Brussels and Amsterdam Expectations Theory
exchanges. The proposition that the difference between short-
and long-term interest rates can be explained by
European Association of Securities Dealers the course short-term interest rates are expected
(EASDAQ) to take over time.
A pan-European stock market for emerging
growth companies. The rules and structure are Expiry
similar to NASDAQ. The date on which an option or warrant expires.
European Monetary Union (EMU) Ex-Rights (XR)

The creation of a single European currency, the The period during which the purchase of
euro, and the European Central Bank (ECB), which a company’s shares does not entitle the new
sets monetary policy across the eurozone. shareholder to participate in a rights issue
announced by the issuing company. Shares are
Exchange usually traded ex-rights (XR) on or within a few
Marketplace for trading investments. days of the company making the rights issue
announcement.
Exchange Rate
Rate at which one currency can be exchanged for Fair Value
another. The theoretical price of a futures contract.
374
Fallen Angel Flat Rate

A bond that has migrated from investment to non- The annual simple rate of interest applied to a cash
investment grade. It has increased credit (default) risk. deposit.
Federal Reserve Bank (Fed) Flat Yield

US Central Bank. Branches in main financial centres See Running Yield.
of the US. Fights inflation and controls markets
using interest rates and control of money supply. Flight to Quality
The movement of capital to a safe haven during
Fiduciary Duty periods of market turmoil to avoid capital loss.
An individual in whom another has placed the
utmost trust and confidence to manage and Floating Rate Notes (FRNs)
protect property or money. The relationship Debt securities issued with a coupon periodically
wherein one person has an obligation to act for referenced to a benchmark interest rate.
another’s benefit.
Floor
Financial Conduct Authority (FCA) A package of interest rate options whereby at
The UK regulator responsible for business conduct each of a series of future fixing dates, if agreed
of fund management, product selling, broker- reference such as LIBOR is lower than that of strike
dealer firms, banks, market abuse and investor rate, the option buyer receives the difference
compensation. between them, calculated on an agreed notional
principal amount for the period until the next
Financial Gearing fixing date. See Collar.
The ratio of debt to equity employed by a company
within its capital structure. Floor-Based Market
See open outcry.
Fiscal Policy
The use of government spending, taxation and Flotation
borrowing policies to either boost or restrain First issue of shares by a company on a stock
domestic demand in the economy so as to exchange. An example of an initial public
maintain full employment and price stability. Also offering (IPO).
known as Stabilisation Policy.
Forex or FX
Fixed-Income Securities Abbreviation for foreign exchange trading.
Bonds and preference shares. Holder receives a
regular fixed income. This may be waived in the Forward
case of preference shares. A derivatives contract that creates a legally binding
obligation between two parties for one to buy and
Fixed Interest Security the other to sell a pre-specified amount of an asset
A tradable negotiable instrument, issued by a at a pre-specified price on a pre-specified future
borrower for a fixed term, during which a regular date. As individually negotiated contracts, forwards
and predetermined fixed rate of interest based are not traded on a derivatives exchange.
upon a nominal value is paid to the holder until it
is redeemed and the principal is repaid. Forward Exchange Rate
An exchange rate set today, embodied in a
Fixed-Rate Borrowing forward contract, that will apply to a foreign
Borrowing where a set interest rate is paid. exchange transaction at some pre-specified point
in the future.
375
Forward Rate Fund
The implied annual compound rate of interest that Usually a single asset class over which several
links one spot rate to another assuming no interest investors have pooled ownership.
payments are made over the investment period.
Fund Manager
Franked Income Firm that invests money on behalf of its customers.
Income that has already had withholding tax
deducted at source. Higher-rate taxpayers may Fund of Funds
have a further liability. Non-taxpayers may be able A fund of funds is a multi-manager fund. It has one
to reclaim the deduction. overall manager that invests in a portfolio of other
existing investment funds and seeks to harness
Frequency Distribution the best investment manager talent available
Data either presented in tabulated form or within a diversified portfolio.
diagrammatically, whether in ascending or
descending order, where the observed frequency Fundamental Analysis
of occurrence is assigned to either individual The calculation and interpretation of yields, ratios
values or groups of values within the distribution. and discounted cash flows (DCFs) that seek to
establish the intrinsic value of a security or the
Front Office correct valuation of the broader market. The use
The investment management area of an investment of fundamental analysis is nullified by the semi-
institution. Includes portfolio managers, analysts, strong form of the efficient markets hypothesis
economists, strategists and risk management. (EMH).
FTSE 100 Fungibility

Main UK share index of 100 leading shares A good or asset’s interchangeability with other
(pronounced ‘Footsie’). individual goods/assets of the same type. Assets
possessing this property simplify the exchange/
FTSE 250 trade process, as interchangeability assumes that
UK share index based on the 250 shares everyone values all goods of that class as the same.
immediately below the top 100.
Future
FTSE 350 A derivatives contract that creates a legally
Index combining the FTSE 100 and FTSE 250 indices. binding obligation between two parties for one to
buy and the other to sell a pre-specified amount
FTSE All Share Index of an asset on a pre-specified future date at
Index comprising around 98% of UK listed shares a price agreed today. Futures contracts differ
by value. from forward contracts in that their contract
specification is standardised so that they may be
Full Listing
traded on a derivatives exchange.
Those public limited companies (PLCs) admitted
to the London Stock Exchange’s (LSE) official Future Value
list. Companies seeking a full listing on the LSE The accumulated value of a sum of money invested
must satisfy the UK Listing Authority’s (UKLA) today at a known rate of interest over a specific
stringent listing requirements and continuing term.
obligations once listed.
G30
Fully Paid A private sector group that sets objectives for
No further instalments are due on a new issue. efficient markets.
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Gaming Grey Market

Ability to guess both the existence of large liquidity Period between the announcement of an issue
and the pricing mechanism being used. A very and the time the issue takes place. Investors can
risky strategy often used in dark pools if another buy and sell the shares during this period for
investor anticipates this and you miss your chance settlement after the issue date.
to deal at the favourable price.
Gross Domestic Product (GDP)
Gearing A measure of the level of activity within an economy.
The amount of borrowing versus debt on a More precisely, GDP is the total market value of all
company’s Balance Sheet (Net debt/Ordinary final goods and services produced domestically in
shareholders’ funds). Warrants and options also an economy typically during a calendar year.
exhibit gearing; ie, a small move in the price of
the underlying asset can be magnified in the Gross National Product (GNP)
movement in the price of the option. Gross domestic product adjusted for income
earned by residents from overseas investments
Geometric Mean and income earned in the UK by foreign investors.
A measure of central tendency established by
taking the nth root of the product (multiplication) Gross Redemption Yield (GRY)
of n values. The annual compound return from holding a bond
to maturity, taking into account both interest
Geometric Progression payments and any capital gain or loss at maturity.
The product (multiplication) of n values. Also known as the yield to maturity (YTM).
Gilt-Edged Market Maker (GEMM) Growth Stock

A firm that is a market maker in gilts (UK Company that is expected to achieve higher than
government bonds). average earnings growth. Growth stocks usually have
a high P/E ratio relative to the market as a whole.
Gilts
UK government securities issued primarily to Guaranteed Bonds
finance government borrowing. Also see Public Sold on a limited basis by life funds as single-
Sector Net Cash Requirement (PSNCR). premium products. Income is guaranteed over the
selected term and the capital is returned on maturity.
Global Custody
See Custody. Guaranteed Funds
Provide limited downside for the investor, usually
Global Depository Receipt (GDR) by the purchase of derivatives. Capital may be
Negotiable OTC securities, usually priced in US guaranteed.
dollars, issued by foreign companies. Listed on
London and Luxembourg stock exchanges. Settled Harmonised Index of Consumer Prices (HICP)
in Euroclear or Clearstream. Standard measurement of inflation throughout
the European Union. Also known as Consumer
Global Investment Performance Standards (GIPS) Prices Index (CPI).
New set of minimum performance presentation
standards for investment managers. Sponsored Hedge
by AIMR and intended for global comparison of Taking an opposite position to the main strategy
investment performance. of a portfolio. For example, the sale of futures
contracts or purchase of put options, could limit
or prevent a loss in the event of a market decline.
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Hedge Fund Income Elasticity of Demand (YED)
A limited partnership with few investment The effect of a small percentage change in income
restrictions. Usually based offshore (eg, Cayman on the quantity of a good demanded.
Islands) but shares in the fund are often quoted
in Luxembourg or Dublin. Hedge funds can use Income Tax
a number of strategies including sell short ie sell Tax paid on earned and unearned income by UK
stock they do not own to profit from price falls. investors.
Some hedge funds gear up to increase leverage
(may result in large losses eg, LTCM). Independent Financial Adviser (IFA)
A financial adviser who is not tied to the products
Hedging of any one product provider and is duty-bound to
A technique employed to reduce the impact of give clients best advice. IFAs must establish the
adverse price movements in financial assets held, financial planning needs of their clients through
typically by using derivatives. a personal fact-find and satisfy these needs with
the most appropriate products offered in the
High Yield Stocks marketplace.
Shares that have a higher than average dividend
yield or those where a high proportion of the total Index
return is derived from dividend income. Examples A basket of shares/bonds to provide a benchmark
include utilities. for performance measurement. May be single
sector/country, regional or global.
Holder
Investor who buys put or call options. Index-linked Government Bonds
Some issuers increase the coupon and redemption
Iceberg Orders value in line with an inflation indicator. In the UK,
Generally specify an additional display quantity, index-linked Gilts are linked to the RPI-X. US
smaller than the overall order quantity. The order index-linked T-bonds are linked to the CPI.
is queued along with other orders but only the
display quantity is printed to the market depth. Index-Tracking Fund
Fund that aims to match the returns on a particular
Immobilisation index. Also called passive management.
Immobilisation means that share certificates are
held in a vault and do not move. Transfer of Inflation
ownership takes place by means of an electronic The rate of change in the general price level or the
transfer within their books of record, a process erosion in the purchasing power of money.
known as book entry transfer.
Inflation Risk Premium (IRP)
Immunisation The additional return demanded by bond
Passive bond management techniques that investors based on the volatility of inflation in
comprise cash matching and duration-based the recent past.
immunisation.
Information Ratio
Income The extra return from a portfolio versus the
Receipts from earnings or investments owned. benchmark relative to the extra risk.
Income Account Inheritance Tax (IHT)

Account relating to the income (actual and Tax on the value of an estate when a person dies.
accrued) of a portfolio.
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Initial Charge International Securities Identification Number (ISIN)

Charge imposed on buyers of new shares/units An internationally recognised unique securities code.
in a collective investment scheme. Used to pay
commission to IFAs. Interpolation
A method by which to establish an approximate
Initial Margin Internal Rate of Return (IRR).
The collateral deposited by exchange clearing
members with the clearing house when opening In-the-Money
certain derivative transactions. Call option where exercise or strike price is below
current market price (or put option where exercise
Initial Public Offering (IPO) price is above).
The first issue of any class of security.
Intrinsic Value
Insider Dealing The amount by which the exercise price of an
Knowingly trading in shares when in possession option or warrant is in-the-money.
of price-sensitive information that is not widely
known. This is illegal in most countries. Inverted Yield Curve
When the redemption yields of short-dated bonds
Institutional Funds are higher than those of long-dated ones.
Assets managed by investment banks, life
assurance and fund management companies. Invest
Includes pension schemes, insurance funds, unit To employ (money) in the purchase of anything
trusts and investment trusts. from which interest or profit is expected.
Integration Investment Bank

Third stage of money laundering. Business that specialises in raising debt and equity
for companies.
Interest Rate Parity
The mathematical relationship that exists Investment Company with Variable Capital (ICVC)
between the spot and forward exchange rate for Alternative term for an Open-Ended Investment
two currencies. This is given by the differential Company (OEIC).
between their respective nominal interest rates
over the term being considered. Investment Trust
A company whose shares are quoted on the
Internal Rate of Return (IRR) London Stock Exchange (LSE), with a fixed
The discount rate that when applied to a series of number of shares. The company invests in shares
cash flows produces a net present value (NPV) of other companies. The value of the shares in the
of zero. Also known as the discounted cash flow fund is set by supply and demand as well as the
(DCF) Yield. value of the fund (NAV). Closed-ended funds.
International Central Securities Depository (ICSD) Irredeemable Security

See Euroclear and Clearstream. A security issued without a pre-specified
redemption or maturity date.
International Fisher Effect
The proposition that, in a world of perfect capital Issuing House
mobility, nominal interest rates should take full An investment bank that organises a new issue.
account of expected inflation rates so that real It is responsible for launching and marketing the
interest rates are equal worldwide. new securities in return for a fee from the issuer.
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Jensen’s Alpha Liquidity
See Alpha. The ease with which a security can be traded
in a market or converted into cash. Liquidity
Junk Bond is determined by the amount of two-way trade
Bond that has been given a low rating by the conducted in a security. Liquidity also describes
credit rating agencies. that amount of an investor’s financial resources
held in cash.
Key Features
Factual information that must be sent out on Liquidity Preference Theory
request to inform new investors in an authorised The proposition that investors have a natural
fund, of the scheme objectives, charges and preference for short-term investments and,
dealing procedures. therefore, demand a liquidity premium in the
form of a higher return the longer the term of the
Keynesians investment.
Those economists who believe that markets are
slow to self-correct and who therefore advocate Liquidity Risk
the use of fiscal policy to return the economy back The risk that shares may be difficult to sell at a
to a full employment level of output. reasonable price.
Kondratieff Cycles Listed Investments

Long-term economic cycles of 50 years+ duration Investments that have an official listing on one
that result from innovation and investment in new of the world’s recognised stock exchanges. Also
technology. known as quoted investments.
Kurtosis Loan Stock

Probability distribution of a real-valued random A corporate bond issued in the domestic bond
variable. Higher kurtosis means more of the market without any underlying collateral, or
variance is due to infrequent extreme deviations, as security.
opposed to frequently modestly-sized deviations.
London Clearing House (LCH.Clearnet)
Layering The institution that clears and acts as central
Second stage in money laundering. counterparty to all trades executed on member
exchanges.
Letter of Renunciation
Form attached to an allotment letter, which is London InterBank Offered Rate (LIBOR)
completed, should the original holder wish to sell A benchmark money market interest rate. The rate
the entitlement. See renounceable documents. of interest charged by one bank to another from
overnight loans. LIBOR is quoted daily. FRNs are
Leverage quoted relative to LIBOR.
See gearing.
London Metal Exchange (LME)
Liabilities Market for trading in derivatives of certain metals
Money owed. such as copper, zinc and aluminium.
Limit Order London Stock Exchange (LSE)

Order type used on a system such as SETS. If not The UK market for listing and trading domestic
completed immediately, the residual quantity is and international securities.
displayed on the screen as part of the relevant queue.
380
Long Marginal Cost (MC)

Used to indicate a holding of a security or purchase The change in a firm’s total cost resulting from
of futures contracts producing one additional unit of output.
Long Position Marginal Revenue (MR)

The position following the purchase of a security The change in the total revenue generated by a
or buying a derivative. firm from the sale of one additional unit of output.
Long-Dated Gilts Mark to Market

Gilts with remaining time to maturity > 15 years. Valuing the price of a stock or portfolio on a daily
basis, to record profits/losses.
Macaulay Duration
See Duration. Market
All exchanges are markets – electronic or physical
Macroeconomics meeting places where assets are bought or sold.
The study of how the aggregation of decisions
taken in individual markets determines variables Market Capitalisation
such as national income, employment and The total market value of a company’s shares or
inflation. Macroeconomics is also concerned other securities in issue. Market capitalisation
with explaining the relationship between these is calculated by multiplying the number of shares
variables, their rates of change over time and or other securities a company has in issue by the
the impact of monetary and fiscal policy on the market price of those shares or securities.
general level of economic activity.
Market Maker
Managed Funds A market professional who buys and sells stock
See pooled funds. on behalf of the broker-dealer firm. In London,
market makers are obliged to post firm two-
Manager of Managers way prices throughout the trading day. Market
(MOM) Fund makers are exempt from stamp duty and are able
A multi-manager fund. It does not invest in other to sell stock short, ie, sell more than they own.
existing retail collective investment schemes.
Instead it entails the MOM fund arranging Market Segmentation
segregated mandates with individually chosen The proposition that each bond market can be
fund managers. divided up into distinct segments based upon term
to maturity, with each segment operating as if it is
Manager’s Fee a separate bond market operating independently
Charge made from the value of a portfolio’s assets of interest rate expectations.
payable to the investment management company.
Market Timing
Mandate See Active Management.
Contractual description of the service that a client
will receive from the institution (eg, investment Markets in Financial Instruments Directive
management, custody). (MiFID)
MiFID came into effect on 1 November 2007. It
Margin replaced the Investment Services Directive (ISD)
See Initial Margin and Variation Margin. and covers the regulation of certain financial
services for the 30 member states of the European
Economic Area (EEA).
381
Marking to Market interactions determine the relative prices and
The process of valuing a position taken in a quantities of factors of production, goods and
securities or a derivatives market either at the services demanded and supplied.
close of the market or in real-time.
Mid Price
Maturity Half way between the bid-offer spread (see above).
Date when the capital on a bond is repaid. OEICs and SICAVs operate on a mid-price basis.
Mean-Variance Analysis Minimum Efficient Scale (MES)

The use of past investment returns to predict The level of production at which a firm’s long-run
the investment’s most likely future return and average production costs are minimised and its
to quantify the risk attached to this expected economies of scale are maximised.
return. Mean variance analysis underpins Modern
Portfolio Theory (MPT). Mode
A measure of central tendency established by the
Median value or values that occur most frequently within a
A measure of central tendency established by data distribution.
the middle value within an ordered distribution
containing an odd number of observed values Modern Portfolio Theory (MPT)
or the arithmetic mean of the middle two values The proposition that investors will only choose to
in an ordered distribution containing an even hold those diversified, or efficient, portfolios that lie
number of values. on the efficient frontier. According to the theory,
it is possible to construct an efficient frontier’ of
Medium Term Notes (MTNs) optimal portfolios offering the maximum possible
Medium-dated loan stock with maturity of five to expected return for a given level of risk.
ten years.
Modified Duration (MD)
Medium-Dated Gilts A measure of the sensitivity of a bond’s price
Medium-dated gilts with five-15 years remaining to changes in its yield. Modified duration
to maturity. approximates a bond’s convexity.
Member Firm Momentum

A firm that is a member of a stock exchange or Extent to which prices are influenced by strong
clearing house. investor buying/selling.
Memorandum of Association Monetarists

The legal document that principally defines a Those economists who believe that markets are
company’s powers, or objects, and its relationship self-correcting, that the level of economic activity
with the outside world. The Memorandum also can be regulated by controlling the money supply
details the number and nominal value of shares and that fiscal policy is ineffective and possibly
the company is authorised to issue and has issued. harmful as a macroeconomic policy tool. Also
known as new classical economists.
Microeconomics
Microeconomics is principally concerned with Monetary Policy
analysing the allocation of scarce resources within The setting of short-term interest rates by a central
an economic system. That is, microeconomics is bank in order to manage domestic demand and
the study of the decisions made by individuals achieve price stability in the economy. Monetary
and firms in particular markets and how these policy is also known as stabilisation policy.
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Monetary Policy Committee (MPC) Naked bear

Committee run by the Bank of England which A short seller (or the writer of a call option, or seller
sets interest rates. of financial future or CFD), ie, does not possess the
underlying asset but believes the price will fall.
Money The risk is unlimited if the price rises.
Anything that is generally acceptable as a means
of settling a debt. NASDAQ Composite
NASDAQ stock index.
Money Laundering
Aiding drug traffickers, arms dealers and other NASDAQ-OMX
criminals to invest their proceeds and take ‘clean’ A major stock exchange group. Its trading systems
money out of the system. An international criminal are used in the stock exchanges of countries such
offence. It is an offence not to report the suspicion as Dubai and Egypt.
of money laundering by a client.
National Association of Securities Dealers
Money markets Automated Quotations (NASDAQ)
Short-dated securities, eg, treasury bills, CD, CP, The second-largest stock exchange in the US.
etc. Compete with liquid funds (eg cash deposits). NASDAQ lists certain US and international stocks and
provides a screen-based quote-driven secondary
Money Weighted Rate of Return (MWRR) market that links buyers and sellers worldwide.
The internal rate of return (IRR) that equates the NASDAQ also operates a stock exchange in Europe
value of a portfolio at the start of an investment (NASDAQ OMX Europe).
period plus the net new capital invested during the
investment period with the value of the portfolio National Central Securities Depository (NCSD)
at the end of this period. The MWRR, therefore, Only deals with domestic instruments.
measures the fund growth resulting from both the
underlying performance of the portfolio and the National Debt
size and timing of cash flows to and from the fund A government’s total outstanding borrowing
over this period. resulting from financing successive budget
deficits, mainly through the issue of government-
Morgan Stanley Capital International indices backed securities.
(MSCI)
Global, sector and regional indices, eg, EAFA Negotiable Security
(Europe, America and Far East). Compete with A security whose ownership can pass freely from
FTSE International indices. one party to another. Negotiable securities are,
therefore, tradable.
Multilateral Trading Facility (MTF)
Regulated activity which allows you to trade Net Asset Value (NAV)
shares or other securities by means other than on This is the aggregate value of the securities in a fund,
a recognised investment exchange. net of liabilities (eg, charges, tax manager’s fee). This
value is used as the basis for valuing the units (or
Multi-Manager Funds shares) in a collective investment fund. A company’s
A fund that offers a portfolio of separately break-up value. Used by value investors as a measure
managed funds. There are two main types: fund- of the price to pay for a company’s shares.
of-funds and manager of managers.
Net Present Value (NPV)
Multiplier The result of subtracting the discounted, or present,
The factor by which national income changes as a value of a project’s expected cash outflows from
result of a unit change in aggregate demand. the present value of its expected cash inflows.
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Net Redemption Yield (NRY) Normal Distribution
The annual compound return from holding a bond A distribution whose values are evenly, or
to maturity taking account of both the coupon symmetrically, distributed about the arithmetic
payments net of income tax and the capital gain or mean. Depicted graphically, a normal distribution
loss to maturity. is plotted as a symmetrical, continuous bell-shaped
curve.
Neutral Position
The same investment in a stock/sector/region, as Normal Market Size (NMS)
the relevant benchmark weighting. The average size of bargains transacted in a
particular share. A market maker’s prices are firm
New Issue for NMS. Prices are negotiable for deals outside
A new issue of ordinary shares whether made by an NMS. NMS is 2.5 per cent of the average daily
offer for sale, an offer for subscription or a placing. volume, calculated on an annual basis.
Also known as an Initial Public Offering (IPO).
Normal Profit
New Paradigm The required rate of return for a firm to remain in
The term applied to an economy that can produce business taking account of all opportunity costs.
robust economic growth without accompanying
inflation through the employment of productivity- Offer Price
enhancing new technology. Price at which dealers sell stock. The price at which
securities (or units in a collective investment fund)
NIKKEI 225 are sold to the investor.
Main Japanese share index.
Offshore Funds
Nil Paid Collective investment funds run outside the UK.
A new issue of shares on which no payment to the Usually minimal regulatory oversight (and investor
company has yet been made. protection) and lower tax regime than the UK, EU
or US.
Nominal Return
Return on an investment not adjusted for inflation Open
(ie, headline return). Initiate a transaction, eg, an opening purchase or
sale of a future. Normally reversed by a closing
Nominal Value transaction.
The face or par value of a security. The nominal
value is the price at which a bond is issued and Open Economy
usually redeemed and the price below which a Country with no restrictions on trading with other
company’s ordinary shares cannot be issued. countries.
Nominee Open Ended Investment Company (OEIC)

Legal owner of securities that are held by a third Open-ended mutual funds that may have several
party on behalf of the underlying beneficial owner. sub-funds and different share classes.
Nominee accounts may be pooled (ie, the details
of the beneficial owners are only known to the Open Offer
nominee company) or designated (ie, individual Offer to shareholders where they can apply to
owners are identified on the register, along with increase the allocation made to them, but offer to
the nominee). buy the rights not taken up by others.
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Open Outcry Over-The-Counter (OTC)

Trading system used by some derivatives Unregulated markets for dealing in assets or
exchanges. Participants stand on the floor of the securities.
exchange and call out transactions they would like
to undertake. Over-the-Counter (OTC) Derivatives
Derivatives that are not traded on a derivatives
Open-Ended Funds exchange owing to their non-standardised
For example, OEICs and unit trusts (mutual funds contract specifications. They are bilateral
in the US). Cash inflows from new investors transactions.
increase the NAV of the fund and new units are
created. Redemptions (outflows) from the fund Overweight P/E Ratio
cause the NAV to shrink. Investors’ units are A larger investment in a stock/sector/region than
re-purchased and may be cancelled. the relevant benchmark weighting.
Open-Ended Investment Company (OEIC) Packaged Product

Collective investment vehicle similar to unit A life policy, unit trust or OEIC, ITC saving scheme,
trusts. Alternatively described as an investment stakeholder pension or personal pension
company with variable capital (ICVC) and in
Europe as a SICAV. Par
The nominal (or face) value of a security. Fixed-
Opening income securities are usually redeemed at par. It
Undertaking a transaction which creates a long or is generally illegal for a company to issue its shares
short position. at a discount to par.
Opportunity Cost Pari Passu

The cost of forgoing the next best alternative Of equal ranking. New ordinary shares issued
course of action. In economics, costs are defined under a rights issue, for instance, rank pari passu
not as financial but as opportunity costs. with the company’s existing ordinary shares.
Option Partly Paid

A derivatives contract that confers from one party Investors in a new issue may be requested to pay
(the writer) to another (the holder) the right but the full purchase price in instalments and the
not the obligation to either buy (call option) or shares will trade in partly paid form until they are
sell (put option) an asset at a pre-specified price fully paid.
on, and sometimes before, a pre-specified future
date, in exchange for the payment of a premium. Passive Management
An investment approach employed in those
Ordinary Shares securities markets that are believed to be price-
Shares which confer full voting and dividend efficient. The term also extends to passive bond
rights to the owner. management techniques collectively known as
immunisation.
Out-of-the-Money
Call option where the exercise or strike price is Permanent Interest Bearing Securities (PIBS)
above the market price or a put option where it Irredeemable fixed interest securities issued by
is below. mutual building societies. Known as perpetual
subordinated bonds (PSBs) if the building society
Out-Of-The-Money demutualises.
An option or warrant that is not worth exercising.
385
Perpetuities the shareholding, for cash before the shares are
An investment that provides an indefinite stream offered to outside investors.
of equal pre-specified periodic payments.
Preference Shares
Physical Delivery Fixed income shares which pay a fixed dividend
Delivery of securities (or certificates evidencing (which is quoted as a net percentage of par).
ownership rights) to the buyer’s custodian. Preference dividends must be paid before ordinary
dividends, but the dividend may be passed.
Placement Preference shareholders rank above ordinary
First stage of money laundering. shareholders if the company is wound up.
Placing Premium
A new issue may be placed with a small number of The amount of cash paid by the holder of an option
institutions, thus reducing the costs. to the writer in exchange for conferring a right. Also
the difference in the spot and forward-exchange rate
Plain Vanilla or Vanilla Swap that arises when interest rates in the base currency
A swap which has a very basic structure in which are higher than those in the quoted currency. For
the counterparties to the trade exchange a fixed example, the share price of an investment trust may
rate for a floating rate, and the notional principal be above the NAV, and is said to be at a premium.
amount is the same over the life of the swap. Also, the price paid to buy the option.
Pooled Funds Present Value

Large funds in which several investors have an The value of a sum of money receivable at a known
interest. Life companies usually refer to managed future date expressed in terms of its value today.
funds. A present value is obtained by discounting the
future sum by a known rate of interest.
Population
A statistical term applied to a particular group Price Elasticity of Demand (PED)
where every member or constituent of the group The effect of a small percentage change in the
is included. price of a good on the quantity of the good
demanded. PED is expressed as a figure between
Portfolio
zero and infinity.
Group of assets to meet the needs of a specific
investor. Prima Facie
At first sight. For instance, a portfolio’s past
Posting
performance provides prima facie evidence of a
Administration term used to describe transfer of
portfolio manager’s skill and investment style.
an entry from the journal to the ledger.
Primary Data
Potential Output Level
Data commissioned for a specific purpose.
The sustainable level of output produced by an
economy when all of its resources are productively Primary Market
employed. Also known as the full employment The market for newly-issued securities.
level of output.
Private Equity
Pre-Emption Rights Unquoted shares in a company. May never have
The rights accorded to ordinary shareholders been listed on the Stock Exchange or may have
under company law to subscribe for new ordinary been issued to raise capital in a buy-out (eg, MBO).
shares issued by the company, in which they have
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Production Possibility Frontier (PPF) lose their money. Stocks that are the subject of
The PPF depicts all feasible combinations of output pump-and-dump schemes are sometimes called
that can be produced within an economy, given the chop stocks.
limit of its resources and production techniques.
Purchasing Power Parity (PPP)
Programme Trade The nominal exchange rate between two countries
Computer-driven trades that are driven by price that reflects the difference in their respective rates
limits. of inflation.
Prospectus Put Option

Legal document accompanying the issue of shares An option that confers a right but not the
in a share class by a company or investment fund. obligation on the holder to sell a specified amount
Contains details of investment objectives and of an asset at a pre-specified price on or sometimes
charges. before a pre-specified date.
Provisional Allotment Letter Put-Through

A document sent to those shareholders who Also known as an agency cross, when a broker
have certificated holdings and are entitled to matches a buyer and seller of a security. In such
participate in a rights issue. The letter details the cases each party obtains a price advantage.
shareholder’s existing shareholding, their rights
over the new shares allotted and the date(s) by Qualifying Corporate Bonds (QCBs)
which they must act. UK corporate bonds issued in sterling without
conversion rights. QCBs are free of UK capital
Proxy gains tax (CGT).
The means by which the beneficial owner instructs
their representative to vote at a shareholder Qualitative Analysis
meeting. Appointee who votes on a shareholder’s Determining the value of an investment by
behalf at company meetings. examining non-numeric characteristics, eg,
people, products.
Public Sector Net Cash Requirement (PSNCR)
The extent to which a government needs to Quantitative Analysis (Quant)
borrow, mainly through the issue of government- Use of mathematical techniques to make
backed securities, to finance a budget deficit as investment decisions.
a result of its spending exceeding tax revenue for
the fiscal year. Quantity Theory of Money
A truism that formalises the relationship between
Pull to Maturity the domestic money supply and the general price
A term used to explain why the price of short- level.
dated bonds is less affected by interest-rate
changes than that of long-dated bonds. Quartile Ranking
Relative ranking of a fund against its peer group
Pump and Dump in a league table that is divided into four quartiles.
A form of fraud that involves artificially inflating
the price of an owned stock through false and Quoted Currency
misleading positive statements, in order to sell This is the second currency quoted in a currency
the cheaply purchased stock at a higher price. pair on the FX markets. For example, if you are
Once the operators of the scheme “dump” their looking at a USD/JPY quote then the quoted
overvalued shares, the price falls and investors currency is the yen.
387
Quote-Driven existing shareholders in the case of a rights issue;
Dealing system driven by securities firms who renounceable certificate - sent to shareholder in
quote buying and selling prices. the case of a capitalisation; split receipt - replaces
the above during the initial dealing period.
Real Assets Each includes instructions to either register the
Investments that are tangible, eg property, securities in the holder’s name or sell the rights.
commodities. The prices are expected to keep
pace with inflation. Repo
A repurchase agreement. An agreement to sell
Real Rate of Return securities and buy back (repurchase) at a later
Nominal return adjusted for inflation. date.
Redeemable Security Reserve Ratio

A security issued with a known maturity or The proportion of deposits held by banks as
redemption date. reserves to meet depositor withdrawals and
central bank credit control requirements.
Redemption
The repayment of principal to the holder of a Residence
redeemable security. Cash taken out of an open- There is no statutory definition of residence. It
ended fund. is where a person lives. A person may have more
than one residence or no residence at all. In the
Redemption Date (Maturity) UK, a person is generally deemed resident for tax
The end of a fixed period, when the nominal purposes if he is physically present in the UK for six
value of a redeemable security will be repaid to months within a tax year, or makes habitual and
the investor. substantial visits to the UK.
Registered Stock Resistance Level

Stock is registered in the name of the owner (or A term used in technical analysis to describe the
the nominee). This is the most common form of ceiling put on the price of a security resulting
issue in the US and UK. from persistent investor-selling at that price level.
Registrar Resolution
An official of a company who maintains the share A proposal on which shareholders vote.
register.
Retail Bank
Regression Analysis Organisation that provides banking facilities to
A statistical technique used to establish the degree individuals and small/medium-size businesses.
of correlation that exists between two variables.
Retail Prices Index (RPI)
Reinvestment Risk An expenditure-weighted measure of UK inflation
The inability to reinvest coupons at the same rate based on a representative basket of goods and
of interest as the gross redemption yield (GRY). services purchased by an average UK household.
This in turn makes the GRY conceptually flawed.
Retained Earnings
Renounceable Documents The part of a company’s profit that is not paid away
Negotiable, bearer securities. Allotment letter as a dividend. Used to produce future earnings.
- issued to successful applications in a new
issue; provisional allotment letter - sent to the
388
Return on Equity (ROE) Securitisation

Company earnings divided by net asset value The packaging of rights to the future revenue
(NAV). stream from a collection of assets into a bond issue.
Reverse Yield Gap Segregated Portfolios

Is the excess of the gross redemption yield Separate portfolios with ownership of securities
of long-dated bonds, minus the grossed-up separately identified.
dividend yield of equities.
Self-Invested Pension Plan (SIPP)
Rights Issue Has a single member. Aimed at individuals
The issue of new ordinary shares to a company’s wishing to benefit from greater flexibility with
shareholders in proportion to each shareholder’s investments. Often effected by higher-paid self-
existing shareholding, usually at a price deeply employed professionals.
discounted to that prevailing in the market. Also
see Pre-emption Rights. Separate Trading of Registered Interest &
Principal Securities (STRIPs)
Running Yield STRIPs are created when a government security
The return from a bond calculated by expressing is stripped into its component parts (coupons
the coupon as a percentage of the clean price. + principal). Each part is sold as a separate zero
Also known as the flat yield or interest yield. coupon security.
Sample Settlement
A statistical term applied to a representative The delivery or receipt of securities in exchange
subset of a particular population. Samples enable for payment.
inferences to be made about the population.
Settlor
Scheme Particulars The creator of a trust.
Document providing detailed information about a
unit trust. Details include charges, types of units, Share Buyback
payment dates, equalisation process, investment The redemption and cancellation by a company
restrictions. of a proportion of its irredeemable ordinary
shares subject to the permission of the Court and
Scrip Issue agreement from tax authorities.
Issue of free shares to current shareholders. Often
used instead of a cash dividend (scrip dividend Share Capital
alternative). The nominal value of a company’s equity or
ordinary shares. A company’s authorised share
Secondary Data capital is the nominal value of equity the
Pre-existing data. company may issue, whilst issued share capital
is that which the company has issued. The term
Secondary Market share capital is often extended to include a
Marketplace for trading in existing securities. company’s preference shares.
Securities Share Split

Bonds and equities. A method by which a company can reduce the
market price of its shares to make them more
marketable without capitalising its reserves. A share
split simply entails the company reducing the
389
nominal value of each of its shares in issue whilst Sortino Ratio
maintaining the overall nominal value of its share A ratio developed by Frank Sortino, to differentiate
capital. A share split should have the same impact between good and bad volatility in the Sharpe
on a company’s share price as a bonus issue. ratio.
Shares Special Resolution

Form of security that represents a shareholder’s Proposal put to shareholders requiring 75% of the
stake in a company (see equities and preference votes cast.
shares).
Speculate
Sharpe Ratio To engage in the buying or selling of an asset, in
A measure of the excess return earned on a order to profit by a change in the market price.
portfolio, per unit of absolute risk (standard
deviation). Split
Where a company splits one share into several,
Short Position with a corresponding reduction in the share price
The position following the sale of a security not and the par value.
owned or selling a derivative.
Spot
Short Selling Spot price or spot rate is the current prevailing
Selling more of an asset than the investor owns price/rate. This would apply to deals for standard
in order to make a profit once the price falls. This settlement, ie not a forward.
is usually not permitted for authorised funds and
pension funds, but may be a strategy of hedge Spread
funds. The fund will need to borrow stock to The difference between the bid and offer prices.
cover a short position.
Stabilisation Policy
Short-Dated Gilts See Fiscal Policy and Monetary Policy.
Gilts with a time to maturity of less than five years
(Financial Times) or seven years (Bank of England). Stag
A person who rapidly buys and sells shares to
Sinking Fund make a profit.
Provision for repayment of the capital, either by
gradually establishing a counterparty fund, or by Stamp Duty
using the annual provision to buy in through the Tax on purchases of certain assets.
market or by ballot. This will reduce the market
Standard Deviation
risk (ie, reduce the duration) and the default risk of
A measure of absolute volatility. It is the measure
the bond.
of the square root of the variance of each return
Societe d’Investissement a Capital Variable from the mean. The higher the figure, the greater
(SICAV) the volatility (ie, risk).
An open-ended collective investment fund.
Statement of Investment Principles (SIP)
Usually operated under the UCITS Directive. Sells
A written statement of the principles governing
units in the fund to the public. Operates on a
investment decisions. Legally required for
single (mid) pricing basis.
stakeholder and occupational pensions.
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Stock Exchange Structured Product

An organised market place for issuing and trading Anything using derivatives, whether they are call
securities by members of that exchange. and put options, futures, zero coupon bonds or
swaps, to enhance, leverage, protect or guarantee
Stock Exchange Automated Quotation (SEAQ) an investment return.
The London Stock Exchange’s (LSE) screen-based
quote-driven trading system for fixed income and Subordinated Loan Stock
AIM shares that displays firm bid and offer prices Loan stock issued by a company that ranks above
quoted by competing market makers during the its preference shares but below its unsecured
mandatory quote period. creditors in the event of the company’s liquidation.
Stock Exchange Daily Official List (SEDOL) Substitute

Details of daily trading, price moves, corporate A good is a substitute for another if a rise in the
actions and entitlements on the London Stock price of one results in an increase in demand for
Exchange’s (LSE). the other. As substitute goods perform a similar
function to each other, they typically have a high
Stock Exchange Electronic Trading Service (SETS) price elasticity of demand (PED).
The London Stock Exchange’s (LSE) screen-based
order-driven trading system that electronically Supply Curve
matches buy and sell orders input to the system. The depiction of the quantity of a particular good
or service firms are willing to supply at a given
Stock Lending price. Plotted against price on the vertical axis and
An agreement to lend securities. Title of quantity on the horizontal axis, a supply curve
ownership is transferred to the counterparty and slopes upward from left to right.
the borrower of the stock pays a fee to the lender.
Voting rights transfer to the borrower, but any Swap
income is usually repaid to the lender. An over-the-counter (OTC) derivative whereby
two parties exchange a series of periodic payments
Straight Through Processing (STP) based on a notional principal amount over an
Electronic messages to generate deal tickets, agreed term. Swaps can take the form of interest
confirm trade details and send settlement rate swaps, currency swaps, commodity swaps and
instructions to clearing house and custodian. equity swaps.
Strategic Asset Allocation T+3

The choice of assets to be held in a client portfolio The term T+3 identifies when a trade will settle. T
and the limits set on the weightings by the client. refers to the trade date and T+3 identifies that the
transaction will settle three business days after the
Strike Price trade date.
See Exercise Price.
Tactical Asset Allocation (TAA)
STRIPS The weightings (holdings) of each asset class and
The principal and interest payments of those market relative to the benchmark. Used to produce
designated gilts that can be separately traded superior returns over the chosen time period.
as zero coupon bonds (ZCBs). STRIPS is the
mnemonic for Separate Trading of Registered Tail
Interest and Principal. The amount of government stock sold in an
auction below the average price. The larger the
tail, the wider the spread of accepted bids.
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Takeover Top Down
When one company buys more than 50% of the Investment strategy that relies on decisions about
shares of another. asset classes, markets and industry sectors before
stock selection.
Tap Stocks
Government stock that may be issued in small Top-Slice
amounts after the initial issue. To sell part of a holding to reduce its weight in a
portfolio.
Technical Analysis
The analysis of charts depicting past price and Tracker Funds
volume movements to determine the future course Funds that seek to produce returns in line with an
of a particular market or the price of an individual underlying benchmark (usually a stock index). The
security. Technical analysis is nullified by the manager does not take active bets. The fund may
weak form of the Efficient Markets Hypothesis buy stocks or track an index using quantitative
(EMH). techniques or derivatives.
Tender Tracking Error

A method of setting prices for new issues. Potential The volatility of returns of a fund relative to its
investors are asked to tender an amount and price. benchmark.
Tick Trash and Cash

Financial markets move in different size price Deliberately spreading false bear stories in
increments, and the minimum price movement order to depress the share price, and using the
is known as a tick. Futures markets often have opportunity to buy cheaply.
specific tick sizes, but stock markets have a tick
size of 0.01. Tick sizes and tick values are part of Treasury Bills
the contract specifications for all financial markets. Short-dated securities issued by the Central Bank,
to finance government expenditure. Treasury bills
Tick Value do not pay coupons but are redeemed at par.
The monetary value of one tick.
Treasury Stock
Time Value Government fixed income securities.
That element of an option premium that is not
intrinsic value. The term time value also relates Treynor Ratio
to a sum of money which, by taking account of A measure of the extra return earned by a portfolio,
a prevailing rate of interest and the term over relative to the risk taken, versus other portfolios.
which the sum is to be invested or received, can be
expressed as either a future value or as a present Trust
value, respectively. A means of holding assets (legally owned by
trustees) on behalf of underlying beneficial
Time Weighted Rate of Return (TWRR) owners. Investment portfolios within a trust may
The unitised performance of a portfolio over an be professionally managed eg charitable trust,
investment period that eliminates the distorting unit trust.
effect of cash flows. The TWRR is calculated by
compounding the rates of return from each Trustee
investment sub-period, a sub-period being An individual or a group of people or independent
created whenever there is a movement of capital institution responsible for the management of the
into or out of the portfolio. trust, as defined by the trust deed. The trustees
392
have the power to veto any investment they feel Unemployment

does not adhere to the trust deed. The percentage of the labour force registered as
available to work at the current wage rate.
Trustees
The legal owners of trust property who owe a duty Unfranked Income
of skill and care to the trust’s beneficiaries. Income on which no withholding tax has been
deducted. The investor may have a tax liability.
Two-Way Price
Prices quoted by a market maker at which they are Unit Trust
willing to buy (bid) and sell (offer). A fund whereby money from investors is pooled
together and invested collectively on their behalf
UCITS Directive into an open-ended trust.
A European Directive governing Undertakings For
Collective Investment Schemes. UCITS funds are Unit-Linked Policy
authorised by the local regulator and subject to A policy where returns are directly linked to
investment and borrowing restrictions. They can the underlying assets. Units are purchased with
be marketed throughout the EEA. premiums and are valued on a daily basis. They can
be purchased in a variety of life assurance funds.
UK Corporate Governance Code
The code that embodies best corporate governance Unlisted/Unquoted Securities
practice for all public limited companies (PLCs) A security that is not listed on a stock exchange
quoted on the London Stock Exchange (LSE). and is traded OTC, eg, Eurobonds, ADRs, and
Also known as the Code of Best Practice. Private Equity.
UK Listing Authority (UKLA) Valuation Point

The body responsible for setting and administering Time when open-ended retail mutual funds are
the listing requirements and continuing obligations valued, and the unit price is calculated.
for public limited companies seeking and obtaining
a full list on the London Stock Exchange (LSE). Value at Risk (VAR)
An estimate of the maximum expected loss,
Umbrella Fund over a specified period within a given degree of
A single authorised scheme with any number of confidence.
sub-funds. Investors (shareholders) may switch
(transfer) from one share class to another. Variation Margin
The cash that passes between exchange clearing
Undated Gilts members daily via the clearing house in settlement
Gilts without any redemption date or yield, eg, of the previous day’s price movement in an open
War Loan. derivatives contract.
Underlying Venture Capital

The asset from which a derivative is derived. New capital injected into a company to pay for
further developments, R&D or to improve the
Underweight balance sheet.
A lower investment in a stock/sector/region than
the relevant benchmark weighting. Volatility
A measure of the extent to which investment
Underwriter returns, asset prices and economic variables
A firm that agrees to underwrite a new issue, for a fluctuate. Volatility is measured by the standard
fee, thereby guaranteeing the securities will be sold. deviation of these returns, prices and values.
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Warrants Writer
Negotiable securities issued by public limited Party selling an option. The writers receive
companies (PLCs) that confer a right on the holder premiums in exchange for taking the risk of being
to buy a certain number of the company’s ordinary exercised against.
shares on pre-specified terms. Warrants are
essentially long-dated call options but are traded XETRA DAX
on a stock exchange rather than on a derivatives German shares index, comprising 30 shares.
exchange.
Yellow Strip
Weighting Section on each SEAQ display, showing the most
Percentage holding of a security in a portfolio, favourable prices.
relative to the percentage (weight) in the
underlying benchmark. Underweight means the Yield
portfolio holds a smaller percentage than that The interest earned on holding a security. Derived
in the benchmark. Overweight portfolios hold a from coupon or dividends.
higher percentage.
Yield Curve
Wealth Management Association (WMA) The depiction of the relationship between the
(Formerly APCIMS) gross redemption yields (GRYs) and the maturity
The trade association that represents UK of bonds of the same type.
stockbrokers’ interests.
Yield Gap
Withholding Tax The spread (difference) between government
Tax deducted from investment income that is paid bonds and equity yields.
to foreign investors. May be offset against the
Yield to Maturity
investor’s domestic tax liability.
See Gross Redemption Yield.
With-Profits Policy
Zero Coupon Bonds (ZCBs)
A policy in which the policyholder has the right
Bonds issued at a discount to their nominal value
to amounts above the basic sum assured or death
that do not pay a coupon but which are redeemed
benefit, principally as the result of profits made on
at par on a pre-specified future date.
the investment of a fund.
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ABBREVIATIONS
ABS bp
Asset-Backed Securities Basis Point
ACD BPV
Authorised Corporate Director Basis Point Value
ADR CAP
American Depository Receipt Chargeable Accounting Period
AER CAPM
Annual Equivalent Rate Capital Asset Pricing Model
AGM CAPS
Annual General Meeting Combined Actuarial Performance Services
AIC CBOT
Association of Investment Companies Chicago Board of Trade
AIM CD
Alternative Investment Market Certificate of Deposit
AMEX CDO
American Stock Exchange Collateral Debt Obligation
APCIM CDS
Association of Private Client Investment Managers Credit Default Swap
APT CFD
Arbitrage Pricing Theory Contract for Difference
AUT CGT
Authorised Unit Trust Capital Gains Tax
AVC CHF
Additional Voluntary Contribution Swiss franc
B2B CIS
Business to Business Collective Investment Scheme
B2C CME
Business to Consumer Chicago Mercantile Exchange
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CNAV DVP
Constant Net Asset Value Delivery versus Payment
CP EAFA
Commercial Paper Europe, America and Far East
CPI EASDAQ
Consumer Prices Index European Association of Securities Dealers
Automated Quotations
CRFOI
Cash Flow Return On Investment EBIT
Earnings Before Interest and Tax
CSD
Central Securities Depository EBITDA
Earnings before Interest, Tax, Depreciation and
CSDA Amortisation
Contractual Settlement Date Accounting
EC
DB European Community European Currency
Defined Benefit
ECB
DC European Central Bank
Defined Contribution
ECN
DCF Electronic Communications Network
Discounted Cash Flow
EEA
DI European Economic Area
Depository Interest
EIB
DJIA European Investment Bank
Dow Jones Industrial Average
EMH
DMO Efficient Markets Hypothesis
Debt Management Office
EMU
DR European Monetary Union
Depositary Receipt
EPS
DRIP Earnings per Share
Dividend Reinvestment Plan
ESMA
DTCC European Securities Markets Authority
Depository Trust Clearing Corporation
396
ETC Freddie Mac

Electronic Trade Confirmation Federal Home Loan Mortgage Corporation
ETF FRN
Exchange-Traded Fund Floating Rate Note
ETN FTSE
Exchange-Traded Note Financial Time Stock Exchange
ETP FX
Exchange-Traded Product Foreign Exchange
EU GARP
European Union Growth at a Reasonable Price
EURIBOR GBP
Euro InterBank Offered Rate Great Britain Pound, Sterling
EV GDP
Enterprise Value Gross Domestic Product
EVA GDR
Economic Value Added Global Depository Receipt
Fannie Mae GE
Federal National Mortgage Association General Electric
FATCA GEMM
Foreign Account Tax Compliance Act Gilt-Edged Market Maker
FCA GIPS
Financial Conduct Authority Global Investment Performance Standards
FCP GNI
Fonds Commun de Placement Gross National Income
Fed GNP
Federal Reserve Bank Gross National Product
FHLB GRY
Federal Home Loan Bank Gross Redemption Yield
FOF HICP
Futures and Options Fund Harmonised Index of Consumer Prices
397
HNWI IPS
High Net Worth Individual Investment Policy Statement
ICE IRP
InterContinental Exchange Inflation Risk Premium
ICMA IRR
International Capital Market Association Internal Rate of Return
ICVC IRS
Investment Company with Variable Capital Interest Rate Swaps (
IFA IAS
Independent Financial Adviser International Accounting Standards
IFRS IASB
International Financial Reporting Standards International Accounting Standards Board
IHT ISCD
Inheritance Tax International Central Securities Depository
ILG ISD
Index-Linked Gilt International Securities Depository
IMA ISIN
Investment Management Association International Securities Identification Number
IMF ISMA
International Monetary Fund International Securities Market Association
IOSCO ISO
International Organisation of Securities International Organisation for Standardisation
Commissioners
JPY
IPD Japanese Yen
Investment Property Databank
KIID
IPFA Key Investor Information Document
International Project Finance Association
KYC
IPMA Know Your Customer
International Primary Market Association
LCH
IPO London Clearing House, now LCH.Clearnet
Initial Public Offering
398
LIBOR MTF
London Interbank Offered Rate Multilateral Trading Facility
LIFFE MTN
London International Financial Futures and Medium Term Note
Options Exchange
MWR
LME Money Weighted Rate of Return
London Metal Exchange
MVA
LSE Market Value Added
London Stock Exchange
NAIRU
LTATC Non-Accelerating Inflation Rate of Unemployment
Long-Term Average Total Cost
NASDAQ
LTV National Association of Securities Dealers
Loan-to-Value Automated Quotations
MC NAV
Marginal Cost Net Asset Value
MD NBV
Modified Duration Net Book Value
MES NCSD
Minimum Efficient Scale National Central Securities Depository
MiFID NMS
Markets in Financial Instruments Directive Normal Market Size
MOM NPV
Manager of Managers Net Present Value
MPC NRV
Monetary Policy Committee Net Realisable Value
MPT NRY
Modern Portfolio Theory Net Redemption Yield
MR NYSE
Marginal Revenue New York Stock Exchange
MSCI OBSR
Morgan Stanley Capital International Old Broad Street Research
399
OEIC ROCE
Open-Ended Investment Company Return on Capital Employed
OFT ROE
Office of Fair Trading Return on Equity
OPEC RPI
Organisation of Petroleum Exporting Countries Retail Price Index
OTC S&P
Over-the-Counter Standard & Poor’s
P/E SDLT
Price/Earnings Stamp Duty Land Tax
PED SDRT
Price Elasticity of Demand Stamp Duty Reserve Tax
PER SEAQ
Price Earnings Ratio Stock Exchange Automated Quotation
PIK SEC
Payment in Kind Securities and Exchange Commission
plc SEDOL
Public Limited Company Stock Exchange Daily Official List
PPF SETS
Production Possibility Frontier Stock Exchange Electronic Trading Service
PPP SICAV
Purchasing Power Parity Societe Investissement a Capital Variable
PSNCR SIP
Public Sector Net Cash Requirement Statement of Investment Principles
PTR SIPP
Portfolio Turnover Self-Invested Pension Plan
QI SIX
Qualified Intermediary SIX SIS Ltd is the national CSD for the Swiss
financial market
RFQ
Request for Quote SML
Securities Market Line
400
SPV VAT
Special Purpose Vehicle Value Added Tax
SRI VNAV
Socially Responsible Investment Variable Net Asset Value
STP WACC
Straight Through Processing Weighted Average Cost of Capital
STRIPs WAL
Separate Trading in Registered Interest & Principal Weighted Average Life
Securities
WAM
TAA Weighted Average Maturity
Tactical Asset Allocation
WMA
TER Wealth Management Association
Total Expense Ratio
XD
TIPS Ex-Dividend
Treasury Inflation-Protected Securities
XED
TWRR Cross Elasticity of Demand
Time Weighted Rate of Return
XR
UCITS Ex-Rights
Undertakings for Collective Investments in
Transferable Securities XS
Ex-Scrip
UKLA
United Kingdom Local Authority YED
Income Elasticity of Demand
USD
US Dollar YTM
Yield to Maturity
VaR
Value at Risk ZCB
Zero Coupon Bond
401
402
Multiple Choice
Questions
404
Multiple Choice Questions

The following questions have been compiled to reflect as closely as possible the examination standard
that you will experience in your examination. Please note, however, they are not the CISI examination
questions themselves.
1. Which of the following has the capacity to enter into a contract that will bind a trust?
a. Beneficiary
b. Settlor
c. Trust protector
d. Trustee
2. Which of these correlation coefficients indicates the weakest relationship between two assets?
a. +1
b. +0.2
c. –0.5
d. –1
3. I n terms of the financial planning process, which of the following stages comes immediately after
an adviser has determined the client’s requirements?
a. Assess existing assets and potential solution
b. Formulate a strategy to meet objectives
c. Produce recommendations and a financial plan
d. Ascertain the client’s preferences and expectations
4. An economic cycle would typically follow which sequence of events?

a. Acceleration, boom, recovery, recession, deceleration
b. Recession, deceleration, recovery, acceleration, boom
c. Recovery, acceleration, boom, deceleration, recession
d. Recovery, boom, acceleration, deceleration, recession
5. Which of the following statements supports the strong form of the Efficient Markets Hypothesis?
a. Future share prices can be predicted using historical share price data
b. Share prices reflect all available information known or knowable about the companies in
question
c. Privately available information is not instantly reflected in share prices
d. Investors do not always process freely available information accurately
405
6. Which of the following BEST describes the unique feature of a convertible bond?
a. It can be redeemed early by either party
b. It can be converted into cash
c. It can be converted to equity in the issuing company
d. It can be converted into another grade of debt
7. Most convertible bonds pay a lower coupon than similar bonds. The reason for this is that
investors find which of the following characteristic attractive?
a. They are secured and therefore are backed by specific assets
b. They have a third-party guarantee, usually by a bank or fund
c. They include an option to convert the debt into the issuer’s shares
d. They are always senior and secured debt, with a higher credit rating
8. If a government decides to deal with a current account deficit by allowing the value of its
currency to decline against other currencies, what will be the impact on a company?
a. It will reduce its costs for importing raw materials
b. The cost of services it obtains from abroad will be cheaper
c. Profits earned in other currencies will be worth less when translated into sterling
d. Its goods will be more competitive in overseas markets
9. Which one of the following statements describing a bond’s price and yield quotations are TRUE?
a. Traders use the yield curve as a measure of the returns and liquidity of bonds with the same
maturity of different issuers
b. They move in opposite directions, meaning that as a bond’s price falls, its yield will rise,
reflecting the fact that the coupon payment does not change
c. Every bond’s coupon represents the percentage of the principal amount or par that will be
paid on a quarterly basis
d. They move in the same direction, reflecting the bond’s basic credit standing, but their
relative spreads usually lag behind
10. A bond is currently priced at 110, has a Macaulay duration of 7.5, has a flat yield of 4.5% and a
GRY of 4.25%. If interest rates were to rise by 1%, what would the approximate affect on its price?
a. 102.09
b. 109.85
c. 110.15
d. 117.91
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11. Which of the following is the most accurate in relation to a bond’s prices?
a. Bonds are quoted clean and the purchaser pays the clean price
b. Bonds are quoted clean, but the purchaser pays the dirty price
c. Bonds are quoted dirty and the purchaser pays the dirty price
d. Bonds are quoted dirty, but the purchaser pays the clean price
12. You are discussing with a client the intended use of derivatives to enhance the performance of his
substantial portfolio. You are attempting to ensure that he has the required level of knowledge
that will enable you to judge suitability and appropriateness and so ask how he intends to use
them. Which statement would indicate he has some understanding of how they operate?
a. If I want to hedge against a fall in the market I would go long the future and buy calls on
specific shares
b. If I want to leverage a position where a share is going to rise significantly I will write call
options
c. If I want to be able to take short positions I will write put options and go long the future
d. If I want to protect my portfolio against market falls I will go short the future and buy put
options
13. Investor A invested $6,000 at 4% p.a. compounded quarterly, whilst investor B invested $6,000 at
3.8% p.a. compounded annually. Based on gross interest, how much more will investor A receive
by the end of the first year compared to investor B?
a. $8.73
b. $12.00
c. $12.35
d. $15.62
14. What would an American Depository Receipt (ADR) holder expect to receive when the issuing
company makes a rights issue?
a. Shares in the underlying security
b. New shares in ADR form
c. Proceeds of the sale of the rights
d. Revaluation of the ADR
407
15. A Real Estate Investment Trust is more advantageous than a traditional property investment trust
for which reason?
a. REITS do not pay corporation taxes if they distribute at least 90% of their profits to
shareholders
b. REIT investors pay less income tax on dividends
c. REITS pay more CGT but less income tax
d. Rental income in a REIT is not taxed
16. A client has an ethical investment strategy and wants to ensure that none of his money is
invested in companies involved in areas he disagrees with. Which type of fund would be most
suitable for his needs?
a. Fund A which employs positive screening techniques
b. Fund B which employs negative screening technique
c. Fund C which uses positive engagement to identify companies that have the most
responsible approach
d. Fund D which undertakes research to identify companies that have best in class social
engagement strategies
17. Which element of a client’s risk profile is objective rather than subjective?
a. Risk tolerance
b. Risk perception
c. Attitude to risk
d. Risk capacity
18. A client will not sell his XYZ shares below the $5.35 he paid for them. What is this an example of in
behavioural finance terms?
a. Anchoring
b. Familiarity bias
c. Herding
d. Regret
19. Your client says she feels she is a cautious investor and does not want to risk any capital loss at
any time. What would be the most appropriate portfolio for her?
a. 100% cash
b. 20% cash/60% bonds/20% equity
c. 25% cash/65% bonds/10% equity
d. 30% cash/65% bonds/5% equity
408
20. When assessing the risk and return of a diversified portfolio and comparing it to the performance
of other similar portfolios, a manager is most likely to use which of the following?
a. Information Ratio
b. Jensen Measure
c. Sharpe Ratio
d. Treynor Ratio
21. A lack of liquidity, high management costs and void periods are characteristics associated with
investment in which of the following assets?
a. Commercial property
b. Depository interests
c. Eurobonds
d. Hedge funds
22. A fund converts its holding in preference shares into ordinary shares. Which of these statements is
true?
a. Counterparty risk has increased
b. Default risk has decreased
c. Market risk has increased
d. Systemic risk has decreased
23. An investor has £10,000 which he wishes to deposit in an interest-bearing account for up to 12
months. Which of the following accounts would provide the investor with the best rate of return?
a. A no notice deposit account paying 5% payable half-yearly
b. A one-year fixed rate bond offering 5% payable at maturity
c. An instant access account paying 5% interest monthly
d. A one-month notice account paying 5% interest quarterly
24. As part of the rebalancing of a portfolio, a portfolio manager decides to sell and buy similar bonds
in all respects apart from the yield on which both trade. The result is that the underlying client
moves out of the more to the less highly priced bond. This process is known as which of the
following?
a. Bond Switching
b. Anomaly Switching
c. Redemption Switching
d. Price Switching
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25. Bond 1 has a Standard & Poor’s rating of B and Bond 2 has a Standard & Poor’s rating of BBB. This
usually means that Bond 1:
a. has a higher yield than Bond 2.
b. is lower risk than Bond 2.
c. has a smaller coupon than Bond 2.
d. is cheaper than Bond 2
26. Bonds have differing sensitivities to changes in yields. Which of the following statements correctly
places the bonds mentioned in the order of most to least sensitive?
a. 17/8% Index-linked Treasury Gilt 2022; 4% Treasury Gilt 2022; Gilt strip repayable 2022; 3½%
War Loan
b. 3½% War Loan; Gilt strip repayable 2022; 17/8% Index-linked Treasury Gilt 2022; 4% Treasury
Gilt 2022
c. 4% Treasury Gilt 2022; 17/8% Index-linked Treasury Gilt 2022; Gilt strip repayable 2022; 3½%
War Loan
d. Gilt strip repayable 2022; 17/8% Index-linked Treasury Gilt 2022; 4% Treasury Gilt 2022; 3½%
War Loan
27. Why is the gross redemption yield considered to a better way of representing the return on a
bond investment?
a. As well as taking into account actual return, it includes a formula for comparing the return
against benchmark rate such as the consumer prices index
b. It includes a comparison against other benchmark bonds and thus provides a ‘true’ rate of
return against the overall bond markets
c. It includes the three key factors of price, all of the coupon payments and the repayment of
the principal
d. It provides a real return compared to LIBOR, EURIBOR and a basket of other major global
interest rates
28. Which of the following describes the exercise price of a call option?
a. Amount of premium the writer receives when selling the option
b. Premium given for the purchase of the option
c. Price at which the buyer of the option may buy the underlying
d. Price at which the buyer of the option may sell the underlying
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29. Which of the following best describes the purpose of a dividend cover calculation?
a. It establishes whether an issuer of asset-backed securities has enough earned revenue to
enable it to maintain its interest payments to holders
b. It attempts to assess the likelihood of the current net dividend paid to shareholders being
maintained by using its EPS
c. It measures cash assets against dividend forecast to predict future dividend yields
d. It is a direct ratio of gross dividend versus EPS
30. Which of the following is the best description of benchmarking?

a. The monitoring of the overall performance of a portfolio by comparison to a peer group
b. The setting of realistic targets for profits upon each asset purchase
c. The financial analysis and comparative analysis of direct products sectors
d. The plotting of prices of identical assets trading on multiple regulated markets and MTFs
31. Twenty points have been quoted for a particular forward FX trade. This represents the difference
between:
a. The base currency`s forward price and that of the traded currency
b. The relative premium of forward delivery vs any discount
c. The spot price and the forward outright rate
d. The spread for the spot bid and offer prices
32. Tactical Asset Allocation may be considered to be an `active` strategy, since it uses:
a. A long-term approach to asset allocation that is based on the historic returns of each asset
class. Any changes are due to shifts in an investor`s risk/return profile
b. A stochastic model to test a wide range of possible portfolios. Once this portfolio is chosen,
its asset allocation will remain in line with the model`s predictions
c. Some flexibility in asset allocation, by taking into account a component of market timing,
shifting to assets that perform better in certain economic conditions
d. The most active method of Modern Portfolio Theory, when determining a portfolio`s asset
allocation. Once set, any changes are only triggered by major cash inflows or withdrawals
33. Securities analysts and investors used a company’s liquidity ratio to establish which of the
following?
a. Does it have access to sufficient cash to meet its ongoing liabilities
b. Does it have the sufficient ongoing cash to meet its long-term liabilities
c. How the company’s profit margin measures relative to its competitors
d. Measure the company’s capital ratio relative to its sector
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34. An investor is using the capitalisation rate to estimate the value of a buy-to-let property. How is it
calculated?
a. Gross annual rent divided by the property`s sale price
b. Sale price divided by the net annual rent
c. Net operating income divided by the sale price
d. Sale price divided by the gross operating income
35. Which characteristic is most typical of a client classified as a high risk or speculative?
a. High levels of financial knowledge and a keen interest in financial matters
b. May have experience of investment products containing equities and bonds
c. Usually prepared to give up a certain outcome provided rewards are high enough
d. Usually make up their minds quickly but may suffer from regret at bad decisions
36. A yield curve represents the relationship between:

a. Interest rates and credit risk
b. Interest rates of two currencies
c. Interest rates and bond maturities
d. Interest rates on government and non-government bonds
37. Your client is aged 37, has a balanced attitude to risk and wishes to invest for long-term capital
growth. Based on the following portfolio, which course of action would you recommend?
Cash 75,000
Bond 95,000
Equities 30,000
Total 200,000
a. Leave the portfolio unchanged
b. Reduce the fixed interest and increase cash
c. Reduce cash and invest in fixed interest
d. Reduce cash and increase equity investments
38. Which type of security issued by an investment trust would you expect to carry the highest
degree of investment risk?
a. Capital shares
b. Income shares
c. Unsecured loan note
d. Zero dividend preference shares
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39. Which of the following is the best example of how a portfolio manager can limit potential losses
on portfolios by giving up some of the potential profits?
a. By using derivatives as insurance
b. By implementing a programme of product diversification
c. By intense strategic asset allocation
d. By setting stop loss limits on all investments
40. Which statement comparing trusts and foundations is correct?

a. A trust has a founder and a foundation has a settlor
b. A trust is a legal entity and a foundation is not
c. A trust can be used for commercial purposes and a foundation cannot
d. A trust has a council and a foundation has officers
41. What is the Macaulay duration of an annual coupon-paying bond priced at £98 where the sum of
the individual present values of the cash flows multiplied by the time periods at which they occur
is 540?
a. 1.8 years
b. 2.755 years
c. 5.29 years
d. 5.51 years
42. During a lengthy consultation, a client expresses his need for high liquidity allied to a short
investment timescale. Which of the following products is likely to be the MOST suitable?
a. Short-dated bonds
b. Exchange-traded funds
c. Equities
d. Split capital investment trusts
43. You are analysing the key features of a hedge fund. Which area differs significantly and would
require more evaluation compared to other indirect investments such as an onshore mutual
fund?
a. Arrangements for encashment of your holding
b. Asset servicing arrangements
c. Trading undertaken through multiple brokers
d. Use of a mix of custodian arrangements
413
44. Which of the following removes the impact of cash flows in and out of a portfolio when
measuring performance?
a. Total return.
b. Time-weighted rate of return.
c. Holding period return.
d. Money-weighted rate of return.
45. A financial adviser has recommended that his client adopt the following investment allocation
strategy.
Asset Class 1 - International equities (30%)
Asset Class 2 - UK equities (30%)
Asset Class 3 - Government Bonds (25%)
Asset Class 4 - Corporate bonds (10%)
Asset Class 5 - Cash (5%)
When considering the client`s diversification requirements, it should be noted that:
a. Diversification among Asset Classes 2, 3 and 4 are only likely to be maximized in times of low
interest rates
b. Diversification between Asset Class 1 and 2 are likely to reduce in times when markets are
volatile and under stress
c. Diversification is more likely if the holdings in Asset Class 3 are reduced at the same time as
Asset Class 4 holdings are increased
d. Diversification will be less difficult to achieve if Asset Class 5`s holdings are redistributed
amongst the other four asset classes
46. In order to mitigate interest rate risk, a short-term money market fund should have?
a. A maximum weighted average maturity (WAM) of 60 days
b. A maximum weighted average life (WAL) of 120 days
c. 10% of the fund invested in overnight deposits
d. Between 20-30% invested in securities due within one week
47. A portfolio was worth $500,000 at the beginning of the year and $550,000 at the end of December
of that year. The transactions that took place during the year were a cash injection of $15,000 at
the end of March and a cash withdrawal of $7,000 at the end of September. What is its money
weighted rate of return?
a. 8.24%
b. 8.43%
c. 11.38%
d. 11.63%
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48. The current exchange rate is GBP1/US$1.65 and the interest rates in the US and UK for the next
year are 3% and 4% respectively. What is the one year forward rate of exchange using interest rate
parity?
a. US$1.6341
b. US$1.6540
c. US$1.6995
d. US$1.7165
49. Total expense ratio is used in conjunction with which of the following?
a. Analysis of company accounts
b. Collective investment schemes
c. Discretionary investment management
d. Performance measurement
50. In which type of swap transaction might you expect there to be an exchange of the principal
amount?
a. Asset swap
b. Currency swap
c. Equity swap
d. Interest rate swap
51. How does a subdivision or stock split affect an investor’s holdings in the company?
a. It decreases the number of shares held, increases the share price and has no effect on the
investor’s book cost
b. It decreases the number of shares held, reduces its share price and increases the value of the
investor’s holding
c. It increases the number of shares held, reduces the share price and has no effect on the
investor’s book cost
d. It increases the number of shares held, increases the share price and increases the value of
the investor’s holding
52. With which type of indexation methodology used for index trackers is investment performance
most exposed to both tracking error and counterparty risk?
a. Full replication
b. Optimisation
c. Sampling
d. Synthetic
415
53. The order book for a share is shown below.
Buy Queue Sell Queue

7,000 shares 1.24 3,550 shares 1.25
5,150 shares 1.23 1,984 shares 1.26
19,250 shares 1.22 75,397 shares 1.26
44,000 shares 1.22 17,300 shares 1.27
An investor has placed an execute and eliminate order to buy 5,000 shares at 1.25. Which
statement correctly describes what action will take place with this order?
a. As the entire order cannot be filled, the whole order will be eliminated from the order book
b. It will automatically execute against the order to sell 3,550 shares at a limit of 1.25 and the
balance of the order will be cancelled
c. It will automatically execute against the order to sell 3,550 shares and the balance of the
order will remain on the order book as a limit order
d. It will automatically execute against the order to sell 3,550 shares and the balance of the
order will be executed against the second order to sell 1,984 shares
54. Which of the following characteristics is TRUE of hedge funds? Hedge funds usually:
a. Only use derivatives for efficient portfolio management
b. Focus on relative investment returns typically against a sector average
c. Adopt an unauthorised collective investment scheme structure
d. Have a high correlation with world equity and bond markets
55. Which of the following statements is CORRECT in respect of the trading of corporate bonds?
a. Corporate bonds trading takes place on major exchanges only
b. The majority of corporate bonds trading takes place in decentralised, dealer based OTC
markets with a limited amount of dealing on major exchanges
c. Corporate bonds dealing is equally split between major exchanges and decentralised,
dealer-based, over the counter markets
d. The majority of corporate bonds dealing takes place on major exchanges, with some dealing
on decentralised, dealer-based, over the counter markets
56. Which of the following is the best description of subordinated bonds?

a. They are bonds where the coupon rate varies according to ability to pay and thus have an inferior
ranking within the capital structure hierarchy but have the same market risk as a senior note
b. They have a semi-superior status within the capital structure hierarchy and have greater risk
than a senior note but less than a secured note
c. They have an inferior ranking within the capital structure hierarchy and have a greater risk
than a senior or secured note
d. They have the lowest ranking within the capital structure hierarchy and are effectively zero
coupon bonds, rarely paying interest
416
57. During the course of a typical economic cycle, an investment manager made the following
strategic switches:
Switch A – Defensive equities to interest-rate-sensitive equities
Switch B – Exchange-rate-sensitive equities to basic industry equities
Switch C – Cyclical consumer equities to commodities
Switch D – General industrial equities to capital spending equities
Assuming these switches were theoretically sound, which one of the following statements is
TRUE?
a. Switch A occurred at the peak of the bull market
b. Switch B occurred during the early part of the bear market
c. Switch C occurred as inflation began to cause concern
d. Switch D occurred as the recession took hold
58. If a share price falls, which of the following is TRUE?

a. P/E ratio rises; dividend yield falls
b. P/E ratio falls; dividend yield rises
c. P/E ratio rises; dividend yield rises
d. P/E ratio falls; dividend yield falls
59. Which of the following objective factors would be an indication that an investor will accept higher
risk investments?
a. One with specific commitments to meet
b. One with limited assets and few liabilities
c. A younger person planning for retirement
d. One with a specific investment timescale and goal
60. In which type of trust is the income typically payable to a beneficiary for their lifetime and the
capital held for others on that person’s death?
a. Bare trust
b. Discretionary trust
c. Accumulation trust
d. Interest in possession trust
61. What are the three components of a client’s risk profile?

a. Risk tolerance, risk perception and risk aversion
b. Risk tolerance, risk perception and risk capacity
c. Attitude to risk, risk aversion and risk capacity
d. Attitude to risk, risk perception and risk tolerance
417
62. If the current yield curve is described as normal, what would this indicate?
a. Yields on shorter dated stocks are higher than longer dated stocks but lower than medium
dated
b. Yields on shorter dated stocks are significantly higher than longer dated stocks
c. Yields on shorter dated stocks are significantly lower than longer dated stocks
d. Yields on shorter dated stocks are similar to longer dated stock
63. Which of the following bonds would be worth converting?

a. Bond A which is priced at 95 and is convertible into ordinary shares which are priced at $7.25
and are convertible at a rate of 12 shares per $100 nominal
b. Bond B which is priced at 98 and is convertible into ordinary shares which are priced at $5.10
c. Bond C which is priced at 93 and is convertible into ordinary shares which are priced at $3.75
d. Bond D which is priced at 89 and is convertible into ordinary shares which are priced at $3.10
64. Which of the following describes a market in which only the bid and ask offers of designated
market makers, dealers or specialists are displayed?
a. Amount driven
b. Order driven
c. Price driven
d. Quote driven
65. Which of the following is compared to the current price to determine whether an investment
trust share is trading at a discount or premium?
a. Bid price
b. Mid market price
c. Net asset value
d. Offer price
66. Investor A has a one-year fixed rate bond with her High Street bank and Investor B has a two-year
fixed rate bond, at the same annual rate as Investor A, with her High Street building society. When
comparing the risks associated with these investments:
a. Investor A has a greater capital risk exposure than Investor B
b. Investor A has a lower inflation risk exposure than Investor B
c. Investor A and Investor B have the same interest rate risk exposure
d. Investor A and Investor B have both mitigated their operational risk exposure
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67. A company issued 6% cumulative redeemable preference shares at 125p. They are currently
priced at 150p and can be converted into ordinary shares at the rate of 4 to 1. If the ordinary
shares are priced at 500p, what is the conversion premium?
a. 5%
b. 10%
c. 15%
d. 20%
68. As retirement approaches, the investment style that a client will most likely adopt would be which
of the following?
a. Increasing risk to maximise sums available at retirement
b. Placing greater emphasis on long-term investments
c. Gradually moving investments into more secure products
d. Introducing more growth oriented investments
69. In futures pricing, basis is defined as the difference between:

a. Cash price and the future price
b. Cost of carry and the future price
c. Future price and the option price
d. Spot price and cost of carry
70. Under the ‘accrual concept’ of accounting:

a. Revenue is based on income when received and expenses when paid
b. Revenue is based on income when earned and expenses when paid
c. Revenue is based on income when received and expenses when incurred
d. Revenue is based on income when earned and expenses when incurred
71. Diversification is best achieved by combining securities whose returns:

a. Are as positively correlated as possible
b. Are as negatively correlated as possible
c. Have similar standard deviations
d. Have widely different standard deviations
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72. A machine was purchased by a company for $32,000, has a useful economic life of five years and
is estimated to have a disposal value at this point of $2,000. What is the annual depreciation using
the straight line method?
a. $4,400
b. $5,667
c. $6,000
d. $6,400
73. The phenomenon identified by behavioural science as ‘mental accounting’, manifests itself in
what way, during the process of establishing a client’s capability and circumstances?
a. A client is likely to suppress soft facts, as they do not see them as being relevant to the
process
b. A client who is not an experienced investor, is likely to have a natural aversion to taking risk,
due to the intense pain of sustaining financial loss
c. Unless the client has trust in the adviser at the outset, they are likely to be reluctant to
disclose their full financial position
d. Where there is more than one investment objective, a client may have a different attitude to
risk in respect of each objective
74. Which of the following statements concerning CIS charges is correct?

a. Unit trusts are dual priced and purchases incur an additional initial charge
b. ETFs are single priced and dealing incurs a dilution levy
c. Investment Trust pricing depends on demand and supply and incurs initial commission
d. OEICs are single priced and may charge a dilution levy
75. Following a liquidation there are sufficient funds to pay preference shareholders. Consequently,
they will receive:
a. The pre-liquidation market price
b. The nominal value
c. The equitable value decided by the liquidator
d. The unpaid net dividends only

76. Under the Capital Asset Pricing Model, if a stock has a beta of 1.2 this means that:
a. It has outperformed its sector average by 20%
b. It is 20% more volatile than the market
c. Its profits grew by 20% over the last 12 months
d. Its dividend level is likely to fall by 20%
420
77. A company’s shares are currently trading at £5. If it implements a 1 for 4 rights issue at a
discounted market price of £4, what will be the theoretical post-issue share price?
a. £4.50
b. £4.70
c. £4.75
d. £4.80
78. One of the characteristics of an open-ended investment company (OEIC) that is attractive to most
investors is:
a. Since they are open-ended, they cannot trade at a discount to their net asset value
b. Their structure allows them to invest in only one fund at a time, to limits any risks, such as FX
risk
c. They are closed-ended, therefore can trade at a discount or premium to its net asset value
d. Since they do not have any dealing charges, their bid-offer spread can be wide when
liquidity is limited
79. If a company’s share price is $1.10 and its net asset value per share is $1.00, then 1.1 will represent
the company’s:
a. Price/earnings ratio.
b. Price to book ratio.
c. Earnings per share.
d. Z-score analysis.
80. Which of the following is likely to have the greatest liquidity risk and so is least suitable to meet
any cash needs of a client?
a. A shareholding in an FTSE 100 company
b. An investment in an inflation protected bond
c. A ahareholding in an open ended investment company
d. A shareholding in an emerging markets company
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Answers
1. D Chapter 6, Section 3.1.2 LO 6.3.1

The trustees have the legal capacity to enter into a legally binding contract for a trust.
2. B Chapter 6, Section 1.4 LO 6.1.4

High correlation between two assets gives a coefficient of +1.0 (perfect positive correlation) or –1.0
(perfect negative correlation). Assets with a high level of correlation (close to +1) tend to move in the
same direction at the same time. Assets with strong negative correlations (close to –1) tend to move in
opposite directions but are still strongly related to one another. Assets with a low correlation (close to
0) tend to move independently of each other and have the weakest relationships.
3. B Chapter 6, Section 1 N/A

The financial planning process can be divided into five distinct stages: determining the client’s
requirements; formulating the strategy to meet the client’s objectives; implementing the strategy by
selecting suitable products; revisiting the recommended investments to ensure they continue to meet
the client’s needs; periodically revisiting the client’s objectives and revising the strategy and products
held, if needed.
4. C Chapter 7, Section 2.3.1 LO 7.2.3

Cycles typically assume a recovery, acceleration, boom, deceleration and recession pattern.
5. B Chapter 7, Section 2.1.3 LO 7.2.1

EMH has a number of key assumptions and the strong form purports that share prices reflect all available
information known or knowable about the security in question.

A convertible bond is one that gives the holder an option to convert the bond into the shares of the
issuing company.

Typically, a convertible bond will pay a lower coupon, as this is compensated for by an option to convert
into the equity of the issuer at the conversion date. Convertibles are often subordinated, meaning that
all senior creditors must be settled in full before any payment can be made to holders in the event of
insolvency.

If a country’s currency falls in value against other countries, then imports will be more expensive and
exports cheaper.
422

There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price
of bonds falls and vice versa. Bond yields in turn reflect the required rate of return (and credit risk
premium) which varies as interest rates move up and down.
10. A Chapter 2, Section 4.2.2 LO 2.3.2

Modified duration is Macaulay duration/(1+GRY) = 7.5/4.25= 7.194245%. So, a 1% increase in rates
should lead to an approximate fall of 110–(110*7.194245%)=102.09

Bonds are quoted clean but settle at the dirty price which includes accrued interest.
12. D Chapter 4, Section 3.1 LO 4.2.2

Going short futures and buying put options would benefit from a falling market.
13. D Chapter 1, Section 1.3.1 LO 1.1

D = (6,000 x 1.014) – (6,000 x 1.038) = 15.62

ADR shareholders are unable to take up a rights issue and instead receive the proceeds of the sale of
any rights.

REITs are tax transparent provided they distribute a certain proportion of their profits.

‘Dark green’ funds would be most appropriate as they screen out companies that fail to meet their
ethical standard.

Risk capacity is the client’s ability to absorb any losses that may arise from making a particular
investment. Risk tolerance and risk perception are partly subjective, but risk capacity is largely a matter
of fact.

Anchoring refers to the fact that people tend to base their decisions on reference points that are often
arbitrarily chosen, for example, choosing to sell shares is influenced by what they paid for them.
19. A Chapter 6, Section 1.3 LO 6.1.3

The client’s risk profile is cautious and she does not want to risk any capital loss, therefore making
exposure to bonds or equities inappropriate.
423
The Treynor ratio is used for comparing diversified portfolios.

A distinguishing feature of property investment is its lack of liquidity, costs associated with its
management and void periods when the property is not rented.
22. C Chapter 3, Sections 1.1.2 and 3 LO 3.1.1, 3.2.1

Converting preference shares into ordinary shares will expose the holding to greater market or price
risk.
23. C Chapter 1, Section 1.3.1 LO 1.1

Where interest is paid monthly and added to the account, the subsequent interest will be on a higher
balance, so, as all of the accounts are paying the same rate, then the one paying monthly must offer the
best rate of return.

Anomaly switching involves moving between two bonds similar in all respects apart from the yield and
price on which each trades. This pricing anomaly is exploited by switching away from the more to the
less highly priced bond.

Securities with a rating of BB and below (which includes B but not BBB) are considered non- investment
grade and so will have a higher yield to compensate for the risk.

A bond sensitivity to changes in interest rates depends on a number of factors including its coupon
and period to redemption. 3½% War Loan is irredeemable and will be the most sensitive to changes in
interest rates followed by the gilt strip which carries no income. The index linked gilt carries a lower flat
yield than the conventional gilt.

Unlike flat yield, the GRY takes into account the total return from a bond after considering the price paid,
all of the coupon payments and the repayment of the principal.

It is the pre-agreed price at which the option can be exercised to buy the underlying.

Dividend cover attempts to assess the likelihood of the existing dividend being maintained.
424

Portfolio performance may be measured by reference to a relevant peer group.
31. C Chapter 4, Section 1.4 LO 4.1.2

An outright forward rate is composed of the spot price plus a certain percentage.

Tactical asset allocation is about making short term changes to portfolio’s asset allocation.
33. A Chapter 3, Section 4.3.2 LO 7.3.2/7.3.3

Liquidity ratios aim to establish whether a company has the resources to meet its operating requirements
from its working capital on a timely basis and whether it can actually realise those resources quickly
enough. In other words, does it have sufficient ability to raise cash when required, to pay off the
liabilities as they fall due.

The capitalisation rate is calculated by dividing the net income by the cost of the property.

Clients classified as ‘high risk’ or ‘adventurous’ are ones whose priority is capital growth and who
understand and accept that in order to achieve it there is a significant risk to their capital.

The relationship between yield and maturity is known as the term structure of interest rates and can be
illustrated diagrammatically by a yield curve.

Given the client’s age, attitude to risk, investment objective and timescale, then increasing the equity
allocation would probably be most appropriate.

Capital shares receive no income but are entitled to all the capital in the trust, once any loans have
been repaid and the income and preference shareholders have been paid out. They therefore carry the
highest investment risk.

Portfolio insurance (also referred to as hedging) is a technique for limiting the potential loss on a
portfolio using derivatives, at the expense of giving up some of the potential profits.
425
A trust can be used for commercial purposes. A trust is not a legal entity, has trustees and is created by
a settlor.

Macaulay duration, or duration is given by: )sum of present value of the cash flows x time to being
received)/NPV of the cash flows or price = 540/98 = 5.51 years.

The client needs high liquidity and can only invest for the short term, so of the investment types quoted
only short dated bonds would meet the criteria.

Hedge funds typically have less frequent valuation points at which holdings can be sold and in-built
delays before funds are released.

The time weighted rate of return (TWRR) removes the impact of cash flows on the rate of return
calculation.

Global equity markets are highly interlinked and in times of market stress move together as correlation
compression takes place.
46. A Chapter 1, Section 2.3 LO 1.2

Risk mitigation standards for a short term money market fund require it to have a maximum WAM of 60
days to mitigate interest rate risk.

The MWR is:
£550,000 -£500,000 – £8,000

MWRR = ________________________________________
[ _9___
£500,000 + (£15,000 × _12 _3___
) + (-£7,000 × _12 ])
£42,000 £42,000
= ________________________ = _________ = 8.24%
£500,000 + £11,250 – £1,750 = £509,500
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The forward rate on one year’s time will be based on the spot rate adjusted by the relative interest
rates. So US$1.65 x 1.03 will be equivalent to £1 x 1.04. The one year forward rate will be based on
US$1.6995 = £1.04. Dividing both sides by 1.04 = US$1.6995/1.04 = £1.04/1.04. The one-year forward
rate = US$1.6341 = £1.

TERs are used to compare costs between collective investment schemes.

Currency swaps are interest rate swaps made in two different currencies that require an exchange of the
loan principal at the beginning and at the end of the swap period.

A subdivision, also referred to as a stock split, covers the case where a company increases the number of
issued securities, for example by dividing every one share currently existing into four shares of a quarter
of the old nominal amount.

All will have some degree of tracking error, but synthetic replication generally increases counterparty
risk.

Execute and eliminate orders are filled in whole or in part at, or better than, the stipulated price with any
unfilled portion of the order being automatically deleted from the system.

Hedge funds are typically structured as unauthorised funds as regulators do not permit them to be
marketed to retail investors.

The bond market is instead more oriented towards ‘over-the-counter’ market trading, rather than
on-exchange trading.

Subordinated bonds are ones which have a junior or inferior status within the capital structure hierarchy
and have greater risk than a senior or secured note.
427
Switch A – likely to occur at the start of a bull market; Switch B – likely to occur during the growth
phase of a bull market; Switch C – likely to occur as growth decelerates as interest rates rise to suppress
inflation; Switch D – likely to occur during the growth phase of a bull market.

The PE ratio is calculated as price/earnings per share and the dividend yield is calculated as dividend/
price so a fall in the price will lower the PE ratio and raise the dividend yield.

Timescale – the timescale over which a client may be able to invest will determine both what products
are suitable and what risk should be adopted. For example, there would be little justification in selecting
a high-risk investment for funds that are held to meet a liability that is due in 12 months’ time. By
contrast, someone in their 30s choosing to invest for retirement is aiming for long-term growth, and
higher-risk investments would then be suitable. As a result, the acceptable level of risk is likely to vary
from scenario to scenario.

An interest in possession is the right to receive an income from the trust fund, or use of the trust assets,
usually for life with the assets passing on to other beneficiaries following that person’s death or some
other specified event.

Risk profile is made up of a combination of attitudes – risk tolerance and personal opinion or perception
– and risk capacity.
Tolerance, attitude, capacity.

A normal yield curve depicts the commonly observed relationship of long-term interest rates being
higher than short-term interest rates.

$100 nominal of the bond is valued at $89 and is convertible into 30 ordinary shares worth $93 at $3.10
per share.

Quote-driven trading systems employ market makers to provide continuous two-way, or bid and offer,
prices during the trading day in particular securities regardless of market conditions.

The net asset value of an investment trust is reported daily to the stock exchange and its price will then
be at either a discount or premium to that figure.
428
66. B Chapter 1, Section 1.4.2 LO 1.1

As Investor A is locked in for a shorter term, she has a lower inflation risk exposure. Investor A and
Investor B have similar exposure to capital risk if the deposit taker defaults. Their exposure to interest
rate risk is different due to their different fixed terms. Poor service from the deposit taker could expose
either to operational risk.

The premium = (4 x 150 ÷ 500) – 1 x 100 = 20%.

As a generalisation, a client approaching retirement will be seeking to secure growth that has previously
been made so that it is available to meet their needs in retirement and to reduce the impact of a market
fall at that point.

Basis measures the difference between cash and futures prices.

The accrual concept requires accounts to reflect revenue and expenses as they are earned and incurred.

Diversification is best achieved by combining securities whose returns ideally move in the opposite
direction to one another.

It is (32,000 – 2,000) ÷ 5 = $6,000.

Clients may have more than one objective and will ‘mentally account’ for how these can be reconciled.
74. D Chapter 5, Sections 1.1.3, LO 5.1.1, 5.2.1

2.3.3 and 3.1.2 5.3.1
OEICs are single priced and may impose dilution levies as this method of pricing does not provide the
ability to recoup dealing expenses and commissions within the spread.

Following liquidation, preference shares are repaid at their nominal value if there are sufficient funds
available.

Beta is a measure of the sensitivity of a stock’s return to the returns of the market as a whole.
429
If, for example, 20 shares are held, the post-issue share price will be (20 x 5) + (5 x 4) ÷ 25 = £4.80.

The value of an OEIC’s share is determined by the net asset value (NAV) of its underlying investments.
This characteristics of an OEIC means that it cannot trade at a discount to NAV, as an investment trust
can.

Price to book ratio = share price divided by net asset value per share.

Emerging market shares are potentially exposed to greater liquidity risk.
430
Syllabus Learning Map
432
Syllabus Unit/ Chapter/

Element Section
Element 1 CASH AND MONEY MARKETS Chapter 1

Cash Deposits
1.1
On completion, the candidate should:
Analyse the key features, risks and returns of cash deposits:
• Types - types of account; foreign currency accounts
• Characteristics - capital security; interest options
1.1.1 • Returns - rates of interest; interest rate comparisons; effect of Section 1
charges and penalties
• Risks - default risk; deposit insurance; credit risk assessment;
inflation risk; interest rate risk
Analyse the factors to take account of when selecting cash deposits:
1.1.2 Section 1
• access; security; liquidity; interest rates
Money Market Funds
1.2
On completion, the candidate should:
Analyse the key features, risks and returns of money market funds:
• Types - types of funds; constant and variable NAV
• Characteristics - structure and operation; charges and tax;
1.2.1 supervision; underlying investments Section 2
• Returns - rates of interest
• Risks - interest rate risk; credit risk; liquidity risk; credit ratings;
use of weighted average maturity and weighted average life
Analyse the factors to take account of when selecting money market
funds:
1.2.2 Section 2
• uses of money market funds
• selection criteria
Element 2 BONDS Chapter 2

Characteristics and Types of Bonds
2.1
On completion, the candidate should be able to:
Understand the main purposes for issuing bonds and their key
features:
2.1.1 • Structures Section 1.1
• Where issued
• classifications
433
Element Section
Analyse the main investment characteristics of the major
government bond classes:
• Issuers - supranationals; sovereign governments; public
2.1.2 Section 1.2
authorities: local government/ municipalities
• Types - conventional; dual dated; undated; floating rate; zero
Coupon; inflation protected
Analyse the main issuers of corporate debt and the main investment
characteristics of secured and unsecured debt:
• Issuers and types of corporate bonds
• Security - seniority; fixed and floating charges; impact of
security; redemption provisions
2.1.3 Section 1.3
• Types of secured debt - debentures and secured debt;
securitisation process and asset backed and mortgage backed
securities
• Types of unsecured debt - income bonds; subordinated bonds;
high yield; convertible bonds
Analyse the main investment characteristics, behaviours and risks of
Eurobonds and foreign bonds:
2.1.4 • Issuers - sovereign, supranational and corporate Section 1.4
• Types of Eurobond - straight, FRN/ VRN, subordinated, asset
backed, convertible
Understand the role, structure and characteristics of global
corporate bond markets:
• How bonds are issued and the main participants involved
• Market structure - decentralised dealer markets; dealer provision
2.1.5 Section 1.5
of liquidity; bond pools of liquidity; market supervision and
regulation
• Trading conventions - clean and dirty pricing; day count
conventions; settlement
Risk and Return
2.2
Analyse the specific features of bonds from an investment perspective:
• Coupons - coupon and payment date; floating rate coupons;
other types of coupon
• Redemption provisions - maturity date; embedded put or call
2.2.1 Section 2
options
• Inflation protection - methods of index linking; impact on coupons
and maturity payments; Return during a period of zero inflation
• Other characteristics - convertible bonds; exchangeable bonds
434

Element Section
Analyse the risks associated with bonds and the role of credit rating
agencies:
2.2.2 • General risks Section 3
• Market risks
• Default risk
Bond Analysis
2.3
Analyse fixed income securities using the following valuation
measures, and understand the benefits and limitations of using them:
• Flat yield
2.3.1 Section 4.1
• Gross redemption yield (using internal rate of return)
• Net redemption yield
• Yield curves
Analyse the factors that influence bond pricing:
• Relationship between interest rates and bond prices and how
2.3.2 modified and Macaulay duration are used Section 4.2
• Yield to maturity; credit rating; impact of interest rates; market
liquidity
Analyse sovereign, government and corporate credit ratings from an
investment perspective:
Sections 4.2,
2.3.3 • Country rating factors; debt instrument rating factors; Use of
4.3, 4.4
credit enhancements
• Investment & sub-investment grades; impact of grading changes
Understand how bond prices are calculated and the main methods
of quotation:
• differences in yield, spread and price quotation methods
2.3.4 Section 4.5
• spread over government bond benchmark
• spread over/under LIBOR or other benchmark rate
• spread over/under swap rates
Element 3 EQUITIES Chapter 3

Characteristics and Types of Equities
3.1
Analyse the investment characteristics of equities:
• Types - ordinary and common shares; preference or preferred
3.1.1 Section 1.1
shares
• Rights - dividends; voting; pre-emption
435
Element Section
Analyse the characteristics of depositary receipts
• Depositary receipts - types; issue process; rights to dividends and
3.1.2 other events Section 1.2
• Depositary receipts
• Globally registered shares
Understand the role, structure and characteristics of equity markets:
• How new equity issues are undertaken and the role of the
participants
3.1.3 • Order driven and quote driven markets Section 1.3
• on-exchange and off-exchange trading
• pre- and post-trading transparency
• registration and safe custody
Understand the conventions of equity markets:
• Trading conventions - settlement conventions; Delivery versus
3.1.4 Payment; ex-dividend periods Section 1.4
• Regulatory considerations - best execution; timely execution;
allocation and aggregation; conflicts of interest
Risk and Return
3.2
Analyse the sources of return and the risks associated with equities,
including:
3.2.1 Section 3
• Liquidation
• Impact of market volatility
Analyse the impact of mandatory and voluntary corporate actions
on equity holdings:
3.2.2 • Income events - dividends; dividends with options Section 2
• Capital events - bonus issues; stock splits; reverse stock splits
• Capital raising events - rights issues; open offers; placings
Equity Analysis
3.3
Apply an understanding of legal requirements to prepare accounts
and of the framework for financial statements:
• Responsibility for preparation and required information in
3.3.1 accounts Section 4.1
• Objectives and qualitative characteristics of financial statements
• International financial reporting standards
• Auditors reports
Understand the purpose, structure and content of financial
3.3.2 Section 4.2
statements produced under IFRS
436

Element Section
Analyse equities using the following profitability, liquidity and
gearing ratios:
• Return on capital employed (ROCE); Asset turnover; Net profit
3.3.3 margin; Gross profit margin; Equity multiplier Section 4.3
• Working capital (current) ratio; Liquidity ratio (acid test); Z score
analysis
• Financial gearing; Interest cover
Analyse equities using the following investor ratios:
• Earnings per share (EPS)
• Earnings before interest, tax, depreciation, and amortisation
(EBITDA)
3.3.4 Section 4.3.4
• Earnings before interest and tax (EBIT)
• Historic and prospective price earnings ratios (PERs)
• Dividend yields and Dividend cover
• Price to book ratio (P/B)
Apply the principles of the following investment valuation methods

to the process of equity analysis:
3.3.5 • Dividend valuation models Section 4.4
• Earnings and asset valuation models
• Shareholder valuation models
Understand the main challenges and limitations of performing

3.3.6 Section 4.5
financial analysis
Element 4 OTHER INVESTMENTS Chapter 4

Foreign Exchange
4.1
Analyse the characteristics, risks and return of foreign exchange (FX)
from an investment perspective:
4.1.1 • Basic structure and operation of the foreign exchange market Section 1
• FX quotes - quoting conventions; currency pairs
• Determinants of spot foreign exchange prices
Calculate forward exchange rates using:
4.1.2 • premiums and discounts Section 1.4
• interest rate parity
Understand the characteristics and pricing of FX futures, options
4.1.3 Section 1.5
and swaps
437
Element Section
Apply an understanding of how FX transactions are used for:
• Foreign currency cash management
4.1.4 Section 1.6
• Speculation
• Hedging foreign currency exposure
Property
4.2
Understand the characteristics of the main types of direct and
indirect property investments:
• Sectors - residential; buy-to-let; commercial
4.2.1 Section 2
• Types - freehold; lease structures
• Operation - conveyancing; costs; valuation finance and gearing
• Investment funds - range of indirect investment vehicles available
Analyse the sources of risk and return associated with investing in
property and property funds
• Factors affecting returns - capital growth; yield; location and
4.2.2 Section 2.2
quality; occupancy rate; tenant creditworthiness; term and
structure of lease
• Risks - liquidity; volatility; sector risk
Analyse property and property funds from an investment perspective
• cash flow and average yield
• capitalisation rate
4.2.3 • rental value and review Section 2.2
• reversionary value
• investment performance measurement
• role of Investment Property Databank
Derivatives
4.3
Understand the core concepts, terminology, characteristics and uses of:
• Futures
4.3.1 Section 3.1
• Options
• Swaps
Apply an understanding of how derivatives strategies are used
within portfolio management for the purposes of:
• Hedging
4.3.2 Section 3.2
• Immunization
• Speculation
• Rebalancing
438

Element Section
Element 5 COLLECTIVE INVESTMENTS Chapter 5
5.1 Open Ended Funds

Analyse the key features, risks and returns of open ended funds:
5.1.1 Section 1
• Types; characteristics; pricing; dealing
Analyse the factors to take account of when selecting Open ended
Funds:
5.1.2 Section 1
• fund size; risk rating; total expense ratio; portfolio turnover;
liquidity; counterparty risk
5.2 Exchange Traded Funds
Analyse the key features, risks and returns of exchange traded funds:
5.2.1 Section 2
• Types; characteristics; pricing; dealing
Analyse the factors to take account of when selecting funds:
5.2.2 Section 2
• replication methodology; counterparty risk; liquidity; costs
5.3 Closed ended Funds

Analyse the key features, risks and returns of closed ended funds:
• Types; characteristics; pricing; dealing.
5.3.1 Section 3
• Specialist funds - private equity; infrastructure; project finance;
forestry
Analyse the factors to take account of when selecting closed ended
funds:
5.3.2 Section 3
• discounts and premiums; gearing; liquidity; fund size; total
expense ratio; portfolio turnover; counterparty risk
5.4 Life Assurance based investments
Analyse the key features, risks and returns of life assurance based
investments:
5.4.1 • Insurance vs assurance Section 4
• Types: insurance policies; insurance bonds; unit-linked insurance
products
Analyse the relative merits and limitations of investing in life
assurance based investments compared with other forms of direct
and indirect investment
5.4.2 • Taxation of insurance-based investments Section 4
• Uses in investment, financial protection, retirement and pension
planning
439
Element Section
5.5 Alternative Investment Funds
Understand the key features of Hedge Funds:
• Types of hedge funds
5.5.1 Section 5.1
• Investment strategies
• Use of short and long positions
Analyse the factors to take account of when investing in Hedge
Funds compared with other forms of direct and indirect investment
5.5.2 Section 5.2
• Sources of risk and return
• Due diligence
Analyse the key features, relative merits and limitations of investing
in the following alternative investment funds compared with other
forms of direct and indirect investment:
5.5.3 Section 5.2
• Absolute return funds
• Structured products
• Commodities and commodity funds
5.6 Fund selection and fund provider research

Understand the range of research available for mutual funds and
5.6.1 Section 6
their relative merits and limitations in the fund selection process
Element 6 FINANCIAL ADVICE Chapter 6
6.1 Investment Advice Process

Apply fundamental principles of financial planning to wealth
management scenarios:
6.1.1 Section 1.1
• Structured advice process; gathering client information; risk
assessment
Understand the key principles of behavioural finance and its impact
6.1.2 Section 1.2
on attitude to risk
Advise on investment objectives; constraints, investment strategy
6.1.3 Section 1.3
and suitability criteria
6.1.4 Analyse a client’s financial position; asset and cash flow projections Section 1.4
Understand the main considerations that should be taken into
account when developing investment strategies for:
6.1.5 • Trusts and charities Section 1.5
• Ethical and socially responsible investment
• Sharia’a and other faith based values
440

Element Section
Understand the use and importance of investor policy statements
and the range of investment solutions available for wealth
management clients:
6.1.6 Section 1.6
• Investment policy statements
• Investment solutions - wraps and other platforms; multi asset
funds and target date funds; discretionary portfolio management
6.2 International Considerations

Understand the concept of domicile and its impact on international
wealth management:
6.2.1 • Types of domicile Section 2.1
• Impact of domicile on tax
• Succession issues
Understand the concept of residency and its impact on taxation
issues in international wealth management:
• Meaning of residency
6.2.2 Section 2.2
• Worldwide versus territorial tax systems
• Impact on liability to tax
• Double taxation treaties and withholding taxes
Understand how the increase in international tax transparency
policies impact on international wealth management:
6.2.3 • Tax avoidance versus tax evasion Section 2.3
• Tax information sharing; EU Savings Directive; US Qualified
Intermediaries; FATCA
Trusts and Foundations
6.3
Understand the fundamentals of trusts and their use in international
wealth management:
• Types of trusts - definition; fixed interest; discretionary trusts;
6.3.1 other types Section 3.2
• Establishing a trust - certainties; role of parties
• Uses of trusts - main uses; types of assets held; sham trusts
• Private trust companies
Understand the fundamentals of foundations and their use in
international wealth management:
• Types of foundations - private; corporate; charitable; special
purpose
6.3.2 Section 3.2
• Establishing a foundation - charter; role of founder, foundation
council and other parties
• Uses of foundations - types of assets held; restrictions on
commercial activities; international business companies
441
Element Section
Understand the essential differences between trusts and
6.3.3 foundations and be able to distinguish them for other legal Section 3.3
concepts
Understand how offshore trusts are used for money laundering and
6.3.4 Section 3.4
steps that should be taken to counter threats
Element 7 PORTFOLIO MANAGEMENT Chapter 7

Risk and Return
Understand the sources of return sought by investors and how these
can be compromised by various risks:
7.1.1 • Returns - types of investment return and related investment Section 1
objectives
• Risks – market, credit, liquidity, concentration and systemic
Analyse the effects of volatility and correlation on investments and
asset classes:
7.1.2 • Volatility of returns: data distribution Section 1.3
• Standard deviation
• Positive, negative, zero and cross-correlation
Asset Allocation
7.2
Understand the main principles of portfolio construction theory and
the need for diversification:
7.2.1 • Modern Portfolio Theory Section 2.1
• Capital Asset Pricing Model
• Efficient Markets Hypothesis
Analyse the key approaches to investment allocation for bond,
equity and balanced portfolios, including an appreciation of their
limitations:
7.2.2 • Strategic asset allocation - factors influencing strategic allocation Section 2.2
decisions; selection of benchmark; model portfolios
• Tactical asset allocation - impact of market timing decisions on
asset allocation
Analyse the impact of economic, financial and stock market cycles
on the investment process:
• trade cycles
7.2.3 • business cycles Section 2.3.1
• asset price bubbles
• economic shocks
• difficulty in forecasting national and international trends
442

Element Section
Understand key economic and business indicators from an
investment perspective:
• Gross Domestic Product
• Interest rates
• Consumer price & inflation indices
7.2.4 Section 2.3.2
• Unemployment rate
• Stock market and foreign exchange indices
• Money supply changes
• Leading, lagging and coincident indicators
• Pro cyclic, counter cyclic and acyclic indicators
Analyse the impact of economic trends and indicators on asset
7.2.5 Section
classes and sector allocation
Investment management
7.3
Analyse the main cash, bond and equity portfolio management
strategies and their short and longer term implications for investors:
• Cash management
7.3.1 • Active and passive equity management strategies Section 3.1
• Active and passive bond strategies
• Alternative investment exposure
• Core- Satellite asset allocation
Understand the purpose and concept of benchmarking, the range
7.3.2 of weighting methods used in index construction, and the range of Section 3.2
published indices available
Understand the main factors influencing the selection or
7.3.3 construction of appropriate benchmarks for wealth management Section 3.2
clients
Apply an investment strategy for a wealth management client from
the perspective of:
• Investment objectives
• Risk appetite
• Tax situation
7.3.4 Section 3.3
• Total expense ratio (TER) and level of portfolio turnover (PTR)
• Suitability requirements
• Benchmarking
• Liquidity and timing factors where asset accumulation and
decumulation are relevant features
443
Element Section
Understand the responsibilities of managing a client portfolio
including:
• Monitoring and rebalancing the portfolio in light of market
developments
7.3.5 • Developing recommendations for ongoing investment purposes Section 3.4
• Reviewing and reporting on investment strategy and performance
• Regular and periodic communication with the client
• Changes in client circumstances
• Efficient administrative support
Evaluating investment performance
7.4
Calculate the main measures used in evaluating investment
performance, and know how they are applied:
• Holding period return
7.4.1 Section 4.1
• MWRR and TWRR
• Risk adjusted returns - Sharpe ratio; Treynor ratio; Jensen ratio;
Information Ratio
Analyse portfolio performance in terms of:
• Risk adjusted returns
7.4.2 Section 4.2
• Contributions to return arising from asset allocation, currency
movements, stock selection and timing
444
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.
Element Number Element Questions

1 Cash and Money Markets 4
2 Bonds 13
3 Equities 13
4 Other Investments 11
5 Collective Investments 12
6 Financial Advice 13
7 Portfolio Management 14
Total 80
445
446
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Behavioural Finance
Wealth
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Biases and Heuristics
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Edition 1, April 2014

This learning manual relates to syllabus

Learning manual version: 1.3 (April 2015)

With best wishes for your studies.

Lydia Romero, Director of Learning

Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403

Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431

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Cash and Money Markets

2. Money Market Funds 13

This syllabus area will provide approximately 4 of the 80 examination questions

1.1 Types of Accounts

Classification of Savings Accounts

1.1.1 Islamic Savings Accounts

1.1.2 Overseas Accounts

European Union (EU) Savings Directive

1.1.3 Foreign Currency Deposits

1.2 Characteristics of Cash Deposits

The interest rate applied to the deposit is usually:

Returns on competing accounts require close inspection as:

1.3.1 Interest Rate Comparisons

The following example highlights this point.

Example – Effect of Interest Payment Frequency

Day 1 Deposit 25,000.00 25,000.00

At end of Q1 Interest added 187.50 0.00

At end of Q2 Interest added 188.91 0.00

At end of Q3 Interest added 190.32 0.00

At end of year 1 Interest added 191.75 750.00

Resulting balance 25,758.48 25,750.00

Calculating an Annual Equivalent Rate (AER)

The result is converted into a decimal to give 0.0075.

You then get the first step in the formula of (1 + 0.0075).

1.3.3 Tax Treatment

1.3.4 Extension Rates

• Deposit-taking institutions are of varying creditworthiness; default risk must be assessed.

1.4.1 Default Risk

• the creditworthiness of the bank or savings institution; and

Credit Default Swaps (CDSs)

1.4.2 Inflation Risk

Real Interest Rates

2012 US UK Japan Germany France Italy Canada

Real Return –0.3 –1.0 0.9 –0.6 0.3 2.2 0.4

Source: based on data from UK Treasury

1.4.3 Interest Rate Risk

1.5 Selection Factors

Assessing Savings Account Features

2. Money Market Funds

Money Market Funds Globally

2013 Q1 (EUR billions)

US Europe Australia Brazil Canada Japan

2,027 1,012 277 44 22 15

2.1 Types of Money Market Funds

Constant and Fluctuating NAVs

Characteristics of Money Market Funds

Money Market Instruments

Risk Mitigation Standards

2.5 Selection Criteria

• short-term home for cash balances;

This syllabus area will provide approximately 13 of the 80 examination questions

1. Characteristics and Types of Bonds

1.2 Government Bonds

1.2.1 Features of Government Bonds